Credit and Banking
=> parts marked with Arabic numerals are theory and parts marked with Roman numerals
are empirics.
1.Chapter 1: Why do banks exist? Are banks special?
1.1 What do banks do? What is special about banks?
Definition of a bank: an institution whose current operations consists of granting loans and
receiving deposits from the public.
=> Current ⇔ trade credit granted by other firms (pay invoice 𝑥 days later). A bank’s main
purpose is to give loans, it is not the other firm’s objective to give a loan.
=> Loans and deposits: fragility of banks:
- All depositors may need liquidity at the same time.
- Lines of credit may be drawn at the same time (a credit line given to a company who
can at any time demand the use of said line).
=> Public: justification for regulation: Banks provide unique services: liquidity and means of
payment. Small depositors not armed to assess safety and soundness of banks.
The functions/role of banks:
- Liquidity and payment services: “money” exists as it reduces transaction costs.
You accept money since you expect to use it again in the future. Money has positive
value because of payment services (e.g., legal tender). The functions of money:
means of payment, store of value, and unit of account. Banks have a role in these
payment systems. In the past checking accounts and payment services were often
loss-leaders. Banks would use these checking accounts to track your usage, gauge
your credit worthiness etc, however the obligation to share all information that banks
face today has reduced their “monopoly” on information in a way. There are however
new threats: stablecoin, Fintech, open banking regulation, …
- Managing Financial Risks:
- Liquidity risk: some deposits (e.g., sight deposits) are withdrawable at any
time but invested into long-term loans by banks (source of bank fragility).
- Interest rate risk: loans are often fixed rate but deposit rates can vary every
day.
- Credit risk: loans may not be (fully) repaid to banks due to defaults of firms
and households.
- Financial market risk:
- Proprietary trading by banks exposes them to shocks in financial
market prices
- “Originate and hold model” (when a loan is granted they would keep
them on their balance sheet until maturity) has changed to “originate
and distribute” (a loan would be granted and then sell off the loan)
model with margins being replaced by fees.
, - Alleviating Asymmetric Information Problems:
- Ex-ante Asymmetric Information: one party (can be either party) has more
information than the other; e.g., the borrower has more information about the
project than the lender. This leads to adverse selection. Banks will screen
borrowers to mitigate this.
- Interim Asymmetric Information: borrower can secretly change the distribution
of payoffs due to moral hazard (the borrower could use the money differently,
taking on more risk).
- Ex-post Asymmetric Information: borrower observes the generated cash-flows
but the lender does not. Borrower may divert some of the cash-flow
(cash-flow diversion i.e. tell the bank that the project was not as successful as
predicted).
- Economic growth: bank-oriented economies in the 1980s grew very fast, the core
function of banks (credit intermediation) is good for economic growth. Auxiliary
services however, (e.g. asset management) leads to more volatile growth.
=> A question that arose is if banks are generating crowding out effects in terms of
human capital? Finance becomes a magnet for the best and brightest => is it not
better to put these smart people in function of something “useful”.
1.2 Who wants to borrow from banks?
Basics of credit rationing according to Tirole: fixed investment model: an entrepreneur needs
an investment 𝐼 for a project but only possess 𝐴 < 𝐼. He will then go borrow the remaining
amount, note that he is protected by LL (limited liability). There is obviously a moral hazard
for the entrepreneur:
There are many more assumptions for this model:
- Borrowers and investors are risk-neutral
- Rate of return expected by investors (risk-free rate due to risk- neutrality) is zero.
- Lenders are in a competitive market, therefore make zero profit: 𝑝𝐻𝑅𝑙 = 𝐼 − 𝐴.
- To compute the interest rate 𝑖 , note that 𝑅𝑙 = (1 + 𝑖)(𝐼 − 𝐴). Therefore interest rate
1
𝑇 = ( 𝑝 − 1) reflects a default premium.
𝐻
- In good state: 𝑅 = 𝑅𝑏 + 𝑅𝑙 (total income 𝑅 is divided over the borrower and the
lender).
- In bad state 𝑅 = 0.
- Project is viable only in the absence of moral hazard:
- Then positive NPV if the borrower behaves: 𝑝𝐻𝑅 − 𝐼 > 0.
- But negative NPV if she does not: 𝑝𝐿𝑅 − 𝐼 + 𝐵 < 0.
, - Therefore no loan that gives incentives to misbehave will be granted (either the
lenders must lose money or borrower would be better off consuming A):
[𝑝𝐿𝑅𝑙 − (𝐼 − 𝐴)] + [𝑝𝐿 𝑅𝑏 + 𝐵 − 𝐴] < 0.
