Lecture notes
Global banking
Table of Contents
Global banking................................................................................................................................... 1
Lecture 1: Financial Intermediaries: Rationale ....................................................................................... 3
Live Session 1 ............................................................................................................................................................ 4
Lecture 2: Financial intermediaries as delegated monitors in a new window ...................................... 7
Live Session 2 .......................................................................................................................................................... 10
Simulation game: intro ............................................................................................................................. 15
Lecture 3: Financial intermediaries as liquidity creators in a new window ....................................... 17
Live Session 3 .......................................................................................................................................................... 21
Lecture 4 Liquidity Risk Management ................................................................................................... 23
Live Session 4 .......................................................................................................................................................... 28
Lecture 5 Regulation: Deposit insurance and other guarantees .......................................................... 33
Live session 5 ........................................................................................................................................................... 36
Lecture 6 Regulation: Capital Adequacy ............................................................................................... 40
Live session 6 ........................................................................................................................................................... 45
Lecture 7: Geographic Diversification .................................................................................................... 49
Live session 7 ........................................................................................................................................................... 52
Lecture 8: Interest rate risk 1 – pass-through ....................................................................................... 55
Lecture 8: Interest rate risk 2 and 3 – duration gaps ............................................................................ 58
Lecture 8: Interest rate risk 4 – negative IR policy ............................................................................... 63
Lecture 9: Live session material credit risk ........................................................................................... 65
Lecture 9: Portfolio credit risk ................................................................................................................ 72
Lecture 10: Bank capital – part 1 ............................................................................................................ 74
Lecture 10: Bank capital – part 2 ............................................................................................................ 79
Live session Bank competition ................................................................................................................. 85
Functional diversification: follow up on geographical diversification ................................................. 91
Live session climate change and financial institution ............................................................................ 96
,2
,Lecture 1: Financial Intermediaries: Rationale
A world without FIs
Households lend money/cash directly to the firm/corporations. Finance contracts are offered from
corporations to households, like equity and debt.
When FIs are useless
In a perfect world, FIs are redundant: Modigliani-Miller result.
Assumptions:
1. Complete markets
2. Symmetric info, and so on…
However, the real world is plagued by frictions, also known as agency costs.
Problems in a world without FIs:
- Adverse selection: prior to purchasing a firm’s debt/equity, investor may not know the quality of
the firm.
o the poorest (adverse) quality of firms have the greatest incentive to issue securities. Good
firms find inconvenient to issue securities since they have to be sold at a discount.
- Moral hazard: after purchasing a firm’s securities, investors need to monitor the firm’s managers.
o may have the incentive to spend investors money on excessively risky projects/perquisite.
§ Managers may also exert less effort than promised.
- Maturity and liquidity
o The firm’s debt or equity may have characteristics not attractive to investors.
§ Most important characteristics is maturity and liquidity.
• Problem: price risk as a result of liquidating.
To sum up
- Lower level of fund available – investors don’t want to lend and firms don’t want to borrow.
- Higher information costs – economies of scale reduce costs of screening and monitoring firms.
- Higher price risk for investors.
FI’s: intermediate between firms and householders.
- Intermediate firm and household – broker.
- Asset transformation- give money to the corporation and issue long term stock and bonds. They
receive cash from households and issue deposits.
Major functions of FIs
1. Broker: FI provides information about the quality of the security issued.
a. when there are costs for screening the quality of the firm’s securities, the broker reduces
such costs through economies of scale.
i. Efficient way to produce information and reduce adverse selection.
2. Asset transformer: FI transforms primary securities (e.g. bonds, loans, stocks) issued by firms into
secondary securities (e.g. bank deposit). In this way FI solves two problems:
3
, a. FI’s act as a delegated monitor to efficiently produce information on the firm’s ongoing
activities and reduce moral hazard. The average monitoring cost is lower for FI’s since
they exploit economies of scale.
b. FIs can provide maturity intermediation: the maturities of its assets differ from the
maturity of its liabilities.
i. FIs create liquidity: household hold securities with very short maturity, like
demand deposits, where price risk is almost absent.
Other services provided by FIs:
- Transmission of monetary policy
- Credit allocation
- Payment services
- Intergenerational wealth transfers or Time intermediations
- Denomination intermediation
The important services banks provide make them worth of receiving special regulatory attention.
The troubles affecting banks have negative externalities on the rest of the economy.
Example: a bank failure may destroy household savings and restrict firm’s access to credit with contagious
effects on the rest of the economy. Also: systemic risk: failure of large interconnected banks may cause the
failure of other banks. Makes them too big to fail.
Too big to fail examples
- Bear Stearns
o Were about to fail but got bailout.
- AIG
o Government had to buy a 79% stake. AIG was heavily involved in CDS market and would
have brought down many banks.
- Citigroup
o Received 25 billion dollars in October 2008 and another 20 billion in November 2008.
Regulation
Regulation must impose private costs. E.g. capital requirements.
Regulation also provides benefits. E.g. Too-big-to-fail protection.
Live Session 1
Polls
When are FIs useless/redundant?
- Under very special conditions: Modigliani Miller assumptions
What is adverse selection?
- The investors don’t know the quality of the assets.
