This document provides an overview of financial innovation, globalization, and regulation. It discusses key innovations like securitization, collateralized debt obligations, and adjustable-rate mortgages. It describes how securitization transforms illiquid assets into marketable securities. The document also examines financial globalization through international financial markets and banking, and the benefits this provides to both savers and borrowers globally by allowing funds to flow across borders. Finally, it touches on the role of regulation in the financial system.

1. Learning Unit #6
Financial Innovation, Globalization,
and Regulation

2. Objectives of Learning Unit
• Financial Innovation
– New Products, Services, Organizations, Production
• Financial Globalization
– International Financial Markets
– International Banking
• Financial Regulation
– Why, Who, What, & How

3. Financial Innovation
• Financial innovation: Introduction of new
product & service, new organization, new
production method, new marketing method
etc. in financial system
• Changes in technology, regulation, economic
condition, competition & demand lead to
innovation in the financial system.

4. Recent Financial Innovation
• Innovation in financial services and products
– Securitization
– Collateralized-debt obligation (CDO)
– Subprime loans
– Adjustable-rate mortgage loans
• Innovation in financial organization
– Special purpose entity (SPE)
– Structured investment vehicle (SIV)
– Hedge funds (Refer to Learning Unit #3)
• Innovation in production method
– Online banking/investment

5. Securitization
• Securitization: A process of transforming illiquid financial
instruments into marketable (liquid) financial instruments
– Ex. Banks (originator) made mortgage loans to households
(borrowers). Next, the banks sell the mortgage loans to a
securitization firm which pool various mortgage loans as its assets.
Then, the securitization firm issues standardized debt instruments (e.g.
mortgage-loan backed bonds) to savers.
– Securitization turns illiquid asses (mortgage loans which cannot be
traded in the secondary market) into marketable securities (bonds
which can be traded in the secondary market).
– Like mutual funds, the payment to bond holders by the securitization
firm is backed of payments on mortgage loans by borrowers
(households). The value of bond is based on the value of mortgage
loans that the securitization owns as assets.

6. Process of Securitization
Source: US Federal Deposit Insurance Corporation
http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spapr1707.html

7. Public Securitization Organization
• Government-sponsored entity (GSE)
– The government established securitization firms for sole
purpose of providing funds to particular segments of
economy.
• Government National Mortgage Association (Fannie Mae),
Federal Home Loan Mortgage corporation (Freddie Mac), &
Government National Mortgage Association (Ginnie Mae)
securitize mortgage loans to provide more funds to banks for
mortgage loans.
• Student Loan Market Association (Sallie Mae) securitizes federally
guaranteed student loans.
– By purchasing particular (student) loans, GSE (Sallie Mae)
provides more funds to financial intermediaries and
encourage them to make even more (student) loans to
borrowers (students).

8. Private Securitization Organization
• Special purpose entity (SPE)
– Financial institutions establish SPE to securitize
particular loans of own and others.
• Ex. Bank of America SPE (Endeavor) purchases
mortgage loans from Bank of America and issues asset-
backed securities (ABSs).
• Ex. Bear Sterns SPE purchased subprime mortgage
loans from Bear Stern Commercial Mortgage and other
mortgage firms and issued asset-backed securities.

9. Types of Securitized Assets
• Any illiquid financial instruments (mostly
consumer and business loans)
– Mortgage loans
– Home equity loans
– Student loans
– Credit card receivables
– Automobile loans

10. Types of Securitization
• SPE issued different types of marketable securities
backed by various types of assets:
– Collateralized debt obligations (CDOs): a type of asset-
backed securities (issued by SPE for securitization). They
are backed by a pool of bonds, loans, and other financial
assets rather than a particular type of assets.
– Collateralized mortgage obligations (CMOs): a mortgage-
backed securities.
– Collateralized bond obligations (CBOs): securities backed
by a pool of junk (low grade, high risk) bonds.

11. Structured Investment Vehicle
• Structured investment vehicle (SIV): raises funds by
issuing short-term securities and uses its proceeds to
purchase long-term securities.
– During the subprime mortgage loan crisis, a financial
institution established a SIV which issued commercial
papers or other short-term securities (which were often
purchased by the SIV’s parent financial institution), then
the SIV purchased mortgage-backed securities issued by
SPE (which was often owned by the same financial
institution which owned the SIV).
– Ex. Wachovia bank lost $40 million mortgage-baked CP
issued by its Boston-based Evergreen Investment
Management Co. unit in 2007.

