Innovation often results from multiple factors coming together to develop a better way of doing things, or a product that ushers in the next technological wave.

New research shows that banking deregulation leads to more risk-taking incentives among the companies that banks loan money to, because banks are forced to accept more risk due to increased competition. Borrowing firms where this effect is most pronounced also make the biggest investments in research and development, the research shows.

“The message is quite clear,” says co-researcher Scott Liao, a professor of accounting at the University of Toronto’s Rotman School of Management. “Financial development is super-critical to firm innovation, and where there’s any policy change from the banking regulation, we will see the ripple effects. This is another example.”

Liao’s and his fellow researchers looked at what happened after deregulation in 1994 under the U.S. Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed banks to open branches beyond their home state. The researchers focused on 225 smaller firms with less than $75 million in capitalization, reasoning that companies this size would be the most likely to rely on local financing and therefore experience the most pronounced effects from the regulatory change.

In the decade after the deregulation, the number of branches operated by out-of-state banks skyrocketed, from 62 in 1994 to 24, 728 in 2005. But the researchers were most interested in what happened to executive compensation for the companies that banks loaned to in deregulation’s aftermath.

They found that CEO pay became nearly 50 per cent more sensitive to company share volatility after deregulation. That’s because firm managers were incentivized — through mechanisms such as stock options and bonuses — to chase greater rewards through greater risk, aligning their interests more closely to shareholders’.

The effect was strongest among companies operating in states that had fewer financing options and lower banking competition before the branching deregulation, and that ended up with fewer regulatory restrictions after the change.

Banks generally stand to lose more than they gain from borrowers’ risky activity, such as investments in research and development, because the money they make from loans is fixed, explains Liao. That’s why banks try to minimize their risk exposure, including examining executive compensation before approving loans, to identify how much risk-taking it encourages.

Deregulation changes things because when the doors to competition are thrown open, banks are forced to accept more risk in order to capture a share of the market. At the same time, they can spread out their own lending risk and lower their costs through exposure to the more diverse group of borrowers that deregulation tends to provide.

“If regulators allow banks to compete more, you will see more innovation,” says Liao. While he acknowledges that more competition comes with its own risks, showing that there is a relationship with innovation, “is the beginning point to understand how banking regulation affects companies producing goods and services.”

The research was conducted with Daniel Bens of INSEAD and Barbara Su of Temple University. It was published in Contemporary Accounting Research.