Model Of Financial Intermediation Research Articles

Optimal banking with delegated monitoring

We propose a model of financial intermediation based on delegated monitoring, where firms' returns are private information that lenders can ascertain through costly state verification. Our model has two key features: lenders cannot commit to their verification strategies and there are aggregate shocks. Simple debt contracts are Pareto optimal with or without intermediation. We show that the benefits of intermediation can be limited by financial instability in the presence of aggregate shocks. However, a well-designed resolution mechanism ensures the Pareto optimality of financial intermediation, and a bail-out policy can restore financial stability.

Bank-platform competition in the credit market

We analyze the equilibrium in the credit market when a bank and a lending platform compete to offer credit to borrowers. The platform does not manage deposit accounts, but acts as an intermediary between the borrower and investor, offering a risky contract such that the investor is only reimbursed if the borrower is successful. We show that the platform business model of financial intermediation may generate unexpected effects in the credit market. In particular, investor participation in the platform sometimes decreases when the platform attracts better-quality borrowers. When it competes with the platform, depending on the respective distributions of borrower and investor types, the bank may expand the supply of credit to low-quality borrowers, or restrict it to high-quality borrowers. Bank-platform competition expands the total supply of credit, but has an ambiguous impact on borrower surplus, because some borrowers may have higher repayments.

The Size Distribution of the Banking Sector and Financial Fragility

AbstractWe study the role of the size distribution of the banking sector for bailout policy and financial fragility in a model of financial intermediation with limited commitment and noisy sunspots. In particular, due to the different costs of mitigating depositors' losses, differences in financial fragility arise endogenously in the sense that the large banking market admits a higher degree of instability. Moreover, the desire to reduce differences in the amount of bailout funding across segments of the banking system leads the fiscal authority to collect less taxes ex‐ante but ends up rendering the scope for run equilibria larger.

Long-term bank lending and the transfer of aggregate risk

Long-term loan contracts transfer aggregate risk from borrowing firms to lending banks. When aggregate shocks increase the future default probability of firms, banks are not compensated for the rising default risk of existing contracts. The flip side is that firms benefit from not facing higher interest rates in recessions. If banks are highly leveraged, this can lead to financial instability with severe repercussions in the real economy. If banks are well capitalized, the risk transfer stabilizes the economy. To study this mechanism quantitatively, we build a macroeconomic model of financial intermediation with long-term defaultable loan contracts and calibrate it to match aggregate firm and bank exposure to business cycle risks in the US. We find that moving from Basel II to Basel III capital regulation eliminates banking crises, increases output in the long run and improves welfare.

Long-Term Bank Lending and the Transfer of Aggregate Risk

Long-term debt contracts transfer aggregate risk from borrowing firms to lending banks. When aggregate shocks increase the future default probability of firms, banks are not compensated for the default risk of existing contracts. If banks are highly leveraged, this can lead to financial instability with severe repercussions in the real economy. To study this mechanism quantitatively, we build a macroeconomic model of financial intermediation with long-term defaultable loan contracts and calibrate it to match aggregate firm and bank exposure to business cycle risks. Our model exhibits banking crises that closely resemble observed crisis episodes. We find that such crises do not arise in an economy with short-term debt. Our results on the role of long-term debt completely reverse if financial regulation is implemented to increase banks' risk bearing capacity. The financial sector is then well equipped to take on the aggregate risk, such that long-term lending stabilizes the business cycle by providing insurance to the corporate sector.

Banking Competition, Increasing Returns to Scale, and Financial Fragility

How do liquidity creation and financial fragility depend on the dual effects of increasing returns to scale and banking competition? We study this question in a model of financial intermediation with limited commitment. In the absence of scale economies, the degree of fragility is independent of the amount of bank investment and the scope for instability of a monopolistic bank is strictly contained in that of its competitive counterpart. Yet, when the minimum scale effect is present, the conventional results may be overturned. In particular, the competitive bank facing an intermediate scale threshold for the high asset return is able to deliver the highest welfare to depositors but is most prone to panics when runs are highly unlikely. That is, due to increasing returns in normal times, the intermediary behaves aggressively by providing high payments in the short-term but only low output will be realized should run behavior emerge. In contrast, the monopolistic bank that engages in rent-seeking, strategic behavior is most susceptible to runs if both the minimum scale requirement and the propensity to panic are sufficiently high. To be specific, the potential failure to qualify for increasing returns tightens depositors’ participation constraints, especially in a more crisis-prone economy. Thus, if the bank fails to earn high returns on its assets and the prospect of a run is high, it must augment payoffs on early demandable deposits, leaving itself excessively illiquid and unstable. In addition, there exist economies where the competitive bank is better for stability than the monopolist as relative fragility depends on respective minimum scales facing banks.