12. Adjustable-rate Mortgage Loans
• Adjustable rate mortgage loans: mortgage loans on
which the interest rate changes when a market interest
rate changes.
– Interest rate on most adjustable-rate mortgage loans is
based on the U.S. Treasury bill rate.
– The interest rate on adjustable-rate mortgage loans is
changed every six months or so.
– In general, interest rates on adjustable-rate mortgage loans
are lower than those of fixed-rate mortgage loans at the
beginning due to higher risk for borrowers (lenders lower
the initial interest rate to compensate for higher risk that
borrowers must bear).

13. Loans for Bad Credit
• Prime loans are made to borrowers with good
credit, while borrowers with bad credit can still
borrow from financial institutions.
– Subprime loans: loans made to borrowers who
are not qualified for prime loan due to low credit
rating or higher risk. Ex. Countrywide Financial
– Alt-A loans: loans made to borrowers whose
financial profile is between prime and subprime.
– NINJA loans: loans made to borrowers with "no
income, no job and no assets“ where lenders
ignore credit check of borrowers.
– Payday loans: short-term loans until borrower’s
next payday. Ex. Cash Advance

14. Types of Subprime Mortgage Loans
• Interest-only payment loans: borrowers pay only
interest for the first 5 years.
• Pay option loans: borrows have flexibility of
payments (interest only, full payment, or minimum
balance payment).
• Hybrid loans: fixed-rate for first few years, then
converted to adjustable-rate.
– Ex. 2-28 loan is a 30-year loan that offers a low fixed
introductory rate for the first two years, then resets to a
higher adjustable rate for 28 years.

15. Shadow Banking System
• Shadow banking: Non-depository financial institutions,
such as hedge funds and investment banks, provide
financial services very similar to banking services (e.g.
mortgage loans).
• Shadow banking system provided funds to mortgage
firms through securitizations.
• Shadow banking was not subject to the banking
regulation, allowing them to take too much risk and to
create financial products (e.g. sub-prime loans) which
could not be allowed for banks under regulation.
• This lead to the financial crisis in 2008 in the U.S.

16. Financial Globalization
Financial system extends beyond the border.
• Globalization of non-financial business
─ As borrowers and lenders (U.S. multinational corporations) expand
their businesses to foreign countries, they require more variety of
financial services to financial institutions domestically and abroad.
─ Ex. Bank of America provides financial services to IBM in the U.S.
and its foreign subsidiaries.
• Services to savers and borrowers
─ Savers seek better opportunities in foreign countries (higher return and
lower risk)
─ Ex. You want to purchase stocks of Toyota Motors in Japan.

17. Benefits of Financial Globalization
• Savers can earn higher return
• Borrowers can borrow at lower cost
– Interest rates vary from one country to another. Savers often can find
higher lending rates in other countries, while borrowers often can find
lower borrowing rates in other countries.
– Ex. Interest rates are close to zero percent in Japan. Where can
Japanese savers earn a higher interest rate? Where can U.S. business
firms borrow at a low interest rate?
• Channel funds from one country to another
– One country may not have enough savers to match needs of borrowers.
They can borrow from foreigners where funds move from savers in
one country to borrowers in another country.
– Ex. The U.S. households do not save enough. Where can the U.S.
business firms obtain funds for their business expansions?

18. Globalization of Two Channels
• Globalization of direct finance
– International financial markets: savers can
purchase financial instruments issued by foreigner
borrowers
– Ex. U.S. savers purchase Toyota Motors stocks or
Chinese savers purchase U.S. Treasury bonds.
• Globalization of indirect finance
– International banking: Domestic banks expand
their banking businesses abroad.

19. International Financial Markets
• International Money Market
Eurodollars: U.S. dollars deposited in foreign countries
Ex. Ex. King of Kuwait deposits U.S. dollar at Zurich office
(Switzerland) of Credit Suisse Bank (Swiss bank).
• International Bond Market
Foreign Bonds: Bonds sold in a foreign country and denominated in a
currency of that country
Ex. Microsoft issues bonds in Germany and receives euro payments (euro
is currency of Germany), because Microsoft spends it to build Research
lab in France (France uses euro as its currency).
Eurobonds: Bonds sold in a foreign country and denominated in a
currency not of that country
Ex. Microsoft issues bonds in Germany and receives U.S. dollar payments
(U.S. dollar is not currency of Germany), because Microsoft spends it to
purchase Yahoo stocks in the U.S.

