CHAPTER 13
Financial Innovation
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 compensation, and volatile interest a nd inflation rates have
triggered finanacial innovations
 The role of computer and information technologies in fostering financial innovations and
globalization
 The direction of financial innovation in upcoming years
Chapter Outline
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
The Road from There to Here
Major Causes of Financial Innovation
The Beginning Regulatory Structure
The Analytic Foundations of Financial Innovation
Early Financial Innovations
Innovations in the Payments System
Other Recent Innovations
A.
Derivatives
B.
Swap Agreements
C.
Securitization
Other Characteristics of the Financial System
Answers to Review Questions
Briefly discuss the incentives that have led to a rapid pace of financial innovation in the
last 40 years.
Because financial claims are fungible and because other incentives h ave been present, the last
forty years have seen a high level of financial innovation. This has occurred because the
benefits of innovating have exceeded the costs.
The incentives to innovate include rising interest rates -which led to disintermediation, volatile
interest rates which increased interest rate risk, technological advances which affected
payments technologies, and increased competition.
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What is disintermediation? When is disintermediation likely to
occur? What factors can reduce it? If I take my funds out of
my credit union and put them in a money market mutual fund,
have I disintermediated? Why or why not?
Disintermediation is the removal of funds from a financial intermediary. Disintermediation is
likely to occur when direct lending in a financial market offers a higher rate of return.
Removing regulations, especially Regulation Q, can help reduce disintermediation because the
intermediary is able to offer higher rates to compete with open market instrument when interest
rates rise. If I take my funds out of my credit union and put them in a money market mutual
fund, I have not disintermediated because my funds are still deposited in a financial
intermediary, the money market mutual fund.
Discuss the roles that technology and regulation play in aiding financial innovation. Will
innovation always occur to exploit loopholes in regulations?
Financial innovation is the adoption of new technologies and products to increase profitability.
In recent years, technological advances in telecommun ication and computer technologies have
led to many innovations that have reduced the cost of making payments and transferring funds.
Information technologies have also fostered the creation of new financial products and the
globalization of finance.
Innovation will occur to find loopholes in regulations whenever the regulations are binding —
that is, whenever the regulations force the intermediary into behavior that it would not
otherwise adopt and hence causes it to earn less profit. The pace of innovat ion accelerates
whenever the benefits increase. For example, when interest rates rise, the benefits of finding
ways around Regulation Q interest rate ceilings increased. Also, when interest rate and
exchange rate volatility increased, the benefits to fin ding innovations that hedged interest rate
and exchange rate risk increased.
What are nondeposit liabilities? Give some examples. What are
negotiable CDs? How do nondeposit liabilities differ from
negotiable CDs? What are retail sweep accounts?
Nondeposit liabilities are borrowed funds, such as Eurodollar borrowings, fed funds, and
repurchase agreements, which are not deposits and not subject to reserve requirements or
Regulation Q ceilings. Nondeposit liabilities often result from the re -labeling of deposit
liabilities to nondeposit liabilities to get around regulations that pertain to deposits.
Negotiable CDs are large certificates of deposit, which have a secondary market. Unlike
nondeposit liabilities, negotiable CDs do not entail the re -labeling of deposit liabilities because
negotiable CDs are deposit liabilities.
A more recent innovation, retail sweep accounts are the re -labeling of deposit liabilities to
nondeposit liabilities. First appearing in 1994, they “sweep” balances out of transaction s
accounts that are subject to reserve requirements and into other deposits (usually money
market deposit accounts) that are not. Required reserves fall by the amount of funds in sweep
accounts multiplied by the required reserve ratio. As required reserve s fall, ceteris paribus,
banks have more funds to lend.
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What is Regulation Q? Regulation D? Discuss ways banks have found
to get around both regulations.
Regulation Q set interest rate ceilings on deposits at commercial banks. Regulation Q was
enacted during the Great Depressions in the 1930s and was phased out in the early 1980s.
Regulation D prescribed reserve requirements on deposits at commercial banks. Banks found
innovations to get around both regulations. For example, nondeposit liabilities s uch as fed
funds, repurchase agreements, and Eurodollar borrowings re -labeled deposit liabilities to nondeposit liabilities and got around both regulations. Negotiable CDs are another innovation that
got around interest rate ceilings and reserve requireme nts.
What is securitization? How does securitization reduce interest
rate risk? Name some types of liabilities that are now
securitized.
Securitization is the process whereby relatively illiquid financial assets such as mortgages are
packaged together and sold off to individual investors. Securitization turns relatively illiquid
instruments into quite liquid investments called asset -backed securities. A market maker agrees
to create a secondary market by buying and selling the securities. Securitization ori ginated in
the mortgage market in the early 1980s, when mortgage loans began to be packaged together
and sold off as securities in the secondary market often with government insurance
guaranteeing that the principal and interest would be repaid. Securitiza tion became popular
because it provides a way of protecting against interest rate risk in an environment of increased
interest rate volatility. Securitization offers reduced credit risk because of the pooling of
assets.
