Summary part 1 + list of important terms

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.


Chapter A: Trends in domestic and international banking

 

Introduction

 

In this chapter we will discuss the major changes that have taken place in the banking sector. Some key ratios that will be used in this book are in attachment A.1.

 

Banks had to evolve because of the increased competition from within and outside the banking sector. The banks had to change their structure. There are three trends within the developed countries that made the activity and strategy of the banks change:

  1. Deregulation
  2. Financial innovation
  3. Globalization

 

Deregulation

 

The deregulation of financial markets and banks in particular has played a significant role in explaining the development of the financial sector. Deregulation consists of the removal of impositions by government bodies and the removal of self-imposed restrictions. The process of deregulation has come in three faces across developed economies:

  1. Lifting of quantitative controls on bank assets and the ceilings on interest rates on deposits.
  2. The specialization of business between banks and other financial intermediaries slowed down which allowed both parties to compete in each other’s markets.
  3. The increasing competition from new entrants and from incumbents and other financial intermediaries.

 

Financial innovation

 

Financial innovation is any change in the scale, scope and delivery of financial services. It is not the extension or imitation of a financial product that already exists in another market. In generally there are three forces that stimulated financial innovation:

  • Instability of the financial environment; unpredictable inflation, exchange rates and interest rates. This led to an increased demand to seek for instruments to reduce these risks.
  • Regulation; the regulation of the USA domestic banks led to the development of the Eurodollar market.
  • The development of technology in the financial sector; the application of computer technology and telecommunication.

 

Financial instability, regulation and technology put pressure on banks to innovate. Goodhart identified three principal forms of structural change due to financial innovation:

  • The switch from asset management to liability management. Asset management is that Banks manage their assets regarding duration and type of lending subject to the constraint provided by their holdings of reserve assets. Liability management is the ability to create liabilities by, for example, borrowing in the interbank market.
  • The development of variable-rate lending. This led to the rapid expansion of bank balance sheets.
  • The introduction of cash management technology. Cash management was improved by the innovation of new financial products like the credit card and electronic fund transfer (EFT).

 

Globalization

 

The globalization of banking in particular has paralleled the globalization of the financial system and the growth in multinational corporations in general. The internationalization of banking after the wars resulted from the push factors of regulation in home country and the pull factors of following customers.

 

Canals (1997) divides the process of globalization into three strands:

  1. Creation of branch network in foreign countries.
  2. A merger or outright takeover.
  3. An alliance supported by minority shareholding of each other’s equity.

 

What also increased the globalization process is the harmonization of regulation; For example the creation of the EU as a single market with a single passport for banking services. Also establishment of the General Agreement on Trade and Services (GATS) stimulated globalization. The GATS include a removal of capital account restrictions, allowing market access, ensuring equivalent regulatory treatment for foreign banks as domestic banks and move towards a harmonizing regulatory practice with international best practice.

 

The pace of the globalization was even more increased by the increasing trend to securitization. Securitization is the process by which banks unload their marketable assets onto the securities market. It can also be seen as the process of disintermediation whereby the company sector obtains direct finance from the international capital market with the aid of its investment bank.

 

Profitability

 

Financial innovation and globalization lead to the expanding of a bank’s balance sheets in both domestic and foreign assets. In most cases profits as percentage of assets decline. The increased interest rates accompanied with a rise in inflation increased margins because a significant proportion of deposits paid no interest, whereas all assets except the minimal deposits at the Bank of England earned interested linked to the official bank rate. This is known as the endowment effect. See attachment A.2 for the formula.

 

The endowment effect was reduced during the early 1980s by the innovation of interest-bearing demand deposits. Also competition from within the banking system and from non-banking financial intermediaries (NBFIs) declined.

 

Banks face competition on both sides of the balance sheet:

  • Asset side; Competition from specialist consumer credit institutions, NBFIs and the forces of disintermediation.
  • Liability side; Competition from mutual funds and an array of liquid savings products offered by NBFIs.

 

See attachment A.3 for the banking service equilibrium.

When the demand (D) and the supply (S) intersect we are at the banking service equilibrium. As a response to the competition of NBFIs and the forces disintermediation the demand will fall. The banks have to lower their cost structure, which shifts the supply curve down, to reach an equilibrium with the same quantity. Although the quantity is the same, the price has changed. The price is lower as a result of the decreased cost structure. An individual bank can only restore profitability by reducing its costs.

