Bank Concentration and Firm Investment:

Empirical Evidence from India

Abubakr Saeed and Olusegun Vincent

ABSTRACT: This paper investigates the impact of bank concentration on firm-level invest-
ment across firm groups classified according to size, investment destination, and debt
maturity structure. Using data of 302 manufacturing firms for the period 2000–2009,
we show that elevated financial constraints are associated with small and medium-size
enterprises and firms that are dependent on short-term debt and exhibit high levels of
sensitivity of investment to cash flow. Our empirical finding confirms that bank concentra-
tion exerts a positive impact on firms’ financial constraints on investment. This effect is
more pronounced for small firms and firms dependent on short-term debt. However, our
results are indifferent to domestic versus foreign investing firm groups.
Key words: developing economy, financial constraints, financial reforms, internal finance,
investment–cash flow sensitivity.

In the perfect market of Modigliani and Miller (1958), firms’ financial decisions remain
irrelevant to real activity. However, in the real world, financial considerations significantly
complicate investment activities. Firm investment decisions are influenced mainly by
the distortionary effects of asymmetric information and agency and transaction costs
that create a wedge between the cost of internal and external finances. To mitigate such
market frictions, an impressive array of financial reforms have been implemented around
the world. The aim of these financial reforms has been to promote a diversified, efficient,
and competitive financial system with the ultimate objective of improving their lending
efficiency. Since the banking sector is the pivotal constituent in most financial systems,
reforms have been directed mainly toward it. The effects of such reform are also reflected
in bank market concentration.
Major competing theories concerning bank concentration make two contradictory
predictions about the relation between bank concentration and financial constraints. On
the one hand, banks in a concentrated market may curb the supply of funds by provid-
ing loans at a high interest rate and exacerbate firms’ financial constraints; on the other
hand, banks in concentrated markets may reduce the information asymmetries and agency
problems between lender and borrower, leading to easing firms’ financial constraints.
Similarly, empirical studies have derived conflicting results, but most of these studies
focus on developed countries. There is no conclusive evidence to indicate the effect of
bank concentration on financial constraints, especially for developing countries. Several
attempts have been made to examine the link between bank concentration and firms’ access
to finance in developed countries (Black and Strahan 2002; Cetorelli 1997; Huang 2008;
Ogura 2008; Ratti et al. 2008; Rice and Strahan 2010; Saeed and Esposito 2012; Zarutskie
2006), but studies analyzing such issues in developing countries have been limited.

Abubakr Saeed (abubakr.saeed@brunel.ac.uk) is a Ph.D. candidate at the Brunel Business School,

Brunel University, Uxbridge, UK. Olusegun Vincent (olusegun.vincent@brunel.ac.uk) is a senior
partner at Segun Vincent and Co. and a research fellow at the Brunel Business School, Brunel
University.

Emerging Markets Finance & Trade / May–June 2012, Vol. 48, No. 3, pp. 85–105.
© 2012 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540-496X (print)/ISSN 1558-0938 (online)
DOI: 10.2753/REE1540-496X480305
86  Emerging Markets Finance & Trade

This paper contributes to the existing literature by providing new evidence on the
impact of bank concentration on financial constraints across different types of firms in
India. Specifically, we address two questions: Does bank concentration reduce financial
constraints in the Indian market, and, if so, does this effect differ across firm size, debt
maturity structure, and investment destination? India is a good test case of the effect of
bank concentration on firms’ financial constraints for two reasons. First, India is among
the world’s leading economies in terms of banking sector liberalization and has a high
“banking sector reform and interest liberalization” index as computed by the World Eco-
nomic Forum. Second, the Indian banking sector has been subject to important structural
transformation and achieved major reform milestones.
Our study spans almost a decade (2000–2009) and covers the period when the impact
of reforms on the market was fully felt. Only a few attempts (e.g., Bhaduri 2005; Ghosh
2006) have been made to empirically analyze the extent of financial constraints in the
Indian context. However, these studies are limited to investigating the effect of financial
liberalization in general and do not examine explicitly the impact of changes in the
banking sector on firms’ financial condition. Therefore, unlike the existing literature on
financial constraints, our analysis offers a unique insight into the impact of concentra-
tion on firms in general and across firm size, debt structure maturity, and investment
destination in particular.
One of the main problems in measuring the effect of financial constraints on investment
is how to rank firms’ likelihood of being constrained. Existing empirical studies have
proposed various segmenting variables, for instance, the dividend payout ratio (Fazzari et
al. 1988), the leverage ratio (Whited 1992), firm size (Devereux and Schiantarelli 1990),
and group affiliation (Hoshi et al. 1991). We classify our firms using one conventional seg-
menting measure, firm size, and two novel variables, firm investment destination and debt
maturity structure. According to these measures, we rank firms as small and medium-size
enterprises (SMEs) or large enterprises; as domestic or foreign direct investment (FDI)
firms;1 and as firms dependent on short-term debt or long-term debt. To study the effects
of financial reforms in a less developed country, we utilize a panel-data approach and data
on 302 Indian manufacturing firms. There is a surfeit of research on the relation between
Indian firm investment and financial constraints (see “The Indian Context” section), but
this article is, to our knowledge, the first to bring together two important strands of lit-
erature that have matured independently: the impact of bank concentration on investment
and the impact of financial constraints on investment.
Using a panel of annual data on Indian firms, we found that firms are financially con-
strained irrespective of their size, investment destination, and debt maturity structure. Our
results indicate that high bank concentration increases the supply of funds in the market.
In particular, bank concentration relaxes financial constraints, and this easing appears
more pronounced for SMEs and firms dependent on short-term debt.
The next section provides an overview of related theoretical work. The third briefly
outlines the Indian financial system. In the fourth section we describe the estimation
methodology and firm-level data set. The fifth section reports and discusses the results,
and the sixth gives the concluding remarks.

