DP8170 Financial Frictions, Investment, and Institutions

Author(s): Stijn Claessens, Kenichi Ueda, Yishay Yafeh
Publication Date: December 2010
Keyword(s): corporate governance, creditor rights, Financial friction, institutions, investment
JEL(s): G30, O16, O43
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8170

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.