Do bank liquidity shocks hamper firms’ innovation?

This paper highlights the importance of bank-based finance for the innovation activity of UK firms. It identifies both theoretically and empirically how bank shocks affect firms’ innovation. We develop a theoretical model, and test its predictions using a new matched bank-firm-patent dataset for the UK. We find that bank distress during the 2008 and 2011 crises negatively affected firms’ innovation behavior. After carefully controlling for several potential biases in estimation we find that firms whose relationship banks were distressed not only patented less, but those patents were of lower technological value, less original and of lower quality. The negative effect is significantly larger in the case of small and medium size enterprises (SMEs). We also find that banks’ specialization in financing innovation mitigates the impact of bank distress on innovation.