Schumpeterian creative destruction and temporal changes in business models of US banks

Abstract

Schumpeter theorizes that capitalism is characterized by a constant process of creative destruction. Newcomers introduce disruptive innovations and technologies that replace older, less efficient business practices. Thus, established firms must either continually adapt or perish. Christensen (1997) argues that large, established firms cannot innovate as fast as newcomers and thus are likely to perish over time. We test these predictions in the setting of the United States banking sector. We examine banks’ credit and liquidity risks as proxies for their business models, as well as their reliance on brokered deposits, commercial real estate loans, off-balance sheet items, and noninterest income as proxies for operational strategies. We find that banks’ credit and liquidity risks increased significantly over the last 40 years or so, indicating a steady change in banks’ business models. This trend stems primarily from progressively aggressive business models introduced by incoming cohorts. Older cohorts respond to changing market conditions by increasing the aggressiveness of their own business models, but not as much as the newcomers. Surprisingly, surviving large banks among older cohorts change their business models faster than smaller banks from the same cohorts. Thus, while we find support for Schumpeterian creative destruction and Christensen’s (1997) arguments, we also find that large and established banks are better able to adapt to new market conditions, perhaps because they have superior access to resources and talent necessary to implement transformation. Our findings at least partly explain why the dominant players in the US banking sector have remained the same decade after decade.

Keywords: Creative destruction; Disruptive innovation; Liquidity risk; Credit risk; Dominant Banks; Cohort risk

JEL Classification: G01; G21; G28