Economic Development and Relationship-Based Financing

60 Pages Posted: 17 Mar 2008 Last revised: 31 Oct 2018

See all articles by Mariassunta Giannetti

Mariassunta Giannetti

Stockholm School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Swedish House of Finance

Xiaoyun Yu

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); European Corporate Governance Institute (ECGI); National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER); China Academy of Financial Research (CAFR)

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Date Written: September 22, 2014

Abstract

Formal finance involves costly information acquisition about distant entrepreneurs, while relationship-based finance allows financiers to fund a narrow circle of close entrepreneurs without engaging in costly information acquisition. We show that in developing economies with low capital endowments, relationship-based finance is optimal because only high-quality entrepreneurs receive funding. However, formal finance may emerge in equilibrium and has the only effect of shifting rents from entrepreneurs to financiers. In more developed economies with higher capital endowments, formal finance becomes necessary to prevent low-quality entrepreneurs from being funded. Nevertheless, relationship-based financing may persist in equilibrium and capital may be allocated to low-quality close entrepreneurs even when there are high-quality distant entrepreneurs.

Keywords: Finance and growth; Information acquisition; Competition for capital; Relationship-based vs.arm's length financial systems

JEL Classification: G3, O16

Suggested Citation

Giannetti, Mariassunta and Yu, Xiaoyun, Economic Development and Relationship-Based Financing (September 22, 2014). Review of Corporate Finance Studies Forthcoming, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 153/2007, AFA 2009 San Francisco Meetings Paper, Available at SSRN: https://ssrn.com/abstract=959188 or http://dx.doi.org/10.2139/ssrn.959188

Mariassunta Giannetti (Contact Author)

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Xiaoyun Yu

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

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