An Incomplete Contracts Approach To Bank Structure And Firm Innovation

Innovation-driven strategy is the top priority of China's economy development, since the factor-driven approach by which China has enjoyed nearly four-decade high growth has been identified unsustainable. In 2014, firms have contributed 84.2% of growth of total R&D expense, which is a manifestation of its role as a major market player. Financing constraint has been the significant factor impeding firm's innovation. The improvement of financial structure which will ease the financing constraint of firm's innovation is a dynamic progress, while, in the context of bank-based financial system, China's effort to improve the innovation financing support provided by banking system is regarded as a priority and improvement.This paper examines the respective impact of market structure and ownership structure on firm's innovation input (R&D expense), and correspondingly figures out the direction of banking industry reform from market structure and ownership structure. It is organized as follows:part one is introduction; part two is literature review; part three is theoretic analysis; part four, five and six are empirical analyses; part seven is conclusion.This paper makes use of incomplete contract theory to develop a theoretic model to explain the mechanism how bank structure affects firm's innovation, In the paradigm of incomplete contract, it examines how bank can obtain innovation surplus from firms. This paper uses finance data of 126 commercial banks, from 2007-2014, to measure the market structure and ownership structure at the provincial level. It uses system GMM to measure respectively the impacts of market structure and ownership structure on listed firm's innovation input with a panel of listed firms in China, and therefore to explore the impacts of different levels of market competition and government ownership in banking system on various firm's innovation inputs.This paper offers the following four conclusions:(1) Incomplete contracts theory presents a new approach to explain the relation between bank structure and firm's innovation investment. In the bank-based financial system, bank as a creditor will receive control rights in an incomplete contracting setting. The bank with market power will obtain innovation surplus by holding up the firm in the renegotiation. Market power, both the measure of market structure in the form of competition and ownership structure in the form of concentration ratio, and the implicit collateral provided by government are the major determinants of the expected return of the innovating firm and the bank.(2) From 2007 to 2014, the provincial banking markets present a state of monopolistic competition with increasing competition, and the interest rate liberalization significantly improves the competition. The government ownership of banking system is decreasing at provincial level, and those of the eastern regions are significantly lower than the mid-western regions. The government ownership of banking system is positively correlated with banking competition, which is enlarged by interest rate liberalization.(3) The effect of bank market structure on firm's innovation investment is consistent with the information hypothesis of incomplete contracts setting. Firm's propensity to innovate increases with bank's market power, as well as bank's expected return on firm's innovation. In the bank-based financial system, with the rapid economic growth, the access to credit for firm innovation can decrease when bank competition is harsher. In a concentrated banking market, the bank with market power will significantly increase the innovation inputs of private firms and high-tech firms. In a competitive banking market, bank's long-term loan is positively correlated with non-high-tech firms' innovation input, which implies that bank competition increase the access to loan for the innovation investment of non-high-tech firms.(4) The implicit collateral provided by the government to state-owned enterprises will improve the innovation level and expected innovation return, and hence the access to credit for state-owned enterprises' innovation is determined by the type of implicit collateral provided by the government. State-owned banks have a preference for funding state-owned enterprises' innovation. With the high government ownership of banking system, state-owned banks can obtain higher expected return when funding the innovations of state-owned enterprises. Low level of government ownership of banks will facilitate the innovation investment in non-high-tech firms. High level of government ownership of banks will crowd out the innovation investment in large SOEs.The conclusions highlight the policy suggestions designated to improve the following four aspects:(1) The improvement of market structure should be the direction of the ongoing banking system reform. In the bank-based financial system, increased competition will reduce the access to credit for firm's innovation. (2) The improvement of contestability of banking market should be the key sector of banking system reform. Supply-side reform should be conducted to remove both economic and legal barriers of banking market entry and exit mechanism. (3) The differentiated policy to abolish implicit collateral provided to SOEs and increase the specific credit access to high-tech SOEs should be the policy selection of the ongoing banking system reform. (4) The strengthening of creditor rights by improving the related institutions should be undertaken to enforce the discretionary transfer of control rights which will increase the bank's role in the corporate governance in the form of exercising control rights in the renegotiation.