Introduction of Raghuram Rajan:
Raghuram Rajan, the Reserve Bank of India’s current governor, is an accomplished economist who has made significant contributions to the fields of finance, central banking, and international finance. He has received numerous accolades, including the Fisher Black Prize and the Financial Times Goldman Sachs Business Book of the Year Award.

Matchstick Theory:
Rajan’s lecture focuses on matchstick theory, a stripped-down economic model that simplifies complex concepts to reveal underlying factors at work. Matchstick theory helps isolate key dimensions and understand their impact on the real world, even though it may not perfectly reflect its complexities.

Why Banks?:
Rajan seeks to address the question of why banks exist in the first place and their importance in the economy. He emphasizes that banks play a crucial role in facilitating transactions, reducing transaction costs, and providing liquidity.

Benefits of Banks:
Banks offer convenience, reduce transaction costs, and provide liquidity by connecting those who have excess funds with those who need them. They facilitate payments, credit, and savings, which are essential for economic growth and development.

Challenges and Criticisms:
Rajan acknowledges that banks can also be a source of instability and face various challenges, such as financial crises and accusations of excessive risk-taking. He recognizes criticisms of economic theory, including its simplification of the real world, but argues that it can still provide valuable insights.

Conclusion:
Rajan’s lecture underscores the importance of banks in the economy, highlighting their role in facilitating transactions, reducing transaction costs, and providing liquidity. While banks can be sources of instability, matchstick theory helps economists understand the underlying factors at work and gain insights into how the real world functions.

Why Do We Have Banks?:
Banks have illiquid assets and demandable liabilities, making them prone to runs. Traditional explanations for this structure, such as tax advantages, deposit insurance, and too big to fail, are insufficient.

Efficiency of Banks:
Banks may have an efficiency property that makes them a worthwhile device. Narrow banking proposals, which would limit banks to funding liquid assets with liquid deposits, are often suggested after crises.

Post-Financial Crisis Arguments:
Raising bank capital reduces reliance on demand deposits. The question is whether this kills any efficiency associated with demand deposits. Other than revenge, is there a reason to raise bank capital, and what are the consequences?

Research Rationale:
This research aims to provide a rationale for thinking about regulation, crises, and other banking issues. It is based on work done with Doug Diamond, who is considered the father of modern banking.

Setup for the Basic Idea:
There is a project that only one entrepreneur can do. A financier raises money from investors and passes it on to the entrepreneur. The basic idea stems from two factors: The entrepreneur’s specificity in doing the project. The financier’s specificity in monitoring the entrepreneur.

Specific Human Capital:
The entrepreneur has a unique idea and skills that are specific to the project’s success. The financial institution develops specific skills and knowledge about the project, building a relationship with the entrepreneur.

Commitment Issues:
Modern society lacks formal commitment mechanisms like slavery. Individuals can easily walk away from projects or agreements, creating friction in the process.

Debt Contracts and Commitment:
Debt contracts commit the entrepreneur to repay the financial institution. Demandable debt commits the financial institution to repay investors, ensuring liquidity and enabling the bank to manage funds.

Why Direct Investment in Entrepreneurs Doesn’t Work:
The model raises the question: why can’t investors directly invest in entrepreneurs instead of going through a financial intermediary? This question will be addressed later in the presentation.

Missing Slide:
The speaker mentions a missing slide but continues the discussion without it.

Key Points:
An entrepreneur needs to borrow money for a long-dated project, and the project returns a cash flow at the end of the period. The entrepreneur can walk away from the project at any time before the cash flows are due, which creates a renegotiation risk for the financial. If the entrepreneur tries to renegotiate the payment down, the financial will liquidate the project for the collateral value, X2. The entrepreneur knows that he can get at least X2 from the financial, so he will offer to pay X2, and the financial will accept. The project is illiquid because the entrepreneur can only pledge X2, which is less than the cash flow that the project can produce. Investors have even less ability to extract value from the project than the financial, so they can only raise beta X2 from the financial, where beta is less than 1. This creates a second layer of illiquidity, and the entrepreneur can only borrow beta X2 from the investors directly. The intermediary can come in between and extract X2 from the entrepreneur, but unless he has his own money at work, he can’t borrow more than beta X2 from the investors. Even if the intermediary has some money, he faces an opportunity cost if he gets a better investment opportunity later. This creates an illiquidity premium that the financial will demand from the entrepreneur. It would be better if the financier could commit his human capital to the investors so that he could raise X2 from the investors rather than extricate it from the entrepreneur.

Mechanism for Banker Commitment to Depositors:
Demandable deposits create a collective action problem for depositors, incentivizing them to run on the bank if the banker threatens to renegotiate debt. This collective action imposes discipline on the banker, preventing them from attempting to reduce deposit payments. The banker commits to paying deposits in full, solving the commitment problem.

Benefits of Demand Deposits for Depositors and Entrepreneurs:
Depositors receive the full amount of money they deposited, ensuring they are not taken advantage of by the banker. Entrepreneurs are protected from asset liquidation, as the banker can raise more deposits or issue new deposits to meet liquidity needs. The bank becomes a source of liquidity, providing depositors with access to their funds and preventing the need for asset liquidation.

