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This paper uses firm level data from a cross-section of 57 countries to study how financial development affects innovation in small firms. The analysis finds that relative to large firms in the same industry, spending on research and development by small firms is more likely and sizable in countries at higher levels of financial development. The estimates imply that among firms doing research and development in a country like Romania, which is at the 20th percentile of financial development, a 1 standard deviation decrease in firm size is associated with a decrease of 0.7 standard deviations in research and development spending. In contrast, this decrease is only 0.2 standard deviations in a country like South Africa, which is at the 80th percentile of the distribution of financial development. Small firms also report producing more innovations per unit of research and development spending than large firms, and this gap is narrower in countries at higher levels of financial development. As a robustness check, the author shows that these patterns are stronger in industries inherently more reliant on external finance.

Access to Finance --- Debt Markets --- Education --- External finance --- Finance and Financial Sector Development --- Financial Development --- Financial market --- Financial systems --- Firm performance --- Informational asymmetries --- International Bank --- Lenders --- Market failures --- Microfinance --- Science and Technology Development --- Science Education --- Scientific Research and Science Parks --- Small loan

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This paper shows how badly a market economy may respond to a positive productivity shock in an environment with asymmetric information about project quality: some, all, or even more than all the benefits from the increase in productivity may be dissipated. In the model, based on Bernanke and Gertler (1990), entrepreneurs with a low default probability are charged the same interest rate as entrepreneurs with a high default probability. The implicit subsidy from good types to bad means that the marginal entrant will have a negative-value project. An example is presented in which, after a positive productivity shock, the presence of enough bad type's forces the interest rate so high that it drives all entrepreneurs out of the market. This happens in an industry in which there are good projects that are productive. The problem is that they are contaminated in the capital market by bad projects because of the banks inability to distinguish good projects from bad. One possible explanation for the lack of development in some countries is that screening institutions are sufficiently weak that impersonal financial markets cannot function. If industrialization entails learning spillovers concentrated within national boundaries, and if initially informational asymmetries are sufficiently great that the capital market does not emerge, then neither industrialization nor the learning that it would foster will occur.

Access to Finance --- Asymmetric information --- Banks & Banking Reform --- Borrowers --- Capital market --- Debt Markets --- Default --- Default probability --- Economic Theory & Research --- Exchange --- Finance --- Finance and Financial Sector Development --- Financial fragility --- Financial market --- Financial markets --- Good --- Implicit subsidy --- Informational asymmetries --- Interest --- Interest rate --- International bank --- Macroeconomics and Economic Growth --- Market --- Market economy --- Markets and Market Access --- Negative shock --- Lyon

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October 2000 - Financial liberalization reduces imperfections in financial markets by reducing the agency costs of financial leverage. Small firms gain most from liberalization, because the favoritism of preferential credit directed to large firms tends to disappear under liberalization. Laeven uses panel data on 394 firms in 13 developing countries for the years 1988-98 to learn whether financial liberalization relaxes financing constraints on firms. He finds that liberalization affects small and large firms differently. Small firms are financially constrained before liberalization begins but become less so after liberalization. The financing constraints on large firms, however, are low both before and after liberalization. The initial difference between small and large firms disappears over time. Laeven hypothesizes that financial liberalization has little effect on the financing constraints of large firms because they have better access to preferential directed credit in the period before liberalization. Financial liberalization also reduces imperfections in financial markets, especially the asymmetric information costs of firms' financial leverage. Countries that liberalize their financial sectors tend to see dramatic improvements in political climate as well. Successful financial liberalization seems to require both the political will and the ability to stop the preferential treatment of well-connected, usually large, firms. This paper-a product of the Financial Sector Strategy and Policy Department-is part of a larger effort in the department to study the benefits and risks of financial liberalization. The author may be contacted at llaeven@worldbank.org.

Administrative Controls --- Allocation of Cred Banking Sector --- Banks and Banking Reform --- Barriers To Entry --- Credit Programs --- Currencies and Exchange Rates --- Debt Markets --- Deposits --- Developing Countries --- Directed Cred Emerging Economies --- Economic Theory and Research --- Emerging Markets --- Finance and Financial Sector Development --- Financial Intermediation --- Financial Liberalization --- Financial Literacy --- Financial Market --- Financial System --- Household Savings --- Informational Asymmetries --- Interest --- Interest Rate --- Interest Rates --- Investment --- Investment and Investment Climate --- Macroeconomics and Economic Growth --- Non Bank Financial Institutions --- Private Sector Development --- Securities --- Securities Markets