bs_bs_banner

The Japanese Economic Review

The Journal of the Japanese Economic Association
The Japanese Economic Review doi: 10.1111/jere.12131
Vol. 68, No. 2, June 2017

DO BANK LOANS TO FINANCIALLY DISTRESSED

FIRMS LEAD TO INNOVATION?
By MINJUNG KIM and JUNGSOO PARK
Sogang University

This study scrutinizes the association between a bank loan to a financially distressed
firm and technological innovation. Using probit model estimations based on a compre-
hensive Korean manufacturing firm-level data set on innovation and bank loans, we first
find that a bank loan to a troubled firm with a weak incentive system has no or little
effect on innovation. Second, beneficial effects on innovation are observed when the
firm has a strong incentive-based pay system. Third, financially distressed firms with
strong incentive systems pursue product innovation rather than process innovation.
Finally, the innovation performance of these firms strengthens with more stable financ-
ing.
JEL Classification Numbers: O31, G21.

1. Introduction

Troubled firms under financial distress may face difficulty in renewing their existing
loans as well as in obtaining new loans to support their recovery. Banks will provide
additional loans to financially distressed firms, only if these firms are likely to earn suf-
ficient future profits to pay off their loans. Hoshi et al. (1991) demonstrate that banks
grant additional credit if they perceive the risks and financial distress of the firm as a
temporary problem. In this case, the bank anticipates that the future profits of the dis-
tressed firms are likely to cover the bank’s current borrowing costs. However, when
these financially distressed firms are given loans, they may respond in two different
ways. The firm may use this renewed opportunity as a basis to innovate and compete in
the market. In contrast, it may choose not to innovate and just use these funds to pro-
long its existence. The latter may occur if the firms can reasonably anticipate that the
banks would not cut off funds in the future, as the banks may fear realization of losses
on their own balance sheet, as suggested by Peek and Rosengren (2005). For this rea-
son, the banks will face a challenge when making decisions about loans to financially
distressed firms.
From the firms’ perspective, their decision to innovate depends on a multitude of fac-
tors. These factors include internal as well as external conditions, such as market condi-
tions, prospects of sales, degree of competition in the market, and degree of internal
incentive-based compensation. In terms of innovative efforts, employees of a firm may
respond differently to different internal incentive systems. We focus on this issue and
specifically investigate the innovative behaviour of financially distressed firms, taking
into account their internal incentive systems. This study attempts to find out whether
different incentive systems influence the financially distressed firms to innovate when
bank loans are granted. Clarifying this relationship may be helpful for banks when they
are making loan decisions.
Financial distress leads to non-performing loans which may contribute to the
deterioration of the financial soundness of the banking sector. In a worst case scenario,
these loans may lead to bankruptcy of firms and financial institutions. It is claimed that

– 244 –
© 2016 Japanese Economic Association
 M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

the Asian financial crisis of 1997 was in part due to the existence of huge non-perform-
ing loans (Bai and Wang, 1999; Huang and Xu, 1999; Kornai et al., 2003). In spite of
the potentially hazardous outcomes of non-performing loans, banks continue to allocate
credit to financially unsound borrowers for several reasons. Dewatripont and Maskin
(1995) explain that creditors estimate the value of liquidation and provide refinance to
financially distressed firms to recoup their past investments. Peek and Rosengren (2005)
suggest that perverse incentives lead banks to provide additional loans to troubled firms.
More specifically, troubled banks have an incentive to allocate credit to severely
impaired borrowers to avoid the realization of losses on their own balance sheet.
Existing studies on the effects of bank loans to financially distressed firms emphasize
how these loans can lead to hazardous outcomes on the financial system. In particular,
the inefficiency of investments that caused the financial crisis in Asian countries has
been analysed (Krugman, 1998; Bai and Wang, 1999; Huang and Xu, 1999; Kornai
et al., 2003; Peek and Rosengren, 2005). These studies point out that financial assis-
tance to unsound firms boosts the firms’ propensity to invest excessively in risky pro-
jects and these overinvestments in risky projects lead to excessive economic expansion.
Bai and Wang (1999) employed a theoretical model to illustrate that the government
insurance program against business risks induced rational investors to restructure their
portfolios by investing more in risky projects and less in safer projects. Consequently,
providing finance to distressed firms results in inefficient resource allocation, which is
associated with high volatility and high average growth of the economy.
So far, most of the existing studies on the effect of loans to distressed firms have
neglected the role of strategic decisions of the agents within the firms. When these firms
are provided with loan extensions, the agents’ behaviours in relation to utilizing resources
may depend on many internal and external factors. For instance, if a firm has a compen-
sation scheme with a strong incentive system that rewards good performance, the
managers and employees will exert effort to pursue better performance given a renewed
opportunity for recovery. Their efforts may enhance the probability of successful inno-
vation. However, if the compensation scheme is not linked to performance, there is little
incentive to innovate for the agents in the firm given the bank loan. Top executives
reside at the strategic apex of their firms. They make, influence, and are ultimately
responsible for critical resource allocations pertaining to investments in new products
and technologies. These decisions are likely to be influenced by how executives are
rewarded, as suggested in Balkin et al. (2000). Balkin et al. (2000) find that CEO
short-term compensation, consisting of an annual salary and bonus, is related to innova-
tion as measured by the number of patents and R&D spending. In addition, there is evi-
dence that the compensation of scientists and engineers in high-technology firms is
often linked to meeting innovation goals, such as achieving significant technological
project milestones (Riggs, 1983; Balkin and Bannister, 1993).1 Quinn and Rivoli (1991)
argue that firms can use employment and compensation practices to foster innovation
and provide support for innovation by employees. More specifically, a system that
allows profit sharing by employees and provides employment assurance will foster inno-
vation in the firm.
This study scrutinizes the association between a bank loan to a financially distressed
firm and technological innovation. Assuming that innovative efforts are related to

