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Contents 1 General Introduction 1 1.1 What Is a Bank, andWhatDo BanksDo? . . . . . . . . . . . 1 1.2 Liquidity and Payment Services . . . . . . . . . . . . . . . . . 5 1.2.1 Money Changing . . . . . . . . . . . . . . . . . . . . . 6 1.2.2 Payment Services . . . . . . . . . . . . . . . . . . . . . 8 1.3 Transforming assets . . . . . . . . . . . . . . . . . . . . . . . . 8 1.4 Managing Risks . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.4.1 Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . 11 1.4.2 Interest Rate and Liquidity Risks . . . . . . . . . . . . 12 1.4.3 Off-Balance-SheetOperations . . . . . . . . . . . . . . 12 1.5 Monitoring and Information Processing . . . . . . . . . . . . . 14 1.6 The Role of Banks in the Resource Allocation Process . . . . . 15 1.7 Banking in the Arrow-DebreuModel . . . . . . . . . . . . . . 16 1.7.1 The Consumer . . . . . . . . . . . . . . . . . . . . . . 18 1.7.2 The Firm . . . . . . . . . . . . . . . . . . . . . . . . . 19 1.7.3 The Bank . . . . . . . . . . . . . . . . . . . . . . . . . 19 1.7.4 General Equilibrium . . . . . . . . . . . . . . . . . . . 20 1.8 Outline of the Book . . . . . . . . . . . . . . . . . . . . . . . . 22 2 The Role of Financial Intermediaries 33 2.1 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . 40 2.1.1 Economies of Scope . . . . . . . . . . . . . . . . . . . . 41 2.1.2 Economies of Scale . . . . . . . . . . . . . . . . . . . . 43 2.2 Coalitions of Depositors and Liquidity Insurance . . . . . . . . 45 2.2.1 TheModel . . . . . . . . . . . . . . . . . . . . . . . . . 46 2.2.2 Characteristics of theOptimal Allocation . . . . . . . . 47 2.2.3 Autarky . . . . . . . . . . . . . . . . . . . . . . . . . . 48 2.2.4 Market Economy . . . . . . . . . . . . . . . . . . . . . 48 2.2.5 Financial Intermediation . . . . . . . . . . . . . . . . . 51 2.3 Coalitions of Borrowers and the Cost of Capital . . . . . . . . 53 2.3.1 A Simple Model of Capital Markets with Adverse Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 2.3.2 Signaling Through Self-Financing and the Cost of Capital 57 2.3.3 Coalitions of Borrowers . . . . . . . . . . . . . . . . . . 59 2.3.4 Suggestions for further Reading . . . . . . . . . . . . . 61 2.4 Financial Intermediation asDelegatedMonitoring . . . . . . . 64 2.5 The Choice BetweenMarketDebt and BankDebt . . . . . . . 71 2.5.1 A Simple Model of the Credit Market with Moral Hazard 72 2.5.2 Monitoring and Reputation (Adapted from Diamond 1991) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 2.5.3 Monitoring and Capital (Adapted from Holmström and Tirole 1997) . . . . . . . . . . . . . . . . . . . . . . . . 79 2.5.4 Financial Architecture (Boot and Thakor 1997) . . . . 84 2.5.5 Credit Risk and Dilution Costs (Bolton Freixas 2000) . 87 2.6 Liquidity Provision to Firms . . . . . . . . . . . . . . . . . . . 92 2.7 Suggestions for further reading . . . . . . . . . . . . . . . . . . 94 2.8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 2.8.1 Strategic Entrepreneurs and Market Financing . . . . . 98 2.8.2 Market vs. Bank Finance . . . . . . . . . . . . . . . . 99 2.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 2.9.1 Strategic Entrepreneurs and Market Financing . . . . . 101 2.9.2 Market vs. Bank Finance . . . . . . . . . . . . . . . . 102 2.9.3 Economies of Scale in Information Production . . . . . 106 2.9.4 Monitoring as a Public Good and Gresham's Law . . . 