 

When a merger takes place unit costs have been reduced as a result of economies of scale through consolidation, branch closures and labour shedding. The merged bank is able to close branches and concentrate branch business on surviving branches.

 

Usually competition is seen as a good thing. However, competitive pressure has driven banks to consolidate. A consolidation is the merger and acquisition of smaller companies into larger companies. A consolidation, however, differs from a merger in that the consolidated companies could also result in a new entity.

Technologies have lowered the barriers to entry. The treat of entry ensures that incumbent banks will behave in a competitive matter.

 

Across most of the developed economies there has been a decline in net interest margins, reduction in unit costs, restructuring through downsize and merger, and increase in diversification as banks have moved into traditionally non-banking financial services.

 

The future

 

Banks are more and more opening up to sell new products but this does not go without the associated risks. Because of this risk management systems have been developed.

 

The bank in the future is very likely to be a financial institution like the current universal banks that provide all types of banking and financial service. Unlike the modern universal bank, the future bank may be a contract bank that will supply all financial services but source individual services form other financial institutions.

 

The twenty-first century bank might include the following features:

  1. Deconstruction: The process of decomposing services into their component parts which can then be priced and provided separately.
  2. Overcapitalization: many banks in the developed economies find themselves with excess capital, meaning too much capital necessary to support the existing or expected level of assets.
  3. Cross-subsidization will be eroded as new entrants pick out the services that are most profitable.
  4. Banks will separate core competencies from delivery.
  5. Banks will gravitate towards delivery of financial services for which the capital market would be a greater source of funds than the traditional deposit (securitization).
  6. A higher proportion of the bank’s income will come from off-balance sheet business.
  7. The structure of the bank will change and will move in the direction of what Llewellyn (1996) calls contract banking. Contract baking means that the bank will have a contract to deliver financial services to its customer. It sources service from other banks, NBFIs and from the capital market.

 

Chapter B: The impact of the capital market

 

Introduction

 

We are now going to examine how the presence of the capital market improves the welfare of agents in the economy. The capital market is a market where firms and individuals borrow on a long-term basis. The opposite is a money market where funds are lent and borrowed on a short-term basis. There are two parties involved in the capital market:

  • Deficit units who wish to spend more than their current income.
  • Surplus units whose current income exceeds their current expenditures

 

We assume a world in which the individual agent accepts the interest rate, thus is a price taker. The welfare of the agent will be improved when saving and investment decisions are improved.

 

The role of the capital market

 

To examine the role of the capital market we use a two-period model. This model has the following assumptions:

  1. The market is a perfect capital market. This means that the individual can lent/borrow as much as he wishes at the current interest rate, the individual has perfect knowledge and access to the capital market is costless.
  2. No distortionary taxes.
  3. The agents maximize their utility.
  4. Investment opportunities are infinitely invisible.
  5. Investment is subject to diminishing returns.

 

The figure in attachment B.1 shows the equilibrium without a capital market. On the x-axis we see the consumption and income in period 1 and on the y-axis the consumption and income in period 2. We first assume that Y1=Y2, but a person’s income in period 2 may be higher because of saving goods in period 1. The physical investment opportunities line (PIL) represents assumption 5 of the model. The individual’s utility function is represented by the line U. The steeper the slope of this curve, the greater is the time preference for consumption in period 1.

Point Z represents the initial endowment point. At this point, the individual’s initial endowments are equal to consumptions in period 1 and 2. The individual can move to point Q by saving Y1-C1 in period 1. A key point to note in this analysis is that we are in an autarky.

 

If we want to introduce the capital market into this model we have to add the financial investment opportunities line (FIL). Financial investment opportunities are defined for a given level of wealth, which is conditional on the initial endowment for this agent. The individual maximizes consumption in period 1 by saving all income in period 1, Y1=0. The slope of the FIL is – (1+r).

 

The optimum production plan will occur when the present value of output is maximized. This is at point T, where FIL and PIL intersect see attachment B.2. The agent’s utility is maximized at point P, the tangency point of the agent’s best utility curve and the FIL. A saving of Y1-C1 in period 1 will increase consumption in period 2 with C2-Y2.  The individual’s consumption possibilities are given by:

 

C2 = Y2 + (1+r) Y1     and    C1 = Y1 + Y2/(1+r)

 

As a result of the introduction of the capital market the utility has increased. This is because the equilibrium point of the saver, P, lies above the PIL.

