Microeconomics of Banking: Tutorial 2
• At the beginning of the tutorial, different groups are randomly selected to
present different parts of the exercise.
• After the tutorials, a sample solution will be available on Blackboard.
• Each group has 10 minutes for presentation.
Exercise 1 Maturity Transformation 100 points
Maturity transformation is one of the key functions of a modern banking system.
This exercise builds on the model of liquidity transformation derived in the lecture
and studies how maturity transformation makes banks vulnerable to bank runs.
Consider the model from the lecture:
• A competitive bank with access to a long term technology yielding R > 1 per
unit of investment at the final stage t = 2 and λ per unit of investment at the
interim stage t = 1.
• In addition, there are M depositors with one unit of endowment each.
• At t = 0, borrowers and banks know that the borrower has a consumption
need c1 at t = 1 with probability π and a consumption need c2 at t = 2 with
probability 1 − π.
• Borrowers are risk neutral so that their utility function from the perspective of
t = 0 is U = πc1 + (1 − π)c2 .
• At t = 0, borrowers deposit their endowment at the bank against the bank’s
promise of receiving c1 when withdrawing at t = 1 and c2 when withdrawing at
t = 2.
• At the same time, t = 0, the bank invests I of borrowers’ deposits into the long
term technology and saves M − I.
1.1 Liquidity Transformation: Optimal Allocation 20 points
Repeat the derivation of the optimal deposit schedule (cF1 I , cF2 I ) from the lecture.
1
1.2 Benefit of Financial Intermediation 20 points
Recall the solution of autarky from the lecture. Provide, in few sentences, the intuition
of liquidity transformation and how it serves depositors.
1.3 Bank Run total of 60 points
Extend the model by an unexpected liquidity shock to depositors. Therefore use the
following notation. At t = 0, when agreeing on the deposit schedule (c1 , c2 ) and
when making the investment I, both bank and depositors believe that a portion of π
depositors will withdraw at t = 1 and 1 − π at t = 2. Now instead, assume that at
t = 1, banks and depositors learn that a share π 0 > π of depositors want to withdraw
at t = 1, i.e. more depositors than expected want to withdraw at t = 1. Since
investment in the long term technology I is already decided at t = 0, the bank has
to liquidate L of the long term technology in order to satisfy the increased deposit
withdrawals. Recall, liquidation at t = 1 yields a per unit return of ` < 1.
For your derivations assume that I = (1 − π)M so that c2 = R and c1 = 1.
Proceed as follows:
1.3.1 15 points
Determine how much of the long term technology has to be liquidated L in order to
satisfy the increased deposit withdrawals π 0 M c1 .
1.3.2 15 points
Given the liquidation L of the long term technology, how much can depositors with-
draw at t = 2 at most. Determine c02 (π 0 ).
1.3.3 15 points
Depositors who are supposed to withdraw c02 (π 0 ) at t = 2 want to withdraw c1 at
t = 1 instead if c02 (π 0 ) < c1 . Show for which level of π 0 , t = 2 depositors withdraw at
t = 1 as well.
1.3.4 15 points
Interpret briefly the above threshold for π 0 .
Microeconomics of Banking Tutorial 2