Full summary advanced banking
E_FIN_AB (2024/2025).
Lecture 1 Introduction
Yellow parts are extremely important, which are the topics that I remember from last
year’s test.
The four functions of the financial system are:
1. Financial structure: set of institutions that allow transferring of money (from
savers to investors)
Langeveld and Pagano conclude that the real world is characterized by
transaction costs owing to asymmetric information between users and
providers of funds and limited enforcements of contracts. Comparative
advantages can emerge because of this: in a financial structure that is
dominated by banks as intermediate can mitigate fractions but sometimes also
exacerbate them
2. Asymmetric information: Banks can limit asymmetric information, which is
raised rom the fact that one party has better information then the other.
We had to assess probability of default (PD) It may be the case that you
know the person sitting next to you fairly well . You have the best information
about your level of ‘credit risk’
In general: One party of a transaction has a better information position than the other
party:
Two types of information asymmetries exist:
1. Ex ante (adverse selection) only high risk borrowers apply for a loan
2. Ex post(moral hazard): once a loan is granted borrowers take on extra risk
Banks reduce information asymmetries on two ways:
1. Manage ex ante and ex post information asymmetries (screening,
monitoring)
2. Reduce transactions costs, as banks are able to generate economies of scale
(the slides don’t provide that much information. One of the test questions is to
mention the two forms of information asymmetry and mention at least three ways to
limit them.
, 3. Delegated monitoring
The savers do not directly borrow to lenders, but it goes through a bank
why?
Delegated monitoring pays when the cost of monitoring is lower than the
savings from monitoring ( K< S) (quite straightforward)
When there is one borrower and more lenders then delegated monitoring pays
when the cost of delegated monitoring is lower then the cost that the borrower
has of monitoring each client individually (K + D ≤ min[S, m ∗ K])
Diamond (1986):
- Banks avoid duplication of effort of the monitoring of borrowers by small
investors
- Banks monitor loan contracts and issue unmonitored deposit contracts
- If a bank is diversified across loans then the default change on its deposits
is arbitrarily zero
Banks have comparative advantage if the
- Are sufficiently diversified
- The capacity of individual lenders is small (m is large)
- Cost of delegating monitoring is small
This is mostly the case in Europe, while the US is much more market based.
Public policy and a comparative advantage for banks play a role in this.
Banks do have a large comparative advantage in the following cases:
1. Relationship lending is important, e.g. small- and medium-sized
enterprise
2. There is a lot of tangible, pledge able collateral
3. When contract enforcement is difficult: When you have a conversation
between lender and borrower, you also need to be certain that you can
enforce a contract, a bank could have a better position in doing that.
4. Bank-based and market-based systems
Financial systems differ. In the US mostly market based. In Europe heavily
bank based!
- Direct finance: sector in need of funds borrows from another sector via a
financial market (market-based)
- Indirect finance: a financial intermediary obtains funds from savers and
uses these savings to make loans to a sector in need of finance (bank-
based)’
Do differences in financial structure have implications for growth or stability?
, Initially: no effect of financial structure on economic growth (Levine, 2002)!
However recent evidence suggests:
- Capital-based systems can boost economic growth in two ways: 1.
Improves total-factor productivity 2. Boosts firms’ investments
- Bank-based systems associated with more volatility in two ways: 1. Higher
leverage 2. More exposed to house prices
Public policy:
1. Promotion of ‘national champions’. Does a country need to have a national
bank?
2. Leniency of supervision (week 2)
3. Inadequate regulation.
4. Promotion of ‘regional champions’.
They also point out steps ‘in the right direction’
1. Single Supervisory Mechanism (SSM), alternative way of supervision. How
do you organize this.
2. Resolution
3. Capital Markets Union (CMU)
Main takeaways:
Lecture 2 Financial (in)stability and crises
Three topics in this lecture:
1. Financial stability
2. Systemic risk
3. Banking crises
Financial stable is: ‘A financial system is considered stable when its markets and
institutions—including banks, savings and loans, and other financial product and
service providers—are resilient and able to function even following a bad shock. This
means that households, communities, and businesses can count on having the
, resources, services, and products they need to invest, grow, and participate in a well-
functioning economy.
Can a financial system continuing the support of the real economy? This lecture
focusses on the relation between the financial system and the real economy.
Various ways of instability:
I Banking crisis: large part of banking sector in trouble
I Sovereign debt crisis: restructuring or default of government debt
I Currency crisis: external value of currency falls suddenly
I Stock market crisis: stock market valuation collapses
I ... or combinations of the above.
Problems with instability/crisis:
1. Pressure on government finances
- Depositor insurance
- Recapitalization
2. Economic costs
- GDP shortfall
Banking crisis can start in various ways: 1 shortcoming in management or fraud.
Government policies (direct and indirect) or macroeconomic booms and bursts.
During the financial crisis of 2008 there were various vulnerabilities:
- I Boom in U.S. housing market
- I Banks repackaged mortgages (‘originate to distribute’)
- I Complex products (securitization): where is the risk?
- I Shortcoming in credit ratings agencies
- I Credit booms in E.U. countries
- I Interconnected financial system
In 2008 cooling of the housing market, there was no resilience so mortgage defaults,
loan losses of banks, too big to save it spread across Iceland, Cyprus, Ireland etc.
and a liquidity crisis
Two views on banking crisis
1. Panic view: crisis is random Diamond/Dybvig (1983)
Diamond/Dybvig (1983)
This classic paper makes three points:
1. Banks are helpful: They can provide better risk sharing than competitive
markets.
