The 33 reference contexts in paper Christopher F. Baum, Dorothea Schäfer, Oleksandr Talavera (2008) “The Impact of the Financial System's Structure on Firms' Financial Constraints” / RePEc:boc:bocoec:690

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    Oleksandr Talaverac aDepartment of Economics, Boston College, Chestnut Hill, MA02467 USA bDIW Berlin, Mohrenstraße 58, 10117 Berlin cSchool of Economics, University of East Anglia, Norwich NR47TJ, UK Abstract We estimate firms’ cash flow sensitivity of cash to empirically test how the financial system’s structure and activity level influence their financialconstraints. For this purpose we merge
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    Almeida et al. (2004),
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    a path-breaking design for evaluating a firm’s financial constraints, with Levine (2002), who paved the way for comparative analysis of financial systems around the world. We conjecture that a country’s financial system, both in terms of its structure and its level of development, should influence the cash flow sensitivity of cash of constrained firms but leave unconstrained firms unaffected.
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    , Mohrenstraße 58, 10117 Berlin cSchool of Economics, University of East Anglia, Norwich NR47TJ, UK Abstract We estimate firms’ cash flow sensitivity of cash to empirically test how the financial system’s structure and activity level influence their financialconstraints. For this purpose we merge Almeida et al. (2004), a path-breaking design for evaluating a firm’s financial constraints, with
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    Levine (2002),
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    who paved the way for comparative analysis of financial systems around the world. We conjecture that a country’s financial system, both in terms of its structure and its level of development, should influence the cash flow sensitivity of cash of constrained firms but leave unconstrained firms unaffected.
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    To address this issue, we begin by observing the liquidity policy of firms and relating it to the degree of financial frictions. While the traditional definition of financial constraints defined in terms of investment–cash flow sensitivity is highly controversial (e.g.
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    Fazzari et al. (1988) and Kaplan and Zingales (1997)),
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    we follow the recently developed approach of Almeida et al. (2004). They consider a firm as financially constrained if it accumulates cash out of its cash flow. Second, we interact cash flow with proxies for the country-specific financial structure.
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    While the traditional definition of financial constraints defined in terms of investment–cash flow sensitivity is highly controversial (e.g. Fazzari et al. (1988) and Kaplan and Zingales (1997)), we follow the recently developed approach of
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    Almeida et al. (2004).
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    They consider a firm as financially constrained if it accumulates cash out of its cash flow. Second, we interact cash flow with proxies for the country-specific financial structure. The latter measures reflect the relative importance (measured by activity or size) of the stock market compared to that of the banking sys2 tem (Levine (2002)).
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    Second, we interact cash flow with proxies for the country-specific financial structure. The latter measures reflect the relative importance (measured by activity or size) of the stock market compared to that of the banking sys2 tem
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    (Levine (2002)).
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    Finally, we consider whether our results are robust after controlling for the level of development of the financial system. We employ annual firm-level manufacturing sector data obtained from GlobalCOMPUSTAT.
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    Our empirical model quantifies the degree to which the effects of cash flow on cash may be strengthened or weakened by the structure of the financial system. We observe that companies located in marketbased financial systems are more likely to be financially constrained. In contrast to earlier research such as
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    Levine (2002),
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    we find a significant role for financial structure while the level of financial development maintains its significance in explaining financial frictions. Hence, reduction of financial constraints, the main mechanism for turning stimuli from the financial sector into economic growth, depends on both the structure and the development of the financial system.
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    Literature Review Researchers have expended considerable effort in trying to understand the nature of financial constraints faced by firms. Information asymmetry, moral hazard and agency conflicts negatively affect the firm’s borrowing capacity, which may cause an underinvestment problem.
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    Fazzari et al. (1988)
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    initiate a new stream of literature on financial constraints and propose to employ a measure of investment-cash flow sensitivity as a 3 gauge of financial frictions. If firms’ access to external capital markets is limited, their reliance on internal resources implies that internally generated cash flows will influence their investment path.1 However, Kaplan and Zingales (1997) argue that these res
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    Fazzari et al. (1988) initiate a new stream of literature on financial constraints and propose to employ a measure of investment-cash flow sensitivity as a 3 gauge of financial frictions. If firms’ access to external capital markets is limited, their reliance on internal resources implies that internally generated cash flows will influence their investment path.1 However,
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    Kaplan and Zingales (1997)
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    argue that these results are controversial, as they find that “those firms classified as less financially constrained exhibit a significantly greater investment–cash flow sensitivity than those firms classified as more financially constrained” (p.169).2This debate was further fueled by the investigations of Fazzari et al. (2000) and Kaplan and Zingales (2000).
