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5007-Money and Banking www.ephilipdavis.com
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EC5007
Money and Banking Part 1: Economics of Banking In this part of the course we focus on banks. These are the most important of a number of financial intermediaries that channel funds from those who have a surplus of assets to those requiring external finance, as well as offering a large number of additional financial services. Banks are also subject to important risks, which necessitate both a complex system of regulation and also sophisticated risk management by the bank itself. The aim of this part of the module is to provide an overview of the main economic and financial aspects of banks’ activities, drawing heavily on country data and historical examples as well as theory. Three aspects of banking economics are covered. · In Section 1, we probe the nature of banking and the justification for banks’ existence, with a major focus on the theory of intermediation (and the role of asymmetric information therein) and the industrial approach based on the nature of competition among banks. · In Section 2, we focus on bank risks – interest rate, market, liquidity and credit risks. · In Section 3, in the light of these risks, it is natural to then address the safety net of lender of last resort and deposit insurance and regulation of banking activities, which in effect protect the authorities against moral hazard. · As applications of banking economics, in Section 4, we examine two crucial innovations of recent decades, namely off balance sheet/securitisation activities and international banking, in the light of the three earlier sections. We show how issues of banks’ comparative advantages, risks and regulatory issues arise in the context of these innovations.
Learning
Outcomes:
(i)
Justify the existence and explain the activity of banks. (ii)
Demonstrate comprehension of the nature of bank risks together with the Course text:
Greenbaum and Thakor (1995) "Contemporary Financial Intermediation", Dryden Other useful books.
Freixas and Rochet (1997) "Microeconomics of Banking", MIT Press Davis (1995), "Debt, financial fragility and systemic risk", Oxford Heffernan (1996) “Modern banking in theory and practice”
Further points - This handbook facilitates note taking during lectures. If you do not take notes you will not remember the important explanations and additional points that are made. - Refer frequently to this summary to understand where the current material fits into the overall subject. - The course cannot be seen in parts but is an integrated subject, all of which is needed for a proper understanding - Pay close attention to the core theoretical concepts that recur throughout the course, as well as historical examples. - Seminars are in the form of group presentations and will give valuable insights to all members of the course. - Become familiar with the Bankscope database, for presentations and also as background for dissertations.
Relevant outcome Part
1 The nature and justification of banking (a) Lecture 1: Introduction to data and theoretical concepts (i) and (ii) · Introduction to bank data · Introduction to theoretical concepts · Functions of the financial system and its evolution
Reading (source): Greenbaum
and Thakor Ch 1 Rybczynski T (1997), “A new look at the evolution of the financial system”, in ed. J Revell “The recent evolution of financial systems”, MacMillan, London. (Library) Merton R C and Bodie Z (1995):"A conceptual framework for analysing the financial environment", in eds D B Crane et al "The global financial system, a functional perspective", Harvard Business School Press 1995 (Library) (b) Lecture 2: The nature of financial intermediation: (i) · Why are there intermediaries? · Functions of intermediaries · Approaches to the theory of intermediation · Intermediaries and functions of the financial system · The evolution of financial systems and the role of banks · Evidence on banks’ uniqueness Reading: Greenbaum and Thakor Part II, Chs 2 and 3 Freixas and Rochet Chs 1 and 2 Davis E P and Mayer C P (1991), "Corporate finance in the euromarkets and the economics of intermediation", CEPR Discussion Paper, No. 570 (Library) Allen F and Santomero A M (1998) :"The theory of financial intermediation", Journal of Banking and Finance, 21, 1461-14 85 (Library) Bhattacharya S and Thakor A (1993): Contemporary Banking Theory" Journal of Financial Intermediation, 3, 2-50 (Library)
