Contemporary Financial Intermediation Dedication To Elaine, Regina and Nate My spiritual lenders of last resort Stuart I. Greenbaum To my parents, Lata and Viru, and my family, Serry, Richard, Cullen, Stina, Aiden and Lily, For everything that made this possible Anjan V. Thakor To Angela, Nuria and Mireia The much valued counterforce in life Arnoud W. A. Boot Contemporary Financial Intermediation FOURTH EDITION Stuart I. Greenbaum Olin Business School, Washington University in St. Louis, St. Louis, MO, United States Anjan V. Thakor Olin Business School, Washington University in St. Louis, St. Louis, MO, United States Arnoud W. A. Boot University of Amsterdam, Amsterdam, The Netherlands Academic Press is an imprint of Elsevier 125 London Wall, London EC2Y 5AS, United Kingdom 525 B Street, Suite 1650, San Diego, CA 92101, United States 50 Hampshire Street, 5th Floor, Cambridge, MA 02139, United States The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, United Kingdom Copyright © 2019 Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher. Details on how to seek permission, further information about the Publisher’s permissions policies and our arrangements with organizations such as the Copyright Clearance Center and the Copyright Licensing Agency, can be found at our website: www.elsevier.com/permissions . This book and the individual contributions contained in it are protected under copyright by the Publisher (other than as may be noted herein). Notices Knowledge and best practice in this field are constantly changing. As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary. Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility. To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress ISBN: 978-0-12-405208-6 For Information on all Academic Press publications visit our website at https://www.elsevier.com/books-and-journals Publisher: Candice Janco Acquisition Editor: Scott Bentley Editorial Project Manager: Susan Ikeda Production Project Manager: Paul Prasad Chandramohan Cover Designer: Mark Rogers Typeset by MPS Limited, Chennai, India Abbreviated Contents Preface xi 9. Special Topics in Credit: Acknowledgments xv Syndicated Loans, Loan Sales, About the Authors xvii Introduction xix and Project Finance 205 Part V Part I Off the Bank’s Balance Sheet 215 The Background 1 10. Off-Balance Sheet Banking 1. Basic Concepts 3 and Contingent Claims Products 217 11. Securitization 249 Part II What is Financial Intermediation? 21 Part VI The Funding of the Bank 283 2. The Nature and Variety of Financial Intermediation 23 12. The Deposit Contract, Deposit 3. The What, How, and Why Insurance, and Shadow Banking 285 of Financial Intermediaries 55 13. Bank Capital Structure 317 Part III Part VII Identification and Management Financial Crises 329 of Major Banking Risks 87 14. The 2007–2009 Financial Crisis 4. Bank Risks 89 and Other Financial Crises 331 5. Interest Rate Risk 101 6. Liquidity Risk 121 Part VIII Bank Regulation 353 Part IV “On Balance Sheet” Banking 15. Objectives of Bank Regulation 355 16. Milestones in Banking Legislation 131 Activities and Regulatory Reform 397 7. Spot Lending and Credit Risk 133 8. Further Issues in Bank Lending 169 v vi Abbreviated Contents Part IX Part X Financial Innovation 427 The Future 441 17. The Evolution of Banks 18. The Future 443 and Markets and the Role of Financial Innovation 429 Subject Index 455 Extended Contents Preface xi Other Nondepository Intermediaries 41 Acknowledgments xv Credit Rating Agencies 48 About the Authors xvii The Role of the Government 48 Introduction xix Financial Intermediaries on the Periphery 49 Conclusion 51 Review Questions 51 Appendix 2.1 Measurement Distortions Part I and the Balance Sheet 51 The Background 1 3. The What, How, and Why of Financial Intermediaries 55 1. Basic Concepts 3 Introduction 55 Introduction 3 How Does the Financial System Work? 56 Risk Preferences 3 Business Financing: Debt 63 Diversification 5 Fractional Reserve Banking and Riskless Arbitrage 7 the Goldsmith Anecdote 64 Options 7 A Model of Banks and Regulation 66 Market Efficiency 8 The Macroeconomic Implications of Market Completeness 9 Fractional Reserve Banking: The Fixed Asymmetric Information and