1. Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?
Thorsten Beck, Asli Demirguc-Kunt and Vojislav Maksimovic

2. The issue Recent research in corporate suggests that These conclusions
underdeveloped legal and financial systems constrain firms
constraints diminish as financial and legal development occurs
These conclusions
based on samples of largest firms
infer the existence of general constraints
do not examine specific constraints
Recent work on corporate finance suggests that financial and legal system play an important role in relaxing firms’ external financing constraints and facilitating their growth. There is some evidence that the importance of these constraints diminish as country’s financial and legal system develop.
These results are based on (1)samples of large, listed firms; (2) papers try to identify firm constraints from accounting data based on a financial model of the firm,
(3) And since these constraints are not observed, it is not possible to investigate the impact of specific constraints.

3. In this paper we ...
Use detailed firm-level data for 54 countries (World Business Environment Survey) to examine
How is firm growth affected by different financial, legal and corruption obstacles?
Which specific obstacles have an effect?
Are small and medium size enterprises (SMEs) affected differently by different obstacles?
Are SMEs constrained everywhere in the same way or much more in countries with underdeveloped financial and legal systems and higher levels of corruption?
What do we do in this paper?
We use a unique survey data base, WBES. This is a survey data base was put together under the leadership of World Bank with the cooperation of many other agencies and it covers over 4000 firms in 54 countries. And it has answers to specific questions regarding different constraints firms face.
So, using this data base, we try to answer the following questions:
How is firm growth affected by different financial, legal and corruption constraints?
Which specific constraints have an effect?
Are small and medium size enterprises (SMEs) affected differently by different constraints?
Are SMEs constrained everywhere in the same way or much more in countries with underdeveloped financial and legal systems and higher levels of corruption?

4. Background
La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998)
Demirgüç-Kunt and Maksimovic (1998), Rajan and Zingales (1998), Love (2000)
King and Levine (1993), Levine and Zervos (1998) and Beck, Levine and Loayza (2000)
So, just to give a brief background, there is a large literature that argues that a country’s legal and financial system is a significant determinant of firm financing and growth. La Porta et al. papers identify important differences between legal systems and show their importance for external finance. Demirguc-Kunt and Maksimovic use firm level data and rely on a financial planning model to obtain the maximum growth rate individual firms can attain without access to external finance. If firms are growing faster than this rate, this reveals that they are externally-financed and potentially constrained. This approach allows us to associate the proportion of externally-financed firms in a country to specific country charateristics – such as the level of financial and legal development.
Rajan and Zingales use industry level data and show that those industries that are more dependent on external finance in US, grow faster in countries with better developed financial systems.
Love follows Fazzari Hubbard and Petersen and defines firms to be financially constrained if they are observed to have a high correlation between long-term investment and internal financing, after controlling for investment opportunities.And then she shows that the sensitivity of investment to cash flow depends negatively on financial development.
And of course at the country level, Levine – with various co-authors – has shown that financial development promotes growth and that differences in legal origins explain differences in financial development.

5. WBES 4000 firms in 54 countries Stratified sample
by number of employees: 5-50; , 501+
Detailed questions on specific obstacles
So, while the results of this literature suggest that underdeveloped financial and legal systems can constrain firms, these constraints are not generally observed. This is the advantage of the WBES data base we use. It actually covers 10,000 firms in 80 countries – but a lot of those are empty so we end up with over 4000 firms in 54 countries.
Unlike other data sets, this data is geared towards small firms. It is stratified – covers three groups of firms based on employment. Small firms are those that have between 5 to 50 employees, medium firms have between 51to 500 employees and large firms have over 500 employees. 40% of the observations come from small firms, another 40 % from medium firms and another 20 % from large firms.
And the main purpose of the survey is to identify constraints to firm growth and thus the survey has a large number of questions on the nature of financing and legal constraints firms face, as well as corruption issues.Information on firms is more limited but the survey includes data on firm sales, industry, growth, number of competitors, some information on ownership, if the firm is an exporter or has been receiving subsidies from national or local authorities.

