1. Financial and Legal Institutions and Firm Size Thorsten Beck, Asli Demirguc-Kunt and Vojislav Maksimovic

2. 2 Motivation What determines firm size and how is this relevant for SME research? Firm size and institutions It may be that in the absence of developed institutions, it is optimal for firms to stay small. Then subsidizing SMEs to make them grow may not be successful or may even be counterproductive unless institutional shortcomings are addressed first.

3. 3 Institutional Determinants of Firm Size Corporate finance literature suggests that –financial and legal institutions could affect firm size in opposing ways If institutions are underdeveloped, firms’ internal markets may be more efficient than public markets – inverse relationship. But large firms are also subject to agency problems which are more difficult to control if institutions are underdeveloped –The relationship between firm size and institutional development depends on the relative importance of these effects

4. 4 Focus on largest firms Even if with underdeveloped institutions, it is optimal for firms to substitute internal markets for external markets and become larger, financing constraints may prevent this – blurring the relationship. Thus, to test if transactions costs or agency costs are more dominant, we need to focus on firms that can determine their size without such constraints Recent papers suggest that it is the largest firms that are likely to be the least constrained.

5. 5 In this paper we... Use firm-level data for 100 largest manufacturing firms in 44 countries averaged over 1988-97 (Worldscope) to examine Institutional determinants of firm size –Are the largest firms in countries with developed financial systems larger? –Is there a positive or negative relationship between firm size and the efficiency of the legal system? –Are these relationships different in industries with a higher external financing need or higher ratio of intangible assets?

6. 6 Data Dependent variable – total sales of firm in US$ Independent variables – financial development (private credit), legal development (judicial efficiency) and others Controls – firm (NFATA, NSNFA, ROA); industry dummies; macro (GDP, GDP/CAP, inflation, education, openness); other institutions (corruption, property rights)

7. 7 Firm Size – Billions of US$

8. 8 Empirical model Firm Size = f( Finance, Legal, Control vbls) Robustness: Random country effects Clustering at the country and industry level Multicollinearity between financial and legal vbls Including different controls and alternative measures Different size measure and focusing on top 25 firms

9. 9 Determinants of Firm Size

10. 10 Economic Effects are also Significant If Turkey had the same financial development as Korea (Private Credit =1.06 instead of 0.14), largest firms in Turkey would have been double the size ($1.3 billion instead of $598 million) If Indonesia had the same legal development as Chile (Jud. Eff= 7.25 instead of 2.5) its largest firms would have been $252 million instead of $168 million, a 50% larger size

11. 11 Size Determinants - Channels

12. 12 Channels… How does financial system impact size? –Firms in industries with a higher need for external finance are larger in countries with more developed financial institutions –Firms in industries with a naturally higher ratio of intangible to fixed assets are larger in countries with more developed financial institutions The channels through which legal system effectiveness impacts firm size are not clear

13. 13 Conclusions Firms are larger in countries with more developed financial sectors and efficient legal systems Agency costs dominate. No support for the view that large firms can compensate for underdevelopment of financial and legal institutions through use of internal markets. Financial development allows firms to operate on a larger scale by facilitating access to external finance and a more efficient asset allocation.

14. 14 Policy implications Results suggest that optimal firm size increases with institutional development Efforts to promote SMEs and encourage their growth may not be effective since optimal firm size is smaller in the absence of well developed financial institutions and efficient legal systems. Well-developed institutions appear to be a pre- requisite for the development of large corporations.