Innovation, bank monitoring, and endogenous financial development

We analyze the interaction between growth and financial development in a model of product innovation. Innovation is risky and can be monitored only imperfectly and at a cost. Financial intermediaries emerge endogenously to avoid the duplication of monitoring activities and negotiate contracts with innovators which induce optimal effort through a combination of incentives and monitoring. A positive correlation emerges between growth and financial development. The optimal degree of monitoring depends on factor prices and increases with capital accumulation. Improved monitoring, in turn, allows 'banks' to offer better insurance terms to entrepreneurs and yields a higher level of innovative activity.