Microeconomics of Banking / Edition 2

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Overview

Over the last thirty years, a new paradigm in banking theory has overturned economists' traditional vision of the banking sector. The asymmetric information model, extremely powerful in many areas of economic theory, has proven useful in banking theory both for explaining the role of banks in the economy and for pointing out structural weaknesses in the banking sector that may justify government intervention. In the past, banking courses in most doctoral programs in economics, business, or finance focused either on management or monetary issues and their macroeconomic consequences; a microeconomic theory of banking did not exist because the Arrow-Debreu general equilibrium model of complete contingent markets (the standard reference at the time) was unable to explain the role of banks in the economy. This text provides students with a guide to the microeconomic theory of banking that has emerged since then, examining the main issues and offering the necessary tools for understanding how they have been modeled. This second edition covers the recent dramatic developments in academic research on the microeconomics of banking, with a focus on four important topics: the theory of two-sided markets and its implications for the payment card industry; "non-price competition" and its effect on the competition-stability tradeoff and the entry of new banks; the transmission of monetary policy and the effect on the functioning of the credit market of capital requirements for banks; and the theoretical foundations of banking regulation, which have been clarified, although recent developments in risk modeling have not yet led to a significant parallel development of economic modeling.Xavier Freixas is Dean of theUndergraduate School of Economics and Business Administration and Professor at the UniversitatPompeu Fabra, Barcelona. Jean-Charles Rochet is Professor of Mathematics and Economics at theUniversity of Toulouse School of Economics.

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What People Are Saying

Mathias Dewatripont

FROM THE FIRST EDITION:"The authors have provided an extremely thorough and up-to-date survey of microeconomic theories of financial intermediation. This work manages to be both rigorous and pleasant to read. Such a book was long overdue and should be required reading for anybody interested in the economics of banking and finance."-- Mathias Dewatripont, Professor of Economics, ECARE, Université Libre de Bruxelles

Franklin Allen

From the 1st Edition:"The book is a major contribution to the literature on the theory of banking and intermediation. It brings together and synthesizes a broad range of material in an accessible way. I recommend it to all serious scholars and students of the subject. The authors are to be congratulated on a superb achievement." --Franklin Allen, Nippon Life Professor of Finance and Economics, Wharton School, University of Pennsylvania

Raghuram Rajan

"This is an excellent introduction to the theory of banking. It assumes little prior knowledge but quickly takes the reader to the frontiers of the field.
It should be required reading in any Ph.D level course on banking, as also for anybody who has an interest in the theoretical foundations of banking."--Raghuram G.
Rajan, Eric Gleacher Distinguished Service Professor, Graduate School of Business,
University of Chicago

From the Publisher
"At last the profession has an advanced book on the theory of banking. Freixas andRochet make a real contribution to the profession by integrating a disparate but growing literature on intermediation. They show the role that these institutions play in the economy and the complex nature of optical decision making in an imperfect capital market. The book should be required reading for serious students in the area." Anthony M. Santomero , Richard K.

Mellon Professor of Finance, Wharton School, University of Pennsylvania

Praise for the first edition: "The authors have provided an extremely thorough and up-to-date survey of microeconomic theories of financial intermediation. This work manages to be both rigorous and pleasant to read. Such a book was long overdue and should be required reading for anybody interested in the economics of banking and finance." Mathias Dewatripont, Professor of Economics, ECARES, Université Libre de Bruxelles

Praise for the first edition: "The book is a major contribution to the literature on the theory of banking and intermediation. It brings together and synthesizes a broad range of material in an accessible way. I recommend it to all serious scholars and students of the subject.

The authors are to be congratulated on a superb achievement." Franklin Allen ,Nippon Life Professor of Finance and Economics, Wharton School, University of Pennsylvania

Praise for the first edition: "This book provides the first comprehensive treatment of the microeconomics of banking. It gives an impressive synthesis of an enormous body of research developed over the last twenty years. It is clearly written and a pleasure to read. What I found particularly useful is the great effort that Xavier Freixas and Jean-Charles Rochet have taken to systematically integrate the theory of financial intermediation into classical microeconomics and finance theory. This book is likely to become essential reading for all graduate students in economics, business, and finance." Patrick Bolton , Barbara and David ZalaznickProfessor of Business, Columbia University Graduate School of Business

"The events of the summer and fall of 2007 underline the importance of the role played by banks in the economy. The Microeconomics of Banking provides an outstanding exposition of the theory of banking. The second edition is even better than the first.

