Models of the Banking Firm

Textbook Model Perfectly Competitive Bank Monopoly Bank Imperfect Competition Model

See economics of Banking ch 6 for eq ations! "b lk of #ork to be learned for this topic$ Why have a model for a banking firm? %ther firms don&t have model so #hy sho ld banking have different types' ( They create money "monetary mechanism$ ( They have higher leverage than most ordinary firms! ")!* for normal and + for banks on average$, -s there is a central bank as a lender of last resort or fallback it&s possible to have this level of leverage! Textbook Model Banks are a passive agent in the monetary transmission system! This vie# stems from the money m ltiplier approach to the determination of the money s pply! ( Bank Balance Sheet ".eposits, /eserves, 0oans$ ( Money m ltiplier ( Credit and .eposit M ltipliers "see #orkings$ Problems with the model ( c "c rrency to deposits ratio$ is a choice variable o tside of banks control dictated by interest rate setting by the bank! ( k "reserves to deposits ratio$ is a choice variable to the banks ( 1 "s pply of base money$ is not exogeno s b t s ally s pplied on demand by central bank! Developing the analysis of the banking firm

2 Baltensperger "3+4)$ Perfectly ompetitive Bank -ss mptions5 (/isk2free, short term, liq id assets added s ch as T2 bills "T$ (Bank is a price taker in liq id market, taking rT as a given!
(Cost f nction to describe management costs of servicing loans and deposits added! 6C".,0$7 ( 0oan and deposit markets also perfectly competitive 2 /., /0 taken as given (0oans are imperfect s bstit tes for Treas ry bills (/eserves earn no interest (Bank #ants to max profit See eq ations! !mprovements ( Perfect competition is too restrictive so drop this ass mption! "no price takers$ ( Incorporate risk analysis The Monopoly Bank "#lein$Monti Model% ( Market for Treas ry Bills is perfectly competitive and bank is a price taker so /T is a constant in monopoly! ( 0oan and deposit makers are Imperfectly competitive ( 0oans are imperfect s bstit tes to T bills ( /eserves earn no interest ( Bank maximises profit ( Bank faces a fixed cost sched le Problems ( Profit earned excl sively from monopoly po#er ( 8o analysis of costs of s pplying loans ( -ss mption that price maker in loan and deposit market and that yo are a price taker in the T2bills market! ( 0oans and deposits determined independently of each other!

( 8o risk analysis 2 oversimplified balance sheet! !mperfect ompetition 9xtending :lein2Monti model to Co rnot Imperfect Competition! ( n banks ( Banks maximise profits ( taking deposits and loans of other banks as given! n ; 3 is monopoly and at the other end is n ; <= The margin of intermediation "spread bet#een loan rate and deposit rate$ narro#s as competition intensifies! The spread narro#s ntil the demand for loans and deposits is hori>ontal "perfect competition$ and the spread falls to rtk! Problems ( Competition can be intensified even if lo#er n mbers of banks are recorded "Merger?takeovers decrease n mbers b t give banks more po#er$ ( Imperfections exist in the market aren&t capt red eg! Incomplete?Imperfect info, ncertainty, transaction costs! ( -ss mption of price maker in loan and deposits and price taker in t2 bills market! &ood things ( Simplistic, po#erf l analytical capability ( -llo#s the banking sector to be vie#ed as a single representative bank! '(mmary of Banking Models ( - model is not reality, b t for an economic model to be sef l it has to address reality in its concl sions! ( The model of the banking firm makes a n mber of nrealistic ass mptions, b t it makes a strong empirical prediction! ( Competition drives do#n the margin of intermediation "spread bet#een the loan rate and deposit rate$! ( In the limit the margin is given by the reserve ratio and the marginal costs of s pplying loans and deposits!