108 2.9.5 Intermediation and Search Costs (Adapted fromGehrig 1993) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 2.9.6 Intertemporal Insurance . . . . . . . . . . . . . . . . . 111 2.10 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 2.10.1 Economies of Scale in Information Production . . . . . 114 2.10.2 Monitoring as a Public Good and Gresham's Law . . . 115 2.10.3 Intermediation and Search Costs . . . . . . . . . . . . 117 2.10.4 Intertemporal Insurance . . . . . . . . . . . . . . . . . 121 3 The Industrial Organization Approach to Banking 139 3.1 AModel of a Perfect Competitive Banking Sector . . . . . . . 142 3.1.1 TheModel . . . . . . . . . . . . . . . . . . . . . . . . . 142 3.1.2 The CreditMultiplier Approach . . . . . . . . . . . . . 144 3.1.3 The Behavior of Individual Banks in a Competitive Banking Sector . . . . . . . . . . . . . . . . . . . . . . 146 3.1.4 The Competitive Equilibrium of the Banking Sector . . 148 3.2 TheMonti-KleinModel of aMonopolistic Bank . . . . . . . . 153 3.2.1 TheOriginalModel . . . . . . . . . . . . . . . . . . . . 153 3.2.2 TheOligopolistic Version . . . . . . . . . . . . . . . . . 156 3.2.3 Empirical Evidence . . . . . . . . . . . . . . . . . . . . 158 3.3 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . 159 3.3.1 Does Free Competition Lead to the Optimal Number of Banks? . . . . . . . . . . . . . . . . . . . . . . . . . 160 3.3.2 The Impact of Deposit Rate Regulation on Credit Rates164 3.3.3 Bank Network Compatibility . . . . . . . . . . . . . . . 169 3.3.4 Empirical Evidence . . . . . . . . . . . . . . . . . . . . 170 3.4 The Scope of the Banking Firm . . . . . . . . . . . . . . . . . 172 3.5 Beyond price competition . . . . . . . . . . . . . . . . . . . . 173 3.5.1 Risk taking on investments . . . . . . . . . . . . . . . . 174 3.5.2 Monitoring and incentives in a financial conglomerate . 182 3.5.3 Competition and screening . . . . . . . . . . . . . . . . 186 3.6 Relationship Banking . . . . . . . . . . . . . . . . . . . . . . . 193 3.6.1 The Ex PostMonopoly of Information . . . . . . . . . 195 3.6.2 Equilibrium with Screening and Relationship Banking . 200 3.6.3 Does Competition Threaten Relationship Banking? . . 202 3.6.4 Intertemporal Insurance . . . . . . . . . . . . . . . . . 203 3.6.5 Empirical Tests of Relationship Banking . . . . . . . . 205 3.7 Payment Cards and Two-SidedMarkets . . . . . . . . . . . . 212 3.7.1 AModel of the Payment Card Industry . . . . . . . . . 213 3.7.2 Cards Usage . . . . . . . . . . . . . . . . . . . . . . . . 215 3.7.3 MonopolyNetwork . . . . . . . . . . . . . . . . . . . . 216 3.7.4 Competing Payment Card Networks . . . . . . . . . . 217 3.7.5 Welfare Analysis . . . . . . . . . . . . . . . . . . . . . 218 3.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 3.8.1 Extension of the Monti-Klein Model to the Case of Risky Loans (Adapted fromDermine 1986) . . . . . . . 220 3.8.2 Compatibility between Banking Networks (Adapted from Matutes and Padilla 1994) . . . . . . . . . . . . . . . . 221 3.8.3 Double Bertrand Competition . . . . . . . . . . . . . . 223 3.8.4 Deposit Rate Regulation . . . . . . . . . . . . . . . . . 224 3.9 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 3.9.1 Extension of the Monti-Klein Model to the Case of Risky Loans . . . . . . . . . . . . . . . . . . . . . . . . 225 3.9.2 Compatibility between Banking Networks . . . . . . . 226 3.9.3 Double Bertrand Competition . . . . . . . . . . . . . . 229 3.9.4 Deposit Rate Regulation . . . . . . . . . . . . . . . . . 