Banking theory

from Wikipedia, the free encyclopedia

The bank theory (also: theory of financial intermediation ) comprises the theoretical research of the bank as a financial intermediary . The general definition of a financial intermediary sees its activity in the production, trading and brokering of financial contracts and financial services.

The focus is on researching the existence of banks. Based on the microeconomic standard model, imperfections, e.g. B. Modeled information asymmetries .

Function of financial intermediation

The aim of the theory of financial intermediation is to economically justify the existence of credit institutions . This justification requires evidence of which tasks financial intermediaries can do better than the capital market.

Delegated monitoring

Their most important function is seen in delegated monitoring , i.e. H. Deputy monitoring of borrowers (typw. company) for the (indirect) lender (typw. households), as it would be for the latter too great effort themselves to reviewing the credit rating to worry former or creditworthiness.

Diamond made an important contribution to explaining the existence of banks through delegated monitoring.

Incentive effects of repeated interaction

In addition, there is a second positive effect: companies that need more loans will be less likely to defraud a bank with false information. If you did so, you would have to fear for your reputation and future credit. In a market with a few banks, this disciplining function affects companies.

In so-called relationship banking , the contribution by Petersen and Rajan is particularly relevant.

If companies were to borrow directly from individual subjects, word of fraudulent practices would get around less quickly. This justification by banks is based on the findings of the new institutional economics , namely asymmetrical information and transaction costs .

Insurance against individual fluctuations in consumption

In their analysis of bank runs , Diamond and Dybvig show how a financial intermediary offers a kind of insurance against uncertain consumer wishes. In this way, liquidity shocks are absorbed by the investors and an increase in benefit is achieved for the depositors through maturity transformation.

Credit risk management

The banking theory also examines special measures that serve to limit the likelihood and size of loan defaults.

Further research contributions

The starting point of the banking theory is the most important product of the bank: the loan agreement.

  • Gale / Hellwig: Standard Loan Agreement

Financial intermediary versus capital market

With increasing technical progress, companies become more transparent, information more available and transaction costs lower. Financial intermediaries therefore compete today with the capital market , which also efficiently mediates money capital between subjects with a capital surplus and subjects with a need for capital. In Anglo-Saxon countries, capital market-based financing dominates, while companies in Germany and Japan mainly rely on credit institutions for financing. In the professional world, the relative advantages of both financial systems are discussed, whereby the relative loss of importance of banks compared to the capital market is also evidenced by the term disintermediation .

Existence of banks

Starting a business is about showing which services financial intermediaries can do better than other institutions. Against this background, development tendencies and suitable regulatory measures can be better assessed. It is also about the importance of risk transformation. Banks can accordingly opt for more or less risk, depending on the design of the risk transformation. Examining the question of existence provides clues as to how large a bank should be at the optimum, i.e. H. whether many small banks or one large bank can best perform its functions. The legislature can accordingly promote or prevent bank mergers.

In perfect markets there are no explanations for the existence of financial intermediaries. Therefore, imperfect (capital) markets are viewed with frictions . The aim is to show the advantages of financial intermediaries over market solutions. This is the case when it is possible to reduce the costs caused by the friction.

The model from Diamond

Diamond models asymmetric information in the form of ex post uncertainty to infer the existence of banks. In his model, the outcome of the project is only known to the entrepreneur.

An entrepreneur's investment project provides income in two possible forms. The financiers have sufficient assets that they can jointly finance the entrepreneur's project. The risk-neutral investors demand at least one repayment in the expected value with interest in the amount of the market return. With symmetrical information , contracts that meet these requirements are possible.

In the case of asymmetrical information , a debt contract with a penalty function is concluded and a repayment amount equal to the repayment amount that each borrower receives. This is to ensure that the borrower does not use his information advantage over the lenders.