Literature Review
Financial constraints as a consequence of imperfection of capital markets have been
considered an important investment-determining factor. Financial constraints prevent
 May–June 2012  87

firms from accessing external finance, ultimately rendering them unable to undertake the
optimal investment that they would have if internal funds had been adequate to finance
investment. Empirical research—for example, the pioneering work by Fazzari et al.
(1988) and subsequent studies by Athey and Thomas (1994), Badarau-Semenescu and
Semenescu (2010), Cleary (1999), and Gilchrist and Himmelberg (1998)—has relied
on information asymmetry, managerial agency problems, and transaction costs to eluci-
date the rationale for financial constraints. The authors reported that internal funding of
firms facing tighter financial constraints tends to have a bigger effect on investment and
interpreted this as evidence of the existence of such information-driven capital market
imperfections. Kaplan and Zingales (1997) started a heated debate by challenging the
generality of interpretation made by Fazzari et al. (1988). They provided contrary evidence
that higher sensitivities of investment to cash flow cannot be interpreted as evidence of
firms’ financial constraints.2
Since the seminal paper by Fazzari et al. (1988), a large body of empirical literature has
focused on the relation between financial constraints and investment. One important con-
cern in research remains how to classify firms according to perceived financial constraints.
Most studies have adopted a sorting measure that focuses on a firm’s characteristics that
are linked to information or contracting costs. For instance, Fazzari et al. (1988) classified
firms’ financial constraints by their dividend payouts, Devereux and Schiantarelli (1990)
by their size, Hoshi et al. (1991) by their group affiliation, and Gilchrist and Himmelberg
(1998) and Whited (1992) their bond rating. Despite the differences in the classification
schemes, most studies conclude that sensitivity of investment to cash flow is higher for
constrained firms.
To mitigate such market frictions, since the early 1990s, several developing countries
have tried to replace their severely constrained control system with a liberalized market
system. The objective of such reforms is to enhance the supply of funds through a reduced
external financial premium; therefore, the banking sector always remained central to
reforms. Financial reforms of the banking sector have consisted primarily of the removal
of controls on interest rates, restraining directed credit programs, and mitigating barriers
to entry in the banking sector (Laeven 2002; Lucke et al. 2007).
The foremost studies concerning the impact of bank concentration are summarized
in Beck et al. (2004) by two opposing hypotheses. The first, the structure performance
hypothesis, suggests that banks use market power to extract rents. It predicts that market
power results in a lower supply of funds at a higher cost. The second hypothesis, the
information-based hypothesis, suggests that market power reduces the asymmetric and
agency costs in the market, which results in a greater credit supply at a lower rate.
Using the structure performance hypothesis, Guzman (2000) showed that banks in
monopolistic markets tend to ration credit more strictly than banks in competitive mar-
kets, which leads to a lower capital accumulation rate. Hannan (1991) provided strong
evidence that concentration is associated with higher interest rates across U.S. banking
markets. In a contrary thread of literature, Cetorelli (1997) examined the role of banking
concentration in the capital accumulation process, arguing that banks in concentrated
markets have incentive to establish relationships with borrowers if they are allowed to
hold claims on equity. Marquez (2002) extended that argument, positing that reduction in
concentration may lower banks’ ability to screen borrowers, which will drive up interest
rates and reduce the availability of loans. In a less concentrated banking market, there
is less information sharing, and information on borrowers may become more dispersed,
which lowers a bank’s ability to screen borrowers. Similarly, using a series of large panels
88  Emerging Markets Finance & Trade

of firm-level data from fourteen European countries for the period 1992–2005, Ratti et
al. (2008) found that in a highly concentrated banking sector, firms are less financially
constrained. Furthermore, these results were tested in different economic cycles, and it
was found that fewer financial constraints are associated with higher bank concentration,
even during volatile periods, and that this pattern of easing financial constraints is more
marked during recessions.
Empirical evidences based on a single country have consistently found support for
the information-based hypothesis. For example, Petersen and Rajan (1995) provided evi-
dence of the existence of relationship-based lending practices in a concentrated market.
In examining bank loans to small firms, they found that despite the information-related
market frictions associated with young and small firms, more credit is available to young
and small firms in concentrated banking markets, but later, as firms grow older, banks
are compensated by charging higher interest rates. The positive impact of bank concen-
tration diminishes as firms become old and large. Similarly, Ogura (2008) reported that
higher market concentration in the Japanese banking sector enhances the availability of
loans to financially constrained firms through establishing relationship banking. Using
Italian data, Bonaccorsi and Dell’Ariccia (2004) found that concentration benefits firms
in industries where information asymmetries are more important.
Beck et al. (2004) examined the institutional development element in the concentra-
tion–financial constraint nexus and found that bank concentration increases financing
impediments to firms, but only in countries with a low level of economic and institutional
development. Similarly, Cetorelli and Gambera (2001) used industry-level data from both
developed and developing countries. They showed that a concentrated banking sector
exerts a depressing effect on industry growth rate; however, it does facilitate the growth
of industries where young firms depend heavily on external financing.

The Indian Context

The Indian banking sector has long been characterized as highly regulated and financially
repressed. There has been a significant degree of state ownership and far-reaching regula-
tions concerning, among other issues, the allocation of credit and the setting of interest
rates. In 1991, reform measures were initiated and sequenced to create an enabling envi-
ronment for banks to overcome administrative constraints. The reforms consisted mainly
of easing prudential regulations and supervision, interest rate deregulation, reduction in
reserve requirements, partial privatization of state-owned banks, and alleviation of strict
entry and exit regulations for both domestic and foreign banks (Shirai 2001).
As a major step toward enhancing competition, FDI in the private banking sector was
allowed. The number of foreign banks increased from nine in 1994 to twenty-one by
1999. As a result of the reforms, the number of overall banks increased rapidly. Thirty
new domestic and foreign banks entered the market after 1994, and by 2007 the banking
sector comprised seventy-eight banks, including twenty-eight public sector banks with
majority state ownership, twenty-three private banks, and twenty-seven foreign banks.
The market share with respect to total assets of public sector banks declined from 90
percent in 1980 to 68 percent in 2007, whereas the asset share of domestic private banks
increased to 20 percent during this period (Das 2010).
With regard to privatization of public sector banks, a 1994 amendment to the Bank-
ing Regulation Act of 1949 allowed state-owned banks to offer up to 49 percent of their
equity to the private sector. So far, this has led to the partial privatization of eleven state-
 May–June 2012  89

