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Financial Development and Industrial Capital Accumulation

In a decentralized-decisions economy under uncertainty, the financial system can be seen as the complex of institutions, infrastructure, and instruments that the society adopts to minimize the costs of transacting promises under agents’ incomplete trust and limited information. Building on a microeconomic, general equilibrium model that portrays such fundamental function of finance, this study analytically shows that, in line with recent empirical evidence, the development of financial infrastructure stimulates larger and more efficient capital industrial accumulation. The study also shows that economies with more developed financial infrastructure can better absorb exogenous. | Financial Development and Industrial Capital Accumulation by Biagio Bossone World Bank Summary In a decentralized-decisions economy under uncertainty the financial system can be seen as the complex of institutions infrastructure and instruments that the society adopts to minimize the costs of transacting promises under agents incomplete trust and limited information. Building on a microeconomic general equilibrium model that portrays such fundamental function of finance this study analytically shows that in line with recent empirical evidence the development of financial infrastructure stimulates larger and more efficient capital industrial accumulation. The study also shows that economies with more developed financial infrastructure can better absorb exogenous shocks to output. The results call for addressing a crucial question concerning financial sector reform sequencing early in development banks provide essential financial infrastructural services as part of their exclusive relationships with borrowers while further economic development requires such services to be provided extrinsically to the bank-borrower relationships clearly at the expense of bank rents. Financial sector development is thus characterized by a discontinuity in that banks are to be supported early on in development while they need to be weakened later on precisely to foster development. This raises the question of when and how optimally to generate and manage the discontinuity before it is forced upon the society by traumatic and costly events such as bank crises. I wish to thank R. Rajan and L. Zingales for their seminal ideas on the relationship between financial and industrial development that have largely inspired this work. Of course I remain the only responsible for the opinions expressed in the text which do not necessarily coincide with those of the World Bank. As usual my deepest gratitude goes to my wife Ornella for her unremitting support. 1. Objective of the study The large body