Leverage regulation, innovation, and systematic risk

This paper examines how leverage regulation affects firms’ innovation incentives and systematic risk exposure. Exploiting China’s 2018 leverage regulation reform that introduced industry-specific leverage thresholds for state-owned enterprises, we employ a regression discontinuity design to identify causal effects. We find that stronger leverage regulation significantly reduces firms’ patenting activities, particularly invention patents, without evidence of changes in patent quality. Additional analyses suggest that this decline reflects a contraction in internal innovation activities rather than substitution towards external technology acquisition. Importantly, we show that leverage regulation increases firms’ systematic risk, consistent with the view that reduced innovation weakens growth opportunities and changes the composition of firm value. In contrast, we find limited short-run effects on operating performance and valuation, consistent with the long-horizon nature of innovation outcomes. Overall, our findings highlight how leverage regulation can influence firms’ innovation incentives and risk exposure through a regulatory discipline channel.