Banking in Theory and Practice - Universitetet i oslo...Facts, trends, and myths 3 Economics of...
Transcript of Banking in Theory and Practice - Universitetet i oslo...Facts, trends, and myths 3 Economics of...
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Banking in Theory and Practice
Jin Cao(Norges Bank Research, Oslo & CESifo, Munchen)
August 23, 2017
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Outline
1 Bank, Banking and Financial IntermediationWhat are banks?Why are banks needed?
2 The of World of Banking in a NutshellInside banks: numbers and jargonsFacts, trends, and myths
3 Economics of BankingMicroeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Disclaimer
(If they care about what I say,) the views expressed inthis manuscript are those of the author’s and shouldnot be attributed to Norges Bank.
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
What is a bank?
“An institution whose current operation consists in grantingloans and receiving deposits from the public” (Freixas & Rochet,2008)
“Current operation”: must be its main business;
“ Granting loans and receiving deposits”: it is anintermediary doing banking activities, although nowadays“ loans” and “ deposits” shall be interpreted in a broaderway;
Banks are highly regulated , much more than other financialintermediaries;
Banks usually have the access to central bank’s operationalfacilities.
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
Bank as financial intermediary
Financial intermediary “specializes in the activities of buyingand selling financial claims” (Freixas & Rochet, 2008),including (not mutually exclusive)
Brokers who buy and sell securities on behalf of investors;
Dealers who trade securities for its own account ;
Collective investment entities who pool money frommany (small) investors by issuing securities which arerepresentative of a bundle of marketable securities theypurchase;
Banks. Since banks may contain the other three, in therest of this course, “ financial intermediary” and “ bank” areinterchangeable unless specified otherwise.
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
Banks’ many faces: entities
Even by narrowest definition, banks differ from each othervery much by their customers, business models, servicesand roles in financial intermediation.
USA Commercial banks S&L Credit unions
UK Commercial banks Building societies
France Commercial banks Mutual and co-op Saving banks
Germany Commercial banks Co-op Saving banks
Japan Ordinary banks Co-op Trust banks
Norway Commercial banks Saving banks
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
Banks’ many faces: services
By different business models, banking services can be roughlydivided into (again, they do not mutually exclude)
Retail banking providing services of accepting depositsand issuing loans to individuals and small businesses;
Wholesale banking providing large funding servicesbetween (mainly) financial institutions. Banks maycooperate as sydicate for very large loans
More international, more in foreign currencies;Often involved in trading assets such as securities viaoff-balance-sheet activities;Interbank market is the most important part of moneymarket (financial instruments with short maturity,comparing to capital market where maturity is longer).
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
Banks’ many faces: services (cont’d)
Universal banking providing whole range of financialservices, deposits, loans, insurance, security services... e.g.,single entity like Deutsche Bank AG or banking holdingcompany with many subsidiaries like Citigroup;
Shadow banking providing banking services in non-bank,non-licensed financial institutions. It involves most largebanks, gets too big to be neglected, yet is still muchunder-regulated and poorly understood
In 2013, shadow banking accounted for one-fourth of globalfinancial intermediation, 50% of total bank assets, 81% inUSA, Euro Area and UK;Including hedge funds, special purpose vehicles (SPV),money market mutual f unds (MMMF), etc.
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
What are banks?Why are banks needed?
Why are banks so special?
From the perspective of funding (liability side)
Bank deposits are repayable on demand at their face value,are used as immediate substitute for money ;By collecting deposits from a large number of investors,banks diversify risk of deposit withdrawal and may invest inlong term (illiquid) assets;
From the perspective of investment (asset side)
Bank loans are non-marketable assets with a great contentof private information;By screening and financing those loans with demanddeposits, banks have incentives (and exclusive information)to act as information producer and delegated monitor .
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
A stylized bank’s balance sheet
Assets Euro Liabilities Euro
Cash 100 On call deposits 3000Reserve deposited in the central bank Can be withdrawn anytime
Liquid assets 1000 Time deposits 2500Safe, e.g. government securities “Certificate of deposit”, term deposits
Loans 6000 Bonds 1000Risky, e.g. corporate loans, mortgages Borrowing from financial market
Fixed assets 200 Equity 800“Tangible”, properties, plants, etc. Shareholders’ claim of ownership
Total 7300 7300
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Stylized profit and loss (income) account
Here is the stylized bank’s financial statement from its profitand loss income account
EuroInterest income 700+ Non-interest (fee) income 600Less interest expenses (funding cost) 600Less operating expenses 500= Gross profit 200
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
The key indicators
Here are some key indicators reflecting the bank’s profitability
Return on assets (ROA) = 2007300 × 100% = 2.7%
Return on equity (ROE) = 200800 × 100% = 25%
Net interest margin (NIM) = 700−6007000 × 100% = 1.4%
(only for interest-earning assets)
Leverage ratio (LEV) = 7300800 = 9.1
Operating expense (OE) ratio = 5007300 × 100% = 6.8%
J. C. Introduction
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Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Total bank assets versus GDP
But... how different are banks in reality, comparing withthose we have in mind and learn from classes? Let’s have alook at the real world facts, trends, and mysteries.First: Why should we care about banking sector at all?Because it’s tooooooo big ! (Total bank assets / GDP ratio. Source:OECD, Federal Reserve Bank, ECB, Norges Bank, Deutsche Bundesbank)
Some countries, such as Ireland, the Netherlands and the UK, experienced dramatic changes in total banking sector assets up until the time where the financial crisis hit.
