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The Political Economy of Financial Fragility

Enrico C. Perotti

University of Amsterdam - Finance Group; Centre for Economic Policy Research (CEPR); Tinbergen Institute

Erik Feyen

World Bank - Finance & Markets Global Practice; Ahead Analytics Inc

April 2005

AFA 2006 Boston Meetings Paper

Financial liberalization under weak regulatory institutions is often followed by financial crises. We argue that poor regulation may be the deliberate outcome of lobbying interests capturing the reform process. Lobbying on investor protection may be directed at limiting entry, in which case reforms will focus on deepening rather than broadening access to capital. Interestingly, lobbying may deliberately create financial fragility. When blocking entry is too costly, limiting access to refinance after a shock forces inefficient exit, and protects more established producers.

We model access to finance in a setting where investor protection is a legislative or enforcement choice taken by politicians subject to lobbying. Richer entrepreneurs will lobby for lower investor protection to limit access to finance and thus entry by poorer entrepreneurs. Poor investor rights induce ex post incentives to default for firms requiring more external finance, and may cause investors to refuse financing to valuable projects. Richer and thus less leveraged entrepreneurs can still credibly promise to repay their loans and will be able to raise the finance needed to enter. In our dynamic setting, investor protection affects not only entry, but also exit, which arises when entrepreneurs are not able to obtain refinancing after an external shock.

We obtain three distinct policy outcomes, corresponding to different financial regimes. They lead to different entry and exit rates, and different degrees of financial fragility. In countries with high democratic accountability, bribing politicians to block entry of poor entrepreneurs is too expensive for the rich. Thus investor protection will be set so as to ensure access for all to finance and refinance after a shock. At intermediate levels of accountability, lobbying to block ex ante access is still too costly, but investor protection may be set deliberately low so as to limit access to refinancing after a shock. This reduces competition for rich producers as the poorer, more leveraged producers are forced to exit. This form of involuntary default is a case of deliberately induced fragility. Finally, when democratic accountability is very weak, the rich find it attractive to lobby for very low investor protection so as to block any access by poor entrepreneurs. We term this case a narrow financial equilibrium.

We present supporting empirical evidence for a broad sample of countries, showing how profits in more financially dependent industries fall less in more corrupt countries after a crisis, and confirm that this is associated with higher exit rates.

Number of Pages in PDF File: 32

Keywords: financial dependence, exit, entry, growth, minority protection, political economy, lobbying

JEL Classification: G31

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Date posted: March 19, 2005  

Suggested Citation

Perotti, Enrico C. and Feyen, Erik, The Political Economy of Financial Fragility (April 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=686661 or http://dx.doi.org/10.2139/ssrn.686661

Contact Information

Enrico C. Perotti (Contact Author)
University of Amsterdam - Finance Group ( email )
Plantage Muidergracht 12
Amsterdam, 1018 TV
+31 20 525 4159 (Phone)
+31 20 525 5285 (Fax)
HOME PAGE: http://www.fee.uva.nl/fm/people/pero.htm
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Tinbergen Institute ( email )
Gustav Mahlerplein 117
Amsterdam, 1082 MS
Erik H. B. Feyen
World Bank - Finance & Markets Global Practice ( email )
1818 H Street, N.W.
Washington, DC 20433
United States
+1 (202) 458 2038 (Phone)
+1 (202) 522 3184 (Fax)
Ahead Analytics Inc ( email )
Washington, DC
United States
HOME PAGE: http://www.aheadanalytics.com
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