Credit constraints as a barrier to the entry and post-entry growth of firms
GAICIL Insights
Creative destruction needs a bank account.1 Credit constraints as a barrier to the entry and post-entry growth of firms, by P. Aghion, T. Fally and S. Scarpetta, studies how financial development shapes the continuous process in advanced market economies by which firms enter, expand if successful and exit if competition becomes unbearable. Drawing on harmonized firm-level data for 16 industrialized and emerging economies, the authors examine finance's effects on entry, size at entry and post-entry growth.
The findings are clear. Access to finance matters most for the entry of small firms and in sectors more dependent on external finance. This holds after controlling for other potential entry barriers, including labor market and entry regulations. Financial development has either no effect or a negative effect on entry by large firms. Finance also helps new firms expand if successful. Both private credit and stock market capitalization matter for promoting entry and post-entry growth. Big firms barely need deep finance; small ones cannot live without it.
The method is a difference-in-difference test of whether industries more dependent on external financing show greater firm dynamism in countries with more developed financial markets. Financial development is proxied by private credit and stock market capitalization, instrumented with regulatory indicators of banking and securities markets.
Selection is the story. Small firms face the largest financial constraints. Finance improves selection by letting small firms compete on a more equal footing with large firms and seize growth opportunities. Without adequate finance, creative destruction is distorted in favor of large incumbents. A shallow capital market is an invisible subsidy to whoever is already big.
The policy conclusion is direct. Despite significant progress, many countries, including those in Continental Europe, should improve their financial markets to get the most out of creative destruction, encouraging entry of new, especially small, firms and post-entry growth of successful young businesses.
The application to AI is direct. Artificial intelligence innovation is often driven by small, young firms heavily dependent on external finance. Financial development is crucial for their entry and growth. Economies with deep financial markets, including active venture capital and equity markets, are better placed to foster AI startups and let successful ones scale. The AI race is partly a race between capital markets.
Equity matters especially. AI startups often lack tangible collateral and generate uncertain returns, making equity finance particularly important. Developed equity markets let investors share in innovative firms' upside, supporting growth. Deepening equity markets can strengthen the AI ecosystem. A startup with nothing to pledge but code needs an investor, and a loan will rarely do.
Selection shapes AI competition too. If finance lets small firms compete with large incumbents, it supports the creative destruction driving innovation. In AI markets, where large firms hold significant advantages, access to finance for challengers helps maintain competition and dynamism. Finance can serve as competition policy by other means.
The cross-country scope guides both groups. Emerging economies developing AI capabilities can benefit from financial development supporting innovative firms' entry and growth. Advanced economies with underdeveloped equity markets may gain from reforms too. Europe's AI gap may be partly a financing gap.
Robustness to other barriers matters. Labor and entry regulations also affect firm dynamics, and finance matters even after accounting for them. Supporting AI entrepreneurship comprehensively means tackling financial, regulatory and labor market barriers together.
Read as a whole, financial development is a key enabler of creative destruction. Access to finance promotes entry by small firms and the growth of successful newcomers, improving selection and competition. As AI drives a new wave of entrepreneurship, deep and efficient financial markets will help the most promising AI firms enter, grow and challenge incumbents.
A hard question for governments worried about AI concentration: the deepest structural remedy may sit in securities and banking regulation, ahead of antitrust. If challengers cannot raise money to enter and scale, no competition authority can conjure them into existence.
Introduction
Advanced market economies are characterized by a continuous process of creative destruction. Market forces and technological developments play a major role in shaping this process, but institutional and policy settings also influence firms’ decision to enter, to expand if successful and to exit if competition becomes unbearable. In this paper we focus on the effects of financial development on the entry of new firms and the expansion of successful new businesses. Drawing from harmonized firm-level data for 16 industrialized and emerging economies, we find that access to finance matters most for the entry of small firms and in sectors that are more dependent upon external finance. This finding is robust to controlling for other potential entry barriers (labour market regulations and entry regulations). On the other hand, financial development has either no effect or a negative effect on entry by large firms. Access to finance also helps new firms expand if successful. Both private credit and stock market capitalization are important for promoting entry and post-entry growth of firms. Altogether, these results suggest that, despite significant progress over the past decade, many countries, including those in Continental Europe, should improve their financial markets so as to get the most out of creative destruction, by encouraging the entry of new (especially small) firms and the post-entry growth of successful young businesses.