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    cash flows will influence their investment path.1 However, Kaplan and Zingales (1997) argue that these results are controversial, as they find that “those firms classified as less financially constrained exhibit a significantly greater investment–cash flow sensitivity than those firms classified as more financially constrained” (p.169).2This debate was further fueled by the investigations of
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    Fazzari et al. (2000) and Kaplan and Zingales (2000).
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    Doubts about the measurement of financial constraints brought forth Almeida and Campello (2002)and Moyen (2004), which broaden the analysis from the traditional cash flow–investment paradigms. The innovative approach of Almeida et al. (2004) is based on the concept that scrutiny of the firm’s financial management should indicate financial market imperfections earlier and more clearly than the obse
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    , as they find that “those firms classified as less financially constrained exhibit a significantly greater investment–cash flow sensitivity than those firms classified as more financially constrained” (p.169).2This debate was further fueled by the investigations of Fazzari et al. (2000) and Kaplan and Zingales (2000). Doubts about the measurement of financial constraints brought forth
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    Almeida and Campello (2002)and Moyen (2004),
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    which broaden the analysis from the traditional cash flow–investment paradigms. The innovative approach of Almeida et al. (2004) is based on the concept that scrutiny of the firm’s financial management should indicate financial market imperfections earlier and more clearly than the observed path of capital investment expenditures, which typically exhibits time-to-build lags.
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    Doubts about the measurement of financial constraints brought forth Almeida and Campello (2002)and Moyen (2004), which broaden the analysis from the traditional cash flow–investment paradigms. The innovative approach of
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    Almeida et al. (2004)
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    is based on the concept that scrutiny of the firm’s financial management should indicate financial market imperfections earlier and more clearly than the observed path of capital investment expenditures, which typically exhibits time-to-build lags.
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    Along these lines they study the relationship between the firm’s generated cash flow and its cash balances. Data on US firms reveal that financially constrained firms exhibit a relatively higher propensity to save cash out of their cash flows. A natural question is, therefore, whether the results of
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    Almeida et al. (2004)
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    are country-specific. Country-comparison studies on the relation between financial constraints and the financial environment are few in number and are exclusively based on the traditional proxy for external financing restrictions:the cash flow sensitivity of capital investment expenditures.
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    Country-comparison studies on the relation between financial constraints and the financial environment are few in number and are exclusively based on the traditional proxy for external financing restrictions:the cash flow sensitivity of capital investment expenditures. For instance,
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    Mairesse et al. (1999)
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    examine the cash flow 1See also Gilchrist and Himmelberg (1996) and Hoshi et al. (1991). 2For instance, see also Cleary (1999), Gomes (2001), and Cummings et al. (2006). 4 sensitivity of equipment and R&D investments of American, French and Japanese companies.
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    Country-comparison studies on the relation between financial constraints and the financial environment are few in number and are exclusively based on the traditional proxy for external financing restrictions:the cash flow sensitivity of capital investment expenditures. For instance, Mairesse et al. (1999) examine the cash flow 1See also
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    Gilchrist and Himmelberg (1996) and Hoshi et al. (1991).
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    2For instance, see also Cleary (1999), Gomes (2001), and Cummings et al. (2006). 4 sensitivity of equipment and R&D investments of American, French and Japanese companies. They find that both types of investment are more strongly affected by cash flow for US companies operating in a market-based financial environment compared to the firms located in the bank-based (Japanese) or mixed (French)finan
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    on the relation between financial constraints and the financial environment are few in number and are exclusively based on the traditional proxy for external financing restrictions:the cash flow sensitivity of capital investment expenditures. For instance, Mairesse et al. (1999) examine the cash flow 1See also Gilchrist and Himmelberg (1996) and Hoshi et al. (1991). 2For instance, see also
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    Cleary (1999), Gomes (2001), and Cummings et al. (2006).
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    4 sensitivity of equipment and R&D investments of American, French and Japanese companies. They find that both types of investment are more strongly affected by cash flow for US companies operating in a market-based financial environment compared to the firms located in the bank-based (Japanese) or mixed (French)financial systems.
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    They find that both types of investment are more strongly affected by cash flow for US companies operating in a market-based financial environment compared to the firms located in the bank-based (Japanese) or mixed (French)financial systems. Similar evidence is found in results from
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    Bond et al. (1999))
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    for German (bank-based) and British (market-based) financial systems. In addition, Bond et al. (2003) confirm the finding of a higher cash flow sensitivity (stronger financing restrictions) in market-based financial systems employing data for Belgian, French, German and British companies.
