Historical Development of the Banking System and Financial Innovation

1. Historical Development of the Banking System and Financial Innovation By: Hyesun Lim, Melisa Boel, Osama, Yu Tian, and Sunghee Park

2. The Beginning • The modern commercial banking industry in the United States began when the Bank of North America was chartered in Philadelphia in 1782. • Due to the vast achievement of this bank, many more came into business. • There was much debate over whether the federal government or the state should charter banks. • Alexander Hamilton: supported greater centralized control of banking and federal chartering of banks. This led to the establishment of the Bank of the United States in 1791.

3. Bank of the United States The Bank of the United States has components of both a private bank and a central bank (government agency that oversees the banking system and is responsible for the amount of money and credit supplied in the economy).

4. Problems Distrust The distrust of moneyed interests in the big cities led to political pressures to eliminate the Bank of the United States. Eventually, in 1811, the bank’s charter was not renewed. However, there was a definite need for a central bank to aide the federal government in raising funds during the War of 1812, so Congress created the Second Bank of the United States in 1816. Apprehension between advocates and rivals of centralized banking power were a big problem during the process of the second central bank in the United States. When Andrew Jackson became elected in 1832, he vetoed the re-chartering of the Second Bank of United States as a national bank, and its charter lapsed in 1836. Rising Tension

5. Until 1863: - all commercial banks were chartered by the banking commission of the state in whish each operated - no national currency existed - banks obtained funds primarily by issuing banknotes (currency circulated by the banks that could be redeemed for gold) - banks failed on a regular basis, which in turn made their banknotes worthless

6. A Glimpse of Hope National Bank Act of 1863 Created a new banking system of federally chartered banks (called national banks), which were supervised by the Office of the Comptroller of the Currency. As a result, the United States now has a dual banking system in which banks supervised by the federal government and banks supervised by the states operate side by side. Central banking reappeared in the country when the Federal Reserve System was created in 1913 to promote an even safer banking system. All national banks had to become members of the Federal Reserve System and became subject to a new set of regulations issued by the fed. State banks had the option to become members or not, but many turned it down due to the high costs of membership.

7. Great Depression 1930-1933: During this time, 9,000+ bank failures wiped out the savings of many depositors at commercial banks. To prevent future loss, the Federal Deposit Insurance Corporation (FDIC) was established in 1933, which provided federal insurance on bank deposits. Member banks of the Federal Reserve System were required to purchase FDIC insurance for the depositors, where non-Federal Reserve banks had the option to buy it.

8. Glass-Steagall Act Provisions in the banking legislation in 1933 prohibited commercial banks from underwriting or deal in corporate securities and limited banks to the purchase of debt securities approved by the bank regulatory agencies. This was brought about because investment banking activities of the commercial banks were blamed for many bank failures. Under the Glass-Steagall Act, commercial banks had to sell off their investment banking operations.

10. Conclusion -The Office of the Comptroller of the Currency has the primary supervisory responsibility for the 1,850 national banks that own more than half of the assets in the commercial banking system. - The Federal Reserve and the state banking authorities have joint primary responsibility for the 900 state banks that are members of the Federal Reserve System. - The Fed also has regulatory responsibility over companies that own one or more banks (which are called bank holding companies) and secondary responsibility for the national banks . - The FDIC and the state banking authorities jointly supervise the 4,800 state banks that have FDIC insurance but are not members of the Federal Reserve System. - The state banking authorities have sole jurisdiction over the fewer than 500 state banks without FDIC insurance.

11. Example of Financial Innovation The Banker is a leading financial magazine that “investigates, expose, and pass expert comment on the critical development in the global banking sector.” The Banker Global Financial Intelligence Since 1926 The Banker Awards is an annual awards event held every year recognizing the top financial institutions. Some of the awards categories include Bank of the Year, Innovation in Technology, and Central Banker of the Year.

