40 Pages Posted: 30 Jan 2006 Last revised: 22 Jul 2009
Date Written: February 19, 2009
We study how financial system architecture evolves through the development of banks and financial markets. The predominant existing view is that banks and markets compete, which often contradicts actual patterns of development. We show that banks and markets exhibit three forms of interaction: they compete, they complement each other, and they co-evolve. Co-evolution is generated by two elements missing in previous analyses of financial system architecture: securitization and bank equity capital. As banks evolve via improvements in credit screening, they securitize higher-quality credits in the capital market. This encourages greater investor participation and spurs capital market evolution. And, if capital market evolution is spurred by exogenous shocks that cause more investors to participate, banks find it cheaper to raise equity capital to satisfy endogenously-arising risk-sensitive capital requirements. Banks thus serve previously-unserved high-risk borrowers, stimulating bank evolution. Numerous additional results are drawn out.
Keywords: Financial System Architecture, Bank Evolution, Capital Market Evolution
JEL Classification: G10, G21
Suggested Citation: Suggested Citation
Song, Fenghua and Thakor, Anjan V., Financial System Architecture and the Co-Evolution of Banks and Capital Markets (February 19, 2009). Third Singapore International Conference on Finance 2009. Available at SSRN: https://ssrn.com/abstract=879288 or http://dx.doi.org/10.2139/ssrn.879288
By Ross Levine