Journal of

BANKING &
E L S E VI E R F I NANC E
Journal of Banking & Finance 20 (1996) 917-948
The design of financial systems: An overvi ew
Anjan V. Thakor
Finance School of Business Department ~f Finance. Indiana Unirersity, Bloomington, IN 47405. USA
Received 15 February 1995; accepted 15 May 1995
Abstract
I exami ne the mul t i facet ed aspects of financial system design, focusi ng on the real
effects of this design, My exploration of the key issues and my revi ew of the related
literature pertain to three di mensi ons of financial syst em design: (i) the permi ssi bl e scope of
activities for banks and other depository financial intermediaries, (ii) the regulations
dictating the structure of the banking industry, and (iii) i nformat i on disclosure requi rement s
in the financial market. 1 address a di verse set of issues such as borrowers' choi ces of
fi nanci ng source and bow these are affected by financial system design, the impact of
financial system desi gn on the capital structure and corporat e control deci si ons of nonfinan-
cial firms, the relationship between financial system architecture and the liability claims of
banks, the issues surrounding the desired permi ssi bl e scope of banking and bank industry
structure, and the overall design of a financial system.
JEL class!fication: G I; G2; G32:G34
Keywords: Financial systems : Markets and institutions
1. I nt r o duc t i o n
Th e r e has r e c e nt l y been a s ur ge o f a c a d e mi c i nt er es t in t he de s i gn o f f i nanci al
s ys t ems . In t hi s paper , I of f e r s o me t hought s on t he mu l t i f a c e t e d as pect s o f
* Tel.: 812-855-8568; fax: 812-855-8679.
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918 A. V. Thakor / Journal (~f Banking & Fi nance 20 (1996) 917- 948
financial syst em design, exami ni ng along the way the burgeoning literature on this
subject. My discussion focuses on:
the key pol i cy-rel at ed questions in financial syst em design;
the analytical issues involved in theoretical explorations of these questions;
the manner in which research on this issue is likely to draw upon our
knowl edge in a variety of seemingly disparate subfields, not only potentially
generating unifying t hemes but also pushing the frontiers of our comprehension
of contracts, institutions and markets;
the potential of future research to illuminate policy initiatives concerning the
regulation of institutions and markets;
the implications of financial syst em design for the real and financial decisions
of firms; and
possible paths along which financial systems may evol ve in the future.
In principle, financial syst em design encompasses a myri ad of institutional and
market details, regulations, and disclosure requirements. For simplicity, I shall
focus on three of the many aspects of financial syst em design: (i) the permissible
scope of activities for banks and other depository financial intermediaries, (ii)
regulations dictating the structure of the banking industry, and (iii) information
disclosure requirements in the financial market. These aspects clarify the exoge-
nous instruments that can be used to influence financial syst em design. Different
financial syst em designs will manifest themselves in different divisions of activi-
ties between financial institutions and markets.
My focus on these three aspects of financial syst em design enables me to
restrict the scope of this paper to the seven questions listed below. Prominent by
their absence are considerations related to the design of securities exchanges and
related market microstructure issues, details of the bankrupt cy code, and bank
regulation except that concerned with industry structure and banking scope.
Question 1: Why do we care about f i nanci al system design? This is perhaps the
most obvious policy-related question on this subject. There are many reasons why
a systematic exami nat i on of financial system design is important. First, as reported
by King and Levi ne (1992), the size of the financial syst em is strongly correlated
with the level of economi c development; see Fig. 1. Their paper finds that the
citizens of the richest countries hold more of their annual incomes in liquid assets
beyond their monet ary liabilities than their counterparts in poorer countries. The
' t radi t i onal ' interpretation of this data would be that rich countries have larger
financial syst ems because these countries are further along on the economi c
devel opment curve, i.e., economi c performance drives financial scope. Such an
interpretation relies on the assertion that financial syst ems are outcomes of the real
requirements of an economy, not the drivers of its performance. The details of
financial syst em design - particularly the division of financial activity between
intermediated and nonintermediated sources - is of little relevance.
The strength of the recent research on this issue, however, is in the observation
that the causality may often be reversed, and the design of the financial syst em
A. V. Thakor / Journal ~( Banki ng & Fi nance 20 (1996) 917- 948 919
ft.
Q
o
"6
_5
Per ca~ta income
Fi g. I. Fi nanci al s i ze and r eal per capi t a i ncome, 1985. Sour ce: Ki ng and Le vi ne ( 1992) .
could impinge on real activity and economi c development. There is a variety of
ways in which this could happen; these mechani sms are explored in King and
Levi ne (1992), Bernanke (1988), Gale (1992), and Boot and Thakor (1996),
among others. Pagano (1993) summari zes some of these mechanisms. In particu-
lar, he points out that financial devel opment can raise the proportion of savings
allocated to investment, increase the social marginal productivity of capital, and
influence the private savings rate. This viewpoint, theretore, sheds new light on
the implications of the growing importance of financial services in devel oped
economi es, as depicted in Fig. 2.
Question 2: Why have financial systems in different countries historically been
so disperse in design? Economists have been groping for a satisfactory answer to
this question for some time. There are many dimensions along which financial
syst ems differ. For exampl e, Mayer (1988) points out that in France, Germany,
Japan and the U.K., stock markets were relatively unimportant as a source of
funds for corporations during 1970-85. By contrast, U.S. firms relied relatively
heavily on bond financing in the capital market during this period; see Fig. 3. This
evidence is merel y part of a larger body of evidence suggesting that the intermedi-
at ed/ i nst i t ut i onal segment of the financial syst em is more important in Europe and
Japan than in the U.S., and financial markets are more important in the U.S. than
in Europe and Japan. An exampl e of such evidence appears in Frankel and
Mont gomery (1991), and is shown in Fig. 4. Apart from 1985-89, when compa-
nies were borrowing to repurchase shares, securities have been much more
important in the U.S. than elsewhere. We would like to know why.
Question 3: How do f r ms choose their source of (external) financing and how
might this choice be affected by information disclosure requirements in financial
920 A. V. Thakor / Journal t~[ Banking & Finance 20 (1996) 917-948
Financial
Services
as%of
GNP
30
I
2 8 -
2 t
24
22
2O
18
16
14
12
10
8
6 J
4
2 I
O-
F-
U.S. Britain
1980
i
Japan
1990
b
W. Germany
- - Country
Employment
in Financial
Services
as%of
Total
Employment
2 0 - ,
18
14
12
lo~462s
0
U.S.
1980
J
Britain
1990
Japan
W. Germany
Country
Fig. 2. The growth of financial services in selected countries. Source: Greenbaum and Thakor (1995).
markets and by the development of the financial system? It is now widely believed
that firms not only care about their capital structures, but also about where they
borrow from, conditional on the decision to acquire debt. How is this choice
affected by the information disclosure requirements that exchange-listed securities
must abide by'? There has recently been considerable research that has sharpened
our understanding of this aspect of corporate decisionmaking (see, e.g., Diamond,
A. V. Thakor / Journal of Banki ng & Fi nance 20 (/996) 917- 948 921
107
France
m Germany
I Japan
m USA
1 1
-2 -2
42
26
5 4
-4 -3
-10
Retentions Loans, Trade Credit Bonds Shares
deposits
and short term
securities
Fig. 3. Net financing of private physical investment by companies in France, Germany, Japan, the U.K.
and the U.S. for the period 1970-85. Source: Mayer (1988).
1991a). Yet much r emai ns t o be done on t he quest i on of how f i nanci al s ys t em
des i gn af f ect s t he bor r owe r ' s choi ce.
Question 4: Are capital structure and corporate control decisions of nonfinan-
cial firms potentially influenced by financial system design? It has r ecent l y come
to be under s t ood t hat a f i r m' s choi ce of capi t al st r uct ur e can i nf l uence f ut ur e
cont est s for cont r ol of t he f i nn. Mor e ove r , t he r ol e of t he capi t al mar ket is l i kel y
to be di f f er ent f r om t hat of banks in det er mi ni ng t he out comes of cor por at e cont r ol
cont est s. Thus, t here is r eason to s us pect t hat f i nanci al s ys t em desi gn can i mpact
capi t al st r uct ur e and me r g e r / t a k e o v e r deci si ons.
Question 5: How are the liabilit), claims of banks likely to be affected by the
architecture of the financial system? We woul d l i ke to know i f t he var i et y, nat ur e
and vol ume of depos i t s used by banks are i mpact ed by how t he f i nanci al s ys t em is
conf i gur ed. The i ssue her e is one of l i qui di t y cr eat i on ( Di a mond and Dybvi g,
1983).
9 2 2 A. V. Thakor / J ournal of Banking & Finance 20 (1996) 917-948
3o k
20
1 0
- 1 0 - -
-20
1965-69
80 United Kingdom
Uni t ed S t a t e s
70
60
50
40
20 i
1 o r
1970-74 1975- 79 1980, 84 1985-89
-10 {
1965-69
{ A . . . .
1970-74 1975-79
I i _ _
1980-84 1985-89
70
60
40 ~
% iii i
20
10
0
G e r m a n y
70 { - J a p a n
f i l l
1 - -
........ I
I ~
I I
i I I
I ...........
