Technological innovation and the design of the financial system.

Abstract

This dissertation analyzes the role of the financial system in funding innovative technologies and the associated relative advantages of market and bank finance. We observe that innovations have no history of returns from projects implementing the new technology; whereas standard technologies have a long history of project outcomes. We view markets as clearinghouses of information that cross-sectionally <italic> proxies for a project history</italic>. In a market, any agent may contribute a market order without commitment to a market maker who sets a fair interest rate or rejects the project based on the information contained in the order flow. As markets only noisily reveal informed investors information, they promote aggregation of costly information through trading profits to the informed. The market's information acts to select out good new technologies and provide them funding. Alternatively, banking is a competitive oligopoly of capital lending firms acting in informational isolation but capable of a special function: <italic> monitoring</italic> of the borrowing firm. By monitoring, a bank keeps an entrepreneur from undertaking a wasteful but personally more profitable project in place of the lower profit innovation (post-lending asset substitution moral hazard). Over the innovation life cycle, there is a dynamic interaction between learning (about a new technology) and the optimal funding source. For example, initially a financial market may be the optimal supplier of funds for a technology; however, as learning occurs and technological uncertainty is resolved, moral hazard costs may come to dominate any benefits from additional information aggregation. Therefore, as technological uncertainty is resolved, it may become optimal for an entrepreneur to refinance with bank funds. Additionally, the model permits conclusions on the matching of the financial system with the economy's overall technological advancement. A banking system may be more able to promote the economic catch-up of a developing economy than a market. If the primary financial needs of these economies is the finance of standard technologies, whose pre-dominant funding issues are moral hazard and less experienced management, banking has a clear advantage. Lastly, the model is completely consistent with small markets consisting of <italic>private placements</italic> and innovation-funding banks representing <italic>venture capital firms</italic>.