Risk sharing and firm size : Theory and international

This paper investigates the relation between financial development and firm size. The model shows that the quality of laws, by affecting the level of monitoring costs, has an effect on risk sharing and, through this channel, on the investor basis and the availability of external finance to firms. If, because of high monitoring costs, the provision of finance to projects is concentrated in very few individuals, the risk premium rises steeply with the amount of funds firms demand. As a consequence, in countries where the financial system does not favor risk sharing, the larger the optimal size of a firm would be, the higher is the cost of external finance; this limits firm size. Empirical evidence is also provided. The cost of debt is higher for firms demanding larger loans, even after controlling for leverage and other firm characteristics. Moreover, in countries where the financial system is less developed, financial constraints, indeed, appear more stringent for firms whose optimal size is larger.