Microeconomics of Banking

Abdullah Al Mahmud, PhD

Professor

Course code: B-101

 Relationship banking
• Relationship banking can help to minimise the principal-agent,
adverse selection and moral hazard problem arising b/w a bank
and borrowers and bank and depositors.
• Under relational banking lenders and borrowers have a relational
contract
– Bank and borrower and bank and depositors will try to give
full information to each others (better flows of information).
– Further an understanding b/w both parties that in future
there may be need of some monitoring
 Relationship banking (cont.)
• Example
– A good example in this regard is bringing of new product in
the market. If an investor goes to bank for loan, the bank will
see her/his record, no financial difficulty, no default, loan
granted and a clause may be introduced for monitoring or
altering the clauses of contract.
• Relationship banking is very common in Japan and Germany
• However, some time relationship banking may go wrong.
– Example: Jurgen Schneider/Duetche Bank
 Arms’ length banking
• An extreme opposite is an arms’ length transactional or classical
contract where many banks compete for the costumers business
and customers shop around several banks.
– Both parties will try to disclose bear minimum information
and stick to the contract clauses.
• UK and USA banking system is working under this system
 Risk in Banking
• Banks are useless in a world without market frictions, or, banking
is a field in economics with market frictions;
• Financial intermediation exists to reduce frictions, such as
transaction cost , liquidity risk , asymmetric information, etc., and
improve social welfare;
• However, the structure of intermediation is intrinsically fragile:
needs institutional designs to stabilize it;
• On the other hand, such shaky structure may be necessary to
descipline the banks’ behavior.
 Risk in Banking (cont.)

• All profit maximising firms face two types of risks:

– Microeconomic risk (new competitive threat); Macroeconomic risk
(the effect of recession)
• Additional potential risks include:
– Breakdown in technology;
– Commercial failure of a supplier or customer;
– Political interference; National disaster
• Banker on the other side face some additional risks
• Bankers job is to manage these risks. Risk management is the
primary responsibility of bank management.
• Some risk are easy to think, calculate and manage, but some are
difficult to even calculate.
• Additionally, banks manage the risk arising from on and off-
balance sheet business.
 Risk in Banking (Cont.)
Types of risk a modern day bank face
– Credit
– Liquidity and funding
– Settlement and payment
– Interest rate
– Foreign exchange
– Gearing or leverage
– Market or price
 Definition of risks a bank face
Credit risk
– probability of default on a loan agreement.
• risk that an asset or a loan will become irrecoverable due to
outright default.
Liquidity and funding risk
– Liquidity risk
• of insufficient liquidity for normal operating requirements
– financing wage bills etc.
• the ability of the bank to meet its liabilities when they fall
due. It simply means shortage of liquid assets
– Funding risk
• bank is unable to finance its day-to-day operations
smoothly. This is called maturity mismatching
 Definition of risks a bank face

Interest rate risk

– Interest rate risk arises from interest rate mismatches in both
the value and maturity of interest sensitive assets, liabilities
and off-balance sheet items.
• Asset-Liability Management (ALM) manages interest rate
risk.
– If banks have excess fixed rate assets they are
vulnerable to rising interest rate and
– if excess fixed rate liabilities they are vulnerable to
falling rates.
» Typically banks are asset sensitive meaning a fall
in interest rates will reduce net interest income by
increasing the banks’ cost of funds relative to its
yield on assets.
 Definition of risks a bank face

Market or Price risk

– Banks face market (or price) risk on instruments traded in well-
defined markets.
– equities, bonds holding by bank (price incr./decr.)
• Two types- general (systematic) and specific (unsystematic)
• A bank can be exposed to market risk (general and specific)
in relation to debt and service
– fixed and floating rate debt instruments such as:
» bonds, debt derivatives, futures and options on
debt instruments, interest rate and cross country
swaps and forward foreign exchange positions,
equities and equity derivatives (equity swaps),
futures and options on equity indices, options and
futures warrants.
 Definition of risks a bank face

Foreign exchange or currency risk

• Under flexible exchange rates a bank with global operation face
such type of risk and it
– arises usually due to adverse exchange rate fluctuation which
effects the bank foreign exchange position taken on its own
account or on the behalf of its customers.
– Banks engage in spot, forward, and swap dealing faces this
risk. Banks have large positions, which changes dramatically
within minutes.
Gearing or leverage risk
– Banks are highly geared (leveraged) than other businesses.
• Suppose banks confirm to a risk asset ratio of 8%.
– An 8% capital ratio translates into a 1150% ratio of “debt”
(liabilities) to equity in contrast to 60-70% debt-equity ratio
for commercial firms.
 Management of Risk in Banking

