FINANCIAL MARKETS

Research Paper

Financial markets

Course/Unit code Assignment Assignment Course/Unit name

number due date

BAFI 3182 3 14/09/2018 Financial Markets

Student Name Student ID

Luong Vien Tai S3651323

Lecturer/Teacher’s name Tutor / Marker’s name (if applicable)

Jain Upasana
Table of Contents

Abstract.................................................................................................................................................1

Introduction...........................................................................................................................................1

Global financial crisis in 2008.................................................................................................................2

Difficulty to finance R&D by innovative firms.......................................................................................3

Financing restrictions of banks................................................................................................................3

Binding credit constraint..........................................................................................................................4

Conclusion..............................................................................................................................................4

Limitations..............................................................................................................................................5

References.............................................................................................................................................6
Abstract

The purpose of this paper is to investigate the impact of financial crisis on the relationship between banks
and innovative firms. Focusing on R&D activities to introduce different kind of new products is the main
purpose for innovative firms. The Lehman Brothers bankruptcy was used as an example among banks to
identify the consequence of the financial crisis, the collapse of the Lehman’s is particular focus on its use
of Repo transactions. This Repo transactions has taken in depth to have a better understanding about the
causes of the recession and how its effect financial system until now. The study concludes that innovative
firms are likely to suffer due to mistrust of banks to innovators after the crisis which creates credit
constraints model to apply.

Keywords: Financial crisis, bankruptcy, repurchase agreements (repo), innovation firms, credit
constraints, Basel Accord

Introduction

Research and Development (R&D) activities are playing an important role of sustained economic growth
and development. Nowadays, many businesses are trying to achieve competitive advantage, however, it is
not enough for businesses to mainly rely on their core competencies. Improvements need to be made in
order to maintain an edge on the competition and have a stable position in the marketplace. The best way
to achieve this goal is focusing on creating innovations (Gerguri 2010).

Innovations usually comes with the word ‘New’, it is a process of creating new product or service, new
technologies or method of production. In addition, innovations not only increase consumer surplus but
also improve the quality standard as well as reduce the costs, these would be beneficial to firm and bring
advantage over rivals (Gerguri 2010). Even though, there are opportunities that help businesses to
increase their revenue, risks are also available which is unable to avoid. Financing of innovations is
always a difficulty faced by organizations, as mainly rely on internal source of financing is insufficient to
run the whole process due to high salary of employees. Hence, external resources are needed and the risk
exists when banks are concerning about the success of the R&D project and uncertainty with respect to
the acceptance level of the new product in the marketplace.

Although the global financial crisis occurred in 2008, this event has affected deeply to the financial
markets. The crisis not only brought many banks to bankruptcy, especially the collapse of Lehman
Brothers but also create mistrust between innovators and banks as money lenders. After the crisis, many
banks have forced themselves to change the financial system by improving risk control and stricter
regulations concerning equity. These changes has made innovative firms to suffer from shortage of capital
as it would be more difficult to borrow money from banks due to interest rate would be higher and even
higher barriers when considering innovative firms with risky activities.

The aim of this report is to show how the global financial crisis has impacted on the relationship between
innovative firms and banks. The analysis has made to see whether banks are supporting risky activities
from innovative firms or mainly support on non-innovative firms. Furthermore, deeper research have
taken to see how innovative firms finance their R&D and investigate whether they are relying more on
internal or external sources of finance.

Global financial crisis in 2008

Global financial crisis occurs during the period of 2007-09 and it has spread across the world which
affected on both developed and developing countries. The financial crisis not only affected on
macroeconomic factors but microeconomic factors as well, this crisis began with the United States when
the house price bubbles and risky mortgages, it comes to the end when Federal Reserve raised the interest
rate. House price started to decline sharply which caused people mortgages balance to exceed the value of
the homes (Agbetsiafa 2011).

As the housing price bubble burst, this has directly affect on the investment bank Lehman Brothers and
led to bankruptcy due to poor decision making. At the time of 2006, the balance sheet of Lehman
Brothers increased significantly with many long-term investments through short-term borrowing, these
assets also included mortgage-back securities. In the following year, Lehman Brother decided to continue
taking the risk with aggressive growth despite mortgage securities started to show problems. Because of
ignoring current risk and taking more risks, all of their assets could not be sold when the crisis happened
(Hines et al. 2011).

Repurchase agreement (Repo) is a common financing tool used not only by Lehman but also other
investment banks. Repo is a contract between two parties, one is buyer and one is seller where one party
will buy assets from the other party and then resell it to the seller at a given period of time with a certain
maturity. The transaction involves immediate payment, financial instruments and securities, when using
this type of financing, all collateralized assets and other related obligation of the firms get funded will be
remained on the balance sheet (Florea 2014). At the time of financial crisis, there are lots of firms
borrowing the funds under repo agreements with short term financing. Once the assets started to devalue,
hence credit crunch occurred. When borrowers unable to repay the loans which results in the increment of
bad debt, therefore this caused many banks become insolvent.
The impact of recent financial crisis on innovation firms access to external finance

Difficulty to finance R&D by innovative firms

There are two sources of financing R&D which are internal and external. The major open self-financing is
reinvestment of profit, this also known as retained profit, many big firms often have 25 percent from the
revenue remains as a turnover (Bazilinska 2008). Other internal sources includes sale of assets or
reduction in working capital, these sources can work as both short and long term finance which could be
beneficial to the firm. In reverse, the most common form of external source is bank loan which is
preferred by many businesses.

