10-1

Financial Innovation and Banking Industry Structure

Responses to Changes in Risk

1. Adjustable-rate mortgages

2. Financial Derivatives

Responses to Changes in Technology

Major change is improvement in computer technology

– Increases ability to collect information

– Lowers transaction costs

Examples:

1. Bank credit and debit cards

2. Electronic banking facilities

3. Junk bonds

4. Commercial paper market

5. Securitization

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Avoiding RegulationsRegulations Driving Financial Innovation

1.Reserve requirements

To bank, they’re a tax on deposits = i r

2.Deposit-rate ceilings (Reg Q)

As i , look for loopholes to escape reserve requirement tax and deposit-rate ceilings

Examples

1. Money market mutual funds

2. Sweep accounts

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The Decline in Banks as a Source of Finance

10-4

Decline in Traditional Banking: WhyLoss of Cost Advantages in Acquiring Funds (Liabilities) i disintermediation

1.Deposit rate ceilings and regulation Q

2. Money market mutual funds

3. Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool

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

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Decline in Traditional Banking: Response

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

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Responses to Branching Restrictions

1. Bank Holding Companies

A. Allowed purchases of banks outside state

B. BHCs allowed wider scope of activities by Fed

C. BHCs dominant form of corporate structure for banks

2. Automated Teller Machines

Not considered to be branch of bank, so networks allowed

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Bank Consolidation and Number of Banks

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Bank Consolidation / Nationwide Banking Bank Consolidation: A Good Thing?

Cons:

1. Fear decline of small banks and small business lending

2. Rush to consolidation increase risk taking

Pros:

1. Community banks will survive

2. Increase competition

3. Increased diversification of bank loan portfolios: lessens likelihood of failures

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10-13

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Bank Failures

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Why a Banking Crisis in 1980s?Early Stages1. Decreasing profitability: banks take risk to keep profits up2. Deregulation in 1980 and 1982, more opportunities for risk taking3. Innovation of brokered deposits enabled circumvention of

$100,000 insurance limit4. i , net worth of S&Ls

A. Insolvencies B. Incentives for risk taking

Result: Failures and risky loans

Later Stages: Regulatory Forbearance1. Regulators allow insolvent S&Ls to operate because

A. Insufficient fundsB. Sweep problems under rugC. FHLBB cozy with S&Ls

2. Huge increase in moral hazard for zombie S&Ls: now have incentive to “bet the bank”

3. Zombies hurt healthy S&LsA. Raise cost of fundsB. Lower loan rates

4. Outcome: Huge losses

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Non-Bank Financial InstitutionsLife Insurance Companies1. Regulated by states2. Hold illiquid long-term assets3. Poor returns caused insurance demand 4. Became managers of pension funds5. Increased competition from banks

Property & Casualty Insurance Companies1. Regulated by states2. Hold more liquid assets3. Insurance crisis

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Other InstitutionsPension Funds1. Rapid growth: encouraged by tax policy2. Bigger role in stock market3. Problem of underfunding4. Private: regulated by Dept. of Labor and insured by

Penny Benny under ERISA Act of 19745. Public Plans

A. Social SecurityB.State and local plans

Finance Companies1. Minimal regulation by states2. Rapid growth3. Three types:

A. Sales finance companiesB.Consumer finance companiesC. Business finance companies

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Mutual Funds1. Regulated by SEC2. Open-end vs. closed-end3. Load vs. no-load4. Money market mutual funds5. Hedge funds

Government Financial Intermediation1. Federal credit agencies:

FNMA, GNMA, FHLMC, Farm Credit System, SLMA2. Moral hazard problem of government loan guarantees

Securities Market Institutions1. Investment banks2. Securities brokers and dealers3. Organized exchanges4. All are regulated by SEC