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Econ315 Money and Banking: Learning Unit #06: Financial Globalization, Innovation, and Regulation
- 1. Learning Unit #6 FinancialInnovation, Globalization, and Regulation
- 2. Objectives of LearningUnit • Financial Innovation – New Products, Services, Organizations, Production • Financial Globalization – International Financial Markets – International Banking • Financial Regulation – Why, Who, What, & How
- 3. Financial Innovation • Financialinnovation: 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: Aprocess 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 SecuritizedAssets • 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 BadCredit • 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 SubprimeMortgage 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 systemextends 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 FinancialGlobalization • 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 TwoChannels • 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 ForeignMarkets 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 • Internationalbanking: 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 InternationalBanking • 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 • Offshoredeposit: 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 inthe 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 inthe World, 2011
- 28. Financial Regulation • Financialregulation: 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 FinancialRegulation • 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 Availableto 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 Soundnessof 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 Thegovernment 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 Agenciesin 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 Agenciesof the U.S. Financial System
- 37. Recent Trend inFinancial 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 Reformof 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 forFinancial 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 ofFinancial 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 notcopy, 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