FINANCIAL MARKETS AND INSTITUTIONS

A survey conducted by the Edelman Trust Barometer in 2021 has revealed the fact that people do not trust the financial
services sectors that much, meaning that – as of today – the public sector is not really able to capture the economic role and
the social value added of financial services and financial intermediaries in general.
Financial intermediaries are entities that specifically act as intermediaries between savers and borrowers in the financial
system. They play a very crucial role in mobilizing savings from surplus units (savers: their income exceeds their
expenditures) and channelling them to deficit units (borrowers: their expenditures exceed their income) in the form of
loans, investments, and other financial instruments. In other words, financial institutions basically facilitate the flow of
funds between savers and borrowers by offering various financial services and products. It is important to remark,
nonetheless, that a deficit unit is not necessarily entering a new financial contract with surplus units: a deficit unit can also
sell some financial assets out of its wealth surplus units. Some common types of financial intermediaries include banks,
credit unions, pension funds, insurance companies, investment funds and mortgage companies.

Financial markets can be classified according to different criteria:

o by maturity of traded products: money market and capital markets;
o by the kind of financial contracts traded: equity, debt, option and more detailed distinctions;
o by organizational structure of the market: centralized (electronic platform, exchange) or decentralized (OTC)
o and whether they act of the primary or secondary market .
The key functions of financial intermediaries include:
1. depository functions: financial intermediaries accept deposits from savers, such as individual and businesses, and
provide a safe place for them to hold their funds. Depository institutions, such as banks and credit unions offer
savings accounts, checking accounts and other deposit accounts where savers can store their money;
2. lending and investment functions: financial intermediaries provide loans and investment to borrowers, such as
individuals, businesses and governments using the funds collected from savers. They evaluate creditworthiness,
assess risks, and provide loans or investment based on their risk appetite and investment objectives. Banks, for
example, proved loans to businesses and individuals, while investment funds invest in securities such as stocks
and bonds;
3. risk management functions: financial intermediaries engage in risk management by diversifying and managing
risks associated with their lending and investment activities. They may use various risk management tools such as
diversification, hedging and insurance to mitigate credit risk, market risk and other risks;
4. payment and settlement functions: financial intermediaries facilitate payment and settlement activities by
providing payment services such as checking accounts, wire transfers, and electronic fund transfers. They enable
individuals, businesses and governments to transfer funds and settle transactions in an efficient way;
5. transformation functions: financial intermediaries engage in financial transformation by converting short-term
deposits from savers into longer-term loans and investment to borrowers. This transformation function helps in
aligning the maturity and risk characteristics of assets and liabilities, and facilitates efficient allocation of funds in
the economy;
6. information and advisory functions: financial intermediaries provide information and advisory services to savers
and borrowers to help them make informed decisions. They provide financial advice, investment
recommendations, and other informational services to assist clients in managing their financial affairs.
As a consequence, the economic role of the financial systems can be summarized in three main tasks:
o allocation and reallocation of funds: ensure that funds are channelled to their most efficient use by performing
such activities as lot size transformation (collecting funds and transform them into large investments) or
 geographical transfer (eliminating geographical distance through various subsidiaries). They also exert control to
ensure that funds are efficiently deployed;
o diversification and allocation of risk: ensure that risk can be pooled among many agents and ensure that risks are
held by those units suited best to bear them;
o providing payment services: provide an efficient medium of exchange in order to facilitate trade in goods and
services and ensure efficient allocation.
In the last, years, non-bank FIs – like insurance companies, asset management firms, investment funds, hedge funds,
private equity firms, and fintech companies - have been playing and increasing important role in the financial system.
These increasing importance of such entities in the financial sector is due to a series of factors. First of all, they provide a
chance for diversification of financial services: non bank FIs offer, indeed, a diverse range of financial services and products
beyond traditional banking services. In addition, they often leverage technology and innovation to disrupt traditional
financial service models and provide more convenient, efficient, and customer-centric solutions. Fintech companies, for
instance, use technology to offer online lending, digital payments, robo-advisory services and other innovative financial
products and services. This has led to increased competition, improved customer experiences, and expanded access to
financial services, particularly for undeserved or marginalized populations. Non -bank FIs are also able to operate across
borders and engage in cross-border activities, including cross-border investments, international trade finance and global
risk management. This globalization of non-bank FIs has facilitated increased capital flows, cross-border investments, and
international trade, contributing to economic growth, financial integration, and global connectivity. Eventually, non-bank
FMIs also represent sources of alternative investment forms for both businesses and individuals, specifically when
traditional banking channels may be constrained or unavailable (for instance, PE and VC firms can provide equity or debt
financing to start-ups and small and medium-sized enterprises (SMEs) that may have limited access to bank loans. This can
help promote entrepreneurship, innovation, and economic growth.

NON-BANK FINANCIAL ASSETS

BANK CREDIT

Of course, different characteristics of financial markets relate to different roles:

o equity, debt and options market allow for a certain risk sharing and determine corporate control;
o organizational structure of the market (centralized or decentralized [OTC}) have implications for matching
efficiency and search costs:
o existence of a primary and secondary market increases liquidity of financial claims.
At the same time, also intermediaries (be them banks or non-banks) play a fundamental economic role in terms of direct
finance. The preferences and needs of lenders and borrowers differ with respect to the size, term to maturity, risk,
information and liquidity of the single intermediary and these differences might easily prohibit capital reallocation.
Financial intermediaries, then, aim at offering funding for deficit units at terms that better suit the deficit units’ needs and
– at the same time- they create new claims that (better) suit the needs of the surplus units. This way, financial
intermediaries create value. Efficiency gains achieved by financial intermediaries are the following:
o maturity transformation: finance long-term assets with short term liabilities;
o liquidity transformation: finance illiquid (long-term and non-tradeable) assets with liquid (short-term tradeable
or withdrawable) liabilities;
o search and transaction costs reductions;
o lot size transformation: pooling of saver’s funds;
o risk reduction by diversification and information production.
More specifically, different types of financial intermediaries specialize in absolving one or more of these crucial functions:
o banks and other deposit-taking institutions: transform maturity, liquidity and lot size;
o insurance companies: pool and diversify idiosyncratic risks of investors;
o pensions funds and mutual funds: pool and diversify idiosyncratic risk of investments;
o brokers and market makes: limit search and transaction costs.
How to measure the development of the financial system?
Usually, in order to measure the efficiency and development of the financial system, the reference point is given by three
major criteria: depth, access and efficiency of both financial institutions and financial intermediaries.

As one might easily assume, then, a well-developed financial system also plays a critical role in determining the economic
growth of a country. Indeed, a well-functioning and efficient financial system is essential for mobilizing savings, allocating
capital to productive investments, facilitating transactions, managing risks, and promoting economic activity; and these are
all activities which reveal crucial for supporting a country’s economic activity and promoting investment, also fostering an
inclusive growth.
Nonetheless, the more developed the financial system of a country is, the less its development and well-functioning seem
to contribute to a nation’s economic growth. This is known as the “too much finance” – effect: it is a phenomenon where an
excessive expansion of the financial sector relative to the real economy might have negative effects on economic growth
and stability of a single country and only recently evidence was collected to explain such a phenomenon. As a matter of
fact, when the financial sector becomes to large and dominates the overall economy, it can have detrimental consequence
for the country itself dues to a series of effects. These include:
1. too many resources distracted from other industries;
2. too complex institutions becoming too opaque implying a difficulty to govern and supervise them, as well as, an
additional cost requirement in order to bail them out;
3. the financial sector/institutions become too powerful, enabling them to extract rents.
BLOCK 1 - FRICTIONS IN FINANCIAL MARKETS

As one might know, SMEs play a crucial role in the European economy. They are considered the backbone of the European
business landscape and contribute significantly to the Economic growth, job creation, innovation, and social cohesion. As a
matter of fact, SMEs are a major driving force behind economic growth in Europe and they account for over 99% of all
businesses in the European Union (EU), contributing significantly to GDP, employment and exports. In addition to this, they
are significant job creators in Europe and they provide employment opportunities in various sectors and regions
(especially in rural areas. They play a vital role in regional development in Europe and contribute to balanced economic
development across regions by creating employment opportunities, promoting local entrepreneurship, and supporting
community development.
An ECB survey investigated the access to financing of European enterprises, distinguishing firms across size and across
countries and having an annual panel structure. The survey revealed some interesting insights into the financing problems
which European enterprises could face and – more specifically – reveals the fact that European SMEs (despite their crucial
role in the economy) often face multiple difficulties in receiving a bank loan. More specifically, they are often discouraged
to ask for a loan or even rejected once the request was filed. This suggests the presence of a problem of credit rationing.
Credit rationing implies that irrespective of the interest rate that the borrower is willing to pay, the lender is not willing to
grant a lowan (in the requested amount). This cannot occur under perfect capital market assumptions, since one of the
fundamental ones is that a firm can always obtain financing for an investment with positive net present value (NPV).
Nonetheless, especially I periods of bank stress, SMEs are credit rationed and do not obtain the required amount for either
performing fixed investments or buying their inventory.
But why are SMEs subject to credit rationing? Well, SMEs are small and therefore are mostly less diversified both in the
pool of their financing sources and in the business they are active in. Moreover, they do not issue tradeable securities and
have lower reporting requirements. In other words, they appear opaque to banks and firms active in the financial services
activity. This is also in contrast with the
Standard models of financial markets assume that all market participants have the same information:
1. Buyers and sellers of financial assets (e.g. SME owner and investors) have the same information on the firm’s
prospects → symmetric information about characteristics of an investment;
2. Firm’s suture (investment) strategy can be precisely specified and controlled by outside investors → symmetric
information about the action of management.
But actually both are rather unrealistic assumptions: financial markets are, indeed, characterized by frictions and
imperfections. We distinguish more specifically between:
o Hidden characteristics: investors does not know as well as the SME’s manager/owner whether a firm has a high or
low default probability and they also fear to accidentally lending to high risk firms, with low repayment
probabilities. They require compensation for this additional uncertainty (lemons premium) and – consequently-
also low risk firms need to pay more than the adequate risk premium in order to obtain financing. At this point,
low risk firms stop demanding credit and high risk borrowers will be the only ones staying in the market, causing
a problem of adverse selection. If high risk firms cannot pay the adequate risk premium, investors at this point
would prefer not to lend at all → Financial markets dries up and firms are funding constrained.
o Hidden action: managing owner can take decisions which reveal unobservable to creditors and managers can, in
this way, excessively invest in risky or safe projects, thereby creating an overinvestment problem. More specifically,
if they invest in excessively risky projects, they would (in the good state of the world) receive the same return but
with higher risk. This strategy can still reveal beneficial, since – if lucky – the firm would be able to retain high
amounts of residual cashflows. At the same time, though, if unlucky, the company will lose everything it invested in
the project, thereby inflicting capital losses to creditors. If the manager invests safe, they never default and only
obtain low but deterministic residual cashflows. At this point, investors anticipate the owner’s opportunistic
decision (moral hazard) and require the owner to retain sufficient cashflow rights to have “skin in the game.” Only
a fraction of cashflow rights can be used to raise external funding (credit) to prevent manager from excessive risk
taking. → Firms are credit constrained.

Hidden action Hidden actions generates moral hazard and this is specifically induced by overborrowing (asses
substitution, cash diversion, perk consumption and low effort of the management). A moral hazard attitude increases
benefits to borrower at the expense of expected returns to financiers.

Assumptions - Entrepreneur:
o Two period economy: t = 0,1;
o Entrepreneur (managing owner) is risk neutral;
o Entrepreneur has no time preference;
o Entrepreneur has risky investment project with a fixed investment volume I in t = 0;
o Managing owner only has cash A in t= 0 with I > A;
o He can consume cash immediately or invest in his own project, i.e. no alternative interest bearing investment
available → no discounting of future returns and no risk premium (r = 0)
o if he invests he has to borrow I -A
The hidden action:
o if the project succeeds, the return is R and if it fails the return is 0;
o entrepreneur’s effort (high or low) affects the project’s success probability: p H − pL =∆ p> 0
o but behaving reduced entrepreneurs benefits by B;
o whether the entrepreneur behaves with high or low effort is their private information:

Lenders:
o lenders are risk-neutral;
o lenders have no time-preferences;
o lenders’ alternative investment is holding cash → no discounting of future returns and no risk premia;
o many lenders → projects are scarce and funds abundant causing competition among lenders, driving down the
expected interest on financing contracts to r = 0. Lenders must only recoup their funds in expected terms.

