INSEAD Library

Includes bibliographical references and index

Digitized

Microeconomics of Banking Contents List of Figures Preface 1 Introduction 1.1 What Is a Bank, and What Do Banks Do? 1.2 Liquidity and Payment Services 1.21 Money Changing 1.2.2 Payment Services 1.3 Transforming Assets 1.4 Managing Risks 1.4.1 Credit Risk 1.4.2 Interest Rate and Liquidity Risks 1.4.3 Off-Balance-Sheet Operations 1.5 Monitoring and Information Processing 1.6 The Role of Banks in the Resource Allocation Process 1.7 Banking in the Arrow-Debreu Model 1.7.1 The Consumer 1.7.2 The Firm 1.7.3 The Bank 1.7.4 General Equilibrium 1.8 Outline of the Book 2 The Role of Financial Intermediaries 2.1 Transaction Costs 2.1.1 Economies of Scope 2.1.2 Economies of Scale 2.2 Coalitions of Depositors and Liquidity Insurance 2.2.1 The Model xv xvii 1 1 2 3 4 4 5 5 5 6 6 7 7 8 9 9 9 10 15 18 18 19 20 20 2.2.2 Characteristics of the Optimal Allocation 2.2.3 Autarky 2.2.4 Market Economy 2.2.5 Financial Intermediation 2.3 Coalitions of Borrowers and the Cost of Capital 2.3.1 A Simple Model of Capital Markets with Adverse Selection 2.3.2 Signaling through Self-Financing and the Cost of Capital 2.3.3 Coalitions of Borrowers 2.3.4 Suggestions for Further Reading 2.4 Financial Intermediation as Delegated Monitoring 2.5 The Choice between Market Debt and Bank Debt 2.5.1 A Simple Model of the Credit Market with Moral Hazard 2.5.2 Monitoring and Reputation 2.5.3 Monitoring and Capital 2.5.4 Financial Architecture 2.5.5 Credit Risk and Dilution Costs 2.6 Liquidity Provision to Firms 2.7 Suggestions for Further Reading 2.8 Problems 2.8.1 Strategic Entrepreneurs and Market Financing 2.8.2 Market versus Bank Finance 2.8.3 Economies of Scale in Information Production 2.8.4 Monitoring as a Public Good and Gresham's Law 2.8.5 Intermediation and Search Costs 2.8.6 Intertemporal Insurance 2.9 Solutions 2.9.1 Strategic Entrepreneurs and Market Financing 2.9.2 Market versus Bank Finance 2.9.3 Economies of Scale in Information Production 2.9.4 Monitoring as a Public Good and Gresham's Law 2.9.5 Intermediation and Search Costs 2.9.6 Intertemporal Insurance 3 The Industrial Organization Approach to Banking 3.1 A Model of a Perfect Competitive Banking Sector 3.1.1 The Model 21 21 22 23 24 25 26 28 28 30 34 34 36 39 42 43 46 47 49 49 50 50 51 52 53 54 54 55 57 58 60 62 69 70 70 3.1.2 The Credit Multiplier Approach 3.1.3 The Behavior of Individual Banks in a Competitive Banking Sector 3.1.4 The Competitive Equilibrium of the Banking Sector 3.2 The Monti-Klein Model of a Monopolistic Bank 3.2.1 The Original Model 3.2.2 The Oligopolistic Version 3.2.3 Empirical Evidence 3.3 Monopolistic Competition 3.3.1 Does Free Competition Lead to the Optimal Number of Banks? 3.3.2 The Impact of Deposit Rate Regulation on Credit Rates 3.3.3 Bank Network Compatibility 3.3.4 Empirical Evidence 3.4 The Scope of the Banking Firm 3.5 Beyond Price Competition 3.5.1 Risk Taking on Investments 3.5.2 Monitoring and Incentives in a Financial Conglomerate 3.5.3 Competition and Screening 3.6 Relationship Banking 3.6.1 The Ex Post Monopoly of Information 3.6.2 Equilibrium with Screening and Relationship Banking 3.6.3 Does Competition Threaten Relationship Banking? 