Contemporary Financial Intermediation

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1 Contemporary Financial Intermediation

3 Contemporary Financial Intermediation Second Edition Stuart I. Greenbaum Washington University in St. Louis Anjan V. Thakor Washington University in St. Louis AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO Academic Press is an imprint of Elsevier

4 Academic Press is an imprint of Elsevier 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA 525 B Street, Suite 1900, San Diego, California , USA 84 Theobald s Road, London WCIX 8RR, UK This book is printed on acid-free paper. Copyright ß 2007, Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Permissions may be sought directly from Elsevier s Science & Technology Rights Department in Oxford, UK: phone: (+44) , fax: (+44) , permissions@elsevier.com. You may also complete your request on-line via the Elsevier homepage ( by selecting Support & Contact then Copyright and Permission and then Obtaining Permissions. Library of Congress Cataloging-in-Publication Data Greenbaum, Stuart I. Contemporary Wnancial intermediation / Stuart I. Greenbaum, Anjan V. Thakor. 2nd ed. p. cm. Originally published: Fort Worth : Dryden Press, Includes bibliographical references and index. 1. Banks and banking United States. 2. Financial services industry United States. 3. Intermediation (Finance). 4. Bank management. I. Thakor, Anjan V. II. Title. HG2491.G dc British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN 13: ISBN 10: For information on all Academic Press publications visit our Web site at Printed in the United States of America

5 To Elaine, Regina, and Nate My spiritual lenders of last resort Stuart I. Greenbaum To my parents, Lata and Viru For everything that made this possible Anjan V. Thakor

7 Abbreviated Contents Preface Acknowledgments About the Authors xv xix xxi PART I THE BACKGROUND 1 A Friendly Conversation 3 Chapter 1 Basic Concepts 13 PART II WHAT IS FINANCIAL INTERMEDIATION? 39 Chapter 2 The Nature and Variety of Financial Intermediation 41 Chapter 3 The What, How, and Why of Financial Intermediaries 91 PART III MAJOR ON-BALANCE-SHEET RISKS IN BANKING 125 Chapter 4 Major Risks Faced by Banks 127 Chapter 5 Spot Lending 169 vii

8 viii ABBREVIATED CONTENTS Chapter 6 Further Issues in Bank Lending 227 Chapter 7 Special Topics in Credit: Syndicated Loans, Loan Sales, and Project Finance 279 PART IV OFF THE BANK S BALANCE SHEET 293 Chapter 8 Off-Balance Sheet Banking and Contingent Claims Products 295 Chapter 9 Securitization 345 PART V THE DEPOSIT CONTRACT 395 Chapter 10 The Deposit Contract and Insurance 397 PART VI BANK REGULATION 439 Chapter 11 Objectives of Bank Regulation 441 Chapter 12 Milestones in Banking Legislation and Regulatory Reform 479 PART VII OVERALL MANAGEMENT OF THE BANK 519 Chapter 13 Management of Risks and Opportunities in Banking 521 PART VIII CORPORATE CONTROL AND GOVERNANCE 559 Chapter 14 Mergers and Acquisitions 561 Chapter 15 Investment Banking 587 PART IX THE FUTURE 609 Chapter 16 The Future 611 INDEX 619

9 Extended Contents Preface Acknowledgments About the Authors xv xix xxi PART I THE BACKGROUND 1 A Friendly Conversation 3 Introduction 3 The Conversation: Follow-Up to the Conversation: Chapter 1 Basic Concepts 13 Introduction 13 Risk Preferences 13 DiversiWcation 16 Riskless Arbitrage 19 Options 20 Market EYciency 21 Market Completeness 22 Asymmetric Information and Signaling 24 Agency and Moral Hazard 29 Time Consistency 32 ix

