The efficiency of financial systems is of central importance to many of the current policy debates regarding the stru cturing of financial systems. This is particularly interesting in the context of the emerging market-based economies in Eastern Europe. The financial systems currently in place in these countries are perhaps best viewed as interim arrangements designed to facilitate transition to systems with less emphasis on the central planning of capital allocation. The financial sectors in West ern Europe and the US face equal challenges : h ow will they evolve , and w ill any one system dominate?

In D iscussion P aper No . 1197, Research Fellow Arnoud Boot and Anjan Thakor begin with basic assumptions about the types of primitive agents and the nature of informational asymmetries in the economy, and then provide a theory that explains which agents coalesce to form banks and which agents trade in the capital market. Their theory incorporates a model of financial market equilibrium with sufficient richness to enable market prices to convey decision-relevant information to firms , and makes it possible to extract broader implications regarding the configuration of financial systems. The borrower's choice between bank and financial market funding is examined in this framework, and it is shown that borrowers of higher observable qualities access the financial market directly . Further more , a financial system in its infancy is likely to be bank dominated, and financial innovation causes a decline in the relative importance of banks in lending.

Financial System Architecture
Arnoud W Boot and Anjan V Thakor

Discussion Paper No. 1197, August 1995 (FE)