Chart 2.1: Total banking sector assets relative to the country's GDP
Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque National de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: The banking sector of a country refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks are included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007 and was hence included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while data for Finland were obtained from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.
The United States and the Nordic countries have the lowest total assets to GDP ratio in our sample. The US not only had the smallest banking sector throughout the period, but also showed a very stable total assets to GDP ratio, which actually never exceeded 100 percent. The Nordic countries, on the other hand, experienced a significant increase in the relative size of the banking sector, illustrated by the distinct increase in total assets to GDP ratios from 2005 onwards. In the case of Finland, total assets doubled between 2005 and 2011.
As for Norway, Chart 2.1 illustrates that the banking sector has increased substantially over the past decade. Total assets amounted to 93 percent of GDP in 1999, rising to around 160 percent of GDP in 2009. After the financial crisis, the relative size of the Norwegian banking sector remained stable, in contrast to the decline we observe in other countries.
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J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Growth in bank assets
...and growing extremely fast! (Growth in total bank assets, withyear 2000=100. Source: OECD, Federal Reserve Bank, ECB, Norges Bank,Deutsche Bundesbank)
Hence, let Figure 2.4 presents the total assets of the banking sector indexed to the stock in year 2000, an arbitrarily chosen base year. We see that Ireland, but also the UK and the Nordic countries experienced a dramatic increase in banking sector assets up until the financial crisis hit in 2007-2008. Moreover, the growth in banking assets in Norway actually exceeded that of the other three Nordic countries as well as that of the UK.
From 2000 to 2011 the banking sector in Norway and Finland increased between three and four times. The two countries have experienced a banking sector growth that is not by any other northern European country. They also distinguished themselves from the rest of the countries in our sample, as their growth continued also after the financial crisis hit in 2008.
Chart 2.4: Growth in total banking sector assets (index 100=2000)
Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: As a general rule, Tte banking sector of a country refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: in the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks are included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are also included. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was therefore included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.
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J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Domestic financing: bank versus market
...and is the engine for the real economy. (Total domesticfinancing through banking sector versus financial market. Source: OECD)Chapter 3: Comparative financial systems
41
Figure 3.1: International comparison of banks and markets, 2009
Sources: OECD Statistics (for GDP data); World Federation of Exchanges (for stock exchange data); European Banks Federation; Bank of England; Federal Reserve Bank of USA; Bank of Japan.
The relative importance of different financial institutions is heterogeneous across countries. In terms of the different forms in which gross financial assets are held (directly by households, by pension funds, by insurance companies, by mutual funds), most assets are owned directly by households (except for the UK). In the USA and UK, pension funds are much more important than in other countries. In Germany, and to some extent in Japan, pension funds are relatively unimportant (please refer to Table 3.2 in Allen and Gale, 1998, p.48). Why are there differences in the relative importance of different financial intermediaries in different countries? What are the implications in terms of investment decisions of individuals in different countries?
From the perspective of households, there is a clear difference between the assets held in the USA, UK, Germany and Japan. As regard to the total portfolio allocation of assets, households in the USA and UK hold a greater proportion of their assets as shares than is the case in the other countries we consider here (Germany, Japan and France). Overall (direct and indirect holdings via pension funds, insurance companies and mutual funds), equity constitutes 45 per cent of household assets in the USA, and 52 per cent in the UK (even more than in the USA). This contrasts sharply with Japan and Germany, where the corresponding values are 12 per cent and 13 per cent. For cash and cash equivalents (which include bank accounts) and bonds the reverse is true. In Japan 52 per cent of assets are held in cash and cash equivalents and 13 per cent in bonds, while in Germany the figure is 36 per cent in both (please refer to Table 3.3 in Allen and Gale, 1998, pp.50–51). In the USA only 19 per cent of assets are held in cash and cash equivalents, and 28 per cent in bonds.
Activity 3.1
As you work throughout this section, fill in the table below on the household percentage of assets owned.
USA UK Germany Japan
Equity
Cash and cash equivalents
Bonds
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Bank claims/GDP Market capitalisation/GDP
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Domestic financing: bank versus market (cont’d)
...while the cross-country differences are still very muchdistinguished
In countries with market-based financial system, such asUSA on one extreme, equity market is a much moreimportant source of funding, comparing with bank lending;In countries with bank-based financial system, such asGermany on the other extreme, equity market is a much lessimportant source of funding, comparing with bank lending;In countries with hybrid financial system, such as UK,equity market and bank lending are almost equallyimportant financing sources for the economy;
...and financial systems are evolving over time, too.
