Beck, Demirguc-Kunt, and Maksimovic investigate how a country's financial institutions and the quality of its legal system explain the size attained by its largest industrial firms in a sample of 44 countries. Firm size is positively related to the size of the banking system and the efficiency of the legal system. Thus, the authors find no evidence that firms are larger in order to internalize the functions of the banking system or to compensate for the general inefficiency of the legal system. But they do find evidence that externally financed firms are smaller in countries that have strong creditor rights and efficient legal systems. This suggests that firms in countries with weak creditor protections are larger in order to internalize the protection of capital investment.This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to understand the determinants of firm size.

The authors investigate how a country's financial institutions and the quality of its legal system explain the size attained by its largest industrial firms in a sample of 44 countries. Firm size is positively related to the size of the banking system and the efficiency of the legal system. Thus, the authors find no evidence that firms are larger in order to internalize the functions of the banking system or to compensate for the general inefficiency of the legal system. But they do find evidence that externally financed firms are smaller in countries that have strong creditor rights and efficient legal systems. This suggests that firms in countries with weak creditor protections are larger in order to internalize the protection of capital investment.

Using a unique firm-level survey data base, covering fifty four countries, the authors investigate whether different financial, legal, and corruption issues that firms report as constraints, actually affect their growth rates. The results show that the extent to which these factors constrain a firm's growth depends very much on its size, and that it is consistently the smallest firms that are most adversely affected by all these constraints. Firm growth is more affected by reported constraints in countries with underdeveloped financial, and legal systems, and higher corruption. So, policy measures to improve financial, and legal development, and reduce corruption are well justified in promoting firm growth, particularly the development of the small, and medium enterprise sector. But the evidence also shows that the intuitive descriptors of an "efficient" legal system, are not correlated with the components of the general legal constraints that predict firm growth. This finding suggests that the mechanism by which the legal system affects firm performance, is not well understood. The authors' findings also provide evidence that the corruption of bank officials, constraints firm growth. This "institutional failure" should be taken into account, when modeling the monitoring role of financial institutions in overcoming market failures due to informational asymmetries.

Using a unique firm-level survey data base covering 54 countries, Beck, Demirguc-Kunt, and Maksimovic investigate whether different financial, legal, and corruption issues that firms report as constraints actually affect their growth rates. The results show that the extent to which these factors constrain a firm's growth depends very much on its size and that it is consistently the smallest firms that are most adversely affected by all three constraints. Firm growth is more affected by reported constraints in countries with underdeveloped financial and legal systems and higher corruption. So, policy measures to improve financial and legal development and reduce corruption are well justified in promoting firm growth, particularly the development of the small and medium enterprise sector. But the evidence also shows that the intuitive descriptors of an quot;efficientquot; legal system are not correlated with the components of the general legal constraints that predict firm growth. This finding suggests that the mechanism by which the legal systems affects firm performance is not well understood. The authors' findings also provide evidence that the corruption of bank officials constrains firm growth. This quot;institutional failurequot; should be taken into account when modeling the monitoring role of financial institutions in overcoming market failures due to informational asymmetries.This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to understand the link from the financial sector to economic development. The authors may be contacted at [email protected], [email protected], or [email protected].