Small business productivity and access to financing

Karthik Krishnan, Debarshi Nandy, Manju Puri 26 September 2014

a

A

The Dodd-Frank act of 2011 included a clause that completely deregulated expansion by banks across state borders through opening up new branches. Some called this feature a giveaway to big banks and detrimental for community banks. Others saw it as a boon for community banks, since they will be able to expand into newer markets at a lower cost. This debate, however, also feeds into the question of what will happen to small businesses when banks are free to expand across state borders.

In particular, free market proponents argue that the free flow of capital leads to greater access to capital, allowing firms to invest efficiently. To the proponents of this argument, allowing banks to expand freely across geographic locations will enhance the efficiency with which capital is allocated to the most productive firms. Thus, firms can use more capital (or cheaper capital) to invest in productive projects that they would otherwise not have access to and enhance their productivity. On the other hand, it is also possible that firms may utilise this additional capital in wasteful expenditures (Jensen and Meckling 1976). This question has important policy implications, particularly when local, state, and national government budgets are stressed by economic conditions. For them, the pertinent question is how they can spur growth of local entrepreneurial firms.

The Interstate Banking and Branching Efficiency Act and firm productivity

In our forthcoming paper in the Review of Financial Studies (Krishnan et al 2014), we study how the interstate expansion of banking and bank branching  allowed by the Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 affected firm-level productivity of small and large firms. Various regulations in the US restricted intra as well as interstate banking dating back to the 19th century. The McFadden Act of 1927 restricted cross-state banking and state-level regulations prevented banks from intra-state expansions. Although banks tried to get around these regulations by forming multi-bank holding companies, the Douglas Amendment to the 1956 Bank Holding Company Act effectively prevented banks' expansion across state borders, unless states explicitly permitted such expansion. However, states gradually dismantled these restrictions and many states had laws in place allowing interstate banking by 1992, which primarily took the form of allowing out-of-state banks to buy in-state banks. However, interstate bank branching was still not allowed until the passing of the IBBEA in 1994.

The passing of the IBBEA effectively permitted bank holding companies to operate branches across state lines. However, states were given the ability to erect roadblocks to branch expansion, effectively allowing states to dissuade interstate branching based on the following four dimensions:

  • States could require that a bank seeking to cross its boundaries should have existed for a minimum number of years, subject to a maximum restriction of five years;
  • States could disallow de novo interstate bank branching, i.e., the opening up of individual branches by an out-of-state bank;
  • States could make interstate acquisition of banks more difficult by requiring that all branches of an in-state target bank be acquired by an out-of-state bidder bank; and,
  • States could restrict the fraction of deposits an out-of-state bank could acquire in that state.

The IBBEA originally set this restriction on deposit concentration at 30%, but states had discretion to increase or decrease the cap. These provisions provided states with the tools to effectively constrain interstate bank branching. Many states successfully utilised these provisions to bar out-of-state banks from setting up branches within their borders. The IBBEA was passed in 1994, but states had discretion to set up their interstate bank branching regulations under the IBBEA any time before 1997.

In our paper, we use data from the US Census Bureau on a large and comprehensive sample of private manufacturing firms and analyse how the banking deregulations allowing the entry of out-of-state banks into a state affected the performance of firms in those states.

  • Our results show that the productivity of firms located in a state increased subsequent to that state allowing out-of-state banks to cross its borders. In particular, we find that firms located in states that allowed a greater degree of deregulation (i.e., imposed fewer restrictions) on the entry of out-of-state banks experienced a greater increase in their productivity following banking deregulation in that state.

This result supports the idea that allowing capital to flow freely across geographic borders can result in improved performance, thereby unlocking greater value.

We then investigate the source of this increase in value following greater ability of banks to expand across states. In order to further investigate whether this relationship is causal, we conduct a novel test. The US Small Business Administration (SBA) provides financial support to firms that the US government considers small. For manufacturing firms, this definition is based on the firm having fewer than a specific number of employees that is pre-specified by the Small Business Administration and may vary by industry. We investigate the impact of banking deregulations for firms that are just below the threshold (which implies that they are eligible for financial support from the SBA) relative to firms that are just above the threshold (thus ineligible for financial support from the SBA). The idea is that firms that are just below the threshold are similar to firms that are just above the threshold in all respects other than the availability of financing from the SBA. Thus, firms just below the threshold are relatively financially unconstrained compared to firms just above the SBA threshold. Based on our expectations, the positive impact of interstate banking and branching deregulations on productivity should be higher for firms just above the SBA threshold, and this is precisely what we find. The fact that we compare the productivity gains of a control group of firms (SBA eligible) that are very similar to firms that are relatively financially constrained (SBA ineligible) helps us to rule out any other effects that may be driving our results.

We also find that our results are stronger across firms that are smaller and more financially constrained.

  • Specifically, smaller firms experienced a larger proportion of the productivity increase following the deregulation.

Our results are consistent regardless of the measure of firm size used, including total number of employees, total assets, and sales. Moreover, our results are stronger for industries that are net users of cash.

Concluding remarks

Our results are broadly supportive of the idea that letting capital flow freely between geographic locations can help smaller and financially constrained firms to invest in productive projects and thus enhance their performance. This evidence supports the part of the Dodd-Frank Act that allows free interstate branching by banks. It suggests that firms would be able to invest more effectively if artificial barriers to the flow of capital were removed. We must caution, however, that our results apply specifically to the context of geographic restrictions on bank lending in the national context. We cannot draw additional conclusions regarding the opening up of foreign banking in the US, as such interpretations can be complicated by other issues related to international trade, international law, tax treaties, culture, and politics. 

References

Jensen M C and W H Meckling (1976), “Theory of the firm: Managerial behaviour, agency costs and ownership structure”, Journal of Financial Economics, Vol. 3, 305-360

Krishnan K, D K Nandy and M Puri (forthcoming), “Does financing spur small business productivity? Evidence from a natural experiment”, Review of Financial Studies.

a

A

Topics:  Financial markets Productivity and Innovation

Tags:  small business productivity, Interstate Banking and Branching Efficiency Act, Small Business Administration

Assistant Professor of Finance and Thomas Moore Faculty Fellow at the D'Amore-McKim School of Business Administration, Northeastern University

Associate Professor of Finance in the International Business School, Brandeis University

J.B. Fuqua Professor of Finance at the Fuqua School of Business, Duke University

Events