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Profitability in banking
You might think it leads to higher market power and pricemarkup, but... (Source: Federal Reserve Bank)
FRED Graph ObservationsFederal Reserve Economic DataLink: http://research.stlouisfed.org/fred2Help: http://research.stlouisfed.org/fred2/help-faqEconomic Research DivisionFederal Reserve Bank of St. Louis
USNIM Net Interest Margin for all U.S. Banks, Percent, Quarterly, Not Seasonally Adju
Frequency: Quarterly, End of Periodobservation_date USNIM
1984-01-01 3.781984-04-01 3.871984-07-01 3.911984-10-01 3.951985-01-01 3.971985-04-01 4.041985-07-01 4.041985-10-01 4.061986-01-01 3.941986-04-01 3.951986-07-01 3.931986-10-01 3.921987-01-01 4.011987-04-01 3.991987-07-01 4.031987-10-01 4.071988-01-01 4.011988-04-01 4.031988-07-01 4.081988-10-01 4.211989-01-01 4.211989-04-01 4.191989-07-01 4.121989-10-01 4.131990-01-01 4.001990-04-01 4.001990-07-01 4.001990-10-01 4.031991-01-01 4.081991-04-01 4.111991-07-01 4.161991-10-01 4.201992-01-01 4.331992-04-01 4.441992-07-01 4.491992-10-01 4.541993-01-01 4.511993-04-01 4.511993-07-01 4.521993-10-01 4.491994-01-01 4.91
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Net Interest Margin for all U.S. Banks (01.1984-07.2014)
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Profitability in banking (cont’d)
...Another example from UK, NIM of Barclays Group1979-2012 (Domestic banking versus international banking. Source:British Bankers Association)
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Profitability in banking (cont’d)
...However, return to shareholders is quite stable, exceptsome really lean years. Where does the profit come from?(Source: Federal Reserve Bank)
FRED Graph ObservationsFederal Reserve Economic DataLink: http://research.stlouisfed.org/fred2Help: http://research.stlouisfed.org/fred2/help-faqEconomic Research DivisionFederal Reserve Bank of St. Louis
USROE Return on Average Equity for all U.S. Banks, Percent, Quarterly, Not Seasona
Frequency: Quarterly, End of Periodobservation_date USROE
1984-01-01 11.971984-04-01 10.571984-07-01 11.111984-10-01 10.661985-01-01 12.331985-04-01 12.071985-07-01 12.191985-10-01 11.221986-01-01 11.881986-04-01 10.741986-07-01 10.771986-10-01 10.011987-01-01 11.431987-04-01 -5.961987-07-01 0.331987-10-01 1.551988-01-01 10.901988-04-01 11.371988-07-01 13.441988-10-01 13.321989-01-01 14.661989-04-01 14.211989-07-01 8.951989-10-01 7.711990-01-01 12.001990-04-01 10.921990-07-01 9.551990-10-01 7.541991-01-01 10.091991-04-01 9.211991-07-01 8.881991-10-01 8.011992-01-01 12.771992-04-01 13.331992-07-01 13.491992-10-01 13.241993-01-01 16.191993-04-01 15.641993-07-01 15.931993-10-01 15.631994-01-01 14.88
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Return on Average Equity for all U.S. Banks (01.1984-07.2014)
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Profitability in banking (cont’d)
International comparison (Return of average equity across countries.Source: OECD, Federal Reserve Bank, ECB, Norges Bank, DeutscheBundesbank)
half of previous decade, with average ROE up to around 13 percent, and delivers the highest ROE in the sample from 2008 onwards.
Chart 2.9: Return on shareholder equity (RoE) in the banking sector
Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank(NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: The return on shareholder equity is defined as after-tax income relative to shareholder equity. The banking sector of a country, as a general rule, refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks have been included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was henceincluded in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion. In the case of Belgium, the return on equity in the banking sector reached -41.7 percent in 2008. In Ireland the return on equity was -36.7 percent in 2008 and -65.2 percent in 2009. In order not to blur the picture for the years prior to 2008, these latter three values were not included in the chart.
Finally, we combine the yearly data on total assets to GDP presented in Chart 2.1 with thereturn on total assets presented in Chart 2.8, and present the relationship between size and returns in the banking sector in Chart 2.10.We are not able to comment on the causality
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15
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Funding resources: deposit versus others
You might think banks are just deposit institutions... nolonger true. Where does the rest of money come from?(Share of deposits in bank liabilities. Source: OECD, Federal Reserve Bank,ECB, Norges Bank, Deutsche Bundesbank)
Chart 2.16: Customer deposits to total assets ratio
Sources: OECD, Bank of England (BoE), Deutche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlansche Bank (DNB). Note: The banking sector of a country, as a general rule, refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks have been included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was hence included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.
2.6 Cross-country differences in market structure
We next turn to an examination of the market structure of the Norwegian banking sector compared with that of the other countries in our sample. This section presents a brief cross-country comparison, focusing on differences across European banking sectors. A more thorough discussion of the market structure of the banking sector in Norway is provided in Section 4.
To obtain a comprehensive picture of the differences in competition across banking sectors in Europe, we take a closer look at two different indices of market concentration for a set of northern European countries.
