FOUNDATIONS OF MICRO- BANKING THEORY CHAPTER 2: Why do financial intermediaries exist? CHAPTER 3: The Industrial Organisation approach to Banking CHAPTER 4: The Lender-Borrower Relationship

CHAPTER 5: The equilibrium and rationing in the credit market CHAPTER 6: Macroeconomic consequences of financial imperfections

CHAPTER 7: Bank runs and systemic risk CHAPTER 8: Risk management CHAPTER 9: Regulation

CHAPTER 1 Why do financial intermediaries exist? The Classical theory First generation Second generation

Preliminary: –What is a financial intermediary? -Deposits - Loans - Contracts (cannot be resold (not anonymous (not necessarily standard

What is the difference with mutual funds?

1.1The Classical theory 1.1.1A transaction cost approach (Benston and Smith, 1976) Institutions emerge because they allow to diminish contracting costs: 1) costs of becoming informed 2) costs of structuring, administering and enforcing financial contracts 3) cost of transferring financial claims

1.1The Classical theory (continued) –1.1.2Transformation of assets (Gurley and Show, 1960) maturity convenience of denomination risk (indivisibilities) (Merton, 1989) It is implicitly assumed that these asset transformation services are provided more efficiently outside the firm.

Implications  economies of scale  economies of scope  reputational capital  reduction in search costs

1.1The Classical theory (end) –1.1.3Payment system (Fama, 1980)

1.2First Generation The delegated monitoring approach (Diamond 1984) Diamond-Dybvig: Liquidity insurance Ex ante uncertainty defines the liquidity shock

Diamond-Dybvig model: one good three period economy. Continuum of consumer-depositors, each endowed with one unit of the good Random preferences (not VNM)

Consumers U(C 1 ) Early diers or impatient consumers U(C 2 ) Late diers (patient consumers) C t is consumption at time 1 or 2 and U is increasing and concave.

Technology Long run technology t=ot=1t= R (R>1) Storage technology t=ot=1 -1 1

Efficient solution: ex ante insurance against preferences shocks with C< R if relative risk aversion is larger than 1.

Market solution: early diers consume 1 late diers consume R which is not ex ante efficient Financial intermediation A FI may provide deposits which entail a larger consumption for early diers and lower consumption for late diers thus reaching the efficient allocation.

Intertemporal Smooting An extension (Allen and Gale, 1997) The focus is on intertemporal smoothing. Some generations face a large return, others a smaller one. Since each generation lives only two periods, it cannot enter an explicit insurance contract. Banking provides this type of insurance and is ex ante Pareto efficient.  Ex ante uncertainty defines the liquidity shock

1.3 Second generation: Co-existence of financial intermediaries and financial markets Agents differ by –their history of repayments –their collateral –their rating –Their information

Additional motivation:  Schumpeter, Gerschenkron  External finance premium  US-UK vs. Japan-Germany financial structures (Short term vs. long term)

1.3.1Diamond (1991): Monitoring and reputation Consider a population of firms that have investment projects of three different non- observable types: –1)high risk, high return and negative net present value –2)low risk low return and positive net present value projects. –3)strategic firms which are able to choose their type between the two previous ones.

The main issue is the moral hazard problem for the strategic firms The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay. MAIN RESULT:good history firms will issue securities.

1.3.2Holmstrom and Tirole (1995) (Monitoring and collateral) Moral hazard on the project choice: The entrepreneur chooses the probability of success The project with a lower probability of success has private benefits B for the entrepreneur.

The bank is able to monitor the choice of projects by diminishing B to b. If the firm brings in sufficient collateral, or a sufficient stake in the project no monitoring is needed.  Otherwise monitoring is needed.

 What gives the banks an incentive to monitor? Their stake in the project (differs from rating agencies)  What makes bank loans costly? The supply of loans is limited by the bank’s capital.

1.3.3 Boot and Thakor With some probability firms have access only to a good project and with the complementary probability they are strategic. Firms are heterogeneous as they differ in this probability The banks’ role is to force the firms to choose the good project The financial market helps the firms to make the right investment by signalling (via prices) the overall environment the firms face.

1.3.4 Bolton-Freixas (2000) Banks are able to monitor and to renegotiate firms in financial distress Bond holders will always liquidate firms that default. The financial market imperfection stems from adverse selection (Myers Majluf)

Firms differ by their riskiness Bank loans are at a premium Result: risky firm prefer bank loans, safe firms prefer bonds Consistent with empirical evidence regarding the effect of monetary policy on small firms

1.3.4 Gorton-Pennacchi (1990) Informed insiders Some agents have priviledged information Consumers have Diamond-Dybvig preferences The design of securities is endogenous Then in equilibrium there is a riskless security which can be interpreted as a bank.

TO SUMMARIZE There is no a unique view Apart from the transaction costs Intertemporal insurance, screening and monitoring are the main reasons why financial intermediatiaris may emerge. Consider a population of firms that have investment projects of three different non- observable types: )high risk, high return and negative net present value )low risk low return and positive net present value projects. )strategic firms which are able to choose their type between the two previous ones. The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay.