Economics of banking - Lecture 1
Financial institutions improve welfare through efficient allocation of capital. When financial
institution break down we see financial and economic crises. In 2008, Lehman Brothers triggered
a global recession. It was undercapitalised, had to write down part of their commercial and real
estate assets, a run on the bank followed as everyone sold their stock, the FED wanted to bail
them out but didn’t want to use taxpayers’ money: they went bankrupt.
Bad lending practices were the main cause of the problem: subprime lending in the US home
market. Mortgages were transferred to intermediaries and resold in financial markets:
securitisation of mortgages. When the housing bubble burst, liquidity shortages in US financial
markets caused Lehman to collapse, which led to the global crisis.
Financial system
Firms use external and internal
resources to fund investment: external
financing through banks & other
institutions is what we focus on. The
financial system is a process of
allocation of resources from those with
surpluses and no use to those with
need and productive use. Can be done
by direct allocation of resources, so
through stock and bonds markets, or
indirect allocation of resources through
banks.
As seen in the graphic, below is the
direct finance system, whereas the
indirect system goes through financial
intermediaries which we study.
Markets drawbacks
Markets, so direct finance, don’t ensure efficient allocation of resources when frictions exist:
Transaction costs; asset indivisibility; or agency problems.
Then there’s some investments not suited for direct finance through financial markets, such as
small business lending or mortgages. Banks’ expertise helps determine ordinary investors which
projects are good.
Banks
Why use banks instead of directly dealing with a counter-party:
-Decreased transaction costs: economies of scale.
-Reduced risk exposure: Risk sharing & diversification as banks take on many investments, and
they allow investors to for example diversify easily through mutual funds.
-Agency problems solved by banks:
1) Adverse selection in financial markets: The less risky projects don’t get funded since investors
can’t gauge which project is risky, rather assuming they all are risky to be sure. This makes the
interest rate they ask the average of all borrowers, which would be too high for the borrowers
not taking large risks; only those taking large risks and thereby being able to pay more interest
when the project works out are able to borrow, as they’re more eager to pay higher interest
rates, increasing the market interest rate. This makes good quality sellers not willing to sell at
the average price, meaning only bad quality sellers remain. ‘Lemons problem‘ is adverse
selection due to asymmetric information, as the average price reflects the lower quality goods
in the market and this squeezes out high quality sellers. Can cause market breakdown; certain
borrowers even with positive-NPV projects can’t borrow due to adverse selection friction
stemming from the asymmetric information problem.
Banks have the expertise needed to screen borrowers to solve adverse selection.
2) Moral hazard: A principal delegating a task to an agent, respectively the financier delegating to
a manager who borrows the money to run a project. Moral hazard is the agent not acting in
the principal’s interest; manager not acting in financier interest.
,Banks monitor an agent after approving a loan, and also make them sign covenants.
So through acting as information processors, banks solve agency problems of adverse selection
and moral hazard by monitoring and screening borrowers.
We see the EU and Japan mostly rely on bank-based funding, whereas the US is more market
based.
What banks do
Commercial banks take deposits and make loans.
Investment banks raise debt and equity, give M&A advice, etcetera.
Universal banking: Both commercial and investment bank in one: taking deposits and making
loans, engaging in investment banking with Debt and Equity raising and advice, and also offering
insurance for example.
Balance
Most important bank assets: loans and securities,
since they earn interest and thus income.
Most important liabilities: deposits. What remains on
that side is bank’s equity.
For Dutch banks: Loans make up about 70% of
assets, securities another 15%, cash + liquid assets
10%, some very little fixed assets remain.
Liabilities: 85% deposits (mostly households, some
interbank) and other short-term debt. Equity only 5%.
Income statement
The income statement consists of retail income from
commercial banking: interest income (loans) minus
interest expense (deposits).
Non-interest income and expenses stem from
investment banking.
Chapter 1 - Why study financial markets
Financial markets transfer funds form people with an
excess to those with a shortage, such as bond and stock markets. They greatly promote
economic efficiency and growth.
A security (financial instrument) is a claim on the issuer’s future income or assets (any financial
claim or piece of property subject to ownership). A bond is debt security promising to make
payments periodically.
Bond markets enable firms and governments to get funding and determine the interest rates: the
cost of borrowing, so the price paid for the rental of funds. Interest rates affect consumers’
willingness to spend and businesses’ investment decisions.
A common stock is a share of ownership in a corporation and a security, since it lays claim on the
earnings and assets of the firm.
Currency conversion takes place in the foreign exchange market at the foreign exchange rate.
Banks and other financial institutions make financial markets work: Instead of going directly to
firms, investors can lend indirectly to them through financial intermediaries, institutions that
borrow from people who’ve saved and loan it to others.
Banks are financial institutions accepting deposits and making loans, and are the most important
financial institutions. Other financial institutions include insurance companies, finance companies,
pension funds, mutual funds, and investment banks.
,The money supply consists of anything generally accepted in payment for goods and services or
repayment of debts. Aggregate output is the total production of goods and services, and moves in
business cycles of upward and downward movements. The aggregate price level rises with
inflation, which is caused by increases in the money supply.
Monetary policy is the management of money and interest rates, for which the central bank is
responsible. Fiscal policy are government spending and taxation decisions.
Chapter 2 - An overview of the financial system
Direct finance is blue: borrowers directly
getting funds from lenders in financial
markets by selling them securities. Securities
are assets for the person who buys them but
liabilities for the issuer.
Financial markets are critical for efficient
allocation of capital (wealth, either financial or
physical, employed to produce more wealth).
