Topics, readings, and assignments


Raison d'être of financial intermediaries

§  information asymmetry  - adverse selection and moral hazard

§  maturity, liquidity and risk transformation

§  screening and monitoring


Lecture 1 Notes

Note on the Banking Industry – short overview of the U.S. banking industry

Recommended readings:

The Future of finance and the theory that underpins it. London School of Economics, 2010. Chapter 1 – What do banks do?

Chapter 1 is written by Adair Turner, the former chairman of the FSA (Financial Services Authority), U.K.’s bank regulator before 2012


Akerlof, George A., “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, August 1970, 488-500.

Classical work on the economics of asymmetric information for which Akerlof received a Nobel prize in economics in 2001.



U.S. Banking Industry

§  historical review of U.S. banking industry

§  deposit insurance: arguments for and against

§  functions of a central bank

§  monetary policy and interest rates


Lecture 2 Notes

Additional notes on central banks (from F. Mishkin)


Case 1: The U.S. Banking Panic of 1933 and Federal Deposit Insurance


Assignment: submit your group’s write up where you address the following questions:

1.      Why do bank panics recur?

2.      Should Roosevelt agree to bank insurance? Are there any alternative reforms of the banking system which are preferable from an economic point of view? From a political point of view?

3.      Why does Glass want to separate commercial and investment banking? Are his arguments compelling?  Are there any other reasons to do that (the separation)?

4.      Comment on relevance of 1933 solutions to recent events (2007-2009).


Recommended readings:

·        Money in the modern economy: an introduction. By Michael McLeay, Amar Radian and Ryland Thomas. BoE Quarterly Bulletin, 2014 Q1

·        Money creation in the modern economy. By Michael McLeay, Amar Radian and Ryland Thomas. BoE Quarterly Bulletin, 2014 Q1


Additional readings:

The Federal Reserve System: Purposes and functions (chapters 1-3 are the most relevant, read other chapters if you are interested in the operational aspects of the FED)


Bernanke, Ben, S. “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” The American Economic Review. June 1983, 237-276.

The former chairman of the U.S. Federal Reserve is an expert on the Great Depression.  The article provides his insights on the topic, which many argue were important in implementing the actual FED policies during the 2007-2009 crisis and still shape the actions of the central bank. 



Measuring financial performance of financial intermediaries

§  balance sheet

§  income statement

§  ROE decomposition

§  key performance ratios (net interest margin, efficiency, etc.)

§  capital requirements


Lecture 3 Notes


Recommended readings:

·        Economics of Retail Banking Note, HBS, #9-602-153, Rev. March 24, 2006

·        Bank funding costs: what are they, what determines them and why do they matter? Bank of England, Quarterly Bulletin, Q3, 2014


Additional resources:

·        JPMorgan Chase 2014 Annual Report (link to annual reports - read Chairman’s letter to shareholders)

·        Fifth Third Bank annual/quarterly reports and SEC filings


Recommended readings/links: 

·        The Future of Finance: The rise of the new Shadow Bank, Part 1, Goldman Sachs, March 13, 2015

·        The Future of Finance: The Socialization of Finance, Part 3, Goldman Sachs, March 13, 2015

·        U.S. banks reporting from FDIC (combined income, balance sheet, etc.)

·        Investment banking scorecard (regional and global equity and debt issued, fees, etc.)



Bank lending to businesses and consumers

§  credit analysis

§  lending policies

§  pricing of traditional bank products

§  estimating expected credit losses


Lecture Notes 4: lending policies and procedures

Additional slides on business lending


Case 2: Santa Fe Trading Company


·        Submit group case write up where you address all questions listed at the end of the case;

·        Submit Excel spreadsheet


Traditional loan pricing example (Excel)


Required reading (coursepack):

·        HBS #9-209-107: An Introduction to Consumer Credit. February 20, 2009.

·        HBS #9-291-026 Note on Bank Loans, Rev. October 29, 1993


Recommended readings: 

·        Highly recommended reading for the case (Santa Fe): Rose, Peter S. and Hudgins Sylvia C., Bank Management & Financial Services. McGraw Hill, 7th Edition, 2008. Chapter 16 – lending policies and procedures

·        A Brief Postwar History of US Consumer Finance, HBS Working Paper 11-058



Innovations in lending and alternative finance

§  Marketplaces: Zopa, Lending Club, Prosper,

§  Alternative lenders: Kabbage, OnDeck;

§  Economics of alternative lenders


Lecture 5 Notes (overview of intermediation risks)


Case 3: - From a hot idea to an established market player?

Assignment: submit your group’s write up where you address the following questions:

1.      What is Zopa’s value proposition?  How does it differ to traditional retail banks?

2.      How sustainable is Zope’s competitive advantage?

3.      What strategic options for traditional retail bank such as RBS in responding to Zopa?  Which of these options should the established banks pursue?  Why?

4.      Would you invest in Zopa (as a lender or an investor in the company itself)? Why or why not? 

5.      Lending Club (LC) is a marketplace in the U.S., which is similar to Zopa.  Using LC’s SEC filings, earning reports, and other resources estimate company’s addressable market and potential revenue/net income.  Do you agree with equity analyst estimates of LC stock price?  Provide your reasoning.

Additional resources:

·        Lending Club SEC filings

·        Equity analyst reports – initial, Q2 results

·        Federal Reserve Bank of New York, Consumer Credit Panel

·        The Hourglass Effect, A Decade of Displacement, Frank Rotman, QED investors

·        LendIt USA 2015 Conference, Signature Keynote: Laurence H. Summers (video)


Suggested reading/links:

·        Understanding Alternative Finance. The UK Alternative Finance Industry Report 2014.  University of Cambridge.

