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Can developments in the banking industry affect technological progress? Researchers have been generally sceptical that innovative firms, especially listed ones, could benefit from banking credit to finance their innovative activities. But a study argues for a re-think of that assumption.

Alminas Zaldokas of HKUST and his co-authors Mario Daniele Amore and Cédric Schneider, looked at a sequence of actual events –the staggered passage of interstate deregulation in the US banking industry during 1980s and 1990s. these deregulations, out-of-state bank holding companies were allowed to acquire banks chartered in deregulating states which led to an increase in banking across US state boders. The authors showed that such banking sector liberalization had a positive effect on firm innovation, as measured by patent-based metrics.

“The relationship between economic prosperity and banking development has been widely debated, but establishing the direction of causality has proven to be a challenging task. We focused on manufacturing firms’ innovative performance and exploited the passage of interstate banking deregulation, which allowed banks to expand geographically, increased the availability and quality of credit, and was associated with the adoption of new screening and monitoring technologies.

“We found this deregulation spurred corporate innovation, driven mainly by firms being located closer to entering banks as well as firms operating in industries requiring high external capital,” they said.

They showed that interstate banking deregulation caused a 12.6 per cent rise in the number of patents granted to firms. Moreover, the quality of patents was also higher based on a 10.1 per cent increase in the frequency with which patents were cited in future patents. “This suggests firms exposed to deregulation adopted a bolder innovation policy,” the authors said.

How were the deregulated banks able to support this? The authors looked at the supply side and found these banks were more willing to take risks once they became better diversified geographically as they could expand across US states and become less exposed to the state-level economic conditions. This gave them the freedom to lend to riskier borrowers.

The authors also showed that industries where deregulation had a higher impact on patenting experienced more output growth. From 1995-2000, the five industries with the largest deregulation estimates grew an average 4.9 per cent per year but the five industries with the smallest deregulation estimates grew by only an average 0.2 per cent per year.

“Since innovation is a key driver of economic progress, the importance of our results goes beyond the effect on corporate patenting,” they said. “Overall our research suggests that bank geographic diversification is an important determinant of banks’ willingness to take risk, and thus contributes to technological progress and growth.”