1. Fenghua Song Smeal College of Business, Penn State University Anjan V. Thakor Olin Business School, Washington University in St. Louis, and ECGI Financial Markets, Banks and Politicians 1

2. 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 2

3. 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? 3

4. 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… 4

5. 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 stage- dependent? 5

6. PURPOSE OF THE PAPER To theoretically address these questions and generate a theory of financial system evolution with endogenously- determined political intervention at different stages of evolution. KEY RESULTS 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. Highest- quality (lowest-risk) borrowers financed by the capital market. 6

7. 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 7

8. 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 8

9. SKETCH OF MODEL Borrowers and Investment Opportunities 9 Invest $1 for project development Project arrives Project does not arrive

10.  Borrowers are atomistic 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 10

11.  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 11

12.  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 Posteriors on borrower quality 12

13.  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  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 13

14. 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  More reputable banks earn higher profits from off-balance sheet activities 14

15. 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 15

16. SEQUENCE OF EVENTS 16 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

17. 17 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

18. KEY RESULTS 18 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

19. KEY RESULTS (cont’d) 19 Proposition 1: Borrower’s Choice of Funding Source

20. KEY RESULTS (cont’d) 20 Corollary 1: Corollary 2:

21. KEY RESULTS (cont’d) 21 Proposition 2: Bank Size

22. KEY RESULTS (cont’d) 22 Lemma 4: Proposition 2: Early Stage

23. KEY RESULTS (cont’d) 23 Proposition 3: Intermediate Stage Proposition 4: Advanced Stage

24. CONCLUSION 24 Three key results 1. Distinct hierarchy of financing sources 2. 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 Earliest stage: government ownership with equity subsidies Intermediate stage: no intervention Advanced stage: direct-lending regulations Riskiest Excludes Intermediate risk Bank financing Least risky Financial Market