Idiosyncratic Uncertainty, Asymmetric Information, and Private Credit

We propose firm-specific (idiosyncratic) uncertainty as a key cross-country determinant of the total credit allocated to the private sector. We show that in the presence of informational asymmetry in the credit market, theory suggests that higher uncertainty lowers the ratio of private credit to output by reducing the former proportionally more than the latter. Output falls because the higher uncertainty enlarges economic distortions and reduces aggregate capital accumulation. Credit falls proportionally more because the higher uncertainty allows firms to earn larger rents and increases their internal funds, while it reduces the overall financing required in the lower output environment. Thus, a country with higher idiosyncratic uncertainty is characterized by a lower credit-to-output ratio. We show that this theoretical prediction is supported by regression analysis.