Chapter 1: Why Are There Banks? (Sections 1.1–1.4) Flashcards
(9 cards)
In a classical two‐period general equilibrium model with no uncertainty or information frictions, why do banks earn zero profit?
Because deposit rates and loan rates both equal the bond market rate 𝑟, so banks simply intermediate at the same price and make no surplus.
What two key roles do real‐world banks play that the frictionless GE model omits?
Managing asymmetric information between borrowers and lenders, and providing liquidity transformation by pooling and insuring against idiosyncratic shocks.
What is the basic setup of the Diamond–Dybvig model for liquidity transformation?
A continuum of identical investors who face random liquidity shocks in period 1; early withdrawal yields a low return 𝐿<1, waiting yields 𝑅>1.
How does a bank improve on autarky in Diamond–Dybvig?
By pooling deposits and offering a contingent claim: a fixed payout if you withdraw in period 1 and a different fixed payout if you wait to period 2, thus insuring against idiosyncratic liquidity shocks.
What mechanism in Diamond–Dybvig gives rise to bank runs?
Self‐fulfilling panic: if depositors believe others will withdraw, even patient ones rush to withdraw, depleting the bank’s liquid reserves.
Why do banks delegate monitoring instead of letting each investor monitor directly?
Delegated monitoring centralizes the cost of verifying borrower outcomes, achieving economies of scale and reducing per‐investor monitoring expenses.
How does monitoring mitigate moral hazard in lending?
By imposing credible threat of audit, banks design incentive‐compatible contracts that make safe projects optimal for borrowers, who internalize the cost of deviation.
What problem does adverse selection create in credit markets?
Lenders can’t distinguish high‐quality from low‐quality borrowers, so they offer an “average” rate that may drive good projects out of the market.
How do “coalitions of borrowers” (banks) solve adverse selection?
By pooling projects, borrowers reduce variance per unit and can commit to retaining a smaller equity stake as a credible signal of quality, lowering financing costs.