~ ~ ~ 0
1965-69 1970- 74 1 9 7 5 - 7 9 1980- 84 1985-89 1965-69 1970- 74 1975- 79 1980- 84 1985-89
F u n ~ s r a i ~ : l t h r o u g h s e c u r i t i e s
Ftmds raised t h r o ~ honk loans
Fig. 4. Percentage of total business funds raised through securities and bank loans, 1965-89. Source:
Frankel and Montgomery (1991).
Question 6: What should be the permissible scope of banking? S i n c e the
p e r mi s s i b l e s c o p e o f banki ng and the r e gul at i on o f banks and f i nanci al mar ke t s
can po t e nt i a l l y i n f l u e n c e the e v o l u t i o n o f a f i nanci al s y s t e m, l earni ng about
f i nanci al s y s t e m d e s i g n ma y s he d n e w l i ght o n o pt i ma l r e gul at or y po l i c i e s . For
e x a mp l e , mu c h o f t he c o nt e mpo r a r y l i t erat ure on uni ve r s al ve r s us res t ri ct ed
c o mme r c i a l ba nki ng de a l s wi t h a part i cul ar s l i c e o f the s e t o f i s s ue s pert i nent t o
A. V. Thakor / Journal of Banking & Finance 20 (1996) 917-948 923
financial syst em design, such as potential conflicts of interest in universal banking,
(see, e.g., Rajan, 1991; Kroszner and Rajan, 1994a; Berlin et al., 1994; Kanatas
and Qi, 1993; Puri, 1994). Thus, financial syst em design is an important issue
even in highly devel oped economi es such as the U.S.
Question 7: What is the significance of banking industry structure and how
should a new financial system be designed? There is great diversity in banking
industry structures in different countries. We would like to understand the
significance of this diversity. Moreover, the design of new financial systems is a
key policy issue in the emergi ng market -based economi es in Eastern Europe. As
Boot and Thakor (1996) point out, the financial syst ems currently in place in these
countries are best viewed as interim arrangements designed to facilitate transition
to syst ems that are less dependent on centrally planned capital allocation (see also
Catte and Mastropasqua, 1993; Checchi, 1993). There are many who would like to
know how these nascent financial systems should be designed and what the
stability implications of different designs are likely to be.
The rest of the paper is organized as follows. Section 2 exami nes the interaction
between real and financial decisions and the different mechani sms by which the
financial syst em could drive economi c performance (Question 1). Section 3
addresses the issue of the observed diversity of financial syst ems (Question 2).
Section 4 takes up the question of how firms choose their source of financing,
particularly in light of the interactions highlighted in Section 2 (Question 3).
Section 5 focuses on issues of capital structure and corporat e control (Question 4).
Section 6 considers the manner in which bank liabilities are affected by financial
syst em design (Question 5). In Section 7, I turn to the role of the permissible
scope of banking in financial syst em design and its potential i mpact on financial
innovation incentives (Question 6). In Section 8, I attempt to synthesize the
insights of previous sections to draw conclusions about financial syst em design
(Question 7). Section 9 concludes with thoughts about the future evolution of
financial systems. I also discuss at this stage the importance of the political
envi ronment and the political economy of financial syst em design. Wherever
appropriate, I note the maj or unresolved issues in the existing literature.
2. Real and f i nanci al deci si ons
Since an important reason for the interest in financial system design is that this
design may influence real decisions, I consider that issue in this section. Given the
large and growing literature on this topic, I will not attempt an exhaustive
discussion of the ways in which the financial syst em affects real decisions. Rather,
I will focus on six interesting mechani sms by which financial syst em activity may
be propagated to the real sector. These are depicted in Fig. 5.
924 A. V. Thakor / Journal ?f Banki ng & Fi nance 20 (1996) 917- 948
Financial Systcm
, . o o f 7
l I
Fig. 5. The ways in which the financial system may affect the real sector.
2.1. Screening and monitoring actiuities of banks
A si gni fi cant economi c funct i on served by fi nanci al i nt ermedi ari es is to screen
potential bor r ower s to generat e si gnal s about their credi t wort hi ness. ~ Ramakr i sh-
nan and Thakor (1984) first f or mal i zed this intuition to provi de a t heory that
rat i onal i zed the endogenous f or mat i on of perfect l y di versi fi ed nondeposi t or y
fi nanci al i nt ermedi ari es whose pri nci pal funct i on is to certify borrowers. 2 Con-
t empor aneousl y Di amond (1984) rat i onal i zed perfect l y diversified banks that
moni t or ed their bor r ower s' cash fl ows in a cost l y st at e-veri fi cat i on f r amewor k.
Later, Boyd and Prescot t (1986) expl oi t ed the screeni ng role of banks to show how
these institutions coul d enhance aggr egat e i nvest ment in soci al l y beneficial pro-
j ect s by generat i ng signals that facilitate a reduct i on in the i nvest ment capital
di vert ed to i nferi or projects. By exami ni ng the rol e of banks in altering aggr egat e
i nvest ment patterns, Boyd and Prescot t thus br ought to light an i mport ant link
3
bet ween the real and fi nanci al sectors.
A si mi l ar poi nt was made by Ki ng and Levi ne (1992), who j oi ned the insights
of the cont empor ar y financial i nt ermedi at i on literature with those of new gr owt h
t heory. 4 Ki ng and Levi ne obser ve that many capital i nvest ment s that el evat e
product i vi t y i nvol ve intangible capital goods whose value is often di ffi cul t to
i See Allen (1990) and Bhattacharya and Thakor (1993).
2 Millon and Thakor (1985) rationalized imperfectly diversified certification agencies.
3 See also Chan (1983).
4 See also the review by Mayer and Vives (1992).
A.V. Thakor /Journal of Banking & Finance 20 (1996) 917-948 925
establish. In this setting, as in Boyd- Pr e s c ot t , financial i nt ermedi ari es arise
endogenous l y as a market mechani sm for screeni ng ent repreneurs, but unlike
Boyd- Pr e s c ot t , i nt ermedi ari es hel p fi nance i nt angi bl e assets. Economi es possessed
wi t h bet t er financial syst ems - in particular, bet t er financial i nt ermedi ari es - are
mor e adept at eval uat i ng assets whose val ues are di ffi cul t to establish. Thi s implies
that a bet t er devel oped financial syst em leads to hi gher product i vi t y and gr owt h
t hr ough superi or physi cal capital accumul at i on and mor e effi ci ent i nvest ment s in
i nt angi bl e and human capital.
An even mor e dramat i c potential i mpact of screeni ng on real act i vi t y was
deri ved by Gal e (1992) in the cont ext of a model in whi ch banks can acqui re a
cost l y screeni ng t echnol ogy. Banks have const rai nt s on their capaci t y to screen
bor r ower s, and it is cost l y for bor r ower s t o appl y f or loans. Gal e shows the
exi st ence of mul t i pl e equilibria, some i nvol vi ng (si gni fi cant ) bank l endi ng and
ot hers i nvol vi ng little or no bank l endi ng. The latter class of equilibria - called
' f i nanci al col l apse' by Gal e - arises f r om an adverse selection effect. I f all banks
except one decl i ne to lend, then the sol e l ender will attract a rel at i vel y hi gh
pr opor t i on of bad bor r ower s who fi nd it profi t abl e to expl oi t the debt cont ract by
i nvest i ng in hi gh-ri sk projects, assumi ng that their part i ci pat i on is masked by the
presence of at least some good borrowers. A key to the model is that had
bor r ower s benefi t more f r om bank l oans because their proj ect s have hi gher
vari ance and t herefore provi de great er ri sk-shi ft i ng benefits. Gi ven l oan appl i ca-
tion costs, each bor r ower makes its appl i cat i on deci si on based on a t r adeof f
bet ween the cost of appl yi ng and the expect ed val ue of a bank loan; the latter is
decl i ni ng in the probabi l i t y of bei ng rat i oned. Since for any gi ven rat i oni ng
probabi l i t y, the value of a bank l oan is l ower t o good borrowers than bad, the good
bor r ower s exit earlier than the bad when the rat i oni ng probability rises. Thus,
when there is onl y one bank that is wi l l i ng to lend, the rat i oni ng probabi l i t y is
high, causi ng good borrowers to exit and causi ng the pool of bor r ower s to cont ai n
a hi gher proport i on of bad bor r ower s than when all banks are wi l l i ng to lend. The
sole l ender recogni zes this, and its scr eeni ng capaci t y const rai nt s then lead it to
reject a rel at i vel y hi gh proport i on of credi t applicants. Appl i cat i on cost s for
bor r ower s now furt her deter good bor r ower s f r om appl yi ng because t hey percei ve
a l ow l i kel i hood of recei vi ng credit. Thi s process cont i nues until no good
bor r ower s remai n, whi ch then leads banks to deci de not to screen and si mpl y
reject all applicants. 5
Cessat i on of l endi ng is not the onl y equi l i bri um, however. I f all but one bank
deci de to lend, then it will be profi t abl e f or the sole devi ant to screen and lend as
well. Thus, financial col l apse pot ent i al l y arises f r om a coordi nat i on failure.
