Financial Innovation and Risk, the Role of Information

IMF Working Papers, November 1, 2010

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Financial innovation has increased diversification opportunities and lowered investment costs, but has not reduced the relative cost of active (informed) investment strategies relative to passive (less informed) strategies.
The paper studies an economy with linear production technologies, some more risky than others.
Investors can use low quality public information or collect high quality, but costly, private information.
Information helps avoid excessively risky investments.
Financial innovation lowers the incentives for private information collection and deteriorates public information: the economy invests more often in excessively risky technologies.
This change in investment behavior alters business cycle properties and can reduce welfare by increasing the likelihood of "liquidation crises".

Financial innovation increases diversification and lowers transaction/investment costs.
Despite cost reductions, the relative cost of active (informed) strategies remains higher than passive strategies, leading to reduced private information acquisition.
Lower private information collection and deterioration of public information together cause more frequent investments in excessively risky production technologies.
The shift toward riskier investments affects business cycle dynamics and raises the probability of severe outcomes described as "liquidation crises".

Changes in information provision and incentives for private information collection are central to assessing the systemic risk consequences of financial innovation.
Policies that only focus on lowering transaction costs without addressing incentives for information acquisition may inadvertently increase systemic risk and the likelihood of liquidation crises.
Strengthening mechanisms that preserve or enhance incentives for private information acquisition, or improving the quality of public information, could mitigate the welfare costs associated with some forms of financial innovation.

Author: Roberto Piazza
Date: November 1, 2010
Series: Working Paper No. 2010/266
Issue: 266
Volume: 2010
Pages: 31
DOI: https://doi.org/10.5089/9781455210732.001
Stock No: WPIEA2010266
ISBN: 9781455210732
ISSN: 1018-5941
Preview citation format (Chicago): Roberto Piazza. "Financial Innovation and Risk, the Role of Information", IMF Working Papers 2010, 266 (2010), accessed 9/17/2026, https://doi.org/10.5089/9781455210732.001
Subjects: Business cycles, Financial sector development, Moral hazard, Systemic risk, Technology
Keywords: appendix E, business cycle, mover accent, WP

IMF Working Papers — Financial Innovation and Risk, the Role of Information, Roberto Piazza, Working Paper No. 2010/266 (November 1, 2010).