owned banks (Roland 2006). Despite the expansion of private sector equity holding in
public banks, the government has found it difficult to accept genuine competition in the
public sector and is committed to maintaining strong administrative control, such as the
ability to appoint key personnel and influence corporate strategy. The banking sector is
still predominantly under government ownership, with nearly 70 percent of the banking
sector’s assets belonging to state-owned banks (Shirai 2001).
These drastic changes in the ownership structure of the Indian banking sector, along
with the liberal entry of private and foreign banks, have affected overall concentration in
the banking sector. Evidence of this change can be seen in the declining share of public
banks in terms of total assets, which decreased from 91 percent in the year 1990–91 to
72 percent in 2008–9. In contrast, market share of private banks increased from 4 per-
cent in 1990–91 to 20 percent in 2008–9. Similarly, foreign banks increased their share
from 5 percent in 1990–91 to 9 percent in 2008–9 (Sharma and Bal 2010). Evidence
of competitive pressure on the Indian banking sector is clearly indicated in the decline
in the five-bank asset concentration ratio from 0.51 in 1991–92 to 0.44 in 1995–96 and
thereafter to 0.41 in 2001–2 (Ghosh 2006).
The impact of such a liberalized banking sector on firms’ access to finance and ulti-
mately investment has been measured mostly through empirical investigations. Several
studies address the Indian case. For instance, in a study focusing on Indian bank effi-
ciency, Bhattacharya et al. (1997) found that Indian public sector banks improved their
efficiency in the deregulated environment. In addition, the study observed faster approval
in the lending efficiency of foreign-owned banks. A more recent study by Gormley
(2010) empirically analyzed the efficiency of the Indian banking sector covering the
post-liberalization period. Gormley reported that banks perform well or poorly in a seg-
mented market, depending on the type of bank. For example, a drop in domestic bank
credit is observed for group-affiliated firms, whereas foreign banks finance only profit-
able firms. To observe the overall effects of financial reforms on firms’ access to credit,
Bhaduri (2005) estimated the sensitivity of investment to cash flow on a sample of 362
firms, with mixed results. Large and mature firms in the sample experienced a substantial
decrease in financial constraints in the postliberalization era. Subsequently, Ghosh (2006)
estimated an investment equation to measure the impact of financial liberalization on
financial constraints to investment. He reported that in the postreform period the banking
sector improved access to external financing for financially constrained firms. This effect
was more noticeable in the case of small firms. In the same vein, Ganesh-Kumar et al.
(2001) categorized firms according to their outward orientation. They found that exporters
experienced fewer financial constraints after having access to low-cost credit. Numerous
studies have estimated an investment equation using firm-year data to analyze the impact
of Indian financial reforms. However, to our knowledge there is no study considering
independently the impact of bank concentration on financial constraints to investment.
Das (2010) and Shirai (2001) discussed a different, but related, issue and employed the
Herfindahl-Hirschman Index (HHI) and mobile bank concentration methods to estimate
the bank market concentration in an analysis of the technical performance of the Indian
banking sector.

Econometric Model and Data Set

A firm is generally considered financially constrained if cost or unavailability of external
financing limits its capacity to undertake the optimal investment that it would have made
90  Emerging Markets Finance & Trade

if internal funds had been adequate to finance the investment. In standard practice, internal
capital is used as an explanatory variable of annual investment outlay, and magnitude of
sensitivity of this relationship would determine the extent of financial constraints faced
by a firm. Although a number of studies have called into question the validity of this
methodology (Alti 2003; Kaplan and Zingales 1997; Moyen 2004), many authors nev-
ertheless support the use of investment–cash flow correlation as an indicator of financial
constraints (Bond and Meghir 1994; Gilchrist and Himmelberg 1998; Whited 1992). As
Poncet et al. (2010) pointed out, although no theoretical consensus has been reached
yet, investment–cash flow sensitivity methodology for measuring financial constraints
continues to be applied and supported in empirical results and survey evidence.
We adopt this methodology and, following the specifications of Fazzari et al. (1988)
and Manole and Spatareanu (2010), estimate a reduced-form investment equation with
sales growth as a measure for growth opportunity. Tobin’s q is regarded as the most
widely accepted proxy for measuring firms’ growth opportunities (see Hubbard 1998 for
a survey), but since our sample also includes firms that are not publicly traded, we do not
have a direct measure of Tobin’s q. Specifically, we estimate the following equation:
I it CFit CFit S D
= β0 + β1 + β2 * Con + β3 it −1 + β 4 it + β5 creditor right + εit .
K it −1 Kit −1 Kit −1 Kit −1 Kit −1
Here, Iit, Kit, CFit, Sit, and Dit denote investment, capital stock, cash flow, sales, and debt
of firm i at time t, respectively, and εit stands for the idiosyncratic error term. Our essen-
tial variable of interest (CFit /Kit * Cont ) is the measure of bank concentration interacted
with the fraction of cash flow to capital stock. Because market imperfections caused by
an underdeveloped financial system may also affect financial constraints on investment,
we include a country-level variable, creditor right, to measure the intensity of creditor
rights protection in the country. We do not include the lagged dependent variable as a
regressor owing to data limitation because using the lagged dependent variable as a
regressor would have required dropping the first firm-year observations. Such loss of
observations generates problems in estimation (especially when instruments with lags
of order three are used). This problem is more pronounced for smaller subsample firms
that are short-term debt dependent and for SMEs, which account for 553 and 734 firm-
year observations, respectively. Besides, we are not the first ones to exclude a lagged
dependent variable from the regressor list. Empirical studies with a relatively smaller
data set, such as those by Cleary (2006) and D’Espallier and López-Iturriaga (2009),
used such a specification.
Given the econometric settings in the model, the coefficient on cash flow will reflect
the firm’s dependence on internal funds. A positive and significant sign for β1 would
reflect the presence of financial constraints on the firm in the financial market. Our next
coefficient of interest is β2, the interaction between bank concentration and cash flow. We
would anticipate observing a negative and significant coefficient if bank concentration
reduces the investment–cash flow sensitivity, or, put another way, if bank concentration
alleviates the financial constraints to firms by changing the cost of external sources of
financing. However, if bank concentration augments financial constraints for accessing
external financing, the coefficient of interest would be positive and statistically significant.
Emerging countries offer new investment opportunities to firms from developed countries
and are attracting a growing proportion of global FDI. Because of this fact, many emerg-
ing countries’ firms exhibit high growth rates (Peng 1997). We therefore introduced a
lagged variable, sale (S), to capture firm growth. A high growth rate is an indicator of a
 May–June 2012  91

