Syllabus/achievement requirements

* - articles are essential readings

All books and articles are available online.

Part I Introduction

We start this semester with a brief introduction to banking and the economics of banking. Different from most of the previous courses, the economics of banking stems from various frictions and market failures --- exactly because of these frictions and failures, banking becomes necessary and welfare improving. However, banks themselves are subject to frictions and failures, too; therefore, they are also sources of inefficiencies and instabilities.

We first explain why banking is special and important, and show how real-world banks are working through a Mickey Mouse example. Then we present an overview on banking industry and the structure of the course. Overall, we start the semester in a linear way, going through the terms and jargons that are unfamiliar to outsiders and will be frequently used in the rest of the semester.

References: The lecture will be mostly based on the lecture notes; however, interested readers can take a look at the reading list in the end of the notes.


Part II The Microeconomics of Banking

In this part, we look into various financial frictions and market failures that motivate banking, and investigate the new problems arising from banking within the corresponding contexts.

Chapter 1 Fragile Banks

In this chapter, we start with one friction that people may have different preferences on liquidity. Potential lenders may have relatively short time preference for consumption, while potential borrowers may need long term funding. Without intermediaries, long term projects with high yields are probably never funded. Banks who provide funding for long assets via rolling over debts from lenders thus help improve social welfare.

However, the maturity mismatch between bank assets and liabilities exposes banks to liquidity risks, that they may not be able to roll over debts and / or meet the withdrawal demand, leading to bank runs. We further discuss how everything looks like in the real world in a seminar on securitized banking.


This chapter is based on

* Diamond, D. W. and Dybvig, P. H. Bank Runs, Deposit Insurance, and Liquidity, 1983. Journal of Political Economy, 91: pp. 401-419

Cao, J. and Illing, G. Endogenous Exposure to Systemic Liquidity Risk, 2011. International Journal of Central Banking, 7(2): pp. 173-216.

And more readings can be found in the lecture notes for interested readers.

Chapter 2 Limited Liability, Liquidity Hoarding, and Market Freezes

We continue with another friction, limited liability, in this section. Banks’ limited liability creates conflicts between banks and their clients, that banks have strong incentive to gamble for the high yields on the heads as long as their losses on the tails are limited. In this section we discuss the issue in the context of liquidity management; we will see how banks’ excess risk-taking incentive leads to inefficiencies in building liquidity buffers, and how this leads to market freezes that turn liquidity shocks to systemic liquidity crunches.


This chapter is based on

* Diamond, D. W. and Rajan, R. G. Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes, 2011. Quarterly Journal of Economics, 126(2): 557-591.

However, we also briefly discuss

Tirole, J. "Consumer Liquidity Demand" in Tirole, J. The Theory of Corporate Finance, 2006. Princeton, Princeton University Press. Chapter 12

Tirole, J. Illiquidity and All Its Friends, 2011. Journal of Economic Literature, 49(2): pp. 287-325.

Chapter 3 Moral Hazard, Bank Capital, and Market Segregation

From this section on, we examine the consequences of asymmetric information. The lending-borrowing relationships are strongly featured by asymmetric information: Lenders have limited knowledge about the credibility of borrowers (principal agent problem). Banks who have expertise in producing information thus can select the truly credit-worthy borrowers and ensure they behave properly for lenders’ interests, improving social welfare.

However, the same principal agent problem holds for banks, too. Once they are monopoly of information, they might not work for lenders’ best interests, either. In order to convince lenders, banks need to “skin-in-the-game” and put their own stake in the lender-borrower relationships. We will discuss the consequences to the credit market.


This chapter is based on

* Holmstrom, B. and Tirole, J. Financial Intermediation, Loanable Funds, and the Real Sector, 1997. Quarterly Journal of Economics, 112(3): pp. 663-691.

Chapter 4 Adverse Selection and Credit Rationing

Besides moral hazard, the other consequence of asymmetric information is adverse selection. When the quality of the borrowers is private information, low quality borrowers may drive high quality ones out of credit market and lead to market break-down. Banks as information producer thus can screen the credit-worthy borrowers, and improve social welfare. However, as long as the screening technology is not perfect, banks may want to reduce type-I error and leave some (possibly eligible) borrowers unserved. The consequence is a persistent excess demand in the credit market.


