EFI: Part B

Dr. Afrasiab Mirza

Email: a.mirza@bham.ac.uk
About the Course
To understand why banks are important
and how they operate.
To apply economic models in uderstanding
banking behaviour
Tounderstand the risks faced by banks and
how they attempt to manage those risks
To understand banking failures and financial
crises
Topics covered
Banks and what they do
The Role of Financial Intermediaries
The IO Approach to Banking
Managing Risks in the Banking Firm
Bank Runs and Systemic Risk
 Assessment
➢Assignment

➢Final Exam (Part B)

Textbooks

Frexias
X. and Rochet J-C., (2006) Microeconomics of
Banking. Second Edition.

Matthews K. and Thompson J., (2008) Economics of

Banking. Second Edition, Chichester;Wiley.
What is a Bank?
An institution whose current operations consist in
granting loans and receiving deposits from the
public.
◦This is the definition regulators use when deciding
whether a financial intermediary has to submit to banking
regulation

◦The word “current” is important because most industrial

or commercials firms sometimes lend money to their
customers or borrow from their suppliers
 The fact that both loans are offered AND deposits are
taken is key: this combination is what is typical of
commercial banks.

 Finally, the term “public” emphasizes that banks provide

unique services (liquidity and means of payment) to the
general public.

 However the public is not able to assess the safety and

soundness of financial institutions.

Moreover, the payment system is a public good provided

by private firms.

These two reasons (protection of depositors and safety

of the payments system) have been the primary reasons
for government regulation of banks.
What do banks do ?
Banks play a crucial role in the allocation of capital /
savings in the economy

“A well developed and smoothly functioning financial

system facilitates the efficient life-cycle allocation of
household consumption and the efficient allocation of
physical capital to its most productive use in the business
sector” Merton (1993)

The key thing here is that banks decide who gets the
loans. Hopefully, the best companies (that are the most
productive) will get the loans and not the worst.
Banking Operations
Contemporary banking theory classifies banking functions
into four main categories:

Offering liquidity and payment services

Transforming assets

Managing risks

Processing information and monitoring borrowers

Liquidity and Payment Services
Money has changed from commodity money (e.g. in the
form of gold, silver) to fiat money where the money itself
has no value but it’s value is backed by some institution like
the central bank

Historically, banks have helped manage fiat money by:

– Allowing people to exchange between different

currencies

– By allowing people to pay using money (payments)

Transforming Assets
There are three types of asset transformations:

1.Convenience of denomination: bank chooses the unit size

(denomination) of its products (deposits and loans) for the
convenience of its clients

2.Quality Transformation: thisoccurs when bank deposits

offer better risk-return characteristics than direct
investments

3.Maturity Transformation: occurs when bank transforms

securities with short maturities (preferred by depositors)
into securities with long maturities (preferred by investors)
Managing Risks
There are usually three sources of risk affecting banks:

1.CreditRisk: arises through loan-making or lending activity

and refers to the possibility that the money lent by the
bank may not be paid back

2.InterestRate and Liquidity Risk: when transforming

securities the bank takes a risk because it borrows using
short-term interest rates but lends via long-term rates

3.Off-Balance-Sheet Operations: many bank products do

not correspond to genuine accounting liabilities (for
example swaps, hedging contracts, underwriting securities)
and so do not appear on bank balance sheets but often
these imply many risks
Monitoring and Information
Processing
Banks play a special role in the financial system by
screening and monitoring borrowers (often banks develop
long term relationships with borrowers)

This is one of the key difference between borrowing from

banks versus borrowing by issuing securities in financial
markets

However, bond prices typically reflect information about

the borrower whereas the value of bank loans is private
information of the bank so we say banks loans are
“opaque”
The Role of Banks in Resource
Allocation
Banks exert a considerable influence on capital allocation,
risk sharing and economic growth

Often bank lending is a key source of financing for

entrepreneurs to start new companies

Underdeveloped countries typically have less developed

financial sectors and thus have less investment and growth
(although this is not always true)

