We develop a model where institutions form connections through swaps of projects in order to diversify their individual risk. These connections lead to two different network structures. In a clustered network groups of financial institutions hold identical portfolios and default together. In an unclustered network defaults are more dispersed. With long term finance welfare is the same in both networks. In contrast, when short term finance is used, the network structure matters. Upon the arrival of a signal about banks’ future defaults, investors update their expectations of bank solvency. If their expectations are low, they do not roll over the debt and there is systemic risk in that all institutions are early liquidated. We compare investors’ rollover decisions and welfare in the two networks.
This paper uses a single-country setting, India, to examine the complex linkages between legal and business environments, financing channels, and growth patterns of different types of firms. Despite the English common-law origin, a British-style judicial system and a democratic government, Indian firms appear to be beset by weak investor protection in practice and poor legal and government institutions characterized by corruption and inefficiency. With extensive country- and firm-level data sets, including both cross-country and within-India firm samples and our own surveys of small and medium firms, we find that to a large extent Indian firms conduct business outside the formal legal system and do not rely on formal financing channels from markets and banks for most of their financing needs. Instead, firms across the board, and in particular, small and medium firms, use non-legal methods based on reputation, trust and relationships to settle disputes and enforce contracts, and rely on alternative financing channels such as trade credits to finance their growth. The scope, methodologies, and results of our paper paint a more complete picture of the law-finance-growth nexus and how businesses and investors respond to the limitations of legal system and formal financial system than existing studies.
In countries such as Germany, the legal system ensures that firms are stakeholder oriented. In others, like Japan, social norms achieve a similar effect. We analyze the advantages and disadvantages of stakeholder-oriented firms that are concerned with employees and suppliers compared to shareholder-oriented firms in a model of imperfect competition. Stakeholder firms are more (less) valuable than shareholder firms when marginal cost uncertainty is greater (less) than demand uncertainty. With globalization shareholder firms and stakeholder firms often compete. We identify the circumstances where stakeholder firms are more valuable than shareholder firms, and compare these mixed equilibria with the pure equilibria with stakeholder and shareholder firms only. The results have interesting implications for the political economy of foreign entry.
Economic growth in Africa has long been disappointing. We document that the financial sectors of most sub-Saharan African countries remain significantly underdeveloped by the standards of other developing countries. We examine the factors that are associated with financial development in Africa and compare them with those in other developing countries. Population density appears to be considerably more important for banking sector development in Africa than elsewhere. Given the high costs of developing viable banking sectors outside metropolitan areas, technology advances, such as mobile banking, could be a promising way to facilitate African financial development. Similarly to other developing countries, natural resources endowment is associated with a lower level of financial development in Africa, but macro policies do not appear to be an important determinant.
The spectacular economic growth in East Asian economies such as China, South Korea and Taiwan over the past five decades contradicts most of the existing research on law, institutions, finance, and growth. We propose an alternative view based on the comparison of legal institutions and alternative institutions outside the legal system. Despite well-known advantages, the legal system, as a monopolist institution, can be captured by interest groups and become a barrier to innovations. Moreover, in a dynamic environment alternative institutions can adapt and change much more quickly than when the law is used, as this process does not require persuading the legislature and the electorate to revise the law. We argue that in fast-growing economies and during early stages of economic growth, efficient alternative institutions are the main driver for finance, commerce and growth. In static environments with low and predictable growth, legal institutions can play a more important role in supporting finance and commerce. In these environments, however, viable alternative institutions and competition among different types of institutions remain keys to ensuring that the most efficient mechanism prevails and sustains long-term growth.