Financial Innovation Flashcards
What is financial innovation
» the introduction or creation of new financial products, services or processes.
Financial innovation is driven by the desire to earn profits
» What is the difference between the two?
» The process of researching and developing new financial products and services (innovations) that meet customer needs and are likely to be profitable: financial engineering.
Recent financial innovations
» Mobile banking financial services e.g. M-Pesa in Kenya.
» Digital currencies e.g. cryptocurrencies and proposed CBDC.
» Remittance technology e.g. WorldRemit.
Investment crowdfunding
opens up and enables the process of raising equity capital more democratic.
Peer to peer (P2P) lending
Direct lending between lenders and borrowers online outside traditional financial intermediaries like banks.
UK has the largest P2P lending market in Europe.
P2P platforms in the UK include: Zopa, Funding Circle UK etc.
Types of financial innovation
Responses to changes in demand conditions: interest rate volatility.
» Adjustable-rate mortgages
Flexible interest rates keep profits high when rates rise.
Lower initial interest rates make them attractive to home buyers.
» Financial derivatives
Payoffs are linked to previously issued (i.e., derived from) securities. Ability to hedge interest rate risk.
Futures contracts, in which the seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed-on price,
Avoidance of existing regulations
» Loophole mining and innovations occur to avoid regulation.
Reserve requirements implication
Reserve requirements act as a tax on deposits.
- Because up until 2008 the Fed did not pay interest on reserves, the opportunity
cost of holding them was the interest that a bank could otherwise earn by lending the reserves out. For each dollar of deposits, reserve requirements therefore
imposed a cost on the bank equal to the interest rate, i,
Restrictions on interest paid on deposits
Restrictions on interest paid on deposits led to disintermediation.
- the Fed set maximum limits on the interest rate that could be paid on
savings and time deposits. To this day, banks are not allowed to pay interest on corporate checking accounts. The desire of banks to avoid these deposit rate ceilings
also led to financial innovations.
If market interest rates rose above the maximum rates that banks paid on sav-
ings and time deposits under Regulation Q, depositors withdrew funds from banks
to put them into higher-yielding securities. This loss of deposits from the banking
system restricted the amount of funds that banks could lend (called disintermediation) and thus limited bank profits. Banks had an incentive to get around deposit
rate ceilings, because by so doing, they could acquire more funds to make loans
and earn higher profits.
Money market mutual funds
Bruce Bent and the Money Market Mutual Fund Panic of 2008.
- Money market mutual funds issue shares that are redeemable at a fixed price (usually $1) by writing checks. For example, if you buy 5,000 shares for $5,000, the money market fund uses these funds to invest in short-term money market securities (Treasury bills, negotiable certificates of deposit, commercial paper) that provide you with interest payments.
In addition, you are able to write checks up to the $5,000 held as shares in the money market fund. Although money market fund shares effectively function as checking account deposits that earn interest, they are not legally deposits and so are not subject to reserve requirements or prohibitions on interest payments. For this reason, they can pay higher interest rates than deposits at banks.
Sweep accounts
any balances above a certain amount in a corporation’s checking account at the end of the business day are removed and invested in overnight securities that pay the corporation interest.
- Helps to avoid the “tax” from reserve requirements
Responses to changes in supply conditions
information technology.
» Bank credit and debit cards
Improved computer technology lowers transaction costs. Contactless cards.
» Electronic banking ATM – automated teller machine
Home banking.
Mobile banking - M-Pesa.
Virtual banking - Monzo, N26, Starling etc.
Mobile (digital) wallets - Wechat pay, Alipay. Alipay vs Wechat pay, who is leading the market?
Junk Bonds
Some firms that had fallen on bad times, known as fallen angels, had previously issued long-term corporate bonds with ratings that had now fallen below Baa, bonds that were pejoratively dubbed “junk bonds.”
With the improvement in information technology in the 1970s, it became easier for investors to acquire financial information about corporations, making it easier to screen out bad from good credit risks. With easier screening, investors were more willing to buy long-term debt securities from less-well-known corporations with lower credit ratings. With this change in supply conditions, we would expect that some smart individual would pioneer the concept of selling new public issues of junk bonds, not for fallen angels but for companies that had not yet achieved investment-grade status.
Commercial paper market
Commercial paper is a short-term debt security issued by large banks and corporations.
Improvements in information technology also help explain the rapid rise of the commercial paper market. We have seen that improvements in information technology made it easier for investors to screen out bad from good credit risks, thus making it easier for corporations to issue debt securities. Not only did this make it simpler for corporations to issue long-term debt securities, as in the junk bond market, but it also meant they could raise funds by issuing short-term debt securities, such as commercial paper, with greater ease.
Innovation benefitting the economy
Some of this business has been replaced by the shadow banking system, in which bank lending has been replaced by lending via the securities markets, with the involvement of a number of different financial institutions.
Similarly, to maximize their profits, financial institutions develop new products to satisfy their own needs as well as those of their customers; in other words, innovation—which can be extremely beneficial to the economy—is driven by the desire to get (or stay) rich.
This view of the innovation process leads to the following simple analysis: A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable.
To survive in the new economic environment, financial institutions had to research and develop new products and services that would meet customer needs and prove profitable, a process referred to as financial engineering.
Securitisation
Securitisation is:
» A financial innovation that entails lumping together of a large number of financial instruments.
Securitization is the process of bundling small and otherwise illiquid financial assets (such as residential mort- gages, auto loans, and credit card receivables), which have typically been the bread and butter of banking institutions, into marketable capital market securities. Securitization is the fundamental building block of the shadow banking system.
» For instance, mortgages, autoloans then dividing them into smaller different pieces that appeal to different types of investors.
Transforms otherwise illiquid financial assets into marketable capital market securities.
loan origination ⇒ servicing ⇒ bundling ⇒ distribution Due to process involved, securitisation is also known as
originate-to-distribute business model.
Main objective of securitisation is to diversify risk
