Banking & Regulation
Econ 455/555 & MFIN455/55
Prof. Tanju Yorulmazer
Lecture: Financial Intermediaries & Risks
Financial intermediaries
Questions
• What do financial intermediaries do?
– Intermediate between providers and users of financial capital
• What are the risks they get exposed to?
– Credit risk
– Liquidity risk
– Interest rate risk
• How do they manage these risks?
– Credit analysis
– Risk management: Value at Risk, Expected Shortfall, Liquidity
management…
Financial Intermediary
• An economic agent who specializes in intermediating
between providers and users of financial capital.
• One type of FI is a Commercial Bank (CB). CB granting loans
and receiving deposits from the public:
– The combination of lending and borrowing is typical of a CB
– CBs provide unique services to the general public:
– Channel funds from savers to investors
– Liabilities act as money, payment and liquidity services
Types of FI
• FIs are divided into two groups broadly:
– Deposit taking institutions: Commercial Banks
– Non-depository institutions:
– Venture Capitalists, Insurance Companies, Investment Funds, Pension
and Mutual Funds, Hedge Funds, Investment Banks
• In contrast with non-financial firms
– FIs hold relatively large quantities of financial claims (contracts of the
indebtedness of their clients) as assets
– FIs tend to be more leveraged
Types of bank assets
Bank Assets
Loans
Commercial
& Industrial
Securities
Consumer
Cash
Bank assets
• Commercial and Industrial loans (C&I)
– Transaction, working capital, term loans…
• Consumer loans
– Direct loans, credit cards, mortgages
• Securities
– Commercial paper, government securities...
• Cash and reserves
Lending
• How do banks acquire loans?
• Spot market
• Originate and keep them on their own books
• Purchase loans originated by other intermediaries
• Forward market
• Loan commitment: Promise to lend in the future
Risks Financial Intermediaries Face
Financial Intermediation
• The balance sheet of a financial intermediary:
Assets
Liabilities
Liquid/safe assets
Short-term debt
Illiquid/risky assets
Long-term debt
Equity
• Banks hold risky/illiquid assets.
• Credit risk: Banks can experience losses from the risky assets.
• Capital acts as a buffer and can help prevent costly failures.
Financial Intermediation
• The balance sheet of a financial intermediary:
Assets
Liabilities
Liquid/safe assets
Short-term debt
Illiquid/risky assets
Long-term debt
Equity
• Banks hold risky/illiquid assets typically with long maturities.
• Liabilities (short-term debt or deposits) usually have short
maturity (maturity/liquidity mismatch).
• Liquidity risk: When debt holders want to withdraw (or not
rollover) bank needs to come up with cash. Costly liquidation.
• Can lead to the failure of the bank.
Financial Intermediation
• The balance sheet of a financial intermediary:
Assets
Liabilities
Liquid/safe assets
Short-term debt
Illiquid/risky assets
Long-term debt
Equity
• Banks hold assets typically with long maturities.
• Liabilities (short-term debt or deposits) usually have short
maturity (maturity mismatch).
• Interest rate risk: When interest rates change, it can expose the
bank to interest rate risk.
Risks
• Credit Risk
• Risk management: Credit analysis, Value-at-Risk (VaR) models
• Capital regulation: Basel capital requirements
• Liquidity Risk
• Liquidity management
• Liquidity regulation: Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR)
• Interest Rate Risk
A Simple Framework
• Eisenbach, Keister, McAndrews and Yorulmazer (2014)
Assets
Liabilities
Liquid/safe assets (m)
Short-term debt (s)
Illiquid/risky assets (y)
Long-term debt (l)
Equity (e)
• Builds on the framework of Diamond & Dybvig (1983) (we will talk
in detail)
• Credit risk, solvency risk, illiquidity risk.
A Simple Framework: Assets
• Three dates t=0,1,2.
• Assets:
• Bank holds cash (m) and risky assets (y).
• Risky assets have a random return of θ at t=2.
• θ realized at t=1.
• If liquidated at t=1, risky asset pays τθ < 1.
• Bank holds cash m.
• Cash has a gross return r1=1 (for simplicty) between t=0 and t=1.
• Cash has a gross return rs between t=1 and t=2.
A Simple Framework: Liabilities
• Three dates t=0,1,2.
• Liabilities:
• Bank has short-term debt (s), long-term debt (l) and equity (e).
• Long-term debt matures at t=2 and promises rl.
• Short-term debt has the same promised return as cash (for
simplicity).
• Promises r1=1 between t=0 and t=1 and rs between t=1 and t=2.
• Matures at t=1 and needs to be rolled over after observing θ.
A Simple Framework: Solvency
• Solvency:
• If the bank can meet its debt obligations any remaining funds at
t=2 are paid out to equity holders.
• If the bank cannot meet its obligations, it enters bankruptcy.
– A fraction φ of assets is lost to bankruptcy costs (lawyer fees).
– Remaining assets distributed to debtholders on a pro-rata basis.
– Bankruptcy costs are high so that a short-term debt holder will rollover if
and only if the bank is solvent (very important!!!).
A Simple Framework: Returns
• Assume: rs < rl < 1/τ.
• Long-term debt has a higher promised return than short-term debt.
• Liquidating the risky asset is very costly.
• Neither form of finance dominates the other.
• Assume: τθ < 1.
• Risky asset does not dominate cash in terms of returns.
A Simple Framework: Solvency
• Solvency:
• The bank is solvent if it can meet all its contractual obligations in both
periods.
• A fraction α of short-term creditors do not rollover.
• Solvency depends on:
• Return from assets θ (credit risk)
• Fraction α of short-term creditors that do not rollover (liquidity risk).
Solvency at t=1 and t=2
• Note that if the value of the assets at t=2 is negative, the bank is already
insolvent at t=1.
• In this case, the debt holders who withdraw at t=1 receive a pro-rata share
share of the liquidation value in expectation.
• Debt holders who do not withdraw receive nothing.
• If the value of the assets at t=2 is positive, debt holders who withdraw at
t=1 receive full payment.
• In that case, the bank is solvent at t=2 if the value of the assets at t=2 is
enough to pay the remaining debt.
A Simple Framework
• A fraction α of short-term creditors do not rollover.
• Bank needs αs units of cash to pay short-term creditors at t=1.
• Use cash first (αs<m)
• Liquidate the risky asset only when cash is not enough (αs>m).
• Liquidating the risky asset decreases bank value and can force the bank into
insolvency.
A Simple Framework: Value at t=2
• Case I: Bank has enough cash for withdrawals at t=1
• For αs ≤ m, the bank uses cash for payments at t=1.
• The value of the assets at t=2 is given as:
θy + rs (m − αs )
• Bank is solvent if:
θy + rs (m − αs ) ≥ (1 − α )srs + lrl
A Simple Framework: Solvency at t=2
• For αs ≤ m, the bank is solvent at t=2 if:
θ≥
srs + lrl − mrs
=θ
y
• Solvency threshold is independent of α.
A Simple Framework: Value at t=2
• Case II: Bank does not have enough cash for withdrawals at t=1
• For αs > m, the bank needs to liquidate some of the risky asset:
αs − m
τθ
• The value of the assets at t=2 is given as:


