A linear programming approach

TLDR: In this paper, an empirical test of the theory of financial innovation is carried out within the context of a linear programming model of commercial bank behavior, and the financial innovations discussed below fall largely into the new product category.

Abstract: Yhe analysis of the innovation of financial instruments and practices is not nearly as well-developed as its counterpart in the real sector. The theoretical and empirical studies on product and process innovation by Mansfield (l 968), Nelson and Winter (1973), Schmookler (1966), and Schumpeter (1939) are well-known. This paper is concerned with the microeconomics of financial innovation. Drawing on the work of Silber (1975) which outlines the forces that induce financial institutions to create new instruments or adopt new practices, an empirical test of the theory of financial innovation is carried out within the context of a linear programming model of commercial bank behavior. Innovation has been given very specific and somewhat more general meanings. Schumpeter (1939) related the term to the implementation of a new process or method that alters the production possibilities of a firm. Mansfield (1968), Scherer (1973), and Schmookler (1966), include both new processes and new products in their analyses. The financial innovations discussed below fall largely into the new product category. There also has been considerable interdisciplinary work by behavioral scientists and economists on the characteristics of the innovative firm, including studies by Cyert and March (1963), Becker and Stafford (1967), and Knight (1967). Nelson and Winter (1973) have carried that analysis one step further, towards an 'evolutionary theory' of innovation. Their approach stresses an incremental search process that is triggered by a firm's rate of return falling below target levels. Our approach in the financial sector parallels, with appropriate modifications, the Nelson-Winter analysis in the real sector. One final word of introduction concerns the definition of financial innovation. When dealing with innovation in the real sector it is possible to lihait the scope by an objective criterion: an innovation is a new product or process that qualifies for