Anjan V. Thakor

Can Relationship Banking Survive Competition

We develop a model of the banking firm that is intended to reflect contemporary trends in the evolution of banks. In particular, we focus on the effects of both interbank and capital market competition on the role of banks in funding corporations. In our model, banks can choose to provide loans that are similar to capital market funding (transaction loans) or loans that involve unique bank-specific services (relationship loans). Borrowers can choose one of these two types of bank loans or directly access the capital market. Our key result is that, contrary to what many believe, a bank’s optimal response to increased competition is to expand relationship lending relative to its transaction lending. The behaviour of the absolute level of relationship lending with respect to increasing competition is non-monotone. Initially, an elevation in competition leads to an increase in the expected level of relationship lending, but then the expected level of relationship lending falls as competition rises further. Moreover, the viability of relationship banking depends significantly on the reputational quality of banks.

Information Reliability and a Theory of Financial Intermediation

This paper is an analysis of when it will be beneficial for agents engaged in the production of information to form coalitions. The model is cast in a financial market framework, thus leading to an identification of conditions sufficient for the existence of financial intermediaries. Intermediation is shown to improve welfare if informational asymmetries are present, and the information generated to rectify these asymmetries is potentially unreliable. The usual appeal to transactions costs to explain intermediation is not needed.

Collateral and Rationing: Sorting Equilibria in Monopolistic and Competitive Credit Markets

The authors examine how market structure affects credit allocation under universal risk neutrality and asymmetric information about borrowers. They consider both monopolistic and perf ectly-competitive banks and examine the role of collateral in each ca se. When a bank is a monopolist on the loan side, they find collatera l is never used and asymmetric information results in reduced bank le nding. Under perfect competition, collateral has a useful sorting rol e. Moreover, rationing is possible even with collateral availability and perfectly-elastic deposit supply. In this setting, the authors sh ow co-signers are valuable. Social welfare properties of the monopoly and competitive equilibria are also compared. Copyright 1987 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

MORAL HAZARD AND SECURED LENDING IN AN INFINITELY REPEATED CREDIT MARKET GAME

The authors analyze repeated moral hazard with discounting in a competitive credit market with risk neutrality. Even without learning or risk aversion, long-term bank-borrower relationships are welfare enhancing. The main result is that the borrower obtains an infinite sequence of unsecured loans at below spot market cost following the first good project realization. This contract produces first-best action choices. Prior to this stage, the borrower gets secured loans with above-market borrowing cost. The optimal contract thus displays a selective memory feature, taking only one of two forms at any given point in time, depending on prior history. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

The economics of bank regulation

The authors review the economics of bank regulation as developed in the contemporary literature. They begin with an examination of the central aspects of modern banking theories in explaining the asset transformation function of intermediaries, optimal bank liability contracts, coordination problems leading to bank failures and their empirical significance, and the regulatory interventions suggested by these considerations. In particular, the authors focus on regulations aimed primarily at ameliorating deposit-insurance-related moral hazards, such as: cash-asset reserve requirements, risk-sensitive capital requirements and deposit insurance premia, and bank closure policy. Moreover, they examine the impact of the competitive environment (bank charter value) and industry structure (scope of banks) on these moral hazards. They also examine the implications of banking theory for alternatives to deposit insurance.

Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results

The authors examine collateral in a competitive equilibrium in which borrowers can choose hidden actions and may additionally possess hidden knowledge. Apart from explaining the widespread use of collateral despite deadweight costs, they show that an increase in the riskless interest rate causes equilibrium loan rates and collateral requirements to increase, a decline in the deadweight costs of collateral reduces the equilibrium collateral use under moral hazard, and an increase in the borrowers project size reduces equilibrium collateral use under moral hazard. Some of these predictions are tested and found to be supported by the data. Copyright 1991 by Royal Economic Society.

Bank funding modes: Securitization versus deposits

We examine a banks choice of whether to fund the loans it originates by emitting deposits or to sell the loans to investors. With common knowledge of loan quality and laissez faire banking, we find that the choice is irrelevant. With asymmetric information but without government intervention, we find that better quality assets will be sold (securitized) and poorer quality assets will be funded with deposits. Public regulation can influence the banks choice; subsidies can cause a bank to favor deposit funding, but mutual funds and third-party insurers may mitigate the effects of governmental subsidies.

Megamergers and expanded scope: Theories of bank size and activity diversity

We point to the vast empirical literature in banking to argue that the current expansion of scale and scope in banking represents a puzzle. We then present two explanations that help us to understand why banks are getting bigger and doing more. Our explanations suggest that banks may be doing this to increase their shareholders’ wealth and/or merely to enhance the reputation of their management (CEOs). The latter could lead to herd behavior involving banks that increase size and scope despite a dissipation of shareholders’ wealth. Alternatively, increasing size and scope may oAer strategic benefits (and hence increase shareholder wealth) in an environment with suAcient profitability in current operations and substantial uncertainty about future core competencies. We explore conditions under which either one of these competing explanations may dominate. ” 1999 Elsevier Science B.V. All rights reserved.

Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting

We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.

Banking deregulation: Allocational consequences of relaxing entry barriers

Abstract We present an equilibrium analysis to predict the long-run allocational consequences and risk implications of banking deregulation. Loan demand and deposit supply functions are derived from primitive assumptions about the preferences of individuals, and banks are viewed as (differentiated) competitors in a spatial context. We find that a relaxation of entry barriers into banking improves the welfare of borrowers and savers at the expense of bank stockholders. Equilibrium loan interest rates fall and equilibrium deposit interest rates rise as banking becomes more competitive. Despite this, the equilibrium debt-equity ratios of banks increase as entry barriers are relaxed. We also examine the implications of capital standards and find that an increase in the minimum capital requirement benefits borrowers but hurts depositors.