How technological innovation shapes financial innovation: Substitution effects versus knowledge diffusion

Abstract

The innovation of new financial products, processes, and services is a key driver of economic development and technological progress. Yet, the issue of how new technology itself affects financial innovation activity is not well understood. We argue that, although new technologies can spur financial innovation via knowledge spillovers, they can also lead to the “crowding out” of financial innovation by increasing the relative profitability of competing investment opportunities. To test our hypotheses, we use time-series data during 2005–2019 on the occurrence of major waves of non-financial innovation and their impact on firms' financial patenting and the hiring of financial inventors. We find evidence of aggregate-level crowding-out in the earlier part of the sample: firms tend to shift from financial to non-financial patenting following the onset of an innovation wave. A likely driver of this substitution effect is a relative labor demand shift away from financial inventors and toward non-financial inventors. This demand shift appears to be stronger among firms with fewer financial or real constraints and those with better access to local inventor human capital. In more recent years, substitution effects have diminished, likely due to the increasing breadth and attractiveness of financial patenting. Overall, our results shed light on the economic trade-offs that drive financial innovation and suggest that the growing integration of finance with non-financial technology has increasingly blurred the lines between different innovation types.