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Additional info for Towards a New Paradigm in Monetary Economics (Raffaele Mattioli Lectures)
5) In the absence of bankruptcy risk, the marginal return on a loan is just the interest rate charged. But with bankruptcy costs, there may be a marked discrepancy between the interest rate charged and the expected marginal return to lending and between the expected marginal return to lending and the cost of capital; the latter difference is the marginal bankruptcy cost, φ. g. 5b). 4 ) as a result of an increase in the bank’s net worth at. (Panel A illustrate the case where EYN is a constant; panel B where there is diminishing returns).
Hence Eat+1 is lower and the probability of bankruptcy is higher. ) The implications of this theorem are striking. It means that, were we in a competitive banking regime, we should never see a bank with deposits and holding government T-bills. There are, to be sure, dynamics that are more complicated than those captured in our simplified model. Banks may hold T-bills or any other liquid asset for “liquidity” purposes, because they may expect to invest them next period and it can be costly to 82 Note that these opportunity sets are defined relative to the information of the bank; that is, additional loans may be perceived to be riskier, simply because the bank has little information on these new borrowers, or because of its limited information, the bank is unable to screen borrowers.
By charging higher interest rates (the interest rate effect), changing the composition of their portfolio, for instance towards riskier loans (the loan-composition effect) and, say, monitoring less intensely. 75 As the bank moves to the right along the RR curve, the interest rate increases and the expenditure on screening presumably decreases. It is useful for later analysis to consider two special cases. The first is where the only decision of the bank is the interest rate charged. Earlier, it has been shown that the mean return increases, and then decreases, as r increases.