• Approaches to the management of risks

– Credit risk
• Credit risk analysis/credit evaluation
– Interest rate risk (through assets liability management (ALM))
• Gap analysis
• Duration analysis
• Duration gap analysis
– Liquidity and funding
• Gap analysis
– Foreign exchange
• Hedging
– Market or price
• VaR and Stress Testing
– Asset securitisation and derivatives
 Credit Risk Management
• Credit risk techniques are probably among the best –developed tools
available to bankers and they have long experience of assessing and
managing this risk. Essentially, following are the widely used
techniques to manage credit risk.
– Screening
– Monitoring
– Long-term customer relationships
– Loan commitments
– Collateral
– Compensating balances
• The credit risk analysis departments usually use two types of methods.
– Qualitative & Quantitative
 Liquidity risk management

– Triggered when majority of the customers are interested to

get their money back due to bad management or perception
of bank failure
– All the times the bank must be able to meet the cash flow
obligation arising from deposit withdrawals (normal case as
well as in stress)
– The best way to deal with this type of risk in modern
banking is to use the gap analysis.
 Market Risk Management
• Banks participate in buying and selling of financial
instruments in various and diverse markets around the globe.
Adverse changes in the price of these instruments can expose
the banks significantly and effect the value of their portfolio.
This is called market risk.
• Two widely methods to calculate the exposure of market risk
are:
– Value at Risk (VaR): calculates market risk faced by a bank
in everyday normal market condition.
– Stress testing: calculates market risk in abnormal market
condition.
Securitized Banking

Abdullah Al Mahmud PhD

Associate Professor

Course code: B-101

 Securitization
• Modern banking, heavily relying on securitization,
– Allowing borrowing / lending between large financial
institutions, reducing transaction cost ;
– Better risk sharing, allowing better and wider access to financial
market (at the cost of more fragility);
In this chapter we will see
– How securitization works in a simple example as well as in
reality;
– How modern banking system is organized based on
securitization: repo market and shadow banking.
 Securitization
An example of how securitization improves investors’access to
financial market
Asset A needs 400 initial investment, asset B needs 250, and asset
C needs 300. Payoffs in different states:
Asset A Asset B Asset C Sum

State 1 1000 800 0 1800

State 2 800 200 400 1400
State 3 200 200 600 1000
State 4 0 0 400 400

Mean 500 300 350 1150

Investor 1 has 400, needs to get a safe, risk-free payoff; investor 2

has 200, no specific preference over the states; and investor 3 has
350, needs at least 100 in state 1.
 Securitization
Consider a pure matching market where there is no
intermediary. Investors and entrepreneurs try to match
each other:
• Investor 1 cannot invest because all assets are risky;
• Investor 2 cannot invest because no project needs as
less as 200;
• Investor 3 can invest on asset B. She cannot invest on
asset A because A needs 400, neither on asset C
because of her special preference;
Only asset B can be financed.
 Securitization
Consider there is a bank who can pool the investors’funds and
try to finance as many projects as possible:
• Given the investors’equal seniority over claiming the bank’s
debts, it is impossible for all the three projects to get
financed;
• If all the projects are financed, the bank can only pay a
proportion of the payoff in state 4 (400) to investor 1 so
that the maximum payoff of investor 1 in this state is
below 400. This contradicts with investor 1’s preference;
It’s only possible to finance B+ C, or A only.
 Securitization
One of the most important type of securitization is mortgage
financing, which takes its first step through m ortgage backed
securities (M BS)
 Securitization
First, mortgage loan originator (e.g. banks or other lending
institutions) pool many mortgage loans and sell them to a
special purpose vehicle (SP V), which is
• Usually subsidiary of a big financial institution (“sponsor ”),
and Bankruptcy remote from parent company such that the
parent cannot claw back the loans when it gets
bankrupted;
Then SPV finances the purchase via issuing investment-grade
securities (MBS) with different seniorities (“tranches”)
• When assets return, securities with highest seniority get
repaid first;
• When there’s loss in assets, securities with lowest
seniority bear the loss first.
 Securitization
With securitization widely at work, traditional banking has nowadays
evolved to securitized banking
 Securitization
Securitization is the engine of modern banking, playing a
central role
• Through originate-to-distribute, banks don’t hold loans in
balance sheets any more (“off-balance-sheet ”) — less cushion
(reserves, capital...) needed to meet regulation;
• Banks purchase MBS/C DOs with high ratings,
(seemingly) reducing risks on balance sheets;
Most prominent difference from traditional banking
• Borrowers / lenders are now big institutions, reducing
transaction costs;
• High quality assets are used as collateral in funding
through repurchase agreement (repo).
Securitization
Securitization
Traditional vs Securitized Banking