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Intermediated Versus Direct Investment: Optimal Liquidity Provision and Dynamic Incentive Compatibility
TL;DR: In this article, the authors analyze the problem of optimal liquidity provision through bank deposit contracts in a simple continuous-time equilibrium model under uncertainty and show that at the optimum, liquidity provision is negatively correlated with the degree of irreversibility of the market investment opportunity.
Abstract: The existing banking literature leaves largely unanswered the question: what is the viability of bank liquidity provision if investors can dynamically re-adjust their portfolios? To address this question, I analyze the problem of optimal liquidity provision through bank deposit contracts in a simple continuous-time equilibrium model under uncertainty. My model introduces the possibility of investors' directly investing in the market, which gives rise to a moral hazard problem in the use of deposit contracts. I argue that this can severely restrict liquidity provision and characterizes incentive-compatible deposit contracts as second-best mechanisms to provide liquidity. The analysis shows that at the optimum, liquidity provision is negatively correlated with the degree of irreversibility of the market investment opportunity. In particular, when the market investment opportunity is completely reversible, deposit contracts cannot provide any insurance against liquidity risks.
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TL;DR: In this paper, the authors developed a simple model of corporate ownership structure in which costs and benefits of ownership concentration are analyzed and derived predictions for the trade and pricing of blocks, and provided criteria for the optimal choice of ownership structure.
Abstract: The paper develops a simple model of corporate ownership structure in which costs and benefits of ownership concentration are analyzed The model cornpares the liquidity benefits obtained through dispersed corporate ownership with the benefits from efficient management control achieved by some degree of ownership concentration The paper reexamines the free-rider problem in corporate control in the presence of liquidity trading, derives predictions for the trade and pricing of blocks, and provides criteria for the optimal choice of ownership structure THE RECENT INCOMPLETE CONTRACTING approach in corporate finance has considerably improved our understanding of how small firms determine their capital structure The basic setting considered in this line of research is one where a founder-manager seeks funding from one or several financiers The main premise is that the founder-manager, in her dealings with the financiers, is primarily concerned with maintaining her private benefits of control For small firms these are often quite large relative to the financial returns Thus, for a small firm the problem of determining the financial structure often reduces to the problem of how to obtain fundingr while giving away as little control as possible to the financiers Of course, most financiers insist on some form of protection, so that the final compromise reached in most financial contracts for small firms is one resembling a debt contract (or a venture capital contract), which protects the founder-manager's control as long as the firm is performing adequately' This perspective for small firms does not extend naturally to large firms because the private benefits of control of the managers for large firms are likely to be small relative to the firm's monetary returns, so that protection of these benefits is not an overriding consideration Moreover, large firms
751 citations
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TL;DR: In this paper, the authors review the existing literature to analyze the various implications of these developments and what they portend for bank regulation, and conclude that banks and markets have become increasingly integrated and codependent, and that this is at the root of the 2007-2009 credit crisis.
Abstract: The banking landscape is in flux. Financial institutions and markets have become deeply intertwined and competitive pressures have intensified. Stability issues have become paramount, aptly illustrated by the credit crisis of 2007-2009. In this paper we review the existing literature to analyze the various implications of these developments and what they portend for bank regulation. We begin by discussing the economics of banking to better understand the fundamental forces driving the financial services industry. We discuss how banks choose between relationship and transaction lending, the role of debt versus equity instruments, and the economic functions of banks. We conclude that banks and markets have become increasingly integrated and co-dependent, and that this is at the root of the 2007-2009 credit crisis. In this context, we also focus on credit rating agencies and new intermediaries like private equity firms, which one could interpret as intermediation driven from the equity side, and examine their impact on financial fragility. We address the regulatory challenge coming from financial fragility, and focus on this in the context of the “mushrooming” of the financial sector with greater diversity in institutions and an increasingly blurred distinction between intermediaries and financial markets.
54 citations
TL;DR: In this paper, the authors examine the implications of the increasing integration of banks and financial markets for the evolution of each as well the design of prudential regulation and conclude that it is becoming more and more difficult to isolate banking risks from financial market risks.
Abstract: In this chapter we examine the implications of the increasing integration of banks and financial markets for the evolution of each as well the design of prudential regulation. The growth of the use of depository-banking-originated mortgage-backed securities sold in the market and used as collateral to back short-term funding transactions in the shadow banking sector illustrates this intertwining of banks and markets, and the potential systemic risk dangers of this, as is apparent from the recent crisis. An important implication of this integration is that it is becoming more and more difficult to isolate banking risks from financial market risks. Building on contemporary theories of financial intermediation, relationship banking and securitization, we show how these theories inform us about the underlying causes of the seismic shifts that have occurred in financial markets in recent years, and what they suggest about the kinds of regulatory reforms that may be most fruitful. We end with a list of open research questions suggested by our analysis.
16 citations
TL;DR: In this article, the authors consider a bank with access to bond and insured deposit financing and show that deposit finance acts as a commitment device, that has the potential to raise the overall debt capacity of the bank and increase pledgable assets.
Abstract: We consider a regulated bank with access to bond and insured deposit financing. Bank manager-owners have specific abilities, which allows them to extract rents. We show that deposit finance acts as a commitment device, that has the potential to raise the overall debt capacity of the bank and increases pledgable assets. Our focus is on the optimal mix of bond and deposit financing. We find that in the optimum, the bank chooses a debt structure so as to align internal incentives with external constraints. The model predicts that banks with more risky assets or with more specific abilities use deposit financing to a lesser extent.
11 citations
TL;DR: In this article, the authors use a model in which financial market access of households restrains the efficiency of the liquidity insurance that banks' deposit contracts provide to households that are subject to idiosyncratic liquidity shocks.
Abstract: Following Diamond (1997) we use a model in which financial market access of households restrains the efficiency of the liquidity insurance that banks' deposit contracts provide to households that are subject to idiosyncratic liquidity shocks. But in contrast to these approaches we assume spatial monopolistic competition among banks. Since monopoly rents are assumed to bring about inefficiencies, improved financial market access that limits monopoly rents also entails a positive effect. But this beneficial effect is only relevant if competition among banks does not sufficiently restrain monopoly rents already. Thus, our results suggest that in the bank-dominated financial system of Germany, in which banks intensely compete for households' deposits, improved financial market access might reduce welfare because it only reduces risk sharing. In contrast, in the banking system of the U.S., with less competition for households' deposits, a high level of households' financial market participation might be beneficial.
5 citations