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 rates Distance matters Investment 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) Do we obtain separation?

What implications? Deposit rate regulation Effect of reserve requirements

Why separation may break down Demand for loans and deposit supply are non separable Non separable operating cost functions liquidity risk credit 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 banks Regulation 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 banks Consider 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 rate No 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 setting Monitoring 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=2 In 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 setting Two 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 loans Reduces hold up by « main bank » Introduces a disciplinary device Reduces incentives to become over- indebted

Japelli and Pagano (1993) Local markets, borrowers switching locations Pure 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 banking Boot 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 bank Interest rates Borrowing from several banks: age, size and transparency favors less bank dependency IPO 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 profitable As 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 efficient But 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