Essays in banking and interest rates

This dissertation includes three papers on banking and interest rates. The first paper presents a theoretical model that studies the effect of universal banking on economic performance. I show that universal banks, because of their ability to extend the horizons of their relationships with borrowing firms, are more willing than are specialized commercial banks to insure firms against the financing risks associated with innovation. However, universal banks' leniency towards firms discovered to be bad credit offsets their advantages in encouraging innovation. Comparative statics investigations suggest that when information asymmetry in an economy is severe, the advantages of universal banks become more important, while when firms become larger, the advantages of specialized commercial banks become larger. The second paper provides empirical support for the theoretical predictions in the first paper. I find that small firms in countries with universal banking systems grow significantly faster than small firms in countries with specialized banking systems while no significant difference is found for large firms. In addition, the positive effect of universal banking on firm growth seems to be even more obvious in developing countries. The third paper studies whether three popular macroeconomic models can generate the behavior of nominal and real term structure found in data. Different from King and Watson (1996), it uses data on UK index-linked bonds to get a better measure of ex-ante real interest rates. It is found that all three models are able to generate the downward sloping real term structure, the procyclical 1-year nominal rate and the countercyclical nominal yield spread. However, only the sticky price model and the liquidity effects model are able to generate the counter-cyclical behavior of 1-year real rate and the pro-cyclical behavior of real yield spread. Finally, only the sticky price model is able to generate the upward-sloping average term structure of nominal interest rates for maturities between 2 and 6 years.