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The Growth of Finance, Financial Innovation, and Systemic RiskLecture 2 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI
The Size of Finance • Astonishing rise of the share of U.S. GDP coming from the financial sector since World War II (Philippon 2012) • This pattern is common to many other countries (Philippon and Reshef 2013) • Much of this expansion comes from services to consumers such as asset management and credit intermediation (Philippon 2012, Greenwood and Scharfstein 2013)
The Size of Finance (cont’d) • This growth has proven difficult to explain: • Maybe relative cost of finance rose due to low productivity. However, wages in finance grew faster than elsewhere. • Conventional explanations: socially unproductive innovation and rent seeking (e.g. Philippon 2012, Greenwood and Scharfstein 2013)
Source of Finance Income? • Key Question:Where do financial market players obtain their remuneration from? • Standard theory: remuneration to specific asset managers comes from their superior performance. • Problem: Professional money managers underperform passive strategies net of fees (Jensen 1968) • Average mutual fund underperformance of 65 b.p. a year. • Investors pay substantial additional fees to brokers and advisors.
Professional Money Management • Performance is only part of what managers seek to deliver • Managers/advisors mostly advertise trust, dependability, not past performance (Mullainathan et al. 2008). • Some studies argue advisors provide intangible benefits or “babysitting” • GSV’s “Money doctors” paper (2013) presents a model where this perspective is taken seriously.
Trust and Money Management • Key assumption: investors are too anxious to take risk on their own. They need to hire a manager they trust. • Managers might have skills and knowledge, but in addition they provide investors with comfort/peace of mind • Finance is a service, and like many services is not only about performance • Trust describes confidence in the manager based on: • Personal relationships, familiarity, connections to friends and colleagues, communication and schmoozing, advertising... • Trust does not derive from past performance • Trust is not only security from expropriation (Guiso, Sapienza, Zingales, 2004, 2008) • Analogy with medicine, another service
Mainresults • Each manager can charge fees to his trusting investors. • Managers underperform the market net of fees. • Fees are higher in riskier asset classes. • Rational expectations: trust boosts risk taking and welfare. • If investors erroneously think that some assets are “hot”: • Trusted managers pander to beliefs to charge higher fees. • They let investors chase returns by proliferating products • Trust reduces the benefit of being contrarian by reducing mobility of investors across differently performing managers
Finance and the Preservation of Wealth • GSV (2013) “Finance and the Preservation of Wealth” paper uses the idea of trust to study the growth of finance. • More benign view: the growth of finance is a natural by product of a maturing economy. • Embody our previous model of asset management (GSV 2012) into a Solow-style growth model with diminishing returns to capital • Use the model to shed light on the dynamics of intermediation, financial sector income, and the unit cost of finance
The Basic Mechanism • Financial risk taking plays two functions: • “Wealth preservation”: allows savers to move wealth forward • “Growth”: allow savers to access growth opportunities • Key assumption (GSV 2012): Investors need trusted financial intermediaries to take advantage of these investments. • On their own, people utilize inefficient self-storage ( e.g. cash in mattresses or gold). • Savers are willing to delegate risky investment to a trusted intermediary (“money doctor”) who gives them peace of mind. Trust reduces the investor’s cost of bearing unfamiliar risks. • As the economy matures, K/Y rises. Savers are willing to pay more for wealth preservation. This drives growth of finance.