The central assumption is the private information of the borrower about the project outcome. The lender must incur costs to obtain this information himself. Diamond compares two ways for the borrower to deal with this information asymmetry: monitoring versus punishment. Monitoring costs must be reduced by blaming the information asymmetry on the financial intermediary. If this type of delegation takes place, the solution with the involvement of an intermediary is more efficient than without an intermediary. This is Diamond's rationale for banks.

Optimal bench size

Diamond shows in his model that a financial intermediary (bank) is more successful when it finances a large number of projects. Accordingly, a single large bank would be the best . This could as far as possible exhaust all diversification possibilities. In this way she achieves approximately completely risk-free deposits and completely eliminated delegation costs .

From a certain size, R = I applies.

Theoretically, however, it can be argued that financial intermediaries consist of a large number of individuals as they grow in size, which creates internal incentive problems for the organization ( Leibenstein's X inefficiency ).

There is also empirical work on the efficient size of a company , which focuses on economies of scale in the form of positive economies of scale. Up to the efficient company size, efficiency potentials can be realized through internal growth or merger.

More declarations of existence

Neoclassical declaration of existence:

  • Lending business: Delegated monitoring leads to economies of scale by lowering transaction costs (without financial intermediary costs n * m (transaction costs between m lender and n borrower)), with financial intermediary costs n + m (between financial intermediary and m lenders and between financial intermediary and n borrowers).
  • Contributions by Gurley and Shaw in 1960 and by Benston and Smith in 1976.

Information economic explanations

  • Deposit business: cushioning of liquidity shocks and maturity transformation (see Diamond and Dybvig: Bank Run)
  • Lending and deposit business: provision of liquidity
  • Leland and Pyle 1977: predecessor of Diamond 1984.

Banking regulation

The theoretical justification for banking regulation supports the goal of orientation towards the common good. In this way, fundamental statements can be made about the level of capital requirements and the usefulness of deposit protection systems. It provides indications for a suitable premium structure. It reveals the effect of maturity transformation , with which banks can better assess opportunities, risks and dangers. It offers insights into how to prevent a bank run in order to prevent negative effects on the entire economic system.

The Diamond and Dybvig model: Bank Run

Deposits are borrowed capital and cannot be traded. If the deposits are deducted, the repayment will be made one after the other. Because bank investments are not tradable, they are suitable for protecting consumers against the uncertainties of consumption. In their model, Diamond and Dybvig assume an ex ante uncertain temporal occurrence of consumption desires. The savers are risk averse. The technology is not risky per se.

The disadvantage of consumer protection is that it can lead to bank runs. The model shows that the market mechanism does not lead to any improvement in the allocation of goods. However, the introduction of a financial intermediary can bring about an improvement in Pareto.

Comparison of the models "Diamond and Dybvig" with "Diamond"

Differences between the two models
Diamond Diamond and Dybvig
considered periods One-period model Two-period model
secure repayment Project results R (success) and 0 (failure) possible secure gross return from R
Repayment in the event of project termination no possibility to terminate the project prematurely (income in period 1 either 0 or R) After a period, the project can be canceled on repayment of the invested capital (gross interest of 1)
Risk attitude of investors Investors risk-neutral (like all other parties involved, can be extended to risk-averse actors) Investors are risk averse, concave period utility functions
Investments uncorrelated centrally to lower the delegation costs below the penalty costs of direct financing relationships only one investment opportunity, project returns are not risky

Loan Agreement and Loan Rationing

It clarifies the character of loans compared to other forms of financing, with which the bank can better assess typical problems. The theory shows the consequences of the lack of tradability of loans (no secondary market ). It provides information about reasonable loan conditions, that is the interest rate, collateral and volume. Problems with credit rationing, the question of why banks do not allow interest rates to rise when demand increases, but stop granting loans. They show the criteria according to which companies decide how to raise capital, which affects marketing considerations. Theory provides information about the role of non-banks (e.g. brokers or rating agencies ) in the financial markets, which can be used to assess prospects for future developments.

