TAILIEUCHUNG - A Theory of Banks, Bonds, and the Distribution of Firm Size∗

Banking sector reforms have been sequenced to correspond with changing regulations of the foreign exchange market. The government has allowed the exchange rate to gradually float (as opposed to a “crawling” peg), and full current account convertibility has been introduced, with de facto capital account convertibility for nonresidents, and calibrated liberalization for residents. Other recent measures include foreign participation in the Indian foreign exchange market, unlimited hedging of genuine foreign exchange risk, and the introduction of new instruments such as interest rate and currency swaps, options, and forward contracts. Capital Market Reforms Significant effort has similarly. | FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES A Theory of Banks Bonds and the Distribution of Firm Size Katheryn N. Russ University of California Davis Diego Valderrama Federal Reserve Bank of San Francisco October 2009 Working Paper 2009-25 http publications economics papers 2009 The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. A Theory of Banks Bonds and the Distribution of Firm Size Katheryn N. Russ t Diego Valderrama Í University of California Davis Federal Reserve Bank of San Francisco August 2009 This version 10 15 2009 Abstract We draw on stylized facts from the finance literature to build a model where altering the relative costs of bank and bond financing changes the entire distribution of firm size with implications for the aggregate capital stock output and welfare. Reducing transactions costs in the bond market increases the output and profits of mid-sized firms at the expense of both the largest and smallest firms. In contrast reducing the frictions involved in bank lending promotes the expansion of the smallest firms while all other firms shrink even as it increases the profitability of both small and mid-size firms. Although both policies increase aggregate output and welfare they have opposite effects on the extensive margin of production promoting bond issuance causes exit while cheaper bank credit induces entry. When reducing transactions costs in one market the resulting increase in output and welfare are largest when transactions costs in the other market are very high. 1 Introduction While it is widely accepted that bank and bond market development affect small firms differently it is not clear how altering the relative costs between different financial instruments affects the allocation of capital and output across firms in .

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