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The Co-Evolution Of Banks And Capital Markets – Implications For Planned New Financial Regulation

  • Published Date: September 2010

New research published in the September 2010 Economic Journal casts doubt on the usefulness of the ‘banks versus capital markets’ distinction that is often made in comparing the financial systems of the euro area (‘bank-based’) and the UK and United States (‘market-based’).

The study by Professors Fenghua Song and Anjan Thakor argues that, particularly at a time when financial regulation is being fundamentally rethought, policy-makers should not focus on banks and markets separately. Instead, they should view them as integral parts of a co-evolving system. The researchers conclude:

‘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 too.

‘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 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.’

The optimal configuration of banks and capital markets and how each should be regulated have become centre-stage issues due to the recent financial turmoil. But to address these issues in a thoughtful manner requires a deeper understanding of the financial system as a whole, which involves asking a few key questions.

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

Song and Thakor study these questions in a theoretical analysis of financial system evolution. Challenging the dominant view that the primary form of interaction between banks and financial markets is that they compete – a view that implies that each develops at the expense of the other – they find that banks and markets exhibit three forms of interaction: they compete; they complement each other; and they co-evolve.

Strong institutions like banks are necessary for markets to work well, and well-functioning markets are essential for institutions to be sufficiently well-capitalised to expand credit availability to borrowers without increasing the risk of the banking system beyond prudent levels.

The researchers 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.

The analysis shows that markets and banks are linked in the manner of co-dependence through two channels: 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: banks and markets co-evolve with each other.

This analysis has important policy implications. The financial systems of countries exhibit significant differences. There are bank-based (euro area) and market-based (US and UK) systems, classifications that are based on the shares of banks and other intermediaries in total financing. A longstanding debate is which system is superior in elevating aggregate credit extension and real-sector economic growth.

The findings of this study cast doubt on the usefulness of such ‘banks versus markets’ distinctions. When attempting to influence the architecture of a financial system, the analysis prescribes that regulators should not narrowly focus on banks and markets separately, but should view them as integral parts of a co-evolving system.


Notes for editors: ‘Financial System Architecture and the Co-evolution of Banks and Capital Markets’ by Fenghua Song and Anjan Thakor is published in the September 2010 issue of the Economic Journal.

Fenghua Song is at the Smeal College of Business, Pennsylvania State University. Anjan Thakor is at the Olin Business School, Washington University in St. Louis.

For further information: contact Fenghua Song on +1 814 863 4905 (email:; Anjan Thakor on +1 314 935 7197 (email:; or Romesh Vaitilingam on +44-7768-661095 (email: