A new theory of innovation and growth: the role of banking intermediation and corruption

Purpose There has been an increased interest in the role of the financial sector and institutional quality in the development process. Design/methodology/approach This paper addresses the relationship between corruption and financial sector development by constructing a Schumpeterian endogenous growth model, allowing for the entry of competitive firms with an explicit role for politics and banking. Findings Assuming that technologically advanced firms are located in developed countries and backward firms in developing countries, the model in this study suggests that low corruption are more growth enhancing in the former group of countries. Better institutions stimulate entry by reducing banking screening costs and entry is more growth enhancing in sectors closer to the technological frontier. Research limitations/implications The model in this study is a partial equilibrium analysis and one should include a role for labour markets to address the household’s problem and enrich the model’s conclusions. Secondly, the model specification rests on the fact that the degree of corruption is correlated with the level of institutions. Even though this might be subject to some criticism, this is a common practice across the literature and so, it is clearly a matter of taste. Practical implications The main policy conclusion is that anti-corruption policy initiatives should prioritize corruption that distorts incentives with respect to productive investment that directly and negatively affects growth. Originality/value This paper addresses the relationship between corruption and financial sector development by constructing a Schumpeterian endogenous growth model, allowing for the entry of competitive firms with an explicit role for politics and banking.