Abstract
This paper analyzes the impact of financial regulation on the process of financial innovation. We use a discrete investment choice model to examine the potential trade-off between a more innovative and a more stable financial system, which regulators might face when intervening in the process of financial innovation. While the trade-off holds in a simple setting, it can break when inefficiencies are added into the model. We find clumping behavior and preemptive moves as two examples of inefficiencies that break the trade-off. Regulators can combat those inefficiencies and thereby improve both innovativeness and stability at the same time.
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