Small and Medium Enterprise Financing in Transition Economies

By Barth, James R.; Lin, Dongyun et al. | Atlantic Economic Journal, March 2011 | Go to article overview

Small and Medium Enterprise Financing in Transition Economies


Barth, James R., Lin, Dongyun, Yost, Keven, Atlantic Economic Journal


Introduction

Small and medium enterprises (SMEs) foster market diversification, promote innovation, and provide many employment opportunities. Yet SMEs are credit insufficient and vulnerable to credit crunches during financial crises. In this study, both demand and supply side factors influencing SMEs' financing conditions in the transition economies of Central and Eastern Europe are examined.

Some trends are relevant to small business lending, which include financial consolidation, financial liberalization, financial regulatory reform, and institutional development. Financial consolidation increases market concentration. Greater market power may cause lenders to manipulate supply and raise prices. However, lenders with greater market power also have greater incentive to acquire expensive borrower information and are more effective at screening borrowers, since they can extract a surplus in the long run. This helps mitigate information asymmetry (Beck et al. 2004; Dell'Ariccia and Marquez 2004; Jimenez et al. 2009; Presbitero and Zazzaro 2009; Okura 2007).

Financial liberalization induces foreign entry. Foreign entrants cope with crossborder barriers exacerbating information asymmetries. They tend to lend to transparent borrowers based on hard information and have less incentive to lend to opaque borrowers, because of comparative disadvantages in processing soft information (Berger and Udell 2006; Detragiache et al. 2006; Dell'Ariccia and Marquez 2004; Sengupta 2007; Maurer 2008). Encountering competition from out-of-market lenders directs local lenders toward opaque borrowers, where they can create comparative advantages against outside lenders. Foreign entrants in transition economies should therefore enhance small business lending (Dell'Ariccia and Marquez 2004; Memmel et al. 2008; Neuberger et al. 2008).

One country characteristic explaining cross-country variation in SMEs' financing conditions is institutional development. Information asymmetry is a mechanism through which institutional development affects SMEs' access to credit. An effective credit rating system improves creditors' abilities to sort borrowers; better contract enforcement, efficient collateral regime, and well functioning legal system all mitigate the negative impact of information asymmetry (Okura 2007; Sengupta 2007; Haselmaun et al. 2008; Maurer 2008; Hauswald and Bruno 2009). On the contrary, ill-functioning institutional infrastructure can exacerbate information asymmetries. SMEs in transition economies are more opaque and therefore more vulnerable to institutional underdevelopment (Beck and Demirguc-Kunt 2006; Claessens 2006). Effects of foreign entry and market concentration on small business lending are also influenced by the domestic country's institutional environment. Many expected benefits of financial consolidation and liberalization are not achievable before institutional development reaches a certain threshold (Beck et al. 2004; Volz 2004; Maurer 2008; Haiss and Kichler 2009).

Public interest view and private interest view are two opposing perspectives of how to regulate banks (Barth et al. 2006). Government under the public interest view is motivated by a desire to benefit the broader civil society and maximize social welfare. According to the public interest view, governments regulate banks to facilitate the efficient functioning of banks by mitigating market failures from information asymmetry (Beck and Demirguc-Kunt 2006; Jimenez et al. 2009). The private interest view considers government to be motivated by a narrow concept of self-interest and a tendency to serve various interest groups. Under the private interest view, bank regulatory practices should rely more on market discipline, information disclosure, and significant oversight of the regulatory process itself (Barth et al. 2006).

Variable Selection

The source for the dependent variables and firm-specific variables is the European Bank for Reconstruction and Development-World Bank Business Environment and Enterprise Performance Surveys (BEEPS) of 1999, 2002, and 2005 (Fries et al. …

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