Investment in innovation is unlike other type of investments and there are three main factors that show the
difference. Firstly, expenditure for R&D is like an investment in human capital as mostly is spent on
highly educated staff. Therefore, it can be said that the success of a particular innovative firm is mainly
based on experienced people. Secondly, all the fund in R&D cannot be used as collateral value. Last is
about the interest rate, in order to be successful, R&D project require a large amount of fund which is
commonly funded by the bank and there will not be a thing of large funding with low interest rate,
therefore the higher the risk, the higher interest rate.

Raising funds for innovative firms is always challenging and the near-collapse of the financial system
even brings more difficulty which led to credit to businesses more tightened. Innovative firms can raise
funds using their intellectual property and other intangible assets, because firms can easily get funded
using the intellectual property they owned through sales or licensing. However, it would create upfront
cash and future revenue stream for the organization therefore this method not considering as top priority
(Jarboe 2010). Hence, debt financing is taken into consideration by innovative firms to fund R&D project
with the asset is pledged as collateral.

Financing restrictions of banks

During the global recession in 2008, the collapse of Lehman Brothers has marked as an important event
which made many banks financial system to reform. The entire bank industry was affected as they afraid
that giving out loans is risky and could not be paid back in a given time (Bartmann 2017). The crisis has
created mistrust between banks which has made banks implemented a stricter risk management, this could
help banks to avoid losses from defaults after mistakes have been made from the crisis. In addition, due to
the breakdown of the interbanking market led to many organizations to reduce their creditworthy level by
banks (Giebel 2015). Related to innovative firms, this is a huge disadvantage as they are relied heavily on
this external source of finance.

This stricter risk management was induced by the Basel Accord II, this regulation was issued by Basel
Committee on Banking Supervision with the aim of setting capital standard for banks to follow in order to
prevent insolvent (Giebel 2015). The whole purpose of Basel Accord II is to protect international
financial system and its support risk management system for banks in order to overcome insufficient
capital funds to cover liabilities (Kuvalekar 2017). Fears of financial instability of banks never seem to be
away as they have experienced insufficient capital to cover its liabilities, this occurs when borrowers are
unable to pay back their loans. A loan is an asset of a bank and it gives the bank a claim over borrowers
as they can make money from interest received but once it is unpayable, banks will suffer from loss on its
asset and that is one of the risks that bank exposes itself to through trading activities. In addition, solution
for this problem after Basel II brought into effect is risk models. This model can help banks to measure a
firm’s market risks and rating each individual firm by scoring them with the (credibility) level (Herr
2016). Furthermore, banks will likely to have low risk-weighted value when making less risky loans or
investments; however, this seems not to apply the same way for innovative firms as they are running risky
activities with high chance of default. Therefore, lead to credit constraint model to apply.

Binding credit constraint

Credit constraint is applied to measure a particular firm is an innovative firm or a non-innovative firm and
also identifies innovative activities run by the company as well as the way they use the fund for the
project. There is a specific type of equation use to measure the credit constraint by banks. Moreover,
bereft of internal funds has made many innovators to discontinue their R&D activities, hence making
them to raise funds in the capital market where they will face financing constraints. In addition, provide
collateral assets when borrowing is necessary as they way for lenders to secure the loan, however R&D
cannot act as viable collateral which makes innovators to encounter binding financing constraints. This
model has forced many innovators to postpone their projects or even abandon altogether which has a
direct effect to the growth of the economy (Leitner 2016).

Conclusion

In today’s fast moving and unpredictable business environment, innovative activities are becoming more
important to help increase in competitive advantage in order to survive in the marketplace. Unfortunately,
barriers between banks and innovators create difficulty for firms’ access to the external source of finance.
The restrictions began after the financial crisis which has negatively impact on different banks and bring
challenges for companies with respect to borrowing. The investment bank Lehman Brothers is a lesson
for other banks to learn, hence stricter regulations have applied and financial system has reformed. These
have made innovators to encounter binding credit constraints which postponed all R&D projects when
internal source of finance is insufficient.

Limitations

Our study has a set of limitations. First, our analysis was not broad enough and materials used are less
than ideal. In depth research about non-innovative firms should be taken into analysis in order to know
how banks treat non-innovative firms differently from innovative firms. The future studies should take
non-innovative firms into discussion rather than just focus on innovators. Second, only take Lehman
Brother investment bank bankruptcy as an example without considering any collapse of companies after
financial crisis was not enough. Therefore, in future studies researchers could make an analysis of the
trust from innovative firms to banks after the crisis instead of just one way around in this report.
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