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金融学ch10 Financial Innovation


Chapter 10
Financial Innovation

Copyright ?2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives
? What financial innovation is and why it has ocurred at a rapid pace since the mid-1960s ? The major types of financial innovations since 1960 ? How regulations, increased competition, and volatile interest and inflation rates have triggered financial innovations ? The role of computer and information technologies in fostering financial innovations and globalization ? The direction of financial innovation in upcoming years
2

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”

3

Causes of Financial Innovation
? New computer and information technologies available ? Avoidance of regulations ? Increased competition from other financial and nonfinancial institutions ? Higher volatility of prices, inflation, interest rates, and exchange rates
4

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

5

The Beginning Regulatory Structure
? Interest Rate Ceilings
– interest payments on demand deposits were prohibited – interest rates on time and savings deposits were not to exceed ceilings set by regulators
? by holding down interest rates on deposits, the rates on loans could also be held down reducing the banks’ incentives to seek highrisk, high-yield loans
6

The Beginning Regulatory Structure
? FDIC
– the presence of deposit insurance eliminated bank runs or panics

7

The Beginning Regulatory Structure
? Limitations on Assets
– the Glass-Steagall Act separated commercial banking from investment banking – banks were no longer allowed to own or underwrite corporate securities
? the assets that banks were permitted to hold were limited to cash assets, government securities, and loans
8

The Beginning Regulatory Structure
? In addition, to curb loans to stock speculators, limits were put on the proportion of stock purchases that could be financed by borrowing
– these limits were called margin requirements

9

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

10

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

11

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

12

Example
Question:
? Treasury STRIPS are a type of government security that allows investors to register and trade ownership of the interest (coupon) payments and the principal amount of the security. The coupon and principal payments can each be sold separately at a discount. What risk is this innovation effectively allowing the investor to unbundle?
13

?

Example
Answer:
? Treasury STRIPS offer the advantage that each coupon payment and the principal amount associated with the security may be sold separately at a discount to investors. The investor’s gain is the difference between today’s (discounted) price of either the coupon payment or the principal and the future payment received upon maturation of the STRIP. This mitigates the risk arising from the uncertainty associated with the future direction of interest rates.
14

Example
? In other words, STRIPS protect the investor from losses associated with reinvesting the coupon payments at a lower interest rate because interest rates may have fallen since the security was issued. With Treasury STRIPS, there are no coupon payments thus avoiding the possibility that such payments may have to be reinvested at a lower interest rate.
15

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) – banks responded by developing money market mutual funds
16

Financial Innovation
? Since the mid-1970s, banks have been challenged by a sharp rise in competition from 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
17

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
18

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. 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.
19

Benefits Increased

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 there 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

20

Early Financial Innovations
? One way to reduce this burden is for banks to shift from deposits to nondeposit liabilities
– these include Eurodollar borrowings, fed funds, and repurchase agreements
? exempt from reserve requirements ? not subject to Regulation Q ceilings

21

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

22

Example
Question: ? Assume a reserve requirement of 10 percent. If Chemical Bank is successful in getting Microsoft to convert a $2 million demand deposit to a Eurodollar deposit, how much can Chemical Bank lend out because of this transaction?
23

Example
Answer:
? Chemical Bank is required to hold reserve assets equal to 10 percent of the $2 million demand deposit liability. There are no reserve requirements on eurodollar deposits. ? Therefore, when Microsoft converts its $2 million demand deposit at Chemical Bank to a eurodollar deposit excess reserves increase by $200,000. Chemical Bank can safely lend all excess reserves.
24

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 25

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

26

Early Financial Innovations
? Retail Sweep Accounts
– 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

27

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
28

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 the market in the early 1980s

29

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
30

Deregulation
? Two other laws in the mid- and late1990s provided further deregulation
– eliminated most restrictions on interstate banking – allowed banks to merge with securities and insurance firms

31

Innovation in the Payments System
? The payments mechanism is the means by which transactions are completed
– how money is transferred among transactors

? The payments mechanism has been significantly affected by changes in technology
– ATM machines, cash cards, debit cards, home banking, direct pay deposit, direct billing

32

Innovation in the Payments System
? An electronic funds transfer system does not eliminate the need for deposit accounts
– it is just a more efficient way of transferring funds from one deposit account to another

33

Derivatives and Other Recent Innovations
? A derivative is an instrument that is routinely used to separate the total risk of a financial asset into subparts
– derives its value from the underlying assets – examples include forward, futures, options, and swap agreements

