Banks as Catalysts for Industrialization

Much of the recent growth and development literature is based on the notion that economies may exhibit multiple equilibria, due to coordination failures. Surprisingly, little attention has been given to analyze which economic institutions may solve such failures. We examine the role of banks as 'catalysts for industrialization. When there are limits to contracting, and complementarities exist among investments of different firms, we derive coordination costs endogenously and show that banks can acts as catalysts provided that: (i) they are sufficiently large to mobilize a critical mass of firms, and (ii) they possess sufficient market power to make profits from coordination. We also show that the costs of coordination depend critically on the contracting instruments available to banks. In particular, allowing banks to hold equity reduces and sometimes eliminates the cost of coordination. We use our results to interpret the patterns of early industrialization of Belgium, Germany, and Italy in the late 19th century. These countries experienced quick industrialization with the active involvement of large and powerful universal banks, which engaged in both debt and equity finance.