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Economic Development and Relationship-Based Financing

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  • Mariassunta Giannetti
  • Xiaoyun Yu

Abstract

Formal finance involves the costly acquisition of information about distant entrepreneurs, while relationship-based finance allows financiers to fund a narrow circle of close entrepreneurs without acquiring costly information. In developing economies with low capital endowments, relationship-based finance is optimal because only high-quality entrepreneurs receive funding. However, formal finance may emerge in equilibrium, and it has the only effect of shifting rents from entrepreneurs to financiers. In more-developed economies with higher capital endowments, formal finance becomes necessary to prevent funding of low-quality entrepreneurs. Nevertheless, relationship-based financing may persist in equilibrium, and low-quality close entrepreneurs are funded even when there are high-quality distant entrepreneurs.

Suggested Citation

  • Mariassunta Giannetti & Xiaoyun Yu, 2015. "Economic Development and Relationship-Based Financing," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 4(1), pages 69-107.
    • Handle: RePEc:oup:rcorpf:v:4:y:2015:i:1:p:69-107.
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    File URL: http://hdl.handle.net/10.1093/rcfs/cfu010
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