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J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Intermediation structure
You might think lending to / borrowing from banks is assimple as this
Households with cash surplus lend to banks, given that theymay withdraw when needed (demand deposits);Those who need cash borrow from banks, and banks makesure that they repay as scheduled;And banks profit from the spread between borrowing andlending rates (interest margin).
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4 Financial complexity and systemic risk
How many other [financial] innovations can you tell me that have been as import-ant to the individual as the automatic teller machine, which in fact is more of a mechanical than a financial one?
(Paul Volcker)
The modern finance is a system of extremely high complexity, with structures and products that are hardly understandable by outsiders. The complexity of the financial system grows exponentially with financial innovation in the past decade, but what such complexity implies for financial stability is seldom dis-cussed in the research (Brunnermeier and Oehmke (2009) is one of the few excellent reviews on this issue). During the current financial crisis, financial market is blamed to be over- complicated. In the financial turmoil, the panic grows mostly out of the suspicion that something indiscernible is rotten in the banks, and investors get tremendous loss from the financial products that are too complicated to understand. The financial system gets more and more complicated in many ways. One prominent feature is that the intermediation structure becomes much more soph-isticated than it used to be. An example by Shin (2010a) shows how the interme-diation chain for mortgage evolves. Traditionally, as Figure 4.1 shows, the bank takes short- term deposits from the households and issues loans to long- term bor-rowers. The bank collects the mortgage repayments from the borrowers and then returns some of the proceeds to the depositors. In contrast, the same thing is nowadays carried out through a very long inter-mediation chain (see Figure 4.2), involving many sophisticated financial products. First, the mortgages are pooled and financed by the mortgage- backed securities (MBS), and these securities are owned by the asset- backed securities (ABS) issuers and may be further tranched into new products such as collateralized debt
Households Bank HouseholdsMortgage Deposits
Figure 4.1 Short intermediation chain (source: Shin, 2010a, pp. 101).
04 199 Banking.ch04.indd 78 17/10/11 13:53:40
T&F PROOF
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Intermediation structure (cont’d)
...However, in reality the process goes through a lengthychain, involving institutions you may have never seen orheard about: why such a fuss?
In fact, banks sell your mortgage loans before theyoriginate. If they cannot sell, they wouldn’t even issue!
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Financial complexity and systemic risk 79
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obligations (CDO). The investment banks hold these CDO, but they get funding from the commercial banks in the repo market. The commercial banks raise funds by issuing short- term commercial paper. Money market funds buy such commercial paper, and the individual investors or the households hold the shares of the money market funds. This complicated procedure is not restricted to the mortgage business (whose failure is believed to be the trigger of the crisis), but also applies to many financial services such as credit cards and students’ loans. The advantage, as people claim, is that the financial innovation such as CDO helps grease the wheels so that in the normal time the financial institutions can easily raise funds in a very liquid market. However, as is seen in the crisis, such complexity undermines the stability of the financial system and leaves all the financial institutions in the quagmire when time turns bad. Financial complexity makes little trouble in the traditional theories of finan-cial economics, where the economic agents are rational in the sense that they know all the details of the economy and they are able to make optimal decisions based on all the information they acquire. However, financial complexity makes much difference in a more realistic setup, where the agents are only boundedly rational. Rubinstein (1998) presents numerous occasions where bounded ration-ality needs to be considered, among which two are of special interest to our dis-cussion. The first is that one can hardly get to know all the information in the financial system all the time; it is beyond anyone’s capability. The second is that even there is no asymmetric information and the complete set of information is available – the development of information technology such as the Internet helps make information widely available – the quantity of information is likely to be too huge for anyone to process, due to the limited computation capacity. As a result, the market participants are only able and willing to possess a subset of information. In a complicated financial system, this implies that financial institutions along the long intermediation chain may gradually lose the tracking and control of some risks. The asset prices may fail to reflect the true risks, and the financial institutions may hold too thin buffer to weather the systemic events.
ABS issuer
Mortgage pool
Households
Money market fund
Households
Securities firm Commercial bankABS
Mortgage
MBS
Money market fund shares
Short-term paper
Repo
Figure 4.2 Long intermediation chain (source: Shin, 2010a, pp. 101).
