20240226_125.364 Week 01

Welcome to 125.
364
Bank Financial
Management
SCHOOL OF ECONOMICS & FINANCE
What is this course about?

 An application of finance and economic theory to the
financial management and operation of banks in
New Zealand and internationally, from a risk and
regulation perspective. Attention is also given to the
fragility of modern banking and its impact on
systemic risk..
1.2
Overview of the topics covered
1.3
Learning Outcomes (I)

1. Discuss how modern banks, through their roles in the
provision of the payment system and as financial
intermediaries, contribute to economic development.
2. Apply selected principles and concepts of modern finance

and economic theory to the practice of banking regulation.
3. Identify the main risks faced by banks’ financial managers

and discuss how they are reflected on their balance sheet
and income statements.
1.4
Learning Outcomes (II)

4. Evaluate the effectiveness of a range of
techniques used to measure and manage banks’
risk.
5. Discuss financial stability issues related to
the banking industry, particularly in relation to
banking crises and systemic risk.
1.5
Formal requirements to pass this course

 To achieve a pass in the course, a student must
normally achieve as a minimum total on all
assessments (being the sum of marks on the test
and assignment) of 50 out of 100. There is no
minimum mark required for the test,
assignment, and the final exam.
1.6
The Assessment 1 - Albany Internal
Worth
Maximum of 20% of final mark
The Assessment 2
The Assessment 3
Required textbook
 The required textbook for 125.364 Bank Finance
Management is:
Saunders, A., Cornett, M. M., & Erhemjamts, O. (2024).

Financial Institutions Management: A Risk Management
Approach (11th ed.). New York: McGraw-Hill.
 You may also purchase an electronic copy of the textbook

from the publisher link as:
https://www.mheducation.com/highered/product/financial-insti
tutions-management-risk-management-approach-saunders-cor
nett/M9781264413041.html
1.10
Internal timetable
 A three-hour lecture + one-hour workshop
Day Time Room
Tuesday (Lecture) 2.00 pm to 4.00 pm SNW300

10.00 am to 11.00
Friday (Workshop) QB6
am
1.12
Communicating with each other (I)

Important Notice: This is a one-way forum from
me to you. Look here for important updates about this
course. Note that these announcements will
automatically be sent to your registered email address.
If you see an email with 125.364 in the subject line,
PLEASE READ IT - it will be important!
 Student Discussion Forum: A forum for making

contact and forming student groups with students in
your region.
1.13
Topic 1
Economic Role and Uniqueness of
Financial Intermediaries
Mishkin Ch08
Textbook Ch01
Financial Structure
• Direct finance / financial market
– Borrowers borrow funds directly from lenders by selling them
financial instruments (securities).
• Indirect finance (intermediation) / financial intermediaries

– A financial intermediary stands between the lender-savers and the
borrower-spenders.
Cycle of money
Basic Facts about Financial Structure

1. Stocks are not the most
important source of external
financing for business.
2. Issuing marketable debt and
equity securities is not the
primary way in which
businesses finance their
operations.
3. Indirect finance is many times
more important than direct
finance.
 Insurance companies, Pension funds,
and Mutual Funds
Basic Facts about Financial Structure

4. Financial intermediaries,
particularly banks, are the
most important source of
external funds used to finance
businesses.
 56% in the U.S. and more
than 70% in German, Japan,
and Canada
Regulators
Basic Facts about Financial Structure (cont.)
5. The financialBanks/system is among the most heavily regulated

Financial
sectors of the economy.
intermediation
Depositors Shareholders
Basic Facts about Financial Structure (cont.)
6. Only large, well established corporations have easy access to

securities markets to finance their activities.
7. Collateral is a prevalent feature of debt contracts for both

households and businesses.
 Secured/unsecured debt
8. Debt contracts typically are extremely complicated legal

documents that place substantial restrictions on the behaviour of
the borrower.
 Implication: There are varying degrees of information asymmetry across
the financial system
Two Factors which…

... could make financial market dysfunctional;
… explain the above 8 basic facts;
… explain why financial intermediaries are important.
• Transaction costs
• Asymmetric information
Let’s look at them in turns.

