BANKING AND CAPITAL MARKETS - ASSIGNMENT ONE

Banking and Capital Markets - Assignment One



Banking and Capital Markets - Assignment One

Introduction

Banks have traditionally played an important part in the financial system by acting as financial intermediaries. They brought together ultimate savers and borrowers. However, today banks do much more than just that. Banks have become financial services firms. There are people who think that banks are not necessary for the financial system any more. Nevertheless, banks still exist and it is hard to imagine life without a basic bank account.

Theories of existence of Banks

In order to give firm ground to our argument and to illustrate the paradox, we will first review the doctrines of the theory of banks. These are specifications, relevant to the financial services industry, of the agency theory, and the theory of imperfect or asymmetric information. Basically, we may distinguish between three lines of reasoning that aim at explaining the raison d'être of financial intermediaries: information problems, transaction costs and regulatory factors. First, and that used in most studies on banks, is the informational asymmetries argument. These asymmetries can be of an ex ante nature, generating adverse selection, they can be interim, generating moral hazard, and they can be of an ex post nature, resulting in auditing or costly state verification and enforcement. The informational asymmetries generate market imperfections, i.e. deviations from the neoclassical framework Many of these imperfections lead to specific forms of transaction costs. Financial intermediaries appear to overcome these costs, at least partially. For example, Diamond and Dybvig (1983) consider banks as coalitions of depositors that provide households with insurance against idiosyncratic shocks that adversely affect their liquidity position. Another approach is based on Leland and Pyle (1977). They interpret financial intermediaries as information sharing coalitions. Diamond (1984) shows that these intermediary coalitions can achieve economies of scale. Diamond (1984) is also of the view that financial intermediaries act as delegated monitors on behalf of ultimate savers. Monitoring will involve increasing returns to scale, which implies that specializing may be attractive. Individual households will delegate the monitoring activity to such a specialist, i.e. to the financial intermediary. The households will put their deposits with the intermediary.

They may withdraw the deposits in order to discipline the intermediary in his monitoring function. Furthermore, they will positively value the intermediary's involvement in the ultimate investment (Hart, 1995). Also, there can be assigned a positive incentive effect of short-term debt, and in particular deposits, on bankers (Hart and Moore, 1995). For example, Qi (1998) and Diamond and Rajan (2001) show that deposit finance can create the right incentives for a bank's management. Illiquid assets of the bank result in a fragile financial structure that is essential for disciplining the bank manager. Note that in the case households that do not turn to intermediated finance but prefer direct finance, there is still a “brokerage” role for financial intermediaries, such as investment banks (see Baron, 1979 and 1982). Here, the reputation effect is also at stake. In financing, both the reputation of the borrower and that of the financier are relevant (Hart and Moore, 1998). Dinç (2001) studies the effects of financial market competition on a bank reputation mechanism, and argues that the incentive for the bank to keep ...