04 199 Banking.ch04.indd 79 17/10/11 13:53:40
T&F PROOFJ. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Inside banks: numbers and jargonsFacts, trends, and myths
Intermediation structure (cont’d)
...Actually in reality the procedure looks like this!`
The Shadow Banking SystemConceptualized, designed and created by Zoltan Pozsar, The Federal Reserve Bank of New York, November, 2009
Short-Term Funding Short- to Long-Term Cash
MMDAsHouseholds, Businesses, Governments CDs
Equity Funding Long-Term Investments
Equity Equity
`
Equity
Short-Term Debt InstrumentsRegulated Money Market Unregulated Money Market
Agency MBS Agency Discount Notes Intermediaries Intermediaries
*Conforming mortgages RRsOther*
Liquidity Puts A1 *ARS, MMMFsA1 CP
AAA ABCPAA-BBB BDPEquity RRs
*Conforming student loans 2a-7 MMMFs Other*A1 *ARS, MMMFs, as well as A1
A1 (AAA) ABS Tranches CP MTNs and term ABS CPA1 ABCP ABCP
AAA BDP BDPAA-BBB RRs RRs Short-Term SavingsEquity Other* Other*
*Conforming SBA loans *TOBs and VRDOs A1 *ARS, MMMFs Money Market PortfoliosCP
ABCPBDPRRs
Other*A1 AAA Offshore (non-2a-7) MMMFs *ARS, MMMFs, as well as A1
AAA AA-BBB A1 MTNs and term ABS CPABCP AA-BBB LTD MTNs CP ABCP
Equity Repo Equity Supers CNs* ABCP BDPLTD Haircuts BDP RRs
Households Equity O/C High-Yield CLOs RRs Ultra-Short Bond Funds Other* Households and Nonprofits(LBO Loans) Other* A1 *MMMFs
A1 *TOBs and VRDOs CPAAA ABCP
AA-BBB BDP2nd Lien Equity RRs
Equity O/C O/C O/C Other*CP *FHC affiliate Consumer ABS *ARS, MMMFs, as well as A1
ABCP (Credit Card ABS) MTNs and term ABS CPBDP A1 ABCP
AAA BDPAA-BBB RRs
Equity O/C Equity Other* Nonfinancial CorporatesO/C *ARS, MMMFs
an BanksDW
AAA TAFAA-BBB FX Swaps
LTD MTNs Tri-Party Repo System TSLFSupers CNs* Federal, State TSLF
Nonfinancial Businesses Equity Tri-Party Clearing Banks* and Local Governments PDCFCPFFTALFAMLF
MMIFFML, LLC
Equity O/C O/C an Banks ML II, LLC
*BoNY and JP Morgan Chase ML III, LLC
LSAPs
RoWO/C Equity (Foreign Central Banks) Equity
RMBS(1st lien, private label) MTNs Cash Reinvestment Accounts
CP A1 A1ABCP AAA CPBDP AA-BBB ABCP
Equity BDP RoWGovernments RRs (Sovereign Wealth Funds)
Equity O/C Subprime ABS Other* *Done by custodian banks(2nd lien, subprime, HELOCs) Trading Book *MMMFs, MTNs, term ABS and on an agent basis.
A1 TOBs and VRDOsAAA
AA-BBBEquity
Haircuts Cash Reinvestment Accounts *Issued to central banksCMBS and High-Yield CLOs A1 in exchange for investibe FX
(LBO Loans) CP Long-Term SavingsA1 ABCP
AAA BDP Fixed Income Portfolios*AA-BBB RRs MTNs
Equity Equity Other* *Done by real money accounts*MMMFs, MTNs, term ABS and on a principal basis.
TOBs and VRDOs CNs*Bank, Shadow Bank and Corporate Debt
Consumer ABS(Card, Auto, Student Loan)
CP A1AAA Cash
AA-BBB MTNsEquity LTD Equity Portfolios*
Haircuts EquityEquity O/C Other ABS
(Floorplan, Equipment, Fleets)A1 AAA *Mutual Funds, ETFs, Separate Accounts
AAA AA-BBB *Bank and Corporate DebtAA-BBB MTNsEquity CNs*
O/CCP Middle-Market CLOs
ABCP (Loans to SMEs) Cash
LTD AA-BBB EquityEquity Equity Equity
*Term ABS and CDOdebt and equity tranches
Public Equity
CashMTNsLTD
Structured Credit EquityEquity
*Hedge Funds and Private Equity(only credit exposures)
Maiden Lane LLC
3/11/08 and 3/16/08, respectively
Portfolio Protection*
EquityHouseholds, Businesses, Governments
Households, Businesses, Governments Equity and the Rest of the World (RoW)
Equity
AA-BBBEquity Equity
Source: Shadow Banking (Pozsar, Adrian, Ashcraft, Boesky (2010))
Commercial Bank*
Step (7): Wholesale Funding (Shadow Bank "Depositors")
ABS Reserves
Warehouse Hedges
Long-Term Synthetic Liabilities Broker-dealer CVA desks, ABS pipeline hedges,
Counterparty Hedges Warehouse Hedges
Equity
Debt Insu-rance
TLGP
Who
lesa
le F
undi
ng(T
erm
Deb
t Fun
ding
)
*Funded by UST's $50 billion
No Explicit
Fees
GSEs, DoE, SBA Federal Government
Agency Debt PurchasesAgency MBS Purchases
Insurance Guarantees
Step (4): ABS Warehousing
Finance Company*
The "Synthetic" Shadow Banking System
Broker-Dealers*
Funded Synthetic CDOs*
Consumers
Finance Company*
Fannie and Freddie*
Credit Hedge Funds
(Credit-Linked Notes) Unfunded Synthetic CDOs*
Single-Name and Index
CDS Indices
Single-Name and Index
Assets Bond(s)
Sovereign CDS
Protection Bought
Protection Sold
Agency Debt Purchases
Proprietary trading desks, credit hedge funds, etc.
