Summary for the Global Banking course at Tilburg University of Part 1 (F. Castiglionesi) and Part 2 (P. Danisewicz). Contains all the theory of synchronic and asynchronous lectures.
L1 Financial Intermediaries: rationale and risks ..................................................................................... 2
L2 Financial Intermediaries as Delegated Monitors ................................................................................ 3
L3 Financial Intermediaries as Liquidity Creators ................................................................................... 5
L4 Liquidity Risk Management ............................................................................................................... 6
L5 Regulation: Deposit insurance and other guarantees ........................................................................ 7
L6 Regulation: Capital Adequacy ........................................................................................................... 8
L7 Geographic Diversification............................................................................................................... 10
Guest lecture ........................................................................................................................................ 11
L9 Capital Regulation and Credit Supply .............................................................................................. 13
L10 – Monetary Policy and Interest Rate Risk Management ................................................................ 14
L11 Credit Management ....................................................................................................................... 17
L12 Impact of Global Banks ................................................................................................................. 18
L13 Climate Change and Financial Institutions .................................................................................... 19
L14 Fintech........................................................................................................................................... 20
L15 FinTech Credit Markets ................................................................................................................. 22
1
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L1 Financial Intermediaries: rationale and risks
• With complete markets, complete and symmetric information and so on, there is no need of FI to
match investors with savers. However, the real world is far from perfect, and frictions are present.
These frictions are also known as agency costs: information is not complete. Therefore, savers would
prefer not to lend and there are higher information costs
• Problems in a world without Financial Intermediaries:
1. Adverse selection
- Prior to purchase a firm’s debt or equity, investors may not know the quality of the firm
- The poorest (adverse) quality firms have the greatest incentive to issue securities. Good firms
find inconvenient to issue securities because they have to be sold at a discount.
2. Moral Hazard
- After purchasing a firm’s securities, investors need to monitor the firm’s managers.
- Once managers have control of other people’s money, they may have the incentive to spend it
on excessively risky projects or perquisite consumption.
3. Maturity and Liquidity
- Firm’s debt or equity may have characteristics that may not be attractive to investors/savers
➔ So, without FI:
o Lower level of fund available (investor would prefer not to lend)
o Higher information costs (economies of scale reduce cost of screening and
monitoring)
o Less liquidity in the economy
o Higher price risk for investors
• Major functions of FIs:
1. Broker; intermediate between firms and household.
- Provides information about quality of security issued
- Reduces cost of screening through economies of scale
➔ Efficient way to produce information and reduce adverse selection
2. Asset Transformer; transforms primary securities (loan, bonds, stocks) issued by firms into
secondary securities (bank deposits)
- Give cash to the corporation and get long term stocks and bonds and get cash from the
households and issue short term deposits
- Solves 2 problems:
1. Act as a delegated monitor to efficiently produce information and therefore reduce moral
hazard and the average monitoring cost is lower,
2. Provide maturity intermediation, the maturities of its assets differ from the maturities of its
liabilities.
- Other services of FIs: Transmission of monetary policy, Credit allocation, Payment services
• Special regulatory attention is needed because when a bank fails this has negative externalities on the
rest of the economy. It has a contiguous effect on the rest of the economy (affect households and
firms), and they are too-big-to-fail (can cause other banks to fail -> systematic risk)
- Benefits of regulation:
o Access to the discount window and deposit insurance
o Access to TARP funds to boost capital
o Too-big-to-fail protection
• Regulation must impose private costs:
- No more than 10% of equity to single borrower
- On site examination can be long and costly
- Capital requirement
- Banks can be forced to invest in the communities which they take deposits
• Different types of risk the banks face:
1. Interest rate risk; mismatch in maturities between assets and liabilities. When everybody wants
to withdraw their cash
- Refinancing risk: asset have longer maturities than liabilities
- Reinvesting risk: assets have shorter maturities than liabilities
- Main issue: matching maturities is inconsistent with the asset transformation function
2. Credit risk: promised cash flows on financial claims hold by FI are not paid
- Can be firm or household specific but can also be systematic.
- How to deal with it?
2
, o Screening before (less adverse selection)
o Monitoring after (reduce moral hazard)
o Diversification (reduce firm-specific)
o Pricing higher credit risk with higher interest rates
3. Off-balance-sheet risk; Off-balance sheet activities do not appear in the balance sheet instead
involve the creation of contingent A and L => affect the future balance sheets (standby letters of
credit, loan commitments, derivative positions).
4. Liquidity risk; Risk of being forced to sell assets within a very short period of time to meet
sudden increase in withdrawals. This may generate a run which may turn the liquidity risk into
insolvency risk. Also, risk of contagion panics/systemic effects, as the fall of one bank may
cause the confidence in other to drop as well.
5. Insolvency Risk; Risk of insufficient capital to offset sudden decline in assets relative to
liabilities. Inability to meet debt obligations.
6. Market risk; Risk of losses from actively trading assets and derivatives, present when a FI
takes an open (unhedged) long or short position in securities and prices change opposite of
expectation
7. Fintech Risk; Risk of technology enabled innovations in financial services that result in new
business models with material effect on the provision of financial services
• Can be types of risk for every type of firms, not interesting for this course:
8. Foreign exchange
9. Sovereign
10. Technology and operational risk
L2 Financial Intermediaries as Delegated Monitors
Financial Intermediation as Delegated Monitoring: A simple example Douglas W. Diamond, 1996
• Why do investors lend to banks who then lend to borrowers, instead of lending directly?
• Delegated monitoring focuses only on asset services (service bank offers to borrowers). Borrowers’
loans are the bank’s assets. Model shows that reduced monitoring costs are a source of competitive
advantage of the bank.
• Overview:
- K= individual costs of monitoring
- M= number of lenders per borrower
- m*K= total cost of monitoring -> when monitoring is delegated the costs are lower
- D= delegation cost -> imposed as depositors can’t verify the monitoring of the bank
- S= savings from monitoring
- Delegated monitoring is optimal if and only if: K + D < min [mK, S]
• In case there is no delegated monitoring -> monitoring is expensive.
- So, without monitoring investors aZ, where a<1 and Z is the reported realization of the project,
while V is the actual realization.
- The borrower’s payoff is V-aZ -> the borrower has an incentive to report the lowest possible Z
as the investors cannot observe Z because they do not monitor.
- Therefore, aZ will turn out lower than the investment made by investors and an equity
contract cannot be optimal.
➔ Investors must induce the borrower to tell the true outcome Z=V. They can do so by imposing
a penalty for low realizations, for example by liquidation of borrower’s assets. In case of
liquidation, there are no proceeds for both borrower and investor.
• Liquidation: investor liquidates borrower’s assets for all payments, V, lower than threshold f. The
optimal contract without monitoring is then a debt contract with face value f.
- Payment = f
o Payment > f avoids liquidation
o Payment < f induces liquidation
- Computing f: f=required return / probability of realization (liquidation avoided)
• When investors do not observe borrower’s cash flows and they do not monitor then:
1. Equity contracts do not work
2. Debt contracts is best (induces borrower to repay to avoid liquidation)
3. The cost of unmonitored debt f-1
• Monitoring leads us to observe the true V. The benefit of monitoring is the expected savings in
liquidation costs.
- S = probability of realization when liquidation is induced * realization value when liquidation is
induced
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