An Interest Group Theory of Financial Development



The purpose of this dissertation is to examine the institutions that underpin financial systems. Political and legal institutions function in tandem to shape financial policy, in part, by determining the ability of those who benefit from financial repression
to block development. I find that legal institutions that fail to protect private property rights generate a dichotomy between entrenched corporate interests and aggregate welfare. For this reason, politicians are influenced by powerful, elite special interest groups when forming financial policy. My thesis contributes to current explanations of the variance in financial development across countries by analyzing the effect of private interests on financial policy and examining the institutional obstacles that policymakers face when reforming the financial system.

The context of this dissertation is embedded in a large literature examining the role of finance on growth. In a recent revitalization of this research, Levine (1997) demonstrates the critical causal relationship between financial structure and economic development by explaining the purpose of financial systems within society, how they operate, and the mechanisms by which they affect and are affected by economic growth. Shleifer and Vishny (1997) produce a second watershed paper under the finance and development umbrella. Their article examines the different ways economies deal with the problem of corporate governance: the set of laws and institutions created to ensure that firms share their profits with the suppliers of capital. The authors focus on two differentiating features of corporate governance systems across countries: ownership concentration and the degree of legal protection of investors. Shareholder rights determine the competency of the financial system to allocate society’s resources efficiently. High ownership concentration is a market response to the agency costs that plague financial systems with weak corporate governance institutions. A juxtaposition of Shleifer and Vishny (1997) and Levine (1997) reveals that the effectiveness of a financial system to generate economic growth is dependent on the institutional structure in which the system is embedded.

A Simple Model of Financial Development

The set up of the financial system is loosely based on Matsuyama (2000). I make several crucial modifications to Matsuyama’s original framework in order to capture the\ process of political reform in the credit system of an emerging economy. Furthermore, my model assumes that agents face a decreasing returns to scale production technology in contrast to the constant returns function in Matsuyama’s paper. There exists a small closed economy populated with a continuum of agents. Agents live for two periods. In the first period, individuals make their investment decisions and in the second period, they consume final wealth. Additionally, there are two sources of heterogeneity across agents: they are endowed with different amounts of initial wealth, w, and some have access to an investment project. At the beginning of period one, each individual receives a wealth endowment, w > 0 .

Biasis and Mariotti (2003) provide a theoretical model that implements the story told by Rajan and Zingales. The authors show that soft bankruptcy laws, which are indicative of low levels of financial development, may actually increase social welfare by reducing the potential for inefficient liquidation caused by imperfect credit markets. However, imperfect sanctions against default impose a collateral requirement that prevents poor agents from accessing the credit market, thus, the gains to rich entrepreneurs are bought at the expense of the poor. Within their model, the authors point out that the “[a]gents with different initial resources typically have different preferences towards the bankruptcy law. Hence different laws can be chosen in different countries, reflecting the political influence of the different social classes, and possibly at odds with social welfare.”

Url Download Reference : http://drum.lib.umd.edu/handle/1903/2950/ umi-umd-2743.pdf

Copyright : Nela N. Thomas Richardson 2005






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