Global banking
Lecture 1: financial intermediaries: why do they exist and what are
the risks?
In a perfect world, financial intermediaries (FIs) are not useful (Modigliani-Miller conditions hold)
- Complete markets
- Symmetric information
- No taxes, no bankruptcy costs
However, the real world is affected by frictions, agency costs (asymmetric information).
Problems in a world without FI
- Adverse selection; there is asymmetric information on the quality of the firm. Example: good
firm is worth $10, bad firm $4. A rational investor would pay the average of $7. The bad firm
will have the greatest incentive to issue the securities. Good firms will not issue securities
because they have to sell at discount ($7<$10) as a result, only bad firms will issue shares.
- Moral hazard; occurs after purchasing the shares of a firm. The manager should be
monitored because he is willing to spend the money for himself / only risky projects. The
manager can also exert less effort than promised.
- Maturity & liquidity; the debt and equity may not be as liquid as the investors wishes. You’ll
have to liquidate the debt and equity and the current price and this price might not be
beneficial to you
So, in a world without FI’s:
- there is a lower level of fund available (investors don’t lend and the firms don’t borrow)
- higher information costs (with FIs, the EOS reduce costs of screening)
- less liquidity in the economy
- higher price risks for investors
The world without FIs looks like this:
A world with FIs
Functions of FIs (broker / asset transformer)
1
, - Broker: the FI provides information about the quality of the security issued. The costs for
screening is reduced by economies of scale. This is efficient to produce information and
reduce the adverse selection problem.
- Asset transformer; transforms primary securities (loans, bonds) issued by firms into
secondary securities (bank deposit). This solves 2 problems:
o Lower monitoring costs because FIs exploit EOS and the FI acts as delegated monitor
to efficiently produce information on the firm’s ongoing activities and reduce moral
hazard
o maturity transformation, the maturity of the assets are different than of the
liabilities. They create liquidity; households hold securities with short maturity (low
price risk)
Other services provided by FIs (commonly banks): monetary policy, credit allocation, payment
services, insurances, pension funds, mutual funds.
Why do banks need regulatory attention?
When a bank fails, this has effect on the whole economy (negative externalities). It can destroy the
savings of households and restrict firm’s access to credit with contagious effects on the rest of the
economy employment, production, lower sales. Also, banks are connected to the failure may
cause other banks to default as well (systematic risk) too big to fail (Bear Stearns, AIG & Citigroup)
Regulation imposes private costs:
- capital requirements (equity more expensive than deposits)
- forcing banks to invest in the communities in which they take deposits
- examinations long and costly
- no more than 10% of equity to single borrower
Regulation benefits: access to discount window & deposit insurance, access to TARP funds to boost
capital, too-big-to-fail protection.
Q&A Session 27/10
- When are FIs useless or redundant? Under very special conditions (MM assumptions -
Complete markets, Symmetric information, No taxes, no bankruptcy costs)
- What is adverse selection: the investors don’t know the quality of the assets
- What is moral hazard? The manager…
o Does not provide effort on the job
o Invests in petty projects (company of your family)
o Seeks M&A for “empire building” (lot of acquisition to make the company bigger but
this does not maximize the value of the company)
- If A FI is acting purely as a broker, can only tackle this one problem: adverse selection,
reducing the asymmetric information problem. Does not create any liquidity!
- What is the function of the FI as asset transformer? Transform long-term assets into short-
term assets, it is about maturity transformation. With securitization you reduce the risk in
the balance sheet
- Why do banks need special regulatory attention? They have negative externalities on the
economy.
- 2 firms that want to issue shares, one is worth $50 and one is $10 and the investors do not
know the quality of the firms, how much are you willing to pay? 50+10=60/2 = $30
2
, - Consider that investors pay $30 for the shares when the firm is worth $50. Is the firm willing
to issue the shares? Only if the payoff of its investment is higher than $20. You sell your firm
at a $20 discount so you need to have a higher payoff of investment. Example: you find a
covid vaccine, you are willing to sell your share for a low price because people don’t believe
you yet, but if you’re right you will become very rich so the payoff is high in the future so
now you’re willing to sell at a discount
Knowledge transfer (lecture 1, synchronous)
Risks of financial intermediaries
Interest rate risk: mismatch between assets & liabilities.
