The Development and Structure of Financial Systems

The Development nd Structure of Finncil Systems Shnkh Chkrborty y Tridip Ry z Revised: September 2006 Abstrct Firms rise externl nnce vi monitored bnk lons nd non-monitored borrowing in dynmic generl equilibrium model. Access to credit nd ech type of nncing depend on the welth distribution due to morl hzrd. We study the depth of credit mrkets ( nncil development) nd conditions under which the nncil system relies more on either type of externl nnce ( nncil structure). Initil inequlity, investment size nd institutionl fctors determine the level of nncil development, while nncil structure is shped by the investment technology nd legl nd nncil institutions. The model s predictions re consistent with historicl nd recent development experience. Keywords: Finncil Development, Finncil Structure, Bnk Finnce, Mrket Finnce, Credit Frictions. JEL Clssifiction: E44, 20, 30, O5, O6 This pper ws written when the second uthor ws t the Hong Kong University of Science nd Technology. Finncil support from Hong Kong RC Competitive Ermrked Reserch rnt 200-02 (Project No. HKUST6073/0H) is grtefully cknowledged. For helpful discussions nd suggestions we thnk Joydeep Bhttchry, Nncy Chu, Sty P. Ds, Sudipto Dsgupt, Cludin Kwok, Roul Minetti, Kunl Sengupt, Steve Turnovsky, Yong Wng nd seminr prticipnts t vrious plces this pper ws presented. We re especilly grteful to the co-editor, Crl Chirell, n ssocite editor nd two nonymous referees of this journl for comments nd suggestions. All remining errors re ours. y Deprtment of Economics, University of Oregon, Eugene, OR 97403-285. Emil: shnkhc@uoregon.edu z Deprtment of Economics (Plnning Unit), Indin Sttisticl Institute, 7, S.J.S. Snsnwl Mrg, Qutb Institutionl Are, New Delhi 006, Indi. Emil: tridip@isid.c.in

Introduction Systemtic evidence over the lst decde hs documented robust nd positive reltionship between nnce nd economic development. This positive reltionship motivtes our pper. But our interest goes deeper, into the roles vrious prticipnts ply in the nncil system. We begin with the century-old debte on the e ccy of bnks versus nncil mrkets. Some commenttors hve cited ermny nd Jpn s experience to rgue tht bnks re better t mobilizing svings, identifying good investment nd exercising corporte control. Observers on the other side of the debte point to the UK nd US s evidence tht nncil mrkets hve n dvntge over bnks in informtion cquisition, corporte control nd risk mngement. This debte is s relevnt tody s it ws historiclly. A globl trend, fvoring nncil mrkets, hs emerged over the lst two decdes. This is true even in trditionlly bnkbsed developed countries like Frnce nd Jpn which hve incresed the role of nncil mrkets since the mid-eighties (Allen nd le, 2000). In developing nd trnsition countries, mrket- nnce is nding incresing fvor s bnking crises hve become widespred nd s government interventions, prticulrly in the bnking sector, hve been thoroughly discredited (Allen nd le, 2000, Holmstrom, 996, Demirgüc-Kunt nd Levine, 200). Yet, s Allen nd le (2000) point out, it is uncler why nncil mrkets re suddenly seen s the pnce. Missing from the globl policy debte is cler understnding of the dynmic implictions of ech type of nncil system nd, more speci clly, how the nncil system itself evolves. So our primry gol is to write down nd nlyze n explicit dynmic model of nncil structure. We see this s necessry step to ddressing policy issues rised by the bnk-versus-mrket debte, especilly in developing nd trnsition economies. Wht We Do The bene ts of nncil system depend on the degree to which externl nnce fcilittes industriliztion. But in second-best world infested with credit frictions, ccess to credit is constrined by welth levels nd internl sset positions of individuls nd rms. There is thus n intimte connection between the welth distribution nd nncil development. We construct dynmic model tht incorportes this interdependence. In the model, mnufcturing requires lrge-scle investment which cnnot be funded by internl ssets only. Potentil entrepreneurs my borrow using monitored bnk lons (bnk nnce) or non-monitored sources like bonds nd equities (mrket nnce) or combintion See Levine (2005) for n up-to-dte survey of this literture. 2

of the two. Credit frictions rise becuse owner-mngers of mnufcturing rms my choose n inferior technology in order to enjoy privte bene ts. The incentive to do so is greter the lower the personl stke n owner hs in her investment project (Holmstrom nd Tirole, 997). Under this incentive problem, welth thresholds determine who invests nd the kind of nncil instruments they use. Poorer individuls do not obtin ny funding since they cnnot gurntee lenders the required return; they insted work for wge. Others obtin lons nd produce cpitl using risky technology. When investment succeeds, these cpitlists hire workers to operte the mchinery nd produce nl good. Among cpitlists, welth thresholds gin determine how they borrow. Individuls of medium welth levels re ble to borrow only through combintion of intermedited (bnk) nd unintermedited (mrket) nnce. Bnk nnce entils monitoring tht prtilly elimintes the incentive problem; perceiving this, direct lenders re willing to lend. 2 Cpitlists who re welthy enough, on the other hnd, do not hve to be monitored nd use only mrket nnce. In this wy the welth distribution determines ccess to credit mrkets ( nncil depth) nd dependence on ech type of externl nnce ( nncil structure). The wge erners who were rtioned out of the credit mrket my ultimtely ccumulte enough ssets to become cpitlists. Whether or not this hppens depends on their lbor income, which in turn depends on the extent of industriliztion. At the sme time tody s cpitlists my nd themselves denied ccess to credit in the future if they su er losses on their current investment. Min Findings The dynmic interply of the welth distribution nd borrowing choices determines the pth of nncil development nd structure. We identify initil inequlity, investment size nd institutionl fctors s key determinnts of nncil development, while nncil structure is shped by investment technology nd the nture of its legl nd nncil institutions. An unequl distribution, speci clly lrge pesnt popultion reltive to cpitlists, hurts nncil development since few individuls obtin credit. The sprse industriliztion tht results from this prevents workers from ccumulting enough to ccess credit mrkets in the future. Low to moderte degrees of inequlity, however, see the emergence of developed nncil systems. Even then, nncil depth is negtively relted to inequlity, prediction consistent with evidence from cross-section of countries. Initil inequlity lso impcts n economy s historicl nncil structure by reducing dependence on monitored nnce 2 Costly monitoring mkes bnk nnce more expensive, but necessry, lterntive to mrket nnce. 3

it results in more mrket-oriented nncil systems, pttern we observed during Western Europe s industriliztion. The investment technology plys vitl role. When investment requirements re too lrge reltive to verge welth levels, fewer individuls obtin credit: industriliztion nd nncil development remin low. Lrger cpitl requirements lso promote bnk-bsed nncil system, t lest during the initil stges of nncil development. This outcome mtches well Western Europe s historicl experience. In prticulr, the British industril revolution occurred in industries, textiles for exmple, tht did not cll for enormous investments (Lndes, 969). ermny, in contrst, ws involved in hevy mnufcturing nd chemicls, both of which required lrge injections of externl cpitl. Such technologicl di erences could hve plyed key role in Britin s historicl relince on mrket nnce nd ermny s dependence upon its bnking systems (Blig nd Polk, 2004). We show tht investment technologies tht re riskier re more conducive to mrketbsed systems becuse lrger proportion of cpitlists cn ccumulte enough ssets to shed their relince on bnk intermedition. Finlly, institutionl fctors like gency costs shpe nncil system in intuitively plusible wys. Bnk-bsed systems result when bnk monitoring is prticulrly e cient in resolving gency problems, lthough it depends upon monitoring costs s well. Our theoreticl results lend credence to recent empiricl evidence, LPort et l. (997, 998) nd Levine (2002) in prticulr, tht shows institutionl nd legl fctors to be importnt determinnts of nncil structure. Recent Relted Literture This pper contributes to the emerging literture pioneered by Bnerjee nd Newmn (993) nd lor nd Zeir (993) on the dynmic link between credit frictions nd welth distribution. 3 Similr to some of these ppers, n importnt feture of our model is the dependence of fctor prices on welth distribution. In generl, such dependence cn give rise to complicted non-liner dynmics (see for exmple Aghion nd Bolton (997)). An dvntge of our frmework is its bility to circumvent this problem nd esh out interesting nd empiriclly plusible predictions regrding nncil development. The key innovtion we bring to this literture is rich nncil structure nd fuller understnding of the determinnts of nncil development. Tretment of nncil systems in the existing literture is incomplete since its min gol hs been to chrcterize distributionl dynmics or study occuptionl choices. Wht is missing, speci clly, is the vriety 3 Recent work in this re include Aghion nd Bolton (997), Piketty (997) nd Mookherjee nd Ry (2002). 4