1
“Since executives are the leader of firms, the form and structure of executive pay should mirror the
pay strategies applied to scientist and engineers and other key employees” (Werner and Tosi, 1995).

– 245 –
© 2016 Japanese Economic Association
 The Japanese Economic Review

long-run growth pursuits, we posit that their behaviour depends on internal conditions.
Based on a comprehensive Korean firm-level data set on innovation and bank loans, we
test whether bank loans to troubled firms lead the firms to achieve innovation if the
firms have a strong internal incentive system. Our findings show that strong incentive
schemes lead financially distressed firms to utilize additional bank loans to achieve tech-
nological innovation. Furthermore, we find that the financially distressed firms with a
strong incentive scheme tend to achieve frontier innovation when they obtain extra
funds. Product innovation rather than process innovation is more likely to occur when
bank loans are provided to distressed firms with a strong incentive scheme. However, if
a financially distressed firm has a more relaxed compensation scheme, it is unlikely to
engage in innovative activities when provided with loans.
This research aims to contribute to the literature in two respects. First, we focus on
the behaviour of the distressed firm in relation to innovative activities and present
empirical evidence on the relationship between bank loans and innovation. Our study is
distinguished from the existing published studies in that most of these studies investi-
gate the effects of bank loans on financially distressed firms in relation to the financial
soundness of banking systems or the aggregate economy. Our study suggests that bank
loans to troubled firms can play a beneficial role by promoting innovation. This study
provides empirical evidence that may constitute a basis for understanding innovative
behaviours of financially distressed firms. Second, this analysis differs from the existing
studies as we take into account the strategic decisions of the agents within the firms.
With these new considerations, our study contrasts with existing studies and provides
new evidence that additional credit provided to financially distressed borrowers can play
a beneficial role and is not necessarily hazardous.
This paper is organized as follows. Section 2 presents our model and describes the
data. Section 3 provides empirical evidence on the association between bank loans and
the innovative performance of financially distressed firms contingent on an incentive-
based system. Section 4 concludes.

2. Model and data description

2.1 The model

This study aims to examine whether a stronger compensation scheme can induce a trou-
bled firm that obtains additional funds to exert effort to achieve technological innova-
tion. This research question is investigated using a comprehensive Korean firm-level
data set on innovation and bank loans. We set our sample comprised of financially dis-
tressed firms in manufacturing, as innovative activities are concentrated in the manufac-
turing sector. The baseline empirical model is presented in Equation (1):

Yit ¼ a0 þ b1 FDFLit þ b2 FDFLit  Incentiveit þ b3 Incentiveit þ CXit þ eit : (1)

The dependent variable Yit, Innovation, is a binary variable that measures whether the
firm achieves innovation. We first estimate our model with Innovation as a dependent
variable which encompasses product and process innovation all together. We, then, sepa-
rate out product from process innovation and estimate models with product and process
innovation as separate dependent variables.

– 246 –
© 2016 Japanese Economic Association
 M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

FIGURE 1. A time sequence of a typical firm’s actions

The explanatory variable FDFL is a binary variable representing financially distressed

