Chapter 9 Financial Innovation. 2 Major causes of financial innovation Major causes of financial innovation The Analytic foundations of financial

Chapter 9

Financial Innovation

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Major causes of financial innovation The Analytic foundations of financial inno

vation Early financial innovations

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What is Financial innovation?

Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries.

金融创新：金融服务业产生的新型金融工具、金融市场和金融机构；人们消费、储蓄、借贷的新方法；金融中介机构经营方式和经营范围的改变。

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driving force of Innovation

The driving force behind innovation is that participants in the economy are simply trying to came as close as possible to achieving their objectivesif circumstances pose a barrier to achieving an

objective, there is an incentive to find a way around the obstacle “necessity is the mother of invention”

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Causes of Financial Innovation

New computer and information technologies available

Avoidance of regulations Increased competition from other financial

and nonfinancial innovations Higher volatility of prices, inflation, interest

rates, and exchange rates

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The Beginning Regulatory Structure

The regulatory structure in place at the beginning of the 1970s was a product of the Great DepressionThe Glass-Steagall Act of 1933

created interest rate ceilings (Regulation Q)created deposit insuranceplaced limits on the types of assets that commercial

banks could hold

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An FI compares the costs and benefits associated with altering a prevailing portfolio practiceif the benefits > costs, the FI has a clear

incentive to innovate and alter the prevailing practice

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Since the 1970s, computer and telecommunications technologies have become increasingly availablehave reduced the transactions costs associated

with managing, moving, and monitoring fundshave allowed for the globalization of financial

markets

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Technological advances have also allowed the risks associated with a particular financial asset to be unbundledallows the specific risks of one financial asset to

be borne by different investorsmakes the financial market more efficient

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The persistent inflation and rising interest rates in the late 1960s and 1970s led to an incentive for banks to develop new products to avoid the binding effects of Regulation Qnet lenders simply looked for alternatives outside

the banking system (disintermediation脱媒 )banks responded by developing money market

mutual funds

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Since the mid-1970s, banks have been challenged by a sharp rise in competition form other domestic and global financial and nonfinancial institutionsto respond, all FIs have become less

specialized and more alikebank holding companies offer investment and

financial advice, leasing, data processing, and tax planning

financial holding companies provide services that go far beyond the scope of banking

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The greater volatility of prices, stock values, interest rates, and exchange rates increases the risks associated with intermediationthis has led to the development of new assets

financial forwards, futures, and options markets attempt to hedge interest rate and exchange rate risks

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The Reasons for Financial Innovation over the Past 40 Years

Costs FellComputer and telecommunications technology reduced the transactions costs of managing, 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.

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recap

Financial innovation is the creation of new financial instruments, markets, and institutions, new ways for people to spend, save, and borrow funds, and changes in the operation and scope of activities by financial intermediaries.

Financial innovation will occur whenever the benefits of innovating are greater than the costs. The last 40 years have seen rapid financial innovation.

By the 1960s, the regulatory structure that was put into place in the 1930s (the Glass-Steagall Act) was inhibiting bank profitability, giving a strong incentive to innovate around the regulations.

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Ongoing from the 1970s, advances in computer technology increased the fungibility （替代性：一种金融工具转化为另一种金融工具的难易程度。） of funds (the ease with which a financial instrument can be converted to another) and fostered financial innovation.

Higher interest rates which increased disintermediation made innovating around interest rate ceilings more profitable.

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Increasing competition from other intermediaries and nonfinancial corporations also increased the benefits of innovation to meet the increased competition.

Greater price and interest rate volatility increased the benefits of finding innovations to reduce the risks from increased uncertainty.

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Early Financial Innovations

Reserve requirements specify the reserve assets that banks and other depository institutions must hold as a proportion of their deposit liabilitiesif the requirements force banks to hold more

reserves than they otherwise would, this constitutes a tax on bank earningswhat cannot be loaned cannot earn interest

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One way to reduce this burden is for banks to shift from deposits to nondeposit liabilities

非存款负债：借入资金，即不受存款准备金限制的非存款，如借入的欧洲美元、联邦基金和回购协议。these include Eurodollar borrowings, fed funds,

and repurchase agreementsexempt from reserve requirementsnot subject to Regulation Q ceilings

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Eurodollarsdollar-denominated deposits held abroadU.S. banks borrow Eurodollar deposits to obtain

additional funds

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Fed Fundsreserves that banks trade among themselves

for periods of one to several daysthe interest rate determined in the market for

fed funds is the fed funds ratestarting in the 1960s, large banks came to

look at the fed funds market as a permanent source of funds

smaller banks with fewer lending opportunities tended to be net lenders in this market

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Overnight Repurchasing Agreementan agreement in which a bank takes a

government security from its asset portfolio and sells it with the simultaneous agreement to buy it back tomorrow at a price set today the difference in the selling and buying prices is

the interest the lender receives from the bank

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Retail Sweep Accounts（零售隔夜账户）一种金融创新，通过将那些受到准备金管制的交易账户的隔夜余额提取出存入不受准备金管制的账户，存款债务变成非存款债务。sweep balances out of transactions accounts

that are subject to reserve requirements and puts them in other deposits (such as money market deposit accounts) that are not

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Negotiable Certificates of Deposit (CDs)creation of a secondary market for CDs in

1961a corporation with excess funds can invest in

a negotiable CD with the knowledge that the CD could be sold in the secondary market if funds were needed before the CD matures

reserve requirements on all negotiable CDs were eliminated by the end of 1973

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As these innovations weakened the effectiveness of various regulations, regulators recognized the difficulty of controlling financial flows and the market for financial servicesthey decided to deregulate （放松管制） the

market in the early 1980s

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Deregulation

Legislation was enacted by Congress in 1980 and 1982phased out regulation Qexpanded the asset and liability powers of

banks and thriftsallowed thrifts to offer checkable depositsestablished reserve requirements that applied

to and were the same for all depository institutions

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Deregulation

Two other laws in the mid- and late-1990s provided further deregulationeliminated most restrictions on interstate

bankingallowed banks to merge with securities and

insurance firms

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recap

Early financial innovations include the development of nondeposit liabilities such as Eurodollar borrowings, negotiable CDs, repurchase agreements and fed funds.

Eurodollar borrowings (Borrowings by banks of funds in the Eurodollar market) are not subject to interest rate ceilings (Regulation Q) or reserve requirements (Regulation D).

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Large banks used the repurchase agreement and fed funds markets as permanent sources of funds to lend. Thus, banks can keep lending despite central bank restraint in the provision of funds.

Negotiable CDs allowed banks to attract additional funds to lend because they can be sold in secondary markets if the funds are needed before the CDs mature.

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In the early 1980s, Congress passed two major deregulation statutes that phased out Regulation Q ceilings, expanded the asset and liability powers of banks and thrifts, allowed all thrifts to offer checkable deposits and established the same reserve requirements for all depository institutions.

Retail sweep accounts are a more recent innovation that relables deposit liabilities to nondeposit liabilities by “sweeping” balances out of transactions accounts that are subject to reserve requirements and into other accounts that are not.

Two other laws in the 1990s removed restrictions on interstate banking and allowed banks to merge with securities firms and insurance companies.

Documents

Chapter 9 Financial Innovation. 2 Major causes of financial innovation Major causes of financial innovation The Analytic foundations of financial