Incentives to innovate and financial crises

In this paper I develop a model of a competitive financial system with unrestricted but costly entry and an endogenously determined number of competing financial institutions ("banks" for short). Banks can make standard loans on which plentiful historical data are available and unanimous agreement exists on default probabilities. Or banks can innovate and make new loans on which limited historical data are available, leading to possible disagreement over default probabilities. In equilibrium, banks make zero profits on standard loans and positive profits on innovative loans, which engenders innovation incentives for banks. But innovation brings with it the risk that investors could disagree with the bank that the loan is worthy of continued funding and hence could Withdraw funding at an interim stage, precipitating a financial crisis. The degree of innovation in the financial system is determined by this trade-off. Welfare implications of financial innovation and mechanisms to reduce the probability of crises are discussed. (C) 2011 Elsevier B.V. All rights reserved.