Although research shows that financial development accelerates aggregate economic growth (Levine, 2006), economists have devoted few resources to resolving conflicting theoretical predictions about the distributional effects of financial development. Some theories imply that financial development disproportionately helps small firms. If smaller firms find it more difficult to access financial services due to greater information and transaction costs, then financial development that ameliorates these frictions will exert an especially positive impact on smaller firms (Galor and Zeira, 1993; Aghion and Bolton, 1997)). In contrast, if fixed costs prevent small firms from accessing financial services, then financial development will disproportionately help larger firms (Greenwood and Jovanovic, 1990; Haber et al., 2003).
Besides assessing theoretical disputes, political economy and public policy considerations motivate our study of the cross-firm distributional effects of financial development. If financial development affects small firms differently from large ones, then firms might disagree about the desirability of financial reforms. Even if financial development helps all firms, one set of firms might oppose financial reforms that diminish the group’s comparative power, which is consistent with influential work on the political economy of financial policies such as Kroszner and Stratmann (1998), Kroszner and Strahan (1999), Rajan and Zingales (2003), Pagano and Volpin (2005), and Perotti and von Thadden (2006). Rather than analyzing political lobbying by firms of different sizes, we examine whether financial development has cross-firm distributional effects. In addition, the World Bank pours about $2 billion per year toward subsidizing small firms, which further motivates our examination of the cross-firm distributional effects of financial development.
One of the most active areas of research on liquidity over the past two decades has been an examination of its effect on asset prices. Beginning with the pioneering work of Amihud and Mendelson (1986), much of the earlier research has focused on whether the level of liquidity is an attribute of individual securities that affects their required rate of returns. Consistent with the notion that investors must be compensated for the higher transaction costs that they bear in less liquid markets, these studies have generally found a positive illiquidity-return relation across stocks using a variety of liquidity measures. In addition to the level of liquidity, other aspects of liquidity are also found to influence expected returns. Chordia, Subrahmanyam, and Anshman (2001) find that the variability of dollar volume and share turnover has a significant negative effect on stock returns and Chan (2002) documents that stocks with greater persistence in illiquidity have higher average returns.
The recent discovery of commonality in liquidity by Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and Seppi (2001), and Huberman and Halka (2001) has raised a new question about the role of liquidity in asset pricing. Namely, their findings have initiated researchers to seek whether market-wide liquidity is an important factor in explaining the cross-section of stock returns. Pastor and Stambaugh (2003) create a return reversal measure, which captures order-flow induced temporary price fluctuations, and find that expected stock returns are cross sectionally related to liquidity risk. Acharya and Pedersen (2003) use a scaled version of Amihud’s (2002) illiquidity ratio, which is a price impact proxy given by the ratio of absolute return to dollar volume, and find that liquidity risk is indeed a priced factor. Wang (2003) confirms these results using institutional equity flow as a measure of aggregate liquidity. Eckbo and Norli (2002) provide a comprehensive analysis on this issue and find that all factors, except for the return reversal measure, significantly affect the cross section of portfolio returns.
The threat of “natural” and “man-made” disasters continues to grow in many parts of the world do to a confluence of factors, including population growth and economic development, climatic changes and weather cycles, geologic activity, and political unrest. Figures 1 and 2 underscore the growing significance of catastrophe risk in terms of both actual and potential catastrophe losses. 1 The nature and severity of the catastrophe threat varies among countries and regions of the world but its implications raise certain common issues and increasing global integration intensifies the inter-dependencies between countries and the rippling effects of a disaster. At its core, the problem of catastrophe risk poses a number of challenges to mitigating its effects, financing the costs that are incurred, and responding to the needs of those affected.
The regulation of insurance and reinsurance companies, among other government policies, has significant implications for the management and financing of catastrophe risk. At present, the risk and cost of catastrophes are borne by many “stakeholders” in different ways in the interaction of public and private sectors that influence their incentives and economic efficiency. This paper examines the different regulatory systems and government policies of the United States (US) and the European Union (EU) generally and how they address catastrophe risk financing specifically. The link between the fundamental philosophies and elements of these regulatory systems and their treatment of risk financing is important. Current policies and the prospects for reforming any specific policy depend on the government frameworks in which they reside.
