Why is this bad for Europe? Because it creates staggering costs for society. Here’s what our studies found:
- Firms that were more leveraged before the financial crisis had it tougher in the lean years, and will have it tougher when the next crisis comes around;
- Bank debt is not suited to finance intangible investment and innovation. Banks like collateral. They are not keen to provide debt financing for the acquisition of the intangible assets that are so important to innovation. Our analysis shows that firms with more diversified financing (e.g. trade credit, bank financing, grants and equity financing) invest more in intangibles and in innovation;
- Innovation is also about taking risks, which is why equity finance is so important, and why debt, which needs stable returns, isn’t so good. Our analysis also shows that Europe lags behind the US when it comes to leading innovators, particularly among small and young firms. Less effective growth finance might be one of the causes.
So in practice, does bank debt just feel right?
In our experiment, firms picked the debt offer in 80% of all presented options. The experiment, detailed in the European Investment Bank’s annual Investment Report, helps explain the large share of debt financing in Europe, also by pointing to a lack of demand for equity.
This aversion to equity financing was not explained by any other variable that we controlled for. It cannot easily be explained by economic theories. But we have some ideas about what can be done to improve the situation.
What can be done?
First, European regulators should level the playing field for equity financing. Interest rates on debt financing are usually tax deductible. Profits are taxed, and so are dividends on equity.
Second, we need to move forward with the Capital Markets Union to create a true single market and a cross-border European market. In this, we especially need to prioritise private equity and venture capital investment. Extensive bank financing is currently crowding out equity financing – and in the process, crowding out companies that would benefit from more equity financing. Naturally, public listings for equity are important as well, but less practical for smaller firms, which are slightly more enthusiastic towards equity financing.
Only if these measures are taken will firms change their approach. That’s the best way forward for European innovation finance.