The role of banks in the development of new businesses in emerging economies

The role of banks in the development of new businesses in emerging economies

Faiçal Belaid, PhD Economics

How bank lending boosts or impedes economic activity is a fundamental question in financial economic research, and has been assessed in many studies. In recent research, I focus on whether the link is different for young firms.

The key dimension through which the financial system impacts economic development is through the provision of external finance to new businesses or start-ups. Given start-ups’ role in enhancing employment growth, innovation, competition and exports, their financing has important implications for the economy. The two most common start-ups financing mechanisms are equity (internal finance) and bank debt. In underdeveloped financial systems with limited access to venture capital banks are the most important providers of external financing to start-ups. The use of debt by start-ups has significant implications for their profit performance, risk profile and the potential of the business expansion.

A situation where banks charge high interest rates for start-ups, reflecting a risk premium or rent-seeking if competition is limited can negatively affect their performance. Lending to start-ups can entail high lending costs (agency costs, monitoring costs and enforcement costs), leading banks to charge higher interest rates, thereby extracting a large share of start-ups’ rents. This impedes start-ups’ performance by squeezing down their profits and their market shares. Also, the higher cost of borrowing creates a financing barrier for start-ups. While the interest rate on loans is an input cost for all firms, we are interested in whether the impact of interest rates on profit is higher for start-ups than the one for existing firms.
I study the role of the Tunisian bank-centered financial system in financing firms at the time of creation. I find evidence that bank debt costs impede firms’ performance, and that this is more pronounced during the early stage of firms’ life cycle (the first five years of activities). Further, the impeding effect of bank debt on start-ups’ performance is relatively stronger for firms with low amount of collateral. My study finds that the weight of bank debt cost is more pronounced for new businesses than for existing firms which negatively impacts start-ups’ performance.

In countries where the financial system is bank-centered, banks can also take advantages of their monopolistic power and apply higher interest rates than what a competitive risk premium would warrant. This would impede firms’ development.

This study on the role of bank funding on new businesses development in an emerging economy complements the growing theoretical and empirical literature on firm’s capital structure. Policy makers should seek to develop alternative funding strategies for new businesses, such as venture capital. A state owned companies of venture capital could be one possible solution to promote this. Doing so will improve the sustainability of new firms and enhance jobs creation and economic growth.