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Microeconomics of Banking
by Freixas, Rochet
| ISBN: 9780262375283 | Copyright 2023
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The third edition of a leading text on the microeconomic foundations of banking, comprehensively updated with new coverage of the 2008 Global Financial Crisis, fintech, and the latest research in banking theory.
The banking industry has undergone seismic change in the twenty-first century, from the overhaul of regulation in the wake of the 2008 Global Financial Crisis to the digitalization of the economy and the disruption of traditional business models by ascendant tech giants. Now in a comprehensively updated third edition, this essential graduate-level text on the microeconomic foundations of banking provides the rigorous theoretical approach required to understand these new structures and norms, functioning as a user's guide to recent academic literature. Microeconomics of Banking offers a comprehensive view of the evolution of banking theory and the rapidly changing realm of financial intermediation, examining the central issues and offering the necessary tools for understanding how they have been modeled.
New edition highlights:
•Up-to-date coverage of the latest research in banking theory as well as the events of the global financial crisis and resultant Basel III regulatory framework
•New chapters on liquidity and systemic risk
•New material throughout on cryptocurrencies, fintech, and other facets of a digitalized economy
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| Contents (pg. v) | |
| Preface to the Third Edition (pg. xiii) | |
| 1. Introduction (pg. 1) | |
| 1.1 What Is a Bank, and What Do Banks Do? (pg. 1) | |
| 1.2 Liquidity and Payment Services (pg. 2) | |
| 1.2.1 What Came First: Money or Credit? (pg. 2) | |
| 1.2.2 Money Is Memory (pg. 3) | |
| 1.2.3 Money as a Bubble (pg. 5) | |
| 1.2.4 The Three Functions of Money (pg. 5) | |
| 1.2.5 Money Changing (pg. 6) | |
| 1.2.6 Payment Services (pg. 6) | |
| 1.3 Managing Financial Risks (pg. 7) | |
| 1.3.1 Transformation Risk (pg. 7) | |
| 1.3.2 Credit Risk (pg. 8) | |
| 1.3.3 Financial Markets Risk (pg. 8) | |
| 1.4 Alleviating Asymmetric Information Problems (pg. 9) | |
| 1.4.1 Ex Ante Asymmetric Information (pg. 9) | |
| 1.4.2 Interim Asymmetric Information (pg. 9) | |
| 1.4.3 Ex Post Asymmetric Information (pg. 9) | |
| 1.5 Banking in aWorld without Frictions (pg. 9) | |
| 1.5.1 The Consumer (pg. 10) | |
| 1.5.2 The Firm (pg. 11) | |
| 1.5.3 The Bank (pg. 11) | |
| 1.5.4 The Competitive Equilibrium (pg. 11) | |
| 1.6 Outline of the Book (pg. 12) | |
| 1.7 Problem (pg. 13) | |
| 1.8 Solution (pg. 14) | |
| Notes (pg. 14) | |
| References (pg. 15) | |
| 2. Banks and Informational Frictions (pg. 17) | |
| 2.1 Introduction (pg. 17) | |
| 2.2 Maturity Transformation and Liquidity Insurance (pg. 18) | |
| 2.2.1 The Diamond-Dybvig Model (pg. 19) | |
| 2.2.2 The Symmetric Pareto Optimal Allocation (pg. 19) | |
| 2.2.3 Autarky (pg. 20) | |
| 2.2.4 Financial Markets (pg. 21) | |
| 2.2.5 Bank Deposit Contracts (pg. 22) | |
| 2.3 Financial Intermediation as Delegated Monitoring (pg. 23) | |
| 2.4 Moral Hazard and the Monitoring Role of Banks (pg. 24) | |
| 2.5 Credit Risk and Dilution Costs (pg. 28) | |
| 2.5.1 The Model (pg. 28) | |
| 2.5.2 Bond Financing (pg. 28) | |
| 2.5.3 Equity Issue (pg. 29) | |
| 2.5.4 Bank Loan (pg. 29) | |
| 2.6 Further Reading (pg. 30) | |
