Bank development, competition, and entrepreneurship: International evidence

Highlights

• Less bank market competition facilitates the creation of new businesses.

• Bank development does not affect firm creation after controlling for bank competition.

• The financial crisis did not change the effect of bank competition on firm creation.

Abstract

This paper uses a panel database for 84 countries over the 2002–2017 period to analyze the importance of bank development and bank market competition for enhancing new business creation. The results show that less bank market competition facilitates the creation of new businesses. Bank development, however, is not associated with a higher entry rate of new businesses. Less bank market competition and lending relationships appear to be a main channel for reducing the cost of debt and overcoming traditional adverse selection and moral hazard problems between banks and newly created firms. The global financial crisis did not modify the positive effect of less bank market competition on new firm registration. The results are robust to controls for equity market development, the ability of banks to hold equity positions in nonfinancial firms, the costs and days required for starting a business, and any other omitted time-invariant variables at country level.

Introduction

How entrepreneurial firms obtain funding is a key issue in new firm creation. For this reason, entrepreneurial finance literature has gradually increased over recent decades, focusing mainly on the US (Denis, 2004) and on specific sources of financing (Wright et al., 2016; Wu et al., 2016). Greater adverse selection and moral hazard problems in entrepreneurial firms lead the literature to focus on outside equity funding, such as venture capital and business angels, even though research shows that new entrepreneurial firms rely heavily on “traditional” external debt sources, including bank financing (Cassar, 2004; Cumming, 2005; Robb and Robinson, 2014). In this context, empirical evidence shows the relevance of bank development for enhancing entrepreneurship through increased availability of funds (Rajan and Zingales, 1998; Klapper et al., 2006; Aghion et al., 2007). Moreover, not only financial development but also bank market competition may be important for entrepreneurship. Literature on small and medium size firms documents that less bank competition increases the availability of credit by promoting lending relationships that reduce adverse selection and moral hazard problems between banks and small and medium size debtors (Petersen and Rajan, 1994, 1995; Berger and Udell, 2002; Cetorelli and Strahan, 2006). However, the literature does not simultaneously analyze the importance of bank development and competition for entrepreneurship. Therefore, it is not clear if the relevance of bank development for entrepreneurship remains once differences in bank competition are considered.

For the above reasons, this paper aims to provide new empirical evidence on the relative importance of bank development and competition for enhancing the creation of new firms. Additionally, I use data around the onset of the recent global financial crisis to analyze whether the roles of bank development and competition change during banking crises. Therefore, this paper aims to answer the following questions. What is the relative importance of bank development and competition for enhancing entrepreneurship? Does the role of bank development for entrepreneurship remain after controlling for bank competition? How do banking crises modify the above roles? I use a recent and extensive database on new business registration collected by the World Bank that provides a unique indicator of new business registration, allowing a homogeneous measure of entrepreneurship across countries and over time.

This paper presents several differences from previous empirical studies. First. it jointly analyzes the relevance of bank development and bank competition on new firm entry. Rajan and Zingales (1998), Klapper et al. (2006), and Aghion et al. (2007) analyze the relevance of bank development but do not control for the influence of bank competition on the rate of new firm creation. However, bank competition may be an important determinant of debt availability for entrepreneurial firms even in developed bank markets. Banking literature highlights that less bank competition may increase debt availability and reduce its cost through the establishment of lending relationships when information asymmetries between banks and borrowers are relevant (Petersen and Rajan, 1994, 1995; Berger and Udell, 2002). The presence of important information asymmetries in entrepreneurial firms may therefore convert less bank competition and lending relationships into a relevant channel for increasing debt availability in these firms. Following these arguments, I test in this paper if less bank competition is useful for increasing a country’s rate of new firm creation. Moreover, the relevance of bank development for new firm creation may diminish once we isolate the influence of bank market competition. For this reason, I also test whether or not the influence of bank development on new firm creation remains after controlling for bank competition.

Second, this paper uses an international database and analyzes more countries than previous studies analyzing the effect of financial development on entrepreneurship. The sample includes 84 countries over the 2002–2017 period and uses the recent and extensive database on new business registration collected by the World Bank which provides an indicator of new business registration, allowing for a homogeneous measure of entrepreneurship across countries and over time.¹ This number of 84 countries contrasts with the 41 countries analyzed in Rajan and Zingales (1998), the 23 European countries analyzed in Klapper et al. (2006), and the 16 analyzed in Aghion et al. (2007). A higher number of countries increases the variation in bank development and competition within the sample and, therefore, increases the reliability of the results. It also allows us to control and analyze interaction with other country characteristics such as the ability of banks to hold equity positions in non-financial firms and the administrative costs of new firm registration. Moreover, the use of a panel dataset over the 2002–2017 period reduces concerns on the potential omission of relevant country variables because I include country fixed-effects in all the estimations to control for any time-invariant variable at country level.

Finally, this paper provides evidence on how the roles of bank development and competition in enhancing entrepreneurship change during periods of banking crises. Klapper and Love (2011) provide evidence for the relevance of bank development during banking crises and show that, after the onset of the 2007–2009 global financial crisis, countries with more developed banking systems experienced a more intense drop in new firm registration. However, the role played by bank market competition in entrepreneurship during the crisis remains unknown. This analysis is important because it has implications in terms of pro-cyclicality and financial stability. For instance, if a positive effect of less bank competition on entrepreneurship during normal periods turns into a negative one during crises, less bank market competition would increase pro-cyclicality and reduce the benefits of using less market competition to promote entrepreneurship during normal periods. None of the above-mentioned papers analyzes the potential change in the effect of bank competition on entrepreneurship during banking crises.

I provide unique evidence. The findings of this paper do not indicate that a more developed banking system is enough to increase lending to entrepreneurial firms and promote business creation in a country. Rather, I find that it is bank competition that plays an important role for entrepreneurship. In particular, more new businesses are created in countries with less bank competition. The positive effect of less bank competition on new firm creation is consistent with less bank competition allowing banks and firms to reduce their greater adverse selection and moral hazard problems through lending relationships. Less bank competition and lending relationships may therefore help contribute to explain the documented presence of debt in the capital structure of entrepreneurial firms. Additionally, I confirm that the global financial crisis had a more negative impact on entrepreneurship in countries with more developed banking systems. However, I do not find that the crisis changed the average positive influence of less bank market competition on the rate of new firm creation.

The results do not change when I additionally control for the ability of banks to hold equity positions in nonfinancial firms and for the costs, days, and procedures required in each country to register a business. Moreover, there are no significant interactions between less bank competition and these other country variables. This suggests that the positive effect of less competition on new firm creation is independent of affiliation between banking and commerce and of the administrative costs of new firm registration in a country. Equity market development always has a positive influence on the rate of new firm creation, consistent with the relevance of outside equity on financing new businesses. The results are robust to alternative proxies for bank competition, alternative estimation methods, and the inclusion of additional country variables.

The rest of the paper is organized as follows. Section 2 analyzes the related literature and discusses the hypotheses tested in the empirical analysis. Section 3 describes the data, sample, and variables. Section 4 explains the empirical analysis, and Section 5 presents the results and robustness checks. Finally, Section 6 concludes.