Project efficiency:
o project is efficient, i.e. it has a positive NPV only if the entrepreneur decides to behave: p H R−I > 0;
o project is inefficient, i.e. has negative NPV if entrepreneur shirks: p L R−I <0
As a consequence: expected project return only recover the initial investment if entrepreneur behaves: p H R> p L R−I

Financing contract:
o focus on credit contracts which specify an initial funding volume C and a repayment R L ≤ R
o credit contracts are subject to limited liability. The borrower can at the maximum lose her investment;
o lender’s returns given project failure must be 0.

STEP 1: how to ensure that entrepreneurs behaves? → entrepreneurs prefer to behave if :

p H ( R−R L ) ≥ p L ( R−R L ) + B → ∆ p ( R−R L ) ≥ B

B
with R B=R−RL (borrower return), is the minimum return that must be left to the borrower. And since R=R B + R L,
∆p

the maximum repayment to lenders that will just keep entrepreneurs from
B
shrinking is given by: R L=R− . This represents the maximum pledgeable
∆p
repayment to lenders.

STEP 2: what is the maximum credit? → lenders are risk neutral and have zero
discount rate. As a consequence, they only require not to lose money on average.
In addition, lenders know that entrepreneurs behaves if R L ≤ R L . So, for R L ≤ R L
, the lender will provide credit for an amount equal to: C= p H R L. The maximum available credit will consequently be:
C= p H R L. For higher repayments, R L > R L entrepreneur shirks and lenders will consequently provide credit up to:
C= p L R L .
As we can see from the graph, the credit supply function is non-monotonically increasing in the promised repayment: even
if the entrepreneur promises a higher payment than R L, they could not obtain a larger credit. Actually, the creditor receives
in such a case less money, since they are perceived to promise a higher payment just to anticipate the fact that they won’t
behave properly (they would put low effort).
Indeed, even if the lender increases the promised repayment, moral hazard eventually leads to decreasing expected
returns. This translates into backward bent supply function of funds.

STEP 3: when is investment feasible? → the investment volume is given by I and

as a consequence, a project is considered feasible if I ≤ C+ A . Only if the firm
has sufficient retained earnings it can pursue the project: if the firm has too little
equity (retained earnings) it cannot pursue the project and causing those kind of
firms not to be able to pursue positive NPV projects.
A firm credit, then, is constrained if:

I ≤ C+ A= p H R L + A= p H ( R−B /∆ p ) + A

This implies that the more severe a firm’s moral hazard problem (the larger B):
o the less credit it obtains (tighter borrowing constraints);
o the more equity it must have
to pursue a given investment.

SUMMING UP:

o to align incentives of borrowers and lenders, borrowers must retain a minimum fraction of cashflow rights;
o this limits how much cashflow can be promised to financiers;
o this in turn limits credit availability: the more severe the moral hazard problem:
1) the larger the minimum retained cashflow;
2) the lower the available credit and;
3) the more retained earnings are needed.

How to contain moral hazard? One solution which FIs put into practice with the aim of containing moral hazard is to ask
the creditor to pledge collateral. Pledging existing assets as collaterals has two effects:
1. pledging collateral provides investors also with some return if firms default. As a consequence, financiers have
higher expected returns and are automatically willing to provide more funding;
2. transfer of assets is a cost to the borrower. This implies that the borrower will have stronger incentives to avoid
defaults and even with lower retained cashflow right, they are pushed to behave properly and not to incur in any
moral hazard problem. More cashflow can also be promised to investors without deterring the borrower’s
incentives.
There are consequently two important considerations to make about the collateral option. First of all, even if the collateral
is worthless to the lender, it alleviates the borrower’s funding constraint. If it is worthless to the lender, this basically
means that it does not increase the lender’s return in case of default, but we still need to consider the fact that it is worthy
to for the borrower. This means that the pledging of a collateral basically alleviates the borrower’s tendency to behave
incorrectly.
So, the “stick” effect still works: more of the firm cashflow can be promised to financiers without deterring the borrower’s
incentives. But how credible is such a collateralization? Actually, if the borrower is smart enough to anticipate that the
collateral is worthless to the bank and rather simply represents a cost for them, then the punishment does not appear
effective to the borrower, who will eventually not have an incentive to behave properly.
Secondly, collateralization is costly: transfer of collateral involves for both the firm and the bank some kinds of transaction
costs and the pledged collateral is often worth less to the lender than to the borrower. This implies that collateralization
involves deadweight losses. The collateral, indeed, represents a pure loss for the firm: it cannot even sell it and use the
proceeds to avoid defaulting.

IN SUM THEN:
o the hidden action problems help us understand why particularly opaque firms (SMEs) can be financially
constrained;
o their ability to borrow to pursue even positive NPV projects is limited (irrespective of the interest rate they are
willing to pay);
o without sufficient equity, they might fail to pursue positive NPV investments and collateralization helps alleviate
this funding constraints;
o collateral is nonetheless not always available and collateralization involves deadweight losses.
Moral hazard problem can make financial markets inefficient.

Hidden characteristics Hidden characteristics basically are the opposite of an hidden action. They simply represent an
uncertainty about the present: you simply cannot assess today whether a firm will behave well or not and you have, as well,
insufficient information on whether the project will perform good or bad. As a consequence, there are some characteristics
of the borrower which affect their ability and probability to repay. This characteristics are, nonetheless, know only to the
borrower but will be unobservable to the lender. Only the borrower knows whether the project they plan to pursue with a
loan will have high or low success probabilities and this informational asymmetry can lead to credit rationing.
The intuition behind credit rationing is the following: because the lender cannot distinguish borrowers with high and low
success probabilities, she must randomly pick a borrower. At this point, the lender faces the risk of accidentally lending to a
borrower who will unlikely repay and, as a compensation for the risk incurred, they will charge an additional premium (→
lemon premium). Borrowing costs, at this point, are primarily increasing for safe borrowers, because they are the ones
which are more likely repaying the premium. As a consequence, charging an additional premium drives out safe borrowers
from the pool of applicants, and eventually only risky borrowers would be willing to accept the higher premium. Hidden
information, then, can lead to adverse selection: only the risky borrowers remain in the pool of loan applicants and
knowing that only risk borrowers remain in the pool, investors refuse to lend and credit market dries up.

Assumptions – Lenders:
o lenders are risk neutral and apply discount rates of zero;
o lenders are competitive, which implies that borrowers do have market power to extract the project’s surplus
o lenders only need to break even (get on average money back=
o we assume limited liability: no repayment in case of project failure;
o repayment of R L in case of successful project
o the retained return of the borrower will be: R B=R−RL

Entrepreneurs:
~
o many entrepreneurs with an investment of a fixed volume I and an uncertain return: R ∈ { 0 ; R };
o a fraction of α of the entrepreneur are of the good type;
o good entrepreneurs have a relatively high success probability p;
o thus, they have a positive NPV investment: pR−I >0 ;
o a fraction (1-α) of the entrepreneurs is of the bad type;
o bad entrepreneurs have a much lower success probability q;
o such that their investment has negative NPV: qR−I < 0;
o the type of an entrepreneur is only known by
himself (private information)
o entrepreneurs have no funds available.

Lenders:
o when deciding to lend, investors randomly pick
a borrower not knowing her type;
o given that the contractual repayment is R L
this implies:
CASE 1: MARKET BREAKDOWN → if mR < I , investors cannot recover their investment even if borrower promise
maximum feasible repayment. In this case, lenders refuse funding and market dries up. Good entrepreneurs, consequently,
suffer from being pooled with bad ones and they do not receive funding to pursue their valuable investment projects.
Positive NPV projects are, consequently, not used and we face an underinvestment problem.
It is important to take into account the fact that the average success probability m declines with a decreasing fraction of
good firms α: m=αp+ ( 1−α ) q . A larger fraction of bad firms makes a market break-down more likely: mR < I .
Opaque firms (firms for which good and bad borrowers are hard to separate) can be credit rationed: the large the fraction
of bad firms in the pool of opaque firms, the more likely they are all rationed. They will not receive funding, no matter what
interest rate they pay.

CASE 2: POOLING → if mR ≥ I a contract that allows investors to break even is

feasible and lenders reveal to be competitive. Equilibrium repayment at this
¿
point would be R L and is determined by investors’ break-even condition:

¿ ¿ I
mR L=I → R L =
m

Conclusion:
o if firms are opaque, borrowers with good credit risk are pooled with borrowers with bad credit risk;
o good borrowers pay the average risk premium, i.e. they overpay for credit;
o good borrowers must overpay to cover the losses lenders incur when they accidentally lend to bad debtors;
o as the share of good borrowers declined they are eventually not able to pay the mark-up. This means that with too
many borrowers in the pool the market dries-up;
o over the business cycle (from boom to bust) SME experience overinvestment followed by underinvestment.
o over the business cycle, the fraction of high to low quality firms varies: in boom periods, many good firms are
available to be finance and SMEs consequently experience overinvestment.
o in periods of downturns, instead, the fraction of bad firms increases and SMEs are credit rationed and suffer from
underinvestment;
o hidden characteristics concept helps to understand the boom-bust cycle in SMEs investment.

Why are good borrowers not able to indicate to lenders that they are good credit risk? Borrowers cannot use the
contractual interest rate R L to signal their type. If they pay less, then bad creditors find this also appealing, meaning that
bad borrowers tendentially mimic the behaviour of bad borrowers in order to have access to the credit.
If the bank, instead, offers higher R L, then they pay even more. This implies that this behaviour does not reduce funding
costs. But good firms would be willing to incur a cost if it identifies them as good credit risk and thus reduces their funding
costs. So what they should do is: they should approach the bank and disclose that they would not accept a high interest
rate. This automatically signals that you are a good borrower, since the bad borrowers would not care about how much
they would repay since they highly likely won’t repay anything.

Signalling How to contain hidden characteristic problem? Being pooled with bad firms is costly for good firms, since they
pay information rent. Good firms, indeed, might be willing to use costly signals in order to convey their true credit risk to
lenders. Conditions for this doing are the following:
1. contractual arrangement under costly signalling must not appeal to bad borrowers;
 2. investors understand signal and offer credit contract with low risk premia;
3. the cost from signalling must be outweighed for good borrowers by the benefit from being identified as a good
borrower.
Possible applications of signalling are the following: reputation, equity, collateral and credit rating.
Collateralization implies the transfer of an asset contingent on failure. Since the project failure is more likely for bad rather
than for good borrowers, pledging collateral will reveal more costly for bad borrowers rather than for good ones. Collateral
can, therefore, have two effects:
o reduces information rent: since bad borrowers more likely will be positive about transferring collateral,
collateralization implies that gross repayments (including the expected collateral value transfer) of bad borrowers
increases relative to good borrowers. Bad borrowers will contribute more to lenders’ breaking even and good
borrowers will avoid huge overpay to ensure break-even of banks.
o deters bad borrowers from also demanding credit: sufficiently high collateral imposes too high of expected losses
to bad borrowers, which will face such high costs not able be offset by the benefits from pooling with good
borrowers. Bad types are, this way, deterred from mimicking; i.e. they rather do not demand credit. Good
borrowers instead, still prefer to deter bad borrowers from mimicking, if lower risk premium offsets costs from
collateralization.
Takeaway: it is better for good borrowers to pledge more collateral, the more severe the asymmetric problem, i.e. the
worse the bad borrowers (the lower q with constant p ) and the larger the fraction of bad borrowers (1-α).
Nonetheless, collateral is not often available and the transfer of collateral is costly

Rating Agencies Good firms can reduce their funding costs if they are revealed as good credit risk, so they have a
willingness to pay for a certification. That is the main reason for rating agencies to exist. Firms pay an agent for assessing a
true success probability and this agent, in their turn, credibly conveys her assessment to investors. A good rating reduces
good firms’ funding costs and compensates them for rent paid to agent. Bad firms won’t buy a costly certification. As a
consequence, having a rating serves as a signal.

