Seung Jung Lee and Viktors Stebunovs
First published August 2011
We exploit variation in commercial bank capital ratios across states to identify the impact of higher capital ratios on firm creation and size in the manufacturing industries. We control for omitted financial and nonfinancial variables that may affect firm dynamics by exploiting variation in external finance dependence across industries. Our panel regressions suggest that, for industries dependent on external finance, a percentage point increase in the capital ratio has no statistically significant effect on firm creation but leads to a decline in average firm size, as measured in employees, of 0.7 to 1.4 percent the following year and a decline of 4 to 6 percent in the long term. The number of firms might not necessarily decline in response to more limited access to finance as setting up a business may not be that costly and some of the displaced workers may actually establish new businesses. Our results highlight the potential effects that tightening capital adequacy standards, such as Basel III, may have on firm dynamics in the industries dependent on external finance.