Financial Institutions I:
The Economics of Banking
Prof. Dr. Isabel Schnabel
Gutenberg School of Management and Economics
Johannes Gutenberg University Mainz
Summer term 2011
Monday 2.15 p.m. - 3.45 p.m., Tuesday 2.15 p.m. - 3.45 p.m., RW 3
V1
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I. Introduction
I.1. Topic and Objectives of the Course
I.2. Organization of the Course
II. Do Financial Institutions Matter?
II.1. The Irrelevance of Banks
II.2. The Functions of Banks
II.3. Empirical Evidence
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I. Introduction
I.1. Topic and Objectives of the Course
I.2. Organization of the Course
II. Do Financial Institutions Matter?
II.1. The Irrelevance of Banks
II.2. The Functions of Banks
II.3. Empirical Evidence
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I.1. Topic of the Course
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Traditionally, financial intermediaries (such as banks) play no
role in economic literature
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Argument: When markets are perfect and complete (world
of Arrow-Debreu), there is no added value from financial
intermediation
⇔ But: Banks appear to be very important in practice
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Bank loans are the most important form of external financing
→ Impact on innovation activities and economic growth
Banks play an important role in providing means of payment
(especially deposits) and payment systems
Banks act as market makers in financial markets
Banks advise households and firms in investment decisions
...
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Asymmetric Information
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1970s: Revolution of economic theory through the discovery of
the importance of asymmetric information in many
economic problems
Bank relationships are characterized by a high degree of
asymmetric information
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Banks ↔ borrowers
Banks ↔ depositors
Bank owners ↔ bank managers
Theory of asymmetric information has profoundly changed
banking theory and has now become the standard foundation
of any banking model
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Objectives of the Course
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Broad overview of the theory of banking: Why do banks exist?
How do they behave (competitive behavior, risk-taking)? . . .
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Discussion of topics relevant to economic policy: Why are
banks unstable? Why have banks to be regulated? How should
banks be regulated? . . .
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Students shall be introduced to current research as well as
policy discussions in this area
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Such knowledge is also useful if you plan to work in the
financial sector
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Prior knowledge in contract theory, economics of information,
bank management, and econometrics is useful, but not
required (course is self-contained)
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I. Introduction
I.1. Topic and Objectives of the Course
I.2. Organization of the Course
II. Do Financial Institutions Matter?
II.1. The Irrelevance of Banks
II.2. The Functions of Banks
II.3. Empirical Evidence
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I.2. Organization of the Course
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Monday afternoon: Lecture or tutorial
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Tuesday afternoon: Lecture
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Tutorials are held by Florian Hett (florian.hett@uni-mainz.de)
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Course website:
http://www.financial.economics.uni-mainz.de/441.php
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All course material (slides, additional literature etc.) can be
downloaded from that website
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Login/password are announced in class
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How to Contact Us
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Please do not hesitate to ask questions in class - your fellow
students will appreciate this
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You may also ask questions directly after the course
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Please do not send emails with questions with regard to the
content of the course
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Last lecture: Question time concerning all parts of the course
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Suggestions how to improve the course are welcome at any
time
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We strongly encourage you to participate actively in class
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In order to stay informed, please subscribe to our Newsboard
(see website)
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We also invite you to subscribe to the newsboard of the
Brown Bag Seminar (our internal research seminar)
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Who can Participate
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MIEPP students: 6 LP
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MoM students: 6 LP
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Module “Financial economics”
Can be combined with “Topics in Financial Economics”
(winter term) or “Empirical Banking and Finance” (next
summer term)
Module “Financial institutions”
Can be combined with “Topics in Financial Institutions”
(winter term) or “Empirical Banking and Finance” (next
summer term)
Diploma students (VWL, BWL, Magister): 6 KP
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Kernfach Volkswirtschaftspolitik/Volkswirtschaftstheorie
Wahlfach Weder
AVWL
Please note that you cannot get credit if you already
participated in the course “Mikroökonomik des Bankwesens”
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Reading Materials
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Detailed information on related literature is given in class
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Required reading is marked by a star (*)
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Modern textbook on banking theory: “The Microeconomics
of Banking” by Xavier Freixas and Jean-Charles Rochet, MIT
Press 2008 (2nd edition)
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Main references will be journal articles (which will be provided
on our website)
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Goal: At the end of this course, students should be able to
read and understand research articles from the area of banking
and to discuss current policy issues related to the financial
sector
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Course is an excellent preparation for writing a thesis in this
field
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Final Exam
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There will be a written final exam covering all parts of the
course
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Exam questions are in English, diploma and MoM students
(but not MIEPP students) will be allowed to answer in
German
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You can bring one piece of paper on which you can write
anything that you find hard to remember
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Please note that the retake exam is taking place at the end of
the summer break (also for diploma students!)
