Financial Liberalization, Financial Restraint, and Entrepreneurial Development

Abstract

Listen

Translate article

This paper considers the efiects of flnancial sector reform on entrepreneurial development with a focus on identifying policies appropriate for fostering entrepreneurial discovery and learning. Using a simple model of occupational choice with moral hazard, it analyzes the efiects of Financial Liberalization policies on the development of industrial entrepreneurship. The analysis shows that in a fully liberalized and competitive banking economy (i) banks may fail to flnance potential industrial entrepreneurs because of poaching externality, and (ii) systematically favor short-term projects with front-loaded returns at the expense of projects with strong learning efiects. We show that two types of policies are helpful in escaping from a no entrepreneurial experimentation equilibrium: (1) intersectoral policies that improve the relative profltability of new industrial lending and (2) intertemporal policies that aim to ensure that enough share of the net present value of rent on successful entrepreneurship can be appropriated by the flnancier bank. Among intersectoral policies, a tax on the deposit interest rate coupled with a subsidy to the new industrial flnancing works better than simple deposit rate control policies for entrepreneurial discovery. Among intertemporal policies, a dual track policy where competition is preserved in the lending to competing activities (agriculture) but limited duration monopoly is awarded to industrial lending is shown to be efiective in inducing banks to experiment with new industrial entrepreneurs.. In a dual track regime, the government can use a tax on second period lending rate to eliminate the distortion resulting from the constraint faced by a bank because of time inconsistency. While deposit rate policies can encourage entrepreneurial discovery in a competitive banking economy, it is not efiective in weeding out short-termism in project choice. The dual track policy can be especially useful for reducing the bias against the projects with low initial returns but strong learning and productivity gains later. Our analysis thus shows that well-designed deposit rate policies and temporary restriction on competition in banking as advocated recently in the Financial Restraint paradigm are appropriate when the focus of development strategy is the discovery of entrepreneurial talents and stimulating dynamic learning.