Table of contents for Microeconomics of banking / Xavier Freixas and Jean-Charles Rochet.

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Counter
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
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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
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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.