The Role of Financial Development and Bank Competition in Relationship between Financial Constraints and Firm Performance.

Abstract

The interconnections between finance and real sector of the economy have long been investigated for their profound implications. The access to finance is fundamental for firm survival and growth. The financial system consists of financial institutions and markets that can allocate funds to more productive usage. Firms without access to required finance are unable to exploit growth opportunities. Due to asymmetric information, access to finance is more challenging for small and medium-size enterprises. Given the importance of financial development and access to finance, this study examines the relationship between financial constraints and firm performance. The current study focuses on small and medium enterprises as there is a sparsity of studies in this area due to the non-availability of firm-level data. World Bank Enterprise Survey (WBES) covers panel data of 471 firms in two ways survey from 2007 to 2015. This firm-level rich dataset provides information to measure the variables of financial constraints and firm performance. Multiple measures of financial development and bank competition were used to see the moderating role of these variables between financial constraints and firm performance. The study first documents the financial constraint faced by SMEs in Pakistan. The study results show how financial constraints have a negative impact on firm performance. Sales growth and labor productivity have a positive relationship with access to finance. Firm ix innovation is also dependent on credit availability as credit constraints firms are less likely to innovate both in product and technology. The role of financial development and bank competition is investigated in this regard. The result indicates the importance of a well-developed and competitive banking sector can ease the effect of financial constraints on firm performance. Furthermore, the research has real implications for financial policymaking. It shows the importance and nature of financial constraints faced by SMEs. It also shows the role of the banking sector in alleviating the credit constraints of small and medium enterprises. Keywords: financial constraints, firm performance, productivity, innovation, financial development, bank competition, WBES.