5 Although the description makes it appear as if these events are sequential, they are not -
everything happens simultaneously.
926 A. V. Thakor / Journal q[" Banking & Finance 20 (1996) 917-948
2.2. Cr e di t r at i oni ng by bank s
In an at t empt t o expl ai n why pr of i t - ma xi mi z i ng banks woul d t ol er at e an exces s
d e ma n d f or l oans r at her t han r ai si ng t he pr i ce f or cr edi t , St i gl i t z and We i s s ( 1981)
de ve l ope d a mode l in whi ch a b a n k ' s e xpe c t e d pr of i t is not monot oni c a l l y
i ncr eas i ng in t he l oan i nt er est rat e. The nonmonot oni c i t y can st em f r om adver s e
sel ect i on or mor al hazar d or bot h. Adve r s e s el ect i on ar i ses f r om t he as s umpt i on
t hat t he bank f aces bor r ower s who are obs e r va t i ona l l y i ndi s t i ngui s habl e but are
het er ogeneous in cr edi t ri sk. Whe n t he bank r ai ses i t s l oan i nt er est rat e, t he saf er
bor r ower s dr op out of t he cr edi t mar ket bef or e t he r i s ki er bor r ower s do becaus e
t he saf er bor r owe r s ' gr eat er l i kel i hood o f r e pa yi ng t hei r l oans makes t hem mor e
s ens i t i ve t o t he l oan i nt er est rat e. Cons equent l y, t he bank r ecogni zes t hat an
i ncr eas e in i t s l oan i nt er est rat e causes t he bor r owe r pool to become r i ski er , and it
ma y di s c ove r t hat i t s e xpe c t e d pr of i t peaks at an i nt er est rat e t hat is l ess t han t hat
needed to cl ear t he mar ket ; cr edi t r at i oni ng is t he r esul t .
Rai s i ng t he l oan i nt er est rat e coul d al so e xa c e r ba t e asset - subst i t ut i on mor al
hazar d. I f bor r owe r s coul d choos e bet ween saf e and r i s ky asset s and t he bank was
unabl e t o obs er ve whi ch asset was chosen, St i gl i t z and We i s s show t hat a
s uf f i ci ent l y l ar ge i ncr eas e in t he l oan i nt er est r at e coul d cause t he bor r owe r ' s
pr ef er ence to swi t ch f r om t he saf e to t he r i sky pr oj ect . Hence, the bank may agai n
f i nd i t s e xpe c t e d pr of i t peaki ng at an i nt er est r at e at whi ch t her e is an exces s l oan
demand.
A we a kne s s o f t he St i gl i t z and We i s s anal ys i s is t hat t he bank is mer el y a
pas s i ve condui t f or t he t r ansf er of funds f r om s aver s t o bor r ower s - it pr ovi des no
s cr eeni ng or moni t or i ng ser vi ces. 6 Paper s by Th a k o r and Ca l l a wa y ( 1983) and
Tha kor ( 1996) f ocus on noi sy scr eeni ng by banks and der i ve st ochast i c cr edi t
r at i oni ng as an equi l i br i um out come. Thakor ( 1996) f ur t her s hows t hat r i s k- bas ed
capi t al r equi r ement s - such as t he Bank for I nt er nat i onal Set t l ement s capi t al
gui del i nes - t end t o i ncr ease such r at i oni ng.
I f bank l oans are s ome how uni que and not r eadi l y r e pl a c e a bl e by al t er nat i ve
cr edi t sour ces, t hen cr edi t r at i oni ng by banks wi l l de pr e s s capi t al i nves t ment and
r et ar d e c onomi c gr owt h. Mor eover , i f f i nanci al mar ket s , wi t h pr i ce- t aki ng agent s
c ompe t i ng to pr ovi de f unds, are l ess pr one t o r at i on cr edi t , one mi ght be t empt ed
to c onc l ude t hat encour agi ng t he de ve l opme nt o f t he f i nanci al mar ket as a vi abl e
al t er nat i ve t o banks coul d r esul t in hi gher aggr egat e i nvest ment . But such a
concl us i on woul d be pr emat ur e si nce t hi s l i t er at ur e has not expl i ci t l y cons i der ed
t he i ncent i ves t hat l ead to t he endogenous de t e r mi na t i on of mar ket s and i nst i t u-
t i ons wi t hi n a f i nanci al syst em. I wi l l have mor e t o say on t hi s l at er.
6 Another weakness is that the rationing in their model is heavily dependent on the assumption that
only a debt contract can be used by the bank in extending a loan. However, Williamson (1987) crafts a
model in which the debt contract arises endogenously, and one encounters the Stiglitz-Weiss kind of
credit rationing.
A. V. Thakor / Journal of Banking & Finance 20 (1996) 917-948 927
2.3. Bank ' s rol e in l i qui di t y creat i on and t he i mpact o f bank runs
Banks pr ovi de a host of qual i t at i ve as s et t ransf ormat i on ( QAT) ser vi ces. An
i mpor t ant QAT s er vi ce is l i qui di t y creat i on. Banks cr eat e l i qui di t y by i ssui ng
l i qui d de pos i t c l a i ms agai ns t i l l i qui d l oans. Di a mond and Dybvi g ( 1983) f or mal -
i zed t hi s r ol e of banks in a mode l in whi ch the super i or i t y of bank f i nanci ng over
f i nanci al ma r ke t f undi ng is due t o t he s uper i or r i sk shar i ng pr ovi de d by t he bank.
Howe ve r , a coor di nat i on f ai l ur e can l ead to a ' b a d ' Nas h equi l i br i um in whi ch
' l ong- l i ve d' de pos i t or s pr emat ur el y wi t hdr aw t hei r depos i t s becaus e t hey bel i eve
ot her s wi l l as wel l . 7 Thi s run on t he bank is di s r upt i ve si nce t he onl y way the
bank can sat i sf y de pos i t or s ' de ma nd is to l i qui dat e l oans. Gi ven t he as s umpt i ons
t hat pr emat ur e l oan l i qui dat i on is cost l y and l oans are i l l i qui d - t hey cannot be
8
sol d in t he mar ket - it f ol l ows t hat bank r uns adver s el y i mpact t he real sect or.
2.4. Loan c ommi t me nt s and ot her l ong- t erm cont ract s
Ove r 80% of c omme r c i a l and i ndust r i al l endi ng by U. S. banks is done vi a l oan
commi t ment s . A bank l oan c ommi t me nt is a pr omi s e by t he bank to l end up to a
pr edet er mi ned a mount at pr e de t e r mi ne d t er ms. As expl ai ned by Thakor et al.
(1981), when a bor r owe r acqui r es a bank l oan c ommi t me nt , it pur chas es a put
opt i on.
Wi t h bor r owe r r i sk aver si on, it is not obvi ous why cus t omer s de ma nd l oan
c ommi t me nt s . Va r i ous paper s have pr ovi de d expl anat i ons . For e xa mpl e , Boot et
al. ( 1987, Boot et al. (1991), s how t hat a l oan c ommi t me nt can at t enuat e bot h
ef f or t - aver s i on and as s et - s ubs t i t ut i on mor al hazar d. 9 The i nt ui t i on is as f ol l ows.
Under a l oan c ommi t me nt , a bank can set the pr omi s e d l oan i nt er est rat e l ow
enough to ensur e t hat t he bor r owe r wi l l choos e t he f i r st - best ef f or t or pr oj ect .
Whe n t he s econd- bes t spot l endi ng out come is di s t or t ed away f r om t he f i r st - best ,
t he bank wi l l expect t o ma ke a l oss on t he l oan i t sel f. Howe ve r , it can r ecoup t hi s
l oss by char gi ng a c o mmi t me n t f ee at t he t i me t hat it sel l s t he commi t ment . Si nce
t hi s fee is t r eat ed as a sunk cost by t he bor r owe r at t he t i me t hat it makes its
a c t i o n / p r o j e c t choi ce, it does not af f ect t hat choi ce. Hence, t he fi rst best is
at t ai ned.
An i mpor t ant pr edi ct i on of t hi s t heor y is t hat bank l oan c ommi t me nt s r esul t in
i mpr ove d i nves t ment deci s i ons . Mor eover , t he l oan c ommi t me nt cont r act usual l y
has a ' ma t e r i a l adver s e c ha nge ' cl aus e whi ch per mi t s t he bank to not honor t he
c ommi t me nt i f it j u d g e s t he b o r r o we r ' s f i nanci al condi t i on to be unaccept abl e at
t he t i me of c ommi t me nt t akedown. ~0 The economi c cont r i but i on of t hi s cl ause
7 In Diamond-Dybvig's model, such beliefs arise as sunspot phenomena.
Bernanke (1988) discusses the disruptive effects of bank failures during the 1930s in the U.S.
See also Houston and Venkataraman (1994).
~ Boot et al. (1993) rationalize this discretion.
928 A. V. Thakor / Journal ~)[ Banki ng & Fi nance 20 (1996) 917- 948
means that the loan commi t ment out come cannot be replicated by exchange-traded
put options, and the financial market cannot provide the same investment effi-
ciency as bank financing for those borrowers who demand loan commi t ment s.
