Model Of Financial Intermediation Research Articles

Financial intermediation, variability and the development process

In this paper we build a model of financial intermediation that explains the pattern of GDP variability in an economy during the development process. We find evidence that per capita output is more volatile in middle-income economies than in both low and high-income economies. We show that, if the model economy is in the early or in the mature stages of development, there is a unique equilibrium. However, in the middle stages of development, multiple equilibria exist. Moreover, we find that in economies with imperfect credit markets, per capita output volatility tends to be higher than in economies with perfect or non-existent credit markets.

Implementing efficient allocations in a model of financial intermediation

In a finite-trader version of the Diamond and Dybvig (J. Polit. Econ. 91 (1983) 401) model, the ex ante efficient allocation is implementable by a direct mechanism (i.e., each trader announces the type of his own ex post preference) in which truthful revelation is the strictly dominant strategy for each trader. When the model is modified by formalizing the sequential-service constraint (cf. Wallace (Fed. Reserve Bank Minneapolis Quart. Rev. 12 (1988) 3)), the truth-telling equilibrium implements the symmetric, ex ante efficient allocation with respect to iterated elimination of strictly dominated strategies.

Financial dollarization

We present a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet. We show that minimum variance portfolio (MVP) allocations provide a natural benchmark to estimate the scope for dollarization of assets and liabilities (financial dollarization) as a function of macroeconomic uncertainty. Within this benchmark, we find that financial dollarization displays high persistence whenever the expected volatility of the inflation rate remains high in relation to that of the real exchange rate, even after price stabilization has been achieved. The empirical evidence confirms that MVP dollarization approximates financial dollarization closely for a broad sample of countries.

Financial Intermediation without Exclusivity

Futures exchanges and other financial intermediaries assume counterparty risks and, in return, demand guarantees that these counterparties will deliver on their promises. It is often argued that, to attract volume, financial intermediaries would settle for excessively low contractual guarantees. In Santos and Scheinkman (2001), we model financial intermediation in an environment where traders may choose to default, and we examine the characteristics of the equilibrium. In particular, we investigate whether competition implies excessively low standards. We show that, in fact, when society punishes default and intermediaries can impose collateral requirements effectively to limit the size of positions, competition leads to a (constrained) optimal amount of contractual guarantees. In Santos and Scheinkman (2001) we assume that exchanges cannot control the size of the positions taken by individuals, but we preclude investors from participating in more than one exchange. This ignores the effect that trading with one financial intermediary may have on the risks faced by other intermediaries. Financial intermediaries typically cannot control the amount of risk that counterparties will take with other intermediaries. In this paper we examine the effect of dropping the exclusivity assumption. We show that the constrained optimum can no longer be implemented as a standard Nash equilibrium with free entry. Nonetheless this allocation is the only one that can be sustained as an anticipatory equilibrium (Charles Wilson, 1977). To break a candidate anticipatory equilibrium it must be possible to add a contract that is profitable and that does not become unprofitable when the now unprofitable contracts from the original menu are withdrawn. If one views this requirement as reasonable, nonexclusivity reproduces the outcome that obtains when intermediaries enjoy exclusivity but cannot control the size of positions taken against them by traders. A superficially similar result holds in the insurance model of Richard Arnott and Joseph E. Stiglitz (1993). In that model, the price of insurance is simply the ratio of what the client pays in the favorable state versus what he receives in the adverse state. As a consequence, if insurers cannot control the size of policies, it makes no difference whether a client buys from one or many insurance companies: clients will buy as much as desired at the lowest price. As we will show below, in our model of financial intermediation, agents may want to combine several contracts, and this is precisely the reason why the original equilibrium does not survive as a Nash equilibrium once exclusivity is dropped.

Crash-Free Sequencing Strategies for Financial Development and Liberalization

This paper uses a stylized model of financial intermediation to characterize the exact circumstances along various paths of economic growth, financial development, and liberalization that can trigger a financial crisis. It shows how to avoid financial crises through proper sequencing of various financial development and liberalization measures. The results of the paper show that naive combinas of financial development and liberalization processes can give rise to financial crises. In some typical situations, in order to avoid a financial crisis, it is important that financial liberalization be accompanied by financial development, in the form of improvements in the financial sector's efficiencies. In the case of fast growing economies, financial development becomes even more imperative.

