Chapter 10: Innovation and Structure in Banking and Finance Chapter Objectives Explain why bankers and other financiers innovate. Explain how widespread unit banking in the United States affected financial innovation. Explain how the Great Inflation of the 1970s affected banks and banking. Define loophole mining and lobbying and explain their importance. Describe how technology changed the banking industry after World War II. Define traditional banking and describe the causes of its demise. Define industry consolidation and explain how it is measured. Define financial conglomeration and explain its importance. Define industry concentration and explain how is it measured.

1. Early Financial Innovations Chapter Objectives Explain why bankers and other financiers innovate. Explain how widespread unit banking in the United States affected financial innovation. Why do bankers and other financiers innovate in the face of branching restrictions and other regulations?

1. Early Financial InnovationsWhy innovation? Six functions delivered by financial systems: Moving funds across time and space The pooling of funds Managing risk Extracting information to support decision-making Addressing moral hazard and asymmetric information problems Facilitating the sale of purchase of goods and services through a payment system

1. Early Financial InnovationsEarlier in America Restricted markets unit banks no interstate banking or branching Restricted competition no interstate banking or branching local monopolies Stable profits/spreads

Spreads between sources of funds and uses of funds were large and stable, leading to the infamous rule – Borrow at 3 percent, lend at 6 percent, and golf at 3 p.m. 1. Early Financial Innovations

2. Innovations Galore the aggregate price level rose over 110% “The Great Inflation” caused increases in  Interest rates  Interest rate volatility  Interest rate risk

2. Innovations Galore Bankers responded to the increased interest rate risk by inducing others to assume it – Solution was to get borrowers to take on the risk by inducing them to promise to pay some market rate Bankers’ response to increased competition and disintermediation – Finding new and improved ways to connect to customers, e.g. ATMs

3. Loophole Mining and Lobbying Competition for profits drives bankers and other financiers to look for regulatory loopholes – A process called loophole mining Permissive regulatory system: A system that allows financiers to engage in any activities they wish that are not explicitly forbidden – It is easier for financial innovation than a restrictive regulatory system

3. Loophole Mining and Lobbying Disintermediation: The opposite of intermediation, when investors pull money out of banks and other financial intermediaries

3. Loophole Mining and Lobbying DisintermediationLoophole miningNon-bank banksSweep accounts Bank holding companies Regulatory reform

3. Loophole Mining and Lobbying Sweep accounts Lowered reserve requirements Insignificant reserve requirements?

3. Loophole Mining and Lobbying Bank holding companies Added services Financial service companies?

4. Banking on Technology Computing Technology Credit cardsDebit cardsATMs Online banking Securitization

The process of combining multiple mortgages or other loans into a single instrument, usually for resale to institutional investors such as hedge funds or investment banks Securitization 4. Banking on Technology

5. Banking Industry Profitability and Structure Disintermediation DeregulationCompetition Technology Operating EfficienciesCompetition

5. Banking Industry Profitability and Structure Effect of competition Banks pay more for deposits Liabilities cost more Banks charge less interest on loans Assets return less Profitability decreases

5. Banking Industry Profitability and Structure Deregulation: Major developments In early 1930s, commercial and investment banking activities were strictly separated by legislation called Glass-Steagall – Gradual erosion of Glass-Steagall in the late 1980s and 1990s and de jure elimination in 1999 allowed investment and commercial banks to merge and to engage in each other’s activities

Regulatory changes, called deregulation, and the decline of traditional banking – Resulted in banks beginning to merge in large numbers, a process called consolidation – Banks began to enter into nonbanking financial activities, like insurance, a process called conglomeration 5. Banking Industry Profitability and Structure Deregulation: Major developments

5. Banking Industry Profitability and Structure Effect of competition Consolidation and Conglomeration Less profitability More competition Deregulation

5. Banking Industry Profitability and Structure Evolution of industry structure Advantages ConsolidationEconomies of Scale Banks merge Diversify geographically ConglomerationEconomies of Scope Banks add services Diversify operations

5. Banking Industry Profitability and Structure Evolution of industry structure Disadvantages Consolidation Banks merge Encourage too much risk? Conglomeration Banks add services Lose efficiencies of specialization? Create moral hazard: “too big to fail”?

A measure of market concentration calculated by summing the square of the market shares of the companies operating in a given market Alternatively N-concentration Index Herfindahl Index 5. Banking Industry Profitability and Structure

Evolution of industry structure Concentration: Fewer banks control larger share of assets, deposits, capital Starting a new bank is not as difficult as it sounds The U.S. allows individuals to establish other types of depository institutions Foreign banks can enter the U.S. market relatively easily – U.S. banks can operate in other countries.