1. Chapter 15 Financial Innovation ©2000 South-Western College Publishing

2. 2 Financial Innovation The creation of new financial instruments, markets, and institutions in the financial services industry New ways for people to spend, save, and borrow funds Changes in the operation and scope of activity by financial intermediaries

3. 3 Glass-Steagall Act of 1933 Banking legislation enacted in response to the Great Depression Established Regulation Q ceilings Separated commercial and investment banking Created the FDIC

4. 4 Regulation Q Interest rate ceilings on deposits at commercial banks established during the Great Depression and phased out after 1980

5. 5 Fungible means... A characteristic referring to the ease with which a financial instrument can be converted to another

6. 6 Disintermediation The removal of funds from a financial intermediary

7. 7 The Reasons for Financial Innovation in the Past 35 Years Computer and telecommunications technology reduced the transactions costs of moving and monitoring funds 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 Costs Fell Benefits Increased Exhibit 15 - 1

8. 8 Nondeposit Liabilities Borrowed funds, such as Eurodollar borrowings, fed funds, and repurchase agreements, that are not deposits and not subject to reserve requirements

9. 9 Regulation D A regulation that prescribed reserve requirements on some deposits

10. 10 The Anatomy of Eurodollar Borrowing Exhibit 15 - 2 General Motors Chase New York Chase London $1,000,000 Eurodollar Deposit $1,000,000 Eurodollar Loan $1,000,000 Demand Deposit

11. 11 Deregulation The dismantling of existing regulations

12. 12 Depository Institutions Deregulation and Monetary Control Act of 1980 Phased out Regulation Q Established uniform and universal reserve requirements Increased the assets and liabilities depository institutions could hold Authorized NOW accounts Suspended usury ceilings

13. 13 Usury Ceilings Maximum interest rates that FIs are allowed to charge borrowers on certain types of loans

14. 14 Universal Reserve Requirements Reserve requirements established by the Fed to which all depository institutions would be subject

15. 15 Uniform Reserve Requirements The same reserve requirements across all depository institutions would apply to particular types of deposits

16. 16 Garn-St. Germain Depository Institutions Act of 1982 Additional deregulation act that authorized money market deposit accounts and Super Now accounts

17. 17 Reregulation Imposing new regulations in response to innovations that weakened existing regulations

18. 18 Securitization The process whereby relatively illiquid financial assets are packaged together and sold off to individual investors Result in Pass-through Securities

19. 19 Financial Market Changes in the 1990s Exhibit 15 -2 Fls are less specialized because of mergers with other financial services firms and because of engaging in other activities Interest rate ceilings are eliminated increasing competition and reducing profit margins Securitization is increasing and spreading from the mortgage market to many other markets Collateralized mortgage obligations allow prepayment risks to be different classes of bondholders Securitization is increasing and spreading from the mortgage market to many other markets Collateralized mortgage obligations allow prepayment risks to be different classes of bondholders Fls and payment mechanisms are automated Fls and payment mechanisms are automated Fls are making extensive use of derivatives and other instruments to unbundle risks Banks are relying on fee income as their share of intermediation declines Banks are relying on fee income as their share of intermediation declines Geographic barriers to deposit taking, loan granting and other services are reduced Financial Market Changes