 

Market rate of interest

 

Through the capital market savers can channel their surplus resources to borrowers with deficit resources. We separate the investment-production decision from the savings-consumption decision to develop the classic loanable funds theory. This theory explains how the rate of interest is determined by the interaction of savers and investors.

 

The figure on the next page shows the equilibrium rate of interest determined by interaction of savings and investment decisions by agents. The higher the interest rate, the higher is the level of savings. The equilibrium rate of interest is where savings and investment intersect, S(r) = I(r). With Sr > 0 and Ir < 0. See attachment B.3 for the graph.

 

This theory was criticized by Keynes, because the classical economists assumed that investment equals savings at all times. In the loanable funds theory the financial counterpart to savings and investment decision is the flow supply and demand for financial securities. 

 

Savings represent the flow demand for securities, S = ΔBd

Investment represent the flow supply of securities, I = Bs

Where Δ is the change of the level of stock and B is the stock of bonds as a proxy for all securities. When the rate of interest rises, the price of securities falls and the flow demand for securities increases. The demand and supply equations can be specified:

ΔBd = f(r)

ΔBs = g(r)

f ' > 0 ; g’ < 0

 

When a firm wants to attract funds for investment they will increase the flow supply for securities. This will shift the ΔBs line to the right, to ΔBs 1. This will lower the price of securities and raise the rate of interest from r0 to r1. See attachment B.4 for the graph.

 

When there is an increased desire for households to save, then ΔBd increase. This will shift this line to the left. Again a higher interest rate and a lower price are reached.

 

Chapter C: Banks and financial intermediation

 

Now we will examine the role of financial intermediation in general and banks in particular. Financial intermediation is borrowing by deficit units from financial institutions rather than directly from surplus units themselves. The major external source of finance for individuals and firms comes from financial intermediaries. Financial intermediaries can be distinguished by four criteria:

  1. Their liabilities are specified for a fixed sum that is not related to the performance of their portfolio.
  2. Deposits are short-term and always much shorter than their assets.
  3. A high proportion of liabilities are chequeable.
  4. Neither their assets nor liabilities are in the main transferable.

 

We often make a distinction between financial intermediaries who accept deposits and make loans directly to borrowers (banks, building societies) and those who lend via the purchase of securities (insurance companies, pension funds). The latter do not fulfill criteria 1 and thus we will focus on the first group, the dominant institutions of which are banks. 

 

Borrowers and lenders

 

The utility functions of borrowers and lenders differ from each other and therefore they have to be transformed.

  • Borrowers require large quantities of funds whereas lenders generally will only have smaller amounts of funds. The bank will collect a number of smaller deposits, bundle them together and lent them out a larger sum. This is called size transformation.
  • Lenders have a strong preference for loans with a short horizon. In contrast to the borrower who wants to have security of the funds over the life of the project or investment.
  • Lenders prefer assets with low risk whereas borrowers prefer risky operations. Borrowers are willing to pay a higher price than necessary to remunerate lenders where risk is low. This is referred to as risk transformation. Two types of risks are:
    • Default risk: The possibility that the borrower will default an fail to repay either or both the interest due on the loan and the principal itself.
    • Price risk: Variation in the price of the financial claim

 

The price risk is mainly absent on the asset’s side of the balance sheet. The main risk for banks is the default of their borrowers. A method to reduce their risk is spreading their loans over different segments of the economy. The different segments can be based on geographical location, industry etc. In this way the bank reduces the loss of a failure in a segment. Banks also obtain collateral from their borrowers, which reduces the risk of an individual loan. Another thing a bank can do is hold sufficient capital to meet unexpected losses. Because of all these things a bank can offer relatively riskless deposits while making risky loans.

 

Transaction costs

 

There are different cots involved in transferring funds from surplus to deficit units. The main categories of costs are:

  • Search costs: These costs involve transactors searching out agents willing to take an opposite position. Like a borrower seeking for lenders.
  • Verification costs: Arise from the need of the lender to evaluate the proposal for which the funds are required.
  • Monitoring costs: When the loan is made, the lender will like to monitor the progress of the borrower and ensure that the funds are used in accordance with the purpose agreed.
  • Enforcement costs: Are incurred by the lender when the borrower violates any of the contract conditions.

