Global banking
Part 1: Introduction to banks and the banking sector
Chapter 1: What is special about banking?
1.1 Introduction
1.2 The nature of financial intermediation
Why when do people/companies borrow money?
- Borrowers are short on cash
- Borrowers have a positive economic value, because they are expected to generate
a profit (cash) in the future, if not one would not be able to repay the loan
- Borrowers are liquidity constraint: they cannot sell part of their assets to raise cash,
because these assets are illiquid
- Borrowers (deficit units): economic units whose total expenditure exceeds their
total receipts
- Lenders (surplus units): economic units whose total receipts exceeds their total
expenditure.
Example: Young dentist
- For a recently graduated dentist setting up his own practice requires a significant
investment
- Because of his qualification as a dentists, banks expect he will earn a high income.
Therefore, the young dentist has a high economic value.
- Because of his expected income, the young dentist can borrow the necessary funds
from a bank.
- Without banks (the ability to borrow) the young dentist would need to work for
many years before he would be able to save all the money needed to set up his
own practice.
1
,Borrowers vs lenders
Lenders’ requirements Borrowers’ requirements
- The minimization of costs - The minimization of costs
- Minimization risk, especially default - Funds at a specific date
risk, and the risk of assets (loans) - Timing of repayment: over a
dropping in value specific period, at a specify time in
- Liquidity: the ability to convert an the future…
asset into cash without incurring a o A company getting a loan to
loss in value or major costs. (The make an investment
future is uncertain. Maybe at some o Household getting a
point in the future, you might want mortgage
to get out.)
CONFLICT BETWEEN BOTH
Direct finance vs Financial intermediation
Direct finance Financial intermediation
- Borrowers and lenders do business Solving two problems
directly with each other 1. Banks can pool, and do not need to
- Example: a company issuing a bond match lenders and borrowers one-
- There still is some form of on-one
intermediation (investment banks), 2. Costs are lower due to economies of
but the funds are raised from the scale
market directly, not from the
intermediary.
Problems:
1. The incompatibility of the needs/preferences of lenders and borrowers
2. Difficulty and cost of matching lenders and borrowers
But:
Information asymmetries still lead to substantial transaction costs:
- Assessing the client
- Negotiating the loan
- Monitoring the borrower
- Recovery in case of default
2
, Recent evolutions:
Securitisation Shadow banking
- Banks convert illiquid assets on - The financial stability board defines
their balance sheet (e.g. “shadow banking” as: “credit
mortgages) into tradable financial intermediation involving entities
instruments bonds/notes and activities outside the regular
- This way these assets are removed banking system”
from their balance sheet and are - The ECB uses the concept of “non-
transferred to and traded on the bank financial intermediation” or
financial markets NBFI
- See later on when we discussing the - This creates concerns, as NBFI’s are
banking crisis not regulated
1.3 The role of banks
Banks are able to match lenders with borrowers by performing a transformation function.
Size transformation Maturity transformation Risk transformation
- Typically, depositors hold - Banks convert demand - Individual borrowers can
smaller amounts of money deposits into medium- and default
with the bank that borrowers long-term loans - Banks reduce this risk by
need. - So, banks borrow short and diversifying their loans over
- Banks transform the smaller lend long many different clients
amounts of the deposits in - As a result, there is a - Banks also screen and monitor
larger amounts for loans (no mismatch between the assets borrowers
matching 1-on-1) and the liabilities of a bank - Banks hold excess capital to
- So, banks enjoy economies of - This mismatch creates liquidity cover unexpected losses
scale, allowing them to pool risk, the risk of not having
small deposits into larger loans enough liquid funds to meet
client’s demands
1.4 Information economics
Asymmetric information
The following three issues create asymmetric information:
o Everyone has less than perfect information
o Not everyone has the same information
o Some parties to a transaction have “inside information” that is not available
to both sides of the transaction
- Asymmetry of information works both ways
3
, - Example of mortgage
o A bank will always have less information about the ability to repay than the
household itself.
o The household is less informed about how mortgages are being priced than
a bank itself.
Transaction costs and economies of scale
- Dealing with the asymmetry of information leads to transaction costs, such as:
medical check-ups when you apply for a loan, processing questionnaires…
- If borrowers would need to obtain a loan without intermediation, and would need
to find a lender themselves on the financial markets, then transaction costs would
be imperatively high
- However, by pooling many borrowers and many lenders, bank generate significant
economies of scale, lowering transaction costs significantly
- Banks transform primary securities (loans) into secondary securities (bank
accounts)
- Banks also enjoy some economies of scope, but this is less important in this context
Remark:
Primary securities also exist without
financial intermediation. Secondary
securities do not.
Adverse selection and moral hazard
Example of adverse selection with second-hand cars
- Most buyers of second-hand cars cannot tell whether a car is actually any good or
not before having both it. They have much less information about the car than the
seller.
- Buyers don’t trust they are being offered a good car; they fear all cars are “lemons”
- As a result, all cars of the same type sell at the same, low, price
- If too many cars are lemons this price will be very low, and as a result owners of
good (non-lemon) second-hand cars will not offer them sale. The market turns into
a “lemons market”
- To avoid getting into a lemons market sellers can use “signalling” and buyers can
use “screening”.
