Financial Inovation - Banking - Lecture Slides, Slides of Banking and Finance

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Banks are financial intermediaries who aim to earn profits.

In the United States there are approximately 7,

commercial banks, 1,200 saving and loan associations, 400

mutual savings banks, and 8,000 credit unions.

 Created a quilt of overlapping jurisdictions.  1,850 National Banks primarily supervised by a department of the Treasury.  The federal reserve and state authorities have joint responsibility for the other 900 state banks.  The fed also has responsibility over companies that own one or more banks and secondary responsibility for national banks.  The FDIC and state authorities jointly supervise the 4.800 state banks that have FDIC insurance but are not members of the Fed.  The state banking authorities have sole jurisdiction over the fewer than 500 banks without FDIC insurance.  Several Proposals have been raised to create one independent supervisory agency, but none have successfully passes congress, and the future regarding consolidation is highly uncertain.

 Due to increase in volatility during these decades, grave uncertainty about returns on investments , which is what we call “interest rate risk”  The large fluctuations in the interest rates are risky because it can lead to large gains, but also massive losses. Decade 3month Treasury Bills (%) 1950 1.0%-3.5% 1960 N/A 1970 4.0%-11.5% 1980 5.0%-15.0%

Due to these fluctuations, two financial innovations came about:  Adjustable-rate mortgages: (mortgage loans on which interest rates change based on the market interest rate. Not fixed) Institutions prefer these over fixed mortgage rates.  Financial Derivatives (ex: Hedges, forwards contracts) A way for institutions to protect themselves.

 Bank Credit and Debit Cards

 The low cost of processing financial transactions sparked a rise in bank credit.  The sudden demand of bank credit lead to the innovation of Debit Cards.  And then shortly following was the Credit Card; where you could defer your payments.

 Electronic Banking

 Computer technology allowed for even lower cost’s by allowing customers to interact through an electronic facility and not a human being.  One important for is the ATM; allowing customers to get cash, make deposits, transfer funds, and check balances all without speaking to a teller.  The most commonly known today is a virtual bank; accessible only online.

 Junk Bonds

 Introduced when technology made financial research easier allowing more investors into the market.

 Commercial Paper Market

 Saw a rapid rise with the new technology; and with the development of the money market mutual fund.

 Securitization

 The process of making illiquid assets marketable capital market securities.  Bundled a portfolio of loans with varying small denominations, collect the interest and principal, then pass them through to a 3 rd^ party  This process played a big role in today’s crashing home market.

The financial industry is heavily regulated. Why?

-Large amount of losses can be incurred

 Reserve Requirements -i x r -A hidden tax on banks  Restriction on interests paid on deposits -deposit rate ceilings -disintermediation

 Two financial innovations

 Money Market Mutual Funds

 Sweep Accounts

 Money Market Mutual Funds

-Functions like a checking account where you can

deposit your money

-Potential to earn a much higher return than putting

your money in banks deposit

 Sweep Accounts

-Sets up a cash account for a client

-Any cash above the average balance will be

deposited into investments that can be quickly

liquidated

-Allows banks to pay a higher interest on these

checking accounts

The role of traditional banks was to make long-term loans and find them by issuing short term deposits, a process known as “borrowing short and selling long.” Financial innovations have caused a more competitive environment in banking industry, with traditional banking going into a decline

Decline in thrift institutions: 20% market share in late 70’s to 4% today. Moreover, financial intermediary assets fell from 40% from 1960 to 1980 to 18% in 2008. To see how these problems came to fruition, we need to look at the decline in cost advantages in acquiring funds (liabilities) and lost income advantages (assets).

 These incidents lead to the disintermediation process, where people took their money out of banks and sucked out higher yielding investments.  Lead to the financial innovation of money market mutual funds : depositors could now obtain checking account-like services while earning high interest on their funds.  Regulation Q price ceilings on time deposits were raised to help banks raise funds.  - This unfortunately lead to a higher cost in acquiring funds.

 Advances in information technology has made it easier for firms to issue securities to the public. Securitization is the process by which illiquid financial assets such as bank loans and mortgages are transformed into marketable securities.  Banks no longer have an advantage in making loans due to securitization, and due to improvements in computer technology, risks can be easily evaluated through computers.  Many people prefer going through the commercial paper market , which has allowed finance companies to extend operations at the bank’s expense.