Local Bank Financial Constraints and Firm Access to External Finance

The question of how financing frictions in the banking sector affect lending behavior andeconomic activity has long been of concern to the literature on financial institutions. Mostrecent empirical work on the lending channel and credit crunches has focused on two issues:whether financing frictions exist and, if so, whether shocks to the financial position of a bankhave any real effect on investment. 1The question of whether constrained financialintermediaries lead to underinvestment has, however, received little attention. This is afundamental empirical question since, as pointed out by Allen and Gale (2004), the effect ofcontracting imperfections in the intermediation markets on the efficiency of investment istheoretically ambiguous. On the one hand, financial frictions may be incentive-efficient if theyarise as a solution to an agency problem between the owners of capital and bank managers(Hart and Moore (1995), Jensen (1986), Stulz (1990)). On the other hand, even if bankmanagers act in the best interest of current shareholders, frictions may lead to underinvestmentwhen there is asymmetric information about the value of bank assets (Myers and Majluf (1984),Stein (1998)).To provide compelling empirical evidence that frictions in financial intermediation marketslead to underinvestment, three hypotheses must be tested. First, that banks face frictions intheir access to external financing. Second, that these financing frictions prevent banks fromundertaking profitable investment opportunities. And third, that the lending opportunitiesforgone by constrained banks are not be arbitraged by other unconstrained financialintermediaries. In this paper I show empirically that the three hypotheses hold true in thecontext of local banks in emerging markets. The potential effects of constrained financialintermediaries on the efficiency of investment are first order in this context, due to the2