Cursed financial innovation

Botond Koszegi and Péter Kondor

No 1098, 2015 Meeting Papers from Society for Economic Dynamics

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.

Date: 2015
New Economics Papers: this item is included in nep-ino
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Citations: View citations in EconPapers (2)

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