Freixas and Rochet are exceptional scholars who have contributed significantly to the field. They have managed to explain banking in a comprehensive and comprehensible way. This book is essential reading for anybody who wishes to understand banking." Franklin Allen , WhartonSchool of Business, University of Pennsylvania

"This is an excellent introduction to the theory of banking. It assumes little prior knowledge but quickly takes the reader to the frontiers of the field. It should be required reading in any Ph.D level course on banking, as also for anybody who has an interest in the theoretical foundations of banking." Raghuram G. Rajan , Eric Gleacher Distinguished ServiceProfessor, Graduate School of Business, University of Chicago

Franklin Allen
From the 1st Edition:"The book is a major contribution to the literature on the theory of banking and intermediation. It brings together and synthesizes a broad range of material in an accessible way. I recommend it to all serious scholars and students of the subject. The authors are to be congratulated on a superb achievement." —Franklin Allen, Nippon LifeProfessor of Finance and Economics, Wharton School, University of Pennsylvania
Mathias Dewatripont
FROM THE FIRST EDITION:"The authors have provided an extremely thorough and up-to-date survey of microeconomic theories of financial intermediation. This work manages to be both rigorous and pleasant to read. Such a book was long overdue and should be required reading for anybody interested in the economics of banking and finance."— Mathias Dewatripont, Professor ofEconomics, ECARE, Université Libre de Bruxelles
Raghuram Rajan
"This is an excellent introduction to the theory of banking. It assumes little prior knowledge but quickly takes the reader to the frontiers of the field. It should be required reading in any Ph.D level course on banking, as also for anybody who has an interest in the theoretical foundations of banking."—Raghuram G. Rajan, Eric Gleacher Distinguished Service Professor, GraduateSchool of Business, University of Chicago
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Product Details

  • ISBN-13: 9780262062701
  • Publisher: MIT Press
  • Publication date: 4/30/2008
  • Edition description: second edition
  • Edition number: 2
  • Pages: 392
  • Sales rank: 1,452,507
  • Product dimensions: 7.00 (w) x 9.00 (h) x 0.62 (d)

Meet the Author

Xavier Freixas is Dean of the Undergraduate School of Economics and Business Administration and Professor at the Universitat Pompeu Fabra, Barcelona.

Jean-Charles Rochet is Professor of Mathematics and Economics at the University of ToulouseSchool of Economics.

