3.1. How to induce depositors?

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

4 ratings

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

4 ratings

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

Banks (2) – Asset Transformation and Liquidity Creation. Banks’ Vulnerability with Respect to Runs

Week 3 of the Course is devoted to the analysis of creation of liquidity – namely, we do answer the question of how a bank attracts depositors. You will get introduced to asset transformation and will learn how the presence of banks in capital markets makes the money circulation in the economy more efficient. You will analyze the market participants’ preferences and the “safety cushion” of a bank. We will study the mechanism of bank runs and feel how vulnerable the bank is with respect to runs. You will learn what methods of fighting bank runs have been used in centuries, and realize why the role of government in regulating of the banking business is so important. We will discuss deposit insurance as a universal and effective mechanism of preventing runs.

3.1. How to induce depositors?4:19

3.2. Liquidity creation (1) – the model of liquidity11:27

3.3. Liquidity creation (2) – the mechanism10:16

3.4. Banks’ vulnerability with respect to runs15:56

3.5. Ways to fight bank runs (1) – suspension of convertibility4:46

3.6. Ways to fight bank runs (2) – deposit insurance9:03

3.7. Problems of deposit insurance12:00

3.8. Deposit insurance and the need to regulate6:04

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Welcome to the third week of our capitals markets course.

In the previous week and in the previous final episode, we said that,

we introduced a bank as a powerful intermediary that allows

workable schemes to provide financing for

borrowers by collecting the money from a large group of depositors.

And we said, that the only problem was that,

although this system seems to be great for a bank because the bank makes money there.

But, it's so far,

has not been preferred by the depositors.

So, the depositors could otherwise go direct to

the borrowers and enjoy basically the same terms,

at least the same monetary terms.

Now, will try to cope with this problem and invent something that will

induce the depositors to lend the money through a bank.

In order to do so, we have to go back to the idea of what depositors value.

We already in this course,

quite a bit of time, mention the situation that,

rational investors, they operate on the basis of maximization of their expected utility.

Therefore, in reality, these depositors value not only the amount of money they got,

but also the timing of this money.

So, in what follows,

we will specify the time component,

not in the way it is used in corporate finance in order to deal with discounting,

because in the beginning of this course we said that,

to this end, we ignore the time value of money.

But, we will study the world in which there are couple of points in the future,

in which depositors can enjoy the receipt of a certain amount of money.

And, we will claim that the ability to

get this money at a certain point is also kind of valuable for these people.

Well, let's say the most simplistic example,

you deposited some money with the bank for a time deposit, and you know that,

if you waited until the expiration of this contract,

you will get this amount of money with some interest.

But what if you needed the money in-between.

By this contract, you cannot get this money back with

any interest and sometimes you are even forced to pay a penalty.

And when you were opening this time deposit,

you were not in the position to liquidate that,

mainly to get the money earlier.

But then the situation has changed, and then,

you preferred to not only forfeit the interest,

but maybe even to agree to pay this penalty,

because you do need the money earlier.

So we'll try to incorporate all that in the model.

So, what would we do here?

We will throughout this week,

build this model in the following way.

First of all, we will show how liquidity can be created.

Then, we will see that this liquidity may be created by a bank,

so that the bank would indeed deliver on its promises.

And then as always,

when we will have come up with some solution,

we will take a breath of relief, and then we'll say great.

But then we will see that the model that we will have

built and we will have realized, is vulnerable,

is unfortunately not so solid,

and is quite challenged by the market reality.

And then we will start thinking what can be done with that.

We will offer some of the remedies at the end of this week,

and then study them in greater detail,

in the next fourth week.

So for now, we are moving towards the model of liquidity.

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