Financial Markets, Banks and
Politicians
Fenghua Song
Smeal College of Business, Penn State University
Anjan V. Thakor
Olin Business School, Washington University in St. Louis,
and ECGI
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MOTIVATION
 Considerable recent interest in financial system architecture:
how do banks and markets evolve together as part of a financial
system?
 Numerous papers have been devoted to understanding this
issue theoretically:
 Allen and Gale (1997), Boot and Thakor (1997)
and empirically:
 Beck and Levine (2002), Demirguc-Kunt and Levine (2001),
Levine (2002)
 More recently, Song and Thakor (2010) have shown that banks
and financial markets exhibit three forms of interaction:
 they compete
 they complement
 they co-evolve
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MOTIVATION (cont’d)
 These theoretical and empirical contributions have really
advanced our understanding of how financial systems evolve
and how this evolution affects the allocation of credit.
 However, numerous unresolved issues…
(1) Bank Size
 Large banks have TBTF protection
 This distorts risk choices and may induce correlated asset
choices (e.g., Acharya and Yorulmazer (2007))
What determines bank size and how does privately-optimal
bank size change as the financial system evolves?
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MOTIVATION (cont’d)
(2) Political Intervention
 Expanded credit availability generates political benefits
 Tempts politicians to intervene in banks
 In emerging markets, cozy ties between bankers and
politicians as well as state ownership of banks allow for a
great deal of political influence in credit markets (e.g., Brown
and Dinc (2005), Dinc (2005), and La Porta, Lopez-de-Silanes
and Shleifer (2002))
 Recent financial crisis has shown that even advanced
economies like U.S. are not immune to political influence
(e.g., Calomiris and Wallison (2009))
These developments raise a host of very interesting questions…
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QUESTIONS
 What is the (privately optimal) architecture of the financial
system (relative roles of banks and markets) and how does
it evolve?
 Given the economics of how financial systems evolve, what
is the optimal banking industry structure in terms of bank
size and the number of banks?
 What is the nature of political intervention in the financial
system and what are its effects? Is the intervention stagedependent?
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PURPOSE OF THE PAPER
To theoretically address these questions and generate a
theory of financial system evolution with endogenouslydetermined political intervention at different stages of
evolution.
KEY RESULTS
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Using the cost of becoming an informed trader in the
capital market to index the stage of development of the
financial system (higher cost in the earlier stages of
development), we show:
1. Riskiest borrowers excluded from financial system.
Intermediate-risk borrowers funded by banks. Highestquality (lowest-risk) borrowers financed by the capital
market.
KEY RESULTS (cont’d)
2. Early stage of development:
 Small financial market
 A few banks
 Political intervention takes form of government ownership of
banks in exchange for subsidized equity infusion
 Larger banks than without political intervention
3. Intermediate stage:
 Financial market larger
 Optimal configuration is to have a larger number of banks,
and banks are larger than in the earlier stage (without
government intervention)
 No government intervention
 Measure of borrowers receiving credit from either a bank or
the financial market expands relative to the initial stage
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KEY RESULTS (cont’d)
4. Advanced stage:
 Cost of borrowing in financial market is lowest
 Bank profits are the highest
 Financial market is the largest
 Optimal configuration is to have more and larger banks
 Political intervention reappears, but this time with direct-
lending laws that require (some) banks to lend to the riskiest
borrowers who would otherwise not be served.
All forms of government intervention increase systemic risk
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SKETCH OF MODEL
Borrowers and Investment Opportunities
Invest $1 for project development
Project arrives
Project does
not arrive
Symmetric info about q.
Let q denote " borrower quality"
h is density of q on [0, 1]
Borrower has opportunit y to enhance project payoff
at cost Z  0 (unobserva ble to others) if macro condition
is favorable, i.e., v  1. No such opportunit y if v  0.
Realized value of v can only be observed by traders
who become informed at a cost
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 Borrowers are atomistic
For each q, there are Nˆ  0 borrowers,
1
 Nˆ h(q)dq  Nˆ
0
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Financing Sources
 At t=0, borrower can:
 borrow directly from capital market
 take bank loan
Direct Capital Market Financing
 Traders
 Liquidity traders: exogenous and random aggregate demand
 Discretionary agents:
 At a private cost, can become informed about macro condition by
generating a private signal that perfectly reveals v at t=1
(borrowers do not observe v directly)
 Informed traders demand debt only when signal indicates v=1
 Each trader atomistic
 Measure of informed traders is Ω
 All demand orders submitted to a market maker who
observes only total demand, D, but cannot distinguish
between informed demand and noise trades
 Market maker sets debt price (interest rate on debt) to clear
the market, conditional on information contained in D
Bank Loan
 Bank screens borrower and then decides whether to fund
loan
 Bank raises its own financing from debt and equity
 Capital requirement C for lending $1 to borrower with quality
q. Bank thus raises equity capital of C and borrows 1-C from