Assumptions:
o assume firms solicit rating from a rating agency → this would cost them a fee of c;
o the agency uses the resources to check the borrowers quality and reveals it to the public;
o agents assumed to have incentives to assess and convey information truthfully and reputation might induce them
to do so

What does it pay to have a rating? Take the baseline framework: assess the firm’s willingness to pay for a clear signal. A
firm can pay c and then market learns success probability q or p of respective project. You also take m=αp+ ( 1−α ) q and
assume funding is feasible in pooled markets mR > I .Without certification, good borrower’s expected payoff follows from
investors’ break-even condition:

I
m R L > I → R B =R−
m

Since they are identified as good borrowers , after being certified their payoff with certification is:

G G I +c
p RL =I +c → R B =R−
p

At this point, good firms will basically need to balance costs and benefits from having their rating: the cost is given by c,
whereas the benefit is given by the reduced interest which you can pay after signalling that you are a good borrower.
Certifying is preferable for good borrowers if:

RGB > R B → R−
I +c
p
I
> R− →
c
m I +c
< ( 1−α )
p−q
p ( )
In words:
o if the cost of adverse selection for good borrowers exceed the certification costs per unit invested, then the good
borrowers prefer to invest in the signal;
o if this condition holds, then good borrowers will acquire a rating.

Takeaways:
o since rating costs are mostly fixed costs, they only pay off for large firms (with large funding needs relative to the
rating costs). Only for fairly large firms, credit rating are means to overcome hidden information problems;
o they only pay off for relatively good firms: the better a borrower’s credit quality relative to the average firm, the
more attractive it is to get a rating;
 o the more bad firms in the market, the more attractive it is for a good firm to get a rating.

TOPIC 2 – COMMERCIAL BANKING

As we hinted in the previous chapter, firms external source of financing are largely bank loans and – more specifically –
very opaque firms (SMEs) mostly rely on bank funding. Large part of banks’ asset side are loans to non – financial sector
and, in particular, firms (SMEs). In addition to this, informational asymmetries cause substantial inefficiencies in financial
markets, i.e. credit rationing and collateral is considered as an effective method in order to mitigate credit rationing.
Nonetheless, inefficiencies remain: 1) not all entrepreneurs have collateral and 2) collateralization causes deadweight
losses. Rating mitigate adverse selection, but they represent an efficient way of performing signalling if and only if they
present a cost advantage for large firms, are based on hard information and are not subject to any kind of conflict of
interest.
Why do most investors not perform screening or monitor? There are mainly two reasons:
1. Information production fails because it is unprofitable:
a) The informed trader can, indeed, not trade on his information;
b) Market moves against informed investors trading and consequently, prices adjust to informed investors’
demand (e.g. due to momentum traders).
As a consequence, informed traders cannot recoup their info costs and investors will not invest in info in the first
place.
2. Information costs are classifiable as fixed costs:
a) Retail investors only invest in a small amount and need to diversify;
b) Private investors, instead, cannot invest sufficient amounts in individual assets to break even on information
costs.
Consequently, fixed information costs result in being prohibitively high for retail investors.
Mainly because of these two reasons, then, investors usually delegate the monitoring activity
directly to banks. As a matter of fact, if we assume lenders to be risk-averse, we imply that
they would like to invest in a diversified portfolio. On this premise, we also assume that each
lender has to acquire info for each borrower: given a fixed info cost c , a number m of lenders
and n of borrowers, each lender will bear n∗c info costs, whereas funding costs for each
borrower will be m∗c . As we can see, then, in this case both lenders and borrowers are
forced to incur in some costs to collect information and we have a problem of duplication of
information costs.
The total transaction cost incurred as to collect information will then be n∗m∗c. The most
likely outcome will be that investors will give up on the information collection practice as the
cost of decisions will result in being prohibitively high.
At this point, then, it is more convenient for investors to delegate monitoring to one bank: a
bank can, indeed, prevent the duplication of info costs and if the bank finances borrowers, each
borrower is only monitored once. If info costs are also assumed to be represented by c for the
single bank, then the bank reduces total costs of monitoring borrowers from n∗m∗c to n∗c .
But, how do banks exactly overcome frictions in information gathering? Institutional investors
(such as banks) invest larger sums in each investment project and – in the most extreme cases-
they become the sole financiers of a firm. This way, banks can actually economize on information costs and prevent the
replication of information,
thereby exploiting economies of
scale in information production.
They also eliminate the free-rider
problem in information
production: being them the sole
financiers they manage to
capture all benefits from screening
and monitoring. Banks benefit
from information acquisition!
Pre-lending: Mitigating the hidden information problem Consider the case with good and bad firms that are
indistinguishable for lenders and there are competing banks in the market (they are large investors). These banks can
invest an amount c in information gathering. This allows banks to screen pool of loan applicants and – after screening- α’
> α is the share of good firms selected. At this point, bank’s break-even condition will be the following:

[ α ' p+ ( 1−α ' ) q ] R ' L =m' R'L=I +c

Consequently, the cost of a bank loan will be the following:

' I +c
R L= '
m
where m’ > m. At this point, then, the average success probability of loan applicants after screening is higher than before.
Banks’ funding costs are also lower than the costs of funding from uninformed investors, if:

' I +c I ¿
R L= < =R L
m
'
m
And this is true, if and only if:

'
c m −m
<
I m
This means that, if relative increase in repayment probability exceeds average screening costs, banks can mitigate hidden
information problem. What is the effect on the market outcome, then?
I ¿
1. banks overcome credit rationing: as a matter of fact, if R< =R L ,uninformed investors do not lend, thereby
m
'
causing a problem of underinvestment. If this condition holds and R L < R , banks will grant a loan. This means that
– while opaque firms are rationed by investors in the credit market due to the information asymmetry – banks will
still be willing to offer them a loan. Funding becomes now feasible because banks can screen which ensures that
fewer bad firms are funded;
I ¿
2. Banks reduce uncertainty premium: if =R L =R ,, investors do also lend, thereby causing the opposite problem
m
' ¿
of overinvestment. If this condition holds – for which R L < R L < R holds, screening reduces the uncertainty
' ¿
premium and good firms’ funding costs decline R L < R L. Banks’ screening, then, ensures that fewer bad firms are
funded and overinvestment is mitigated.

Post-lending: Role of Covenants Covenants are an important instrument to contain moral hazard and they basically
represent clauses in the credit contract. Affirmative covenants basically require some action by borrowers (i.e. purchase a
fire insurance or maintain a certain equity ratio), whereas negative covenants restrict the borrower’s actions and prohibit
asset sales or increases in leverage beyond a threshold. These clauses restrict the borrower’s action and reduce the moral
hazard problem. So, what is moral hazard all about if hidden action can simply be prevented by covenants? As you might
understand, covenants are written in a contract before it is signed, but they reveal to be effective only if the lender
monitors whether the borrower complies with the covenants. Monitoring. Then. Requires fixed information costs and small
investors unlikely monitor and enforce that borrower comply with the covenant.
Assume our baseline hidden action model is the following:
 o Borrower can shrink to extract some private benefit B;
o Shrinking reduces success probability from p H to p L
Further assume that banks can invest c in information and this permits banks to monitor (and thus use) covenants. In this
case, it becomes extremely hard for the borrower to shrink. This kind of set up reduces a borrower’s private benefit from
shrinking to B’ < B.
If a bank monitors, then the entrepreneur is pushed to behave if and only if:

'
' ' ' ' ' B
p H R B ≥ p L RB + B → R L ≤ R L =R−
∆p
The bank will, thus, provide required funding if the break-even condition holds such that:

( )
'
' ' ' B
p H R =C ≥ I − A+ c → A ≥ A =I −p H
L R− +c
∆p
More specifically:

( )
'
Bank funded firms require retained earnings given by: A ≥ A ' =I − p H R−
B
o +c
∆p
o Firms funded by uninformed investors, instead, require: A ≥ A =I − p H
❑
'
( R−
B
∆p )
of retained earnings.
'
The bank, then. Alleviates funding constraints if A > A , which is a condition holding only if:

( )
'
B−B
c < pH
∆p

Banks alleviate funding constraints, if the additional costs of monitoring are offset by the lower agency rent, i.e. the higher
pledgeable returns.
Overcoming asymmetric information Since banks are large and often exclusive financiers of firms, they economize on the
costs of information gathering. This permits them to alleviate asymmetric information problems and resulting firm funding
constraints. So, banks are in a good position to overcome frictions in financial markets and improve efficiency.
But can we be sure that banks also exploit this option? Banks can screen and monitor firms and thereby alleviate funding
constraints that result from informational asymmetries, but whether banks really engage in monitoring and screening
(invest in c ) is generally not observable. Ultimately, bankers do not invest their own money: so, while asymmetric
information problem in firm financing is alleviated through banks, the funding of banks might suffer from similar agency
conflicts (moral hazard). Thus, banks’ financiers must incentivize bank managers and the information asymmetry problem
is only shifted.
Who monitors the monitor? We saw that, if lenders are risk averse, total monitoring costs amount to n∗m∗c, given a fixed
info costs c , a number m of lenders and a number n of borrowers. The presence of a bank as monitor reduces the info costs
in corporate lending to n∗c ,but the bank must be screened/monitored, too, which brings about additional information
costs. Assume the information costs is always c . At this point, we observe that as long as either n> 2and m ≥2 or n ≥ 2 and
m>2 banks still saves in information costs, spending an amount equal to ( n+ m) c <n∗m∗c.
Key question: are the assumptions underlying this argument reasonable?
1. What if investors are not risk averse enough to invest in very diversified portfolios?
2. What if costs of monitoring a bank were very different from monitoring a firm?
For instance, risk neutral investors tend not to diversify: if lenders are risk neutral, indeed, and all investments pay the
same expected returns, they will most likely invest only in one project and each lender will monitor one single borrower. At
this point, total borrowing costs will amount to m∗c, but there still is a problem of duplication of monitoring costs (if
m>n).
A bank can, nonetheless, still eliminate the duplication of costs of monitoring firms, but the bank must be monitored too.
Duplication of the cost of monitoring the bank can – at this point – not be prevented, with a bank total monitoring costs
amounting to ( m+1 )∗c .
Banks, nonetheless, are not always able to reduce information costs. As a matter of fact, we recall that the info costs in
direct financing are the following: m∗c, and the information costs of involving a bank in the process are ( m+1 )∗c .
Consequently, if the costs for monitoring bank and firm are identical, a bank can simply not
reduce the overall information costs and improve efficiency. Only if monitoring a bank is easier
(or not needed at all) banks can alleviate market inefficiency.
In addition to this, if banks are large and hold a (fully) diversified portfolio, chances of
succeeding by shrinking are reduced for bankers and the incentive problem is consequently
alleviated. The need to monitor the bank is consequently reduced or even eliminated and one
witnesses only limited (or no) cashflow fluctuations given the fact that bankers behave. More
specifically, funding of diversified banks involves less or no info costs since the costs of the delegated monitoring vanishes.
Banks minimize info costs in firm financing by avoiding duplication and diversified banks minimize, consequently, the
overall frictions due to the informational asymmetries.
Important takeaways – Risk transformation: the argument about diversified banks shows why risk transformation of banks
is important:
o Banks grant risky loans that require monitoring;
o Invest in a diversified portfolio;
o Refinance with safe debt;
o No need for investors to monitor the bank
This argument shows that there are synergies (economies of scope) between risk transformation and monitoring. Only
because of these synergies, banks can improve efficiency as delegated monitors and this argument applies to many large
financial institutions not only to banks.
According to this idea, then, also in banking there are economies of scale playing a role: larger banks can better diversify
and therefore incur in smaller agency costs. Taken at face value, then, an economy should have only one banks and this
argument does not even take inefficiencies due to banks’ market power into account. There are no countervailing
diseconomies of scale (social or institution specific) considered. This reasoning helps to understand why banks
predominantly finance with debt and why this debt needs to be rather safe. The model does not capture why the debt
claims are deposits: why do banks predominantly refinance with demandable deposits, i.e. deposits that can be withdraw
at the depositors’ discretion.

Retail Deposits So fa, models provide a rationale for large financial institutions that grant long-term loans and enter long-
term lending relations. These models also provide a rationale for financial institutions with a long-term investment
horizon. Nonetheless, these financial institutions do not necessarily need to be banks. The main characteristic of banks –
for which those were so far considered- is the fact that it largely refinances through deposits.
Bank deposits, then, provide liquidity insurance to investors and demand deposits are redeemable at any time. Time
deposits have mostly short maturity and are typically rolled over: they offer a very liquid investment opportunity. Banks,
then, use short-term of redeemable claims to refinance long-term illiquid loans. They only hold reserves (cash and money
on accounts of the CB) to repay the expected withdrawals (fractional reserve banking). The rest is invested in long-term
illiquid assets (e.g. loans), which generally pay a larger yield than the reserves. When investing a share of the deposited
amounts in loans, banks can still pay a return on deposits that exceeds the return on reserves. At the same time, deposits
provide investors with full discretion when to withdraw.
Investors don’t know when they need funds for purchases: long-term investments have, indeed, long-run returns but
cannot be liquidated prematurely without large transaction costs. The need of early purchases represents an idiosyncratic
liquidity risk. By pooling these idiosyncratic risks, share of investors with needs of early purchases become deterministic.
Banks only hold amounts needed to repay impatient depositors: repayment to patient, long-run depositors are refinanced
through returns on long-term investments and banks economize on reserve holdings and no long-term assets need to be
prematurely sold. The fact that bank deposits can be withdrawn at any time causes impatient depositors (with early need
for purchases) to withdraw early and receive higher yield than they would receive on reserves or on asset sales. Patient
depositors, instead, withdraw later and receive less than long-run return on investment but still more than impatient
depositors. Banks insure against idiosyncratic liquidity risks which welfare enhancing given risk averse investors.

