Session 10 Flashcards
Smoothing?
economic agents tend to prefer to smooth out consumption instead of consuming everything later and nothing now
- holds due to diminishing marginal returns to consumption: the value of an additional unit of consumption declines as consumption increases
- With the diminishing marginal returns to consumption, indifference curve is bowed toward the origin(convex): the more goods in the present, the less the agent values an additional good now relative to one in the future
- The point of tangency between the indifference curve and the budget constraint (F) shows how much the agent decides to spend now and later given the income stream and credit conditions
Borrowing?
- Borrowers trade future consumption for present consumption
- A higher interest rate makes present consumption relatively more expensive
- So, a higher interest rate reduces lifetime utility = a lower indifference curve
Determinants of access to credit markets?
- Creditworthiness and financial history (Example slides)
- Employment type and income
- Availability of collateral (a borrower’s property pledged to secure a loan)
- Local access to formal finance
- Regulation
- Market conditions
Lending as principal-agent problem? What to lenders do to adress problem? what does this lead to?
Lending is a principal–agent relationship: the lender (the principal) would like to ensure that the borrower (the agent) repays a loan, but cannot enforce this directly through a contract
-> market failures due to contract incompleteness ← Moral hazard
To address this issue, lenders
- balance between demanding higher interest rates from riskier borrowers, while keeping interest rates sufficiently low to not make default more attractive than paying back
-require borrowers to put some of their own wealth at stake (in the form of collateral or equity)
Leads to credit rationing: borrowers with less wealth face unfavourable lending terms or are denied loans, as they cannot provide enough collateral or equity
Securitization mortages? Pros and cons?
- Pool individual mortgages to create “securities”, mitigating individual borrower risks
- Sell these securities to investors, essentially offering them the future payment streams in exchange for immediate capital
- Securities can be continuously traded in financial markets
Pros
– Frees up capital for mortgage originators, enabling them to issue new loans
- Creates opportunities for small investors to access “low-risk” investments with potentially higher returns compared to other fixed-income assets (e.g. bonds)
- Enhances liquidity in the housing finance system and can lower borrowing costs for homeowners
Cons
- Asset composition can lack transparency, obscuring the true risk profile
- The transfer of default risk can lead to moral hazard, with originators (banks) less motivated to check borrower’s creditworthiness
– Risk amplification: rising housing prices inflate security values, enabling higher bank borrowing and lending, which can further drive up prices, potentially leading to a housing bubble and financial instability
Subprime mortgage crisis`?
- Deregulation: The Glass-Steagall Act, which separated commercial and investment banking, was repealed in 1999. This allowed banks to engage in riskier activities
- Market conditions: the booming housing market provided an incentive for banks to expand lending to high-risk (subprime) individuals
- Crisis: many of those high-risk mortgages defaulted, leading to the housing bubble burst and a broader economic downturn
Securitization and subprime mortgage crisis:
- Overly optimistic beliefs about continual increases in housing prices led to aggressive lending practices
- Incentives to increase lending volume made credit rationing too low: credit was extended to borrowers who should not have received credit
Determinants of access to investment market?
- Financial literacy (capacity to process economic information and make informed financial decisions is crucial for sound investment decisions)
- Regulatory environment for investors (stable, transparent, and predictable regulatory framework, combined with rule of law, enhances investment opportunities)
- Political stability (political unrest or uncertainty leads to less secure property rights, reducing investment opportunities )
Commercial banks?
are firms that make profits through lending and borrowing activities
- They use deposits of their customers to make loans or investments
- Note: the boundaries between commercial and investment banking are better defined now than they were in 2007, before the financial crisis: commercial banks today mostly invest in safe assets like government bond.
Base money, Bank money, Broad money?
- Base money is the legal tender including:
-> Cash held by households, firms, and banks
-> Balances held by commercial banks at the central bank (reserves) - Bank money, commercial banks can effectively create money when they make loans (Slides)
- Broad money includes both bank money and base money, representing the total money supply circulating the economy
Money market and short term interest rate?
- To manage daily transactions, commercial banks regularly borrow base money from each other in the money market
- The price of borrowing base money from other financial institutions is the short-term interest rate. determined by:
- Demand for base money: amount of transactions commercial banks have to make (the fraction that isn’t cleared with bank money between banks)
- Supply of base money: set by the central bank
Maturity transformation? Risks?
Banks provide a service to the economy known as maturity transformation (Maturity= length of loan), which involves:
- Accepting deposits which can be withdrawn on demand (short-term)
- Making loans which have a fixed repayment date, often in the long-term (e.g., 30-year mortgages)
Maturity transformation bridges the gap between short-term savers and long-term borrowers, facilitating long-term investments and planning in the economy. Risks:
- Liquidity risk: the risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss
- Default risk: the risk that loans will not be repaid
Policy and bank lending rates?
- Central bank sets the policy (interest) rate (also called base rate/official rate) through supply of base money. This rate applies to banks that borrow base money from each other, and from the central bank
- This has an effect on bank lending rate (also called marked interest rate), which is the average interest rate charged by commercial banks to firms and households
-> Different from and typically higher than the short-term interest rate
Bank run due to asset depreciation?
- Banks do maturity transformation by offering long-term loans, which leaves them at any time with insufficient liquid cash to cover mass withdrawals
- Any increase in withdrawals diminishes a bank’s liquidity (base money), forcing it to sell assets at lower values and incur big losses
- Assets can depreciate, e.g. due to a (bond) crisis or central banks increasing policy rates to manage inflation
- This depreciation makes depositors worried that now it’s even more likely for the bank to be insolvent with increases in deposit withdrawals, potentially triggering more withdrawals and creating a self-perpetuating cycle
Preventing bank runs? Risks of that?
- Deposit insurance
- Protects depositors’ funds up to a certain amount (€100k in the EU, $250k in the US, none in NZ)
- Increase banks’ moral hazard (taking on more risk than without insurance)
-> But because it’s partial insurance, depositors still have incentives to punish banks that take excessive risks
- In bad times, it reduces panic among depositors and prevents the cascade effect of withdrawals - Central bank facilities
- Central banks can serve as a lender of last resort and extend lines of credit to struggling banks at a discount rate
- However, banks may hesitate to use this facility as it signals weakness - Bank capital requirements
- Regulations ensuring banks maintain adequate capital (equity) relative to assets
- Enhances depositor confidence and curbs excessive lending risks
- Constains lending ← during recessions, this potentially slows recovery