There are some who believe that a key difference between the financial market
and banks is that the latter can make long-term commi t ment s with discretion
regarding when to honor them, whereas investors in the financial market cannot. ~
It is an interesting research question to ask why. Although I have not seen a paper
that specifically addresses this, Boot et al. (1993) suggest a possible explanation.
In particular, they argue that the discretionary aspect of the bank loan commi t ment
facilitates a more rapid devel opment of bank reputation than is possible without
that discretion. Moreover, it is the desire to devel op/ pr ot ect this reputation that
induces the bank to honor its commi t ment even when it is not legally obligated to
do so. By contrast, since there are numerous small investors typically providing
funding to any borrower in the financial market, reputational concerns are of little
consequence, and it is unlikely that discretionary commi t ment s would be honored
in the financial market. Consequently, such commi t ment s are unlikely to be
depl oyed in a financial market setting.
A somewhat different perspect i ve appears in Mayer (1988) and Shleifer and
Summers (1988). Both papers emphasi ze the importance of long-term relation-
ships. They start with the premi se that explicit contracting is essentially incom-
plete, and this makes it desirable for firms to enter into long-term implicit
contracts with various stakeholders - empl oyees, suppliers, creditors, etc. These
implicit contracts (or l ong-t erm commi t ment s) produce significant ex ante gains.
For example, Jaggia and Thakor (1994) formal l y show that implicit contracts by
firms that translate into l ong-t erm empl oyment commi t ment s encourage empl oyees
to invest more in nonmarket abl e, firm-specific human capital than would be
possible with only explicit wage contracts. Of course, these are ' discretionary
promi ses' in the sense of Boot et al. (1993) in that firms are not legally obliged to
honor them. Moreover, it is costly ex post to honor such contracts. The key point
then is that the financial market provides numerous opportunities - more so than
bank financing does - to violate these implicit contracts. Jaggia and Thakor
(1994) demonstrate that formal bankruptcy provides one mechani sm for invalidat-
ing implicit long-term wage commi t ment s. Shleifer and Summers (1988) point to
the possibility of takeovers of publicly traded firms as another mechani sm. The
possibility that these implicit contracts will be violated ex post then weakens their
ex ante (desirable) incentive effects. One advantage of bank-oriented financial
structures is that this probl em is less serious. As discussed earlier, reputational
incentives deter banks from not honoring implicit contracts.
Much more needs to be done on this issue, however. From the loan-commit-
ments or long-term contracting perspective, there are real effects associated with
t] See, for example, Bhattacharya and Thakor (1993) and Sabani (1992).
A. V. Th a k o r / J o u r n a l ~?f Banki ng & Fi nance 20 (1996) 917- 948 929
changes in the rel at i ve pr opor t i ons of bank and financial market fi nanci ng. Thus,
compr ehendi ng key di fferences in the abilities of banks and financial market s to
credi bl y pr ecommi t to fut ure out comes is l i kel y t o prove very useful in cont em-
pl at i ng overal l fi nanci al syst em desi gn.
2.5. Debt restructuring
Di fferent fi nanci al syst ems may di ffer in the manner in whi ch t hey restructure
the debt s of fi nanci al l y di st ressed bor r ower s. To the extent that debt rest ruct uri ng
has real effect s, this means that opt i mal fi nanci al syst em desi gn must al so be
condi t i oned on the real effect s of that desi gn,
Thi s vi ewpoi nt is suggest ed by the wor k of Sabani (1992), who devel ops a
model in whi ch banks accumul at e bor r ower - speci f i c propri et ary i nformat i on in the
post - l endi ng stage of the rel at i onshi p. Such i nf or mat i on provi des i ncent i ves for the
i ncumbent bank to prot ect the rel at i onshi p by rest ruct uri ng the debt of its
fi nanci al l y distressed borrower. Sabani shows that this f r amewor k pr oduces
Par et o- r anked multiple equi l i bri a and that there is less rest ruct uri ng by banks in
compet i t i ve, market -ori ent ed economi es of the Angl o- Saxon mode than in bank-
ori ent ed syst ems of the Ge r ma n- J a pa ne s e mode. Thus, there is a potential t ensi on
bet ween compet i t i on and commi t ment (to restructure). ~2
A quite di fferent appr oach appears in Berlin and Mest er (1992). They posi t that
coor di nat i on difficulties make it mor e di ffi cul t for loan covenant s to be renegot i -
ated in the fi nanci al mar ket than by banks (see also Wi l son, 1994). Such
renegot i at i on may be necessi t at ed by r andom shocks to the l ender ' s i nformat i on
about the borrower. Berlin and Mest er concl ude that banks will tend to negot i at e
l oan cont ract s that have st ri ngent covenant s but will be willing to renegot i at e these
covenant s if warranted. Thus, bor r ower s who pose a relatively onerous asset-sub-
stitution mor al hazard to the l ender and al so di spl ay si gni fi cant i nformat i on
volatility prefer to bor r ow f r om banks. 13
It is natural to assume that the bor r owe r ' s ant i ci pat i on of whet her a loan will be
rest ruct ured will affect its ex ante choi ce of i nvest ment project. In this case,
i nvest ment choi ces will be part l y dri ven by whet her the bor r ower has access to
bank or financial mar ket fi nanci ng. Mor eover , the anal ysi s of Sabani (1992)
suggest s that bor r ower s' i nvest ment choi ces are al so likely to be i nfl uenced by the
degree of compet i t i on in banki ng. Thus, details of financial syst em desi gn are
likely to be hi ghl y pert i nent to the real sector.
i~ Dewatripont and Maskin (1990) suggest that bank-oriented economies persist with bad projects too
long, whereas market-oriented economies cut off good projects too early.
~3 Thakor and Wilson (1995) show that risk-based bank capital requirements will reduce the extent of
restructuring by banks and hence reduce bank loan demand.
930 A. V. Thakor / Journal of Banking & Finance 20 (1996) 917-948
2.6. The feedback role of the financial market
There have been numerous papers that have suggested that the financial market
can emi t signals that contain payoff-rel evant information not available in profits or
other reported summary measures. The additional information conveyed by the
financial market can then be used for a variety of purposes, with significant real
effects.
One strand of this literature suggests that stock prices provide signals for the
efficient allocation of investment (see, e.g., Grossman, 1976, Grossman, 1978;
Grossman and Stiglitz, 1980). This t heme is also devel oped in Allen (1992), who
takes a somewhat broader vi ew that stock market signals can lead to i mproved real
deci si onmaki ng in general; I discuss this paper in greater detail in the next section.
Anot her strand of this literature relies on the dependence of managerial
incentive contracts on stock prices. Ramakri shnan and Thakor (1984) derived
optimal incentive contracts for managers in publicly traded firms who choose
effort that affects real payoffs. The contracts they derive provide optimal risk
sharing and effort incentives, and depend heavily on st ock-market information.
Thus, the feedback role of the financial market is in providing information
regarding managerial performance that then affects effort input decisions of
managers. This issue is also confronted by Hol mst r om and Tirole (1993), who
devel op a model in which stock prices contain information not available in the
f i r m' s own information set, and therefore permi t more efficient contracting and
superior real decisions.
3. Fi nanci al system diversity
As I ment i oned in the Introduction, there is a great deal of variety in financial
syst ems across different countries. A bri ef summar y of these distinctions appears
below. |4
The U.S. has far more banks than any other country. Moreover, the ten largest
U.S. banks account for a significantly smaller portion of total lending in the
U.S. than their counterparts do in Japan and Europe. That is, the U.S. banking
industry is much more fragmented than that in other countries.
Western European and Japanese banks have traditionally had more powers
(wider scope) than U.S. banks. For exampl e, while Japanese banks have, like
their U.S. counterparts, been barred from universal banking, they have had a
greater ability to hold equity in borrowing firms and exercise corporate control.
German, Swiss and Dutch banks have been permitted to be ' uni versal ' and
J4 See Allen (1992) and Greenbaum and Thakor (1995).
A. V. Thakor / Journal t~] Banki ng & Fi nance 20 (1996) 917- 948 931
engage in investment banking and insurance in addition to their usual commer-
cial banking functions.
Long-term relationships between banks and their borrowers are much more
extensive in countries like Japan and Germany than in the U.S.
In the U.S. there is considerable competition between depository financial
intermediaries and financial markets. This competition is much more limited in
other countries.
The U.S. has far more publicly listed firms than any other country.
There is considerably more information about publicly listed firms that is
available in the public domain in the U.S. than in most other countries.
The market for corporate control is significantly more active in the U.S. than in
other countries.
In general, financial markets in the U.S. are more highly developed than those
in other countries. For example, the futures and options markets in the U.S.
display far more liquidity than those in Germany.
