Financial development and the allocation of external finance

We examine whether financial markets development facilitates the efficient allocation of resources. Using European micro-level data for 1996–2005, we show that firms in industries with growth opportunities use more external finance in financially more developed countries. This result is particularly strong for firms that are more likely to be financially constrained and dependent on domestic financial markets, such as small and young firms. Our findings are robust to controlling for technological determinants of external finance needs and to using different proxies for growth opportunities. Interestingly, the explanatory power of the measures of technological determinants identified in prior work decreases significantly once growth opportunities are controlled for.

► We examine whether financial markets development facilitates the efficient allocation of resources using European micro-level data.
► We show that firms in industries with growth opportunities use more external finance in financially more developed countries.
► Our results are particularly strong for small and young firms.
► Technological determinants of external finance needs do not explain external finance use once growth opportunities are controlled for.