Financial innovations, idiosyncratic risk, and the joint evolution of real and financial volatilities

This paper presents a model in which financial innovations explain three widely discussed stylized facts regarding trends in economic volatility over the past two decades. Aggregate volatility of real variables such as output has fallen. In particular, the covariance between firm and industry activities has declined, and so has employment volatility for the majority of firms. In contrast, the volatility of quantities of financial variables has increased at both the firm and aggregate level. The model links these outcomes to a single hypothesized cause: advances in financial technology brought about by a declining cost of information processing. As a result, the marginal cost of external funds has likely declined, reducing the need for firms to smooth cash flows. Firms, trading off cash-flow vs. production smoothing, therefore have more incentive to smooth production. This explains why financial volatility may go up as real volatility goes down. Moreover, financial innovations have likely also altered the composition of volatility toward a greater share of idiosyncratic risk, by facilitating diversification and thus lowering the premium demanded on idiosyncratic risk. At the margin, the cost advantage to projects with idiosyncratic returns reduces the covariance of financial as well as real activities across firms. Since variance and covariance of real quantities trend in the same direction, real aggregate volatility declines. But the net effect on financial variables is ambiguous and so can yield greater aggregate volatility. The paper then presents evidence that the share of idiosyncratic risk has risen in bank portfolios, indicating that the same has occurred for individual borrowers as well.

Measuring real bank output:considerations and comparisons

The real output of banks is better estimated by counting the number of service transactions they provide than by using the balances of loans and deposits deflated by a price inde

Risk Bearing, Implicit Financial Services and Specialization in the Financial Industry

This paper makes three points regarding the proper measurement of the output of financial intermediaries. Two of them concern the measurement of nominal financial output, especially banking output. First, we show that, to impute the nominal value of implicitly priced financial output, it is necessary to adjust each reference rate of interest (also called “the user cost of funds”) for the risk inherent in that corresponding financial transaction. Otherwise, nominal financial output will be overstated, and the bias can be large (about 25 percent). Second, we argue that, according to finance theory, the required risk correction can be implemented practically at the level of industries (e.g., the banking sector as a whole). The third point concerns the construction of a financial services price index, and thus applies to the measurement of real output. We argue that the reference rates or the related rate spreads, which are used to impute the nominal output of financial institutions, are not the right implicit price deflators for deriving the real output of financial institutions