20. International Stock Markets
• Each capitalist economy has own stock
market.
– Tokyo Stock Exchange in Japan
– London Stock Exchange in U.K.
– Frankfurt Stock Exchange in Germany
– Shanghai Stock Exchange in China
– National Stock Exchange of India

21. Example of Foreign Markets on Barron’s
Foreign Markets section of Barron’s presents stock
prices of foreign companies traded in foreign stock
markets and foreign stock market indexes.
– See “How to Interpret Foreign Markets of Barron’s” on
Blackboard
– On Foreign Markets, Barron’s provides latest stock prices and
their changes over one week of some large foreign
corporations traded in various foreign stock markets, and
latest key foreign market indexes and their changes over one
week.

22. International Banking
• International banking: U.S. banks operate their
businesses across boarders.
• In 1960, only eight U.S. banks operated branches in
foreign countries with $4 billion assets. Currently,
over 100 American banks have branches abroad with
assets totaling over $1.5 trillion.

23. Reasons for International Banking
• International trade and multinational corporations
– When American firms operate abroad, they need banking
services in foreign countries, preferably with American
banks with a long-term relationships.
• Avoiding domestic banking regulation
– overseas branches are subject to host country’s banking
regulations which are usually less restrictive than those in
U.S., allowing American banks to engage in profitable
services (investment banking, insurance).
• Accessing funds overseas - Eurodollar.

24. Off-Shore Deposits
• Offshore deposit: deposits held in countries
that will not subject them to domestic
regulations.
– Avoid reserve requirements or restrictions on
taking the deposits outside the country (capital
control).
– Ex. Eurodollars, Euro yens, Offshore euro

25. Structure of U.S. Banking Overseas
• Open foreign branch offices
– Ex. London branch office of Bank of America, Cayman island branch
office of Citibank
• Edge Act corporation: a special subsidiary engaged primarily
in international banking.
– exempt from some U.S. banking regulation in order to compete with
foreign banks.
– A U.S. bank may establish a subsidiary in foreign countries or acquires
foreign banks.
• International banking facilities (IBFs): accept time deposits
from and to make loans to foreigners.
– Not subject to either reserve requirements or any restrictions.
– A U.S. bank may establish and operate IBFs in the U.S. as if the IBFs
are in foreign countries.

26. Foreign Banks in the U.S.
• Foreign banks hold more than 10% of the total bank
assets in the U.S and nearly 16% market share of the
market lending to U.S. corporations.
• International Banking Act of 1978
– foreign banks are treated like other U.S. banks in terms of
regulation.
• Recent acquisition of U.S. banks by foreign banks
and financial institutions.
– Ex. RBC Centura Bank: Centura Bank in NC was acquired
by Royal Bank of Canada in 2006.

27. Largest Banks in the World, 2011

28. Financial Regulation
• Financial regulation: the various government
agencies regulate both financial markets and
financial institutions.
• The financial system is among the most
heavily regulated sectors in the U.S.

29. Reasons for Financial Regulation
• Two major reasons
– Increase Information Available to Investors
– Ensure the Soundness of Financial System
• Two minor reasons
– Effective monetary policy
– Ensure equal opportunity

30. Increase Information Available to Investors
• Main problem in the financial system is asymmetric
information faced by saver-lenders and borrower-
spenders.
• The government can reduce the asymmetric
information problem in financial system and increase
efficiency by increasing the amount of information
available to savers-lenders and borrower-spenders.
– Disclosure requirement by SEC

31. Ensure the Soundness of Financial System
• Stable economic system requires a stable financial system.
– Financial panic: widespread collapse of financial intermediaries led the
U.S. economy into Great Depression in 1930s.
• The government ensures a stable financial system by enforcing
financial institutions to conduct sound business and assuring
savers-lenders.
– Restrictions on entry, assets, and activities: The government prohibits
financial institutions to take too much risk and require them to prepare
for the worst. Ex. SEC, OCC
– Examination and disclosure: The government makes sure financial
institutions follow their requirements and restrictions. Ex. OCC, FDIC
– Deposit insurance & pension guarantee: The government prevents a
financial panic by assuring savers their funds. Ex. FDIC, Penny Benny

32. Effective Monetary Policy
• The Federal Reserve conducts monetary policy
through interaction with the financial system.
• To ensure its effectiveness, the Federal
Reserve sets the reserve requirement to banks
and the margin requirement to security dealers
and investment banks.

