Financial institutions and Crises
Midterm prep
Reading list lecture 1-5 (Greenbaum and Thakor (2016, 2019))
Lecture 1: Asymmetric Information and Credit Markets
o Chapter 1 Basic concepts, p. 10-15 (Market for lemons).
o Chapter 8, p. 177-182 Credit rationing.
o Bernanke, B. S. 1992 Credit in the Macroeconomy, FRBNY Quarterly
Review, Spring 1992/93, 50-70. (The second half of the paper, section III
onwards, on monetary policy will not be covered in this course).
o Objectives:
1. Define the financial system and credit creation processes.
2. Understand how and why informational asymmetries make credit
(financial) markets special.
Lecture 2: Bank Models and Accounting
o Chapter 2 The nature and variety of financial intermediation.
o Chapter 3 The what, how and why of financial intermediaries.
o Chapter 4 Bank risks.
o Bank of England, Quarterly Bulletin 2014 1Q, Money Creation in the modern
economy.
o Norway’s Financial System 2024, Norges Bank; The financial System, 1
Financial Markets, pages 17 – 51
o Objectives:
1. Get sense of different types of financial intermediaries.
2. Get familiar with bank sheets and income statements.
3. Understand how impairments of financial instruments are accounted
for.
Lecture 3 and 4: Credit risk/bank assets
o Chapter 7 (skip examples) Spot lending and credit risk.
o Chapter 10 (skip examples and subsection on the pricing of loan
commitments) Off-balance sheet banking and contingent claims
products.
o Objectives lecture 3:
1. Get familiar with the main elements and vocabulary on IFRS9
for impairments of loans.
2. Understand what goes into giving a loan (“the lending function”).
3. Understand off-balance commitments.
o Objectives lecture 4:
1. Understand the use of covenants.
2. Understand off-balance sheet items.
3. Understand the development and pros/cons of fractional reserve
banking.
Lecture 5: Liability risks and deposit insurance
o Chapter 6, incl. Appendix Liquidity risk.
o Chapter 12 The deposit contract, deposit insurance, and shadow
banking, p. 300-312.
o Chapter 10 + 11: Money markets.
o The Norwegian Banks’ Guarantee Fund; The deposit guarantee
scheme’s guarantee liability 2024.
Summarized key points from each chapter with learning
objectives
Chapter 1 and 8
Define the financial system and credit creation process:
o The financial system consists of institutions, markets, and instruments
that facilitate the flow of funds between savers and borrowers.
o Credit creation occurs when banks accept deposits and use a portion
to issue loans, effectively expanding the money supply.
o The fractional reserve system allows banks to lend out a portion of
deposits while keeping reserves to meet withdrawal demands.
o Chapter 8’s relevance: Credit creation is affected by loan pricing, risk
assessment and rationing, which influence banks’ decisions.
Understand how and why informational asymmetries make credit
(financial) markets special:
o Informational asymmetry occurs when one party in a financial
transaction has more information than the other (e.g. borrowers know
more about their ability to repay than lenders).
o This creates two key problems:
Adverse selection: Riskier borrowers may seek loans while
safer borrowers may avoid them.
Moral hazard: Borrowers might take excessive risks after
receiving credit, increasing the chance of default.
o Why credit (financial) markets are special: Unlike goods markets,
financial markets must assess future cash flows and behavior, requiring
risk assessment tools (e.g., credit scores, financial statements).
o Chapter 8’s relevance: Banks counteract these risks with loan
covenants, collateral requirements, and credit rationing.
Chapter 2, 3 and 4
Get a sense of different types of financial intermediaries:
o Financial intermediaries facilitate the movement of funds by
transforming short-term deposits into long-term loans and managing
risk.
o Types of financial intermediaries:
Commercial banks (deposit-taking institutions).
Investment banks (facilitate capital markets, mergers &
acquisitions).
Insurance companies (manage risk through policies).
Hedge funds & mutual funds (pool investments).
Non-bank financial institutions (shadow banking)
o They differ in their funding, risk exposure and regulatory treatment.
Get familiar with bank sheets and income statements:
o Balance sheet structure:
Assets: Loans, reserves, securities.
Liabilities: Deposits, borrowing, equity capital.
o Income statement components:
Interest income (from loans and investments).
Non-interest income (fees, commissions).
Expenses: Interest paid on deposits, operational costs.
Understand how impairments of financial instruments are accounted
for:
o Impairment refers to expected credit losses on loans and other
financial assets.
Occurs when loans are at risk of default, requiring banks to
adjust their expected recoveries.
o Banks adjust their balance sheets to account for potential losses,
following accounting rules like IFRS9.