10 x CONTENTS Nash Equilibrium 34 Revision of Beliefs and Bayes Rule 35 PART II WHAT IS FINANCIAL INTERMEDIATION? 39 Chapter 2 The Nature and Variety of Financial Intermediation 41 Introduction 42 What Are Financial Intermediaries? 43 The Variety of Financial Intermediaries 50 Depository Financial Intermediaries 53 Nondepository Intermediaries 61 The Role of the Government 72 Financial Intermediaries on the Periphery 72 Conclusion 75 Appendix 2.1: Measurement Distortions and the Balance Sheet 76 Appendix 2.2: Guide to Federal Reserve Regulations 78 Chapter 3 The What, How, and Why of Financial Intermediaries 91 Introduction 92 Fractional Reserve Banking and the Goldsmith Anecdote 93 A Model of Banks and Regulation 97 The Macroeconomic Implications of Fractional Reserve Banking: The Fixed CoeYcient Model 103 Large Financial Intermediaries 107 How Banks Can Help to Make Nonbank Financial Contracting More EYcient 109 The Empirical Evidence: Banks Are Special 110 Ownership Structure of Depository Financial Institutions 112 The Borrower s Choice of Finance Source 115 Conclusion 117 Appendix 3.1: The Formal Analysis of Large Intermediaries 119 PART III MAJOR ON-BALANCE-SHEET RISKS IN BANKING 125 Chapter 4 Major Risks Faced by Banks 127 Introduction 127 The Source of Business Risk 128

11 CONTENTS xi Credit, Interest Rate, and Liquidity Risks 129 The Term Structure of Interest Rates 132 Duration 141 Convexity 146 Interest Rate Risk 148 Liquidity Risk 151 Conclusion 157 Case Study: Eggleston State Bank 158 Appendix 4.1: Dissipation of Withdrawal Risk Through DiversiWcation 164 Appendix 4.2: Lender-of-Last-Resort Moral Hazard 164 Chapter 5 Spot Lending 169 Introduction 171 Description of Bank Assets 171 What Is Lending? 177 Loans Versus Securities 179 Structure of Loan Agreements 180 Informational Problems in Loan Contracts and the Importance of Loan Performance 182 Credit Analysis: The Factors 185 Sources of Credit Information 206 Analysis of Financial Statements 208 Loan Covenants 212 Conclusion 215 Case Study: Indiana Building Supplies, Inc. 216 Appendix 5.1: Trends in Credit Analysis 222 Chapter 6 Further Issues in Bank Lending 227 Introduction 228 Loan Pricing and ProWt Margins: General Remarks 228 Credit Rationing 238 The Spot Lending Decision 246 Long-Term Bank-Borrower Relationships 248 Loan Restructuring and Default 255 Conclusion 265 Case Study: Zeus Steel, Inc. 266

12 xii CONTENTS Chapter 7 Special Topics in Credit: Syndicated Loans, Loan Sales, and Project Finance 279 Introduction 279 Syndicated Lending 280 Project Finance 287 Conclusion 290 PART IV OFF THE BANK S BALANCE SHEET 293 Chapter 8 Off-Balance Sheet Banking and Contingent Claims Products 295 Introduction 296 Loan Commitments: A Description 299 Rationale for Loan Commitments 304 Pricing of Loan Commitments 315 The DiVerences Between Loan Commitments and Put Options 317 Loan Commitments and Monetary Policy 320 Other Contingent Claims: Letters of Credit 321 Other Contingent Claims: Swaps 323 Other Contingent Claims: Credit Derivatives 329 Risks for Banks in Contingent Claims 330 Regulatory Issues 334 Conclusion 335 Case Study: Youngstown Bank 336 Chapter 9 Securitization 345 Introduction 346 Preliminary Remarks on the Economic Motivation for Securitization and Loan Sales 348 DiVerent Types of Securitization Contracts 351 Going Beyond Preliminary Remarks on Economic Motivation: The Why, What, and How Much Is Enough of Securitization 363 Strategic Issues for a Financial Institution Involved in Securitization 383 Comparison of Loan Sales and Loan Securitization 386 Conclusion 386 Case Study: Lone Star Bank 387

