DP1197 | Financial System Architecture

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The main purpose of this paper is to take a step towards building a theory of financial system architecture. We begin with basic assumptions about the types of primitive agents and the nature of informational asymmetries in the economy, and then provide a theory that explains which agents coalesce to form banks and which agents trade in the capital market. Our theory incorporates a model of financial market equilibrium with sufficient richness to enable market prices to convey decision-relevant information to firms and makes it possible to extract broader implications regarding the configuration of financial systems. The borrower's choice between bank and financial market funding is examined in this framework, and it is shown that borrowers of higher observable qualities directly access the financial market. Moreover, a financial system in its infancy is likely to be bank dominated, and financial innovation causes a decline in the relative importance of banks in lending.