Corporate Financial Constraints, Bank Governance,and Financial System Stability

Financial constraints are frictions that prevent firms from funding all desired investments, which might affect firm value and aggregate economic activity. We investigate whether and how bank governance, especially private vs. non-private bank ownership, affects financial constraints of small and medium-sized enterprises (SMEs). We focus on SMEs because they are more opaque, bank-dependent and riskier than large firms. Given the significant differences between private and non-private banks’ objectives, governance, and organizational structure we expect a different impact on corporate financial constraints. Based on a rich dataset on German SMEs from the period 1995-2007, we find that an increase in relative borrowings from non-private banks reduces corporate financial constraints significantly. There is no such effect for private banks, and the reduction of financial constraints becomes stronger in periods of low regional economic growth, and for the smallest and relatively risky firms. Our findings highlight two important features of a financial system that consists of private and non-private banks: aggregate corporate financial constraints are reduced and corporate borrowings become less cyclical, reducing the volatility of economic activity.