What motivates financial innovation across countries? The influences of performance aspiration and economic freedom.
| Verfasser | Su, Yiyi |
| Posten | RESEARCH ARTICLE |
Abstract Examining behavioral explanations for financial innovation, this paper focuses on the performance aspiration effects on financial innovation in nations with different levels of economic freedom. We empirically test our ideas by employing a dataset of financial innovation by derivative exchanges across 40 countries from 1995 to 2010. Our results show that, for the economically free nations, financial innovation increases as performance deviates from aspiration. In contrast, for the least economically free nations, financial innovation decreases as performance deviates from aspiration. These findings are largely consistent with our predictions and also demonstrate the importance of national context for understanding firm behavioral motivations for financial innovation.
Keywords Financial innovation * Performance aspiration * Economic freedom * Cross-country research
1 Introduction
A key, but often overlooked, form of innovation in the world is financial innovation. Such innovation helps make the financial markets more efficient, but can bring about undesirable, or even destructive, outcomes (Frame and White 2004). For instance, the financial crisis of 2008 was in part driven by financial innovation that ultimately had a very negative impact. It is argued that one underlying reason for such crisis is that financial organizations seek to maximize profits by innovating more financial instruments than needed (Santoro and Strauss 2012). However, in many parts of the world there is also a recognized lack of willingness to innovate (Al Janabi 2006). Thus, there appears to be a rich range of financial innovation across the world, which leads to the research questions--what motivates financial innovation across countries? Why do some financial organizations differ from others in terms of their innovation behaviors?
Although prior studies have identified the technological, macroeconomic and regulatory factors that potentially condition the rate of financial innovation (see a review by Frame and White 2004), these macro-level explanations cannot account for behavioral differences in financial innovation. Our contention is that a theory of financial innovation must include the factors that motivate managers within financial organizations to initiate financial innovation. Hence, we argue that a behavioral explanation is critical for understanding financial innovation decisions.
Cyert and March's (1963) behavioral theory of the firm provides a good theoretical platform for firm behavior. This theoretical perspective highlights the role of performance aspiration in firm decision making: that is, firms utilize an aspiration level for performance evaluation and performance relative to aspiration motivates organizational change and risk taking. An aspiration level is used by "boundedly rational" decision makers to determine the boundary between success and failure in continuous measures of performance (March and Simon 1958). An extensive body of research has adopted this perspective for investigating firm realized risk (Miller and Chen 2004) and risky decisions, such as R&D and innovation (Greve 2003; Chen and Miller 2007), growth (Greve 2008), and internationalization (Jung and Bansal 2009).
Unfortunately, this line of research has produced competing rationales and inconsistent results. For example, the research has primarily indicated that low performing firms tend to initiate problemistic search (Cyert and March 1963), though some studies suggest that organizations exhibit risk averse in response to adversity (Staw et al. 1981). Similarly, whereas some studies have argued that high performing firms have slack resources and, consequently, a higher risk propensity (e.g., Baum et al. 2005), others point out that high performance does not necessarily accumulate resources (e.g., Greve 2003). To address such inconsistencies, prior studies have identified the contingencies that moderate organizational response to performance aspiration (e.g., Audia and Greve 2006; Desai 2008; Greve 2011; Park 2007). So far, however, the contingencies that have been identified are primarily based on organization-level characteristics. The relative dearth of research into the country-level institutional context for performance aspiration is surprising, given that the institutional framework has been found to have profound implications for firm behavior (Peng et al. 2008; Meyer et al. 2009; North 1990).
By examining behavioral motivations across countries, our study attempts to reconcile the competing rationales in the behavioral research by identifying the institutional contingency under which performance relative to aspiration facilitates or depresses financial innovation. Specifically, we focus on an institutional quality indicator--economic freedom--that has been studied in entrepreneurial action (McMullen et al. 2008), entry strategy (Meyer et al. 2009) and pure strategy (Shinkle et al. 2013) research. We theoretically link it to the four major concepts in Cyert and March's (1963) classic book, A Behavioral Theory of the Firm: quasi resolution of conflict, uncertainty avoidance, problemistic/slack search, and organizational learning. The central argument of our study is that the underlying assumptions behind each concept are contingent on the level of economic freedom in a country. Therefore, the four concepts serve as the behavioral mechanisms that economic freedom moderates the relationship between performance aspiration and financial innovation.
We test our ideas in a typical financial sector--the derivative exchange industry--across 40 countries during the period 1995-2010. The specific financial innovation we analyze is exchange-traded derivative innovation--listing a new futures or options product (e.g., crude oil futures or S&P 500 Index options). Given that the failure of financial markets arouses systematic externalities (Brunnermeier et al. 2009; Santos 2001), the derivative exchange industry as well as other financial sectors has emerged as one of the most closely regulated industry in the world. Such a context represents a desirable setting for testing how economic freedom shapes financial innovation behavior.
Our study supports our claim that economic freedom determines a firm's response to performance aspiration in the domain of financial innovation after controlling for firm, industry, country and time effects. Our results show that, whereas both problemistic and slack search hypotheses are valid in economically free nations, the threat rigidity hypothesis applies in the least economically free nations. Our findings suggest that behavioral motivation as well as macro-level and other organizational determinants should be considered for explaining financial innovation. Furthermore, our study contributes to the behavioral research by theoretically examining Cyert and March's (1963) four major concepts under institutional contingency. This is also among the first work to employ a longitudinal organizational dataset to test Cyert and March's (1963) behavioral theory of the firm across countries.
2 Theory and Hypotheses
2.1 Economic Freedom as Institutional Contingency
By definition, economic freedom refers to the extent to which the economic institutions guarantee the "absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself' (Beach and O'Driscoll 2003, p. 50). In prior studies, the term "economic freedom" has generally been synonymous with "market orientation" (Shinkle et al. 2013), "market-related institutions" (Makhija 2004) and "market-supporting institutions" (Meyer et al. 2009). By economic freedom, the economic institutions of a specific economy can be divided along a spectrum, ranging from free-market institutions to centrally planned ones. At one extreme, the free-market institutions assume the market to be the most efficient method of resource allocation (Scherer 1980) and include legal systems, regulatory regimes, property rights and information systems that pertain to the functioning of the market mechanisms (Meyer et al. 2009; Peng and Wang 2005). At the other extreme, the centrally planned institutions regard state coordination as critical for social welfare and rely on the overlapping vertical hierarchies to allocate resources and exert social controls (Komai 1992; Vlachoutsicos and Lawrence 1990). Such an institutional environment fails to ensure effective markets and even undermines the markets (Meyer et al. 2009). In other words, some countries like China have a low level of economic freedom but very strong national institutions, vice versa. Lying somewhere in between are transitional economies, which are in transition from a centrally planned to a market-based system (Peng and Heath 1996; Shinkle et al. 2013).
The extant literature has pointed out that organizational objectives, process and performance vary according to the level of economic freedom in a country (e.g., Makhija and Stewart 2002; Meyer et al. 2009; McMullen et al. 2008; Peng and Heath 1996). It is reasonable to infer that such effects may also exist on a firm's behavioral motivation for financial innovation. Specifically, we highlight that Cyert and March's (1963) four major concepts serve as the mechanisms through which economic freedom shapes financial innovation behavior.
The first concept is quasi resolution of conflict, which assumes that the conflicting goals exist within organizations. As for financial organizations, organizational goal varies with national context. Whereas financial organizations (e.g., exchanges, commercial or investment banks) in market economies are generally economic actors that pursue performance goals (Peng and Heath 1996), financial organizations in centrally planned economies are largely state-controlled and so do not emphasize the maximization of operational...
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