The lender will have to make sure the borrower will work when establishing a contract. This
means that 𝑝𝐻𝑅𝑏 ≥ 𝑝𝐿𝑅𝑏 + 𝐵, if this is valid we have an incentive compatibility constraint
(𝐼𝐶𝑏) for the borrower, ensuring he will work. Effectively this means that we must make sure
𝐵
that 𝑅𝑏 ≥ △𝑝
. Therefore the highest expected income that can be pledged to lenders
without jeopardizing borrower’s incentives (Expected net pledgeable income):
𝐵
𝑃 = 𝑝𝐻(𝑅 − △𝑝
). Since Lenders must break even a necessary condition for the borrower to
𝐵
receive funding is (lender’s individual rationality constraint, 𝐼𝑅𝑙): 𝑃 = 𝑝𝐻(𝑅 − △𝑝
) ≥ 𝐼 − 𝐴.
This means that the firm must have sufficient cash to convince banks to step in: 𝐴 ≥ 𝐴.
=> Because the lenders break even (𝑝𝐻𝑅𝑙 − 𝐼 + 𝐴 = 0), the borrower receives the entire
NPV if the project is funded. His net payoff (“net” because we subtract A, that is the
opportunity cost of investing rather than consuming).
=> When the lender does not issue the loan to the borrower because 𝐴 < 𝐴, we speak of
credit rationing, this is a situation in which lenders limit the amount of credit they provide to
borrowers even when the borrowers are willing to pay a higher interest rate. To reduce this
𝐵
phenomenon mathematically we need to reduce 𝐴 = 𝐼 − 𝑝𝐻(𝑅 − △𝑝
), for example by
reducing the private benefit 𝐵.
Remarks:
- Entrepreneur receives NPV: 𝑝𝐻𝑅𝑏 − 𝐴 = 𝑝𝐻(𝑅 − 𝑅𝑙) − 𝐴 = 𝑝𝐻𝑅 − 𝐼. Will always be
the case with a competitive financial market.
- Reputational capital/scope for diversion (shortcut). 𝐴 increases with 𝐵. Note: Courts
can help reduce 𝐵.
- In this model it is irrelevant if the investors have an equity stake or if it’s simply a
debt. If there were to be collateral in case of failure of the entrepreneur then it will
make a difference!
Debt overhang: a firm can struggle to acquire funding for a project that would otherwise
receive funding because they have previous unpaid debt (senior). Example: 𝐴 < 0, a new
investment cannot be acquired solely because renegotiation with initial investors is
infeasible. If the borrower had no cash making the situation: 𝐴 + 𝑃𝐻𝐷 > 0 (the return the
firm can offer the investor is 𝑝𝐻𝑅 − 𝐷), the funding will not be given. What are possible
solutions?:
- Bargaining with initial investors, who have cash. No one receives anything if there
𝐵
is no investment. Investment: choose 𝑅𝑏 such that 𝑅𝑏 ≥ △𝑝
and 𝑝𝐻(𝑅 − 𝑅𝑏) − 𝐼 ≥ 0.
𝐵
This is feasible since: 𝑝𝐻(𝑅 − △𝑝
) − 𝐼 = 𝐴 > 0.
, - If initial investors don’t have funds to invest and we can only bargain with new
𝐵
investors. The income that can be pledged to new investors: 𝑝𝐻(𝑅 − 𝐷 − ∆𝑝
)<𝐼
by assumption so sufficient funding is not possible in this case.
- If initial investors don’t have funds to invest and we bargain with new and initial
−𝐴
investors. There could be debt forgiveness: 𝐷 → 𝑑, where 0 ≤ 𝑑 ≤ 𝑑 = 𝑝𝐻
, which
𝐵
makes 𝑝𝐻(𝑅 − 𝑑 − ∆𝑝
) = 𝐼.
=> However if there are many investors, such as bondholders then there can be a
freerider problem where holders will want others to forgive so they may be fully
repaid.
1.3 Investor activism: active role of banks/other financial
intermediaries
Active vs. Passive monitors:
Why study investor activism?:
- Difference between equity and debt-based corporate governance:
- Bank-based systems: debt and concentrated shareholdings.
- Market-based systems: proxy fights, takeovers, compensation schemes
- Why do blocks (large shareholders) often trade at premium or discount (when a large
shareholders’ stake changes owner it gives the new owner the right to act in the firm,
therefore the premium)?
- Monitoring cost.
- Learning by lending.
- Block illiquidity.
- Benefits from control.
