We did that on the example of two independent projects.
But clearly, if a bank has more, then, well, this matrix, if you have three,
it becomes three dimensional, but then it becomes an n-dimensional matrix that
is really difficult to imagine, but can be easily done with the use of proper math.
But the important thing is that the more projects the bank has,
and the more diversified they are,
then the probability of poor outcomes of the group of these projects goes down.
And the bank can deliver on its obligations to its depositors with
a higher probability.
Now at the same time, we said that depositors are willing
to deposit the money with the bank only if it pays back to them
some interest that at least compensates them for
these poor boxes in which depositors cannot recover all their money.
And then we went ahead and said that we set up a scheme, and in the scheme,
everything was great, but the fact that neither the borrowers nor
the depositors got any kind of a carrot, if you will.
And we said that the poor thing is, that although the bank that does monitoring and
ensures the efficiency of this kind of operations and
plays a pivotal role in capital markets.
The problem is that the bank is vulnerable, and
if you changed the terms of this contract just a little bit,
then you can immediately see the situation which the bank fails.
So the bank cannot easily share money with both end parties of these contracts.
It cannot reduce the face value it charges to the borrowers.
Or it cannot erase the interest rate it offers to its depositors.
And the key story happens on this part between the bank and
the depositors because depositors cannot monitor and
this is debt contract liquidation, so we have to be careful about that.
But you have to offer something, and
this something, roughly speaking, is called liquidity.
That's what the bank produces, and
the second fundamental function of a bank is creation of liquidity.
Well, this seems to be an enigmatic statement so far.
And we will devote our third week
to the analysis of this liquidity creation, what exactly the bank does,
what problems we see on this path, and how these problems have to be dealt with.
So from now on we will, in the beginning of the third week,
we will say that the bank will offer to its depositors some kind of a special
carrot that will indeed engage them in depositing the money with the bank.
So here I will take an interim stop, and
I wish you good luck with your assignments, and I see you in week three.