While there are many conjectures about the reasons for this diversity in the
configuration of financial systems, I do not believe we have anything close to an
integrated theory that accommodates all of the relevant stylized facts related to this
diversity and also generates additional testable predictions. Perhaps the beginning
of the contemporary literature on this subject can be traced to Sah and Stiglitz
(1986), who explored the project selection ramifications of different ways of
organizing economic systems. They suggest that there will be more Type-II project
selection errors in market-oriented economies and more Type-I project selection
errors in bureaucracy-oriented economies. As for the architecture of financial
systems in particular, a preliminary step was taken by Allen (1992) in a descriptive
essay on comparative financial systems. Allen considers a model in which the
manager' s information set does not include all that is of relevance for optimal real
decisions. The more complex the technology employed by the firm and the greater
the frequency with which payoff-germane new information arrives in the market,
the less complete will be the manager' s information. Since the decisions the
manager makes are conditioned on his own information, optimality in decision-
making will be sacrificed due to the incompleteness in the manager' s information.
This not only makes the manager value the information of others that he does not
possess, but it also creates a divergence of opinions about how the firm should be
run, leading in turn to a role for corporate control contests.
In this framework, the financial market is viewed as a mechanism for aggregat-
ing many diverse opinions and hence providing information about optimal deci-
sion rules in corporations that is superior to that attainable through bank borrow-
ing. The reason is that the bank provides a 'single check' as opposed to the
'multiple checks' of the financial market. Multiple checks are provided by the
financial market through a variety of mechanisms - market prices, trading volume,
takeover attempts, etc. It follows from this that capital will be allocated in the
financial market when optimal decision rules are hard to formulate, and there is
932 A. V. Thakor / Journal qf Banking & Finance 20 (1996) 917-948
little consensus on how the fi rm shoul d be run; for exampl e, when i nformat i on
decays rapi dl y and new i nf or mat i on arrives al most const ant l y. Al l en cites biotech-
nol ogy as an exampl e of such an industry. In contrast, banks are desirable
institutions for al l ocat i ng r esour ces in situations in whi ch there is consensus on
deci si onmaki ng, and the mai n pr obl em is moni t or i ng firms.
Al l en uses this f r amewor k to rat i onal i ze the di ver gent pat t erns of financial
mar ket devel opment in di fferent countries. He poi nt s out that his t heory is
consi st ent with the i mpor t ance of the st ock market in the U. K. duri ng the 19th
cent ury when it was the first count r y to go t hrough the Industrial Revol ut i on. It is
al so consi st ent wi t h the fact t hat the U.S. has relied most heavi l y on st ock market s
in the 20th cent ury when it was the first count r y to go t hrough the post -Indust ri al
Revol ut i on. And the predi ct i on is that as the U.S. goes t hr ough the ' I nf or mat i on
Revol ut i on' , the rel at i ve i mpor t ance of the financial mar ket will gr ow.
Al l en al so ext ract s the i mpl i cat i ons o f his t heory f or the devel opment of
financial institutions in Europe. St ock market s will need to devel op furt her in the
advanced economi cs o f West ern Eur ope i f new t echnol ogi es and industries are to
emerge. In East ern Europe, on the ot her hand, the task is to build basic industries
where the t echnol ogy is fami l i ar and opt i mal deci si on rules are well known, t5
The devel opment o f banks shoul d t herefore be gi ven pri ori t y over the devel opment
of fi nanci al market s.
Al l en' s f r amewor k is appeal i ng because it is si mpl e and seems t o explain quite
a bit. However , because it is onl y an initial step, it leaves numer ous quest i ons
unanswered. For exampl e, i f there are di mi ni shi ng margi nal returns to addi ng
mor e agent s to the pool of agent s whose opi ni ons are bei ng aggr egat ed, then how
many agent ' s opi ni ons do we need to aggregat e before we come cl ose to
mi mi cki ng the aggr egat i on ef f i ci ency o f the financial mar ket ? I f this number is
around say seven or eight, then it is di ffi cul t to see what advant age the financial
market offers to l arge firms relative to bank fi nanci ng, since each large U.S.
company has rel at i onshi ps with seven t o eight banks on average. Mor eover , given
the moni t or i ng advant age of banks, i f the opt i mal number exceeds eight, why do
not we observe each fi rm appr oachi ng a l arger number of banks rat her than goi ng
to the financial mar ket ? Al so, why is it that the financial mar ket is unabl e to
provi de the moni t or i ng servi ces t hat banks pr ovi de?
I bel i eve that we will begi n to underst and these issues onl y when formal model s
are craft ed to deal wi t h them. Recent papers by Allen and Gal e (1994a) and Boot
and Thakor ( 1996) represent initial stabs at formal model i ng. I di scuss these
papers in Sect i on 7.
15 These rules are well known to managers in developed countries. Whether this is true in Eastern
Europe is questionable.
A. V. Thakor / Journal (~]'Banking & Finance 20 (1996) 917-948 933
4. Bor r owe r ' s choi ce of f i nanci ng s ource
How does a bor r ower deci de whi ch source of credit to use at any gi ven time,
condi t i onal on havi ng deci ded to acqui re debt ? Thi s quest i on was formal l y
art i cul at ed by Di amond ( 1991a) in the cont ext of a model in whi ch a bor r ower can
choose bet ween a bank and the financial market. In Di a mond' s model , some
bor r ower s can substitute ri sky assets for safe ones to the l ender ' s detriment. Banks
speci al i ze in resol vi ng this asset -subst i t ut i on moral hazard probl em t hr ough moni -
toring. However , the l onger that a bor r ower keeps r epayi ng its loan - wi t h the
probabi l i t y of r epayment in any gi ven peri od enhanced by the choi ce of the sal e
proj ect in that peri od - the bet t er is its credi t reput at i on and the l ower are the
interest rates on future loans. Thi s means that a bor r ower with a better reput at i on
will percei ve a hi gher present value of its net payof f s from future bank loans.
Under the assumpt i on t hat a bor r ower who defaul t s in any gi ven peri od is then
forever excl uded from the capi t al mar ket or bank bor r owi ng, it fol l ows that
bor r ower s with better reput at i ons at t ach a l ower value to choosi ng the risky proj ect
over the safe one. Indeed, a reput at i onal cut of f is r eached such that once the
bor r ower ' s credit reput at i on exceeds that cut off, the bor r ower will al ways prefer
the safe proj ect over the ri sky proj ect . Gi ven this, bank moni t or i ng is unnecessary.
Thus, Di a mond' s model pr oduces the predi ct i on that bor r ower s wi t h nascent credit
reput at i ons appr oach banks, whereas mor e mat ure bor r ower s with wel l -est abl i shed
credi t reput at i ons access the capital mar ket di rect l y. Thi s predi ct i on seems r oughl y
consi st ent with the st yl i zed facts.
Numer ous aut hors have si nce exami ned vari ous facets of the bor r ower ' s choi ce
of fi nanci ng source. Raj ah (1992) focuses on the i nt ert emporal accumul at i on of
propri et ary bor r ower - speci f i c i nf or mat i on by rel at i onshi p lenders like banks. He
shows that this leads to an i nformat i onal monopol y for an i ncumbent bank and
distorts the bor r ower ' s effort choi ce away from the first best. Thus, Raj an' s
hypot hesi s is or t hogonal to the earlier research on the value of l ong- t er m bank-
bor r ower rel at i onshi ps, in that it hi ghl i ght s the di st ort i onary nature of such
rel at i onshi ps rather than its ear l i er - ment i oned benefits. Thi s leads Raj an to con-
cl ude that bor r ower s who percei ve si gni fi cant future rents from their proj ect s will
wi sh to avoi d bank fi nanci ng at present in order to precl ude the future expropri a-
tion of si gni fi cant port i on of these rents by i nformat i onal l y pri vi l eged banks, t6
A di fferent appr oach was suggest ed by Campbel l (1979). He f ocused on the
t ensi on bet ween sharehol ders and bondhol ders. As s umi ng that the terms of debt
are renegot i abl e, Campbel l ar gued i nformal l y that sharehol ders, represent ed by
i~ The notion that bank lending is profitable and often a substitute for capital market funding is
provided empirical support by Benveniste et al. (1993), who find that the commercial bunking industry
experienced positive wealth effects when Drexel Burnham Lambert - a major underwriter of junk
bonds (a close substitute for bank loans) - failed.
934 A. V. Thakor / Journal t?f Banking & Finance 20 (1996) 917-948
management , may prefer to borrow from a bank in order to conceal favorable
news from bondholders. Campbel l was therefore the first to raise the possibility
that confidentiality concerns could tilt the bor r ower ' s choice in favor of bank
financing.
This intuition was enriched and formal i zed by Yosha (1995) and Bhattacharya
and Chi esa (1995). Yosha exami nes f i r ms' choices between bilateral (bank) and
multilateral (public) financing after firms have acquired some proprietary informa-
tion. I f a firm chooses multilateral financing, it faces a greater probability that its
proprietary information will be leaked to competitors. But if it chooses bilateral
financing, its competitors may infer that the firm has something to hide and react
in a way that reduces the f i r m' s profit. Yosha shows that in equilibrium, the
high-quality firms (that have most to lose from their information being leaked)
choose bilateral financing, and that the cost differential between the two financing
source choices keeps competitors from unambi guousl y inferring that these firms
are hiding information. Bhat t acharya and Chiesa also focus on information-shar-
i ng/ di scl osur e issues in the context of bilateral (single bank) and multilateral
(multiple banks or the financial market ) financing regimes. The novelty of their
approach is in the conclusion that the choice of financing arrangement can serve as
a precommi t ment to enforce an ex ante desired information-sharing rule that may
otherwise prove difficult to i mpl ement ex post. This can affect ex ante incentives
to make investments that generate future information. Thus, the design of the
financial syst em can significantly i mpact R&D investments.