Transaction Costs
• The time and money spent in carry out financial transactions.
• It limits the investment selection as well as diversification.
• Tools to solve this problem: financial intermediaries, e.g.
mutual funds
– Economies of scales: the reduction in transaction costs per dollar
of transactions as the size of transactions increases.
– Expertise in technology.
To achieve the advantage
– It can also provide liquidity services. of diversification
Mutual funds: FI that sells shares to individuals and then invest the proceeds in
bonds or stocks.
Asymmetric Information
• Asymmetric information is a situation that arises when
one party’s insufficient knowledge about the other party
involved in a transaction makes it impossible to make
accurate decision when conducting the transaction.
• The unequal knowledge that each party to a transaction

has about the other party.
• An important aspect of financial markets

• The presence of asymmetric information leads to:
– Adverse selection: the problem created by
asymmetric information before the transaction occurs.
• Potential bad credit risks are the ones who most actively
seek out loans. Because adverse selection increases the
chances that a loan might be made to a bad credit risk,
lenders might decide not to make any loans, even though
there are good credit risks in the marketplace
• The presence of asymmetric information leads to:
– Moral hazard: the problem created by asymmetric
information after the transaction occurs.
 The lender runs the risk that the borrower will engage in
activities that are undesirable from the lenders point of
view because they make it less likely that the loan will be
paid back.
 Because moral hazard lowers the chance that the loan will
be paid back, lenders may decide that they would rather
not make loans.
• The analysis of how asymmetric information
problems affect economic behavior is called
Agency Theory
Adverse Selection
• Lemons problem by Akerlof (1970)
– George Akerlof, “The Market for Lemons”, QJE (1970)
• Example: Consider a used car market. It’s reasonable to assume that
owner of the used car knows more about its quality than potential buyers.
Initial distribution of car quality

$10 $5 $0
(prob = 0.4) (prob = 0.2) (prob = 0.4)
Average quality = $5 Rational expectation price =
$5
Quality of cars offered at

$5
$5 $0
(prob = 1/3) (prob = 2/3)
Average quality = $1.67
Adverse Selection (cont.)

Rational expectation price =
$1.67
Quality of cars offered at

$1.67 Rational expectation price =
$0 (prob = 1) $0
• Similar lemons problem in debt and stock markets as well: the

interaction between the inclination of the informed to strategically
manipulate and the anticipation of such manipulation by the
uninformed will result in a dysfunctional market.
• Explains fact 1 and 2 (equity and marketable debt is not the
primary ways of financing.)

• How the theory implement in the financial markets?
• The potential buyer of stocks or bonds can’t distinguish between good firms
with high expected profits and low risk and bad firms with low expected profits
and high risk.
1. Willing to pay only a price (Interest rate) that reflects the average quality of firms
issuing securities– a price that lies between the value of securities from bad firms
and the value of those from good firms.
2. If the owners or managers of a good firm have better information that they are sure
they have a good firm they will not accept the undervalued price that is offered by
the potential buyer.
3. The only firms willing to sell at the price offered will be bad firms because the price
offered is higher than the securities are worth.
4. But the potential buyer is not willing to hold securities of bad firms, and hence he
will decide not to purchase securities in the market.
5. Therefore, this securities market will not work very well because few firms will sell
securities in it to raise capital

• Exp
How the theory implement in the financial markets?
labuyer
• rim ins ofwstocks or bonds can’t distinguish between good firms
Theppotential
ary profits
with high expected hyand low risk and bad firms with low expected profits
and high risk. sou
ma
rce rket
1. of(Interest
Willing to pay only a price ablthat reflects the average quality of firms
rate)
inabetweenethesevalue of securities from bad firms
issuing securities– a price thatflies
nc i cur
and the value of those from good firms.
n g
If the owners or managers of a good firm have (
i ties that they are sure
2.
Fac pricearthat
better information
they have a good firm they will not accept the undervalued t 1 e nisooffered by
the potential buyer. & 2 t th
3. The only firms willing to sell at the price offered will be bad firms )because theeprice
offered is higher than the securities are worth.
4. But the potential buyer is not willing to hold securities of bad firms, and hence he
will decide not to purchase securities in the market.
5. Therefore, this securities market will not work very well because few firms will sell
securities in it to raise capital
Tools to Solve Adverse Selection Problems

1. Private production and sale of information
– E.g. rating agencies
– Can’t solve adverse selection problem completely
because of Free-Rider problem.
Occurs when people who don’t pay for
information take advantage of the
information that other people have paid for.