230 4 The Lender-Borrower Relationship 253 4.1 Why Risk Sharing Does Not Explain All the Features of Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 4.2 Costly State Verification . . . . . . . . . . . . . . . . . . . . . 259 4.2.1 Incentive Compatible Contracts . . . . . . . . . . . . . 261 viii 4.2.2 Efficient Incentive Compatible Contracts . . . . . . . . 263 4.2.3 Efficient Falsification-Proof Contracts . . . . . . . . . . 266 4.3 Incentives to Repay . . . . . . . . . . . . . . . . . . . . . . . . 268 4.3.1 Nonpecuniary cost of bankruptcy . . . . . . . . . . . . 268 4.3.2 Threat of Termination . . . . . . . . . . . . . . . . . . 270 4.3.3 Impact of Judicial Enforcement . . . . . . . . . . . . . 273 4.3.4 Strategic Debt Repayment: The Case of a Sovereign Debtor . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 4.4 Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 4.5 The Incomplete Contract Approach . . . . . . . . . . . . . . . 288 4.5.1 Private Debtors and the Inalienability of Human Capital290 4.5.2 Liquidity of Assets and Debt Capacity . . . . . . . . . 294 4.5.3 Soft Budget Constraints and Financial Structure . . . . 297 4.6 Collateral as a Device for Screening Heterogenous Borrowers . 303 4.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 4.7.1 Optimal Risk Sharing with Symmetric Information . . 310 4.7.2 Optimal Debt Contracts with Moral Hazard (Adapted fromInnes 1990) . . . . . . . . . . . . . . . . . . . . . 311 4.7.3 The Optimality of Stochastic Auditing Schemes . . . . 313 ix 4.7.4 The Role of Hard Claims in Constraining Management (Adapted fromHart andMoore 1995) . . . . . . . . . . 314 4.7.5 Collateral and Rationing (Adapted from Besanko and Thakor 1987) . . . . . . . . . . . . . . . . . . . . . . . 315 4.7.6 Securitization (Adapted from Greenbaum and Thakor 1987) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 4.8 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318 4.8.1 Optimal Risk Sharing with Symmetric Information . . 318 4.8.2 Optimal Debt Contracts withMoral Hazard . . . . . . 319 4.8.3 The Optimality of Stochastic Auditing Schemes . . . . 320 4.8.4 The Role of Hard Claims in Constraining Management 322 4.8.5 Collateral andRationing . . . . . . . . . . . . . . . . . 322 4.8.6 Securitization . . . . . . . . . . . . . . . . . . . . . . . 324 5 Equilibrium in the Credit Market and its Macroeconomic Implications 339 5.1 Definition of Equilibrium Credit Rationing . . . . . . . . . . . 341 5.2 The Backward Bending Supply of Credit . . . . . . . . . . . . 344 5.3 EquilibriumCredit Rationing . . . . . . . . . . . . . . . . . . 346 5.3.1 Adverse Selection . . . . . . . . . . . . . . . . . . . . . 347 5.3.2 Costly State Verification . . . . . . . . . . . . . . . . . 351 x 5.3.3 Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . 352 5.4 Equilibriumwith a Broader Class of Contracts . . . . . . . . . 356 5.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362 5.5.1 TheModel ofMankiw (1986) . . . . . . . . . . . . . . 362 5.5.2 Efficient Credit Rationing (Adapted from DeMeza and Webb 1992) . . . . . . . . . . . . . . . . . . . . . . . . 363 5.5.3 Too Much Investment (Adapted from De Meza and Webb 1987) . . . . . . . . . . . . . . . . . . . . . . . . 364 5.6 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365 5.6.1 TheModel ofMankiw (1986) . . . . . . . . . . . . . . 365 5.6.2 Efficient Credit Rationing . . . . . . . . . . . . . . . . 366 5.6.3 TooMuch Investment . . . . . . . . . . . . . . . . . . 368 6 The Macroeconomic Consequences of Financial Imperfections 379 6.1 AShortHistorical Perspective . . . . . . . . . . . . . . . . . . 