None of the above papers address i n t r a f i r m incentive probl ems faced by the
borrower, and the potential i mpact of the choice of financing source on the
resolution of these problems. Wilson ( 1994) devel ops a model in which divisional
managers have a propensity to overi nvest in some projects due to private benefits.
They are able to overinvest because they know more about their project a priori
than their supervisors do. In the interim stage, when more financing is needed to
sustain the project, additional information may arrive that reduces the informa-
tional gap between divisional managers and their supervisors. But by this time, the
initial investment is a sunk cost and therefore is ignored by senior management .
Additional funding at the interim stage is therefore provided if the s u b g a me NPV
(ignoring the initial investment) is nonnegative. Anticipating this, the divisional
manager somet i mes invests in projects that produce private benefits for him but
have negative ex ante NPV for the firm.
Wilson observes that one way to ameliorate this moral hazard is to have a
liquidity constraint on interim financing that effectively raises the hurdle rate for
that kind of financing. This ensures that threats by senior management to choke of f
interim financing for ex-ant e-negat i ve-NPV projects are credible. Now, if there is
a bank that is providing financing, the firm faces only a ' sof t ' budget constraint
since the relatively easy renegotiability of bank financing means that the firm can
acquire what ever additional funds it needs to maxi mi ze NPV at the interim stage.
In this case, it is not subgame perfect for the firm to deny interim financing to
A. V. Thakor / Journal of Banking & Finance 20 (1996) 917-948
Table 1
Real effects associated with borrower's choice of financing source
935
Paper Role of bank Role of financial market
Diamond (1991a) resolves asset-substitution mor al provides residual funding for
hazard through monitoring borrowers with sufficiently
high credit reputations
exploits ex post informational provides "arms-length'
monopoly due to its relationship financing that avoids
with borrower and t he r e by effort-avoidance moral
depresses borrower's effort-supply hazard
incentives
provide greater confidentiality
of R&D information generated
by borrower
provides financing to borrowers
that do not face significant
intrafirm incentive problems
Rajan (1992)
Bhattacharya and Chiesa
(1995)
Wilson (1994)
may help to implement ex
ante efficient information-
sharing arrangements
helps attenuate intrafirm
incentive problems that
lead to overinvestment
projects with negative ex ante NPVs. On the other hand, the firm faces a ' harsh'
budget constraint with financial market fi nanci ng - whatever constraint is imposed
ex ante on the fi rm' s interim funds cannot be relaxed. The firm can choose the
constraint ex ante in such a way that moral hazard is efficiently dealt with.
An interesting commonal i t y among all of these papers is that the fi rm' s choice
of fi nanci ng source has real effects. Table 1 summarizes the real effects predicted
by each of these papers. What this means is that how the financial system is
configured will matter to the real sector because of its impact on the borrower' s
choice of fi nanci ng source. For instance, if the financial market is relatively
underdeveloped, Rajah (1992) and Wi l son (1994) would predict that effort-avoi-
dance and overi nvest ment moral hazard are likely to be exacerbated. On the other
hand, an underdeveloped banki ng system will mean that there will be an excessive
reliance on borrower reputation and a relatively poor resolution of asset-substitu-
tion moral hazard (Diamond, 1991a).
5. Co r po r a t e c o nt r o l a nd capi t al s t r uc t ur e
The design of the financial system can affect information aggregation and the
outcomes of corporate control contests. This in itself can influence the fi rm' s
capital structure. There is also another way in which the design of the financial
system can affect capital structure. It has recently been shown that the availability
of a bank loan commi t ment can affect the fi rm' s choice of capital structure (see
Shockley, 1995). Both these effects imply real effects of financial system design
since it is well known that capital structure can affect i nvest ment decisions.
936 A.V. Thakor / Journal q]Banki ng & Fi nance 20 (1996) 917- 948
5.1. b~formation and corporate control
We have a l r e a dy seen how i nf or mat i on aggr egat i on can be of val ue to t he f i r m
when de c i s i onma ki ng is compl ex. Ther e ar e ma ny i nst ances in whi ch f i r ms engage
vol unt ar i l y in di r ect exchanges of i nf or mat i on. Exa mpl e s are t r ade associ at i ons,
car t el s and r es ear ch j oi nt vent ur es. Vi ves ( 1984) shows t hat i f goods are subst i -
t ut es and t her e is Ber t r and compet i t i on or i f goods ar e c ompl e me nt s and t here is
Cour not compet i t i on, i nf or mat i on shar i ng is opt i mal .
Ther e is al so a pr et t y ext ens i ve l i t er at ur e on t he f or mat i on of car t el s and
i nf or mat i on exchange. Al t hough many paper s have s hown t hat i nf or mat i on shar i ng
wi l l not be opt i mal in many si t uat i ons (e. g. , Rober t s, 1985; Cr amt on and Pal f r ey,
1990), Ki hl s t r om and Vi ves ( 1996) devel op a mode l in whi ch i nf or mat i on is
exchanged.
Res ear ch j oi nt vent ur es are anot her way to exchange i nf or mat i on. Kat z ( 1986)
has e xpl or e d t he i ncent i ves f i r ms have t o shar e t he cost s of and knowl edge cr eat ed
by r esear ch. Bha t t a c ha r ya et al. ( 1990) exami ne t he opt i mal l evel of i nf or mat i on
shar i ng and i t s i mpl ement at i on. Bhat t achar ya and Chi es a ( 1995) anal yze the
i mpact of t he conf i gur at i on of t he f i nanci ng sour ce on i nf or mat i on shar i ng
i ncent i ves.
I f di r ect vol unt ar y exchange of i nf or mat i on is not suf f i ci ent , ot her mechani s ms
may come i nt o pl ay. One such me c ha ni s m is pr ovi de d by t he mar ket for cor por at e
cont r ol . Ma nne ( 1965) has s ugges t ed t hat an i mpor t ant at t r i but e of mar ket - bas ed
e c onomi c s is t he f act t hat di f f er ent ma na ge me nt t eams can compet e for t he cont r ol
of asset s. As Al l e n ( 1992) obser ves, pr oxy fi ght s, di r ect shar e pur chases and
mer ger s r epr es ent t hr ee pr omi nent ma r ke t - ba s e d me c ha ni s ms f or t he t r ansf er of
cont r ol . Thes e t hr ee me c ha ni s ms can be i nt er pr et ed in t he cont ext of t he Al l en
( 1992) mode l de s c r i be d ear l i er .
Suppos e a r ai der has access to bet t er i nf or mat i on t han t he i ncumbent manage-
ment of t he fi rm, and is t her ef or e in a pos i t i on to i mpl e me nt bet t er deci si ons.
However , i t is l i kel y to be di f f i cul t to convi nce s har ehol der s t hat the r ai der wi l l
make bet t er de c i s i ons t han t he exi st i ng management . Thi s i mpl i es that, wi t h many
s har ehol der s and f r agment ed owner s hi p of the fi rm, pr oxy fi ght s are l i kel y to be
di f f i cul t for r ai der s to wi n, an obs er vat i on cons i s t ent wi t h the st yl i zed facts.
Cons equent l y, it ma y be neces s ar y for the r ai der to s i mpl y of f er t ar get shar ehol d-
ers a s uf f i ci ent l y hi gh pr e mi um over the cur r ent st ock pr i ce t o i nduce t hem to sel l
out. Thi s can be a c hi e ve d wi t h a t ender of f er to pur chas e shar es at a pr emi um. ~7
17 Of course, this will raise the usual free-rider problem highlighted by Grossman and Hart (1980).
However, as pointed out by Bagnoli and Lipman (1988), this problem can be avoided with nonatomistic
shareholders. Grossman and Hart (1980) suggested that "exclusionary devices' - such as permitting the
raider to exclude from sharing in the post-takeover gains those shareholders who do not tender their
shares to the raider - could eliminate the free-rider problem. Shleifer and Vishny (1986) propose that a
large minority shareholder could also help overcome the free-rider problem.
A V. Thakor / J o u r n a l ~?f Banking & Finance 20 (19961 917- 948 937
It is, of course, possible that when opinions are sufficiently diverse, the raider
will not be able to overcome the holdout problem raised by Grossman and Hart
(1980). Efficient information sharing may then be possible only with a (negoti-
ated) merger.
The point is that the design of the financial system can affect the efficiency
with which information relevant to corporate decisions is shared/aggregated. A
well-developed financial market facilitates the information aggregation process by
making corporate control contests easier. This is consistent with the stylized fact
that the U.S., with its relatively more complex real technologies, also has a better
developed financial market.
The observation that corporate control contests are facilitated by a greater
degree of development of the financial market has other implications as well. In
particular, Harris and Raviv (1991) have shown that a firms's capital structure may
depend on the tension between two control considerations. If the firm has too little
debt, then its incumbent management risks losing control to a raider who can
increase firm value simply through an elevation of the firm' s leverage. On the
other hand, if the firm has too much debt, then its incumbent management risks
losing control to the bondholders if bond covenants are violated. Thus, the optimal
capital structure balances the probability of losing control to a corporate raider
against the probability of losing control to bondholders.