33. Ensure Equal Opportunity
• The financial system provides funds to borrowers-spenders to
take their productive opportunities, but due to asymmetric
information and other economic and social condition not every
borrowers can benefit from the financial system
• The government ensures every borrowers have equal
opportunity to obtain funds for better their lives.
– Financial aid to students: Students, who lack funds for higher
education, usually do not have a good credit due to no or short job
experience, so they cannot get funds to pay for schools. It is beneficial
for students and the society that they receive higher education, so the
government ensures that students get funds to go to school. Ex. Sallie
Mae
– community reinvestment: Financial institutions consider borrowers in
inner city or rural community as risky. To revitalize those community
they need funds, and the government ensures those community get
necessary funds.

34. Government Financial Intermediation
The government involves in financial
intermediation by
• Setting up federal credit agencies that directly engage
in financial intermediation
− Mortgage loan securitization by Ginnie Mae, Fannie Mae,
and Freddie Mac
• Supplying government guarantees for private loans
− Federally guaranteed student loans (Stafford loan) by
Sallie Mae, College Loan Corporation, Bank of America

35. Financial Regulatory Agencies in U.S.
• Security and Exchange Commission (SEC): regulate organized
exchanges and financial markets, requires disclosure &
restricts insider trading
• Office of the Comptroller of the Currency (OCC): regulates
commercial banks, imposes restrictions on assets & examines
bank’s operations.
• Federal Deposit Insurance Corporation (FDIC): insures
deposits up to $100,000 at banks & examines bank’s
operations.
• Federal Reserve System: regulate banks, sets reserve
requirements & examines bank’s operations.

36. Principal Regulatory Agencies of the U.S. Financial
System

37. Recent Trend in Financial Regulation
• Since the Great Depression, the financial system had been
highly regulated.
• Since late 1970s the financial system has been deregulated.
• Due to recent financial scandals in 2000s the financial system
is now subject to more regulation.
– Savings & Loan crisis in 1980s
– Junk bonds and insider trading in 1980s
– Conflict of interest (Enron & Arthur Andersen) and insider trading
(Martha Stewart) in early 2000s
– Subprime loan crisis (Countrywide Financial & Bear Sterns) in 2007
and now
– Collapse of securitization markets (Lehman Brothers, Fannie Mae) and
credit default swaps (AIG) in 2008

38. Financial Regulatory Reform of 2009
• The Obama administration proposed the overhaul of
the financial supervision and regulation, responding
to the financial crisis in 2008. Its objectives are
– Promote robust supervision and regulation of financial
firms
– Establish comprehensive supervision of financial markets
– Protect consumers and investors from financial abuse
– Provide the government with the tools it needs to manage
financial crises
– Raise international regulatory standards and improve
international cooperation.

39. Action Plans for Financial Regulatory Reform
• In order to achieve these objectives, the government will
– Abolish the Office of Thrift Supervision and merge with the
Office of the Comptroller of the Currency
– Establish new consumer protection agency
– Require all financial institutions, not limited to banks, to hold
enough capital and liquidity
– Supervise the securitization markets and the all over-the-
counter derivatives, including the credit default swaps
– Consolidate supervision over large financial institutions to the
Federal Reserves
– Empower the FDIC to take over troubled financial institutions
beyond banks.

40. Financial Regulation Abroad
• Many developed countries like U.K.,
Germany, Japan, and Canada have the similar
financial system as the U.S. and their financial
regulations are similar to the U.S.
• Major difference between the U.S. and other
developed countries is the banking regulation,
where the U.S. banks are most regulated
among developed countries.

41. International Coordination of Financial
Regulation
• As more banks engage in the international banking
and the financial markets throughout the world
become more integrated, the need for international
coordination of financial regulation has increased.
• Basel Accord
– Standardize minimum capital requirement of banks across
countries.
• Financial Regulatory Reform of 2009 in the U.S.

42. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University