4
Global banking
Table of Contents
Global banking................................................................................................................................... 1
Lecture 1: Financial Intermediaries: Rationale ....................................................................................... 3
Live Session 1 ............................................................................................................................................................ 4
Lecture 2: Financial intermediaries as delegated monitors in a new window ...................................... 7
Live Session 2 .......................................................................................................................................................... 10
Simulation game: intro ............................................................................................................................. 15
Lecture 3: Financial intermediaries as liquidity creators in a new window ....................................... 17
Live Session 3 .......................................................................................................................................................... 21
Lecture 4 Liquidity Risk Management ................................................................................................... 23
Live Session 4 .......................................................................................................................................................... 28
Lecture 5 Regulation: Deposit insurance and other guarantees .......................................................... 33
Live session 5 ........................................................................................................................................................... 36
Lecture 6 Regulation: Capital Adequacy ............................................................................................... 40
Live session 6 ........................................................................................................................................................... 45
Lecture 7: Geographic Diversification .................................................................................................... 49
Live session 7 ........................................................................................................................................................... 52
Lecture 8: Interest rate risk 1 – pass-through ....................................................................................... 55
Lecture 8: Interest rate risk 2 and 3 – duration gaps ............................................................................ 58
Lecture 8: Interest rate risk 4 – negative IR policy ............................................................................... 63
Lecture 9: Live session material credit risk ........................................................................................... 65
Lecture 9: Portfolio credit risk ................................................................................................................ 72
Lecture 10: Bank capital – part 1 ............................................................................................................ 74
Lecture 10: Bank capital – part 2 ............................................................................................................ 79
Live session Bank competition ................................................................................................................. 85
Functional diversification: follow up on geographical diversification ................................................. 91
Live session climate change and financial institution ............................................................................ 96
,2
,Lecture 1: Financial Intermediaries: Rationale
A world without FIs
Households lend money/cash directly to the firm/corporations. Finance contracts are offered from
corporations to households, like equity and debt.
When FIs are useless
In a perfect world, FIs are redundant: Modigliani-Miller result.
Assumptions:
1. Complete markets
2. Symmetric info, and so on…
However, the real world is plagued by frictions, also known as agency costs.
Problems in a world without FIs:
- Adverse selection: prior to purchasing a firm’s debt/equity, investor may not know the quality of
the firm.
o the poorest (adverse) quality of firms have the greatest incentive to issue securities. Good
firms find inconvenient to issue securities since they have to be sold at a discount.
- Moral hazard: after purchasing a firm’s securities, investors need to monitor the firm’s managers.
o may have the incentive to spend investors money on excessively risky projects/perquisite.
§ Managers may also exert less effort than promised.
- Maturity and liquidity
o The firm’s debt or equity may have characteristics not attractive to investors.
§ Most important characteristics is maturity and liquidity.
• Problem: price risk as a result of liquidating.
To sum up
- Lower level of fund available – investors don’t want to lend and firms don’t want to borrow.
- Higher information costs – economies of scale reduce costs of screening and monitoring firms.
- Higher price risk for investors.
FI’s: intermediate between firms and householders.
- Intermediate firm and household – broker.
- Asset transformation- give money to the corporation and issue long term stock and bonds. They
receive cash from households and issue deposits.
Major functions of FIs
1. Broker: FI provides information about the quality of the security issued.
a. when there are costs for screening the quality of the firm’s securities, the broker reduces
such costs through economies of scale.
i. Efficient way to produce information and reduce adverse selection.
2. Asset transformer: FI transforms primary securities (e.g. bonds, loans, stocks) issued by firms into
secondary securities (e.g. bank deposit). In this way FI solves two problems:
3
, a. FI’s act as a delegated monitor to efficiently produce information on the firm’s ongoing
activities and reduce moral hazard. The average monitoring cost is lower for FI’s since
they exploit economies of scale.
b. FIs can provide maturity intermediation: the maturities of its assets differ from the
maturity of its liabilities.
i. FIs create liquidity: household hold securities with very short maturity, like
demand deposits, where price risk is almost absent.
Other services provided by FIs:
- Transmission of monetary policy
- Credit allocation
- Payment services
- Intergenerational wealth transfers or Time intermediations
- Denomination intermediation
The important services banks provide make them worth of receiving special regulatory attention.
The troubles affecting banks have negative externalities on the rest of the economy.
Example: a bank failure may destroy household savings and restrict firm’s access to credit with contagious
effects on the rest of the economy. Also: systemic risk: failure of large interconnected banks may cause the
failure of other banks. Makes them too big to fail.
Too big to fail examples
- Bear Stearns
o Were about to fail but got bailout.
- AIG
o Government had to buy a 79% stake. AIG was heavily involved in CDS market and would
have brought down many banks.
- Citigroup
o Received 25 billion dollars in October 2008 and another 20 billion in November 2008.
Regulation
Regulation must impose private costs. E.g. capital requirements.
Regulation also provides benefits. E.g. Too-big-to-fail protection.
Live Session 1
Polls
When are FIs useless/redundant?
- Under very special conditions: Modigliani Miller assumptions
What is adverse selection?
- The investors don’t know the quality of the assets.
4