One can obtain funds in a financial market in
two ways:
-Issue a debt instrument (bond or mortgage)
paying a fixed amount with either a short-
term (less than a year) or long-term maturity.
-Issuing equities, such as common stock,
which are claims on net income (after
expenses and taxes) and assets of a
business.
Owning equity instead of debt makes you a residual claimant: the corporation must first pay debt
holders, the residual gos to equity holders. This means they benefit directly from profit or asset
value increases as equity means ownership. Debt markets are often substantially larger than
equity markets.
A primary market is where new issues of a security (bond or stock) are sold to initial buyers.
A secondary market is a financial market where securities can be resold. Primary markets are not
well known and often behind closed doors, as investment banks engage in underwriting securities
by guaranteeing a price for their securities and selling them to the public.
Secondary markets like NYSE are better known, though not stock markets but bond markets are
the largest by trading volume. Foreign exchange markets, futures markets, and options markets
are also secondary markets. Brokers are agents of investors matching buyers with sellers of
securities. Dealers link buyers and sellers by trading at stated prices.
Secondary markets make financial instruments more liquid as it becomes easier and quicker to
raise cash by selling securities. They also help determine prices of securities that issuing firms sell
in the primary market.
Secondary markets can be organised as exchanges or as over-the-counter markets. Exchanges
see buyers and sellers (or their agents and brokers) meet in one central location and conduct
trades. Over-the-counter OTC markets have dealers at different locations with an inventory of
securities, ready to buy and sell them ‘over the counter’ to anyone willing to accept their prices.
OTC markets are in computer contact and see all prices, making them very competitive and not
very different from an organised exchange.
Most of the largest corporations have their shares traded at organised stock exchanges. The US
gov bond market however is an OTC market, since about 40 dealers establish a market by
trading. OTC markets are decentralised without a central physical location.
The money market has only short-term debt instruments (<1 year), the capital market trades
longer-term debt instruments and equity instruments.
Money market instruments
The money market (<1 year) are the debt instruments with the least price fluctuations because of
their short maturity, making them the least risky. Money Market Instruments MMI include:
, -Treasury bills: short-term debt instruments of governments of 1/3/6 moth maturity to finance
government spending. They don’t pay interest but sell at a discount. Highly liquid and (almost)
impossible to default since it could even issue currency to pay off debt.
-Bank bills are like treasury bills, only issued by banks and mostly borrowed by other banks. Sold
at greater discounts (so higher yield) to reflect risk of default.
-Certificates of deposit CD are debt instruments very important for commercial banks and sold to
depositors that pay annual interest of a given amount and the principal at maturity.
-Commercial paper are short-term debt instruments issued by large banks and well-known firms.
-Interbank deposits where surplus banks lend to cash-short banks.
-Gilt repurchase agreements repos are effectively short-term loans (<2 weeks) of gilt-edged
securities (bonds, Treasury bills from the UK government). The borrowing party sells a gilt-edged
security to a lender and promises to repurchase it at some maturity, giving the lender a collateral
in the form of gilts.
Capital market instruments
Capital market instruments are debt and equity instruments with maturity exceeding one year,
having far wider price fluctuations than MMI and considered fairly risky:
-Stocks, exceeding any other type of security in the capital market in value.
-Mortgages, loans to households or firms for purchasing reals structures that are also collateral.
-Corporate bonds, long-term bonds issued by strongly credit-rated firms, usually with biannual
interest payment and face value upon maturity. Convertible bonds allow the holder to convert into
a specified number of shares, reducing interest payments.
-Long-term government bonds, local authority bonds, bank bonds.
Internationalisation of financial markets
US dominance in financial markets is fading.
The traditional instruments in the international bond market are foreign bonds: bonds sold in a
foreign country and denominated in that country’s currency. Porsche selling bonds in the US in
dollars is a foreign bond, US railroad company’s bonds sold in pounds in Britain too.
Newer is the Eurobond, a bond denominated not in the currency of the country in which it’s sold,
but in a currency other than that of the country it’s sold: bond in US dollars sold in London. 80%
of new issues in international bonds are Eurobonds.
One variant of the Eurobond is Eurocurrencies: foreign currencies deposited in banks outside the
home country, such as US dollars deposited in foreign banks outside the US or in foreign
branches of US banks (eurodollars specifically). So euro refers to anything not being denominated
in the currency of where it is held or located. Eurodollars, dollars held outside the US, are short-
term deposits earning interest and are therefore similar to short-term Eurobonds.
Eurobonds aren’t necessarily in euro’s; most are denominated in US dollars.
Function of financial intermediaries: indirect finance
Indirect finance involves a financial intermediary between lender-saver and borrower-spender, the
process of which is called financial intermediation, and has traditionally been the primary route for
funding going from lenders to borrowers.
Transaction costs are the time and money spent in carrying out financial transactions, and are a
major problem for those with excess funds (lender-savers) since small savers and borrowers
might be frozen out of financial markets due to high transaction costs.
Financial intermediaries reduce transaction costs since they’ve developed expertise in them and
take advantage of economies of scale. A financial intermediary’s low transaction costs mean that
it can provide its customers with liquidity services, services making it easier to conduct
transactions such as current accounts for customers.
Financial institutions also reduce investors’ exposure to risk, uncertainty about the return
investors will earn on assets, through risk sharing: creating and selling assets with risk
characteristics that people are comfortable with, and the funds acquired by selling these can be
used to take on far more risky projects by the intermediary itself. Low transaction costs allow
intermediaries to share risk at low cost, making them profit on the spread between returns on
risky assets and the payment made on the assets they’ve sold. This asset transformation turns
risky assets into safer assets for investors.
