Financial Markets and Institutions (2-downloads)

Are We Headed 

for a Cashless Society?

Predictions of a cashless society have been around

for decades, but they have not come to fruition. For

example,

Business Week predicted in 1975 that elec-

tronic means of payment “would soon revolutionize

the very concept of money itself,” only to reverse

itself several years later. Pilot projects in recent years

with smart cards to convert consumers to the use of 

e-money have not been a success. Mondex, one of

the widely touted, early stored-value cards that was

launched in Great Britain in 1995, is only used on a

few British university campuses. In Germany and

Belgium, millions of people carry bank cards with

computer chips embedded in them that enable them

to make use of e-money, but very few use them. Why

has the movement to a cashless society been so slow

in coming?

Although e-money might be more convenient and

may be more efficient than a payments system based

on paper, several factors work against the disappear-

ance of the paper system. First, it is very expensive to

set up the computer, card reader, and telecommuni-

cations networks necessary to make electronic money

the dominant form of payment. Second, electronic

means of payment raise security and privacy con-

cerns. We often hear media reports that an unautho-

rized hacker has been able to access a computer

database and to alter information stored there.

Because this is not an uncommon occurrence,

unscrupulous persons might be able to access bank

accounts in electronic payments systems and steal

funds by moving them from someone else’s accounts

into their own. The prevention of this type of fraud is

no easy task, and a whole new field of computer sci-

ence has developed to cope with security issues. A

further concern is that the use of electronic means of

payment leaves an electronic trail that contains a

large amount of personal data on buying habits.

There are worries that government, employers, and

marketers might be able to access these data,

thereby encroaching on our privacy.

The conclusion from this discussion is that although

the use of e-money will surely increase in the future,

to paraphrase Mark Twain, “The reports of cash’s

death are greatly exaggerated.”

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Part 6 The Financial Institutions Industry

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. This is exactly what Michael Milken of Drexel Burnham Lambert, an invest-

ment banking firm, started to do in 1977. Junk bonds became an important factor

in the corporate bond market, with the amount outstanding exceeding $200 billion

by the late 1980s. Although there was a sharp slowdown in activity in the junk bond

market after Milken was indicted for securities law violations in 1989, it heated up

again in the 1990s and 2000s.

Commercial Paper Market

Commercial paper is a short-term debt security

issued by large banks and corporations. The commercial paper market has under-

gone tremendous growth since 1970, when there was $33 billion outstanding, to

over $2.2 trillion outstanding at the end of 2006. Indeed, commercial paper has been

one of the fastest-growing money market instruments.

Improvements in information technology also help provide an explanation for the

rapid rise of the commercial paper market. We have seen that the improvement 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 easier for corporations to issue long-term debt securities in the junk bond

market, but it also meant that they could raise funds by issuing short-term debt secu-

rities such as commercial paper more easily. Many corporations that used to do their

short-term borrowing from banks now frequently raise short-term funds in the com-

mercial paper market instead. The development of money market mutual funds has

been another factor in the rapid growth in the commercial paper market. Because

money market mutual funds need to hold liquid, high-quality, short-term assets such

as commercial paper, the growth of assets in these funds to around $1.9 trillion has

created a ready market in commercial paper. The growth of pension and other large

funds that invest in commercial paper has also stimulated the growth of this market.

Securitization

An important example of a financial innovation arising from improve-

ments in both transaction and information technology is securitization, one of the most

important financial innovations in the past two decades, and one which played an espe-

cially prominent role in the development of the subprime mortgage market in the mid-

2000s. Securitization is the process of transforming otherwise illiquid financial assets

(such as residential mortgages, auto loans, and credit card receivables), which have

typically been the bread and butter of banking institutions, into marketable capital

market securities. As we have seen, improvements in the ability to acquire informa-

tion have made it easier to sell marketable capital market securities. In addition, with

low transaction costs because of improvements in computer technology, financial insti-

tutions find that they can cheaply bundle together a portfolio of loans (such as mort-

gages) with varying small denominations (often less than $100,000), collect the

interest and principal payments on the mortgages in the bundle, and then “pass them

through” (pay them out) to third parties. By dividing the portfolio of loans into stan-

dardized amounts, the financial institution can then sell the claims to these interest

and principal payments to third parties as securities. The standardized amounts of

these securitized loans make them liquid securities, and the fact that they are made

up of a bundle of loans helps diversify risk, making them desirable. The financial

institution selling the securitized loans makes a profit by servicing the loans 

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Chapter 19 Banking Industry: Structure and Competition

465

(collecting the interest and principal payments and paying them out) and charging

a fee to the third party for this service.

Avoidance of Existing Regulations

The process of financial innovation we have discussed so far is much like innova-

tion in other areas of the economy: It occurs in response to changes in demand and

supply conditions. However, because the financial industry is more heavily regu-

lated than other industries, government regulation is a much greater spur to inno-

vation in this industry. Government regulation leads to financial innovation by

creating incentives for firms to skirt regulations that restrict their ability to earn prof-

its. Edward Kane, an economist at Boston College, describes this process of avoid-

ing regulations as “loophole mining.” The economic analysis of innovation suggests

that when the economic environment changes such that regulatory constraints are

so burdensome that large profits can be made by avoiding them, loophole mining and

innovation are more likely to occur.

Because banking is one of the most heavily regulated industries in America, loop-

hole mining is especially likely to occur. The rise in inflation and interest rates from

the late 1960s to 1980 made the regulatory constraints imposed on this industry even

more burdensome, leading to financial innovation.

Two sets of regulations have seriously restricted the ability of banks to make prof-

its: reserve requirements that force banks to keep a certain fraction of their deposits

as reserves (vault cash and deposits in the Federal Reserve System) and restric-

tions on the interest rates that can be paid on deposits. For the following reasons,

these regulations have been major forces behind financial innovation.

1. Reserve requirements.

The key to understanding why reserve require-

ments led to financial innovation is to recognize that they act, in effect, 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 inter-

est rate, i, that could be earned if the reserves could be lent out times the frac-

tion of deposits required as reserves, r. The cost of i

⫻ r imposed on the bank

is just like a tax on bank deposits of i

⫻ r per dollar of deposits.

It is a great tradition to avoid taxes if possible, and banks also play this

game. Just as taxpayers look for loopholes to lower their tax bills, banks seek

to increase their profits by mining loopholes and by producing financial inno-

vations that allow them to escape the tax on deposits imposed by reserve

requirements.

2. Restrictions on interest paid on deposits.

Until 1980, legislation prohib-

ited banks in most states from paying interest on checking account deposits,

and through Regulation Q, the Fed set maximum limits on the interest rate

that could be paid on time deposits. To this day, banks are not allowed to

pay interest on corporate checking accounts. The desire to avoid these