PROGRAM INTRODUCTION
PRACTICAL INFORMATION
1. Exam
Questions
● 1 question about the visit of the NBB (4 points)
● 1 question about the part of Jan Bouckaert (chapter 1-4: 8 points)
● 1 question about the part of Jo Swyngedouw (chapter 5,7,8: 8 points)
2. Bank runs
1929: US 2007: Great Britain 2023: Silicon Valley Bank
⇒ not only an academic topic, let alone only a historical event
1
,WHAT’S DIFFERENT ABOUT BANKS? - part 1
What is a bank? What do banks do?
1. What do banks do?
Most important activities
● collect money (deposits)
● lend money (loans)
● provide liquidity through a transformation function
→ short-term deposits are transformed into long-term investments
1.1 Operational definition
Current
In contrast to banks, non-financial corporations only occasionally engage in lending from or borrowing to their
customers or suppliers (eg. customer credit through delay of payment).
Granting loans and receiving deposits
● narrow banks or mutual funds collect deposits and invest in (publicly) traded securities
● finance or credit companies finance loans by issuing debt/equity
Public
● provision of liquidity and payment services to the grand public
● each depositor is
○ “small”, unlike an institutional investor (large number of small, dispersed customers)
○ “ill-informed” about the bank’s condition
→ customers don’t know what the bank does with their money, but they trust regulation
● the bank offers a public good: safe financial payment/deposit system
● government intervention is appropriate
○ protection of depositors
○ safe payment system (eg. avoid phishing)
1.2 Banks’ activities
Banks have multiple activities
● offering access to a liquid payment system
○ money changing and storage
○ payment services
● short term to long term asset transformation (= maturity transformation)
● risk management, to optimize their internal organizations and reduce their exposure to risks
○ credit risk
○ interest rate risk
○ liquidity risk
● lending information processing and monitoring of borrowers
→ eg. assess riskiness of loans by checking customer’s income, history …
2
,Banks can be regarded as retailers of financial securities
● they buy the securities issued by borrowers: granting loans
● they sell these securities to lenders: collecting deposits
Complexity issues typical of banks: loans and deposits…
● are non-marketable financial contracts
● remain on the bank’s balance sheet until they expire
● differ in characteristics (see lecture 2)
2. Why do banks/financial intermediaries exist?
Banks can serve as means to solve for market imperfections
● scale and scope economies: borrowers can diversify their risk
● informational asymmetries and information economics
→ eg. borrowers know when they will need their money back while the bank doesn’t
○ ex ante: adverse selection
→ attract the wrong borrowers (eg. increasing interest rates attracts risk-taking people)
○ interim: moral hazard
→ ex post changing behavior (eg. if insured against theft, you don’t always lock the door)
○ ex post: costly state verification
→ how to check if the contract was respected
● banks as “pools of liquidity” or “coalition of borrowers” to create welfare
○ provision of insurance to households against their (only privately observed) idiosyncratic
liquidity
○ creates a “free-rider” problem…
→ if too many banks rely on others to hold sufficient reserves, overall liquidity falls
Therefore, banks need to get the right incentives to produce efficient outcomes.
● depositors delegate the monitoring of borrowers to banks
● liquid deposit contracts and bank capital (“equity”) provide good incentives
○ banks want to minimize their equity to increase the ROE
○ regulators don’t want this because of the risk
2.1 Banks as “pools of liquidity” and “liquidity insurers”
Central idea
● households deposit savings with bank
● deposits are withdrawable when households encounter consumption needs
If household withdrawals are not (perfectly) correlated (not everyone withdraws at the same time)...
① a bank’s total cash reserve increases less than proportionally with the number of depositors
→ the probability of you needing liquidity = p and the chance all of you need it at the same time = pn
3
, ② a fractional reserve system is…
● viable
○ a fraction of the deposits can be used to finance long-term, illiquid investments
○ the remaining fraction can be held to meet liquidity demand
● fragile
○ withdrawals motivated by other reasons than consumption needs may happen (risk)
3. A simple model
Model characteristics
● one-good economy (eg. potatoes)
○ both a consumption good (eat them) and an investment good (plant them)
○ you can’t do both, and you can’t harvest during growth
● three periods
● continuum of ex ante identical households (ex post they might differ)
● each household has one unit of the good at t = 0
● consumption of the good happens at either t = 1 or t = 2
● a “liquidity shock” happens if a household learns at t = 1 that consumption is
○ early (t = 1) and utility is 𝑢(𝐶1)
○ late (t = 2) and utility is ρ 𝑢(𝐶2) with 0 < ρ < 1 (discount factor for consumption utility)
From an ex ante perspective, a depositor’s utility equals
● π𝑖 = probability of being type i with i = 1, 2 and π1 = 1 − π2
𝑖
● 𝑐𝑖 = the consumption of an agent of type i at date t
Characteristics of the utility function
● type 1 means that you need to consume early
● type 2 means that you need to consume late
● 𝑈 is an increasing, concave function
○ marginal utility goes down (eg. the more potatoes you consume, the less utility for extra)
○ risk averse → willing to buy insurance and have a certain outcome with higher probability
The good can be
● stored across periods
● invested in a long-run technology at t = 0, returning
○ R > 1 at t = 2 (“late” consumption)
○ L < 1 when liquidated at t = 1 (“early” consumption)
→ if you would’ve known you would need consumption at t = 1, it was better to store it
4
PRACTICAL INFORMATION
1. Exam
Questions
● 1 question about the visit of the NBB (4 points)
● 1 question about the part of Jan Bouckaert (chapter 1-4: 8 points)
● 1 question about the part of Jo Swyngedouw (chapter 5,7,8: 8 points)
2. Bank runs
1929: US 2007: Great Britain 2023: Silicon Valley Bank
⇒ not only an academic topic, let alone only a historical event
1
,WHAT’S DIFFERENT ABOUT BANKS? - part 1
What is a bank? What do banks do?
