Community Research and Development Information Service - CORDIS

FP7

MARKET STRUCTURE Report Summary

Project reference: 331728
Funded under: FP7-PEOPLE

Final Report Summary - MARKET STRUCTURE (Banking Market Structure and Firms Financing in Financial Turmoil”)

The project has explored the link between banking market structure and credit conditions for firms in non-financial sectors. The effects of specific features of the financial market structure (e.g., banks’ headquarters and branch location, characteristics of the bank organisational structure) on firms’ access to credit – in price and non-price terms have been examined. The focus has been on three particular aspects:
• Geographical distance between the bank and the borrower;
• Banks’ organisational structure;
• The regional structure of the banking market.
In addition, differences in the supply of credit between innovating and non-innovating firms have been investigated. A final issue of the project was the effect of public funding on research and development (R&D) activities on firms and the role of knowledge transfer.

Geographical distance
The traditional view of lending suggests that local banks benefit from a close proximity to borrowers and local credit markets and from a thorough understanding of the socio-economic environment. According to this view, the comparative advantage of local banks is further enhanced by their non-hierarchical organisational structure, which facilitates the use of soft information, especially when lending to small businesses. As a consequence, the combination of local knowledge and soft information creates an effective barrier against competition from non-local banks. Recently, however, the rapid and extensive technological developments in the banking industry have led to local credit markets being increasingly contested by national and inter-regional transaction banks that use automated technologies and impersonal communication modes to underwrite loans at a lower rate. Competition between local and transaction banks may show up in the role of collateral in credit decisions. Competition from transaction banks limits the ability of the local banks to charge high interest rates and some marginally profitable projects are consequently rejected. Collateral reduces this inefficiency and makes lending to some marginal borrowers feasible. Thus, according to this lender-based theory, collateral arises as a competitive device used by local banks to attract borrowers. However, the project findings show that the lender-based view of collateral is not confirmed by empirical analysis. Based on data from Italian banks, collateral requirements decrease with the distance between a borrower and the local bank, i.e. pledged collateral is lower when the information advantage of the local lender is lower and the costs of monitoring collateral are higher. In addition, interest rates are increasing in distance. These results are consistent with borrower-based explanations for collateral which focus, for instance, on differences in risks according to borrowers, rather than with the lender-based view. These results may have some relevance both for firms, as distance from lender is negatively correlated with the costs associated with the use of collateral, and for policy makers interested in enhancing competition on locally originated loans contested by local and transactional banks.

Organisational structure
The findings also show that banks’ organisational structure, in particular the allocation of decision-making authority within the bank’s hierarchy, has important implications for the provision of credit to firms. The underlying rationale relates to the existence of agency problems within the banking institutions and a trade-off between more informed decisions via the allocation of authority versus possible loss of control. Using unique datasets to empirically examine the importance of organisational structure for the shape of the loan contract, the project results show that loan contract characteristics such as interest rates and collateral requirements are sensitive to the hierarchical allocation of decision-making authority within the bank’s organisation. In particular, incidence and degree of collateralisation are lower when the decision-making authority is higher along the organizational structure of the bank. This has consequences for the ability and willingness of banks to finance different types of borrowers and, by extension, affects the shape of the offered loan contracts. Moreover, it has implications for policy initiatives related to the importance of the organisational structure of financial institutions for financing of SMEs and our understanding of the relative advantage of lending institutions with different characteristics in lending to small businesses and entrepreneurial firms.

Local banking market structure
In addition to the borrower proximity and organisational structure of the banks, a relevant aspect for the provision of credit to firms is the banking market structure. In the project, the composition of local credit markets is related to the connection between local credit dynamics and the national evolution. In markets with a large share of local banks with a closer familiarity with the local economy, and a lower presence of geographically dispersed banks with greater functional distance, a lower sensitivity of local credit variation to the national evolution may be expected, in particular during more severe periods of credit crunch. The project’s preliminary findings confirm these conjectures, in particular with respect to the financial crisis. These results are of high relevance for firms. In times of credit crunch, the access to credit of firms that operate with local banks should be less restricted than for firms operating with functionally distant banks.