=> parts marked with Arabic numerals are theory and parts marked with Roman numerals
are empirics.
1.Chapter 1: Why do banks exist? Are banks special?
1.1 What do banks do? What is special about banks?
Definition of a bank: an institution whose current operations consists of granting loans and
receiving deposits from the public.
=> Current ⇔ trade credit granted by other firms (pay invoice 𝑥 days later). A bank’s main
purpose is to give loans, it is not the other firm’s objective to give a loan.
=> Loans and deposits: fragility of banks:
- All depositors may need liquidity at the same time.
- Lines of credit may be drawn at the same time (a credit line given to a company who
can at any time demand the use of said line).
=> Public: justification for regulation: Banks provide unique services: liquidity and means of
payment. Small depositors not armed to assess safety and soundness of banks.
The functions/role of banks:
- Liquidity and payment services: “money” exists as it reduces transaction costs.
You accept money since you expect to use it again in the future. Money has positive
value because of payment services (e.g., legal tender). The functions of money:
means of payment, store of value, and unit of account. Banks have a role in these
payment systems. In the past checking accounts and payment services were often
loss-leaders. Banks would use these checking accounts to track your usage, gauge
your credit worthiness etc, however the obligation to share all information that banks
face today has reduced their “monopoly” on information in a way. There are however
new threats: stablecoin, Fintech, open banking regulation, …
- Managing Financial Risks:
- Liquidity risk: some deposits (e.g., sight deposits) are withdrawable at any
time but invested into long-term loans by banks (source of bank fragility).
- Interest rate risk: loans are often fixed rate but deposit rates can vary every
day.
- Credit risk: loans may not be (fully) repaid to banks due to defaults of firms
and households.
- Financial market risk:
- Proprietary trading by banks exposes them to shocks in financial
market prices
- “Originate and hold model” (when a loan is granted they would keep
them on their balance sheet until maturity) has changed to “originate
and distribute” (a loan would be granted and then sell off the loan)
model with margins being replaced by fees.
, - Alleviating Asymmetric Information Problems:
- Ex-ante Asymmetric Information: one party (can be either party) has more
information than the other; e.g., the borrower has more information about the
project than the lender. This leads to adverse selection. Banks will screen
borrowers to mitigate this.
- Interim Asymmetric Information: borrower can secretly change the distribution
of payoffs due to moral hazard (the borrower could use the money differently,
taking on more risk).
- Ex-post Asymmetric Information: borrower observes the generated cash-flows
but the lender does not. Borrower may divert some of the cash-flow
(cash-flow diversion i.e. tell the bank that the project was not as successful as
predicted).
- Economic growth: bank-oriented economies in the 1980s grew very fast, the core
function of banks (credit intermediation) is good for economic growth. Auxiliary
services however, (e.g. asset management) leads to more volatile growth.
=> A question that arose is if banks are generating crowding out effects in terms of
human capital? Finance becomes a magnet for the best and brightest => is it not
better to put these smart people in function of something “useful”.
1.2 Who wants to borrow from banks?
Basics of credit rationing according to Tirole: fixed investment model: an entrepreneur needs
an investment 𝐼 for a project but only possess 𝐴 < 𝐼. He will then go borrow the remaining
amount, note that he is protected by LL (limited liability). There is obviously a moral hazard
for the entrepreneur:
There are many more assumptions for this model:
- Borrowers and investors are risk-neutral
- Rate of return expected by investors (risk-free rate due to risk- neutrality) is zero.
- Lenders are in a competitive market, therefore make zero profit: 𝑝𝐻𝑅𝑙 = 𝐼 − 𝐴.
- To compute the interest rate 𝑖 , note that 𝑅𝑙 = (1 + 𝑖)(𝐼 − 𝐴). Therefore interest rate
1
𝑇 = ( 𝑝 − 1) reflects a default premium.
𝐻
- In good state: 𝑅 = 𝑅𝑏 + 𝑅𝑙 (total income 𝑅 is divided over the borrower and the
lender).
- In bad state 𝑅 = 0.
- Project is viable only in the absence of moral hazard:
- Then positive NPV if the borrower behaves: 𝑝𝐻𝑅 − 𝐼 > 0.
- But negative NPV if she does not: 𝑝𝐿𝑅 − 𝐼 + 𝐵 < 0.
, - Therefore no loan that gives incentives to misbehave will be granted (either the
lenders must lose money or borrower would be better off consuming A):
[𝑝𝐿𝑅𝑙 − (𝐼 − 𝐴)] + [𝑝𝐿 𝑅𝑏 + 𝐵 − 𝐴] < 0.
