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Economies of Scope, Financial Intermediation, and Innovation

We study a two-period model in which informational economies of scope that provide a cost advantage to universal banks offering "one-stop" shopping also enable these intermediaries to "lock in" their clients with switching costs that would be incurred if they changed intermediaries. This (limited) market power that universal banks enjoy reduces the financial innovation they undertake to help sell their clients' securities relative to the innovation by specialized - i.e., stand-alone - intermediaries. We show that this lower level of innovation in capital markets dominated by universal banks leads to reduced real investment and lower security price efficiency. This in turn prevents universal banks from using scope economies to completely dominate the market for financial services. Our analysis identifies economy and firm characteristics that motivate either the integration or segmentation of financial services.