firm’s financial health and future profitability and opens access to external finance, which
in turn exerts a positive impact on firm investment level, so we would anticipate a posi-
tive coefficient for sales coefficient β3. As argued by Lang et al. (1996) and Hovakimian
and Titman (2006), high leverage might be interpreted as high debt capacity and lower
financial constraints. A well-functioning financial system gives a firm adequate leverage
and makes it less dependent on internal capital. In these circumstances, there may be a
positive relation between investment and leverage, and we would expect a significant and
positive coefficient for β4. The investment also depends on the degree of financial reforms.
One of the most striking outcomes of financial reform is effective creditor rights protec-
tion, which entails efficient financing contracts, as well as their good implementation. It
consequently reduces the costs of external financing, so a firm’s investment would not
be highly sensitive to internal funds. Therefore, given the significance of creditor rights
protection, it is more appropriate for us to augment the investment model by a creditor
rights index. For this variable, a positive relationship between investment and creditor
rights is anticipated.
Considering the dynamic nature of the investment relationship, and to deal with joint
endogeneity of explanatory variables and potential simultaneity biases associated with
panel data, this study uses a generalized method of moments (GMM) estimator. Since the
work of Arellano and Bond (1991), GMM techniques have been widely used in estimat-
ing dynamic panel data models. The GMM is a system of equations that uses both the
lagged levels and lagged differences as instruments in a single system. Fluctuations in cash
flow, particularly in sales, are likely to be associated with firm-specific characteristics.
Therefore, in order to take into account heteroskedasticity of the second moment of the
error term (εit) and the potential endogeneity problem, the GMM estimation procedure
is appropriate to use.
The consistency of the GMM estimator in producing unbiased and consistent results
depends on the validity of instrumental variables that are lagged variables of the system.
For this purpose, a Sargan test of overidentifying restrictions that tests the validity of the
instruments is used. In addition, first-order autoregressive and second-order autoregressive
models are used to test serial correlation of the error term. Appropriate lagged values of the
right-hand variables are used as instruments: CFi,t–z /Ki,(t–1)–z , Si,t–z /Ki,(t–1)–z , and Di,t–z /Ki,(t–1)–z
for z > 3, where z is as large as possible given data availability. Use of lagged endogenous
variables as instruments is valid only if the error term is serially uncorrelated. In several
specifications, the null hypothesis of no second-order serial correlation was rejected, so
we had to use lags of order three as instruments in such specifications. With an instrument
lagged three periods, the null hypothesis of no second-order serial correlation cannot be
rejected at any conventional significance level; therefore, it supplies evidence that valid
orthogonality conditions and instruments are used. Moreover, time dummies are also
included in the instrument set.

Data Set
This study uses firm data drawn from the Osiris database of Bureau van Dijk. Osiris
consists of information on accounting and financial statements for privately and publicly
owned firms around the world. In addition, the BankScope database of Bureau van Dijk
is used for calculating bank concentration.
We have yearly data for the 2000–2009 period for a sample consisting of 302 firms. We
limit our focus to manufacturing establishments. Our sample selection criterion approves
92  Emerging Markets Finance & Trade

only firms that have observations for at least five years. Firm-level data are eliminated if a
firm has missing values for explanatory variables. In addition, we try to mitigate the effect
of outliers and errors in the data by excluding all observations for which variables have
extreme deviating values from their means. For this purpose all variables are Winsorized at
the 5th and 95th values. We also eliminate the firm years if their values for capital stock and
sale are found to be negative. After applying these restrictions and screening for apparent
coding errors and missing variables, an unbalanced panel of 2,741 observations of 302 firms
remained for estimation. Because the Indian financial system has undergone substantial
bank deregulation and banking reforms that have significantly changed the level of bank
concentration in the market, we use more-recent-period data (2000–2009) in our analysis
to capture the exact and contemporary effects of bank concentration.
To measure the degree of bank concentration at the country level during the period
2000–2009, we use two techniques—the percentage of assets held by the three largest
banks (k-bank concentration ratio) and the HHI. The k-bank concentration ratio is one of
the most frequently used measures of banking concentration in the empirical literature
(Bikker and Haaf 2001). Data on banks’ market share is obtained from the BankScope
database of Bureau van Dijk. It is measured as the sum of the three largest banks’ market
share. A higher concentration ratio indicates higher market power of these banks and low
degree of competition in the market. As can be seen in Table 1, the three-bank concentra-
tion declined from 0.34 in 2000 to 0.30 in 2009. HHI is defined as the sum of squares of
market share of each bank in terms of total assets. It can be written as Sni=1si2, where i is
the number of banks and s is their market share. HHI fluctuated considerably between
0.52 and 0.62 during this period (see Table 1), possibly because of the entrance and exit
of banks, mainly through mergers, reducing the number of banks in the market.
Values for our macroeconomic control variable, creditor right, which is used to portray
the intensity of creditor rights in the country, is taken from a previous study by La Porta
et al. (1998).3 The creditor right index ranges from 0 to 4.
Because our main intention in this study is to address the extent to which the impact of
bank concentration varies across firms, we classify our sample firms based on size, invest-
ment destination, and debt maturity structure. Following these classification strategies,
we divide the sample into SMEs and large firms, domestic and foreign direct investing
firms, and firms dependent on short-term debt and long-term debt. Following the World
Bank, we set $15 million for total assets as a cutoff for defining SMEs, which produces
a total of 96 SMEs and 206 large firms (summary statistics of total assets are provided
in Table 2). Furthermore, firms are also classified as domestic or foreign investors. We
expect firms investing in foreign markets to experience a lower degree of financial con-
straints than firms relying solely on the domestic market. Guariglia and Mateut (2005)
provided a convincing rationale in support of this notion, arguing that globally engaged
firms have access to both domestic and international financial markets, which enables
them to diversify their sources of financing and associated risks. In addition, demand from
foreign markets makes them less subject to domestic monetary contractions or downturns
in the domestic business cycle. This stable position provides a signal to external financial
markets that a firm is sufficiently productive to earn profit and resilient to market shocks,
which enhances its likelihood of obtaining external financing. So, firms that invest outside
the country at least once during the sample period are considered FDI firms. This sample
classification criterion left us with a total of 190 domestic and 112 FDI firms.
Capacity to borrow long-term debt depends on characteristics of a firm such as
credit history, collateral size, growth opportunities, and firm–bank relationship. These
 May–June 2012  93