Ingeneral, banks are good at dealing with aggregate risks

but not at financing new technologies relative to markets
Banking in the Arrow-Debreu
Model
Banking cannot exist within standard economic theory
(Arrow-Debreu framework) because markets can do
everything banks can do

Typicallywe need to introduce informational frictions to

allow banks to have a meaningful role in economic theory

Toillustrate this point we will look at a simple economic

model of banking
Simple Model of Banking
Consider a model with two dates (t=1,2) with a unique
physical good, initially owned by the consumers and taken
as a numeraire

Some of the good will be consumed at date 1, the rest

being invested by the firms to produce consumption at
date 2

All agents behave competitively (take prices as given)

There are three principle actors: consumers, firms, and

banks
The Relationships
The Consumer
Chooses consumption profile (C1, C2) via allocation of savings S
between bank deposits Dh and securities (bonds) Bh. Has initial
endowment w1. The consumer’s objective to maximize utility subject
to budget constraints:

◦Max u(C1, C2)

 C1 + Bh + Dh = w1

 pC2 = Profitf + Profitb + (1+r) Bh + (1+rD)Dh

where p is the price of C2, and Profitf and Profitb represent the
profits of the firm and of the bank, and r and rD are the interest
rates paid by bonds and deposits
The Firm
The firm chooses its investment level I and its financing (through bank
loans Lf and issuance of securities Bf) in a way that maximizes its profit:

◦Max Profitf

 Profitf = pf(I) – (1+r)Bf – (1+rL) Lf

where I = Bf + Lf and f denotes the production of the representative

firm and rL is the interest rate on bank loans.
The Bank
The bank chooses its supply of loans Lb, its demand for deposits Db,
and its issuance of bonds Bb in a way that maximizes its profits:

◦Max Profitb = rL Lb – r Bb – rD Db

 Lb = Bb + Db
General Equilibrium
General equilibrium is characterized by a vector of interest rates (r,
rL, rD) and three vectors of demand and supply levels – (C1, C2, Bh,
Dh) for the consumer, (I, bf, Lf) for the firm, and (Lb, Bb, Db) for the
bank such that:

◦Eachagent behaves optimally (his or her decisions solve Ph, Pf, or Pb

respectively

◦Each market clears:

 I=S (good market)

 Db = Dh (deposit market)

 Lf = Lb (credit market)

 Bh = Bf + Bb (bond market)
Solving for the equilibrium
From the above equations it is clear that the only possible equilibrium
is such that all interest rates are equal: r = rL = rD

Then, this must mean that from Pb that banks make zero profit at
equilibrium

Moreover, theirdecisions have no effect on other agents because

households are completely indifferent between deposits and securities

Similarly, firms are completely indifferent as to bank credit versus

securities

This is the banking analogue of Modigliani-Miller Theorem in finance

Main Result
If Firms and households have unrestricted access to perfect financial
markets, then in a competitive equilibrium:

◦Banks make a zero profit

◦The size and composition of banks’ balance sheets have no effect on

other economic agents
(we can also extend this result to include uncertainty)
Solution
The previous result explains why we cannot use standard economic
theory to study banks.

There are two complementary ways out of this disappointing result:

◦Theincomplete markets paradigm, which explains why financial

market cannot be complete and shows why banks exist.

◦The industrial organization approach to banking which considers that

banks essentially offer services to their customers, and that financial
transaction are the only visible counterpart to these services. As a
result, the cost of providing these services has to be introduced, as
well as some degree of product differentiation.
there is potentially large actors in the economy.
Reading List
FR Chapter: 1

MT Chapters :1, 2 and 3

Diamond, D.W. (1984). “Financial Intermediation and Delegated

Monitoring” Review of Economic Studies, 51, 728-762

Leyland, H.E and Pyle, D.H. “Informational Asymmetries, Financial

Structure and Financial Intermediation”. Journal of Finance, 32, 371-387

Mayer, C (1990). “ New Issues in Corporate Finance”. European

Economic Review, 32, 1167-1189