Innovations, rents and risk

Publication Date
Financial Markets Group Discussion Papers DP 659
Publication Date
Paul Woolley Centre Discussion Papers No 13
Publication Authors

We offer a rational expectations model of the dynamics of innovative industries. The fundamental value of innovations is uncertain and one must learn whether they are solid or fragile. Also, when the industry is new, it is difficult to monitor managers and make sure they exert the effort necessary to reduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimism and growth. But increasingly confident managers end up requesting large rents. If these become too high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise to endogenous crises and fat tails in the distribution of aggregate default risk. We calibrate our model to fit the stylized facts of the MBS industry’s boom and bust cycle.