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Bank funding constraints and the cost of capital of small firms

Author

Listed:
  • Oana Peia

    (ESSEC Business School and THEMA (UMR 8184) - ESSEC Business School - THEMA - Théorie économique, modélisation et applications - CNRS - Centre National de la Recherche Scientifique - CY - CY Cergy Paris Université)

  • Radu Vranceanu

    (ESSEC Business School and THEMA (UMR 8184) - ESSEC Business School - THEMA - Théorie économique, modélisation et applications - CNRS - Centre National de la Recherche Scientifique - CY - CY Cergy Paris Université)

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.

Suggested Citation

  • Oana Peia & Radu Vranceanu, 2015. "Bank funding constraints and the cost of capital of small firms," Working Papers hal-01109331, HAL.
  • Handle: RePEc:hal:wpaper:hal-01109331
    Note: View the original document on HAL open archive server: https://essec.hal.science/hal-01109331
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Bank finance; Small business; Global games; Optimal return; Strategic uncertainty;
    All these keywords.

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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