Three essays on financial intermediation

This Ph.D. thesis consists of three essays on financial intermediation. The main orientation of this dissertation is theoretical. All three essays are connected in that they deal with important features related to the literature on financial intermediation. Chapter 1 develops a model of financial intermediation to evaluate the impact of the monetary policy stance in the credit quality of loans extended in a bank-dependent economy. An important lesson from the Great Recession 2007-2009 is that the monetary policy stance may spur the risk appetite of the banking industry. Based on the costly state verification paradigm, I present a theoretical model with heterogeneous loan applicants and costly information acquisition in which financial intermediation activity is driven by a trade-off between processing information prior or after loan origination. Through changes in the diligence to determinate the credit standards, information processors shift the probability of the bankruptcy state and the riskiness in the composition of the pool of borrowers. Under this environment, a loose monetary policy decreases the diligence devoted by intermediaries to verify the creditworthiness of loan applicants, increasing the leverage of the non-financial sector. Moreover, it leads to a deterioration of the credit quality in the composition of the pool of borrowers which increases the likelihood of the bankruptcy state. Chapter 2 evaluates the role of Central Bank intermediation during solvency crises to restore the efficient allocation of capital in the economy when the interbank money market freezes. On the policy front, the tensions originated in financial markets after the bank run of Lehman Brothers required monetary authorities to go beyond conventional policy measures. To study how monetary authorities can replace the role of the extinguished interbank money market to allocate efficiently capital in the economy during systemic times, this chapter explores the subsidization of counterparty risk via credit policies. The basic idea is that Central Banks can intervene in the economy to reallocate savings to those banks with liquidity needs. When tensions in the money market arise due to the uncertainty about the solvency situation of specific counterparties, Central Banks can absorb the credit risk perceived in the market and subsidize the asymmetry in the marginal funding cost across regions. A model of liquidity and fears about bank runs is presented in chapter 3. In this chapter I, along with Hugo Rodriguez, study self-fulfilling panics in a modern banking system wherein nominal deposit arrangements are designed as means of payment. In an economy exposed to pure liquidity risk with endogeneous money creation, we show that classical bank runs caused by panics do not occur. A relevant discussion about financial instability is whether the failure of banking institutions is driven by sudden panics that force solvent banks to fail, or it is reflected by the fundamental deterioration in bank specific variables. Based on the traditional liquidity problem of Diamond and Dybvig (1983), our framework incorporates three elements into the theoretical literature of bank runs. First, the chain of intermediation starts when borrowers need money to make payments. Second, to offset liquidity risk, banks manage a demand for reserves from the central bank. Third, the maturity mismatch between banks assets and liabilities is inherent to the creation of new loans. Under such setting, there is a price mechanism that adjusts the demand for consumption each period, making the real value of deposit contracts contingent on the mass of withdrawals. This result does not support the self-fulfilling hypothesis of bank runs.