Incentive constraints:
o Consider that the bank offers a contract that does not pay more on early withdraw than on late withdrawals:
d 2 ≥ d1 ;
o This implies that patient investors do not benefit from withdrawing early;
o Given that Q∗d 1 ≥ d 2 impatient investors (and only those) withdraw early (you would basically need to find an
incentive that renders this contract useful as an insurance for patient investors);

Deposit contract:

Given that banks received deposits from many investors it can apply the law of large numbers, which allows to derive the
following refinancing conditions:
o The bank holds reserves only to match the repayments to impatient investors: γ∗d 1=( 1−I );
o Bank refinances repayment in t=2 to patient investors with return on long-term investments: (1- γ ¿∗d 1=R∗I
Given banks compete for deposits in t=0, they also offer deposit contract that maximize investors’ expected utility:
o Given impatient investors withdraw, c i1=d 1 and c i2=0 ;
o Given patient investors holding their deposits until t=2, , c W w
1 =0 and c 2 =d 2
As a consequence, in t=0 investors’ expected pay-off is:

E [ U ] =γ∗Q∗d 1 + ( 1−γ )∗d 2

OPTION 1: From the refinancing condition, then, we know that: d 1=(1−I )/γ and d 2=R∗I /(1−γ ). Inserting in the
expected payoff gives the following: E [ U ] =Q∗( 1−I ) + R∗I . Your objective is – at this point- to maximize this payoff
with respect to I. Since the derivative of this payoff is −Q+ R , given that Q> R , we come to the conclusion that the optimal
investment to perform will always be I =0.
The deposit contract will therefore most likely present the following conditions: d 1=1 /γ and d 2=0
Does this contract work? No, this type of contract does not work. As a matter of fact, it will attract only impatient investors,
since patient ones will actually not have an incentive to hold the deposit, since they won’t receive any payoff given that they
held it until t=2 . Not only would patient investors not have an incentive to hold their deposits, but they even won’t enter
into the contract at all, since – knowing their preference to maintain there deposits long-term- they will choose more
advantageous options for depositing their money.
Obviously, if d 2 = 0 patient investors have no reason to wait and only if d 2 ≥ d1 , they will not withdraw. It is consequently
optimal to give maximum incentive compatible early cash to impatient investors: d 2=d 1. Given this condition and taking it
into account, the refinancing condition will be given by:
¿
(1−I )/γ =R∗I /(1−γ )→ I =(1−γ )/¿

You basically need to create a contract such that only those people who really need the money as of right now will be
pushed to withdraw their money early, whereas those who do not need the money immediately will not be pushed to
withdraw – having an incentive to hold their deposit.
Given this assumption and reinserting it in the refinancing condition gives:

¿ ¿ ¿ R
d =d 1=d2 =
γ∗R+ ( 1−γ )

The deposit contract, then, provides patient and impatient investors with the same repayment (but at different points in
time). The larger fraction of patient investors, then, the large will the repayment be. As a consequence, the bank can keep
more funds for two periods and it investors more in the interest bearing asset. This can therefore pay more on deposits
(both early and late).
¿
Since 1> γ >0 , it follows that R> d >1. This implies that the bank, compared to the market, smooths cash repayments of
patient and impatient investors. Market trading, then, provides investors with cash, more specifically:

i ¿
o c 1=1< d if impatient
o c w2 =R< d ¿ if patient

Deposit contracts provide – at this point – investors with a liquidity insurance that goes beyond the insurance provided by
a secondary financial market. Due to this smoothing, indeed, investors obtain more cash when they particularly need it.
¿ ¿
This also increases investors’ expected pay-offs with a deposit contract: E [ U ] =γ∗Q∗d + ( 1−γ )∗d compared to the
¿
expected pay-off with market trading, which will instead be: E [ U ] =γ∗Q∗d + ( 1−γ )∗R .
The intuition behind this is the following: investors derive the highest payoff from early cash if they are impatient.
Compared to the market outcome, then, they basically benefit from smoother pay-outs across types. Ex-ante they are
willing to reduce long-term pay-out if patient and to increase the short-term repayment if impatient, even though this
means that more is held in liquidity and overall deposit returns shrink. Compared with market allocation, deposit contract
provides some reallocation from patient to impatient investors. Because of no-arbitrage condition between primary
market (initial investments) in t=0 and the secondary market in t=1, financial market cannot achieve such a high liquidity
insurance.
What about insurance contracts signed in t=0? Such insurance contracts do not have to take the no-arbitrage condition
into account. The contract would indeed require that investors with a liquidity shock get a pay-out paid by patient
investors. There is, nonetheless, a problem: investors’ type are not observable publicly and ex-ante: for the bank. It is not
easy to observe whether the depositor really has a good application where to invest the money or not. Patient investors, at
this point, can also pretend to be impatient in order to obtain a more advantageous payout: direct decentralized insurance
against liquidity shock does not work.
In sum: if long-term investments provide a high long-term return, investors bear a large liquidity risk. Their repayment
varies strongly depending on when they need cash. Bank deposits smooth investors repayments and they insure investors
against the risk of being “impatient.” Because these “liquidity shocks” are typically unobservable, market mechanisms fail
in providing such an optimal insurance. Deposit contracts are self-revealing: only truly impatient depositors will eventually
withdraw.

The downside of liquidity transformation If patient investors expect other patient investors to withdraw early, then they
basically anticipate that the bank has to liquidate long-term assets at unfavourable rates (L< 1). This basically reduces the
~e ~e
potential for repayment d 2 such that d 2 <d 1 and it becomes preferable for a patient investor to withdraw and try to be first
in line at the bank’s counter. At this point, if patient investors expect other patient investors to withdraw in t=1, they will
run and the bank is forced to liquidate all assets. Consequently, a bank run might occur as a self-fulfilling prophecy.
In run, depositors receive on average only the following amount:

d 1 = ( 1−I ) + L∗I =1−( 1−L ) I

C ¿ ¿ ¿

C
Given that the liquidation return per unit of the asset is L<1 it follows that d 1 <1. This implies that depositors are worse
off in a run than if they had invested in cash. Whether deposit contract actually provides better liquidity insurance depends
on patient depositors’ expectations in t=1. BUT, if investors would already anticipate in t=0 that there will be a run, they
will not invest in deposits in the first place. A run only occurs if they change their expectations.
In sum, there is a good equilibrium in which the deposit contract provides an efficient insurance against idiosyncratic
liquidity shocks and a bad equilibrium in which a run occurs and only some investors are worse off if they held only cash.
Which equilibrium prevails in undetermined and only depends on depositors’ expectation.

How to rule out the “run” equilibrium?

1. Suspension of convertibility: bank commits neve to liquidate long-term investment. The bank only repays d 1to
each withdrawing investor as long as it has liquidity. Patient investors can always expect to receive d 2 no matter
how many other patient investors withdraw early. This way, run equilibrium is eliminated.
2. Deposit insurance: a deposit insurance promises to repay depositors in case the bank is unable to do so. It a
deposit insurance is credible, depositors know they get their deposits fully repaid. No matter what they expect
other patient depositors to do they hold on to their deposits and no patient depositor finds a reason to withdraw
early. Only impatient depositors, whose withdrawals the bank can always serve, withdraw. A credible deposit
insurance never has to actually step in, BUT INSURANCE MUST BE CREDIBLE.

But in general, why do banks refinance risky opaque long-term investments (loans to SMEs) with short-term demandable
deposits that expose them to a run? Given the mutual enforcement of solvency and liquidity problems, why aren’t the risky
investments and the liquidity insurance done by two separate financial institutions? A research by Calomiris & Mason
(AER 2003) bank runs usually coincide with a period of time immediately following the peak of a specific business cycle.
Why this? Well, because depositors do not simply panic, but they rather respond to news about the bank and the overall
economy. In a period of peak for the current business cycle, indeed, depositors and investors tend to have an optimistic
view of the future and when their expectations are let down by the business cycle slowing down, they panic and withdraw
their deposits. This implies that runs and the underlying liquidity mismatch are an important mean as to discipline banks
and their managers. Banks are more likely to suffer from a run if the managers shrinks (e.g. invests in too risky projects),
making bad news more likely. Given that bank manager wants to avoid a run, they behave. Such a disciplining effect might
be particularly needed if the bank invests in opaque assets and this might also be the reason why banks combine opaque
illiquid assets with deposit funding.
1. Following the argument that banks pool liquidity risks, runs are unintended by product of the efficiency enhancing
liquidity insurance;
2. Here the threat of a run is an integral part of the welfare enhancing role of banks. The threat of a run avoids bank
managers moral hazard and makes banks efficiency enhancing.
Re-evaluating the potential bank-avoidance policies then, if the bank could suspend convertibility of deposits into cash it
would of course undermine the threat of a run, but at the same time it could force depositors in an orderly bankruptcy.
This would eliminate the efficiency enhancing role of deposits. A deposit insurance promises to repay depositors in case
the bank is unable to do so, which would also undermine the depositors’ incentive to run in response to bad information
about the banks’ performance. A deposit insurance also eliminates the efficiency enhancing effect of deposit funding and a
deposit insurance fosters bank managers’ moral hazard.
In sum: banks engage in liquidity transformation and they only hold a fraction of the demandable (i.e. liquid deposits) that
they raise in cash. They invest the remainder in long-term illiquid assets and this exposes them to the risk of a bank run.
There are two key rationales for this liquidity transformation:
1. Depositors are more efficiently insured against idiosyncratic liquidity shocks;
2. It allows depositors to discipline banks and thus improve efficiency.
Only this additional disciplining effect might ensure that banks play their role as efficient delegated monitors.
Runs can still occur due to pure panic, but deposit insurance can avoid these panic-based runs. The same may nonetheless
still induce moral hazard on the bank side if banks are not regulated in other ways.
TOPIC 3 – FINANCIAL CONTAGION AND GOVERNMENT INTERVENTION

As one might have noticed, historically economists care more about banking crises than crises in any other industries. But
why so? Well, as a first point, banking crises do not only involve usual default costs, but they even bring about:
o Direct costs of banking crises: the contribution of the banking sector to GDP growth declines, which brings about a
lower demand for inputs of the banking sector;
o Costs for banks stakeholders: employees lose their job and equity holders, creditors and depositors lose part of
their assets.
In addition to this, as was pointed out also in the previous topics, banks have a special role in overcoming informational
problems: they finance borrowers that have no other source of funding. As a consequence, also borrowers are obliged to
face costs related to the banking crises: in an individual bank’s crisis, borrowers would have to pay a premium to switch to
other banks, whereas in a widespread banking crisis, borrowers with asymmetric information problems find no funding.
Moreover, banks are known for providing liquidity and insurance to investors and, consequently, banking crisis leads to
liquidity shortage in economy and precautionary liquidity hoarding.
Looking at a potential individual banking crises, we would also realize the fact that the latter is peculiar also with respect
to crises in other industries. These peculiarities of the banking industries also bring about some additional costs. As a first
point, the failure of a single firm in other industries might reveal beneficial for competitors. The latter gain market share
and increase their profits. In the banking sectors, conversely, failure of one institute often impairs the profitability and
stability of other banks:
o Costumers’ beliefs in banks’ stability and soundness is essential for the banking industry and already the failure of
one institution might undermine this belief;
o Banks are interdependent: this implies that the failure of one institute generates large losses at other banks.
More specifically, contagion appears to be – then- the most peculiar aspect of the banking industry. The crisis of individual
banks brings about welfare losses, but these losses are usually of macroeconomic importance. Nonetheless, financial
contagion might cause domino effects. The failure of one bank can bring about severe negative externalities for other
banks, and if spill-overs are unsustainable for other banks, those might also collapse leading to further chain reactions. The
weaker overall condition of the banking sectors, the more likely are such chain reactions and due to the latter, the crisis of
one bank can cause the failure of the whole financial system and lead to a crisis of macroeconomic importance. Channels of
financial contagion are the following:
 1. Informational contagion;
2. Contagion through interbank credit exposures;
3. Liquidity hoarding in the interbank market:
4. Contagion through fire-sales;
5. Repo-runs;
6. The doom-loop

Information contagion between banks Banks are inherently fragile and exposed to self-fulfilling crises. For instance, if
bank A with a similar portfolio as of bank B fails, depositors of bank B might view the failure of bank A as a signal that bank
B is also in trouble. As a consequence, they decide to withdraw on a large scale which then indeed also generates a crisis at
bank B. The crisis of A triggers also bank B’s failure (failure of A coordinates expectations of B’s depositors). There are no
links between banks, only similar loan portfolio and correlated returns.

