Financing Development: The Role of Information Costs

TLDR: In this article, a costly state verifier framework is embedded into the standard growth model to address how technological progress in …nancial intermediation aects the economy, and the framework has two novel ingredients.

Abstract: To address how technological progress in …nancial intermediation aects the economy, a costly- state veri…cation framework is embedded into the standard growth model. The framework has two novel ingredients. First, …rms dier in the risk/return combinations that they oer. Second, the e¢ cacy of monitoring depends upon the amount of resources invested in the activity. A …nancial theory of …rm size results. Undeserving …rms are over …nanced, deserving ones under funded. Technological advance in intermediation leads to more capital accumulation and a redirection of funds away from unproductive …rms toward productive ones. Quantitative analysis suggests that …nance is important for growth.

Figures

Figure 2: Capital-to-GDP ratio, 1947-2002

Figure 9: The impact of technological improvement in the nancial sector on the capital-tooutput ratio

Figure 7: The loan portfolio

Figure 12: The impact of a move to nancial best practice on the gap in GDP per worker

Figure 2: Capital-to-GDP ratio, 1947-2002

Figure 3: The cross-country relationship between per-capita GDP, on the one hand, and interest-rate spreads and capital-output ratios on the other

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Financing Development: The Role of Information Costs
Jeremy Greenwood, Juan M Sanchez, Cheng Wang
October 2007
Working Paper # 07023

NBER WORKING PAPER SERIES
FINANCING DEVELOPMENT:
THE ROLE OF INFORMATION COSTS
Jeremy Greenwood
Juan M. Sanchez
Cheng Wang
Working Paper 13104
http://www.nber.org/papers/w13104
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
May 2007
The views expressed herein are those of the author(s) and do not necessarily reflect the views of the
National Bureau of Economic Research.
© 2007 by Jeremy Greenwood, Juan M. Sanchez, and Cheng Wang. All rights reserved. Short sections
of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full
credit, including © notice, is given to the source.

Financing Development: The Role of Information Costs
Jeremy Greenwood, Juan M. Sanchez, and Cheng Wang
NBER Working Paper No. 13104
May 2007
JEL No. E44,O11,O16,O43
ABSTRACT
How does technological progress in financial intermediation affect the economy? To address this question
a costly-state verification framework is embedded into a standard growth model. In particular, financial
intermediaries can invest resources to monitor the returns earned by firms. The inability to monitor
perfectly leads to firms earning rents. Undeserving firms are financed, while deserving ones are under
funded. A more efficient monitoring technology squeezes the rents earned by firms. With technological
advance in the financial sector, the economy moves continuously from a credit-rationing equilibrium
to a perfectly efficient competitive equilibrium. A numerical example suggests that finance is important
for growth.
Jeremy Greenwood
Department of Economics
University of Pennsylvania
3718 Locust Walk
McNeil Building, Rm 160
Philadelphia, PA 19104-6297
and NBER
eag@jeremygreenwood.net
Juan M. Sanchez
Department of Economics
University of Rochester
Rochester, NY 14627
sncz@troi.cc.rochester.edu
Cheng Wang
Department of Economics
Iowa State University
Ames, IA 50011
chewang@iastate.edu

1 Introduction
Financial development “accelerates economic growth and improves economic performance
to the extent that it facilitates the migration of funds to the best user, i.e. to the place in
the economic system where the funds will earn the highest social return,” noted Goldsmith
(1969, p. 400) some thirty …ve years ago. Ever since then, economists have been developing
theories and searching for empirical evidence connecting …nancial and economic development
together. Information production plays a key role in this process of steering of funds to the
highest valued users in two ways. First, intermediaries collect and analyze information
about potential investments before funds are committed by savers. Second, after savers
have devoted their funds to investment, intermediaries monitor the activities of borrowers
to ensure that the best return is attained. If the costs of information production drop, then
…nancial intermediation should become more e¢ cient with an associated improvement in
economic performance. The current analysis provides a theoretical model of how reductions
in the cost of information processing allow for more e¢ cient capital allocation. A numerical
example illustrates that the impact, of a reduction in the cost of information processing, on
the e¢ cacy of intermediation might be quite large.
1.1 Facts
Some stylized facts of the kind illustrated in Figure 1 were o¤ered by Goldsmith (1969) to
suggest that …nancial intermediation might be important: First, the ratio of business debt
to GDP has risen. In 1952 business debt was 30% of GDP.
1
Today it is 65%. Second, the
value of …rms relative to GDP has also moved up. In 1951 …rms were worth 50% of GDP,
while today they are valued at 176%. Third, the size of the …nancial sector has increased.
Output of the …nancial sector as a percentage of GDP rose from 2% in 1950 to 8% today.
All of this may be evidence of improved intermediation; now it is easier for …rms to enter
stock and bond markets and raise funds.
1
Data sources are provided in Appendix 11.2.
1