firms that succeed in obtaining additional bank loans. In this study, we are interested in
the degree of incentive-based compensation that may influence the firm’s performance.
If a firm rewards employees more based on their performance, the portion of perfor-
mance-based pay in the total payments to employees would be greater. In our model,
the variable Incentive is proxied by the ratio of performance-based compensation to total
compensation.
The variable FDFL is interacted with the variable Incentive to see how the innovative
efforts of the FDFs with bank loans change with different internal conditions. The coef-
ficient b1 captures the innovative efforts of a distressed firm with bank loans and the
coefficient b2 measures how the innovative efforts of this firm additionally respond to a
stronger performance-based compensation system. X is a vector including firm-specific
control variables which may potentially influence innovation.
As technological innovations require time to materialize, a time lag between the
explanatory and dependent variables needs to be appropriately considered. Figure 1
illustrates a time sequence of a typical firm’s actions regarding bank loans and innova-
tive activities. First, based on a specific criterion representing financial distress of a firm
at time t  1, we screen and construct a sample composed only of financially distressed
firms.2 Then, if the firm acquires a bank loan in the following period at time t, the
respective firm is defined as an FDFL. We then measure Innovation, which includes all
technological innovations achieved in the succeeding 3 years from t + 1 to t + 3 to
allow for the innovative efforts to be realized. We have allowed a time lag between the
timing of bank loans and occurrence of innovation in order to reduce the potential pres-
ence of an endogeneity bias problem.3 We use contemporaneous values for other control
variables which are included in the regression. As the original innovation data from the
Korean Innovation Survey (KIS) provided by the Science and Technology Policy Insti-
tute (STEPI) are only available in repeated cross-section format for the years 2002,
2005, 2007 and 2010, our data sample is a firm-level pooled cross-section data set. As
the dependent variable is a binary variable measuring successful innovation, we estimate

2
The exact method is described in the following section.
3
To examine a potential selection bias problem, we have performed a group t-test to see whether the
firms with bank loans and those without bank loans have different innovation records. Innovation
records were measured as the innovation achieved at t  1, which is one period before the loan deci-
sion. The t-statistic was 1.4423 and the P-value was 0.1498. Thus, we cannot reject the null that the
two groups are the same in terms of innovation record.

– 247 –
© 2016 Japanese Economic Association
 The Japanese Economic Review

a probit model. Time-specific and industry-specific constants are included to control for
omitted time-specific and industry-dimension characteristics.

2.2 Data description

The empirical implementation requires data on the financial condition of firms, bank
loans and innovation. As these variables are not available in a single database, we
merge two separate sets of data: a data set containing innovation outcome and a data set
containing financial information. KIS provided by the STEPI contains comprehensive
information on the innovation activities of manufacturing firms. The survey was con-
ducted in four waves, in 2002, 2005, 2007 and 2010. As for the financial information,
we rely on a KIS-Value data set, managed by the National Information and Credit Eval-
uation, which contains comprehensive information on financial and corporate activities
of externally-audited corporations and stock-exchange listed firms in Korea. To imple-
ment our empirical analysis, the KIS-Value data set is merged with the KIS data set.
Although there are four waves of data in the KIS data set, most of the firms are
observed only once. Therefore, our data set is basically a pooled cross-section data set
with industry specification.
To proxy the degree of innovation performance, we utilize two alternative variables
for the dependent variable. The first variable Innovation1 is a binary variable reflecting
broad occurrence of innovation. The variable indicates whether a firm has successfully
launched a new or improved product or process over the 3 years spanning from t + 1 to
t + 3. This variable is broadly defined and reflects innovation that includes not only the
frontier product or process innovation introduced new to the market, but also products
or processes that imitate and follow those of its competitors. The second choice of inno-
vation variable Innovation2 is narrowly defined as to only include occurrence of frontier
product or process innovation that is new to the market. This innovation variable may
reflect frontier innovative efforts of the firms to compete in the market.
There are several approaches to measuring the level of financial distress of a firm and
its probability of bankruptcy. Three different models are widely used to predict the
default risk of a firm: (i) multiple discriminant analysis (e.g. Altman, 1968); (ii) multiple
choice analyses, such as probit (e.g. Zmijewski, 1984); and (iii) the Merton (1974)
model, which computes distance to default using stock returns and volatility (Acharya
et al., 2007; Eisdorfer, 2008). To identify financially distressed firms, we use Altman’s
z-score approach in this study. Altman (1968) is a pioneer in the study of modern ana-
lytical techniques for estimation of the likelihood of borrower default. More specifically,
Altman (1968) developed a discriminant function, which is used to predict the probabil-
ity that a firm will go into bankruptcy within 2 years. Altman’s z-score, calculated from
the discriminant function, provides criteria that distinguish whether firms are likely to
default. According to Altman’s z-score formula, the lower the z-score is, the higher the
probability of default.4 Among various models for evaluating the financial health of
companies, Altman’s z-score has demonstrated to be very reliable in a variety of con-
texts and countries (Eidleman, 1995). The z-score model has been employed in numer-
ous studies to evaluate financial conditions of firms from various industries and periods

4
The discriminant function of Altman’s z-score is as follows: Z = 1.2 9 (working capital)/(total
assets) + 1.4 9 (retained earnings)/(total assets) + 3.3 9 (EBIT)/(total assets) + 0.6 9 (market value
of equity)/(book value of total debt) + 0.999 9 (sales)/(total assets).