Refinancing risk: when assets have longer maturities than liabilities (this the case for banks)
Reinvestment risk: assets have shorter maturities than liabilities.
Main issue: matching maturities of assets & liabilities is inconsistent with the asset transformation
function (mismatch due to borrowers wanting LT loans & depositors want ST liquid funds)
Credit risk: the borrower does not repay its debt.
Firm specific credit risk: associated with the specific types of project risk taken by that firm
Systematic risk credit risk: macro-conditions, recession – affecting all borrowers
How to deal with credit risk?
- Screening before underwriting a loan (less adverse selection)
- Monitoring after underwriting the loan (reduce moral hazard)
- Diversification: negatively correlated returns (firm-specific risk can be reduced but systematic
risk cannot)
- Pricing higher interest rates (credit card has a high interest rate due to high defaults)
Off-balance-sheet risks
There is a growth of off-balance sheet activities (derivative positions, loan commitments).
Off-balance sheet activities do not appear in the balance sheet involve the creation of contingent
A&L affect the future balance sheets
Speculative activities using off-balance sheet items create considerable risk (crisis 2007-2009)
Liquidity risk
Risk of being forced to sell assets in a very short period of time in order to meet sudden increase in
withdrawals. May generate run, turns liquidity problem into solvency problem. Risk of contagion
panics (systemic effects): once 1 bank goes down, the confidence in other banks falls as well.
main focus is on liquidity risk!
Insolvency risk: Risk of insufficient capital to offset sudden decline in value of assets relative to
liabilities.
Market risk: Risk of losses from actively trading assets & derivatives. FI are not very active in this.
Trading risk is present whenever a FI takes an open (unhedged) long or short position in securities
and prices change in a direction opposite of what is expected.
Other risks (not very specific for only FIs but they are a classic topic in risk management of any type
of firm.)
- foreign exchange risks; derivatives, working with multiple currencies
3
, - sovereign risk; bribe the government, impossible to hedge
- technology; might fail, take internet banking as an example.
- Operational; fraud of employees, risk that the support system breaks down
- macro risks; increases inflation > interest rates >increased unemployment > affects credit risk
Lecture 2 Financial intermediaries as delegated monitors
Douglas, Diamond 1996 “ financial intermediation as delegated monitoring: a simple example”
Q: Why do investors lend to banks who lend to borrowers, instead of lending directly?
Important to understand: type of financial contracts written by banks and why are these contracts
optimal? (everybody is better off)
DM (delegating monitoring) focuses only on asset services. Asset services: the services the bank
provides to the borrowers. Reduced monitoring costs are a source of bank’s competitive advantage.
K = individual cost of monitoring
m = lenders per borrowers, total costs of monitoring is MK
D = delegation cost
S = savings from monitoring
to save monitoring costs, you can delegate monitoring to only one lender (the bank)
However, delegating the monitoring gives rise to a new problem: the costs, it is not verifiable
whether monitoring has been undertaken by the bank. Once we give the money to the bank, they
can decide whether to monitor or not.
Theory must explain why intermediation leads to an overall improvement.
DM is optimal if:
K + D < min[mK, S]
Example
Assume a borrower needs 1$ million (1 unit), has a positive NPV project with uncertain realization V.
H = 1.4 million with probability 0.8 and L=1 million with probability 0.2 (1-0.8)
The probability p is known to everybody but only the borrower observed the realization of the
project (asymmetric info)
We have m=10,000 investors and each has 1/m of the 1 million (each investor $100)
Monitoring the borrower costs K=$200 , so the mK is $200 * 10,000 = $2 million
Monitoring is expensive, so let’s see what the best contract is without monitoring.
An equity contract cannot be optimal. The profit-sharing depends on the value of the project
reported by the borrower (Z) aZ is the payment that goes to investors.
The borrower’s payoff is therefore V-aZ, which is maximized when Z=1. The borrower always reports
the smallest value of V=Z=1, no incentive to report Z=1.4
No payment higher than ‘a’ to investors with equity contract.
To solve this problem, we want the borrower to tell the truth about the realization of V, to obtain
higher payments.
Debt contracts: Investors impose a penalty when the borrower announced a low V and low
payments. We assume liquidation of the borrower’s assets (value of realized project = 1), in case of
liquidation/bankruptcy there are no proceed both for the borrower and the investors.
