Financial Innovation and Bank Risk Taking

This paper investigates the effect of one change in the financial sector, namely, the growing ease with which assets created by the banking sector can be sold to other investors. Of interest is whether this reduced cost of value communication leads to higher levels of risky lending by the banking sector. Of equal interest is whether these same changes result in riskier banks, i.e., ones that are more vulnerable to instability and failure. The results suggest that the risky asset portfolio held by the banking sector unambiguously increases as a result of the innovations considered. A reduction in illiquidity increases the banking sector's willingness to provide risk capital for real sector investment. On the other hand, it does not imply that the portfolios of banks will become more risky. Rather, there exists a trade-off between external shock risk, which is alleviated by increased asset liquidity, and the risk taking by banks on the returns of their assets, which is encouraged by these market changes.