Financial Innovation with Endogenous Experimentation

Zhaohui Chen, Alan Morrisson, and William Wilhelm

We present a model in which a long-lived bank endogenously learns about the environment for financial innovation through experimentation on its clients. When the bank has superior knowledge of the state of the world facing its clients, it may engage in inefficient or “reckless” experimentation because it cannot commit to do otherwise. We show that strong client relationships can mitigate the incentive to pitch innovative products to clients for whom they are not appropriate. We also explore the limits of internal monitoring systems intended to prevent such behavior. Finally, we show that greater banker mobility can complement monitoring  systems because bankers will have incentive to visibly seek out weak monitoring environments only when the expected collective benefits from financial innovation are especially large.