383 6.2 The Transmission Channels ofMonetary Policy . . . . . . . . 386 6.2.1 The Different Channels . . . . . . . . . . . . . . . . . . 390 6.2.2 ASimpleModel . . . . . . . . . . . . . . . . . . . . . . 392 6.2.3 Credit View versus Money View: Justification of the Assumptions and Empirical Evidence . . . . . . . . . . 395 xi 6.2.4 Empirical Evidence on the Credit View . . . . . . . . . 400 6.3 Financial Fragility and Economic Performance . . . . . . . . . 402 6.4 Financial Development and EconomicGrowth . . . . . . . . . 413 7 Individual Bank Runs and Systemic Risk 431 7.1 BankingDeposits and Liquidity Insurance . . . . . . . . . . . 434 7.1.1 AModel of Liquidity Insurance . . . . . . . . . . . . . 434 7.1.2 Autarky . . . . . . . . . . . . . . . . . . . . . . . . . . 435 7.1.3 TheAllocation... . . . . . . . . . . . . . . . . . . . . . 436 7.1.4 TheOptimal (Symmetric) Allocation . . . . . . . . . . 437 7.1.5 AFractional Reserve Banking System. . . . . . . . . . 438 7.2 The Stability of the Fractional Reserve System... . . . . . . . . 442 7.2.1 The Causes of Instability . . . . . . . . . . . . . . . . . 442 7.2.2 A First Remedy to Instability: Narrow Banking . . . . 444 7.2.3 Regulatory Responses: Suspension... . . . . . . . . . . 446 7.2.4 Jacklin's Proposal: Equity versusDeposits . . . . . . . 449 7.3 Bank Runs and Renegotiation . . . . . . . . . . . . . . . . . . 452 7.4 Efficient Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . 459 7.5 InterbankMarkets and theManagement... . . . . . . . . . . . 464 7.5.1 TheModel of Bhattacharya andGale (1987) . . . . . . 465 7.5.2 The Role of the InterbankMarket . . . . . . . . . . . . 466 xii 7.5.3 The Case of Unobservable Liquidity Shocks . . . . . . 467 7.6 Systemic risk and contagion . . . . . . . . . . . . . . . . . . . 469 7.6.1 Aggregate liquidity and banking crises . . . . . . . . . 470 7.6.2 Payment systems andOTC operations . . . . . . . . . 474 7.6.3 Contagion through interbank claims . . . . . . . . . . . 477 7.7 The Lender of Last Resort:... . . . . . . . . . . . . . . . . . . . 482 7.7.1 Four Views on the LLRRole . . . . . . . . . . . . . . . 484 7.7.2 Liquidity and solvency: a coordination game . . . . . . 488 7.7.3 The practice of LLRassistance . . . . . . . . . . . . . 492 7.7.4 The Effect of LLR and Other Partial Arrangements . . 494 7.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497 7.8.1 Bank Runs andMoral Hazard . . . . . . . . . . . . . . 497 7.8.2 Bank runs . . . . . . . . . . . . . . . . . . . . . . . . . 498 7.8.3 Information-Based Bank Runs... . . . . . . . . . . . . . 500 7.8.4 Banks' Suspension of Convertibility... . . . . . . . . . . 501 7.8.5 Aggregate Liquidity Shocks (adapted fromHellwig (1994))504 7.8.6 CharterValue . . . . . . . . . . . . . . . . . . . . . . . 506 7.9 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507 7.9.1 Banks Runs andMoral Hazard . . . . . . . . . . . . . 507 7.9.2 Bank runs . . . . . . . . . . . . . . . . . . . . . . . . . 508 xiii 7.9.3 Information-Based Bank Runs . . . . . . . . . . . . . . 509 7.9.4 Banks' Suspension of Convertibility . . . . . . . . . . . 510 7.9.5 Aggregated Liquidity Shocks . . . . . . . . . . . . . . . 514 7.9.6 CharterValue . . . . . . . . . . . . . . . . . . . . . . . 515 8 Managing Risks in the Banking Firm 531 8.1 Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 8.1.1 Institutional Context . . . . . . . . . . . . . . . . . . . 533 8.1.2 Evaluating the Cost of Credit Risk . . . . . . . . . . . 