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Research Highlights 2006: Finance and Private Sector Development

Research Highlights
  Countries are likely to benefit more from allowing market participants to monitor and 
     discipline financial institutions than from regulation
  Small and medium-sized enterprises face financing constraints that may limit growth opportunities
  Costly entry regulations can hamper the creation of new firms
Publications in 2006
Forthcoming in 2007

Finance and Private Sector Development research were merged into a single team in September 2006. Current policy concerns and research in the financial sector are organized around two different, albeit not fully independent, dimensions—access to financial services and risk management. The current research program also includes significant private sector development elements, such as entrepreneurship and firm informality, which will be emphasized even more going forward.


The research on access to finance—which is important in promoting growth and alleviating poverty—includes documenting and benchmarking access to financial services by small firms and poor households, and identifying underserved groups and analyzing barriers to building more inclusive financial systems. Another thread of this research evaluates the channels through which access to finance can contribute to growth through promoting entrepreneurship, innovation, and the process of technology adoption. The goal is to evaluate the impact of firms’ financing constraints and households’ inability to access financial services on economic growth and poverty alleviation, and to identify different ways of improving this access, ranging from microfinance innovations to improving how mainstream financial institutions and systems function.

The research on risk management—which is important for ensuring the sustained effectiveness of financial systems and financial stability over the long run—investigates the impact of supervision strategies, as well as the impact of compliance with Basel Core Principles on bank stability, the interaction of bank insolvency resolution and deposit insurance policies, and the impact of financial globalization on bank efficiency and access to financial services. New work includes the area of capital market development and insurance.

Research on the private sector focuses on understanding determinants of firm entry and performance. Central to this research is the importance of firm dynamics—changes in the composition of the private sector and entry and exit over time—and how this affects firm productivity and growth. In addition to access to finance discussed above, special areas of investigation are the determinants and consequences of informality, innovation, and governance and their impact on firm performance. Finally, this work includes a study of the impact of the business environment and its reforms on firm performance to identify the most effective reforms and help prioritize reform efforts and maximize their impact.

Research Highlights

Selected publications this year include a book on bank regulation and supervision, a special journal issue on access to finance for small and medium enterprises (SMEs) and other papers on SME financing, and papers on entrepreneurship. The team also organized a conference on Financing of Corporations in Emerging Countries (March 28-29, 2006) jointly with the Darden Business School, and another conference on Bank Regulation and Corporate Finance: Challenges for the Future (October 26-27, 2006) jointly with the Journal of Financial Intermediation. (Agenda and papers available at under events.)

Countries are likely to benefit more from allowing market participants to monitor and discipline financial institutions than from regulation

If followed, the Basel II recommendation to strengthen supervisory powers may do more harm than good in developing countries. Rather, countries ought to focus on strengthening the incentives and ability of market participants to monitor and discipline financial institutions.

These findings are published in a book and related papers based on a multiyear research project to assemble and analyze a unique cross-country database on bank regulation and supervision in over 150 countries [13, 40, 51]. The book, which was reviewed in The Economist, offers the first comprehensive cross-country assessment of the impact of bank regulation on the operation of banks, challenging the validity of the Basel Committee’s influential approach to bank regulation. It provides an important warning to policy makers that what works for advanced countries may not be best practice for developing countries. This has important lessons for Bank staff working on supervision issues and for client countries.

Small and medium-sized enterprises face financing constraints that may limit growth opportunities

As our earlier research has shown, a large Small and Medium Enterprise (SME) sector may not promote growth [53]. One reason may be that SMEs face greater financing constraints which prevent them from fulfilling their growth opportunities. A series of papers in the Journal of Banking and Finance explore SME financing constraints and the most effective ways to relax them [12, 15, 16, 19, 20, 22, 24, 26, 31].

Although firm entry (especially smaller firms) and growth can be improved by developing institutions and building a more enabling business environment, institution-building is a long-term process fraught with many challenges. In the interim, innovative lending technologies hold promise and governments can facilitate their adoption by providing the necessary regulatory frameworks.

Some technologies, such as factoring are particularly promising in the short term, since they rely on institutions to a lesser extent. Others such as trade-credit, credit-scoring, asset-based lending, however, can all be useful for relaxing the financing constraints of SMEs and their use would improve with development of institutions over time.

These new lending technologies also challenge the conventional wisdom that small and local banks have an advantage in SME financing; rather, large, national (or even foreign-owned) banks might have an advantage in utilizing these new techniques. Evidence suggests foreign institutions have an important role to play in facilitating the adoption of these technologies, whereas public banks have been less useful in the past.

Costly entry regulations can hamper the creation of new firms

Costly entry regulations are affecting industries like computers and communications that should naturally have high entry, and are forcing new entrants to be larger and causing incumbent firms to grow more slowly. This work—which studied the effect of entry regulations based on a comprehensive firm-level database of 35 European countries—highlights the importance of a supportive regulatory environment for the creation of new firms. Furthermore, the findings suggest that onerous regulations that discourage entry and competition also dampen the performance of incumbent firms and discourage private sector development. Since entrepreneurship is a critical part of the growth process, these results have important implications for policy makers seeking to promote new firm creation.

In related work jointly conducted with the International Finance Corporation, a new time series, multi-country database is being compiled through surveys of business registries, measuring firm entry and exit and the percentage of newly registered firms in the formal sector. Data suggest a strong correlation between entrepreneurship and the quality of the legal and regulatory environment, as well as ease of access to finance [33, 49, 55].


Asli Demirgüç-Kunt, Senior Research Manager

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