Table 1.Total number of banks and trends in concentration ratios in the Indian
banking sector
State-
Number of owned Foreign Private Three-bank
banks banks banks banks HHI concentration

2000 99 27 42 30 0.62 0.34

2001 92 27 35 30 0.61 0.34
2002 97 27 40 30 0.56 0.33
2003 93 27 33 30 0.57 0.32
2004 90 27 33 30 0.56 0.32
2005 87 27 31 29 0.57 0.32
2006 84 28 29 27 0.54 0.31
2007 78 28 27 23 0.52 0.30
2008 88 28 31 29 0.54 0.30
2009 86 28 29 29 0.53 0.30

characteristics are less related to internal funds, which reduces the effect of cash flow
on investment for such firms. Following Pal and Kozhan (2008), therefore, we predict
that firms having long-term debt access are less constrained than their counterparts with
access only to short-term debt. Financial constraints are higher for firms that need to
periodically negotiate their external sources (in case of short-term debt). In the renegotiat-
ing process, firms have to bear additional renegotiation costs and risks that could force
early liquidation of the investment project (Abor and Biekpe 2007; Barclay and Smith
1995; Diamond 1991). Furthermore, firms lacking long-term borrowing capacity main-
tain higher information asymmetry problems, and consequently they cannot satisfy the
conditions for long-term borrowing. A firm is considered short-term debt dependent if it
used more short-term debt than long-term debt during most of the available consecutive
years (but with a minimum of three consecutive years). Similarly, a firm that utilized
more long-term debt than short-term debt in most of the available consecutive years
(but, again, with a minimum of three) is considered long-term debt dependent. After this
criterion is applied, 59 firms are classified as short-term-debt dependent and 243 firms
as long-term-debt dependent.
Our dependent variable is defined as the firm investment scaled by level of capital
stock for a given year and is measured as net capital expenditure plus depreciation. The
key independent variable used to measure the existence of financial constraints is cash
flow. We measure cash flow as firm operating net income at the end of period plus the
depreciation. Our variables for growth opportunities and leverage level (sales and debt)
are measured as the total sales and total debt for a given period. Table 3 presents defini-
tions along with sources of the variables used in this analysis. The mean of our dependent
variable, the ratio of investment to capital stock I /K, is 0.74, and the standard deviation
is 1.30 (see Table 2). The mean of debt to capital stock ratio for the entire sample is 1.58,
which shows the strong reliance of Indian firms on debt. Within the groups, the ratio of
investment to capital stock is higher for large firms, FDI firms, and firms that are long-
term debt dependent. Considerable variation in debt usage can be seen among SMEs
(1.58) and large firms (3.75).
Table 4 presents the distribution of firm groups across the industries. It can be observed
that a significant portion (about 43 percent in the full sample) of firms belong to three
94  Emerging Markets Finance & Trade

Table 2. Descriptive statistics

Investment/ Cash flow/ Sale/ Debt/ Total assets
capital capital capital capital (dollars)

All firms
Mean 0.74 0.43 3.19 1.58 1,323,416
Median 0.42 0.24 2.36 1.13 1,000,000
Maximum 1.62 1.96 9.00 7.41 547,302,000
Minimum –1.13 –1.71 –0.12 0 698
Standard 1.30 0.72 2.72 1.85 3,748,491
deviation
SMEs
Mean 0.35 0.200 2.89 1.58 754,983
Median 0.17 0.13 1.97 1.12 16,000,000
Maximum 1.62 1.25 9.00 7.41 49,390,000
Minimum –1.07 –1.71 0 0 698
Standard 1.34 0.82 3.13 1.69 1,982,762
deviation
Large
Mean 0.39 0.56 0.22 3.75 3,423,984
Median 0.38 0.32 0.09 2.69 85,250,000
Maximum 1.32 1..96 7.94 4.84 547,302,000
Minimum –1.13 0 –0.12 0 1,200,000
Standard 0.20 0.99 0.80 3.20 29,700,230
deviation
Domestic
Mean 0.49 0.35 3.52 1.43 782,982
Median 0.27 0.19 2.42 1.12 35,800,000
Maximum 1.87 1.25 9.00 3.33 32,200,000
Minimum –1.13 –1.38 –0.12 0 698
Standard 1.13 0.84 3.68 1.49 2,203,550
deviation
FDI
Mean 1.01 0.72 3.48 1.51 1,293,284
Median 0.72 0.42 2.46 1.23 72,900,800
Maximum 1.62 1.96 4.94 7.41 547,302,000
Minimum –0.83 –1.71 0 0 1,200,000
Standard 1.18 0.99 2.73 1.57 19,403,232
deviation
Short-term debt
dependent
Mean 0.61 1.20 5.83 1.40 623,691
Median 0.88 0.74 6.16 1.35 30,000,000
Maximum 1.35 1.23 9.00 3.26 71,400,000
Minimum –1.06 –0.63 0 0 698
Standard 1.48 1.53 3.50 1.11 1,645,232
deviation
Long-term debt
dependent
Mean 1.08 0.32 2.75 1.39 2,982,729
Median 0.32 0.119 2.34 1.11 68,005,000
Maximum 1.62 1.96 4.33 7.41 547,302,000
Minimum –1.13 –1.71 –0.12 0 970
Standard 1.17 0.61 2.03 1.44 24,560,872
deviation
 May–June 2012  95

Table 3. Variables and data sources

Variable Definition Source

I Change in net capital expenditure from period t – 1 to t, plus Osiris

accumulated depreciation
K Fixed assets of period t – 1 Osiris
CF Firm operating net income at the end of period t plus the Osiris
accumulated depreciation
S Total sale at the end of period t Osiris
D Total debt at the end of period t Osiris
HHI Sum of squares of individual market share of each bank in BankScope
terms of assets.
3-bank- Share of the total assets of three largest banks on the total BankScope
concentration assets of all commercial banks
Creditor right It is measured by adding 1 for each following activity: (1) the La Porta et
country imposes restrictions, such as creditors’ consent or al. (1998)
minimum dividends to file for reorganization; (2) secured
creditors are able to gain possession of their security once
the reorganization petition has been approved (no automatic
stay); (3) secured creditors are ranked first in the distribution
of the proceeds that result from the disposition of the assets
of a bankrupt firm; and (4) the debtor does not retain the
administration of its property pending the resolution of the
reorganization.

industries: chemical and allied products, industrial and commercial machinery and com-
puter equipment, and primary metal industries. In domestic firm’s sample, the chemical
and allied products industry accounts for more than 25 percent of firms.

