Why are Profits from Financial Innovation So Difficult to Identify? Innovation Clusters and Productive Opacity

Abstract

The empirical literature identifying gains from financial innovation to financial institution stockholders is sparse. The literature identifying financial firms' contributions to stockholder value resulting from long term commitment to innovation is, to our knowledge, nonexistent. Several authors note that the protection of financial engineering innovations from imitation is particularly challenging. We consider the implications for the structure of financial innovation, proposing a stylized representation of the innovative process called "the cluster hypothesis." Under the hypothesis, innovations occur in symbiotic collections of transparent "external innovations," together with opaque "internal innovations." Only the latter provide economic rents. We find evidence that innovation-induced opacity drives long run relative rewards at added risk for financial institution stockholders.