Roadmap • Basic Setup (Households, Money Managers, Production) • Equilibrium Analysis with a fixed number of money managers: • Dynamics of the Capital Stock • Predictions on the Dynamics of Finance • Shocks to Trust and Productivity • Endogenous entry of intermediaries • Dynamics of Fees and Unit Cost of Finance
Households . • Overlapping generations of (measure 1 of) young and old • Young at supply their unit labor at wage • Wage is fully saved by investing in two assets: • Safe storage, which yields at time • Risky asset yielding an average return and variance • Risky investment needs management. If saver hires manager at fee , his consumption at is:
Households (cont’d) . • Mean variance preferences over portfolio return: • Risk aversion is manager-specific and decreases in trust • Optimal delegated portfolio share with manager : • Decreases in fees, return from storage, risk • Increases in expected return and trust
Money Management . • Managers at equal distance along the unit circle. Trust of investor i in manager j decays with distance: • Tradeoff: moving away from closest manager may reduce fees but will also entail less trust and thus risk taking • Optimal manager choice: Manager j wins over competitor j’ all investors whose distance from j is less than:
Money Management (cont’d) . • At symmetric equilibrium , the profit of j is equal to: • The optimal (equilibrium) fee is equal to: • Sharing rule: fee increases in excess return • Falls in “generalized trust” , increases in specific trust
Production . • At t firms produce: • Value added plus un-depreciated capital • : shock to value added and to capital stock, and • Before learning , firms hire workers at fixed wage , and pledge to money managers (capitalsuppliers) the rest:
Production (cont’d) . • Given the aggregate supplies and , equilibrium factor returns at time t are: • The variance of the risky return is • Key properties: • The wage is the marginal product of labor • The average return of the risky asset is 1 + the average marginal product of capital
Equilibrium Dynamics . • The law of motion for the aggregate capital stock is: • where: • Noteworthy Features: • Difference with Solow model: endogenous intermediation • Intermediation increases in generalized trust and decreases in specific trust (increases in the number of managers)
Equilibrium Dynamics (cont’d) . • Under some parameter conditions, the economy converges to a steady state and such that: • Risk taking and thus the capital stock increase in the waste from storage, in productivity and in the number of managers. • Higher waste from storage increases the excess return of the risky asset. This increases supply of funds. • Higher productivity increases the excess return of the risky asset and the real wage. This increases demand and supply of funds. • The higher is the number of managers, the higher is competition among them. This reduces fees, risk taking and intermediation.
Equilibrium Dynamics (cont’d) . • Convergence to the steady state: • Higher capital stock increases wages and savings, this increases demand for intermediation, which further increases investment. • What are the transitional dynamics of the financial sector? • How does the financial sector react to shocks?
Transitional Dynamics . • Equilibrium fees fall as capital increases toward its s.s.: • The income share of finance goes up as capital increases towards its s.s.: • Both results are due to decreasing returns to capital: growing role of capital preservation vs. growth services as K/Y increases toward the steady state
Reaction To Shocks . • Suppose that capital is initially at steady state : • If productivity permanently drops to : on impact the income share of finance increases, and goes to its original level in the long run. The s.s. capital stock falls. • If trust permanently drops to : on impact the income share of finance drops, and it continues to drop until the new steady state. The s.s. capital stock falls. • Productivity and trust shocks exert opposite short run effects. Lower productivity renders capital preservation more important, lower trust less important.
Empirical Predictions • The finance income share increases over time with an economy’s wealth to income ratio • The finance income share fluctuates with changes in investor trust (goes down when trust in finance drops) • Unit fees for specific products fall over time • Consistent with the evidence in Greenwood and Scharfstein (2012) for equity and bond funds.
Empirical Predictions . • Dynamics of Wealth to income ratio for U.S.:
Empirical Predictions (cont’d) . • Growing finance income share in the postwar period is common to many countries (Philippon and Reshef 2013), just as W/Y seems to be increasing for many countries (Piketty and Zuckman 2012)
Empirical Predictions (cont’d) . • Decline of finance after adverse shock to trust: • It took decades to rebuild the U.S. financial sector, much longer than to rebuild productivity
Puzzling Feature . • Unit costs (finance income/financial assets) has increased despite falling unit fees:
Entry of New Intermediaries . • This can be viewed as the result of competitive entry. • is endogenous. Entry condition: • Under certain parameter conditions, the model with entry converges to a unique steady state , , Profit of eachintermediary Opportunitycost of time needed tosetup new intermediary
Entry of New Intermediaries (cont’d) . • Rewrite entry condition as: • As the capital stock increases toward the steady state: • The unit profit for wealth preservation goes up • Entry of new intermediaries takes place (/customization) • Management fees fall (owing to decreasing returns and entry) • Income share of finance increases
Entry and Unit Cost of Finance . • Finance income over financial wealth (which includes managed risky assets and non-intermediated storage) is: • Fees decrease over time, risk taking increases as closer (more trusted) managers become available through entry • As new managers enter, the composition of investment shifts toward higher fee/higher risk products (for which proximity with manager is more important)
Robustness • Results are Robust to: • Productivity and population growth • Irreversibility of transformation of consumption into capital (trading of capital between the elderly and the young)
Conclusions • By incorporating in a neoclassical growth model the idea that savers are willing to pay fees to take financial risk with trusted money managers we obtain: • Growth of finance income share of GDP as W/Y grows • Fluctuation in size of finance with changes in investor trust • Entry of financial intermediaries and customization • Decline in fees • Increase in unit cost of finance (fees x risk taking) • Without denying agency and other problems, finance should grow as the economy matures, for preservation of wealth becomes increasingly important