Incentives to Innovate and Financial Crises

Abstract

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 either make standard loans on which plentiful historical data are available and there is unanimous agreement on default probabilities. Or they 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 may disagree with the bank that the loan is worthy of continued funding and may hence withdraw funding at an interim stage, precipitating a financial crisis. The degree of innovation in the financial system is determined by this tradeoff. Possible mechanisms to eliminate crises are discussed.