Term Savings
Commercial Banks
AA-BBB
Synthetic Exposures*Counterparty Risks*
Credit Bets
Term Savings
Hedgers*
Deposits
Bank EquityReal Money Accounts*
Equity Portfolios
Money Market "Portfolios"
Loans
The
Tra
ditio
nal B
anki
ng S
yste
m("
Orig
inat
e-to
-Hol
d-to
-Mat
urity
-and
-Fun
d-w
ith-D
epos
its")
unfunded liabilities, etc.
Loans, ABS and
CDOs
Unfunded Protection
Referencing ABS and single-name CDS *Referencing single-name CDS indices, etc. *Inability to meet
TreasurysCDS
AAA AAAAAA[…]
Equity
Loan(s)
Structured Credit and Loan
negative basis traders, real money accounts, etc.
Speculators*
Unfunded Protection Protection
Sold
*Market Makers
Funded Protection
"Naked" Positions
Funded ProtectionCounterparty Hedges
HedgesFunded
Protection *Referencing corporate loan indices, etc.*Hedging Motives
Insured Assets
*Speculative Motives
indices, etc.
Ultimate CreditorsBond(s) CDS
Unfunded Protection Protection
Sold[…]
CDS Counterparty Hedges
Funded Protection
Ultimate Borrowers Corporate CDS CDPCs CPDOs* Short-Term Synthetic Liabilities
Warehouse Hedges
Synthetic Credit Liabilities
Priv
ate
Ris
k R
epos
itori
es
The
"Sy
nthe
tic"
Shad
ow B
anki
ng S
yste
m(D
eriv
ativ
es-B
ased
Risk
Rep
osito
ries)
Warehouse Hedges
Loans, ABS and
CDOs
Counterparty Hedges Warehouse Hedges Warehouse and Counterparty Hedges
AAALoans, ABS and
CDOs
9/19/2008 10/21/2008 11/10/2008
Subprime ABS Reserves
ABCP RMBS
10/7/2008 11/25/2008 3/24/2008 10/11/2008 12/12/2007 12/12/2007
Tri-Party Collatera
lReserves ABCP Reserves
Non-repo MM instrume
nts
Reserves$ FXCP
Reserves AAA Reserves Warehoused ABS
ReservesCDS on
CDOsReserves
CPFF TALF Maiden Lane III LLC TAF FX Swaps TSLF/PDCF
Equity Equity
Priv
ate
Cre
dit T
rans
form
atio
n
(T
ail R
isk A
bsor
ptio
n)
Prov
isio
n of
Ris
k C
apita
l
Priv
ate
Ris
k R
epos
itori
es
*Unaffiliated with originators!
Credit Insurance (Mortgage Insurers)
Cre
dit H
edge
s
PremiaCredit
Insurance PremiaCredit
Insurance Premia
Credit Insurance (Par Puts)
Client Funds
Cre
dit "
Ref
eren
ces" Mortgage Insurers* Monoline Insurers*
*Unaffiliated with originators! *Unaffiliated with originators!
MTNs
Equity TranchesMezz
ABSSuper Senior
Credit Insurance (AIG FP)
Credit Insurance (AIG FP)
[…]
MTNsLTD
Loans
AAA (A4)
*Public and Private Pension Funds,
Debt Tranches
Pension Funds, Insurance Companies*
Structured Credit Portfolios*
Term Savings
HG ABS
Super Senior
Structured Credit
Credit Insurance (Monolines)
A4 and AA-BBB ABS Tranches
AAA
Diversified Insurance Co.
LPFCs
Client Funds
Long-Term Debt
Alternative Asset Managers*
Pension Liabilities
Captive Finance Company *Capital Notes
Loans
AA-BBBREITs
BDPMTN
*Independent conduitIndustrial Loan Company*
A1
Loans ABCP LoansCP
LTD
The
"E
xter
nal"
Sha
dow
Ban
king
Sys
tem
(DBD
s: O
rigin
ate-
to-D
istr
ibut
e Mod
el |
Inde
pend
ent S
peci
alist
s: O
rigin
ate-
to-F
und
Mod
el)
Repos
Off-
Bala
nce
Shee
tEquity Liquidity Puts*
A2 & A3 (AAA) ABS Tranches
Public Equity
Term SavingsABS
Agency LTD
Structured Credit
Long-Term nstruments (LTD)
Cash Collateral
ABCPLoans ABCP
MTNs LoansPrivate LTD
AA-BBB
*Broker-dealer affiliate *ARSs, TOBs, VRDOs *Medium-term debt
Inde
pend
ent S
peci
alis
ts' C
redi
t Int
erm
edia
tion
Proc
ess
Standalone Finance Company Credit Hedge Fund
LoansLoans
*Finance company affiliate
[…]
Term SavingsLTDs
Cash Collateral
Securities Lending*Agency Debt*
Who
lesa
le F
undi
ng(M
ediu
m-T
erm
Fun
ding
)
Securities Lent
Loans AAA (A2-A3)
Cash Collateral
LoansLong-Term Munis
Short-Term Munis
LoansAgency DebtABS
Industrial Loan Company* AAALocal Governments
LoansBrokered Deposits
AA-BBB
Tax Revenues
Muni Bonds
Brokered Deposits
Brokerage Clients' Cash
Balances
FX Reserves Bonds*Mezzanine CDOs Super
SeniorsPrincipal Securities Lending
BBB
Supers
*Broker-dealer affiliate
Savings: Export
Revenue"Equity"
Tax Revenues
State Bonds
*Broker-dealer affiliate AA-BBB
Loans AA-BBB Repos
EquityTax Revenues Bonds
