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Finance, Innovation and Growth: Changing Patterns and Policy Implications

Final Report Summary - FINNOV (Finance, innovation and growth: Changing patterns and policy implications)

Executive summary:

The FINNOV project was a timely and relevant research project. Understanding the links between financial markets, innovation and economic growth helps us see how what initially seemed to be a financial crisis contained in the US subprime mortgage market, was transformed into a broader economic crisis that penetrated various industrial sectors and geographical regions, with devastating social consequences on a global scale.

Defining and promoting effective arrangements to supply finance and monitor and redistribute the returns to innovation was our central concern. FINNOV approached the issue from several angles. An inter-disciplinary approach was followed to analyse different kinds of bank and venture funding, the operation of equity markets and innovation, the evolution of markets, and the consequences of the varied forms of finance in Europe on income distribution and employment generation. Empirical techniques include econometric studies, using time series and panel data analysis, as well as survey based case studies across different sectors and countries were used. Finally, although much of the current debate on financing of innovative companies in Europe is based on models and data derived from experience in the USA, we argue that Europe needs to develop its own approach, adapted to its own circumstances. In this report we highlight empirical evidence and theoretical models to underpin the evolution of a distinctive and self-confident European approach to the financing of innovative businesses.

Project Context and Objectives:
FINNOV (see online) was a research collaboration between seven European institutions aimed at understanding the relationship between changing financial markets, innovation dynamics, and economic performance. The project studied how these relationships influence economic growth as it is experienced by individuals, businesses and the wider economy. Our main goal with this research was to assist policy makers to better coordinate innovation policy with financial market reform policy.

The nature of the current crisis and also the means for recovery are not only financial but touch broader economic structures. Indeed, as FINNOV researchers have shown, crises like the one we are currently experiencing are a regular occurrence - at least every three decades - and are not accidental; they are rather endogenous to the market system (Perez, FINNOV DP 2.12). However, the realm of finance plays a quite important role both in the emergence of these regular crises but most importantly during the phase of exiting them and entering a period where future potential for new economic growth are deployed. In other words, in every economic crisis throughout history, a major financial collapse seems to mark the start of an era of reform which opens new possibilities for economic and social development. We live in such an era right now and the role of governments and policy makers is quite crucial in taking action and creating a more sustainable and equitable future for Europe. In doing so, new knowledge on the role of the financial system in the economy and society is absolutely crucial.

Our research objectives were formulated based on the pragmatics of the current economic situation in an EU context and the associated policy challenges outlined above. Indeed, the financial crisis has dramatically changed the economic environment, perceptions of it and the priorities of policy-making. While short-term objectives are crucial to stabilise the economy in this phase of turmoil, long-term objectives are equally important for a resumption of growth and for the competitive future of firms and nations. The EU 2020 Strategy states that Europe's future prosperity is dependent on developing a knowledge-based economy driven by innovation. To stimulate the supply of innovation it calls for increased public and private investment in Research and Development (R&D) to match the proportions of GDP being invested in Research and Development (R&D) by Europe's major competitors. However the success of this strategy depends equally on the successful translation of innovation into economic growth.

The overall purpose of FINNOV research was to contribute to the above strategy by improving economists' and policy makers' understanding of the interaction between financial markets and innovation-led growth and the effect of such growth on the social distribution of risks and rewards. Given the strong negative effect of the recent financial crisis on many European economies, a central element of the FINNOV research programme was to determine how European governments and institutions can ensure that the financial system supports investment in innovation in sustainable and equitable ways. The project did so in the context of three broad aims:

Project Results:

In the midst of a global economic crisis that continuously changes form (from banking to sovereign, and now to EuroZone crisis) and threatens global economic stability with potentially major social consequences, the FINNOV research results come in to offer insights to policy makers that will help them design ways to exit the crisis and create a sustainable and equitable model of economic growth in Europe (EC, 2010).

The nature of the current crisis and also the means for recovery are not only financial but touch broader economic structures. Indeed, as FINNOV researchers have shown, crises like the one we are currently experiencing are a regular occurrence - at least every three decades - and are not accidental; they are rather endogenous to the market system (Perez, FINNOV DP 2.12). However, the realm of finance plays a quite important role both in the emergence of these regular crises but most importantly during the phase of exiting them and entering a period where future potential for new economic growth are deployed. In other words, in every economic crisis throughout history, a major financial collapse seems to mark the start of an era of reform which opens new possibilities for economic and social development. We live in such an era right now and the role of governments and policy makers is quite crucial in taking action and creating a more sustainable and equitable future for Europe. In doing so, new knowledge on the role of the financial system in the economy and society is absolutely crucial.

But what is the role of the financial system in the current crisis? Although this is a broader economic growth crisis - rather than just financial - we observe a changing (or changed) role of the financial system within the economy. More specifically, in recent years, it seems to be abandoning its role to support the financial needs of the 'real' or 'productive' economy. Indeed, the financial system has become a self-reproducing institution and a vehicle for inequality. This phenomenon is known as 'financialization', the practices of which at the firm and market levels create significant discontinuities at the economic system and more particularly, in the relationship between innovation – economic growth – and social development. FINNOV researchers, who are world-leading innovation experts and acknowledge the significance of innovation in society and economy, observe that due to financialization of the economy, instead of the financial system supporting innovation that leads to value creation and economic growth, we have innovation supporting the financial system, through value extraction (and in some cases value destruction). This shift in the relationship between financial dynamics and industrial dynamics has been the source of a series of economic and social problems:

1) The financial system does not support innovation that leads to sustainable and equitable economic growth.
The long-term economic performance of Europe depends not only on its ability to generate new knowledge and inventions, but crucially on translating invention into innovation and innovation into economic growth. It is in relation to their role in the exploration, manufacturing and commercialization of novelty that the analysis of credit and financial markets is of the first importance. Defining and promoting effective arrangements to supply finance and monitor and redistribute the returns to innovation is our central concern.

