After the 1994–95 “Tequila Crisis,” Argentina put in place a state-of-the-art banking system reflecting the latest recommendations of the Basel Committee on banking supervision. By 1999, the country had experienced several years of rapid growth, fueled in part by capital from large global banks that had recently entered the Argentine market. But did the entry of foreign banks and the introduction of strong regulation improve small firms’ access to capital? Since small firms are a leading driver of growth in developing countries, the answer to this question has important implications for all emerging markets.
To study small firms’ access to capital, Professor Daniel Paravisini set out to determine whether local banks in Argentina faced liquidity constraints and, if so, how those constraints affected small firms. Bank regulation is only one of several factors that could contribute to creating liquidity constraints. Still, evidence of such constraints would suggest that stringent regulation might have adverse economic consequences, and that regulators should weigh those consequences against the goal of preventing a financial crisis.
If banks are unconstrained, they will fund all investment opportunities with a projected rate of return higher than the banks’ marginal cost of capital. But if banks are constrained, they will pass up some profitable investment opportunities, to the detriment of the economy. In seminal research on the Great Depression published in the 1980s, Federal Reserve Chairman Ben Bernanke showed that liquidity constraints in the banking sector magnify recessions and exacerbate negative shocks to the economy.
To test for liquidity constraints in Argentina, Paravisini examined loan data from 1999, a year in which the Inter-American Development Bank provided lending credits to Argentine banks in an effort to stimulate the small-business sector. In a related research project, he found that when development agencies use local banks to distribute targeted lending credits, the banks tend to reallocate the money — for example, by relabeling existing small-business loans as program loans — so that only a small fraction of the program funding actually reaches the target sector. The Argentine data showed a pass-through rate to the target sector of just five to eight cents on the dollar.
So what did the Argentine banks do with the rest of the money? “One possibility was to give it back to shareholders or reduce other debt at the market price,” says Paravisini, “but in fact they lent out 60 or 70 cents on the dollar.” If banks are unconstrained — that is, if they are already funding all profitable investment projects available to them — a positive liquidity shock will not induce them to expand their lending. So the fact that the Argentine banks were actually lending out most of the program funding — albeit not to the target sector — proves that they had previously faced liquidity constraints. Moreover, the banks’ risk profiles did not change when they expanded their loan portfolios, a finding that suggests they had been passing up profitable lending opportunities.
Even if small banks are constrained, shouldn’t the arrival of large, foreign banks make it easier for small firms to get funding? Not necessarily, says Paravisini. Commercial-banking markets tend to be segmented, with large banks lending to large firms and small banks lending to small firms, so an entrepreneur who has been turned down by a local bank isn’t likely to get a loan from Citibank. Furthermore, frictions related to information often prevent borrowers from switching banks. “If I’m a lender and you’re a small firm, when I lend to you, I get to know things about you that other banks don’t know,” Paravisini says. “If anyone’s going to be willing to lend to you, it should be the bank that knows you, so if you try to move, this gives other banks a bad signal.” Thus the entry of foreign banks into an emerging market may not improve small firms’ access to capital.
Further research is needed to separate the effects of regulation from other factors contributing to the liquidity constraints of small banks. But Paravisini’s research suggests that regulators should consider the impact of rigorous regulation on the small-business sector. “If small banks are constrained due to regulation, because there are very tight capital requirements or they’re forced to issue subordinated debt, then this is just a cost of having appropriate regulation,” he says. “The purpose of regulation, in the end, is to avoid financial crises. If banks being liquidity constrained is a consequence of this, then it’s a cost you have to balance against the benefits of preventing a financial crisis.”
Daniel Paravisini is assistant professor of finance and economics at Columbia Business School.