| 2.7 Problems (pg. 31) | |
| 2.7.1 Market versus Bank Finance (pg. 31) | |
| 2.7.2 Banks and Moral Hazard (pg. 32) | |
| 2.8 Solutions (pg. 32) | |
| 2.8.1 Market versus Bank Finance (pg. 32) | |
| 2.8.2 Banks and Moral Hazard (pg. 33) | |
| Note (pg. 34) | |
| References (pg. 34) | |
| 3. The Industrial Organization Approach to Banking (pg. 37) | |
| 3.1 The Old Approach to Monetary Policy: Money and Credit Multipliers (pg. 38) | |
| 3.2 Perfectly Competitive Banking (pg. 39) | |
| 3.2.1 The Model (pg. 39) | |
| 3.2.2 How Do Interest Rates Influence the Volumes of Deposits and Loans? (pg. 40) | |
| 3.2.3 The Competitive Equilibrium (pg. 40) | |
| 3.3 Imperfect Competition (pg. 41) | |
| 3.3.1 The Monti-Klein Model of a Monopoly Bank (pg. 42) | |
| 3.3.2 The Oligopoly Version (pg. 43) | |
| 3.3.3 Product Differentiation (pg. 44) | |
| 3.3.4 Empirical Evidence (pg. 47) | |
| 3.4 Is There a Trade-off between Competition and Financial Stability? (pg. 47) | |
| 3.4.1 The Fragility View (pg. 47) | |
| 3.4.2 The Stability View (pg. 48) | |
| 3.4.3 The Impact of Capital Requirements (pg. 48) | |
| 3.4.4 Empirical Evidence (pg. 49) | |
| 3.5 Competition and Lending Standards (pg. 50) | |
| 3.5.1 The Screening Externality (pg. 50) | |
| 3.5.2 Lending Standards through the Business Cycle (pg. 51) | |
| 3.5.3 Empirical Evidence (pg. 51) | |
| 3.6 Relationship Banking (pg. 52) | |
| 3.6.1 A Simple Model (pg. 52) | |
| 3.6.2 Public and Private Information about Borrowers (pg. 53) | |
| 3.6.3 Empirical Evidence (pg. 53) | |
| 3.7 Platform Competition and Two-Sided Markets (pg. 55) | |
| 3.7.1 A Model of the Payment Card Industry (pg. 56) | |
| 3.7.2 Card Use (pg. 57) | |
| 3.7.3 Monopoly Network (pg. 57) | |
| 3.7.4 Competing Networks (pg. 58) | |
| 3.7.5 Welfare Analysis (pg. 59) | |
| 3.7.6 Bigtechs (pg. 59) | |
| 3.8 Further Reading (pg. 60) | |
| 3.9 Problems (pg. 62) | |
| 3.9.1 Double Bertrand Competition (pg. 62) | |
| 3.9.2 Deposit Rate Regulation (pg. 63) | |
| 3.10 Solutions (pg. 63) | |
| 3.10.1 Double Bertrand Competition (pg. 63) | |
| 3.10.2 Deposit Rate Regulation (pg. 64) | |
| Notes (pg. 65) | |
| References (pg. 65) | |
| 4. The Lender-Borrower Relationship (pg. 69) | |
| 4.1 The Complete Information Benchmark (pg. 70) | |
| 4.2 Costly State Verification (pg. 72) | |
| 4.2.1 Incentive-Compatible Contracts (pg. 72) | |
| 4.2.2 Efficient Incentive-Compatible Contracts (pg. 73) | |
| 4.3 Debt as the Least Information-Sensitive Security (pg. 74) | |
| 4.4 Incentives to Repay (pg. 75) | |
| 4.4.1 Promise to Lend Again (pg. 75) | |
| 4.4.2 The Impact of Judicial Enforcement (pg. 76) | |
| 4.5 Sovereign Debt (pg. 78) | |
| 4.5.1 The Eaton-Gersovitz Paradigm (pg. 78) | |
| 4.5.2 Critiques of the Eaton-Gersovitz Paradigm (pg. 79) | |
| 4.5.3 The Political Economy Approach (pg. 80) | |
| 4.6 Complements (pg. 81) | |
| 4.6.1 Moral Hazard (pg. 81) | |
| 4.6.2 Incomplete Contracts (pg. 82) | |
| 4.6.3 Soft Budget Constraints (pg. 83) | |
| 4.7 Further Reading (pg. 85) | |
| 4.8 Problems (pg. 86) | |
| 4.8.1 Optimal Risk Sharing with Symmetric Information (pg. 86) | |
| 4.8.2 Optimal Debt Contracts with Moral Hazard (pg. 86) | |
| 4.8.3 The Pareto Frontier in the Townsend Model (pg. 87) | |
| 4.8.4 The Optimality of Stochastic Auditing Schemes (pg. 87) | |
| 4.9 Solutions (pg. 88) | |
| 4.9.1 Optimal Risk Sharing with Symmetric Information (pg. 88) | |
| 4.9.2 Optimal Loan Contracts with Moral Hazard (pg. 88) | |
| 4.9.3 The Pareto Frontier in the Townsend Model (pg. 89) | |
