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Chapter 15
Financial Innovation
©2000 South-Western College Publishing
Financial Innovation
•The creation of new financial
instruments, markets, and
institutions in the financial
services industry
•New ways for people to spend,
save, and borrow funds
•Changes in the operation and
scope of activity by financial
intermediaries
2
Glass-Steagall Act of 1933
•Banking legislation enacted in
response to the Great Depression
•Established Regulation Q ceilings
•Separated commercial and
investment banking
•Created the FDIC
3
Regulation Q
Interest rate ceilings on
deposits at commercial
banks established during
the Great Depression and
phased out after 1980
4
Fungible means...
A characteristic referring to
the ease with which a
financial instrument can be
converted to another
5
Disintermediation
The removal of funds from a
financial intermediary
6
The Reasons for Financial Innovation in the Past 35 Years
Costs Fell
Computer and telecommunications
technology reduced the transactions costs
of moving and monitoring funds
Benefits
Increased
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
Exhibit 15 - 1
7
Nondeposit Liabilities
Borrowed funds, such as
Eurodollar borrowings, fed
funds, and repurchase
agreements, that are not
deposits and not subject to
reserve requirements
8
Regulation D
A regulation that prescribed
reserve requirements on
some deposits
9
The Anatomy of Eurodollar
Borrowing
General Motors
$1,000,000
Demand Deposit
Chase New York
Chase London
Exhibit 15 - 2
10
Deregulation
The dismantling of
existing regulations
11
Depository Institutions Deregulation
and Monetary Control Act of 1980
• Phased out Regulation Q
• Established uniform and universal
reserve requirements
• Increased the assets and liabilities
depository institutions could hold
• Authorized NOW accounts
• Suspended usury ceilings
12
Usury Ceilings
Maximum interest rates
that FIs are allowed to
charge borrowers on
certain types of loans
13
Universal Reserve
Requirements
Reserve requirements
established by the Fed to which
all depository institutions would
be subject
14
Uniform Reserve
Requirements
The same reserve requirements
across all depository institutions
would apply to particular types of
deposits
15
Garn-St. Germain Depository
Institutions Act of 1982
Additional deregulation act
that authorized money
market deposit accounts and
Super Now accounts
16
Reregulation
Imposing new regulations in
response to innovations that
weakened existing regulations
17
Securitization
•The process whereby relatively
illiquid financial assets are
packaged together and sold off
to individual investors
•Result in Pass-through
Securities
18
Financial Market Changes in the 1990s
Geographic barriers
to deposit taking,
loan granting and
other services are
reduced
Banks are relying
on fee income as
their share of
intermediation
declines
Fls are making
extensive use of
derivatives and
other instruments
to unbundle risks
Fls are less specialized
because of mergers with
other financial services
firms and because
of engaging in other activities
Financial
Market
Changes
Fls and
payment
mechanisms
are automated
Interest rate
ceilings are eliminated
increasing
competition
and reducing profit
margins
Securitization
is increasing and
spreading from the
mortgage market to
many other markets
Collateralized
mortgage obligations
allow prepayment
risks to be different
classes of bondholders
19
Exhibit 15 -2