In this paper, we present a new model of shadow banking and securitization. In the model, a financial intermediary can originate or acquire both safe and risky loans, and can finance these loans both from its own resources and by issuing debt. The risky loans are subject to both institution-specific idiosyncratic risk and aggregate risk. Critically, but in line with the actual experience (e.g., Bernanke et al. (2011)), outside investors are only interested in riskless debt (they are assumed to be infinitely risk averse). When outside investors’ wealth is limited, demand for riskless debt is low, so intermediaries’ own wealth and returns from safe projects are sufficient to guarantee whatever riskless debt they issue. At higher levels of investor wealth and demand for riskless debt, however, intermediaries cannot generate enough collateral with safe projects, and an intermediary’s own risky projects cannot serve as useful collateral for riskless debt because they are vulnerable to 3 idiosyncratic risk.
To meet the demand for riskless debt, intermediaries diversify their portfolios by buying and selling risky loans to eliminate idiosyncratic risk, similarly to Diamond (1984). Their assets in the form of loan portfolios, and their liabilities in the form of riskless debt issued to finance these portfolios, both grow together. Intermediaries essentially pursue a carry trade, in which they pledge the returns on their loan portfolio in the worst aggregate state of the world as collateral for riskless debt, and earn the upside in the better states of the world. As intermediaries expand their balance sheets by buying risky projects, they increase systematic risk of their portfolios, raise their leverage, and endogenously become interconnected by sharing each other’s risks. This is our critical new result: the very diversification that eliminates intermediary-specific risks by pooling loans so as to support the issuance of debt perceived to be riskless actually raises the intermediaries’ exposure to tail aggregate risks. Still, under rational expectations, riskless debt is always repaid, and the system is very stable. The expansion of activity financed by the shadow banking system is Pareto-improving, as in standard models of risk sharing (Ross (1976), Allen and Gale (1994)).
Things change dramatically when investors and intermediaries neglect tail risks, perhaps because they do not think about truly bad outcomes during quiet times. Gennaioli, Shleifer, and Vishny (GSV 2012) argue that the neglect of tail risk is critical to understanding aspects of the crisis. There is growing evidence that even sophisticated investors prior to the crisis did not appreciate the possibility of sharp declines in housing prices (Gerardi et al. (2008)), and did not have accurate models for pricing securitized debt, particularly Collateralized Debt Obligations (Jarrow et al. (2007), Coval, Jurek, and Stafford 4 (2009a)). GSV show that, with neglected risk, new financial products provide false substitutes for truly safe bonds, and as a consequence can reduce welfare.