Financial Deepening

Abstract

This article proposes a tractable model of the evolution of financial structure. Firms invest out of internal assets and by borrowing from banks and the financial market. In the presence of moral hazard, whereby owner–managers may intentionally reduce profitability of investment to appropriate resources, banks can monitor firms and partially alleviate agency problems. Under the optimal financial contract, banks monitor and outside investors lend to firms only if they borrow from banks too. The model is broadly consistent with financial development facts. Capital accumulation is facilitated by an increasing reliance on both types of external finance. Initially firms rely more heavily on expensive bank finance. With further development, banks eliminate much of the agency problem and firms substitute in favour of cheaper market finance. The short- and long-run effects of financial sector reforms are considered. JEL: E44, G20, O16