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 - Department of Finance; China Academy of Financial Research (CAFR)
April 2, 2014
ECGI - Finance Working Paper No. 153/2007
AFA 2009 San Francisco Meetings Paper
This paper explores under what conditions financiers allocate capital on the basis of prior relationships with close entrepreneurs, instead of acquiring costly information on distant entrepreneurs. We show that when the economy's capital endowment is relatively small, relationship-based financing is optimal because only high-productivity entrepreneurs receive funding. As the capital endowment increases, costly information acquisition becomes crucial for preventing low-productivity entrepreneurs from being funded. However, financiers may still find it optimal to fund connected entrepreneurs even if these have low productivity. Since competition for capital is low if financing is based on prior relationships, entrepreneurs enjoy high rents. High quality entrepreneurs may thus have no incentives to promote financiers' information acquisition, but rather run inefficiently small firms.
Number of Pages in PDF File: 52
Keywords: Finance and growth; Information acquisition; Competition for capital; Relationship-based vs.arm's length financial systems
JEL Classification: G3, O16working papers series
Date posted: March 17, 2008 ; Last revised: April 3, 2014
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