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Finance Seminar

Authors:

• Kose John
  New Yok University

• Simi Kedia
  Rutgers University

Two different financial systems with some opposing features have evolved in the advanced economies, namely the insider system and the outsider system. In this paper, we provide a theoretical framework where the features of the optimal governance system are derived as a function of economy-wide parameters, such as the degree of development of markets and the quality of the institutions, and firm-specific parameters, such as the productivity of its technology. Our results include the following: (1) For a degree of relative development of markets below a threshold, internal governance systems dominate for all firms in the economy independent of productivity, (2) When the development of markets in an economy is above that threshold, either system may emerge as optimal depending on the productivity of the technology. There are marked differences in the residual agency costs under the two systems when the scale of investment is large. It is shown that insider systems constitute the optimal governance system for technologies that are optimally implemented at a small scale while outsider systems dominate for technologies that are optimally implemented at large scales. These results provide a new argument for the potential convergence towards outsider systems based on technological growth.