Regional Financial System and the Financial Structure of Small Firms

A large share of small business failures is attributed to financial structure mismanagement. Most of our knowledge on financial structure of small firms is from the streams of financial access and capital structure. The implications from capital structure stream are threefold: (1) small firms are more debt based, (2) small firms tend to bootstrap their finances, and (3) small firms are more credit rationed. Beyond that it is well known in capital structure1 research that owner, firm, and industry characteristics are important for these results. In the stream of financial access, research from the policy angle has been toward financial institution availability, rules and regulations, time for application, etc. The emphasis in this stream is mainly on banks and borrowers. The central message is that small borrowers have many problems in the access front mainly in developing economies. Until recently, these two research streams have been distinct from each other. Faulkender and Petersen (2006) unite these two in an effort to show that supply of capital is as important as demand for capital in determining capital structure choice of firms. It is still an open issue whether this result is applicable to small firms. Geography of firm finance is mostly a black-box in economic geography as well as finance literature. This paper contributes by empirically testing for the effect of regional presence of lending institutions on different financing options utilized by SMEs. Not just utilization but how these are combined by SMEs is also analyzed. To do so, we introduce a modified measure of lending operational distance, which we call the “Commercial Operational Distance.” This measure is calculated for both local as well as national lending institutions. Overall, we perform the analysis for two levels: rural and urban. The central question that we address is: how does regional commercial operational distance affect the usage and combination of finances.