Deposit Markets, Lending Markets and Bank Screening Incentives

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Title: Deposit Markets, Lending Markets and Bank Screening Incentives
Author: Mukminov, Rinat
Contributor: Svenska handelshögskolan, institutionen för nationalekonomi, nationalekonomi
Hanken School of Economics, Department of Economics, Economics
Publisher: Svenska handelshögskolan
Date: 2015-01-28
Belongs to series: Economics and Society – 286
ISBN: 978-952-232-272-2 (printed)
978-952-232-273-9 (PDF)
ISSN: 0424-7256 (printed)
2242-699X (PDF)
Abstract: In the period from 2007 to 2009 the world experienced the deepest financial crisis since the Great Depression. The world economy was in the most severe recession since the Second World War. The financial crisis was followed by a debt crisis in the euro area, which is still far from being resolved. The world economy is yet to recover from the crisis. The financial crises are recurring phenomena. The financial crisis of 2007-2009 is in many ways similar to the previous crises. It has been argued that banks’ poor screening incentives at the peak of the business cycle are one of the main causes of the recurring crises. Bank screening literature argues that in boom times, when the majority of loan applications are good, the price competition between the banks intensifies, leading to lower returns from screening loan applicants. As a consequence, screening standards decline and many bad loans end up on the bank balance sheets. Defaults of the bad loans lead to a deterioration of the banks’ loan portfolios, which causes credit crunches and bank crises. There is also an emerging finance literature arguing that a lower cost of funds, such as a lower cost of deposits, cheaper credit in the interbank market, a lower discount rate, encourages the banks to take excessive risks. Excessive risk-taking by the banks can also lead to a bank crisis. These two approaches explain excessive bank risk-taking from two different points of view: the former one from the point of view of bank revenues, while the latter approach explains excessive risk-taking from the point of view of bank costs. The aim of this dissertation is to build a bridge between these two approaches. This dissertation contributes to the screening literature by explicitly introducing the cost of funds into a bank screening model. This is novel, as most previous bank screening literature has assumed the deposit market to be fully competitive with zero interest rate, thus ignoring the impact of the deposit interest rate on bank screening incentives. This dissertation also extends the literature, which explores the effects of costs of funds on the bank risk-taking, by explicitly modelling the banks’ investment in screening of potential loan applicants.
Subject: banking
bank screening
industrial organisation approach to banking
deposit market
cost of funds
lending market
bank screening incentives
adverse selection
banking duopoly
banking regulation

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