Financial markets, financial intermediation, and bailout policy [Elektronische Ressource] / vorgelegt von Dmitri V. Vinogradov

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FinancialMarkets,FinancialIntermediation,andBailoutPolicyDISSERTATION ZURERLANGUNGDESGRADES EINESDOKTORS DERWIRTSCHAFTSWISSENSCHAFTEN(DOCTOR RERUM POLITICARUM)DERFAKULTÄT FÜRWIRTSCHAFTS- UNDSOZIALWISSENSCHAFTENDERUNIVERSITÄTHEIDELBERGvorgelegt vonDMITRI V. VINOGRADOVgeborenam16.06.1972inNovorossiyskHeidelberg2006AcknowledgementsIamdeeplyindebtedtomysup ervisor Prof. Jürgen Eichberger, for his belief in me andinvaluable support. My warmest words of gratitudegoalsotomydearteacherProf.RevoldEntov, for his involvement in my development as a scholar and as an individual. I also thankProf. Hans Gersbach and Prof. Eva Terberger for fruitful discussions and exchange of ideas,which helped me to structure this dissertation.A special thank I address to my colleage and coauthor Prof. Marina Doroshenko for hercooperation at all stages of my research and for her constructive criticism with regard to myresearch. I am grateful to Prof. Andy Mullineux for reading and commenting some of mypapers, which served as a basis for this dissertation.I thank seminar and conference participants in Heidelberg, Cambridge, Nice, Strasbourgand Helsinki for their critique and comments. Dr. John Bryan Speakman, Eckard Mauer-mann and Richard Jackson helped me with English formulations, thank them a lot.

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FinancialMarkets,FinancialIntermediation,
andBailoutPolicy
DISSERTATION ZURERLANGUNG
DESGRADES EINESDOKTORS DERWIRTSCHAFTSWISSENSCHAFTEN
(DOCTOR RERUM POLITICARUM)
DERFAKULTÄT FÜRWIRTSCHAFTS- UNDSOZIALWISSENSCHAFTEN
DERUNIVERSITÄTHEIDELBERG
vorgelegt von
DMITRI V. VINOGRADOV
geborenam16.06.1972
inNovorossiysk
Heidelberg
2006Acknowledgements
Iamdeeplyindebtedtomysup ervisor Prof. Jürgen Eichberger, for his belief in me and
invaluable support. My warmest words of gratitudegoalsotomydearteacherProf.Revold
Entov, for his involvement in my development as a scholar and as an individual. I also thank
Prof. Hans Gersbach and Prof. Eva Terberger for fruitful discussions and exchange of ideas,
which helped me to structure this dissertation.
A special thank I address to my colleage and coauthor Prof. Marina Doroshenko for her
cooperation at all stages of my research and for her constructive criticism with regard to my
research. I am grateful to Prof. Andy Mullineux for reading and commenting some of my
papers, which served as a basis for this dissertation.
I thank seminar and conference participants in Heidelberg, Cambridge, Nice, Strasbourg
and Helsinki for their critique and comments. Dr. John Bryan Speakman, Eckard Mauer-
mann and Richard Jackson helped me with English formulations, thank them a lot.
The last but not the least, I thank my beloved parents, Tamara and Vladimir Vinogradovs,
for their understanding and support wherever and whenever I am and whatever I plan, even
if it seems unrealistic.
2Ta b l e o f C o n t e n t s
ACKNOWLEDGEMENTS 2
NOTATION 8
INTRODUCTION 13
CHAPTER 1 The Theory of Banking and Bank Regulation: brief history of
thought 17
1.1 TheTheoryofBankingandFinancialIntermediation ................... 17
1.2 TheOriginsofBankingTheory........................................ 20
1.2.1 BanksasTradingInstitutions.................................. 21
1.2.2 BankingRisks................................................ 21
1.2.3 BankingandReserves 23
1.2.4 BankingandGovernmentPolicy .............................. 25
1.2.5 TheNeedforaNewApproach................................ 27
1.3 TheStartoftheModernBankingTheory. 29
1.3.1 BanksasPortfolioManagers.................................. 31
1.3.2 BanksastheCoreofthePaymentSystem...................... 32
1.4 Functions offinancialintermediaries................................... 33
1.4.1 Reductionoftransactioncosts................................. 34
1.4.2 Liquidityprovision........................................... 35
1.4.3 Informationprovision......................................... 36
1.4.4 Debtrenegotiation............................................ 37
1.4.5 FinancialIntermediationinthisDissertation ................... 39
1.5 Financial Intermediation, Macroeconomy and
FinancialCrises....................................................... 40
1.5.1 FinancialIntermediationandEconomicGrowth................ 41
1.5.2 FinancialIntermediationandMacroeconomicShocks .......... 43
1.5.3 FinancialIntermediationandFinancialCrises.................. 44
1.5.4 MacroeconomicIssuesinthisDissertation..................... 45
1.6 RegulationandIntermediation......................................... 46
31.6.1 CapitalRegulation............................................ 47
1.6.2 DepositInsurance ............................................ 49
1.6.3 BailoutPolicy................................................ 50
1.6.4 RegulationoftheStructureofBankingSystem................. 51
1.6.5 MonetaryPolicy.............................................. 53
1.6.6 RegulatoryIssuesinthisDissertation.......................... 53
1.7 Summary............................................................. 54
CHAPTER 2 Ambiguity in Bailout Policy and Efficiency of Intermediation 56
2.1 BailoutsandRescueBeliefs ........................................... 56
2.1.1 FailureResolutions 58
2.1.2 ConstructiveAmbiguity....................................... 59
2.1.3 RescueBeliefs ............................................... 62
2.2 MarketEconomy...................................................... 63
2.2.1 Markets 64
2.2.2 Households .................................................. 65
2.2.3 Equilibrium 66
2.3 IntermediatedEconomy:CommitmenttoLiquidation................... 67
2.3.1 Banks........................................................ 69
2.3.2 InsolvencyResolution ........................................ 70
2.3.3 Households 72
2.3.4 SupplyofDeposits ........................................... 74
2.3.5 MonopolisticEquilibrium..................................... 76
2.3.6 CompetitiveEquilibrium...................................... 79
2.4 IntermediatedEconomy:AmbigousBailouts........................... 83
2.4.1 BailoutandDecision-Making................................. 83
2.4.2 MonopolisticEquilibrium 85
2.4.3 CompetitiveEquilibrium 88
2.5 IntermediatedEconomy:uncertainbailoutrule ......................... 90
2.5.1 Households .................................................. 92
2.5.2 Banks........................................................ 93
2.5.3 MonopolisticEquilibrium..................................... 94
2.5.4 CompetitiveEquilibrium...................................... 97
2.6 Summary............................................................. 98
APPENDIX 2.A Proofs 102
CHAPTER 3 Regulatory Forbearance and Intergenerational Workout
Incentives 113
3.1 LimitedLiabilityversusUnlimitedLiability...........................113
3.2 AmbiguityandForbearance ..........................................115
3.3 MacroeconomicEnvironmentinaDynamicContext...................118
43.4 MarketEconomy.....................................................119
3.4.1 Entrepreneurs ...............................................119
3.4.2 Consumers..................................................121
3.4.3 Equilibrium.................................................121
3.5 Intermediatedeconomy123
3.5.1 Bailouts123
3.5.2 Sequenceofevents ..........................................124
3.6 IntermediatedEconomy:NoInternalizationofBailoutCosts...........127
3.6.1 SupplyofDeposits128
3.6.2 ObjectiveFunctionoftheBanks..............................130
3.6.3 MonopolisticEquilibrium....................................131
3.6.4 CompetitiveEquilibrium.....................................133
3.7 IntermediatedEconomy:RegulatoryForbearance......................135
3.7.1 SupplyofDeposits ..........................................136
3.7.2 ObjectiveFunctionoftheBanks136
3.7.3 MonopolisticEquilibrium138
3.7.4 CompetitiveEquilibrium139
3.8 Ambiguity, Beliefs and Forbearance: Implications of the Dynamic
Setting ..............................................................141
3.9 Summary............................................................144
APPENDIX 3.A Proofs 146
CHAPTER 4 Markets versus Financial Intermediation: Dynamic General
Equilibrium Analysis 148
4.1 FinancialIntermediationintheMacroeconomicContext ...............148
4.2 BasicGeneralEquilibriumModel.....................................151
4.2.1 AgentsandDecisions........................................151
4.2.2 InteractionsintheBasicModel...............................156
4.2.3 EquilibriumintheBasicModel ..............................157
4.2.4 ComparisonwithBenchmarkCases ..........................164
- Böhm and Puhakka (1988) .................................. 164
- Diamond (1965) ........................................... 166
- Bernanke and Gertler (1987, 1989, 1990)...................... 167
4.3 TheModelwithFinancialIntermediation..............................168
4.3.1 AgentsandDecisions........................................169
4.3.2 IntermediationandInteractions...............................171
4.3.3 MarketsandEquilibrium.....................................172
4.4 EvolutionoftheEconomy............................................174
4.5 Equivalence..........................................................176
4.6 Summary............................................................178
5APPENDIX 4.A Proofs 179
CHAPTER 5 Banks versus Markets in Processing a Macroeconomic Shock 184
5.1 ProductionShock....................................................184
5.1.1 ShockParameter ............................................186
5.1.2 DegreesofShock............................................187
5.2 MarketEconomyExposedTotheProductionShock ...................191
5.2.1 Decision-MakingandEquilibrium............................191
5.2.2 EvolutionBeforetheShock..................................194
5.2.3 EvolutionAftertheShock....................................194
5.3 IntermediatedEconomyExposedTotheProductionShock.............196
5.3.1 Decision-MakingandEquilibrium196
5.3.2 EvolutionBeforetheShock198
5.3.3 EvolutionAftertheShock200
5.4 PaymentShock ......................................................202
5.4.1 DescriptionofthePaymentShock............................203
5.4.2 MarketEconomyExposedtoaPaymentShock ...............204
5.4.3 IntermediatedEconomyExposedtoaPaymentShock.........206
5.5 RegulatoryInterventions .............................................207
5.5.1 LiquidityInjections..........................................207
5.5.2 DepositRateCeiling.........................................209
5.6 IntermediatedEconomy:RegulatedDynamics.........................210
5.6.1 LiquidityInjections210
5.6.2 DepositRateCeiling213
5.7 WelfareConsiderations...............................................215
5.7.1 SmallProductionShock .....................................216
5.7.2 Middle-SizedProductionShock..............................216
5.7.3 SevereProductionShock217
5.7.4 PaymentShock..............................................218
5.8 Summary............................................................220
APPENDIX 5.A Deposit Interest Rate under Perfect Competition in the Banking
Sector 222
APPENDIX 5.B Variation of the Macroeconomic Shock 224
APPENDIX 5.C Proofs 226
CHAPTER 6 Handling a Financial Crisis: Russian Default in 1998 and
International Comparison 228
6.1 TheCrisisandtheModel.............................................228
6.2 StylizedFactsaboutRussianEconomyin1998-1999 ..................230
6.3 EvolutionofRussianCrisisAftertheDefault..........................233
66.3.1 Capital Deterioration, Liquidity Injections and Slow
Recovery....................................................234
6.3.2 InterestRateMargin.........................................238
6.3.3 WealthEffectsoftheCrisis ..................................240
6.3.4 PolicyImplications..........................................242
6.4 InternationalComparison.............................................243
6.4.1 JapaneseCrisis..............................................244
6.4.2 SwedishCrisis246
6.4.3 OtherExamples248
6.5 Summary............................................................250
APPENDIX 6.A Chronology of the Russian Financial Crisis 1998 252
CONCLUSION 265
REFERENCES 269
7Notation
The following is a list of notation, which does not pretend to be a complete list of defini-
tions of respective variables, but rather serves as a short reference list.
