JEM185 - Microeconomics of Banking Spring 2023

Teacher: Karel Janda

TA: Vojtech Misak, Tersoo Iorngurum

Email: Karel-Janda@seznam.cz

Office hours: Monday 9:30-10:50, 12:30-13:10 room 408, Opletalova 26; Wednesday 12:45-14:45 room 182NB, W. Churchilla Square 4.

Explanations:

W.Churchilla Square 4 is the main building of Prague University of Economics and Business.

Opletalova 26 is the building of Institute of Economic Studies of Charles University.

I have no office hours on: February 22, March 22, During May 2023-September 2024 I will be at UC Berkeley.

Literature:

X. Freixas and J. Rochet: Microeconomics of Banking, Cambridge, MIT Press, 1997 (1st edition) or 2008 (2nd edition) - main textbook.

R. Gibbons: Game Theory for Applied Economists, Princeton University Press, 1992 - good treatment of signalling and other game theoretic issues.

(If you do not like Gibbons, you may want to look at any of a number of other game theory textbooks or to many microeconomics textbooks which usually contain a section(s) on game theory).

A few additional references for those who want more books to study:

Jean Tirole: The Theory of Corporate Finance, Princeton University Press, 2006

Patrick Bolton, Mathias Dewatripont: Contract Theory, 2005

Bernard Salanie: The Economics of Contracts: A Primer, 2005

Martin J. Osborne: An Introduction to Game Theory, 2003

Oliver Hart: Firms, Contracts, and Financial Structure, 1995

Mathias Dewatripont, Jean Tirole: The Prudential Regulation of Banks, 1994

J. Laffont and D. Martimort: The Theory of Incentives: The Principal-Agent Model. Princeton University Press, 2002

Description: This course uses asymmetric information approach of a modern microeconomics theory to explain the role of banks in the economy. The course provides description of the functions of banks and explains the needs for financial intermediation. The emphasize is on the structural weaknesses of the banking sector that may justify public interventions. The course deals with the optimal contracting between lender and borrower, the persistence of rationing in the credit market, the use of collateral and the solvency problems.

Content:

The main emphasize of the course is on the theoretical microeconomic aspects of banking.

Therefore a good knowledge of microeconomic theory on intermediate level with calculus is necessary.

The familiarity with simple calculus techniques of optimization as used in microeconomic models is essential. The understanding of basic probability theory and comfort with using expected values is very useful. A preliminary knowledge of the institutional aspects of banking is helpful but it is not necessary. These institutional aspects will be reviewed in class when needed. This course does not require any knowledge of advanced techniques of continuous time finance.

Intended Audience: Master (magistr in Czech terminology) and Ph.D. level students interested in banking or optimal contracting.

The Topics Covered (FR chapter numbers here are based on 1st edition - you do not need to read 2nd edition, the 1st edition is perfectly O.K. for our class.)

Lecture 1: Introduction to microeconomics of banking - functions of bank, banking in general equilibrium theory (Freixas, Rochet (FR) ch. 1)

(Why Lecture 4 follows Lecture 1? Because we do not cover former Lectures 2 and 3 in this class any more. They dealt with game theory issues, which I now cover in special dedicated game theory class.)

Lecture 4: Why do financial intermediaries exist? Liquidity insurance (FR ch.2.2)

Lecture 5: Information sharing coalitions. (FR ch. 2.3)

Lecture 6: Financial intermediation as delegated monitoring (FR ch. 2.4)

Lecture 7: Coexistence of direct and intermediated lending - A simple model of the credit market with moral hazard, Monitoring and Reputation (FR ch. 2.5)

Lecture 8: Coexistence of direct and intermediated lending - Monitoring and capital. Optimal contracts when cash flows are observable (FR. ch. 2.5. , ch. 4.1)

Lecture 9: Costly state verification. Incentives to repay - Threat of termination. (FR ch. 4.2, ch. 4.3)

Lecture 10: Moral hazard (FR ch. 4.4)

Additional material, to be covered time permitting:

Strategic debt repayment (FR ch. 4.3.2),

Collateral and loan size as devices for screening heterogenous borrowers (FR ch. 4.6)

Exams:

Exam 1: March 6, 2023, 11:00-12:20, room 109
Exam 2: March 20, 2023, 11:00-12:20, room 109
Exam 3: April 3, 2023, 11:00-12:20, room 109
Exam 4: April 24, 2023, 11:00-12:20, room 109

Libraries, teaching texts availability:

I will try to provide you with relevant handouts. There are libraries with books relevant to our class both at Prague University of Economies and Business and Institute of Economic Studies. I asked the librarians at Prague University of Economies and Business and Institute of Economic Studies to put one copy of the main textbook for our class on reserve. I also arranged for a few copies of Microeconomics of Banking and An Introduction to the Economics of Information: Incentives and Contracts to be available for take-home loans at Institute of Economic Studies library. In addition, the best economic library in Prague is at CERGE-EI on Politickych veznu 7 street. The CERGE-EI library has all the books relevant for our class, some of them available for take-home loans.

You may also buy the textbooks over the Internet or order them through some local bookshop like http://bohemia.starman.net/en/home.aspx

Course requirements: The students are evaluated according to written exams. There will be 4 exams available to take for this class. 2 exams with highest score will determine your score. Each of these two exams may give you up to 50 points. The thresholds for the grades are as follows: A: 90+ to 100; B: 80+ to 90; C: 70+ to 80; D: 60+ to 70; E: 50+ to 60; F: 50 or less. Therefore, borderline results are assigned the lower grade (e.g., 90 is B).

Cheating or other academic dishonesty during exam implies 0 for a particular exam and 10 points taken away from total in the case of slight dishonesty (20 points in the case of serious dishonesty). Any communication among the students during the exam is considered as cheating. Therefore during the exam communicate only with the exam supervisor. You may take watch and simple calculator for exams. Do not take any mobile phones or any other electronic devices for exams.