An implication of this logic is that the expected control cost of equity is likely
to be higher in better developed financial markets because the threat of a hostile
takeover is greater. This means that we should expect a heavier reliance on debt in
such markets. The empirical prediction then is that leverage ratios of firms should
be higher in the U.S. than in, say, Germany.
An offsetting consideration is that economies in which banks are dominant are
also characterized by long-term bank-borrower relationships to a greater extent
than economies in which banks play a lesser role. These relationships can help
mitigate moral hazard and encourage greater use of debt. Boot and Thakor (1996)
develop an infinite-horizon model of banking in which tong-term contracts im-
prove efficiency by reducing reliance on collateral to resolve effort-avoidance
moral hazard. To the extent that such moral hazard reduces optimal leverage,
economies dominated by banks are also likely to have firms that borrow more
from banks and have hi gher leverage ratios.
What is missing, of course, is an integrated theory that accounts for all of these
effects. The Harris-Raviv model does not consider the value of banks or relation-
ships between borrowers and lenders. I think this is a particularly interesting open
research question that deserves attention.
5.2. Banks and corporate capital structure
The fact that banks can make loan commitments that involve discretionary
promises to lend in the future at predetermined terms has an important implication
938 A. V. Thakor / Journal o f Banki ng & Fi nance 20 (1996) 917- 948
for the capital structures of nonfinancial firms. Shockley (1995) has recently
shown in an interesting model that a firm that purchases a bank loan commi t ment
will acquire more nonbank debt than a firm that does not have a loan commi t -
ment. The intuition is that a loan commi t ment attenuates the underinvestment
moral hazard associated with risky debt (see Myers, 1977) and thus i mproves the
terms of nonbank debt.
Again, the implication is that bank financing is associated with higher leverage
ratios for those who borrow from banks. Moreover, the result that bank loan
commi t ment financing resol ves underi nvest ment moral hazard implies i mproved
decisions related to a particular financial syst em design.
6. Li qui di ty, bank liabilities and financial system desi gn
As mentioned in Section 2, an important QAT service provided by banks is that
of liquidity creation. In the process of creating liquidity, banks end up mi smat ch-
ing their balance sheets as they typically finance (illiquid) long-maturity assets
with (liquid) liabilities of varying but shorter maturities. Di amond (1991b) has
examined the liability maturity decision and shown that liquidation incentives and
control considerations play significant roles in this decision.
What is particularly interesting about liquidity creation by banks is that it
typically involves a demand deposit contract constrained by a sequential service
constraint (SSC). In the Di amond and Dybvi g (1983) model, the SSC plays a
pivotal role in generating bank runs. Thus, it forces the bank to cope with risk in
the process of creating liquidity. There are some who believe that the SSC is j ust
part of the technology of banking. For exampl e, in continuous time, serving
withdrawals sequentially until funds were exhausted would be a natural way of
doing business; the SSC in Di a mond- Dybvi g' s model can then be viewed merel y
as a way to approxi mat e this continuous-time phenomenon in discrete time.
However, there are others who believe that the SSC is a contract design paramet er
that must either be rationalized endogenously or be excluded from the demand
deposit contract. This is the approach taken by Calomiris and Kahn (1991), who
propose that the SSC solves a free-rider probl em in depositor monitoring. In their
model, uninsured depositors moni t or bank management to prevent activities like
fraud and excessive risk taking. Without the SSC, however, depositors have an
incentive to free-ride on the costly monitoring performed by others, and the
monitoring mechani sm consequently breaks down. The SSC prevents free-riding
because monitoring depositors precipitate a run on the bank when they detect
untoward behavior, and it is the monitoring depositors who are first in line to
withdraw. A free-riding deposi t or would get a lesser expected payof f upon
withdrawal due to his later position in the withdrawal queue.
In the Cal omi r i s- Kahn framework, bank runs are socially desirable. This
makes it difficult to j uxt apose this insight about the SSC with its role in the
A. V. Thakor / Journal of Banking & Finance 20 (1996) 917-948 939
Diamond-Dybvig model in which runs are productively disruptive. Moreover, it
makes it virtually impossible to visualize a meaningful role for deposit insurance.
These issues were resolved by Peters (1995). In his model, bank runs are often ex
p o s t i nef f i ci ent but ex ant e effective in disciplining bank management. The SSC
increases the marginal payoff to a depositor from becoming an informed monitor
and thus leads to a high probability of a bank run. However, this probability may
be higher than that needed to discipline management and thus leads to excessive
ex post inefficiencies. Peters shows that partial deposit insurance reduces the
marginal payoff to a depositor from becoming an informed monitor and thus
reduces the probability of a bank run. The level of deposit insurance coverage can
be calibrated to ensure that the probability of a bank run is no more than that
needed to align the incentives of bank management with those of depositors.
The connection of these liability management issues with banking scope and
financial system design was recently highlighted by Peters and Thakor (1995).
They craft a model in which depositors must be incented to monitor the asset
choices of bank managers and the bank' s managers must be incented to monitor
borrowers. Their key result is that it is impossible to provide bot h of these
incentives at their first-best levels in a single bank. They prescribe f u n c t i o n a l l y
s e par at i ng the bank into: (i) a pure liquidity-creation bank that has access to
insured deposits and is permitted to invest only in assets whose payoffs are
invariant to bank monitoring, and (ii) an uninsured bank that can invest in any
asset (a sort of universal bank).
A somewhat different functional separation prescription emerges from the
analysis of Craine (1995). Craine shows that various distortions can be diminished
by separately chartering banks that invest in 'private-information' assets - those
about which the bank has proprietary information - and those that invest in
public-information assets. In a separating equilibrium, the public-information
banks raise funds through insured deposits and the private-information banks raise
funds through uninsured liabilities.
These functional separation prescriptions are reminiscent of the ' narrow bank"
proposal originally made by Simons (1934, Simons (1935), but are different in
their underlying logic and details. In particular, these contemporary proposals
focus on the impact of informational frictions and organizational design issues.
Moreover, they do not necessarily prescribe a narrow bank that produces no net
liquidity; this prescription is at the heart of the original Simons proposal.
Policy discussions of the merits of these proposals often revolve around the
uniqueness of i ns ur ed banks in providing liquidity. If we limit the scope of
federal deposit insurance to a smallish slice of the banking industry a n d if deposit
insurance is critical to creating net liquidity - as it is in Diamond and Dybvig
(1983) - then narrow banking could be deleterious to liquidity creation. However,
it has been suggested that liquidity can be effectively created by means other than
deposit insurance. For example, cash flow partitioning creates liquidity outside the
banking sector in Boot and Thakor (1993a); see also Gorton and Pennacchi (1990).
940 A. V. Thakor / Journal of Banki ng & Fi nance 20 (1996) 917- 948
Indeed, the financial innovation analysis of Boot and Thakor (1995) suggests that
there may be mo r e liquidity created in financial-market-dominated economi es than
in bank-domi nat ed economi es due to the stronger incentives for financial innova-
tion in the former. On the other hand, the Allen and Gale (1994a) argument is that
the n a t u r e of financial instruments available for liquidity management differ
across the two types of economies. In particular, cross-sectional risk sharing is
likely to be better in market -domi nat ed economies, whereas intertemporal risk
sharing is likely to be better in bank-domi nat ed economies.
7. Scope of banking and financial innovation
In casual discussions about financial syst em design, one hears the argument that
it is likely to be influenced by regulatory restrictions on the scope of banking. For
exampl e, it is claimed that the 1933 Gl ass- St eagal l Act, that has separated
commerci al and investment banking in the U.S. for over six decades, has had a
maj or i mpact on the devel opment of banking and financial markets in the U.S.,
and provides a plausible explanation for the differences in financial systems across
different countries (see Saunders and Walter, 1994).
Numerous authors have recently exami ned whether the Gl ass-St eagal l restric-
tions make sense anymore (e.g., Rajan, 1993; Puri, 1994). Traditional arguments
against universal banking have focused on conflicts of interest arising from the
dual role of universal banks in commerci al lending and securities underwriting
(see Kanatas and Qi, 1993). These conflicts may be manifested in misrepresenta-
tion of the financial condition (or quality) of a borrower whose capital market
issue is being underwritten by the lender or a delay in taking a borrower to the
financial market because profits on lending exceed those on underwriting.
