Banks as Delegated Risk Managers

Risk management, although of major importance in the banking industry in practice, plays only a minor role in the theory of banking. We reduce this gap by putting forward a model in which risk managers - specialists that can find out correlations between risky assets - endogenously take over typical functions of banks. They grant loans, they consult on financial questions with firms that are threatened by bankruptcy, and they sign tailor-made hedge transactions with these firms. Delegation costs are innately low if banks assume the function of risk managers in an economy. Risk management can be seen as a core competence of banks.

Banks without Parachutes - Competitive Effects of Government Bail-out Policies

Lecture on the first SFB/TR 15 meeting, Gummersbach, July, 18 - 20, 2004The explicit or implicit protection of banks through government bail-out policies is a universal phenomenon. We analyze the competitive effects of such policies in two models with different degrees of transparency in the banking sector. Our main result is that the bail-out policy unambiguously leads to higher risk-taking at those banks that do not enjoy a bail-out guarantee. The reason is that the prospect of a bail-out induces the rotected bank to expand, thereby intensifying competition in the deposit market and depressing other banks’ margins. In contrast, the effects on the protected bank’s risk taking and on welfare depend on the transparency of the banking sector

Umbrella Branding and the Provision of Quality

Consider a two-product firm that decides on the quality of each product. Product quality is unknown to consumers. If the firm sells both products under the same brand name, consumers adjust their beliefs about quality subject to the performance of both products. We show that if the probability that low quality will be detected is in an intermediate range, the firm produces high quality under umbrella branding whereas it would sell low quality in the absence of umbrella branding. Hence, umbrella branding mitigates the moral hazard problem. We also find that umbrella branding survives in asymmetric markets and that even unprofitable products may be used to stabilize the umbrella brand. However, umbrella branding does not necessarily imply high quality; the firm may choose low-quality products with positive probability

License Auctions and Market Structure

We analyze the interplay between license auctions and market structure in a model with several incumbents and several potential entrants. The focus is on the competitiveness induced by the number of auctioned licenses. Moreover, we study how the auction format affects the incentives for explicit or tacit collusion among incumbents. A crucial role is played by the relation between the number of incumbents and the number of licenses. If the number of incumbents is greater than the number of new licenses, we show that auctioning more licenses need not result in greater competitiveness. If the number of licenses exceeds the number of incumbents, we display plausible conditions under which all incumbents get a license. Finally, we suggest a positive role for some auction formats in which the number of licenses is endogenously determined at the auction. We illustrate some results with examples drawn from European license auctions for 3G mobile telephony.

On the Long-Run Evolution of Technological Knowledge

This paper revisits the debate about the appropriate differential equation that governs the evolution of knowledge in models of endogenous growth. We argue that the assessment of the appropriateness of an equation of motion should not only be based on its implications for the future, but that it should also include its implications for the past. We maintain that the evolution of knowledge is plausible if it satisfies two asymptotic conditions: Looking forwards, infinite knowledge in finite time should be excluded, and looking backwards, knowledge should vanish towards the beginning of time (but not before). Our key results show that, generically, the behavior of the processes under scrutiny is either plausible in the future and implausible in the past or vice versa, or implausible at both ends of the time line.endogenous technological change, Malthus, long-run growth

Credit Risk Transfer and Bank Competition

We present a banking model with imperfect competition in which borrowers’ access to credit is improved when banks are able to transfer credit risks. However, the market for credit risk transfer (CRT) works smoothly only if the quality of loans is public information. If the quality of loans is private information, banks have an incentive to grant unprofitable loans in order to transfer them to other parties, leading to an increase in aggregate risk. Nevertheless, the introduction of CRT generally increases welfare in our setup. However, under private information, higher competition induces an expansion of loans to unprofitable firms, which in the limit offsets the welfare gains from CRT completely.access to credit, bank competition, credit derivatives, Credit risk transfer, public and private information

The Threat of Capital Drain: A Rationale for Public Banks?

This paper yields a rationale for why subsidized public banks may be desirable from a regional perspective in a financially integrated economy. We present a model with credit rationing and heterogeneous regions in which public banks prevent a capital drain from poorer to richer regions by subsidizing local depositors, for example, through a public guarantee. Under some conditions, cooperative banks can perform the same function without any subsidization; however, they may be crowded out by public banks. We also discuss the impact of the political structure on the emergence of public banks in a political-economy setting and the role of interregional mobility.Public banks; cooperative banks; capital drain; credit rationing; financial integration; privatization.

The Politician and his Banker

Should the European Union grant state aid through an institution like the European Investment bank? This paper evaluates the efficiency of different measures for granting state aid. We use a theoretical model with firms that differ in their creditworthiness and compare different types of subsidies with indirect subsidization through public banks. We find that, in a large parameter range, the politician prefers public banks to direct subsidies because they avoid windfall gains to entrepreneurs and they economize on screening costs. For similar reasons, they may increase social welfare relative to subsidies. One important prerequisite for this result is that public banks must not be allowed to fully compete with private banks. However, from a welfare perspective, a politician uses public banks inefficiently often

Bank Size and Risk-Taking under Basel II

This paper discusses the relationship between bank size and risk-taking under Pillar I of the New Basel Capital Accord. Using a model with imperfect competition and moral hazard, we find that small banks (and hence small borrowers) may profit from the introduction of an internal ratings based (IRB) approach if this approach is applied uniformly across banks. However, the banks’ right to choose between the standardized and the IRB approaches unambiguously hurts small banks, and pushes them towards higher risk-taking due to fiercer competition. This may even lead to higher aggregate risk in the economy.Basel II, IRB approach, bank competition, capital requirements, SME financing

Observable Reputation Trading

Is the reputation of a firm tradable when the change in ownership is observable? We consider a competitive market in which a share of owners must retire in each period. New owners bid for the firms that are for sale. Customers learn the owner’s type, which reflects the quality of the good or service provided, through experience. After observing an ownership change they may want to switch firm. However, in equilibrium, good new owners buy from good old owners and retain high-value customers. Hence reputation is a tradable intangible asset, although ownership change is observable