Archive for November 9th, 2009

Understanding Banking- Mechanism Design Approach

November 9, 2009

In 2007, when Riksbank Committee awarded the Economics prize to Mechanism Design Theory, I realized there is something like this in economics.


Adam Smith’s classical metaphor of the invisible hand refers to how the market, under ideal conditions, ensures an efficient allocation of scarce resources. But in practice conditions are usually not ideal; for example, competition is not completely free, consumers are not perfectly informed and privately desirable production and consumption may generate social costs and benefits. Furthermore, many transactions do not take place in open markets but within firms, in bargaining between individuals or interest groups and under a host of other institutional arrangements. How well do different such institutions, or allocation mechanisms, perform? What is the optimal mechanism to reach a certain goal, such as social welfare or private profit? Is government regulation called for, and if so, how is it best designed?

And mechanism design helps in understanding these questions.

I came across this paper which analyses Banking using Mechanism Design. It is written by Fabrizio Mattesini, Cyril Monnet and Randall Wright.

The authors study banking using the tools of mechanism design, without a priori assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and certain frictions – including limited commitment and imperfect monitoring – they describe the set of incentive feasible allocations and interpret the outcomes in terms of institutions that resemble banks. The bankers in the authors’ model endogenously accept deposits, and their liabilities help others in making payments. This activity is essential: if it were ruled out the set of feasible allocations would be inferior. The authors discuss how many and which agents play the role of bankers. For example, they show agents who are more connected to the market are better suited for this role since they have more to lose by reneging on obligations. The authors discuss some banking history and compare it with the predictions of their theory. 

I couldn’t understand bulk of the paper as it is highly technical. But usage of mechanism design to study why banks exist sounded useful to me.

The paper says having a third agent take care of deposits makes it more credible that the parties will honor their transactions. This third agent resembles a bank.

An implication is that delegated storage may be useful: If you deposit your output with a third party who has less incentive or ability to liquidate it for strategic reasons, others are more willing to give you credit. Thus, claims on deposits can be used to facilitate transactions, and this resembles banking. This activity can be part of an e¢ cient arrangement even if the third party has an inferior storage technology. Thus, bank liabilities can be useful for payments even if dominated in return. Although other things being equal, it is obviously better if the bank has access to good storage or other investment opportunities.

 We want to ask, however, why the third party is less inclined than you to renege on obligations. In our approach, future rewards and punishments mitigate strategic behavior, but monitoring is imperfect (opportunistic deviations are detected only probabilistically). Agents with a higher likelihood of being monitored have a greater incentive to make good on obligations and, hence, are better suited to take on the responsibility of holding deposits.

 All these are features we assume to be associated  with a bank. The authors however begin ignoring these assumptions about a bank. And arrive at these ideas using mechanism design theory.




Add Meir Kohn’s works to your reading list

November 9, 2009

I don’t remember which blog/article pointed to a paper by Meir Kohn. He is an eco professor at Dartmouth who has done tonnes of work on financial history to understand whether it helps in economic growth.

What is amazing is his phd was in Operations Research. He took up economic/financial history as he was intrigued by monetary economics and high inflation in Israel.

He explains in this article:

Because of the severe inflation Israel was undergoing at the time, I became interested in monetary theory and macroeconomics. My dissatisfaction with the existing ways of modeling money led me to work on an alternative theory. Together with others, I helped to develop what came to be known as the cash-in-advance approach to money.

What is this cash-in-advance theory? explains ( Kohn’s paper here):

The cash-in-advance constraint is a modeling idea. In a basic Arrow-Debreu general equilibrium there is no need for money because exchanges are automatic, through a Walrasian auctioneer. To study monetary phenomena, a class of models was made in which money was required to make purchases of other goods. In such a model the budget constraint is written so that the agent must have enough cash on hand to make any consumption purchase. Using this mechanism money can have a positive price in equilibrium and monetary effects can be seen in such models. 

Hmm. Well what Kohn says next is what I found more interesting:

Although the cash-in-advance approach was an improvement over the existing ways of modeling money, I had by the early 1990s come to the conclusion that mathematical modeling was of very limited value in advancing our understanding of the economy. At the time I was writing textbooks on Money and Banking and on Financial Institutions. Reading some financial history, I found it much more illuminating than the mathematical models to which I, and many others, had devoted so much effort. I therefore decided to redirect my efforts in that direction.

My initial goal was to achieve a better theoretical understanding of the workings and function of financial systems through a study of financial history. However, the most important and interesting question about financial systems is what difference they make to overall economic progress. So I was drawn into a more general study of the process of economic development and growth.


He has since then spent nearly a decade on 2 projects. One on pre-industrial Europe Financial System and its impact on growth. He is testing out his lessons on Chinese financial system and growth. The reports are available online.

Both look excellent stuff . I was reading the paper on deposit banking in 1600s and is quite fascinating.

There are also 2 papers which look like must read:

Add Kohn to your reading list. Those interested in Economic/Financial history that is…

Mint’ new column on economic research papers

November 9, 2009

There were 2 news paper columns that I know of that track latest economic research papers.

  1. Okonomos in Business Standard. Mainly written by T C A Srinivasa-raghavan who bid his farewell to the column on Aug 22, 2008. After that the column was carried on for a while, but seems to have stopped for time being.
  2. Grey Matter in Economic Times- This one is pretty good and written mainly by Jaideep Misra and Mythili Bhusnurmath. It comes on Tuesdays in the edit page. I cannot locate a separate link for the same.

Now Manas Chakravary of Mint has started a column dedicated for economic research papers called Simply Economics.  It comes on Saturday with Lounge, Mint’s weekend weekly. Again, I can’t find a dedicated link to the column.

Manas is an extremely prolific writer and covers economic research in his other columns as well (Capital Account). However, Simply Economics is mainly to cover economic research. There have been 4 pieces till now – 1, 2, 3 and 4.

Great stuff so far. I hope he continues with this column.

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