1. Chapter 18 Commercial Banking Industry: Structure and Competition G. M. Wali Ullah Lecturer Independent University, Bangladesh (IUB)

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-2 Financial Innovation FIs innovating new financial products to maximize profits and satisfy customer needs Response to Changes in Demand Conditions: – Major change- huge increase in interest-rate risk starting in 1960s – Adjustable-Rate Mortgages are an example of the reply to interest-rate volatility (reducing interest rate risk) – Banks also started using financial derivatives (i.e. forward contracts) to hedge risk

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-3 Financial Innovation Response to Changes in Supply Conditions – Major change is improvement in computer technology 1.Increases ability to collect information 2.Lowers transactions costs 3.This lead to many innovations on the supply side.

4. 18-4 Financial Innovation: Credit and Debit Cards Many store credit cards existed long before WWII. Improved technology in the late 1960s reduced transaction costs making nationwide credit card programs profitable. The success of credit cards led to the development of debit cards for direct access to checkable funds. Bank earns through loans made to credit card holder and from store payments made on card purchases (i.e. 5% of the purchase price) ANZ Grindlays Bank introduced credit card concept in Bangladesh in 1991. National Bank was the first local bank to offer credit cards in 1997.

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-5 Financial Innovation: Electronic Banking Automatic Teller Machines (ATMs) were the first innovation on this front. Today, over 250,000 ATMs service the U.S. alone. Automated Banking Machines combine ATMs, the internet, and telephone technology to provide “complete” service. Virtual banks now exist where access is only possible via the internet.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-6 Financial Innovation: Electronic Payments The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money. The U.S. is still far behind some European countries in the use of this technology.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-7 Financial Innovation: E-Money Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card. E-cash refers to an account on the internet used to make purchases. bKash is a prime example in the Bangladeshi market.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-8 Financial Innovation: Junk Bonds Prior to 1980, debt was never issued that had a junk rating. The only junk debt was bonds that had fallen in credit rating. Junk bonds has higher default risk (bad credit rating) but offers higher yields compared to safer bonds (good credit rating). ↑default risk ↑return (yield) Michael Milken of Drexel Burnham assisted firms in issuing original-issue junk debt, and almost single-handedly created the market.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-9 Financial Innovation: Commercial Paper Market Commercial paper refers to unsecured debt issued by corporations with a short original maturity. The development of money market mutual funds assisted in the growth in this area.

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-10 Financial Innovation: Securitization Securitization refers to the transformation of illiquid assets into marketable capital market instruments. Today, almost any type of private debt can be securitized. This includes home mortgages, credit card debt, student loans, car loans, etc.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-11 Financial Innovation: Avoidance of Existing Regulations Regulations Behind Financial Innovation 1.Reserve requirements Reserve amount sits idle, without earning interest. Acts as Tax on deposits = i  r 2.Deposit-rate ceilings (Reg Q) Regulation Q sets highest ceiling for interest rates to be paid by banks on time deposits When market interest rates rise above maximum ceiling rate, deposits withdraw funds from banks to invest in higher return providing market securities.

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-12 Financial Innovation: Avoidance of Existing Regulations Money Market Mutual Funds: – Issue shares that are redeemable at a fixed price (usually $1) by writing checks. – Although money market fund shares effectively function as checking account deposits that earn interest, they are not legally deposits and so are not subject to reserve requirements or prohibitions on interest payments. – For this reason, they can pay higher interest rates than deposits at banks.

13. Financial Innovation: Avoidance of Existing Regulations Sweep Accounts: – Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement taxes are avoided. – Development of information technology made it possible to conduct additional transactions required in Sweep accounts inexpensively. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-13

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-14 Financial Innovation and the Decline in Traditional Banking Loss of Cost Advantages in Acquiring Funds (Liabilities) – Beginning of Disintermediation because 1.Deposit rate ceilings and regulation Q 2.Money market mutual funds

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-15 Financial Innovation and the Decline in Traditional Banking Loss of Income Advantages on Uses of Funds (Assets) 1.Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization 2.Finance companies more important because easier for them to raise funds

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 18-16 Banks' Response Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking 1.Expand lending into riskier areas (e.g., real estate) 2.Expand into off-balance sheet activities 3.Creates problems for U.S. regulatory system Similar problems for banking industry in other countries