Financial system design is likely to have many important effects on credit allocation and economic development. The ramifications of this for the structuring of financial systems in ex-communist economies are transparent. Three streams of academic research are particularly relevant. First, there is research on financial innovation and security design: this literature seeks to explain what motivates innovation and how securities are designed, priced and marketed. A second literature is concerned with the policy question of banking scope, whether the banking system should contain functionally separated commercial and investment banks or universal banks. The focus here has largely been on potential conflicts of interest associated with universal banking. Lastly, attention has focused on the broader issue of financial system design: this literature has sought to address the manner in which financial system design impinges on individual risk-sharing opportunities, the allocation and cost of capital for corporations, corporate governance, and the restructuring of firms in financial distress.

In Discussion Paper No. 1237, Research Fellow Arnoud Boot and Anjan Thakor explore how the structure of a country's financial sector affects incentives for financial innovation. They examine the impact of banking scope – the choice between universal and functionally separated banking – on the incentives of institutions to engage in financial innovation. The analysis also sheds light on a host of related system design issues, such as the desirability of concentration in banking, potential `path dependence' in the evolution of a financial system, and the desirable starting point of a new financial system. The analysis focuses on the impact of two key aspects of financial system design on financial innovation: the degree to which the banking system is functionally separated (or universal) and the degree of fragmentation in the banking system. Both are important in driving the results, the main one of which is that financial innovation in a universal banking system is stochastically lower than innovation in a financial system in which commercial and investment banks are separated. This result is accompanied by a host of policy implications regarding the effects of fragmentation and the evolution of financial systems.

Banking Scope, Financial Innovation, and the Evolution of the Financial System
Arnoud W Boot and Anjan V Thakor

Discussion Paper No. 1237, September 1995 (FE)