Historical Development: the Banking System and Financial Innovation

1. Historical Development:the Banking System and Financial Innovation Economics 350 Presentation 4/26/2010 Group 4

2. Part 1:Historical Development of the banking system Banks are financial intermediaries who aim to earn profits. In the United States there are approximately 7,000 commercial banks, 1,200 saving and loan associations, 400 mutual savings banks, and 8,000 credit unions. The Economics of Money, Banking, and Financial Markets; Mishkin; page 275

3. The beginning of banking: TODAY: Financial Crisis accelerates and ongoing fundamental change in the banking industry as banks diversify their services to become more competitive. www.bls.gov/oco/cg/cgs027.htm

4. Multiple regulatory agencies: • Created a quilt of overlapping jurisdictions. • 1,850 National Banks primarily supervised by a department of the Treasury. • The federal reserve and state authorities have joint responsibility for the other 900 state banks. • The fed also has responsibility over companies that own one or more banks and secondary responsibility for national banks. • The FDIC and state authorities jointly supervise the 4.800 state banks that have FDIC insurance but are not members of the Fed. • The state banking authorities have sole jurisdiction over the fewer than 500 banks without FDIC insurance. • Several Proposals have been raised to create one independent supervisory agency, but none have successfully passes congress, and the future regarding consolidation is highly uncertain.

5. Part 2:Financial innovation & the “shadow banking system”

6. What is Shadow Banking System? • The shadow banking system consist of non-bank institutional intermediaries between investors and borrowers. • Ex: An institutional Investor willing to lend money to a corporation. The shadow banking institution will be the financial intermediary to channel these funds. • With the current financial crisis, this banking system is quickly growing into important financial intermediary

7. Why Was Demand So Low? • Due to increase in volatility during these decades, grave uncertainty about returns on investments , which is what we call “interest rate risk” • The large fluctuations in the interest rates are risky because it can lead to large gains, but also massive losses.

8. The Two Solutions: Due to these fluctuations, two financial innovations came about: • Adjustable-rate mortgages: (mortgage loans on which interest rates change based on the market interest rate. Not fixed) Institutions prefer these over fixed mortgage rates. • Financial Derivatives (ex: Hedges, forwards contracts) A way for institutions to protect themselves.

9. Part 3:responses to change in supply conditions Information Technology Has had 2 effects on changes in supply: Lowered the cost of processing financial transactions. Made it easier for investors to acquire information.

10. The Response: • Bank Credit and Debit Cards • The low cost of processing financial transactions sparked a rise in bank credit. • The sudden demand of bank credit lead to the innovation of Debit Cards. • And then shortly following was the Credit Card; where you could defer your payments. • Electronic Banking • Computer technology allowed for even lower cost’s by allowing customers to interact through an electronic facility and not a human being. • One important for is the ATM; allowing customers to get cash, make deposits, transfer funds, and check balances all without speaking to a teller. • The most commonly known today is a virtual bank; accessible only online. • Junk Bonds • Introduced when technology made financial research easier allowing more investors into the market. • Commercial Paper Market • Saw a rapid rise with the new technology; and with the development of the money market mutual fund. • Securitization • The process of making illiquid assets marketable capital market securities. • Bundled a portfolio of loans with varying small denominations, collect the interest and principal, then pass them through to a 3rd party • This process played a big role in today’s crashing home market.

11. Part 4:avoidance of existing regulations The financial industry is heavily regulated. Why? -Large amount of losses can be incurred

12. Government Regulation • -At first it reduces the profits of firms • -Over time firms find ways to avoid regulations. These are called financial innovations. • The process of avoiding regulations is called “loophole mining.” • Banking is one of the most heavily regulated industries in America. Two reasons: • Reserve requirements • Restriction on interests paid on deposits

13. requirement • Reserve Requirements -i x r -A hidden tax on banks • Restriction on interests paid on deposits -deposit rate ceilings -disintermediation

14. Innovation • Two financial innovations • Money Market Mutual Funds • Sweep Accounts • Money Market Mutual Funds -Functions like a checking account where you can deposit your money -Potential to earn a much higher return than putting your money in banks deposit • Sweep Accounts -Sets up a cash account for a client -Any cash above the average balance will be deposited into investments that can be quickly liquidated -Allows banks to pay a higher interest on these checking accounts

15. Other Innovation • Technology also helped greatly expand the level of financial innovations -Cheaper and faster to use these financial innovations Example: SEC Accuses Goldman Sachs of Fraud • Goldman Sachs is being sued because it sold packaged mortgages to investors that they believed were going to fail. Once these mortgages failed, these investors lost a lot of money. • These mortgages were picked out by a third party (John Paulson) and it was not disclosed to investors. The mortgages were represented by a credible firm, ACA Management. • The issue here: Goldman did not disclose the specific guy who picked out the mortgage, but instead called him a third party affiliates. This is an example of banks trying to work around the system in order to make a profit.