Relative Performance Evaluations in a Model of Financial Intermediation

This paper focuses on the delegation by bank managers of lending decisions to their agents, typically subordinate employees of the bank. We assume that agents may base their decisions about lending to borrowers on decisions other banks have made about these same borrowers. Then we show that there exist some lazy or negligent agents who neither directly monitor the borrower nor imitate the other banks if managers use relative performance evaluations as incentive schemes. In addition, it is shown that the learning or adjustment process of agents exhibits cyclical dynamics. Journal of Economic Literature Classification Numbers: D82, D83.

Crash-Free Sequencing Strategies for Financial Development and Liberalization

In the context of a stylized model of financial intermediation, this paper characterizes the circumstances along the paths of financial development, financial liberalization and economic growth that can trigger a financial crisis. It shows how to avoid financial crises through the proper sequencing of various financial development and liberalization measures. Usually, financial development should accompany, and even take priority over, financial liberalization. This is especially true in the case of fast growing economies.

Comment on Banking in Transition Economies: Does Efficiency Require Instability

Transition economies have been a very interesting laboratory of financial reform. While obviously some differences existed among these economies at the start of transition, there was, in terms of financial sector development, much commonality. Under central planning, banks were the passive recipients of household savings, since bank deposits were often the only asset households could hold. Banks were mere accounting agencies, keeping track of the financial transactions that resulted from planned allocations. Normal banking skills, including risk management, project screening and selection, and a diversified menu of instruments to attract savers, were absent. The other components of a financial system were rudimentary, and in most countries nonbank finance simply did not exist. Initially, one bank performed all lending. Early attempts at market reform in most countries saw this divided into a two-tier system, comprising one central bank and a number of commercial banks, often specialized by sector. But this had very little effect on banks' behavior. Since then, transition economies have pursued quite different financial reform paths, and have adopted and experimented with a range of reform approaches for the financial sector, with, at least at face value, quite different outcomes. There is thus potentially much to be learned from the outcomes for financial reform in these countries and in general. So far, much of the learning has been done without the benefit of an analytical model. This paper is therefore very useful as it can help provide this and thus guide the analysis of outcomes and further policy making. The paper is one of the first attempts to apply some of the recent models of financial intermediation for developed countries to transition economies and as such it provides much insight. My comments on the paper are in three parts: the description of the banking systems and reform in transition economies; the model, its assumptions, and applicability to transition economies; and the lessons for policy and empirical work. The descriptive part of the paper provides useful background for the issues at hand. It provides the macroeconomic, financial, and institutional development context in which financial reform took place. It highlights the unique linkages between enterprise restructuring and financial reform in transition economies, and the large differences in macroeconomic developments among countries since the onset of transition.

Strategic dimensions of correspondent banking

Correspondent banking, the provision of services by one bank to another, has been a neglected area of academic research, and literature lacks a comprehensive theoretical framework to describe correspondent relationships. The bulk of previous studies have been conducted in the USA, where the regulatory environment places particular requirements on correspondent banking relationships that are difficult to generalise to countries such as Australia. This paper explores two theoretical frameworks for correspondent banking. The first sees correspondent banking in a financial contracting cost‐reduction framework, in line with theoretical models of financial intermediation. The second framework is based on Dunning’s (1979) eclectic theory of international investment. Correspondent banking is viewed as a strategic tool to be used when a banking firm does not at present possess a full range of ownership‐specific, locational and internalisation advantages. The paper reviews the traditional and modern functions of correspondent banking and the structural arrangements that can be put in place to organise these activities. Case studies of two banks, operating in Australia, are used to illustrate the different strategic and structural approaches that can be utilised in respect of correspondent banking.

Financial intermediation under information asymmetry: implications for capital market efficiency in selected developing countries

Considers the methods whereby income is likely to grow in developing countries, given imperfect information and the need for credit for investment. Looks at the link between financial intermediation and economic growth for nine countries between 1969 and 1992, using a financial intermediation model, comparing demand‐following and supply‐leading financial linkages. Finds that financial structure variables explain income growth better than investment variables in five countries ; demand‐following intermediation fitted two countries better; and the supply‐leading channel fitted three countries better. Concludes that financial intermediaries mobilize domestic resources for economic growth in several countries.

Dollarization of Financial Intermediation: Causes and Policy Implications

This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries, and policy implications are explored.

Dollarization of Financial Intermediation: Causes and Policy Implications

This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank`s balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries, and policy implications are explored.

Multiple reserve requirements: An irrelevance result

This paper examines the rationale for multiple reserve requirements in the context of a general equilibrium model of financial intermediation developed by [ Romer (1985) Financial intermediation, reserve requirements, and inside money. A general equilibrium analysis, Journal of Monetary Economics 16, 175–194.]. In this framework, it is shown that the existence of a bond reserve requirement is irrelevant: adding a bond reserve requirement to the model is no different than adjusting the currency reserve requirement.

