FOUNDATIONS OF MICROBANKING 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?
1.1 The Classical theory
• 1.1.1
A 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
1.1 The 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
1.1 The Classical theory (end)
– 1.1.3Payment system (Fama, 1980)
1.2 First 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(C1)
consumers
•
U(C2) Late diers (patient
consumers)
Ct is consumption at time 1 or 2 and U
is increasing and concave.
Early diers or impatient
Technology
• Long run technology
•
t=o
t=1
•
-1
(R>1)
• Storage technology
•
t=o
• -1
1
t=2
R
t=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)
1.3.1 Diamond (1991):
Monitoring and reputation
• Consider a population of firms that have
investment projects of three different nonobservable 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 .