Ebook Which Firms Benefit More from Financial Development?
It has long been recognized that there is a pervasive positive cross-country correlation between the level of a country’s financial development and its level of economic activity (e.g., Goldsmith, 1969, or King and Levine, 1993), with causality possibly running both ways. Finance theory surveyed in Levine (1997) contends that financial development can foster corporate growth because financial intermediaries play a key role in overcoming market frictions due to moral hazard and asymmetric information. These frictions give rise to financial constraints and represent a fundamental source of external finance costs, which ought to be lowered through financial development. Efficient financial institutions provide external finance even to informationally opaque businesses, that is to firms with little information available on their economic and financial status.
There is much survey evidence suggesting that small and young firms from both developed and developing countries are constrained in their access to external finance. Applying the logic of finance theory, it is therefore likely that company size or age serve as effective proxies for the extent of market frictions, particularly the extent of information asymmetries, that firms face. Under this assumption, small and young firms are likely to benefit disproportionately from the development of financial institutions and markets. Yet, so far there is relatively little research asking whether this is the case. In this study, we measure the extent to which the development of national financial systems boosts the growth rate of small and young firms more than that of large and old firms.
We follow much of the recent finance-and-growth research and apply (a variant of) the Rajan and Zingales (1998) identification strategy. This strategy was developed to avoid the fundamental identification problem of measuring the effect of finance on growth, which would call for isolating the part of the variation in financial development that is unrelated to unobservable current and future growth opportunities. Rajan and Zingales assume that different industries have a different, technologically determined need for external finance. They form a proxy for this need based on several assumptions and regress industry growth from a sample of countries on country and industry fixed effects as well as on the interaction between a measure of industry external finance dependence and a proxy for country financial development. Their regressions suggest that industries predicted to be in greater need of external finance grow faster in countries with more developed financial markets, conditional on all (potentially unobservable) country and industry specific factors driving growth.
Clearly, this strategy can also be applied to compare the impact of financial development on firms facing a differential degree of informational opaqueness, such as firms of different size or age. We expect that, due to information asymmetries, small and young firms are on average more financially constrained than larger and older companies. Using size or age as a proxy for information asymmetry substitutes for an overt quantification of the firm-specific extent of financial constraints. We therefore measure the growth effect of the interaction between a firm’s age (size) and a country’s level of financial development. In short, we apply the Rajan-Zingales strategy at the firm level.
This approach helps to uncover the mechanism of the finance-growth effect in a novel way. In the Rajan-Zingales framework, the mechanism is based on external sources of finance being more costly than internal ones. Hence, lowering the overall costs of external finance benefits disproportionately those firms that face higher need of external finance (for industry-specific, presumably technological reasons). In contrast, in our study the mechanism consists of lowering the relative costs of external finance for businesses that are more informationally opaque because of their size or age. Our mechanism is therefore closely tied to the underlying fundamental source of external finance costs: information asymmetry. It corresponds to the screening and evaluation process performed by financial intermediaries deciding upon granting external finance.
Relying on a large firm-level data set covering EU-15 firms with more than 100 employees or more than 20 million Euro of total assets between 1995 and 2003, the Amadeus database, we regress firms’ average value-added growth rates on an interaction of firms’ size or age with several dimensions of country-level financial infrastructure. We hesitate to use a linear specification of the interaction of financial development indicators with firm size and age because it is not clear that information asymmetry decreases proportionately with firms’ age or size and because we wish to impose few functional form restrictions. Hence, we interact financial development with indicators of a firms’ position in quintiles of the firm size or age distribution. Our regressions further condition on a set of firm-level pre-determined controls and a full set of country and industry dummies. We therefore ask whether, for example, Greek financial institutions differ significantly from those of the UK in their ability to overcome information asymmetry (identify profitable projects) of young and/or small companies relative to their ability to provide external finance for projects of older and/or larger companies.
We find little significant difference in the effect of financial development across firms of different size. On the other hand, using the oldest companies as the benchmark group, there is strong evidence of a disproportionate positive effect of financial development on all except perhaps the youngest firms. Specifically, we recover an inverted-U shape of the interaction between age and financial development, such that firms of approximately median age appear to benefit the most from financial development.
Next, we explore several alternative explanations for the age shape of the financial-development growth effect. A key explanation is that freshly incorporated companies in less financially developed countries adjust to the state of financial systems by having unusually high shares of equity capital in total assets. They therefore do not need as much external finance in early stages of company existence, which helps to explain why, in our basic specifications, very young firms appear to benefit less from financial development. Indeed, among those youngest companies that have low shares of equity capital in total assets, there is a strong disproportionate effect of financial development. We conclude that financial development fosters growth of young companies even within a set of some of the most developed countries of the world.
The structure of the paper is as follows: In the next section we relate our approach to the existing literature. Section 3 presents our methodology while Section 4 describes the data. Section 5 covers the empirical analysis and Section 6 summarizes the findings.
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