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Any questions?
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I. Introduction
I.1. Topic and Objectives of the Course
I.2. Organization of the Course
II. Do Financial Institutions Matter?
II.1. The Irrelevance of Banks
II.2. The Functions of Banks
II.3. Empirical Evidence
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II.1. The Irrelevance of Banks
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Reading material: Freixas/Rochet, p. 7–11
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Assumptions of perfect and complete markets:
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Completeness of the market system (Arrow/Debreu markets)
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No transaction costs, indivisibilities, trading restrictions,
taxes
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Sufficient condition: For each state of the world, there exists a
security (“contingent claim”), which has a positive payoff in
this state of the world and no payoff otherwise
Financial contracts (i. e., combinations of payment streams)
can be traded freely and in any quantity (also short sales, no
minimum trade volumes)
No informational asymmetries
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All market participants are subject to the same information
(which does not have to be complete)
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Banks in General Equilibrium - A Simple Model
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Assumptions of the model:
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2 periods, t = 1, 2
1 good
Perfect competition
3 (representative) agents: households (h), firms (f ), banks (b)
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Maximization Problem of Households
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Households are endowed with ω1 units of the good
→ can be consumed or saved
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Household choose their consumption profile over time
(C1 , C2 ) and the allocation of savings to bank deposits (Dh )
and bonds (Bh ) to maximize their utility
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Household are the owners of firms and banks
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r = interest rate on bonds, rD = interest rate on bank
deposits
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Maximization problem of households:
max u(C1 , C2 )
s.t. C1 + Bh + Dh = ω1
C2 = (1 + r )Bh + (1 + rD ) Dh + Πf + Πb
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Maximization Problem of Firms
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Firms choose investment I and finance investment through
bank loans (Lf ) and bonds (Bf ) to maximize profits
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Production function: f (I )
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rL = interest rate on bank loans
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Profits Πf are distributed to households in period 2
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Maximization problem of firms:
max Πf = f (I ) − (1 + r )Bf − (1 + rL )Lf
s.t. I = Bf + Lf
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Maximization Problem of Banks
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Banks extend loans (Lb ) and finance through deposits (Db ) to
maximize profits
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Assumption: Banks do not finance through bonds (Bb = 0)
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Profits Πb are distributed to households in period 2
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Maximization problem of banks:
max Πb = rL Lb − rD Db
s.t. Lb = Db
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General Equilibrium
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Endogenous variables: Prices (interest rates r , rD , rL ) and
quantities (C1 , C2 , Bh , Bf , Dh , Db , Lf , Lb , I )
A general equilibrium is charaterized by two conditions:
1. All agents behave optimally.
2. All markets are cleared.
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Market clearing:
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Goods market: Investment = savings, I = ω1 − C1
Deposit market: Supply = demand, Dh = Db
Loan market: Supply = demand, Lb = Lf
Bond market: Supply = demand, Bf = Bh
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General Equilibrium
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Bonds and deposits are perfect substitutes for households
⇒ r = rD
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Bonds and loans are perfect substitutes for firms
⇒ r = rL
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Result 1: In general equilibrium, all interest rates have to be
equal, r = rL = rD
⇒ Banks make zero profits (independent of competition)
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Result 2: Given Result 1, B, L and D appear only in the
combination B + D = B + L ⇒ Thus, they cannot be
determined separately because all agents are indifferent
between different types of investment/financing
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In this sense, banks are “irrelevant”
(cf. Modigliani/Miller Theorem, 1958, on the irrelevance of
capital structure)
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Extension to a World with Uncertainty
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Each market participant can realize any desired stream of
payments by buying and selling securities (“contingent
claims”)
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This implies that bank deposits or bank loans can be
replicated by a combination of “contingent claims”
→ For the allocation in the economy it is irrelevant whether
deposits and loans exist or not
⇒ Banks are also “irrelevant” in a world with uncertainty
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Conclusion: The existence of banks can only be explained in
