1. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. CHAPTER 13 Financial Innovation

2. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Reasons for Financial Innovation over the Past 40 Years Costs Fells Benefits Increased Computer and telecommunications technology reduced the transactions costs of managing, moving, and monitoring funds. Increased global and domestic competition from other financial intermediaries increased the benefits of innovation to meet and beat the competition The rise in inflation and interest rates caused disintermediation and increased the profits of getting around certain regulations such as Regulation Q. Increased volatility caused the development of innovations to hedge the risks of losses from increased uncertainty.

3. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. A Simple Interest Rate Swap This Year Bank OneBank Two Two-year loans earn 9% fixedTwo-year loans earn 8% variable Deposits cost 5% variableDeposits cost 6% fixed Next Year Rates Go Up—No Swap Bank OneBank Two Loans earn 9% fixedLoans earn 12% variable Deposits cost 9% variableDeposits cost 6% fixed Next Year Rates Go Down—No Swap Bank OneBank Two Loans earn 9% fixedLoans earn 5% variable Deposits cost 2% variableDeposits cost 6% fixed Next Year Rates Go Up—They Swap Bank OneBank Two Loans earn 9% fixedLoans earn 12% variable Deposits cost 6% fixedDeposits cost 9% variable Next Year Rates Go Down—They Swap Bank OneBank Two Loans earn 9% fixedLoans earn 5% variable Deposits cost 6% fixedDeposits cost 2% variable The swap allows both banks to be happy all the time!

4. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Financial Market Changes in the 1990s and Early 2000s Financial Market Changes Geographical barriers to deposit taking, and loan granting, and other financial services are reduced. Banks are relying on fee income as their share of intermediation declines. FIs are making extensive use of derivatives and other instruments to unbundle risk. FIs and payments mechanisms are more automated. Interest rate ceilings are eliminated, thereby increasing competition and reducing profit margins. FIs are less specialized due to mergers with other financial services firms and engaging in other activities. Securitization is increasing and spreading from the mortgage market to many other markets. Collateralized mortgage obligations allow prepayment risks to be different for difference classes of bondholders.