• Ideal condition: individual banks do not take excessive risk, the system is diverse and robustlow systemic risk
• Excessive size of banks is seen as main contribution of systemic risk

3 experiments- perspective of the investor/ supervisor holding the market portfolio of banks

1. Change size
2. Change business model
3. Change both simultaneously

Trade-off between diversity and diversification

Too many to fail problem

Extending portfolio theory to banking

RESULTS:

• Risk in FED portfolio peaks during savings and loan crisis, returns also drop, but overall remain stable at 0,2%
• Increase in risk aversion decreases portfolio risk and return, but risk is not completely eliminated
• Non interest rate income reduces aggregate profits while increasing risk

CONCLUSION:

Medium to high risk aversion, the supervisor prefers to reduce bank concentration (size)

Largest banks are overrepresented in the current portfolio compared with the optimal portfolio

Suggestions calls to break up the banks, but disagreement on how to do it, costly because banks benefit from economies of scale

BASED ON THIS BRIEFLY ANSWER THE FOLLOWING QUESTIONS:

Recently, the Dutch government, through its top prosecutor, decided to press charges against ABN AMRO, for money laundering. ABN AMRO is a Dutch bank. Interestingly enough, since being bailed out during the recent crisis, its stock is 56% percent owned by ... the Dutch government. The prosecutor is looking to fine ABN AMRO if the bank is indeed found to be guilty of money laundering.

1. Suppose one of the measures the government is considering, is to replace the CEO of ABN AMRO with the minister of finance of the Netherlands. What type of asymmetric problem would be reduced, and what role would the minister of finance place in this asymmetric information problem after he takes on the dual role as CEO of ABN AMRO? (5 points)
2. Suppose that the prosecutor finds that the money laundering has generated mostly non-interest income, and hardly any interest income. Also, suppose that the prosecutor finds that ABNAMRO was part of a money laundering scheme that mostly involved large US banks. In what way would that affect the interpretation of the findings of Bos, Lamers and Purice (2014, part of the course literature), assuming for the moment that ABN AMRO is a US bank? (5 points)
3. Suppose that a new central bank governor in the US is much more risk averse than the current one. How would that change the optimal portfolio of banks according to the findings of Bos, Lamers and Purice (2014)? Explain your answer! (5 points)