Banking & Regulation

Econ 455/555 & MFIN455/55

Prof. Tanju Yorulmazer

Lecture: Financial Intermediaries & Risks

Financial intermediaries
Questions
• What do financial intermediaries do?
– Intermediate between providers and users of financial capital

• What are the risks they get exposed to?

– Credit risk
– Liquidity risk
– Interest rate risk

• How do they manage these risks?

– Credit analysis
– Risk management: Value at Risk, Expected Shortfall, Liquidity
management…
Financial Intermediary
• An economic agent who specializes in intermediating
between providers and users of financial capital.

• One type of FI is a Commercial Bank (CB). CB granting loans

and receiving deposits from the public:

– The combination of lending and borrowing is typical of a CB

– CBs provide unique services to the general public:

– Channel funds from savers to investors
– Liabilities act as money, payment and liquidity services
Types of FI
• FIs are divided into two groups broadly:

– Deposit taking institutions: Commercial Banks

– Non-depository institutions:
– Venture Capitalists, Insurance Companies, Investment Funds, Pension
and Mutual Funds, Hedge Funds, Investment Banks

• In contrast with non-financial firms

– FIs hold relatively large quantities of financial claims (contracts of the

indebtedness of their clients) as assets
– FIs tend to be more leveraged
Types of bank assets

Bank Assets

Loans Securities Cash

Commercial Consumer
& Industrial
Bank assets
• Commercial and Industrial loans (C&I)
– Transaction, working capital, term loans…

• Consumer loans
– Direct loans, credit cards, mortgages

• Securities
– Commercial paper, government securities...

• Cash and reserves

Lending
• How do banks acquire loans?

• Spot market
• Originate and keep them on their own books
• Purchase loans originated by other intermediaries

• Forward market
• Loan commitment: Promise to lend in the future
Risks Financial Intermediaries Face
Financial Intermediation
• The balance sheet of a financial intermediary:

Assets Liabilities
Liquid/safe assets Short-term debt
Illiquid/risky assets Long-term debt
Equity

• Banks hold risky/illiquid assets.

• Credit risk: Banks can experience losses from the risky assets.
• Capital acts as a buffer and can help prevent costly failures.
Financial Intermediation
• The balance sheet of a financial intermediary:
Assets Liabilities
Liquid/safe assets Short-term debt
Illiquid/risky assets Long-term debt
Equity

• Banks hold risky/illiquid assets typically with long maturities.

• Liabilities (short-term debt or deposits) usually have short
maturity (maturity/liquidity mismatch).
• Liquidity risk: When debt holders want to withdraw (or not
rollover) bank needs to come up with cash. Costly liquidation.
• Can lead to the failure of the bank.
Financial Intermediation
• The balance sheet of a financial intermediary:
Assets Liabilities
Liquid/safe assets Short-term debt
Illiquid/risky assets Long-term debt
Equity

• Banks hold assets typically with long maturities.

• Liabilities (short-term debt or deposits) usually have short
maturity (maturity mismatch).
• Interest rate risk: When interest rates change, it can expose the
bank to interest rate risk.
Risks
• Credit Risk
• Risk management: Credit analysis, Value-at-Risk (VaR) models
• Capital regulation: Basel capital requirements

• Liquidity Risk
• Liquidity management
• Liquidity regulation: Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR)

• Interest Rate Risk

A Simple Framework
• Eisenbach, Keister, McAndrews and Yorulmazer (2014)

Assets Liabilities
Liquid/safe assets (m) Short-term debt (s)
Illiquid/risky assets (y) Long-term debt (l)
Equity (e)

• Builds on the framework of Diamond & Dybvig (1983) (we will talk
in detail)

• Credit risk, solvency risk, illiquidity risk.

A Simple Framework: Assets
• Three dates t=0,1,2.
• Assets:
• Bank holds cash (m) and risky assets (y).

• Risky assets have a random return of θ at t=2.

• θ realized at t=1.
• If liquidated at t=1, risky asset pays τθ < 1.

• Bank holds cash m.

• Cash has a gross return r1=1 (for simplicty) between t=0 and t=1.
• Cash has a gross return rs between t=1 and t=2.
A Simple Framework: Liabilities
• Three dates t=0,1,2.
• Liabilities:
• Bank has short-term debt (s), long-term debt (l) and equity (e).

• Long-term debt matures at t=2 and promises rl.

• Short-term debt has the same promised return as cash (for

simplicity).
• Promises r1=1 between t=0 and t=1 and rs between t=1 and t=2.
• Matures at t=1 and needs to be rolled over after observing θ.
A Simple Framework: Solvency
• Solvency:
• If the bank can meet its debt obligations any remaining funds at
t=2 are paid out to equity holders.

