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In a similar vein, Morck et al. (1998) show that established, well-connected ﬁrms in Canada
(as measured by family inheritance of control) are less eﬃcient and had negative abnormal stock
returns when the 1998 Canada-U.S. free trade agreement reduced barriers to foreign capital.
The next section of the paper outlines a theoretical framework suggesting the way cronyism
in ﬁnance aﬀects incentives and decisions at the levels of the government, bank and ﬁrm. Section
3 describes our methodology and data Section 4 discusses our empirical results. Section 5
provides the robustness tests. Section 6 concludes. 2 The Model In this section we present a simple analytical framework in order to facilitate an understanding
of the nature of cronyism we have in mind. Our approach to the problem is based on the recent
literature on the soft-budget constraint (SBC) problem of transition economies (Dewatripont
and Maskin (1995), Mitchell (1997), and Berglof, Gerard, and Roland (1998)).
We consider a three-tier hierarchy of authority with the government at the apex, the bank
in the middle and the entrepreneur/ﬁrm at the bottom. In such an environment, a soft-budget
constraint at the government-bank level, implying that the government will bail-out the bank 3 in the event of ﬁnancial distress caused by loans to poor quality projects, can ﬁlter down to the
next level causing ﬁrms to shirk in terms of eﬀort. This in turn can increase the likelihood of
the poor outcome in the ﬁrst place. We ﬁrst describe the basic framework and then introduce
cronyism and corporate governance changes.
First consider the bank-ﬁrm interaction. The economy consists of a continuum of risk neutral entrepreneurs normalized to unity. Each entrepreneur is the owner of a blueprint for
an investment project that requires a capital outlay for the purchase of productive assets. These
assets can then be combined with entrepreneurial labor to produce a return on the investment.
Projects can be of two types, high quality, in proportion θ or low quality, in proportion 1 − θ.
Good projects always yield a gross return of Rg and private beneﬁts of Bg to the entrepreneur.
The return from bad projects depends on the level of entrepreneurial eﬀort. The entrepreneur
can exert a high level of eﬀort, in which case the returns are the same as the good project. If
the entrepreneur exerts a low level of eﬀort on bad projects then the project return is zero.
Entrepreneurs have no wealth and hence have to rely on external ﬁnance from the bank. Exante, the bank knows the distribution of project types in the population but not the type of
any particular ﬁrm. We thus have a combination of adverse selection and moral hazard. We
assume that project returns can be claimed in their entirety by the bank.
If a bad project fails on account of entrepreneurial shirking, the bank has two options. It can
liquidate the ﬁrm’s assets and obtain a liquidation value of L, with the entrepreneur re...
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This document was uploaded on 02/28/2014 for the course ECONOMICS fn314 at Harvard.
- Fall '13