 

When there is no bank then the cost/return structure of the saver and borrower, with R as the rate of interest and T as the costs incurred, is, see attachment C.1.

 

When we introduce a bank this cost/return structure will change because the bank has a transaction cost C. The costs incurred by the borrower and lender will change, due to the introduction of the bank, to T’B and T’S. See attachment C.2 for the formulas.

 

The introduction of the bank will lower the cost of the financial transaction because the borrower’s and saver’s cost fall by more than the amount of the costs, C, raised by the intermediary (the bank). See attachment C.3 for the condition formula.

 

The existence of transaction costs changes the FIL.

  • For a borrower with TB, the slope of the FIL will change to – (1 + r + TB).
  • For a saver with TS, the slope of the FIL will change to – (1 + r - TS).

There exists a gap between the saving and borrowing rates so that the interest rate charge for borrowing would always be higher than that paid to savers.

 

Costs are also lowered for borrowers through size and maturity transformation. We consider here the scale of costs and the time at which the individual loans mature. In addition to economies of scale, also scope economies are also likely to be present. Scope economies arise from diversification of the business. With all this research it is fairly to say that the introduction of banks lowers the costs of transferring funds from deficit to surplus units.

 

Liquidity insurance

 

When there is no perfect information, consumers are unsure when they will require funds to finance consumption in case of unanticipated events. People need liquidity to offset the shocks that can occur to the economy. The existence of banks enables customers to change their consumption pattern in response to shocks. The value of this service permits a fee to be earned by the financial intermediary.

 

Diamond and Dybvig used a three-period model. The decisions for period 1 and 2 are made in period 0. There are two periods needed to be productive. The consumer are divided into early (begin period 1) and late consumers (end period 2). In this model the financial intermediary acts as an insurance agent.

 

Asymmetry of information

 

In general the borrower has more information about the loan than the lender. So the borrower should know more about the risk of the project. Asymmetric information raises two problems:

  • Moral hazard: The risk that the borrower may engage in activities that reduce the profitability of the loan being repaid.
  • Adverse selection: The lender may select projects that are wrong in the sense that they offer a lower change of meeting the outcomes specified by the borrower than loans for other more viable projects that are rejected.

 

Asymmetric information and the consequences moral hazard and adverse selection reduce the efficiency of the transfer of funds from surplus to deficit units. How can the introduction of a bank help us to overcome this problem? The literature gives us three answers to this question:

 

  1. Information-sharing coalitions.

Banks are subjected to scale economies in their borrowing and lending activities so that they can be considered as information-sharing coalitions. Leyland and Pyle have the most contribution to this argument. The lender must collect information but this is very costly to obtain.

 

It is also very difficult to determine the quality of information. According to Leyland and Pyle, the price of information will reflect the average quality, so that high-quality information seeking firms will lose money.

 

They also argue that a way to get information of a project a firm can offer collateral security, and so a coalition of borrowers can do better than an individual borrower.

 

  1. Role of banks in delegated monitoring

Banks operate as delegated monitors for borrowers. Monitoring is referred to as the collection of information about a firm, its investment projects and its behavior before and after the loan application is made. Some examples of monitoring are; examining a firm’s creditworthiness, seeing if the borrower keeps the terms of the contract.

 

A bank has an advantage in the monitoring process because it has private information concerning the client’s flows of income and expenditures. This is a very important factor. Another fact is that banks are the main operators in the payment mechanism. Lenders have an incentive to delegate the monitoring to a third party.

 

Diamond considers three types of contracting arrangement between lenders and borrowers:

  • No monitoring.
  • Direct monitoring by investors.
  • Delegated monitoring via an intermediary.

This is a so called ‘all or nothing’ approach, it is very expensive and inefficient.

 

  1. A mechanism for commitment

The banks provide a mechanism for commitment to a long-term relationship. It is impossible to write a contract that specifies all possible outcomes; there is an absence of complete contracts. Mayer (1990) stated that if banks have close relationships with their clients, this may give them an alternative commitment. This relationship may help to overcome the problems of moral hazard and adverse selection.

 

Operation of the payments mechanism

 

It is always necessary for the public to keep money balances, i.e. bank deposits, to finance their transactions. This gives banks a great advantage over other financial institutions because they can use these funds held on deposit as a means to purchase interest-earning assets so as to earn profits. The operation of the payments mechanism by banks gives them a great advantage over rivals in the role of financial intermediaries.

