Corporate innovation is essential for a myriad of reasons, including changing customer needs, differentiation from competitors, need for improvement and growth. Deloitte believes that about two-thirds of the companies innovate to differentiate themselves from competitors, while half innovate to satisfy growing customer needs.
“(Innovation) is a key driver of economic development at the country level as well as corporate growth, competitiveness and eventually business success,” says Connie X. Mao, professor of finance at the Fox School.
Her recent research demonstrates how bank geographic diversification impacts corporate innovation. “I wanted to try to understand what the determinants of a corporation are and how government regulations either spur or hinder corporate innovation,” she says.
In the late 1980s and 1990s, state legislatures passed several acts allowing bank holding companies to acquire out-of-state banks. Such deregulation permitted banks to diversify business geographically. Customers now had more options to satisfy their financial needs, thus leading to increased competition among banks in the financial industry.
But how does this impact the way firms borrow money from these banks?
Mao investigates two specific channels deregulated banks employ that spurs growth in borrowing firms: availability of cash loaned for investments (supply of capital) and restrictions placed on capital supplied (debt covenants).
Banks are afraid of taking excessive risks, so they enforce debt covenants in loan contracts like restricting how much firms can invest and how much a borrowing company should rely on its debt versus wholly-owned funds to finance its operations.
“However, this is not doing firms any favors,” explains Mao. “With tighter debt covenants, firms find themselves restricted to pursue potentially profitable endeavors in the long run.”
When banks relax debt covenants and increase available capital, borrowing firms have more money, fewer restrictions and greater control over operational flexibility. Firms then can easily borrow money to try and test new product ideas without worrying about financial constraints.
Mao believes that relaxing debt covenants is beneficial not only to borrowing firms but also to lending financial institutions. She says, “When banks provide loans with more friendly debt covenants, they generally charge a higher rate of interest than they would charge on loans with stricter covenant terms, thus making (the banks) more money.”
Offering lenient terms of financing to firms comes with a risk of default. However, Mao’s study finds that banks are usually able to mitigate that risk. “When banks are geographically diversified, their risk is diversified as well. They become more tolerable to taking risks,” she
says.
Her research finds that deregulation is especially helpful for firms engaging in mergers and acquisitions since tighter debt covenants restrict a firm’s capability to invest freely. However, this puts smaller firms at risk of takeovers by public companies.
Being acquired by a bigger firm might not necessarily be a bad thing. Mao believes that interstate banking deregulations exert less influence over financial decisions of smaller, private borrowing firms, thus encouraging the growth of new ideas and enhancing product innovation.
This research is of significance to state and federal regulators who wish to understand more about how deregulation affects industries. Interstate banking deregulations were implemented as a way to enhance competition among banks and ultimately benefit consumers.
“Any regulation proposed usually takes several years to implement,” says Mao. In other words, the effects of these regulations were not evident immediately when these acts were passed by state legislatures.
“An increase in competition among banks and an increase in capital supply are good things and what state regulators intended,” says Mao. “But (the fact) that these regulations would push banks to eventually encourage corporate innovation was an unintended yet welcome consequence.”