Key Concepts in Banking and Finance
Trends in Banking
- Balance Sheet Efficiency: Ramp up customer relationship programs, increase cross-selling efforts, invest in product lines that attract stable deposits.
- M&A: View targets with a focus on efficiencies, growth factors, funding profile, technology, compliance.
- Growth: Investing in customer analytics, leveraging digital technologies, determine and implement prudent underwriting standards.
- Compliance and Risk Management: Incorporate risk management into performance management programs and employee training.
- Data Management: Relying on chief data officers to establish tighter connections with front-office functions and derive greater value from data assets.
Risk Preference
- Risk-Neutral Agent: Indifferent between the certainty of receiving the expected value of a gamble and the uncertainty of the gamble itself.
- Risk-Averse Individuals: Prefer a certain amount to a gamble with the same expected value.
- Risk-Preferring Individuals: Always prefer the riskier of two outcomes having the same expected value.
Diversification
If you hold numerous risky assets, your return will be more predictable. Returns should be perfectly positively correlated. Idiosyncratic risk and systematic risk. Variance of a 2-asset portfolio. All risks are not diversifiable (e.g., natural calamities). Costs of administration increase as the number of securities increases.
Options
It is the RIGHT to either buy or sell an asset at a predetermined price at some future time or over some fixed time interval.
- Call Option: Gives the right to buy at a fixed price (strike price) at or before t=1. C (t=1) = S-X, if S>P, 0 if S≤P. Theory of call option pricing explains the value of call option at t=0.
- Put Option: The owner to sell an asset at a fixed price at or before t=1. P (t=1) = X-S, if S
Market Efficiency
Security price = true value. If prices reflect all available information, then changes reflect only new information. News, and hence changes, are not predictable.
- Weak Form Efficiency: Prices reflect all historical information.
- Semi-Strong Efficiency: Reflects all publicly available information.
- Strong Form Efficiency: Reflects even private information. If markets are strong form efficient, there would be no role for financial intermediaries for information production.
Market Completeness
There should be at least as many securities as there are states of the world. Investors can construct portfolios to attain any income distribution they desire. It’s like saying, “We have Idli and Vada, but we need Paratha too!” Markets become more complete if the existing securities cannot replicate the payoffs of the new security.
Asymmetric Information and Signaling
Insiders know more about the business than shareholders; borrowers know more than lenders. Used car market; health insurance; IPOs. Sellers use certification mechanisms to signal quality (e.g., Maruti True Value; reputed Investment bank underwriters such as Goldman Sachs).
Agency and Moral Hazard
Incentives of the principal and agent diverge. Managers may expropriate wealth from shareholders; majority from minority; shareholders from bondholders; borrowers from lenders, and so on.
Nash Equilibrium
Prisoner’s dilemma. If prisoner 1 confesses and informs on prisoner 2 (who does not confess and inform on 1), then prisoner 1 will be freed. Let 4 be the payoff equivalent to being set free after confessing, and 5 if set free without confessing. If prisoner 1 opens his mouth, 2 gets 0. If both confess, both will be convicted; let 1 be the payoff.