Innovation: Learning from China's Banking System

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This is an inaccurate characterization because today's bank lending in almost all cases requires existing cash flow and collateral that most entrepreneurs starting up do not have. Furthermore, if there are banks that conduct entrepreneurial lending, they are small, specialized banks that are not receiving the large Troubled Asset Relief Program (TARP) funds from Treasury. Companies the size of Goldman Sachs (GS) and JPMorgan Chase (JPM) that have received large sums of government money service other multinational corporations, not entrepreneurs. Finally, angels and venture capitalists do not use loans from banks to make investments; they use their own equity capital to make equity investments. Thus, rather than propping up failed financial institutions, the government should increase funding to inventors, scientists, and entrepreneurs over and beyond the paltry amount supplied by venture capitalists if President Barack Obama is sincere about investing in the long-term, sustainable prosperity for the U.S.

Taking a Chance on New Ideas

An innovation bank could be set up to increase scarce resources to entrepreneurs and inventors that they otherwise would not receive because their ideas or projects may be deemed too long term or too risky by private investors. According to PricewaterhouseCoopers, the percentage of first-time venture capital financing was only 20% of all VC investments in 2008, meaning that most of these investments are not with entrepreneurs with new, untested ideas or products. More than 90% of proposals landing on the desks of venture capitalists get rejected, and a great majority are turned down because VCs are profit-seeking entities with a low tolerance for risk. Like hedge funds, they run in herds and often make the mistake of rejecting an idea just because no one else has already funded it.

They have also relatively short time horizons because they want to bring companies public or sell them to conglomerates as soon as possible in order to realize a profit. So an idea with merit will get rejected if it's going to take longer than five years to become a viable business due to the advanced research required. A large opportunity lies in helping these rejected entrepreneurs turn their dreams into reality.

A government-sponsored bank would raise concerns of fraud and corruption, as evidenced by the examples of Fannie Mae (FNM) and Freddie Mac (FRE). Probably no institution is free from the vulnerability of some degree of waste. However, such waste and corruption can be minimized by structuring the right incentives and punitive measures. For instance, a possible guideline for the government to provide an equity investment in a startup may require the entrepreneur to put a significant financial stake in the company and provide proof that the idea works, like having a working prototype and patent. To ensure that innovation bank investors work for the public interest, they may be required to allocate a set percentage or number of investments in specific sectors—such as clean tech—and receive bonuses tied to the success of their investments while also being subject to clawbacks of their bonuses if their investments sour quickly.

Overseeing the portfolio and operations of such a bank would require an independent, qualified, and objective group. A possible model is to create a rotating panel of professors and scientists who don't have conflicts of interest, are bound by confidentiality agreements, have the expertise to evaluate the technology, and are selected by governors in each state. While the actual product or service may not be disclosed to the public, names of companies or entrepreneurs and the amounts they received from the government should be disclosed in the spirit of transparency.

Americans may not like the idea of the government picking winners and losers as the U.S. strays ever further from a free market model. But the government is already picking winners and losers through the multiple bank and auto bailouts. The question is no longer whether Americans will stick with free market capitalism, but rather who will benefit from the government largess. Until now the answer has been the large failed companies that have legions of lobbyists badgering Congress to support them—while entrepreneurs have received no equity shares because they have no money or voice in Washington. But the future doesn't have to be a repeat of the past. Politicians can still choose to continue throwing good money after bad, or they can invest in new ideas and products that lead to a promising future. It's time to urge them to make the right choice.

Ann Lee is an adjunct professor teaching economics and global affairs at New York University. She has also taught at Beijing University and Pace University and is a former investment banker and credit derivatives trader.