Financial development, legal systems and SME finance: Cross-country evidence

Abstract

This paper provides a comprehensive investigation into the selection of different sources of finance for both short-term and long-term projects by SMEs, utilizing cross-country data from the World Bank. The results highlight the crucial roles played by financial development and legal system in the countries where SMEs operate. Specifically, with better developed financial systems, SMEs are more likely to use formal sources of external finance from formal sources (e.g., bank and non-bank institutions) to meet their short term and long term financing needs, highlighting the importance of financial development in accessing external finance for SMEs. Furthermore, this paper provides evidence on the moderating effects of legal systems on the favourable impacts of financial development on SME finance. In particular, the effects of financial development on SMEs’ access to external finance are more pronounced in countries with stronger investor protection, such as common law countries, than in those civil law countries, highlighting the importance of legal syystems in facilitating SME financing and suggests that policymarkers should consider strengthening investor protection on promote SME growth and development.