State Governments AAA Prime Broker
Super Seniors
Repos
Loans
*Broker-dealer affiliate
AAA
Securities Lent
AA-BBB ABSHigh-Grade CDOs
Asset Manager,Off-
Bala
nce
Shee
t
Securities Lending*
Supers
Private MTNs Cash
CollateralLoans ABCP
Federal Government
Tax Revenues
Treasury Bonds
Credit Hedge Fund*
Broker-Dealer*
Loans Repos
MTNs
OMO Collatera
l
Savings: FX
Reserves
Local Currency
Single-Seller Conduit
DB
Ds'
Cre
dit I
nter
med
iatio
n Pr
oces
s
Medium-Term Instruments Agent Securities Lending
Loans
AA-A
Private Equity
Euro Deposits
Portfolio Companies
Firms
ABCP
LBO Loans
*European bank affiliated
AAAABCP
Arbitrage Conduit
Assets
LoansBusinesses
Reverse Repos
CRE CRE Loans
LoansBonds
Europe
AA-BBB
Businesses Europe
Savings: Excess Cash
"Equity"
Federal Reserve
Invest- ments
C&I Loans
[…]Euro
Deposits
Reserves
Savings: Excess Cash
"Equity"
Who
lesa
le F
undi
ng(O
vern
ight
Fun
ding
)
Mezz ABSMezz CDO
ABS Collateral
Eur
opea
n B
anks
' Sha
dow
Ban
king
Act
ivite
s
Cash lendingfor
securities collateral
Mezz CDO
The
"In
tern
al"
Shad
ow B
anki
ng S
yste
m(P
rivat
e O
rigin
ate-
to-D
istr
ibut
e Mod
el)
CP
ABCP
*FHC affiliate *ARSs, TOBs, VRDOs
Multi-Seller Conduit*
Goods &
ServicesLoans Loans AA-BBB ABCP
LoansMTNs
Sweep Accounts
Long-Term Munis
Loans ABCP
Equity Liquidity Puts*
Off-
Bala
nce
Shee
t
AA-BBB
Loans
Structuring and
SyndicationLoans
Reverse Repos* ABCP
Equity AAA Savings: Excess Cash
BBB
SupersAAA
*BHC affiliate
"Equity"ABS
$1 NAV Shares
BDPs
BDPs
AssetsLoans
*FHC affiliate
ABCPHome1st Lien
Subprime Homeowners
$1 NAV Shares
AA-BBB Loans CP$1 NAV Shares$1 NAV
SharesHigh-Grade CDOs
AA-A
Supers *Capital Notes
$1 NAV Shares
SIV, SIV-Lite
Off-
Bala
nce
Shee
t
Home1st Lien Loans
Dollar Deposits
Loans
Securities
$1 NAV Shares
Direct Investmen Short-
Term Savings
FHC
s' C
redi
t Int
erm
edia
tion
Proc
ess
$1 NAV Shares
ReposCP
LoansABCP
AA-BBB
$1 NAV Shares
(Retained Portfolios)
Off-
Bala
nce
Shee
t
Loans*
Agency MBS
Discount Notes Loans A1Private
ABSAgency Debt
Munis ARSs TOBs
orVRDOs
FFELP ABS
Private ABS
Agency Debt
(Retained Portfolios)
CPABS
FH LBs Fannie and Freddie Cash "Plus" Funds
Agency Bills
The
Gov
ernm
ent-S
pons
ored
Sha
dow
Ban
king
Sys
tem
(Pub
lic O
rigin
ate-
to-D
istr
ibut
e Mod
el)
Enhanced Cash Funds
$1 NAV Shares
Ultimate Borrowers CMOs Direct Money Market Investors Ultimate Creditors
Loans*
Agency Pass-
Throughs
Agency MBS
CMO Tranches
Corporate TreasurersA1
Off -Balance Sheet ABS Intermediation
On -Balance Sheet ABS Intermediation
The
GSE
s' C
redi
t Int
erm
edia
tion
Proc
ess
FHLBs
(Time-Tranched Agency MBS)
Federal Government
Off-
Bala
nce
Shee
t
Agency MBS
Discount Notes
MMMF Insurance
The "Cash" Shadow Banking System Deposit Insurance (FDIC)
Liability Insurance (Federal Government)
Credit Insurance (GSEs, DoE, SBA)
Liability Insurance (Federal Government)
Liability Insurance (EU Government)
Insurance Premia
Deposit Insurance
FDIC
No Explicit
Fees
No Explicit
Fees
Implicit Insurance
Federal Government
11/25/2008
Agency MBS Reserves
Deposit Insurance (FDIC)
Publ
ic R
isk
Rep
osito
ries
(T
ail R
isk A
bsor
ptio
n)
Publ
ic R
isk
Rep
osito
ries
Publ
ic C
redi
t Tra
nsfo
rmat
ion
(T
ail R
isk A
bsor
ptio
n)
European Sovereign andQuasi-Sovereign States
Bank Equity
11/25/2008
Temporary PBGC
Pension Funds
Client Funds
Dollar Deposits
Equ
ity F
undi
ng
Agency Debt Reserves
Discount Window
Loan Collateral
Agency Debt Reserves
Term SavingsT
radi
tiona
l Ban
ks' L
endi
ng P
roce
ss
Asset Managers*
Bank Treasurers
Bank EquityLoans
Bank Equity
LGIPs
Loans
Exchange Stabilization Fund
$1 NAV Shares
Insurance Premia
*Asset Managers, Insurance Companies and
ABS
Implicit Insurance
9/18/2008
MMMF Guarantee
Households, Businesses
Checking Account
and the Rest of the World
The Traditional Banking System
CDs
Ultimate CreditorsDepositors
Deposits Equity
Step (1): Loan Origination
TBAMarket
Step (3): ABS Issuance
Short-Term
Savings
Ultimate Borrowers
Reserves
11/25/2008
