Journal of Monetary Economics 32 (1993) 513-542. North-Holland Finance, entrepreneurship, and growth Theory and evidence* Robert G. King University of Virginia, Charlottesville. VA 22901, USA Federal Reserve Bank of Richmond, Richmond, VA 23261, USA Ross Levine The World Bank, Washingron, DC 20433, USA Received March 1993, final revision received September 1993 How do financial systems affect economic growth? We construct an endogenous growth model in which financial systems evaluate prospective entrepreneurs, mobilize savings to finance the most promising productivity-enhancing activities, diversify the risks associated with these innovative activities, and reveal the expected profits from engaging in innovation rather than the production of existing goods using existing methods. Better financial systems improve the probability of successful innovation and thereby accelerate economic growth. Similarly, financial sector distortions reduce the rate of economic growth by reducing the rate of innovation. A broad battery of evidence suggests that financial systems are important for productivity growth and economic development. Key words: Financial markets; Economic development JEL classification: 01; 03 1. Introduction A prominent feature of the recent literature on economic growth is a renewed interest in the links between financial systems and the pace of economic develop- ment. On the theoretical side, a new battery of models articulates mechanisms Correspondence to: Robert G. King, Department of Economics, University of Virginia, Rouss Hall 116, Charlottesville, VA 22901, USA. *This research was supported by the World Bank project ‘How Do National Policies Affect Long Run Growth?. We thank Marianne Baxter, Joydeep Bhattacharya, Gerard Caprio, Bill Easterly, Alan Gelb, Ronald McKinnon, Paul Romer, Steve Saeger and Mark Watson for helpful comments. Sara Zervos provided excellent research assistance. 0304-3932/93/SO6.00 0 1993-Elsevier Science Publishers B.V. All rights reserved