of nncing choices tht rms typiclly fce. In contrst, our interest lies rst nd foremost in these choices nd how they shpe the development nd structure of nncil systems. 4 At the other end of the spectrum lies the corporte nnce literture on rm nncing choices. This literture usully dels with sttic (often prtil equilibrium) models of developed nncil systems. Conclusions bout developing societies re hrd to infer, even though nncil reforms in developing countries hve borrowed extensively from the experience of developed systems. We drw insights from Dimond (99) nd Holmstrom nd Tirole (997) which nlyze the link between rm nncing choices nd some form of sset distribution. Dimond (99) considers how rm switches from expensive (nd monitored) bnk nnce to cheper forms such s public debt s it develops better reputtion, which of course is form of sset. Holmstrom nd Tirole (997), whose incentive structure we dopt here, observe how incentive problems nd ccess to di erent types of externl nnce depend on rm s internl ssets. Neither of these ppers incorporte the feedbck tht mcro-fundmentls hve on nncing choices. Once these re tken into ccount, we show how the typicl life-cycle story of rm nncing choices, s rticulted by the nnce literture, cn fll prt unless initil conditions nd policy prmeters re pproprite for long-run nncil development. Finlly, our pper is relted to Blig nd Polk (2004) who nlyze sttic prtilequilibrium model in which ll rms borrow using either monitored or non-monitored debt (but not both, s in this pper). They discuss how investment size nd entrepreneuril welth explin the historicl development of the Anglo-Sxon nd ermn nncil systems. Our dynmic model shows tht the reltionship between rm nncing choices nd investment size (welth) posited by Blig nd Polk is temporry, relevnt only during the initil stges of development. The reltionship disppers in the long-run unless investment size (welth) gives rise to history-dependence, in which cse the very process of nncil development cn be crippled. The pper is orgnized s follows. The model is developed in section 2 nd optiml 4 reenwood nd Smith (997) study dynmic model of bnks nd equity mrkets. They re interested in how these two types of externl nncing emerge endogenously to fcilitte growth through liquidity provision nd speciliztion. The key di erences with our pper re tht bnks exist here to ddress gency problems nd our focus in on how the mix of two types of externl nnce wht we cll nncil structure chnges over time. We re lso primrily interested in the demnd for vrious types of externl nnce (the supply side is sideshow) nd bstrct from growth issues (see Chkrborty nd Ry, 2006). Turnovsky (2000, chpter 9) discusses some erly ppers, focusing on the short-run, tht incorporte the Modiglini-Miller theorem in mcro-environment. 5

nncil contrcts chrcterized in section 3. Section 4 looks t the sttic generl equilibrium while section 5 nlyzes the dynmics nd its implictions for nncil development nd structure. Section 6 contins further discussions on wht our nlysis dds to the literture nd to the policy debte. Section 7 concludes. 2 The Model Consider smll open economy populted by continuum of gents of mesure one. Time is continuous nd successive genertions re connected by bequest motive. An gent is born with n initil welth,, received s bequest from her prent nd lbor time endowment of one unit. This lbor cn be either supplied inelsticlly to the lbor mrket or used to oversee n investment project tht produces cpitl. Inheritnce is the sole source of heterogeneity mong newly borns. We denote the cumultive distribution of gents t t by t () nd ssume tht the initil distribution 0 is continuous nd di erentible. Preferences re given by the wrm-glow utility function: u t = c t b t ; 2 (0; ); where c denotes consumption nd b denotes bequest left to o spring. iven relized income z, optiml consumption nd bequests re liner functions of z: c t = z t ; b t = ( )z t : () The indirect utility function is then lso liner in income, U t = 'z t with ' ( ), implying tht gents re risk-neutrl. Similr to Bnerjee nd Newmn (993), newly born gents become economiclly ctive only when they become mture. Time to mturity, T, is distributed exponentilly with the density function h(t ) = e T, > 0, cross members of the sme cohort. All economic ctivity occurs t the instnt n gent becomes mture: she chooses her occuption nd erns income ccordingly, gives birth to one o spring, consumes, leves bequests nd dies. There is thus no popultion growth nd members of cohort do not ll die t the sme time. Without loss of generlity we set = so tht gents live for unit length of time on verge. 2. Production nd Occuption Whether or not n individul is worker or cpitlist is determined by ccess to externl nnce. Production of cpitl requires n indivisible investment of size q. Only individuls 6

ble to rise the requisite funds (from internl nd externl sources) become cpitlists, the rest join the lbor force. A worker supplies her unit lbor endowment to the lbor mrket, erning wge income w t. A cpitlist s income, on the other hnd, is uncertin. In prticulr the investment project is risky successful project yields cpitl mounting to q ( > ), while filure yields nothing. Successful cpitlists become producers of nl goods by hiring workers to operte the cpitl. This cpitl deprecites completely upon use. Mrkets for the nl good nd for lbor re perfectly competitive. We ssume n Arrow- Romer type technologicl spillover in the nl goods sector. Speci clly, for successful cpitlist j, the privte technology for producing the unique consumption good is constnt returns to scle in privte inputs: Y j t = K j t (At N j t ) ; 2 (0; ); (2) Here A t denotes time-dependent lbor-e ciency tht is common to ll nl goods producers. Lbor e ciency A depends upon cpitl per worker, k, through lerning-by-doing externlity: A t = ^Ak t : (3) Productivity improvements in ny prticulr rm spills over instntneously to the rest of the economy, becoming public knowledge. The socil (intensive-form) production function is thus n Ak type technology y t = Ak t, where A ^A. It remins to chrcterize the investment decision fcing potentil cpitlist. An individul with ssets t < q cn become cpitlist only if she is ble to borrow the shortfll q t. To obtin rich nncil structure, we introduce n gency problem similr to tht in Holmstrom (996) nd Holmstrom nd Tirole (997). Speci clly, the probbility of success of investment depends upon n unobserved ction tken by the cpitlist her choice on how to spend q. She cn spend it on n e cient technology tht yields q units of cpitl with probbility, but uses up ll of q: Alterntively, she cn spend it on one of two ine cient technologies. One of these technologies is low morl hzrd project, costing q vq, leving vq for the cpitlist to pproprite. This project too yields q units of cpitl when it succeeds, but it succeeds less often, with probbility B <. The other ine cient technology is high morl-hzrd project, costing q V q. This leves V q in privte bene ts. Both ine cient technologies crry the sme probbility of success, B, but since 0 < v < V < by ssumption, the cpitlist would prefer the high morl-hzrd project over the 7

low morl-hzrd one. Only the e cient technology is, however, economiclly vible. 5 tble below summrizes these investment choices. The Tble Project ood Low Morl Hzrd High Morl Hzrd (low privte bene t) (high privte bene t) Privte Bene t 0 vq V q Success Probbility B B 3 The Finncil Sector Cpitl is perfectly mobile cross borders so tht this smll open economy hs free ccess to the interntionl cpitl mrket. investment, r, is tken s given. The time-invrint (gross) world rte of return on Supply of lons in the domestic nncil sector comes from two sources: through nncil intermediries or bnks, nd directly from workers nd interntionl investors. Workers re indi erent between bnk deposits, lending directly to cpitlists nd investing on the interntionl cpitl mrket s long s ll three yield n expected return of r. In other words, r is the return tht bnks promise their depositors s well s the expected return on direct lending. 6 On the demnd side, lons re obtined by individuls who invest in the production of cpitl; they invest their entire welth, borrowing the reminder from the domestic nncil sector. Credit-constrined gents work for the cpitlists. They deposit their welth with bnks or lend directly to domestic cpitlists or the interntionl cpitl mrket. Cpitlists fce perfectly elstic supply curve of lonble funds since they cn freely ccess the interntionl cpitl mrket. Avilbility of domestic investble resources therefore does not concern us. Wht mtters is how cpitlists borrow. Direct borrowing from 5 To ensure this we ssume Aq r q > 0 > B Aq r q + V q. Here r is the world return on investment nd we nticipte tht successful cpitlist s return per unit cpitl produced, t, equls A in equilibrium (see eqution () below). 6 Note tht we do not llow direct investment (FDI) by foreign investors. Implicitly we re ssuming TFP di erences between the domestic nd foreign economies (A > A) becuse of which these investors ern higher returns from directly investing in their home countries. There my be other resons too. For exmple, foreign direct investors my fce setup costs which domestic cpitlists do not, nd relisticlly they my lso fce exproprition risks or problems with reptriting pro ts. 8

domestic (workers) nd foreign investors will be referred to s direct (or mrket) nnce, nd should be thought of s occurring through the purchse of one-period corporte bonds nd equities. Borrowings intermedited by the bnking sector will be clled indirect (or bnk) nnce. Bnk nnce plys speci c role. Bnks hve monitoring technology tht llows them to inspect borrowing cpitlist s ctivities nd ensure tht she conforms to the terms greed upon in the nncil contrct (Hellwig, 99; Holmstrom nd Tirole, 997). Direct lenders (workers nd foreign investors) do not possess this technology. Thus, s in Dimond (984, 99), bnks re the delegted monitors. Bnk monitoring prtilly resolves the morl hzrd problem nd reduces cpitlist s opportunity cost of being diligent. By choosing to monitor borrowers, bnks re ble to eliminte the high morl-hzrd project but not the low morl-hzrd one. For instnce, bnk could stipulte conditions tht prevent the rm from implementing the high morlhzrd project when it negotites lon contrct with the bnk. But such monitoring is privtely costly for the bnk nd requires it to spend nonveri ble mount per unit invested by the cpitlist. Evidently, bnk monitoring will be n optiml rrngement only if the gins from resolving the incentive problem is commensurte with monitoring costs. 3. Optiml Contrcts Fced with the incentive problem outlined bove, cpitlist will behve diligently to the extent tht she receives n incentive-comptible expected pyo nd whether or not she is monitored. Consider the nncing options prospective cpitlist fces in borrowing from bnks or from the mrket. Since bnks monitor rms while outside investors do not, we shll refer to the former s informed investors. We consider optiml contrcts tht induce cpitlists to invest in the good project. Direct Finnce An optiml contrct between cpitlist nd direct nnciers hs simple structure. Cpitlisti invests her entire welth, i t, in her own project since tht yields return strictly higher thn she would otherwise obtin. Direct lenders provide the remining, q i t: Neither prty is pid nything if the investment fils. When the project succeeds, the cpitlist erns n mount x C t > 0 while uninformed investors re pid x U t > 0. Denote successful cpitlist s rte of return per unit cpitl produced by t. Since successful project produces q units 9

