Finance and growth
Introduction
• What is finance?
– Instruments: loans, shares, other securities
– Institutions: banks, stock markets, etc.
• Why could finance matter for growth?
– Firms need finance in order to invest,
especially if they do not have cash
– E.g. more loans or more efficient banks allows
firms to invest more
– Investment -> economic growth
The financial sector
•
Functions:
1. Produces information ex ante about possible
investments and allocate capital
2. Monitor investments and exert corporate
governance after providing finance
3. Facilitate the trading, diversification, and
management of risk
4. Mobilize and pool savings
5. Ease the exchange of goods and services
•
Financial development:
– How well does the financial sector provide these
functions
Outline
1. Theory
2. Empirical evidence
•
Reference besides Aghion and Howitt:
– Finance and growth, Ross Levine,
Handbook of economic growth (2005)
1. Theory
The functions of finance
–
Functions
1. Produces information ex ante about possible investments
and allocate capital
2. Monitor investments and exert corporate governance after
providing finance
3. Facilitate the trading, diversification, and management of
risk
4. Mobilize and pool savings
5. Ease the exchange of goods and services
–
Two additional topics:
•
•
Bank- versus market-based finance
The link between credit constraints, inequality, and growth
1. Producing information and
allocating capital
• There are large costs associated with evaluating firms,
managers, and market conditions
• Individual savers may not have the ability to collect,
process, and produce information on possible
investments
• THEN, high information costs may prevent capital from
flowing to its highest value use
• Financial intermediaries may reduce the costs of
acquiring and processing information and thereby
improve resource allocation
• « The banker is not so much primarily a middle man. He
authorizes people to innovate.», Schumpeter (1912)
• How does this work? Model solved in class
2. Monitoring firms and exerting
corporate governance
• Shareholders and creditors are willing to
lend more if they can induce managers to
maximize firm value (monitoring)
– This prevents managers from shirking or
pursuing projects that benefit themselvse (e.g.
empire building)
Shareholders
•
Shareholders can exert effective corporate governance by voting on crucial
issues, such as mergers, acquisitions, electing boards of directors etc.
– HOWEVER, a number of frictions prevent managers from maximizing
shareholders’ value
• Information asymmetries between managers and small shareholders
• Lack of expertise and incentives from shareholders -> free rider problem -> too little
monitoring
• Inefficient protection of minority shareholders (one share one vote) or poor enforcement
– One solution is concentrated ownership
• HOWEVER, the controlling shareholder may also act in his own interest, to the
detriment of smaller shareholders (e.g. provides jobs or business deals to related
parties)
• Controlling shareholders are often families with great political influence -> they can
influence the national policies to their own interest
– Another solution is to have a liquid stock market with informative prices
• THEN, it is possible to link managerial compensation to stock prices. A high stock price
means that investors expect the firm to perform well in the future.
• This way, the interests of the manager are aligned with the interests of the shareholders
• The same mechanism holds if it is easy to organize takeovers -> Then, with takeover, it
becomes possible to fire managers who underperform
Creditors
• Debt contracts may be more efficient because
they require less monitoring
– The debt contract is very simple because it only
includes an interest rate
– Monitoring only needs to happen in case of default
• Banks are better monitors because they
overcome the free riding problem and prevent
duplication of monitoring effort
• Banks often develop long term relationships with
their creditors, which can help overcome the
cost of information acquisition
• How does this work? Model solved in class
3. Risk amelioration
•
•
Less risk induces investors to invest more -> economic growth
Efficient financial institutions mitigate the risks associated with individual projects:
–
–
•
Efficient stock markets allow investors to buy different stocks with uncorrelated returns
Banks can lend to firms with uncorrelated risks
3 types of risk:
–
Cross-sectional risk
•
–
Intertemporal risk
•
–
E.g., if you lend to an ice-cream factory, you lose money if the weather is bad. But if you lend BOTH to
an ice-cream factory and to an umbrella factory, you are fine on average
E.g. life insurance company
Liquidity risk
•
•
•
•
•
High return projects are often less liquid (i.e. the return comes later) than low return projects
The problem is that investors may need liquidity before the returns are realized (liquidity shock)
Banks can help mitigate this risk by holding many such illiquid projects or a mix of illiquid and liquid
projects
Liquid stock markets can make illiquid projects more liquid by making them easily transferable
Finally, firms may need extra liquidity injections (extra credit) to complete a project
4. Pooling of savings
• Financial intermediaries mobilize savings.
• It overcomes the transaction costs
associated with collecting savings from
different individuals
• This function is particularly useful in the
case of large indivisible projects
• It also helps investors hold diversified
portfolios
5. Easing exchange
• Economic growth requiers higher specialization
(Adam Smith) which requires more transactions
• Problem: Transaction costs
• Financial institutions can help in reducing these
transaction costs:
– E.g. credit card or bank transfers, rather than
payment in cash
– Paypal facilitates transactions on Ebay, by increasing
trust
6. The case for bank-based finance
• Banks solve the free rider problem of atomistic
market participants, as they have greater
incentives to search for information on valuable
projects
– If they don’t do it, nobody will do it
– They don’t have to display the information they
collected, so they can take advantage of this
monoplistic position. By contrast, private information
collection by market participants is immediately
revealed in the stock price
• Takeovers are not always socially beneficial, as
they may simply benefit the raider
The case for market-based finance
• Banks with close ties to their creditors may have too high
an influence on them
– Banks can extract rents from firms because they have a lot of
private information
– In case of debt renegotiation or liquidity injection, banks have a
lot of bargaining power and can extract more of the future profits
of the firms
-> this may reduce the effort extended by firms to undertake
innovative ventures
– Banks may be more risk averse and favor conservative and slow
growth strategies
– Banks may not be effective gatherers of information in new and
uncertain situations (think of venture capital)
– Main banks may exert influence over corporate decisions or fail
to bankrupt distressed firms because of long run ties
The case for both bank- and
market-based finance
• It does not matter whether finance comes
from banks or markets
• Bank and market-based finance are
complementary:
– the availability of both systems may spur
competition to provide finance
– Each system may be more appropriate for a
certain type of firms: e.g. banks finance lowrisk projects, markets high-risk ones
7. Credit constraints, inequality, and
growth
• We have seen that inequality harms economic
growth because it implies more redistribution
and thus less investment
• But is this still true if we introduce credit
constraints?
• Main result: Reducing inequality can have a
positive effect on growth if inequality is the
consequence of credit constraints
• Model solved in class
• Some references:
– Banerjee and Newman (1993), Galor and Zeira
(1993), Benabou (1996)
2. Empirical Evidence
King and Levine (1993)
• They use various measures of financial
development and show positive correlation with
subsequent economic growth
• Endogeneity issue:
– Does finance causes growth or does growth causes
finance?
• Robinson (1952): « where enterprise leads finance follows »
• Miller (1988): « the idea that financial markets contribute to
economic growth is a proposition too obvious for serious
discussion »
Levine, Loayza, Beck (2000)
• Use legal origins as an instrument
• The argument:
– Legal origins are exogenous
– Legal origins cause investor protection
– Investor protection causes financial
development
First stage
Second stage
Rajan and Zingales (1998)
• Growth in industries that rely more heavily on
external finance should benefit more from higher
financial development than growth in industries
that do not rely so much on external finance
• They regress the value-added of industry k in
country i on:
– Country and industry dummies
– The share of industry k in total manufacturing in
country i
– The interaction between:
• Financial development (stock market+credit) in country i and
• Industry k’s dependence upon external finance
The measure of dependence on
external finance=(I-CF)/I