Optimal branching strategy, local financial development, and SMEs’ performance

Abstract

This paper examines whether and to what extent development of the local-level financial sector improves SMEs’ performances. While only a handful of studies examines the relationship between local financial development and firm growth, no theoretical basis has been provided in those studies to understand transmission channels and instruments through which local financial development works in favor of firm growth. This paper attempts to fill that gap. In a theoretical framework, this paper shows that an optimal number of bank branches in an area works as an instrument of the transmission channel from financial development to growth, which helps reduce excess liquidity and increase SMEs’ access to bank credit by creating links between the demand and supply of liquidity. Banks default credit risk and cost of branch expansion determine the optimal number of branches in an area: a higher number of branches will reduce asymmetry of information about borrowers and monitoring costs, leading to lower default risks. Using new firm-level survey data of 1084 SME manufacturing firms from Bangladesh, our empirical analysis suggests that there is a threshold level of bank branches that can improve SME performance at the sub-district level. Our findings highlight the importance of potential returns to an optimal branching strategy of banks at the sub-national level that will lead to inclusive finance and growth within a country.