a framework where at least one assumption of the
Arrow-Debreu model is violated, such that different types of
investment and financing are no longer perfect substitutes
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I. Introduction
I.1. Topic and Objectives of the Course
I.2. Organization of the Course
II. Do Financial Institutions Matter?
II.1. The Irrelevance of Banks
II.2. The Functions of Banks
II.3. Empirical Evidence
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II.2. The Functions of Banks
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Reading material: Freixas/Rochet, p. 1–7
Traditional view of banks:
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Asset side of balance sheet: Extension of long-term,
information-sensitive, non-tradable loans
Liabilities side of balance sheet: Financing through short-term,
non-securitized deposits (often sight deposits)
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Even though bank activities are much broader than suggested
by this simplistic description, the combination of these two
activities makes banks special
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Financial innovation (such as money market funds or credit
risk transfer) substantially challenges this traditional business
model
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Legal Definition of Banks, here: Kreditwesengesetz
(KWG), § 1
(1) Kreditinstitute sind Unternehmen, die Bankgeschäfte
gewerbsmäßig oder in einem Umfang betreiben, der einen in
kaufmännischer Weise eingerichteten Geschäftsbetrieb erfordert.
Bankgeschäfte sind
1. die Annahme fremder Gelder als Einlagen oder anderer
rückzahlbarer Gelder des Publikums, sofern der
Rückzahlungsanspruch nicht in Inhaber- oder
Orderschuldverschreibungen verbrieft wird, ohne Rücksicht
darauf, ob Zinsen vergütet werden (Einlagengeschäft),
2. die Gewährung von Gelddarlehen und Akzeptkrediten
(Kreditgeschäft),
3. ...
⇒Major bank activities: Taking in deposits and extending
loans
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Banking Regulation
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Firms that conform with the definition of banks in the
applicable banking law are subject to strict regulation and
supervision, in Germany by Bundesanstalt für
Finanzdienstleistungsaufsicht (BaFin) and Deutsche
Bundesbank
Types of regulation:
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Barriers to market entry (license requirements)
Capital requirements (Basel Accord, Basel II or III)
Liquidity regulation
Regulation of lending (loan volume restrictions, reporting
requirements on large loans)
Deposit insurance
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Why Banks Are Regulated
1. Systemic risk: The failure of an individual bank may spill
over to the remaining banking sector (financial contagion),
breakdown of financial systems has high economic costs
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Experience from the Great Depression: Strong recession was
attributed (among other things) to the breakdown of the
financial system
A large part of current banking regulation and supervision
stems from that time period
Recent financial crisis underlines the importance of the
financial system for the real economy
Systemic externalities justify government intervention
2. Protection of depositors: Depositors are too small and
uninformed to monitor their bank properly
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Banks versus Markets
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Main function of the financial system: matching investors and
borrowers
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What distinguishes banks and markets? What can financial
intermediaries do that market cannot?
Major functions of banks:
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1. Provision of payment systems
2. Transformation of assets
a Lot size transformation
b Maturity transformation
c Risk transformation
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II.2.1. Provision of Payment Systems
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In a world without transaction costs, money is not needed
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But: In reality, barter transactions are very expensive, problem
of the “double coincidence of needs”
→ Use of money is efficient
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The role of banks in the payment system changed with the
different types of money used
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Types of Money
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Goods, such as specie (gold, silver), but also cigarettes
Fiat money, especially paper money
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Money is valuable only because some institution guarantees its
value
This can be private banks (“bank notes”), today it would
typically be a central bank
It is crucial that agents trust in the value of money: in earlier
times this worked through explicit gold coverage of the
circulating currency, today through central banks’ reputation
of being committed to price stability in its monetary policy
“Bank money” = deposits at banks that can be transferred
through cashless payments
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Historical Functions of Banks in the Payment System
1. Banks as money changers
2. Banks as safe-keepers (deposit business)
3. Banks as producers of bank money
4. Banks as issuers of paper money
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1. Banks as Money Changers
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Circulation of a large variety of coins
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Coins were not accepted everywhere
→ Banks exchanged different coins (especially at international
market places and fairs)
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Content of precious metal was hard to check
→ Banks specialized in sorting out “good” from “bad” coins
(in England, early bankers were goldsmiths)
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2. Banks as Safe-Keepers (Deposit Business)
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Banks acted as safe-keepers of coins or bullion and were
obliged to return the same objects that had been deposited
Why was this useful?
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Protection against theft, fire etc.
Banks specialized in storage technologies (building of safes
etc.)
