The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 2

1. The Growth of Finance, Financial Innovation, and Systemic RiskLecture 2 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI

2. 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)

3. The Size of Finance (cont’d)

4. Composition of Growth of Finance

5. Output of Financial Sector

6. UnitCost of Finance (Income/Output)

7. 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)

8. 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.

9. 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.

10. 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

11. 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

12. 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

13. 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.

14. 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

15. 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:

16. 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

17. 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:

18. 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

19. 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:

20. 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

21. 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)

22. 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.

23. 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?

24. 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

25. 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.

26. 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.

27. Empirical Predictions . • Dynamics of Wealth to income ratio for U.S.:

28. Dynamics of Wealth to income ratio for other countries…

29. 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)

30. 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

31. Puzzling Feature . • Unit costs (finance income/financial assets) has increased despite falling unit fees:

32. 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

33. 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

34. 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)

35. 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)

36. 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