Economics of banking
Lecture 1: Course introduction; CH 1-3
Without frictions, markets are efficient allocation mechanism:
• No transaction costs.
• No agency problems.
Not everyone has knowledge which are good projects.
• Or the risk appetite.
Banks:
Instead of directly dealing with a counterparty, work via a bank:
• Decreased transaction costs.
o Economies of scale.
• Reduced risk exposure.
o Diversification.
• Agency problems.
o Adverse selection.
▪ Screening before approving the loan (Stiglitz and Weiss, 1981; relationship
banking Boot, 2000)
o Moral hazard:
▪ Monitoring after approving then loan.
▪ Covenant.
EU Bank:
• Bank-based
US Bank:
• Market based.
o = bonds.
o = debt securities.
,Equity = stock market
What do banks do?
• Commercial banks & Universal banks:
o Take deposits.
o Make loans.
• Universal banks:
o Insurance.
o Investment banking.
▪ Raising debt and equity; M&A advice, etc.
Commercial bank = Retail bank.
Balance sheet of a bank:
Income statement of a bank:
,Lecture 2; Interest rates, CH 4-6.
Yield = Coupon payment / face value
Face value = Coupon payment / Yield
(𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 ∗ 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒)
𝐶𝑃𝑁 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
n = t = year
Real interest rate = YTM (interest rate) – Inflation rate
• Discount bonds: Bonds that promise a single payment (face value) upon maturity.
• Coupon bonds: Bonds that promise multiple payments (coupon payments) before maturity
and one payment, the face value, at maturity.
• Zero coupon bonds: does not issue such interest payments.
• Corporate bond: With corporate bonds, the bond issuer may default—that is, it might not
pay back the full amount promised in the bond prospectus.
Interest rates and banks’ business models:
Most important asset = loans
Most important liabilities = deposits
and bonds.
, Yield curve:
• Banks ‘live’ off the yield curve.
What is the yield curve:
• “Term structure”, different interest rates paid by bonds with same level of risk but different
maturities.
o Often default-free, riskless government bonds.
o Benchmark for debt rates in the market.
Yield curve plots equilibrium interest rate:
• Demand factors
o Wealth
o Expected interest rate.
o Expected inflation.
o Risk
o Liquidity
• Supply factors
o Expected profitable opportunities (corporate)
o Budget deficit (government)
o Expected inflation.
Lecture 1: Course introduction; CH 1-3
Without frictions, markets are efficient allocation mechanism:
• No transaction costs.
• No agency problems.
Not everyone has knowledge which are good projects.
• Or the risk appetite.
Banks:
Instead of directly dealing with a counterparty, work via a bank:
• Decreased transaction costs.
o Economies of scale.
• Reduced risk exposure.
o Diversification.
• Agency problems.
o Adverse selection.
▪ Screening before approving the loan (Stiglitz and Weiss, 1981; relationship
banking Boot, 2000)
o Moral hazard:
▪ Monitoring after approving then loan.
▪ Covenant.
EU Bank:
• Bank-based
US Bank:
• Market based.
o = bonds.
o = debt securities.
,Equity = stock market
What do banks do?
• Commercial banks & Universal banks:
o Take deposits.
o Make loans.
• Universal banks:
o Insurance.
o Investment banking.
▪ Raising debt and equity; M&A advice, etc.
Commercial bank = Retail bank.
Balance sheet of a bank:
Income statement of a bank:
,Lecture 2; Interest rates, CH 4-6.
Yield = Coupon payment / face value
Face value = Coupon payment / Yield
(𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 ∗ 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒)
𝐶𝑃𝑁 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
n = t = year
Real interest rate = YTM (interest rate) – Inflation rate
• Discount bonds: Bonds that promise a single payment (face value) upon maturity.
• Coupon bonds: Bonds that promise multiple payments (coupon payments) before maturity
and one payment, the face value, at maturity.
• Zero coupon bonds: does not issue such interest payments.
• Corporate bond: With corporate bonds, the bond issuer may default—that is, it might not
pay back the full amount promised in the bond prospectus.
Interest rates and banks’ business models:
Most important asset = loans
Most important liabilities = deposits
and bonds.
, Yield curve:
• Banks ‘live’ off the yield curve.
What is the yield curve:
• “Term structure”, different interest rates paid by bonds with same level of risk but different
maturities.
o Often default-free, riskless government bonds.
o Benchmark for debt rates in the market.
Yield curve plots equilibrium interest rate:
• Demand factors
o Wealth
o Expected interest rate.
o Expected inflation.
o Risk
o Liquidity
• Supply factors
o Expected profitable opportunities (corporate)
o Budget deficit (government)
o Expected inflation.
