This article examines the liquidity-investment relation of Chinese SMEs in comparison to large firms, and specifically focuses on the exogenous IPO event to observe how the responses of firm investment to cash flow change subsequent to the IPO. We find that the sensitivity of fixed investment to cash flow varies with firm size, and the over-reliance on internal funds by SMEs has reduced more prominently after the IPO than their larger counterparts, providing new evidence that liquidity constraints of investment are not constant in the same firm but shift along the life cycle. Our results strongly suggest that other financial resources to cover the cash flow shortfalls resulting from timing differences between the operating and investment cycles need to be considered in the examined relation and previous studies may have underestimated the impact of liquidity constraints on firm investment.

This article uses a contingent-claims valuation method to compare debt financing, investment, and risk choices of a firm adopting the second-best strategy with those of a firm adopting the first-best strategy. The former bears the agency costs, as conjectured by Jensen and Meckling (1976) and Myers (1977), because it chooses suboptimal investment timing and risk levels, while the latter is able to avoid them. For plausible parameter values, we find that the second-best firm that takes on more debt will under-invest and bear excessive risk. We also find that the agency costs of debt are 15.8% of the first-best firm value, which is higher than that found by Leland (1998) and Mauer and Sarkar (2005).

In this paper we set out to show that China has certain significant specificities in terms of the gradual (i.e. "step by step") approach it has followed in implementing reforms affecting its financial system. This is in contrast with the traditional shock or "big bang" therapy adopted by other emerging or transition countries, on the basis of what is known as the Washington Consensus, which notoriously prescribes the immediate, wholesale introduction of market-oriented systems through large-scale liberalisations and privatizations. Nevertheless, as we will endeavour to demonstrate the process of reform of China's financial system has not prevented problems of financial fragility from arising in the banking sector, and of corporate governance for firms, such as to threaten the very sustainability of growth in the future.

We argue that the existing literature, which justifies banking regulation by either market failures or regulation capture, cannot explain why banking is one of the most regulated industries and why banking regulation is a relatively recent institution in market economies. We present a new theory of banking regulation based on government failure. We first explain that banking as a market institution is intrinsically stable and effective, since its unique financial structure, i.e. most funds come from deposits, makes it very difficult for a bank to be refinanced when its investment projects are unsuccessful, thereby hardening their budget constraint and disciplining the bank’s investment decisions. However, the advent of modern governments, who have both the resources and incentive to bail out failing banks, destroys the stabilizing mechanism of banking. We call this government failure. Banking regulation is an institutional resolution to the government failure by restricting banks’ investment decisions before they fail. We provide historical as well as contemporary evidence to support the theory and explore predictions of the theory that are not derived in the existing theories.

Soft budget constraint refers to the situation where an economic entity expects to obtain economic assistance when in financial difficulties. During the past decade, a sizable literature has accumulated explaining the causes and consequences of the soft budget constraint. Many of the theories have traced soft budget constraint on enterprises to that on banks. However, why do banks often face soft budget constraint? How to mitigate the resulting problems? In this paper, we first show that owing to their special financial structure, banks as market institutions intrinsically face hard budget constraint and nevertheless remain stable and effective. Since banks’ finance mostly comes from deposits, it is very difficult for banks to be refinanced when their investment projects are unsuccessful due to the sequential service arrangement for bank deposits. This limitation hardens the budget constraint on banks and disciplines bankers’ investment decisions. However, the advent of instantaneous-social-welfareminded modern governments, which have both the resources and the incentives to bail out failing banks, gives rise to the soft budget constraint of banks. This causes bankers’ moral hazard problems. As an institutional solution to the resulting banking instabilities, banking regulation emerged in order to restrict banks’ investment decisions. We provide historical evidence on the genesis and symptoms of, and institutional solution to the soft budget constraint of banks over the past six hundred years to support our theory. We also conduct contemporary econometric analysis to show how the lack of government commitment to a hard budget constraint gives rise to a strict banking regulation. We further explore the predictions of our theory in the paper.