R&D as a signal to lenders
Access to credit plays a crucial role for all firms, but financial resources are particularly vital for innovation projects. With respect to research and development (R&D) expenses, it has been argued that debt financing is less suitable than internal resources or equity to finance innovative firms, due to the presence of tougher moral hazard problems, riskier activities, lower availability of collateral, and potential investors’ difficulties in valuing investment projects. Nevertheless, the impact of bank loans on firm propensity to innovate, i.e. whether firms’ investment in innovation is affected by credit availability, remains an open question, especially with respect to small- and medium-sized enterprises (SMEs). The aim of this part of the project was to identify the degree to which bank loans can provide support for the adoption of investments in innovative activities undertaken by SMEs. We show that the SMEs’ probability to innovate is positively influenced by several factors related to external finance: access to credit, captured by a measure of credit availability and a measure of credit tightness; loan size, i.e. the amount of granted credit by the bank for such investments; firm size; and lastly, firm location.
In a reverse perspective we also investigate whether banks’ lending behaviour reflects prudential preferences toward the nature of innovative SMEs, and how lending behaviour influences the pricing and supply of bank loans. Motivated by the argument that riskier activities and asymmetric information will typically exacerbate banks’ difficulties in the evaluation of projects to be financed, thus leading to potential credit constraints, we contribute to the empirical literature by looking at the context of lending to small business innovative firms from a bank-side perspective. The results obtained partially confirm theoretical arguments according to which innovative firms have more difficulty obtaining credit. For instance, we find a positive relationship between a firm’s innovation intensity and the interest rate paid on its bank loans. This result is consistent both with the notion of information-based frictions and with the riskier nature of innovative firms compared to traditional ones. However, we also find that innovative firms face less binding credit limits than non-innovative firms, and are thus less likely to overdraw funds, a particularly costly way of obtaining credit that will be only used if no other forms of credit are available. These findings suggest that, on one hand, banks regard innovative firms as riskier, and charge them a higher interest. On the other hand, banks recognise SMEs certified innovative activities as a positive signal which facilitates access to finance and provides less binding credit limits. Again, these results should be of high relevance for firms. For instance, innovation activities may reduce the presence of credit constraints among those firms that may suffer more from financing constraints, thus helping to avoid costly overdrawing of funds as a “finance of last resort”.

Effects of public R&D funding
The project has been integrated with the analysis of public interventions in a context of imperfect capital markets. As firms cannot completely internalise the benefits of R&D investments since knowledge has the characteristics of a public good, the social return of R&D spending is greater than the return of firms, with the consequence that the level of private R&D expenditure is lower than the optimal social level. Given that R&D investments cannot be used as a collateral and are characterised by high risk and uncertainty, information asymmetries between borrowers and lenders may lead private firms to discard socially valuable R&D projects. In such circumstance, public interventions are crucial to solve market failures to subsidise and incentivise the adoption of R&D investments among firms. In this framework, we empirically analysed whether public regional funding is able to stimulate additional private R&D investments and additional outputs and whether these measures of funding had heterogeneous effects. Overall the results indicate that the measure granting individual research was successful in stimulating outcome variables related to R&D inputs of subsidized firms. Subsidised firms experience a significant increase of R&D expenditure, total amount of wages and tangible investments. The impact on R&D investments is statistically significant both in the short- and medium-term, and appear stronger in the latter. Further findings suggest a positive impact also on firms’ performance, with an increase of productivity and patents. However, the measure targeted to collaborative research had weaker and less clear effects. In addition, we analyse the factors that affect the importance of academic knowledge for firms’ innovative activities with an empirical approach that simultaneously considers both demand-side factors for university knowledge related to industry, and supply-side ones related to university. The research confirms the important role of firms’ structural characteristics and managerial choices in influencing the value of knowledge generated at university. Firms operating in knowledge intensive sectors, with internal R&D efforts and oriented towards open search strategies and radical innovation consider universities an important sources of knowledge. On the other hand, the relationship between firm size and the importance of university knowledge appears more complex. Overall, with the increase of firm size, the value of academic knowledge increases too but at a decreasing marginal rate.

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Contact

Boockmann, Bernhard (Director)
Tel.: +497071989611
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Record Number: 182366 / Last updated on: 2016-05-13
Information source: SESAM