Social Trust as a Monitoring Role : The Effect of Cultural Fractionalization on the Efficiency of Financial Intermediation

Combining rich and novel datasets from China, we investigate how city-level cultural fractionalization affects social trust and the efficiency of financial intermediation. Using an instrumental variable approach, we find that cultural fractionalization significantly lowers the efficiency of financial intermediation. Further individual-level and firm-level evidence supports the social capital channel, showing that the level of social trust is lower in cities with larger cultural fractionalization. Our theoretical and empirical analyses both suggest that social trust rooted in local cultures plays a monitoring role in the financing process, which helps reduce the efficiency loss arising from moral hazard and information asymmetry