16. Part 5:Financial innovation & the decline of traditional banking In the beginning… The role of traditional banks was to make long-term loans and find them by issuing short term deposits, a process known as “borrowing short and selling long.” Financial innovations have caused a more competitive environment in banking industry, with traditional banking going into a decline

17. Importance of commercial banks as a source of funds to non-financial borrowers has declined dramatically:- From 40% in 1974 to less than 24% in 2008 Decline in thrift institutions: 20% market share in late 70’s to 4% today. Moreover, financial intermediary assets fell from 40% from 1960 to 1980 to 18% in 2008. To see how these problems came to fruition, we need to look at the decline in cost advantages in acquiring funds (liabilities) and lost income advantages (assets).

18. Decline in Cost Advantages of Acquiring Funds (Liabilities) • Until the 1980’s banks were subject to deposit rate ceilings that restricted them from paying interests on checkable deposits and limited them to paying a maximum interest rate of 5% on time deposits, a policy known as Regulation Q. • Until the 1960’s these restrictions were advantageous because their major source of funds was checkable deposits, so banks with zero interest had a low cost of funds. • Rise in inflation in the 1960’s lead to higher interest rates, which made investors more sensitive to yield differentials on assets.

19. Decline in Cost Advantages of Acquiring Funds (Liabilities) • These incidents lead to the disintermediation process, where people took their money out of banks and sucked out higher yielding investments. • Lead to the financial innovation of money market mutual funds: depositors could now obtain checking account-like services while earning high interest on their funds. • Regulation Q price ceilings on time deposits were raised to help banks raise funds. • - This unfortunately lead to a higher cost in acquiring funds.

20. Decline on Income Advantages on Uses of Funds (Assets) • Advances in information technology has made it easier for firms to issue securities to the public. Securitization is the process by which illiquid financial assets such as bank loans and mortgages are transformed into marketable securities. • Banks no longer have an advantage in making loans due to securitization, and due to improvements in computer technology, risks can be easily evaluated through computers. • Many people prefer going through the commercial paper market, which has allowed finance companies to extend operations at the bank’s expense.

21. Decline on Income Advantages on Uses of Funds (Assets) • Many small private equity houses are finding it harder to raise cash, and they look to private financial funds to raise the cash. Traditional banks have not been fulfilling the task of lending to small and medium businesses, borrowers can look to raise funds non-traditionally. (FT Business Financial Times, 2009) The recent economic downturn has been a key reason why these firms have opted to lend by non-traditional means.

22. Bank’s Response • Declines in profitability, which usually results in an exit from the industry, was the cause of bank failures in the 1980’s There are two alternatives to maintaining traditional lending activities:

23. Bank’s Response 1. Expansion into new and riskier means of lending: - Place greater percentage of total funds into commercial real estate loans. - Increased lending for corporate takeovers and leveraged buyouts 2. Also by pursuing new balance sheet activities that are more profitable, thus doubling their share of income - Advances in “shadow banking system”, a system in which bank lending is replaced by lending via the securities model • In 2005, banks started offering interest-only and other types of non-traditional mortgages to borrowers with weak credit. • Banks have since been more conservative with who qualifies due to new federal regulation, effective in December 2005. • This limited the ability for lenders to take out mortgages. (Block and Kirchhoff, 2005)

24. International Financial Innovation • New financial innovations has lead to a decline in traditional banking roles in Japan and many European countries • Securitization has been popular as it makes it cheaper to finance activities by issuing securities rather than going through banks. • The Eurobond market has made it more attractive to access offshore and foreign capital markets, resulting in a loss in bank loan business. • This proves that the decline in traditional banks isn’t just a national issue, but a global issue as well.