2.7. Delegated monitoring (2) – banks’ vulnerability to runs

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

ALLEVIATION OF MORAL HAZARD – DEBT AND EQUITY CONTRACTS. BANKS (1) – DIVERSIFICATION AND MONITORING

In Week 2 we will consider certain ways of overcoming problems caused by private information and evaluate them. We will know why some methods work while others don’t, and why. You will learn the core differences between equity and debt financing, study debts contracts with liquidation and see the core inefficiency of that kind of a debt contract. Based on a simple model you will study diversification and delegated monitoring and see how they contribute to the efficiency of lending. We will find out how a bank emerges as a key financial intermediary responsible for asset monitoring. You will be able to see why the bank can make money and to calculate its profit in different cases. At the end of Week 2 we will pose a fundamental question: How does the bank attract depositors?

2.1. Infeasibility of equity financing in the presence of unobservability7:11

2.2. Debt contract with liquidation (DCL) as a means of alleviation of moral hazard. The inefficiency of DCL6:41

2.3. Monitoring as a universal and efficient way of overcoming unobservability5:20

2.4. Multiple lenders (1) – the model8:19

2.5. Multiple lenders (2) – bank contracts5:15

2.6. Delegated monitoring (1) – the interaction of the parties and bank’s profit12:09

2.7. Delegated monitoring (2) – banks’ vulnerability to runs5:21

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now we are arriving at the end of the second week, and in this final episode,

I will briefly wrap up what we just did and what we did throughout this week.

We started out, we've saying that in the presence of unobservability,

there are significant limitations to the ways

that financing of even nice projects phases.

And we said that unfortunately, given this equity financing,

it's not feasible at all.

We invented, let's say, or

put forward a solution in the form of debt contract liquidation.

So we can say like this, equity,

No, so from here, we went to a debt contract liquidation.

We said great, but inefficient.

And from here, well actually from here too, we arrived at monitoring.

And we said that monitoring is great to the extent you have few big investors.

And the reality of the market is such that instead we have

a huge crowd of small investors.

And we said that for this crowd, we have to engage in delegated monitoring.

And that brings us to the existence of an intermediary.

And this intermediary we call the bank, and the bank does diversification,

And delegated monitoring.

And as a result, makes money.

That's what we did.

We did that on the example of two independent projects.

But clearly, if a bank has more, then, well, this matrix, if you have three,

it becomes three dimensional, but then it becomes an n-dimensional matrix that

is really difficult to imagine, but can be easily done with the use of proper math.

But the important thing is that the more projects the bank has,

and the more diversified they are,

then the probability of poor outcomes of the group of these projects goes down.

And the bank can deliver on its obligations to its depositors with

a higher probability.

Now at the same time, we said that depositors are willing

to deposit the money with the bank only if it pays back to them

some interest that at least compensates them for

these poor boxes in which depositors cannot recover all their money.

And then we went ahead and said that we set up a scheme, and in the scheme,

everything was great, but the fact that neither the borrowers nor

the depositors got any kind of a carrot, if you will.

And we said that the poor thing is, that although the bank that does monitoring and

ensures the efficiency of this kind of operations and

plays a pivotal role in capital markets.

The problem is that the bank is vulnerable, and

if you changed the terms of this contract just a little bit,

then you can immediately see the situation which the bank fails.

So the bank cannot easily share money with both end parties of these contracts.

It cannot reduce the face value it charges to the borrowers.

Or it cannot erase the interest rate it offers to its depositors.

And the key story happens on this part between the bank and

the depositors because depositors cannot monitor and

this is debt contract liquidation, so we have to be careful about that.

But you have to offer something, and

this something, roughly speaking, is called liquidity.

That's what the bank produces, and

the second fundamental function of a bank is creation of liquidity.

Well, this seems to be an enigmatic statement so far.

And we will devote our third week

to the analysis of this liquidity creation, what exactly the bank does,

what problems we see on this path, and how these problems have to be dealt with.

So from now on we will, in the beginning of the third week,

we will say that the bank will offer to its depositors some kind of a special

carrot that will indeed engage them in depositing the money with the bank.

So here I will take an interim stop, and

I wish you good luck with your assignments, and I see you in week three.

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