Forty years of regional development policies have induced massive capital inflows and real income transfers into Italy's Mezzogiorno but have not closed its income gap with the North. In Discussion Paper No. 674, Research Fellow Riccardo Faini, Giampaolo Galli and Curzio Giannini examine the contribution of inefficient financial intermediation to this lack of convergence. Southern financial institutions have higher operating costs, default rates and interest rates, but differences between borrowing firms in the two regions account for only half the average interest rate differential. Southern banks charge Southern firms higher interest rates than Northern banks (even controlling for risk), which reflect their higher operating costs and suggest that they are sheltered from external competition.

Faini, Galli and Giannini attribute Southern firms' failure to take advantage of Northern banks' lower interest rates to informational problems. Southern banks can gather the information needed to identify individual borrowers' risk levels, while external banks must resort to rationing. To support this view, they note first that Southern banks charge even higher interest rates to `local' firms those in their own province but there is no such effect in the North. Second, for a sub- sample of firms in Sicily that borrow from local and external banks, local banks charge more but provide most of their finance. Third, Southern firms make greater use of existing credit lines with Northern banks, which suggests that the latter resort to rationing.

Faini, Galli and Giannini then use the estimates from their interest rate equations to show that Southern firms are no more difficult to screen then others, but Southern banks screen less efficiently. Risk exerts a larger effect on Southern firms' borrowing, which may be because the regulatory framework discourages borrowing on longer-maturity and riskier projects. High-risk firms in the South often face liquidity constraints in investment decisions, with a lack of external finance preventing them from undertaking profitable projects.

Faini, Galli and Giannini conclude that increased competition is the key to enhancing both operative and allocative efficiency, so the property of local banks should be made contestable to reduce external banks' informational disadvantage. The Southern financial sector's cost efficiency and screening abilities may be improved by encouraging bank mergers and reducing the separation between commercial banks and special credit institutions. The current upper limits on interest rates for long-term loans, which discourage the financing of riskier projects, should also be abolished.

Finance and Development: The Case of Southern Italy
Riccardo Faini, Giampaolo Galli and Curzio Giannini