of cpitl, we hve x C t + x U t = t q. 7 In order to invest in the good project, cpitlist-i must ern n incentive comptible expected income. Moreover, the contrct should stisfy ech lender s prticiption constrint, tht is, lenders should be gurnteed t lest s much s they would ern on the interntionl cpitl mrket. Combining these two constrints, we cn show (see Appendix A. for detils) tht only cpitlists with welth exceeding t would be ble to obtin direct nnce, where t q V f r t r g : (4) B Indirect Finnce Indirect or intermedited nnce entils three prties to the contrct: the bnk, uninformed investors nd the cpitlist. An optiml contrct here too stipultes tht no one erns nything when the project fils. In cse of success, totl returns, t q, re divided up s x C t + x U t + x B t = t q; with x B t denoting the bnk s returns. Besides the incentive comptibility constrint of the cpitlist nd the prticiption constrint of the uninformed investors, we hve to tke into ccount n dditionl incentive comptibility constrint, tht for bnk monitoring. Moreover the lon size hs to be chosen optimlly to mximize bnk pro ts subject to the cpitlist s incentive constrint nd the bnk s incentive nd resource constrints. Finlly, the bnking sector erns zero pro ts in competitive equilibrium. Together these hve the following implictions (see Appendix A.): (i) bnk nnce is reltively more expensive thn direct nnce (due to monitoring costs), tht is, the (gross) return on bnk lons, r L t ; is greter thn r =, the return promised to direct lenders in cse of success = r rt L > r ; (5) B nd (ii) cpitlists with welth t > i t t ; where t q v f r t ( + )r g ; (6) B 7 Since project returns re observble nd veri ble, optiml contrcts between direct nnciers nd cpitlists my be interpreted either s debt or s outside equity. For n equity contrct, the cpitlist sells shre s t of her project return, x U t = s t ( t q). For debt contrct, the cpitlist borrows q t, promising to repy return of r = in cse of success. The implicit return on equity when projects succeed hs to be r = for both ssets to be held simultneously, tht is, s t ( t q) = r (q is tht neither of these is monitored lending. 0 t )=. Agin, wht mtters

re ble to convince uninformed investors to supply the remining funds for the investment project only fter the bnk lends n mount (nd grees to monitor) 8 lt i = B B q: (7) Cpitlists with welth level below t cnnot obtin ny externl nnce, direct or indirect. 3.2 Occuptionl Incomes Denote individul-i s income by zt. i Consider the cse where i does not obtin ny externl nnce since her welth is too smll, i t t. Her income consists of lbor ernings nd returns on investment in the domestic nd/or interntionl cpitl mrket zt i = w t + r i t: Next consider those who borrow both from bnks nd the mrket, tht is, using mixed nnce. For these cpitlists with i t 2 [ t ; t ), equtions (5) nd (7) imply tht income from successful project would be zt i = t q rt L lt i ^r [q lt i i t] = [ t ( + )^r ] q + ^r i t; where ^r r =. Filure gives them zero returns. Finlly, cpitlists with dequte welth, i t t, borrow only from the mrket nd ern zt i = t q ^r q t i = (t ^r )q + ^r i t; from successful project. Of course, we re ssuming tht the rte of return from the project ( t ) is high enough for the cpitlist s prticiption constrint to be stis ed. Tht is, we require tht cpitlist s expected income zt i is greter thn r i t, wht she could ern for sure by investing her entire welth on the domestic nd interntionl cpitl mrkets. This will be true under pproprite restrictions on nd the nl goods technology (, A). 8 In order tht the lon size does not exceed investment size, tht is lt i q; monitoring costs should not be so high s to mke it impossible for bnk intermedition to resolve gency problems. Hence, we restrict monitoring cost to ( B )= B. It is lso nturl to ssume tht t > t, or else there will be no demnd for intermedition since monitoring would be too costly to be socilly useful. This is true s long s the expected gin from monitoring exceeds its cost: (V v)=( B ) r :

Ernings for ech type of economic gent re thus given by 8 w t + r i t; for i t 2 [0; t ) >< zt( i i t) = [ t ( + )^r ] q + ^r i t; with prob. 0; otherwise ) for i t 2 [ t ; t ) (8) ) >: ( t ^r )q + ^r i t; with prob. 0; otherwise for i t 2 [ t ; ) To summrize properties of optiml lon contrcts nd externl nncing choices, we note tht given q > i t nd the welth distribution t, (i) individuls with i t < t re unble to obtin ny externl nnce nd work s lborers; (ii) individuls with i t 2 [ t ; t ) obtin externl nnce from bnks s well s households: they borrow n mount lt i from bnks t the lon rte rt L, given by (5) nd (7) bove, gree to being monitored, nd rise the remining (q lt i i t) directly from investors t the rte ^r ; optiml contrcts gurntee these cpitlists incentive comptible pyments such tht they behve diligently; (iii) individuls with i t t borrow only from investors, pying them return of ^r ; here too, incentive comptible pyments to these cpitlists ensure tht investments occur in the good project; nd (iv) income in ech cse is given by (8) bove. 4 enerl Equilibrium in Period t Figure outlines the decisions fcing representtive gent ( rm ) born with ssets. Once she becomes economiclly ctive, the gent mkes occuptionl nd nncing decisions depending on how her ssets compre to the welth thresholds nd. Individuls re sorted into three ctegories: those who work (no credit ccess), those who become cpitlists using intermedited nd unintermedited lons (mixed- nnce cpitlists), nd those who become cpitlists by borrowing solely from the mrket (mrket- nnce cpitlists). Once investment outcomes re relized nd nl goods re produced, occuptionl incomes re determined ccording to (8). Welth trnsfers re subsequently mde to o springs ( continuing rms ) s speci ed by (). 2

Prmetric ssumptions we mke below ensure tht workers ern strictly lower income thn either type of cpitlist. Moreover, mrket- nnce cpitlists ern higher expected income thn mixed- nnce cpitlists (see eqution (8)). Which of the three occuptions n individul flls into is hence solely determined by her welth. If welth were not constrint, ll gents would wnt to become mrket- nnce cpitlists. Consider the economy t time t. Denote the frctions of the three types of gents by (f t ; f 2t ; f 3t ), where There re f t workers nd f t = t ( t ), f 2t = t ( t ) t ( t ), f 3t = t ( t ). f t cpitlists t ny instnt t. iven the lw of lrge numbers, proportion of these cpitlists succeed in producing cpitl, mounting to K j t = q ech, where j denotes successful cpitlist. The ggregte cpitl stock is then K t = q( f t ) nd the workforce N t = f t. Cpitl per worker is, thus, ft k t = q : (9) Since ll successful cpitlists produce the sme mount of cpitl, given w t, they hire the sme number of workers N j t = f t f t ( f t ) : Note the privte technology (2). In equilibrium, substituting for the lbor ugmenting technologicl progress ((3) nd (9)) into this production function gives output produced by successful cpitlist s Y j t = Aq: Under competitive mrkets, the equilibrium wge rte is given by the privte mrginl product of cpitl, w t = ( )Ak t = ( ) Aq f t ft : (0) A successful cpitlist then erns the income Y b j t = Aq, net of wge pyments w t N j t, from her cpitl q. The (gross) rte of return on cpitl, which we de ned s t bove, is clerly equl to A, the privte mrginl product of cpitl, tht is, t = A: () Due to overll constnt returns to cpitl, this return is time-invrint. Since ll successful cpitlists ern the sme return on cpitl, we ssume, without loss of generlity, tht they produce nl goods using only their own cpitl. 3

Using the equilibrium return on cpitl from () the cuto welth levels de ned by (6) nd (4) now do not depend upon time: where 9 = q; = 2 q; (2) [v =( B ) f A ( + )r g] =r ; 2 [V =( B ) f A r g] =r : It remins to check whether or not worker erns lower income thn cpitlist. This is by no mens gurnteed. For instnce, when there re too few workers, the mrginl product of lbor my be so high tht even individuls who could hve obtined externl nnce choose to work. It turns out tht this hppens when the proportion of creditconstrined gents flls below f e, where f e stis es " # f e ( ) A = A ( + )r : ef We restrict ourselves to empiriclly plusible distributions, those tht re positively skewed. We ssume hence tht 0 stis es f 0 > e f. This ensures tht occuptionl choice is stble over time nd we cn simply focus on the proportions of the three types of gents without hving to worry bout the e ect of income on occuptionl dynmics. 5 Dynmics of Finncil Development nd Structure The nncil system, by which we men the degree to which n economy relies upon externl nnce in generl, nd bnk nd mrket- nnce in prticulr, is determined by ccess to credit mrkets. Drwing upon the instntneous equilibrium from the previous section, we now consider the evolution of this nncil system. iven n initil welth distribution 0, welth thresholds nd determine the proportion of individuls ble to borrow nd the reltive composition of bnk- nd mrket- nnce in ggregte investment. These investment choices led to income reliztions tht determine the subsequent distribution through bequests. The process continues recursively, with chnges in the nncil system trcking the welth distribution through time. 9 Prmetric restrictions in footnotes 5 nd 8 ensure tht < 2 < : 4