• If the bank cannot meet its obligations, it enters bankruptcy.

– A fraction φ of assets is lost to bankruptcy costs (lawyer fees).

– Remaining assets distributed to debtholders on a pro-rata basis.

– Bankruptcy costs are high so that a short-term debt holder will rollover if
and only if the bank is solvent (very important!!!).
A Simple Framework: Returns
• Assume: rs < rl < 1/τ.

• Long-term debt has a higher promised return than short-term debt.

• Liquidating the risky asset is very costly.

• Neither form of finance dominates the other.

• Assume: τθ < 1.

• Risky asset does not dominate cash in terms of returns.

A Simple Framework: Solvency
• Solvency:

• The bank is solvent if it can meet all its contractual obligations in both
periods.

• A fraction α of short-term creditors do not rollover.

• Solvency depends on:

• Return from assets θ (credit risk)

• Fraction α of short-term creditors that do not rollover (liquidity risk).

A Simple Framework
• A fraction α of short-term creditors do not rollover.

• Bank needs αs units of cash to pay short-term creditors at t=1.

• Use cash first (αs<m), liquidate the risky asset only when cash is not enough
(αs>m).

• Liquidating the risky asset decreases bank value and can force the bank into
insolvency.
A Simple Framework: Value at t=2
• For αs ≤ m, the bank uses cash for payments at t=1.

• The value of the assets at t=2 is given as:

θy + rs (m − αs )

• For αs > m, the bank needs to liquidate some of the risky asset:
αs − m
τθ

• The value of the assets at t=2 is given as:

 αs − m 
θ y − 
 τθ 
Solvency at t=1 and t=2
• Note that if the value of the assets at t=2 is negative, the bank is already
insolvent at t=1.

• In this case, the debt holders who withdraw at t=1 receive a pro-rata share
share of the liquidation value in expectation.

• Debt holders who do not withdraw receive nothing.

• If the value of the assets at t=2 is positive, debt holders who withdraw at
t=1 receive full payment.

• In that case, the bank is solvent at t=2 if the value of the assets at t=2 is
enough to pay the remaining debt.
A Simple Framework: Solvency at t=2
• For αs ≤ m, the bank is solvent at t=2 if:

θy + rs (m − αs ) ≥ (1 − α )srs + lrl

srs + lrl − mrs

θ≥ =θ
y

• Solvency threshold is independent of α.

A Simple Framework: Solvency at t=2
• For αs > m, the bank is solvent at t=2 if:

 αs − m 
θ y −  ≥ (1 − α )srs + lrl
 τθ 

srs + lrl + [1 τ − rs ]αs − (1 τ )m

θ (α ) ≥ = θ * (α )
y

• Note that the solvency threshold θ* is increasing in α. Why?

A Simple Framework: Solvency at t=2
• For α=1, we obtain:

s + τlrl − m
θ (1) = =θ
τy

• For θ ≥ θ the bank is always solvent (independent of α).

A Simple Framework: Solvency at t=2
• For θ ≥ θ the bank is fundamentally solvent (independent of α).

• For θ ≤ θ the bank is fundamentally insolvent (independent of α).

• For θ ≤ θ < θ solvency depends on α:

• For θ (α ) ≥ θ (α ) the bank is conditionally solvent.

*

• For θ (α ) < θ * (α ) the bank is conditionally insolvent.

A Simple Framework
• Insolvency, illiquidity

θ
Fundamentally
solvent
𝜃̅

𝜃∗
Conditionally
solvent
Conditionally
insolvent

Fundamentally insolvent

𝑚
1 α
𝑠
Determinants of stability
• Leverage/capital (e).

• Liquidation value (τ).

• Maturity structure of debt (s versus l).

• Liquidity holdings (m).

A Simple Framework
• Liquidation values (effect of τ)

𝜃̅

𝜃 ∗ (𝛼|𝜏low )
𝜃̅(𝜏)

𝜃 ∗ (𝛼|𝜏)

𝜃
𝜃 ∗ (𝛼|𝜏max )

𝑚
1 α
𝑠
A Simple Framework
• Effect of leverage

𝜃̅

𝜃 Lower leverage

𝑚
1 α
𝑠
A Simple Framework
• Insolvency, illiquidity

θ
Fundamentally
solvent
𝜃̅

𝜃∗
Conditionally
solvent
Conditionally
insolvent

Fundamentally insolvent

𝑚
1 α
𝑠
Going forward
• Risk management (θ).

• Liquidity management (m,s,τ,α).

• Regulation:
• Capital (e)
• Liquidity (m,s,τ)