Chapter 9 Financial Innovation

2  Major causes of financial innovation Major causes of financial innovation  The Analytic foundations of financial innovation The Analytic foundations of financial innovation  Early financial innovations Early financial innovations

3 What is Financial innovation?  Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries.  金融创新：金融服务业产生的新型金融工具、金 融市场和金融机构；人们消费、储蓄、借贷的新 方法；金融中介机构经营方式和经营范围的改变。

4 driving force of Innovation  The driving force behind innovation is that participants in the economy are simply trying to came as close as possible to achieving their objectives  if circumstances pose a barrier to achieving an objective, there is an incentive to find a way around the obstacle  “necessity is the mother of invention”

5 Causes of Financial Innovation  New computer and information technologies available  Avoidance of regulations  Increased competition from other financial and nonfinancial innovations  Higher volatility of prices, inflation, interest rates, and exchange rates

6 The Beginning Regulatory Structure  The regulatory structure in place at the beginning of the 1970s was a product of the Great Depression  The Glass-Steagall Act of 1933  created interest rate ceilings (Regulation Q)  created deposit insurance  placed limits on the types of assets that commercial banks could hold

7 Financial Innovation  An FI compares the costs and benefits associated with altering a prevailing portfolio practice  if the benefits > costs, the FI has a clear incentive to innovate and alter the prevailing practice

8 Financial Innovation  Since the 1970s, computer and telecommunications technologies have become increasingly available  have reduced the transactions costs associated with managing, moving, and monitoring funds  have allowed for the globalization of financial markets

9 Financial Innovation  Technological advances have also allowed the risks associated with a particular financial asset to be unbundled  allows the specific risks of one financial asset to be borne by different investors  makes the financial market more efficient

10 Financial Innovation  The persistent inflation and rising interest rates in the late 1960s and 1970s led to an incentive for banks to develop new products to avoid the binding effects of Regulation Q  net lenders simply looked for alternatives outside the banking system (disintermediation 脱媒 )  banks responded by developing money market mutual funds

11 Financial Innovation  Since the mid-1970s, banks have been challenged by a sharp rise in competition form other domestic and global financial and nonfinancial institutions  to respond, all FIs have become less specialized and more alike  bank holding companies offer investment and financial advice, leasing, data processing, and tax planning  financial holding companies provide services that go far beyond the scope of banking

12 Financial Innovation  The greater volatility of prices, stock values, interest rates, and exchange rates increases the risks associated with intermediation  this has led to the development of new assets  financial forwards, futures, and options markets attempt to hedge interest rate and exchange rate risks

13 The Reasons for Financial Innovation over the Past 40 Years Costs Fell Computer and telecommunications technology reduced the transactions costs of managing, moving, and monitoring funds. Benefits Increased The rise in inflation and interest rates caused disintermediation and increased the profits of getting around certain regulations such as Regulation Q. Increased global and domestic competition from other financial intermediaries increased the benefits of innovation to meet and beat the competition. Increased volatility caused the development of innovations to hedge the risks of losses from increased uncertainty.

14 recap  Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries.  Financial innovation will occur whenever the benefits of innovating are greater than the costs. The last 40 years have seen rapid financial innovation.  By the 1960s, the regulatory structure that was put into place in the 1930s (the Glass-Steagall Act) was inhibiting bank profitability, giving a strong incentive to innovate around the regulations.

15 ·  Ongoing from the 1970s, advances in computer technology increased the fungibility （替代性：一种金融工具转化为另一种金融工 具的难易程度。） of funds (the ease with which a financial instrument can be converted to another) and fostered financial innovation.  Higher interest rates which increased disintermediation made innovating around interest rate ceilings more profitable.

16  Increasing competition from other intermediaries and nonfinancial corporations also increased the benefits of innovation to meet the increased competition.  Greater price and interest rate volatility increased the benefits of finding innovations to reduce the risks from increased uncertainty.

17 Early Financial Innovations  Reserve requirements specify the reserve assets that banks and other depository institutions must hold as a proportion of their deposit liabilities  if the requirements force banks to hold more reserves than they otherwise would, this constitutes a tax on bank earnings  what cannot be loaned cannot earn interest

18 Early Financial Innovations  One way to reduce this burden is for banks to shift from deposits to nondeposit liabilities  非存款负债：借入资金，即不受存款准备金 限制的非存款，如借入的欧洲美元、联邦基 金和回购协议。  these include Eurodollar borrowings, fed funds, and repurchase agreements  exempt from reserve requirements  not subject to Regulation Q ceilings

19 Early Financial Innovations  Eurodollars  dollar-denominated deposits held abroad  U.S. banks borrow Eurodollar deposits to obtain additional funds

20 Early Financial Innovations  Fed Funds  reserves that banks trade among themselves for periods of one to several days  the interest rate determined in the market for fed funds is the fed funds rate  starting in the 1960s, large banks came to look at the fed funds market as a permanent source of funds  smaller banks with fewer lending opportunities tended to be net lenders in this market

21 Early Financial Innovations  Overnight Repurchasing Agreement  an agreement in which a bank takes a government security from its asset portfolio and sells it with the simultaneous agreement to buy it back tomorrow at a price set today  the difference in the selling and buying prices is the interest the lender receives from the bank

22 Early Financial Innovations  Retail Sweep Accounts （零售隔夜账户）  一种金融创新，通过将那些受到准备金管 制的交易账户的隔夜余额提取出存入不受 准备金管制的账户，存款债务变成非存款 债务。  sweep balances out of transactions accounts that are subject to reserve requirements and puts them in other deposits (such as money market deposit accounts) that are not

23 Early Financial Innovations  Negotiable Certificates of Deposit (CDs)  creation of a secondary market for CDs in 1961  a corporation with excess funds can invest in a negotiable CD with the knowledge that the CD could be sold in the secondary market if funds were needed before the CD matures  reserve requirements on all negotiable CDs were eliminated by the end of 1973

24 Early Financial Innovations  As these innovations weakened the effectiveness of various regulations, regulators recognized the difficulty of controlling financial flows and the market for financial services  they decided to deregulate （放松管制） the market in the early 1980s

25 Deregulation  Legislation was enacted by Congress in 1980 and 1982  phased out regulation Q  expanded the asset and liability powers of banks and thrifts  allowed thrifts to offer checkable deposits  established reserve requirements that applied to and were the same for all depository institutions

26 Deregulation  Two other laws in the mid- and late-1990s provided further deregulation  eliminated most restrictions on interstate banking  allowed banks to merge with securities and insurance firms

27 recap  Early financial innovations include the development of nondeposit liabilities such as Eurodollar borrowings, negotiable CDs, repurchase agreements and fed funds.  Eurodollar borrowings (Borrowings by banks of funds in the Eurodollar market) are not subject to interest rate ceilings (Regulation Q) or reserve requirements (Regulation D).

28  Large banks used the repurchase agreement and fed funds markets as permanent sources of funds to lend. Thus, banks can keep lending despite central bank restraint in the provision of funds.  Negotiable CDs allowed banks to attract additional funds to lend because they can be sold in secondary markets if the funds are needed before the CDs mature.

29  In the early 1980s, Congress passed two major deregulation statutes that phased out Regulation Q ceilings, expanded the asset and liability powers of banks and thrifts, allowed all thrifts to offer checkable deposits and established the same reserve requirements for all depository institutions.  Retail sweep accounts are a more recent innovation that relables deposit liabilities to nondeposit liabilities by “sweeping” balances out of transactions accounts that are subject to reserve requirements and into other accounts that are not.  Two other laws in the 1990s removed restrictions on interstate banking and allowed banks to merge with securities firms and insurance companies.