Substituting lbor nd cpitl s equilibrium returns into (8), nd using optiml bequests (), we obtin the intergenertionl lw of motion: 8 h ( ) r t + ( ) Aq f t f t i ; for t 2 [0; ) >< b t = ( ) [^r t + fa ( + )^r gq] ; with prob. 0; otherwise ) for t 2 [; ) (3) ) >: ( ) [^r t + (A ^r )q] ; with prob. 0; otherwise for t 2 [; ) Figure 2 depicts this welth dynmics for vrious possibilities (see below); the dotted lines represent expected income from investment. Note tht ll three regimes of (3) re piecewise liner. For this mpping to converge we need to rule out the possibility tht dynsty cn get rbitrry rich over time by simply reinvesting its welth. This is ensured by ( )^r <. We would lso like to rule out dynsty from being ble to self- nnce its entire investment. When investment succeeds, the xed-point of the mpping for t 2 [; ) is given by U = ( )(A ^r )q=[ ( )^r ]. For this to be less thn q, we ssume tht ( )A < : Since investment is undertken only if the return from it (A) is greter thn the return to be pid to lenders, (^r ), this is su cient to ensure ( )^r <. We mintin it henceforth nd, without loss of generlity, restrict ourselves to distributions on the domin [0; U ]. It is importnt to note the nonlinerity of the distributionl dynmics. The current welth distribution nd threshold determine the size of the working clss (f t ) which then determines equilibrium wges through (0). This endogeneity of the wge rte gives rise to nonliner dynmics since the future welth distribution depends upon wges vi optiml bequests. The dynmic behvior of such systems cn be quite complicted (see for exmple Aghion nd Bolton, 997). Fortuntely it is su cient for our purpose to simply trck the evolution of (f t ; f 2t ; f 3t ) insted of conducting complete chrcteriztion of the welth dynmics. 0 A couple of fetures of our model simpli es the tsk. In the rst plce, there is no feedbck from the welth distribution to nd, which re independent of 0 We re interested in two fetures of nncil system, its depth nd structure. Finncil depth is cptured by ( f t ), the proportion of unconstrined borrowers, while the nncil structure is chrcterized by the reltive mesure of cpitlists relying on bnk- nnce (f 2t ) nd mrket- nnce (f 3t ). 5

time. Secondly, constnt returns to cpitl t the ggregte level ( t = A) gurntees tht recursion dynmics for welth levels exceeding is independent of time. 2 Speci clly, welth dynmics for the two upper ctegories re not ected by the endogeneity of the wge rte which impcts only working-clss dynmics. By exploiting the feture of the investment technology tht filure yields zero returns, here too we re ble to precisely chrcterize the dynmics. In wht follows we nlyze the evolution of the nncil system in two stges. First we look t the generl development of the system ( nncil depth). Then we discuss fctors tht determine the structure of developed nncil system if it were to result in the long run. 5. Finncil Development The degree of credit rtioning mong potentil cpitlists determines the depth of nncil system. movement of f. 3 Hence the simplest mesure of nncil development comes from observing the As point of reference, it will be useful to keep in mind the idel nncil system one where welth is no constrint on borrowing (for instnce, if monitoring were costless in which cse there would lso be no distinction between monitored nd non-monitored lending). Since individuls re ex nte identicl, this mens workers nd entrepreneurs must ern the sme expected income in equilibrium. It is esy to show tht this implies n lloction of people between wge employment nd entrepreneurship, sy f, which is lower thn ~ f. Strting from n initil f 0 > ~ f, the economy instntneously jumps to this f. But, s we show below, in world with credit frictions, equilibrium nncil depth ( f ) is lwys lower thn wht we would observe in the idel system. How fr it deprts from the idel system is, however, wht we re interested in. We begin with Figure 2. 4 Suppose tht t frction of the f t working dynsties leve This is feture our pper shres with Bnerjee nd Newmn (993) nd lor nd Zeir (993). 2 See Aghion nd Bolton (997) nd Piketty (997) for models where returns to cpitl depend upon the welth distribution. 3 This mesure corresponds closely to Levine s (2002) mesures of overll nncil development bsed on indictors of ctivity, size, nd e ciency which re ment to proxy for the degree to which ntionl nncil systems provide nncil services: ssessing rms nd monitoring mngers, esing risk mngement, nd mobilizing resources. Since the only service the nncil system provides here is to fcilitte ccess to externl nnce, our mesure f is the sme s his mesure of provision of nncil services. 4 We ssume, for now, tht returns from successful investment re high enough; speci clly, successful mixed- nnce cpitlists become welthy enough so tht their o springs re ble to borrow using mrket 6

bequests exceeding. This mens o springs of these t f t workers will be ble to borrow nd become cpitlists. Figures 2()-(c) di er only in the position of the lowest regime reltive to, nd hence, in t. In Figure 2(), the welth recursion line for [0; ) lies entirely bove so tht t =. This hppens when the wge rte is high enough, tht is, when there re reltively few workers: f f + : ( )( ) Aq We chrcterize dynmics on the two-dimensionl unit simplex in (f ; f 3 ). Since P` f` =, this is su cient to determine the time-pth of f 2t. Suppressing time subscripts, trnsition dynmics when f f is given by the pir of di erentil equtions _ f = ( ) (f 2 + f 3 ) f = ( ) (2 )f ; _ f 3 = f 2 ( )f 3 = ( f ) f 3 : The rst eqution follows from noting tht the out ow from the stock of workers is f wheres the in ow comes from the frction ( ) of cpitlists who su er losses on their investment nd lose their entire welth. The mss of workers, f, decreses or increses over time ccording to whether f exceeds ( )(f 2 + f 3 ). The second di erentil eqution is obtined similrly: the stock of mrket- nnce cpitlists increses s long s mixed- nnce cpitlists moving up, f 2, re more numerous thn mrket- nnce cpitlists su ering losses, ( )f 3. Now turn to Figure 3 for the phse-plne: when f f, the f _ = 0 locus is given by the eqution f = ( )=(2 ) while the f _ 3 = 0 locus is given by f 3 = ( f ). Figure 2(b) looks t nother possibility, where the lowest regime of the trnsition mpping lies entirely below. None of the working dynsties leve bequests exceeding here which mens t = 0. This hppens when the wge rte is low enough, tht is, workers re more numerous: f > f + [ ( )r ] : ( )( ) Aq The corresponding trnsition dynmics is given by: nnce only. _ f = ( ) (f 2 + f 3 ) = ( ) ( f ) ; _ f 3 = f 2 ( )f 3 = ( f ) f 3 : 7

In Figures 3() nd (b), the f 3 = ( f ), when f > f. 5 f _ = 0 locus is given by f = nd the f _ 3 = 0 locus by A third possibility rises when the welth recursion line on [0; ) lies neither fully bove nor fully below. This occurs for f < f < f. In Figure 2(c), working dynsties distributed on [e t ; ) leve bequests exceeding, those on [0; e t ) do not. For scenrio like this, t would depend upon the exct distribution on [0; ) in generl. But moment s re ection shows we do not need detils bout the distribution on this intervl; informtion bout f t lone is su cient to determine the dynmics. To see this, we estblish rst tht t is monotoniclly decresing function of f t. An increse in f t lowers the wge rte by incresing the supply of lbor; this rises e t nd, ceteris pribus, lowers t. Obviously how n increse in f t gets distributed on [0; ) mtters, which is why detiled informtion bout t my be necessry. But recll tht investment filure yields zero income, which mens ll new workers strt out with zero welth. The pool of workers increses when the in ux of cpitlists whose investments hve filed exceeds the out ow of workers who hve ccumulted welth beyond. This mens n increse in f t results in bulging of the distribution t zero; hence such n increse further reduces t. 6 In ddition, t is continuous function of f t. The continuous time demogrphic structure nd continuous initil distribution imply tht chnges in t nd f t (nd hence in e t ) occur in continuous fshion. Thus t, de ned by f t. t (e t )=f t, lso moves continuously with We cn therefore specify the dynmics corresponding to Figure 2(c) by the di erentil equtions: _ f = ( )( f ) (f )f ; _ f 3 = ( f ) f 3 : Appendix A.2 demonstrtes the existence of the _ f = 0 locus for continuous (f t ). Multiple such loci re possible but, genericlly, there will be n odd number of these. Figures 3() nd (b) illustrte dynmics under one nd three such loci respectively. In both cses, when f 0 f, point D represents loclly stble sttionry distribution, while point L is loclly stble sttionry distribution for f 0 > f. Point D, in fct, represents well-developed nncil system nd is given by (f ; f2 ; f3 ) = 2 ; 2 ; 2. Point L 5 f > f since ( )r <. 6 Note the crucil role plyed by the investment technology. If filure resulted in low, but positive, returns, we would need more informtion bout the distribution to determine how t responds to t. 8

