Financial system architecture

This article builds a theory of financial system architecture.We ask: what is a financial market, what is a bank, and whatdetermines the economic role of each? Starting with basic assumptionsabout primitives-the types of agents and the nature of informationalasymmetries-we provide a theory that explains which agents coalesceto form banks and which trade in the capital market. It is shownthat borrowers of higher observable qualities access the financialmarket. Moreover, a financial system in its infancy will bebank-dominated, and increased financial market sophisticationdiminishes bank lending.