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. We show that these roles of banks can generate different consequences for firms’ investment and growth. Positive shocks to banks’ monitoring efficiency boost incumbents’ investment and growth in both the short and long run. Improvements in banks’ efficiency at facilitating firm entry can instead exacerbate managers’ incentives to divert resources outside 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.
 

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