Competition in Financial Innovation

Authors

  • Andrés Carvajal,

    1. Dept. of Economics, University of Warwick, Coventry, CV4 7AL, United Kingdom; A.M.Carvajal@Warwick.ac.uk
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  • Marzena Rostek,

    1. Dept. of Economics, University of Wisconsin–Madison, 1180 Observatory Drive, Madison, WI 53706, U.S.A.; mrostek@ssc.wisc.edu
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  • Marek Weretka

    1. Dept. of Economics, University of Wisconsin–Madison, 1180 Observatory Drive, Madison, WI 53706, U.S.A.; weretka@wisc.edu
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    • We are grateful to Steven Durlauf, Douglas Gale, Piero Gottardi, Ferdinando Monte, Herakles Polemarchakis, Bill Sandholm, Dai Zusai, participants at the 2010 NSF/NBER/CEME Conference at NYU, the 2010 Theoretical Economics Conference at Kansas, the 7th Cowles Conference on General Equilibrium, the XX EWGET in Universidade de Vigo, the 2011 Sorbonne Workshop in Economic Theory, and the seminar audiences at Bonn, Carlos III, CORE, Duke, Iowa, Rice, Warwick (CRETA), and Wisconsin–Madison for comments. We thank the editor and three anonymous referees for numerous helpful suggestions. Andrés Carvajal also acknowledges the financial support of the ESRC, through Grant RES-000-22-3771, and the hospitality of CORE.


Abstract

This paper examines the incentives offered by frictionless markets to innovate asset-backed securities by owners who maximize the assets' values. Assuming identical preferences across investors with heterogeneous risk-sharing needs, we characterize economies in which competition provides insufficient incentives to innovate so that, in equilibrium, financial markets are incomplete in all (pure strategy) equilibria, even when innovation is essentially costless. Thus, value maximization does not generally result in complete markets.

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