The lender will have to make sure the borrower will work when establishing a contract. This
means that 𝑝𝐻𝑅𝑏 ≥ 𝑝𝐿𝑅𝑏 + 𝐵, if this is valid we have an incentive compatibility constraint
(𝐼𝐶𝑏) for the borrower, ensuring he will work. Effectively this means that we must make sure
𝐵
that 𝑅𝑏 ≥ △𝑝
. Therefore the highest expected income that can be pledged to lenders
without jeopardizing borrower’s incentives (Expected net pledgeable income):
𝐵
𝑃 = 𝑝𝐻(𝑅 − △𝑝
). Since Lenders must break even a necessary condition for the borrower to
𝐵
receive funding is (lender’s individual rationality constraint, 𝐼𝑅𝑙): 𝑃 = 𝑝𝐻(𝑅 − △𝑝
) ≥ 𝐼 − 𝐴.
This means that the firm must have sufficient cash to convince banks to step in: 𝐴 ≥ 𝐴.
=> Because the lenders break even (𝑝𝐻𝑅𝑙 − 𝐼 + 𝐴 = 0), the borrower receives the entire
NPV if the project is funded. His net payoff (“net” because we subtract A, that is the
opportunity cost of investing rather than consuming).
=> When the lender does not issue the loan to the borrower because 𝐴 < 𝐴, we speak of
credit rationing, this is a situation in which lenders limit the amount of credit they provide to
borrowers even when the borrowers are willing to pay a higher interest rate. To reduce this
𝐵
phenomenon mathematically we need to reduce 𝐴 = 𝐼 − 𝑝𝐻(𝑅 − △𝑝
), for example by
reducing the private benefit 𝐵.
Remarks:
- Entrepreneur receives NPV: 𝑝𝐻𝑅𝑏 − 𝐴 = 𝑝𝐻(𝑅 − 𝑅𝑙) − 𝐴 = 𝑝𝐻𝑅 − 𝐼. Will always be
the case with a competitive financial market.
- Reputational capital/scope for diversion (shortcut). 𝐴 increases with 𝐵. Note: Courts
can help reduce 𝐵.
- In this model it is irrelevant if the investors have an equity stake or if it’s simply a
debt. If there were to be collateral in case of failure of the entrepreneur then it will
make a difference!
Debt overhang: a firm can struggle to acquire funding for a project that would otherwise
receive funding because they have previous unpaid debt (senior). Example: 𝐴 < 0, a new
investment cannot be acquired solely because renegotiation with initial investors is
infeasible. If the borrower had no cash making the situation: 𝐴 + 𝑃𝐻𝐷 > 0 (the return the
firm can offer the investor is 𝑝𝐻𝑅 − 𝐷), the funding will not be given. What are possible
solutions?:
- Bargaining with initial investors, who have cash. No one receives anything if there
𝐵
is no investment. Investment: choose 𝑅𝑏 such that 𝑅𝑏 ≥ △𝑝
and 𝑝𝐻(𝑅 − 𝑅𝑏) − 𝐼 ≥ 0.
𝐵
This is feasible since: 𝑝𝐻(𝑅 − △𝑝
) − 𝐼 = 𝐴 > 0.
, - If initial investors don’t have funds to invest and we can only bargain with new
𝐵
investors. The income that can be pledged to new investors: 𝑝𝐻(𝑅 − 𝐷 − ∆𝑝
)<𝐼
by assumption so sufficient funding is not possible in this case.
- If initial investors don’t have funds to invest and we bargain with new and initial
−𝐴
investors. There could be debt forgiveness: 𝐷 → 𝑑, where 0 ≤ 𝑑 ≤ 𝑑 = 𝑝𝐻
, which
𝐵
makes 𝑝𝐻(𝑅 − 𝑑 − ∆𝑝
) = 𝐼.
=> However if there are many investors, such as bondholders then there can be a
freerider problem where holders will want others to forgive so they may be fully
repaid.
1.3 Investor activism: active role of banks/other financial
intermediaries
Active vs. Passive monitors:
Why study investor activism?:
- Difference between equity and debt-based corporate governance:
- Bank-based systems: debt and concentrated shareholdings.
- Market-based systems: proxy fights, takeovers, compensation schemes
- Why do blocks (large shareholders) often trade at premium or discount (when a large
shareholders’ stake changes owner it gives the new owner the right to act in the firm,
therefore the premium)?
- Monitoring cost.
- Learning by lending.
- Block illiquidity.
- Benefits from control.
