Want to Help Small Businesses? Increase Competition among Banks

September 16, 2013

Deregulation allows innovation for small businesses, hinders innovation for public companies

In a recent study, “Does Banking Affect Innovation?”, Georgetown University’s McDonough School of Business Professor Jess Cornaggia 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.

The study examined the effects of interstate branching deregulation, which occurred in the mid-1990s, to determine how bank regulation impacted innovation. Using annual patents, mergers and acquisitions, bank loan data, and financial statement items from a sample of U.S. listed corporations and private firms during the period of 1976-2006, Cornaggia and his co-authors found that banking competition reduces state-level innovation by public corporations headquartered in deregulated states.

As a measurement of innovation, Cornaggia and his co-authors examined patent records to identify the quantity of innovation and citation records to identify the quality of innovation. They determined 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.

Deregulation allowed for more innovation from private firms but negatively impacted innovation by public companies.

More Innovation from Private Firms
Deregulation allowed private firms, who had previously been dependent on external financing, the opportunity to receive credit from local banks. This access allowed smaller firms to 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.

Less 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 business become successful by helping banking regulators better understand the effects of regulation.