Financial and Legal Institutions and Firm Size

1
Financial and Legal Institutions and Firm Size

• Thorsten Beck, Asli Demirguc-Kunt and Vojislav
  Maksimovic

2
Motivation

• What determines firm size and how is this
  relevant for SME research?
• Firm size and institutions
• It may be that in the absence of developed
  institutions, it is optimal for firms to stay
  small.
• Then subsidizing SMEs to make them grow may not
  be successful or may even be counterproductive
  unless institutional shortcomings are addressed
  first.

3
Institutional Determinants of Firm Size

• Corporate finance literature suggests that
• financial and legal institutions could affect
  firm size in opposing ways
• If institutions are underdeveloped, firms
  internal markets may be more efficient than
  public markets inverse relationship.
• But large firms are also subject to agency
  problems which are more difficult to control if
  institutions are underdeveloped
• The relationship between firm size and
  institutional development depends on the relative
  importance of these effects

4
Focus on largest firms

• Even if with underdeveloped institutions, it is
  optimal for firms to substitute internal markets
  for external markets and become larger, financing
  constraints may prevent this blurring the
  relationship.
• Thus, to test if transactions costs or agency
  costs are more dominant, we need to focus on
  firms that can determine their size without such
  constraints
• Recent papers suggest that it is the largest
  firms that are likely to be the least
  constrained.

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In this paper we ...

• Use firm-level data for 100 largest manufacturing
  firms in 44 countries averaged over 1988-97
  (Worldscope) to examine
• Institutional determinants of firm size
• Are the largest firms in countries with developed
  financial systems larger?
• Is there a positive or negative relationship
  between firm size and the efficiency of the legal
  system?
• Are these relationships different in industries
  with a higher external financing need or higher
  ratio of intangible assets?

6
Data

• Dependent variable total sales of firm in US
• Independent variables financial development
  (private credit), legal development (judicial
  efficiency) and others
• Controls firm (NFATA, NSNFA, ROA) industry
  dummies macro (GDP, GDP/CAP, inflation,
  education, openness) other institutions
  (corruption, property rights)

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Firm Size Billions of US
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Empirical model

• Firm Size f( Finance, Legal, Control vbls)
• Robustness
• Random country effects
• Clustering at the country and industry level
• Multicollinearity between financial and legal
  vbls
• Including different controls and alternative
  measures
• Different size measure and focusing on top 25
  firms

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Determinants of Firm Size
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Economic Effects are also Significant

• If Turkey had the same financial development as
  Korea (Private Credit 1.06 instead of 0.14),
  largest firms in Turkey would have been double
  the size (1.3 billion instead of 598 million)
• If Indonesia had the same legal development as
  Chile (Jud. Eff 7.25 instead of 2.5) its largest
  firms would have been 252 million instead of
  168 million, a 50 larger size

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Size Determinants - Channels
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Channels

• How does financial system impact size?
• Firms in industries with a higher need for
  external finance are larger in countries with
  more developed financial institutions
• Firms in industries with a naturally higher ratio
  of intangible to fixed assets are larger in
  countries with more developed financial
  institutions
• The channels through which legal system
  effectiveness impacts firm size are not clear

13
Conclusions

• Firms are larger in countries with more developed
  financial sectors and efficient legal systems
• Agency costs dominate. No support for the view
  that large firms can compensate for
  underdevelopment of financial and legal
  institutions through use of internal markets.
• Financial development allows firms to operate on
  a larger scale by facilitating access to external
  finance and a more efficient asset allocation.

14
Policy implications

• Results suggest that optimal firm size increases
  with institutional development
• Efforts to promote SMEs and encourage their
  growth may not be effective since optimal firm
  size is smaller in the absence of well developed
  financial institutions and efficient legal
  systems.
• Well-developed institutions appear to be a
  pre-requisite for the development of large
  corporations.