Financial contagion through credit direct exposure Large part of banks’ assets are claims against other banks. These
interbank claims are often short-term interbank loans and often banks have cross holdings of these interbank loans. Claims
result from the need to reallocate liquidity within the banking sector and a drawback of these claims will be the fact that
they bring about a large credit risk of the lending bank. A default of one bank generates significant loan losses at the
lending bank and if these losses exceed risk bearing capacities of the lending bank, it might also fail. If the lending bank
itself is a borrower at a third bank, then this chain reaction continues leading to the collapse of many banks.
The main intuition behind this concept is the following: banks have a certain depositor base and transactions between
depositors of different banks generate idiosyncratic shocks to reserve holdings of these banks. For instance, if a customer
of bank A purchases goods in the grocery store (customer of bank B), his payment leads to a negative liquidity shock at A
and a positive shock at B. At this point, banks use the interbank market to reallocate reserves and offset these liquidity
shocks: banks that have excess liquidity due to the shock lend liquidity to banks short in liquidity due to the shock. These
interbank loans generate interbank credit exposure.
If one bank fails on its outstanding interbank credit, other banks incur in losses. Nonetheless, if the interbank credit
portfolio is well-diversified (all banks hold only a small amount of credit against each other bank) then each bank’s losses
are limited. If interbank credit exposures are concentrated (e.g. only one bank holds all interbank claims against one other
bank) then the losses are large and more likely to trigger a further failure. If some banking groups are not linked through
interbank credit relations, there are no spill-overs and no contagion between these banking groups. These structure of the
interbank credit network is essential to assess the risk of contagion.

Example Origin of the interbank exposure 1. Assume two banks, A and B, have the following balance sheet. The banks’
equity has a book value of 0.75$ and they both expect that 50% of deposits will be shortly withdrawn. They aim at holding
50% of deposit in reserves.

2. Depositor of A buys something worth of 2$ from depositor of B and depositor of A withdraws and hands over cash to
depositor of B. At this point, depositor of B deposits cash with B.

3. At this point, bank A would hold a too low reserve ratio: R/D = 0 < 0.5, whereas bank B holds a too high one: R/D =
2/3 > 0.5.
4. Bank B, then, lends reserves worth of 1$ to bank A, and Bank B has now an interbank credit exposure against bank A of
1$.

5. Banks A and B hold optimal reserve ratios again (50%) → interbank market allows banks to optimally reallocate
reserves after an idiosyncratic (bank specific) liquidity shocks.

Stability implications of interbank exposure Do additional interlinkages between banks increase or decrease system risks
(domino effects)?
CASE 1 → Assume:

o four banks with the same balance sheet of both Bank A and Bank B;
o assume A and B 1$ liquidity shortage; C and D 1$ excess liquidity.

At this point: C and D lend 1$ to A and B respectively, so that all banks hold the desired reserve ratio.

Suppose now that Bank B fails and cannot repay the 1$

which it borrowed for one of the surplus banks. Bank D
(which originally lent to bank B), with 3/4$ equity is unable to bear the loss of 1$ and will also default. This is a case of
limited contagion since bank C and A seem to be unaffected by bank D’s default.

CASE 2 → Assume now:

o banks C and D diversify and lend both 1/2$ to A and B. This ensures that all banks
meet the reserve ratio.

In this case, nonetheless, this also means that a failure of bank B leads to a loss of 1/2$ for bank
C and D. And, since both have 3/4$ equity, this is sustainable for both. No contagion effect!

CASE 3 → Assume now:

o C borrows from D to lend to both A and B.

In this case, a failure of A to repay brings down C because it has only 3/4$ equity. C is unable to
fully repay D and loss given default might also exceed equity of D. Because of domino effect
three banks fail.
In this case, then, even though interbank network more interwoven/diversified systemic risk is
in this case higher.

→ There is, indeed, the presence of a non-monotonic relation between interconnectedness and stability of the banking
system.
Conclusion: interbank loans are an important means insuring banks against specific liquidity shocks. Various networks of
interbank credit relations can implement an efficient re-allocation of reserves and offset idiosyncratic bank specific
liquidity shocks. The downside of interbank loans is that they create credit exposures that can lead to financial contagion.
The risk of contagion depends on the diversification of credit exposures and on the extent of unconnected islands.
Resilience of the banking sector is not a simple increasing function of bank’s interconnectedness. To contain contagion,
indeed, banks are important links in these chain reactions, in that they would need to hold an additional capital.
Problem: how to identify these systemically important financial institutions?

Critical discussion: if interbank credit risk exposure is a major risk, why do banks not simply choose the most resilient
network structure? There might be other costs of forming a diversified network and banks might prefer consequently the
more fragile incomplete structure. A reason for this might be the interbank monitoring and screening costs, which might
not reveal convenient for the single bank to take up. Another motivation might be given by the lending relationships in the
interbank market, which could allow a single institution to simply economize on the information costs.
Several central banks used supervisory data on bilateral interbank exposure to assess the risk of contagion and they show
that contagion risk is limited. As a consequence, they do not find it profitable at all to choose a more resilient structure and
basically face all the costs related with it.

Financial contagion through fire-sales If one bank is illiquid, the latter is forced to sell off assets. These fire sales
unavoidable lead to depress asset prices. Banks tend to hold similar financial assets and, since their trading book is
market-to-market, with decreasing market prices, other banks have to reduce the value of assets in their books which
reduces equity. Banks, then, have to sell off additional assets to restore equity ratio. Eventually banks become insolvent.

Example Fire sale contagion: 1. Two banks j and h with these given balance sheet:

2. Both banks want to maintain their current leverage ratio (“target leverage ratio”);
3. Banks cannot issue new equity;
4. Asset prices drop by 10 bp per 10 billion Euro sold of the respective assets.

At this point, the exogenous shock reduces the value of asset X by 50% and this also reduces bank j equity by 50%. In
order to maintain the target leverage ratio (L/E = 3) bank has to sell of 75 billion of assets (SO).
Bank h is not affected because it does not hold X .

The sale happens proportionally across its portfolio holdings and, after the first round of sales, the balance sheet of bank j
will be given as follows :

The price impact of bank j ‘s fire sales amounts to the following:

o X = - 0.1071%
o Y = -0.2142%
o Z = -0.4286%
Due to price impact values in j ‘s books are written down and losses reduce again j ‘s equity. A second round of fire sales is
now necessary.
At the same time, price drops also affect bank h : Y: -0.2142% and Z: -0.4286%. This implies that h – at this point – also
incurs in losses although it does not hold asset X. There is, then, a fire sale contagion. Losses reduce h ‘s equity and this will
contribute to a second round of fire sales.

Takeaways: fire sale contagion affects also assets not initially shocked. Shocks also affect banks that are not exposed to
shocked assets and common asset holdings generates contagion between otherwise unrelated banks and assets. The more
illiquid sold off assets, the larger are price effects of fire sales and the more severe spill-overs. A lower leverage ratio mutes
the spiral induced by fire sales and assets can become systemic when their holdings by banks serves as a transmitter of
shocks. This can simply happen if an asset price increases dramatically.

Application: the AV (average vulnerability) index The ECB uses approaches in order to come up with an aggregate
vulnerability index. The Central bank uses detailed balance sheet data on the largest 177 Euro area banks on: leverage
ration and holds for asset classes. The ECB basically assumes a price drop of 10 bp per 10 billion Euro sales of a tradable
asset and an initial 1% drop of all asset values. This way, the ECB measures the share of the total banking system equity
wiped out through fire sales.
What determines the evolution of the AV?
o Illiquidity concentration proxies which describes how concentrated leveraged bank’s holding of illiquid assets are.
Concentration on illiquid assets has also contributed to the spike during the crises, but this does not seem to be
the main driver;
o System leverage is the size-weighted average leverage ratio of the banking system and apparently the AV is highly
correlated with this indicator.

Many assets held by banks serve as liquidity backstops: banks plan to sell these assets and to obtain liquidity. If fire sales
depress prices, banks cannot raise as much liquidity with the given amount of assets as expected and they are also forced
to sell off additional assets to raise same amount of liquidity.
This further contributes to a price depression and further banks end up in a liquidity crisis.

The doom-loop Euro area sovereign debt crisis has highlighted that even in developed countries, crises of banks can be
contagious if the crisis jeopardizes the solvency of the sovereign. Elevated solvency risk of the domestic sovereign further
destabilizes the banking sector. In the specific case of the European Union, sovereign risk and bank risk are highly
correlated with each other in Europe’s monetary union. Thus, a major banking sector problem will cause financial distress
and reckless fiscal management will result in a credit squeeze. As a consequence, the ensuing financial fragmentation
across country borders impairs the operation of area-wide monetary policy and ultimately risks a break-up of the
monetary union, giving rise to redenomination risk. This vicious cycle is understood, then, as a combination of direct and
indirect financial linkages.
As a consequence, unlike crises in most other industries, banking crises severely impair the macroeconomy and banking
crises severely affect access to funding for firms as information capital in the financial sector gets lost. Due to contagion,
small scale banking crises can easily spread to the entire banking sector and impair the functioning of the entire financial
system. Banking crises and sovereign debt crises aggravate each other.

The rationales for intervention There are three main reasons, then, why economists and governments are more worried
about crises in the banking sector than in any other sector:
o Rational I: Bank opacity Bank are more opaque than other firms and evidence is provided by the fact that two
important rating agencies such as Moody’s and S&P disagree twice as often about the rating of banks (and any
other financial firm) than about the rating of non-financial firms. As a matter of fact, it is particularly difficult for
retail depositors to monitor and screen banks and this contradicts the argument that banks are easier to monitor
because of diversification. Depositors, in general, fail to charge an adequate risk premium and market discipline
can consequently not be exerted. They also can make investment mistakes and it is the government duty to protect
customers;
o Rational II: Self-fulfilling Runs Due to liquidity transformation, banks are susceptible to self-fulfilling liquidity
crises. Panics lead to inefficient liquidation of illiquid but solvent banks and given the opacity of banks, depositors
are not at all well informed. As a consequence, market discipline cannot be exerted and contradicts the view that
runs could serve as disciplining devices. Government intervention prevents panics and inefficient failures.
o Rational III: Too big to fail Negative externalities (spill overs and contagion) can bring about large social costs:
1. Borrowers lose access to external financing;
2. Financial contagion affects other financial institutions.
The expected social cost of a failure might outweighs expected costs of recapitalization by government and
government needs to bail out too-big-to-fail banks.
There are three main means to mitigate the likelihood of crises: 1. Mandatory deposit insurance, 2. Lender of last resort
policy, 3. Bail-out policy, 4. Equity requirements.