Mechanism of Bank Run:
Depositors can demand cash or equivalent assets at any time, but the amount they receive depends on their position in the line. The value of the bank’s assets in the market is less than the promised deposit value. In a bank run, depositors rush to withdraw their funds, leading to a depletion of assets and leaving later depositors with nothing. The threat of a bank run disincentivizes the banker from renegotiating deposits, ensuring they fulfill their commitment to depositors.

Banker’s Inability to Renegotiate:
The banker cannot negotiate with depositors to continue the loan agreement after a bank run. Depositors now own the loan, and the entrepreneur can approach them directly for a deal. The entrepreneur can offer depositors an equal or better deal, eliminating the banker’s role as an intermediary.

Transfer of Loan Ownership:
A bank run shifts the ownership of the loan from the banker to the depositors. Depositors have the option to rehire the banker or cut them out of the business. The entrepreneur’s ability to match or exceed the banker’s offer incentivizes depositors to accept the entrepreneur’s deal.

Loss of Banker’s Value and Rents:
The banker’s role becomes redundant once the loan is made and monitored. The banker adds no value to the process, making their presence dispensable. The side deal between the entrepreneur and depositors eliminates the banker’s rents, preventing them from initiating renegotiations.

Disintermediation’s Impact on Banker’s Rents:
Disintermediation strips the banker of their rents even though their skills remain intact. The banker’s skills are overshadowed by the possibility of a side deal between the entrepreneur and depositors. The banker’s inability to renegotiate results in them paying the full X2 amount to the depositors.

Significance of Banks:
Banks play a crucial role in loan origination due to their skills and expertise. The threat of a bank run imposes discipline on the banker, ensuring they act in the best interest of depositors. This discipline is effective because it can lead to the elimination of the banker’s rents, aligning their incentives with those of depositors.

Why can’t investors have demand deposits against the entrepreneur directly?:
Entrepreneurs are essential for value creation and cannot be cut out of the process like banks. Demand deposits against entrepreneurs won’t reduce their rents because they can negotiate and prove their value.

Why do banks, but not venture capitalists, issue demand deposits?:
Venture capitalists actively add value by providing managerial support and advice to startups. This hands-on involvement makes demand deposits ineffective in disciplining venture capitalists.

How do money market mutual funds avoid bank runs?:
Money market funds mark their assets to market daily, ensuring investors know their value. This transparency eliminates the incentive for runs, as investors can always get the current market value. However, money market funds don’t create liquidity and rely on the liquidity of their assets.

How do banks create liquidity and protect borrowers?:
Banks can pledge illiquid assets as collateral, allowing them to borrow more than the market value of those assets. This creates liquidity for borrowers and reduces the risk of liquidation. Banks protect entrepreneurs from unreasonable cash demands by providing a buffer against runs. Entrepreneurs can continue running the project despite borrowing from the bank.

How Banks Provide Reliable Funding:
Banks allow entrepreneurs to raise more funds at a lower illiquidity premium compared to borrowing directly from markets. They can borrow from others to meet depositors’ needs for immediacy, enabling long-term projects with short-term depositors.

Costs of Replacing Deposits with Capital:
Asking banks to replace deposits with capital will make them less risky. However, it will also increase banker rents, intermediation costs, and the cost of capital for firms, making borrowing more difficult.

Uncertainty and Demand Deposits:
Demand deposits have a downside in uncertain environments. If the value of assets or loans decreases, the bank may need to renegotiate with depositors. Depositors, fearing renegotiation, may run, leading to a solvency problem.

Need for Bank Capital:
To buffer against uncertainty, banks need softer, potentially renegotiable claims such as bank capital. Capital absorbs risk in the bank’s capital structure, preventing excessive project liquidation and potential bank failures.

Banks vs. Finance Companies:
Unlike demand deposits, longer-term liabilities such as long-term debt or capital don’t have as harsh properties and allow for negotiation between the bank and the capital holder. More capital buffers the bank from asset value fluctuations but reduces banker discipline and increases the cost of raising money. A completely safe bank with 100% capital would have a high financing cost due to the lack of discipline exerted by demand deposits. A completely deposit-based bank would be prone to crashes due to the lack of a buffer.

Bank Capital and Regulation:
Post-financial crisis, banks were levered too much, leading to a need for more capital. Excessive capital requirements can lead to a capital-induced credit crunch, restricting lending and affecting economic growth. The trade-off between capital and intermediation should be carefully considered when regulating banks.

Bank Capital and Emerging Markets:
Emerging markets face challenges in attracting foreign banks due to higher capital requirements. Stricter capital requirements can limit the activities banks engage in, affecting economic growth and development. Empirical research is needed to determine the optimal level of capital for banks.

Systemic Crises and Intervention:
Systemic crises have severe consequences and warrant more capital than what was available during the global financial crisis. Authorities may intervene to prevent or mitigate systemic crises. Monetary policy can be used as a form of intervention, but it has potential costs if not done properly.