Financial system architecture

This article builds a theory of financial system architecture. We ask: what is a financial market, what is a bank, and what determines the economic role of each? Starting with basic assumptions about primitives-the types of agents and the nature of informational asymmetries-we provide a theory that explains which agents coalesce to form banks and which trade in the capital market. It is shown that borrowers of higher observable qualities access the financial market. Moreover a financial system in its infancy will be bank-dominated and increased financial market sophistication diminishes bank lending.