4
Lecture 1: financial intermediaries: why do they exist and what are
the risks?
In a perfect world, financial intermediaries (FIs) are not useful (Modigliani-Miller conditions hold)
- Complete markets
- Symmetric information
- No taxes, no bankruptcy costs
However, the real world is affected by frictions, agency costs (asymmetric information).
Problems in a world without FI
- Adverse selection; there is asymmetric information on the quality of the firm. Example: good
firm is worth $10, bad firm $4. A rational investor would pay the average of $7. The bad firm
will have the greatest incentive to issue the securities. Good firms will not issue securities
because they have to sell at discount ($7<$10) as a result, only bad firms will issue shares.
- Moral hazard; occurs after purchasing the shares of a firm. The manager should be
monitored because he is willing to spend the money for himself / only risky projects. The
manager can also exert less effort than promised.
- Maturity & liquidity; the debt and equity may not be as liquid as the investors wishes. You’ll
have to liquidate the debt and equity and the current price and this price might not be
beneficial to you
So, in a world without FI’s:
- there is a lower level of fund available (investors don’t lend and the firms don’t borrow)
- higher information costs (with FIs, the EOS reduce costs of screening)
- less liquidity in the economy
- higher price risks for investors
The world without FIs looks like this:
A world with FIs
Functions of FIs (broker / asset transformer)
1
, - Broker: the FI provides information about the quality of the security issued. The costs for
screening is reduced by economies of scale. This is efficient to produce information and
reduce the adverse selection problem.
- Asset transformer; transforms primary securities (loans, bonds) issued by firms into
secondary securities (bank deposit). This solves 2 problems:
o Lower monitoring costs because FIs exploit EOS and the FI acts as delegated monitor
to efficiently produce information on the firm’s ongoing activities and reduce moral
hazard
o maturity transformation, the maturity of the assets are different than of the
liabilities. They create liquidity; households hold securities with short maturity (low
price risk)
Other services provided by FIs (commonly banks): monetary policy, credit allocation, payment
services, insurances, pension funds, mutual funds.
Why do banks need regulatory attention?
When a bank fails, this has effect on the whole economy (negative externalities). It can destroy the
savings of households and restrict firm’s access to credit with contagious effects on the rest of the
economy employment, production, lower sales. Also, banks are connected to the failure may
cause other banks to default as well (systematic risk) too big to fail (Bear Stearns, AIG & Citigroup)
Regulation imposes private costs:
- capital requirements (equity more expensive than deposits)
- forcing banks to invest in the communities in which they take deposits
- examinations long and costly
- no more than 10% of equity to single borrower
Regulation benefits: access to discount window & deposit insurance, access to TARP funds to boost
capital, too-big-to-fail protection.
Q&A Session 27/10
- When are FIs useless or redundant? Under very special conditions (MM assumptions -
Complete markets, Symmetric information, No taxes, no bankruptcy costs)
- What is adverse selection: the investors don’t know the quality of the assets
- What is moral hazard? The manager…
o Does not provide effort on the job
o Invests in petty projects (company of your family)
o Seeks M&A for “empire building” (lot of acquisition to make the company bigger but
this does not maximize the value of the company)
- If A FI is acting purely as a broker, can only tackle this one problem: adverse selection,
reducing the asymmetric information problem. Does not create any liquidity!
- What is the function of the FI as asset transformer? Transform long-term assets into short-
term assets, it is about maturity transformation. With securitization you reduce the risk in
the balance sheet
- Why do banks need special regulatory attention? They have negative externalities on the
economy.
- 2 firms that want to issue shares, one is worth $50 and one is $10 and the investors do not
know the quality of the firms, how much are you willing to pay? 50+10=60/2 = $30
2
, - Consider that investors pay $30 for the shares when the firm is worth $50. Is the firm willing
to issue the shares? Only if the payoff of its investment is higher than $20. You sell your firm
at a $20 discount so you need to have a higher payoff of investment. Example: you find a
covid vaccine, you are willing to sell your share for a low price because people don’t believe
you yet, but if you’re right you will become very rich so the payoff is high in the future so
now you’re willing to sell at a discount
Knowledge transfer (lecture 1, synchronous)
Risks of financial intermediaries
Interest rate risk: mismatch between assets & liabilities.