12. Hans-Ulrich Meister, CEO, Credit Suisse Switzerland • Credit Suisse • If 2008 was a tough year for Credit Suisse in its home market of Switzerland, this year it has shown its powers of recovery. Having lost SFr8.2bn ($8.13bn) last year, its first-half results came storming back with a net profit of SFr3.6bn, return-on-equity of 20.1% and a Tier 1 ratio of 1.5%. • It is the just rewards of a swift response and an agile business model, says Hans-Ulrich Meister, CEO of Credit Suisse Switzerland. "Last year, in response to a dramatic change in the markets, we accelerated the execution of our long-term strategy: we adapted our business model, strengthened our capital position and reduced our risk profile. As a result, Credit Suisse is well positioned to prosper in the new competitive landscape, both in Switzerland and globally." • The bank has delivered on the key priorities it set out in 2008: to maintain capital strength; reduce investment banking risk; maintain client momentum; and accelerate the implementation of its strategy. Towards the latter, Credit Suisse has prepared for the new private banking environment by expanding its footprint and its global wealth management platform. It has refocused the investment bank as a client-centric, capital-efficient operation, with lower earnings volatility; and in asset management it completed the sale in 2009 of part of the traditional investment strategies business, marking a significant step in the focus on asset allocation, Swiss business and alternative investment strategies. • "This award recognises the strength of our business in our Swiss home market, which makes a significant contribution to our overall performance, as well as our role as a trusted financial partner to clients," said Mr Meister. "Our expertise and integrated approach to providing solutions, combining our private banking, investment banking and asset management capabilities, is proving very attractive." http://www.thebanker.com/news/fullstory.php/aid/6990/The_Banker_Awards_2009_-_Country_Winners.html?current_page=NO_PAGE

13. Financial Innovation

14. Responses to Changes in Demand Conditions Interest-Rate Volatility (Higher Interest –Rate Risk) The interest rate on 3 -month U.S. Treasury bills EX) 1950’s : 1.0% ~3.5% 1970’s : 4.0% ~11.5% 1980’s : 5.0% ~15% 2.5% 7.5% 10.0%

15. Responses to Changes in Demand Conditions Adjustable-Rate Mortgage Lending is more attractive IF interest-rate is LOWER • ARM(Adjustable-Rate Mortgage) is mortgage loans on which the interest rate changes when a market interest rate changes. Higher profit to financial institutions issue more  with lower initial interest rates  widespread Financial Derivatives Financial institutions need to protect themselves from Hedge or interest-rate risk Futures contract : the seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed on price Financial derivatives : futures contracts in financial instruments

16. Responses to Changes in Supply Conditions Information Technology -> 2 effects 1) lower the cost of processing financial transactions 2) make it easier for investors to acquire information FINANCIAL INNOVATION

17. <1> Bank Credit and Debit Cards <2> Electronic Banking <3> Junk Bonds <4> Commercial Paper Market <5> Securitization

18. <1> Bank Credit and Debit Cards - Credit Cards - Debit Cards

19. <1> Bank Credit and Debit Cards <2> Electronic Banking - Automated teller machine (ATM) - Automated banking machine (ABM) - Virtual Bank

20. <1> Bank Credit and Debit Cards <2> Electronic Banking <3> Junk Bonds

21. <1> Bank Credit and Debit Cards <2> Electronic Banking <3> Junk Bonds <4> Commercial Paper Market Improvement in information technology Rapid growth in the Commercial Paper Market The development of money market mutual funds

22. <1> Bank Credit and Debit Cards <2> Electronic Banking <3> Junk Bonds <4> Commercial Paper Market <5> Securitization Securitization is the process of transforming otherwise illiquid financial assets(such as residential mortgages, auto loans, and credit card receivables), which have typically been the bread and butter of banking institutions, into marketable capital market securities.