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    They find that both types of investment are more strongly affected by cash flow for US companies operating in a market-based financial environment compared to the firms located in the bank-based (Japanese) or mixed (French)financial systems. Similar evidence is found in results from Bond et al. (1999)) for German (bank-based) and British (market-based) financial systems. In addition,
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    Bond et al. (2003)
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    confirm the finding of a higher cash flow sensitivity (stronger financing restrictions) in market-based financial systems employing data for Belgian, French, German and British companies. However, to the best of our knowledge, evidence on how the financial architecture affects a less ambiguous indicator for the existence of financial constraints—the cash flow sensitivity of cash—has not been produ
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    A particularly interesting issue is whether the severity of obstacles in credit markets is correlated with the degree of a country’s financial development. Previous research has shown that financial development has an effect on the severity of financial constraints facing firms
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    (Love (2003)),
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    but there have been very few firm-level studies investigating the joint effect of structure and development on the degree of financial frictions.4,5A proper inquiry into this issue requires a cross-country approach based on similar empirical methodologies. 3See Levine (2002) for a detailed review of the literature describing differences of market-based and bank-based financial systems. 4Using firm
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    research has shown that financial development has an effect on the severity of financial constraints facing firms (Love (2003)), but there have been very few firm-level studies investigating the joint effect of structure and development on the degree of financial frictions.4,5A proper inquiry into this issue requires a cross-country approach based on similar empirical methodologies. 3See
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    Levine (2002)
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    for a detailed review of the literature describing differences of market-based and bank-based financial systems. 4Using firm level data, Demirg ̈u ̧c-Kunt and Maksimovic (2002) find that financial development is robustly linked with access to external markets, but there is no support for either the bank-based or market-based view. 5Khurana et al. (2006) study the linkage between financial developm
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    based on similar empirical methodologies. 3See Levine (2002) for a detailed review of the literature describing differences of market-based and bank-based financial systems. 4Using firm level data, Demirg ̈u ̧c-Kunt and Maksimovic (2002) find that financial development is robustly linked with access to external markets, but there is no support for either the bank-based or market-based view. 5
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    Khurana et al. (2006)
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    study the linkage between financial development and the cash flow sensitivity of cash, but they do not focus on the nature of a more highly developed financial system as we do in this study. 5 3. Empirical Implementation 3.1.
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    Model Design To investigate whether firms’ obstacles in obtaining external funds are affected by the country’s financial system we must model how financial constraints are related to indicators of financial system structure.
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    Almeida et al. (2004)
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    develop a basic econometric model which links firms’ stocks of cash to their cash flow. A firm is considered asfinancially constrainedif it builds up its stock of cash out of its cash flow. Their theoretical and empirical model is well suited for our purpose after augmenting their basic specification with country-level attributes of financial markets.
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    constrained if its liquidity ratio is responsive to cash flows 6We replace missing values for income before extraordinary items by operating income minus operating expenses. 6 (∂(∆CashHoldings)/∂CashF low=α+β Structureit>0). In contrast, unconstrained firms are not expected to show a statistically significant relationship between the liquidity ratio and cash flow (α+β Structureit= 0). Following
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    Levine (2002),
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    we make use of two different measures of financial structure: StructureActivityandStructureSize. The first indicator,StructureActivity, measures the activity of stock markets relative to that of banks.
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    It is measured as the natural log of the market capitalization ratio (stock market capitalization/GDP) to the bank credit ratio.7 The elements ofXare intended to control for a firm’s financial characteristics that influence their managers’ liquidity policy. The choice of variables is motivated by prior research on the determinants of cash holdings (e.g.,
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    Opler et al. (1999) and Harford (1999)),
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    subject to data availability. To control for economies of scale in cash management, we include the natural log of assets,Size, as a measure of firm size. As Global COMPUSTATdoes not include the information needed to construct Tobin’sQ(e.g., number of shares outstanding and stock price), we employ theratio of future investment to current investment,LeadInvestment, as a measure of the firm’s investm
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    The average (median) liquidity ratio (Cash) for our sample is 13.07% (8.49%) and the average (median) value of the CashF lowratio is 11.42 (9.09). These values ofCashF loware comparable to those in Table 2 of
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    Acharya et al. (2007).
