Banks Are Best
Firms with formal financing do best, study finds
China is one of the largest and fastest-growing economies in the world,
despite the fact that its financial systems and institutions are underdeveloped,
under strict central control and notoriously inefficient. It has also proven to
be an excellent laboratory for researchers to explore basic principles of
finance, identifying what works and what doesn’t.
A new study by Vojislav Maksimovic, Dean’s Chair Professor of Finance, has
found that even a dysfunctional formal banking system is better than none. It
upends conventional wisdom (and past financial research) that small, unsecured
loans from family and friends or from local moneylenders or strongmen have
fueled China’s remarkable growth.
“The idea is that you have more incentive to repay because you have a
relationship, or because bad things will happen to you if you don’t repay the
loan,” says Maksimovic. “Some people have suggested that this is the key to the
‘Chinese miracle.’ What we found was quite the opposite.”
Maksimovic studied 2,400 private-sector firms in China using data from the
2003 Investment Climate Survey that was led by the World Bank. About 20 percent
of those firms were financed through formal channels, a number comparable to
other developing countries.
Maksimovic and his co-authors found that while there was wide use of informal
financing, bank financing was really the predictor of firm success. Small firms
with bank funding grew faster than those financed from alternative channels.
Firms that received bank loans had higher sales growth, were more productive,
and had a higher rate of profit reinvestment.
This connection between bank financing and the success of small firms is
important, especially for policymakers in nations with developing economies. “It
is important because how you develop policy depends on what you believe,” says
Maksimovic. “If you believe that formal and informal financing do equally well,
then perhaps you do not put as much emphasis on strengthening the banking
sector, putting in regulations and controls; instead you would let an organic
system grow up to finance small firms through informal means. But countries
really need to have a formal banking system in place, for small firms to go to.
The better firms will try to do that. ”
Funding from informal sources also can’t be scaled up beyond a certain point,
because their monitoring and enforcement mechanisms aren’t equipped to handle
larger firms. For long-term success, firms must “graduate” to more formal
financing, says Maksimovic.
It is often difficult to get published data about private firms in nations
with developing economies. By working with the World Bank, Maksimovic had access
to data far in advance of when public records would become available.
“Most of the research done by finance professors used to be very
U.S.-centric,” says Maksimovic, “because that’s where the data is. But we’re
finding that more of our students now come from developing countries, and more
students are working with companies outside the U.S. So it is important that
they understand the differences between how things work in the U.S. and how they
“Formal versus Informal Finance: Evidence from China” was co-authored by
Vojislav Maksimovic; Meghana Ayyagari, PhD ’04, George Washington University;
and Asli Demirguc-Kunt, of the World Bank; and published in The Review of
Financial Studies. This research was partially funded by a grant from the
National Science Foundation. For more information, contact