Financial System Architecture and the Co‐evolution of Banks and Capital Markets

Abstract

We examine financial system architecture evolution and show that banks and markets exhibit three forms of interaction: competition, complementarity and co‐evolution. Co‐evolution is generated by two elements missing in previous analyses: securitisation and bank equity capital. As banks evolve via improvements in credit screening, they securitise higher quality credits. This encourages greater investor participation and spurs capital market evolution. And, if capital market evolution is spurred by greater investor participation, banks find it cheaper to raise equity capital to satisfy endogenously arising risk‐sensitive capital requirements. Bank evolution is thus stimulated as banks consequently serve previously unserved high‐risk borrowers. Numerous additional results are obtained.