1950 1960 1970 1980 1990 2000
0.0
0.3
0.6
0.9
1.2
1.5
1.8
Business
debt
Business debt / GDP
Year
Market value of firms / GDP
Market value of firms
1950 1960 1970 1980 1990 2000
0.2
0.3
0.4
0.5
0.6
0.7
1930 1940 1950 1960 1970 1980 1990 2000
0.00
0.02
0.04
0.06
0.08
0.10
Financial sector output / GDP
Year
Size of financial
sector
Figure 1: Trends in …nancial intermediation
Direct measures of the impact of improved e¢ ciency in the …nancial system on the
economy are hard to come by. Improvements in the e¢ ciency of …nancial intermediation,
due to improved information production, are likely to reduce the spread between the internal
rate of return on investment in …rms and the rate of return on savings received by savers.
The spread between these returns re‡ects the costs of intermediation. This spread will
include the costs of ex ante information gathering about investment projects, the ex post
information costs of policing investments, and the costs of misappropriation of savers’s funds
by management, unions, etc. that arise in a world with imperfect information. One may
observe little change in the rate of return earned by savers over time, because aggregate
savings will adjust in equilibrium so that this return re‡ects savers’rates of time preference.
If the wedge between the internal rate of return earned by …rms and the rate of return
received by savers falls, due to more e¤ective intermediation, then the capital stock in the
economy should rise. Indeed, there is some evidence that this may be the case. Figure 2
plots the capital-to-GDP ratio for the business sector of the economy, where the capital stock
includes intangible investments such as …rms’research and development, following the lead
2

Frequently asked questions

Q1. What have the authors contributed in "Financing development: the role of information costs" ?

To address this question a costly-state verification framework is embedded into a standard growth model. A numerical example suggests that finance is important for growth. 

Q2. What is the implication of the current model?

An implication of the current model is that as the state of technology in the intermediation sector advances the spread between borrowing and lending rates in an economy will shrink, while its capital-to-output ratio and level of aggregate output increases. 

Q3. What is the effect of a rise in the probability of detecting fraud?

A rise in the probability of detecting fraud relaxes the incentive constraint (8), and makes it easier to lend more capital to rms. 

Q4. What is the reason why rms can earn rents?

The inability to audit perfectly, and therefore the necessity to rely on incentive-compatible contracts, implies that rms can earn rents. 

Q5. What is the standard deviation of TFP across active rms?

The parameters selected for m; v; 2 m; 2 v, and imply that the standard deviation of TFP across active rms lie in the 0.264 to 0.284 range, at least for values of z that result in the model exhibiting capitalto-output ratios that are in accord with the postwar data. 

Q6. How much of the dispersion in output would be explained by financial development?

Dispersion in cross-country output would fall by 8 percentage points from 77% to 64%.9 Financial development explains about 19% of the cross-country dispersion in output by this metric. 

Q7. What is the rst-order condition associated with the maximization of l?

R( ; w)k max l f k l1 wlg: (P2)The rst-order condition associated with this maximization is(1 ) k l = w;which givesl =(1 ) w1= k: (2)Substituting the solution for l into the maximand and solving yields the unit return function, R( ; w), orr = R( ; w) = (1 )(1 )= w (1 )= 

Q8. What is the effect of the increase in wages on the set of active projects?

This increase in wages causes the set of active projects, A(w), to shrink, with the projects o¤ering the lowest expected return being culled. 

Q9. What is the rst-order condition associated with the contracting problem?

The rst-order condition associated with this problem leads to the well-known Euler equation1 c = (1 + br0) 1 c0 : (1)11As prelude to solving the contracting problem between a rm and a nancial intermediary, consider the problem faced by a rm that receives a loan in terms of capital in the amount k. 

Q10. What is the likelihood of a successful audit?

The likelihood of a successful audit depends upon both the amount of resources devoted to monitoring and the technological state of the auditing technology.