We document empirical support for a key micro-level channel—innovation by young, private firms—through which financial sector deregulation affects economic growth. We find that intrastate banking deregulation, which increased the local market power of banks, decreased the level and risk of innovation by young, private firms. In contrast, interstate banking deregulation, which decreased the local market power of banks, increased the level and risk of innovation by young, private firms. These contrasting effects on innovation also translated into contrasting effects on economic growth. Our study suggests that the nature of financial sector deregulation crucially affects its potential benefits to the real economy

I illustrate the effect of financial innovation on portfolio risks by using an example with risk-sharing needs and belief disagreements. I consider two types of innovation: product innovation, formalized as an expansion of new financial assets; and process innovation, formalized as a reduction in transaction costs. When belief disagreements are large, both types of innovation increase portfolio risks. Moreover, endogenous financial innovation is directed towards speculative assets that increase portfolio risks

This paper presents new evidence on the relationship between competition and innovation by extending previous literature from manufacturing to financial services. We introduce a new measure of overall innovation by estimating and enveloping annual minimum cost frontiers to create a global frontier. The distance to the global frontier constitutes each bank’s technology gap, which decreases if the bank manages to innovate. Our innovation measure enables us to derive and estimate the model of Aghion et al. (2005b) at the firm level for the US banking industry. Based on individual bank Call Report data for the period 1984–2004, consistent with theoretical and empirical work by Aghion et al., we find evidence of an inverted-U relationship between competition and innovation that is robust over several different specifications. Further evidence on major structural changes in the US banking industry indicates that banks moved beyond their optimal innovation level and that interstate banking deregulation resulted in lower bank innovation. Policy implications to financial reform and prudential regulation are discussed also

We find that greater institutional ownership is associated with more innovation. To explore the mechanism, we contrast the “lazy manager” hypothesis with a model where institutional owners increase innovation incentives through reducing career risks. The evidence favors career concerns. First, we find complementarity between institutional ownership and product market competition, whereas the lazy manager hypothesis predicts substitution. Second, CEOs are less likely to be fired in the face of profit downturns when institutional ownership is higher. Finally, using instrumental variables, policy changes, and disaggregating by type of institutional owner, we argue that the effect of institutions on innovation is causal

We explain a counterintuitive empirical finding: Firms facing more import competition do more innovation. In our model, factors are trapped inside a firm. An increase in import competition encourages a firm to innovate by reducing the opportunity cost of inputs. Without trapped factors, trade liberalization leads to a small permanent increase in the worldwide rate of growth. With trapped factors, firms that face more import competition do relatively more innovation. The extra innovation induced by trapped factors induces a small permanent increase in aggregate output, consumption, and welfare, generalizing the appropriate estimate of the gains from trade

Competition and intellectual property (IP) protections are complements in stimulating innovation. When IP is appropriable, a market for inventions forms and competitive pressures increase incentives to innovate. Competition among producers, the demand side of the market for inventions, and competition among inventors, the supply side of the market for inventions, create incentives to innovate. When IP is not fully appropriable, markets for inventions are limited and competitive pressures can decrease incentives to innovate. Firms vertically integrate R&D and production and share technology to appropriate the returns to IP. This implies that antitrust policy and IP protections are complements

We re-evaluate the cross-sectional asset pricing implications of the recursive utility function of Epstein and Zin, 1989, Epstein and Zin, 1991, using innovations in future consumption growth in our tests. Our empirical specification helps explain the size, value and momentum effects. Specifically, we find that (і) the beta associated with news about consumption growth has a systematic pattern: beta decreases along the size dimension and increases along the book-to-market and momentum dimensions, (іі) innovation in consumption growth is significantly priced in asset returns using both the Fama and MacBeth (1973) and the stochastic discount factor approaches, and (ііі) the model performs better than both the CAPM and Fama–French model

This paper documents a systematic shift in the nature of innovation in information technology (IT) toward increasing dependence on software. Using a broad panel of U.S. and Japanese publicly listed IT firms in the period 1983 to 2004, we show that this change in the nature of IT innovation had differential effects on the performance of the IT industries in the United States and Japan, resulting in U.S. firms increasingly outperforming their Japanese counterparts, particularly in more software-intensive sectors. We provide suggestive evidence that human resource constraints played a role in preventing Japanese firms from adapting to the documented shift in IT innovation

We study a broad sample of firms across 32 countries and find that strong shareholder protections and better access to stock market financing lead to substantially higher long‐run rates of R&D investment, particularly in small firms, but are unimportant for fixed capital investment. Credit market development has a modest impact on fixed investment but no impact on R&D. These findings connect law and stock markets with innovative activities key to economic growth, and show that legal rules and financial developments affecting the availability of external equity financing are particularly important for risky, intangible investments not easily financed with debt

We provide a real options framework for the analysis of product development that incorporates research and exploration actions, product attribute value-enhancing actions with uncertain outcome, as well as preemption and innovation options. We derive two-stage analytic formulas and propose a general multi-period solution using a numerical lattice approach. Our analysis reveals that exploration actions are more important when the project is out or at-the-money (near zero NPV) and less important for high project values. In a multi-stage setting, exploration actions are important even for in-the-money projects, when follow-on actions exist that can enhance the expected value of the project. With path-dependency, early actions are more valuable since they enhance the impact or reduce the cost of subsequent actions. Preemptive controls affecting rare event (jump) frequency and innovations that introduce positive jumps are more valuable for firms with higher frequency of competitive threats involving low volatility