We investigate the interaction between the banking sector and corporate governance in an economy where banks act both as monitors of managerial frictions and as facilitators of new firm creation. We find that, when banks engage in relational lending with borrowing firms, these two activities can generate different consequences for incumbent firms’ investment and growth. The calibrated general equilibrium model reveals that positive shocks to banks’ monitoring efficiency boost incumbents’ investments and growth in both the short and the long run. Increases in banks’ efficiency at entry can instead depress investment and growth by exacerbating managers’ incentives to divert resources for out-of-firm projects. Quantitative experiments indicate that banking development that increases the overall banking efficiency can induce a hump-shaped response of output growth and welfare. We test the mechanisms of the model using data from the Italian corporate and banking sector.
 

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