Working Paper Series: Special Edition of 2016 to 2018 Interns

Section 5, which discusses the financing patterns of firms in both regions and the empirical results. Section 6 concludes the study and Section 7 puts forward some policy recommendations.

2 Literature Review It is easier to finance large firms at the expense of small enterprises due to the cost involved in processing small scale loans and the required rates which are usually far above the prevailing maximum (McKinnon, 1973). Perhaps one of the earliest attempts to understand constraints to firm financing is a seminal paper by (Stiglitz & Weiss, 1981) who sought to explain that banks ration credit in the form of limiting the number of loans made available as opposed to increasing interest rates or collateral requirements in the presence of imperfect information in capital markets. Imperfections in the capital market can have far-reaching and debilitating effects on firms’ performance and investment decisions. Several studies have highlighted these issues: (Fazzari, et al., 1988) finds that capital market imperfections were found to have binding constraints on firms’ investments decisions. Schinatarelli (1995), found evidence of agency problems and adverse selection arising out of imperfections in the financial market that creates a wedge between firms and external financers (loan suppliers and equity investors) see also studies by Hubbard (1997). In an effort to mitigate issues with capital market imperfection and informational opaqueness of small firms, which usually cast a dark cloud over their credibility, lenders have turned to diverse lending technologies. Relationship lending theory argues that lenders can overcome this information asymmetry problem by employing relationship-lending technologies in their assessments. Petersen & Rajan (1994) finds strong evidence between relationships and the availability of credit. Findings suggested that the longer the relationships and the closer ties small firms establish with banks, the greater the amount of financial products purchased. Similar findings by Berger & Udell (1995) showed that smaller firms with longer banking relationships required less collateral and enjoyed lower interest rates.

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