4
Part 1: Introduction to banks and the banking sector
Chapter 1: What is special about banking?
1.1 Introduction
1.2 The nature of financial intermediation
Why when do people/companies borrow money?
- Borrowers are short on cash
- Borrowers have a positive economic value, because they are expected to generate
a profit (cash) in the future, if not one would not be able to repay the loan
- Borrowers are liquidity constraint: they cannot sell part of their assets to raise cash,
because these assets are illiquid
- Borrowers (deficit units): economic units whose total expenditure exceeds their
total receipts
- Lenders (surplus units): economic units whose total receipts exceeds their total
expenditure.
Example: Young dentist
- For a recently graduated dentist setting up his own practice requires a significant
investment
- Because of his qualification as a dentists, banks expect he will earn a high income.
Therefore, the young dentist has a high economic value.
- Because of his expected income, the young dentist can borrow the necessary funds
from a bank.
- Without banks (the ability to borrow) the young dentist would need to work for
many years before he would be able to save all the money needed to set up his
own practice.
1
,Borrowers vs lenders
Lenders’ requirements Borrowers’ requirements
- The minimization of costs - The minimization of costs
- Minimization risk, especially default - Funds at a specific date
risk, and the risk of assets (loans) - Timing of repayment: over a
dropping in value specific period, at a specify time in
- Liquidity: the ability to convert an the future…
asset into cash without incurring a o A company getting a loan to
loss in value or major costs. (The make an investment
future is uncertain. Maybe at some o Household getting a
point in the future, you might want mortgage
to get out.)
CONFLICT BETWEEN BOTH
Direct finance vs Financial intermediation
Direct finance Financial intermediation
- Borrowers and lenders do business Solving two problems
directly with each other 1. Banks can pool, and do not need to
- Example: a company issuing a bond match lenders and borrowers one-
- There still is some form of on-one
intermediation (investment banks), 2. Costs are lower due to economies of
but the funds are raised from the scale
market directly, not from the
intermediary.
Problems:
1. The incompatibility of the needs/preferences of lenders and borrowers
2. Difficulty and cost of matching lenders and borrowers
But:
Information asymmetries still lead to substantial transaction costs:
- Assessing the client
- Negotiating the loan
- Monitoring the borrower
- Recovery in case of default
2
, Recent evolutions:
Securitisation Shadow banking
- Banks convert illiquid assets on - The financial stability board defines
their balance sheet (e.g. “shadow banking” as: “credit
mortgages) into tradable financial intermediation involving entities
instruments bonds/notes and activities outside the regular
- This way these assets are removed banking system”
from their balance sheet and are - The ECB uses the concept of “non-
transferred to and traded on the bank financial intermediation” or
financial markets NBFI
- See later on when we discussing the - This creates concerns, as NBFI’s are
banking crisis not regulated
1.3 The role of banks
Banks are able to match lenders with borrowers by performing a transformation function.
Size transformation Maturity transformation Risk transformation
- Typically, depositors hold - Banks convert demand - Individual borrowers can
smaller amounts of money deposits into medium- and default
with the bank that borrowers long-term loans - Banks reduce this risk by
need. - So, banks borrow short and diversifying their loans over
- Banks transform the smaller lend long many different clients
amounts of the deposits in - As a result, there is a - Banks also screen and monitor
larger amounts for loans (no mismatch between the assets borrowers
matching 1-on-1) and the liabilities of a bank - Banks hold excess capital to
- So, banks enjoy economies of - This mismatch creates liquidity cover unexpected losses
scale, allowing them to pool risk, the risk of not having
small deposits into larger loans enough liquid funds to meet
client’s demands
1.4 Information economics
Asymmetric information
The following three issues create asymmetric information:
o Everyone has less than perfect information
o Not everyone has the same information
o Some parties to a transaction have “inside information” that is not available
to both sides of the transaction
- Asymmetry of information works both ways
3
, - Example of mortgage
o A bank will always have less information about the ability to repay than the
household itself.
o The household is less informed about how mortgages are being priced than
a bank itself.
Transaction costs and economies of scale
- Dealing with the asymmetry of information leads to transaction costs, such as:
medical check-ups when you apply for a loan, processing questionnaires…
- If borrowers would need to obtain a loan without intermediation, and would need
to find a lender themselves on the financial markets, then transaction costs would
be imperatively high
- However, by pooling many borrowers and many lenders, bank generate significant
economies of scale, lowering transaction costs significantly
- Banks transform primary securities (loans) into secondary securities (bank
accounts)
- Banks also enjoy some economies of scope, but this is less important in this context
Remark:
Primary securities also exist without
financial intermediation. Secondary
securities do not.
Adverse selection and moral hazard
Example of adverse selection with second-hand cars
- Most buyers of second-hand cars cannot tell whether a car is actually any good or
not before having both it. They have much less information about the car than the
seller.
- Buyers don’t trust they are being offered a good car; they fear all cars are “lemons”
- As a result, all cars of the same type sell at the same, low, price
- If too many cars are lemons this price will be very low, and as a result owners of
good (non-lemon) second-hand cars will not offer them sale. The market turns into
a “lemons market”
- To avoid getting into a lemons market sellers can use “signalling” and buyers can
use “screening”.
4