a - share of deposits in the financial portfolio of a household in an intermediated econ-
omy; (1 − a) - share of the risk-free asset in the financial portfolio of a household in an
intermediated economy (Ch. 2)
a - a part of the initial endowment of a consumer, which is deposited with a bank int
period t (Ch. 3)
b - capital repayment, i.e. payoffs from an entrepreneur to workers for the use of bor-t
rowed funds in period t (Ch. 4, 5)
B - total capital repayments of all entrepreneurs to all workers within the period t (Ch.t
4, 5)
c - consumption of an agent in period t (Ch. 4, 5)t
OEc -period’s t consumption of the entrepreneurs who are old in that period (Ch. 4)t
OWc -period’s t of the workers who are old in that period (Ch. 4)t
YEc -period’s t consumption of the entrepreneurs who are young in that period (Ch. 4)t
YWc -period’s t of the workers who are young in that period (Ch. 4)t
d - aggregate deficit in the economy (Ch. 5)t+1
Wd -deficit of an indifidual creditor (worker) (Ch. 5)t+1
s td - state-contingent deficit in a bank: the difference between the yields from investmentt
and the payoffs to depositors in period t in state of natures ,s ∈{H, L} (Ch. 3)t t
D - amount of deposits (Ch. 1, 2)
8D - upper bound for the amount of deposits (Ch. 2)
dD - demand for deposits (Ch. 2);
dD - aggregate demand for deposits in period t (Ch.3)t
dD - aggregate demand for deposits in a competitive banking sector (Ch. 2)c
sD - supply of deposits (Ch. 2);
sD - aggregate supply of deposits in period t (Ch.3)t
∗D - equilibrium amount of deposits in the intermediated economy (Ch. 2)
e - wage expenditures of an individual entrepreneur in period t (Ch. 5)t
eE - expected profit of an entrepreneur in period t (Ch. 3, 4, 5)t
s tE - state-contingent profitofanentrepreneurinthestateofnatures ∈{H, L} in periodtt
t (Ch. 3, 4, 5)
E( w | Ω ) - expectation of w conditional on Ω (Ch. 4)t+1 t t+1 t
f - production function (Ch. 4, 5)
eG - expected payoff (gains) to a household (Ch. 2)
eG - expected payoff (gains) to a consumer in period t (Ch. 3)t
sG - state-contingent payoff to a household in state of natures ∈{H, L} (Ch. 2)
i - index for an agent (Ch. 2, 3)
I - externalfinanceobtainedbyanentrepreneur in the form of credit in period t and usedt
to acquire capital k (Ch. 4)t+1
k - units of good invested in the production during period t (Ch. 3); units of capital usedt
in the production f in period t (Ch. 4, 5)
k - steady state level of k before the shock occurs (Ch. 5)t
l - units of labor used in the production f in period t (Ch. 4, 5)t
l - steady state level of l before the shock occurs (Ch. 5)t
m - natural number, used in indexing periods after the shock (Ch. 5)
M - stock of liquid funds available to the Regulator (Ch.5)
M - the size of the liquidity injection by the Regulator in period t (Ch. 5)t
M(s ) - space of probability distributions over the value of the signal in the period t (Ch.t
4)
n - natural number, used in indexing periods after the shock (Ch. 5)
9n - growth rate of the population size in the model of Diamond (1965) (Ch. 4)g
N - size of the population in the model of Diamond (1965) (Ch. 4)t
p - probability of the state of nature "H"; (1 − p) - probability of the state of nature "L"
(Ch. 2, 3, 5)
q - shock parameter, determines the degree of the shock in period t (Ch. 5)t
q - threshold value of the shock parameter, which distinguishes between the small shock
and the middle-sized one (Ch. 5)
q - threshold value of the shock parameter, which distinguishes between the middle-sized
shock and the severe one (Ch. 5)
r - rate of interest, existing on one-period loans from period t to period t+1(Ch. 4)t
r - steady state level of r before the shock occurs (Ch. 5)t
Cr - rate of return on credit of the period t −1, which is repaid in period t (Ch. 5)t
Dr - rate of return on deposits (Ch. 2)
Dr - rate of return on deposits of the period t −1, which is repaid in period t (Ch. 3, 5)t
D Dr - equilibrium deposit rate of return in a competitive banking sector (Ch. 2); r -thec c, t
same in period t (Ch. 3)
D Dr - equilibrium deposit rate of return in a monopolistic banking sector (Ch. 2); r -them m,t
same in period t (Ch. 3)
Dre gr - deposit rate ceiling
F Fr - rate of return on risk-free investment (Ch. 2); r - the same in period t (Ch. 3)t
H Hr - rate of return on risky investment in state of nature "H" (Ch. 2); r -thesameint
period t (Ch. 3, 5)
L Lr - rate of return on risky investment in state of nature "L" (Ch. 2); r -thesameint
period t (Ch. 3, 5)
Mr - rate of interest at which the liquidity assistance is available tofinancial institutions
in distress (Ch. 5)
sr - state contingent rate of return on risky asset in state of natures ∈{H, L} (Ch. 2)
sre - state rate of return on bank’s portfolio in the state of nature s ∈{H, L};
the rate of return which depositors face in case of the liquidation of the bank (Ch. 2)
s tre - state contingent rate of return on bank’s portfolio in state of nature s in period t;tt
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