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Table of Contents

Figures
Preface
1 General Introduction
1.1 What Is a Bank, and What Do Banks Do?
1.1.1 Liquidity and Payment Services
1.1.2 Asset Transformation
1.1.3 Managing Risk
1.1.4 Monitoring and Information Processing
1.1.5 The Role of Banks in the Resource Allocation Process
1.2 Banking in General Equilibrium Theory
1.2.1 The Consumer
1.2.2 The Firm
1.2.3 The Bank
1.2.4 General Equilibrium
Notes
References
2 Why Do Financial Intermediaries EXist?
2.1 Transaction Costs
2.1.1 Economies of Scope
2.1.2 Economies of Scale
2.2 Liquidity Insurance
2.2.1 The Model
2.2.2 Autarky
2.2.3 Market Economy
2.2.4 Optimal Allocation
2.2.5 Financial Intermediation
2.3 Information Sharing Coalitions
2.3.1 A Basic Model of Capital Markets with Adverse Selection
2.3.2 Signaling Through SelfFinancing
2.3.3 Coalitions of Borrowers
2.3.4 Related Justifications of FIs with Asymmetric Information
2.4 Financial Intermediation as Delegated Monitoring
2.5 CoeXistence of Direct and Intermediated Lending
2.5.1 A Simple Model of the Credit Market with Moral Hazard
2.5.2 Monitoring and Reputation (adapted from Diamond, 1991)
2.5.3 Monitoring and Capital (adapted from Holmström and
Tirole, 1993)
2.5.4 Related Contributions
2.6 Problems
2.6.1 Economies of Scale in Information Production
2.6.2 Monitoring as a Public Good and Gresham's Law
2.6.3 Intermediation and Search Costs (adapted from Gehrig, 1993)
2.7 Solutions
2.7.1 Economies of Scale in Information Production
2.7.2 Monitoring as a Public Good and Gresham's Law
2.7.3 Intermediation and Search Costs
Notes
References
3 The IndustrialOrganization Approach to
Banking
3.1 A Model of Perfect Competition in the Banking Sector
3.1.1 The Model
3.1.2 The Standard Approach: The Credit Multiplier
3.1.3 The Behavior of Individual Banks in a Competitive Banking Sector
3.1.4 The Competitive Equilibrium of the Banking Sector
3.2 The MontiKlein Model of a Monopolistic Bank
3.2.1 The Original Model
3.2.2 The Oligopolistic Version
3.2.3 Empirical Evidence
3.3 Analyzing the Impact of Deposit Rate Regulation
3.4 Double Bertrand Competition
3.5 Monopolistic Competition
3.5.1 Does Free Competition Lead to the Optimal Number of Banks?
3.5.2 The Impact of Deposit Rate Regulation on Credit Rates
3.5.3 Bank Network Compatibility
3.6 Branch versus Unitary Banking
3.7 AppendiX 1: Empirical Evidence
3.8 AppendiX 2: Measuring the Activity of Banks
3.8.1 The Production Approach
3.8.2 The Intermediation Approach
3.8.3 The Modern Approach
3.9 Problems
3.9.1 EXtension of the MontiKlein Model to the Case of Risky
Loans (adapted from Dermine, 1986)
3.9.2 Compatibility between Banking Networks (adapted from Matutes
and Padilla, 1994)
3.10 Solutions
3.10.1 EXtension of the MontiKlein Model to the Case of
Risky Loans
3.10.2 Compatibility between Banking Networks
Notes
References
4 The LenderBorrower Relationship
4.1 Why Risk Sharing Does Not EXplain All the Features of Bank
Loans
4.1.1 Optimal Contracts When Cash Flows Are Observable
4.1.2 EXtensions and Applications of the RiskSharing Paradigm
4.2 Costly State Verification
4.2.1 Incentive Compatible Contracts
4.2.2 Efficient Incentive Compatible Contracts
4.2.3 Efficient FalsificationProof Contracts
4.2.4 Dynamic Debt Contracts with Costly State Verification
4.3 Incentives to Repay
4.3.1 Threat of Termination
4.3.2 Strategic Debt Repayment: The Case of a Sovereign Debtor
4.3.3 Private Debtors and the Inalienability of Human Capital
4.4 Moral Hazard
4.5 The Incomplete Contract Approach
4.5.1 Delegated Renegotiation
4.5.2 The Efficiency of Bank Loan Covenants
4.6 Collateral and Loan Size as Devices for Screening Heterogenous
Borrowers
4.6.1 The Role of Collateral
4.6.2 Loans with Variable Size
4.7 Problems
4.7.1 Optimal Risk Sharing with Symmetric Information
4.7.2 Optimal Debt Contracts with Moral Hazard (adapted from Innes, 1987)
4.7.3 The Optimality of Stochastic Auditing Schemes
4.7.4 The Role of Hard Claims in Constraining Management (adapted
from Hart and Moore, 1995)
4.7.5 Collateral and Rationing (adapted from Besanko and Thakor, 1987)
4.7.6 Securitization (adapted from Greenbaum and Thakor, 1987)
4.8 Solutions
4.8.1 Optimal Risk Sharing with Symmetric Information
4.8.2 Optimal Debt Contracts with Moral Hazard
4.8.3 The Optimality of Stochastic Auditing Schemes
4.8.4 The Role of Hard Claims in Constraining Management
4.8.5 Collateral and Rationing
4.8.6 Securitization
Notes
References
5 Equilibrium and Rationing in the Credit
Market
5.1 Definition of Equilibrium Credit Rationing
5.2 The Backward Bending Supply of Credit
5.3 How Adverse Selection Can Lead to a Backward Bending Supply
of Credit
5.3.1 The Model of Stiglitz and Weiss (1981)
