The Beneficial Coexistence of Banks and Markets: The Role of Capital Requirements and Underwriting

Abstract

We propose a model of financial system architecture that highlights the positive interaction between banks and markets in a setting where each agent believes that she can evaluate information better than any other agent. Banks emerge endogenously and their interaction with markets is facilitated by the use of underwriting and regulatory capital requirements. Bank Capital reassures market investors that the underwriting contract will be fulfilled. The profits they make on underwriting enable banks to fund more projects in the future. Thus, a complementarity loop is achieved which results in the financing of positive NPV projects that were previously denied credit.

Keywords: Bank Capital Requirements, Co-evolution of Banks and Markets, Diversity of Opinion

JEL Classification: G21, G22