Lecture 1: The structure of the financial system
Learning objectives:
Explain the main functions of the financial system.
Differentiate between the roles of financial markets and financial intermediaries.
Explain why financial development may stimulate economic growth (or not).
Describe the advantages and disadvantages of bank-based and market-based financial
systems.
Bank-based finance is the route of funds from lenders-savers through banks to borrowers-spenders.
This is a form of indirect finance. In financial markets, there is a free-rider problem, because an
investor acting upon their private information makes their preferences known. This dissuades
investors from gathering their own data. Banks on the other hand keep the information they acquire
and thus circumvent this problem.
Market-based finance is the route of funds from lenders-savers through financial markets to
borrowers-spenders. This is a form of direct finance.
Some researchers argue that financial markets and financial intermediaries may provide
complementary growth-enhancing financial services to the economy.
The functioning of financial systems is vitally linked to economic growth: a well-functioning financial
system allocates funds to their most productive uses. Some recent studies conclude that at
intermediate levels of financial depth, there is a positive relationship between the size of the
financial system and economic growth. However, at high levels of financial depth, more finance is
associated with a higher likelihood of financial crises and less growth. Thus resilience of the financial
system declines.
Financial markets specialize in high-uncertainty investment, since shareholders become the owners
of the firm and thus benefit from the upside and incur losses from the downside. A bank-based
system on the other hand specialises in low-uncertainty investment, because with a debt contract
the bank does not benefit from the upside.
The main task of the financial system is to channel funds from those with a surplus to sectors that
have a shortage of funds. In doing so the financial sector performs two main functions:
1. Reducing information costs: overcome an information asymmetry between borrowers
and lenders which can occur ex ante (adverse selection) and ex post (monitoring).
2. Reducing transaction costs: for example, by pooling funds.
3. Facilitating the trading, diversification and management of risk : for example, by providing
liquidity and through securitization.
The law and finance view focuses on the interplay between rights and laws and the financial system.
It states that a well-functioning legal system facilitates the operation of both financial markets and
intermediaries. Law systems usually differ in their protection of shareholders versus creditors.
,A credit rating agency is a firm which provides ratings on securities. These credit ratings are forward-
looking opinions on credit risk. They perform two key functions:
Offer an independent assessment of the ability of issuers to meet their debt obligations
Offer monitoring services through which they influence issuers to take corrective actions to
avert downgrades.
With bank-based finance, it is often stated that when there is an adverse shock to the economy, the
bank-based system can make the shock worse. Tis is due to the fact that when there is an adverse
shock, capital buffers of banks may shrink and make them reluctant to provide credit. This however
may thus exacerbate the economic shock, because less people can get credit for their businesses.
Corporate governance: the set of mechanisms arranging the relationship between stakeholders of a
firm, notably holders of equity (shareholders) and the management of the firm.
Shareholders have several mechanisms at their disposal to perform corporate governance:
Appointment of the board of directors
Executive compensation (e.g. performance-linked compensation)
The market for corporate control (mergers, takeovers etc.)
Concentrated holdings: the more concentrated the holdings are, the more shareholders can
exert influence (due to a larger incentive to do so).
Monitoring by financial intermediaries
When talking about sustainable finance there are some factors to consider:
Role of government: internalize all costs and benefits to society of economic activities
(internalize externalities), by establishing something like a carbon tax.
Role of finance and financial managers : integrate climate-related risks into strategic decision
making and risk management (and thereby pricing higher/lower interest rates).
o Physical risks: losses from the increasing severity and frequency of extreme climate-
related weather events.
o Transition risks: losses from the process of adjustment towards a low-carbon
economy (e.g. stranded assets).
Shadow banking: the traditional banking model (issuing banks hold loans until they are repaid), was
increasingly replaced by the originate and distribute banking model: banks pool loans and then
tranche and sell them via securitization. This securitization lead to a non-regulated shadow banking
system, in which institutions support bank-style maturity transformation outside of banks and
without access to a central bank. These are often hedge funds, investment banks and other non-bank
financial firms.
Lecture 2: Financial crises
, Learning objectives:
Explain the characteristics of different types of financial crises
Understand the link between sovereign and banking crises
Explain the main theoretical model of banking crises
Understand the pro-cyclicality of the financial system
Explain the main drivers and contagion mechanisms of the 2007-2009 financial crisis
Explain the Euro crisis
The core of the lecture is about the global financial crisis of 2007-2009 and the EU sovereign debt
crisis of 2010-2012. These crises have a specific pattern. The GFC started with strong growth in bank
mortgage credit, leverage, which had a feedback on asset prices. Increasing interconnectedness
within the financial system due to shadow banking (‘long intermediation chains’), eventually there
was a macro shock that triggered this crisis.
The EU sovereign debt crisis of 2010-2020 saw strong growth in government debt during and after
the GFC, banks were increasingly holding government bonds and as such there was an increasing
interconnectedness between banks and governments.
There are three main types of crises:
Sovereign debt crisis: there is a major restructuring of or default on public debt. It is good to
take note of whether the public debt is mainly financed by domestic or foreign creditors,
since if its funded by foreign creditors this type of crisis may coincide with a currency crisis.
Banking crisis: a large part of a country’s banking system is insolvent, this is about the
banking system as a whole, making is a systemic crisis.
Currency crisis: the value of a country’s currency falls suddenly. It is good to note that
countries with fixed exchange rates are vulnerable to a confidence crisis.
There are several costs associated with a banking crisis. There’s not only the direct costs of rescuing
banks (fiscal costs), but also a loss of GDP (output loss) and an increase in public debt.
A bank run is what happens when a lot of depositors demand their deposits back from a bank. This is
what originally led to banking crises, however today there is mostly a different party demanding their
funds back. A modern bank run mostly happens when wholesale funding falls away when investors
put pressure on the banks.
The Diamond and Dybvig model states that banking runs are a self-fulfilling prophecy. This is a
liability-side theory that states that if for whatever reason deposit holders withdraw their funds then
the bank has to do something. First it will do so by selling liquid assets, but then it has to sell illiquid
assets on which it will make large losses (especially is the crisis is systemic, due to a market-wide
freezing up). It is self-fulfilling in the sense that if everyone believes the bank to be healthy then
everyone will stay, however if there is suddenly an expectation that the bank is not healthy then it
becomes self-fulfilling (the bank will become unhealthy).
The Allen and Gale model (box 2.5) focuses on business cycles. Often crises are started by shocks to
the asset-side (it is an asset-side theory), this model proposes that there is a macro-shock to the
asset-side. This then wipes out equity buffers, which can trigger a run by depositors. The model
proposes that there are different types of consumers (early consumers, who consume in period 1 and
late consumers who consume in period 2), there are three periods t = 0,1,2 and the model closes in
the second period. Any losses and gains are distributed through the late deposit holders (since there
is no equity). In this model the central question becomes: when will late consumers decide to