→ Economies of scale
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In later periods, banks promised to return not the same, but
comparable objects, which reduced transaction costs
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Initially, the deposited coins were not lent (no loan business)
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3. Banks as Producers of Bank Money
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A next step in the evolution of banks was the keeping of
accounts
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Delivered coins were credited on accounts
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Money could be transferred to other accounts within the
same bank
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But: No overdrawing
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Famous example of such a bank: Bank of Amsterdam
(founded 1609) (see Adam Smith 1776, Wealth of Nations,
Book IV, Chapter III, Part I)
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Clearing systems among different banks developed much later
(Germany vs. USA)
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Bank of Amsterdam
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Delivered coins were credited in a currency created by the
bank itself (“Bankgeld”) (no physical production)
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Bank money traded at a premium (agio) compared to
circulating money, the quality of which was mostly below the
current money standard
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Bank was subject to a public guarantee
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In the 18th century, Amsterdam bank money became the lead
currency in international trade (comparable to the US dollar
today)
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Payments were done through bills of exchange, nominated in
Amsterdam bank money
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Loans were also granted through bills of exchange (most of
which were closely related to trade transactions)
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4. Banks as Issuers of Paper Money
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Towards the end of the 18th century / beginning of the 19th
century, metallic money was increasingly replaced by paper
money (“fiat money”) (lower transaction costs)
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“Bank notes” were issued by the banks themselves (today:
only by central banks)
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Famous example: U.S. Free Banking Era (1837–1862), see
Gorton (Journal of Political Economy 1996)
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Summary
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Historically, banks’ loan business with private creditors was
negligible
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Loan business started only in the 19th century (exception:
pawn shops)
Loan business with sovereign debtors is much older (example:
house of Fugger)
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The modern version of a bank that combines loan and
deposit business is a rather recent phenomenon
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Question: Why is such a combination optimal (and why was is
not in earlier times)?
Alternative: Two different banks, one of which takes in
deposits and buys bonds, whereas the other extends loans and
finances through bonds
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Such a division of labor was observed in the 19th century
between private bankers and savings banks in Germany
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II.2.2. Transformation of Assets
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A “modern” bank transforms small, liquid, safe deposits
into large, illiquid, information-sensitive/risky loans
(Gurley/Shaw 1960):
1. Lot size transformation
2. Maturity transformation
3. Risk transformation
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Question: Under which conditions can banks fulfill a function
that cannot just as well be fulfilled by capital markets?
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1. Lot Size Transformation
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Loan amounts are typically larger than investment volumes
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Financial intermediaries bring together large and small players
by pooling small deposits to be able to extend large loans
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2. Maturity Transformation
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Loans are often long-term (e. g., for investment projects) and
cannot be liquidated at short notice without incurring
substantial losses
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Depositors want to access their funds at any time
Consequence:
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The bank is itself illiquid → Danger of bank runs
(Diamond/Dybvig, Journal of Political Economy 1983)
The bank is subject to interest rate risk from maturity
transformation → When interest rates rise, funding rates
adjust immediately, but not loan rates (cf. Savings & Loans
crisis in the United States in the 1980s, see also the liquidity
problems of special purpose vehicles in the recent crisis)
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3. Risk Transformation
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Loans are risky and suffer from various informational
problems, but depositors are looking for safe investments
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Depositors acquire a claim towards their bank, not towards
the borrower
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Why can banks offer a better risk-return trade-off than the
capital market (Diamond, Review of Economic Studies 1984)?
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How do banks deal with information problems?
→ Monitoring, long-term relationships
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Banks versus Markets
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Financial markets also fulfill the three functions:
1. Lot size transformation: Total security flotation vs. trading
of single shares, but: minimum fees make the trading of small
quantities unattractive
2. Maturity transformation: Through secondary markets
→ Here the investor bears the risk of price/interest changes
(which he may not like)
3. Risk transformation: Through diversification or special
products tailored to the risk appetite of investors (e. g.,
minimum interest rates etc.), but: small firms cannot easily
enter the capital market due to information problems
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Recent Trends in the Financial Sector
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Disintermediation:
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Increasing interconnectedness of the financial system:
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Firms increasingly finance through markets
Growing importance of investments in securities for households
(e. g., old-age provisions), firms, and also banks
Consolidation: Increasing significance of large banks through
large-scale mergers, also cross-border (partly caused by the
financial crisis)
Conglomeration: Merger of banks and insurance companies
to form large, global bancassurance companies
Credit risk transfer: Transfer of banks’ credit risks to third
parties through securitization (e. g., Mortgage-Backed
Securities, Collateralized Debt Obligations/CDO) or credit
derivatives (e. g., Credit Default Swaps/CDS)
Increasing Complexity of financial products
→ New role of banks as advisors
Development of a largely unregulated shadow banking
system
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Program of Next Week
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II.3. Do Financial Institutions Matter? - Empirical
Evidence
III. Why Do Banks Exist?
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III.1.: Transaction costs (Freixas/Rochet, p. 15–20)
III.2: Liquidity insurance, model by *Diamond and Dybvig
(Journal of Political Economy, 1983) (Freixas/Rochet, p.
20–24)
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