13 CONTENTS xiii PART V THE DEPOSIT CONTRACT 395 Chapter 10 The Deposit Contract and Insurance 397 Introduction 398 The Deposit Contract 399 Liability Management 407 Deposit Insurance 409 The Great Deposit Insurance Debacle 431 Conclusion 435 PART VI BANK REGULATION 439 Chapter 11 Objectives of Bank Regulation 441 Introduction 442 The Essence of Bank Regulation 443 The Agencies of Bank Regulation 446 Market Structure and Competition 451 The Basel I Capital Accord 459 Safety and Soundness Regulation: Bank Portfolio Restrictions 466 Consumer Protection, Credit Allocation, and Monetary Control Regulation 467 Conclusion 475 Chapter 12 Milestones in Banking Legislation and Regulatory Reform 479 Introduction 480 Milestones of Banking Legislation 480 Problems of Bank Regulation 489 The 1991 FDICIA and Beyond 497 Liquidity Constraints, Capital Requirements, and Monetary Policy 504 The Basel II Capital Accord 506 The Debate Over Capital Requirements 512 Conclusion 515 PART VII OVERALL MANAGEMENT OF THE BANK 519 Chapter 13 Management of Risks and Opportunities in Banking 521 Introduction 522 Opportunities and Risks in Banking 524

14 xiv CONTENTS Day-to-Day Management 528 Crisis Management and Enterprise Risk Management 545 Strategic Planning 546 Case Study 554 Conclusion 556 PART VIII CORPORATE CONTROL AND GOVERNANCE 559 Chapter 14 Mergers and Acquisitions 561 Introduction 562 Recent Trends in Mergers and Acquisitions in Banking 562 Corporate Control Issues 563 Mergers in Banking 572 Hostile Takeovers in Banking 577 Conclusion 582 Chapter 15 Investment Banking 587 Introduction 587 What Investment Banks Do 588 Risk Management, Structured Finance, and Investment Banks 598 Conclusion 602 Appendix PART IX THE FUTURE 609 Chapter 16 The Future 611 Introduction 611 Future Opportunities for Banks: Expanded Role for Relationship Banking and the Implications for Universal Banking, Financial Innovation, and Globalization 612 Risk Management by Banks 614 The Basel Initiative and Future Capital Accords 614 Conclusion 618 INDEX 619

15 Preface In writing this book we set out to modernize the teaching of bank management at universities and collegiate schools of business. Our goal is to expand the scope of the typical bank management course by (1) covering a broader, but still selective, variety of Wnancial institutions, and (2) explaining the why of intermediation, as opposed to simply describing institutions, regulations, and market phenomena. Our approach is unapologetically analytical, and we have tried to make analysis an appealing feature of this book. We will consider the book a success if it leads students to not only discover the endless subtlety and plasticity of Wnancial institutions and credit market practices, but also develop an appreciation for why these institutions, market practices, and governmental regulations are encountered. The unifying theme is that informational considerations are at the heart of what most banks do. The novelty of our approach lies in both the analytical orientation and our choice and sequencing of topics. We begin with the questions of why Wnancial intermediaries exist and what they do. We believe that understanding the why of Wnancial intermediation will prepare the readers for the inescapable volatility of the future. Regulations, institutions, and claims will change, but the functional foundations on which Wnancial intermediaries are built will remain basically the same. Pedagogy Each chapter (except A Friendly Conversation and Chapter 1) begins with a glossary of terms that students will encounter while reading that chapter and will revisit throughout the book. Key nonbanking concepts are discussed in Chapter 1 to provide students with a clear basis on which to proceed. Within each subsequent chapter, we provide numerical examples, laying out each step from idea to solution. Each chapter ends with review questions, and many chapters include case studies to help students appreciate the power of the concepts as well as the complexities. xv

