Bank funding constraints and the cost of capital of small firms

Oana Peia and Radu Vranceanu

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Abstract: This paper analyzes how banks' funding constraints impact the access and cost of capital of small firms. Banks raise external finance from a large number of small investors who face co-ordination problems and invest in small, risky businesses. When investors observe noisy signals about the true implementation cost of real sector projects, the model can be solved for a threshold equilibrium in the classical global games approach. We show that a "socially optimal" interest rate that maximizes the probability of success of the small firm is higher than the risk-free rate, because higher interest rates relax the bank's funding constraint. However, banks will generally set an interest rate higher than this socially optimal one. This gives rise to a built-in inefficiency of banking intermediation activity that can be corrected by various policy measures.

Keywords: Bank finance; Small business; Global games; Optimal return; Strategic uncertainty (search for similar items in EconPapers)
Date: 2015-01
New Economics Papers: this item is included in nep-ban, nep-ent, nep-ppm and nep-sbm
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Working Paper: Bank funding constraints and the cost of capital of small firms (2015)
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