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DoesBankingCompetitionAffectInnovation?[e-mail](812)[e-mail](812)[e-mail](812)[e-mail][phone]ThisVersion:August2013 *Wethankananonymousreferee,MatthewBillett,AlexanderBorisov,MichaelFuerst,PhilipStrahan,BillSchwert(theeditor),JasonSturgess,KrishnamurtySubramanian,GregoryUdell,andseminarandconferenceparticipantsatIndianaUniversity,the2013WesternFinanceAssociationmeetings,andthe2012FinancialManagementAssociationmeetingsforhelpfulcomments.Allerrorsbelongtotheauthors.  DoesBankingCompetitionAffectInnovation?AbstractWeexploitthederegulationofinterstatebankbranchinglawstotestwhetherbankingcompetitionaffectsinnovation.Wefindrobustevidencethatbankingcompetitionreducesstate-levelinnovationbypubliccorporationsheadquarteredwithinderegulatingstates.Innovationincreasesamongprivatefirmsthataredependentonexternalfinanceandthathavelimitedaccesstocreditfromlocalbanks.Wearguethatbankingcompetitionenablessmall,innovativefirmstosecurefinancinginsteadofbeingacquiredbypubliccorporations.Therefore,bankingcompetitionreducesthesupplyofinnovativetargets,whichreducestheportionofstate-levelinnovationattributabletopubliccorporations.Overall,theseresultsshedlightontherealeffectsofbankingcompetitionandthedeterminantsofinnovation.JELclassifications:G21,G28,G34,O16,O31Keywords:Bankingcompetition,Innovation,Accesstofinance,Externalfinancedependence,Mergersandacquisitions,Economicgrowth1 1.IntroductionWhatdrivesinnovation?Understandingthedeterminantsofinnovationisimportantbecauseinnovationsestablishcompanies’competitiveadvantages(Porter,1992)andareimportantdriversofeconomicgrowth(Solow,1957).Agrowingliteraturetakesupthistask,documentingpositiveandnegativeempiricallinksbetweeninnovationandvariouscompanyandmarketcharacteristics.However,thisliteraturecontainsfewempiricalstudiesexaminingthelinkbetweencapitalmarketdevelopmentandinnovationoutput.Wecontributetothisnascentliteraturebyexaminingtheeffectsofstate-levelbankingcompetitiononinnovation.Amajorchallengefacingtheempiricalinnovationliteratureisthatinnovationislikelyendogenouswithcompanyandmarketcharacteristics,includingstate-levelbankingcompetition.Thus,acorrelationbetweenbankingcompetitionandinnovationmaytelluslittleaboutthecausaleffectofbankingcompetitiononinnovation.WealleviateendogeneityconcernsbyexploitingthestaggeredderegulationofinterstatebankbranchinglawsintheUnitedStates.TheU.S.CongresspassedtheInterstateBankingandBranchingEfficiencyAct(IBBEA)in1994.Inadditiontoallowingunrestrictedinterstatebanking,theIBBEAlegalizedinterstatebranchingacrosstheU.S.startingin1997.AsRiceandStrahan(2010)explain,“AllowinginterstatebranchingwasthewatershedeventofIBBEA”(page861).RiceandStrahanshowthat,whenstatesrelaxbankbranchingrestrictions,morebankbranchesopenandcompetewithoneanother.Thisincreaseincompetitionexpandstheavailabilityofcreditwithinastateandlowersthecostofcapitaltherein.Weconstructtestsusingthesederegulatoryeventsasplausiblyexogenousincreasesinthesupplyofstate-levelfinance.GiventheeconomiceffectsdocumentedbyRiceandStrahan(2010),weexpectstate-levelinnovationtoincreasefollowingderegulationbecausecompaniesheadquarteredwithinderegulatingstatescouldtakeadvantageofthegreatersupplyoffinancetoincreaseinnovationoutput.Surprisingly,however,wefindrobustevidencethatincreasesinbankingcompetitioncausestates’innovationoutputstodecline.Wefindthatstatesthatarecompletelyopentointerstatebranchinggenerateatotalof30.8%fewerpatents(i.e.,920fewerpatents)threeyearsafterbranchingderegulationthanstateswiththemostrestrictionsoninterstatebranching.Wefindasimilarresultwhenweusepatentcitationsasaproxyforinnovation:Statesthatarecompletelyopentointerstatebranchinggeneratepatentsthatreceiveatotalof23.2%fewercitations(i.e.,9,068fewercitations)threeyearsafterbranching2 deregulationthanstateswiththemostrestrictionsoninterstatebranching.Theseresultsarerobusttocontrollingforstate-levelandstate-industry-levellaborforceconcentration,bankingderegulatoryeventsthatprecedeIBBEA,statefixedeffects,andyearfixedeffects.Togainaclearerunderstandingofthisresult,wedecomposestate-levelpatentsintopatentsproducedbypubliccorporationsandprivatefirms.1Privatefirmscouldbemoresensitivetolocalbankingconditionsthanpubliccorporations,sotheeffectsofstate-levelbankingcompetitioncouldbedifferentforthesetwogroups.Indeed,wefindtheoverallnegativeeffectofderegulatoryeventsonstate-levelinnovationisdrivenbycorporationsheadquarteredwithinderegulatingstates.Incontrast,relativetocorporations,privatefirmsexperienceincreasesininnovationoutputfollowingderegulatoryevents.(Wefindnodirecteffectofderegulationonprivatefirms’innovationoutputs.)Thesefindingssupportthenotionthatsmall,privatefirmstakeadvantageoftheimprovedcreditconditionstofinanceinnovativeprojects.Althoughthestaggeredderegulationofinterstateba