1. What do banks do?
Most important activities
● collect money (deposits)
● lend money (loans)
● provide liquidity through a transformation function
→ short-term deposits are transformed into long-term investments
1.1 Operational definition
Current
In contrast to banks, non-financial corporations only occasionally engage in lending from or borrowing to their
customers or suppliers (eg. customer credit through delay of payment).
Granting loans and receiving deposits
● narrow banks or mutual funds collect deposits and invest in (publicly) traded securities
● finance or credit companies finance loans by issuing debt/equity
Public
● provision of liquidity and payment services to the grand public
● each depositor is
○ “small”, unlike an institutional investor (large number of small, dispersed customers)
○ “ill-informed” about the bank’s condition
→ customers don’t know what the bank does with their money, but they trust regulation
● the bank offers a public good: safe financial payment/deposit system
● government intervention is appropriate
○ protection of depositors
○ safe payment system (eg. avoid phishing)
1.2 Banks’ activities
Banks have multiple activities
● offering access to a liquid payment system
○ money changing and storage
○ payment services
● short term to long term asset transformation (= maturity transformation)
● risk management, to optimize their internal organizations and reduce their exposure to risks
○ credit risk
○ interest rate risk
○ liquidity risk
● lending information processing and monitoring of borrowers
→ eg. assess riskiness of loans by checking customer’s income, history …
2
,Banks can be regarded as retailers of financial securities
● they buy the securities issued by borrowers: granting loans
● they sell these securities to lenders: collecting deposits
Complexity issues typical of banks: loans and deposits…
● are non-marketable financial contracts
● remain on the bank’s balance sheet until they expire
● differ in characteristics (see lecture 2)
2. Why do banks/financial intermediaries exist?
Banks can serve as means to solve for market imperfections
● scale and scope economies: borrowers can diversify their risk
● informational asymmetries and information economics
→ eg. borrowers know when they will need their money back while the bank doesn’t
○ ex ante: adverse selection
→ attract the wrong borrowers (eg. increasing interest rates attracts risk-taking people)
○ interim: moral hazard
→ ex post changing behavior (eg. if insured against theft, you don’t always lock the door)
○ ex post: costly state verification
→ how to check if the contract was respected
● banks as “pools of liquidity” or “coalition of borrowers” to create welfare
○ provision of insurance to households against their (only privately observed) idiosyncratic
liquidity
○ creates a “free-rider” problem…
→ if too many banks rely on others to hold sufficient reserves, overall liquidity falls
Therefore, banks need to get the right incentives to produce efficient outcomes.
● depositors delegate the monitoring of borrowers to banks
● liquid deposit contracts and bank capital (“equity”) provide good incentives
○ banks want to minimize their equity to increase the ROE
○ regulators don’t want this because of the risk
2.1 Banks as “pools of liquidity” and “liquidity insurers”
Central idea
● households deposit savings with bank
● deposits are withdrawable when households encounter consumption needs
If household withdrawals are not (perfectly) correlated (not everyone withdraws at the same time)...
① a bank’s total cash reserve increases less than proportionally with the number of depositors
→ the probability of you needing liquidity = p and the chance all of you need it at the same time = pn
3
, ② a fractional reserve system is…
● viable
○ a fraction of the deposits can be used to finance long-term, illiquid investments
○ the remaining fraction can be held to meet liquidity demand
● fragile
○ withdrawals motivated by other reasons than consumption needs may happen (risk)
3. A simple model
Model characteristics
● one-good economy (eg. potatoes)
○ both a consumption good (eat them) and an investment good (plant them)
○ you can’t do both, and you can’t harvest during growth
● three periods
● continuum of ex ante identical households (ex post they might differ)
● each household has one unit of the good at t = 0
● consumption of the good happens at either t = 1 or t = 2
● a “liquidity shock” happens if a household learns at t = 1 that consumption is
○ early (t = 1) and utility is 𝑢(𝐶1)
○ late (t = 2) and utility is ρ 𝑢(𝐶2) with 0 < ρ < 1 (discount factor for consumption utility)
From an ex ante perspective, a depositor’s utility equals
● π𝑖 = probability of being type i with i = 1, 2 and π1 = 1 − π2
𝑖
● 𝑐𝑖 = the consumption of an agent of type i at date t
Characteristics of the utility function
● type 1 means that you need to consume early
● type 2 means that you need to consume late
● 𝑈 is an increasing, concave function
○ marginal utility goes down (eg. the more potatoes you consume, the less utility for extra)
○ risk averse → willing to buy insurance and have a certain outcome with higher probability
The good can be
● stored across periods
● invested in a long-run technology at t = 0, returning
○ R > 1 at t = 2 (“late” consumption)
○ L < 1 when liquidated at t = 1 (“early” consumption)
→ if you would’ve known you would need consumption at t = 1, it was better to store it
4
