Chapter 10: Innovation and Structure in Banking and Finance

Chapter Objectives• Explain why bankers and other financiers innovate.• Explain how widespread unit banking in the United States affected financial innovation.• Explain how the Great Inflation of the 1970s affected banks and banking.• Define loophole mining and lobbying and explain their importance.• Describe how technology changed the banking industry after World War II.• Define traditional banking and describe the causes of its demise.• Define industry consolidation and explain how it is measured. • Define financial conglomeration and explain its importance.• Define industry concentration and explain how is it measured.

1. Early Financial Innovations

Chapter Objectives• Explain why bankers and other financiers innovate.• Explain how widespread unit banking in the United States

affected financial innovation.

Why do bankers and other financiers innovate in the face of branching restrictions and other regulations?

1. Early Financial Innovations

Why innovation?

Six functions delivered by financial systems: • Moving funds across time and space• The pooling of funds • Managing risk• Extracting information to support decision-making • Addressing moral hazard and asymmetric information problems• Facilitating the sale of purchase of goods and services through a

payment system

1. Early Financial Innovations

Earlier in America

Restricted markets

unit banksno interstate banking or branching

Restricted competitionno interstate banking or branching

local monopolies

Stable profits/spreads

• Spreads between sources of funds and uses of funds were large and stable, leading to the infamous 3-6-3 rule– Borrow at 3 percent, lend at 6 percent, and golf at

3 p.m.

1. Early Financial Innovations

2. Innovations Galore

1968-1982the aggregate price level rose over 110%

“The Great Inflation”caused increases in

Interest ratesInterest rate volatility

Interest rate risk

2. Innovations Galore

• Bankers responded to the increased interest rate risk by inducing others to assume it– Solution was to get borrowers to take on the risk by

inducing them to promise to pay some market rate • Bankers’ response to increased competition and

disintermediation– Finding new and improved ways to connect to

customers, e.g. ATMs

3. Loophole Mining and Lobbying

• Competition for profits drives bankers and other financiers to look for regulatory loopholes– A process called loophole mining

• Permissive regulatory system: A system that allows financiers to engage in any activities they wish that are not explicitly forbidden– It is easier for financial innovation than a restrictive

regulatory system

3. Loophole Mining and Lobbying

• Disintermediation: The opposite of intermediation, when investors pull money out of banks and other financial intermediaries

3. Loophole Mining and Lobbying

Disintermediation

Loophole mining

Non-bank banks

Sweep accounts

Bank holding companiesRegulatory reform

3. Loophole Mining and Lobbying

Sweep accountsLowered reserve

requirements

Insignificant reserve

requirements?

3. Loophole Mining and Lobbying

Bank holding companies

Added services

Financial service

companies?

4. Banking on Technology

Computing Technology

Credit cards

Debit cards

ATMs

Online banking

Securitization

• The process of combining multiple mortgages or other loans into a single instrument, usually for resale to institutional investors such as hedge funds or investment banks

Securitization

4. Banking on Technology

5. Banking Industry Profitability and Structure

Disintermediation

Deregulation

Competition

Technology

Operating Efficiencies

Competition

5. Banking Industry Profitability and Structure

Effect of competition

Banks pay more for deposits• Liabilities cost more

Banks charge less interest on loans• Assets return less

Profitability decreases

5. Banking Industry Profitability and Structure

Deregulation: Major developments

• In early 1930s, commercial and investment banking activities were strictly separated by legislation called Glass-Steagall– Gradual erosion of Glass-Steagall in the late 1980s and

1990s and de jure elimination in 1999 allowed investment and commercial banks to merge and to engage in each other’s activities

• Regulatory changes, called deregulation, and the decline of traditional banking– Resulted in banks beginning to merge in large numbers, a

process called consolidation– Banks began to enter into nonbanking financial activities,

like insurance, a process called conglomeration

5. Banking Industry Profitability and Structure

Deregulation: Major developments

5. Banking Industry Profitability and Structure

Effect of competition

Consolidation and Conglomeration

Less profitability

More competition

Deregulation

5. Banking Industry Profitability and Structure

Evolution of industry structure

AdvantagesConsolidation Economies of ScaleBanks merge Diversify geographically

Conglomeration Economies of ScopeBanks add services Diversify operations

5. Banking Industry Profitability and Structure

Evolution of industry structure

DisadvantagesConsolidationBanks merge Encourage too much risk?

ConglomerationBanks add services Lose efficiencies of specialization?

Create moral hazard: “too big to fail”?

• A measure of market concentration calculated by summing the square of the market shares of the companies operating in a given market

• Alternatively N-concentration Index

Herfindahl Index

5. Banking Industry Profitability and Structure

5. Banking Industry Profitability and Structure

Evolution of industry structure

• Concentration: Fewer banks control larger share of assets, deposits, capital

• Starting a new bank is not as difficult as it sounds• The U.S. allows individuals to establish other types of

depository institutions• Foreign banks can enter the U.S. market relatively

easily– U.S. banks can operate in other countries.