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Tilburg university Master Finance 2021/2022 Global banking part 1 – 323067Global Banking
Part 1 – Fabio Castiglionesi
Lecture 1 Asynchronous Financial intermediaries: Rationale and risks
Objectives:
- Explain the special role of FIs in the financial system
- Highlight the functions that FIs provide
- Explain why FIs receive special regulatory attention
A world without FIs
When FIs are useless
In a perfect world FIs are redundant: Modigliani-Miller result
Assumptions:
- Complete markets
- Symmetric information and so on..
However, the real world is plagued by frictions, also known as agency costs.
Problems in a world without FIs
1) Adverse selection:
Prior to purchasing a firm’s debt or equity, investors may not know the quality of the firm.
Example:
A good firm is worth $10 and a bad firm is worth $4. A rational investor would pay the
average $7.
The poorest (adverse) quality firms have the greatest incentive to issue securities. Good
firms find it inconvenient to issue securities since they have to be sold at a discount.
2) Moral hazard:
After purchasing a firm’s securities, investors need to monitor the firm’s managers.
Managers may have the incentive to spend investors’ money on excessively risky projects or
perquisite consumption.
Managers may also exert less effort than promised.
3) Maturity and Liquidity:
The firm’s debt or equity may have characteristics that may not be attractive to investors.
Most important characteristic is maturity and liquidity.
Example:
Debt and equity may not be sufficiently liquid, as they have to be liquidated on spot at
current prices (price risk).
4) Summing up:
- Lower level of fund available (investors would prefer not to lend or firm not to borrow)
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,Tilburg university Master Finance 2021/2022 Global banking part 1 – 323067
- Higher information costs (economies of scale reduce costs of screening and monitoring
firms)
- Less liquidity in the economy
- Higher price risk for investors
A world with FIs
Major functions of FIs
1) Broker:
As a broker, the FI provides information about the quality of the security issued. When there
are costs of screening the quality of the firm’s securities, the broker reduces such costs
through economies of scale. This is an efficient way to produce information and to reduce
the adverse selection problem.
2) Asset transformer:
The FI transforms primary securities (e.g., loans, bonds, stocks) issued by the firms into
secondary securities (e.g., bank deposit). In this way a FI solves two problems:
A) The FIs act as a delegated monitor to efficiently produce information on the firm’s
ongoing activities and reduce moral hazard. The average monitoring cost is lower for FIs
since they exploit economies of scale.
B) The FIs can provide maturity intermediation: the maturities of its assets differ from the
maturities of its liabilities. FIs create liquidity: households hold securities with very short
maturity, like demand deposits, where price risk is almost absent.
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Other services provided by FIs:
- Transmission of monetary policy
- Credit allocation (areas of special needs such as home mortgages, farms, and small
businesses)
- Payment services (FedWire and CHIPS, check clearing, cash)
- Intergenerational wealth transfers or Time intermediation (life insurance and pension funds)
- Denomination intermediation (mutual funds)
Regulation:
The important services banks provide make them worth of receiving special regulatory attention.
The troubles affecting banks have negative externalities on the rest of the economy.
Examples:
- A bank failure may destroy household savings and restrict firm’s access to credit with
contagious effects on the rest of the economy (lower sales, production, employment)
- Failure of large interconnected banks may cause the failure of other banks (systematic risk)
making them too big to fail
Regulation must impose private costs:
- No more than 10% of equity to a single borrower
- On site examinations can be long and costly
- Capital requirements (equity more expensive than deposits)
- Banks can be forced to invest in the communities in which they take deposits
Regulation also gives benefits:
- Access to the discount window and deposit insurance
- Access to TARP funds to boost capital
- Too-big-to-fail protection
Lecture 1 Synchronous Financial intermediaries: Rationale and risks
Risks of Financial Intermediaries:
The rationale behind the existence of FIs implies that they face certain risks. Risk measurement and
management are quantitative subjects.
1) Interest rate risk:
The mismatch in maturities between assets and liabilities.
Two types of interest rate risk:
Refinancing risk: When assets have longer maturities than liabilities
Reinvestment risk: When assets have shorter maturities than liabilities
A bank usually faces refinancing risk: The risk that the cost of rolling over the liabilities rise
above the returns on assets.
Main issue:
Matching maturities of assets and liabilities is inconsistent with the asset transformation
function (recall: Mismatch due to borrowers wanting long-term loans and depositors
wanting short-term liquid funds).
Method to measure interest rate risk: Chapters 8 and 9
Instruments to hedge interest rate risk: Chapters 22-24
2) Credit risk:
Risk that promised cash flows on financial claims hold by FIs (such as loans) are not paid in
full (i.e., they default).
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Firm specific credit risk: Associated with the specific types of project risk taken by that firm
Systematic credit risk: Associated with the macro-conditions affecting all borrowers (e.g.,
recession).
How to deal with it?
Screening before underwriting a loan (less adverse selection)
Monitoring after underwriting the loan (reduce moral hazard)
Diversification: negatively correlated returns (firm-specific risk can be reduced but
systematic risk cannot)
Pricing higher credit risks with higher interest rates (e.g., credit card)
Methods to measure credit risk: Chapters 10 and 11
3) Off-balance-sheet-risks:
Striking growth of off-balance sheet activities (standby letters of credit, loan commitments,
derivative positions). Off-balance sheet activities do not appear in the balance sheet instead
involve the creation of contingent A and L => affect the future balance sheets. Speculative
activities using off-balance sheet items create considerable risk (as the 2007-2009 crisis
showed)
The specific nature of the o-b-s risks is in Chapter 16
4) Liquidity risks:
Risk of being forced to sell assets in a very short period of time in order to meet sudden
increase in withdrawals. May generate a run, which may turn liquidity problem into solvency
problem! Risk also of contagion panics (or systemic effects): once one bank goes down, the
confidence in other banks falls as well.
The study of the nature of liquidity risk: Chapter 12
How to manage liquidity risk: Chapter 18
Regulation on how to deter liquidity risk: Chapter 19
This is the main focus of the first part of the course
5) Insolvency risks:
Risk of insufficient capital to offset sudden decline in value of assets relative to liabilities
Management and regulation of insolvency risk: Chapter 20
6) Market risks:
The risk of losses from actively trading assets and derivatives. Trading risk is present
whenever a FI takes an open (unhedged) long or short position in securities and prices
change in a direction opposite to what is expected.
Market risk measurement models: Chapter 15
7) Other risks:
Foreign Exchange Risks
Sovereign Risk
Technology and Operational Risks
Macroeconomic Risks
These risks are not particularly proper of FIs, but they are a classic topic in the risk
management of any type of firm.
a) Foreign exchange risks:
Exchange rate changes affect the value of a FI’s asset and liabilities abroad. To hedge foreign
exchange risk, work with multiple currencies or offset them with derivatives.
Measurement and evaluation of f-e-r: Chapter 13
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