Deposit Insurance Independent financial institutions (DI) guarantee the repayment of deposits. Depositors are repaid by
DI irrespective of whether the bank is illiquid or insolvent. Government regulation requires banks to obtain coverage by DI.
The probability that DI must step in depends on the riskiness of the bank and the remaining susceptibility to panics.
Expected costs of a bank’s failure for DI varies with the bank’s riskiness and to avoid cross-subsidy, contributions to DI
should be risk-based (“polluter” pays principle). Nonetheless, risks are hard to quantify because of the bank’s opacity:
contributions are typically not (sufficiently) risk-sensitive and deposit insurance increased the risk-taking incentives of
banks (they basically have an additional incentive to gamble with your money).
Given that DI is not risk based, depositors should retain some incentives to monitor (we assume, indeed, that such
institutions would have the instruments to discipline banks):
1. Wholesale deposits and interbank deposits are not covered: as a consequence, wholesale depositors have a
primary interest in monitoring the banks’ doing;
2. DI covers retail deposits, but only up to a certain volume: in this way, also richer households and non-financial
firms should be able to assess the risk and exert a sort of market discipline;
3. Even lower volume retail deposits are often only partially guaranteed in order to preserve the monitoring
incentives.
Modes of financing deposit insurance are specifically two:
o Ex-ante contributions: accumulation of levied contributions held in reserves;
o Ex-post contributions: contributions have to be paid by surviving banks only in the event of a failure.
Both of these methods, nonetheless, have specific drawbacks. Ex-ante contributions, specifically, are not usually able to
precisely estimate the sum with which one should contribute with – it could be that the established sum is eventually not
enough. With a low ex-ante coverage ratio, DI cannot guarantee a large scale failure and runs on large banks can actually
not be eliminated. Conversely, high ex-ante coverage ratio is costly and distorts efficient liquidity transformation. With ex-
post contributions, instead, some issues arise. First of all, a single bank might be forced to require excess liquidity at other
banks, and if other banks do not have excess funds, then ex-post contributions might even generate a channel of financial
contagion. In addition to this, ex-post contributions might not be provided timely enough to meet cash needs depositors
and runs are, thus, not prevented at all.
Since 1994, the EU requires minimum standards for national deposit insurance schemes: The Deposit Guarantee Scheme
Directive (DGSD). This measure initially set minimum requirements of insurance granted: 90% of coverage deposits up to
20.000€, ex-ante coverage non-risk sensitive only related to a bank’s liabilities to private non-banks and a 3-month
maximum payout period. In 2009 the norm was updated and established the coverage of 100% of deposits up to 100.000€.
The payout was to be performed in 20 working date and the bank could require risk-based contributions. In 2014, the most
recent version of the norm postulated an EU-wide harmonized scheme (no longer minimum standards for each country). It
imposed a coverage for retail deposits up to 100.000€ and the DI was required to hold 0.8% of covered deposits in
reserves. Commitments by banks to a DI were also considered, but only limitedly and only if collateralized (ex-post
contributions). The contributions were also regulated and supposed to be both risk- and size-based with repayment in
maximum 7 working days.
In sum: to contain distorting effects, deposit insurances is mostly incomplete and does not need to eliminate all risks of
liquidity crises. To sufficiently contain risk of panics and resulting liquidity crises, deposit insurance is mostly
complemented by a lender of last resort.

Lender of Last Resort Even with a DI wholesale depositors and non-covered retail, depositors might still be led to panic.
As a matter of fact, even solvent banks might be unable to obtain liquidity in interbank markets and as a last resort
typically central bank lends liquidity to overcome liquidity shortages. Central banks serve as LOLR because only those can
create cash or cash equivalent reserves. Central banks can, indeed, provide liquidity to individual banks on the market as a
whole and LOLR should not undermine market discipline. Central banks should, indeed, only lend to illiquid and not to
insolvent banks.
Bagehot’s rule was, indeed, applied in order to exactly contain LORL’s moral hazard effect: lend freely against good
collateral, valued at pre-crisis levels, and at a penalty rate. The land freely formula refers to the non-present restrictions in
volume. This is meant to prevent self-fulfilling liquidity crises, implying that irrespective of the size of liquidity shortage,
the bank can borrow sufficiently. Against good collateral , instead, is a formula to ensure that LOLR only lends to solvent
but illiquid banks and does not lose public money. In addition, it also ensures that banks have no incentives to overinvest in
bad assets.
Valued at precise levels refers to the fact that CB should correct for the price depressing impact of the liquidity shortage
when assessing the value of the collateral and at a penalty rate refers to the fact that they should ensure the LOLR is
indeed the lender of last resort (and not the first person who comes to rescue the bank). Furthermore, it should contain
the moral hazard to underinvestment in liquidity. The problem with the penalty rate mechanism is that it might regenerate
self-fulfilling runs: if depositors expect that the bank has to pay a large penalty which might endanger bank solvency, it can
induce depositors to run. Problems with good collateral are the following: if the collateral is obviously good, a bank should
also receive liquidity from other banks and a LOLR is often exactly needed because quality of collateral is extremely hard to
assess.
There are fundamentally three types of LOLR instruments: open market operations, standing facility and emergency
liquidity assistance. Standing facilities and emergency liquidity assistance are classifiable as measures to provide liquidity
to individual troubled banks, whereas open market operations provide liquidity to markets as a whole. Usually, they
represent an instrument to offset aggregate liquidity shortages and stabilise short-term interest rate at the policy target.
Given frictionless interbank markets, runs on one bank could also be prevented by an increased volume in the open market
operations.
Central banks usually have two ways of performing open market operations: 1) buying marketable assets from banks in the
financial market; 2) allots liquidity to the market through repo auctions. When it comes to standing facilities, instead,
central banks lend directly to individual banks at a pre-announced term and condition, and this is implemented at
discretion of banks. At the marginal lending facility (MLF), banks can borrow as much as they need against collateral,
whereas at the deposit facility banks park excess reserves. The ECB, specifically, accepts a wide range of collateral, some of
which is not accepted in private repos (particularly during crisis). It applies also fixed haircuts on different classes of
collateral and those haircuts are not sensitive to changing market conditions. Haircuts are, indeed, applied to current
market value to derive collateral value. On aggregate, the Euro area banking system is over-collateralized.
The Emergency liquidity assistance, the Central Bank provides exceptional individual liquidity assistance to troubled banks
(terms and conditions to be eligible are usually case specific) and, supposedly, banks with insufficient eligible collateral are
preferred. Also the National central banks can theoretically provide emergency liquidity assistance (ELA) to domestic
banks, with the exception that they bear an excess amount of risk and can decide about the collateral which needs to be
pledged. The ELA provided by national central banks to commercial banks is granted at an interest rate needed to be 1%
(100 bp) above the interest rate charged on MLF loans. This suggests than national central banks is providing liquidity at a
higher rate with respect to the nominal refinancing operations of the ECB. In addition to this, in order to be considered
eligible for the ELA, banks must meet CRR or have a plan to meet it in 24 weeks. ECB can intervene by vetoing the
transaction and it is prohibited for the central banks to finance their respective or foreign governments.
Also the LOLR policy, nonetheless, presents some fundamental drawbacks. First of all, it reduces the incentive to withhold
sufficient liquidity, thereby pushing to the moral hazard of banks to create underinvestment in liquidity both at an
individual and aggregate level. In addition to this, it is extremely difficult to tell apart illiquidity and insolvency at short –
notice and LOLR might mistakenly lend to and bail out insolvent banks. This creates incentives for excessive risk taking
which increases the bank’s riskiness and the costs for the LOLR.

Bail-out policy The government guarantees a variety of bail-out instruments:

o Debt guarantees: government guarantees bank bonds issued by the troubled bank or it’s interbank credit;
o Governmental recapitalisation: government provides funding to troubled banks and acquires an equity stake in
the bank;
o Bad bank: government sponsors a financial entity (bad bank) that buys up illiquid or distressed assets potentially
at subsided prices from troubled bank;
o Distress merger: government provides subsidised funding to an acquirer of a distressed bank.
Depending on the specific design of the bail-out, initial debt and equity holders might benefit substantially in event of
crises. Bail-out expectations can undermine market discipline and foster risk-taking.

Digression: the European Banking Union The doom-loop in Euro area has highlighted national banking supervision and
safety-net combined with a common monetary policy seems to have contagious effects. The banking supervision in crises
countries might be too lenient in order to avoid bail-out costs for domestic sovereign and national supervisors do not
usually consider costs of a domestic bank failure to other countries. In addition to this, the expected costs of a bail-out by
domestic government increase the sovereign default risk, impairing further banking stability. Private national DI schemes
have proven insufficient in case of macro-crises and domestic governmental back-up of DI aggravates doom-loop.
Motivations for the happening of a banking unit are the following: 1) promote risk-sharing in Euro area with a centralized
and harmonized government intervention; 2) foster cross border banking integration with a level playing field to improve
resilience and risk-sharing.

The objective of a single resolution mechanism (SRM) was

to implement an harmonized resolution mechanism for
troubled banks in the Euro areas in order to contain
negative spill-overs of a bank failure. Failing banks,
indeed, immediately fall under control of the Single
Resolution Board (SRB). Bail-ins of equity and junior debt
were implemented in order to cover leases, limit bail-out
costs to governments and exert market discipline. SRB
enforces and manages asset sales, as well as, distressed
banks take-overs and will only build up a single resolution
fund to cover the remaining losses. Banks are required to
pay risk-based contributions in order to avoid affecting tax
payers.

Capital Regulation Capital regulation starts off with the idea of minimum capital requirements and basically defines how
much of the bank owners’ capital is at risk. Equity is considered – in this scheme- to be a buffer against losses and reduces
the riskiness of deposits and other liabilities. It also contributes to reducing the susceptibility to self-fulfilling runs since
liquidation losses are first borne by equity holders. In addition to this, the additional presence of equity allows to increase
the protection of the deposit insurance, reducing the risk of financial contagion mechanisms.
In second instance, equity also reduces the bank owners’ risk-taking incentives. The larger the equity ratio, the larger the
losses borne by bank owners, with a higher equity ratio owners bear larger part of the downside risks of investments.
Risky investments are less attractive for owners.
Capital regulation, then, in this sense, presents an important complement to contain the risk-taking incentives generated
by other measures like deposit insurance, lender of last resort and governmental bail-out expectations.

The incentive effect of capital requirements – A simple framework

Assumptions:
 o Bank refinances with deposits d and equity e;
o Bank has two investment projects with fixed volume I :
R
- Risky projects: p R∗R −I <0
- Safe: pS∗R −I >0 ,with pS > p R and R R > R S
S

o Bank refinances with deposits d and equity e;

o Bank needs I =e +d
o Bank owners are risk-neutral
o Depositors are risk-neutral and do not discount future consumption:
o Deposits in long supply ( they just want to break even and the only alternative they have is cash)

→ Depositors will provide funds as long as they get money back in expected terms.

CASE 1: NO GOVERNMENT INTERVENTION → we assume also that there is no government intervention possible and
consequently assume that the banks’ investment choice is observable before depositors even invest. If the bank chooses
R R
risky depositors, they require a given payment of D R ensuring breakeven: p R∗D =d → D =d / p R( p R is the risk
premium the bank requires risky depositors to pay in order to break even).
S S
If, instead, the bank chooses safe depositors, it requires repayment D S ensuring breakeven: pS∗D =d → D =d / pS .
As a consequence, if the bank chooses risky bank owners, net returns are:

Π R= p R ( RR −D R )−e= p R∗RR −d−e=p R∗R R−I <0

If the bank, instead, chooses risky bank owners, net returns are:

Π S = pS ( R S−D S )−e=p S∗RS −d−e= p S∗R S−I <0

Without any government intervention, deposits are fairly priced and default risk premium is reflected in the deposit rate.
Bank owners, in this case, have to incentive to take excess risk.

CASE 2: WITH GOVERNMENT GUARANTEES → now, consider that the government guarantees the face value of the
deposits (either through a DI; LORL, or bail-out policy): if the guarantee is credible, depositors know that in case of a bank
default they still get D. If bank chooses risky required repayment D ensuring break-even: p R∗D+ ( 1− pR )∗D=d →
D=d .
If, instead, the bank chooses safe required repayment D ensuring break-even condition, then: pS∗D+ ( 1−p s )∗D=d ,
then it is the same. If the deposits are guaranteed, the deposit rate does not reflect the bank’s default risk.
Then, if the bank chooses risky bank owners, net returns are the following:

Π R= p R ( RR −D ) −e= pR∗R R− p R∗D−e= p R∗R R −I + ( 1− pR )∗d

With the government guarantee, bank owners not only realize NPV of project, but they also receive a subsidy because the
guaranteed implies a reduction in banks’ funding costs. The subsidy is the bigger the larger the banks’ default risk. If bank
chooses safe, bank owners net returns are:

Π S = pS ( R S−D ) −e= p S∗R S− p S∗D−e= pS∗R S−I + ( 1− p S )∗d

If the bank chooses safe, the subsidy is obviously smaller.

