high. Hall’s conclusion is that “small and new innovative firms experience high costs of capital that are only partly mitigated by the presence of venture capital,” while “evidence for high costs of R&D capital for large firms is mixed”. In more recent work, Benfratello et al. (2006) use firm data from Italy to investigate the effect of regional banking development on innovative activities, and find evidence of a stronger positive for small Prior research thus suggests that financial development has a disproportionately positive affect on innovation by small firms. This innovation channel could be one reason behind the heterogenous impact of finance on firm growth. Moreover, the observed higher productivity and lower spending on innovation in small firms suggests that financial growth could lead to a more optimal interfirm allocation of spending on innovation. This hypothesis implies that as financial markets develop, there is relatively more R&D investment by smaller firms, and that relative R&D productivity in larger firms rises. In this paper, I use data on firms from 57 countries to see if this dual pattern shows up in cross-country data from developing economies.

I find that within industries, relative R&D spending in smaller firms is more likely and sizable in countries at higher levels of financial development. The estimates imply that among firms doing R&D in a country at the 20th percentile of financial development, a one standard deviation decrease in firm size is associated with a decrease of 0.7 standard deviation in R&D spending. In contrast, this decrease is only 0.2 if financial development is at the 80th percentile of its distribution across countries. My second finding also supports the hypothesis: small firms report producing more innovations per unit R&D than large firms, but this gap is narrower in countries at higher levels of financial development.

To verify further that the observed patterns relate to financing, I exploit the crossindustry dimension of my data, interacting financial development with a measure of an industry’s inherent reliance on external finance. I find that the association between financial development and innovation by small firms relative to large ones is stronger in industries more dependent on external finance. I also show that the patterns are robust to controlling for another factor that could have a heterogeneous effect on innovation, namely entry regulation.

Finally, I find that relative R&D by small firms is significantly associated with bank development but not with measures of stock market development. This is consistent with previous research on the source of financing of R&D projects. While banks are the main source of R&D financing in European countries, and a significant source in the U.S. (Herrera and Minetti (2007), Berger and Udell (1998)), the sources of funds vary with the size of the R&D project. Aghion et al. (2003) find that UK firms that report positive but low R&D use more debt finance than firms that report no R&D, but the use of debt finance falls with R&D intensity. They suggest that this is so because firms go first for debt as it involves giving up less control rights than new equity. But eventually, debt is harder because R&D involves intangible assets.

An ideal test of the hypothesis that financial development spurs innovation by small firms relative to large firms would involve comparing small and large firms across markets that randomly differ in the degree of financial development. Such exogenous variation is rarely possible in cross-country analysis, where it is likely that financial development is correlated with other determinants of innovative activities. For example, 3