Economic partnerships and other transactions have some degree of information asymmetry between the contracting parties. As such, the information environment is vital when it comes to determining relationship quality and stability. In many markets, superior private information is seen as a competitive advantage when compared to publicly available information.

Understanding the connection between financing relationships and asymmetric information is crucial for banks’ operations. To further investigate this relationship, a study by Farzad Saidi and Alminas Žaldokas aimed to examine how fluctuations in the value of firms’ private information are linked to the depth and stability of their banking relationships.

In particular, the study focused on firms’ innovation disclosure through patents and the associated signalling value in loan contracting. According to the authors, “In lending and other relationships, private information about borrowers is valuable because it is costly to acquire.” This becomes even more valid for highly uncertain investments for which borrowers seek financing, such as corporate innovation.

Patents, which aim to protect the intellectual property of innovators, involve producing public information through innovation disclosure. However, since through such information disclosure, other competitors in the market may have access to certain technical knowledge, firms often need to decide whether it would be more beneficial to patent their innovation or keep it a secret.

The authors argue that innovating firms face an interplay between the patenting–secrecy trade-off and their banking relationships. “The analysis is based on the premise that tighter bank–firm relationships reduce informational asymmetry between lenders and borrowers through private information acquisition, whereas patents produce public information through innovation disclosure,” they say.

To investigate the innovation consequences of mandatory patent disclosures, the researchers looked into the American Inventor’s Protection Act of 1999, which requires firms’ patent applications to be made public after 18 months of filing, rather than when granted.

The authors found that such increased innovation disclosure helped firms switch lenders, resulting in a lower cost of debt, while facilitating their access to syndicated-loan and public capital markets. Their findings suggest that public-information provision through patents and private information in financial relationships are substitutes, and that innovation disclosure makes credit markets more contestable.

The authors show that when more information about corporate innovation becomes publicly available, the incumbent bank partly loses the advantage that it had in financing the firm due to its previously undertaken information acquisition. This is significant as it can lead to issues with bank–firm relationships, as other banks can become more competitive in financing the firm, resulting in a lower cost of borrowing.

“Thus, our results suggest that switching costs in banking relationships might be endogenous to product market considerations of firms’ innovation disclosure,” note the authors.