Refinancing risk: when assets have longer maturities than liabilities (this the case for banks)
Reinvestment risk: assets have shorter maturities than liabilities.
Main issue: matching maturities of assets & liabilities is inconsistent with the asset transformation
function (mismatch due to borrowers wanting LT loans & depositors want ST liquid funds)
Credit risk: the borrower does not repay its debt.
Firm specific credit risk: associated with the specific types of project risk taken by that firm
Systematic risk credit risk: macro-conditions, recession – affecting all borrowers
How to deal with credit risk?
- Screening before underwriting a loan (less adverse selection)
- Monitoring after underwriting the loan (reduce moral hazard)
- Diversification: negatively correlated returns (firm-specific risk can be reduced but systematic
risk cannot)
- Pricing higher interest rates (credit card has a high interest rate due to high defaults)
Off-balance-sheet risks
There is a growth of off-balance sheet activities (derivative positions, loan commitments).
Off-balance sheet activities do not appear in the balance sheet involve the creation of contingent
A&L affect the future balance sheets
Speculative activities using off-balance sheet items create considerable risk (crisis 2007-2009)
Liquidity risk
Risk of being forced to sell assets in a very short period of time in order to meet sudden increase in
withdrawals. May generate run, turns liquidity problem into solvency problem. Risk of contagion
panics (systemic effects): once 1 bank goes down, the confidence in other banks falls as well.
main focus is on liquidity risk!
Insolvency risk: Risk of insufficient capital to offset sudden decline in value of assets relative to
liabilities.
Market risk: Risk of losses from actively trading assets & derivatives. FI are not very active in this.
Trading risk is present whenever a FI takes an open (unhedged) long or short position in securities
and prices change in a direction opposite of what is expected.
Other risks (not very specific for only FIs but they are a classic topic in risk management of any type
of firm.)
- foreign exchange risks; derivatives, working with multiple currencies
3
, - sovereign risk; bribe the government, impossible to hedge
- technology; might fail, take internet banking as an example.
- Operational; fraud of employees, risk that the support system breaks down
- macro risks; increases inflation > interest rates >increased unemployment > affects credit risk
Lecture 2 Financial intermediaries as delegated monitors
Douglas, Diamond 1996 “ financial intermediation as delegated monitoring: a simple example”
Q: Why do investors lend to banks who lend to borrowers, instead of lending directly?
Important to understand: type of financial contracts written by banks and why are these contracts
optimal? (everybody is better off)
DM (delegating monitoring) focuses only on asset services. Asset services: the services the bank
provides to the borrowers. Reduced monitoring costs are a source of bank’s competitive advantage.
K = individual cost of monitoring
m = lenders per borrowers, total costs of monitoring is MK
D = delegation cost
S = savings from monitoring
to save monitoring costs, you can delegate monitoring to only one lender (the bank)
However, delegating the monitoring gives rise to a new problem: the costs, it is not verifiable
whether monitoring has been undertaken by the bank. Once we give the money to the bank, they
can decide whether to monitor or not.
Theory must explain why intermediation leads to an overall improvement.
DM is optimal if:
K + D < min[mK, S]
Example
Assume a borrower needs 1$ million (1 unit), has a positive NPV project with uncertain realization V.
H = 1.4 million with probability 0.8 and L=1 million with probability 0.2 (1-0.8)
The probability p is known to everybody but only the borrower observed the realization of the
project (asymmetric info)
We have m=10,000 investors and each has 1/m of the 1 million (each investor $100)
Monitoring the borrower costs K=$200 , so the mK is $200 * 10,000 = $2 million
Monitoring is expensive, so let’s see what the best contract is without monitoring.
An equity contract cannot be optimal. The profit-sharing depends on the value of the project
reported by the borrower (Z) aZ is the payment that goes to investors.
The borrower’s payoff is therefore V-aZ, which is maximized when Z=1. The borrower always reports
the smallest value of V=Z=1, no incentive to report Z=1.4
No payment higher than ‘a’ to investors with equity contract.
To solve this problem, we want the borrower to tell the truth about the realization of V, to obtain
higher payments.
Debt contracts: Investors impose a penalty when the borrower announced a low V and low
payments. We assume liquidation of the borrower’s assets (value of realized project = 1), in case of
liquidation/bankruptcy there are no proceed both for the borrower and the investors.
4