Financialization however by shifting the role of financial markets away from the real economy, has created a growing gap between the two. Questions are raised, therefore, on whether the financial system rewards or penalizes innovation. Do innovative firms receive more finance than non-innovative ones? Do they grow more? Do they get better credit ratings? How does the shareholder revolution affect Research and Development (R&D) spending? And do some well-positioned economic actors reap significant returns even when their actions result in value destruction rather than value creation?

As we found in FINNOV, what is interesting and relevant to policy makers about this gap between financial markets and the real economy, is that it is hugely affected by the differences amongst financial agents and institutions (Demirel and Mazzucato, FINNOV DP 2.2). Indeed, market selection seems to operate on a broad mix of firm characteristics rather than on innovation per se. Currently, the financial system and EU industrial policy seem not to take into serious consideration the wide diversity in the relationship between innovation and finance across firms, sectors and countries. As a result, financial markets instead of rewarding the most innovative firms, they tend to penalise them, thus, undermining growth prospects.

FINNOV addressed this issue in its first policy brief (Do financial markets reward innovation?) and provided the following important lessons for policy-makers:
- Understanding what is the broad mix of firm characteristics based on which market selection operates, and how they differ between sectors, is crucial for innovation-led growth targets.
- Financial reform should aim to help credit markets create valuation tools which reward the most efficient firms, rather than penalize many of them. In particular, the tradition of linking the economic and financial soundness of a business activity to a single "rating" measure should be abandoned in favour of more structured assessment devices.
- The 'credit crunch' itself tends to penalize the most innovative firms. In order to make sure that post-crisis growth is achieved, financial reform should aim to help not penalize the most innovative firms during the post-crisis recovery.
- The EU must ensure that this highly financialized business model of stock buybacks cannot take root in Europe.
- In terms of the relationship between financial markets and innovation, the key lesson is that one size will not fit all the important actors in this policy space. Policy must be guided by models which adequately take heterogeneity into account, and which study the co-evolution between heterogeneity and the competitive selection mechanism.

2) Financial innovation creates financial bubbles and crises with tendencies for contagion and with devastating social consequences.
A financial bubble is an event in which the processes that connect the price and fundamental value of an asset malfunction and fail to self-correct, causing price and value to diverge to the point that the pricing mechanisms undergo a catastrophic failure, causing widespread societal and economic damage.

The role of financial bubbles in innovation is addressed in our second policy brief (Dynamics of financial bubbles) where FINNOV researchers made the following suggestions that would help harness the dynamics of financial bubbles and their impact on innovation and growth:
- The costs of financial bubbles are often huge in both financial and social terms. Financial bubbles have occurred repeatedly throughout history, and there is nothing in FINNOV research to suggest they will disappear. Indeed, evidence suggests they are getting more regular and more damaging. Financial innovations designed to promote the measurement, management and efficient trading of risk did not defuse the most recent bubbles, and actually contributed to them.
- Policy makers in the EU should be suspicious of financial institutions claiming that they will move country if they are more tightly regulated. Herding behavior, whose prevalence and potentially adverse impact are confirmed by this research, undermines self-regulation and strengthens the case for external regulation of the financial sector.
- Financial crises can in some instances be predicted as bubbles show themselves at the macro level in increased activity in untraded services such as finance and construction. Rising prices for real estate and financial products may indicate a mispricing problem that may be getting out of hand.
- To mitigate the devastating effects of financialization and the possibilities for the emergence of bubbles, industrial innovation policy needs to incorporate more effectively policies on the management of financial innovation.
- The liquidity drought following market crisis and bubbles adversely affects young and potentially fast growing firms. Regulatory interventions are recommended to facilitate access to credit to high-potential innovating firms.
- In order to reduce large price fluctuations, policy makers need to mitigate the herding effect on stock markets.
- In case of synchronization and positive feedbacks, policy makers must not underestimate the impact that noise traders have on price dynamics.
- There are a number of mechanisms that can cause major failures in financial markets, through synchronization of actors' behaviour and herding.
- On the real estate markets, there should be no preferential treatment of owning vs. renting. For example, interest on mortgages should not be exempt from taxes.
- Mortgage backed securitization should be restricted. The originators (mostly banks) should keep at least 51% of the mortgage to make sure they have an incentive to check borrowers' creditworthiness thoroughly and monitor closely how the loan is performing.

3) Based on the creation and perpetuation of certain 'myths', the financial system creates dysfunctional incentives and opportunities across a range of sectors that can undermine productive investment.

This dysfunction goes beyond simple short-termism, to situations where unproductive value extraction is encouraged at the expense of value creation. Big part of the problem is that our collective understanding of financial markets remains stuck in the past, at a time when financial technologies for pricing and (re)trading assets and risk were immature, national markets were relatively unconnected, and banks and firms did not have electronic markets to assist them in the allocation of resources. Under such conditions, private and public risks and rewards were generally aligned, and conventional economic theory could reasonably assume that markets would self-correct and that market-based trading, combined with private ownership of assets, would ensure the convergence of public and private benefits.