While it is accepted that banking regulation affects the devel opment of the
financial market, we do not understand very well all of the richness in the
interplay between bank regulation and the evolution of the financial system. For
exampl e, i f conflicts of interest between the commerci al and investment banking
parts of a universal bank are serious, why would the market itself not provide the
necessary signals to discipline the universal bank? In particular, if these conflicts
were sufficiently serious, it would be optimal for the universal bank to provide
c r e d i b l e separation between its commerci al and investment banking activities. Or
put a little differently, if a universal bank were really inefficient from a conflict-
of-interests standpoint, market forces would make it unnecessary to have regula-
tion to outlaw universal banking. Indeed, the empirical evidence provided by
Kroszner and Rajah (1994a) supports the market discipline argument and militates
against the notion that these conflicts are of significance. They compare the
performance of securities underwritten by commerci al and investment banks prior
to the Gl ass- St eagal l Act and find no significant difference in the qualities of
issues underwritten by commerci al and investment banks. In a subsequent paper,
A. IL Thakor / Journal t~f Banking & Fi nance 20 (1996) 917- 948 941
Kroszner and Rajan (1994b) find that the market performance of underwritten
securities in the 1920s was better when underwriting was done by a separately
capitalized securities affiliate than when it was done by a securities division of the
universal bank. Consistent with this, commerci al banks during this time almost
uniformly moved towards the affiliate structure, which involved greater separation
between lending and underwriting.
7.1. Fi nanci al innoL, at i on
In a series of papers, Allen and Gale have explored the economi c incentives
underlying financial innovation (see, e.g., Allen and Gale, 1994b). The basic
premise of these papers is that financial innovation i mproves the risk-sharing
opportunities available to investors. Since successful innovation often leads to the
emergence of new markets, this perspective is useful in understanding the develop-
ment of futures and options markets.
A somewhat different approach is taken by the earlier-mentioned Boot and
Thakor (1993a) paper. Boot and Thakor explain financial innovation in terms of
the incentives of investors to acquire costly information in an adverse-selection
economy. They show that innovation that produces more information-sensitive
partitions of existing securities stimulates greater information acquisition by
investors. This enhances the liquidity of the f i r m' s securities and leads to more
efficient market pricing.
Whether innovation leads to the emergence of new market s that expand
risk-sharing opportunities or i mproves liquidity in existing markets, it is likely to
have real consequences. Consider improved risk sharing first. It has been shown
that corporate hedging and other risk-reduction initiatives like conglomerate
mergers may i mprove investment decisions (see, e.g., Ramakri shnan and Thakor,
1991). An intuitive way to think about this is to visualize a principal-agent
framework in which managerial incentive contracts make the manager ' s payoff
sensitive to idiosyncratic risk to cope with effort-aversion moral hazard. In this
case, the greater the variance of the idiosyncratic risk, the lower will be welfare
(see Ramakrishnan and Thakor, 1984), so that hedging this risk can be welfare-im-
proving.
Consider next more efficient market pricing. As shown by Myers and Majluf
(1984), asymmet ri c information about firm valuation can result in the firm
eschewing posi t i ve-NPV projects. Thus, financial innovation that reduces the
impact of informational asymmet ri es can help diminish underinvestment distor-
tions.
An open research question that interests me is whether financial innovation
incentives are affected by financial system design. Are bank-dominated financial
systems more or less l i kel y to innovate than market-dominated systems'? Does the
permissible scope of banking influence how much financial innovation occurs?
This issue has recently been addressed by Boot and Thakor (1995). They show
942 A. V. Thakor / Journal of Banki ng & Fi nance 20 (1996) 917- 948
that a financial syst em with a concentrated universal banking industry exhibits
stochastically lower innovation than a functionally separated financial syst em in
which commerci al and i nvest ment banking are kept distinct by regulatory fiat.
This provides a perspect i ve on the greater rate of financial innovation in the U.S.
than in continental Europe.
8. Overall financial system design
I have discussed a wide variety of issues related to financial syst em design. The
ultimate goal, of course, is to j oi n the insights of these seemi ngl y disparate strands
of the literature to craft a unified theory of financial syst em design. This has not
happened yet. But two recent papers have taken modest initial steps.
Allen and Gal e (1994a) build a theory that seeks to explain the welfare
implications of two promi nent designs - the market -domi nat ed U.S. financial
syst em and the bank-domi nat ed German financial system. They argue that bank-
dominated syst ems provi de better intertemporal risk sharing than market -domi nat ed
systems. The reason is that banks are better equipped to make long-term commi t -
ments that are essential to attain desired intergenerational wealth transfers and risk
sharing. In the Al l en- Gal e framework, such commi t ment s are unavailable in the
financial market because they are unraveled by competition in a manner similar to
the competitive unraveling of the optimal (from a risk-sharing standpoint) pooling
contract in the Rothschild and Stiglitz (1976) insurance model.
On the other hand, market -domi nat ed systems provide better cross-sectional
risk sharing at any point in time than bank-domi nat ed systems. The reason is that
there are more instruments available to economi c agents for hedging their risk
exposure in the financial market than with banks.
There is thus no unambi guous answer to the question of which financial market
design is better from a welfare standpoint. Moreover, the Al l en- Gal e approach
suggests that the German financial syst em achieves a better allocation of risk
across generations, whereas the U.S. financial syst em achieves a superior intragen-
erational allocation of risk.
A different aspect of financial syst em design is explored by Boot and Thakor
(1996). They start with assumpt i ons about primitives - the types of agents in the
economy and their endowment s of wealth and information. They show that agents
who choose to specialize in monitoring borrowers to deter asset-substitution moral
hazard will prefer to coalesce and form banks. On the other hand, agents who
choose to acquire payoff-rel evant information about firms that is unavailable to the
managers of these firms will prefer to trade independently in the financial market.
In addition to rationalizing the emergence of banks and financial markets from
primitives, Boot and Thakor also show that borrowers with high observable credit
qualities will opt for financial market financing, and those with relatively low
observable credit qualities will opt for bank financing. Thus, they provide a theory
A. E Thakor / Journal t~f Banking & Finance 20 (1996~ 917-948 943
of the borrower' s choice of financing source that is predicated on observable
differences in credit attributes. An important feature of the Boot-Thakor analysis
is that both bank financing and capital market funding have real effects. The real
effect associated with bank financing comes from the fact that the bank is more
effective in enforcing a choice of the socially preferred project by the borrower.
The real effect associated with financial market funding arises from the ' feedback'
provided by the market to the firm' s manager that induces him to improve his
decisions with respect to investments in enhancing project payoffs. That is, the
manager does not possess all of the information he needs for optimal decisions; he
obtains some of this information by observing financial market trading, and this
leads to more efficient decisions.
The importance of industry structure in financial system design should also be
appreciated. The Boot and Thakor (1996) analysis shows that the demand for bank
credit is lower when the banking industry is concentrated than when it is
fragmented. The reason is that the price of bank credit is higher in concentrated
banking industries. Moreover, problems of relationship-specific informational
monopolies are also likely to be more acute in concentrated banking systems
(Rajah, 1992). On the other hand, Boot and Thakor (1995) show that the more
concentrated the unir' ersal banking industry, the lower will be the rate of financial
innovation, and hence the slower will be the pace at which the financial market
evolves. Thus, industry structure can profoundly influence how the financial
system configures itself.
As we consider overall fifiancial system design, can we say anything about the
relationship between the design of the financial system and its stability'? Recently,
Allen and Gale (1995) have suggested that bank-dominated economies in which
banks do not face considerable competition from financial markets have a greater
ability to smooth asset returns over time than market-dominated economies. They
present an example of an economy in which the incompleteness of financial
markets leads to underinvestment in reserves, and for a broad class of welfare
functions, the optimum requires the holding of large reserves in order to smooth
asset returns over time. They argue that a long-lived intermediary may be able to
implement the optimum. However, it would be premature to conclude from this
that bank-dominated financial systems are more stable. The Allen-Gale analysis
does not deal with a multibank financial system with the possibility of bank runs
and contagion-induced panics. The question of which system is more stable
remains open at this point.
9. Concl usi on
While there has been a great deal of work done in related areas, we have a lot
to learn when it comes to overall financial system design. I believe that this topic
represents perhaps the most exciting research possibility in the area of institutions
944 A. V. Thakor / Journal of Banki ng & Fi nance 20 (1996) 917- 948
and markets. What I suspect it will teach us is that we need to rethink the way we
visualize institutions and markets. We tend to view institutions and markets as
distinct and competitive. Yet, as Merton (1993) has pointed out, they also
compl ement each other since financial market innovations often open up new
business opportunities for banks in the risk management arena.
No discussion of the design of financial systems would be complete without a
discussion of the political envi ronment and the political economy of design. It is
apparent that the recent discussions of repealing the Gl ass-St eagal l Act in the U.S.
and adopting interstate branching have been greatly politicized. For example, the
securities and insurance industries have been opposed to Gl ass-St eagal l repeal,
whereas small banks have been opposed to interstate branching. Unfortunately,
there has been little analysis of these issues. Exceptions are papers by Boot and
Thakor (1993b), Campbell et al. (1992), and Kane (1989, Kane (1990).
The distinctions between institutions and markets will continue to become even
more blurred, and market forces will press on to make national regulators less
important and regulatory restrictions such as Gl ass-St eagal l obsolete. If research
on financial system design yields a good harvest, we may have something to say
about how financial systems will evolve in the future and what the welfare
implications of this evolution are likely to be.
Acknowledgements
Prepared initially for a keynote address at the 7th Annual Australian Fi nance
and Banki ng Conference.
I thank an anonymous referee, David Hirshleifer and Patty Wilson for helpful
comment s and Kathleen Petrie for research assistance. Only I am responsible for
any infelicities, however.
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