16 xvi PREFACE Moreover, because some chapters contain basic as well as more technical materials, more advanced discussions are isolated in boxes. Interesting, but inessential, information is likewise presented in isolated passages. This provides the instructor with enhanced Xexibility in customizing the course. Organization The book contains 16 chapters and A Friendly Conversation. In Part I, the introductory chapter consists of dialogues among three friends about banking in both 1991 and It is a mix of sound ideas and naiveté. Much of what is discussed in this chapter will be unfamiliar to a student without previous exposure to the subject. The chapter challenges students knowledge of the issues, and it could be covered the Wrst day of class to obtain students viewpoints on various issues. We refer back to this conversation throughout the book in end-of-chapter review questions that test the students expanding knowledge. A Friendly Conversation could also be discussed at the end of the course to gauge the changes in the students viewpoints. Chapter 1 discusses the key concepts of information economics, game theory, market completeness, options, and other topics we use throughout the book. We recommend that these concepts, which are central to the issues encountered in subsequent chapters, be discussed when needed in the context of subsequent chapters, rather than being dealt with at the outset of the course. Remaining chapters address eight distinct topics. In Part II, Chapters 2 and 3 examine the functions of Wnancial intermediaries. Chapter 2 describes the variety of Wnancial intermediation and the basic services provided by Wnancial intermediaries. Chapter 3 sets forth the information-based theory of Wnancial intermediation and explains how banks evolved from goldsmiths. Part III addresses the three basic business risks of banks: interest rate, liquidity, and credit risks. Chapter 4 discusses how these risks are related. Interest rate risk is explained from the vantage point of the arbitrage-free term structure of interest rates (under both certainty and uncertainty). In addition, we consider the importance of information as a source of liquidity risk. Chapter 5 focuses on credit risk and the lending decision. Credit rationing and other lending anomalies are examined in Chapter 6. New in this edition, Chapter 7 covers a few special topics in credit, including syndicated loans, loan sales, and project Wnance. Part IV deals with ov-balance sheet banking. Chapter 8 discusses commercial bank contingent claims, including loan commitments, letters of credit and bankers acceptances, interest rate swaps, and related contracts like caps, collars, and swaptions. Chapter 9 addresses securitization. Part V covers the liability side of the bank s balance sheet. Chapter 10 explains particular aspects of the demand deposit contract and also examines deposit insurance. Bank regulation is covered in Part VI by Chapters 11 and 12. First, we consider the diverent regulations to which banks are subject, and the economic/political rationale for each. The history of U.S. banking regulation as well as the institutional structure of regulation are examined. Then in Chapter 12, we turn to an analysis of proposals for regulatory reform. In particular, we discuss the 1991 FDIC Improvement Act, and the Basle II Capital Accord adopted in 2004.

17 PREFACE xvii In Part VII, Chapter 13 pulls together the key management questions found in previous chapters. It discusses both the day-to-day and the strategic management of opportunities and the three key business risks interest rate, liquidity, and credit risks in banking. It also discusses crisis management. Part VIII deals with corporate control and governance in banking. Chapter 14 discusses bank mergers and acquisitions. In Chapter 15, we discuss issues concerning investment banking. Finally, in Part IX s Chapter 16, we look to the future, conjecturing about the evolution of banking in the United States and elsewhere. There are three main themes in our discussion: the continuation of globalization in banking, risk management by banks, and international capital regulation. We believe it will be diycult to cover the entire book in one academic quarter or even one semester. Students for whom this book is intended are not accustomed to thinking about asymmetric information and agency issues, so it takes time to become familiar with the basic concepts. We recommend that the instructor select a subset of topics, keeping in mind that it would probably require two semesters to comfortably complete the entire book. Possible course outlines are included in the Instructor s Manual. Whatever the approach chosen by the instructor, we hope that this book provides an accessible, if intellectually challenging, rendering of contemporary banking thought. Our own experience in teaching these materials has been rewarding. We hope the same is true for others. Supplementary Materials Instructor s Manual/Test Bank/Transparency Master: Initially prepared by Daniel Indro of Kent State University and revised for this edition by Jian Cai of Washington University in St. Louis, the Instructor s Manual includes lecture notes and outlines for each chapter, as well as answers to the end-of-chapter questions and case studies. To over instructors more Xexibility, the Instructor s Manual provides citations of recent articles that instructors can include in their class. Summaries and discussion questions are provided to help incorporate these articles for class discussion. The Test Bank overs approximately 500 questions and problems for use on exams, homework assignments, and quizzes. A set of overheads is also available for all chapters except the Wrst one so that instructors can use these in their classroom presentation.