The dysfunctionality of the financial system and sustainable routes to financial reform were addressed in our third policy brief (Reforming a dysfunctional system). Policy recommendations, which envision a more realistic understanding of the role of the markets, of the State and of other economic actors (i.e. SMEs) and their practices (VC, stock buybacks, risk management methods etc.) included:
- Government policy-makers should reject 'the myth of the market economy' and recognize the important role played by the State in supporting and encouraging innovation.
- Current financial indicators have a bias against innovative, high potential firms. Governments may therefore wish to adopt selective policies to support firm growth.
- Governments should audit and regularly evaluate the channels that they use to support Research and Development (R&D), innovation and other business investment. Evaluations should be transparent and independent. They should take into account long-term and distributional effects, as well as identifiable social returns.
- Without Government support, a society will have to forego innovation. Governments have a key role in investing strategically over the long term in areas where businesses do not, or cannot, invest, such as pre-competitive stages of technology development.
- The role of VC has to be considered within the overall architecture of innovation financing, which includes complementary and alternative instruments. Among them, corporate venture capital, technology development contracts and intermediate Research and Development (R&D) organizations can be effectively used to remedy the limitations of the pure VC model.
- Public input to hybrid VC is, in effect, a way to recapture for the taxpayer a return on state-funded early stage research that could otherwise be captured entirely by private VC funds.
- Blanket public support for 'SMEs' via subsidies and tax breaks is misguided and is often based on unrealistic expectations of their role in the economy.
- Bank lending to innovative firms of all sizes will increase only when credit scores do not penalize the higher risk associated with long-term productivity enhancing investments.
- Stock buybacks and other short-term modes of resource allocation can create perverse incentives. They were considered a manipulation of the market and banned in many European countries before the late 1990s. Such constraints should be reconsidered.
- Far from being myopic, institutional investors can influence firms to be more innovative.
- Policy makers should avoid 'in-breeding' and encourage diversity in risk management practices.
- Regulation should return to simple, enforceable rules that rule out certain forms of risk-taking or risk-transfer, and be aware of the limits of quantification of risk.

To summarise the above, the following five messages to EU policy makers were drawn from FINNOV research in relation to the role of the financial system in innovation and growth:
1. De-financializing the economy through re-regulation of finance (i.e. separate investment activity from banking activity);
2. Redirecting the financial system in the economy towards aligning its practices with real, productive economy value-creation. For example, revisit biased financial indicators, discourage short-termism, develop better tools for evaluation of financial products and so on.
3. Embracing and fostering heterogeneity and diversity;
4. Re-invigorating demand for finance;
5. Rejecting the 'myth of the market economy' and recognizing the important entrepreneurial role played by the State in supporting and encouraging innovation (i.e. Mazzucato, FINNOV DP 2.8).


WP 2: SELECTION: Co-evolution of Industry Dynamics and Financial Dynamics
A main objective of FINNOV research was to explore the co-evolution between industry dynamics and financial dynamics. WP2 was devoted to this endeavour.

WP 2 Summary
The stock market's valuation of innovative vs. non-innovative firms affects resource allocation in the economy, and therefore represents a key transmission mechanism from finance to the real economy. WP 2 focused on this interplay between firm level innovation and financial performance.

WP 2 research extended existing work on finance and innovation by exploring which types of firm level characteristics are essential catalysts for achieving better stock-market valuation via innovation. Traditionally the literature has shown that firm level innovation (measured by firm's stocks of Research and Development (R&D) and patents) positively affects market value. However, recent work from members of this work package, has shown that the relationship between Research and Development (R&D) and firm growth is far from clear (Demirel and Mazzucato, FINNOV DP 2.1). Firms that invest in innovation do not always grow more than non-innovative firms. Only firms with certain types of characteristics benefit from their innovative efforts (Demirel and Mazzucato, FINNOV DP 2.2). To what degree is this also true for financial performance? That is, are the firm level characteristics needed for innovation to translate into growth the same as those needed for innovation to translate into higher market value? How does this differ between sectors and periods in the 'industry life-cycle'?

WP2 Detailed description of work and policy implications
While exploring the co-evolution between financial and industry dynamics, WP 2 made a significant contribution to our knowledge in three areas: the relationship between Research and Development (R&D) and growth, between Research and Development (R&D) and stock prices and finally on the role of VC in the clean-tech industry. More specifically:

1) Research and Development (R&D) and Growth
To explore the relationship between Research and Development (R&D) and growth, we studied firm growth dynamics in the US pharmaceutical industry between 1950 and 2003 (Mazzucato and Demirel, FINNOV DP 2.7; Mazzucato and Parris, FINNOV DP 2.4). We chose this particular industry to study the properties of firm growth because it is a particularly innovative sector which has undergone intense changes in its knowledge base over the last 50 years. We asked whether the (time series) patterns of firm growth, as well as the evolution of the firm size distribution, has changed alongside such transformations, and in particular, whether the degree to which firm growth can be described as 'random'-as opposed to more 'structured' (e.g. due to various types of increasing returns) - has changed over time. Central to this question was the different growth behaviour of (a) small and large firms and (b) firms located in different regions of the US. One of our key results, not found in the existing literature, concerned the facts that the presence of 'structure' is not a static characteristic of growth dynamics but emerges in a specific period of time (post-1980s), and that differs between geographic regions. Another key result was that regional differences only matter for the innovative firms. More particularly, we have found that the growth advantage of small pharmaceutical firms increases after the 1980s as small firms become more active in patenting and their patenting activities become more 'persistent'.

2) Research and Development (R&D) and Stock-Prices
Focusing on the pharmaceutical industry, A sector with one of the highest sectoral Research and Development (R&D) intensities and patenting rates, we explored at the evolution of the relationship between stock returns and innovation over time (between 1974 and 1999), both over the industry's life-cycle and over the course of time as the intensity of innovation investments change (Mazzucato and Tancioni, FINNOV DP 2.3). In recent finance literature the role of technological change is highlighted in increasing firm specific (idiosyncratic) and aggregate stock return volatility, yet innovation data is not used in these analyses, leaving the direct relationship between innovation and stock return volatility untested. We used firm-level patent data to investigate the relationship between volatility and innovation and we asked whether firms which invest more in innovation (more Research and Development (R&D) and more patents) and/or which have more important innovations (patents with more citations) experience more volatility in their returns. Given that returns should in theory be higher, on average, for higher risk stocks, we also looked at the effect of innovation on the level of returns.

