International banking lecture 2 key concepts

What are the assumptions of the Arrow-Debreu world? Explain each

Completeness (all possible states of the world are known and you can trade a security that pays off in each possible state), costless trading (No transaction costs/taxes/fees), unrestricted trading (Any payment stream can be traded in any quantity with perfect divisibility/no minimum size/short sales allowed), no informational asymmetries (everyone has the same information which need not be complete but must be symmetric)

What is the (informal) set-up of the arrow-debreu world?

households split savings between bonds and bank deposits, firms choose how much to invest into both bonds or bank loans, banks choose how much to lend and how many deposits to take

WHat happens if firms and households have unrestricted access to perfect financial markets? (2)

Banks make zero profit, size and composition of banks’ balance sheets have no effect on any other agent

what can be said if r = rL = rD? (interest rate on bonds = interest rate on deposits (household) = interest rate on loans (firm))

banks margin is zero no matter how competitive the sector is, making banks basically irrelevant

What is Modigliani-Millar (1958) theory?

in a frictionless world, the value of a firm does not depend on how it is financed and rearranging claims on a given cash flow does not create value

What is the difference between a deposit and a loan in terms of the bank

deposit is a security issued by the bank, loan is a security bought by the bank

what are two routes out of the irrelevance result? Explain

Transaction costs (introduce fixed costs/indivisibilities/search costs), asymmetric information (introduce private information)

What is the ‘transaction cost’ argument?

bank stands between savers (households) and firms carrying out investment projects, cuts costs as direct deals between households and firms is very costly

What theory did Diamond and Dybvig come up with?

why banks are useful and why the very same feature makes them fragile

What are banks modelled as to Diamold and Dybvig?

insurance against liquidity shocks

what is liquidity shock?

When some households don’t know whether they will be early or late consumers

What is a demand deposit

withdrawable deposit at any time, insures a household against turning out to be an early consumer and liquidating early

Why can banks do demand deposit but not individuals?

liquidity shocks are independent across households

what are two results of Diamonds theory?

a bank funded by demand deposits can raise welfare above what a market delivers by insuring depositors against the liquidity shock (optimal risk-sharing), can result in a bank run

what happens at t=0 during investment?

consumers invest their endowment

what happens at t=1 during investment?

consumers privately learn their type (type 1 and type 2), projects can be liquidated and type 1 consumes

what happens at t=2 during investment?

Long-term projects mature (type 2), and type 2 consumes

What happens if you interrupt a long-term investment?

destroys value relative to leaving it alone

What is meant by households being risk averse

unitity rises with consumption (not linear) but each extra unit adds less than the one before, so marginal utility falls faster than consumption rises

What is it meant by households being impatient?

projects return must outweigh impatience

what are the 4 steps for the model for why banks exist? Explain each

Autarky (no trade at all), financial market (consumers can trade at t=1), planners solution (what would a social planned who could see types do?), implementation (can we get there without seeing types?)

Explain autarky

No trade, each consumer puts certain amount into long-term project and 1 minus that certain amount into storage, choosing the certain amount at t=0 before knowing their type

Explain financial market

now investor can sell the claim on the project allowing the project to mature with someone else without being destroyed

Explain what happens in type 1

holds maturing project but wants goods now (sells claims)

Explain what happens in type 2

holds stored goods but wants consumption later (buys claims)

give the process of the market equilibrium (3)

each consumer puts some share into storage, and 1 minus that share into the long-term project, at t=1 type 1s sell securities to type 2s in exchange for goods to consume now (no project is liquidated early and no goods are stored pointlessly), storage covers early consumption and the long-term return covers late consumption

whats the problem with the planner?

can observe types, so knows eactly how many early consumers there are, so can give different amounts to different people meaning nothing never gets liquidated early

liquidity insurance explaination

early consumers get more in the market equilibrium and late consumers get less (marginal utility falls faster than consumption rises)

What is meant by the ‘first-best’

what you could achieve if the private information problem simply disappeared

what does the liquidity insurance do in the Diamond model?

smooths consumption by raising consumption in the type 1 and lowering consumption in type 2, protecting risk-averse consumers

What does the Diamond-Dybvig model miss out?

Asset side is not modelled (riskless projects, no lending decision, no information problem), results rely on there being no other securities markets, deposits are not a means of payment

What is the ex post (diamonds) way to solving asymmetric information (2)

spend money on monitoring, design contract so the inform party behaves (has incentives)

explain the set-up of delegated monitoring

lots of entrepreneurs each needing one unit of funds for risky project, lenders are small so each project needs ‘m’ of them, project returns are risky and independent across entrepreneurs

What is the issue with delegated monitoring?

Only the entrepreneur sees how his project turned out, and lenders would need to pay a monitoring cost, so entrepreneur can lie about how much they need to give to the lender

How does the delegated monitoring problems cause issues for projects?

Good projects go unfunded as lenders are aware that entrepreneurs can lie about their earnings

What are 2 solutions to the delegated monitoring issues?

Non-monetary penalties, monitoring

what is the non-monerary penalties solution? Give some examples

fix a repayment the entrepreneur has promised, and if they do not pay this they receive a non-monetary penalty (e.g. bankruptcy, processing costs, loss of reputation, new job search costs, prison)

What problem is there with non-monetary penalties?

entrepreneur gets punished even when they are telling the truth if theyre project geniunly did badly

What is the monitoring solution?

Lenders pay a certain amount to monitor the projects

How are banks used to drop monitoring costs?

one agent monitors on everyones behalf so only one cosst

What issues are there with banks monitoring? (2)

Banks don’t get gain if theres a penalty contract (debt) with the borrower, depositors cannot monitor the bank

How does diversification make a bank possible?

bank is punished only if its total receipts fall short of what it promised depositors

What does Diamonds model predict?

banks matter most where information problems are severe, banks are funded by debt, deposits are safe even though every loan is risky, banking has economies of scale, banks loans are illiquid