3.6.4 Intertemporal Insurance 3.6.5 Empirical Tests of Relationship Banking 3.7 Payment Cards and Two-Sided Markets 3.7.1 A Model of the Payment Card Industry 3.7.2 Card Use 3.7.3 Monopoly Network 3.7.4 Competing Payment Card Networks 3.7.5 Welfare Analysis 3.8 Problems 3.8.1 Extension of the Monti-Klein Model to the Case of Risky Loans 3.8.2 Compatibility between Banking Networks 3.8.3 Double Bertrand Competition 3.8.4 Deposit Rate Regulation 71 72 75 78 78 79 80 81 81 84 87 88 88 89 89 93 95 99 99 102 103 104 104 107 108 109 110 111 111 112 112 113 113 114 3.9 Solutions 3.9.1 Extension of the Monti-Klein Model to the Case of Risky Loans 3.9.2 Compatibility between Banking Networks 3.9.3 Double Bertrand Competition 3.9.4 Deposit Rate Regulation 4 The Lender-Borrower Relationship 4.1 Why Risk Sharing Does Not Explain All the Features of Bank Loans 4.2 Costly State Verification 4.2.1 Incentive-Compatible Contracts 4.2.2 Efficient Incentive-Compatible Contracts 4.2.3 Efficient Falsification-Proof Contracts 4.3 Incentives to Repay 4.3.1 Nonpecuniary Cost of Bankruptcy 4.3.2 Threat of Termination 4.3.3 Impact of Judicial Enforcement 4.3.4 Strategic Debt Repayment: The Case of a Sovereign Debtor 4.4 Moral Hazard 4.5 The Incomplete Contract Approach 4.5.1 Private Debtors and the Inalienability of Human Capital 4.5.2 Liquidity of Assets and Debt Capacity 4.5.3 Soft Budget Constraints and Financial Structure 4.6 Collateral as a Device for Screening Heterogeneous Borrowers 4.7 Problems 4.7.1 Optimal Risk Sharing with Symmetric Information 4.7.2 Optimal Debt Contracts with Moral Hazard 4.7.3 The Optimality of Stochastic Auditing Schemes 4.7.4 The Role of Hard Claims in Constraining Management 4.7.5 Collateral and Rationing 4.7.6 Securitization 4.8 Solutions 4.8.1 Optimal Risk Sharing with Symmetric Information 4.8.2 Optimal Debt Contracts with Moral Hazard 4.8.3 The Optimality of Stochastic Auditing Schemes 4.8.4 The Role of Hard Claims in Constraining Management 115 115 116 117 118 127 128 130 131 132 133 134 134 135 137 139 143 146 147 149 150 153 157 157 158 159 160 160 161 161 161 162 163 164 4.8.5 Collateral and Rationing 4.8.6 Securitization 5 Equilibrium in the Credit Market and Its Macroeconomic Implications 5.1 Definition of Equilibrium Credit Rationing 5.2 The Backward-Bending Supply of Credit 5.3 Equilibrium Credit Rationing 5.3.1 Adverse Selection 5.3.2 Costly State Verification 5.3.3 Moral Hazard 5.4 Equilibrium with a Broader Class of Contracts 5.5 Problems 5.5.1 The Model of Mankiw 5.5.2 Efficient Credit Rationing 5.5.3 Too Much Investment 5.6 Solutions 5.6.1 The Model of Mankiw 5.6.2 Efficient Credit Rationing 5.6.3 Too Much Investment 6 The Macroeconomic Consequences of Financial Imperfections 6.1 A Short Historical Perspective 6.2 The Transmission Channels of Monetary Policy 6.2.1 The Different Channels 6.2.2 A Simple Model 6.2.3 Credit View versus Money View: Justification of the Assumptions and Empirical Evidence 6.2.4 Empirical Evidence on the Credit View 6.3 Financial Fragility and Economic Performance 6.4 Financial Development and Economic Growth 7 Individual Bank Runs and Systemic Risk 7.1 Banking Deposits and Liquidity Insurance 7.1.1 A Model of Liquidity Insurance 7.1.2 Autarky 7.1.3 The Allocation Obtained When a Financial Market Is Opened 7.1.4 The Optimal (Symmetric) Allocation 7.1.5 A Fractional Reserve Banking System 164 165 171 172 173 175 175 177 178 181 185 185 185 186 186 186 187 188 193 195 196 197 198 200 202 203 209 217 218 218 219 219 220 220 7.2 The Stability of the Fractional Reserve System and Alternative Institutional Arrangements 7.2.1 The Causes of Instability 7.2.2 A First Remedy for Instability: Narrow Banking 7.2.3 Regulatory Responses: Suspension of Convertibility or Deposit Insurance 7.2.4 Jacklin's Proposal: Equity versus Deposits 7.3 Bank Runs and Renegotiation 