·        A Cynic’s Guide To Fintech

·        Financial Times series on P2P (peer-to-peer) lending – articles on alternative lending universe

·        Lend Academy: website dedicated to peer-to-peer lending; check out podcasts (in particular #42 - an interview with Kathryn Petralia, co-founder of Kabbage) – you can listen the podcasts or read the transcripts

·        Special report: International banking, The Economist, May 9, 2015



Payment function: from the bill of exchange to Visa/MasterCard to Bitcoin

§  history: medieval fairs and bills of exchange, metallic money, gold standard

§  economics of modern payment systems: checks in the U.S.; economics of credit cards, merchant services;

§  bitcoin

§  economics of challengers - estimating market potential and expected financial performance


Lecture 6 notes (payments)


Recommended readings:

·        HBS: Consumer Payment Systems – United States. #9-909-006, Rev. July 20, 2011

·        Innovations in payment technologies and the emergence of digital currencies. By Robleh Ali, John Barrdear, Roger Clews and James Southgate

·        The economics of digital currencies. By Robleh Ali, John Barrdear, Roger Clews and James Southgate


Additional reading:

·        Cash Continues to Play a Key Role in Consumer Spending: Evidence from the Diary of Consumer Payment Choice, Federal Reserve Bank of San Francisco, April 29, 2014

·        The 2013 Federal Reserve Payments Study, Federal Reserve System, December 19, 2013; Exhibits from the Study

·        Strategies for Improving the U.S. Payment System, Federal Reserve System, January 26, 2015

·        A Billion Here, a Billion There: The Statistics of Payments. SWIFT, April 2009.

·        Getting Rid of Paper: Savings from Check 21, Federal Reserve Bank of Philadelphia, Working Paper No. 12-12, May 2012



Investments and money management

§  history of financial instruments and stock exchanges (New York, London,)

§  money management: mutual funds, retirement funds;

§  rating agencies

§  innovations in money management business  (‘robo advisors,’ etc.)

§  speed trading: economics, efficiency and fairness;


Lecture 7 Notes – mutual funds


Case 4: Betting on Failure: Profiting from Defaults on Subprime Mortgages (Case KEL880)

Assignment: submit your group’s write up where you address the following questions:

1.      Replicate the table in Exhibit 5 under the following alternative assumptions

a.      Principal received is $10/month.  Principal reductions remain as specified.

b.      Principal received remains $5/month, but writedowns associated with earlier defaults are 20/month beginning in six months.

2.      Suppose that immediately after the bonds were issued, $290,000,000 of principal was repaid on the underlying mortgages.  How would Exhibit 10 be affected?

3.      Anthony Keating picked an MBS that he expected would contain a high rate of mortgage default.  Based on the data in the case, does his choice seem reasonable?

4.      Suppose the principal writedowns on the underlying mortgage pool continue at the same rate as those observed in September 2008.  How long will it be until tranche B is completely wiped out? (hint: review Exhibit 13)

5.      The case documents that 41% of the outstanding loan pool has been delinquent for 90 or more days. Assuming that the borrowers behind these mortgages never pay and the lender ultimately forecloses on the properties, estimate the principal writedowns that the pool will eventually experience, assuming a recovery rate of 70%.  What will be the effect on tranche B?  Tranche M2?

6.      [advanced and optional] Use the prices in Exhibit 14.  Assume that the defaults/losses described in Question 5 will occur in exactly twelve months, with no other defaults in the pool. The other 59% of the loan pool will prepay in full, also in twelve months.  Assume, too, the mortgage bonds receive interest monthly at the rate given in Exhibit 10 and that scheduled and additional unscheduled principal payments remain at the September 2008 level.  What is the internal rate of return (IRR) to an investor who buys Bond M2?  Bond M6?

7.      Given the information in the case, what investment strategies are available to you to make money when homeowners with mortgages in this particular deal default?  Which of these strategies seems most appealing? 

Required reading:

·        (Coursepack) Introduction to Credit Default Swaps, 2010.


Additional reading:

·        High Frequency trading and dark pools: An interview with John Succo. Business Horizons (2013) 56, 715-722.

·        Investment Company Institute (see the latest annual report for comprehensive industry data)



Investment banks, money market mutual funds, and the shadow banking system

§  securitization

§  credit default swaps and other innovations in financial products

§  innovation in finance vs. systemic risk (AIG story)



Lecture 8 Notes – investment banks

Notes on housing market

Case 5: The Tip of the Iceberg: JP Morgan Chase and Bear Stearns (A), 2009

Assignment: submit power point, (optional) Excel file and the write up where you address the following questions:


1.      What activities did Bear Stearns undertake? Was it a commercial bank or an investment bank?

2.      SEC Chairman Christopher Cox noted that Bear Stearns was an adequately capitalized institution as of March 10, 2008. Do you agree with his assessment? Are well-capitalized financial institutions invulnerable to crisis?

3.      What is a “fortress balance sheet”? Evaluate the mechanisms used to manage JPMC, and how they enhanced or impeded their position as the bank best positioned to buy Bear.

4.      From a commercial perspective, what are the pros and cons for JPMC of buying Bear?

5.      What responsibility does Dimon have to the financial “system”?


Additional reading:

·        Timeline of financial crisis 2007-2010 from New York Fed

·        Levine, Ross. An Autopsy of the U.S. Financial System. NBER Working Paper 15956, April, 2010

·        Gorton, Gary B. The Subprime Panic. NBER Working Paper 14398, October 2008.

·        Gorton, Gary B. Questions and Answers about the Financial Crisis, February 2010. Prepared for the U.S. Financial Crisis Inquiry Commission.