1. Private production and sale of information (cont.)
– E.g. rating agencies
– Can’t solve adverse selection problem completely because of
Free-Rider problem.
– Because of free-riders, investors who paid for information
will not have any advantage from purchasing the information
and they wish they should never paid for this information in
the first place.
– the free-rider problem prevents the private market from
producing enough information to eliminate all the asymmetric
information that leads to the adverse selection problem

2. Government regulation
– To encourage or enforce firms to reveal honest
information. E.g. independent auditors, disclosure
requirement.
Special government agencies require firms

selling their securities to have independent
audits to certify that the firm is adhering to
standard accounting principles and
disclosing accurate information about sales,
assets, and earnings

2. Government regulation
– To encourage or enforce firms to reveal honest
information. E.g. independent auditors, disclosure
requirement.
– However, disclosure requirement doesn’t always
work well, nor eliminates adverse selection problem.
e.g. the collapse of Enron, WorldCom
– Explain fact 5 (FIs are heavily regulated)
why financial markets are among the most heavily
regulated sectors in the economy
Tools to Solve Adverse Selection Problems (cont.)
3. Collateral and net worth Assets – liabilities
– Collateral and net worth reduce the consequences

of adverse selection.
• It reduces the lenders’ losses in the event of a default.
• It reduces the likelihood of default.
– Explain fact 7 (a common feature of debt
contracts) Can use assets to pay off the
loans

e.g. guarantee (warranty or
4. Financial intermediation reputation) from car dealers
– Specialised in producing information and distinguishing good firms.
– How banks avoid free-rider problem?  by making private (non-
traded) loans.
• An important element in the bank’s ability to profit from the information it
produces is that it avoids the free-rider problem by mainly making private
loans rather than purchasing securities that are traded in the open market.
• hold mostly non-traded loans is the key to its success in reducing
asymmetric information in financial markets.
– Explain fact 3 and 4 (indirect finance / banks are the most important
sources of financing.)
4. Financial intermediation
– The severer the asymmetric information problems,
the more important the FIs.
– Explain fact 6 (only well-established firms have
easy access to security market.)
• Because investors have fewer worries about adverse
selection with well-known corporations
e.g. commercial paper

– Since information about private firms is harder to
collect in developing countries than in
industrialized countries, there is a greater role for
banks and smaller role for securities markets in
developing countries?
– Since information about private firms is harder to
collect in developing countries than in
industrialized countries, there is a greater role for
banks and smaller role for securities markets in
developing countries?
– Is this true?
Moral Hazard
• Asymmetric information problem that occurs
after the transaction takes place.
• Can be found in equity and debt contracts.

Moral Hazard in Equity Contracts

• Principal-agent problem: the separation of ownership
(principal) and management (agent).
– Separation of ownership and management involves moral
hazard
– Because a manager has more information about his

activities than the stockholder does
– The managers in control (the agents) may act in their own

interest rather than in the interest of the owners (principals)

– Agents (managers in control) may
1. have different goals than the owners

2. have less incentives to maximize firm’s profit
3. not provide a quick and friendly service to the firm’s customers
4. spend money unnecessarily on decoration and artificial issues
5. waste time in their own personal leisure
6. not be honest with the firm’s owner
7. diverting funds for their own personal use,
8. pursue corporate strategies that enhance their own personal
power but do not increase the firm’s profitability.

• Principal-agent problem can be solved by:
i.e. monitoring
– Decreasing the asymmetric information.

• Principal-agent problem can be solved i.e.
by: monitoring
The problem is
1. Costly state verification - monitoring process can
be costly in terms of time and money.
2. Free rider problem - If you know that other
stockholders are paying to monitor the activities of
the firm you hold shares in, you can take a free ride
on their activities and save yourself some expenses.
The problem occurs when every stockholder think
the same. The result is no one will spend any
resources to monitor the firm.

• Principal-agent problem can be solved by:
i.e. monitoring
– Aligning the incentives of agent with those of

principal.
e.g. stock option
Tools to Solve Principal-Agent Problem

• Production of information: monitoring
– It is a costly state verification, which makes equity contract less
desirable.
– Free-rider problem decreases monitoring.
– Explain fact 1 (stock are not the most important source of
Debt works as monitors too (although interest of
financing) debtholders and shareholders may be different).
• Debt contracts
– Debt contract holders receive contractual fixed payments instead
of residual claim  monitoring is less frequent needed.
– Explain fact 1 (debt are used more frequently than equity
contracts)
Tools to Solve Principal-Agent Problem (cont.)