Takeaway
In this paper, we used a harmonized firm-level database to assess the role of financial development on firm entry, the size at entry and post entry performance of new firms. We implemented a difference-in-difference approach in which we test whether those industries with greater dependence on external financing experience greater firm dynamism in countries with more developed financial markets. We proxy financial development with outcomes measures (private credit and stock market capitalization) but also instrument them with regulatory indicators of banking and securities markets. Since entry and post-entry growth of new firms are likely to depend on a host of other factors, in our empirical analysis we also consider start-up regulations and employment protection legislation that, by raising entry costs or labor adjustment costs, may discourage entry and post-entry growth. A first finding of our empirical analysis is that finance matters most for the entry of small firms, especially in sectors that are more dependent upon external finance. This should not come as a big surprise: small firms are those who face the largest financial constraints, as discussed in several papers (e.g. by Bernanke and Gertler, 1990, World Bank, 2005). But our findings also imply that finance helps improve the selection process by allowing small firms to compete on a more equal footing with large firms. More finance permits small firms to take advantage of growth opportunities especially in growing sectors where large firms would be predominant otherwise.1
Higher entry in turn can be shown to be growth-enhancing, as entrants can force inefficient incumbents to exit or force efficient ones to innovate (see Aghion et al., 2006). A second finding is that financial development improves post-entry growth of firms. Of course, one might argue that higher post-entry growth mainly reflects a better selection at entry and the improved access to credit for smaller entrants. However, we saw that the positive impact of financial development on post-entry growth holds if we try to control for the size of entrants. A third finding is that our results are robust to the inclusions of other regulations that may also affect entry and post-entry growth. While there is evidence that stringent employment protection legislation affects the entry of firms in more volatile sectors, the impact of this legislation on post entry growth is not clear cut. Fourth, while our results suggest that both private credit and stock market capitalization are important for promoting entry, the latter plays a stronger role for post-entry growth. This result is consistent with the view that market-based financing has a crucial role for boosting investment in capacity expansion. Indeed several studies have stressed the in bank-based systems the links between lenders and small borrowers tend to be weaker and potentially less effective especially in the case of innovative start-ups.
33 While the development of stock markets depends on the level of development of the country, several studies have also highlighted the significant role of legal systems (civil vs. common law) as well as other factors that are more amenable to policy interventions, such as accounting standards and regulations (Demirguc-Kunt and Levine, 1999).2 Based on our findings, a main policy indication is that many countries, including those in Continental Europe, should probably make further progress in improving their financial markets, so as to boost aggregate entry, and particularly the entry of small firms, to better select the best projects, and to promote post-entry growth of successful new firms. Other regulations also have an impact on entry and on specific sectors (e.g. highly volatile sectors in the case of employment protection) but seem to have a weaker role in driving post entry growth. Further promoting financial reforms aimed at fostering competition while maintaining stability objectives may have strong overall effects on growth performance, without necessarily facing the strong opposition as in the case of, for example, reforms in labor regulations. Our empirical results provide only tentative indications of the direction of further reforms in financial markets and it is, of course, beyond the scope of this paper to provide any specific policy recommendation. However, drawing from available summary indicators of regulations in banking and securities markets, there is clear evidence that there is a long way to go in several countries.
Many of them have undertaken significant deregulations over the past decade, and improvements in information and communication technologies have raised competitive pressures in most segments of financial markets. Nevertheless, there remain significant differences in the stringency of regulations, even across the OECD countries in our sample. These differences are likely to affect the degree of competition in the banking sector and securities markets and raise the costs and choices for both savers and users of external finance. Our results also suggest that in several ways, stock market capitalization and equity play an important role, especially in term of post-entry growth.
Notes
- P. Aghion, T. Fally & S. Scarpetta, Credit constraints as a barrier to the entry and post-entry growth of firms, 22 Econ. Pol'y 732 (2007), https://doi.org/10.1111/j.1468-0327.2007.00190.x. Takeaway source: Conclusions and policy considerations, reproduced from a free author or repository copy. ↩
- Demirguc-Kunt, Asli and R.E. Levine, (1999), "Bank-Based and Market-Based Financial Systems: CrossCountry Comparisons" (July), World Bank Policy Working Paper No. 2143.. ↩
Cite as: P. Aghion, T. Fally & S. Scarpetta, Credit constraints as a barrier to the entry and post-entry growth of firms, 22 Econ. Pol'y 732 (2007), https://doi.org/10.1111/j.1468-0327.2007.00190.x
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