This paper investigates the effect of interbank market integration on small firm finance in the build-up to the 2007–2008 financial crisis. We use a comprehensive data set that contains contract terms on individual loans to 6047 firms across 14 European countries between 1998:01 and 2005:12. We account for the selection that arises in the loan request and approval process. Our findings imply that integration of interbank markets resulted in less stringent borrowing constraints and in substantially lower loan rates. The decrease was strongest in markets with competitive banking sectors. We also find that in the most rapidly integrating markets, firms became substantially overleveraged during the build-up to the crisis.

This paper provides the first empirical evidence that bank regulation is associated with cross-border spillover effects through the lending activities of large multinational banks. We analyze business lending by 155 banks to 9,613 firms in 1,976 different localities across 16 countries. We find that lower barriers to entry, tighter restrictions on bank activities, and to a lesser degree higher minimum capital requirements in domestic markets are associated with lower bank lending standards abroad. The effects are stronger when banks are less efficiently supervised at home, and are observed to exist independently from the impact of host-country regulation.

Using a pan-European data set of 8.5 million firms, we find that firms with high debt financing invest relatively more, than otherwise similar firms, if they are operating in sectors facing good global growth opportunities. The positive impact of a marginal increase in debt on investment in good-global-growth-opportunities sectors disappears if firm debt is already excessive, if it is dominated by short maturities, and during systemic banking crises. Our results are consistent with theories of the disciplining role of debt, as well as with models highlighting the negative link between firm- and bank-related agency problems and corporate investment.

We study the effect of sovereign stress on SMEs’ capital structure using restricted-access data from the European Central Bank. We find that during the sovereign debt crisis, and controlling for borrowers’ quality, firms in stressed countries became more likely to be denied credit, to be credit rationed, and to face higher loan rates. Less creditworthy firms were not more likely to become credit constrained, suggesting no flight to quality in lending. We also find that in order to make up for the decline in bank credit firms in stressed countries began relying considerably more on retained earnings and government subsidies.