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

© 2004 Pearson Addison-Wesley. All rights reserved 10-2 Avoiding Regulations Regulations Driving Financial Innovation 1.Reserve requirements To bank, theyre 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

© 2004 Pearson Addison-Wesley. All rights reserved 10-3 The Decline in Banks as a Source of Finance

10-4 Decline in Traditional Banking: Why Loss 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

© 2004 Pearson Addison-Wesley. All rights reserved 10-5 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

© 2004 Pearson Addison-Wesley. All rights reserved 10-6

© 2004 Pearson Addison-Wesley. All rights reserved 10-7

© 2004 Pearson Addison-Wesley. All rights reserved 10-8 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

© 2004 Pearson Addison-Wesley. All rights reserved 10-9 Bank Consolidation and Number of Banks

© 2004 Pearson Addison-Wesley. All rights reserved 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

© 2004 Pearson Addison-Wesley. All rights reserved 10-11

© 2004 Pearson Addison-Wesley. All rights reserved 10-12

10-13

© 2004 Pearson Addison-Wesley. All rights reserved Bank Failures

© 2004 Pearson Addison-Wesley. All rights reserved Why a Banking Crisis in 1980s? Early Stages 1.Decreasing profitability: banks take risk to keep profits up 2.Deregulation in 1980 and 1982, more opportunities for risk taking 3.Innovation of brokered deposits enabled circumvention of $100,000 insurance limit 4. i, net worth of S&Ls A.Insolvencies B.Incentives for risk taking Result: Failures and risky loans Later Stages: Regulatory Forbearance 1.Regulators allow insolvent S&Ls to operate because A.Insufficient funds B.Sweep problems under rug C.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&Ls A.Raise cost of funds B.Lower loan rates 4.Outcome: Huge losses

© 2004 Pearson Addison-Wesley. All rights reserved 10-16

© 2004 Pearson Addison-Wesley. All rights reserved 10-17

© 2004 Pearson Addison-Wesley. All rights reserved Non-Bank Financial Institutions Life Insurance Companies 1.Regulated by states 2.Hold illiquid long-term assets 3.Poor returns caused insurance demand 4.Became managers of pension funds 5.Increased competition from banks Property & Casualty Insurance Companies 1.Regulated by states 2.Hold more liquid assets 3.Insurance crisis

© 2004 Pearson Addison-Wesley. All rights reserved Other Institutions Pension Funds 1.Rapid growth: encouraged by tax policy 2.Bigger role in stock market 3.Problem of underfunding 4.Private: regulated by Dept. of Labor and insured by Penny Benny under ERISA Act of Public Plans A.Social Security B.State and local plans Finance Companies 1.Minimal regulation by states 2.Rapid growth 3.Three types: A.Sales finance companies B.Consumer finance companies C.Business finance companies

© 2004 Pearson Addison-Wesley. All rights reserved Mutual Funds 1.Regulated by SEC 2.Open-end vs. closed-end 3.Load vs. no-load 4.Money market mutual funds 5.Hedge funds Government Financial Intermediation 1.Federal credit agencies: FNMA, GNMA, FHLMC, Farm Credit System, SLMA 2.Moral hazard problem of government loan guarantees Securities Market Institutions 1.Investment banks 2.Securities brokers and dealers 3.Organized exchanges 4.All are regulated by SEC