 

Direct borrowing from the capital market

 

Banks play an important role with respect to direct borrowing by deficit units. This role takes the following forms of guarantee:

  • Loan commitments
  • Debt guarantees; like the guarantee of bills of exchange on behalf of its customers.
  • Security underwriting; banks advice on the issue of new securities and will take up any quantity of the issue not taken up in the market.

 

For all these activities the bank receives fee income rather than interest receipt. This is called off-balance-sheet business because it does not appear on the balance sheet.

 

Chapter D: Banking typology

 

Introduction

 

In this chapter we will examine different types of banking operation. The basic operation of all types of bank is the same; they accept deposits and make loans. We change the basic balance sheet to a simple stylized bank balance sheet. See attachment D.1 for the balance sheet.

 

The components of this balance sheet explained:

  • Sight deposits are deposits that can be withdrawn without notice.
  • Time deposits are deposits made with a bank for a fixed period of time.
  • Capital represents a shareholder’s interest in the firm and comprises equity, reserves etc.
  • Balances at the Central Bank: the cash required to finance interbank transactions and to meet required ratios.
  • Other liquid assets: assets that can be converted into cash quickly and without loss.
  • Investments consist of holdings of securities issued by the government and in some cases firms.

 

We can distinguish between four types of banking operation:

  1. Retail banking
  2. Wholesale banking
  3. Universal baking
  4. International banking

Main part of the banks provides only retail banking. Most banking firms are universal banks.

 

General features of banking

 

When a country has a high percentage of sight deposits this indicates a significant degree of maturity transformation by the banks in their role as financial intermediaries.

 

Most countries require their central banks to hold a specified balance as proportion of the level of their deposits. This proportion is called the reserve ratio. This ratio varies widely between countries.

 

Banks face a number of risks in their operations:

  • Liquidity risk: Risk that the demand for repayment of deposits exceeds the liquid resourced of the bank.
  • Asset risk: Risk that assets held by banks may not be redeemable at their book value.
  • Foreign currency risk: Risk that exchange rates may move against the bank causing the net value of its foreign currency assets/liabilities to deteriorate.
  • Payments risk: Risk that arises from operation of payments mechanism and the possibility of failure of a bank to be able to make the required settlements.
  • Risk of settlement (Herstatt risk): Risk of loss in foreign exchange trading where one party delivers foreign exchange but the other party fails to meet its end of the bargain.
  • Off-balance-sheet risk: Risk that business that is fee earning will lead to losses through the failure of the counterparties to carry out their obligations.

 

Retail banking

 

 

Retail banking is providing the services of accepting deposits and making loans to individuals and small businesses; the banks act as financial intermediaries. The transactions made are usually of small value but in large volume so the number of transactions in a year is very large.

 

Retail banking involves liquidity and asset risk but these risks are overcome by attracting large numbers of customers, both deposits and borrowers. With respect to the asset risk, the large number of borrowers can also act as an protection since it is unlikely that a small number of loan failures will cause the banks great financial distress.

 

Wholesale banking

 

Wholesale banking deals with a small number of customers but a large size of each account. This is in contrast to retail banking. For very large loans, groups of banks will operate as a syndicate with one bank being denoted as lead bank. This has two advantages for the bank in the aspect of risk management:

  1. Risk from exposure to an individual customer is reduced.
  2. Risk reduction through diversification can be achieved through extending the range of types of customer to whom loans are made.

 

The balance sheet of wholesale banking differs from the balance sheet of retail banking. Some important differences are:

  • Wholesale banking does not operate in the payments mechanism and therefore their holdings of cash and balances at the central bank are lower.
  • Off-balance-sheet assets are more important in wholesale banking.
  • Greater use of foreign currency business.
  • Smaller proportion of sight deposits and a greater volume of trading assets.
  • Wholesale banks make greater use of the interbank market to obtain their funds. When they are short of funds they can raise money through borrowing in the interbank market. Surplus funds will be deposited in the interbank market, this is called liability management

 

Universal banking

 

Universal banks are banks that operate the entire range of financial services ranging through the normal banking service of accepting deposits and making loans, insurance, security services, underwriting and owning shares in client companies. Saunders and Walter (1993) distinguished between four different types of universal bank organization:

  1. A fully integrated bank providing all service within a single firm.
  2. A partially integrated bank that undertakes commercial and investment banking under the same roof but that provides the other services through specialized subsidiaries.
  3. A bank whose core business is not only accepting deposits and making loans but also providing a wide range of financial services through subsidiaries.
  4. A holding company that controls spate subsidiaries set up to provide banking, investment banking and other financial services.