likewise represents less-developed nncil system. Indeed, there we hve (f ; f 2 ; f 3 ) = (; 0; 0), tht is, complete collpse of the nncil structure. In Figure 3(), b f cts s threshold. For vlues of f 0 below b f, the economy converges to the developed nncil system, wheres for vlues bove b f, the long-run outcome is the primitive system. For three loci (f ; f b ; f c ), s in Figure 3(b), the intermedite one cts s locl ttrctor for f 0 2 (f ; f c ). In ddition to the developed nd underdeveloped nncil systems, we now hve third kind, modertely developed nncil structure, t point M. The complete collpse of the nncil system t point L is n unttrctive outcome, consequence of there being no wy out of the working clss when f > f. We eliminte this extreme outcome by perturbing the dynmics slightly. We do so by llowing very smll probbility () of moving up from working- to middle-clss, probbility tht corresponds to winning lottery or some other form of windfll gin not cptured by the model. The phse digrm for one such perturbtion is Figure 3(c). When f f, this perturbtion does not lter the welth dynmics since t =. When f > f, perturbed welth dynmics is given by _ f = ( ) (f 2 + f 3 ) f = ( ) ( + )f ; _ f 3 = ( f ) f 3 : The perturbed locus _ f = 0 (when f > f ) lies to the left of the originl one while the _ f 3 = 0 locus remins unchnged. The sttionry distributions re now represented by D nd L 0, both of which re loclly stble. L 0 still represents very under-developed nncil structure, but we now hve both f 2 nd f 3 > 0. Thus developed, underdeveloped nd even modertely-developed nncil systems my emerge depending upon the initil mesure of credit-constrined individuls, f 0. High vlues of f 0 re prticulrly inimicl to nncil development. For low to moderte vlues, developed nncil system results in the long-run, but even here, the degree to which it develops my depend upon initil conditions. Recll tht f 0 0 (): Clerly, f 0 depends on the initil distribution ( 0 ) nd on the fctors tht determine investment size (q) nd institutionl prmeters (v nd ). 7 We consider these determinnts one by one. 7 An inspection of (2) shows tht depends positively upon investment size, q, nd on the gency problems prmeters v nd. 9

Inequlity nd Finncil Development Welth distribution is key predictor of nncil development. Suppose high vlue of f 0 results from highly unequl initil distribution. Figure 3 shows how developed nncil system (D) results for vlues of f 0 less thn f, tht is, for reltively equl distribution. Under reltively unequl distribution, individul welth levels will be more commonly below. When f 0 > f, these inequities hmper development leding to collpse of credit trnsctions (Figures 3() nd 3(b)), or more plusibly, n underdeveloped nncil system (Figure 3(c)). For moderte degrees of inequlity such tht f < f 0 < f, outcomes depend upon the existence of dditionl sttionry distributions. Persistent nncil underdevelopment results in Figure 3() for vlues of f 0 bove b f, wheres the economy converges to developed nncil regime for vlues below b f. In Figures 3(b) or 3(c), modertely developed nncil system rises when f < f 0 < f c. Not s mny individuls become cpitlists in this cse s they would when f 0 < f, but credit-constrined borrowers re less numerous thn t L 0, nd credit mrkets thicker. Our model thus predicts tht concentrted ownership of ssets like lnd nd nturl resources, which directly or indirectly determine ccess to investment opportunities, would hmper nncil development nd industriliztion. Initil inequities persist when lower cpitl ccumultion signi cntly depresses income for the working clsses, the potentil entrepreneurs of the future. This negtive ssocition between inequlity nd nncil development nds support with vilble evidence. Using dt on income ini from Deininger nd Squire (996) nd indices of nncil depth from Levine (2002), we obtined negtive correltion of 0:49 between inequlity nd nncil development. 8 Indeed, some of the nncilly lest developed countries in Levine (2002) (mostly from Ltin Americ nd Afric) re, t the sme time, chrcterized by severe distributionl problems. This is ll the more evident when we contrst middle-income countries in Est Asi nd Ltin Americ. Est Asi s better sset nd income distribution hs received considerble ttention in the development literture; 9 our model reltes how this di erence my hve 8 For nncil development, we use Levine s (2002) Finnce Aggregte mesure (Column 4, Tble 2), constructed using indictors of nncil ctivity, size nd e ciency over the period 980-95. For Levine s smple of 48 countries this index rnges from 2:2 to :88: For this smple of 48 countries, income ini rnges from 24:9 to 62:5. We use income ini for the yer 980 (s close s possible, permitted by vilbility) s proxy for initil inequlity. Detils vilble upon request. 9 Income ini ws 34:6 in Est Asi nd 53 in Ltin Americ during the 960s; lnd inis were 44:8 nd 82 respectively (Deininger nd Squire, 998, Tbles nd 2). 20

been vitl for their nncil development. Ltin Americn ntions like Argentin, Brzil, Chile, Peru nd Venezuel re by nd lrge nncilly underdeveloped while Hong Kong, Mlysi, South Kore, Tiwn, Thilnd nd Singpore s nncil systems re comprble to those in Western Europe nd North Americ. 20 Investment Size Consider next the e ect of investment size (q). An increse in q rises the cuto, given the welth distribution. This could led to nncil underdevelopment if the economy is pushed over f b or f. c An immedite impliction is tht poorer countries which re chrcterized by high inequlity, such s Ltin Americ nd sub-shrn Afric, ought to rely more on smllnd medium-scle industries for their development. An emphsis on import-substituting hevy industries, for instnce, would be counterproductive in the long-run. Institutionl Fctors Individuls do not di er in terms of their innte bilities in our model nd ccess to credit mrkets is limited solely by informtionl symmetries nd costs. A relevnt question is how better institutions mitigte these symmetries nd wht tht implies for nncil structure. A simple wy to interpret institutions here is through the prmeters, v nd V. These prmeters ect the depth nd structure of nncil system through the nture nd mgnitude of gency problems nd costs of controlling it. As noted erlier, the degree of credit-rtioning, f 0, depends positively upon the institutionl prmeters nd v through. When legl nd nncil institutions re too ine cient (f 0 > f b or f 0 > f), c the nncil system remins underdeveloped in the long run; e cient institutions led to nncil development in the long-run. This prediction is long the lines of recent studies of the legl-bsed view of nncil development in LPort et l. (997, 998), where the qulity nd nture of legl rules nd lw enforcements protecting shreholders nd creditors re seen s fundmentl to nncil ctivity. Systemtic empiricl support for this view, covering wide rnge of countries, is o ered by Levine (2002). 5.2 Finncil Structure Finncil structure refers to the combintion of nncil instruments, mrkets nd institutions operting in n economy (oldsmith, 969). We consider the reltive importnce of 20 See Tble 2 in Levine (2002) nd Tble 3.2 in Demirgüc-Kunt nd Levine (200b). 2

mrket- nd bnk- nnce, t f 3t =f 2t, s n index of structure in our model nd study its evolution. In the nlysis so fr we hve implicitly llowed high investment returns to ensure tht successful mixed- nnce cpitlists move up to the next welth ctegory. Wht if tht were not the cse? We illustrte such scenrio in Figure 5 which depicts welth recursion dynmics for f f (the other two cses would prllel Figures 2(b) nd (c)). It turns out tht the nture of the trnsition dynmics does not chnge here lthough the composition of the sttionry distribution does. Trnsition dynmics corresponding to Figure 5 is given by: when f f ; when f > f ; nd when f < f < f ; _ f = ( ) (2 )f ; _ f 3 = ( )f 3 ; _ f = ( ) ( f ) ; _ f 3 = ( )f 3 ; _ f = ( )( f ) (f )f ; _ f 3 = ( )f 3 : In Figure 6(), when f 0 f ; D represents loclly stble sttionry distribution with developed nncil system, where (f ; f2 ; f3 ) = 2 ; 2 ; 0. As before, when f 0 > f ; point L represents loclly stble sttionry distribution representing less-developed nncil system with (f ; f 2 ; f 3 ) = (; 0; 0), nd when f < f 0 < f c, point M represents modertely developed nncil system. Not surprisingly, the long-run distribution hs no cpitlist relying purely on mrket nnce since middle-clss cpitlists cnnot move up. As before, such n outcome cn be voided with perturbtions tht llow workers to move up to the middle-clss with smll probbility (), nd middle-clss cpitlists to move up with similr probbility ("). Under perturbtion, the sttionry distributions in Figure 6(b) re represented by D 0 when f 0 f, L 0 when f 0 > f nd M 0 when f < f 0 < f c : All three points re loclly stble. Compre now the nncil structure of D (or D 0 ) in Figures 3 nd 6 under di erent rtes of return. When investment returns re low, ll (or very lrge proportion of) eligible 22

