Capital Markets and Financial Institutions – How to Survive Them

In Week 1 we propose the set of assumptions and the framework of our discussion. We will discuss perfect capital markets and see how the deviations from this idealized model that are observed in our real life result in the demand for financial intermediation and for the services of financial institutions.

We will discuss the fundamental problems caused by the existence of private information (moral hazard и adverse selection) and the damage they lead to. Based on the most simplistic models you will be able do delve deeper into the core of these problems and to evaluate their potential scale. You will learn what role the moral hazard plays in insurance, and how the adverse selection and moral hazard problems reduce the efficiency of lending.

In Week 2 we will consider certain ways of overcoming problems caused by private information and evaluate them. We will know why some methods work while others don’t, and why. You will learn the core differences between equity and debt financing, study debts contracts with liquidation and see the core inefficiency of that kind of a debt contract.

Based on a simple model you will study diversification and delegated monitoring and see how they contribute to the efficiency of lending. We will find out how a bank emerges as a key financial intermediary responsible for asset monitoring. You will be able to see why the bank can make money and to calculate its profit in different cases. At the end of Week 2 we will pose a fundamental question: How does the bank attract depositors?

Week 3 of the Course is devoted to the analysis of creation of liquidity – namely, we do answer the question of how a bank attracts depositors. You will get introduced to asset transformation and will learn how the presence of banks in capital markets makes the money circulation in the economy more efficient. You will analyze the market participants’ preferences and the “safety cushion” of a bank.

We will study the mechanism of bank runs and feel how vulnerable the bank is with respect to runs. You will learn what methods of fighting bank runs have been used in centuries, and realize why the role of government in regulating of the banking business is so important. We will discuss deposit insurance as a universal and effective mechanism of preventing runs.

Week 4 of the Course consists of two parts. The first part is devoted to the discussion of challenges and development of banking regulation. We consider the S&L market crash of the 1980’s as a trigger to the initiation of the worldwide regulatory movement. You will get introduced to the Basel process as the basis of the modern bank regulation.

The second part of Week 4 shifts focus somewhat. We will talk about the payment services that are tantamount to banking for the majority of population, at least in the developed world. We will discuss how the fast development of IT technologies, the Internet and the social media influences banking business. But we will see that the most important functions of banking – asset monitoring and liquidity creation – do not disappear but take a new shape. At the very end we will drop a few words about private banking – a very specific area of banking services for high net worth individuals.