Heterogeneous firms and efficient intermediation in Taiwan

Dependent on many small and medium firms for industrial competitiveness in world markets, formal financial institutions faced prohibitive information costs in providing credit. When information costs are significant, credit markets do not work in a smooth Walrasian fashion and banks will tend to ration credit even when they are allowed to raise interest rates. Advice to liberalize Taiwan"s very "rigid" formal financial markets ("get prices right") in the presence of its heterogeneous firm structure would, therefore, not have been practical. Taiwan solved its credit intermediation problem by allowing (and assisting) the development of an active curb market. A dual financial system was thus created which segmented borrowers into "full-information" borrowers, who dealt with the formal financial institutions and "information-intensive" borrowers, who got credit from curb lenders. This paper analyzes the many beneficial effects of this market segmentation, and why financial liberalization, particularly in the early development years, could have created substantial costs of adjustment. (Author abstract)