3) VC and Clean-Tech
Driven by political pressures to cut down CO2 emissions and to find cheaper and renewable alternatives to fossil fuel based technologies, the clean technology sector (cleantech) has risen as an important target for VC investments in recent years. While the economic recession has led to a significant decrease in VC funding across sectors in 2009, cleantech was least affected by the adverse economic conditions, accounting for roughly 25% of all VC investments worldwide and 20% of VC investment in the US (Baker 2010; Thomson 2010). Using a broad definition of cleantech aimed at alternative energy production and/or providing solutions to environmental problems we studied the relationship between innovation and venture capital (VC) funding for 239 UK firms (Parris and Demirel, FINNOV DP 2.6). Our analysis was based on a unique combination of three datasets; (1) FAME, (2) UK Intellectual Property Office patent data and (3) Cleantech Network's Venture Investments data. We found that the majority of VC backed UK cleantech firms do not patent or patent very little.

-Market selection operates on a broad mix of firm characteristics rather than on innovation per se. Understanding what these characteristics are and how they differ between sectors, is crucial for the EU's goal of increasing investment in innovation. Otherwise, public spending on innovation support will be inefficient and fail to target the firms with the greatest potential. In particular, the ''Lisbon Agenda's'' goal of increasing Research and Development (R&D) intensity across EC countries will be informed by greater understanding of which firm specific characteristics must be in place for Research and Development (R&D) investment to affect growth.
- The finding that it is the most innovative firms that cause growth distributions to be 'fat tailed' implies that innovation policy must be very careful not to be derived from studies that assume representative agents and normal distributions.
- In agreement with WP3, WP2 findings indicate that policies must help to develop models for financing innovative firms that include alternatives to the widely adopted venture capital model, especially in order to support the development of radical new environmental technology.
- There needs to be a greater understanding of the appropriate measures for monitoring the innovative performance of small and medium sized companies in the cleantech and nvironmental sector. Approximating the innovative activity in a sector according to signals of investment activity from sources such as venture capital, may overestimate the actual amount of innovative activity occurring.
- Location is found to affect growth differences only for the most innovative firms (i.e. for non innovative firms, location does not matter).
- Innovation variables are important in capturing the levels of 'risk' embodied in firm performance and as such have an impact on both returns (risk-return) and volatility (risk-volatility).
- Public funding could be especially important to support emerging innovation in the cleantech sector

WP 3: EXPERIMENTATION: Capital Markets and Innovation: Financing Business Experimentation in Europe
The work in this package explored ways in which early development and subsequent growth of firms is financed and what are the consequences for innovation. We explored the nature of different innovation financing models and investigated the link between business financing and the characteristics of innovative firms. Our theoretical contribution is the development of a Schumpeterian perspective on the financing of business experimentation. Our empirical contribution consists of a set of novel analyses of the financial foundations of entrepreneurship and the process of creative destruction.

WP 3 Summary
Finance is recognised as a major innovation constraint that closely interacts with the strong uncertainties associated with new products, new services and new business models. A variety of responses and associated financing instruments have been developed in different countries and sectors. Until recently, a large proportion of studies on innovation finance has been focused on the US. While many lessons have been drawn from it that might foster, for example, more effective deployment of VC policies in the European context, much still needs to be learnt in order to: 1) understand the firm- and system- level effects of different modes of innovation finance 2) identify their complementarities (static and dynamic) and limitations and 3) appropriately match policy instruments to the needs of heterogeneous economic contexts.

WP 3 Detailed description of work and policy implications
In analysing the financial foundation of innovation it is important to remember the fact that the vast majority of innovation-related expenditures are financed by firms' internal resources and that firm will typically seek external finance when internal capital is not sufficient or not available. The outcome of financing behaviours is – as a whole – significantly influenced by the borrower's profile as innovators and the lender's ability to evaluate uncertain latent market opportunities against the quality of potential investments (Mina, Lahr and Hughes, FINNOV DP 3.5).

Our comparative analyses of the demand and supply of external capital in the UK and US before the crisis revealed somewhat limited evidence of financing constraints in SMEs. At a time of normal operations of markets the demand for external capital of Research and Development (R&D)-intensive firms did not appear to be higher than less Research and Development (R&D) intensive firms. There are indications that uncertain innovation activities of the potential borrower negatively affect the supply of finance, in line with the expectation that businesses undertaking risky projects will incur higher costs of capital and will have access to suboptimal levels of financial resources. However, while indicators of innovation output (as opposed to input, such as Research and Development (R&D)) did not make any difference on the demand for capital, they did exert strong and significant effects on the probability that lenders will provide finance. This finding confirmed that the supply of finance would respond in different ways to projects with different risk profiles and growth opportunities. However, with the exception of VC and angel finance will tend to reward realised innovation (product and process) over Research and Development (R&D) investments. Importantly, US investors seem to be more reactive to innovation signals than their UK peers. We also found that the likelihood of obtaining finance is positively affected by firm size and the acquisition of technology inputs through the market, both reflections of higher informational transparency. On the contrary, long pay-off periods and intangible capital exert a negative effect on the likelihood of obtaining external finance because they signal greater business risk and are sources of significant information asymmetries firms and potential investors.

In our comparative study of intermediate research organisations, we found that the common themes underlying successful technology developments in intermediate research institutions include
1) Long-term co-funding by the public sector linked to periodic evaluation;
2) Commitment and size of investments required to make a difference, especially at the outset of technological trajectories
3) strong relationships with industrial partners, keeping the organisation's activities close to demand and to customers' input into the innovation process, as a complement to the research remit of higher education institutions.