– 248 –
© 2016 Japanese Economic Association
 M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

(Altman et al., 1995; Carcello et al., 1995; Berger et al., 1996; Subramanyan and Wild,
1996; Alexakis, 2008; Alexeev and Kim, 2008; Kim and Cheong, 2009).5
Furthermore, we study the z-score of corporate workout firms that have experienced
restructuring from 1998 to 2010 in comparison with non-workout firms in order to
review whether the z-score correctly reflects the possibility of bankruptcy in the
case of Korean manufacturing sectors. We find that the average value of z-scores for
62 corporate workout companies that were selected for the corporate workout program
from 1998 to 2010 is 1.15, and 83.9% of these companies have z-scores lower than
1.81. In contrast, the average value of z-scores for 8,184 non-workout firms is 2.37,
and 43.9% of these companies have z-scores lower than 1.81. This implies that corpo-
rate workout firm selections are correlated with low z-scores.
We define a “financially distressed firm (FDF)” if its z-score is below 1.81 at time
t  1.6 A binary variable FDFL is an FDF that obtains a loan and we use two different
versions for FDFL: FDFL1 and FDFL2. The variable FDFL1 is a binary variable
reflecting firms that obtain bank loans at time t even when there were an FDF at t  1.
These are banks with “loan access”. Because technological innovations may take a long
time to reach fruition, the firms may need financing for a prolonged period of time.
Thus, we consider an alternative binary variable FDFL2 to indicate whether a firm suc-
cessfully obtains bank loans for 2 consecutive years; that is, from time t to t + 1.7 This
variable may capture the effect of longer-term financing to FDFs.
We control for other important variables that may influence innovation. To proxy
the innovative potential of the firm’s human capital, we define R&D human capital as
the ratio of the number of R&D researchers over the total number of employees. We
expect that the likelihood of technological innovation increases with higher R&D
human capital.8 Based on the Schumpeterian tradition, we control for the firm size
effect by including log of employees. Large firms have more internal finance and
easier access to external finance. They are likely to engage in risky projects and bene-
fit from economies of scale (Shumpeter, 1942; Raymond et al., 2010). In addition, we
control for the physical capital effect by including the log of capital intensity. As firm
age is known to be associated with innovation, we include firm age. We also control
for the industry-specific and time-specific effects. Description of the variables, sum-
mary statistics, and correlation matrix are all provided in Tables A1 and A2 in the
Appendix.

5
There are several other empirical studies that utilize Altman’s z-score to estimate the financial distress
of Korean corporates. For example, Alexeev and Kim (2008) demonstrated the existence of a soft bud-
get constraint before and after the Korean financial crisis by using Altman’s z-score. Kim and Cheong
(2009) use a z-score to control for financial distress of auditor-designated firms. Altman et al. (1995)
test the accuracy of Altman’s methodology on the Korean firm data for the period of 1990–1993. They
find that Altman’s method shows excellent classification accuracy in predicting financial distress.
6
Altman (1968) claims that “all firms having z-score of greater than 2.99 clearly fall into the ‘non-bank-
rupt’ sector, while those firms having z-score below 1.81 are all bankrupt”.
7
In this case, we count the occurrence of innovation between t + 2 and t + 4. According to our defini-
tions of FDFL1 and FDFL2, firms belonging to FDFL2 also belong to FDFL1.
8
Although R&D expenditure is an important variable that may positively influence innovation, we have
excluded it from the model intentionally. The reason is that bank loans may be used in many ways
including R&D spending to promote innovation and our goal in this study is to capture the whole
effect of bank financing encompassing all these channels of innovation.

