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)
July 1, 2014
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 at no cost. We show that in developing economies with low capital endowments, relationship-based finance is optimal because only high-quality entrepreneurs receive funding. In economies with higher capital endowments, formal finance becomes necessary to prevent low-quality entrepreneurs from being funded. However, there are equilibria in which formal finance and wasteful information acquisition emerge despite relationship-based finance being optimal. Also, in developed economies, relationship-based finance may persist and low-quality close entrepreneurs may be funded instead of high-quality distant entrepreneurs.
Number of Pages in PDF File: 54
Keywords: Finance and growth, Information acquisition, Competition for capital, Connection-based vs.arm's length financial systems
JEL Classification: G3, O16working papers series
Date posted: March 17, 2008 ; Last revised: July 2, 2014
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