CHAPTER 2: An Overview of the Financial System

Outline
1. Financial System Function, Structure, Instruments
2. Function of Financial Intermediaries: Indirect Finance
3. How the Banks Managed?
4. Why does the Regulation of Financial System play such a crucial role?

Functions of Financial Markets (FM)

a. Channels funds from economic agents with saved surplus funds (lender-savers) to those
with shortage of funds (borrower-spenders):
I. Moving funds from those with a surplus of funds to those with shortage
II. Promotes economic efficiency by producing an efficient allocation of capital, which
increases production
III. Directly improve the well-being of consumers by allowing them to time purchases
better

a. Direct finance: borrowers borrow funds directly from lenders in financial

markets by selling them securities (financial instrument)
b. Indirect finance: financial intermediary borrows funds from lender-savers
and then uses these funds to make loans to borrower-spenders
Structures of Financial Markets
1. Debt and Equity markets (debt instruments and equities)
a. Debt instruments: bond/mortgage, interest + principal payments until
maturity date
i. Maturity: short term (less than 1 year), intermediate-term (1-10),
long term (more than 10)
b. Equities: common stock, claims to share in the net income and the assets of
business. Make periodic payments (dividends), no maturity date. Benefit
directly from increase in profitability

2. Primary and Secondary

c. Primary Market
Issuance of New Securities
Investment Bank: it guarantees a price for a corporations securities and then
sells them to the public
Underwriting : It guarantees a price for a corporations securities and then
sells them to the public
d. Secondary Market
i. When securities that have been previously issued (and are thus
secondhand) can be resold
ii. Exchanges and Over-the-counter (OTC)
Organized in two ways:
a. Exchanges where buyers and sellers of securities (or their agents
or brokers) meet in one central location to conduct trades
b. OTC Markets where dealers at different locations who have an
inventory of securities stand ready to buy and sell securities over
the counter to anyone who comes to them and is willing to accept
their prices.
iii. Brokers are agents of investors who match buyers with sellers of
securities
iv. dealers link buyers and sellers by buying and selling securities at
stated prices

3. Money and Capital

Based on the basis of the maturity of the securities traded in each market
e. Money markets deal in short-term debt instruments (less than 1 year)
i. Short-term securities have smaller fluctuations in prices than long-
term securities, making them safer investments.
f. Capital markets longer-term debt and equity instruments (longer than 1
year) + Equity
i. Capital market securities, such as stocks and long-term bonds, are
often held by financial intermediaries such as insurance companies
and pension funds, which have little uncertainty about the amount of
funds they will have available in the future
Financial Market Instruments
1. Money market instruments
a. Treasury Bills -- short-term debt instruments of the government are issued in
3-, 6-, and 12-month maturities to finance the federal government.
b. Negotiable Bank Certificates of Deposit (CD) -- debt instrument, sold by a
bank to depositors, that pays annual interest of a given amount and at
maturity, pays back the original purchase price.
c. Commercial Paper -- short-term debt instrument issued by large banks and
well-known corporations.
d. Repurchase Agreements (repos) -- short-term loans (usually with maturity
term of less than 2 weeks) for which Treasury Bills serve as collateral, an
asset that the lender receives if the borrower does not pay back the loan.
e. Federal Funds -- overnight loans between banks of their deposits at the
Federal Reserve.

2. Capital market instruments

a. Stocks: equity claims on the net income and assets of a corporation.
b. Mortgages: loans to households or firms to purchase housing, land, or other
real structures, where the structure or land itself serves as collateral for the
loans.
c. Corporate Bonds: long-term bonds issued by corporations with very strong
credit ratings.
d. U.S. Government Securities: long-term debt instruments are issued by the
U.S. Treasury to finance the deficits of the federal government.
e. U.S. Government Agency Securities: long-term bonds issued by various
government agencies to finance such items as mortgages, farm loans, or
powergenerating equipment.
f. State and Local Government Bonds: called municipal bonds, are long-term
debt instruments issued by state and local governments to finance
expenditures on schools, roads, and other large programs.
g. Consumer and Bank Commercial Loans: loans to consumers and businesses
made principally by banks, butin the case of consumer loansby finance
companies.