– 249 –
© 2016 Japanese Economic Association
 The Japanese Economic Review

3. Empirical analysis

Table 1 provides the regression results regarding the effect of bank loans to financially
distressed firms on innovative performance. The dependent variable is the binary vari-
able Innovation, representing products or process innovation. According to the degree
of innovative performance, we distinguish broad occurrence of innovation (broad defini-
tion), Innovation1, from frontier innovation (narrow definition), Innovation2. The former
includes not only the innovations that are new to the market, but also innovations which
are imitations of competitors’ technologies. Columns (1)–(4) show the effect of bank
loans on the broad occurrence of innovation, Innovation1. The influence of bank loans
to financially distressed firms on frontier innovation, Innovation2, is presented in col-
umns (5)–(8). As for the bank loans to FDFs, the models (1), (3), (5) and (7) use “loan
access” criterion (FDFL1) and the models (2), (4), (6) and (8) use a “repeated loan” cri-
terion (FDFL2).
Columns (1) and (2) show that, in terms of innovation performance, FDFs with loans
are not statistically different from FDFs that fail to receive extra loans after controlling
for other determinants of innovation. Furthermore, in columns (3) and (4), even when
the performance-based incentive index is interacted with FDFL and included, the inter-
action term, FDFL 9 Incentive, is also statistically insignificant. However, when we use
a narrow definition of innovation as in models (7) and (8), the results show that the
FDFL is still not statistically significant, but the interaction term, FDFL 9 Incentive, is
statistically significant and positive. This contrast in results implies that loans to FDFs
lead to greater probability of frontier innovation if the firm has a strong performance-
based incentive scheme in place. Distressed firms with loans pursue long-termism when
incentives to exert effort are present. In an alternative interpretation, a loan to an FDF
with a strong incentive system may alleviate its liquidity constraint and help foster more
innovative R&D activities which may lead to frontier innovation. We further observe
that the estimated coefficient for the interaction term is greater for the “repeated loan”
case in column (8) than for the “loan access” case in column (7). This implies that add-
ing security to financing increases the incentive to pursue frontier technology research.
As for the control variables, the size of firm measured by the number of employees is
positively and significantly associated with innovative performance, which supports the
Schumpeterian tradition. R&D capacity measured by the share of R&D human capital
has a positive and significant influence on technological innovation.
In Table 2, we distinguish product innovation from process innovation. The separate
results for the product innovation and process innovation are, respectively, presented in
models (1)–(4) and models (5)–(8). We apply the “broad” and “narrow” concepts of
innovation to both product and process innovation, respectively. Models (1), (2), (5) and
(6) are related to the “broad definition” (Innovation1), and models (3), (4), (7) and (8)
are related to the “narrow definition” (Innovation2). As for the bank loans to FDFs,
models (1), (3), (5) and (7) use a “loan access” criterion and models (2), (4), (6) and (8)
use a “repeated loan” criterion.
As for product innovation, models (1)–(4) show that the strong incentive scheme for
FDF with a loan encourages product innovation of both broad and narrow definition.
However, in regards to process innovation, for all process innovation cases in models
(5)–(8), the FDFL having an incentive scheme has no effect on innovation. These find-
ings indicate that an incentive system is relatively more important than process

– 250 –
© 2016 Japanese Economic Association
 TABLE 1
Effect of bank loan to financially distressed firm on innovation (product or process innovation): Probit analysis

Dependent variable: Broad definition of innovation (Innovation1) Dependent variable: Narrow definition of innovation (Innovation2)
(1) (2) (3) (4) (5) (6) (7) (8)
FDFL1 FDFL2 FDFL1 FDFL2 FDFL1 FDFL2 FDFL1 FDFL2
(loan access) (repeated loan) (loan access) (repeated loan) (loan access) (repeated loan) (loan access) (repeated loan)
FDFL 0.094 0.053 0.115 0.068 0.052 0.104 0.077 0.144
(0.752) (0.337) (0.909) (0.415) (0.420) (0.656) (0.623) (0.882)
FDFL 9 Incentive 0.140 0.073 0.328*** 0.571**
(1.173) (0.379) (2.645) (2.567)
Incentive 0.172*** 0.169*** 0.103 0.161** 0.053 0.051 0.089 0.002
(2.767) (2.719) (1.197) (2.455) (0.856) (0.831) (1.091) (0.024)
Log(Worker) 0.362*** 0.363*** 0.358*** 0.358*** 0.335*** 0.337*** 0.317*** 0.300***
(3.916) (3.927) (3.858) (3.837) (3.778) (3.794) (3.551) (3.325)

– 251 –
R&D human capital 0.096*** 0.096*** 0.096*** 0.096*** 0.015*** 0.015*** 0.015*** 0.015***
(8.209) (8.193) (8.181) (8.123) (2.983) (2.980) (2.993) (3.087)
Log(Cap. Intensity) 0.121 0.114 0.115 0.114 0.100 0.099 0.085 0.100
(1.343) (1.273) (1.272) (1.270) (1.083) (1.078) (0.922) (1.082)
Firm Age 0.001 0.001 0.000 0.001 0.006 0.006 0.005 0.005
(0.106) (0.188) (0.007) (0.159) (0.909) (0.944) (0.731) (0.778)
Number of observations 552 552 552 552 529 529 529 529
LR test [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]***
Pseudo R2 0.196 0.196 0.198 0.196 0.0972 0.0976 0.108 0.109

Notes: The dependent variable in columns (1)–(4) is a binary variable Innovation1, which includes successful innovation of new or improved product/process over
the 3 years spanning from t + 1 to t + 3. In columns (5)–(8), the dependent variable is a binary variable Innovation2, which includes successful innovation that is
newly introduced to the market over the 3 years spanning from t + 1 to t + 3. FDFL is financially distressed firms with loans. Incentive is the log ratio of perfor-
mance-based pay to the total compensation of employees. All models include industry-specific and time-specific constants. Z-statistics are in parentheses and
P-values are in brackets. The superscripts ** and *** following the z-statistics and P-values represent 5% and 1% significance levels, respectively.
M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

