Commercial Banks Flashcards
Maturity transformation of deposits
Banks can transform short term deposits into long term loans. Banks allow for long term investments to be made thereby benefitting the economy - assuming this investment leads to some sort positive impact of the economy.
Advantages of banks
Liquidity- availability of funds
0 negotiation costs - increase economic efficiency
Can increase economic welfare
Banks are more than just intermediaries
When may direct lending be better than bank loans?
Banks extract a proportion of the surplus of the Nash bargaining.
If negotiation costs are sufficiently low the benefit from banks is diminished whilst direct lending means a bank does not take a third of the surplus. Therefore direct lending could be favoured.
Why do banks prefer long term loans
They can charge a higher loan and thus more profits.
Similarly depositors that leave their money in the account for both periods get a lather savings rate
How do banks influence a company’s investment
Credit rationing. Banks want to be repaid and hence prefer low risk investments. They therefore ration the amount of capital such that riskier projects cannot be funded they also set loan rates lower in an attempt to discentivise companies (they need a smaller return on their investments to repay the loan therefore the low risk investment may be feasible)
Credit rationing may also imply equity financing in part which should eliminate any moral hazard problem
What drives credit rationing?
Uncertainty.
Advantages of collateral
Induces less risk taking
Helps a bank understand the investment decisions of companies. A company will not pledge capital if they expect to lose it therefore only low risk investors tend to pledge capital.
Reduces uncertainty
Benefit of rehypothecation
Company: may be able to secure more favourable lending conditions ie lower loan rate.
Banks: could secure more funding for additional loans increasing economic efficiency. May increase the banks liquidity due to successful investments coming in. Depositors can access their cash more easily.
Rehypothecation makes collateral more valuable to banks since it can be used in their own financing. Expected profits rise thus more favourable loan conditions can be granted
When is relationships banking important and what benefit can it bring?
Becomes important with increased competition. Relationship banking enables a bank to more effectively price loans, since they learn more about their customer what they can afford etc.
As opposed to transaction banking which does not lead to an accumulation of information and instead is more for one off transactions. More competition makes transaction banking less profitable
Fractional reserve banking
Banks keep a small amount of deposits in reserves and loan the rest out.
Could be subject to a bank run if enough people expect the bank is in a bad position / if enough people withdraw
Effect of deposit insurance
Induces risky behaviour for the bank - they do not need to hold as many deposits and therefore can make more risky loans. It induces moral hazard
Downward pressure on deposit rates to reflect them being risk free.
Less chance of a bank run.
Increases competition between banks
Why should the deposit insurance premia be dynamic?
Deposit insurance can induce risky behaviour for the bank. A dynamic deposit insurance premia can cancel out the profits from more risky behaviour thereby reducing its incentive.
Why might deposit insurance increase competition between banks?
Banks compete more for deposits since they can extract a higher portion of the surplus
Evergreening
Where a bank gives a company an additional loan in the hope it will reduce the bank’s overall losses. Loaning to an existing customer in financial distress, unlikely to repay their initial loan.
New loan could create a profit helping to reduce the loss from the first loan.
In the most optimistic circumstances, new loan may enable the company to escape any financial duress and repay the initial loan in full
Why could illiquid investments (rather than bank deposits) be a problem?
Knowing their investment is less liquid, the investor holds more cash than is optimal to manage ad hoc expenses. This leads to a reduction in economic efficiency
When is rehypothecation feasible
Only with large loans - more likely with large companies
Maturity mismatch
Banks solve maturity mismatch problem, enabling lenders to have ready access to their deposits whilst borrowers can undertake long term loans, since investments are often long term in nature
Trading with direct lending
Enables direct lending to be more liquid improving welfare. Loans are however usually sold at a loss which could be bad for welfare
Accumulation of information
Very costly for the bank however worth it for the profits from relationship banking.
