Anthony M. Santomero

The Theory of Financial Intermediation

Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.

Modeling the Banking Firm: A Survey

THIS PAPER REPORTS on the status of the literature on micro bank modeling and assesses our understanding of the banking firms optimal behavior. This is no mean task, for much has been written on banking, broadly defined, over the past couple of decades. The review is developed in pieces. Each major subproblem is outlined and the analysis used to deal with the issue explicated. This is not the best way to summarize the development of a field, it should be immediately recognized. One would prefer to have a smooth continuum of development, moving the frontier of knowledge evenly through time and across subareas. Yet, this is rarely the way a field develops. More likely, individual questions attract attention and are the subjects of a substantial number of contributions. After a time, the field moves on to the new area of interest. The banking field is no exception. Before embarking upon the review, however, a couple of lines should be devoted to previous attempts. There have been essentially three. First, Pyle (1972) analyzes the uncertainty portfolio models at a time when little existed in the literature, and hence one finds the review a bit vague and sketchy. Baltenspergers contributions (1978, 1980) are the next serious and rather extensive reviews. The quality of these

Commercial Bank Risk Management: An Analysis of the Process

Throughout the past year, on-site visits to financial service firms were conducted to review and evaluate their financial risk management systems. The commercial banking analysis covered a number of North American super-regionals and quasi–money-center institutions as well as several firms outside the U.S. The information obtained covered both the philosophy and practice of financial risk management. This article outlines the results of this investigation. It reports the state of risk management techniques in the industry. It reports the standard of practice and evaluates how and why it is conducted in the particular way chosen. In addition, critiques are offered where appropriate. We discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk, and the elements that are missing in the current procedures of risk management.

Financial Risk Management by Insurers: An Analysis of the Process

On-site visits to financial service firms were conducted to review and evaluate their risk management systems. In the insurance sector, this evaluation covered prominent life/health and property-liability insurers, both in the United States and abroad. The information obtained covered both the philosophy and the practice of financial risk management. This article outlines the results of this investigation. It reports the state of risk management techniques in the industry. It reports the standard of practice and evaluates how and why it is conducted in the particular way chosen. In addition, critiques are offered where appropriate. We discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk, and the elements that are missing in the current procedures of risk management.

Alternative monies and the demand for media of exchange

A new value transfer system using alternative monies is emerging as a result of innovations such as prepaid cards, smart cards and the so-called electronic purse. This paper begins with a review of the changes in the value transfer system that are occurring in the economy. It then proceeds to analyze consumer reaction to this trend. It investigates the effect of variations in the number and type of monies on consumer transactions demand. We investigate the behavior of a representative agent faced with a choice of money with which to transact and ask how variations in their characteristics will affect the consumers choice of transactions vehicle, transaction frequency and average balances in various media. Interestingly, the results are not transparent. Copyright 1996 by Ohio State University Press.

Investment opportunities and corporate demand for lines of credit

Abstract The behavior of a risk neutral corporation in selection of a line of credit is modeled in a new framework where demand for credit lines by a firm arises from the stochastic arrival in continuous time of short-lived opportunities to capture investment projects. The firm needs speed and secrecy to capture projects before competitors. The firm chooses a credit line that balances its up-front commitment cost against the expected extra cost of borrowing in the spot market upon exhaustion of its credit line. The firms demanded credit line depends upon both relative pricing within the contract and the nature of the firms growth opportunities. Interestingly, while credit line demand is positively related to business growth prospects, it is potentially negatively related to uncertainty in those prospects.

Financial Innovation and Bank Risk Taking

This paper investigates the effect of one change in the financial sector, namely, the growing ease with which assets created by the banking sector can be sold to other investors. Of interest is whether this reduced cost of value communication leads to higher levels of risky lending by the banking sector. Of equal interest is whether these same changes result in riskier banks, i.e., ones that are more vulnerable to instability and failure. The results suggest that the risky asset portfolio held by the banking sector unambiguously increases as a result of the innovations considered. A reduction in illiquidity increases the banking sectors willingness to provide risk capital for real sector investment. On the other hand, it does not imply that the portfolios of banks will become more risky. Rather, there exists a trade-off between external shock risk, which is alleviated by increased asset liquidity, and the risk taking by banks on the returns of their assets, which is encouraged by these market changes.

Forecasting required loan loss reserves

Abstract This paper develops a methodology to extract unbiased estimates of loan loss exposure from a banks balance sheet. In addition, it permits institutions to adequately price loans in the face of credit risk even as knowledge of credit losses is changing over time. The approach uses observed outcomes to derive appropriate estimates under two different assumptions about the information environment, viz., one in which the distribution of loan losses is fixed and one in which it is uncertain. The results also shed some interesting light on the income-smoothing discussion in the literature.

Bank credit rationing and the customer relation

Abstract This paper investigates the theory that preference in situations of bank rationing is given to those customers with the strongest customer relation. It has shown that, within a certainty model where competitive pressure among banks requires full compensation for other bank relationships, neither deposit levels nor intertemporal demand would produce the preferential treatment claimed. It has also been shown that the prime borrowers would be unable to bargain effectively for credit line protection from such occasions of credit restriction.

Variable-rate deposit insurance: A re-examination

Abstract This paper investigates the impact of variable-rate deposit insurance on the financial and real sectors of the economy and its role as an absorber of bankruptcy risk within these sectors. A variable-rate system raises the cost of funds to the real sector and increases probability of bankruptcy of the borrowing firms. When such bankruptcies occur, society experiences a dead weight loss. We argue that appropriate deposit insurance pricing must weigh the social costs connected with both financial firm failure and real-sector bankruptcy.