6. Detailed obstacles
Collateral requirements; bank paperwork; high interest rates; need special connections with banks; banks lack money to lend
Availability of info; consistency of interpretation; quality, efficiency; fairness; affordability; consistency of courts; contract enforcement
Corruption of bank officials; need to make “additional payments”; proportion of revenues paid as bribes; time spent by management with officials
In addition to the general constraints, firms were also asked more detailed questions to understand the nature of these constraints better.
For example as part of assessing the importance of financing constraints – the firms were asked to rate how problematic certain issues are for the operation and growth of their business. These are Collateral requirements of banks; Bank paperwork and bureaucracy; High interest rates;Need for special connections with banks to be able to do business with them; Banks lack money to lend; and some access question such as access to foreign banks, to non-bank equity, to export finance, to leasing finance, long-term loans etc.
Similarly we have detailed questions on the legal system. Businesses were asked if information on laws and regulations were available; if the interpretation of laws and regulations were consistent; Quality, efficiency; Fairness; Affordability; Consistency of courts; quality of Contract enforcement. These are generally rated from 1 to 6 with higher ratings representing greater obstacles.
For corruption too, we have detailed survey answers. For example there is a question about corruption of bank officials. The survey also reports what is most troubling for firms: is it the need to make additional payments, not knowing the amount of these payments, or the uncertainty that the job will be done even after the payments are made? There is also information on the proportion of revenues paid as bribes, percentage of management’s time spent with regulators, and the proportion of the value of contracts that need to be paid to gain access to government contracts. We also investigate these variables.

7. Empirical model firm growth=f(control variables, obstacles)
firm growth=f(control variables, obstacles X size)
firm growth=f(control variables, obstacles X institutional variables)
firm growth=f(control variables, obstacles X size X institutional variables)
Of course we are interested in the level of the constraints faced by different firms, but we are also interested in how firm growth is affected by these constraints to determine if these constraints really have an impact.
So we estimate regression equations of this form:
Controlling for firm level and country level factors we try to see if reported constraints have a significant impact on firm’s growth rate. If this impact is different for different size firms, and in different institutional settings. And of course we also want to see if differences in the way different size firms are affected exist everywhere or only in countries with less developed institutions.
We estimate these regressions using firm level data across 54 countries and country random effects.

8. Control variables Firm level Country level government foreign exporter
subsidized
number of competitors
industry
size
Country level
GDP/CAP
inflation
growth
banking sector
legal system
corruption
And very briefly on the control variables. We have limited information on the firms. As firm level controls we use ownership variables – if the the firm has government or foreign ownership- Government firms may face lower constraints or may be less affected by these constraints since they may have soft budget constraints or access to funds at subsidized rates from state owned banks. Similarly foreign firms may be less affected by domestic financial constraints since they could have easier access to the international financial system; but they may find it more difficult to deal with legal or corruption issues compared to domestic firms. Growth rate of firms may also depend on the market structure they operate in. So we also include dummy variables to capture whether the firm is an exporting firm, whether it receives subsidies from the local and national government, and the number of competitors it faces in its market. And of course we control for industry effects by including industry dummies for manufacturing and services industries. Finally, we also explore the impact of firm size.
As far as country level variables – we include gdp/capita, growth rate of gdp/capita – if investment opportunities are correlated, there should be a relation between individual growth rate of firms and the growth rate of the economy.and inflation. Inflation is an important control in that it is an indicator of whether local currency provides a stable measure of contracting. Finally, we include institutional variables to capture financial and legal development and corruption- as I mentioned earlier.

