Should new or rapidly growing banks have more equity?

There is substantial evidence that new banks and rapidly growing banks are risk prone. We study this problem by designing a relationship-lending model in which a bank operates as a financial intermediary and centralised monitor. In the absence of deposit insurance, the bank’s limited liability option creates an incentive problem between the bank and its depositors, the likely outcome of which is a reduction in the amounts of resources allocated to monitoring its borrowers. Hence, the bank must signal its safety to depositors by maintaining the equity ratio held. The optimal equity ratio is dynamic, ie new banks need relatively more equity than established banks, which enjoy profitable old lending relationships – charter value – that reduce the incentive problem. However, if an established bank grows rapidly, its share of old relationships also decreases and the bank will have to raise its equity ratio. With deposit insurance, regulators should set higher equity requirements for new banks and rapidly growing banks than for those in a more established position. The results of the model can be extended to more general inter-firm control of credit institutions.financial intermediation; relationship banking; financial fragility; bank regulation; deposit insurance; moral hazard; product quality

The Effects of Competition on Banks’ Risk Taking with and without Deposit Insurance

We consider the joint effect of competition and deposit insurance on risk taking by banks when the riskiness of banks is unobservable to depositors. It turns out that the magnitude of risk taking depends on the type of bank competition. If the bank is a monopoly or banks compete only in the loan market, deposit insurance has no effect on risk taking. In that case the banks are too risky but extreme risk taking is avoided. In contrast, introducing deposit insurance increases risk taking if banks compete for deposits. Then, deposit rates become excessively high and force the banks to take extreme risks. Regarding the effects of increasing competition when there is deposit insurance, the results imply that deposit competition encourages risk taking but loan market competition does not. Our results can be extended more generally to insurance guaranty funds.deposit insurance; insurance guaranty funds; bank and insurance regulation; moral hazard; credit rationing; financial fragility

Bank panics in transition economies

This paper discusses recent bank runs in seven transition economies (Russia, Bulgaria, Estonia, Hungary, Latvia, Lithuania and Romania), comparing them against the older US experience and theoretical research. Bank runs seem to usually be information based. For example, improvements in bank transparency such as new accounting rules can reveal a bank’s insolvency and trigger a run. However, bank runs, as seen a few years ago in East Asia, Bulgaria and Russia, may also be accompanied by runs on national currencies. We include a bank run model that shows a bank may issue liquid demand deposits and avoid runs without deposit insurance as long as it also issues less liquid time deposits. Self-fulfilling runs are prevented through elimination of the maturity mismatch. The well-known Diamond & Dybvig (1983) model is modified to account for depositors’ risk affinities, whereby high-risk depositors hold their savings as demand deposits and low-risk depositors prefer time deposits. These deposit choices transfer liquidity optimally from low-risk to high-risk depositors who value liquidity. By exploiting these choices, a bank can improve its intertemporal risk-sharing by issuing deposits of varying degrees of liquidity. This maturity transformation does not necessarily raise the economy’s total liquidity.ansition economies; bank panics; bank regulation; financial crises

Screening in the credit market when the collateral value is stochastic

This theoretical paper explores screening with loan collateral when both the collateral value and the probability of project success fluctuate. Some model versions challenge the classic findings of Bester (1985) by showing that high-risk borrowers may in such case be more willing to pledge collateral than low-risk borrowers. Abundant collateral then would not signal low risk. The results may help explain the mixed empirical findings on the role of collateral. The paper also extends the analysis of the topical subprime crises and risky real estate collateral.banking; collateral; screening; signalling; subprime lending

Blanket guarantee and restructuring decisions for multinational banks in a bargaining model

This paper examines blanket guarantee and restructuring decisions in respect of a multinational bank (MNB) using Nash bargaining, when the threat of a panic motivates countries to take decisions quickly. The failure of the bank would cause unevenly distributed externalities between the countries concerned, which influences restructuring incentives. In equilibrium, the bank is either liquidated or one – or both of the countries – recapitalizes it. The partition of the recapitalisation costs is sensitive to the country-specific benefits and costs from recapitalisation, panics and liquidation. The home regulator benefits from the privilege of being the only entity that can legally liquidate the MNB. Rational expectations regarding the bargaining result affect the incentives to declare a blanket guarantee.banking crises; bank restructuring; blanket guarantee; bargaining; deposit insurance

