Client discretion, switching costs, and financial innovation

We analyze the incentives of investment banks to develop innovative product s. We show that client characteristics and market structure affect these in centives significantly. Investment banks with larger market shares have gre ater incentives to innovate and smaller banks are likely to share their inn ovations with the largest bank. Innovation incentives increase in volatile environments and regulatory scrutiny actually encourages loophole exploitat ion activity. Our predictions are consistent with stylized facts and the an alysis has broad testable implications for innovative activity in other mar kets similarly characterized by a lack of comprehensive protection for inte llectual property rights, for example, the software industry.