deposits
 Full deposit insurance
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 Bank Capital:
 Bank raises equity in capital market. Shareholders promised
bank’s loan repayment L minus payment D to depositors
 Same market maker setup as before
 Fraction α of equity ownership surrendered to outside
shareholders
 Bank Screening:
 Occurred at t=0. Only bank privately observes results of
screening
 Private signal s  {s g , sb }
Pr( s  s g | project developmen t succeeds ) 
Pr( s  sb | project developmen fails )  p  (1 / 2, 1]
 Posteriors on borrower quality
Pr( project developmen t succeeds | s  s g )  q g  (q,1]
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Pr( project developmen t succeeds | s  sb )  q b  [0, q)
 Banking Sector Competition:
 Bank screens borrower. If borrower gets competing offer,
then Bertrand competition and zero profit for bank.
Otherwise, loan repayment L set to extract all borrower
surplus
Pr( borrower w ill receive a competing offer )   ( M )  [0,1]
with  '  0, where there are M banks
 Bank entry:
 Entry cost for banks is E>0
 After entry, each bank takes as given: competition structure
of banking, measure of informed traders, borrower’s
financing choices, and then chooses its size to maximize
expected payoff from lending
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Off-Balance Sheet Investments
 Loan commitments as “illusory promises” as in Boot,
Greenbaum and Thakor (1993), and Thakor (2005)
 Investors only wish to deal with good banks that will honor
commitment contracts
Bottom Line:
 Banks has potential reputational benefit from honoring
commitment, but benefit can be realized only if act of
honoring or not honoring is widely observable
Pr(observable )   , where  increases as financial
sytem becomes more developed
 More reputable banks earn higher profits from off-balance
sheet activities
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Politicians:
 Enjoy private benefits from credit market intervention
 Private benefits are increasing in the number of
borrowers receiving credit from financial system
 Strategies:
 Provide direct capital subsidies to banks in exchange
for ownership
 Direct-lending regulations
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SEQUENCE OF EVENTS
Date 0:
 Politicians decide whether to intervene, and in what form
 Regulatory bank capital requirement is set
 Banks make their entry decision, and decision on building
reputation to sell off-balance sheet commitments. The number
of banks in the banking sector is determined
 Each entering bank chooses its size
 If a borrower chooses bank loan, it approaches banking sector
and is matched with an incumbent bank
 Incumbent bank screening
 Borrower may or may not find a competing offer, depending on
the competition structure of the banking sector
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Date 1:
 Discretionary agents decide whether to become informed
 Measure of informed traders is determined
 Market maker observes the total demand, and sets the
price for the debt (with direct market financing) and bank
equity (with bank borrowing)
 Borrower infers the macro condition from the prices and
decides whether invest in payoff enhancement,
conditional on project being available
Date 2:
 Project payoffs are realized and distributed
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KEY RESULTS
Lemma 1: A borrower’s expected payoff from direct capital
market financing is increasing in its prior credit quality and the
measure of informed traders in the market
Borrower’s and Bank’s Expected Payoffs from a Bank Loan
Lemma 2: In the case with a monopoly bank, a borrower’s
expected payoff from bank borrowing is zero. A bank’s expected
payoff from lending to a single borrower is increasing in the
borrower’s prior credit quality and the measure of informed
traders in the market
Lemma 3: In the case with a competing bank, the bank’s net
expected payoff is zero. The borrower’s expected payoff from
bank borrowing is increasing in its prior credit quality and the
measure of informed traders in the market
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KEY RESULTS (cont’d)
Proposition 1: Borrower’s Choice of Funding Source
Given the number of banks in the banking sector ( M ) and each bank' s optimal
choice of size (n*), a borrower chooses its funding source as follows :
(1) There exists a high quality cutoff, qh , such that a borrower w ith q  [qh ,1]
borrows directly from the capital market and the ones with qh  1 approach
the banking sector.
(2) For the latter group of borrowers, there exists a low quality cutoff, ql  qh , such
that only borrowers with q  [ql , qh ) are funded by the banking sector.
qh
(3) The cutoff ql is determined by bank size, i.e.,  [ Nˆ / M ]h(q )dq  n * .
ql
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KEY RESULTS (cont’d)
Corollary 1:
Holding bank size (n*) fixed, bank financing becomes more attractive relative to market
financing with a more competitiv e banking sector, i.e., qh / M  0. When the measure of
informed traders increases, the scope of market financing becomes wider, i.e., qh /   0.
Corollary 2:
If at the early stage of financial system developmen t, the financial market is characteri zed
by low  due to higher informatio n acquisitio n cost, then, holding bank size (n*) fixed, we
have :
(1) a small capital market, i.e., the measure of borrowers choosing direct market capital
1
market financing,
 Nˆ h(q)dq, is small;
qh
(2) a small measure of borrowers funded by the financial system (via banks and markets),
1
given by N  n * M   Nˆ h(q)dq.
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qh
KEY RESULTS (cont’d)
Proposition 2: Bank Size
There exists a privately optimal bank size, n*, and bank lending cutoffs, ql (n*) and qh (n*),
that are jointly determined by the following system of equations :
 qh ( n*)