(c) Lecture 3: The Theory of the Banking Firm and Banking Competition (i) · What do banks produce? · Extensions: types of industrial competition and their application to banking · Models of banking competition · Empirical evidence: Reading: Freixas and Rochet : Ch 3 Santomero A (1984) "Modeling the Banking Firm" Journal of Money Credit and Banking, 16(4), 576-602. (JSTOR) Davis E P and Salo S (1998), "Excess capacity in EU and US banking sectors - conceptual, measurement and policy issues", LSE Financial Markets Group Special Paper No. 105 (WEB)EB) De Bandt O and Davis E P (2000) "Competition, contestability and market structure in European banking sectors on the eve of EMU", Journal of Banking and Finance, 24, 1045-1066 (WEB) (a) Lecture 4: Lending and credit risk
(i) and (ii) · Balance sheet trends · The nature of lending · Decomposition of the lending function · Structure of loan agreements · Information problems - credit analysis and credit information · Loan pricing - theory and evidence · Credit rationing · Customer relationships · Default and restructuring · Risks in lending - particular reference to real estate Reading: Greenbaum and Thakor : Chs 5 and 6 Davis: Ch 1 Jaffee D and Stiglitz J (1990) : "Credit Rationing" in The Handbook of Monetary Economics,Vol II, eds Friedman and Hahn , North Holland (Library) Fama E (1985) : "What’s Different about Banks?" Journal of Monetary Economics , 15, 29-39 (JSTOR) Davis
E P (1993), "Bank credit risk", Working Paper No. 8, Bank of England,
London. (WEB) (a) Lecture 5: Non credit risks (ii) · Interest rate risk · Liquidity risk and the deposit contract · Market liquidity risk The theory of financial instability · Recent episodes of systemic risk
Reading: Greenbaum and Thakor Chapter 4, Chapter 9 Davis Chapter 1
(c) Lecture 6: Risk control in banking (ii) · Opportunities and risks · Example - Drexels and Junk bonds · Example - Japanese banking crisis · Need for risk management · Day to day management and risks arising · Liability management · Value-at-risk models and stress testing · Crisis management · Strategic planning · A critique - the credit rationing theory of financial crises
Reading: Greenbaum and Thakor Chapter 12 Heffernan Chapter 5 Best P W (1998), "Implementing value-at-risk", John Wiley (Library) Guttentag J and Herring R (1984), "Credit rationing and financial disorder", Journal of Finance, 39, 1359-1382 (JSTOR) (a) Lecture 7: Deposit insurance and lender of last resort
(ii) · The deposit contract and bank runs · The issue of runs and contagion · Deposit insurance as a bulwark against runs · Flaws - the issue of moral hazard · The lender of last resort · Comparing LOLR and deposit insurance · Payment system risks · The need for macroprudential surveillance and indicators
Reading: Greenbaum and Thakor Chapters 9 and 10
(b) Lecture 8: Prudential regulation (ii) · Why regulate any economic activity? · Why regulate banks? · Regulatory agencies · Objectives of regulation · Types of regulation: · Bank capital · Other forms of regulation · Relation of regulation to DI/LOLR · International agreements on bank regulation: Reading: Greenbaum and Thakor Chapters 10 and 11 Heffernan Chapter 6 Davis Chapter 5 Bhattacharaya S et al (1998) : "The Economics of Bank Regulation" Journal of Money Credit and Banking, 745-770 (Library) C
Karacadag and M W Taylor (2000), "The new capital adequacy framework",
SUERF Studies No. 8 (Library) Danielsson J et al (2001), “An academic response to Basel II”, LSE Financial Markets Group Special Paper No 130 Part 4: Applications of
banking economics (a) Lecture 9: Off balance sheet activity and securitisation
(i) and (ii) · Reasons for growth in OBS · Loan commitments · Letters of credit · Swaps · Risks in contingent claims · Securitisation · Loan sales · Why does the scope of securitisation differ across countries? · Some realised risks
Reading: Greenbaum and Thakor Chapters 7 and 8 Davis : Ch 7 Bank for International Settlements (1986) : "Recent Innovation in International banking" (LIBRARY) Bhattacharya S and Thakor A (1993): Contemporary Banking Theory" Journal of Financial Intermediation, 3, 2-50 (Library)
(b) Lecture 10: International banking
(i) and (ii) · Definition · Reasons for international banking · Main activities: · Sovereign risks - theory and experience · Foreign exchange risks · Regulation of international banking
Reading: Greenbaum and Thakor Chapters13 and 14 R. C. Bryant (1987) "International Financial Intermediation" The Brookings Institution, Chs: 2,3,4 (Library)
Supplementary topic: The future of banking
(i) and (ii) · The decline of banking · The role of institutional investors in banks’ decline · An economic perspective on banks' future · Current challenges: Reading Davis Chapter 9 Rajan R (1996), “Do banks have a future, an economic rationale”, Bank of Italy working paper No 280 (Library)
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