5.3.2 Risk Characteristics of Loan Applicants
5.4 Collateral as a Sorting Device
5.5 Credit Rationing Due to Moral Hazard
5.5.1 Nonobservable Technology Choice
5.5.2 Nonobservable Capacity to Repay
5.6 Problems
5.6.1 The Model of Mankiw (1986)
5.6.2 Efficient Credit Rationing (adapted from De Meza and Webb, 1992)
5.6.3 Too Much Investment (adapted from De Meza and Webb, 1987)
5.7 Solutions
5.7.1 The Model of Mankiw (1986)
5.7.2 Efficient Credit Rationing
5.7.3 Too Much Investment
Notes
References
6 The Macroeconomic Consequences of Financial
Imperfections
6.1 A Short Historical Perspective
6.2 The Transmission Channels of Monetary Policy
6.2.1 The Money Channel
6.2.2 Credit View
6.2.3 Credit View versus Money View: Relevance of the Assumptions
and Empirical Evidence
6.2.4 Endogenous Money
6.3 The Fragility of the Financial System
6.3.1 Financial Collapse Due to Adverse Selection
6.3.2 Financial Fragility and Economic Performance
6.4 Financial Cycles and Fluctuations
6.4.1 Bankruptcy Constraints
6.4.2 Credit Cycles
6.5 The Real Effects of Financial Intermediation
6.6 Financial Structure and Economic Development
Notes
References
7 Individual Bank Runs and Systemic Risk
7.1 Banking Deposits and Liquidity Insurance
7.1.1 A Model of Liquidity Insurance
7.1.2 Autarky
7.1.3 The Allocation Obtained When a Financial Market Is Opened
7.1.4 The Optimal (Symmetric) Allocation
7.2 A Fractional Reserve Banking System
7.3 The Stability of the Fractional Reserve System and Alternative
Institutional Arrangements
7.3.1 The Causes of Instability
7.3.2 A First Remedy to Instability: Narrow Banking
7.3.3 Regulatory Responses: Suspension of Convertibility or
Deposit Insurance
7.3.4 Jacklin's Proposal: Equity versus Deposits
7.4 Efficient Bank Runs
7.5 Interbank Markets and the Management of Idiosyncratic Liquidity
Shocks
7.5.1 The Model of Bhattacharya and Gale (1987)
7.5.2 The Role of the Interbank Market
7.5.3 The Case of Unobservable Liquidity Shocks
7.6 Aggregate Liquidity Shocks
7.6.1 The Model of Hellwig (1994)
7.6.2 Efficient Risk Allocation
7.6.3 Second Best Allocations under Asymmetric Information
7.7 Systemic Risk and the Lender of Last Resort: A Historical
Perspective
7.7.1 Four Views of the LLR Role
7.7.2 The Effect of LLR and Other Partial Arrangements
7.7.3 The Moral Hazard Issue
7.8 Problems
7.8.1 Different Specifications of Preferences in the
DiamondDybvig Model
7.8.2 InformationBased Bank Runs (adapted from Postlewaite and
Vives, 1987)
7.8.3 Banks' Suspension of Convertibility (adapted from Gorton,
1985)
7.9 Solutions
7.9.1 Different Specifications of Preferences in the
DiamondDybvig Model
7.9.2 InformationBased Bank Runs
7.9.3 Banks' Suspension of Convertibility
Notes
References
8 Managing Risks in the Banking Firm
8.1 Default Risks
8.1.1 Institutional ConteXt
8.1.2 Evaluating the Cost of Default Risks
8.1.3 EXtensions
8.2 Liquidity Risk
8.2.1 Reserve Management
8.2.2 Introducting Liquidity Risk in the MontiKlein Model
8.2.3 The Bank as a Market Maker
8.3 Market Risk
8.3.1 Modern Portfolio Theory: The Capital Asset Pricing Model
8.3.2 The Bank as a Portfolio Manager: The Pyle (1971) and
HartJaffee (1974) Approach
8.3.3 An Application of the Portfolio Model: The Impact of Capital
Requirements
8.4 AppendiX: Institutional Aspects of Credit Risk
8.4.1 Interest Rate and Rate of Return
8.4.2 Collateral
8.4.3 Endorsement and Insurance
8.4.4 Loan Covenants
8.4.5 Information Costs
8.4.6 Accounting
8.4.7 Bankruptcy
8.4.8 Fraud
8.5 Problems
8.5.1 The Model of Prisman, Slovin, and Sushka (1986)
8.5.2 The Risk Structure of Interest Rates (adapted from Merton, 1974)
8.5.3 Using the CAPM for Loan Pricing
8.6 Solutions
8.6.1 The Model of Prisman, Slovin, and Sushka
8.6.2 The Risk Structure of Interest Rates
8.6.3 Using the CAPM for Loan Pricing
Notes
References
9 The Regulation of Banks
9.1 Regulation Theory and Banking Theory
9.1.1 The Justification of Regulation
9.1.2 The Scope of Banking Regulation
9.1.3 Regulatory Instruments
9.2 Why Do Banks Need a Central Bank?
9.2.1 The Monopoly of Money Issuance
9.2.2 The Fragility of Banks
9.2.3 The Protection of Depositors
9.3 Portfolio Restrictions
9.4 Deposit Insurance
9.4.1 The Moral Hazard Issue
9.4.2 RiskRelated Insurance Premiums
9.4.3 Is FairlyPriced Deposit Insurance Possible?
9.4.4 The Effects of Deposit Insurance on the Banking Industry
9.5 Solvency Regulations
9.5.1 The Portfolio Approach
9.5.2 The Incentive Approach
9.5.3 The Incomplete Contract Approach
9.6 The Resolution of Bank Failures
9.6.1 Resolving Banks' Distress: Instruments and Policies
9.6.2 Who Should Decide on Banks' Closure?
9.6.3 Can Banks Be "Too Big to Fail"?
9.7 Complements
Notes
References
IndeX
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