Finance and Development: The Case of Southern Italy

We look at the role of the financial sector in the context of the relatively backward regions of Southern Italy (the so-called Mezzogiorno). Commercial banks in the South typically have higher operating costs and charge higher interest rates than Northern banks. Econometric analysis on a large set of individual loan contracts suggests that borrowers in the South are considerably riskier than those elsewhere in Italy. It also indicates, however, that risk accounts for only half of the 200 basis points average North-South interest differential. The rest is largely accounted for by differences in operating costs. We argue that these findings reflect a situation in which Southern banks have a monopoly of information concerning local firms, with outside banks forced to resort to rationing practices to avoid attracting the worse borrowers. To support this interpretation, we analyse loan contracts of Southern firms who borrow at the same time from local and external banks. We also show that geographical proximity tends to raise interest rates in the South. We then turn to the issue of allocative efficiency and argue that Southern banks tend to perform their screening function less efficiently than banks in the rest of Italy. We finally show that in the South, risk exerts a significantly larger effect on borrowing and that Southern firms whose earnings are more variable are more likely to be liquidity constrained in their investment decision.