Does business networking boost firms’ external financing opportunities? Evidence from Central and Eastern Europe

Abstract

This article argues that networked firms are likely to have an advantage in securing bank finance in countries with weak legal and judicial institutions since it helps banks and other financial institutions to minimize the underlying agency costs of lending. An analysis of recent Business Environment and Enterprise Performance Survey (BEEPS) data from 15 Central and Eastern European (CEE) countries lends some support to this hypothesis. Even after controlling for other factors, firms affiliated to Business Associations (BA) are more likely to secure bank finance. Further, the importance of business networking is particularly evident among firms who borrow from private domestic banks, as these new banks attempt to minimize costs of adverse selection. There is also some confirmation that the significance of networking disappears with improvement in institutional quality.

Keywords:

• business networks
• agency costs
• external firm financing
• bank loans
• transition economies
• endogeneity

JEL Classification::

• G21
• G30
• L14
• M20
• P31

Acknowledgements

Much of the work was done when Sarmistha Pal was visiting the European Bank for Reconstruction and Development (EBRD) and she acknowledges the support of the Chief Economist's Office of the EBRD in general and also that of Erik Berglof, Fabrizio Coricelli, Ralph de Haas and Anita Taci in particular during this period. We would also like to thank seminar participants at Brunel, UCL and Rome where this article was presented. The usual disclaimer applies.

Notes

¹ Recent literature highlights the importance of legal and institutional structures to enforcing contracts and safeguarding shareholders’ and creditors’ rights, thus promoting financial and economic development. In particular, La Porta et al. (1997) suggest that the legal environment matters for the size and the extent of a country's capital market. Demirguc-Kunt and Maksimovic (1998) argued that a developed financial system and a stronger rule of law help relaxing firms' external financing constraints, which in turn facilitates their growth. Beck et al. (2002) showed that, firms that operate in countries with underdeveloped financial and legal systems and higher levels of corruption tend to be more constrained than others.

² We included all institutional variables in an alternative specification, but the competition index was never significant. Thus, the final specification does not include the competition index.