Economic Development and Relationship-Based Financing

Formal finance involves costly information acquisition about distant entrepreneurs, while relationship-based finance allows financiers to fund a narrow circle of close entrepreneurs without engaging in costly information acquisition. We show that in developing economies with low capital endowments, relationship-based finance is optimal because only high-quality entrepreneurs receive funding. However, formal finance may emerge in equilibrium and has the only effect of shifting rents from entrepreneurs to financiers. In more developed economies with higher capital endowments, formal finance becomes necessary to prevent low-quality entrepreneurs from being funded. Nevertheless, relationship-based financing may persist in equilibrium and capital may be allocated to low-quality close entrepreneurs even when there are high-quality distant entrepreneurs.