Financial Intermediation, Loanable Funds, and The Real Sector

We study an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained. We analyze how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring. We show that all forms of capital tightening (a credit crunch, a collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that interest rate effects and the intensity of monitoring will depend on relative changes in the various components of capital. The predictions of the model are broadly consistent with the lending patterns observed during the recent financial crises. I. INTRODUCTION During the late 1980s and early 1990s several OECD countries appeared to be suffering from a credit crunch. Higher interest rates reduced cash flows and pushed down asset prices, weakening the balance sheets of firms. Loan losses and lower asset prices (particularly in real estate) ate significantly into the equity of the banking sector, causing banks to pull back on their lending and to increase interest rate spreads. The credit crunch hit small, collateral-poor firms the hardest. Larger firms were less affected as they could either renegotiate their loans or go directly to the commercial paper or bond markets. Scandinavia seems to have been most severely hit by the credit crunch. The banking sectors of Sweden, Norway, and Finland all had to be rescued by their governments at a very high

Pension Funds and Urban Investment: Four Models of Financial Intermediation

It has been often suggested that public and private pension funds should be, and could be, mobilised to invest in urban infrastructure, housing, and community development. In fact, given the apparent decline in government funding of such areas of concern, it has been suggested that pension funds may be the only ‘new’ sources of finance in the near future. In this paper, I assess the current state of play in the pension fund investment management industry, noting the conservatism of many fund trustees with respect to alternative investment products (AIPs) as well as noting that standard models of asset allocation hardly ever allocate significant resources to such products. It is argued that the rate of adoption and the level of funding of AIPs depend upon solutions to two basic interrelated problems associated with AIPs: the high costs of imperfect information and the lack of adequate measures of product providers' veracity. A set of four institutional solutions to these problems are reviewed, with a focus put upon the design and implementation of AIPs in relation to conventional financial markets. This leads to a consideration of the proper role of government policy with respect to AIPs and the long-term potential of AIPs with respect to product innovation in financial markets in general.

A Comment on a Model of Financial Intermediation: Market Signalling in the Long Run

Article A Comment on a Model of Financial Intermediation: Market Signalling in the Long Run was published on June 1, 1997 in the journal Jahrbücher für Nationalökonomie und Statistik (volume 216, issue 3).

Implementing Efficient Allocations in a Model of Financial Intermediation

In a finite-trader version of the Diamond-Dybvig (1983) model, the symmetric, ex-ante efficient allocation is implementable by a direct mechanism (i.e., each trader announces the type of his own ex-post preference) in which truthful revelation is the strictly dominant strat-egy for each trader. When the model is modified by formalizing the sequential-service con-straint (cf. Wallace, 1988), the truth-telling equilibrium implements the symmetric, ex-ante efficient allocation with respect to iterated elimination of strictly dominated strategies.

Loan commitments and optimal monetary policy

With loan commitments negotiated in advance, the use of ‘tight money’ to restrain nominal spending has asymmetric effects upon different categories of borrowers. This can reduce efficiency, even though aggregate demand is stabilized. An equilibrium model of financial intermediation with loan commitments is developed, and used to analyze the welfare consequences of alternative monetary policies. If demand uncertainty relates primarily to the number of borrowers rather than to each one's demand for credit, an interest-rate smoothing policy is optimal.

A bargaining model of financial intermediation

In a financial market, the investor searches for investment projects and bargains with the entrepreneur about the financial contract. Alternatively, he may delegate search and bargaining to a financial intermediary. Delegation generates a commitment advantage in bargaining. It may, however, induce excessively risky investments because the investor cannot monitor the intermediary's search behavior. This restricts the parameter constellations under which equilibrium intermediation occurs. Competition may not reduce the intermediaries' profits to zero because of incentive restrictions.

A contingent claim analysis of a regulated depository institution

A model of financial intermediation to determine the market value of bank equity, deposits and deposit insurance is developed. The implicit equilibrium interest rate on deposits is derived and analyzed. Three types of risks are considered in the model: interest-rate risk, financial risk and default risk. The effect of different regulatory measures, such as capital adequacy, reserve and liquidity requirements, deposit insurance and interest rate ceilings is analyzed and their impact on the bank behavior is also assessed. Moreover, we investigate the interactions among these measures to determine which are dominant under alternative circumstances, and which are redundant.