Capital requirements as innovation catalysts
Walter Beckert, Peter Eccles, and Paolo Siciliani analyze whether imposing minimum capital requirements on banks helps or hinders their incentive to invest in process innovation. The authors develop a model that features banks competing for insured deposits by setting deposit interest rates, choosing between a “prudent” safe asset and a “gambling” risky asset, and holding equity capital at an opportunity cost.
The authors’ key addition is a cost-reduction parameter representing process innovation: banks can pay a one-time sunk cost upfront to permanently reduce their variable operating costs each period, regardless of whether they invest prudently or riskily. The model then derives comparative statics to examine how this innovation parameter interacts with the optimal minimum capital requirement under differentiated Bertrand competition for deposits.
Findings
- Process innovation makes banks less tempted to gamble.
When a bank invests in cost-reducing technology for example, a better digital platform or AI-driven back-office system, it expects to reap those efficiency gains period after period into the future. But it can only do so if it stays solvent. This gives the bank a stronger reason to behave prudently: the future payoff from innovation is simply too valuable to risk losing through excessive risk-taking. - Capital requirements work better when banks innovate.
The effectiveness of capital regulation depends on how much banks care about their future earnings i.e. their “franchise value.” Process innovation raises that franchise value specifically under prudent behavior, meaning banks become more sensitive to the threat of losing it. This makes capital requirements a more potent deterrent against gambling, extending the range of conditions under which they successfully curb moral hazard. - Innovation can actually reduce the amount of capital regulators need to require.
Because process innovation increases the value of acting prudently by more than it increases the value of gambling, banks need less of a capital “skin-in-the-game” nudge to choose safe behavior. The regulator can therefore set a lower minimum capital requirement and still achieve the same disciplining effect — but only when deposit market competition is not too fierce. - The complementarity breaks down under intense competition.
If banks compete very aggressively for deposits, the gains from innovation can be dissipated through a race to offer higher deposit rates, eroding charter value and restoring the temptation to gamble. - Innovation signals prudence.
Because investing in process innovation is costly upfront and only pays off over a long horizon, it acts as a credible signal that bank management is oriented toward the long run. This can help depositors and markets distinguish well-run, prudent banks from those more inclined to take short-term risks.
Capital requirements and process innovation
Authors: Walter Beckert, Peter Eccles, Paolo Siciliani
From: Bank of England
Zombie credit and missing innovators
Does weakening financial discipline, by making it easier for firms to obtain refinancing even when their projects are unlikely to succeed, help or hurt aggregate innovation? This is the question Philippe Aghion, Antonin Bergeaud, Mathias Dewatripont, and Johannes Matt analyze in this paper.
The authors build a Schumpeterian growth model where firms compete for scarce research labor and differ in their innovation speed: fast firms complete projects unaided, while slow firms need mid-project refinancing. Because lenders cannot commit upfront to refusing that refinancing, a Soft Budget Constraint syndrome emerges where weak firms keep getting funded even when they shouldn’t. In general equilibrium, this crowds out entry by more efficient innovators through a wage competition effect. The model is calibrated to French firm-level data and a counterfactual simulation asks how much of the observed post-2008 growth slowdown is explained by the fall in refinancing costs.
Findings
- Financial discipline determines who innovates, not just how much.
When lenders are strict i.e. willing to cut off slow firms at the refinancing stage, those firms exit and free up research labor. This labor flows to fast-type entrants, who are more efficient innovators. Lax discipline does the opposite: it keeps slow incumbents artificially alive, soaking up the very resources that would have fueled the next generation of innovators. - Easy credit after the GFC was a failure of financial discipline.
The post-2008 decline in interest rates reduced the cost of refinancing slow incumbent firms by approximately 45%. This was not just a macroeconomic shock, it was a systematic weakening of the selection mechanism that normally filters out less efficient innovators. The model replicates 54% of France’s observed post-crisis growth slowdown through this channel alone. - The crowding-out of entrants was the dominant effect.
The weakening of financial discipline had two opposing effects: it helped some slow incumbents eventually complete their innovations (positive), but it drove up research wages and made entry unprofitable for fast-type firms (negative). The negative effect overwhelmingly dominated as entry rates fell 61% relative to the pre-crisis steady state, cutting annual growth by 0.23 percentage points, while the gains from incumbent innovation added back only a fraction of that. - Lax discipline produces an economy of large, slow incumbents.
As financial discipline weakens, the firm size distribution shifts: fewer small, young, fast-growing entrants and more large, entrenched incumbents dependent on continued refinancing i.e. the “zombie firms” documented in Japan, Portugal, and post-GFC Europe. This is not just inefficient; it is self-reinforcing, as large incumbents further crowd the labor market and raise barriers to entry. - There is an optimal level of financial discipline.
The relationship between refinancing stringency and growth is hump-shaped. Some refinancing of slow firms is socially valuable, as it allows projects with a genuine chance of success to be completed. The damage comes from excessive softness: refinancing projects whose expected value is negative simply because the lender cannot credibly walk away.
Firm Dynamics and Growth with Soft Budget Constraints
Authors: Philippe Aghion, Antonin Bergeaud, Mathias Dewatripont, Johannes Matt
From: Collège de France, HEC Paris, Université Libre de Bruxelles, London School of Economics