535 8.1.3 Regulatory Response to Credit Risk . . . . . . . . . . . 543 8.2 Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . 547 8.2.1 ReserveManagement . . . . . . . . . . . . . . . . . . . 548 8.2.2 Introducing Liquidity Risk in the Monti-Klein Model . 551 8.2.3 The Bank as aMarketMaker . . . . . . . . . . . . . . 554 8.3 Interest Rate Risk. . . . . . . . . . . . . . . . . . . . . . . . . 560 8.3.1 The TermStructure of Interest Rates . . . . . . . . . . 562 8.3.2 Measuring Interest Rate Risk Exposure . . . . . . . . . 566 8.3.3 Applications to Asset Liability Management . . . . . . 568 8.4 Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571 8.4.1 Portfolio Theory: The Capital Asset Pricing Model . . 572 xiv 8.4.2 The Bank as a Portfolio Manager: The Pyle (1971), Hart-Jaffee (1974) Approach . . . . . . . . . . . . . . . 575 8.4.3 An Application of the Portfolio Model: The Impact of Capital Requirements . . . . . . . . . . . . . . . . . . . 581 8.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590 8.5.1 The Model of Prisman, Slovin, and Sushka (1986) . . . 590 8.5.2 The Risk Structure of Interest Rates (Adapted from Merton 1974) . . . . . . . . . . . . . . . . . . . . . . . 592 8.5.3 Using the CAPMfor Loan Pricing . . . . . . . . . . . 593 8.6 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594 8.6.1 TheModel of Prisman, Slovin, and Sushka . . . . . . . 594 8.6.2 The Risk Structure of Interest Rates . . . . . . . . . . 597 8.6.3 Using the CAPMfor Loan Pricing . . . . . . . . . . . 597 9 The Regulation of Banks 607 9.1 The Justification of Banking Regulations . . . . . . . . . . . . 609 9.1.1 TheGeneral Setting . . . . . . . . . . . . . . . . . . . 610 9.1.2 The Fragility of Banks . . . . . . . . . . . . . . . . . . 612 9.1.3 The Protection of Depositors and Customers Confidence614 9.1.4 The Cost of Bank Failures . . . . . . . . . . . . . . . . 618 9.2 AFramework for RegulatoryAnalysis . . . . . . . . . . . . . . 620 xv 9.3 Deposit Insurance . . . . . . . . . . . . . . . . . . . . . . . . . 622 9.3.1 TheMoral Hazard Issue . . . . . . . . . . . . . . . . . 624 9.3.2 Risk-Related Insurance Premiums . . . . . . . . . . . . 627 9.3.3 Is Fairly PricedDeposit Insurance Possible? . . . . . . 631 9.3.4 The Effects of Deposit Insurance on the Banking Industry634 9.4 Solvency Regulations . . . . . . . . . . . . . . . . . . . . . . . 637 9.4.1 The Portfolio Approach . . . . . . . . . . . . . . . . . 637 9.4.2 Cost of Bank Capital and Deposit Rate Regulation . . 640 9.4.3 The Incentive Approach . . . . . . . . . . . . . . . . . 644 9.4.4 The Incomplete Contract Approach . . . . . . . . . . . 647 9.4.5 The 3 Pillars of Basel 2 . . . . . . . . . . . . . . . . . . 655 9.5 The Resolution of Bank Failures . . . . . . . . . . . . . . . . . 655 9.5.1 Resolving Banks' Distress: Instruments and Policies . . 657 9.5.2 Information Revelation and Managers Incentives . . . . 659 9.5.3 Who ShouldDecide on Banks' Closure? . . . . . . . . 664 9.6 MarketDiscipline . . . . . . . . . . . . . . . . . . . . . . . . . 669 9.7 Further Readings . . . . . . . . . . . . . . . . . . . . . . . . . 675 9.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679 9.8.1 Moral hazard and capital regulation . . . . . . . . . . . 679 9.9 SOLUTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680 xvi 9.9.1 Moral hazard and capital regulation . . . . . . . . . . . 680
Library of Congress Subject Headings for this publication:
Banks and banking.
Finance -- Mathematical models.
Microeconomics.