The Permanent Effects of Innovation on Financial Depth : Theory and U.S. Historical Evidence from Unobservable Components Models

This paper focuses on innovation as a determinant of the rapid financial deepening that characterized the U.S. economy from 1872 to 1929. After describing the key innovations adopted by national banks in New York City over this period, it presents an example in which better loan monitoring in the presence of adverse selection and a risk-return tradeoff can allow a nearly-competitive intermediary to earn temporary rents by lowering the interest rate on loans. Subsequent use of the improved technology by other lenders and Bertrand competition for loanable funds then raises the deposit rate and encourages flows to the intermediating sector. The implication that permanent reductions in the loan-deposit spread offered by New York City national banks led to increases in financial depth is then examined with a state-space model in which transitory and permanent components are extracted from measures of the loan-deposit spread and financial depth. The permanent components are modeled as independent random walks, with innovations in the permanent component of the spread exerting an influence on financial depth that cannot be attributed to its own permanent component. The maximum likelihood estimates, generated via the Kalman filter, indicate that one percentage point reductions in the spread are related to statistically significant increases of as much as 3.8% in the ratios of intermediary assets to GNP and reductions of as much as 6.4% in the ratios of bank capital to assets. The paper also presents evidence that available proxies for financial innovation are strongly related to spread fluctuations