## Archive for August, 2014

Higher volatility of the macro shock, less efficient financial intermediation or lower banks’ cost of funds increase the projects’ risk in a competitive equilibrium.

Proof — see the Appendix electronic-loan.com.

Macroeconomic volatility increases the distortion associated with excessive risk. While macroeconomic volatility does not impact the expected output or the socially optimal risk, higher macroeconomic volatility induces more frequent partial defaults. This in turn leads banks to increase both the lending interest rate and the project’s risk tolerated. The net effect is a rise in “excessive risk”.

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We preserve all the previous assumptions about the idiosyncratic shock, ц, assuming a modified production function, where projects are also subject to macro shocks

each state may occur with probability 0.5.9 i_et us denote by x) the repayment on project type x, the risk of which is 11. We assume that the realized output is public information. If the contractual repayment exceeds the realized output, the bank gets all output.” Hence,

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Curve CC traces the projects’ risk in the competitive equilibrium, and curve OO corresponds to the projects’ risk in the optimal allocation. As our previous discussion suggested, lower costs of financial intermediation increase the risk tolerated by banks. A combination of low banks’ cost of funds and a high supervision cost would lead to a large excessive risk. This situation is depicted by Figure 4, Panel I, where the excessive risk is about 10% for low interest rates. In these circumstances higher banks’ cost of funds increases welfare, as is depicted by the bold curve in Figure 3. A by product of the higher banks’ cost of funds is that the “excessive risk” distortion shrinks gradually, implying that for a high enough banks’ cost of funds the welfare effects of further increase in the banks’ cost of funds are reversed more.

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We confirm this intuition with the help of a simulation. Figure 3 reports the dependency of welfare on the banks’ cost of funds. The four curves are obtained by increasing sequentially the cost of financial intermediation by increments of 20%, and their relative position corresponds inversely to the cost of financial intermediation. The simulation confirms the presence of an inverted U shape, and reveals that a higher cost of financial intermediation shifts the curves downwards and to the right, increasing thereby the ‘welfare maximizing’ interest rate.

Hence, for an efficient enough technology of exchange, financial integration is unambiguously welfare enhancing, whereas for highly inefficient technologies of exchange, financial integration is welfare reducing [as will be the case if the autarky banks’ cost of funds is below the welfare maximizing’ interest rate]. For intermediation cases, the effect of financial liberalization is ambiguous. If the autarky banks’ cost of funds is high, the first stages of financial liberalization are beneficial, but the latter stages may be welfare reducing.

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Note that the competitive equilibrium conditions (12) are a special case of (12′), for Q = l. Hence, the competitive equilibrium is associated with excessive risk if £2> 1. This is likely to hold the higher the supervision cost к is relative to the start up cost H(l + rc) 1

The welfare effects of financial integration are found by evaluating the implications of a drop in banks’ cost of funds. Applying (15) it follows that

In general, the effect of a drop in banks’ cost of funds is ambiguous, as the sign of — {\x-kz'(fi)]f(x)dx} may be positive. This term measures the net welfare effect of the increase in project’s risk induced by a lower bank’s cost of funds (recall that — <0). It equals — times the sum of the marginal effect of risk on project’s expected income, minus the marginal impact of higher risk on the monitoring cost, -fe'(Д). This sum is zero when the risk allocation is socially optimal, and is negative if excessive risk is undertaken, and positive if too little risk is undertaken add comment. Hence, —{f*[^^^-fc4A)]/(*) Read the rest of this entry »

Financial integration allows domestic banks access to the global pool of savings, offering funds at a cost of r0. We assume that the autarky banks’ cost of funds exceeds the global risk free interest rate [p > ra]. Hence, financial integration is viewed as a process that reduces the banks’ cost of funds to the global level. In these circumstances the patterns of risk undertaking and investment are summarized by (12), where the banks’ cost of funds, rc , drops from p to rQ.

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Claim 3

Less efficient financial intermediation or lower banks’ cost of funds increase the projects’ risk in a competitive equilibrium.

Proof – Let the cost of banks’ monitoring be kz(ji), k being a shift parameter measuring the efficiency of financial intermediation. Equations (7a) and (8) imply that

In terms of Figure 2, a less efficient monitoring technology rotates the bold curve clockwise around A, to AB, leading to higher risk in the competitive equilibrium. Similarly, a lower banks’ cost of fund shifts the bold curve upward, by the extra cost, increasing thereby the risk undertaken in a competitive equilibrium. Note that (8‘) also implies that -—->0. K 4 d[k/{(l + rc)H}]

Hence, we conclude that a higher supervision/start up costs ratio, k/{(l + rc)H}, increases the projects’ risk in a competitive equilibrium.

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Claim 2:

The interest rate and the projects’ risk in a competitive equilibrium are characterized by

the elasticity of supervision cost z with respect to the project’s probability of success, l -jx electronic-loan.com.

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Hence, riskier projects that turned out to be successful are associated with higher output. Entrepreneurs must finance the investment H by bank credit, at a real interest cost of r,. The expected gross income from project type x, denoted by к, is

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Similar to the case of immiserizing growth, it is the interaction between the initial distortion (excessive risk) and globalization of financial markets that leads to these second best results.^ Even in these circumstances, the economy will benefit by financial integration that is accompanied by the proper improvements in the functioning of domestic banks. Furthermore, our paper suggests that financial integration and reforming the banking sector are complementary policies, as the gain of each reform is magnified by the second.

Section 2 outlines the model for the case where overborrowing is endogenously determined by banks facing idiosyncratic risk. Section 3 investigates the welfare effects of financial integration. Section 4 extends the model to account for macroeconomic shocks, and deposit insurance. Section 5 closes the paper with concluding remarks electronic-loan.com.

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