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This paper considers the interactions between the financial sector reform and entrepreneur- ial development.Using simple models of occupational choice and a two-armed bandit model of learning, it analyzes the effects of financial liberalization policies in the form of free entry into banking and free market determination of interest rates on the developmen to f industrial entre- preneurship. The analysis focuses on the two issues: (i) the poaching externality effects in a competitive banking, and (ii) the effects of short-termism in competitive banking for accumula- tion of information capital regarding the entrepreneuriial talents in aneconomy. The analysis of the poaching externality shows that a competitive banking may fail to finance socially efficient experimentation with potential industrial entrepreneurs, as the economy might get stuck in a binding liquidity constraint trap, especially when an economy starts with unfavorable initial con- ditions, like low prior probability of a good industrial entrepreneur or a low productivity industrial sector. Policies of entry restriction as advocated in the Financial Restraint paradigm can relax the liquidity constraint, and thus can increase the supply of credit to the new industrial entre- preneurs under mild conditions. The analysis of short-termism takes, as its point of departure, the widely accepted proposition that competition destroys the franchise value of banks and thus reduces the incentives for the bank to act as a long-term agent. This has important implications for entrepreneurial discovery; a myopic bank ignores the value of information generated by any given industrial experiment for all future loan decisions. Using a two armed bandit model, we demonstrate that, under plausible conditions this undervaluation of information reduces supply of credit to the new entrepreneurs. Our analysis show that a two-track policy where entry restraint is implemented in the industrial sector lending but competition is preserved in the lending to the competing economic activity (like agriculture) can be useful to tackle the problems of poaching externality and undervaluation of information capital by banks.

Financial Liberalization, Financial Restraint, and Entrepreneurial Development