Estimated Results and Discussion

The results of investment regression with bank concentration, measured as HHI, is pre-
sented in Table 5. Looking at the results across the firm groups, observe that cash flow
enters with significant positive coefficients for most classes, indicating that cash flow is
certainly an important determinant of investment for Indian manufacturing firms. Specifi-
cally, the cash flow coefficient appears to be insignificant only for large firms, whereas
it is significantly positive for the rest of the groups.
We next estimate how bank concentration affects financial constraints to firm invest-
ment across the firm groups. Our results show that all the coefficients for interaction
between bank concentration and firm internal cash flow have a negative sign and statistical
significance. This negative relation suggests that country’s bank concentration, in fact,
eradicates the financial constraints, irrespective of firm size, investment destination, and
debt maturity structure.
Turning to within-group analysis, it can be observed that the scale of interaction of
cash flow with investment β2 is higher for SMEs than for their larger counterparts, which
indicates the higher investment–cash flow sensitivity among SMEs. Further, severity of
financial constraints is higher for firms that are short-term debt dependent than it is for
firms that are long-term debt dependent. However, there is no significant variance between
the intensity of financial constraints across domestic and FDI firms; both experience the
same level of financial constraints. Disparity in the magnitude of the cash flow coefficient
across firm size and debt maturity structure may indicate that large firms depend less on
Table 4. Description of firm groups across industries
Short-term Long-term
debt- debt-
SIC dependent dependent
code Industry All firms SMEs Large firms Domestic FDI firms firms firms

1 Mining 3 1 2 0 3 0 3
(0.99) (1.04) (0.97) (0.00) (2.68) (0.00) (1.23)
20 Food and kindred products 17 1 16 13 4 2 15
(5.63) (1.04) (7.77) (6.84) (3.57) (3.39) (6.17)
96  Emerging Markets Finance & Trade

21 Tobacco products 3 1 2 1 2 0 3
(0.99) (1.04) (0.97) (0.83) (1.79) (00) (1.23)
22 Textile mill products 29 15 14 23 6 3 26
(9.60) (15.63) (6.80) (12.11) (5.36) (5.08) (10.70)
24 Lumber and wood products, 2 0 2 1 1 0 2
except furniture (0.66) (00) (0.97) (0.83) (0.89) (00) (0.82)
26 Paper and allied products 7 2 5 5 2 2 5
(2.32) (2.08) (2.43) (2.63) (1.79) (3.39) (2.06)
28 Chemicals and allied 68 29 39 49 19 16 50
products (22.52) (30.21) (18.93) (25.79) (16.96) (27.12) (20.58)
29 Petroleum refining and 9 3 6 4 5 2 7
related industries (2.98) (3.13) (2.91) (2.11) (4.46) (3.39) (2.88)
30 Rubber and miscellaneous 22 11 11 14 8 2 20
plastics products (7.28) (11.46) (5.34) (7.37) (7.14) (3.39) (8.23)
31 Leather and leather products 2 0 2 1 1 0 2
(0.66) (00) (0.97) (0.83) (0.89) (00) (0.82)
32 Stone, clay, glass, and 15 3 12 10 5 2 13
concrete products (4.97) (3.13) (5.83) (5.26) (4.46) (3.39) (5.35)

33 Primary metal industries 26 3 23 22 4 7 21

(8.61) (3.13) (11.17) (11.58) (3.57) (11.86) (8.65)
34 Fabricated metal products 8 4 4 4 4 0 8
(2.65) (4.17) (1.94) (2.11) (3.57) (00) (3.29)
35 Industrial and commercial 36 5 31 23 13 15 21
machinery and computer (11.92) (5.21) (15.05) (12.11) (11.61) (25.42) (8.65)
equipment
36 Electronic and other electrical 18 10 8 7 11 3 15
equipment, except (5.96) (10.42) (3.88) (3.68) (9.82) (5.08) (6.17)
computer equipment
37 Transportation equipment 24 2 22 7 17 4 20
(7.95) (2.08) (10.68) (7.95) (15.18) (6.78) (8.23)
38 Various controlling equipment 4 2 2 0 4 0 4
(1.32) (2.08) (0.97) (00) (3.57) (00) (1.65)
39 Miscellaneous manufacturing 9 4 5 6 3 1 8
equipment (2.98) (4.17) (2.43) (13.16) (2.68) (1.69) (3.29)

Note: Percentages are in parentheses.

May–June 2012  97
Table 5. Investment regression with bank concentration (HHI)
Short-term Long-term
debt-dependent debt-dependent
All firms SMEs Large firms Domestic firms FDI firms firms firms

CFit /Kt–1 1.324*** 1.205*** 0.032 0.829** 0.840* 1.724** 0.273**

(0.476) (3.671) (0.014) (0.510) (0.494) (0.298) (0.881)
CFit /Kt–1 * Con –1.534*** –0.106*** –0.307** –0.995*** –1.028* –1.193* –1.688*
(0.951) (6.825) (0.067) (0.094) (2.341) (1.043) (0.142)
Sit–1 /Kt–1 0.047 0.216*** 1.033** 0.024 0.004 0.005** 0.008*
98  Emerging Markets Finance & Trade

(0.030) (0.084) (0.103) (0.025) (0.068) (0.005) (0.092)

