Abstract:

We investigate the interaction between banking development and corporate governance in a dynamic economy where banks facilitate firm entry and monitor managerial moral hazard over the course of credit relationships. Positive shocks to banks’ monitoring efficiency boost incumbents’ investment and growth. Improvements in banks’ efficiency at facilitating firm entry can instead exacerbate managers’ incentives to divert resources outside incumbent firms, depressing investment and growth. The quantitative analysis reveals that, when corporate governance is imperfect, banking development can induce a hump-shaped response of output growth and welfare. The predictions are consistent with evidence from the Italian corporate and banking sectors.