Liquidity Risk Management in the Islamic Banking: Portfolio of Ijara and Murabaha

Liquidity risk management in finance has always been well known as a necessity for conventional finance and Islamic finance. Conventional financing addresses this risk through known means. Unlike Islamic financing, this has few instruments suitable for Shari’a to manage this risk. If this risk accelerates, the Islamic bank faces significant challenges in the face of their depositors and investment projects. The objective of this study is to show that holding an optimal level of liquidity is necessary for Islamic banks to minimize the liquidity risk. In this paper, we also examine the relationship between profitability and liquidity. This importance is explained by the fact that these banks cannot always count on the support of the central bank, or on the Islamic money market. We refer in particular to the work of Ben Jedidia et al. (2013).Unlike Ben Jedidia et al. paper, our model of financial intermediation and liquidity risk management uses two factors: Murabaha and Ijara. Two analysis were used, the first one is static and the second one is dynamic, to determine the optimal amount to be held by an Islamic bank using the optimization method. The study reveals that the factors in the first analysis are: the anticipated penalty costs, the rate of return on financing, the sharing rate between the bank and the depositors. This study also reveals in a second dynamic analysis that the factors are: the expected marginal cost of penalty, the ratio of the change in deposits to the change in funding.

Social capital and the business models of financial cooperatives: Evidence from Japanese Shinkin banks

AbstractWe investigate the link between social capital and business model choice of financial cooperatives (Shinkin banks) in Japan. We identify two forms of business model, which concentrate on the issuance of loans funded by deposits (traditional) and the investment and management of large investment portfolios (new).Traditionalbusiness models are more likely to emerge in geographic areas with higher levels of social capital. These findings are robust after controlling for bank‐ and prefecture‐level characteristics (such as unemployment, population and income) that may influence bank business model choice. We repeat our analysis for a sample of shareholder‐oriented (regional) banks, but fail to establish any relationship between social capital and this organisational form. Overall, our findings suggest that financial cooperatives in high‐social‐capital areas are more likely to adhere to a traditional model of financial intermediation focused on lending which promotes community and economic development.

Precautionary Liquidity Shocks, Excess Reserves and Business Cycles

This paper identifies a precautionary banking liquidity shock via a set of sign, zero and forecast variance restrictions imposed. The shock proxies the reluctance of the banking sector to lend to the real economy induced by an exogenous change in financial intermediaries' preference for high liquid assets. The identified shock has sizeable and state (volatility) dependent effects on the real economy. To understand the transmission of the shock, we develop a DSGE model of financial intermediation with credit and liquidity frictions. The precautionary liquidity shock is shown to work through two channels: it increases the level of reserves and the deposit rate. The former is a balance sheet effect, which reduces the loan-to-deposit ratio. The higher deposit rate affects the intertemporal decisions of households and the cost of borrowing to firms. The overall effect is a downward co-movement in output, consumption, investment and prices, which is amplified the higher are the long-run risk in the economy and the responsiveness of banks to potential risk.

Identifying credit demand, financial intermediation, and supply of funds shocks: A structural VAR approach

In this paper, we identify three exogenous shocks to credit market: demand for credit, supply of funds into the financial system, and the willingness to lend of financial institutions (financial intermediation), and also, determine the contribution of these shocks to fluctuations in the credit market and overall economic activity. We estimate a structural vector autoregression model where the three credit shocks are identified with a set of sign restrictions motivated by a simple partial equilibrium model of financial intermediation. We find that the credit demand shock explains significantly the variations in the long-term loan rate proxied by the Moody’s Baa corporate bond yield, while the supply of funds shock contributes to most of the fluctuations in the short-term commercial paper rate. The financial intermediation shock drives most of the fluctuations in the quantity of loans as well as the spread between the Baa and commercial paper rates. Of the credit shocks, we find that the financial intermediation shock has the largest impact on real economic activity. In fact, our analysis implies that the sharp decline in output during the 2007–2009 financial crisis is largely attributable to the financial intermediation shock, along with shocks originating outside of the financial system.