cpitlists go through bnk intermedition in the long-run. Tht is, bnk- nnce is reltively more importnt when investment returns re lower (this would be true even for modertely developed nncil system). The long-run nncil structure is, hence, more mrket-bsed for con gurtion like Figure 2 nd more bnk-oriented for sitution like Figure 5. A mrket-bsed system (Figure 2) occurs when the height of C exceeds, tht is when, ( ) r v V ( A r ) : (4) B B This is more likely to occur when V is reltively low nd v reltively high, or when is reltively high but low (holding constnt). 2 On the other hnd bnk-bsed nncil system (Figure 5) results when the height of H is less thn. This hppens if ( ) [ A ( + )r ] < ( ) r V fa r r g : B This inequlity is more likely when V nd re reltively high, or, holding constnt, when is reltively low nd high. 22 Thus, the nncil structure of n economy is determined by the investment technology ( ; ) nd institutionl fctors (, v nd V ). We consider these issues next. Investment Risk Although bnks nd individuls re risk-neutrl in our model, investment risk ects nncil structure through its e ect on welth dynmics. (5) We begin by contrsting two types of investment tht yield the sme expected return, : type-i projects yield high but re riskier since is low, while type-ii projects succeed more often but relize low. 23 Suppose now tht the two project types di er signi cntly in their riskiness so tht Figure 2 depicts welth dynmics for type-i projects while tht for type-ii projects is given by Figure 5. From (4) nd (5) we know tht Figure 2 is more likely to occur when is reltively high but low (holding constnt) while Figure 5 is more likely to occur for the opposite cse. Figures 2 nd 5 led to dynmics shown by Figures 3 nd 6 respectively. We drw two conclusions on the role of investment risk. First, lower leds to higher f so tht credit rtioning is more widespred in the long-run. Secondly, when investment is less risky, ll or lrge proportion of eligible cpitlists go through bnk intermedition in the long-run. In 2 We llow for proportionte decrese in B s well. 22 Agin, we chnge B by the sme proportion s : 23 We llow for proportionte chnge in B between the two project types. 23

other words, bnk- nnce is reltively more importnt for sfer technologies, wheres mrket nnce gins importnce for riskier ones. This dependence of nncil structure on risk is quite distinct from, but complementry to, the ones commonly nlyzed in the nnce literture. Speci clly, since gents re riskneutrl our nlysis misses the typicl portfolio e ect discussed in the literture. 24 At the sme time it brings to the nlysis the mcroeconomic feedbck tht investment risk hs on sset positions nd nncing dynmics, n e ect entirely bsent from the existing literture. Nture of Institutions Institutionl prmeters lso ect long run nncil structure in the model. Recll tht mrket-bsed system is more likely to occur (tht is, (4) holds) when V is reltively low nd v reltively high. On the other hnd, bnk-bsed system (condition (5)) is more likely to occur when V nd re reltively high. It is quite intuitive tht bnk-bsed system is more likely when the residul morl hzrd under bnk monitoring (v) is low reltive to wht incentives would be in the bsence of monitoring (V ). This conclusion is consistent with Demirgüc-Kunt nd Levine s (200b) nding tht countries with strong shreholder rights reltive to creditor rights nd strong ccounting systems (tht is, low V reltive to v) tend to hve more mrket-bsed systems. It my seem surprising tht higher monitoring costs,, led to more bnk-oriented systems even though these costs re borne by the bnking sector. This is esy to understnd once we recognize tht welth nd nncing dynmics depend upon investment ernings. A higher cost of monitoring mens tht bnks need to inject lrger mount of their own resources into the investment project. This forces mixed- nnce cpitlists to rely more hevily on expensive intermedited nnce; consequently less of them re ble to move up to become mrket- nnce cpitlists. 6 Further Discussion 6. Historicl Implictions Severl of the model s implictions shed light on the development of nncil systems during the Industril Revolution. 24 Risk verse gents would clerly mke the nlysis much less trctble. It is to be noted, though, tht the literture is not unequivocl bout whether bnks or mrkets diversify risks better, suggesting only tht both re importnt. Levine (997) nd Allen nd le (200) discuss these issues. 24

Inequlity nd Finncil Structure Consider rst the e ect of initil inequlity on nncing choices. For convenience, ssume tht the initil distribution is lognorml with men 0 nd vrince 2 0, where < 0 <. In Appendix A.3 we estblish tht n increse in 2 0 tends to rise f 0, lower f 20 but increse f 30. Higher inequlity leds to thinner cpitl mrkets since f 0 is lower. But mong those who obtin lons, there is shift towrd mrket nnce nd wy from bnk nnce, incresing the rtio 0. Historicl relince upon the two types of nnce my, in other words, depend upon inequlity. This prediction seems to be corroborted by wht we know bout Englnd nd ermny during the industril revolution. The Anglo-Sxon nncil system, with its creditors pursuing more of hnds-o lending, ws more mrket-oriented. Bnks were mostly concerned with liquidity nd did not engge in long-term lending so tht British industries primrily depended upon internl nnce nd the London Stock Exchnge for their nncing needs (Collins 995, Allen nd le, 2000). ermn industries, in comprison, relied more on bnk nnce. ermn bnkers kept continuous wtch over the development of compnies nd were often represented on the compny bords (Allen nd le, 2000, Blig nd Polk, 2004). At the sme time, substntil evidence suggests Englnd hd more unequl lnd distribution thn ermny (nd Frnce) (Clphm, 936, Soltow, 968). Lndes (969) lso notes tht lrge number of British industrilists were men of substnce, hving ccumulted signi cnt welth from merchnt ctivities. This distributionl di erence between the two regions could prtly explin why the Anglo-Sxon nd ermn nncil systems hve historiclly di ered. Indeed, this lso explins why other societies with better distributions thn Englnd, for instnce Frnce nd Jpn (or the newly industrilizing Est Asin countries), hve trditionlly relied more on bnk- nnce (see Allen nd le, 2000). A systemtic nlysis covering brod smple of countries is clerly required to estblish this reltionship. There is n importnt point to be noted here. The initil distribution hs no permnent impct on nncil structure s long s countries similr in other respects re converging to the sme (developed) nncil system. Interestingly, Allen nd le (2000) point out how there hs been convergence of nncil systems in developed countries s trditionlly bnk-oriented societies such s Frnce, ermny or Jpn hve moved closer towrd mrket nnce since the 980s. One could interpret this s convergence in industrilized country nncil systems (policies, which re exogenous here, would hve clerly plyed role too). 25

Investment Size nd Finncil Structure Investment size (q) hs n impct on initil (historicl) nncil structure. With higher q, fewer individuls re ble to obtin lons either from mrkets or from bnks. At the sme time, the shortfll q i tht hs to be rised through externl nnce is higher for those who do invest. The Holmstrom-Tirole incentive structure hs strightforwrd impliction: due to limited libility, borrower s incentive to be diligent is weker the less her personl stke in the project is, tht is, the more she needs to borrow. The only wy to ttenute this is through incresed monitoring. Higher investment requirements would hence push n economy towrds bnk nnce. But whether or not this hppens depends lso on the welth distribution. A higher q rises the importnce of bnk- nnce under two conditions: when the initil welth distribution mong cpitlists is more equitble, tht is when f 30 =f 20 is low; nd when bnks re prticulrly e ective t resolving incentive problems ( << 2 in (2)) so tht the mesure of individuls bove is sizeble. 25 Historicl evidence, once gin, provides some support of this story. Similr to their nncil systems, distinction is often mde between Englnd nd ermny s industriliztion ptterns. The British process of industriliztion minly relied upon smll- nd mediumscle industries, textile mnufcturing being prime exmple. ermny, on the other hnd, lrgely utilized hevy mnufcturing nd chemicl industries for its development, both requiring fr greter investment thn in the cse of Englnd (see Lndes, 969, nd relted references in Blig nd Polk, 2004). Consistent with the evidence, our model suggests tht this technologicl di erence would be re ected in greter ermn relince on intermedited nnce especilly if bnks re e cient intermediries nd the welth distribution is more equitble. Using sttic model of monitored nd non-monitored debt, Blig nd Polk (2004) highlight the role of investment size for Western Europe s nncil structure. 26 Our dynmic model suggests, though, tht di erences in nncil structure re neutrl in the long run with respect to investment size. As long s f 0 < b f (or less thn f ), di erences in f 0 do not trnslte into di erences in the sttionry distribution, tht is, point D. This is becuse q ects threshold welth requirements ( nd ) s well s expected income from investment. In the short-run, higher q could increse relince upon bnk- nnce but it lso enbles successful cpitlists to ern more. When more of the middle-clss cpitlists move bove 25 This follows from noting tht @ 0 =@q < 0 whenever 2 ( + f 20 =f 30 )g 0 () > g 0 (). 26 In the Blig-Polk model rm borrows using either monitored or non-monitored debt but not both. 26