Signaling 10 Coefficient Model 70 Agency and Moral Hazard 13 Large Financial Intermediaries 73 Time Consistency 15 How Banks can Help to Make Nonbank Nash Equilibrium 16 Financial Contracting More Efficient 74 Revision of Beliefs and Bayes Rule 17 The Empirical Evidence: Banks are Special 75 Liquidity 18 Ownership Structure of Depository Financial Systemic Risk 19 Institutions 76 Disagreement 19 The Borrower’s Choice of Finance Source 78 Mark-to-Market Accounting 19 Conclusion 81 Review Questions 82 Appendix 3.1 The Formal Analysis of Large Intermediaries 82 Part II Appendix 3.2 Definitions 85 What is Financial Intermediation? 21 2. The Nature and Variety Part III of Financial Intermediation 23 Identification and Management Introduction 23 What are Financial Intermediaries? 24 of Major Banking Risks 87 The Variety of Financial Intermediaries 29 Depository Financial Intermediaries 31 4. Bank Risks 89 Investment Banks: Key Nondepository Introduction 89 Intermediaries in the Capital Market 38 Basic Banking Risks 90 Separation Between Investment Banks Credit, Interest Rate, and Liquidity Risks 91 and Commercial Banks Undone 39 Enterprise Risk Management 92 vii viii Extended Contents Conclusion 99 Long-Term Bank–Borrower Relationships 184 Review Questions 100 Loan Restructuring and Default 188 5. Interest Rate Risk 101 Conclusion 195 Introduction 101 Case Study: Zeus Steel, Inc. 195 The Term Structure of Interest Rates 101 Review Questions 200 The Lure of Interest Rate Risk and Its 9. Special Topics in Credit: Syndicated Potential Impact 105 Loans, Loan Sales, and Project Duration 107 Finance 205 Convexity 111 Introduction 205 Interest Rate Risk 112 Syndicated Lending 205 Conclusion 114 Project Finance 210 Case Study: Eggleston State Bank 114 Conclusion 213 6. Liquidity Risk 121 Review Questions 213 Introduction 121 What, After All, is Liquidity Risk? 121 Some Formal Definitions of Liquidity 123 The Management of Liquidity Risk 124 Part V The Difficulty of Distinguishing Between Off the Bank’s Balance Sheet 215 Liquidity and Insolvency Risks and the LLR’s Conundrum 126 10. Off-Balance Sheet Banking Conclusion 127 and Contingent Claims Products 217 Review Questions 127 Introduction 217 Appendix 6.1 Dissipation of Withdrawal Loan Commitments: A Description 219 Risk Through Diversification 127 Rationale for Loan Commitments 221 Appendix 6.2 Lender-of-Last-Resort Moral Who is Able to Borrow Under Bank Loan Hazard 128 Commitments? 229 Pricing of Loan Commitments 229 Part IV The Differences Between Loan Commitments and Put Options 231 “On Balance Sheet” Banking Loan Commitments and Monetary Policy 233 Activities 131 Other Contingent Claims: Letters of Credit 233 Other Contingent Claims: Swaps 235 7. Spot Lending and Credit Risk 133 Other Contingent Claims: Credit Derivatives 239 Introduction 134 Risks for Banks in Contingent Claims 240 Description of Bank Assets 134 Regulatory Issues 242 What is Lending? 139 Conclusion 243 Loans Versus Securities 140 Case Study: Youngstown Bank 244 Structure of Loan Agreements 141 Review Questions 247 Informational Problems in Loan Contracts 11. Securitization 249 and the Importance of Loan Performance 142 Introduction 249 Credit Analysis: The Factors 144 Preliminary Remarks on the Economic Sources of Credit Information 158 Motivation for Securitization and Loan Sales 252 Analysis of Financial Statements 159 Different Types of Securitization Contracts 254 Loan Covenants 161 Going Beyond Preliminary Remarks Conclusion 163 on Economic Motivation: the “Why,” “What,” Case Study: Indiana Building Supplies, Inc. 164 and “How Much is Enough” of Securitization 263 Review Questions 166 Strategic Issues for a Financial Institution 8. Further Issues in Bank Lending 169 Involved in Securitization 275 Introduction 169 Comparison of Loan Sales and Loan Loan Pricing and Profit Margins: General Securitization 277 Remarks 169 Conclusion 278 Credit Rationing 177 Case Study: Lone Star Bank 278 The Spot-Lending Decision 183 Review Questions 281 Extended Contents ix Part VI Stability: Macroprudential Regulation 381 Market Structure, Consumer Protection, Credit The Funding of the Bank 283 Allocation, and Monetary Control Regulation 385 Conclusion 392