© 2016 Japanese Economic Association

 TABLE 2
The effect of bank loans to financially distressed firms on innovation (product innovation vs process innovation): Probit analysis

Product innovation Process innovation

Broad definition Narrow definition Broad definition Narrow definition
(Innovation1) (Innovation2) (Innovation1) (Innovation2)

© 2016 Japanese Economic Association

(1) (2) (3) (4) (5) (6) (7) (8)
FDFL1 FDFL2 FDFL1 FDFL2 FDFL1 FDFL2 FDFL1 FDFL2
(loan access) (repeated loan) (loan access) (repeated loan) (loan access) (repeated loan) (loan access) (repeated loan)
FDFL 0.026 0.013 0.248* 0.245 0.094 0.073 0.053 0.041
(0.209) (0.083) (1.879) (1.451) (0.793) (0.483) (0.344) (0.193)
FDFL 9 Incentive 0.205* 0.482** 0.410*** 0.519** 0.132 0.120 0.234 0.424
(1.740) (2.449) (3.144) (2.332) (1.116) (0.657) (1.435) (1.519)
Incentive 0.059 0.109* 0.173** 0.046 0.037 0.092 0.038 0.027
(0.713) (1.711) (2.012) (0.681) (0.445) (1.431) (0.360) (0.317)
Log(Worker) 0.418*** 0.396*** 0.371*** 0.359*** 0.374*** 0.370*** 0.264** 0.245**
(4.597) (4.323) (3.907) (3.761) (4.278) (4.209) (2.388) (2.190)

– 252 –
R&D human capital 0.058*** 0.060*** 0.014*** 0.015*** 0.029*** 0.029*** 0.006 0.007
(7.033) (7.174) (2.795) (2.835) (4.290) (4.331) (1.100) (1.181)
Log(Cap. Intensity) 0.078 0.081 0.116 0.124 0.057 0.047 0.005 0.010
(0.882) (0.910) (1.186) (1.278) (0.668) (0.554) (0.040) (0.081)
The Japanese Economic Review

Firm Age 0.000 0.000 0.002 0.003 0.007 0.007 0.007 0.007
(0.053) (0.011) (0.275) (0.458) (1.126) (1.077) (0.818) (0.796)
Number of observations 552 552 529 529 541 541 514 514
LR test [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.00]*** [0.105] [0.09]*
Pseudo R2 0.175 0.180 0.142 0.133 0.105 0.103 0.091 0.092

Notes: The dependent variable in columns (1), (2), (5) and (6) is a binary variable Innovation1, which includes successful innovation of new or improved product/
process over the 3 years spanning from t + 1 to t + 3. In columns (3), (4), (7) and (8), the dependent variable is a binary variable Innovation2, which includes suc-
cessful innovation that is newly introduced to the market over the 3 years spanning from t + 1 to t + 3. FDFL is financially distressed firms with loans. Incentive is
the log ratio of performance-based pay to the total compensation of employees. All models include industry-specific and time-specific constants. Z-statistics are in
parentheses and P-values are in brackets. The superscripts *, ** and *** following the z-statistics and P-values represent 10%, 5%, and 1% significance levels,
respectively.
 M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

innovation in inducing firms with loans to achieve product innovation. This result may
be due to different characteristics between product and process innovations.9
In models (1)–(4) and (7)–(8), we observe that interaction term FDFL 9 Incentives is
statistically stronger for the “repeated loan” case than for the “loan access” case. This
implies that a compensation scheme based on performance strengthens an FDF’s innova-
tive behaviour when the loans are provided over a longer term. This may reflect the fact
that the new products and frontier effort innovation take time to achieve and, therefore,
need financing over a longer period of time. The frontier product innovation can be pur-
sued and materialized when the distressed firms are able to receive stable funding.
To evaluate how much an incentive system helps innovation performance of a firm
that has been given a bank loan, we calculate the marginal effects of FDFL 9 Incen-
tives on innovation. For instance, if the incentive system becomes stronger as the share
of bonuses to total wages increases by 1%, the success probability of frontier product
innovation for FDFs with loan access rises by 0.119 and that for FDFs with repeated
loan rises by 0.151, respectively.