34

Forward, Futures, and Options Agreements
? A firm can hedge exchange rate risk through a foreign exchange forward agreement ? A lender can use futures or options to hedge the interest rate risk associated with a long-term loan

35

Swap Agreements
? Interest rate swaps are a financial innovation used to reduce interest rate risk
– two financial institutions will trade interest payment streams to guarantee that their respective payment inflows will more closely match their outflows

36

A Simple Interest Rate Swap

37

Currency Swaps
? In a currency swap, one party agrees to trade periodic payments, over a specified period of time, in a given currency, with another party who agrees to do the same in a different currency
– used as a hedge against foreign exchange risk over a multiyear period
38

Credit Derivatives
? Credit derivatives transfer the risk that the return in a credit transaction falls below a certain rate
– derive their value from the underlying debt instruments – for the purchaser, they hedge default risk – for the seller, a risk is taken on in return for a fee
39

Securitization
? Securitization is the process whereby relatively illiquid financial assets are packaged together and sold to investors
– turns relatively illiquid instruments into liquid investments called asset-backed securities – originated in the mortgage market in the early 1980s
? has spread to other loan and lease markets
40

Example
Question:
? ? Explain the process by which a group of credit card balances could be securitized. Securitization is the process whereby relatively illiquid financial assets (such as credit card balances) are packaged together and sold off as securities to individual investors. Securitization turns relatively illiquid instruments into quite liquid investments called asset-backed securities.
41

Answer:

?

Example
? A market maker agrees to create a secondary market by buying and selling the securities backed by the credit card balances. ? Securitization became popular because it provides a way of protecting against interest rate risk in an environment of increased interest rate volatility. ? Securitization spread from the mortgage market to other markets including credit card balances.
42

Other Characteristics of the Financial System
? Increased competition has led to lower profit margins ? FIs and nonfinancial institutions have moved into each others’ markets ? Mergers are bringing about increased concentration ? FIs have become increasingly automated ? Geographical barriers are eroding 43

Financial Market Changes in the 1990s and Early 2000s
Geographical barriers to deposit taking, and loan granting, and other financial services are reduced.
FIs are less specialized due to mergers with other financial services firms and engaging in other activities. Interest rate ceilings are eliminated, thereby increasing competition and reducing profit margins.

Banks are relying on fee income as their share of intermediation declines. FIs are making extensive use of derivatives and other instruments to unbundle risks.

Financial Market Changes

FIs and payments mechanisms are more automated.

Securitization is increasing and spreading from the mortgage market to many other markets. Collateralized mortgage obligations allow prepayment risks to be different for different classes of bondholders. 44

Summary of Major Points
? Financial innovation is creation of new financial instruments, markets, and institutions to increase profitability
– the last 40 years have seen a high level of financial innovation
? the benefits of innovating have been greater than the costs ? many of the innovations have been due to advances in information and computer technologies
45

Summary of Major Points
? In the 1970s, much innovation centered around evading regulations
– regulations included setting reserve requirements (Regulation D) and interest rate ceilings (Regulation Q), limiting entry, separating commercial and investment banking, and specifying margin requirements

46

Summary of Major Points
? In addition to information and computer technology advances, the incentives to innovate have included rising interest rates that led to disintermediation, volatile interest rates that increased interest rate risk, and increased competition

47

Summary of Major Points
? The relabeling of deposit liabilities as nondeposit liabilities, which avoided both reserve requirements and interest rate ceilings, represented a major form of financial innovation
– included in this group are fed funds, Eurodollar borrowings, and repurchase agreements – the creation of a secondary market for CDs and retail sweep accounts are other major innovations
48

Summary of Major Points
? Beginning in 1980, the banking system was deregulated
– Regulation Q interest rate ceilings were phased out – asset and liability options for banks and thrifts were expanded – two other laws in the 1990s eliminated barriers to interstate branching and allowed banks, securities firms, and insurance companies to merge
49

Summary of Major Points
? The financial sector is becoming more competitive
– derivatives such as financial forward, futures, options, and swaps are increasingly being used to hedge risk and to unbundle risks

? Securitization is the process whereby relatively illiquid financial assets are packaged together and sold off to investors

50

Summary of Major Points
? Geographical barriers for financial services are disappearing ? FIs are becoming less specialized and more concentrated
– banks are expanding into other areas – mergers among large firms have occurred

? Profit margins from lending have fallen ? Financial transactions are becoming increasingly automated 51


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