ECON 310: Banking
32 Cards in this Set
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Definition of a Bank
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A financial intermediary that accepts deposits from savers and makes loans to borrowers.
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Deposits:
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Liabilities - pay out money on demand.
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Loans
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Assets. Receive interest income on loans.
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Core Activities of Banks
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Act as intermediaries between deposit holders and borrowers.
Provide liquidity
Deposit holders and borrowers have different liquidity preferences.
Liquidity preferences may change over time.
Allow for asset transformation
Transformation of value of assets and liabilities through pool…
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Secondary Activities of Banks
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Provision of off balance sheet and fee for service business:
ex. arranging syndicated loans, deposit box facilities, etc.
May provide other "non-banking" services offered by other financial institutions:
Ex. Stockbroker, investment banking activities, etc.
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Principal Agent Problem
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Caused by issue of asymmetric information -> adverse incentives -> problem of adverse selection and moral hazard.
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Adverse Selection
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borrowers of worse than average risk more likely to enter a contract offered:
Some banks do not lend at high interest rates as want to avoid risk borrowers.
Adverse incentives -> borrowers may take greater risks at higher interest rates hence banks reduce size of loan or refuse loans.
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Moral Hazard
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As a result of entering contract, incentives change such that overall risk is altered:
borrowers could take extra risk due to adverse incentives.
Banks could make riskier loans thereby jeopardizing deposits if deposit holders do not monitor banks' behavior.
Bank management could boost …
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Possible solutions to Moral Hazard (and some adverse effects) include:
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Collateral Requirement.
Net Worth Requirement
Restrictive Covenants
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Liquidity Risk
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i.e. risk that settlement is not made at expected time -> assets and liabilities cannot be transferred between agents.
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Operational Risk
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risk associated with operating the bank, such as theft, failure of computer system, large withdrawal of funds by deposit holders, etc.
i.e. risk from threat of operational breakdowns preventing time settlement.
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Main types of Risk Banks are Concerned About:
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Interest Rate and Default Risk.
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Interest Rate Risk
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risk that market interest rates will change, affecting the value of bank's assets
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How to Manage Interest Rate Risk and Definition of each.
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Interest Immunization: process of equalizing time to maturity of assets & liabilities through securitization of loans and investing.
Securitization: banks originate load (agree to provide loan) then sell the loans to investors.
Hedging: banks trade in derivatives to protect against adve…
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Contagion
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spreading of risk from one bank to the banking system as a whole
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How is contagion caused?
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Caused by the fact that banks offer relatively homogenous services -> all exposed to the same risk.
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Contagion at both the Macro and Micro level:
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Macro Level - all banks affected by events such as monetary policy.
Micro Level - marginal borrower goes to all banks until one makes the loan.
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Consequences of Contagion
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Systematic Risk: risk that disturbances in one financial institution spread across whole financial system -> bank runs.
Extensive collapse -> loss of intermediation, money transmission & liquidity services offered by banks -> inefficient allocation.
reduction of money supply
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Prudential Regulation:
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concerned with minimization of social costs of bank failure.
At same time needs to ensure banks do not take advantage of special regulation/protection.
Escalate moral hazard problems -> part of regulatory role to minimize these problems.
Focuses on bank regulation at micro-level (ensur…
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Role of Government Regulators:
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supervise banks to reduce negative externalities
restrict mergers and bank activities to keep banks small.
Provide safety nets (deposit insurance) to prevent bank runs.
Offer services to ensure efficient payments
Require banks to hold reserves to control money supply.
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Reasons for International Regulation:
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Problems with global institutions & markets -> undermining international financial system (environment banks operate in).
If bank branch/subsidiary in another country, which regulator has jurisdiction over branch?
If all multinational banks required to meet some global regulations -> sa…
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Basel Committee
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Failure of 2 major international banks led to the formation of Basel Committee on Banking Supervision.
Comprised of regulators from the G10 + Luxembourg and Switzerland.
Main purpose is to consider regulatory issues related to the operation of international banks in member countries.
O…
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Types of Capital
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Tier 1 (core) capital -> equity capital + disclosed reserves.
Tier 2 (supplementary) capital -> all other capital.
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Short-Term Business Loans
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Self-Liquidating Inventory Loans.
Working Capital Loans
Interim Construction Financing
Security Dealer Financing
Retailer & Equipment Financing
Asset-backed loans.
Syndicated Loans
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Long-Term Business Loans
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Term business loans
revolving credit financing
long-term project loans
loans to support leveraged buyouts.
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Reasons for Asset Backed Securities Include:
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decreased assets on B/S -> boost risk assets ratio/Basel capital ratio (provided credit risk -> third party).
Increased liquidity -> frees up funding tied to loans -> allows new loans to be funded by bank.
Increased marketability of assets -> can be traded on secondary market (unlike or…
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Determinants of interest margin:
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intermediation costs (search, verification, monitoring and enforcement costs).
Cost of capital (rate it borrows at = id)
Risk premium charged on loans
tax payments
desired institutional profits.
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Importance of Monetary Policy by Central Banks
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primary function: conduct money and credit policy to promote sustainable growth in economy and avoid severe inflation.
manage monetary policy with aim of achieving price stability (control inflation).
Prevent liquidity crisis, situations of money market disorder and financial crisis.
E…
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Benefits of Internationalism of Banks
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Ability to spread risks through diversification across markets.
Bigger pool of funds leading to reduced capital costs.
Increased competition due to more players
Transfer of funds from capital-rich to capital-deficient countries.
Achieve through all of this more efficient distribution …
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Impediments to Internationalization of Banking Sector
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Differences in tax regimes, financial & accounting reporting standards, national business cycles & tastes differences.
Barriers to free trade, including:
Tariffs (ex. higher taxes on domestic resident's income from foreign assets).
Non-tariff barriers (i.e. restricting activities of fo…
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Why Regulate Banks?
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Protection for investor:
Quality of financial products not easily observed.
Important for investor to be fully informed when purchasing products.
Concentration of financial firms in market place.
Financial sector -> many different markets.
Competition varies between markets -> inc. c…
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"Looting Hypothesis"
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Managers undertake riskier behavior to try and boost short-term profits -> enhanced status and salary.
Inc. short-term profits -> inc. bank share price -> managers cash in share options.
Well-informed shareholders ignore inc. risk -> sell shares when stock price is high -> capital gain.
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ECON 310: Banking