19 Acknowledgments The second edition of Contemporary Financial Intermediation has benewted from the advice of many colleagues and friends. In particular, we would like to thank Neal Stoughton, Chris Hatina, and Terry Wirtel at Washington University in St. Louis for all their hard work in typing the manuscript. In addition, the following reviewers gave of their time and insight to improve the manuscript in its many stages. Nasser Arshadi, University of Missouri at St. Louis Sheldon D. Balbirer, University of North Carolina at Greensboro Jess Beltz, Hong Kong University of Science and Technology Arnoud Boot, University of Amsterdam Yuk-shee Chan, Hong Kong University of Science and Technology Elizabeth Cooperman, University of Baltimore Robert Eisenbeis, University of North Carolina at Chapel Hill David Ely, San Diego State University Mark J. Flannery, University of Florida Gary Gorton, University of Pennsylvania John H. Hand, Auburn University Jim Johannes, University of Wisconsin at Madison George Kanatas, University of South Florida G.D. Koppenhaver, Iowa State University William Kracaw, Pennsylvania State University Morgan J. Lynge, Jr., University of Illinois at Urbana-Champaign Loretta Mester, Federal Reserve Bank of Philadelphia Todd Milbourn, Washington University in St. Louis Helena Mullins, University of British Columbia Joseph A. Newman, Northern Illinois University Ehud I. Ronn, University of Texas at Austin xix

20 xx ACKNOWLEDGMENTS William Sartoris, Indiana University James Seward, Dartmouth College Case M. Sprenkle, University of Illinois at Urbana-Champaign Ali Tarhouni, University of Washington Greg Udell, New York University James Verbrugge, University of Georgia

21 About the Authors Stuart I. Greenbaum Stuart Greenbaum is the former Dean and professor emeritus at the John M. Olin School of Business at Washington University in St. Louis. He is the 2006 recipient of the Lifetime Achievement Award of the Financial Intermediation Research Society. He was named the Bank of America Professor of Managerial Leadership in Before joining the Olin School in 1995, Greenbaum served for 20 years on the faculty of the Kellogg Graduate School of Management at Northwestern University where he was the Director of the Banking Research Center and the Norman Strunk Distinguished Professor of Financial Institutions. From , he served as Kellogg s Associate Dean for Academic Affairs. Before Northwestern, Greenbaum served as Chairman of the Economics Department at the University of Kentucky, and on the staffs of the Comptroller of the Currency and the Federal Reserve. Greenbaum has served on fifteen corporate boards. He also served on the Dean s Advisory Council of the Graduate Management Admission Council, on the board of AACSB International The Association to Advance Collegiate Schools of Business, Executive Committee of the World Agricultural Forum, and on the board of the St. Louis Children s Hospital. He was thrice appointed to the Federal Savings and Loan Advisory Council, and was twice officially commended for extraordinary public service. Greenbaum has consulted for the Ewing Marion Kauffman Foundation, the Council of Higher Education of Israel, the American Bankers Association, the Bank Administration Institute, the Comptroller of the Currency, the Federal Reserve System, and the Federal Home Loan Bank System, among others. He has on numerous occasions testified before Congressional committees, as well as other legislative bodies. Greenbaum has published two books and more than 75 articles in academic journals and other professional media. He is founding editor of the Journal of Financial Intermediation and has served on the editorial boards of ten other academic journals. xxi

22 xxii ABOUT THE AUTHORS Anjan V. Thakor Anjan Thakor is John E. Simon Professor of Finance and Senior Associate Dean of Programs, Olin School of Business, Washington University in St. Louis. Prior to joining the Olin School, Thakor was The Edward J. Frey Professor of Banking and Finance at the Ross School of Business, University of Michigan, where he also served as chairman of the Finance area. He has served on the faculties of Indiana University, Northwestern University, and UCLA. He has consulted with many companies and organizations, including Whirlpool Corporation, Allision Engine Co., Citigroup, RR Donnelley, Dana Corporation, Anheuser-Busch, Zenith Corporation, Lincoln National Corporation, J.P. Morgan, Landscape Structures, Inc., CIGNA, Borg- Warner Automative, Waxman Industries, Reuters, The Limited, Ryder Integrated Logistics, AT&T, CH2M Hill, Takata Corporation, Tyson Foods, Spartech, and the U.S. Department of Justice. Among many other honors, Dr. Thakor is the winner of the Reid MBA Teaching Excellence Award, Olin School of Business, 2005, and received the Outstanding Teacher in Doctoral Program award for the University of Michigan Business School, April He has published over 100 papers in leading academic journals in Finance and Economics and books of readings. Besides this book, he has published five other books.

Contemporary Financial Intermediation

Contemporary Financial Intermediation Extended Contents Preface Acknowledgments About the Authors xv xix xxi PARTI THE BACKGROUND 1 A Friendly Conversation 3 Introduction 3 The Conversation: 1991 3 Follow-Up