Abstract
As the economy has grown increasingly financialized, the relationship between financial innovation and instability has attracted more attention. Previous research finds that the proliferation of complex financial innovations, like asset securitization and new financial derivatives, helped to erode the market governance arrangements that kept excessive bank risk-taking in check, inviting instability. This article presents an alternative way of understanding how financial innovations and market governance arrangements combine to shape instability. Market governance arrangements also shape how financial firms receive innovations, leading to greater or lesser instability at particular times and places. I illustrate this argument by tracing the effects of changing corporate governance arrangements at large US banks in the 1990s and 2000s. Like non-financial firms in the preceding decade, banks adopted reforms associated with the shareholder value model of corporate governance. These changes to internal bank governance arrangements affected the agendas of bank executives in ways that encouraged expanded use of securitization and derivatives. Drawing from this case, I argue that a full understanding of instability in the financialized era requires closer attention to the (institutionally-structured) interests of financial innovation users—not just to features of financial innovations themselves.
Highlights
As the economy has grown increasingly financialized, the relationship between financial innovation and instability has attracted more attention
By 2003, this gap had narrowed: the share of interest income dropped below 53%, while the share of non-interest income climbed above 47% (DeYoung and Rice 2004, p. 38, their Table 3)
I argue that closer attention to these arrangements, which vary across countries and over time, allows for a deeper understanding of where and when financial instability is most likely to emerge
Summary
Existing scholarship on financial innovation and financial instability explains how complex innovations can disrupt informal and formal market governance arrangements. Previous research finds that banks used tools like securitization to shed less risky assets while retaining riskier ones, which had the effect of increasing risk in the banking industry overall (Jones 2000; Jiangli and Pritsker 2008; Dionne and Harchaoui 2008; Uzun and Webb 2007) Both sources of systemic risk increased with (1) the size of securitization and derivatives markets and (2) the extent of commercial bank exposure to these markets (Nijskens and Wagner 2011; Cetorelli and Peristiani 2012).. Broadened the range of permitted activities for non-bank savings institutions (thrifts)
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