Thus, bank owners will chose risky only if:

Π S < Π R → p S∗R S −I + ( 1− pS )∗d < p R∗R R −I + ( 1− pR )∗d → ( p S R S− p R RR ) < ( p S− p R ) d

If the higher subsidy comes by choosing risky investments and is able to compensate the difference in NPVs, bank owners
will prefer risky. This is because there are guarantees and, thus, risk insensitive deposit rates can induce bank owners to
choose a negative NPV project.
As a consequence, bank owners choose safe if: ( p S R −p R R ) ≥ ( p S −p R ) d . Taking into account that: d=I −e and
S R

substituting for it in the formula, we have that: ( p S R −p R R ) ≥ ( p S −p R ) ( I −e).

S R

S R
So, on an equity requirement of e^ of at least of e ̂ =I −(p S∗R − pR∗R )/( pS − p R) ensures that bank owners refrain
from excessive risk-taking. Such an equity requirement also limits costs to DI or bail-out policy.
Takeaway: implicit and explicit guarantees of bank deposits (or debt in general) undermine a risk-adequate pricing of bank
debt claims and market discipline. This induces banks to take excessive risk and risk-taking always minimizes the subsidy
implied by guarantees. Sufficiently high capital requirement ensure that bank owners have enough to lose in default. As a
consequence, sufficiently high capital requirement contain risk-taking incentives. If risky and safe investment have same
expected returns, only risk-based capital requirements correct risk-taking incentives due to subsidy.

Digression: Capital requirements in the Basel Accords

The Basel Committee on Banking Supervision (BCBS) provides
recommendations on an internationally harmonized banking supervision, which need to be incorporated into national
lows.

o Basel I: risk weights under Basel I were 0, 0.1 and 0.2 on OECD countries’ government debt depending on their
maturity; 0.5 on residential mortgage loans and 1 on all other loans and equity holdings. This first norm does not
take or suggest any risk mitigating technique (hedging, collateral,…) into account and therefore constructs a very
rough bucket, fostering risk-taking withing buckets. Basel I also does not consider more detailed information also
by bank about a single asset risk;
o Basel II: authorizes banks at using standardized or an internal rating-based approach to derive risk weights. The
standardized approach considers weighting buckets based on external rating (S&P, Moody’s,…):
- AAA to AA-: 0.2
- A+ to A- : 0.5
- BBB+ to BB-= 1.0
- Below BB-: 1.5
- Unrated: 1.0
Under the internal rating-based approach, internal ratings (IR) are used to derive weights but the system needs
approval by a regulator. Additional capital surcharges are normally required for operational and market risk;
o Basel III: aims at improving the banking sector’s ability to absorb shocks arising from financial and economic
stress, enhance risk management and governance, and strengthen bank’s transparency and disclosures. One of the
key components of Basel III was basically the introduction of more stringent capital requirements: the regulations
aim to ensure that banks hold enough high-quality capital to absorb losses during times of stress and, more
specifically, the following capital requirements were introduced:
1. Common Equity Tier 1 capital requirement was set to 4.5% of their risk weighted assets. This represents the
highest quality form of capital and includes equity instruments and retained earnings;
2. Tier 1 capital requirements: banks were required to maintain a minimum Tier 1 capital ratio of 6% of their
RWAs (this includes CET1 capital, as well as, other qualifying Tier 1 capital instruments such as non-
cumulative perpetual preferred stocks and other innovative capital instruments;
3. Capital conservation buffer: banks were also required to hold a capital conservation buffer of 2.5% of RWAs in
addition to the minimum capital requirements. This is designed to ensure than banks have a cushion of capital
during time of economic stress and prevents them from the event of operating at the margin (cumbersome
process for both regulators and banks);
4. Systemic buffer: was a capital requirement which went from 0-2.5% of RWAs and is considered part of CET1.
It is a variable capital requirement which depends on how systemic the bank is with respect of the economic
environment of the country they are operating in;
5. Countercyclical buffer: is a macro-prudential tool to address cyclical systemic risks in the banking sector. It is
basically designed to ensure that banks build up capital buffers during periods of economic growth, which can
be used to absorb losses during downturns. The CCyb is defined as CET1 capital and its volume varies from 0-
2.5% of RWAs. During periods of economic expansion, national regulators usually increase the required CCyB
 to ensure that the bank builds up the necessary capital buffer as to face potential future economic downturns
to support lending and economic activity.

o Post – Basel III era: after Basel III was published, the next important regulation amendment was represented by
Basel IV – a set of proposed reforms to the Basel III regulatory framework, which included changes to the
calculation of RWAs, the leverage ratio and the output floor. More specifically, output floor limits the extent to
which a bank’s capital requirement can be reduced using its own internal models to calculate risk-weighted assets.
As a matter of fact, research and data had proven that companies implementing the IRB approach did so in order
to basically lower their capital requirement. The output floor, then, ensures that a bank’s minimum capital
requirement is no lower than 72.5% of the RWAs as if the latter was calculated with the standardized approach. In
other words, even if firms decided to employ the IRB, they would still not be allowed to disclose a capital
requirement calculation lower that 72.5% of RWAs.
The minimum leverage ratio is a regulatory requirement that requires banks to maintain a minimum level of
capital relative to their total exposure. The leverage ratio is calculated as Tier 1 capital divided by total exposure.
Under the Basel III regulatory framework, the minimum leverage ratio requirement is 3%, meaning that banks
must maintain a Tier 1 capital level that is at least 3% of their total exposure. Exposure is in particular measured
on accounting assets with special treatment for derivatives and Securities Financing Transactions (SFT). In
addition to on-balance sheet assets, the exposure measure also includes off-balance sheet items. This mechanism
was designed to further reduce banks’ leeway in manipulating required capital and to mitigate procyclicality in
capital requirements.
Also liquidity requirements were modified in order to promote the resilience of the banking sector and reduce the
risk of liquidity mismatches. The two liquidity requirements introduced by Basel III are the Liquidity Coverage
Ratio (LRC) and the Net Stable Funding Ratio (NSFR). The Liquidity Coverage Ratio (LRC) is a short-term liquidity
requirement that aims to ensure that banks have sufficient high-quality liquid assets (HQLA) to cover their net
cash outflows over a 30-day stress period. The minimum LCR requirement is set at 100%, meaning that banks
must hold enough HQLA to cover their net cash outflows over the 30-day stress period. The Net Stable Funding
Ratio (NSFR) is a longer-term liquidity requirement that aims to ensure that banks have stable funding sources to
support their activities over a one-year period. The NASFR requires banks to maintain a minimum ratio of
available stable funding (ASF) to required stable funding (RSF). ASF represents a bank’s stable funding sources,
such as deposits and long-term debt, while RSF represents a bank’s funding needs over a one-year period.

Limitation of minimum capital requirements

o Minimum equity ratio must account for riskiness of bans’ assets to scale the buffer and incentive effect;
o Risk taking occurs because banks are opaque and risk-based fees guarantees cannot be charged;
o Adjusting capital ratio for risk is hard and almost impossible for regulators → it would require banks to self-assess
riskiness with IRB approach making use of banks’ private info and knowledge (idea of Basel II)
o But banks actually do have incentive to underestimate the riskiness of assets to reduce capital requirements →
Basel II tries to contain banks ability to game risk-weights and reduce capital buffers;
o Regulation is very complex with many (potentially conflicting) requirements.
TOPIC 4 – MARKET – BASED FINANCIAL INTERMEDIARIES
Economic Role of Investment Banks Investment Banks play a fundamental economic role by providing a huge variety of
financial services to corporations, governments and high net worth individuals. Their primary functions are the following:
o Underwriting, including verifying financial data and business claims, facilitating pricing of claims and performing
due diligence;
o Financial and economic research of companies, financial markets and the economy;
o Sales and trading securities, commodities and currencies: market making, placing new offerings and brokerage
services;
o Private placements of claims;
o Securitization and asset-based financing: creating ABS (asset-backed securities)
o Advising on corporate mergers and acquisitions;
o General corporate advisory services with respect to corporate reorganizations, joint ventures, spin-offs, tender
and exchange offers, LBOs and hostile takeovers;
o Wealth management: on behalf of institutional investors and for wealthy individuals.
The relative importance of each of these business lines can, of course, vary according to the bank’s size, strategy and
market conditions. Nonetheless, traditional businesses of IBs like underwriting and asset management have always been
the core of investment banks and have recently regained importance after the 2008 crisis. Trading and commissions have,
instead declined sparkly and revenues for capital market related businesses have generally grown faster than those for any
other sector. Capital intense businesses have consequently gained more and more importance for top tier investment
banks.
These top-tier institutions have, nonehtheless, been able to persist as leaders in the market and there has been witnessed
no significant market entry so far. We can therefore say that the IB industry has an oligopolistic market structure,
generated and fostered by reputational effects.
The common economic role of investment bank businesses, nonetheless, revolves around their ability to provide liquidity
to financial markets through securitization or other valuable instruments like Repos. More specifically, securitization of
investment banks is an alternative mean of risk transformation which allows idiosyncratic risk to be pooled. Tranching of
risks allows, indeed, to generate very safe assets based on this specific pool and these safe assets are presumed to be
information insensitive (meaning that they are not really sensitive to information asymmetries present on the market. they
are easy to value and are therefore widely used as collateral. Nonetheless, if junior tranches are not retained by issuers, this
might create moral hazard when acquiring the underlying assets.
But, how do banks typically refinance their increasing balance sheets? The funding of IBs initially was strongly contrasted
with the one usually implemented by commercial banks. As a matter of fact, they primarily refinanced through insured
deposits and predominantly invested in opaque loans. They hold them until maturity and deposit insurance becomes,
therefore, key in order to mitigate fragility in refinancing.

Because of the Glass- Steagall Act, investment banks were definitely separated from commercial banks through the so-
called Chinese Wall: as a consequence, IBs were forbidden to grant loans or take deposits and started holding huge
securities portfolios with no choice as to make use of them. IBs, nonetheless, resorted once repo financing was introduced:
this basically was a collateralization of short term wholesale refunding used as an alternative to mitigate market fragility.
IBs also used Repo funding to expand in commercial banking activities, since securitization allowed them to basically buy
and resell mortgages or consumer loans as if they were still acting on the commercial banking sector, as well. Nonetheless,
they still managed to respect the Chinese Wall division since securitization allowed them to step into commercial banking
but:
1. Without keeping parts of the assets on their balance sheets;
2. Using securitized portfolios as collateral for further repos. Using short term repos on large scale allowed them to
transform maturity and benefit from increasing their yield curve (top US banks were, indeed, reported to fund
more than 50% of their balance sheets with repos).
Underwriting of Initial Public Offerings (IPOs) An IPO basically describes the process for which the shares of an initially
privately held company are sold in the primary market to new investors (the public). The main concern when
underwriting such a transaction is how to price the transaction, since you can basically not rely on market data. As a
consequence, there are different allocation mechanisms which you can develop for defining share price: 1) fixed price; 2)
auction; 3) book-building. Research has noticed, nonetheless, that comparing price of the sale in the primary market (IPO)
with the trading price in the secondary market on the day after the IPO reveal severe under-pricing. This leaves a lot of
money left on the table (because basically the initial shares sold in a primary market were not sold at the right price and so
the firm raised less capital than they could have). This, of course, is not in line with the perfect capital market assumption
(which states that shares on the market are all rightly priced). Anticipating the under-pricing problem, owners could sell
their shares at a higher price, nonetheless several explanations based on informational asymmetries between different
market participants help understand IPO under-pricing (there might also be strategic reasons why to set a lower price
than the one we anticipate will be set on the market, like rewarding your faithful investors by offering them stocks at a
lower price,…):
1. Under-pricing as a signalling device: in the original market setup, firms are indistinguishable (they can equally be
good or bad). As a consequence, good firms want to signal that they are good and IPO under-pricing is one way to
do so. IPO under-pricing makes. Indeed, going public extremely unattractive for firms with low NPV project. As a
consequence, only high NPV firms raise capital through IPO for further investment, which implies that all those
firms which decide to IPO are indeed good firms. The first trading price of firms shares after severely under-priced
IPOs does reflect the firm quality and consequently good firms actually benefit by being revealed on the market
(also when financing future investments);
2. Compensating uninformed investors: under-pricing leaves some money on the table for investors ordering in the
IPO. Uninformed investors, nonetheless, - who do not know of the IPO under-pricing and do not know whether the
firm is good or bad- are afraid of the winner’s course (they are afraid that in the auction they end up paying more
than they would actually be willing to under normal circumstances). They will particularly obtain a large fraction
of shares if better informed investors do not participate in IPOs. Nonetheless, well informed investors do not
participate only if they perceived the firm as being bad and – at that point – uninformed investors run the risk of
obtaining big stakes only in bad firms. They might refrain then from participating in IPOs. Under-pricing, then,
provides incentives for uninformed investors to participate in IPO and under-pricing compensates uninformed
investors for uncertainty.
3. Compensate informed investors: by participating in an auction, informed investors drive up prices for good firms
and this is good for initial owners of good firms. Alternatively, informed investors could wait and speculate on
their information in the secondary market and IPO under-pricing compensates informed investors for the
revelation of private information in the IPO auction. In order to efficiently incentivize informed investors with
positive information, investors should obtain more under-priced stocks the more aggressively they bid.
Book – building allows investment banks to discretionally allocate more under-priced stocks to specific investors (maybe
you just would like to reward some good investors of yours by offering them even more under-prices stocks). The book-
building process in made up of six different phases:
o Pre-marketing phase: when the IBs compete for the IPO in a sort of beauty context. Sometimes, they even form
syndicates with a lead underwriter and specify the general conditions under which they will bring the firm to the
market (inclusive of the targeted price range). To assess whether an IPO will be successful, they acquire
information through independent research specialists;
o Marketing phase: you as an IB basically perform road-shows to direct institutional investors’ interest and a book
building spread for the IPO is released. Valuation information are very important in such a phase in order to
determine a price range for the stock which we are going to bring to the market;
 o Order taking period: investors’ orders are collected and the book building starts. Institutional investors, as a
consequence, submit a demand schedule revealing valuable information about the firm’s value allowing to
revaluate the price spread and finally fix the issuing price;
o Issuing price is fixed and allotment ratio determined (volume provided to individual investors). The lead
underwriter can discretionally allocate under-priced stocks to specific investors and, after IPO, stocks can be
traded ad typically underwriting investment banks are involved in the market making process. The IB’s discretion
in IPO allocation allows the firm to reward those investors that place aggressive bids and thus reveal useful
information to underwriter in book-building phase. It also allows to reward repeated participation in IPOs and
information revelation, also consenting to build relationships and reputation with informed institutional investors
for rewarding information revelation. Allowing IBs to discretionally allocate shares during an IPO also comes with
some drawbacks, nonetheless: the bank itself ca use discretion rather opportunistically. They allocate under-
priced shares to investors with the sole aim of obtaining additional mandated and can also allocate blocks to
facilitate subsequent take-
overs.