- PE markets are not at all dead
- The distribution of VC investments and their performance is very uneven across sectors.
- If VC is the engine of the high-tech economy it should support a higher share of early stage investments. On its own, the VC model is not delivering.
- The contribution of VC cannot be assessed in isolation from the overall innovation-finance architecture in which it operates.
- This includes: long term public sector investments (especially in the case of general purpose technologies) in the research base; demand/client-driven technology development mechanisms (grants and contracts).
- Internal finance is clearly the most important source of finance for Research and Development (R&D).
- Our comparative study of the UK and US markets for external finance shows that US investors are more selective (but operative on a larger scale) and more reactive to innovation signals.
- Very difficult to find strong evidence of finance gaps at least at times of normal operation of markets. Note as well that at the inception of the current crisis UK firms expressed more concerns about D than access to finance.
- Leadership changes at corporate level impact CVCs with strategic objectives
- Crucial knowledge-broking function of CVC unit with strategic objectives - most effective where corporate is customer/lead user
- CVC unit plays role in fostering corporate long term dynamic capabilities
- Systematic neglect in literature of the evolution over time of a CVC unit focus - recognising variations over time is crucial to reliable assessment of CVC role and performance - explains inconsistency of results of prior CVC research - business model applicability may vary (different sectors/same period; same sector/different periods)

WP 4: PERFORMANCE: Finance, Constraints to Growth, Bankruptcy, and Employment Dynamics
WP 4 studied the transmission mechanisms from credit markets to the real economy. The research contributed to this broad question by looking, from different angles, at the relationship between financial institutions and business firms, and the effects produced by such interactions on a range of key dimensions of firm performance.

WP 4 Summary
A first objective concerned an assessment of the empirical evidence on how differential financial structure and differential sources of financing affect innovative activities of firms, from a comparative perspective across Europe. What are the sources of finance used by European firms, and by small innovative firms in particular? What types of financing have shown more effective for innovation? What is the relative merit of private vs. public funding? An important part of the efforts within this objective are devoted to also understand the role of differential financial markets' institutional set-up in facilitating or hampering innovation.

A second objective questioned the actual 'efficiency' of credit allocation by financial institutions, which is crucial in fostering reallocation of investment and growth opportunities and market shares across heterogeneous firms. What is the evidence on the phenomena of misdirected credit provision? Are financial or liquidity constraints binding? To what extent differential financial structures correlate with actual growth patterns of the firms? To what extent can one observe that financing costs and conditions imposed by financial institutions to financed firms correspond to a 'sound' screening of industrial firms, thereby contributing to an aggregate process of selection of the best performers?

Finally, WP 4 explored the interplay of financial and real side of firms' activity in determining the most extreme case of financial distress leading to firm default. More particularly, we asked whether solid predictions about the probability of default events can be safely assessed, by investors or institutional actors, without considering the real side of firms' industrial characteristics and performance. Thanks to collaboration with people form CERGE – Economics Institute mainly working in WP6, we also explored default dynamics of firms in transition economies of Eastern Europe.

WP 4 Detailed description of work and policy implications
The WP began with a review of some key characteristics of the empirical relationship between finance and innovation in Europe (FINNOV DP 4.1). European innovative firms, and small innovative firms in particular, primarily rely on internal funds to finance investment, due to massive capital market failures. Alternative sources of finance appear to be either ineffective or at least much less important. First, although European venture capital has caught up with US venture capital (mainly due to the growth in UK venture investments) European venture capital appears to have failed to certify the quality and enhance the growth of funded companies. Second, compared with the NASDAQ, there has been little development of trading in high-technology stocks in Europe: the so-called 'New Markets' established in the 1990s have collapsed in the wake of the Internet bubble crash. Conversely, public venture capital as well as Research and Development (R&D) tax incentives seems to have positively affected the performance of high-tech firms.

The results of the research on default dynamics pointed in the same direction. We have shown that industrial characteristics and performance of firms (productivity, operating margins, size, growth) do play a relevant role in predicting default, even in the short run, when financial variables are commonly conceived to be strong predictors of default (Bottazzi, Grazzi, Secchi and Tamagni, FINNOV DP 4.3). Moreover, their predictive power is still high when we add among the regressors two indicators of default probability widely used among investors and practinioners, such as a Distance to Default index and an official credit rating index. The results, beyond suggesting severe capital markets imperfections and contrasting with standard assumptions of complete and fully informed capital markets, support the view that the accuracy of standard risk assessment devices, such as official credit ratings or internal risk management practices maintained by financial institutions, might be biased, devoting too little attention to important industrial/economic factors. Such a tendency can be seen as one of the reasons behind the financialization and short-termism which can be, and has been, invoked among the features of contemporary capitalism which concurred to ignite the current crisis.

- Public venture capital and Research and Development (R&D) tax incentives provide an effective policy to sustain innovation and growth of European firms suffering from shortage of financial resources.
- Challenges in designing such policies are, first, an effort to harmonize public programs across regions and countries, since heterogeneity in programs is very likely to produce coordination and communication failures between the many actors involved. Second, and relatedly, efforts should be put in place towards a more effective integration between national and regional programs.
- Capital markets imperfections create a wedge between financial and industrial performance of firms and, thus, financial indicators alone do not represent a good predictor of firms' default. From the point of view of the strategies of financial institutions, results entail a general advocacy for "financial patience": short-termism is not a good guide for the exploitation of the growth and innovation potential of firms, and even less so the exclusive reliance in financial indicators for the assessment of corporate potential performance.
- Asymmetric effect of credit shortages on firm growth suggest a positive role for selective policy to sustain growth and innovation, as well as support for regulation and policies that enhance effectiveness of capital allocation.
- While previous studies found probability of exit is smaller for larger firms, we show here that the probability of default increases with size.

WP 5: GOVERNANCE: Corporate Governance and Innovation: Implications for Stable and Equitable Economic Growth
A critical aspect of the current financial crisis is the relationship between corporate governance and innovation. In this context, the analysis of the role of stock markets in the innovation process becomes all the more relevant and urgent.