Introduces a forward-looking approach to impairment
recognition.
o They use staging models to classify loans (stages of impairment):
Stage 1: Low credit risk; 12-month expected credit losses (ECL)
recognized.
Stage 2: Increased credit risk; Lifetime expected credit losses
recognized.
Stage 3: Defaulted loans; full impairment recognized.
o Impact on financial statements:
Increased provisions affect profitability.
Stricter impairment accounting reduces pro-cyclicality in
lending.
Chapter 7 and 10
Get familiar with the main elements and vocabulary on IFRS9 for
impairments of loans:
o IFRS9 replaced the old “incurred loss model” with the expected credit
loss (ECL) model, requiring banks to recognize impairments earlier.
o Key elements:
Probability of Default (PD): Likelihood of borrower default.
Loss given Default (LGD): Expected loss if default occurs.
Exposure at Default (EAD): Total exposure at the time of
default.
o Impairments are calculated based on macroeconomic conditions.
Understand what goes into giving a loan (“the lending function”):
o Steps in the lending process:
Loan origination: Assessing borrower creditworthiness.
Credit analysis: Evaluating financial health, collateral, and
repayment capacity.
Loan structuring: Setting terms (interest rate, maturity,
covenants).
Risk mitigation: Using collateral, guarantees, and loan
covenants.
Monitoring: Ensuring compliance with loan terms.
o Bank’s role: Managing credit risk while ensuring profitable lending.
Understand off-balance commitments:
o Off-balance sheet (OBS) items are financial commitments that do not
appear on a bank’s balance sheet but still expose it to risk.
o Examples:
Loan commitments: Agreements to lend money in the future.
Letters of credit: Guarantees payment to a third party.
Derivatives: Interest rate swaps, foreign exchange contracts.
o These commitments impact liquidity risk and must be carefully
managed.
Understand the use of covenants:
o Loan covenants are contractual agreements that impose restrictions
on borrowers.
o Types:
Positive covenants: Require specific actions (e.g., maintaining
financial ratios).
Negative covenants: Restrict certain actions (e.g., taking on
additional debt).
o Purpose:
Protect lenders from risky borrower behavior.
Reduce default probability by ensuring financial discipline.
Understand off-balance sheet items:
o Off-balance sheet transactions increase leverage without adding
liabilities.
o Common off-balance sheet activities:
Securitization (selling loans to third parties).
Credit derivatives (hedging risk).
Special Purpose Vehicles (SPVs) used for risk transfer.
o Risks:
Increased systematic exposure (e.g., 2008 financial crisis).
Lack of transparency in financial reporting.
Understand the development and pros/cons of fractional reserve
banking:
o Fractional reserve banking allows banks to lend out most of their
deposits while holding only a fraction in reserves.
o Process:
Customers deposit money into banks.
Banks lend out a portion of these deposits.
Borrowers spend the money, and it gets redeposited into the
banking system, creating a multiplier effect.
o Pros:
Encourages credit expansion and economic growth.
Efficiently allocates idle funds in the economy.
o Cons:
Creates liquidity risk: If many depositors withdraw funds at
once, the bank may fail (bank run).
Requires central bank intervention (lender of last resort).
Can amplify financial crises when too much credit is extended.
Chapter 6 Liquidity risk
Understand the nature and importance of liquidity risk in banking:
o Liquidity risk arises when banks cannot meet short-term obligations
due to lack of liquid assets.
o A mismatch between assets (loans) and abilities (deposits) can create
liquidity issues.
o Banks manage liquidity risk through liquidity buffers, central bank
borrowing, and interbank markets.
Identify sources of liquidity risk and their impact on financial stability:
o Funding liquidity risk: When banks struggle to obtain funding from
depositors or wholesale markets.
o Market liquidity risk: When banks cannot sell assets quickly without
significant price reductions.
o A liquidity crisis can trigger bank runs, forcing central banks to
intervene.
Understand liquidity regulation and risk management strategies:
o Basel III introduced Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR) to ensure banks maintain sufficient liquid
assets.
o Banks manage liquidity through cash reserves, credit lines, and
securitization.
Chapter 12 The deposit contract, Deposit Insurance, and Shadow
Banking (p. 300-312)
Understand the role of the deposit contract in banking:
o Deposits form the primary funding source for banks.
o Demand deposits allow immediate withdrawals, while time deposits
require holding funds for a set period.
o Banks balance profitability and liquidity while ensuring depositor
confidence.
Study the effects of deposit insurance on banking stability:
o Deposit insurance protects depositors from bank failures, reducing
the risk of bank runs.
o However, it creates moral hazard, encouraging excessive risk-taking
by banks.
o Regulatory bodies oversee insurance schemes to prevent excessive
risk exposure.
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Explore the role of
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