Functions of Financial Intermediaries: Indirect Finance

financial intermediary: move funds from lenders to borrowers by borrowing funds from
the lender-savers and then using these funds to make loans to borrower-spenders.
Financial intermediaries play an important role in the economy because they function to:
1. Lower transaction costs time and money spent in carrying out financial
transactions
Economies of scale
Liquidity services
2. Reduce risk uncertainty about investments return
Risk sharing: with risk characteristics
Diversification: investing in a collection, portfolio, not just 1 type
3. Reduce asymmetric information problems
 Adverse Selection (before transaction): try to avoid selecting the risky borrower.
(Gather information about potential borrower)
The borrowers that are most likely to produce adverse outcomes are also the
ones most likely to seek loans => lenders provide less loans
Moral Hazard (after transaction): ensure borrower will not engage in activities
that will prevent him/her to repay the loan. (Sign a contract with restrictive
covenants)
The borrowers have incentives to engage in undesirable (immoral) activities
that make it more likely that they will not be able to pay back the loan =>
lenders provide less loans
4. Provide multiple financial services to their customers
Economies of scope (lower the cost of information production for each
service by applying one information resource to may different services)
Conflict of interest (arise when a person or institution has multiple
objectives, some of which conflict with each other)

Types of Financial Intermediaries

1. Depository institutions (banks): financial intermediaries that accept deposits from
individuals and institutions and make loans to other people
2. Contractual saving institutions: acquire funds at periodic intervals on a contractual
basis
3. Investment intermediaries
CHAPTER 8: An Economic Analysis of Financial Structure

Outline
How important Direct finance and Indirect finance
What are the main basic facts of financial structure throughout the world

Eight Basic Facts of Financial Structure

1. Stocks are not the most important sources of external financing for businesses
2. Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations
3. Indirect finance is many times more important than direct finance
4. Financial intermediaries, particularly banks, are the most important source of external
funds used to finance businesses.
5. The financial system is among the most heavily regulated sectors of the economy
6. Only large, well-established corporations have easy access to securities markets to
finance their activities
7. Collateral is a prevalent feature of debt contracts for both households and businesses.
8. Debt contracts are extremely complicated legal documents that place substantial
restrictive covenants on borrowers

Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
Economies of scale
Expertise

Asymmetric Information, results in two problems:

1. Adverse selection occurs before the transaction.
2. Moral hazard arises after the transaction

The Lemons Problem: How Adverse Selection Influences Financial Structure

If quality cannot be assessed, the buyer is willing to pay at most a price that reflects
the average quality
Sellers of good quality items will not want to sell at the price for average quality
The buyer will decide not to buy at all because all that is left in the market is poor
quality items
This problem explains fact 2 and partially explains fact 1

Tools to Help Solve Adverse Selection Problems

Private production and sale of information
Free-rider problem
Government regulation to increase information
Not always works to solve the adverse selection problem, explains Fact 5.
Financial intermediation
Explains facts 3, 4, & 6.
Collateral and net worth
 Explains fact 7.

Tools to Help Solve the Principal-Agent Problem

Monitoring (Costly State Verification)
Free-rider problem
Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation
Fact 3
Debt Contracts
Fact 1

Tools to Help Solve Moral Hazard in Debt Contracts

Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4

Summary Table 1: Asymmetric Information Problems and Tools to Solve Them

CHAPTER 10: Banking and the Management of Financial Institutions
Outline
- Banks plays a central role in the financial system
- It is now time to examine:
o The structure of the balance-sheet of banks
o How banks manage their liquidity, assets, liabilities and capital

The bank Balance Sheet

1. Asset
a. Reserves:
i. Required reserves (RR) and excess reserves (ER)
b. Bonds and other securities:
i. Corporate and government bonds
c. Loans:
1. Firms
2. Mortgages
3. Consumers (e.g. overdrafts and credit card loans)
4. Banks (interbank loans)
d. Other Assets
2. Liabilities
a. Sight (transaction) deposits
b. Time deposits
c. Banks deposits and borrowings:
i. From banks (interbank borrowing) and from central banks
d. Debt and other securities
e. Foreign currency deposits
f. Bank capital (or equity or net worth):
i. = Total assets liabilities

Basic Banking
T-account is a simplified balance sheet, with lines in the form of a T, that lists only
the changes that occur in balance sheet. each operation always affects two items of
the balance sheet
Basic Banking: Cash Deposit

Basic Banking: Payment Transaction

 Conclusion:
Increase in reserves = increase in deposit
Basic Banking: Making a Profit
After a new deposit of 100 has been received, ING is obliged to keep a fraction of
deposits as required reserves (assume that the required reserve ratio r = RR/D =
10%)

