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Financial Innovation: The Bright and the Dark Sides

  • Thorsten Beck

    (Tilburg University and Centre for Economic Policy Research and Hong Kong Institute for Monetary Research)

  • Tao Chen

    (The Chinese University of Hong Kong)

  • Chen Lin

    (The Chinese University of Hong Kong and Hong Kong Institute for Monetary Research)

  • Frank M. Song

    (The University of Hong Kong)

"Everybody talks about financial innovation, but (almost) nobody empirically tests hypotheses about it." Frame and White (2004) The financial turmoil from 2007 onwards has spurred renewed debates on the "bright" and "dark" sides of financial innovation. Using bank-, industry- and country-level data for 32, mostly high-income, countries between 1996 and 2006, this paper is the first to explicitly assess the relationship between financial innovation in the banking sector and (i) real sector growth, (ii) real sector volatility, and (iii) bank fragility. We find evidence for both bright and dark sides of financial innovation. On the one hand, we find that a higher level of financial innovation is associated with a stronger relationship between a country's growth opportunities and capital and GDP per capita growth and with higher growth rates in industries that rely more on external financing and depend more on innovation. On the other hand, we find that financial innovation is associated with higher growth volatility among industries more dependent on external financing and on innovation and with higher idiosyncratic bank fragility, higher bank profit volatility and higher bank losses during the recent crisis.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 052012.

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Length: 52 pages
Date of creation: Feb 2012
Handle: RePEc:hkm:wpaper:052012
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