Cursed Financial Innovation

Abstract

We analyze the welfare properties of derivative securities that profit-maximizing banks offer to investors who have inferior information and neglect the information content of the offer, assuming that banks can freely choose both the underlying asset and the form of the security. A monopolist bank's optimal security induces 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, providing more, but still inferior, information to investors also lowers welfare by giving false guidance as to what to bet on. Market-based policies such as increased competition or more access to financial markets tend not to affect welfare, just redistribute profits from banks to investors. However, if information acquisition is a choice for investors, increased competition increases the incentive to acquire inferior information, reducing welfare. Restricting the set of underlying assets — a kind of standardization — increases welfare, and once this policy is adopted, increasing investor information becomes beneficial. (joint with Peter Kondor).