Can Banks Help Firms to Innovate?

By Cagatay Bircan and Ralph De Haas

Innovation is an important driver of economic growth. In countries that operate close to the technological frontier, innovative activity typically involves Research and Development (R&D) and the patenting of new products and technologies. In contrast, in emerging markets innovation often equals imitation as existing technologies are adapted to local circumstances.

Somewhat surprisingly, governments in many emerging markets tend to focus on local R&D as a key source of innovation rather than on reaping the low-hanging fruits of adaptive imitation. Russia is a case in point: President Putin has endorsed a push towards innovation in ‘priority’ sectors such as nuclear and space technology.

As a result of this top-down approach the government-sponsored share of Russian R&D and innovation has gradually increased at the expense of innovation by private companies, many of which also remain plagued by limited access to external finance.

This focus piece discusses whether and how improved access to bank funding would allow Russian firms to innovate more and, if so, which types of innovation would benefit most.

About BEPS and BEEPS...

To get a detailed picture of the impact of the local banking environment on firms’ access to credit and subsequent innovation, we combine three pieces of information: data on the exact geographical location of bank branches across Russia; data on firms’ credit constraints; and data on firm innovation. To this end we link two new and unique micro-datasets.

The Business Environment and Enterprise Performance Survey (BEEPS) was conducted in Russia in 2011-12 among 4,220 firms across 37 regions and was stratified to achieve representativeness across industries, firm size and regions. A special innovation module elicited detailed information about firms’ innovative activity over the past three years.

A separate finance module asked firms about their use of internal and external funding, including bank credit. This module allows us to identify firms with a demand for bank credit and then divide them into those that received bank credit and those that were credit constrained.

The latter include both firms that applied for a loan but were rejected and firms that were simply discouraged from applying in the first place. Uniquely, those firms that used bank credit were also asked to disclose the name of the lender as well as various loan terms.

We combine these firm-level data with another new dataset, the Banking Environment and Performance Survey (BEPS), undertaken by EBRD in 2012. As part of the BEPS, structured face-to-face interviews were undertaken with a large number of bank CEOs.

A specialized team also collected detailed information on the geographical location of bank branch networks. In Russia, geo-coordinates were collected for 45,728 branches of 853 banks. We use the BEPS data to calculate a measure of local bank concentration in each city with one or more BEEPS firms. We also calculate the market share of foreign banks in each of these cities.

Bank credit and innovation

A first look at the innovation data shows a clear difference in innovation activity among borrowing and non-borrowing firms (Table 1). These numbers already suggest that access to credit facilitates innovation: among firms that needed credit, there is a clear difference in the likelihood of innovation activity between those that received credit (57 per cent) and those that did not (43 per cent). The lowest innovation probability (39 per cent) occurs amongst firms that did not even demand a loan.

Table 1: Bank credit and innovation activity

Source: BEEPS Russia 2012

Further analysis in our background paper shows that, when correcting for various firm characteristics, firms in more concentrated banking markets are significantly less credit constrained. Bank concentration is mainly beneficial for small firms which depend more on long-term relationships with banks. A higher local market share of foreign banks reduces firms’ credit constraints.

We then show that this cross-city variation in credit constraints brought about by the local banking environment has a large impact on firm innovation. Credit-constrained firms are less likely to undertake at least one innovation and are also less likely to be involved in several types of innovation at the same time.

Interestingly, we find that bank credit facilitates process and marketing innovation but not product innovation or R&D. This likely reflects that process innovation typically involves the acquisition of new machinery, which banks can accept as collateral.

Finally, we ask whether it matters which bank a firm gets a loan from? We find that getting a loan from a state bank only stimulates innovation by larger firms. In effect, state banks tend to specialize in lending to bigger and older firms and do so at significantly lower interest rates (all else equal). Foreign banks, on the other hand, serve a broad range of firms and give loans at considerably longer maturities.

Conclusions

Our findings suggest that banks can play a crucial role in stimulating technological progress in emerging markets. Our Russia data – based on the combination of two EBRD surveys – show that when firms have better access to credit, they can innovate more. These data also show that foreign banks have been helping a broad spectrum of firms to innovate.

In contrast, state banks have focused more on larger and older firms. This suggests that when EBRD works with foreign rather than state banks in Russia, our credit lines to partner banks may have had a broader outreach and allow smaller business to benefit from access to credit as well.

Our results also show that core innovation activities such as R&D and product innovation may need venture capital or private equity to really take off. Instead, banks can help fund process and other forms of ‘softer’ innovation. This suggests that countries like Russia could benefit from a two-pronged approach in which government efforts to stimulate R&D are complemented by bottom-up and bank-funded private innovation.

With a new round of the BEEPS survey becoming available towards the end of this year, we will be able to analyse to what extent our findings for Russia also apply to firms in the rest of the EBRD region.