Bridging capital gaps to promote innovation in France

Industry and Innovation, Aug 2001 by Cieply, Sylvie

Since 1995, many initiatives have been taken in France to promote the financing of innovative enterprises, particularly when they are small and young.' In 1996, the new technology-oriented equity market, the Nouveau Marche, was established. Since 1997, the BDPME (Banque de Developpement des Petites et Moyennes Entreprises), a partially state-owned financial institution specifically dedicated to small and mediumsized firms, has supplied innovative firms with new financial products dedicated to growth firms with highly specific assets. In parallel, the development of the venture capital industry has become a priority as the reallocation of funds from the privatization of France Telecom to venture capital organizations illustrates. The major aim of this paper is to test propositions as to why these initiatives have been introduced in the French financial system.

To approach this question, the French financial system is analysed within a historical perspective. Until the mid-1980s, the French financial system was a state credit-based system. A state credit-based system is a very special bank-based system. As in a bankbased system, firms are highly financed by banks and self-financing is very low. However, unlike in a traditional bank-based system, as in Germany, the activity of banks depends directly on monetary and industrial policy. Banks are indeed the "driving force" of industrial policy by granting rebate rates to selected sectors. Until the beginning of the 1980s, this system worked in France at the expense of multiple devaluations and a high inflation rate. This system was overhauled in the mid-1980s under the pressure of French budget deficits in the context of the European Integration process, the latter making repeated devaluations untenable. Thus, major financial reforms have been launched in order to free financial institutions from subordination to the state and to institute a competitive financial system (Bertero 1994; ChanelReynaud 1996). With the withdrawal of state ascendancy over the financial sector, the national system of financing has taken a new turn in France.

This paper argues that the French national system of financing has moved toward an equity-based system where banks act within an arm's length model. In this system, the capacity of banks to finance innovation is limited as they become more riskaverse. This move turns the supply of equity to firms into a critical factor. For large firms, the development of financial markets during the mid-1980s responded to their financial needs. In contrast, for small and medium-sized firms (SMEs), French external equity supply could be seen to be inadequate at least until the mid-1990s, with the result that a range of new policies has been launched to cope with French financial gaps and to financially promote innovation by small firms.

In this paper, innovation is perceived in a traditional way as the introduction of new products or/and new processes. It induces investments which are difficult to finance as the assets involved are highly specific, their collateral value is low and the level of risk borne by investors is high (Cobham 1999). More specific analysis is given to the case of small firms as the latter do not have access to global markets, due to information asymmetries and agency problems, yet they contribute largely to innovation in France (Bernard and Torre 1994). In particular, we analyse the financial situation of independent SMEs and especially of new independent firms. When SMEs belong to industrial groups or have close relationships with large firms, these ties can provide significant sources of financing which tend to reduce the apparent capital shortage of SMEs (Hancke and Cieply 1996). However, this financial transfer between large firms and SMEs tends to reduce the independence of small firms and shows the incapacity of the French financial system to finance SMEs.

The next section of this paper highlights the decline of the national system of financing based on credit in France and underlines the difficulty for high-risk SMEs, and especially for innovative small firms, to be financed by banks. The third section examines the supply of equity to small high-risk firms and underlines the existence of capital gaps for several categories of small firms between 1985 and 1995. The fourth section examines new initiatives taken since 1996 to cope with these gaps, which could limit the capacity of small firms to innovate. The final section turns to a discussion of the future viability of this new French model and of its residual weaknesses.

RADICAL TRANSFORMATION OF THE FRENCH NATIONAL SYSTEM OF FINANCING

All financial systems in advanced industrial countries have experienced sweeping changes since the beginning of the 1980s through the process of financial globalization. These changes appear more striking when they concern bank-based systems where the development of markets is a revolution which calls into question the consistency of the pre-existing system. However, not all bank-based systems react in the same way. In Germany, only the large firms' financial model has been affected by the liberalization process and in such a way that the German tradition of shareholders' long-term involvement remains undiminished. By contrast, the financing of SMEs is still based on high external bank financing and close relationships with banks (Deeg 1997). The situation is totally different in France where the small firms' financial model has been deeply affected by the financial reforms as well. The capacity of the French banking sector to finance small firms, in particular during high-risk moments in their life cycle, has been jeopardized by the radical transformation of the banking sector which is now forced by competition to develop an arm's length model with these firms. In this context, we observe the radical evolution of French firms' financial structures.