04 March 2019

VoxEU: Trade and innovation: The Schumpeterian role of banks

Only strong banks can fulfil their Schumpeterian role by efficiently reallocating credit. The column argues that high capital standards, efficient bankruptcy laws, and a lower cost of bank equity improve credit reallocation and thereby support the productive specialisation of the economy. An efficient banking sector also magnifies the gains from trade liberalisation by easing the process of capital reallocation.

Authors analysis has four main results:

• More efficient insolvency laws help banks to extract more capital when liquidating non-performing loans. This creates an incentive to reallocate credit and shifts final investment and output to more profitable firms in the expanding sector, thereby facilitating specialisation in this sector.
• Tighter capital standards boosts credit reallocation. When the regulatory capital ratio is high, banks can more easily absorb loan write-offs and, in consequence, can liquidate non-performing loans more frequently. By speeding up credit reallocation, strong banks shape comparative advantage by shifting investment and output to more innovative firms with better prospects.
• Institutional reforms can make bank equity cheaper relative to debt (deposit) financing. The reforms include better investor protection, or corporate tax reform. Tax reform could eliminate the debt bias by introducing a tax deduction for the notional interest on equity capital. When equity becomes relatively cheaper, banks choose larger voluntary capital buffers. Schepens (2016) found that Belgian banks raised their equity ratios by about 13% compared to other European banks after Belgium introduced a tax deduction like this. With larger buffers, banks can absorb liquidation losses more easily without violating regulatory standards, and accordingly liquidate and reallocate more aggressively. Regulatory and institutional reform can ease the process of creative destruction and help to establish a comparative advantage in innovative industries. Authors also consider reverse causation, and analyse the consequences of a trade liberalisation scenario, which facilitates specialisation by accelerating reallocation and encouraging entry and exit.
• A strong banking sector magnifies the gains from trade liberalisation. It supports the process of credit reallocation from declining to expanding firms, and so facilitates the productive specialisation of the economy.

Authors believe that free trade can yield larger benefits if complementary policies can ease the process of factor reallocation and structural change.

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