Financial Innovations in a World with Limited Commitment: Implications for Inequality and Welfare

Do financial innovations benefit or harm expected welfare? For innovations that provide greater access to banks, researchers have argued that lower transaction costs and better project assessments result in expected welfare gains. Others, however, have shown that with incomplete markets, financial innovations result in expected welfare losses. In this paper, we examine the impacts of financial innovations in economies with incomplete markets and limited commitment. We show that the results critically depend on whether assets are priced fundamentally or not. When priced fundamentally, greater access does improve expected welfare, also resulting in greater consumption inequality. However, when assets carry a premium, there is an additional channel owing to limited commitment. Because of a more severe limited commitment problem, collateral is necessary. A fixed quantity of pledgeable assets are spread across a larger measure of depositors, resulting in less consumption for those with access to banks and consumption inequality decreases. Second, we consider a financial innovation that increases the pledegeability of one type of bank collateral. We also show that the results critically depend on whether assets are priced fundamentally or not. When assets are priced fundamentally, this type of financial innovation does not change welfare nor consumption inequality. In contrast, when assets carry a premium, better collateral results in more consumption for depositors with access to the more sophisticated payment option. We extend our model economy to consider an endogenous decision to access checkable deposits. This allows us to examine the effects of changes in the distribution of costs that are important to the choice of participating in observing buyers’ deposit or not. Third, our analysis demonstrates that collateral in a limited commitment framework provides a mechanism through which financial innovation can increase or decrease the impact that financial innovations have on welfare and inequality.