Week 9 Deck Flashcards
Define Financial Innovation (2)
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 financial innovation and financial engineering
The process of researching and developing new financial products and services (innovations) that meet customer needs are likely to be profitable: financial engineering
What are some recent financial innovations?
- Mobile banking financial services eg M-Pesa in Kenya
- Digital currencies eg cryptocurrencies and CDBC
- Remittance technology eg World Remit
- Investment crowdfunding
§ Opens up and enables the process of raising equity capital more democratic
- Peer to peer (P2P) lending
§ Direct lending between lender and borrowers online outside traditional financial intermediaries like banks
§ UK has the largest P2P lending markets in Europe
§ P2P platforms in the UK include: Zopa, funding circle UK etc
Figure 2 displays P2P consumer lending cumulative loan platform
What are the three types of financial innovation?
- Responses to changes in demand conditions
- Responses to changes in supply conditions
- Avoidance of existing regulations
Types of financial innovation
Explain 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 issues (ie derived from) securities
- Ability to hedge interest rate risk
Types of financial innovation
Explain in terms of avoidance of existing regulations
- Loophole mining and innovations occur to avoid regulation
- Reserve requirements act as tax on deposits
- Restrictions on interest paid on deposits led to disintermediation
- Money market mutual funds
- Bruce bent and the money market mutual fund panic of 2008
- Sweep accounts: any balances above a certain amount in a corporations checking account at the end of the business day are removed and invested in overnight securities that pay the corporation interest
Types of financial innovation
Explain in terms of Responses to changes in supply conditions: information technology
- Bank credit and debit card
- Improved computer technology lowers transactions costs
- Contactless card
- Electronic banking
§ ATM
§ Home banking
§ Mobile banking - M-Pesa
§ Virtual banking - Monzo, n26, starling
§ Mobile (digital) wallets - Wechat pay, Alipay - Junk bonds
- Commercial paper market
- Securitisation
What is Securitisation in terms of shadow banking? (3)
A financial innovation that entails lumping together of a large number of financial instruments
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
What is the process of securitisation and the main objective of it?
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
What were the 3 key financial instruments used prior to the GFC as part of securitisation?
- Mortgage-backed security (MBS)
- Collateralized debt obligation (CDO)
- Credit default swap (CDS)
Explain what is a Mortgage-backed security (MBS)
- Financial asset secured by mortgages, returns are generated from the interest on mortgages
- Credit risk from mortgages default is mitigated using diversification and ‘tranching’
- Diversification: Mortgages for the MBS are taken from different geographical regions in the US
- ‘Tranching’: the junior tranche absorbs default losses before the senior tranche, hence is riskier and yields a higher return
What is a Collaterilaised debt obligation (CDO)?
- Similar to MBS but backed by a bundle of loans (tranched)
- Originally developed as instruments for the corporate debt market
- CDO risk comes from the ‘correlation’ of the underlying loans: high correlation => defaults occur together => high risk
What is a Credit Default Swap (CDS)?
- ‘super-senior’ tranche from the above CDOs had low returns were kept by banks themselves
- AIG sold insurance on these CDOs in the form of CDS (full repayment should the ‘super senior’ tranches ever default)
Draw the diagram which explains the relationship between MBS, CDOs and CDS
SEE NOTES
Explain how securitisation played a prominent role in the development of a new financial innovation
- The subprime mortgage market in the mid 2000s
- Subprime mortgages: new class of residential mortgages offered to borrowers with less than good credit records