 

Because universal banks offer a wide range of financial services and therefore they are more able to attract and keep customers. However, greater specialization may also bring rewards. Universal banking provides scope for improved monitoring and control of the non-financial firms. Another advantage is that has the size and ability to obtain economies of scale and scope.

 

Chapter E: The theory of the banking firm

 

 

Introduction

 

Banks are different from other commercial and industrial enterprises because the monetary mechanism enables them to attract deposits on onward investment. Therefore we need a specific theory for the banking firm. Banks also differ from ordinary firms in the case of leverage.

 

The textbook model

 

Textbooks of economics will usually portray the banking sector as a passive agent in the monetary transmission mechanism. This view comes from the money multiplier approach. The money multiplier is a non-behavioral relationship between changes in the stock of base money and the stock of broad money. We can derive two statements which can be found in attachment E.1.

 

In these formulas H is base money, C is currency in circulation with the non-bank public, R is the bank reserves, M is the broad money and D is bank deposits. Then the money multiplier is m = M/H.

 

We first assume a primitive type of balance sheet with no physical capital and no equity on its liabilities. See attachment E.2 for the balance sheet.

 

If there is a reserve ratio k so that R = kD, then the balance sheet can be represented as;

L = (1 - k) D

 

If we divide this formula by base money we can derive the credit and deposit multiplier, see attachment E.3.

 

The central bank can control supply of base money by using open-market operations to fund the government budget deficit, which is given by the financing constraint, see attachment E.4. Where G is government spending, T is tax receipts and ΔB is the sales of government debt.

 

The supply base of money is not exogenous but usually supplied on demand of the central bank to the banking system. In developing a framework for the analysis of the banking firm, Baltensperger (1980) sets the objective of the bank as a profit function (π), see attachment E.5.

  • rL is the rate of interest charged on loans
  • rD is the interest paid on deposits
  • l is the cost of illiquidity
  • s is the cost due to the default
  • c is the real resource cost

 

The perfectly competitive bank

 

We begin by adding T and rT to the balance sheet to make it more realistic. T stands for government treasury bills and rT is the rate of interest. In the competitive model of the banking firm, the individual bank is a price taker, so rL and rD are constant. The bank’s objective is to maximize profit, see attachment E.6 for the formula. And see attachment E.7 for the equilibrium conditions.

This result shows that the margin of intermediation is given by the product of the reserve ratio and the risk-free rate and the sum of the marginal costs of loan and deposit production by the bank.

 

The monopoly bank

 

A perfectly competitive model is an extreme model; another extreme is the monopoly model. The existence of monopolistic features is something characteristic of financial intermediaries. The information role of banks gives them some monopolistic discretion in the pricing of loans according to risk characteristics.

 

The monopoly bank represents the banking industry as a whole and will face downward-sloping demand for loans with respect to the loan rate and an upward-sloping demand for deposits with respect to the deposit rate, see attachment E.8.

 

Some additional assumptions of this model:

  • The bank faces a scale and allocation decision, and scale is identified by the volume of deposits.
  • The market for bills is perfectly competitive and the bank is a price taker.
  • The loan and deposit markets are perfectly competitive.
  • Loans are imperfect substitutes for bills.
  • Reserves earn no interest.
  • The bank maximizes profits.
  • The bank faces a fixed cost schedule.

 

The interest-setting equations by the monopoly bank can be found in attachment E.9.

 

The figure on the next page shows the equilibrium of loans. It shows that the monopoly bank extends loans until the marginal revenue on loans, described by MRL curve, equals the opportunity cost, the rate of interest on bills. Thus the monopoly bank produces L* loans. See attachment E.10 for the figure.

 

The figure in attachment E.11 shows the equilibrium for deposits. The bank sells deposits until the point where the marginal cost of deposits equals the marginal return from its investment. So the bank supplies D* deposits.

