One of the key channels through which finance affects economic growth is the provision of credit to the most promising firms. Micro and small firms and young firms face the greatest constraints to access to finance because of market imperfections such as information asymmetries and transaction costs. Finance also has a crucial role in supporting innovation. Research shows that the use of external finance is associated with greater innovation by private small, medium, and large enterprises. To promote job creation and economic growth, it is also important to address the financing challenges associated with new entry and with young firms that are financially constrained because of a lack of information and collateral.
Recent research concludes that the provision of microcredit is not enough to spur microenterprise investment and firm growth in part because borrowers have heterogeneous growth prospects, lack managerial capital, and face regulatory barriers and psychological or behavioral constraints. And, in part, debt may not be the appropriate instrument because repayment requirements without grace periods and joint liability discourage risky investment. Theoretically, equity-like contracts may overcome this problem, but they may not emerge because of moral hazard and a weak legal environment. While there is little evidence on the effectiveness of microequity, recent studies suggest that savings products and microinsurance can spur microenterprise investment and growth.
Financial inclusion can be considerably enhanced by improvements in financial sector infrastructure. Mounting evidence indicates that movable collateral frameworks and registries as well as credit information systems can boost lending to small and medium enterprises (SMEs) by overcoming information problems. Encouraging greater competition in the financial sector is critical in promoting innovation among financial institutions and the adoption of technologies that help cover underserved segments such as SMEs.
Business models and product design matter. Leveraging relationships can be vital in lending to micro and small firms. Novel mechanisms deliver credit through retail chains or large suppliers, while relying on payment histories to make loan decisions and lowering costs by using existing distribution networks.
Financial and business training in an effort to enhance financial management leads to greater expertise, although the impacts on business practices and performance tend to be small, depend on context and gender, and show mixed results. The content of training also matters: simple rule-of-thumb training may be more effective than standard business and accounting training.
Direct government interventions in the credit market, such as directed lending programs and risk-sharing arrangements, can have positive effects on the access of SMEs to finance and growth, but it is a challenge to design and manage the interventions properly. This problem is even greater in weak institutional environments where good governance is difficult to establish.
Woman-owned firms and agricultural firms face particular challenges in gaining access to finance. Woman-owned firms tend to be smaller than firms owned by men and grow at a slower rate partly because women have less access to finance.
Agricultural firms are constrained because of geography as well as high seasonal variability and weather-related risks in agricultural production. Financial products, such as insurance, and government programs can help mitigate these risks and promote investment and productivity among agricultural firms.