Empirical Banking: Market vs Bank-based Economies

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Questions and Answers

What allows agents in a comprehensive market to diversify portfolios?

The availability of hedging techniques

The option to insure against all risks

The freedom to participate in the market

The existence of diverse investment opportunities (correct)

What can limit the market participation of younger generations according to the content?

General market instability

High levels of market competition

Low income and high expenses (correct)

Access to more favorable investment options

What is a possible outcome when markets are incomplete?

Market volatility increases dramatically

All risks can be insured against easily

Intermediaries may step in to share risks (correct)

Only wealthy individuals can hedge risks

How did the oil shock in the early 1970s impact households that invested in the stock market?

They experienced a severe reduction in their standard of living Signup and view all the answers

What is a major benefit of financial institutions for individuals and firms compared to markets?

They reduce the volatility of asset values. Signup and view all the answers

What is essential for market completeness regarding risk-sharing?

Claims with varied returns and risks Signup and view all the answers

Which country's households primarily save for retirement through bank accounts and debt-like instruments?

Germany Signup and view all the answers

What is a characteristic of bank-based economies compared to market-based economies?

Greater aggregation of savings through banks Signup and view all the answers

What concept explains individuals accepting lower market returns in some situations for better returns in others?

Intertemporal smoothing Signup and view all the answers

What does intertemporal risk-sharing address?

Risks spread over different time periods Signup and view all the answers

What effect did the oil shock have on German household savings during that period?

It did not halve the value of their savings. Signup and view all the answers

What major shift occurred in the U.S. stock market in the 1980s?

The stock market doubled in real value Signup and view all the answers

Which year marked a sustained boom in Germany similar to that in the U.S. during the ’80s?

1982 Signup and view all the answers

Why might markets be considered incomplete?

Some risks are not diversifiable in the market. Signup and view all the answers

In terms of financial risk, what do banks provide that markets do not?

Stability in return payouts. Signup and view all the answers

What primary factor causes the valuation of assets in markets to fluctuate?

Non-fundamental factors. Signup and view all the answers

What is a primary method through which banks achieve intertemporal smoothing?

Through asset accumulation of low-risk assets Signup and view all the answers

In which financial structure is there a slight advantage to cross-sectional risk sharing?

Intermediated financial systems Signup and view all the answers

What risk do financial institutions face when trying to provide smoothed returns?

Risk of disintermediation Signup and view all the answers

Why might older individuals struggle to sell bonds in the market?

Younger individuals may lack the savings to buy them. Signup and view all the answers

How do banks mitigate the risks associated with stock price fluctuations?

By accumulating liquid assets Signup and view all the answers

Which financial model may be preferable if cross-sectional risk sharing benefits outweigh intertemporal risk smoothing benefits?

The U.S. model Signup and view all the answers

What is a challenge posed by competition between banks and financial markets?

Banks may take excessive risks to gain market share. Signup and view all the answers

Which of the following statements about German banks is accurate?

German banks hold a high level of reserves. Signup and view all the answers

What do financial intermediaries typically maximize?

An ambiguous objective function Signup and view all the answers

In expansionary periods, what is a common behavior of agents?

Investing in financial markets for higher returns Signup and view all the answers

What challenge does a superbank face regarding liquidity?

Maintaining liquidity without intertemporal smoothing issues Signup and view all the answers

What is a problem associated with the 'superbank' concept?

Maintaining liquidity during crises Signup and view all the answers

How does the information environment differ between the U.S. and Germany regarding public companies?

U.S. has many listed firms with strict information regulations Signup and view all the answers

What is required for effective intertemporal risk smoothing?

Accepting lower returns in some scenarios for higher returns in others Signup and view all the answers

What is a barrier to implementing superbanking related to index variables?

They need to be observable, verifiable, and non-manipulable Signup and view all the answers

Which type of firm predominantly relies on internal finance?

Large firms Signup and view all the answers

Which of the following describes a characteristic of complete markets?

Provides perfect intertemporal smoothing Signup and view all the answers

What factor significantly influences external financing needs for smaller firms?

Lack of internal funds Signup and view all the answers

What issue arises due to competition between stock markets and banks?

Increased likelihood of bank defaults Signup and view all the answers

What is one method through which intertemporal smoothing can be achieved?

Asset accumulation of low-risk assets Signup and view all the answers

What is a typical barrier posed by surplus agents wanting to rebalance their portfolios?

They contribute to liquidity problems for banks Signup and view all the answers

Which statement best describes the financing behavior in Germany and the U.S.?

Investment is mainly financed by internally generated funds Signup and view all the answers

What complicates cross-sectional risk sharing in financial markets?

Transaction costs and asymmetric information Signup and view all the answers

How is intergenerational risk sharing generally facilitated?

Via bank reserves that act as insurance against fluctuations Signup and view all the answers

What is the main assertion of the Modigliani-Miller theorem regarding capital structure?

