Read the summary and the most important questions on Financial Markets and institutions

• Lecture 1: Traditional Banking

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• Financial institutions are divided into 2 groups

  1. Depository institutions (Commercial Banks, or CBs)
  2. Non-depository institutinos ( Venture capital, hedge funds, mutual funds etc.

• What is the difference between FIs and Non FIs

  1. Financial intermediaries are highly leveraged 
  2. and hold large quantities of financial claims as assets
     

• What role do Financial intermediaries take: What problem do they solve

  1. Information asymmetry pre-contract  --> leading to adverse selection and duplicated screening
     
  2. Information asymmetry post-contract ---> leading to moral hazard

• What firms typically choose banks as a source of financing?

  • Middle aged firms with tangible assets
  • Able to offer collateral to mitigate moral hazard
  • Hanks loans of short matures --> diminishing total contracting costs
  • Albe to obtain a loan at a lower price

• What choises of finance does a company have?

  • Venture Capital (young firms, no collateral, equity participation)
  • Bank (Middle aged, tangible assets, collateral)
  • Capital Market (Mature firms, credit history, borrowers incentive to limit risk taking, low cost direct acces capital markets)

• Name the 3 dimensions under which there is a mismatch between the assets and the liabilities of a commercial bank

  1. Credit risk: banks claim against borrowers (Asset) is riskier than the depositors claim agains the bank (liabilities) --> hedge via CDS
  2. Interest risk: Assets have longer maturities than liabilities. --Hedge via interest rate swap
  3. Liquidity: Assets have lower liquidity: deposits are redeemable without notice. --> rely on the central bank for liquidity

• Dealer banks are a key player in todays financial markets. What does a dealer bank do?

  The distinction between commercial banks and non-depository institutions is not always clear, especially the case for dealer banks:
  

  • Act as intermediaries in the market for securities
  • Conduct speculative trading
  • Is a prime broker to hedge funds
  • Conventional banking operations
  • Act as an investment bank
  • Operaties under the umbrella of holding companies (large complex financial institutions

• Risks of a dealer bank failing:

  • signifiant stres on its counter-parties and clients, and on prices of assets and securities it holds
  • Reduces the ability of the financial system to absorb negative shocks
  • Creates systematic risk

• What are the 3 Major risk a banks faces?

  1. Default / credit risk. The risk that a borrower does not make a contractual payment on time.
     
  2. Interest rate risk (risk due to mismatch of maturities of assets and liabilities)
  3. Liquidity Risk. Risk that depositors may withdraw funds

• What are the two sources of default risk and how can a bank control for default risk?

  1. "physical" hazard: cash flow variation beyond borrowers control
  2. "moral hazard": borrowers incentive to take actions that increase the banks risk exposure

  
  

  • Screening
  • Monitoring
  • Collateral
  • Diversification