| 4.9.4 The Optimality of Stochastic Auditing Schemes (pg. 89) | |
| Notes (pg. 90) | |
| References (pg. 91) | |
| 5. The Macroeconomic Consequences of Financial Imperfections (pg. 93) | |
| 5.1 A Short Historical Perspective (pg. 94) | |
| 5.2 Transmission Channels of Monetary Policy (pg. 95) | |
| 5.2.1 The Money View and the Interest Rate Channel (pg. 95) | |
| 5.2.2 The Credit View and the Lending Channel (pg. 96) | |
| 5.2.3 Credit View versus Money View: Comparing the Underlying Assumptions (pg. 98) | |
| 5.2.4 Empirical Evidence (pg. 100) | |
| 5.2.5 Nonconventional Monetary Policy (pg. 102) | |
| 5.3 Financial Fragility and Economic Performance (pg. 102) | |
| 5.3.1 First Best Allocation (Perfect Information) (pg. 103) | |
| 5.3.2 Credit Constraints and Limited Liability (pg. 104) | |
| 5.3.3 Macroeconomic Implications (pg. 106) | |
| 5.4 Credit Cycles (pg. 107) | |
| 5.4.1 The Financial Accelerator (pg. 107) | |
| 5.4.2 Changing Credit Standards (pg. 108) | |
| 5.4.3 Collateral-Driven Credit Cycles (pg. 109) | |
| 5.5 Aggregate Credit Rationing (pg. 110) | |
| 5.5.1 The Backward-Bending Supply of Credit (pg. 111) | |
| 5.5.2 Adverse Selection (pg. 111) | |
| 5.5.3 Cash Flow Diversion (pg. 113) | |
| 5.5.4 Moral Hazard (pg. 114) | |
| 5.6 Financial Development and Economic Growth (pg. 115) | |
| 5.7 Further Reading (pg. 118) | |
| 5.8 Problems (pg. 120) | |
| 5.8.1 Adverse Selection and Aggregate Credit Rationing (pg. 120) | |
| 5.8.2 Too Much Investment (pg. 120) | |
| 5.9 Solutions (pg. 121) | |
| 5.9.1 Adverse Selection and Aggregate Credit Rationing (pg. 121) | |
| 5.9.2 Too Much Investment (pg. 121) | |
| Notes (pg. 122) | |
| References (pg. 123) | |
| 6. Bank Runs, Bank Panics, and the Lender of Last Resort (pg. 129) | |
| 6.1 The Fractional Reserve System (pg. 130) | |
| 6.1.1 The Bryant-Diamond-Dybvig Model (pg. 130) | |
| 6.1.2 Implementing the Optimal Allocation (pg. 130) | |
| 6.1.3 Multiple Equilibria (pg. 131) | |
| 6.1.4 Speculative Bank Runs (pg. 132) | |
| 6.1.5 Fundamental Bank Runs (pg. 133) | |
| 6.2 How to Remedy Banks Fragility (pg. 134) | |
| 6.2.1 Narrow Banking: From the Chicago Plan to Stablecoins (pg. 134) | |
| 6.2.2 Deposit Insurance and Prudential Regulation (pg. 134) | |
| 6.2.3 Equity Financed Banks (pg. 135) | |
| 6.3 Interbank Markets (pg. 136) | |
| 6.3.1 Insuring Liquidity Shocks (pg. 137) | |
| 6.3.2 Adverse Selection (pg. 137) | |
| 6.3.3 Liquidity Hoarding (pg. 138) | |
| 6.4 The Lender of Last Resort (LLR) (pg. 138) | |
| 6.4.1 Bagehot’s Doctrine (pg. 138) | |
| 6.4.2 The Practice of LLR Assistance (pg. 139) | |
| 6.4.3 Criticisms of the LLR Policy and the Modern Form of Bank Runs (pg. 140) | |
| 6.5 Further Reading (pg. 142) | |
| 6.6 Problems (pg. 143) | |
| 6.6.1 Nominal Bank Runs (pg. 143) | |
| 6.6.2 Aggregated Liquidity Shocks (pg. 144) | |
| 6.7 Solutions (pg. 145) | |
| 6.7.1 Nominal Bank Runs (pg. 145) | |
| 6.7.2 Aggregated Liquidity Shocks (pg. 145) | |
| Notes (pg. 146) | |
| References (pg. 146) | |
| 7. Liquidity (pg. 149) | |
| 7.1 Introduction (pg. 149) | |
| 7.2 Different Forms of Liquidity (pg. 150) | |
| 7.2.1 Defining Liquidity (pg. 150) | |
| 7.2.2 Public and Private Liquidity (pg. 151) | |
| 7.2.3 Funding Liquidity and Market Liquidity (pg. 151) | |
| 7.3 The Supply of Private Money (pg. 152) | |
| 7.3.1 Do Banks Issue Too Much Money? (pg. 152) | |
| 7.3.2 Shadow Banking (pg. 154) | |
| 7.4 Private and Public Supply of Liquidity (pg. 156) | |