• Government regulation
– To increase reliable information, e.g. standard accounting principles.
– Explain fact 5 (FIs are heavily regulated)
• Financial intermediation: venture capital firms
– Pool resources of its partners and use the funds to help entrepreneurs
starting up new businesses.
– How venture capitalists take full benefits of Verification/monitoring
without free-rider problem?
• Hold non-marketable equity
• Engage in firm’s activities
– Explain fact 3 (indirect finance is more important than direct
finance)
Moral Hazard in Debt Contracts

• The conflict between shareholders and debtholders
• Management may choose investments that maximise

the value of equity at the expense of the debt holders.
• Consider a firm with $100 of principal and interest

payments due at the end of the year. There are two
projects: low-risk and high risk.
Risk-shifting activities; bait and switch

Moral Hazard in Debt Contracts (cont.)

Low risk project High risk project
Prob. V= D+ E V= D+ E
Recession 50% $100 $50 $50
$100 $0 $0
Boom 50% $200 $100 $100 $240 $100 $140
Expected value $150 $100 $50 $145 $75 $70
• To maximise shareholders’ wealth, management will

choose high risk project  Shareholders’ gain at the
cost of debt holders.
Tools to Solve Moral Hazard in Debt Contracts
• Net worth and collateral

– Make the debt contract incentive-compatible (i.e.
align the incentives of borrowers with those of
lenders; risk-shifting activities are less likely).
– Explain fact 7 (common feature of debt contracts)


(cont.)
• Monitoring and enforcement of restrictive covenants
– To discourage undesirable behaviour, e.g. prohibit or limit the
Negative/restrictive
dividends paid.
– To encourage desirable behaviour, e.g. maintain minimum
Positive/affirmative
holdings of assets.
– To keep collateral valuable, e.g. automobile service.
– To provide information, e.g. right to audit and/or request periodic
reports.
– Explain fact 8 (debt contracts place substantial restrictions on
borrowers.)
– However, monitoring and enforcement are costly, plus free-rider
problem exists.

(cont.)
• Financial intermediation
– Solve free-rider problems existing in traded debt
market by making non-traded private loans.
– Explain fact 3 and 4 (indirect finance/banks are

most important source of financing.)
Summary: Asymmetric Information Problems and

Tools to Solve Them
Asymmetric Tools to solve it Explains
information problem fact number
Adverse selection Private production and sale of information 1, 2
Government regulation 5
Collateral and net worth 7
Financial intermediation 3, 4, 6
Moral hazard in equity Monitoring 1
contracts Debt contracts 1
Government regulation 5
Financial intermediation 3
Moral hazard in debt Collateral and net worth 6, 7
contracts Monitoring and enforcement of covenants 8
Financial intermediation 3, 4
Financial Structure, again

• Without financial institutions, excess savings could
only be held as cash or invested in corporate
securities.
Financial Structure, again (cont.)

• However households might find investments in
corporate securities unattractive because of:
– Monitoring costs: expensive, plus free-rider problems.
– Liquidity costs: long-term nature of corporate equity
and debt, plus the lack of a deep, active secondary
market.
– Price risk: the risk that the sale price of an asset will be
lower than the purchase price of that asset, plus
transaction costs.
Financial Institutions’ Functions
1) Brokerage function
– Provide economics of scales in information collection as well as in
transaction costs.
2) Asset transformation function
– Purchase financial claims issued by corporations (primary securities)
and finance these purchase in the form of secondary securities (e.g.
deposits, insurance policy).
2) Asset transformation function (cont.)

– FIs are able to fulfil asset transformation function due
to:
• Lower Information/monitoring costs
– Information producers: loan renewal let FIs gain access to inside
and update information.
– Delegated monitors: greater incentive for information collection and
monitoring activities, and solve free-rider problem.
• Lower liquidity costs and price risk as FIs hold diversified
portfolios.
– Diversification also enables maturity intermediation.
Ability to bear the risk of mismatched
assets and liabilities
Other Aspects of Specialness

e.g. life insurance, superannuation,
• Time intermediation pension funds, etc.
– Wealth transfer between generations.

• Denomination intermediation
– Give individuals indirect access to large denomination
markets.
e.g. money market management fund
• Credit allocation
– Major source of finance in particular sector of an
e.g. rural sector
economy.
next
Other Aspects of Specialness (cont.)

