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Question 1: Bank liquidity transformation and liquidity risks [50 Marks in total]

Liquidation transformation is considered a central function of commercial banks.

a.   Please explain the concept of liquidity transformation, and how it involves both the asset and liability sides of banks’ balance sheets.                              [10 Marks]

b.   Banks also create liquidity with their off-balance sheet activities such as underwriting credit lines. Indeed, commercial banks have a significant presence in the market of (unsecured) credit lines, as illustrated by the table below. Please explain why this is the case by linking to the unique capital structure of commercial banks.      [10 Marks]

Table: Banks versus other lending institutions: fraction of each institution’s lending by loan types

Source: Kashyapetal. (2002)

c.    Liquidity transformation also creates funding liquidity risks (such as the risk of creditor runs or the difficulty to rollover short-term debt). Please explain the panic-driven view of bank runs.                                                          [10 Marks]

d.   The table below documents the timing of system-wide bank runs and economic recession during the national banking era of the U.S. Does the empirical evidence fully support the panic-driven view of bank runs? Please explain why or why not. [10 Marks]

e.   Please give an example of liquidity regulation introduced under the Basel III Accord and explain how the regulation can reduce the risk of bank runs. [10 Marks]

Question 2: Bank Credit Lines [50 Marks in total]

Consider the following case of Holmstrom-Tirole (1998) model. An entrepreneur has a project that faces uncertain financing needs. The  financing need p can be 6, 10, or 13, with corresponding probabilities 1/2, 1/4 and 1/4, respectively. When the project is financed, it will generate an income of 15 if it succeeds, and an income of 0 if it fails. The probability of success depends on whether the entrepreneur works hard. If he works hard, the project will succeed with a high probability PH  = 0.8. If the entrepreneur does not work hard, he will be able to extract a private benefit B = 1.5 but only at the cost of reducing the probability of success to PL = 0.5. We further assume that the credit market is perfectly competitive and banks operating in the market only break even due to competition. Please answer the following questions.

a.   If the financial market is frictionless (e.g., the entrepreneur has no moral hazard problem and can commit to work hard), for which values p should the project be refinanced?                                 [10 Marks]

b.   Now consider the case that the entrepreneur takes await-and-see strategy: to seek financing only after the financing need is known. For which values of p can the project be financed?        [10 Marks]

c.    Please formulate the credit line contract that will maximize the entrepreneur’s expected payoff.              [10 Marks]

d.   Please explain why the mutual commitment is crucial for the bank credit line as an ex-ante arrangement to perform await-and-see strategy,i.e., raising funds in financial markets only after the financing need is realized.     [10 Marks]

Question 3: FinTech [50 Marks in total]

a.   FinTech firms nowadays compete with traditional banks on a number of fronts, from payment services to mortgages as well as consumer/small business lending. Should regulators be concerned with such competition? Please explain why or why not. [10 Marks]

b.   One newtype of financial intermediary is peer-to-peer (P2P lending platforms). Please compare the business model of P2P lending to traditional banks, in terms of their capital structure and the allocation of credit risks. [10 Marks]

c.   The entry of FinTech firms into credit markets can generate efficiency and benefits for the society at large. Please give one example of such benefits. [10 Marks]

d.   The entry of FinTech firms into credit markets can also raise concerns and generate potential risks. Please give one example of such risks. [10 Marks]

e.   Please provide two reasons why FinTech firms should be regulated.  [10 Marks]

Question 4: Credit market friction and inefficiency [50 Marks in total]

Please solve the following variant of the Holmstrom-Tirole model. A risk-neutral entrepreneur has 1 unit of personal wealth and makes an investment decision between Project A and B. When Project A is successful, each unit of investment in the project generates a gross return RA   =  1.2. By comparison, when Project B succeeds, each unit of investment in the project generates a gross return RB   =  1.15. A project generates zero income when it fails. If the entrepreneur works hard, his project will succeed with certainty  (i.e., PH  = 1).  If the entrepreneur shirks, he will reduce the probability of success to PL = 0.8 but will obtain a private benefit that is proportional to the size of investment. While the entrepreneur’s effort affects the probability of success of the two projects in the same way, the amount of private benefit that the entrepreneur can obtain from shirking differs across  the two projects. Shirking on Project A allows the entrepreneur to gain a private benefit BA  = 0.08 for one unit of investment in the project, whereas shirking on Project B only allows the entrepreneur to gain a private benefit BB   = 0.05 for one unit of investment in the project.

a.   If the entrepreneur only invests with his 1 unit of personal wealth, which one of the two projects will he choose? [10 Marks]

Now consider ascenario where the entrepreneur can raise external financing to increase the total size of investment to X  > 1 (in which case the entrepreneur raises X − 1 from external financiers). We further assume that both projects feature constant returns to scale. That is,    when X units are invested in Project A, the project will generate a revenue of X ⋅ RA  if it succeeds. (Similarly, an X units of investment in Project B generates a revenue of X ⋅ RB  in its success.) As mentioned, the entrepreneur’s private benefit is also proportional to the size of   the investment. That is, if X units are invested in Project A, the total gain from shirking equals X ⋅ BA . (Similarly, if X units are invested in Project B, the total gain from shirking equals X ⋅ BB.)

b.   Please calculate the pledgeable  income per unit of investment for  Project A and  B, respectively.          [10 Marks]

c.    Please calculate the maximum size of investment that the entrepreneur can sustain for Project A and B, respectively. [10 Marks]

d.   When reaching the maximum size of the investment of the project with external financing, which project will the entrepreneur prefer? [10 Marks]

It is observed that inefficiency can emerge in a booming credit market in the sense that less  profitable projects are financed before the more profitable ones, and the inefficiency can be mitigated with tightening monetary policy. To gain some insight in this regard, suppose that  with a monetary contraction, the external financiers require an expected net return of 20% on their investment. That is, for X − 1 amount that the financiers invest in the entrepreneur’s project, they require a total repayment of 1.2 ∗ (X − 1).

e.   Given this rising cost of debt, please calculate again the maximum size of investment that the entrepreneur can sustain for Project A and B, respectively, and examine again which one of the two projects the entrepreneur would prefer.                       [10 Marks]