The role of comparing in financial markets with hidden information

This paper studies how comparing can be used to provide information in financial markets in the presence of a hidden characteristics problem. Although an investor cannot precisely estimate the future returns of an entrepreneur’s projects, the investor can mitigate the asymmetric information problem by ranking different entrepreneurs and financing only the very best ones. Information asymmetry can be eliminated with certainty if the number of compared projects is sufficiently large. Because comparing favours centralised information gathering, it creates a novel rationale for the establishment of a financial intermediary.asymmetric information; banking; corporate finance; financial intermediation; ranking; venture capital

Bank Panics, Deposit Insurance and Liquidity

Only abstract. Paper copies of master’s theses are listed in the Helka database (http://www.helsinki.fi/helka). Electronic copies of master’s theses are either available as open access or only on thesis terminals in the Helsinki University Library.Vain tiivistelmä. Sidottujen gradujen saatavuuden voit tarkistaa Helka-tietokannasta (http://www.helsinki.fi/helka). Digitaaliset gradut voivat olla luettavissa avoimesti verkossa tai rajoitetusti kirjaston opinnäytekioskeilla.Endast sammandrag. Inbundna avhandlingar kan sökas i Helka-databasen (http://www.helsinki.fi/helka). Elektroniska kopior av avhandlingar finns antingen öppet på nätet eller endast tillgängliga i bibliotekets avhandlingsterminaler.The dissertation focuses on bank regulation: bank panics, deposit insurance and liquidity. Relevant banking literature is reviewed in the first chapter. The second chapter analyses the adverse selection problem of deposit insurance. It is shown that the deposit insurer can screen low-risk and high-risk banks by designing a self-selection mechanism so that each bank obtains a risk-based insurance premium; high-risk banks obtain full insurance coverage and low-risk bank partial coverage. The demand of deposit insurance crucially depends on whether bank risk is observable to depositors or not. The third chapter studies how bank competition influences the negative incentive effects of deposit insurance. Competition for deposits proves to be more dangerous than competition for borrowers. Depositors favor extreme risk taking, since they receive a high payment whether the bank succeeds or fails. If the bank succeeds, it can pay high interest on deposits, whereas in the reserve case the insurer pays an equal indemnity to fully insured depositors. The fourth and fifth chapters study bank runs. It is shown that a bank can raise demand deposits and yet avoid runs if it also raises time deposits, which have relatively low liquidation value. Hence, runs can be prevented without deposit insurance, and the negative incentive effects of the insurance can also be avoided. The sixth chapter focuses on the incentive problem between the bank and depositors (or the deposit insurer): bank’s shareholders’ limited liability makes risk shifting lucrative. It is shown how intertemporal diversification of lending decisions - bank’s loan portfolio consists of overlapping long-term loans and is thus reinvested gradually over a long time-span - may solve the incentive problem of risk shifting. Moreover, maturity mismatch - illiquidity of long-term loans and liquidity of deposits - proves to be optimal. The bank can commit to a safe lending strategy by investing in illiquid assets. Liquidity of deposits serves as a tool of market discipline, since it gives depositors an option to withdraw deposits immediately when they observe bank’s credit losses. The optimality of maturity mismatch stands in sharp contrast to the implications of the classical bank run models, in which maturity mismatch makes banks susceptible to destructive runs

Experience Goods, Umbrella Branding, and Reputation

This paper examines umbrella brands—brand stretching or brand extension—in a model of experience goods and an infinite number of periods. A monopoly firm has short-run incentives to compromise on product quality so as to save costs, as buyers can observe quality only ex post. The paper shows that the overlapping structure of product launching strengthens umbrella branding, mitigates moral hazard, and makes easier the building of a good reputation and its maintenance. The overlapping structure generates switching costs between strategies.</p