Lend me a hand—bank market power and firm creation in innovative industries

High-growth start-ups disproportionately contribute to economic growth and job creation in developed countries. Academic studies estimate that in the United States they account for about 50% of job creation. Likely, high-growth innovative young companies will play a central role in the post-COVID-19 recovery. In a context in which the pandemic fundamentally shook traditional business models, economies will need the input and flexibility of young innovative start-ups. Among developed countries, there is a significant degree of heterogeneity in the contribution and success of start-ups. Although we are all well aware of success stories from Silicon Valley or Israel, the so-called start-up nation, European start-ups, albeit notable exceptions, face significant hurdles.

To address these problems, most governments of European countries have implemented ambitious policies. The majority of such government inventions are centred around two pillars: on the one hand, they aim at reducing the stigma of failure and cost of experimentation for the entrepreneur; on the other hand, they try to ease the financial constraints of young firms, facilitating their access to external capital. To date, such policy stimuli have yielded mixed results, and we know little about what affects the success of these policies. 

In a recent working paper titled “Lend Me a Hand — Bank Market Power and Innovative Firm Creation,” I study the importance of bank market power and lack of banking competition. Stemming from a stylized theoretical framework, I predict that bank market power could discourage potential entrepreneurs from entering the market, in fear of not being able to secure funding.  As a result, policy stimulus aimed at fostering firm creation of innovative firms is deemed to fail.

To test this prediction, I study the Italian setting. Back in late 2012, the Italian government launched the Start-Up Italy Act (SIA). SIA, which was rolled over in subsequent years, is aimed at young innovative firms. It exempts entrepreneurs of qualifying innovative start-ups from red tape, stringent employment law, and failure procedures. Furthermore, SIA allows for tax deductibility of equity investments in qualifying start-ups, and it gives them preferential access to the Public Guarantee Fund. The latter allows qualifying start-ups to obtain public guarantees on their bank debt, for up to 80% of the loan, and it is meant to help young innovative firms obtain access to finance in a bank-centric system, like the Italian one.

In the paper, I document that SIA has been so far a very successful policy. Following the launch of the program, firm entry rates in innovative industries increased by 50%, meaning that the number of firms created in a quarter in innovative industries grew by 30%. To estimate the effect of the policy, I compare firm creation rates in industries in which qualifying start-ups are more likely to be active (that is, innovative industries, like ICT and R&D), and in industries where qualifying start-ups are less likely to be active (that is, non-innovative industries, like construction or retail trade), before and after the launch of SIA (a difference-in-differences approach). In this way, I can account for changes in the business cycles, as well as local and industry-specific differences.

Figure 1. Difference in firm creation between innovative and non-innovative industries, before and after SIA (red vertical line)

Next, I proceed to estimate the effect of bank market power on the success of the policy. To measure bank market power in each of the over 100 Italian provinces, I develop a new measure, the Return Distance. The return distance measures the difference between the actual average rate of return of short-term loans in a province and the average rate of return as implied by the average delinquency rate of short-term loans (what banks should charge to be compensated for the risk of the average firm not repaying the loan). The advantage of my measure, which correlates well with other more classical measures of banking competition, is that it is simple and requires little data to be calculated.

Figure 2. Difference in firm creation between innovative and non-innovative industries, before and after SIA (red vertical line), in competitive and uncompetitive provinces

Using my measure of bank market power at the local level, I divide the Italian provinces in two groups, competitive and non-competitive provinces. I then compare firm entry rates in innovative and non-innovative industries, before and after the launch of SIA, in competitive and non-competitive provinces (a difference-in-difference-in-differences design). What I find is that firm creation in innovative industries grew (compared with firm creation in non-innovative industries) much less in provinces with less competitive banking sectors (that is, higher bank market power). I find that SIA’s effect in fostering innovative firm creation is more than halved in less competitive provinces.  Furthermore, as the theoretical framework suggests, I find that in non-competitive provinces, guaranteed lending to firms in innovative industries, which should be fostered by SIA, grew less. This suggests that the channel through which bank market power affects firm creation, especially of innovative firms, is indeed that of banks extending less credit, even in the presence of public guarantees. 

My paper shows that there are many factors that a government should take into account in designing policies for young innovative firms. Among them, bank market power seems to have a prominent role, as in the presence of bank market power, innovative entrepreneurs are less likely to be funded. Therefore, even when properly addressing problems like red tape or stigma of failure, it remains difficult to push potential entrepreneurs into innovative firm creation if they expect not to be funded. Building on these findings, the next step on the research agenda will be to understand how banking competition and bank market power affect the venture capital industry through this effect on venture capital’s investment opportunity set.