Banks, venture capitalists and low innovation traps (joint with Javier Suarez, Cemfi)

Abstract:

We analyze how competition between banks and venture capitalists affects young firms’ access to credit and their incentives to innovate. Banks’ long-term funding arrangements provide lending insurance to firms, facilitating the scale-up of moderate-potential firms with limited pledgeable income. Venture capitalists can early identify high-potential firms, cream skimming them from the pool of bank-funded firms while also improving the return to entrepreneurial innovation. The competitive equilibrium is generally constrained inefficient as no financier internalizes the effect of its funding on the balance between the benefits from funding insurance and its impact on the incentives to innovate. Strategic complementarities due to the presence of lending insurance can cause multiplicity of equilibria. When venture capitalists ability to identify innovative projects is limited, subsidizing their funding to firms with taxes on banks leads to constrained efficient outcomes and can eliminate self-fulfilling equilibria with low innovation. The analysis has implications for economies such as the European Union that lag behind the US in terms of both innovation and funding opportunities for rising stars.