Corporate investment efficiency: The role of financial development in firms with financing constraints and agency issues in OECD non-financial firms

Abstract

Corporate investment in firms deviates from optimal level due to financing and agency issues. Managers of the affected firms trap into over- or under-investment causing investment inefficiencies. Earlier research fails to address the ramifications of financial development on over- and under-investment of firms. This study tries to fill this gap. Analyzing an annual unbalanced panel dataset of non-financial firms in 35 OECD member countries from 1990 to 2015, our empirical results show that 1) financial development has a positive impact on corporate investment; and 2) for a one standard deviation increase in financial development, it can help to increase investment efficiency by 0.423% for under investing firms (mostly due to financing constraints), and to reduce investment inefficiency in firms that are currently over investing (mostly due to agency issues) by 0.902%. When economic growth is taken into consideration, financial development is most effective on improving investment efficiency for both under- and over-investment firms in countries with high GDP growth rates. Overall, these findings suggest that monitoring and financing mechanisms of financial development have positive implications on corporate investment efficiency. Our findings are robust to alternative specifications.