Finance and growth

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 capital2. Monitor investments and exert corporate governance

after providing finance3. Facilitate the trading, diversification, and

management of risk4. Mobilize and pool savings5. 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

– Functions1. 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

• 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

– Intertemporal risk• 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 low-risk 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