The firm's value depends solely on its asset's ability to create value. Signup and view all the answers

Which condition does NOT hold in the perfect capital market as per the Modigliani-Miller theorem?

Asymmetric information is present. Signup and view all the answers

In comparing investment in an unlevered firm versus a levered firm, what is a primary benefit of investing in the unlevered firm?

Lower risk as it does not carry debt. Signup and view all the answers

According to the Modigliani-Miller theorem, what happens to the cost of capital when the proportions of debt and equity change?

It remains unaffected by these changes. Signup and view all the answers

What key element of finance is assumed to be non-existent for the Modigliani-Miller theorem to apply?

Transaction costs. Signup and view all the answers

Which of the following best describes firm L in the context of the Modigliani-Miller theorem?

A firm that carries more risk due to its leveraged position. Signup and view all the answers

How does the presence of taxation influence the Modigliani-Miller theorem?

It creates an advantage for debt financing as interest is tax-deductible. Signup and view all the answers

Which of the following scenarios aligns with the implications of the Modigliani-Miller theorem?

Both an unlevered firm and a levered firm can provide the same profit return. Signup and view all the answers

Study Notes

Empirical Banking: Market-based vs Bank-based Economies

Allen and Gale (AL) compared two financial systems: German and US.
The implicit definition of market-based and bank-oriented (or market-oriented and bank-oriented) economies is presented.

The German Financial System

Universal banks handle a full range of activities, including deposits, loans, mortgages, securities issues, and equity investment.
Key commercial banks are Deutsche Bank, Dresdner Bank, and Commerzbank, plus regional banks, foreign branches, and private banks.
Public interest, not profit maximization, is the primary operating principle.
Three-tier structure of savings banks: local, state, and central.
Depositors are shareholders in the cooperative bank system.
Specialist banks concentrate on specific services like mortgages, agricultural credit, and small business lending.
Stock markets, with Frankfurt's being the most important, and bond markets are significant for government debt but less so for firm funding.
Future and options markets opened in 1990 but are less important in volume.
Firm pension schemes are a major source of funds for firms.

The U.S. Financial System

Commercial banks provide short-term lending, residential real estate loans, agricultural loans, and loans to other financial institutions.
Savings and loans/thrifts specialize in mortgages and consumer loans, with depositors as shareholders.
Key stock exchanges are NYSE, AMEX, and NASDAQ, where many firms are listed for initial public offerings.
Bond markets are significant for federal, state, and local government borrowing and corporate debt.
Options and futures exchanges were established in the 1970s.
Firms have varied pension schemes with funds usually invested in stocks or bonds.

Comparison of the German and U.S. Systems

Feature	Germany	U.S.
Universal banking	Yes	No
Bank-firm relationships	Extensive	Limited
Competition	Limited	Considerable
Intermediary interaction	Small	Large
Publicly listed firms	Small	Large
Futures and options	Illiquid	Liquid
Firm information	Limited	Extensive
Market for corporate control	No	Yes

Size of Banking Systems (1988, Percentage of GDP)

Germany: 189%
U.S.: 87%

Comparison of Risks (Household Side)

Cross-Sectional Risk Sharing: Markets allow portfolio diversification, hedging idiosyncratic risk, and portfolio adjustment based on risk tolerance. Market completeness is essential.
Intertemporal Risk Sharing: Markets might be incomplete, or some generations may have incomplete participation. Transaction costs and asymmetric information can affect participation. Intermediaries (banks) can manage risks expensive to hedge via the market (e.g., intergenerational risks). US stock market value halved after oil crisis in the 1970s, but later increased.

Why differences?

Risk sharing can be a function of the structure of the market or intermediary.
Heterogeneity among investors can influence whether bank-based or market-based systems are more effective.

The Firm Side:

Information: Different levels of available information to the public. U.S. has a greater number and more readily available data for firms; Germany has fewer public firms.
Financing: Internal financing is more prevalent than external finance in both countries, with U.S. large firms heavily reliant on internal financing, and smaller firms more reliant on external financing.

Modigliani-Miller Theorem

Firm value is independent of capital structure in a perfect market (no taxes, transaction costs, or asymmetric information).
In reality, companies frequently use debt to obtain lower tax liabilities than equity.
Higher amounts of debt reduce the risk associated with taxation.

The Pecking Order Theory

Asymmetric information leads companies to prefer internal funds first, then debt, and finally equity when raising capital.
Management has higher information but shareholders might have lower information regarding company's performance. Companies tend to issue debt before equity.
Costs of issuing equity are significant. Small firms suffer the highest associated costs.

Conclusions

Comparing welfare of financial systems is complex. Desirable system type depends on various household and firm-specific factors.
Optimal system changes when circumstances necessitate it.

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Description

Explore the differences between market-based and bank-based economies through the comparison of the German and US financial systems. This quiz covers the unique features of the German banking structure, including the role of universal and specialist banks, as well as the emphasis on public interest in banking operations.