Financial innovation and bank risk taking

Abstract

In this paper we investigate the effect of one change in the financial sector, namely, the growing ease with which assets created by the banking sector can be sold to other investors. Of interest is whether the reduced cost of value communication and asset sales leads to higher levels of risky lending by the banking sector. Of equal interest is whether these same changes result in riskier banks, i.e., ones that are more vulnerable to instability and failure. The results suggest that the risky asset portfolio held by the banking sector unambiguously increases as a result of the innovations considered. A reduction in illiquidity increases the banking sector's willingness to provide risk capital for real sector investment. On the other hand, it does not imply that banks will become more risky. Rather, there exists a trade-off between external shock risk, which is alleviated by increased asset liquidity, and the risk taking by banks on the returns of their assets, which is encouraged by these market changes.