Theory of Banking (2004-05)

1. Theory of Banking(2004-05) Marcello Messori Dottorato in Economia Internazionale April, 2005

2. Definition of financial intermediaries • A financial intermediary is: - Economic agent specialized in selling or purchasing financial contracts/financial assets • Financial assets can be: - tradeable (shares, bonds, …) - non tradeable before the end of the contract (credits, deposits, …) (New tools: e.g. securitization) • FIs/Banks: Financial contract (SDC)

3. Non-existence of financial intermediaries in the GEM • GEMs: - complete markets; - no asymmetric information; as if…; - full divisibility. • This makes it possible to design a: risk sharing contract between a lender and a borrower with perfect diversification • It is the optimal contract (without intermediaries)

4. Existence of financial intermediaries (I) Real world (Tobin 1958; Gurley-Shaw 1960): • Incompleteness of markets  transaction costs (Arrow) • Imperfect divisibility  economies of scale, economies of scope. Hence: Empirical explanation for the existence of financial intermediaries (FIs). Theoretical point of view: FIs still based on exogenous assumptions (constraints).

5. Existence of financial intermediaries (II) • Asymmetries of information (AI) as a first principle (Arrow 1963; Akerlof 1970). • AI  FIs improve market efficiency and lead to the dominant solution (often: second best). Several models. Here: Diamond (1984); Diamond-Dybvig (1983)

6. Basics on contract theory with asymmetric/imperfect information • Ex ante AI: Adverse selection; Moral hazard with hidden action; • Ex post AI: Moral hazard with hidden inform. (costly state verification models). • Imperfect information: incomplete contracts

7. Diamond model (1984) • Assumptions: ≥ mn agents with a monetary endowment = 1/m; n firms, each endowed with an indivisible project; each project ex ante identical with I=1, so that L=1; expected gross return on each project, ỹ, is stochastic (ỹiindependent of ỹx V i ≠ x; and f(ỹi) distribution function of yi); • Ex post firm i (i=1,2,…,n) can observe yiwithout costs; mn agents can observe yionly with a positive cost K (verification cost); each agent is not endowed with a private information technology.

8. DM: Form of the contracts • Debt contract (L=1) = 2 types SDC with ex post monitoring  (1+r) = R if y ≥ R y if y < R; DC with a non pecuniary cost C (exog.)  R if y ≥ R C if y < R where (by assump.): K < C < m K

9. DM: Contracts design • Implementation of the 2 debt contracts: SDC: m agents do not monitor each firm (free riding problem, and C < mK); hence, each firm = incentive to declare y = 0. Hence: DC is the most convenient contract XI = R if ya≥ R and R < C XI = C if ya< R or R > C. • Let assume that both contracts are dominated by a contract between each firm and a FI (delegated monitoring)

10. DM: FI and SDC contract • Delegated monitoring: FI prefers SDC to the other contract since nK < nC. • However, SDC between a given FI and each of the n firms is not sufficient; Also, nm contracts between the FI and nm investors: Each investor is promised RD/m in exchange for a deposit 1/m; if E(XFI) < nRD, the bank is liquidated. Given a “reserve return” of each investor equal to R: RD = E [min (∑ỹi - nK), nRD)] = nR • Formally:

11. DM: Expected returns of FI

12. DM: Expected returns of investors • E(XI) = min [E(XFI), nRD]

13. DM: Total cost of delegation • In case of FI’s bankruptcy: CT = E (max [nRD – (∑ỹi – nK); 0]). • Hence: Delegated monitoring more efficient than direct lending if: nK + CT < nmK.

14. DM: Why delegated monitoring increases efficiency • The last condition: nK + CT < nmK (1) is fulfilled if: K < C (by assumption state verification is efficient); m > 1, and the number n of investors is large enough (diversification  by i.i.d.) E (y) > K + R (investments are socially efficient). • (1) becomes K + CT/n < mK with CT/n  0 since n is large.

