DP1237 Banking Scope, Financial Innovation, and the Evolution of the Financial System

Author(s): Arnoud W A Boot, Anjan Thakor
Publication Date: September 1995
Keyword(s): Banking Scope, Financial Innovation, Financial System Design
JEL(s): G10, G24
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1237

This paper explores the implications of financial system design for financial innovation. We begin with assumptions about the investment opportunities of firms, their observable attributes, and the roles of commericial banks, investment banks, and the financial market. We examine the borrower's choice between bank and financial market funding, the commercial bank's choice of monitoring capacity, and the investment bank's choice of whether to invest in financial innovation. Our main result is that financial innovation in a universal banking system is stochastically lower than innovation in a financial system in which commercial and investment banks are functionally separated. This result is accompanied by a host of policy implications regarding the effects of fragmentation and the evolution of financial systems.