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Title: Financial Frictions, Investment, and Institutions

Author(s): Stijn Claessens, Kenichi Ueda and Yishay Yafeh

Publication Date: December 2010

Keyword(s): corporate governance, creditor rights, Financial friction, institutions and investment

Programme Area(s): Financial Economics

Abstract: Financial frictions have been identified as key factors affecting both short-term economic fluctuations and long-term growth. An important policy question therefore is whether institutional reforms can reduce financial frictions and, if so, which reforms are best? We address this question by empirically investigating the effects of institutions on financial frictions using a canonical investment model. We consider two channels by which frictions affect investment: (i) through financial transaction costs at the individual firm (micro) level; and (ii) through the required rate of return at the country (macro) level. Using a panel of 75,000 firm-years across 48 countries for the period 1990-2007, we examine how, through these frictions, institutions affect investment. We find that improved corporate governance (e.g., less severe informational problems) and enhanced contractual enforcement reduce financial frictions affecting investment, while stronger creditor rights (e.g., lower collateral constraints) are less important.

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Bibliographic Reference

Claessens, S, Ueda, K and Yafeh, Y. 2010. 'Financial Frictions, Investment, and Institutions'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8170