15. Diamond-Dybvig model (1983) • A simplified version of DD. • Assumptions: Economy characterized by 1 good and three periods: t=0, t=1, t=2; at t=0 n agents endowed by 1 unity of good and a long-term production technology, whose output is: X1 < 1 in t=1 X2 > 1 in t=2

16. DDM: information structure • Two types of agents  earlier consumers (1), with C in t=1 and later consumers (2), with C in t=2. • Utility of type1 agents : U(C1) Utility of type2 agents : t U(C2) where t<1 is a discount factor • Imperfect information: Agents learn their own type at t=1, but the probability distribution of types (p1 and p2, respectively) is common knowledge at t=0

17. DDM: agents’ choice set • Hence, at t=0, the expected utility of agent i (i = 1, 2,…, n) is: Ui = p1 U(C1i) + p2 t U(C2i) with U’(C) > 0, U”(C) < 0. • At t=0, agent i can choose: (a) to store the endowment so that C1 = C2 = 1 (b) to use the long-term technology so that C1<1 (= X1) but C2>1 (= X2); • (a) is a dominant strategy for type 1 agents, (b) is a dominant strategy for type 2 agents. Mixed strategy is allowed (1 - I)

18. DDM: our aim • We analyze this model in order to show that: the introduction of a FI as a depository institution  improvement in the efficiency of the economy. • Three different institutional structures: Autarky; Market economy; Financial Intermediation.

19. DDM: analytical setting (1) Max Ui= max [p1 U(C1i) + p2 t U(C2i)] s.t. (2) p1C1i = 1 – I (3) p2 C2i = X2 I The sum of (2) and (3) leads to (4) p1C1i + (p2iC2i/X2) = 1 (4) thus becomes the constraint in the max. problem

20. DDM: FOC • Given (1) and (4), determination of FOC by means of a Lagrangian L = p1U(C1i) + p2tU(C2i) + λ [1-p1C1i-(p2iC2i/X2)] (5) δL/δC1: p1U’(C1i) - λp1 = 0 (6) δL/δC2: t p2U’(C2i) - λ (p2/X2) = 0. From (5) and (6): (7) (U’(C1i)/U’(C2i) = t X2; and then: (8) U’(C*1) = t X2 U’(C*2) (FOC)

21. DDM: Autarky At t=1 (9) C1= 1–I+X1 I = 1–I(1-X1) < 1 if I > 0 At t=2 (10) C2= 1–I+X2 I = 1+I (X2-1) > 1 if I > 0 < X2 if I < 1 Hence, suboptimal consumption: FOC is not fulfilled.

22. DDM: market economy • It is sufficient to open a financial market at t=1 where agents can trade goods against a riskless bond (promise to obtain 1 unit of good at t=2) • Type 1 agents, at t=1, sell the bond X2I at a price pT (≤ 1, to be determined). Hence: (11) C1= 1 – I + pTX2I • Type 2 agents, at t=2, purchase the bond (1-I) at a price 1/pT. Hence: (12) C2= X2I + (1 – I)/ pT = 1/ pT (1 – I + pTX2I)

23. DDM: market economy • Given C1= 1 – I + pTX2I (11) C2= 1/ pT (1 – I + pTX2I) (12) it is possible to obtain: pT = C1/C2 • Moreover, (11) and (12)  if pT > 1/X2, then all agents = sellers if pT < 1/X2, then all agents = purchasers Hence, equilibrium in financial market requires pT = 1/X2 This  C1= 1 (11*) and C2 = X2 (12*)

24. Autarky v/s market economy • (11*) and (12*) dominate (9) and (10). But: are (11*) and (12*) compatible with (8) U’(C*1) = t X2 U’(C*2) (FOC) ? According to DD assumptions (U functions are increasing and concave): U’(1) > t X2 U’(X2) Hence: (11*) and (12*) do not fulfill FOC: C1 = 1 < C*1 C2 = X2 > C*2

25. DDM: Financial intermediation • (C*1, C*2) can be implemented by a FI which offers a deposit contract subject to a zero-profit condition. • The contract is: At t=0 n agents deposit their unities of good, and they can get either C*1 at t=1 or C*2 at t=2. • In order to fulfill this contract (n large enough): FI stores: p1 C*1FI invests in the long-term technology: n - p1 C*1

26. DDM: Financial intermediation • Problem: do later consumers always find it convenient to wait for consumption at t=2? Two conditions: (1) Sound expectations that FI can meet its obligations; (2) C*1 < C*2, that is t X2 ≥ 1 given the concavity of the utility functions and eq. 7: (U’(C1i)/U’(C2i) = t X2

27. DDM: Financial intermediation • New assumption: later consumers adopt a strategic behavior. This  possibility of bank run (it is a Nash equilibrium). It is sufficient that a given later consumer has the expectations that other later consumers defect asking for liquidation at t=1.