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Financial System Architecture and the Co-Evolution of Banks and Capital Markets

40 Pages Posted: 30 Jan 2006 Last revised: 22 Jul 2009

Fenghua Song

Pennsylvania State University - Smeal College of Business

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

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Date Written: February 19, 2009

Abstract

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

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

Fenghua Song

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)
814.865.3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/fxs16

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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