MONEY AND BANKING Week 3

Chapter 2 and 8: An Economic Ana !"i" o# $inancia %tr&ct&re 1. Adverse selection (AS) and moral hazard (MH) in financial markets. a. Definitions: AS: Potential high risk borrowers are the ones who most actively seek to obtain funds (before transaction) such that lenders may not !rovide any funds at all. MH: "orrower may engage in activities which make it unlikely that funds will be !aid back (after transaction) such that lenders may not !rovide funds. b. #$am!les: AS: An investor wants to buy cor!orate bonds with low default risk. %e knows that there are firms with low default risk (ty!e A) and firms with high default risk (ty!e ") but he can&t distinguish between ty!es. 'nstead he demands an interest rate which reflects the average default risk across ty!es. (y!e A firms don&t want to borrow at this rate only ty!e " firms do. )nowing this the investor doesn&t buy any bonds since he doesn&t want to buy ty!e " bonds. MH: A !otential homeowner a!!lies for a mortgage at a bank. %e&s earning a good salary but the bank knows that he&s single and he likes !arties and dangerous s!orts such as base *um!ing and free+climbing. )nowing this the bank is aware of the high risk that the mortgage a!!licant burns down the house and gets killed before !aying off the mortgage. (he bank will !robably never make the mortgage. c. 'm!lications for financial structure: AS: 'n terms of the e$am!le !rovided ty!e " firms are the ones which would most actively seek to issue bonds. ,ew bonds will sell in this market and marketable securities are thus not the !rimary source of financing for businesses. MH: 'n terms of the e$am!le !rovided the bank could write restrictions in the mortgage contract asking the a!!licant to carry life insurance which would !ay off the mortgage if he gets killed. ,urther it could ask for fire insurance etc. on the house in order to !revent it from losing value. Debt contracts such as mortgage contracts thus often include substantial legal restrictions. -. 'n general well develo!ed financial systems allow (i) a better allocation of funds from savers to investors. (ii) a better level of screening to identify good investments (reducing A/ !roblems). (iii) a better monitoring and cor!orate control (reducing 0% !roblems). (iv) !roduction of financial services which allow a better management of risk (e.g. financial instruments which suit the need of savers and borrowers hedging instruments to reduce level of risk etc.). "y !roviding these financial services more or less effectively different financial systems !romote economic growth to a greater or lesser degree. /ee A!!lication 1Financial Development and Economic Growth2 on !age 134+133 for a full discussion.

5emember however that a positive correlation between financial develo!ment and economic growth does not necessarily im!ly causation. #conomic growth might leads to better institutional and legal system which could lead to a higher develo!ment of the financial system. 6. 'n his -77- influential article 5oss 8evine finds that what really matters for long+run economic growth is not the s!ecific form (bank versus market+based) of the financial system but its overall level of develo!ment. (he develo!ment of one or the other system might have to do with the !articular origin9characteristics of the legal system (stockholder !rotection laws creditors& laws etc) but as long as there is an efficient allocation of funds no system (or combination of the two systems) is su!erior. 8evine (-77-) !rovides some em!irical evidence in this res!ect. 5ead carefully the first few !ages of the article for a full answer. (here you can also find a discussion of the !ros and cons of a bankbased versus market-based systems. :. (he main reasons for regulations are: Ensure systemic stability: 5egulation increases trust in the financial system and reduces systemic risk: banks are interconnected and the failure of one institution can immediately affect the others (e.g. bank contagion can lead to bank runs). Provide smaller retail clients with protection: ,inancial contracts are com!licated and costs of ac;uiring information are high for small retail clients. 5egulation ensures that these market im!erfections are reduced. Protect consumers a!ainst monopolistic e"ploitation : 5egulation ensures that banks do not abuse of mono!oly !ower in !roduct !ricing. (he main drawbacks or limitations of regulation are: Moral ha#ard: De!osit insurances arrangements and lender+of+last+resort (or the so+ called government safety net) cause !eo!le to be less vigilant and banks to take greater risks in lending. (y!ical e$am!les of the moral hazard created by government safety nets are known as 1too big to fail2 (("(,) or 1too im!ortant to fail2 (('(,) $e!ulatory %orbearance: /trict regulations e" ante might not be o!timal e" post& <hen financial institutions are in trouble they might be !ressures not to a!!ly e$isting regulations. (his is a ty!ical time+inconsistency !roblem which worsens 0% behavior A!ency capture: (he risk that the big !layers (or banks) dictate the rules set by the su!ervisory agency and =ca!ture& the regulatory !rocess itself. ,or e$am!le some argue that "asle '' has too much in!ut from large banks. 'osts o% compliance: %eavy and com!le$ regulation might result in higher costs of financial services for clients and higher entry costs in banking industry which can lead to consolidate mono!oly !ositions. 5ead carefully sections >.1 >.- >.6 and >.: of ?ha!ter > of the book by ?asu @irardone and 0olyneu$ (-774) which is available in "lackboard. Chapter '(: Bankin) and the Mana)ement o# $inancia In"tit&tion" 1. "ank res!onse to de!osit outflows and li;uidity management

a. Ao need to make an ad*ustment. 'nitially B million e$cess reserves (-B instead of the -7 re;uired). After the outflow the re;uired reserves are 13.3 million while the bank !ossesses 1C million reserves. A""et" ,e"er-e" *oan" to +ank" *oan" to c&"tomer" %ec&ritie" '. 0 20 '( *ia+i itie" Depo"it" Borro1in) #rom +ank" Bank capita ./ 0 '(

b. Des the bank must make an ad*ustment the reserve deficiency is now 6 million (13+1B) A""et" ,e"er-e" *oan" to +ank" *oan" to c&"tomer" %ec&ritie" '0 0 20 '( *ia+i itie" Depo"it" Borro1in) #rom +ank" Bank capita .( 0 '(

