The Economics of Banking and Finance - Summary - Tilburg university - Economics
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Course
Economics of Baking and Finance (30L306)
Institution
Tilburg University (UVT)
Book
The Oxford Handbook of Banking
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Summary for the course 'Experimental and Behavioral Economics'. This summary was written in order to study for the final. Everything you need to know is available in this summary. Note: make sure to also study the required readings provided by the ...
,Week 1 – Banking models: what should banks be allowed to do?
Types of banks:
Commercial banks: depositing, payment services and lending.
Investment banks: underwriting of securities → risky.
Universal banks: all of the above activities.
Universal banks:
Advantages of universal banks:
- Economies of scale: lower costs because of its size.
- Economies of scope: efficient use of information gained in one activity to perform
well in another activity.
- Risk diversification: returns to comm./investment banks are not perfectly correlated.
Disadvantages of universal banks not related to policy:
- Potential conflict of interest: bank could sell low-quality securities to avoid taking
losses on their own portfolio.
→ Bad for investment bank clients to safe its own skin.
- Complexity: management could be more difficult → worse risk-return.
Disadvantages of universal banks related to policy:
- Funding used that is protected by deposit insurance: commercial bank could use
deposits that are protected by deposit insurance and use it for the investment bank.
- Bank may become ‘too-big-to-fail’: huge bailout if this happens.
History of universal banking in the US:
- < 1933, universal banking was allowed.
- Glass-Steagall act (1933) → separate commercial and investment banks.
- Reason: conflict of interest.
Universal banking change 1990s:
- Do securities issued by universal banks have low returns? (Kroszner & Rajan, 1994):
- Bonds issued by universal banks → relatively low return before 1933.
- Universal banks with a small part being investment banking, underwrote more
transparent senior bonds.
Scale economies:
- Optimal scale of investment banking, because of large amounts of capital needed.
→ Merge investment banking with commercial banking.
Conclusion:
- In 1990, research concluded that universal banking in the US would not be a
problem. → Gramm-Leach-Bliley act: no barriers for universal banking in the US.
- EU: second banking coordination directive made universal banking model (1989).
3
,Does universal banking increase or reduce banking risk?
- Universal banking allows more risk-return options with diversification benefits
leading to less risk. However, is this the case in reality?
Graphically:
Reduced risk:
A = pre-liberalization (no
universal banking)
B = post-liberalization (universal
banking)
Increased risk:
→ Risk depends on the
indifference curve.
Model:
Portfolio allocation problem:
- A share of w of bank capital into investment banking and the (1-w) into commercial
banking.
- Investment banking has high return and high risk
-
Impact on banking return:
- , because E(RB) > E(RA)
→ Higher w into investment banking increases expected return.
4
, Impact on banking risk:
-
→ Higher w into investment banking can either increase or reduce overall banking risk.
- From w=0 to w>0: reduced risk if the correlation ≤ 0.
- From w=1 to w<0: reduced risk if the correlation ≤ 0.
Assume: correlation ≤ 0
Risk: is an empirical issue
Empirical research:
- Paper: Bank Activity Mix and Funding Patterns: The Impact on Risk and Return.
- Fee income share is used as a proxy for w (share of investment banking component).
- Total operating income: net interest income + non-interest income.
- Fee income share: non-interest income / total operating income.
- ROA: return on assets
5
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