Scribd
Upload
8 views4 pages

Maturity Transformation in Banking Explained

Uploaded by

lilytran2395
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
8 views4 pages

Maturity Transformation in Banking Explained

Uploaded by

lilytran2395
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Microeconomics of Banking: Tutorial 2 Sample

Solution

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 liquidity 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 (c∗1 , c∗2 ) from the lecture.
Solution: Observe the probability π for each borrower to be early consumer
equals the share of early consumers in society. Then a bank which invests I into a
long term technology makes at t = 2:

IR − (1 − π)M c2 ≥ 0 (1)

1
In a perfectly competitive banking market, the bank breaks even and hence:
IR
c2 = (2)
(1 − π)M

When a bank invests I into a long term technology, it has M − I left to pay out
to early consumers at t = 1:

M − I − πM c1 ≥ 0 (3)

In a perfectly competitive banking market, the bank breaks even and hence:
M −I
c1 = (4)
πM
(1−π)M
Notice that for c1 , c2 ≥ 1, R
≤ I ≤ (1 − π)M .

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.
Solution: In autarky, each depositor is on her own. Since depositors do not know
ex ante when they have a consumption need, their ex-post consumption in autarky
is:

c1 =1 − I + λI and (5)
c2 =1 − I + RI. (6)

It is easy to show that under autarky neither the early nor the late consumer are
able to obtain the consumption level that they would be able to obtain with financial
intermediation. The problem is the potential maturity mismatch between consump-
tion need and the realization of the long term technology. Put simply, a consumer
investing on her own might have to liquidate before maturity of the project which
is costly. A bank with many depositors knows with certainty how many depositors
withdraw early and how many late. Notice, they do not know their exact identity
but for the bank knowing the average is enough to balance between investment I and
precautionary savings M − I. This way the bank does not have to do any costly
liquidation.

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

Microeconomics of Banking Tutorial 2


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 λ < 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 .
Solution: In order to satisfy the increased deposit demand at t = 1, the bank
has to liquidate part of the long term technology L ≤ I at a return λ so that

M − I + λL − π 0 M c1 = 0 (7)

With c1 = 1 and I = (1 − π)M ,

(π 0 − π)M
L= (8)
λ

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 ).
Solution: Depositors can at most withdraw what is left in the long term tech-
nology after satisfying the increased demand at t = 1:

(I − L)R − (1 − π 0 )M c02 = 0 (9)


(π 0 −π)M
With I = (1 − π)M and L = λ

π0 − π R
c02 = ((1 − π) − ) (10)
λ 1 − π0

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.
Solution: If too many depositors withdraw early, late consumers know they will
not get their initial deposit back and hence start withdrawing as well.

c02 (π 0 ) < c1 (11)


π0 − π R
((1 − π) − ) <1 (12)
λ 1 − π0
λR πR − λ
(1 − π) + < π0 (13)
R−λ R−λ

Microeconomics of Banking Tutorial 2


1.3.4 15 points

Interpret briefly the above threshold for π 0 .


Solution: Late consumers perfectly anticipate at which amount of early with-
drawals π 0 M there is not enough money left in the long term technology for them to
withdraw at least what they would get if they withdrew early at t = 1. Hence they
also withdraw at t = 1. Therefore this threshold determines at which point a ”run”
on the bank occurs.

Microeconomics of Banking Tutorial 2

Common questions

Powered by AI

In a perfectly competitive banking market, the optimal deposit schedule is derived based on the bank breaking even while investing in long-term technology: c1 = (M-I)/πM and c2 = IR/(1-π)M. This schedule is significant because it ensures that banks can honor withdrawals at both t = 1 and t = 2 by efficiently managing the proportion of deposits invested in long-term projects versus the proportion retained for liquidity, thus minimizing the risk of bank runs while maximizing returns .

The threshold for depositor withdrawals that could trigger a bank run occurs when π′, the observed proportion of early withdrawals, exceeds a value where the anticipated remaining funds in the bank are insufficient to cover late withdrawals comparative to early withdrawals. Mathematically, this is expressed as (1-π)R/(R-λ) < π'. This threshold is significant as it marks the tipping point where late depositors lose confidence and start withdrawing early to avoid potential losses, thus accelerating the bank's liquidity crisis and leading to a bank run .

The model of liquidity transformation explains that banks are vulnerable to bank runs due to maturity mismatch between the short-term liabilities (deposits) and long-term assets (investments). When a higher-than-expected number of depositors withdraw early, the bank may not have enough liquid assets to meet withdrawals without liquidating long-term investments at a loss. This can lead to a bank run as depositors lose confidence in the bank's ability to honor withdrawals .

Consumer anticipation plays a critical role in both preventing and exacerbating a bank run. If late consumers correctly anticipate a bank's inability to honor their withdrawals due to high early withdrawals (exceeding π'), they may preemptively withdraw funds early, contributing to the crisis. Conversely, if consumers are confident in a bank’s liquidity position and ability to manage withdrawals efficiently, they are less likely to initiate withdrawals, thus preventing the occurrence or escalation of a bank run .

The suboptimal return (λ < 1) from liquidated long-term investments during a liquidity shock negatively impacts a bank's operations as it diminishes the funds available for satisfying depositors later. The bank effectively incurs a loss on these liquidations compared to waiting for full maturity returns (R), which strains its financial position and reduces profitability. This can amplify stress on the bank's liquidity and potentially trigger or worsen a run on the bank by diminishing confidence in its stability .

The model illustrates banks' balancing act by showing that the decision on how much to invest (I) in long-term technology versus keeping liquid (M-I) is based on expected withdrawal probabilities (π). By investing an optimal amount I, banks aim to maximize returns while keeping enough in precautionary savings to handle unforeseen increases in withdrawals without costly liquidation. This balance ensures that the bank remains solvent and profitable while being less susceptible to bank runs .

An unexpected liquidity shock, where more depositors withdraw early than anticipated, forces a bank to liquidate part of its long-term technology investment, receiving a reduced return (λ < 1), to meet these increased withdrawals. This affects the bank's ability to pay later withdrawals, as the funds originally intended for long-term investments are reduced. Consequently, if early withdrawal levels exceed a critical threshold (π'), the bank risks a depletion of funds leading to reduced payouts for depositors withdrawing at t = 2, prompting even more depositors to withdraw early and potentially triggering a bank run .

The limitations of the model include assumptions of homogeneous depositor behavior and the exclusion of external factors such as regulatory interventions, interbank lending, and economic conditions, all of which may influence bank run dynamics. The model also assumes perfect information and rational behavior which may not reflect real-world scenarios where information might be asymmetric, and panic, rumors, or strategic behavior could play substantial roles in depositors' actions .

A bank must liquidate part of its long-term technology if there is an unexpected increase in early withdrawals beyond what was anticipated at t = 0. The liquidation quantity L is determined by the need to satisfy the demand π′Mc1 using initial savings and the return from liquidation. It is calculated as L = (π′-π)M/λ, where π′ is the revised higher proportion of early withdrawals, π is the originally expected proportion, and λ is the suboptimal return per unit from liquidated assets .

Financial intermediation allows banks to pool resources from multiple depositors, enabling them to anticipate average withdrawal needs and manage funds more efficiently than individuals can on their own. This pooling reduces the need for costly early liquidation of investments and mitigates maturity mismatch risks, thus providing depositor benefits such as higher potential returns and liquidity security compared to autarky, where individuals face uncertain consumption levels due to random personal liquidity needs .

You might also like