• Transmission of monetary policy
– Liabilities of depository institutions are a significant
component of the money supply that impacts the inflation
rate. Credit creation example
– Actions include setting discount rate, open market operation,
and/or setting reserve requirement. The OCR and how it works
Credit creation: the process by which banks create money from their lending
of investors’ deposits. Credit multiplier = initial deposit/reserve ratio.
back
Credit Creation Example

• Initial deposit (in Bank A) = $1000, reserve
requirement = 20%.
Bank A’s B/S
Assets Liabilities
Reserves = $200 Deposit = $1000 Bank C’s B/S
Loans = $800 Assets Liabilities
Reserves = $128 Deposit = $640
Loans = $512
Bank B’s B/S
Assets Liabilities
Reserves = $160 Deposit = $800
The maximum amount of money that
Loans = $640 ideally can be created = $1000/0.2 =
$5000
Monetary policy & credit creation

(115.114 Lecture Notes)
• Credit creation is the process by which banks create money in

an economy.
– Banks’ hold 10% of their deposits in reserve. $10,000 is injected into
the public’s hands through the Central Bank buying back the public's
bonds.
• Bank A loans $9,000 which is deposited in Bank B
• Bank B lends $8,100 which is deposited in Bank C
• Bank C lends $7,290 which is deposited in Bank D …
– The reserve position would eventually become $10,000 and the
Banking system would have created $100,000 of new loans.
D
Credit multiplier  where D is initial deposit
reserve ratio
10,000
  $100 ,000
0.10
Other Aspects of Specialness (cont.)

• Payment service
– RBNZ:
• NZClear: for high-value debt securities and equities.
• Exchange Settlement Account System (ESAS): allows individual
transactions between financial institutions to be settled electronically as
the transactions happen.
– Registered banks: provide retail and wholesale payment services.
• Failure or inefficiency to provide above services can cause

costly negative externality. FIs are therefore highly regulated.

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20240226_125.364 Week 01

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Welcome to 125.

What is this course about?

Overview of the topics covered

Learning Outcomes (I)

2. Apply selected principles and concepts of modern finance

3. Identify the main risks faced by banks’ financial managers

Learning Outcomes (II)

Formal requirements to pass this course

The Assessment 1 - Albany Internal

Saunders, A., Cornett, M. M., & Erhemjamts, O. (2024).

 You may also purchase an electronic copy of the textbook

Day Time Room

Tuesday (Lecture) 2.00 pm to 4.00 pm SNW300

Communicating with each other (I)

 Student Discussion Forum: A forum for making

• Indirect finance (intermediation) / financial intermediaries

Basic Facts about Financial Structure

Basic Facts about Financial Structure

Basic Facts about Financial Structure (cont.)

5. The financialBanks/system is among the most heavily regulated

Basic Facts about Financial Structure (cont.)

6. Only large, well established corporations have easy access to

7. Collateral is a prevalent feature of debt contracts for both

8. Debt contracts typically are extremely complicated legal

Two Factors which…

Let’s look at them in turns.

• The unequal knowledge that each party to a transaction

• An important aspect of financial markets

Initial distribution of car quality

Quality of cars offered at

Adverse Selection (cont.)

Quality of cars offered at

• Similar lemons problem in debt and stock markets as well: the

Adverse Selection (cont.)

Adverse Selection (cont.)

Tools to Solve Adverse Selection Problems

Tools to Solve Adverse Selection Problems

Tools to Solve Adverse Selection Problems

Special government agencies require firms

Tools to Solve Adverse Selection Problems

Tools to Solve Adverse Selection Problems (cont.)

3. Collateral and net worth Assets – liabilities

– Collateral and net worth reduce the consequences

Tools to Solve Adverse Selection Problems (cont.)

Tools to Solve Adverse Selection Problems (cont.)

e.g. commercial paper

Tools to Solve Adverse Selection Problems (cont.)

Tools to Solve Adverse Selection Problems (cont.)

• Can be found in equity and debt contracts.

Moral Hazard in Equity Contracts

– Because a manager has more information about his

– The managers in control (the agents) may act in their own

Moral Hazard in Equity Contracts

1. have different goals than the owners

Moral Hazard in Equity Contracts

Moral Hazard in Equity Contracts

Moral Hazard in Equity Contracts

– Aligning the incentives of agent with those of

Tools to Solve Principal-Agent Problem

Tools to Solve Principal-Agent Problem (cont.)

Moral Hazard in Debt Contracts

• Management may choose investments that maximise

• Consider a firm with $100 of principal and interest

Risk-shifting activities; bait and switch