Regulation of Financial Innovation Stability vs. Progress?

Abstract

This paper analyzes the impact of financial regulation on the process of financial innovation. We use a discrete investment choice model to examine the potential trade-off between a more innovative and a more stable financial system, which regulators might face when intervening in the process of financial innovation. While the trade-off holds in a simple setting, it can break when inefficiencies are added into the model. We find clumping behavior and preemptive moves as two examples of inefficiencies that break the trade-off. Regulators can combat those inefficiencies and thereby improve both innovativeness and stability at the same time.

Keywords: Financial Innovation, Financial Regulation, Equity Requirements, Growth, Instability

JEL Classification: G28, O31, O43, D60