The Economics of Banking by Kent Matthews

By Kent Matthews

The Economics of Banking describes and explains developments and operations in banking inside an available microeconomic framework. It contains conception with the sensible facets of banking so that it will set banking in the economics paradigm. a prime part on tendencies inside banking leads directly to chapters at the microeconomics of banking, industry constitution and rules. the final goal is to supply a mathematically obtainable microeconomic context that would aid scholars comprehend and learn tendencies and operations in banking.

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As we have seen above, banks can engage in asset transformation as regards size, maturity and risk to accommodate the utility preferences of lenders and borrowers. This transformation was emphasized by Gurley and Shaw (1960), and we need to consider whether this explanation is complete. In fact, immediately the question is raised why ¢rms themselves do not undertake direct borrowing. Prima facie, it would be believed that the shorter chain of transactions involved in direct lending/ borrowing would be less costly than the longer chain involved in indirect lending/ borrowing.

Any bankruptcy cost will be spread over a large number of depositors, making the average cost per depositor quite small. This contrasts with the situation if each lender is concerned with few loans. In such cases the failure of one borrower to service the loan according to the agreement would have a major impact on the lender. Diamond (1984, 1996) presents a more formal model of intermediation reducing the costs of outside ¢nance under conditions of imperfect information. Diamond considers three types of contracting arrangements between lenders and borrowers: (a) no monitoring, (b) direct monitoring by investors and (c) delegated monitoring via an intermediary.

Lenders will prefer assets with a low risk whereas borrowers will use borrowed funds to engage in risky operations. In order to do this borrowers are willing to pay a higher charge than that necessary to remunerate lenders where risk is low. Two types of risk are relevant here for the depositor: default and price risk. Default risk refers to the possibility that the borrower will default and fail to repay either (or both) the interest due on the loan or the principle itself. Deposits with banks generally incur a low risk of default.

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