| 7.4.1 The Model (pg. 156) | |
| 7.4.2 Symmetric Information (pg. 156) | |
| 7.4.3 Moral Hazard (pg. 157) | |
| 7.4.4 Aggregate Shocks (pg. 158) | |
| 7.5 Bubbles: When Asset Prices Diverge from Fundamentals (pg. 158) | |
| 7.5.1 Bubbles as Sources of Liquidity (pg. 158) | |
| 7.5.2 Cash in the Market Pricing (pg. 159) | |
| 7.5.3 Liquidity Spirals (pg. 159) | |
| 7.6 Liquidity Dry-Ups (pg. 160) | |
| 7.7 Liquidity and Collateral Prices (pg. 160) | |
| 7.7.1 Informational Sensitivity of Securities (pg. 161) | |
| 7.7.2 Implications (pg. 161) | |
| 7.8 Further Reading (pg. 162) | |
| 7.9 Problem (pg. 163) | |
| 7.10 Solution (pg. 164) | |
| Notes (pg. 165) | |
| References (pg. 165) | |
| 8. Banking Regulation: The Microprudential Approach (pg. 169) | |
| 8.1 Introduction: Why Are Banks Regulated? (pg. 169) | |
| 8.2 Deposit Insurance and Moral Hazard (pg. 170) | |
| 8.2.1 The Moral Hazard Issue (pg. 171) | |
| 8.2.2 Risk-Related Insurance Premiums (pg. 172) | |
| 8.3 Capital Regulation 1: The Theory (pg. 173) | |
| 8.3.1 The Value at Risk Approach (pg. 173) | |
| 8.3.2 Risk-Weighted Capital Regulation (pg. 174) | |
| 8.3.3 Portfolio Distortions (pg. 175) | |
| 8.3.4 What Level for Banks’ Capital? (pg. 176) | |
| 8.4 Capital Requirements 2: The Practice (pg. 176) | |
| 8.4.1 The Costs of Capital Regulation (pg. 176) | |
| 8.4.2 Empirical Evidence (pg. 177) | |
| 8.4.3 Regulatory Competition (pg. 178) | |
| 8.4.4 Accounting Rules and the Supplementary Leverage Ratio (pg. 178) | |
| 8.4.5 Supervisors’ Information and Managers’ Incentives (pg. 179) | |
| 8.4.6 Market Discipline (pg. 180) | |
| 8.5 Further Reading (pg. 182) | |
| 8.5.1 Banks’ Portfolio and Bankruptcy Risk (pg. 182) | |
| 8.5.2 Liquidity Regulation (pg. 183) | |
| 8.5.3 Disclosure and Market Discipline (pg. 183) | |
| 8.6 Problems (pg. 184) | |
| 8.6.1 Capital Regulation and Speculative Activities (pg. 184) | |
| 8.6.2 Capital Requirements and Business Cycles (pg. 185) | |
| 8.7 Solutions (pg. 185) | |
| 8.7.1 Capital Regulation and Speculative Activities (pg. 185) | |
| 8.7.2 Capital Requirements and Business Cycles (pg. 186) | |
| Notes (pg. 186) | |
| References (pg. 186) | |
| 9. Systemic Risk and Macroprudential Regulation (pg. 191) | |
| 9.1 Introduction (pg. 191) | |
| 9.2 Systemic Risk (pg. 191) | |
| 9.2.1 The Determinants of Systemic Risk (pg. 192) | |
| 9.2.2 Shadow Banks and Systemic Risk (pg. 193) | |
| 9.2.3 Measuring Systemic Risk (pg. 194) | |
| 9.3 Ex Post Policies: Bank Restructuring and Resolution (pg. 195) | |
| 9.3.1 A Bargaining Game between Bankers and Regulators (pg. 195) | |
| 9.3.2 Bank Resolution and Managers’ Incentives (pg. 196) | |
| 9.3.3 Optimal Bailout Mechanisms (pg. 196) | |
| 9.3.4 Debt Overhang after a Banking Crisis (pg. 199) | |
| 9.3.5 How to Restart a Frozen Market? (pg. 199) | |
| 9.3.6 Bail-Ins and CoCo Bonds (pg. 200) | |
| 9.4 Externalities and Macroprudential Policy (pg. 200) | |
| 9.4.1 Nonpecuniary Externalities (pg. 201) | |
| 9.4.2 Fire-Sale Externalities (pg. 202) | |
| 9.4.3 Procyclical Leverage and Credit Cycles (pg. 203) | |
| 9.5 Further Reading (pg. 207) | |
| Notes (pg. 207) | |
| References (pg. 208) | |
| Index (pg. 211) | |
Xavier Freixas
Xavier Freixas is Emeritus Professor at Universitat Pompeu Fabra in Barcelona and Research Fellow at CEPR.
Jean-Charles Rochet
Jean-Charles Rochet is Professor of Economics at the Toulouse School of Economics.
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