Does Financial Innovation Increase Inequality? A Competitive Search Approach

49 Pages Posted: 23 Aug 2019

See all articles by Bong-Geun Choi

Bong-Geun Choi

City University of Hong Kong (CityUHK) - Department of Economics & Finance

Hyun Lee

Analysis Group, Inc.

Date Written: August 21, 2019

Abstract

The distribution of asset holdings among US banks is increasingly concentrated toward a few large banks at the top. Concurrently, the household wealth inequality has increased. This paper provides a theoretical link between these empirical facts, by developing a novel quantitative general equilibrium model that embeds the heterogeneous banking sector into a standard heterogeneous agent model with incomplete-markets. We introduce competitive search to the inter-bank market with adverse selection problem and endogenously generate three different rates of return: savings rate, borrowing rate, and the rate of return on equity. We show that financial innovation — defined as a technological progress that improves the intermediation efficiency — led by the big banks will intensify the adverse selection problem in the inter-bank market and increase the relative size of the big banks over their smaller counterparts. As a result, both the interest rates for borrowing and savings fall, creating even more incentive to borrow for credit constrained households, which ultimately propagates the household wealth inequality.

Keywords: financial innovation, competitive search, financial friction, adverse selection, heterogeneous agent model, welfare, wealth inequality

JEL Classification: E13, E21, E44, G20

Suggested Citation

Choi, Bong-Geun and Lee, Hyun, Does Financial Innovation Increase Inequality? A Competitive Search Approach (August 21, 2019). Available at SSRN: https://ssrn.com/abstract=3440673 or http://dx.doi.org/10.2139/ssrn.3440673

Bong-Geun Choi (Contact Author)

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Hyun Lee

Analysis Group, Inc. ( email )

One South Dearborn
21st Floor
Chicago, IL 60603
United States

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