, they do not need to be monitored so tht relince upon bnk nnce declines. The generl equilibrium dynmics lso suggests second importnt wy investment size ects outcomes, by giving rise to threshold e ects. For given initil welth distribution, the greter the cpitl needs of industriliztion, the more likely it is tht f 0 > ^f in which cse the nncil system will continue to remin underdeveloped. The question of whether bnks or mrkets re more importnt for rms nncing needs becomes less relevnt in such scenrio. 6.2 Life-Cycle of Firms A conventionl wisdom in corporte nnce visulizes rm s life-cycle s follows: the rm relies mostly on internl ssets nd venture cpitlists (the so-clled ngels ) for investment in its erly stges; s it mtures, nncil intermediries strt lending to the rm; nlly, when the rm is mture enough, it rises funds from the mrket. This is the pttern implied, for exmple, by Myers (984) pecking order theory of - nnce. 27 Dimond (99) cptures this feture in dynmic model of rm nncing choices: rms use expensive (nd monitored) bnk nnce in the erly stges of their life-cycle, nd, s they develop better reputtions, switch to cheper forms of nncing such s publicly held debt. A similr life-cycle pttern is discussed by Holmstrom (996, p. 229) for dynmic extension of his sttic model:... rm nncing will hve life cycle in which over time nd ssuming success, rms shift from using more informtion intensive to less informtion intensive cpitl. Our nlysis essentilly crries out wht Holmstrom suggests bove. Doing so mkes it cler why it is importnt to think bout rm- nncing choices in dynmic generl equilibrium frmework. In prticulr our nlysis cutions ginst generlizing from sttic prtil equilibrium models if our gol is to understnd the process of nncil development. As we show in section 5 bove, the life-cycle process nticipted by the nnce literture depends sensitively on mcro-fundmentls like welth inequlity, investment size nd institutionl determinnts. These fctors ect nncil development nd the life-cycle pttern of typicl rm works well only when the nncil system fully develops over time. If initil conditions, policy choices nd prmeters of the economy re not pproprite for long-run - nncil development, rms my nd it di cult to switch to less informtion-intensive sources of nncing even with time nd high levels of internl ssets. 27 For instnce, Fluck (2000, p. 7) sys Myers predicts tht rms will issue debt rst nd outside equity only lter. 27

This lso mens blind push towrds one type of externl nnce in developing countries, s we hve seen in the lst two decdes, is wed without tking into ccount the deeper problems ecting these nncil systems. Policies regrding ptterns of industriliztion, bnking, trnsprency nd vilbility of informtion on borrowing rms, cn ect not just current rm nncing choices but the bility to ccess credit mrkets over time nd to invest in industries tht require hevy dose of investment or those tht re prticulrly risky. 6.3 Policy Considertions We drw severl policy conclusions from the model. First, s is common to most models of mrket imperfections nd non-convexities, temporry policies cn hve permnent e ects in this economy. Consider for exmple (temporry) policy of emphsizing smll-scle enterprise in the erly stges of development. Since investment requirements of these industries re typiclly low, not only cn lrger frction of entrepreneurs ccess credit mrkets, they cn do so by direct borrowing insted of more expensive monitored nnce. This fcilittes nncil depth nd permits greter welth ccumultion, tht is, fster convergence to developed nncil system. Over time, s typicl welth levels rise nd industriliztion needs chnge, ccessing credit mrkets will be less of problem even with rising investment needs. Such permnent e ect of temporry policies is especilly importnt if we think nncil systems remin underdeveloped becuse institutions re ine ective. Ine cient institutions re widespred nd informtionl problems more pronounced in poorer countries presumbly becuse better institutions re costly to implement (similr to the costs of operting mrkets in reenwood nd Smith, 997). In our model, one wy to get round such institutionl bottlenecks is through temporry income redistribution tht relxes credit constrints for sizeble number of potentil entrepreneurs. The bene ts of such redistribution will be persistent if it pushes f 0 below the relevnt threshold, nd in fct, could be politiclly more pltble thn permnent distributive policies such s lnd reforms. Recll our brief discussion of n idel nncil system in section 5. bove. The idel system corresponds to the frictionless counterprt of the economy we hve nlyzed so fr nd mximizes ccess to credit, hence, genertion of income. One cn then view the gol of policy s tking the frictionl economy s close s possible to the idel system. Clerly this mens bnks nd mrkets should hve better ccess to rm-speci c informtion nd tht bnk intermedition be mde more e ective. Long-run nncil sector reforms, in other words, should focus on lowering v, V nd. At the sme time, since the investment 28

technology hs bering on the convergence pth nd stedy-stte outcomes, policies should focus on encourging technologies tht re more productive (higher ) nd less cpitlintensive (t lest initilly). Another gol of policy cn be to push one type of nncing over nother s we hve seen recently in order to increse ggregte income. In this economy both bnk-bsed nd mrket-bsed systems generte the sme DP, but NP di ers. Speci clly, Appendix A.4 shows tht mrket-bsed systems generte higher NP. Policies to rise NP would then involve promoting mrket- nnce. Better disclosure nd bnkruptcy lws will of course help by lowering V. But bnking sector reforms cn help too. While lowering is desirble both s temporry nd permnent policy, lowering v helps only s temporry policy. Lowering v vi legl reforms like better protection of creditor rights nd improving the bnk s role s n enforcer nd protector of these creditor rights enhnces the rech of the bnking sector (lowers ). This is good in the short run s less individuls re credit-constrined, but not so good in the long run since bnk monitoring costs constitute resource drin. Thus, unless this policy is coupled with policies to reduce or V (both of which help cpitlists ccumulte welth fster), the result my be n undesirble (gin for generting higher NP) bnk-bsed system. 28 7 Conclusion This pper hs nlyzed the evolution of nncil system nd identi ed fctors determining its development nd structure. We introduced monitored bnk lons nd non-monitored trdeble securities in dynmic generl equilibrium model nd showed how the pth to nncil development exhibits non-ergodic behvior underdeveloped nncil systems persist in highly unequl societies nd in economies with cpitl-intensive industries or ine cient legl nd nncil institutions. The model s key predictions re consistent with the historicl development of nncil systems during the Industril Revolution. We lso show tht the 28 The reltive ttrctiveness of mrket-bsed system needs to be quli ed. Here we hve bstrcted from growth nd ssumed tht credit-constrined borrowers become workers insted of engging in low-productive trditionl entrepreneuril ctivities which my not bene t s much from industriliztion. We ddress these issues in compnion piece, Chkrborty nd Ry (2006), by bstrcting from the distributionl complictions of this pper. There we show tht bnk-bsed system hs better distributionl outcomes thn mrket-bsed ones (though neither is necessrily better for growth). So how one views the desirbility of one nncil system over nother depends on the reltive emphsis plced on ggregte income versus welth/income distribution. 29

typicl life-cycle nncing decisions of rm, s envisioned by ppers in corporte nnce, cn be hmstrung by wek mcroeconomic fundmentls nd policy prmeters. Finlly we shed light on the bnks-versus-mrket policy debte tht hs in uenced much of nncil sector reforms round the world. Compred to existing works on the dynmic interction between credit mrkets nd the welth distribution, our gol hs been to obtin clerer understnding of wht drives the development nd structure of nncil systems. Hence n importnt contribution of this pper lies in extending the literture by incorporting elements tht llow policy nlysis for developing countries. We conclude by considering some extensions for future work. Throughout the pper we focused on the demnd side of nncil systems. We did this primrily for trctbility. A nturl extension would be to consider how importnt the supply of lonble funds is to nncil structure, for exmple, by looking t closed economy version of the model. A more chllenging extension would be to cpture the emergence of di erent nncil institutions (institutions like bnks nd mrkets re tken s given in our story). For instnce, if there re xed costs to setting up n intermediry (s in reenwood nd Jovnovic, 990), the extent to which bnks emerge nd monitor lending will depend upon, nd ect, the pttern of welth ccumultion. It will be lso interesting to endogenize the interest rte, llowing the welth distribution to ect nncil structure through returns to bnk nd mrket- nnce. Another institutionl spect we hve ignored, nd one likely to be importnt in development, is the qulity of bnk monitoring. In prticulr, bnks do not fce ny incentive problems vis--vis depositors in our model. Extensions incorporting gency problems within the bnking sector my be used to exmine how the qulity of bnk- nnce itself chnges over time nd with respect to mcro-fundmentls. 30

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Appendix A.. Optiml Contrcts Direct Finnce We hve x C t +x U t = t q. Cpitlist-i s incentive comptibility constrint (choosing the good project) is given by Direct lender s prticiption constrint is x C t B x C t + V q: x U t r q i t : Cpitlist s incentive comptibility constrint implies x C t V q B ) x U t = t q x C t t q V q B : Using this, the lender s prticiption constrint gives threshold welth level for ccess to direct nnce r q i t x U t t q V q B ) it t qr V f t r g : B Indirect Finnce Under indirect nnce we hve x C t + x U t + x B t = t q: Here the optiml contrcts need to stisfy the following three constrints: (i) cpitlist-i s incentive comptibility constrint (choosing the good project): x C t B x C t + vq; (ii) bnk s incentive constrint (for monitoring): x B t r q B x B t ; ssuming tht bnks discount monitoring costs t their opportunity cost, r, (iii) prticiption constrint of the uninformed investors: x U t r q lt i t i ; where lt i is the mount tht the bnk lends to cpitlist-i. 34