7.3.1 A Simple Model 7.3.2 Pledgeable and Nonpledgeable Cash Flows 7.3.3 Bank Runs as a Discipline Device 7.3.4 The Role of Capital 7.4 Efficient Bank Runs 7.5 Interbank Markets and the Management of Idiosyncratic Liquidity Shocks 7.5.1 The Model of Bhattacharya and Gale 7.5.2 The Role of the Interbank Market 7.5.3 The Case of Unobservable Liquidity Shocks 7.6 Systemic Risk and Contagion 7.6.1 Aggregate Liquidity and Banking Crises 7.6.2 Payment Systems and OTC Operations 7.6.3 Contagion through Interbank Claims 7.7 Lender of Last Resort: A Historical Perspective 7.7.1 Views on the LLR Role 7.7.2 Liquidity and Solvency: A Coordination Game 7.7.3 The Practice of LLR Assistance 7.7.4 The Effect of LLR and Other Partial Arrangements 7.8 Problems 7.8.1 Bank Runs and Moral Hazard 7.8.2 Bank Runs 7.8.3 Information-Based Bank Runs 7.8.4 Banks' Suspension of Convertibility 7.8.5 Aggregated Liquidity Shocks 7.8.6 Charter Value 7.9 Solutions 7.9.1 Banks Runs and Moral Hazard 7.9.2 Bank Runs 222 222 222 224 225 227 227 228 228 229 230 233 233 234 234 235 236 238 239 242 243 244 246 247 248 248 249 249 250 251 252 253 253 253 7.9.3 Information-Based Bank Runs 7.9.4 Banks' Suspension of Convertibility 7.9.5 Aggregated Liquidity Shocks 7.9.6 Charter Value 8 Managing Risks in the Banking Firm 8.1 Credit Risk 8.1.1 Institutional Context 8.1.2 Evaluating the Cost of Credit Risk 8.1.3 Regulatory Response to Credit Risk 8.2 Liquidity Risk 8.2.1 Reserve Management 8.2.2 Introducing Liquidity Risk into the Monti-Klein Model 8.2.3 The Bank as a Market Maker 8.3 Interest Rate Risk 8.3.1 The Term Structure of Interest Rates 8.3.2 Measuring Interest Rate Risk Exposure 8.3.3 Applications to Asset Liability Management 8.4 Market Risk 8.4.1 Portfolio Theory: The Capital Asset Pricing Model 8.4.2 The Bank as a Portfolio Manager: The Pyle-Hart-Jaffee Approach 8.4.3 An Application of the Portfolio Model: The Impact of Capital Requirements 8.5 Problems 8.5.1 The Model of Prisman, Slovin, and Sushka 8.5.2 The Risk Structure of Interest Rates 8.5.3 Using the CAPM for Loan Pricing 8.6 Solutions 8.6.1 The Model of Prisman, Slovin, and Sushka 8.6.2 The Risk Structure of Interest Rates 8.6.3 Using the CAPM for Loan Pricing 9 The Regulation of Banks 9.1 The Justification for Banking Regulation 9.1.1 The General Setting 9.1.2 The Fragility of Banks 9.1.3 The Protection of Depositors' and Customers' Confidence 9.1.4 The Cost of Bank Failures 255 255 257 258 265 266 266 267 271 273 274 275 277 280 281 283 284 286 286 288 291 296 296 297 298 298 298 300 301 305 306 306 307 308 310 9.2 A Framework for Regulatory Analysis 9.3 Deposit Insurance 9.3.1 The Moral Hazard Issue 9.3.2 Risk-Related Insurance Premiums 9.3.3 Is Fairly Priced Deposit Insurance Possible? 9.3.4 The Effects of Deposit Insurance on the Banking Industry 9.4 Solvency Regulations 9.4.1 The Portfolio Approach 9.4.2 Cost of Bank Capital and Deposit Rate Regulation 9.4.3 The Incentive Approach 9.4.4 The Incomplete Contract Approach 9.4.5 The Three Pillars of Basel II 9.5 The Resolution of Bank Failures 9.5.1 Resolving Banks' Distress: Instruments and Policies 9.5.2 Information Revelation and Managers' Incentives 9.5.3 Who Should Decide on Banks' Closure? 9.6 Market Discipline 9.6.1 Theoretical Framework 9.6.2 Empirical Evidence 9.7 Suggestions for Further Reading 9.8 Problem 9.8.1 Moral Hazard and Capital Regulation 9.9 Solution 9.9.1 Moral Hazard and Capital Regulation Index 310 313 313 315 316 318 319 319 320 323 324 328 329 329 330 332 335 336 337 338 340 340 340 340 349