State-owned financial institutions have been proposed as a way to address market failure, though the literature has also highlighted their pathological problems. This paper examines pitfalls of a statedominated financial system in the case of China, including possible segmentation of the internal capital market due to local government interference and mis-allocation of capital. Even without formal legal prohibition to capital movement across regions, we find that capital mobility within China is low. Furthermore, to the extent some capital moves around the country, the government (as opposed to the private sector) tends to reallocate capital systematically away from more productive regions towards less productive ones. In this context, a smaller role of the government in the financial sector might increase economic efficiency and the rate of economic growth.