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Open Access Publications from the University of California

Banking, Financial Markets and the Implications of Financial Frictions on Firm Innovation and Growth

  • Author(s): Hu, Kun
  • Advisor(s): Ohanian, Lee
  • et al.
Abstract

My thesis consists of three chapters on banking, financial markets, financial frictions and their implications on firm innovation and growth.

Chapter 1:

Much of the research has focused on how financial constraints affect a firm's R&D expenditure, but little has been focused on the type of innovation. Using matched firm-patent panel data of U.S. public firms from 1997 to 2016, Chapter 1 shows that financially constrained firms switch toward internal (improve existing products) from external (develop new product lines) innovation. For an average firm, a one standard deviation decrease in cash-flow ratio leads to a 10-p.p. decrease in the percentage of external innovation. Also, the sensitivity of external innovation to cash flows is higher during the 2007-2009 financial crisis and for firms in sectors dependent on external financing. The empirical findings are robust to various panel regression specifications. Since external and internal innovations generate different quality improvement and growth potential, the interaction between financial constraints and the type of innovation provides a new mechanism by which finance affects firm and economic growth.

Chapter 2:

The firm size-growth relation plays a central role in many economic growth studies. Empirical literature shows that this relation depends on financial market conditions: sometimes small firms grow faster, but growth rates become independent of firm size when frictions are high (Gibrat's law). In contrast to most growth models that assume a fixed size-growth relation, my framework allows it to vary with financial frictions. In the model, firms of different sizes grow by internal (improve existing products) and external (develop new products) R&D, but R&D expenditure is restricted by profits (or cash flows). This setup allows for rich interactions between size-growth relation and compositional change of R&D types in evaluating how financial frictions affect aggregate growth. The model is consistent with the fact that financially constrained firms switch to internal R&D and reduce R&D expenditure. The equilibrium is solved with neural networks. The estimated model suggests a significant drop in growth and welfare after the Great Recession. The importance of size-dependent policies that subsidize small firm R&D more than large firms is also quantified.

Chapter 3 (with TengTeng Xu and Udaibir S. Das):

We analyze how bank profitability impacts financial stability from both theoretical and empirical perspectives. We first develop a theoretical model of the relationship between bank profitability and financial stability by exploring the role of non-interest income and retail-oriented business models. We then conduct panel regression analysis to examine how the level and source of bank profitability affect risks for 431 publicly traded banks (U.S., advanced Europe, and GSIBs) from 2004 to 2017. Results reveal that profitability is negatively associated with both a bank's contribution to systemic risks and its idiosyncratic risks, and an over-reliance on non-interest income, wholesale funding and leverage is associated with higher risks. Low competition is associated with low idiosyncratic risks but high contribution to systemic risk. The paper's findings suggest that policy makers should strive to better understand the source of bank profitability, especially where there is an over-reliance on market-based non-interest income, leverage, and wholesale funding.

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