Asset transformation: banks borrow short and lend long

Assume interest rate on loans is 10%, on deposits is 5% and other costs are 3% of deposits,
then profit will be 1 (= 9-5-3)

General Principles of Bank Management

1. Liquidity Management
Assumption: No Excess reserve

The bank has no reserves and thus also not the required reserves that are at 9
million (10% of 90 million)! To eliminate this shortfall, the bank has 4 basic options
 Fundamental roles of maintaining a healthy level of liquidity:
1. Reduces costs associated with deposit outflows and the subsequent need to
quickly replenish reserves when initially insufficiently large reserves were held
(may be (very) costly)
2. Reduces the probability of bank runs or bank panics (link to financial regulation)
3. With sufficiently large excess reserves, new clients can immediately be given a
loan

2. Asset Management
Three main goals:
a) Seek the highest possible returns on loans and securities
b) Reduce risk
c) Have adequate liquidity (liquidity has different meanings: in the first lecture
liquidity referred to the ability to quickly turn assets into cash without incurring
large value losses )
Four main tools:
a) Find borrowers who pay high interest rates and have low default risk (default
= halting interest payments and/or payment of the borrowed amount)
b) Purchase securities with high returns and low risk (diversifying between
different types of securities)
c) Lower credit (default) and interest-rate risk
3. Liability Management
a. Acquire funds at low cost
b. Banks no longer primarily depend on sight and time deposits as primary
bank funds, i.e. have increasingly also access to other sources of funding
c. When banks see lending opportunities, they may borrow from other banks
in the interbank market and/or issue CDs to raise additional funds
d. Banks manage the asset and the liability sides of the balance sheet (Asset-
Liability Management - ALM)
e. Goal: Minimize cost funding (mainly deposits and own borrowing)
4. Capital Adequacy Management

Strategies for Managing Bank Capital:

 - Buy back/issue new stocks
- Pay higher/lower dividends to stockholders
- Increase/decrease banks assets. This alters the ratio of bank capital relative to
assets: this ratio is at the center of the Basel accords (see below)

Managing Credit Risk (borrowers may default)

1. Screening & monitoring
a. Screening from bad credit risks, collect reliable information
b. Monitoring and enforcement of restrictive covenants, restrict borrowers from
risky activities
2. Specialize in lending (trade-off with diversification) more knowledgeable about the
specialized borrower
3. Long-term customer relationships, cost are higher for new customers
4. Loan commitments, reduces cost for screening and collecting info
5. Collateral (property promised) and compensating balance requirements (collateral
when bank makes commercial loans)
6. Credit rationing (refuse to make loans even though borrowers are willing to pay a
higher or stated interest rate). Two forms: refuse loan of any amount, restrict the size
of loan less than the amount they would like.

Managing Interest-Rate Risk (riskiness of earnings and returns as interest rate

changes)
Example of Exposure to interest-rate risk

Gap Analysis
The gap analysis focusses on the effect of interest rate changes on profits.
Assume: i 5%-points:
GAP = (rate-sensitive assets) (rate-sensitive liabilities) = 20 50 = 30
million
1. Income on assets = + 1 million (= 5% x 20m)
2. Costs of liabilities = + 2.5 million (= 5% x 50m)
3. Profits = 1m 2.5m = 1.5m = 5% x ( 20m 50m) = 5% x (GAP)
Profits = i x GAP
Duration Analysis
The duration analysis focusses on the effect of interest rate changes on the
balance sheet
Duration = average lifetime of a securitys stream of payments
Duration analysis: measures sensitivity of the market value of banks total assets
and liabilities to changes in interest rates. Reason: Changes in the market value
of assets and liabilities affects the capital of bank
(Remember: the longer the maturity of an asset or liability, the stronger its market
value changes with interest rate changes)
% change in market value of security (-%point change in interest rate) x (duration
in years)
Example
E.g. Assume that the duration of assets = 3 years and that the duration of liabilities =
2 years
% change in market value of assets = -5% x 3 = -15% % change in market value of
liabilities = -5% x 2 = -10%
Assets value declines by 15 millions (-15% x 100 million), whereas liabilities
value declines by 9 million (-10% x 90 million)
bank capital declines by 6 million
Application: Strategies for Managing Interest-Rate Risk
Gap and duration analyses are useful tools to assess the degree of exposure to interest-
rate risk
E.g. If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will
reduce bank profits and a decline in interest rates will raise bank profits
Strategies to Manage Interest-rate Risk
a. Rearrange the balance sheet in order to have a balance between rate-
sensitive assets and liabilities (gap analysis) and/or ensure that assets and
liabilities have the same duration (duration analysis)
b. Use financial derivatives (e.g. interest-rate swaps, options, forwards and
futures)

