Limited access to finance is a serious barrier to entry and growth for less established, new or smaller firms. Adequate funding enables entrepreneurs to overcome generic barriers or constraints to expansions. A broad range of evidence has shown that financial underdevelopment and limited bank competition hinder new firm creation and economic growth (Rajan and Zingales 1998; Levine 1999; Beck, Levine, and Loyaza 2000; Black and Strahan 2002; Cetorelli and Strahan 2006; Aghion, Fally and Scarpetta 2006). As poor investor protection limits access to finance (La Porta et al, 1997, 1998), it also has the effect of reducing competition. Thus any factor which fosters financial development, such as common law (La Porta et al, 1997, 1998), or voters preferences (Pagano and Volpin, 2005; Perotti and von Thadden, 2006) may indirectly favor competition.
Rajan and Zingales (2003a, 2004) have extended Stigler’s theory of regulatory capture to finance, and argued that limited financial development may be the result of political influence of established producers seeking to reduce competition. This paper shows how the ability of incumbents to affect investor protection and thus competition depends on the degree of political accountability. In our model, wealthier entrepreneurs need less external finance and thus lobby for weak investor protection, to limit access to funding to competitors. Reduced competition lowers welfare and makes politicians less popular, so the lobby needs to offer compensating political contributions (“bribes”).
The equilibrium level of investor protection (and competition) is the solution of the trade off between the bribes and the increase in market power. Our main predictions are positive relations between effective investor protection and competition, and between investor protection and political accountability.
Next, we provide supporting evidence from a broad cross-country sample of industries. First, better investor protection, and other measures of financial development and financial access, does indeed favor competition and entry in more financially dependent sectors. Interestingly, the financial channel appears dominant relative to generic measures of contestability, such as entry costs, openness and economic development.
Second, we show that after controlling for legal origin effective investor protection is better in more politically accountable countries. A distinct contribution here is that we identify a measure of political accountability which appears both exogenous and robust to the most challenging controls. In general, formal measures of democracy as well as indices of political accountability are positively correlated with investor protection even after controlling for legal origin. However, these proxies rely on subjective evaluations and are clearly endogenous to outcomes (Glaeser et al 2004). Once we pursue the strong test of controlling for GDP per capita as a general measure of institutional quality, we find that formal and subjective measures of democratic accountability are no longer statistically significant.
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