23. Avoidance of Existing Regulations • Why do financial industries such as banking try to avoid regulations? *Edward Kane “Loophole mining”- a process of avoiding regulations

24. Two sets of regulations • Reserve requirements - A cost on a bank equal to the interest rate, i, - The cost of ixr on the bank just like a tax on bank deposits of ixr per dollar of deposits 2. Restrictions on interest paid on deposits - Restricting the amount of fund that banks could lend and thus limiting bank profits

25. Financial Innovations • Money market mutual Fund: issues shares that are redeemable at a fixed price by writing checks. + It uses funds to invest in short-term money market securities that provide you with interest payments. + It enables you to write checks up to the amount of funds held as shares in the money market fund.

26. Financial Innovations • Sweep account: is an account set up at a bank or other financial institution where the funds are automatically managed between a primary cash account and secondary investment accounts. + It enables banks to avoid the “tax” from reserve requirements. + It allows banks to pay interest on checking account.

27. Decline of Traditional Banking • In the he U.S., the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically. • The size of banks’ balance sheet assets has declined by declines in their cost advantages in acquiring funds and declines in income advantages on uses of funds which are caused by financial innovations.

28. Declines in their cost advantages in acquiring funds: Money market mutual funds put the banks at an disadvantage because depositors could now obtain checking-account-like services while earning high interest on their money market mutual fund accounts.

29. Declines in income advantages on uses of funds: A loss of market share has been occurred, and the growth of the shadow banking system had been led by junk bonds, securitization and the rise of the commercial paper market .

30. Banks’ responses: • Expanding into new and riskier areas of lending 2. Pursuing new off-balance-sheet activities that are more profitable and embrace the shadow banking system

31. Financial Innovation Examples Financial innovation is how we progress in our history of studies about the economy, here are some examples that have helped the economy progress since their use.

32. The increased use of digital transferred currency, credit, and funds. • Before the invention and use of electronic currency checks and cash had to be used or carried at all times. However with the invention of digital accounts and currency a simple piece of plastic is all you need to purchase goods and services. Not only does this decrease the demand for cash but it also helps the individual to carry less cash and allow easy transfer of currency.

33. Increased use of interest-sensitive funds by bank and other financial institutions • With the creation of the FED, interest-sensitive funds are seeing an increase of usage due to their sensitive nature with the current status of the economy, by using interest-sensitive funds, banks and other financial institutions are able to better adjust to the current situation and to avoid inflations and recessions.

34. The required reserve system • Prior to the formation of the FED, banks were not required to hold a reserved amount of the deposits that were made to the bank, therefore most of the banks lend out almost every deposit they had, which resulted in some serious problems when withdraws were required but loans could not be called back, with the required reserve amount, “runs” on banks were decreased greatly.

35. the growth of financial markets and of marketable financial instruments • Financial markets have greatly expanded since their beginning of use. Now they cover almost every single market imaginable and the instruments used to run these markets are expanded as well. One example of this is the financial derivatives. Derivatives are basically side investments based on speculation of increasing profits, however this can lead to problems as seen in the mortgage crisis of 2009.

36. variable rate lending or borrowing and maturity shortening • Bonds are a good way for any government to raise money when they need additional resources for government projects, with variable rate lending and borrowing and maturity shortening, both government and bank are left with new options for investment and loaning.

37. Hedging, protection contract • Economies change everyday, and often prices go with the change, but in order to protect investments from serious losses, hedging contracts were introduced and saw major usage among corporations and financial institutions. Hedging is basically a protection against price rise and price fall, applying to selling and buying, basically you want to buy low and sell high, and hedging protects you from low price when selling and high price when buying. Even if you did not utilize hedging, it is often better to be protected than left empty handed unknown what will happen next.

38. Creation of the federal reserve districts • All in all there are a total of 12 federal reserve districts in the US that are responsible for their assigned states, this organized manner allows for checks to be cleared faster and also speeds up the transferring of funds betweens states. It also divides the members of the FED so there is a balance of power amongst the individuals.

39. Monetary tools based on the status of the economy • The fed decides when to increase the circulation of money and when to decrease the circulation of money, it also decides on the set interest rate based on the status of the economy, they manage the circulation and interest rate extremely careful based on the economy by using methods such as open market purchases and open market sales.