Interest On Reserves As Main Monetary Policy Tool

This paper examines the potential role of the interest on reserves as a main monetary policy tool, in a model of financial intermediation with financial and nominal frictions calibrated to US data (1985-2018). The interest on reserves is shown to affect financial spreads and real economic activity, through its effect on the banking system's reserves (balance sheet channel) and the price of safe liquid assets (intertemporal Euler equation channel). It is shown to provide, (i) determinacy when the interest rate is fixed to zero, through the intertemporal Euler equation channel, independently of the reserves-to-deposits ratio, or bank capital restrictions; (ii) similar welfare improvements to an optimal Taylor rule; (iii) an alternative main monetary policy tool for driving the economy out of recessions when the conventional interest rate is trapped at the zero-lower-bound.

Financial stability with sovereign debt

Are government guarantees or financial regulation a more effective way to prevent banking crises? I study this question in the presence of a negative feedback loop between the fiscal position of the government and the health of the banking sector. I construct a model of financial intermediation in which the government issues, and may default on, debt. Banks hold some of this debt, which ties their health to that of the government. The government's tax revenue, in turn, depends on the quantity of investment that banks are able to finance. I compare the effectiveness of government guarantees, liquidity regulation, and a combination of these policies in preventing self-fulfilling bank runs. In some cases, a combination of the two policies is needed to prevent a run. In other cases, liquidity regulation alone is effective and adding guarantees would make the financial system fragile.

Opacity: Insurance and fragility

What are the effects of banks holding opaque, complex assets? Should regulators require bank assets to be more transparent? I study these questions in a model of financial intermediation where opacity determines how long the realized value of an asset remains unknown. By allowing a bank to sell assets before the realization is known, opacity provides insurance to the bank's depositors. However, higher opacity also increases depositors' incentives to join a bank run. In choosing the level of opacity, therefore, a bank faces a trade-off between providing insurance and increasing fragility. If depositors can accurately observe the level of opacity, banks will choose the socially-efficient level. If depositors are unable to observe this choice, however, banks will have an incentive to become overly opaque and regulation to limit opacity can improve welfare.

A DEA model for measuring financial intermediation

It is common practice in data envelopment analysis to assess commercial banks by the efficiency that they display in their operations under different outlooks on their behaviour; yet, even the intermediation approach does not measure actually the success with which commercial banks or a banking sector fulfil their mission of financial intermediaries. Such an assessment is traditionally accomplished by means of the loan-to-deposit ratio that captures rather size or depth of financial intermediation, but no link is sought to best practices that are observed in the banking sector. The paper proposes a model of financial intermediation that permits assessing on a comparative basis the attainment in financial intermediation. The devised index of financial intermediation recognizes through weights that diverse outcomes of financial intermediation exhibit differentiated importance to the economy and is closely connected with the weighted slacks-based measure (WSBM). The WSBM that emerges in this respect encompasses only production variables that define financial intermediation (i.e. deposits and intermediated outputs) whilst other production variables are treated as non-discretionary. The model can be applied in variants for a single commercial bank in one specific year (Model I) or for aggregated bank-years such as one particular bank over the entire period or various banks in one year (Model II). The ideas are demonstrated on a data set of Slovak commercial banks for the period between 2008 and 2016 and the difference of the proposed approach with traditional efficiency measurement under the intermediation approach is discussed.

Identifying Credit Demand, Financial Intermediation, and Supply of Funds Shocks: A Structural VAR Approach

In this paper, we identify exogenous shocks to credit demand, financial inter-mediation, and supply of funds, and determine the contribution of these shocks to fluctuations in the credit market and overall economic activity. We estimate a structural vector auto-regression model where the three credit shocks are identified with a set of sign restrictions motivated by a simple partial equilibrium model of financial inter-mediation. We find that the credit demand shock explains significantly the variations in the long-term loan rate proxied by the Moody's Baa corporate bond yield, while the supply of funds shock contributes to most of the fluctuations in the short-term commercial paper rate. The financial inter-mediation shock drives most of the fluctuations in the quantity of loans as well as the spread between the Baa and commercial paper rates. Of the credit shocks, we find that the financial inter-mediation shock has the largest impact on real economic activity. In fact, our analysis implies that the sharp decline in output during the 2007-2009 financial crisis is largely attributable to the financial inter-mediation shock, along with shocks originating outside of the financial system.

