Foundations of micro banking theory
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FOUNDATIONS OF MICRO-BANKING THEORY. CHAPTER 2: Why do financial intermediaries exist? CHAPTER 3: The Industrial Organisation approach to Banking CHAPTER 4: The Lender-Borrower Relationship. CHAPTER 5: The equilibrium and rationing in the credit market

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Foundations of micro banking theory l.jpg
FOUNDATIONS OF MICRO-BANKING THEORY

  • CHAPTER 2: Why do financial intermediaries exist?

  • CHAPTER 3: The Industrial Organisation approach to Banking

  • CHAPTER 4: The Lender-Borrower Relationship


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CHAPTER 1 Why do financial intermediaries exist? credit market

  • The Classical theory

  • First generation

  • Second generation


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Preliminary: credit market

  • What is a financial intermediary?

  • -Deposits

  • - Loans

  • - Contracts (cannot be resold

  • (not anonymous

  • (not necessarily standard



  • 1 1 the classical theory l.jpg
    1.1 credit marketThe Classical theory

    • 1.1.1 A transaction cost approach (Benston and Smith, 1976)

    • Institutions emerge because they allow to diminish contracting costs:

    • 1) costs of becoming informed

    • 2) costs of structuring, administering and enforcing financial contracts

    • 3) cost of transferring financial claims


    1 1 the classical theory continued l.jpg
    1.1 credit marketThe Classical theory (continued)

    • 1.1.2Transformation of assets (Gurley and Show, 1960)

  • maturity

  • convenience of denomination

  • risk (indivisibilities) (Merton, 1989)

  • It is implicitly assumed that these asset transformation services are provided more efficiently outside the firm.


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    Implications credit market

    • economies of scale

    • economies of scope

    • reputational capital

    • reduction in search costs


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    1.1 credit marketThe Classical theory (end)

    • 1.1.3Payment system (Fama, 1980)


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    1.2 credit marketFirst Generation

    • The delegated monitoring approach (Diamond 1984)

    • Diamond-Dybvig: Liquidity insurance

      Ex ante uncertainty defines the liquidity shock


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    Consumers credit market

    • U(C1) Early diers or impatient consumers

    • U(C2) Late diers (patient consumers)Ct is consumption at time 1 or 2 and U is increasing and concave.


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    Technology credit market

    • Long run technology

    • t=o t=1 t=2

    • -1 - R (R>1)

    • Storage technology

    • t=o t=1

    • -1 1


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    • Efficient solution credit market: ex ante insurance against preferences shocks

      with C< R if relative risk aversion is larger than 1.


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    • Market solution credit market:

      early diers consume 1

      late diers consume R which is not ex ante efficient

    • Financial intermediation

      A FI may provide deposits which entail a larger consumption for early diers and lower consumption for late diers thus reaching the efficient allocation.


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    Intertemporal Smooting  credit market

    • An extension (Allen and Gale, 1997)

    • The focus is on intertemporal smoothing.

    • Some generations face a large return, others a smaller one. Since each generation lives only two periods, it cannot enter an explicit insurance contract. Banking provides this type of insurance and is ex ante Pareto efficient.

    • Ex ante uncertainty defines the liquidity shock


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    1.3 Second generation: credit market

    • Co-existence of financial intermediaries and financial markets

    • Agents differ by

      • their history of repayments

      • their collateral

      • their rating

      • Their information


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    Additional motivation: credit market

    • Schumpeter, Gerschenkron

    • External finance premium

    • US-UK vs. Japan-Germany financial structures (Short term vs. long term)


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    1.3.1 credit marketDiamond (1991): Monitoring and reputation

    • Consider a population of firms that have investment projects of three different non-observable types:

      • 1)high risk, high return and negative net present value

      • 2)low risk low return and positive net present value projects.

      • 3)strategic firms which are able to choose their type between the two previous ones.


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    • The main issue is the moral hazard problem for the strategic firms

    • The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay.

    • MAIN RESULT:good history firms will issue securities.


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    1.3.2Holmstrom and Tirole (1995) (Monitoring and collateral)

    • Moral hazard on the project choice:

    • The entrepreneur chooses the probability of success

    • The project with a lower probability of success has private benefits B for the entrepreneur.


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    1.3.3 Boot and Thakor diminishing B to b.

    • With some probability firms have access only to a good project and with the complementary probability they are strategic. Firms are heterogeneous as they differ in this probability

    • The banks’ role is to force the firms to choose the good project

    • The financial market helps the firms to make the right investment by signalling (via prices) the overall environment the firms face.


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    1.3.4 diminishing B to b.Bolton-Freixas (2000)

    • Banks are able to monitor and to renegotiate firms in financial distress

    • Bond holders will always liquidate firms that default.

    • The financial market imperfection stems from adverse selection (Myers Majluf)


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    • Firms differ by their riskiness diminishing B to b.

    • Bank loans are at a premium

    • Result: risky firm prefer bank loans, safe firms prefer bonds

    • Consistent with empirical evidence regarding the effect of monetary policy on small firms


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    1.3.4 Gorton-Pennacchi (1990) diminishing B to b.

    • Informed insiders

    • Some agents have priviledged information

    • Consumers have Diamond-Dybvig preferences

    • The design of securities is endogenous

    • Then in equilibrium there is a riskless security which can be interpreted as a bank.


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    TO SUMMARIZE diminishing B to b.

    • There is no a unique view

    • Apart from the transaction costs

    • Intertemporal insurance, screening and monitoring are the main reasons why financial intermediatiaris may emerge .

    • Consider a population of firms that have investment projects of three different non-observable types:

    • )high risk, high return and negative net present value

    • )low risk low return and positive net present value projects.

    • )strategic firms which are able to choose their type between the two previous ones.

    • The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay.


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