This chapter is based on

* Stiglitz, J. E. and Weiss, A. Credit rationing in markets with imperfect information, 1981. American Economic Review. 71, 393-410.

Chapter 5 The Industrial Organization of Banking

We discuss the market structure of banking in this section. The key question here is: How does bank competition affect the stability of banking sector? On one hand, competition helps remove certain inefficiencies and improve resource allocation, this may increase the stability of banking sector; on the other hand, competition may also reduce banks’ security buffers and / more force them to take more risks, hence reduce the stability of banking sector. Of course, there is no easy answer to this question, and it really depends on the conditions.


This chapter is based on

* Hellmann, T. F.,Murdoch, K. C. and Stiglitz, J. E. Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?, 2000. The American Economic Review, 90(1): pp. 147-165

* Boyd, J. H. and De Nicolo, G. The theory of bank risk taking and competition revisited, 2005. Journal of Finance 60, 1329-1343.

And we also briefly discuss

Allen, F. and Gale, D. Competition and Financial Stability, 2004. Journal of Money, Credit and Banking, 36(3), pp. 453-480

Vives, X. Competition and stability in banking, 2010. Center for Economic Policy Research, Policy Insight, 50: pp. 1-21.


Part III The Macroeconomics of Banking

In this part, we look at how banking sector is affecting the macroeconomy. That is, how inefficiencies and failures in banking sector amplify booms and busts in the macroeconomy, leading to economy-wide bubbles and crunches.

Chapter 6 Central Banking

In this section we look at the working of “the bank of all banks”. Generally speaking, the central bank tunes the real economy using financial instruments, i.e., conducting monetary policy through various tools. Usually these tools work through the banking sector and affect banks’ credit supply to the real economy; therefore, efficient transmission mechanisms of monetary policy are at the core of efficient monetary policy.

This chapter is based on both general principles and Norwegian reality

* Rødseth, A. Banks, Monetary Policy and Aggregate Demand, mimeo, 2014

* Bernhardsen, T., and Kloster, A. Liquidity management system: Floor or corridor? 2010. Norges Bank Staff Memo, 4.

Chapter 7 Financial Accelerator, Booms, and Busts

In this section we explain how financial frictions in the banking sector can amplify booms and busts in the real economy, leading to bubbles and crises. Financial frictions lead to systemic misallocation of resources, often excess debt exposures and shortages in safety buffers. Therefore, in the boom, leverage allows excess returns, fuelling the bubbly growth; while in the bust, buffer shortages lead to forced deleverage, triggering a vicious cycle into crises.


This chapter is based on

* Bianchi, J. Overborrowing and Systemic Externalities in the Business Cycle, 2011. American Economic Review, 101(7). 3400-3426

* Martin, A. and Ventura, J. Theoretical Notes on Bubbles and the Current Crisis, 2011. IMF Economic Review, 59(1), 6-40.

And we will briefly discuss

Brunnermeier, M. K. and Oehmke, M. Bubbles, Financial Crises, And Systemic Risk, 2013. Handbook of the Economics of Finance, 2: pp. 1221-1288.


Part IV Banking Regulation

Inefficiencies in industries need public intervention, while this is especially crucial for the banking sector. Banking regulation is particularly special, as it focuses more on safety as well as tax payer protection. We start with general principles for banking regulation, then focus more on the sources of systemic risks and the need for macroprudential regulation. In the end, we look through the new updates in the design of new banking regulation framework, and discuss the limits of the instruments.


This chapter is based on

* Borchgrevink, H., Ellingsrud, S. and Hansen, F. Macroprudential Regulation - What, Why and How? 2014. Norges Bank Staff Memo

* The Fundamental Principles of Financial Regulation; Geneva Reports on the World Economy, CEPR, June 2009.

Freixas, X. and Rochet, J. "Regulation of Banks", in Freixas, X and Rochet, J. Microeconomics of Banking, 2008.Cambridge Massachusetts:  MIT Press. Chapter 9 (sections 9.5.3, 9.6 and 9.7 can be skipped).


Published May 23, 2019 4:05 PM - Last modified June 26, 2019 11:23 AM