Would depositors pay to show that they do not withdraw? Theory and experiment

In a Diamond–Dybvig type model of financial intermediation, we allow depositors to announce at a positive cost to subsequent depositors that they keep their funds deposited in the bank. Theoretically, the mere availability of public announcements (and not its use) ensures that no bank run is the unique equilibrium outcome. Multiple equilibria—including bank run—exist without such public announcements. We test the theoretical results in the lab and find a widespread use of announcements, which we interpret as an attempt to coordinate on the no bank run outcome. Withdrawal rates in general are lower in information sets that contain announcements.

Household Financial Decision-Making and Macroeconomic Fluctuations

ABSTRACT This paper introduces household financial decision-making process into the classic financial intermediation model, which allows us to study the impact of households’ portfolio choice on the behavior of financial intermediation and the real economy. Our numerical results show that the incorporation of household financial decision helps stabilize the aggregate economy through the following channel. A negative shock of capital quality reduces the total assets of financial intermediaries and tightens their lending to enterprises. This leads to a decline in social investment and output. Then, the household responds to this by changing their asset composition, which alleviates the impact of the negative shock and thus stabilize the economy.

Financial Stability with Sovereign Debt

Are government guarantees or financial regulation a more effective way to prevent banking crises? I study this question in the presence of a negative feedback loop between the fiscal position of the government and the health of the banking sector. I construct a model of financial intermediation in which the government issues, and may default on, debt. Banks hold some of this debt, which ties their health to that of the government. The government’s tax revenue, in turn, depends on the quantity of investment that banks are able to finance. I compare the effectiveness of government guarantees, liquidity regulation, and a combination of these policies in preventing self-fulfilling bank runs. In some cases, a combination of the two policies is needed to prevent a run. In other cases, liquidity regulation alone is effective and adding guarantees would make the financial system fragile.

Microcredit contract design: A macroeconomic evaluation

Abstract There is now a vast literature investigating the impact of microcredit on poverty in the developing world. Such studies are by and large at the micro-level – investigating the impact of the provision of microcredit loans or a feature of microcredit contracts for a specific microfinance institution (MFI) on measures of well-being such as poverty or female empowerment. While these studies are crucial for understanding the effectiveness of microcredit in various contexts, very little analysis has been at the macroeconomic level with a view to understanding the general equilibrium effects of microfinance. This paper does this, by providing a comprehensive theory that allows the relative importance of the various factors influencing microcredit’s impact to be quantified. We build on Buera et al. (2012) and develop a model of financial intermediation which highlights the roles of credit market imperfections, MFI efficiency and occupational choice. We exploit the large cross-country variation in microcredit features to decipher the important features of microcredit contracts, calibrating the model to data for 21 countries in the early 2000s. We then use the calibrated model to investigate the impact of a number of counterfactual scenarios which may lend insight into microcredit policy, such as training for microcredit clients, credit information-sharing and microcredit itself. We investigate the impact of each policy experiment on poverty, income per capita and entrepreneurship. This paper highlights that the impact of credit policies differs significantly across countries, and therefore that no credit-based policy is a panacea for improving welfare.

Institutionalizing Islamic Banking: The Case of Bank of Khyber, Pakistan

This article discusses the move for conversion of a conventional bank into Islamic one taking the Bank of Khyber (BoK), Pakistan as a case study. It provides an in-depth and emprical narrative of how Islamic banking has been introduced at the Bank of Khyber particularly motivated by political and social incentives to reconstruct the current conventional banking model. Initially, BoK was operating on conventional model of financial intermediation and gradually, an Islamic banking division, a Shari‘ah Board, and multiple Islamic depository and financing processes have been introduced and institutionalized to establish social and political legitimacy within the context. The narrative article highlights the core challenges to the BoK team and value creation of the institutional intervention, particularly shared value creation and collaborative efforts across the industry, from an institutional theory perspective. The narrative carries multiple implications for the Islamic banking professionals and offers practical insights on the process of business model reconstruction within the context of Islamic banking.