E_FIN_AB (2024/2025).
Lecture 1 Introduction
Yellow parts are extremely important, which are the topics that I remember from last
year’s test.
The four functions of the financial system are:
1. Financial structure: set of institutions that allow transferring of money (from
savers to investors)
Langeveld and Pagano conclude that the real world is characterized by
transaction costs owing to asymmetric information between users and
providers of funds and limited enforcements of contracts. Comparative
advantages can emerge because of this: in a financial structure that is
dominated by banks as intermediate can mitigate fractions but sometimes also
exacerbate them
2. Asymmetric information: Banks can limit asymmetric information, which is
raised rom the fact that one party has better information then the other.
We had to assess probability of default (PD) It may be the case that you
know the person sitting next to you fairly well . You have the best information
about your level of ‘credit risk’
In general: One party of a transaction has a better information position than the other
party:
Two types of information asymmetries exist:
1. Ex ante (adverse selection) only high risk borrowers apply for a loan
2. Ex post(moral hazard): once a loan is granted borrowers take on extra risk
Banks reduce information asymmetries on two ways:
1. Manage ex ante and ex post information asymmetries (screening,
monitoring)
2. Reduce transactions costs, as banks are able to generate economies of scale
(the slides don’t provide that much information. One of the test questions is to
mention the two forms of information asymmetry and mention at least three ways to
limit them.
, 3. Delegated monitoring
The savers do not directly borrow to lenders, but it goes through a bank
why?
Delegated monitoring pays when the cost of monitoring is lower than the
savings from monitoring ( K< S) (quite straightforward)
When there is one borrower and more lenders then delegated monitoring pays
when the cost of delegated monitoring is lower then the cost that the borrower
has of monitoring each client individually (K + D ≤ min[S, m ∗ K])
Diamond (1986):
- Banks avoid duplication of effort of the monitoring of borrowers by small
investors
- Banks monitor loan contracts and issue unmonitored deposit contracts
- If a bank is diversified across loans then the default change on its deposits
is arbitrarily zero
Banks have comparative advantage if the
- Are sufficiently diversified
- The capacity of individual lenders is small (m is large)
- Cost of delegating monitoring is small
This is mostly the case in Europe, while the US is much more market based.
Public policy and a comparative advantage for banks play a role in this.
Banks do have a large comparative advantage in the following cases:
1. Relationship lending is important, e.g. small- and medium-sized
enterprise
2. There is a lot of tangible, pledge able collateral
3. When contract enforcement is difficult: When you have a conversation
between lender and borrower, you also need to be certain that you can
enforce a contract, a bank could have a better position in doing that.
4. Bank-based and market-based systems
Financial systems differ. In the US mostly market based. In Europe heavily
bank based!
- Direct finance: sector in need of funds borrows from another sector via a
financial market (market-based)
- Indirect finance: a financial intermediary obtains funds from savers and
uses these savings to make loans to a sector in need of finance (bank-
based)’
Do differences in financial structure have implications for growth or stability?
, Initially: no effect of financial structure on economic growth (Levine, 2002)!
However recent evidence suggests:
- Capital-based systems can boost economic growth in two ways: 1.
Improves total-factor productivity 2. Boosts firms’ investments
- Bank-based systems associated with more volatility in two ways: 1. Higher
leverage 2. More exposed to house prices
Public policy:
1. Promotion of ‘national champions’. Does a country need to have a national
bank?
2. Leniency of supervision (week 2)
3. Inadequate regulation.
4. Promotion of ‘regional champions’.
They also point out steps ‘in the right direction’
1. Single Supervisory Mechanism (SSM), alternative way of supervision. How
do you organize this.
2. Resolution
3. Capital Markets Union (CMU)
Main takeaways:
Lecture 2 Financial (in)stability and crises
Three topics in this lecture:
1. Financial stability
2. Systemic risk
3. Banking crises
Financial stable is: ‘A financial system is considered stable when its markets and
institutions—including banks, savings and loans, and other financial product and
service providers—are resilient and able to function even following a bad shock. This
means that households, communities, and businesses can count on having the
, resources, services, and products they need to invest, grow, and participate in a well-
functioning economy.
Can a financial system continuing the support of the real economy? This lecture
focusses on the relation between the financial system and the real economy.
Various ways of instability:
I Banking crisis: large part of banking sector in trouble
I Sovereign debt crisis: restructuring or default of government debt
I Currency crisis: external value of currency falls suddenly
I Stock market crisis: stock market valuation collapses
I ... or combinations of the above.
Problems with instability/crisis:
1. Pressure on government finances
- Depositor insurance
- Recapitalization
2. Economic costs
- GDP shortfall
Banking crisis can start in various ways: 1 shortcoming in management or fraud.
Government policies (direct and indirect) or macroeconomic booms and bursts.
During the financial crisis of 2008 there were various vulnerabilities:
- I Boom in U.S. housing market
- I Banks repackaged mortgages (‘originate to distribute’)
- I Complex products (securitization): where is the risk?
- I Shortcoming in credit ratings agencies
- I Credit booms in E.U. countries
- I Interconnected financial system
In 2008 cooling of the housing market, there was no resilience so mortgage defaults,
loan losses of banks, too big to save it spread across Iceland, Cyprus, Ireland etc.
and a liquidity crisis
Two views on banking crisis
1. Panic view: crisis is random Diamond/Dybvig (1983)
Diamond/Dybvig (1983)
This classic paper makes three points:
1. Banks are helpful: They can provide better risk sharing than competitive
markets.