Off-Balance-Sheet Activities
Trading financial instruments and generating income from fees and loan sales (affect
bank profits but not visible on balance sheet)
Generation of profits from activities that do not appear on the balance sheet:
o Loan sales (with guarantees)
o Fees from specialized services linked to securitization, derivatives and foreign-
exchange transactions, guarantees of securities and backup credit lines, etc.
Expose banks to increased risk, banks must pay attention to:
a. Risk management procedures
i. Financial futures, options for debt instruments, interest rate swaps,
transactions in the foreign exchange market and speculation.
ii. Principal-agent problem arise
b. Internal controls to restrict employees from taking on too much risk
i. Separation of trading activities and bookkeeping
ii. Limits on exposure
 iii. Value-at-risk
iv. Stress testing

Chapter 11: Economic Analysis of Financial Regulation

Regulation
Regulation: setting of specific rules of behavior that financial firms have to abide
Financial markets are regulated for two main reasons:
1. Increasing information available to investors
Reduce AS and MH problems
2. Ensuring soundness of financial intermediaries
Prevents financial panics (e.g. bank runs) and potential crises

9 Basic Categories of Financial Regulations:

1. Government Safety Net
a. It can short-circuit runs on banks and bank panics, and by providing for the
depositor, it can overcome reluctance to put funds in the banking system.
b. Deposit insurance one form of government safety net, a guarantee such as
that provided by the FDIC (Federal Deposit Insurance Company), depositors
are paid off in full on the first $100,000 deposited if the bank fails. Fully insured
deposits. Two methods of FDIC to handle a failed bank:
 i. Payoff method: allows bank to fail and pays off deposits up to insurance
limit.
ii. Purchase and assumption method: reorganizes the bank, finding a
willing merger partner who assumes (takes over) all of the failed banks
liabilities. More costly than payoff method
c. Moral hazard depositors do not impose discipline of marketplace, banks
have an incentive to take on greater risk
d. Adverse selection risk-lovers find banking attractive, depositors have little
reason to monitor bank
2. Restrictions on asset holdings
e. Attempts to restrict banks from too much risk taking.
3. Capital requirements
f. Leverage ratio amount of capital divided by total assets.
g. Regulatory arbitrage banks keep on their books assets that have the same
risk-based capital requirement but relatively risky.
4. Prompt corrective action
h. To prevent 2 problems when the amount of a financial institutions capital falls
to low levels.
5. Chartering and examination
i. Chartering: screening of proposals to open new banks, prevent adverse
selection
j. Examinations: scheduled and unscheduled, to monitor capital requirements
and restrictions on asset holding to prevent moral hazard
6. Assessment of risk management
k. Greater emphasis on evaluating soundness of management processes for
controlling risk
l. Trading Activities Manual of 1994 for risk management rating
m. Interest-rate risk limits: internal policies and procedures, internal
management and monitoring, implementation of stress testing and VAR.
7. Disclosure requirements
n. Requirements to adhere to standard accounting principles and to disclose wide
range of information
8. Consumer protection
o. The Consumer Protection Act of 1969 (requires all lenders, not just banks, to
provide information to consumers about cost of borrowing.
p. Fair Credit Billing Act of 1974
q. Equal Credit Opportunity Act of 1974
r. Community Reinvestment Act
9. Restrictions on competition
s. Increased competition can also increase moral hazard incentives for financial
institutions to take on more risk. Declining profitability is a result of increased
competition.
t. Disadvantages: led to higher charges to consumers and decreased efficiency
of banking institutions.
Disadvantages/ Dangers of regulation
1. Moral hazard (MH)
Safety-net arrangements create MH problems leading to cases of too big to fail (TBTF) or
too important to fail (TITF)
2. Costs of compliance
Heavy and complex regulation might lead to higher costs of financial services for clients
and create entry barriers for newcomers
3. Regulatory capture
Regulation process may be captured by big banks

