Advanced economies are ever more dependent on innovation and entrepreneurship for their sustained growth (Bottazzi, Da Rin, and Giavazzi (2001), OECD (2001), Scarpetta et al. (2000)). The literature on venture capital increasingly recognizes the importance of venture capital as a specialized form of intermediation suited to support the creation and growth of innovative companies (Hellmann and Puri (2000), Kortum and Lerner (1998)). Yet, we know very little about what forces determine venture capital investment. This is an important issue for economists, as our understanding of how this specialized form of intermediation generates growth, while increasing, is still limited. Research on the economics of venture capital has substantially advanced in recent years. In particular, we are now starting to comprehend how venture financing provides control and support services to innovative companies (Bottazzi, Da Rin, and Hellmann (2003), Casamatta (2003), Landier (2002), Lindsey (2003), and Schiendele (2003)). However, we are still far from grasping how venture capital’s contribution to unfolding the growth potential of individual firms translates into economic growth.
Understanding what drives venture capital investment is obviously relevant for policy, too. To the extent that growth depends on innovation and creative destruction, one could think of fostering productivity by channeling more funds into venture financing of technologically innovative companies. This reasoning has in fact held sweeping influence on the way policy-makers think and act to support technological innovation. In the 1980s it influenced the pioneering Small Business Innovation Research (SBIR) programme in the US (Gans and Stern (2003), Lerner (1999)). Over the last decade, it inspired policies in Europe and in emerging economies. In 2001, for instance, the European Commission transformed the European Investment Fund (EIF) into Europe’s largest venture investor (EIF (2002)), making the increase of the supply of risk capital one of its priorities (European Commission (1998, 2003). Large programmes aimed at fostering venture investing have been implemented in Canada, France, Germany, Israel, Sweden, and the UK, among other countries (see Avnimelech and Teubal (2003), Ayiayi (2002), Cornelius and Isaksson (1998), French Ministry of Industry (2003), German Federal Ministry for Economics and Technology (1999)). Public programmes aimed at venture capital have also been implemented in several emerging economies (Carter, Barger, and Kuczynski (1996), Lerner and Schoar (2003)).
The allowance for loan and lease losses, which was originally referred to as the “reserve for bad debts,” is a valuation reserve established and maintained by charges against the bank’s operating income. As a valuation reserve, it is an estimate of uncollectible amounts that is used to reduce the book value of loans and leases to the amount that is expected to be collected.
Few banks provided reserves for bad debts until the Internal Revenue Service (IRS) allowed the additions to such reserves to be deducted on a bank’s tax return. Although such deductions have been allowed since the passage of the Revenue Act of 1921, no clear-cut guidelines for the amount to be deducted were established until 1965, when the IRS issued Revenue Ruling 65-92. Under this ruling, a bank could make tax-deductible additions to its loan loss reserve until the reserve totaled 2.4 percent of eligible outstanding loans (as defined).
Loan-loss provisioning policy is critical in assessing financial system stability, in that it is a key contributor to fluctuations in banks’ profitability and capital positions, which has a bearing on banks’ supply of credit to the economy (Beatty and Liao, 2009). In principle, loan-loss provisions allow banks to recognize in their profit and loss statements the estimated loss from a particular loan portfolio/s, even before the actual loss can be determined with accuracy and certainty as events unfold and is actually written off. In other words, loan-loss reserves should result in direct charges against earnings during upturns in the economic cycle, as banks anticipate future losses on the loan portfolio when the economy hits a downturn. When these anticipated loan losses eventually crystallize, banks can then draw on these reserves, thereby absorbing the losses without impairing precious capital and preserving banks’ capacity to continue extending the supply of credit to the economy. Ideally, the level of loan loss provisioning, should be able to reflect the beliefs of bank management on the quality of the loan portfolio that they have, indicating that provisions should be able to cover the whole spectrum of expected credit losses if they are to think of provisions as a measure of true credit risk (Dugan, 2009).
In practice, the level of provisioning has had a historically procyclical bias, as it is basically linked to contemporaneous problem assets, so that provisions mainly rise during a downturn (see Borio and Lowe, 2001; Bikker and Hu, 2002; Laeven and Majnoni, 2003), when credit risk has already materialized. There are some factors that contribute to its procyclicality: for one, business cycle developments are hard to identify, and therefore there may exist a disconnect between the timing of loan-loss provisioning and the assessment of credit risk. For another, accounting frameworks only allow provisioning for losses that have already been incurred as of a financial statement date, which does not really address the concept of “expected losses” (Li, 2009). Moreover, a surplus of funds relative to the appropriate level of prudent loans being granted could lead to the chasing of yields and the lowering of credit risk perception, and hence, corresponding provisions. If provisions are not able to cover the whole spectrum of potential loan defaults once an economic downturn occurs, then, naturally, the bank will need to cover the excess loss from its capital. As the recent global credit crisis have shown, the impact of an increase in loan defaults on financial system fragility also depended on whether banks build capital cushions to absorb unexpected loan losses not covered by provision levels.
