Economic Theory

How bank shocks affect the innovation activity of UK firms

Innovation levels and the Research and Development (R&D) efforts which underpin them in UK firms are integral to economic growth prospects.  In a recent article with colleagues I have been looking at what happened to UK firms’ innovation during and after the Great Recession, which started in 2008.

Specifically, by looking at how patent volume, quality and value in a representative sample of all UK innovating firms were affected during the crisis, conditional on the level of bank distress of their main banking partners, we can understand the ways in which the health of the financial system may affect UK firms.

The implication of our approach and our subsequent findings is that a “bank lending channel” was operative in the UK and the restriction of credit flows from UK-based distressed banks (whether domestic or foreign), had material impacts on the patenting activity and patent quality of these key UK companies.

We approached the research problem by using data on UK banks’ distress levels using patenting firms’ balance sheet data and patenting information. We were also careful to control for the effects of the fall in demand and other sources of endogeneity in our results – which would also produce lower innovation levels.

Having isolated the effects from the banking sector distress alone, the interesting result is that large firms were hardly affected at all by their bank’s distress level. The explanation for this result appears to be related to larger firms having access to other sources of finance during a time when bank lending is restricted. This could be either from internal funds or via access to capital markets, or both.

When we looked at SMEs the picture was very different. As SMEs account for a significant fraction of patenting in the UK and have less access to alternative sources of finance, this area was of great interest.

Overall SME innovation fell conditional on the level of bank distress in their main bank lender. By digging further, however, we find that when a bank specialising in lending to patenting firms (i.e. those banks with lending highly concentrated in patenting firms) became distressed, no discernible negative effect on patenting was present.

The corollary to this is that when non-patent-focused banks became distressed, there were substantial negative effects on their client firms. The results suggest a problem of information asymmetry: where non-specialist lenders are themselves distressed, they are likely to withdraw funds from SMEs whose assets cannot be valued accurately.

These results indicate that a previously under-researched source of distress in the innovative behaviour in UK firms may be quite significant, and could have implications for innovation in the UK and its productivity challenges.

There are two policy implications. The first, that credit to SMEs is an important factor in the UK’s ability to innovate successfully and second, that patent-focused specialised lending to SMEs may provide powerful mitigation of such effects. Policy-makers need to ensure that they take this into account when designing regulation of different parts of the financial sector, rather than insisting that one size fits all.


 Dr Ali Kabiri is Head of the Department of Economics and International Studies at the University of Buckingham


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