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Cursed financial innovation

Author

Listed:
  • Botond Koszegi

    (Central European University)

  • Peter Kondor

    (Central European University)

Abstract

We analyze welfare implications of an optimal security offered by a bank to investors with inferior information. Investors are cursed, that is, neglect the information content of the offer. We show that, by financial innovation, rational profit-maximizing issuers induce investors to bet on unlikely market movements at unfavorable terms, creating both excess risk taking and undersaving. Giving more information to the issuer allows it to induce bigger bets, exacerbating both effects and therefore lowering welfare. Furthermore, under plausible circumstances, giving more, but still inferior, information to the investor also lowers welfare by giving investors false guidance on what to bet on. Market based policies as increased competition or more access to financial markets tend not to affect welfare, just redistribute profits from banks to investors. A policy dubbed "uninformed standardization" might improve welfare.

Suggested Citation

  • Botond Koszegi & Peter Kondor, 2015. "Cursed financial innovation," 2015 Meeting Papers 1098, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:1098
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    References listed on IDEAS

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    Cited by:

    1. Yiling Chen & Alon Eden & Juntao Wang, 2021. "Cursed yet Satisfied Agents," Papers 2104.00835, arXiv.org, revised Nov 2021.
    2. Johannes Brumm & Michael Grill & Felix Kubler & Karl Schmedders, 2023. "Re-use of collateral: Leverage, volatility, and welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 47, pages 19-46, January.

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