Basel Capital Accord

Basel I
The impetus was the Latin-American debt crisis of the early 1980s
Basel I introduced capital requirements that aimed at reducing the likelihood of banks
collapsing due to being under-capitalised
Basel I aimed at strengthening the national and international financial system against
the spread of systemic risk through international financial linkages
Global Approach of Basel I
Capital requirement arbitrage: National differences in bank capital requirements
and in regulatory enforcement could induce banks to relocate towards the country
with the most advantageous (i.e. lowest) capital requirements as holding capital
reserves is costly (i.e. causes opportunity costs): risk of a race to the bottom
Guarantee an international level playing field: National differences could also cause
banks in some countries to become more competitive than banks in other countries
Weak Points of Basel I
Basel I was quite crude:
Some risk categories were insufficiently differentiated
Several off-balance sheet commitments were not subjected to capital requirements
(e.g. banks had an incentive to translate commitments subject to capital
requirements into such off-balance commitments (e.g. securitization))
Lack of recognition of asset portfolio diversification
Basel I contained some biases
For instance, preferential treatment for government debtors: credits to them were
always seen as less risky than credits to corporations. However, a number of
corporations have better credit ratings than a number of governments

Basel II (2004)
Basel II addresses the major shortcomings of Basel I by, for instance, reducing the
scope for regulatory arbitrage:
- i.e. of strategies that reduce a banks capital requirements without bringing a
corresponding reduction in risk exposure. Regulatory arbitrage is moving the
credit from a category with high capital requirements to a category with lower
capital requirements.
Basel II is based on three pillars
 Pillar I
This pillar sets the minimum capital requirements
Calculation of RWA (the denominator of the capital ratio) is more sophisticated to
better reflect the risk
Standardised approach: use credit ratings instead of working with crude
borrower categories.
Example: using the credit rating of IBM for loans to IBM
Internal ratings-based approach: the bank itself assesses, for instance, the
probability of default, the loss given default and the correlation to systemic
risk.
Advantage: improved sophistication and degree of detail within this
self-assessment.
Disadvantage: the risk of underestimation of the banks risk exposure
Pillar II
The definition of regulatory capital (the numerator) remains basically unchanged
The general minimum capital requirement (at least 8% of RWA) remains unchanged
It focuses on strengthening the supervisory process
o Step 1: The bank assesses capital adequacy on the basis of its own internal
risk management methodology
o Step 2: National supervisors review whether the capital of the bank is
consistent with its overall risk profile. This step, of course, increases the
relevance of consistent supervisory practices across countries in order to
ensure a level playing field and to prevent undue compliance burden. This
also requires that national supervisors possess sufficient expertise and
integrity.
Pillar III
It focuses on improving market discipline
Increased disclosure of information: The market thus obtains detailed qualitative
and quantitative information concerning the banks credit exposure, reserves,
capital, etc.
This should enable more effective market disciplining. Indeed, it is argued that
market participants then obtain more information on the risk profile of other banks
such that they can avoid dealing with overly risky counterparties
Weak Points
1. Complexity and implementation costs: leading to entry barriers for bank
2. Reliability of credit ratings: standardized approach based on credit ratings which (if
available) must not always be reliable
3. Pro-cyclicality in lending: during bad (good) times, the probability of default and the
expected losses are higher (lower), and Basel II will require more (less) capital and
that could lead to a reduction (increase) in lending (credit crunch): see tutorials
Basel III
Basel II did not prevent the problems in the banking sector in 2007-2008. Supervision
and regulation thus were to be strengthened. Some emergency measures were
already taken in July 2009
 Higher risk weights for securitization exposures to better reflect the risk inherent in
these products
Stricter rules on off-balance sheet operations
Banks are required to conduct more rigorous credit analyses of externally-rated
securitization exposures
The three-pillar framework of Basel II will be upheld, but strengthened:
o E.g. minimum common equity increases from 2% to 4.5% and the overall 8%
will gradually be increased to at least 10.5% in 2019
o Tougher (new) rules on maximum leverage (ratio of capital to total assets)
and liquidity (should cover the normal outflow of 30 days)
o Identification of so-called global systemically important banks (e.g. ING in
NL) for which tougher rules apply (basis: the moral hazard and too-big-to-fail
arguments)
o Reducing the problem of pro-cyclicality in lending through the minimum
requirements via for instance using longer-term horizons for the estimation
of probability of default