DP6910 | Does Idiosyncratic Business Risk Matter?

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Financial market imperfections can prevent entrepreneurs from diversifying away the idiosyncratic risk of their business. As a result idiosyncratic risk discourages entrepreneurial activity and hinders growth, with the effects being stronger in economies with lower risk diversification opportunities. In accordance with this prediction we find that OECD countries with low levels of risk diversification opportunities (as measured by the relevance of family firms or of widely held companies) perform relatively worse (in terms of productivity, investment, and business creation) in sectors characterized by high idiosyncratic volatility. Given that volatility is endogenous with respect to risk diversification opportunities, we instrument its value at the country-sector level with the corresponding sectoral volatility in the US, a country where financial imperfections are less relevant than elsewhere. Diversification measures are instrumented using demographic changes induced by World War II. We also provide firm-level evidence suggesting that firms controlled by less diversified owners display lower mean and dispersion of productivity growth.