WP 5 Summary
WP5 is focused on the relationship between innovation and corporate governance practices of European firms. The crisis calls into question the liquidity of stock markets, the investment behaviour of institutional investors and distribution of shareholder value within the context of the role of finance in the processes of resource allocation and value creation. In this context, the GREThA-led team mainly carried out industry studies with different levels to examine the impact of financial schemes on corporate practices related to innovation and stable and equitable economic growth. Various levels of analysis aimed at revealing the varied role of financial mechanisms in investment and growth strategies of firms of different sizes. The research team approached the issue both from the industry side and finance/investors side. Pharmaceutical and biopharmaceutical industries constituted the major context of the industry-level analysis of WP5 with respect to the competences of the research team.

WP 5 Detailed description of work and policy implications
The main results from WP 5 emerged from the following three studies:

1. The influence of institutional investors on Research and Development (R&D) spending in Europe
A group of WP5 researchers implemented an empirical study designed to examine the relationship between ownership structures of large European companies and their innovative efforts in terms of Research and Development (R&D) spending (Brossard, Lavigne, Dupuy and Sakinc, FINNOV DP 5.3a). The analysis was performed on a sample of 325 highly innovative companies belonging to manufacturing and other industries, over a 8-year period (2002-2009). Contrary to the view that institutional investors have a negative influence on Research and Development (R&D) spending, the researchers found a positive impact of these investors on Research and Development (R&D) expenditures. This result is particularly robust when firms' ownership structure is not over-concentrated. They also examined the effects of investors' short-termism on R&D. The results provided evidence that the entry of short-term investors in the ownership structure has a negative impact on companies' R&D spending. This is consistent with the view that independent long-run investors would motivate and reward managers so that they allocate adequate corporate resources adequate long-term investments such as Research and Development (R&D).

2. Pharmaceuticals and dynamics of corporate strategies
The pharmaceutical and biopharmaceutical industries were the major focus of WP5 in terms of sectoral analysis. Along the course of global corporate restructuring in conjunction with the rising role of financial markets, pharma-related industries became major fields of academic research to observe the impact of new institutional and organizational settings over industry performance, however the changing role of finance over such settings has remained an under-researched field. Focused on specific topics directly linked to the main research proposal, WP5 researchers have first analyzed the financialization of large pharmaceutical firms and the transformation of their business model (Montalban, and Sakinç, FINNOV DP 5.2b). Along with their corporate restructuring through mergers and acquisitions, internalization of new technologies and Research and Development (R&D) reorganization, large US, European and Japanese companies have increased significantly their distribution of dividends and their share repurchases as a part of corporate financial strategy, and have focused on producing blockbuster drugs to generate more revenue out of existing productive activities. The study aimed to show the interlink between productive reorganization and financial motives based on a shareholder perspective.

3. Stock buybacks, executive pay, and investment in innovation
In a number of papers, Lazonick has shown how stock buybacks have become a prime mode of corporate resource allocation in the US economy (Lazonick, FINNOV DP 5.6 and Lazonick, DP5.7). The only purpose of stock buybacks is to boost a company's stock price. Especially given the scale and systematic way that buybacks are done in the United States, this practice should be viewed as stock-market manipulation. Since 1982, however, the US Securities and Exchange Commission has given corporations a 'safe habor' to do large-scale repurchases with fear of manipulation charges being lodged against them. With superior corporate performance defined as meeting Wall Street's expectations of steadily rising targets of quarterly earnings per share, companies turned to massive stock repurchases.

- Ban stock repurchases by established business corporations so corporate financial resources that could be allocated to innovation and job creation are not wasted for the purpose of manipulating a company's stock price.
- Index employee stock options to an indicator of innovative performance so that executives cannot gain from speculation in and manipulation of their companies' stock prices.
- Regulate the employment contract to ensure that people who contribute to the innovation process share in the gains to innovation.
- Creation of work programs that make productive use of and enhance the productive capabilities of educated and experienced workers whose human capital would otherwise deteriorate through lack of other relevant employment. Companies should consider allocating accumulated capital and experienced labor to spinoff enterprises rather than throw the capital on the stock market through buybacks and the workers on the labor markets through layoffs.
- Implementation of taxes on the gains from innovation to fund those government agencies that need to invest in the public knowledge base required for the next round of innovation.

WP 6: ASSETS: Asset Prices, Consumption, and Income Distribution
The current financial crisis was initiated by speculation around subprime mortgage loans in the US housing market. WP 6 conducted an analysis of asset prices, consumption and income distribution in the context of housing markets in newly admitted members of the European Union, starting with the Czech Republic where Micro Census data was readily available.

WP 6 Summary
Prior to a recent decline, property prices had risen dramatically in many European countries. This phenomenon may have been demand driven due to lower mortgage rates and desire of foreigners to own property in new member countries of the European Union. Alternatively, it may well be that lowering barriers to cross-border lending, arising from the liberalising services directive of the EU, or that particular wealth effects arising from housing bubbles in one country (e.g. the UK) are transferred to other countries with the subsequent ramp-up of localised house prices. In other words, we looked for causes of the burst real estate bubble. A (potentially rational) bubble on the housing market can be identified by analyzing a discrepancy between market prices and corresponding fundamentals, e.g. rents. WP 6 analyzed this phenomenon using regional panel data within individual countries.

