Banking, Regulation and Financial Stability
Optional course, MA (Economics) in CITD, SIS, JNU, by Gurbachan Singh

 Course outline and readings

Financial stability and appropriate regulation of the financial system have been important for a long time. All this has become even more important with the events in 2007-08 in the financial systems in many parts of the world. Some aspects are important in any economy (closed or open), while others have added significance in an open economy. Within the financial system, each part (banks, non-bank financial intermediaries, financial markets and the central bank) plays a crucial role. This course will concentrate on the need for and the forms of regulation of banks, on the more recent work on central banking, on currency crisis, and on volatility in stock markets with the perspective of behavioural finance. Real estate (primarily housing) is one of the most important assets for a large fraction of households. While this has always been important, it is only recently that it has received serious attention in academic and policy related writings.

The treatment in this course is micro-theoretic, or macroeconomic in nature, depending on the issues involved. Historical perspective and empirical evidence will be added, wherever required. Prior familiarity with concepts in economics of uncertainty and asymmetric information is very useful. Finally, though formal models will be used, the emphasis will be on economic intuition. It is not a course in banking or pure Finance. Nor is it a course in monetary economics or macroeconomics. However, this course draws on work in finance, banking, money, and macroeconomics. This course takes an integrated view of issues that are common to finance, banking, money, and macroeconomics.   

• A broad perspective on financial system, introduction to microeconomics of banking, including agency problems.

• Financial crisis, contagion, role of the market and that of the government. 

• Fractional reserve banking, liquidity, bank runs, regulation of banks, reserves, deposit insurance, capital adequacy and leverage, unitary banking, lender of last resort, line of credit, collective action problem.

• Different kinds of monetary regimes, price level and financial intermediation.

• Stock market volatility and behavioral finance - noise trader risk, limits to arbitrage, destabilizing speculation.

• Real estate – pricing, volatility, and link with the financial system.

• Currency crisis – first, second and third generation models, and capital account convertibility.

Allen, Franklin, and Douglas Gale, 2007, Understanding Financial Crises, Oxford University Press, chapters 1-5.

Allen, Franklin, and Douglas Gale, 2000, Comparing Financial Systems, The MIT Press, Chapters 3 and 9.

Chang, Roberto, and Andres Velasco, A Model of Financial Crises in Emerging Markets, Quarterly Journal of Economics, 2001, 489-517.

Cowen, Tyler and Randall Krozner. Explorations in the new monetary economics. Oxford: Basil Blackwell, 1994, Chapters 2 and 3.

De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1990) Positive feedback investment strategies and destabilizing rational speculation, The Journal of Finance.

Diamond, Douglas W., and Rajan, Raghuram (2001) Banks and Liquidity, American Economic Review, Papers and Proceedings.

Freixas, Xavier, and Jean-Charles Rochet, 1997, Microeconomics of banking, The MIT Press, Chapters 1-2.

Gallagher, Liam A., and Mark P. Taylor, 2002, (ed) Speculation and Financial Markets, An Elgar Reference collection, Volume I, Chapters 12 and 16.

Goodhart, Charles, and Gerhard Illing, 2002, Financial Crises, Contagion, and the Lender of Last Resort – A Reader, Oxford University Press, Chapters 8, 13 and 15.

Kaminsky; Graciela L., Carmen M. Reinhart, and Carlos A. Végh, 2003, The Unholy Trinity of Financial Contagion, The Journal of Economic Perspectives, Vol. 17, No. 4. (Autumn), pp. 51-74.

Mishkin, Frederic S., 1999, Global Financial instability: Framework, Events, Issues, Journal of Economic Perspectives, volume 13, Number 4, Fall, p. 3-20.

Minsky, Hyman P., The financial instability hypothesis: Capitalistic processes and the behaviour of the economy, in C.P. Kindleberger and J.-P. Laffargue, eds., Financial Crises: Theory, History and Policy, Cambridge University Press, 1982.

Obstfeld and Roggof, Foundations of International Macroeconomics, parts of chapters 8 and 9, The MIT Press, 1996.

The above is indicative of the course contents. The syllabus and readings are tentative, and there can be some changes. There will be two written exams – mid-semester examination (40% weight) and end-semester examination (40% weight). There will be two home assignments with 10% weight each. Though there will be formal lectures in most classes, students are encouraged to discuss and participate in other sessions both within and outside the classroom. The course serves many purposes. It is useful for pursuing research, it helps in understanding and making policy, and it can be useful in decision making in industry.