Lecture 13 Banks.ppt

Lecture 13: Banks What Are Banks? Commercial Banks: Principal activity: receives deposits and makes loans. Investment banks (US): Purchaser or underwriter of large blocks of securities, reseller of them. The word “bank” is misleading, since according to the Glass Steagall Act 1933 they could not accept deposits. Central Banks Other Depository Institutions Savings Banks: The savings bank movement began in the UK early 19th century to help relieve penury. Eleemosynary. Survivors from long ago. Saving and Loan Associations (from building society movement UK) Movement that created them emphasized pooling resources to buy homes. Credit Unions: Cooperative organizations that accept deposits and make loans to members. Adverse Selection Problem with Securities Solved by Banks Adverse selection: Issuers of securities have trouble getting a good price for them, since the market as a whole cannot distinguish good from bad companies. So, only the bad companies are willing to issue securities. The market for securities can break down, owners can’t sell them. Public good nature of information: No one will take trouble to collect information about companies and give it away, can’t sell it for a high price either since others will give it away. Moral Hazard Problem with Securities Solved by Banks Managers or stockholders in a firm have an incentive to take big risks unseen by the bondholders. If bondholders are dispersed, none of them is willing to spend the time to monitor the firm, and none has ability to control management. Banks more prominent in economies of less developed countries because information asymmetry is more of a problem there. Banks Generate Liquidity Because of adverse selection and moral hazard problems, firms often tend to be closely held by people connected to them and knowledgeable about them. But such holdings are inherently illiquid. Banks come to the rescue. Banks create liquidity by accepting short-term deposits and making short-term (effectively long ter