Economic Development and Relationship-Based Financing
Stockholm School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Swedish House of Finance
Indiana University - Kelley School of Business - Department of Finance; China Academy of Financial Research (CAFR)
September 22, 2014
Review of Corporate Finance Studies Forthcoming
ECGI - Finance Working Paper No. 153/2007
AFA 2009 San Francisco Meetings Paper
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.
Number of Pages in PDF File: 54
Keywords: Finance and growth; Information acquisition; Competition for capital; Relationship-based vs.arm's length financial systems
JEL Classification: G3, O16
Date posted: March 17, 2008 ; Last revised: September 23, 2014
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