Andrzejewski Jonas
Ricaurte Walter Roquet Boucher
ECON M831
Corporate Finance and Financial Intermediation
Homework 2, Question 12
08. March 2017
Q12) Can the equilibrium of the model with screening (section 4.6) be affected by changes
in the parameters representing the economic environment?
a) Can the equilibrium of the model with screening (section 4.6) be affected by changes in
the parameters representing the economic environment?
We think (if we have well understood the relation between the question and the theory)
that the main parameter representing the economic environment is θ which represent
the probability for the entrepreneur that he fails with his project and that the project
values zero. We assume a binomial risk: Either he fails, y*=0, or either he succeeds, y*=y
(Freixas & Rochet, Jc (2008))1 .
Indeed, in a good conjuncture (economic boom) there is normally a bigger proportion of
lower risk compared to higher risk. Moreover, the probability to succeed becomes bigger
in comparison of a bad conjuncture (economic recession) and the probability to fail
becomes fewer in comparison to bad conjuncture.
So we have that: β*θL> (1- β)*θH ,
with β the proportion of low risk entrepreneurs with the assumption that we have only
two types of risk: low and high.
We can say that: θLGood_Conj> θLBad_Conj and θHGood_Conj< θHBad_Conj
This means that we get two indifference curves which are related to higher risk and to
lower risk:
θH> θL
(1-θL)*(y-RL)- θL*CL= UL  the indifference curve for a low risk entrepreneur is equal to
the probability to succeed times (y- Repayment) minus the
probability to fail multiplied by collateral (Freixas & Rochet, Jc
(2008)). 2
(1-θH)*(y-RH)- θH*CH= UH  the indifference curve for a high risk entrepreneur is equal to
the probability to succeed times (y- Repayment) minus the
probability to fail multiplied by collateral (Freixas & Rochet, Jc
(2008)).2
With variables:
Θk = risk parameter of borrower (k= L or H)
Y = Succeed of the project
R = Repayment
C = Collateral
k = low or high risk
1
2
Microeconomics of banking 2nd edition, section 4.6 page 153
Microeconomics of banking 2nd edition, section 4.6 page 154
Andrzejewski Jonas
Ricaurte Walter Roquet Boucher
ECON M831
Corporate Finance and Financial Intermediation
Homework 2, Question 12
08. March 2017
Graphically representation of the indifference curves:
First, if we consider the first the case (when the lender knows all private information
about the real risk of the borrowers): The proportion of good- and bad-risk borrowers is
independent of the applied contract. Only the risk is considered. We are not sure about
the movement of the two indifference curves but the intuition would be the following:
Given the increasing risk, endowed by each risky and less risky entrepreneur, the lenders
first increase the value of the collateral to pay in case of failure and secondly increase the
value of the total repayment given the average risk taken. But given his preference for a
total repayment rather than a “mixed contract” he proposes for the safer borrowers a
contract with a repayment RLGC and RLBC (depending on the conjuncture) with RLBC> RLGC
and a contract RLGC and RLBC for riskier borrowers with RLGC> RLBC. We constat here a
changing in the equilibrium given a change in the parameter of economic environment.
Secondly the more complex case for the lender, when the lenders doesn’t know which of
the entrepreneurs is a risky or a safety one. He will here consider the average probability
of failures within the population of borrowers. This average probability is denoted θ*.
With θ*= β*θL + (1- β)*θH. But remind you we are under a good conjuncture so the
average probability of failure is fewer than under bad conjuncture. θ*GC< θ*BC.
Then if the lender doesn’t want that both, good and bad borrowers, are under the RL
contract he has to resort to a “mixed contract”, with a collateral to pay in case of failure
and a repayment to pay in case of success. Good borrowers will take contract P (with the
collateral) and bad borrowers will take contract M (with no collateral). As we can see in
the following graph, the more the proportion of good borrower, the more the
indifference curve of the bad borrowers goes on the left. If the proportion of good
borrowers tends to 1, then we tend to a unitary equilibrium where N=P’(Freixas &
Andrzejewski Jonas
Ricaurte Walter Roquet Boucher
ECON M831
Corporate Finance and Financial Intermediation
Homework 2, Question 12
08. March 2017
Rochet, Jc (2008))3 . So we can say that the difference between M and M’ (repayment of
high risk borrower) represents a loss for the lender and the difference between P and P’
(decrease) represents a gain for the lender. Still here, there is a modification in the
equilibrium because of a change in a parameter linked with economic environment.
b) Can this affect the lending behavior of banks and explain the cyclicality of credit and of
banking crises?