WP 6 Detailed description of work and policy implications
WP 6 focused on the impact of various innovations on asset markets and on households. Since a large portion of the household wealth is tied to real estate, we initially concentrated on property prices. Our first step was to determine whether the real estate prices are too far from values implied by fundamental factors (Zemcik, FINNOV DP 6.1 also published in Czech Journal of Economics and Finance). We used the Czech Republic as a methodological blueprint. From the theoretical perspective, there are two widely used models. In a present value model, a real estate price is calculated as the discounted stream of future cash flows, i.e. rents. A structural model is typically based on a standard demand-supply analysis and included factors affecting both sides of the market. Given that we had access to regional rents in the Czech Republic, the present value was the natural choice in our study. As compared with the behavior of rents, apartment prices exhibit bubble-like behavior in 77% of considered Czech regions and in 52% of the Prague's districts. Testing for bubbles is relevant even after a decline of the housing prices in many countries, including Spain, UK, and Netherlands. When rents and income are compared to the real estate prices in these and other countries, the housing prices still appear overvalued in these and other European countries.

- The development of the mortgage market may have contributed to the creation of real estate bubbles. A more prudent approach to providing credit to households is preferable.
- It is important to identify asset bubbles at an early stage to diminish the impact of their potential collapse on household consumption.
- Private ownership of property may be achieved by de-regulation of the rental market as opposed to easy access to credit.
- Preferential treatment of ownership over renting should be abandoned and the legal framework for rental housing should be changed more in favour of landlords
- Foreign ownership tends to have a positive effect on performance. The positive effect of privatization to domestic owners, to the extent that it exists, takes a number of years to materialize. This finding can serve as a lesson for governments that have to sell some of their assets in distress.
- Our results also suggest there could be benefits from a joint stock market for several relatively small countries

WP 7: AGENTS: Modelling Micro Macro Links and Policy Implications
The main goal of WP7 was to provide a framework to investigate the relationship between innovation, investment, financial fragility, public policies and macroeconomic performance in the presence of heterogeneous financial conditions.

WP 7 Summary
The economy can be conceived as a complex adaptive system which can therefore be studied by means of Agent-based Modelling (ABM) techniques. In order to address the above objectives, then, a multi-agent setting appeared to be the most appropriate environment. In this context WP 7:
- Studied the extent to which the decision to innovate and expand/contract the scale of production by investing or hiring/firing of employees are affected by: i) the availability of finance and ii) the degree of financial fragility/robustness.
- Analysed the impact of different types of financing sources on the firms' profile and explored the impact of different public policies on the financial structure of firms and on their resulting innovation, growth and employment performance.

WP 7 Detailed description of work and policy implications
The recent vicissitudes of the credit market are a natural research issue to be analyzed with ABM and graph theory. If the firms/banks were "isolated units", the bankruptcy of a borrower would be almost unimportant in the credit system. However, given the strong interdependence in credit and interbank markets, the default of one agent can bring about phenomena of financial contagion. Three types of propagation of systematic failure have been studied in the economic literature and investigated in our deliverables.

First, the bank runs, known as self-fulfilling panic (see Diamond and Dybvig, 1983). This line of research was investigated and we proved how self-fulfilling panic may arise from simple imitative phenomena, also known as herding (Gallegati, FINNOV DP 7.1; Tedeschi, Iori, and Gallegati, DP 7.5). In particular, these studies employed agent-based modeling methods to show how herding happens and its effect on panic and on agents' choices.

Results: Default cascades in the interbank market
The first question concerned the role of reserve requirements, reflected by the ß parameter (higher ß means higher reserves). As the reserve ratio increases, the rate of bank failures clearly falls. Obviously, increasing reserves contribute to the stability of individual banks, as shown by a lower value of average bank leverage. However, increasing reserves somewhat reduce the output growth rate, since many firms do not get loans in the credit market. We analyzed how different degrees of linkage in the interbank market affect the bankruptcy of financial institutions.

By increasing linkage, the systemic risk raises in the sense that in any period, more banks fail. Indeed, with 100 percent linkage, the system collapses completely, analogously to a tragedy of the commons (see Hardin, 1968). While the earlier empirical literature on the systemic risk, in line with Allen and Gale's result on the risk sharing role, found a very little evidence of global vulnerability (see Furfine, 2003; Boss et al., 2004; Summer et al., 2002; Bartram et al., 2007). Strong evidence has been collected after the default of Lehman Brothers, showing that interbank linkages strongly impact systemic risk (see Battiston et al, 2009; Castiglionesi and Navarro, 2007) through a high probability of domino effects. So, in line with these new empirical and theoretical works, we found that the default of an agent may increase the systemic risk by increasing the connectivity. In line with our hypothesis that a higher connectivity generates a higher systemic risk, not offset by a lower credit risk. To understand if different linkages in the interbank market have some effect on the real economy. One can immediately see that increasing the interbank connectivity has no effect on system growth. Companies have no benefits from a more strongly linked interbank market. In fact, it does not facilitate the granting of loans to enterprises, but it merely transfers liquidity among financial institutions.

- Agent-based modelling (ABM) can reproduce firm leverage. Leverage is a useful indicator to reproduce business cycle dynamics and to forecast recessions.
- ABM can describe, and so forecast, variations of the tradeoff between inflation and unemployment, that is, the Phillips curve.
- ABM can describe, and so forecast, the negative relationship between the output growth rate and the unemployment growth rate.
- A higher banks connectivity not only increases the agent's financial fragility, but also generates larger bankruptcy cascades due the larger systemic risk.
- High interbank linkages have no effect on economic output, even during boost/boom.
- Higher bank reserve requirements stabilize the economic system, not only by decreasing financial fragility but also dampening avalanches. However, holding in reserve a larger percentage of banks' equity somewhat affects the aggregate output growth by reducing credit to companies. Our simulation results also indicate that heterogeneity alone contributes to instability.
- Interbank lending relationships should be restricted to banks that share similar liquidity characteristics. These results may be specific to our model, but they offer stimulating insights into the nature of contagion.

