https://www.nber.org/system/files/working_papers/w1396/w1396.pdf

Corporate financing and investment decisions when firms have information that investors do not have

Does finance affect economic growth? A number of studies have identified a positive correlation between the level of development of a country's financial sector and the rate of growth of its per capita income. As has been noted elsewhere, the observed correlation does not necessarily imply a causal relationship. This paper examines whether financial development facilitates economic growth by scrutinizing one rationale for such a relationship; that financial development reduces the costs of external finance to firms. Specifically, we ask whether industrial sectors that are relatively more in need of external finance develop disproportionately faster in countries with more developed financial markets. We find this to be true in a large sample of countries over the 1980s. We show this result is unlikely to be driven by omitted variables, outliers, or reverse causality.

/pdf/financial-dependence-and-growth-2meheeba1z.pdf

Financial Dependence and Growth

The author argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive first order relationship between financial development and economic growth. There is evidence that the financial development level is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross-country, case-style, industry level and firm-level analysis document extensive periods when financial development crucially affects the speed and pattern of economic development. The author explains what the financial system does and how it affects, and is affected by, economic growth. Theory suggests that financial instruments, markets and institutions arise to mitigate the effects of information and transaction costs. A growing literature shows that differences in how well financial systems reduce information and transaction costs influence savings rates, investment decisions, technological innovation, and long-run growth rates. A less developed theoretical literature shows how changes in economic activity can influence financial systems. The author advocates a functional approach to understanding the role of financial systems in economic growth. This approach focuses on the ties between growth and the quality of the functions provided by the financial systems. The author discourages a narrow focus on one financial instrument, or a particular institution. Instead, the author addresses the more comprehensive question: What is the relationship between financial structure and the functioning of the financial system?

/pdf/financial-development-and-economic-growth-views-and-agenda-1isr9l81uu.pdf

Financial development and economic growth : views and agenda

No. This paper investigates the relationship between financing constraints and investment-cash flow sensitivities by analyzing the firms identified by Fazzari, Hubbard, and Petersen as having unusually high investment-cash flow sensitivities. We find that firms that appear less financially constrained exhibit significantly greater sensitivities than firms that appear more financially constrained. We find this pattern for the entire sample period, subperiods, and individual years. These results (and simple theoretical arguments) suggest that higher sensitivities cannot be interpreted as evidence that firms are more financially constrained. These findings call into question the interpretation of most previous research that uses this methodology.

/pdf/do-investment-cash-flow-sensitivities-provide-useful-1r9f5xtfzn.pdf

Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints?

This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. We find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.

https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.1994.tb04418.x

The Benefits of Lending Relationships: Evidence from Small Business Data

According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)

/pdf/credit-rationing-in-markets-with-imperfect-information-21n5gppfp1.pdf

Credit Rationing in Markets with Imperfect Information.

increases wages by directly increasing the worker's productivity. This learning explanation is usually associated with human capital theory. However, it seems unlikely that learning explains all the wage differences associated with schooling and work history. Better-educated workers are not a random sample of workers: they have lower propensities to quit or to be absent, are less likely to smoke, drink or use illicit drugs, and are generally healthier. It is unlikely that employers make full use of differences in propensities to quit or to be absent or sick when hiring workers. These characteristics are often not directly observed, and the Americans with Disabilities Act precludes firms from using either poor health or the likelihood of future sickness as a hiring criterion unless it is directly related to job performance.' However, if low levels of education are associated with these unfavorable employee characteristics, and employers are allowed to take education into account when hiring workers, we would expect employers to favor better-educated workers as a means of reducing their costs of sickness and job turnover. In turn, students will take these hiring criteria into account when deciding how long to stay in school. Students will choose a length of schooling to "signal" their ability to employers, and employers will demand a minimum level of schooling

https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.9.4.133

Human Capital vs. Signalling Explanations of Wages

This paper describes the role that informational imperfections in capital markets are likely to play in business cycles. It then developes a simple illustrative model of the impact of adverse selection in the equity market and the way in which this may lead to large fluctuations in the effective cost of capital in response to relatively small demand shocks.The model also derives an expression for the cost of equity capital in the presence of adverse selection and provides informational explanations for several widely observed macro-economic phenomena.

Informational Imperfections in the Capital Market and Macro-Economic Fluctuations

/pdf/incentive-effects-of-terminations-applications-to-the-credit-27zaa42cqo.pdf

Andrew Weiss

Papers

Credit Rationing in Markets with Imperfect Information.

Human Capital vs. Signalling Explanations of Wages

Informational Imperfections in the Capital Market and Macro-Economic Fluctuations

Incentive Effects of Terminations: Applications to the Credit and Labor Markets

Credit Rationing in Markets with Imperfect Information