ˆ

[1   ( M )]w(ql (n*), C )   '  [ N / M ]h(q)dq 
 q ( n*)

 l

n* 
qh ( n*)
 [ Nˆ / M ]h(q)dq
ql ( n*)
 loan |q q
h ( n *)
  mkt |q  qh ( n*)
When the measure of informed trading in the capital market, , increases, the bank' s lower
lending cutoff, ql , decreases, and its size, n*, increases.
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KEY RESULTS (cont’d)
Lemma 4:
The equilibriu m number of banks in the financial system is increasing in the measure
of informed traders in the capital market, i.e., M /   0, and non - decreasing in the
informatio n transpar ency of the economy, i.e., M /   0.
Proposition 2: Early Stage
At an early stage of financial system developmen t, when informatio n acquisitio n and
processing in the capital market are sufficinet ly costly so informed trading () is
sufficient ly low, and informatio n about reputation building is sufficient ly low in
transparen cy (low  ), providing subsidized equity to banks represents an optimal
interventi on strategy for politician s. There is a relatively small number of large
banks in the financial system.
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KEY RESULTS (cont’d)
Proposition 3: Intermediate Stage
There are parametric conditions under whic h, in the intermedia te stage of financial
system developmen t, there are more banks and each is bigger tha n in the early stage
if equity subsidy we re absent in the early stage. Moreover, politician s avoid intervenin g
with either government ownership in exchange for subsidized capital or direct - lending
regulation s.
Proposition 4: Advanced Stage
At an advanced stage of financial system developmen t, there exist parametric conditions
under whic h the optimal strategy of interventi on for politician s is to enact direct - lending
regulation s that require banks to lend to borrowers with lower qualities than they would
absent the se regulation s. Moreover, ther eare larger banks and more of them in the financial
system than in the earlier stages of financial developmen t.
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CONCLUSION
Three key results
1. Distinct hierarchy of financing sources
Riskiest
Excludes
Intermediate risk
Bank financing
Least risky
Financial Market
As financial system evolves, banks get larger, financial
market gets larger, lending scope of entire financial
system expands, and increasingly risky borrowers get
credit
3. Government intervention
2.



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Earliest stage: government ownership with equity subsidies
Intermediate stage: no intervention
Advanced stage: direct-lending regulations