9. Firm growth: the impact of obstacles
Financing
-0.031*** (0.009)
Legal
-0.029*** (0.009)
Here basically we enter the general constraints to the baseline growth equation one at a time and then all together. When entered separately all constraints/obstacles have a negative and significant impact on firm growth as expected.
Corruption
-0.021*** (0.009)

10. Firm growth and individual obstacles
General financing obstacle
Collateral requirements
Bank paperwork/ bureaucracy
High interest rates
Need special connections with banks
Banks lack money to lend -
0.031*** -
0.027*** -
0.028*** -
0.032*** -
0.023*** -
0.029***
(0.009)
(0.008)
(0.008)
(0.010)
(0.009)
(0.008)
General legal obstacle
Overall quality and efficiency of courts
Courts are fair and impartial
Courts are affordable
Courts are consistent
Court decisions are enforced -
0.029*** -
0.003 -
0.004 -
0.009 0.
002
0.011
(0.009)
(0.008)
(0.007)
(0.007)
(0.007)
(0.007)
Then we look at more detailed constraints, again including them in the baseline regressions. We look at all that is available, but I’ll show you the more interesting ones. For financing constraints, we see that collateral requirements, bank paperwork and bureaucracy, high interest rates the need to have special connections with banks, lack of money in the banking system all have significantly constraining effects on firm growth. And some other access variables are not.
We also see that while the general legal constraint has a highly significant impact, none of the detailed indicators develop significance.Nevertheless, the individual constraints predict 50% of the variation in the overall constraint but this predicted variable isn’t significant in the growth regression either. So perhaps firms are able to work through individual constraints although they find them annoying yet collectively legal constraints have an impact.
Also looking at corruption variables, we see that the proportion of revenues paid as bribes is also a good indicator of corruption developing a negative and highly significant coefficient. Corruption of bank officials and the percentage of senior management’s time spent with government officials also reduce firm growth significantly, but only at 10 percent.
General corruption obstacle
Corruption of bank officials
Having to make “additional payments”
Prop. of revenues paid as bribes
Prop. of contract value that must be paid
Prop. of mgmt’s time spent w/gov officials -
0.021** * -
0.017* -
0.003 -
0.037***
0.004 -
0.012*
(0.009)
(0.010)
(0.006)
(0.008)
(0.007)
(0.007)

11. Firm growth and obstacles: large versus small firms
General
financing
obstacle
General
legal
obstacle
General
corruption
obstacle
Large
-0.023**
(0.012)
-0.013
(0.013)
-0.007
(0.012)
Medium
-0.031***
(0.009)
-0.026***
(0.010)
-0.017*
(0.010)
Next, we look at the size issue. So in addition to controlling for firm size, we interact the individual constraints by 3 dummies – small, medium, and large. We see that large firms are affected much less or not at all by these constraints, whereas the impact on the smallest firms is quite significant. Multiplying the coefficients with the mean level of constraints shows that the differences are economically significant. For example, for financing constraints, the effect is 11% per year for small firms and 6% for large firms. This is also true for legal constraints although the mean level of legal constraints is higher for larger firms, the economic impact of these constraints are still higher for small firms. The values are about 9% for small firms and only 3 percent (and insignificant) for large firms. So large firms- although they may face greater legal inefficiencies- seem to be able to better adjust to these inefficiencies and find ways around them. The corruption story is similar: the economic impact of corruption on large firms is about 2% and insignificant, whereas this value is about 8% for small firms.
 Small
-0.034***
(0.009)
-0.040***
(0.011)
-0.030***
(0.010)

12. Firm growth and obstacles: impact of institutional development
General
financing
obstacle
General
legal
obstacle
General
corruption
obstacle
-0.043***
(0.013)
Financing Obstacle
Financing
Obstacle x Priv
0.045*
(0.029)
-0.085**
(0.027)
Legal Obstacle
Legal Obstacle x Laworder
0.014*
(0.009)
Next, we address the issue whether constraints affect firms similarly in all countries or whether the impact depends on the country’s level of financial and legal development and corruption. So we interact the constraints with the institutional variables. The results indicate that firms in financially and legally developed countries with lower levels of corruption are less affected by the constraints. For priv levels of 95% or higher the impact of financing constraints is no longer significant. At highest level of laworder (6), the impact of legal constraint is zero. Again at high levels of corrupt (4- lack of corruption- out of 6) the impact of corruption constraint becomes insignificant. (would be nice to get the sample means for these variables)
-0.084***
(0.026)
Corruption Obstacle
Corruption
Obstacle x Corrupt
0.020***
(0.008)

