Week 3: Financial Institutions and regulations Flashcards
Asymmetric information: 2 main obstacles
- Adverse selection
<Lemon>
Hidden characteristics of a potential borrower BEFORE contracting takes place.
* Borrower knows his/her risk better than the lender.
* If quality cannot be assessed, the buyer (lender) is willing to pay at most a price that reflects the average quality.
* Sellers (borrowers) of good quality items will not want to sell at the price for average quality.
* The buyer (lender) will decide not to buy at all because all that is left in the market is poor
quality items.
Conclusion: If lender only offers a contract which is optimal for a borrower with average risks, this may be unattractive for those with good risks. -->MARKET FAILURE
2. Moral hazard
Hidden action of a borrower AFTER contracting took place.
*Stock market:
Principal (shareholder), agent (manager) --> interest mismatch
*Debt market:
Borrower takes undesirable project, reduces prob of loan given back.
Even if the money is used accordingly, the lender often cannot observe the success of a risky project and profits maybe mis-reported. Thus, (true) ability to repay is unknown by the lender, resp, “costly state verification” necessary
</Lemon>
Tools to solve asymmetric information.
*Private production and sale of information
solving “free rider issue”- people not having info follow people who paid for it.
*Government regulation to increase information
*Monitoring (but individually, monitoring costs are very high, Economies of Scale exist)
*Collateral: something of value pledged by a borrower to the lender in the event of the borrower’s
default.
*(Optimal) Debt Contracts (e.g., with sanctions incase of default)
In general: Financial intermediation (FI) (i.e., pooling of the above measures)
The Roles of Financial Intermediation
- Pooling savings
- Safekeeping and accounting
- Providing liquidity
- Diversifying risk
- Collecting and processing information services
Types of Financial Intermediataries
- Depositary institutions (banks)
Accept deposits from individuals and institutions as liabilities, providing loans and mortgages as assets.
Example: Commercial banks, saving and loans associations, mutual saving banks, credit
unions.
–>mortgages, customer loans. - Contractual savings institutions
Accept premiums and contributions from government, firms and individuals as liabilities, investment in bonds, stocks and government securities.
Example: life insurance, pension funds, retirement funds
—> corporate, government bonds, mortgages, stocks - Investment intermediates (non-depository institutions)
Selling commercial stocks, bonds or shares as liabilities, providing business loans and investment in stocks and bonds as assets.
Example: Finance companies, mutual funds, private equity funds
Depository and non-depository institutions
- There are depository and non-depository institutions that differ by their primary source of funds - the liability side of their balance sheet.
- Depository institutions include commercial banks, savings and loans, and credit unions.
- Commercial banks are institutions established to provide banking services to businesses, allowing them to deposit funds safely and to borrow them when necessary.
Where does banks profit come from?
A bank’s profits come from both service fees and from the difference between what it pays for its liabilities and the return it receives on its assets.
Banks asset side of BS
The asset side of the balance sheet shows what banks do with the funds they raise.
Assets are divided into four broad categories:
* Cash (reserves with central bank incl. vault cash, account at other banks
* Securities (government bonds)
* Loans (business loans; real estate loans; consumer loans; interbank loans).
* All other assets (e.g., real estate)
Banks liability side of BS
The liability side shows the sources us funds. Banks get funds from savers and from borrowing in the financial markets. There are two types of deposit accounts:
* Transaction accounts (checkable deposits).
* Non-transaction accounts (like time deposits).
* Borrowings (from central bank and from commercial banks)
* All other liabilities (e.g., short-term debt instruments
Bank risk
- Liquidity risk
Source: sudden withdrawal prob - Credit risk
Source: Default by borrowers on their
loans - Interest rate risk
Source: Mismatch in maturity of assets and liabilities coupled with a
change in interest rates - Trading (Market) risk
Source: Trading losses in the bank’s own account - Operational risk
Source: Losses from inadequate or failed internal processes, people, and
systems
Sources of bank run and crisis
*Banks’ fragility arises from the fact that they provide liquidity to depositors.
*Can withdrawal deposits at any moment (first come-first serve)
*“lend long and borrow short”–>
maturity mismatch in their balance sheet, and this may result in a liquidity problem
*Reports or rumours
!!!If a bank cannot meet this promise of withdrawal on demand because of insufficient liquid assets, it will fail.
What matters more- if bank is solvent or liquid in a bank run?
What matters during a bank run is not whether a bank is solvent, but whether it is liquid.
* Solvency means that the value of the bank’s assets exceeds the value of its liabilities: it has positive net worth.
* Liquidity means that the bank has sufficient reserves and immediately marketable assets to meet depositors’ demand for withdrawals.
Bank panic and reasons for it
The primary concern is that a single bank’s failure might cause a small-scale bank run that could turn into a system-wide bank panic.
* This phenomenon of contagion: This phenomenon was powerful at the peak of the 2007-2009 global financial crisis.
* Information asymmetries:
depositors cannot tell the difference between a good bank and a bad bank.
* Downturns in the business cycle put pressure on banks as well, increasing the risk of panics.
Possible measures to deal with or to prevent bank runs
- “banking holidays”
- “lender of last resort”
*supervision and regulatory measures
*Deposit insurance
but moral hazard problem: banks may take too much risk!
Three reasons for the government to get involved in the financial system
- To protect savers/depositors.
- To protect bank customers from monopolistic exploitation.
- To safeguard the stability of the financial system.
3 strategies applied to prevent market failures
- Financial Regulation: process of rule making and the legislation underlying the supervisory framework (e.g., Basel III accord)
- Supervision: monitoring the behavior of individual financial institutions and enforcing the
legislation
* Microprudential Supervison: “Traditional” form of financial supervision with focus on
individual financial institution
* Macroprudential Supervision: Focus is on “Systemic Risk” (resp. overall financial stability) due to the inter-connectivity of banks plus their common exposures - Examination of an institution’s books by specialists provides detailed information on the firms’ operation (“conduct-of-business supervision”)