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    8 The country-level measures that we use in our empirical analysis are constructed from the Financial Structure Database of Beck et al. (2000),updated in 2007.9The initial data are from 1960 to 2006. For each country-year, wecompute two different measures of financial structure:StructureActivity, log(total value traded ratio/bank credit ratio) andStructureSize, log(market capitalization ratio/bank
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    The empirical literature investigating firms’ capital structure behavior has utilized 9These data were accessed from http://go.worldbank.org/X23UD9QUX0 in March 2008. 9 various indicators of financial constraints. In line with previous research (e.g.,
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    Fazzari et al. (1988), Gilchrist and Himmelberg (1996))
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    we assume that small firms and firms with low (or zero) dividend payout ratios are those most likely to face binding financial constraints. Conversely, larger firms and those with high dividend payout ratios are much less likely to face credit rationing.
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    Based on the point estimates, smaller (constrained) firms are highly sensitive to the changes in cash flow, while larger, unconstrained firms display a considerably lower sensitivity. The greater sensitivity of small firms supports the conjecture that smaller firms are more likely to be financially constrained, in line with results reported by
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    Almeida et al. (2004).
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    The direct effect of theStructureActivitymeasure is negative and insignificant, but the indirect effects of the measure, interacted withCashF low, are significantly positive, increasing the cash flow sensitivity for small firms in more market-oriented financial systems.
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    When we turn to interpreting the effects of the cash flow sensitivity of cash for those firms hypothesized to be financially unconstrained, we find that their cash management is largelyinsensitive to cash flow. Furthermore, their sensitivity to their country’s financial architecture is essentially nil. [INSERT FIGURES 1,2 HERE] Our results are also in line with pecking order theory
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    (Myers(1977)),
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    which suggests that firms prefer internal financing and try to maintain a stable dividend. If their generated cash flow is higher than capital expenditure, the firm may invest in liquid assets, andvice versa.
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    Models augmented with Financial Development A concern with the regression results shown in Tables 4 and 5 is that they may present an incomplete picture, as not only the structure but also thelevel of a country’s financial development will affect the severity of financial constraints that firms face (e.g.,
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    Love (2003)).
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    Our further analysis is based on the specificationsintroduced in the previous section which we augment with a variable measuring the levelof financial development of the countries covered in the GlobalCOMPUSTATdataset.
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    Our further analysis is based on the specificationsintroduced in the previous section which we augment with a variable measuring the levelof financial development of the countries covered in the GlobalCOMPUSTATdataset. Following
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    Levine (2002),
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    we employ two proxy measures for the strength of financial institutions. The first measure, F inanceActivity, is defined as log(bank credit ratio×total value traded ratio), while the second proxy,F inanceSize, is calculated as log(market capitalization ratio×bank credit ratio).11We present the descriptive statistics for these variables by country in Table 1.
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    Manufacturing companies, facing difficulties in access to external funding, accumulate liquid assets as a cash buffer stock. The interaction term,CF×F inanceActivity, is negative and significant for those firms which area priorilabeled as financially constrained. This result confirms the findings of
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    Love (2003)
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    who underlines the importance of financial development to 11Employing the private credit ratio (the value of financial intermediary credits to the private sector / GDP) instead of the bank credit ratio yields qualitativelysimilar results. 12Full results of the estimations are available from the authors upon request. 13 address obstacles in external financing.
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    The evidence in Tables 4–6 indicate the existence of tighterfinancial constraints for firms operating in market-based financial systems and a negative relationship between financial development and the severity of financial constraints. In a theoretical study,
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    Chakraborty and Ray (2006)
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    suggest that a bank-based financial system encourages participation in production activities and provides funding to a larger number of entrepreneurs. Taking into account that monitoring is able toresolve some of the agency problems associated with raising funds, firms may enjoy better access to funds when monitored by banks rather than by the market.
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    Taking into account that monitoring is able toresolve some of the agency problems associated with raising funds, firms may enjoy better access to funds when monitored by banks rather than by the market. As argued by
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    Allen and Gale (2000),
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    banks have a comparative advantage in selecting investmentprojects based on established technologies. This feature is typical of the manufacturing firms which we study. 5. Conclusions By taking into account country-level financial architecture, we advance our understanding of differences in the severity of the financial constraints facing firms.
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    Conclusions By taking into account country-level financial architecture, we advance our understanding of differences in the severity of the financial constraints facing firms. We approach the empirical challenge in light of the recently proposed theoretical framework developed by
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    Almeida et al. (2004),
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    in which a firm is considered as financially con14 strained if it retains cash out of its cash flow. We augment thecash holdings–cash flow sensitivity link with country-level indices of relative development of the stock market to the development of the banking system.
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