Gale and Hellwig's model: standard loan agreement

The starting point of the banking theory is the description of the product “standard loan agreement ” . Assuming certain expectations of all contracting parties, an investment project will generate a surplus at a future point in time. The repayment that follows is the sum of the borrowed capital and interest. The interest rate is determined using the Fisher Separation assumption . The internal rate of return is used to assess the success of the project . A comparison with the market interest rate shows whether the investment is worthwhile or whether an investment in the capital market is more profitable.

The standard credit agreement specifies the repayment to the lender and the net income of the borrower, including the case of uncertainty. In the first case, this is the full repayment amount or (in the event that the project income falls below this) the entire project income. Similarly, the net profit is the project income minus the repayment, but at least zero.

The Stiglitz and Weiss model: credit rationing

An increase in prices has an impact on both demand and the quality and behavior of consumers.

Borrowers of varying quality are accepted. This is expressed in a different project risk, which can be seen from the distribution of the project income. In order to differentiate between the different project risks, the risk parameter theta is introduced. A high value of the risk parameter theta means a high risk. This is expressed in the probability of low project returns, which is high when the theta is high. For every given loan interest that the bank charges, there is a critical value of the risk parameter theta, above which the borrowers only finance projects that have the optimal risk value, i.e. H. Theta *, exceed. There is therefore an optimal interest rate.

Borrowers only finance projects with risk parameters that exceed the critical theta. If the loan rate rises, the optimal risk value (the critical theta) also rises. The bank's expected income from the lending business is lower, the riskier the projects financed. For the lender, increased risk means a lower expected repayment amount per borrower.

Special contract arrangements

Petersen and Rajan: Relationship Banking

Petersen and Rajan consider solid customer-bank relationships . In the case of a long-term house bank relationship, it is possible for the lender to make a mixed calculation over time when determining the conditions. In this way, problems of asymmetrical information ( adverse selection and moral hazard (increasing the project risk)) can be reduced. The precondition of their model for the authorization of a customer-bank relationship is the monopoly of the lender.

It can be shown that the average quality of borrowers serviced by the bank depends on market power. Low competition has a positive effect on relationship banking. Because with market power, the bank receives more than its invested capital. This makes it more lucrative for banks to serve lower quality borrowers.

Gorton and Kahn: Incomplete contracts

The structure of the model is based on risk-neutral and equally informed lenders and borrowers. They conclude a loan agreement for a period of two periods. At the beginning there is uncertainty about the expected returns from the project. After a period, probabilities of occurrence for the project become known. After two periods, the project yields itself.

Borrowers tend to increase project risk over the term of the loan . This means that the project outcome can have both higher and much lower values. They show that the borrower will increase the project risk as soon as the probability of project success falls below a critical value. The lender, in turn, will modify the repayment of the loan so as to maximize its expected return. An increase in the required repayment is also accompanied by the effect that the probability that the debtor will become insolvent increases. On the other hand, the lender cannot arbitrarily reduce the repayment amount in order to prevent the borrower from increasing the risk.

There are opportunities to renegotiate, particularly in the case of bank loans, with the project income being redistributed. However, there is also a free rider problem.

Loan collateral

In practice, loan collateral plays an important role in financial contracts. Their existence can theoretically be demonstrated using asymmetrical information.

With asymmetrical information , credit security leads to a mitigation of the negative effects of quality and behavioral uncertainty. Loan collateral can be used as a tool to determine the quality of borrowers. As a result, even a liquidation value of zero would be worthwhile for calling in collateral. In this way, the right incentive effects are achieved.

literature

  • DW Diamond, PH Dybvig: Bank Runs, Deposit Insurance, and Liquidity. In: The Journal of Political Economy. Vol. 91, June 1983, pp. 401-419.
  • MA Petersen, RG Rajan: The Effect of Credit Market Competition on Lending Relationships. In: The Quarterly Journal of Economics. Vol. 110, 1995, pp. 407-443.