First, if in high conjuncture (economic boom) the risk will decrease and during low
conjuncture (economic recession) the risk will increase which will have an effect on the
interest rate, the deposit and the liquidity ratio.
The lending behaviour of banks depends on the following (by Usman 1999)4:
LOA = f ( Vd, Ip, Ir, Rr, Lr, Fx, Gdp, Z )
With
LOA: Loans and Advances
Vd: Volume of Deposits
Ip: Investment Portfolio
Ir: Interest Rate (Lending Rate)
Rr: Cash Reserve Requirement Ratio
Lr: Liquidity Ratio
Fx: Annual Average Official Exchange Rate from EU (€) to US ($)
Gdp: Gross Domestic Product at current market price
3
4
Microeconomics of banking 2nd edition, section 4.6 page 156
https://www.researchgate.net/publication/264934631_Determinants_of_Commercial_Banks'_Lending_Behavior_in_Nigeria
Andrzejewski Jonas
Ricaurte Walter Roquet Boucher
ECON M831
Corporate Finance and Financial Intermediation
Homework 2, Question 12
08. March 2017
So in good or bad conjuncture, the probability of failure θ varies (decrease or increase),
we have an effect on the lending rate Ir, Gdp, Repayment R, Collateral and also on the
exchange rate (because of the variation of inflation and interest rates). So we can say
that the variation of θ, induce an effect on the lending behaviour of banks, loans
increases in economic boom, and will decrease in case of economic recession.
The risk of business cycles or other economic cycles adversely affecting the returns of an
investment, an asset class or an individual company's profits. Cyclical risks exist because
the broad economy has been shown to move in cycles – periods of peak performance
followed by a downturn, then a trough of low activity. Between the peak and trough of a
business or other economic cycle, investments may fall in value to reflect the
uncertainty surrounding future returns as compared with the recent past.
Credit cycles are growth cycles (Cyclicality in the amount of new credit) and risk cycles
(cyclicality in the distribution of new credit, credit quality of the marginal borrowers).
This means that it explains a co-movement in the quantity and the quality of credits.
So, with an economic boom (growth cycles) the quantity of credits increases, because
we have less risk, lower interest rates, higher collateral and a lower repayment.
On the other hand, in case of an economic recession, the quality of credits increases,
because we have higher risk, higher interest rates, lower collateral and a higher
repayment. 5
Banks are susceptible to a range of risks. These include credit risk (loans and others
assets turn bad and ceasing to perform), liquidity risk (withdrawals exceed the available
funds), and interest rate risk (rising interest rates reduce the value of bonds held by the
bank, and force the bank to pay relatively more on its deposits than it receives on its
loans).6 So, a change in the economic environment could lead to a banking crisis because
5 http://www.investopedia.com/terms/c/cyclical-risk.asp
6
https://bfi.uchicago.edu/sites/default/files/file_uploads/cui_slides.pdf
http://documents.worldbank.org/curated/en/761051468739458460/pdf/multi-page.pdf
http://www.worldbank.org/en/publication/gfdr/background/banking-crisis
https://www.boundless.com/economics/textbooks/boundless-economics-textbook/economic-crises-33/fundamentals-of-banking-crises- 132/causes-of-banking-crises-524-12620/
Andrzejewski Jonas
Ricaurte Walter Roquet Boucher
ECON M831
Corporate Finance and Financial Intermediation
Homework 2, Question 12
08. March 2017
of the effect on the credit and interest rate risk (described overhead) which suffers the
banks. A banking crisis can be affected by: Bank run, Stock market positive feedback
loops, regulatory Failure and Contagion.
Conclusion
The changes in the parameters representing the economic environment has two
different effects, in case of high or low conjuncture. The relative effects on the
equilibrium again shows that the banks react very sensitive to the change in conjuncture
which explain the cyclicality of credits and could lead to banking crisis but also depends
on the lapse of time and the intensity of the economic environment changes.
Bibliography
Microeconomics of banking 2nd edition, section 4.6 page 153
2
Microeconomics of banking 2nd edition, section 4.6 page 154
3
Microeconomics of banking 2nd edition, section 4.6 page 156
4
https://www.researchgate.net/publication/264934631_Determinants_of_Commercial_Banks'_Lending_Behav
ior_in_Nigeria
5
6
http://www.investopedia.com/terms/c/cyclical-risk.asp
https://bfi.uchicago.edu/sites/default/files/file_uploads/cui_slides.pdf
http://documents.worldbank.org/curated/en/761051468739458460/pdf/multi-page.pdf
https://www.boundless.com/economics/textbooks/boundless-economics-textbook/economic-crises33/fundamentals-of-banking-crises- 132/causes-of-banking-crises-524-12620/