The bnk s return from lending l i t to cpitlist-i is x B t = r L t l i t; (6) where rt L is the (gross) lon rte chrged to borrowers when projects succeed. But the bnk s incentive constrint implies x B t r q: (7) Since bnk nnce is reltively more expensive thn direct nnce (due to monitoring costs), borrowers ccept only the minimum mount necessry so tht rt L lt i = x B t = r q ) l i t(r L t ) = B B r q ( B ) r L t : (8) Cpitlist s incentive comptibility constrint implies x C t vq=( B ). Then x C t + x B t v + r v + r q ) x U t = t q x C t + x B t t q q: B Using this, the uninformed investors prticiption constrint gives v + r t r q lt i i t x U t B q: B It follows tht only cpitlists with welth i t t q l i t(r L t ) r t v + r B q (9) re ble to convince uninformed investors to supply enough funds for the investment project. The Bnk s Problem The competitive bnking sector is pro t mximizing. The ggregte demnd for bnk lons is Z L t = lt(r i t L r Z q )d t = d i2i t ( B ) rt L t ; i2i t where I t denotes the subset of individuls using intermedited nnce. The totl monitoring cost borne by the bnking sector is then Z q d t = ( i2i t 35 B ) r L t L t r :

Let D t denotes the ow of deposits into the bnking sector. Expected bnking pro ts re B t = r L t L t r D t : (20) Bnks fce the resource constrint tht totl lons cnnot exceed totl deposits net of monitoring costs: L t D t Z q d t : i2i t (2) The bnking sector s optimiztion problem in period t is to choose L t so s to mximize B t subject to the cpitlist s incentive constrint nd the constrints (7) nd (2). Since bnk pro ts re incresing in totl lons, (2) holds with equlity: Z ( B ) rt L L t = D t q d t = D t L i2i t r t : (22) Moreover, in competitive equilibrium, the bnking sector erns zero expected pro ts. From (20) we then hve It follows from equtions (22) nd (23) tht nd r L t L t = r D t ; (23) L t = Hence, using (8), we observe tht lt i = r L t B D t ; = r B : (24) B B q: (25) In other words, for ll i 2 I t, bnks nnce xed proportion of the borrower s investment, irrespective of i t. Tking into ccount the optiml lon size (25), the lower welth cut-o (9) becomes t = q v f r t ( + )r g : (26) B A.2. Existence of _ f = 0 locus when f < f < f In the text we hve lredy estblished tht t is continuous nd monotoniclly decresing function of f t. Now de ne z(f ) ( )=[ + (f )] f 36

on the intervl [f ; f ]. Since (f ) is continuous on [f ; f ]; z is lso continuous on [f ; f ]: We hve z(f ) = ( )=(2 ) f < 0 since f > ( )=(2 ) nd z(f ) = f > 0, since f <. Hence, using the Intermedite Vlue Theorem, since z is continuous on [f ; f ] nd since 0 2 [z(f ); z(f )], we cn nd n u 2 [f ; f ] such tht z(u) = 0. In other words, z(f ) = 0 for t lest one vlue of f 2 [f ; f ]. Figure 4() illustrtes this when the line ( )=[ +(f )] intersects f once, t f b. Multiple such intersections re lso possible, but, genericlly, these hve to be in odd numbers. Figure 4(b) depicts three intersections. Figures 3() nd (b) illustrte dynmics under one nd three such intersections respectively. A.3. E ect of n increse in initil inequlity on nncing choices Suppose tht the initil distribution 0 is lognorml with men 0 nd vrince 2 0. Recll tht the lognorml cumultive distribution is given by [(ln x stndrd Norml cumultive distribution function. Then: @ 0 () ln 0 ln 0 @ 0 () ln = @ 0 ; = 0 @ 0 0 0 2 0 0 )=], where is the 0 ln When ln < 0 < ln, the rst derivtive is positive, the second derivtive negtive. Moreover, @[ 0 () 0 ()] ln = @ 0 0 0 0 ln 2 0 0 ln 0 ln + 0 0 is lso negtive in this cse. Thus, s long s ln < 0 < ln, we hve 2 0 2 0 0 0 : ; @f 0 @ 0 > 0; @f 20 @ 0 < 0; @f 30 @ 0 > 0: A.4 NP Clcultions NP = DP + Net interest income from brod (NIA). Since DP is the sme in both systems (the number of workers nd cpitlists re the sme under both systems nd these re the only two fctors of production), let us concentrte on NIA. Assume tht workers supply their svings to the domestic nncil sector rst, nd then invest ny excess on the interntionl cpitl mrket. Similrly, the domestic nncil sector rst relies on the domestic lonble funds mrket before pproching the interntionl cpitl mrket. Since bnks nd entrepreneurs py the world rte of return, r (in n expected sense), the lon mrket lwys clers. 37

Demnd for lonble funds = demnd from bnks seeking deposits (D t ) + demnd from entrepreneurs seeking direct nnce (M t ). D t = M t = B Z Hence demnd for lonble funds is L t = B Z ltd i t q l i t i t dt + Z U q i t dt D t + M t = ( + ) q Z Z U d t + q d t Z U i td t : Supply of lonble (S t ) funds comes from the workers nd is: S t = R 0 i td t. Net lending brod is Z U Z U Z NLA t = S t D t M t = i td t q d t q d t : 0 The lst term in this expression mkes it cler tht the mount spent on monitoring bnkdependent cpitlists is drin from investible resources. Now consider the two nncil systems. Note tht we hve distinguished between the two systems only t the stedy stte nd tht too for developed nncil system. Under mrket-bsed system Z 0 d t = ; 2 while under bnk-bsed system Z d t = ; nd 2 Z U d t = 2 ; Z 0 d t = ; 2 Z d t = 2 ; nd Z U d t = 0: Clerly, the second term in the expression for NLA t is the sme under either system nd the third term is higher (in bsolute vlue) under the bnk-bsed system (s the resource drin due to monitoring cost is higher). We will estblish tht the rst term is higher under the mrket-bsed system. First, in developed nncil system, from t > 0 onwrds ll workers re simply o springs of cpitlists whose investments filed, so tht i t = 0. This is lso true in stedy stte. Hence R 0 i td t = 0 under both systems. Secondly, for mrket-bsed system, in stedy-stte bnkdependent cpitlists re grndchildren of cpitlists whose investments filed. Prents of these bnk-dependent cpitlsts were workers nd left them bequests i t given by the verticl 38

intercept of point A in Figure 2(). Hence in the mrket-bsed system (in stedy stte) R i td t = ( )=(2 ) (verticl intercept of A): Now consider bnk-bsed system. Since there re ( )=(2 ) workers in stedystte, out of the =(2 ) bnk-dependent cpitlists exctly ( )=(2 ) hve welth i t given by the height of point A. Next consider the remining =(2 ) bnk-dependent cpitlists in bnk-bsed system nd the =(2 ) mrket-dependent cpitlists in mrket-bsed system. Compring Figures 2() nd 5 it is cler tht ech of the mrket-dependent cpitlist is welthier thn ny bnk-dependent cpitlist the welth of the mrket-dependent cpitlists is distributed long the bequest line EF in Figure 2() wheres tht of the bnk-dependent cpitlists is distributed long the bequest line CH in Figure 5. Hence mrket-bsed system yields higher NP. 39

Born with sset Becomes economiclly ctive; mkes occuptionl, finncing decisions < ets no finncing; becomes wge erner < Borrows using combintion of (monitored) bnk nd (nonmonitored) mrket finnce Investment succeeds or fils Borrows using only (nonmonitored) mrket finnce Figure : Timeline of Decisions for Typicl Agent Depending on occuption nd investment returns, erns income s per eqution (8) nd trnsfers welth to offspring ccording to ()

b t E o 45 F H C A B t Figure 2(): Recursion Dynmics of Welth Accumultion when f f

b t F E o 45 H C A B t Figure 2(b): Recursion Dynmics of Welth Accumultion when f > f

b t F E o 45 H C A B ~ t t Figure 2(c): Recursion Dynmics of Welth Accumultion when f < f < f

f 3 f = 0 3 f = 0 (when f f) π D f = 0 (when f < f < f ) f = 0 (when f > f) 0 f ˆf f π 2 π L f Figure 3(): Phse Digrm for single Threshold

f 3 f = 0 3 f = 0 (when f f) π D f = 0 (when f < f < f ) M f = 0 (when f > f) 0 b c π 2 π f f f f f L f Figure 3(b): Phse Digrm for two Thresholds

f 3 f = 0 3 f = 0 (when f f) π D f = 0 (when f < f < f ) f = 0 (when f > f) M L 0 b c π 2 π f f f f f L f Figure 3(c): Phse Digrm with Perturbed Welth Dynmics

f π π + λ( f ) π 2 π 0 f f ˆf f Figure 4() f π λ π + ( f ) π 2 π 0 f f b f c f f f Figure 4(b)

b t o 45 F E C H A B t Figure 5: Welth Dynmics with Low Return on Investment ( f ) f

f 3 f = 0 (when f f) f = 0 (when f < f < f ) f = 0 (when f > f) f = 0 3 D M L 0 b c π 2 π f f f f f f Figure 6(): Phse Digrm (for two Thresholds) with Low Investment Return

f 3 f = 0 (when f f) f = 0 (when f < f < f ) f = 0 (when f > f) D M L D L 0 b c π 2 π f f f f f f = 0 3 f Figure 6(b): Phse Digrm for the Perturbed Welth Dynmics with Low Investment Return