QUESTIONS

Questions

Questions

a) Using examples, critically analyse how banks manage the trade-off that they face in the conduct of their activities (1500 words)

Standard capital market theory states that there is a risk-return trade-off in equilibrium. The more risk one is willing to take, the higher the return one will be able to get. This relationship has been extensively analysed in the context of liquid assets that trade in organised markets. However, much less is known about its implications on the behaviour of banks as risk managers and profit maximisers. Banks aggregate profits have been analysed by Schroeder et al. (2006) and Miller (2003), among others, who find that more specialisation tends to yield higher returns but also a higher level of risk. However, the optimal degree of bank specialisation is not analysed by these papers. In addition, they aggregate the different activities of banks, that is, they do not separate market and credit activities. As already explained, the features of liquid assets are well known. Thus, my goal is to focus on the less well understood features of the lending business, which is the main role of banks as transformers of short term investments (deposits) into long term ones (loans).

One can think of this heterogeneity in risk choices as the result of entrepreneurs having projects that differ with respect to their risk-return trade-off, or as entrepreneurs having different preferences for risk.

Moreover, we shut down the traditional channel by assuming that interest rates in the deposit market are given. We can thus isolate the effect of competition in the lending market. It also serves to simplify the analysis by allowing us to keep the number of projects financed by a bank constant.

Understanding the relationship between competition and banking stability is of paramount importance for designing banking regulation and may ultimately help to mitigate the risk of financial crises. The traditional view has held that competition in the banking sector is detrimental for stability since it tends to increase deposit rates and thus erodes the franchise value of banks. Recent literature has challenged this view and has emphasized that there is a counteracting channel, which operates through the loan market. The argument is that competition among banks tends to reduce loan rates, which makes borrowers safer precisely for the same reason that banks become riskier when deposit rates rise.

when banks have control over their risk-taking, the stability impact of lending market competition may be reversed. This is because banks have an optimal amount of risk they want to hold and thus want to offset the impact of safer borrowers on their balance sheet by taking on more risk. Since competition in the loan market at the same time erodes banks' franchise values, they even want to overcompensate the impact of safer borrowers because their risk-taking incentives increase.

Banks arguably have plenty of opportunities to modify their risk-taking. They may direct lending to riskier projects (as in our model) but may also raise risk through various other channels, such as by weakening lending standards, reducing monitoring and ...