Banking

Question 1

What was Christopher James’ main finding?

Answer 1

Empirically, establishing a bank loan agreement (even without any indication of using it) tends to result in significant abnormal return

Question 2

What does Christopher James find about firm size?

Answer 2

That firms using private placements and bank loans on average are 25% smaller than firms using public offerings

Question 3

Who made the finding that establishinging a bank loan agreement tends to result in significant abnormal return

Answer 3

Christopher James (1987)

Question 4

What are the two main types of monitoring and how do they differ?

Answer 4

Passive monitoring: Enforcing debt payments when cash flows cannot be verified
Active Monitoring: Making sure that the borrower acts optimally

Question 5

What is the key idea in Diamon’s model?

Answer 5

Diamon’s model is a model of delegated passive monitoring. It is a model of costly state verification, where firms issue debt and are subject to auditing when they cannot pay back the full face value in order to insure truthtelling.

By delegating the monitoring to a single intermediary can cut the total cost of monitoring, since 1 intermediary rather than many investors will a monitoring cost.
Depositors also need to monitor the intermediary. If there is only 1 firm, there is no benefit in monitoring. However,, if there are multiple firms with less than perfectly correlated returns (in Diamon, returns are i.i.d.), monitoring through the intermediary is less costly than if each depositor would monitor each firm.

Question 6

How to check if firms can obtain unmonitored finance in the model of active monitoring?

Answer 6

Would investors ever be willing to invest if firms invest in the bad project?
If firms only invest in the good projects, would firm be tempted to cheat (lower possibility of paying back funds in the bad project)

Question 7

What is the function of monitoring in the active monitoring model?

Answer 7

It makes firms always choose the good project.

Question 8

What is a necessary condition for the Monotone Likelihood Property?

Answer 8

A necessary condition first order stochastic dominance

Question 9

How can financial innovation help ensure that firms always choose the good projects?

Answer 9

If issuing warrants/options that will only be exercised for bad projects in the good state, the upside of the bad projects will decrease. Firms are tempted to do the bad projects because of the high upside

Question 10

What is a problem with adverse shocks to the banking system?

Answer 10

It may reduce credit supply

Reduce the amount of active and passive monitoring

Question 11

What is the relationship between leverage growth and asset growth if following a passive financing policy?

Answer 11

A negative relationship. When asset increase and agents follow a passive policy, the level of debt will not change. This however implies that the leverage (relative level) must decrease

Question 12

What is the relationship between leverage growth and asset growth if following an active financing policy?

Answer 12

Will show no strong relationship. When asset change debt will increase in proportion, but leverage will stay constant

Question 13

What does Shin find about financing policy of different types of agents?

Answer 13

Households follow a passive policy (negative relationship)
Non-financial firms and commercial bank tend to follow an active policy (no relationship)
Brokers and dealers follow a ‘hyperactive’ policy (positive relationship)

Question 14

In the liquidity shock example, why is the supply curve of assets downwards sloping? (contrary to standard micro economics)

Answer 14

Because the lower the price of the asset, the greater is the amount required to sell in order to meet liquidity demands

Question 15

What are the key feedback mechanisms under active leverage policy?

Answer 15

Up cycle:
Increases in asset values through active policy causes bank to buys assets
This increases asset values
Causes more asset buying

Down cycle:
Decrease in asset values forces banks to liquidate assets
Liquidation puts downward pressure on prices
Lowered prices forces more liquidation

Question 16

What does Ashcraft (2005) find about the economic consequences of bank failures?

Answer 16

Subsidiary banks needed to close as a result of failing related banks. Arguably exogenous failures. There was substantial decline in economic activity in the countries several years after the failures

Question 17

What are the conditions for a clearing vector?

Answer 17

Limited liability

Absolute Priority

Question 18

What is the pi matrix?

Answer 18

What row owes to column

Question 19

How is payments received calculated?

Answer 19

Pi_transpose times payments made

Question 20

What is the core idea of the algorithm from class?

Answer 20

As long as nominal promises exceeds payments made, increase payments by difference as long as equity is non-negative. Start with payment equals to endowments or total promises if possible

Question 21

What are the consequences of bilateral clearing?

Answer 21

Extraction. Bilateral Clearing between Good nodes and Bad or Ugly nodes can increase defaults
Amputation. Bilateral Clearing between bad and ugly nodes can reduce default

Question 22

When is connectivity most dangerous?

Answer 22

When certain nodes take top priority. That can ‘suck’ value out of the network as a whole

Question 23

Who has bargaining power in the model of active monitoring?

Answer 23

The firm has bargaining power and the investor thus breaks even in expectation

Question 24

What type of contract is usely used in the active monitoring model?

Answer 24

A debt contract. The face value (or payment, R) needs to make the investor break even in expectation

Question 25

What does monitoring achieve in the active monitoring model?

Answer 25

That banks do the right projects