The I.O Approach

THE I.O. APPROACH

Issues: Understanding the structure of

competition among financial intermediaries

Understanding the implications of the “uniqueness” of financial intermediaries on the deposit and credit market rates

AT STAKE:

Design an efficient banking industry Define the optimal level of risk,

screening and monitoring Obtain recommendations for the

efficient regulation of the banking industry.

SOME EMPIRICAL FINDINGS

Sticky ratesDistance mattersInvestment policy (Petersen and Rajan)Credit rationing The role of core deposits

Cut and paste I.O.

Monti-Klein

Monopolistic competition

The Monti-Klein Model

Local monopoly Global competition on the interbank

market

The Monti-Klein Model (II)

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DD

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Do we obtain separation?

What implications?

Deposit rate regulationEffect of reserve requirements

Why separation may break down

Demand for loans and deposit supply are non separableNon separable operating cost functionsliquidity riskcredit risk

Cut and paste I.O.(Continue)

Monti-Klein Monopolistic competition

Monopolistic Competition

Bank n-1

Bank n

Bank n+1

Monopolistic Competition: results

Competititon (zero profits) leads to an excessive number of banksRegulation and its effects (Chiappori et al.)Connectivity (Matutes and Padilla)

New approach: competition in the F.I. Industry

Competition and asymmetric information

Relationship banking

Non price competition

Banks compete also by setting the riskiness of their assets and therefore their probability of default. (Matutes and Vives, 1990)

Matutes and Vives 1990

Two types of games can be considered:

If the bank determines first the risk level which is observable and then the depositors choose their bank with perfect information, we have a perfect market which will lead to a minimum risk if the bank has a positive charter value.

The imperfect information game

If the deposit rate is fixed and then the banks choose their level of risk, we have a pure moral hazar situation: depositors will infer that the bank will choose the profit maximizing level. This is zero or the maximal one depending on the cost of bankruptcy (charter value)

Empirical evidence

For once there is a basic agreement:: charter values are negatively related to bank risk.Keeley(1990); Demsets, Saidenberg and Straham(1996); Salas and Saurina(2003)

Competing on the level of monitoring

Boot and Schmeits (2000) Consider first a bank who has to choose its level of monitoring. If the bank is self financed it will choose the optimal level. If depositors have perfect information on monitoring, it will choose the optimal level. If deposit rates do not reflect the monitoring level it will underinvest in monitoring.

Conglomerates and monitoring choice

Consider a conglomerate with two divisions. Bankruptcy occurs only if the two divisions fail.

As a consequence, in a perfect information situation there is public good problem: cost of funds depend on both divisions monitoring efforst while monitoring costs are privately borne.

Conglomerates (continue)

In an imperfect information setting, the result is the opposite. Conglomerates help improve the monitoring costs as the cost of debt is lower

Competition and asymmetric information. Broeker (1990)

Assume imperfect screening on behalf of banksConsider two banks, bank A quoting a smaller interest rate

Bank B will get all the borrowers that are rejected by A, justifying a larger interest rateNo pure strategy equilibrium exists

RELATIONSHIP BANKING

Some empirical observations:James (1987).Lummer and McConnell (1989).Evidence from Banks Bankruptcy.

Points at:Sunk Costs Invested in the relationship.Related to Switch Costs.

An Alternative Explanation: relationship banking

Ex Post Monopoly of Information, Sharpe (1990).Rajan (1992)Dewatripont and Maskin(1995)

THE MODEL

Consider a risk neutral, two periods, zero interest rate settingMonitoring implies a once and for all fixed cost. It is efficient that the same bank monitors

the firm at time t=1 and at time t=2 Limited competition at time t=2 but zero

profits over the two periods implies losses at time t=1 and profits at time t=2.

Interest rates

At time 2 the « main bank » will set interest rates equal to the minimum a competitor could offer and makes a profit.At time t=1 the position of « main bank » (and the time t=2 profits it implies) is auctioned out.

HOLD UP PROBLEM

There is a hold up from the main bank at time t=2In other words: there is intertemporal cross-subsidization from time t=2 to time t=1

IMPLICATIONS

In addition to the standard notion of market power, the ability of the main bank to « capture » its borrowers and extract rents from them is another source of market power. The higher the capacity to capture borrowers, the higher the hold-up and the intertemporal cross-subsidization.

A more sophisticated model

Consider a risk neutral, two periods, zero interest rate settingTwo types of firms (G, B).

ASYMMETRIC INFORMATION

Firms do not know their type initially (at time t=0) and learn whether they are of type G or type B at time t=1.Firms of type G (respectively B) are successful with probability G (respectively B).

Short-term bank financing

At time 1 the «main bank » learns also the firm’s type.The main bank has a monopoly of information, because outsiders cannot distinguish G and B firms.Equilibrium pricing: mixed strategies as in Broeker.Still, « main bank » profits are higher .

IMPLICATIONS

Ex ante competition implies that firms are subsidised at time 0, while G firms are taxed at time 1. I other words, banks will have to pay at time t=0 in order to have access to a monopoly of information at time t=1. Thus, bad firms will be the main beneficiaries of the structure of competition.

CREDIT BUREAUS

Credit bureaus and public credit registers are private or public organizations in charge of centralizing credit information. (Hard information)Information could be negative (black) only or both negative and positive (white)

Effect of information sharing

Better knowledge of the pool of applicants, better pricing of loansReduces hold up by « main bank »Introduces a disciplinary deviceReduces incentives to become over-indebted

Japelli and Pagano (1993)

Local markets, borrowers switching locationsPure adverse selection: Information sharing improves the pool

of borrowers Decreases defaults Decreases credit spreads

PADILLA AND PAGANO(1997)

show that if the entrepreneur has a choice of his effort level, the existence of a hold-up problem will lead them to exert a lower level of effort. As a consequence, the commitment to share private information with other lenders may enhance the banks’ profits.

Competition and relationship banking

How does competition affects relationship banking?Petersen and Rajan (1995): lowers incentives to invest in relationship bankingBoot and Thakor(2000): incentives entrenchment into relationship banking which is shielded from competition.

Empirical findings on relationship lending

Liquidity: Hoshi, Kashyap and Sharfstein(1990) for keiretsus; Houston and James(1999) opposite result for traded firms relying on a single bankInterest ratesBorrowing from several banks: age, size and transparency favors less bank dependencyIPO underpricing

DEWATRIPONT AND MASKIN (RES,1995)

Two types of non observable entrepreneurs: G and B

G require a loan of 1 and obtain R after one period

B require a loan of 1, then an additional loan of 1 will allow to obtain a lottery with a probability of success depending on the bank effort level e.

Firms will not participate if they do not obtain any profit (negative private benefits)For a bank it is efficient to continue financing a bad project even if is not profitable ex ante.Therefore, under bank financing (centralized financing) B and G firms will ask for a loan.

Consider now market finance (i.e. decentralized financing) investors have only 1 unit of resources. Refinancing implies finding a new external financier that will have to be repaid. But this means that at time t=0 the financier has not made a sufficient effort. Continuation of the project is not profitableAs a consequence under decentralized finance the B firms will not ask for funding.

Also as a consequence, centralized finance is here inefficient while decentralized finance is efficientBut notice that for other parameter constellations the opposite could hold true.

SUMMARY

IO models can be helpful in understanding the specifics of the banking industry.Financial Intermediaries idiosyncracy should be acknowledged, ASYMMETRIC INFORMATION RELATIONSHIP BANKING