Banks and capital markets as a coevolving financial system

Fenghua Song, Anjan Thakor, 1 December 2010

a

A

At a time when financial regulation is being fundamentally rethought, the optimal configuration of banks and capital markets within a financial system and how each should be regulated have become centre-stage issue. Banks and capital markets are often viewed as competing sources of financing (e.g. Allen and Gale 1997, Boot and Thakor 1997, and Dewatripont and Maskin 1995). This “banks versus markets” distinction implies that each sector (banks or markets) of a financial system develops at the expense of the other, and hence regulators have to strike a balance between the two when attempting to influence the architecture of the system.

Banks and capital markets as integral parts of a co-evolving system

In Song and Thakor (2010), we put forth a theoretical analysis of financial system evolution that provides an integrated theoretical analysis of the financial system as a whole. Specifically, we ask the following questions:

  • How do financial systems evolve?
  • And is there a specific pattern of development of banks and financial markets that produces the best economic outcome?

Challenging the dominant view that the primary form of interaction between banks and financial markets is that they compete, we find that banks and markets exhibit three forms of interaction. They compete, they complement each other, and they coevolve. Strong institutions like banks are necessary for markets to work well, and well-functioning markets are essential for banks to be sufficiently well-capitalised to expand credit availability to borrowers without increasing the risk of the banking system beyond prudent levels.

We study a financial system plagued by two frictions impeding a borrower’s ability to obtain financing. One is a “certification friction”, which arises due to imperfect information about borrower credit quality. This means that even a creditworthy borrower may be (erroneously) denied credit. The other friction, “financing friction”, arising from the various costs of external finance faced by borrowers, increases a borrower’s financing cost and may cause good investment opportunities to be forgone when borrowers have to rely on external financing rather than internal funds. Banks are better at diminishing the certification friction because of their credit-analysis expertise, whereas capital markets are better at resolving the financing friction by providing a more liquid market for the borrower’s security and thereby lowering borrowing costs.

Our analysis shows that markets and banks are linked in the manner of co-dependence through two channels. These two channels are securitisation and risk-sensitive bank capital requirements. With securitisation, the bank certifies a borrower’s credit quality via credit analysis and the capital market finances the borrower, so each sector of the financial system operates at its best – banks focus on credit analysis and markets focus on providing financing. Improvements in the bank’s credit-analysis technology enhance investors’ confidence in the securitised borrower’s credit quality, which encourages greater investor participation and improves liquidity, thereby lowering the financing friction and spurring capital market evolution. That is, securitisation propagates banking advances to the capital market, permitting market evolution to be driven by bank evolution.

Bank capital connects the two sectors in a different way. Capital market development reduces the financing friction and lowers the bank’s cost of equity capital, which enables the bank to raise additional equity capital to extend riskier loans that it may have previously eschewed. Moreover, as the bank lends to riskier borrowers, it finds it privately optimal to improve its credit-analysis technology to distinguish more accurately between creditworthy and non-creditworthy borrowers. Thus, it is through bank capital that market advances that diminish the financing friction end up being transmitted to banks, permitting banks to more effectively resolve the certification friction and expand their lending scope.

These feedback loops generate a virtuous cycle in which each sector of the financial system benefits from the development of the other. That is, bank evolution spurs capital market evolution, and capital market evolution spurs bank evolution. In other words, banks and markets coevolve with each other.

Policy implications

Our analysis has important policy implications. The financial systems of countries exhibit significant differences. There are bank-based (Eurozone) and market-based (US and UK) systems, classifications that are based on the shares of banks and other intermediaries in total financing. A long-standing debate is which system is superior in elevating aggregate credit extension and real-sector economic growth. Our findings cast doubt on the usefulness of such “banks versus markets” distinctions.

When attempting to influence the architecture of a financial system, our analysis prescribes that regulators should not narrowly focus on banks and markets separately, but should instead view them as integral parts of a coevolving system. As regulators the world over have learned in the recent financial crisis, focusing on bank regulation without attending to the influence of market forces can be dangerous, and contemplating changes in the regulation of financial markets without being cognisant of the mediating influence of banks is unwise as well. Our analysis points to the economic forces at work that connect markets and banks and how these forces ought to shape the future regulation of both banks and markets in a comprehensive way. In particular, our analysis emphasises the importance of bank capital regulation for not only banks but also markets, and the relevance of securitisation for both banks and markets. In a world in which banks and markets are becoming increasingly interconnected, we believe these insights will provide the theoretical foundations for sorting out the pros and cons of alternative regulatory proposals.

References

Allen, Franklin, and Douglas Gale (1997), “Financial markets, intermediaries, and intertemporal smoothing”, Journal of Political Economy 105(3):523-546.

Boot, Arnoud, and Anjan Thakor (1997), “Financial system architecture”, Review of Financial Studies, 10(3):693-733.

Dewatripont, Mathias, and Eric Maskin (1995), “Credit and efficiency in centralized and decentralized economies”, Review of Economic Studies 62(4):541-555.

Song, Fenghua, and Anjan Thakor (2010), “Financial system architecture and the co-evolution of banks and capital markets”, Economic Journal, 120(547):1021-1055.

Topics: Financial markets
Tags: banks, capital markets, financial regulation

Fenghua Song

Assistant Professor of Finance, Smeal College of Business, Pennsylvania State University

Anjan Thakor

John E. Simon Professor of Finance, Olin Business School, Washington University in St. Louis