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Implication of Market Imperfections for Economic Development Finance Essay

As the period section shows, the operation of capital markets does not match the assumptions underlying perfect competition but instead is characterized by market imperfections that can create capital availability gaps. Despite the united states well developed capital markets, a firm’s location, industry, amount and form of capital needed and the number and type of financial institutions serving its area can all affect its access to capital.

Nonetheless, some common capital markets imperfection first, equity capital in amount below several million dollars is not available from public markets and institutional sources. Moreover, for small and early stage firms, equity capital is largely limited to firms in “hot” industries with perceived high growth potential. Second, debt capital for small firms and in amounts below several million dollars in largely available from private financial institutions.

Thus, debt availability is dependent on competition and lending polices within the local banking and commercial finance market. Small business and real estates loan below $50,000 are not available from private financial institutions in most markets and in some cases the threshold may be higher furthermore, regulatory policies, cyclical economic conditions and limited competition all affect the cost and availability of debt.

Several implications for economic development finance practice emerge from this analysis. First, local economic and financial market conditions shape capital supply gaps. Therefore, to design effective intervention strategies, practitioners need to understand local capital market conditions, the private financial institutions active in their region and how their business strategies and lending policies affect capital supply.

The formal aspects of capital market analysis and its application to program design, since capital markets are dynamic, with conditions changing capital availability and economic development from year to year, practitioners also gain critical knowledge through their ongoing engagement in financing transactions and dialogue with private financial institutions, firms and industry associations, second, development finance professionals are in the business of expanding the supply of small amounts of capital and higher risk capital. These are the most ubiquitous capital supply gaps to address.

Finally, the private capital market are the potential imperfection competition (supply side) information access transaction costs rational profit maximizing behavior regulatory factors conclusion public equity market extensive publicly available information provided by firms. Firms followed by analyst, high costs to firm for legal, disclosure, printing and underwriter’s fees cyclical factors and fads affect investor demand, may be discrimination for or against certain industries impose high transaction costs not viable for raising small amount of equity below several million dollars public debt market extensive.

Extensive publicly available information provided by firm credit ratings available high costs to firm for legal, disclose printing and underwriter’s fees cyclical factors and fads affect investor demand, may be discrimination for or against certain industries impose high transaction costs not viable for raising small amounts of debt below several million dollars private equity market limited, depends on location, investment and sector must be collected and analyzed by investor may not be feasible for small transactions low to moderate cost.

Primarily for legal work cyclical factors and fads affects investor demand, may be discrimination for or against certain industries non regulated hard to raise small amounts of equity. Available largely for firms with very high growth potential and capacity for IPO or acquisition private debt market moderate, depends on location, investment and sector must be collected and analyzed by lender, may not be feasible for small transactions low to moderate costs primarily for legal work regulations affect types of loans.

Discrimination for or against certain industries, type of firms, location etc, may occur limits types and level of risk, banks are required to meet community credit needs most important capital source for small firms and development projects, limited supply of long term debt, small loans and riskier financing. Most important financing source for small business and small scale or unconventional development projects, both of which will have little access to the public markets.

Developing relationships with and designing programs that work in tandem with key private capital market institutions, especially commercial banks and venture capital firms, is central to the work of economic development finance.

Expanding capital availability for economic development entails two types of market interventions. 1)Perfecting the operation of existing capital markets and 2)Creating alternative development finance institutions. The first form of intervention changes the operation of private capital market institution either by eliminating the sources of market imperfections that create capital gaps or changing the behaviors, perceptions and risk preferences of private finance and institutions. Practitioners produce the greatest impact by changing the performance of existing capital markets since they are the primary means for financing economic activity and allocate hundreds of billions of dollars of capital.

This critical area of economic development finance practice involves three interventions. Risk sharing tools and policies that encourage private sector institutions to bear greater risks and extend higher risk debt financing. Loan guarantees are the most common example of risk sharing. Other approaches include portfolio based loan insurance and financial incentives. Chapter 8 focus on these interventions. Bank regulatory polices can reduce barriers to economic.

Development investments by financial intermediaries and create incentives and standards to expand services, lending and investment for economic development purposes banks also provide an institutional platform that development finance practitioners can use to address disinvestment and capital market failure. The use of banking regulations and banking institutions to expand capital availability is the focus of absorbing information and other transaction costs for private lenders and investors by collecting and generating information, preparing financing applications, analyzing potential investment or servicing loans.

This is a cross cutting approach that is discussed under program models. Despite the importance of expanding capital availability through private sector financial markets, there are limits to the first intervention strategy. When the institutional structure of capital markets does not support the channeling of sufficient capital to regional economic development needs or when capital availability and economic development.

Private financial intermediaries are too risk averse, it become necessary to establish alternative financial institution to ensure capital availability. New public sector, non profit and community based financial institution can re-direct the region’s own savings and attract external funds to expand the supply of capital to business enterprises and development projects, five alternative development finance institutions are covered in this book, revolving loans funds, a common and easily adaptable finance program.

Economic development finance involves using both strategies, often in complementary and synergistic ways. For example, or region might create loan guarantee programs to expand bank financing for higher risk small business debt of $100,000 or more while also creating a new revolving loan fund or micro enterprise fund to supply debt in smaller amounts.

Similarly state regulations might be altered to allow increased bank, insurance company and pension fund investment in venture capital while new quasi public intermediaries are created to manage this new source of private equity capital. These are only two examples of many ways in which both intervention strategies can be combined. Each community will create its own examples based on local economic development goals and opportunities and in accordance with its capital market environment. As an entry point into economic development finance.

However this presents an incomplete picture of financial markets, ignoring the demand side of the market place, economic development finance practice also requires an understanding of the financing needs of small businesses and development projects and what forms of capital should be supplied to address these needs. Additionally, practitioners needs skills to manage individuals financing transactions such as evaluating whether business or development project can productively use capital and defining the appropriate type and terms of financing to offer.

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