10/10/2013 10:43 am ET Updated Jan 23, 2014

Increase Competition Among Banks to Help Small Businesses

In 1994, the United States Congress sought to relax bank branching restrictions, allowing more bank branches to open and compete with one another through the Interstate Banking and Branching Efficiency Act (IBBEA). By increasing competition, Congress believed more credit would be available and the cost of capital would decrease.

Fast forward nearly 20 years...

After discussing the IBBEA, a few colleagues and I became curious if there was a correlation between banking regulation and the overall impact on state-level innovation. Following previous research on how this expanded access to credit improves productivity and makes it easier for producers to manager operational risk, we wanted to explore if expanded access to credit (via greater competition amongst banks) had allowed firms to become more innovative.

In our study "Does Banking Competition Affect Innovation," we found that banking competition can help small businesses by increasing access to credit -- allowing small businesses to operate independently rather than potentially being acquired by public companies. When small firms are not acquired by corporations, corporations are no longer as innovative, leading to a decline in the aggregate level of innovation in the economy. Corporations provide valuable nurturing to small firms when corporations acquire them. Without corporations, which can mobilize assets and expertise better than small firms, the economy would produce fewer innovations.

Using annual patents, mergers and acquisitions, bank loan data and financial statement items from a sample of US listed corporations and private firms during the period of 1976-2006, we found that banking competition reduced state-level innovation by public corporations headquartered in deregulated states.

To specifically measure innovation, we looked at the number of patents produced by a firm (to measure quantity) as well as the number of citations those patents received (to measure quality). States that were completely open to interstate branching generated a total of 30.8 percent fewer patents and received a total of 23.2 percent fewer citations (significant reductions in innovation) three years after branching deregulation than states with the most restrictions on interstate branching. These statistics showed that deregulation allowed for more innovation from private firms but had an indirect, negative impact innovation by public companies.

Deregulation allowed more innovation from private firms. Prior to these changes, private firms had primarily been dependent on external financing. But with the increased access and opportunity to receive credit from local banks, smaller firms could finance more innovative projects and remain independent from public company acquisitions. These private firms experienced a total of 7.6 percent more patents and 6.4 percent more citations three years after branching deregulation than firms in states with the most restrictions on interstate branching.

Conversely, deregulation reduced innovation from public companies. As smaller firms continued to operate independently, the pool of potential targets within a state contained less innovative firms for corporations to acquire after deregulation. Frequent acquirers headquartered in these deregulated states experienced a negative effect of banking competition, leading to an overall decrease in state-level innovation.
Targets acquired after deregulation produced 21 percent fewer patents over their lifetimes than targets acquired before deregulation.

These findings imply that a liberalized banking sector can potentially help small businesses become successful by helping banking regulators better understand the effects of regulation. However, the impact on public companies and overall state-level innovation decreases due to smaller organizations being able to maintain financing and operations on their own.

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