 

From these two figures we can conclude that when the bill rate rises, then the loan rate and the deposit rate will also rise. And a rise in the loan rate reduces the equilibrium quantity of loans and increases the equilibrium quantity of deposits. The bank substitutes loans for bills at the margin.

 

However this model also does have a number of weaknesses:

  • Profit is earned exclusively from monopoly power.
  • There is no analysis of the costs of supplying loans and deposits.
  • The volumes of loans and deposits are determined independently of each other.
  • The assumption of price maker in the loan and deposit market and price taker in the bill market is questionable.

 

The imperfect competition model

 

We will now look at Cournot competition. To enable aggregation, assume that there are n banks, all facing the same linear cost function.

Each bank maximizes its profits taken the volume of deposits and loans of other banks as given. There is a unique equilibrium where each bank sets its deposits as D* = D/n and loans as L* = L/n. This leads to the equation that can be found in attachment E.12.

 

An important thing to note about these expressions is that the response of the loan rate and the deposit rate to change in the bill rate will depend on the intensity of competition given by the number of banks.

 

The imperfections associated with banking are:

  • Incomplete or imperfect information.
  • Uncertainty.
  • Transaction costs.

 

Chapter F: Models of banking behavior

 

Introduction

 

In this chapter alternative approaches to the banking firm will be discussed. An attempt is made to incorporate uncertainty of yields on assets by appealing portfolio theory, developed as the Tobin-Markowitz model. It will show that the assumption of risk aversion produces a risk premium in the margin of intermediation and explains the role of diversification in the asset management of banks.

 

Asset and liability management

 

The core activity of a bank is all about taking in deposits and transforming them into loans; it is all about asset and liability management. The two fundamental risks a bank faces on its balance sheet are default risk and withdrawal risk. The purpose of holding cash reserves is to minimize withdrawal risk and for the bank not to face cash reserve deficiency.

 

Liquidity management

 

Liquidity management involves managing reserves to meet predictable outflows of deposits. The bank maintains some reserves and it can expect some loan repayment. The bank can also borrow funds from the interbank market. Asset management can be considered as a two-stage, decision-making process. First the bank decides the quantity of reserves to hold and then it decides how to allocate its earnings assets between low-risk, low-return bills and high-risk, high-return loans.

 

The bank faces a continuous outflow of deposits over a specific period of time before new deposits or inflows replenish them at the beginning of the new period. If the withdrawal outflows are less than the stock reserves, the bank does not face a liquidity crisis.

 

A bank will choose the level of liquidity reserves such that the probability of a reserve deficiency is equal to the ratio of the rate of interest on earning assets (r) to the cost of meeting a reserve deficiency (p). The bank chooses a level of reserves such that the marginal benefits (not having to incur liquidation costs) equal marginal costs (interest income foregone).

 

The model states that when there are no reserve ratios, a bank will decide on the optimal level of reserves on the basis of the interest on earnings assets, the cost of meeting a reserve deficiency and the probability distribution of deposit withdrawals.

 

The major effect of imposing a reserve ratio is to reduce the critical value of the deposit withdrawals beyond which a deficiency occurs. An adjustment to the optimal level of reserves R* will only be profitable if the resulting gain more than offsets the costs of the adjustment itself, C. See attachment F.1 for the formula.

v stands for the marginal costs, R0 the reserves before the adjustment and R the reserves after the adjustment.

 

Loan pricing

 

The rate of interest on loans depends on a variety of individual borrower characteristics. One common characteristic is an allowance for risk of default combined with the degree of risk aversion by the bank. Under what conditions would banks sell risky deposits in order to by risky loans? In other words under what conditions does intermediation take place?

 

Consider a bank that faces a choice of three assets; one riskless asset and two assets with uncertain yield. We can see deposits as a negative asset. The profit function of the bank is given by the equation in attachment F.2. Here you can also see other equations that result from this.

π = rLL + rTT – rD D

 

For intermediation to exist the following conditions must hold:

E(rL) – rT > 0              à a positive risk premium on loans

E(rD) – rT < 0              à a negative risk premium on deposits

 

These two conditions combined give us the condition that there must be a positive spread:

E(rL) - E(rD) > 0

 

When the yield on loans and the interest on deposits is zero, then the spread is given by:

E(rL) - E(rD) = β(σ2rL L + σ2rD D)

β is the coefficient of risk aversion.

 

attachment_digital_version_economics_of_banking_part_1_2013-14.doc

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