Dit /Kt–1 0.110*** 0.147 0.012 0.332*** 0.017 0.142*** 0.105
(0.031) (0.187) (0.010) (0.127) (0.037) (0.142) (0.065)
Creditor right 0.194 0.104 0.122*** 0.327 0.128 0.201 0.298***
(0.062) (0.185) (0.001) (0.138) (0.124) (0.173) (0.104)
Observations 2,741 734 1,936 1,660 1,067 553 2,205
Firms 302 96 206 190 112 59 243
Hansen p-value c2 0.103 0.912 0.508 0.717 0.364 0.643 0.192
AR(2) p-value 0.106 0.348 0.236 0.526 0.090 0.102 0.206

Notes: The dependent variable in all the columns is the ratio of investment and first-lag capital stock in firm i at year t. CF/K is the fraction of firm cash flow over first
lag of capital stock; Con is bank concentration (HHI), which is measured as the sum of squares of individual market share of each bank in terms of assets; S is firm sales
volume; D is firm total debt; and creditor right is a measure of creditor rights protection in the country. All the regressions include the year and industry dummies. Stan-
dard errors are in parentheses. * Significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.
 May–June 2012  99

internal finance because of their ability to access external finance. Moreover, firms that
are long-term debt dependent can provide sufficient physical capital as collateral to secure
long-term debts, which makes them less reliant on internal capital. Our findings on the
impact of capital market imperfections on firm investment are consistent with those of
Bhaduri (2005) and Ghosh (2006), who reported that the severity of financial constraints
in the Indian market is greater for small firms. Our empirical results confirm that firm
investment depends on a firm’s cash flow in an underdeveloped financial system that
ultimately restrains firms from undertaking investment at their optimal level.
In the next case, within-group analysis revealed that the coefficient for investment
to cash flow and bank concentration β3 is higher for SMEs. We found that this result
also holds for firms that are short-term debt dependent, whereas bank concentration
coefficients are roughly the same for domestic and FDI firms. Variation in the impact of
bank concentration on financial constraints across firm groups can be interpreted by the
information-based hypothesis (Beck et al. 2004), which proposes that bank concentration
reduces the asymmetric and agency costs in the market, resulting in more credit sup-
ply at lower rates. In line with conventional wisdom, there persists severe information
asymmetry between SMEs and banks. In markets where banks are less concentrated,
however, the information asymmetry is decreased by banks’ gaining inside information
about borrowers, which results in more relationship lending. Since most firms that are
short-term debt dependent in our sample are SMEs, the foregoing rationale can also be
used to analyze their relationship with banks. Banks in concentrated markets reduce
information asymmetry in order to compensate for firms’ inability to provide physical
capital to pledge against the debt. Another plausible explanation provided by Petersen
and Rajan (1995) is that small and young firms receive more financing in concentrated
markets, in which banks seem to smooth interest rates over the life cycle of a firm, charging
a lower interest rate when the firm is small and young and a higher rate when the firm is
old and large. The natural response of large and mature firms faced with higher interest
rates is to rely more on internal funds. Given this scenario, large firms benefit least and
small firms benefit most from the positive impact on interest rates. These results are
also akin to those reported by Ratti et al. (2008) that suggest the positive impact of bank
concentration in capital markets. Table 5 shows that the impact of bank concentration is
indifferent to whether firms are domestic or foreign investing firms. One can infer from
this that bank concentration does not exert a significant discernible impact on foreign
investing firms because of their accessibility to financial alternatives in foreign markets
that can alleviate the financial constraints in the domestic market.
We also include control variables—firm sales and total debt—that might influence a
firm’s financial constraints. As expected, coefficients of sales and debt also enter with a
positive sign. Investment is positively affected by the firm’s total debt, which implies that
the accretion of debt does not deter external financing. Results confirm that a reliable and
efficient legal system increases the scale of firm investments. This finding agrees with
the results of Beck et al. (2004), Demirgüç-Kunt and Maksimovic (1998), La Porta et
al. (1998), and Rutkowski (2006), who found that protection of property rights, creditor
rights, and rule of law influence firm investment.
As robustness checks, we conducted our analysis with a different proxy of bank
concentration—the percentage of assets held by the three largest banks in the market.
Several consistent results emerged from the analysis. Table 6 reports the regression results
with bank concentration, measured as 3‑bank concentration. As previously discovered,
firms are financially constrained irrespective of their size, investment destination, and
100  Emerging Markets Finance & Trade

debt maturity structure (see Table  6). Moreover, bank concentration relaxes financial
constraints on firm-level investment. In terms of magnitude, bank concentration appears
more propitious for SMEs and firms that are short-term debt dependent. The impact of
sales, debt, and credit rights remains positive, as also found earlier; however, the level
of statistical significance is not very widespread across firm groups.
To further assess the reliability of the results, we employed an additional robustness
check. We reestimated the analysis while considering the possibility that when a firm is
incurring financial losses (negative cash flows), investment cannot respond precisely to
cash flow. The logic is that when a cash deficit hits hard, it pushes a firm into financial
distress and the firm undertakes only indispensable investments. Any additional restraint
on investment in response to a further drop in cash flow is impossible, so that investment–
cash flow interaction becomes biased. So, following Fazzari et al. (1998) and Manole
and Spatareanu (2010), we excluded the firm observations having negative cash flows
and reestimated our regression. Table 7 presents regression results for firms with posi-
tive cash flows. As shown in Table 7 (columns 1–7), we do not observe any change in
direction of interaction among the variables. In column 8, we also test the robustness of
our results on the full sample (including firms with negative cash flows) by clustering
the standard error of the idiosyncratic part of the error terms at the year level in order
to examine the possibility of correlated disturbances in each year that may have been
generated because of yearwise country-level bank concentration measures. The positive
effect of bank concentration remains robust to the clustering technique.
Overall, the results from our main model and the revised set of estimations show a
strong link between firm cash flow and investment across all the firm groups. Our overall
findings are consistent with the information-based hypothesis that bank concentration
relaxes the financial constraints in the capital market. The outcomes of bank concentration
are more pronounced for small firms and for firms that are short-term debt dependent
and exhibit higher investment–cash flow sensitivity.

