Economics of Banking and Insurance Assignment: Asymmetric Information
Question 1: Banks' balance sheet and the news
Read WSJ article to Canvas, under week 4. It is titled "BNP A Bank That Gives Investors Something To Believe In". Write a short essay, no more than one page explaining how the article relates to the concepts that we have learned in class about balance sheet, income statement, changes in capital, and financial ratios (on returns on equity and capital ratios).
Question 2: Adverse selection and Signaling
In the class, we have covered the adverse selection problem and we went over the concept of signaling through self-financing. As we discussed, the cost of capital is increasing in the share of self-financing, α. This means that the signal is costly.
- Explain in your own words the concept of the cost of capital being increasing in α and derive (for the parameterization explored in class) how capital costs change with α.
- When a major league baseball players contract has expired, he can either sign a new contract with his current team or become a free agent and sign a contract to play with a different team. If adverse selection is a problem in the market for major league ball players, who do you think are more likely to be injured the season after they sign a new contract: players who re-sign with their current team or players who sign with a new team? Explain. How can the player signal his type? What kind of incentive compatible contract can be written to mitigate adverse selection?
Question 3: Holmstrom and Tirole 1997
The objective of this question is to derive the conclusions of the model that we didn't cover in the last slides of Lecture 4. We will cover the material next class, so this will help you understand the theory underlying the moral hazard problem beforehand. These models are highly stylized, but the real value is in understanding how from a simple set up, robust conclusions can be derived and have policy implications. You can also follow this in the textbook, section 2.5.3.
There are three types of agents: firms, represented by the index f, banks, represented by the index m, and depositors, represented by the index u. Each industrial project owned by the firms has the same cost, I, and returns y, which are verifiable, in case of success and nothing in case of failure. There are good projects, with probability of success pH, and bad projects, with probability of success pL. Bad projects give a private benefit to the borrowing firms, B. If the bank monitors, at cost C, the benefit is reduced from B to b. Investors are risk-neutral, uninformed, and cannot monitor the firms. There is a risk free asset that pays 1+r. Only good projects have positive NPV (like in the slides, pHy > 1 + r > pLy + B.
Firms differ in their capital A, which is public information. The distribution of capital among the continuum of firms is represented by a generic cumulative distribution function G(A). Bank's aggregate capital is exogenous, Km.
- In the case of direct financing (depositor-firm): Derive the minimum amount that firms need to promise investors. What is the maximum amount a firm can directly borrow as a function of its initial capital A?
- In the intermediated lending case (depositor-bank-firm): Derive the minimum amount that firms need to promise banks. Compare it to the value in 1.
- Explain which firms can borrow directly, which firms can borrow from banks, and which firms receive no funds at all, as a function of A.
- What is the role of bank capital in determining the output as a whole? Discuss the effect of a decrease in total Km, while everything else stays the same.
- What happens when there is an overall reduction in A for all firms?
- BONUS: Discuss the notion of bank capital in this model. Why more bank capital increases welfare in this economy?
Attachment:- Assignment Files.rar