Financial Intermediation

• Financial Intermediation explores the roles and reasons for financial intermediaries.

Core Questions

• Why do banks transform assets instead of only brokering and allowing the market to address mismatches?
• How did banks originate?
• What necessitates bank regulation?

Discussion Topics

• Goldsmith model + hands-on exercise
• Macroeconomic repercussions
• The tendency for large financial institutions to form

Paying to Deposit Money?

• Some banks charge depositors for holding their money, implementing negative interest rates, even with modest inflation.
• This affects companies and individual investors, with "custody fees" becoming more common.
• Examples include banks in Baden-Württemberg and Bayern, with negative interest rates from -0.40% to -0.60% on deposits above certain thresholds.

Goldsmiths and Banks

• Imagine an economy using gold for all transactions.
• Carrying and storing gold is inconvenient and risky.
• Goldsmiths offer secure storage for gold, charging a fee.
• Depositors get a receipt to redeem their gold as needed.
• Trust in the goldsmith and the ability to redeem at any time becomes crucial.

Fractional Reserve Banking

• Goldsmiths realize that gold withdrawals from storage are infrequent and have low volatility.
• They start issuing more receipts than actual gold reserves and give loans to borrowers.
• This is the start of fractional reserve banking.
• If goldsmiths print more receipts without additional gold reserves, and lend the receipts, they become illiquid.
• If more than 100 receipts are redeemed, the goldsmith can't pay all on demand because the loan is locked-in for a longer period.

Risks of Goldsmiths

• Concerns arise about the number of loans a goldsmith should make based on uncovered receipts.
• Worries surface about the probability of many depositors demanding gold simultaneously.
• Questions emerge on what happens if depositors lose confidence in the receipts, even if the goldsmith remains solvent.

Instability

• The system is inherently unstable and requires regulation.

Formal Model: Simplified Economy

• Model assumes a single household with defined income, consumption, and savings, with no discounting.
• A fee is charged to deposit money at the bank for the safeguarding cost.
• In a scenario with 'n' households, if the bank holds 100% reserves and all households withdraw after one year, the interest rate is still negative.
• If 'αn' households withdraw after the first year and '(1-α)n' after the second year, the bank needs less than 100% reserves and could invest profitably.

Lending Opportunities

• Loan demand is greater than savings creating cash flow.
• Savers require many investors and high monitoring costs if they have to find the borrowers themselves.
• Borrower's expected payoff is cash flow minus interest payment and payment to lenders for monitoring costs.
• Obtaining loans through a bank reduces the borrower's expected payoff by the monitoring cost ('b') only.

Reserve Requirements

• Bank takes deposits from 'n' depositors and loans to 'm' borrowers, assuming 'ns>mM'.
• Loaned money doesn't need safeguarding, saving cost.
• A bank repays depositors: ns-(ns-mM)φ/s = n(s-φ)+mMφ/s.
• The bank doesn't share profits from the loan but shares the cost saving from reduced monitoring.
• Depositors receive higher payments of 'mMφ/s' compared to a 100% reserve case.

Bank's Reserves

• Formula determines the reserves bank needs in t=1: α[ns-(ns-mM)φ/s] = ns-mM - (ns-mM)φ/s - mb.
• Variables: 'α' (payout), 'ns-mM' (funds after lending), and '(ns-mM)φ/s - mb' (storage and monitoring cost).

Bank Profit Competition

• Lending to firms yields profits, leading to competition and new entries into the market.
• Entry continues until zero excess profit is reached.
• Bank's profit is equally divided among depositors.

Financial Intermediary Existence

• Existence of F.I. is supported through the safeguarding of funds.
• F.I. is efficient in selecting and monitoring borrowers.
• F.I. enables fractional reserve banking.
• Risk of credit means necessity of regulation.

Reconsidering Lending

• If the loan return is uncertain, with a default probability 'u', depositors learn about 'u' and withdraw if the realization is high.
• The liquidation value 'L' is too low to repay all then.

Government Intervention

• The government may insure deposits or act as a lender-of-last-resort, eliminating the need for liquidation.
• In expected terms, loans are efficient but potentially costly.
• Moral hazard arises without incentives to monitor the safeguarding and monitoring efforts of banks.
• Banks could make risky investments with low reserves.

Liquidity Problems

• The liquidity problem is inherent to (otherwise beneficial) fractional reserve banking.
• Liquidity issues are triggered by solvency concerns, driven by perception of high probability of the probability that a borrower will suffer a loss.

Macroeconomic Implications

• Reserve requirements, lending, and money creation are important macroeconomic factors.
• A fixed coefficient model illustrates banks' balance sheets and the creation of money through lending.
• Regulation and insurance mitigate liquidity and insolvency risks.

Money Creation

• Banks create money by issuing new loans, adding to new deposits in the economy.
• Deposits serve as a payment method, further facilitating money creation.

Restraints on Money Creation

• Restraints include: market forces and competition where additional loans must be profitable, and liabilities should be managed.
• Liquidity and credit risk affect pricing of loans and the need for long-term deposits/liabilities.
• The behaviors of households and firms, and repayments of loans.
• Monetary policy influences reserves and interest rates.

"Too Big to Fail"

• Addresses banking activities, firm size, and monopolies.
• Brokerage and size include information re-usability (discussed before) and diversifying risk of misjudgments.
• Asset transformation and size prevent double screening needed to finance a loan or diversify risk for depositors.

Financial Intermediaries

• F.I. as a natural monopoly is established: firms have asymmetric information, so, they can create a fixed incentive payment to prevent moral hazard among investors.

Model Parameters

• A financial information monopoly can be modeled with parameters.
• Whether information is collected is uncertainly known and noisy, which has a cost for the information provider in regard to utility. If the provider does collect information there must be an incentive compatible payment scheme - with a pay of H if the signal says work, and L if the idler does not work.

Risky Incentive Contract

• A risky incentive contract can be used.
• One outcome is firms will join in one bank where they can control each others effect and share payoffs. This creates a natural tendency for larger F.I.s.
• Basel II and Bank size: Firms choose between standard or internal rating when calculating capital requirement. The internal rating allows for more efficient capital management. However this can be too costly for smaller banks and so larger and more profitable banks emerge in the market.