A stochastic frontier approach to modelling financial constraints in firms: An application to India

► We use the stochastic frontier approach to modelling financial constraint at of firms. ► It enables us to estimate a measure of financial constraint of each firm for each time period. ► An application to India shows that investment efficiency was reduced between 1997 and 2006. ► By 2006, business group membership was no longer able to reduce financial constraints of firms. We propose the use of stochastic frontier approach to modelling financial constraints of firms. The main advantage of the stochastic frontier approach over the stylised approaches that use pooled OLS or fixed effects panel regression models is that we can not only decide whether or not the average firm is financially constrained, but also estimate a measure of the degree of the constraint for each firm and for each time period, and also the marginal impact of firm characteristics on this measure. We then apply the stochastic frontier approach to a panel of Indian manufacturing firms, for the 1997–2006 period. In our application, we highlight and discuss the aforementioned advantages, while also demonstrating that the stochastic frontier approach generates regression estimates that are consistent with the stylised intuition found in the literature on financial constraint and the wider literature on the Indian credit/capital market.