Rents, learning and risk in the financial sector and other innovative industries
September 2009
The Paul Woolley Centre Working Paper Series No 4, FMG Discussion Paper 632
Download this paper:
Abstract:
We study innovative industries subject to two risks. First, it is uncertain whether the innovation is strong or fragile. Second, it is difficult to monitor managers, which creates moral hazard and agency rents.
As time goes by and profits are observed, beliefs about the industry are updated. As long as no default occurs, confidence builds up. Initially this spurs growth. But increasingly confident managers end up requesting large rents, curbing the growth of the industry. If rents become too high, investors give up on incentives, and failure rates rise.
If the innovation is fragile, eventually there is a crisis. Our model captures stylized facts of the recent financial innovation wave and generates new implications for risks, returns and rents.