SME performance in transition economies: The financial regulation and firm-level corruption nexus Axel Wieneke a,⇑ , Thomas Gries b a La Trobe University, Faculty of Law and Management, Edwards Road, Flora Hill, Victoria 3550, Australia b University of Paderborn, Warburger Straße 100, D-33098 Paderborn, Germany article info Article history: Received 16 June 2008 Revised 28 August 2010 Available online 9 September 2010 JEL classification: P20 O16 G21 G28 H27 Keywords: Small and medium enterprises Endogenous growth Financial intermediation Corruption Transition economies abstract Wieneke, Axel, and Gries, Thomas—SME performance in transition economies: The finan- cial regulation and firm-level corruption nexus Using a general equilibrium endogenous growth model we explain underperformance in the small and medium enterprise sector as an effect of corruption and non-competitive banking. Limited competition in the banking sector causes a high loan-deposit spread, worsens the initial effect of corruption, and depresses growth. Fostering bank competition, for instance, by allowing foreign bank entry, would be a simple solution to this problem, but frequently, authorities choose to hamper bank competition. Therefore, we explain the persistence of non-competitive banking as a result of governments’ regulatory choice. If the government has a stake in the banking sector there exists a trade-off between current benefits from bank profits and future growth. Firm-level corruption affects intertemporal optimization and distorts the government’s choice towards more restrictive regulation, i.e., less bank compe- tition, even if the deciding institution itself is not corrupt. These results show that the two prominent problems for small and medium enterprises, corruption and finance, are mutually reinforcing. Journal of Comparative Economics xxx (xx) (2011) xxx–xxx. La Trobe University, Faculty of Law and Management, Edwards Road, Flora Hill, Victoria 3550, Australia; University of Paderborn, Warburger Straße 100, D-33098 Paderborn, Germany. Ó 2010 Association for Comparative Economic Studies Published by Elsevier Inc. All rights reserved. ‘‘The activity of branches of foreign banks in the Russian Federation should be limited... In essence it should be forbid- den.” Vladimir Putin (BBC News, 2005) 1. Introduction For developing and transition economies, the growth of a private sector of small and medium enterprises (SMEs) is often regarded as a key to success. With higher efficiency than the large state-owned enterprises, the expansion of the private small business sector is expected to boost growth (McIntyre, 2001). In more advanced transition economies, such as Hungary and Poland, SMEs account for some 50% of GDP; however in other countries, e.g., Slovenia, Russia and 0147-5967/$ - see front matter Ó 2010 Association for Comparative Economic Studies Published by Elsevier Inc. All rights reserved. doi:10.1016/j.jce.2010.09.001 ⇑ Corresponding author. Fax: +61 3 5444 7998. E-mail address: a.wieneke@latrobe.edu.au (A. Wieneke). Journal of Comparative Economics 39 (2011) 221–229 Contents lists available at ScienceDirect Journal of Comparative Economics journal homepage: www.elsevier.com/locate/jce