Financial development and entrepreneurship

Abstract

We empirically investigate the effect of financial development on entrepreneurship for a panel of 136 countries between 2004 and 2017. We add to existing research on the nexus between financial development and entrepreneurship by (1) constructing a novel index of financial development to account for the various dimensions of financial development, (2) using an instrumental-variable approach that exploits the presence of heteroskedasticity in regression residuals to provide causal estimates of the effect of financial development on entrepreneurship and (3) examining the role of the quality of economic and political institutions in mediating this latter effect. As our main result, we show that higher levels of financial development cause higher levels of entrepreneurial activity, especially when economic and political institutions are sound. Our empirical results suggest that financial development beneficially contributes to entrepreneurial activity by satisfying the demand for accessible, cheap and extensive credit on the part of entrepreneurs as well as the demand for the efficient and cost-effective management of risk and information on the part of investors. At the same time, our results speak to the notion that national financial systems need to be imbedded into a sound institutional framework for the economic benefits of financial development to be fully realizable.