Since the mid-1980s, securitization has spread from the mortgage market to other markets
including credit card balances, automobile and truck loans and leases, accounts receivable,
computer leases, home equity loans, student loans, railroad car leases, small business loans,
and boat loans. Banks, finance companies, retailers, thrifts, and others issue asset -backed
securities that provide them with new funds to lend.
Securitization, which is a form of direct finance, has experienced phenomenal growth since the
early 1990s and may replace much of the lending that historically has gone through traditional
intermediaries (indirect finance).
Discuss some characteristics of the financial system of the early
2000s that make it different from earlier periods.
There are many differences in the financial system in the early 2000s than in recent decades.
First, deregulation had made the financial system much less regulated. Also, the financial
sector is becoming more competitive because (1) geographic barriers for financial services are
disappearing; (2) FIs are becoming less specialized; (3) interest rate ceilings and usury laws
have been abolished; (4) securitization is spreading to many markets; (5) financial futures and
options are increasingly being used to hedge risk; (6) financial transacti ons are becoming
increasingly automated; and (7) banks are expanding into other areas, such as data processing,
leasing, etc. In addition, the financial system has become globalized because of technological
advances in the transfer of funds.
How have increased competition and price volatility affected
financial innovation? What are some specific types of
innovation that deal with these factors?
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Increased competition and price volatility are two of the primary factors that have fostered
financial innovation in recent decades. Because banks have faced increased competition from
other financial intermediaries and other nonfinancial institutions, they have innovated into new
product areas in order to meet and “beat” the increased competition. For example, banks have
developed new sources of income such as fee income and new product lines because of
increased competition. Also, the development of nondeposit liabilities allows banks to
maintain lending even if they lose deposits to their competition throug h disintermediation.
Technological advances and new assets have been and are being developed to mitigate greater
competition and price volatility.
How do collateralized mortgage securities differ from mortgagebacked securities? Which has less risk?
Mortgage-backed securities result from the process of securitization of mortgages when
market makers package mortgage loans and sell them to individual investors in the secondary
market. Although mortgage-backed securities sometimes carry government guaran tees, there
are still several risk involved including credit risk, interest rate risk, and prepayment risk.
Prepayment risk is the risk that the mortgages will be paid off or refinanced early when interest
rates fall and the proceeds to the lender will h ave to be reinvested at a lower interest rate.
Collateralized mortgage securities may reduce this risk by redirecting the cash flows of
mortgage related instruments to various classes of bondholders. Collateralization allows a risk
averse investor to choose an instrument with an early repayment of principal. For this reason,
collateralized mortgage securities can offer less risk as compared to mortgage -backed
securities
Defend the following statement. Once an innovation appears, it will remain even aft er the
impetus for its development disappears. Give an example.
As long as there is profit to be gained by utilizing a particular innovation, the innovation will
remain, even after the impetus for its development disappears. An example is money market
mutual funds. The initial impetus was to create a vehicle for small investors to get around
Regulation Q ceilings. Money market mutual funds did not disappear even after Regulation Q
ceilings were removed.
Discuss how banks can reduce their reserve require ments.
Banks can reduce their reserve requirements by encouraging their customers to transfer funds
from deposit accounts subject to reserve requirements into accounts that are not. Examples of
such accounts would be eurodollar deposits, negotiable CDs, a nd retail sweep accounts.
Are financial claims more fungible today than in the past? Why?
Financial claims are more fungible today than in the past because of technological advances in
computer and information technologies. Funds are more easily conv erted into other financial
instruments and transferred globally than in the past.
Why didn’t banks innovate to get around regulations in the 1940s
and 1950s?
There are several reasons why banks didn't innovate to get around regulations in the 1940s and
1950s. First, many of the regulations such as Regulation Q were not constraining in the 1940s
and 1950s. The Regulation Q ceiling rates were lower than open market rates. Second,
financial markets were more segmented and banks did not face as much competit ion from other
financial and nonfinancial institutions as after 1960. Also, during the 1960s, prices, inflation,
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interest rates, and exchange rates became more volatile than before, that made innovations to
deal with volatility more profitable. Financiall y, computer and information technologies led to
cost saving innovations and the proliferation of new financial instruments.
Explain why asset-backed securities are an example of direct
finance. If a bank issues asset-backed securities, how does it
get new funds to lend?
The asset-backed securities market is one where lenders (SSUs) lend their funds directly to
borrowers (DSUs). Thus, the process of securitization that gives rise to the asset -backed
securities market is an example of direct finance. When a bank issues an asset-backed
security, the purchaser does not have a claim on the bank, but rather the pool of assets that
back the security.
When a bank issues an asset-backed security, it obtains fresh funds that are available for new
loans.
Answers to Analytical Questions
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?
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. 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.
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. 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.
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?
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 e urodollar deposits. Therefore, when
Financial Innovation
Microsoft converts its $2 million demand deposit at Chemical Bank to a eurodollar deposit
excess reserves increase by $200,000. Chemical Bank can sa fely lend all excess reserves.
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