The main purpose of this paper is to build an equilibrium model of the capital market, comprising a banking sector as well as a primary securities market, which is consistent with the main stylized facts that are known about stock and credit markets.
The observations we are primarily interested in are the following: All developed market economies have a capital market composed of both intermediated finance and direct finance. The relative size of direct and intermediated finance varies considerably across countries as well as over time. The size of the banking sector also seems to vary with the business cycle. In addition, the composition of bank finance and direct finance varies considerably across firms. Outside equity and bond financing is found predominantly in mature and relatively safe firms, while bank finance (or other forms of intermediated finance) is the only source of funding for start-up firms and risky ventures.
The model we build is consistent with these stylized facts as well as a number of empirical regularities uncovered or corroborated by recent research. Namely that, young riskier firms rely more on bank loans than on financial markets (see Petersen and Rajan (1994) and (1995)); bank loan renegotiation tends to be easier than bond restructurings (see Lummer and McConnel (1989) and Gilson and Lang (1990)); at the beginning of a downturn firms tend to switch from bank lending to commercial paper (see Kashyap, Stein and Wilcox (1993)).
Besides suggesting a plausible and unified explanation for all these observations, the main motivation for building such a model is to improve our understanding of the effects of financial regulation on the structure of the financial system and the effects of monetary policy on the real sector.
Our paper is by no means the first attempt at building such a framework. Recently, there has been renewed interest in the questions of what determines the structure of the capital market and how the financial and the real sector in the economy interact. Our paper adds to a small recent theoretical literature concerned with the coexistence of bank lending and bond financing (most notably, Besanko and Kanatas (1993), Hoshi, Kashyap and Scharfstein (1993), Holmstrom and Tirole (1994) and Repullo and Suarez (1994)). Our main contribution to this literature is to introduce outside equity financing by both firms and banks alongside bank loans and bonds and thus bring our model closer to reality. Although our model is still too stylized to adequately capture the main interactions between financial and real sectors we believe that the introduction of outside equity financing is a significant step forward.
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A Dilution Cost Approach to Financial Intermediation and Securities Marnets