θ y −
αs − m 

τθ 
• The bank is solvent if:


θ y −
αs − m 
 ≥ (1 − α )srs + lrl
τθ 
A Simple Framework: Solvency at t=2
• For αs > m, the bank is solvent at t=2 if:


θ y −
αs − m 
 ≥ (1 − α )srs + lrl
τθ 
• Note that the solvency threshold θ* is increasing in α. Why?
A Simple Framework: Solvency at t=2
• For α=1, we obtain:
θ (1) =
s + τlrl − m
=θ
τy
• For θ ≥ θ the bank is always solvent (independent of α).
A Simple Framework: Solvency at t=2
• For θ ≥ θ the bank is fundamentally solvent (independent of α).
• For θ ≤ θ the bank is fundamentally insolvent (independent of α).
• For θ ≤ θ < θ solvency depends on α:
*
• For θ (α ) ≥ θ (α ) the bank is conditionally solvent.
• For θ (α ) < θ * (α ) the bank is conditionally insolvent.
A Simple Framework
• Insolvency, illiquidity
θ
Fundamentally
solvent
𝜃̅
Conditionally
solvent
𝜃∗
Conditionally
insolvent
𝜃
Fundamentally insolvent
𝑚
𝑠
1
α
Determinants of stability
• Leverage/capital (e).
• Liquidation value (τ).
• Maturity structure of debt (s versus l).
• Liquidity holdings (m).
A Simple Framework
• Liquidation values (effect of τ)
θ
𝜃̅
𝜃 ∗ (𝛼|𝜏low )
𝜃̅(𝜏)
𝜃 ∗ (𝛼|𝜏)
𝜃
𝑚
𝑠
𝜃 ∗ (𝛼|𝜏max )
1
α
Going forward
• Risk management (θ).
• Liquidity management (m,s,τ,α).
• Regulation:
• Capital (e)
• Liquidity (m,s,τ)