Bank Funding Constraints and the Cost of Capital of Small Firms

20 Pages Posted: 27 Feb 2014 Last revised: 16 Jan 2015

See all articles by Oana Peia

Oana Peia

University College Dublin (UCD)

Radu Vranceanu

ESSEC Business School; University of Cergy-Pontoise - THEMA

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Date Written: February 13, 2014

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 coordination 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.

Keywords: bank finance, small business, global games, strategic uncertainty, optimal return

JEL Classification: D82, C72, G21, G32

Suggested Citation

Peia, Oana and Vranceanu, Radu, Bank Funding Constraints and the Cost of Capital of Small Firms (February 13, 2014). Available at SSRN: https://ssrn.com/abstract=2402136 or http://dx.doi.org/10.2139/ssrn.2402136

Oana Peia (Contact Author)

University College Dublin (UCD) ( email )

Belfield
Belfield, Dublin 4 4
Ireland

Radu Vranceanu

ESSEC Business School ( email )

3, Av. Bernard Hirsch
PB 50105
Cergy-Pontoise, 95021
France

HOME PAGE: http://www.essec.fr

University of Cergy-Pontoise - THEMA ( email )

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France

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