No Explicit
Fees
Implicit Insurance
Deb
t Fun
ding
(Sho
rt an
d Lo
ng-T
erm
Dep
osits
Implicit Insurance
Assets
Borrowers
Loans
Asset Manager*AAA
Loans
Checking Accounts
Who
lesa
le F
undi
ng(S
hort-
Term
Fun
ding
)
AA-BBB Arbitrage Conduit
No Explicit
Fees
Implicit Insurance
SBA ABS
(ABS Warehouse Conduits)
Structuring and
Syndication
Single-Seller Conduit
(Warehouse and Term)
SIV
Loans ABCP
(Warehouse and Term)
Loans
Loans
Discount Notes
Step (2): Loan Warehousing
Agency Debt
Equity
Step (5): ABS CDO Issuance
Loans*
*Capital Notes
Off-
Bala
nce
Shee
t
ABCPMezzanine CDOs
Off-
Bala
nce
Shee
t
AA-BBB
Short-Term Munis
LoansBrokered Deposits AAA
and Life and P&C Insurance Companies
CDOs
Subprime, RMBS, CMBS
[…]
Mezz ABS
Hybrid Conduits*FHC affiliated
Maiden Lane II LLCMMIFFAMLF
Trading Books
Catalogue:,Shadow Bank Liabilities
Step (6): ABS "Intermediation"
Trading Books
Repo Conduits
ABCP
Off-
Bala
nce
Shee
t
Loans
Bonds
Assets
"Prime" Homeowners
*DBD affiliate
Loans
Single-Seller Conduit
Multi-Seller Conduit* Broker-Dealer*
Multi-Seller Conduit*
Loans
Bonds
("Rent-a-Conduit")
Broker Sweep Accounts
Single-Seller Conduit
ABS and
CDO Equity
Loans
ABS
Loans
ABSEquity
Hybrid Conduits
ABCP
CP
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Microeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice
Microeconomics of banking
The role of financial intermediation: Why is financialintermediation needed? – Economics of banking as a fieldof incomplete market and market failure;
Banks’ balance sheet choices
Theories of bank capital;Theories of bank debts, funding resources and liquidity risk;Lender-borrower relationship, screening and monitoring,credit risks;
Bank competition, market structure and banks’ risk takingincentives.
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Microeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice
Analytical tools and related fields
Game theory , contract theory and corporate finance
Important to understand banks’ strategic behavior, e.g., incompetition, risk taking, response to regulation;Second best solution under market (especiallyinformational) frictions;Mechanism design for contracts under which banks behaveas desired;
Industrial organization (IO) to better understand bankcompetition
The evolution of market structure and market power; whileMore focus on stability than efficiency.
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Microeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice
Macroeconomics of banking
The linkage of macro economy and banking is centralbank’s monetary policy , or, central banking
How does central bank conduct monetary policy? Targetsand instruments?What’s the optimal monetary policy? How to implement?
The next question is about transmission mechanism
How do banks react to monetary policy by adjustingbalance sheets?What does this imply to aggregate credit supply to firms?Impact on the real economy?
Banking and the real economy
How is business cycle amplified by the banking sector?The role of financial intermediation in growth and volatility?
J. C. Introduction
institution-logo-filenameO
Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell
Economics of Banking
Microeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice
Banking regulation in theory and practice
Financial intermediation corrects market failure andincompleteness, while it creates new failures;
Comparing with other industry, banking regulation is veryspecial
Besides competition structure, banking regulation focusesmore on financial stability ;Needs to look at both the risks inside individual banks andthose in the system level (systemic risk);Macro-finance linkage implies banking regulation has hugeimpact on macro stability ;Unfortunately, exisiting regulatory rules are seldom wellfounded, and issues are poorly understood;Crisis resolution needs to be taken into account, ex anteand ex post.
J. C. Introduction