The Shadow Banking Sector Initially, the phrase “shadow banks” was coined in order to indicate those FIs involved in the
securitization process. Shadow banking, then, is basically referred to the intermediation of funding or credit out side the
traditional banking sector and thereby indicates all kinds of non-bank FIs. What makes FIs different from other banking
institutions is, then, the fact that the banks are allowed to be taken into account for deposit insurance and are allowed to
recur to the LOLR. All in all, then, shadow banks perform similar tasks as regular banks but without having access to LORL
and bail-outs. According to ESA, the shadow banking sector involves all the following institutions: non-MMF investment
funds, OFIs excluding funds, other FIs like FVC, security and derivative dealers, financial corporations engaged in lending
and specialized financial corporations, financial auxiliaries, captive financial institutions and money lenders, insurance
corporations, pension funds,…
The main drivers of the shadow banking sector were and have been the following:
o Financial innovation: securitization allows SBs to invest in a large menu of fixed income assets (makes it easier for
a broad range of investors to take part in the market)
o Regulatory arbitrage: as banks are more regulated, they represent an alternative sources of funding, often also
cheaper than the banks;
o Credit crunch: due to deleveraging after GCF, bank loan supply is restricted;
o Low interest rate environment: since deposits reveal unattractive, investments in diversified stocks or bond
portfolios through shadow banks like investment sides were becoming more attractive.
Even after crises, the shadow banking sector, then continued to grow in terms of the amount of assets under management
and revealed particularly relevant to the GDP growth of single realities. The MFIs assets stagnated a bit after the 2008
crisis, whereas OFIs and other shadow banking institutions like ICPF continued to grow. OFIs assets under management,
nonetheless, also revealed to be very volatile and pro-cyclical partly because of the valuation effects of tradable assets and
partly because purchases are pro-cyclical. Looking at the graph, indeed, we see a clear cyclicality in the peaks of the
shadow banking sector with the business cycle. Overall, nonetheless, we also witness a recovery of net purchases after the
crisis which happened
faster for OFIs than
for the banking
sector in general.
Reasons for procyclicality of fund flows

1. Net flows in & out of mutual funds are performance sensitive: when stock (and bond) prices are declining, Ifs
performance deteriorates and investors are consequently induced to withdraw. Large scale withdrawals can lead
to further price declines;
2. Stock and bond prices decline and deteriorating market liquidity can even cause panic given withdrawals: mutual
fund investors fear other mutual fund investors withdraw forcing funds to sell at fire sales prices. Losses are born
by remaining investors and investors are better off when managing to withdraw before others. Mutual funds,
nonetheless, have a particularly convex performance sensitivity if they are invested in comparably illiquid stocks.

Shadow banking also represent an external funding source for non-financial

firms. During the financial crises, bank’s credit supply often impaired and
banks started suffering loan losses facing the need to recapitalized before they
could provide new credit. At that point, the access to market-based financing
became important for non-financial firms and shadow banks began being
defined as “spare -tires” meaning they were useful for supplying credit when
banks weren’t able to. The expression and its related theory were specifically
coined during the Japan’s recession in 1999. Indeed, before the crisis, MFI
loans represented 50% of NFC external funding and – after the crisis- no
significant contribution was related to those banks anymore. Nonetheless,
empirical evidence contradicts this fundamental hypothesis: market based
funding, indeed, (the one performed by shadow banks) are also procyclical in
the sense that shadow banks do not really act as a substitute of external
funding in crises times. When banks are not able to supply credit anymore,
also non-bank FIs appear to face some fundamental difficulties.
Financial Vehicle Corporations lost in importance during the financial crisis
and non-MMF Investment Funds started to represent in that time the main
driver of the growth of shadow banking since then. The basically became the
main providers of the market-based finance. Non-MMF Ifs assets under
management grew exponentially by a factor of 2.5 after the crisis hit and the
reasons mainly were represented by the low interest rates, the more risk-
taking by investors and the demographic change. These funds are largely
invested in debt and equity securities and are partially driven by valuation
gains. These type of shadow bank institutions hold mainly EA government and
bank bonds, as well as, NFC equity. They hold 13% of EA NFCs’ debt securities
issued and only 9% of EA MFIs debt securities issued. They also hold 9% of
listed NFCs’ and banks equity in EA, but predominantly they hold non-EA
assets, thereby allowing investors to diversify internationally.
Nonetheless, a remarkable cyclicality can be sported in net-purchases of EA
during the sovereign debt crisis. This is clear evidence of shadow banks not
acting as a “spare tire” at all, since they also seem quite inactive once the crisis
hit. Nonetheless, non-MMF Ifs reduced exposure to MFIs since the sovereign
debt crisis and non-EA purchases in debt and equity are, therefore now
dominating. There are different investment funds in the European Area:
o Fixed income funds: are more important than equity and mixed funds.
They are nonetheless limited in their role for risk transformation.
o Money market funds only recently regained importance;
o Other funds are still of minor relevance and only a few hedge funds
domiciled in the Euro Area
The main functions absolved by investment funds are the following:
o Maturity transformation: bond funds have the largest fraction of long-
term assets in terms of initial (and not remaining) maturity. Funds
typically engage in maturity transformation as assets are long-term
mainly whereas shares are redeemable on a daily basis;
o Liquidity transformation: 98% of investment funds are open-end,
meaning they can indeed be redeemed on a daily basis. They hold a
 large portion of marketable assets but are still faily liquid (they have high trading costs). Similar to banks they
provide liquidity insurance but are also exposed to runs risk, particularly open-end real estate funds and bond
funds;
o Leverage: even through liquidity transformation stable at open-end funds, leverage declined substantially. Asset
liquidity dropped and security holdings consequently declined. Hedge funds increased leverage substantially,
instead, causing an increase in fragility and spill overs.
o Credit Intermediation: is very high at MMFs and bond funds, whereas it has only recently increased at hedge funds.
Overall there was a modest decline.

The relevance of Insurance Companies and Pension funds Ever since the beginnings of the shadow banking sector, there
was a concrete increase in the assets under management both at insurance corporations and investment funds. These two
types of non-bank FIs were mainly involved in debt securities as equities, with cash playing a fundamental role due to their
necessity to provide liquidity to clients at any time. Also shares in their portfolios and net purchases remained fairly high.
Differently from what is usually thought, these kinds of shadow banks are also massively investing in rather risky
securities and assets.

Interconnection between banking and shadow banking sector MFIs still represent the main debt financiers of NFCs and
HHs, which hold the vast majority of their fixed-income claims with banks. OFIs instead, provide sizeable credit to NFCs
and also to the rest of the world, representing an important driver of financial globalization. This implies than banks and
the shadow banking sector are actually interconnected in all means of the local economy and they are kind of the driver of
financial globalization. They are both domestically and internationally interlinked with the economy and the other FIs
present in the international and local environment.
In addition to this, another source of interconnection between OFIs and MFIs can be seen in the cross holdings of cash
between the two sectors (the direct loan contract given out by shadow bank sector to the banking sector). The loan
exposure of the banking sector to shadow banking sector is, nonetheless, limited compared to the interbank tower,
whereas loan exposure of OFIs to MFIs is sizeable.
Taken together with credit exposure through debt claims issued by OFIs, banks in Euro Area have also sizeable exposure to
OFIs, roughly amounting to 25% of the EA interbank credit exposure. Banks are, indeed, tendentially providing shadow
banks with different sources of funds: not classical loans but rather debt securities. Overall, aggregate cross-sectoral stock
holdings appear limited and only IFS hold listed bank and OFI stocks.

Conclusion

o the shadow banking system is gaining importance;

o some OFIs such as open-end Ifs are exposed to excessive outflow of risk (similar to bank runs)
o interconnectedness between the banking sector and shadow banks is present along many dimensions;
o crises in the shadow banking sector are likely to have substantial repercussions in the banking sector;
o there is a need to understand these interconnectedness better and a need to regulate the shadow banking sector;
o at least, regulation should be imposed in order to prevent the vulnerability of the banking sector to shadow banks.

FinTech(s) There is no internationally agreed definition for FinTechs. BIS define their credit as “facilitated by electronic
(online) platforms” and not operated by commercial banks. Typical example of FinTechs are peer-to-peer lending or
crowdfunding platforms, but also other things such as crypto wallets, PayPal, Apple Pay,…
They provide a number of benefits, among which we also have:
o faster processing of loan applications (standardization of processes)
o better risk assessment
o better access to finance for regions with bad infrastructure
o more cost-efficient way of providing credit as little operational costs.
They also present some downsides: the automized decision-making can lead to mistakes with ML models sometimes
featuring biases. As a consequence, taking financial decisions might even become too casual and FinTechs often end up
lacking experience or a good funding base.
They are also not homogeneously regulated, with a lot of discrepancy among countries and regions. Normally, the principle
of neutrality should dominate: since banks and FinTechs basically absolve the same role in the economy, they should be
dealt with in the same way as it is dealt with banks. Differences should be applied only in the case for which there is an
additional risk incurred by the client when dealing with FinTech products.

Green Finance The definition of green finance is often based on ESG metrics and there is mostly no separation to the
concept of sustainability. If a company gets certified by a rating provider or a governmental agency, its securities (equities,
bonds, etc) are deemed as “green” financial products. There is nonetheless a wide array of definitions that vary between
countries, sectors and company history and green investing itself is very heterogeneous: green bonds vs. sustainability
linked debt vs. ESG rated equity,…
Climate finance is nonetheless becoming more and more relevant, with its importance generally being acknowledged and
valued by investors. Many firms are now realizing their exposure to climate risk and the latter appears to be clearly priced
by markets. Ratings are, nonetheless, not very reliable. The EU taxonomy was exactly introduced as to create an
harmonized framework of what is “green” in order to avoid greenwashing. It represents a classification scheme provided
under the Climate Delegated Act for Climate Change mitigation and adaptation and specified disclosure requirements for
companies and banks, as well. It imposes specific requirements of disclosure for both companies and banks and appears to
have unclear effects on bank lending (more regulation) and firm behaviour (minimum efforts).
Amongst all the products offered by the branch of green finance, the most widely known are green bonds. They are fixed
income debt for project-specific financing of green activities. They can be issued by corporations or the government and
have been shown to be a successful signalling tool on the market.