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We use firm-level data to explore the effect of a country measure of financial system soundness on the individual firms' financing constraints in low- and middle-income countries. We measure financial system soundness using a data-driven approach and a dynamic factor model to synthesize the IMF's financial soundness indicators into a single index. Our financial soundness index captures the time varying, cross-country dependencies among the indicators and therefore provides a useful tool for monitoring financial stability and assessing the effects of macroprudential policies on firms' behavior. We subsequently examine the effect of our index on the financing constraints of 64,717 non-financial firms in 76 countries during 2010-2018. We include fixed effects to capture country, year and sector heterogeneity. We find that firms operating in countries with higher levels of financial system soundness are associated with lower financing constraints. The effect depends on the individual firm-specific characteristics. The results remain robust after applying various sensitivity tests and endogeneity analysis as well as accounting for various economic and institutional influences.
