Relationship Finance, Market Finance and Endogenous Business Cycles

Luca Deidda and B. Fattouh

Working Paper CRENoS from Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia

Abstract: This paper develops an overlapping generation model with asymmetric information in the credit market such that the interplay between relationship finance supplied by investors who monitor investment decisions ex-ante and market finance supplied by investors who relay on public information can be the source of endogenous business fluctuations. Monitoring helps reducing the inefficiency caused by moral hazard. However, the incentives of entrepreneurs to demand relationship finance to induce monitoring –which is also non-contractible – are weaker the lower is the return to investment. If the return to investment is low enough, entrepreneurs demand too little relationship finance. This leads to an inefficiently low level of monitoring and of entrepreneurial effort. Under decreasing marginal returns to capital, the model generates a reversion mechanism that can induce macroeconomic instability. The economy can experience endogenous business cycles characterized by a pro-cyclical behavior of the relative importance of relationship finance. This is consistent with the pro-cyclical behavior of the indicator of relative importance of relationship finance, which we construct based on quarterly and annual data from the US Flow of Funds Accounts for the non-financial corporate business sector.

Keywords: endogenous business cycles; relationship finance; market finance; monitoring; moral hazard (search for similar items in EconPapers)
JEL-codes: D82 E32 E44 (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-bec, nep-cta, nep-dge and nep-mac
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:cns:cnscwp:201008

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