Banking market structure and firms' financing constraints

I use the Euler-Investment equation to investigate the effect of banking market power, assumed to be increasing in market concentration, on firms' financing constraints in a number of developed and developing countries over the 1991--2002 period. I find evidence for the presence of financing constraints for firms in the sample, as indicated by the sensitivity of firms' investment to availability of internal finance. The results show that banking concentration reduces firms' financing constraints whereby the sensitivity of firms' investment to availability of internal finance decreases as the market becomes more concentrated. I find that small firms are financially constrained and become less financially constrained in more concentrated markets while I find no evidence for either the presence of financing constraints for large firms or for the effect of concentration on sensitivity of large firms' investment to availability of internal funds. I also use three different approaches to investigate the role of institutional environment in influencing the effect of banking concentration on firms' financing constraints. I find that legal system efficiency, financial sector development & the level of restrictiveness of the regulatory environment can each indirectly influence firms' investment through its impact on banking concentration. However, I find that none of these factors can directly affect firms' investment. I find evidence for the differential effect of banking concentration on firms' financing constraints in countries with different levels of institutional development. The overall results show that the beneficial effect of banking market power on access to credit may be limited for certain types of borrowers and only delivered under certain policy conditions influencing the environment in which both banks and firms conduct their businesses.