13. Firm growth and the impact of obstacles: firm size and national differences
Gen. financing obstacle:
Gen. legal obstacle:
Gen. corruption obstacle:
Large -
0.023
Large -
0.060
Large -
0.020
(0.016)
(0.046)
(0.037)
Medium -
0.031** -
0.092**
Medium -
0.067**
Medium
(0.014)
(0.040)
(0.028)
Small -
0.058***
Small -
0.104***
Small -
.117***
(0.014)
(0.044)
(0.029)
Large x Priv -
0.039
Large x Laworder
0.009
Large x Corrupt
0.002
Next, we look at whether institutional development affects all firms in the same way. So we look at interactions of financial constraints with size and institutional variables.Looking at the first column, we see that again small firms are the most affected by financing constraints, however development of the financial system relaxes the these constraints on small firms since the interaction term of the small firms, financing constraint and priv develops a positive and significant coefficient.
Similarly looking at legal and corruption constraints we see that institutional development in these areas help reduce the constraining effect on small and medium firms.
(0.051)
(0.013)
(0.013)
Medium x Priv
0.021
Medium x Laworder
0.018*
Medium x Corrupt
0.018**
(0.038)
(0.010)
(0.009)
Small x Priv
0.097***
0.026***
Small x Laworder
0.015*
Small x Corrupt
(0.039)
(0.010)
(0.009)

14. Our principal findings
All classes of obstacles – financial, legal and corruption – constrain firm growth
Size is of critical importance – smallest firms are the most adversely constrained
Firms that operate in institutionally underdeveloped countries are affected by all obstacles to a greater extent
Marginal institutional development relaxes the constraints for SMEs
What’s the contribution of this paper? First, by making use of a unique survey data base we are able to investigate a rich set of constraints reported by firms and directly test if any of these constraints are significantly correlated with firm growth rates. Second, the data base also allows us to focus on differences in firm size since it has good coverage of small and medium enterprises in 54 countries. Third, we investigate if the extent to which the firms are affected by different constraints depends on the level of development of the financial and legal system and the national level of corruption. Finally, one of the categories of constraints we investigate is corruption, and its impact on firm growth has not been investigated before.
What do we find? We find that..
All classes of constraints -- financial, legal and corruption -- affect firm growth adversely
Size is of critical importance --smallest firms are the most adversely constrained
Firms that operate in institutionally underdeveloped countries are affected by all constraints to a greater extent
Marginal institutional development relaxes the constraints for SMEs

15. Policy implications
Development institutions devote large amount of resources to SMEs
Paper provides evidence that indeed SMEs face greater obstacles compared to large firms and small firms are more constrained by them
Paper also shows that it is the smaller firms that stand to benefit the most from improvements in financial and legal development and reduction in corruption
Thus institutional development helps leveling the playing field
Our results have important policy implications. Development institutions devote large amount of resources to small and medium enterprises (SMEs) because the development of the SME sector is believed to be crucial for economic growth and poverty alleviation. There isn’t a lot of evidence to support this. Another argument is that SMEs are disadvantaged and don’t get equal opportunities because of market imperfections and therefore efforts to promote SMEs are justified based on “leveling the playing field.” Paper provides evidence that indeed SMEs face greater constraints compared to large firms and small firms are more adversely affected by these constraints
Paper also shows that it is the smaller firms that stand to benefit the most from improvements in financial and legal development and reduction in corruption
Thus efforts in this area are justified in promoting the development of the SME sector