4. Conclusion

This study scrutinizes the association between a bank loan to a financially distressed
firm and technological innovation. A comprehensive pooled cross-section data set of
Korean manufacturing firms based on four waves of survey for the years 2002, 2005,
2007 and 2010 are employed in this research.
Our findings suggest that not all financially distressed firms behave the same way in
terms of innovative efforts when financing is provided. Given appropriate internal condi-
tions, bank loans can induce a financially distressed firm to invent new products. The
main findings in this research can be summarized as follows. First, a bank loan to a
troubled firm with a weak incentive system has no or little effect on innovation. Second,
beneficial effects on innovation are observed when the firm has a strong incentive-based
pay system. However, this is only for frontier innovation, and not for imitating existing
innovation. This implies that the distressed firms with an incentive system are taking
greater risk and using this renewed opportunity to overtake the frontrunner in the com-
petition. This may be because firms are trying to recoup losses due to poor performance
in the past. Third, if they receive a bank loan, the financially distressed firms with a
strong incentive system pursue product innovation rather than process innovation.
Finally, the innovation performance of these firms strengthens with more stable financ-
ing.
Unlike other existing studies on financing troubled firms, our findings show that
under appropriate conditions, such as the adoption of a strong performance-based com-
pensation system, bank loans to financially distressed firms can be justified. This new
finding can help policy-makers and financial institutions in making appropriate decisions
when they are faced with the decision of whether to grant loan extensions to financially
distressed firms. Banks should examine and take into account firms’ internal conditions
such as incentive systems. Furthermore, more stable funding may be helpful in maxi-
mizing the effect of these loans.

9
Specific reasons for this difference should be investigated in future research.

– 253 –
© 2016 Japanese Economic Association
 The Japanese Economic Review

As our study does not specify explicit channels of innovation, this research may be
extended to investigate how bank loans are used by a distressed firm and how they are
linked to R&D activities.

Acknowledgements

The authors would like to thank the anonymous referees and participants at the “Work-
shop on Empirical Studies on Firm Dynamics, Job Creation and Productivity Growth in
East Asia, and Beyond” at Sogang University for their valuable comments. This work
was supported by a National Research Foundation of Korea Grant funded by the Korean
Government (NRF-2016S1A3A2923769).

Appendix
TABLE A1
Summary statistics

Standard
Variable Description Observations Mean deviation Minimum Maximum
Innovation1
Product or process Broad definition: Product 569 0.582 0.494 0 1
innovation or process innovation
(binary)
Product innovation Broad definition: Product 569 0.499 0.500 0 1
innovation (binary)
Process innovation Broad definition: Process 569 0.413 0.493 0 1
innovation (binary)
Innovation2
Product or process Narrow definition: Product 569 0.279 0.449 0 1
innovation or process innovation
(binary)
Product innovation Narrow definition: Product 569 0.234 0.424 0 1
innovation (binary)
Process innovation Narrow definition: Process 569 0.107 0.310 0 1
innovation (binary)
FDFL1 FDFL with loan access 564 0.543 0.499 0 1
(binary)
FDFL2 FDFL with repeated loan 564 0.193 0.395 0 1
(binary)
Incentive Ratio of performance- 569 0.138 1.038 6.191 1.949
based bonus to total
compensation (log form)
Log(Worker) Number of workers (log 569 4.693 0.823 2.485 7.435
form)
R&D human Ratio of number of 569 6.379 11.321 0 132.39
capital researchers to total
number of workers
Log(Capital Ratio of tangible assets 569 18.153 0.775 14.025 20.440
Intensity) to total number of workers
(log form)
Firm Age Period since the date of 569 16.763 11.250 2 66
the establishment

– 254 –
© 2016 Japanese Economic Association
 M. Kim and J. Park: Do Bank Loans to Financially Distressed Firms Lead to Innovation?

TABLE A2
Correlation matrix

(1) (2) (3) (4) (5) (6) (7) (8) (9)

(1) 1.000
(2) 0.519 1.000
(3) 0.029 0.022 1.000
(4) 0.006 0.003 0.449 1.000
(5) 0.083 0.066 0.076 0.014 1.000
(6) 0.162 0.151 0.072 0.014 0.174 1.000
(7) 0.291 0.154 0.033 0.015 0.032 0.010 1.000
(8) 0.038 0.073 0.087 0.066 0.036 0.030 0.021 1.000
(9) 0.030 0.004 0.139 0.022 0.174 0.490 0.043 0.129 1.000

Notes: (1) Innovation1 (product or process innovation), (2) Innovation2 (product or process innovation), (3)
FDFL1 (FDF with loan access), (4) FDFL2 (FDFs with repeated loan), (5) Incentive, (6) log(Worker), (7)
R&D human capital, (8) log(Capital Intensity) and (9) Firm Age.

Final version accepted 30 January 2016.

