Investment in Relationship-Specific Assets : Does Finance Matter?

An influential strand of literature starting with the Nobel Prize winning work of Oliver Williamson (1971, 1975) argues that a rational agent underinvests in relationship-specific assets due to the possibility of an opportunistic behaviour on the part of her contractual partner. We first combine the insights from this literature with the theoretical work on financial intermediaries and argue that a strong banking sector can alleviate this well-known holdup problem and stimulate relationship-specific investment. Then we empirically confirm this prediction by showing that industries dependent on relationship-specific investment from their suppliers grow disproportionately faster in countries with a high level of financial development and in US states which deregulated their banking sector. Our work establishes a novel channel through which finance affects the real economy. It also complements the literature that has stressed legally binding contracts as a standard solution to the holdup problem