Conclusion
This paper investigates the impact of bank concentration on firm investment decisions. We
estimated a standard investment–cash flow model using panel data on 302 manufactur-
ing firms for the period 2000–2009. The empirical findings reveal that firms experience
financial constraints irrespective of their group. The constraints were particularly notable
in the case of SMEs and firms that are short-term debt dependent. Our main results show
that concentration in the Indian banking sector relaxes financial constraints on firm-level
investment. This effect is more pronounced for small firms and firms that are short-term
debt dependent than for large firms and firms that are long-term debt dependent. However,
our results are indifferent to domestic and foreign investing firms. This implies that the
information-based hypothesis holds for the Indian banking market.
Finally, the study has some limitations, which may point to useful areas for further
inquiry. Findings are limited to the research setting—we considered differences in per-
ceived financial constraints based on firm size, ownership, and debt maturity structure
but made no attempt to observe the differences in financial constraints across sporadic
exporters, permanent exporters, and nonexporters. Limitation of available data did not
allow us to make such disintegrations. Therefore, gathering a more detailed data set that
enables financial constraints to be measured in this aspect would be a useful avenue for
further study. It is worth noting that this study focuses on a postreform era; it would be
Table 6. Investment regression with bank concentration (three-bank concentration)
Short-term Long-term
debt-dependent debt-dependent
All firms SMEs Large firms Domestic firms FDI firms firms firms

CFit /Kt–1 1.680*** 0.122** 0.011 0.706** 0.685** 1.332** 0.525***

(0.782) (1.968) (0.001) (0.413) (0.732) (1.844) (0.776)
CFit /Kt–1 * Con –1.394 –0.254 –0.407*** –2.506*** –1.880 –1.863*** –1.208**
(0.509) (5.344) (0.072) (0.107) (0.253) (0.442) (0.422)
Sit–1 /Kt–1 0.036 0.168*** 0.601*** 0.015 0.018 0.044 0.016**
(0.005) (0.008) (0.107) (0.026) (0.020) (0.021) (0.004)
Dit /Kt–1 0.108** 0.109 0.002 ** 0.306*** 0.002 0.130*** 0.116
(0.089) (0.270) (0.001) (0.127) (0.008) (0.087) (0.039)
Creditor right 0.152* 0.014* 0.087 0.329 0.104 0.056 0.226***
(0.112) (0.140) (0.002) (0.137) (0.132) (0.142) (0.045)
Observations 2,741 734 1,936 1,660 1,221 533 2,205
Number of firms 302 96 206 190 112 59 243
Hansen p-value c2 0.810 0.669 0.237 0.712 0.471 0.621 0.102
AR(2) p-value 0.208 0.102 0.096 0.517 0.169 0.211 0.154

Notes: The dependent variable in all columns is the ratio of investment and first lag capital stock in firm i and year t. CF / K is the fraction of firm cash flow over first lag
of capital stock; Con is bank concentration (3-banks), which is measured as the share of the total assets of three largest banks in the market; S is firm’s sale volume; D is
firm total debt; and creditor right is a measure of creditor rights protection in the country. All regressions include the year and industry dummies. Standard errors are in
brackets. * Significant at 10 percent, ** significant at 5 percent, *** significant at 1 percent.
May–June 2012  101
Table 7. Investment regression with bank concentration (HHI): excluding firms with negative cash flow (columns 1–7)
(1) (2) (3) (4) (5) (6) (7) (8)
Short-term Long-term
debt- debt- All firms with
Domestic dependent dependent clustered
All firms SMEs Large firms firms FDI firms firms firms errors

CFit /Kt–1 1.554*** 1.114*** 0.499 1.332** 1.268* 1.745*** 0.781* 1.263***

(0.658) (0.503) (0.771) (0.295) (0.127) (0.785) (0.651) (0.036)
CFit /Kt–1 * Con –1.306* –0.245 –0.787*** –0.355*** –0.329* –1.324*** –1.430*** –1.301**
(0.227) (0.202) (0.973) (0.365) (0.128) (0.402) (0.554) (0.051)
Sit–1 /Kt–1 0.126* 0.278* 0.044*** 0.196*** 0.042 0.134 0.060 0.064
102  Emerging Markets Finance & Trade

(0.020) (0.029) (0.015) (0.046) (0.092) (0.040) (0.017) (0.027)

Dit /Kt–1 0.292*** 0.086 0.585 ** 0.131 0.034 0.043 0.052 0.161***
(0.112) (0.520) (0.165) (0.090) (0.008) (0.030) (0.012) (0.022)
Creditor right 1.121* 0.201 0.411 0.430 0.023 0.053** 0.307*** 0.206
(0.621) (0.215) (0.171) (0.662) (0.087) (0.176) (0.210) (0.016)
Observations 2,461 538 1,858 1,660 867 477 1,945 2,741
Number of firms 298 93 205 189 109 57 241 302
Hansen p-value c2 0.838 0.838 0.275 0.712 0.197 0.489 0.765 0.694
AR(2) p-value 0.204 0.124 0.091 0.517 0.359 0.242 0.075 0.147

Notes: The dependent variable in all the columns is the ratio of investment and first-lag capital stock in firm i and year t. CF / K is the fraction of firm cash flow over first
lag of capital stock; Con is bank concentration (HHI), which is measured as the sum of squares of individual market share of each bank in terms of assets; S is firm’s sale
volume; D is firm total debt; and creditor right is a measure of creditor rights protection in the country. All the regressions include the year and industry dummies. In
column 8, sample includes firms with negative cash flows, and standard errors are clustered at year level. Standard errors in brackets. * Significant at 10 percent, ** sig-
nificant at 5 percent, *** significant at 1 percent.
 May–June 2012  103

interesting to conduct a comparative study that also accounts for impacts of prereform
period on the bank concentration–financial constraint nexus.

Notes
1. We restrict our focus to domestic and foreign classification only rather than differentiation
of host countries for firm outward investment.
2. For detailed literature surveys see Bond and Van Reenen (2002) and Schiantarelli (1996).
3. La Porta et al. (1998) calculated the index by adding 1 when (1) the country imposes re-
strictions, such as creditors’ consent or minimum dividends, to file for reorganization; (2) secured
creditors are able to gain possession of their security once the reorganization petition has been
approved (no automatic stay); (3) secured creditors are ranked first in the distribution of the pro-
ceeds that result from the disposition of the assets of a bankrupt firm; and (4) the debtor does not
retain the administration of its property pending the resolution of the reorganization. The index
ranges from 0 to 4.

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