(he bank has the following o!tions: (1) A""et" ,e"er-e" *oan" to +ank" *oan" to c&"tomer" %ec&ritie" '8 0 20 '( "orrow from other banks *ia+i itie" Depo"it" Borro1in) #rom +ank" Bank capita .( 8 '(

"ut it can also: /ell securities "orrow from central bank at the discount or lending rate ?all in loans (if short term loans) not renew loans that mature or sell loans Ac;uire more de!osits which bring in reserves c. Ao bank will turn down that customer because they might loose that customer for ever. "anks have different o!tions like: borrow from other banks issue ?Ds sell some of the bank&s securities to ac;uire the necessary funds. (he o!tions are similar to the ones in !oint b. d. "ank ca!ital is a cushion against losses in the asset side of the balance sheet. Assume that the level of ca!ital is very low (see below). 'f the bank made risky

loans to !eo!le who go into default the bank may become insolvent (assets are smaller than the liabilities). ,rom !age -6C of the book and the lecture notes we can see that the return on e;uity ($(E E net !rofits after ta$ 9 e;uity) is e;ual to the return on assets ( $(A E net !rofit after ta$ 9 assets) times the e;uity multi!lier (EM E assets9e;uity). @iven the same level of assets higher ca!ital leads to lower e;uity multi!lier (EM) and lower $(E. As a result of this banks might feel the !ressure of stockholders to increase the $(E by reducing the level of ca!ital. (here is therefore a trade+off between safety of the bank and return to shareholders. 'f the bank falls short of meeting its ca!ital re;uirements (see A!!lication 1/trategies for 0anaging "ank ?a!ital2 on !age -6C+-:7) the strategies are: (i) raise the ca!ital by issuing new e;uities (ii) reduce the amount of dividends to stockholders increasing the amount of retained earnings which go directly into ca!ital (iii) shirk the size of the bank by selling off loans and reduce liabilities. (his kee!s the level of ca!ital the same but the ca!ital re;uirements (which are calculated in relation to the level of assets) can be met. -. @a! and duration analyses a. 'n million of euros the ga! is (67+B7) E +-7 ?hange in !rofits E F-7G7.7- E +7.:. Aotice that here we assume that checking and saving de!osits are not rate+ sensitive liabilities. <e also assume (like in the book) that reserves are not rate+ sensitive assets. %owever as we will learn in <eek B nowadays reserves held by banks at their res!ective central banks are remunerated at interest rates closely related to the official short+term rate set by the central banks. (herefore reserves should be classified as rate+sensitive assets. (ry to run a ga! analysis under this scenario. b. Decrease of asset value: +7.7-G:E +7.73 (or +3H). (herefore assets lose 7.73GC7 E >.- million in value. Decrease of liability value: +7.7-G- E +7.7: (or :H) liabilities lose 7.7:GC7 E 6.4 in value. Aew asset value is 3-.3 new liability value is 34.: bank is insolvent. c. 'n general a balanced balance sheet is a better strategy in case of uncertain interest rates in the future. 'n this s!ecific case this can be achieved by increasing the rate+ sensitive assets or reducing the rate+sensitive liabilities. ?oncerning the duration analysis the bank might try to match maturities on assets and liabilities better although it is a ty!ical bank task to hold assets with a long maturity and liabilities with a short maturity. 6. ?a!ital re;uirements: a. 8everage ratio: 1B79-777 E >.BH. $)A E 7.BG1777 I 1GB77 I 1G677 I 7.-G-77 E 16:7. $A$ E 1B7916:7 E 11.-H. b. 0ain weaknesses: *ncomplete: 8ooks only at loan default risk not at other ty!es of risk (e.g. interest rate risk).

$isk insensitive capital re+uirement: Divides assets only into : categories from very safe to not very safe. 't does not take account of asset !ortfolio diversification. Actual risk o% o%%-balance-sheet ,(-S. activities not %ully accounted %or: ,or instance 7H ca!ital re;uirements for short+term J"/+ commitments. -asel * lead to some biases: ,or instance credits to government were always seen as less risky than credits to cor!orations. %owever a number of cor!orations have better credit ratings than a number of governments.

c. "asel '' introduces a more com!rehensive and risk+sensitive treatment of banking risks. (his new Accord aims at reducing regulatory arbitrage. 't is based on 6 !illars Pillar / contains the minimum ca!ital re;uirements but in a more advanced way than calculated under "asel '. in !articular banks can choose between two a!!roaches: o /tandardized a!!roach: bank calculates re;uired ca!ital using risk weights based on the e$ternal credit risk assessment of e$ternal rating agencies. o 'nternal ratings+based (*$-) a!!roach: bank calculates the !robability of default itself but uses the standard model for all other calculations. Pillar 0 (new) contains an evaluation of the su!ervisor of the bank&s conduct of risk management. Pillar 1 (new) re;uires additional information to be disclosed by banks about risk e$!osure. "asel '' has a number of weaknesses: "asel '' may have negative effects on financing of /mall and 0edium+sized #nter!rises (SME) as ratings often are not available for /0#s. 'm!lementation costs leads to entry barriers for banks. ?a!ital re;uirements can generate pro-cyclicality in lending: (he in!uts for the '5" a!!roach such as the !robability of default the loss given default and the correlation to systemic risk themselves are !ro+ cyclical. (he ca!ital re;uirements then could become binding in an economic downturn and may even lead to (severely) reduced lending in an economic downturn: the danger of a credit crunch. ,or a dee!er discussion of "asel ' and "asel '' read carefully section >.3 of ?ha!ter > of the book by ?asu @irardone and 0olyneu$ (-774) which is available in "lackboard.