REFERENCES
Acharya, V. V., S. T. Bharath and A. Srinivasan (2007) “Does Industry-Wide Distress Affect Defaulted
Firms? Evidence from Creditor Recoveries”, Journal of Financial Economics, Vol. 85, No. 3,
pp. 787–821.
Alexakis, P. (2008) “‘Altman Ζ-score Model’ and Prediction of Business Failures”, International Journal of
Monetary Economics and Finance, Vol. 1, No. 4, pp. 329–337.
Alexeev, M. and S. Kim (2008) “The Korean Financial Crisis and the Soft Budget Constraint”, Journal of
Economic Behavior and Organization, Vol. 68, No. 1, pp. 178–193.
Altman, E. I. (1968) “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”,
Journal of Finance, Vol. 23, No. 4, pp. 589–609.
———, Y. H. Eom and D. W. Kim (1995) “Failure Prediction: Evidence from Korea”, Journal of
International Financial Management and Accounting, Vol. 6, No. 3, pp. 230–249.
Bai, C. and Y. Wang (1999) “The Myth of the East Asian Miracle: The Macroeconomic Implications of Soft
Budgets”, The American Economic Review, Vol. 89, No. 2, pp. 432–437.
Balkin, D. B. and B. Bannister (1993) “Explaining Pay Forms for Strategic Employee Groups in
Organizations: A Resource Dependence Perspective”, Journal of Occupational and Organizational
Psychology, Vol. 66, No. 2, pp. 139–151.
———, L. R. Gomez-Mejia and G. D. Markman (2000) “Is CEO Pay in High-Technology Firms Related to
Innovation?”, Academy of Management Journal, Vol. 43, No. 6, pp. 1118–1129.
Berger, P. E., E. Ofek and I. Swary (1996) “Investor Valuation of the Abandonment Option”, Journal of
Financial Economics, Vol. 42, No. 2, pp. 257–287.
Carcello, J. V., D. R. Hermanson and H. F. Huss (1995) “Temporal Changes in Bankruptcy Related
Reporting”, Auditing, Vol. 14, No. 2, pp. 133–143.
Dewatripont, M. and E. Maskin (1995) “Credit and Efficiency in Centralized and Decentralized Economies”,
Review of Economic Studies, Vol. 62, No. 4, pp. 541–555.
Eidleman, G. J. (1995) “Z score – A Guide to Failure Prediction”, The CPA Journal, Vol. 65, No. 2,
pp. 52–54.
Eisdorfer, A. (2008) “Empirical Evidence of Risk Shifting in Financially Distressed Firms”, Journal of
Finance, Vol. 63, No. 2, pp. 609–637.
Hoshi, T., A. Kashyap and D. Scharfstein (1991) “Corporate Structure, Liquidity and Investment: Evidence
from Japanese Industrial Groups”, Quarterly Journal of Economics, Vol. 106, No. 1, pp. 33–60.
Huang, H. and C. Xu (1999) “Financial Institutions and the Financial Crisis in East Asia”, European
Economic Review, Vol. 43, No. 4–6, pp. 903–914.
Kim, J.-B. and H. Y. Cheong (2009) “Does Auditor Designation by the Regulatory Authority Improve Audit
Quality? Evidence from Korea”, Journal of Accounting and Public Policy, Vol. 28, No. 3, pp. 207–230.
Kornai, J., E. Maskin and G. Roland (2003) “Understanding the Soft Budget Constraint”, Journal of
Economic Literature, Vol. 41, No. 4, pp. 1095–1136.

– 255 –
© 2016 Japanese Economic Association
 The Japanese Economic Review

Krugman, P. (1998) “What Happened to Asia?”, mimeo., Massachusetts Institute of Technology.

Merton, R. C. (1974) “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates”, Journal of
Finance, Vol. 29, No. 2, pp. 449–470.
Peek, J. and E. S. Rosengren (2005) “Unnatural Selection: Perverse Incentives and the Misallocation of
Credit in Japan”, The American Economic Review, Vol. 95, No. 4, pp. 1144–1166.
Quinn, D. P. and P. Rivoli (1991) “The Effect of American- and Japanese-Style Employment and
Compensation Practices on Innovation”, Organization Science, Vol. 2, No. 4, pp. 323–341.
Raymond, W., P. Mohnen, F. Palm and S. S. van der Loeff (2010) “Persistence of Innovation in Dutch
Manufacturing: Is It Spurious?”, The Review of Economics and Statistics, Vol. 92, No. 3, pp. 495–503.
Riggs, H. E. (1983) Manaaging High-technology Companies, Belmont: Lifetime Learning.
Shumpeter, J. A. (1942) Capitalism, Socialism and Democracy, New York: Harper.
Subramanyan, K. R. and J. J. Wild (1996) “Going-Concern Status, Earnings Persistence, and Informativeness
of Earnings”, Contemporary Accounting Research, Vol. 13, No. 1, pp. 251–273.
Werner, S. and H. L. Tosi (1995) “Other People’s Money: The Effects of Ownership on Compensation
Strategy and Managerial Pay”, Academy of Management Journal, Vol. 38, No. 6, pp. 1672–1691.
Zmijewski, M. E. (1984) “Methodological Issues Related to the Estimation of Financial Distress Prediction
Models”, Journal of Accounting Research, Vol. 22, pp. 59–82.

– 256 –
© 2016 Japanese Economic Association