WP 8: TRAJECTORIES: Modelling Micro Macro Links and Policy Implications
This Work Package reviewed and analysed financial service innovation in the light of current policy concerns about the financial crisis. More particularly, it explored 'technological trajectories' in banking and their relation to regulation.

WP 8 Summary
WP 8 aimed to improve understanding of how shifts from the current trajectory based around re-engineering the risk of default, to one that takes more account of liquidity risks will take place. This analysis integrated research on financial technology within an evolutionary framework that informs public and academic debates and the effective generation and regulation of financial innovations within Europe. There was a particular focus in the project on risk management technologies, and particularly those technologies, such as CDOs and CDSs whose collective failure helped create the recent financial crisis. WP 8 has produced a number of interesting findings and high-level policy interventions, including work that was cited in the recent Vickers Inquiry report into the regulation of the UK financial sector.

WP 8 Detailed description of work and policy implications
WP 8 explored the nature of financial innovations within large financial institutions. Its key focus was on technological trajectories within financial technologies and how financial innovation differed from traditional forms of innovation and what this meant for the social distribution of risks and rewards. The research project built on prior work on financial risk management technologies, and the potential threats that they posed to the financial system. By 2003, building on research on financial crashes, we had already noted that financial technologies were being developed that had the potential for catastrophic failure, and that the then current regulations were making that failure more likely.

One of the main results of WP 8 is that financial products are 'social' objects whose function depends, in part, upon market participants' beliefs and expectations about their status as objects of value (Nightingale and Spears, FINNOV DP 8.1). They are therefore different from traditional technologies, where functions depend largely upon their intrinsic design and 'brute' physical properties. This creates the possibility for feedback loops during which correlations can converge so that the assumptions underlying financial risk management technologies fail to hold, creating the potential for catastrophic failures. This work provides a basis for understanding the importance of regulating financial technologies themselves, as opposed to conventional forms of financial regulation that focus on incentives, information asymmetries, and capital adequacy requirements.

WP 8 also looked at how mathematical models are used in finance and their impact on social and economic relations in financial markets (Spears, FINNOV DP 8.2). Mathematical models are essential to both financial valuation and risk management. However, in certain circumstances, the use of a model by market participants can cause markets to behave in ways contrary to the model's predictions. Models are thus codified bodies of knowledge that under certain circumstances are capable of becoming "self-falsifying". Recently economists and sociologists have noted this property of financial models, yet there has been little systematic classification of social and market conditions under which models can become self-falsifying, and how these conditions interact with the technical properties of models themselves. The paper reviewed the relevant economics and sociology literature to build an initial taxonomy focusing on two broad classes of models: statistical models and arbitrage-free models.

We have also developed the empirical case study of the banking crisis and provided a theoretical focus that draws on the regulation and trajectory literatures (Nightingale and Spears, FINNOV DP 8.1). We showed, through a detailed analysis of primary and secondary sources how seemingly safe technological trajectories in finance can converge into a technology that can create substantial agency failures and incentive problems, drawing on the ideas in the second deliverable.

Relationship with WP 3
In addition WP8 team have been conducting research, related to WP 3, on how financial markets can be restructured to better support innovative firms. From this research two working papers have been produced that are due to be submitted to the Journal of Business Venturing and Research Policy when we get approval for data release from BIS:

'The UK VCT Scheme: An Evaluation' J. Siepel, G. Murray, M. Cowling and P. Nightingale. The paper evaluates the UK VCT scheme which is the largest VC support scheme in Europe and finds that it performs positively but that the extent of improvement in firm performance from funding is very small and may not be worth the considerably financial support it requires.

'From Funding Gaps to Thin Markets' P. Nightingale et al. The paper evaluates the full sample of all hybrid VC funding schemes in the UK against a control sample of 8000 matched firms. The paper finds positive evidence of improvements in performance and draws policy conclusions for the design of schemes in the future that suggest that such public support for VC investment should focus on national or European funds (not regional funds), that such funds should be large (preferably over 50-100m EUROS) and should be specialised.

- Recent suggestions that a variant of clinical trials should be adopted to test the systematic risks of financial innovations (for example by Elizabeth Warren, former head of the Consumer Financial Protection Bureau in the United States), are unlikely to be successful.
- The establishment of a particular model as a 'market standard' method of pricing risk can create destabilizing feedback loops.
- Public policy that encourages 'inbreeding' in risk management approaches may enhance rather than mitigate risk.
- Financial regulators might need to step outside of their traditional passive roles of making and enforcing market rules and ensuring disclosure, toward undertaking more active coordination between large financial services firms.
- Regulators and central banks must be attentive to the ways in which different classes of financial models can lead to market instability in order to effectively intervene where it is appropriate to do so.

Potential Impact:

FINNOV explored the link between the financial sector and the real economy, analysing to what extent financial activities promote or impede innovation and economic growth (at the firm, sector and national level).

FINNOV research has improved policy makers' understanding of the interaction between financial markets and innovation-led growth and the effect of such growth on the social distribution of risks and rewards. Given the strong negative effect of the recent financial crisis on many European economies, a central element of the FINNOV research programme was to determine how European governments and institutions can ensure that the financial system supports investment in innovation in sustainable and equitable ways. FINNOV results will help policy makers design ways to exit the crisis and create a sustainable and equitable model of economic growth in Europe (EC, 2010).

FINNOV findings suggest that EU policy makers should consider:
1. De-financialising the economy through re-regulation of finance (i.e. separate investment activity from banking activity);
2. Redirecting the financial system in the economy towards aligning its practices with real, productive economy value-creation. For example, revisit biased financial indicators, discourage short-termism, develop better tools for evaluation of financial products;
3. Embracing and fostering heterogeneity and diversity;
4. Re-invigorating demand for finance; and
5. Rejecting the 'myth of the market economy' and recognizing the important entrepreneurial role played by the State in supporting and encouraging innovation.

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