C10: Banking Industry - Structure and Competition

What is financial innovation?

The creation of new financial products/services to increase profitability

What drives financial innovation?

Changes in demand, supply (technology), and regulation

What is financial engineering?

The process of designing new financial instruments to meet needs

Why did financial innovation accelerate after the 1960s?

Interest-rate volatility, technology advances, and increased regulation

What are the three types of financial innovation?

Demand-driven, supply-driven, and regulation-avoidance

What is interest-rate risk?

Risk from uncertainty in interest rate movements

How does interest-rate volatility affect innovation?

Increases demand for risk-reducing products

What is an adjustable-rate mortgage (ARM)?

A mortgage with an interest rate that adjusts with market rates

Why do ARMs reduce risk for lenders?

Interest income rises when market rates rise

What is a disadvantage of ARMs for borrowers?

Payments can increase over time

What are financial derivatives?

Instruments whose value is derived from underlying assets

Why were derivatives developed?

To hedge interest-rate risk

What is securitization?

Bundling loans into marketable securities

Why is securitization important?

It is the foundation of the shadow banking system

What is the shadow banking system?

Non-bank financial institutions performing lending via markets

How does shadow banking differ from traditional banking?

Multiple institutions vs one bank doing asset transformation

What is asset transformation?

Funding long-term assets with short-term liabilities

What is the originate-to-distribute model?

Loans are created and then sold as securities

What institutions are involved in securitization?

Originator, servicer, bundler, distributor

How do these institutions earn profits?

Fees at each stage

Why did securitization grow rapidly?

Lower information and transaction costs due to technology

What is a mortgage-backed security (MBS)?

A security backed by mortgage payments

What are subprime mortgages?

Mortgages issued to borrowers with poor credit

Why did subprime lending expand?

Improved credit scoring and securitization

What was the major risk of subprime lending?

High default risk

How did subprime mortgages contribute to the financial crisis?

Widespread defaults on securitized loans

What is information technology’s role in financial innovation?

Lowers costs and improves information access

How did IT affect transaction costs?

Reduced costs, enabling new products

How did IT affect information asymmetry?

Made it easier to assess credit risk

What are credit cards?

Allow borrowing for purchases

How do banks profit from credit cards?

Interest + merchant fees

What are debit cards?

Directly withdraw funds from accounts

What is electronic banking?

Banking via digital platforms (ATM, online, mobile)

What is a virtual bank?

A bank with no physical branches

What is a junk bond?

A high-yield, low-credit-quality bond

Why did junk bonds emerge?

Improved information made risky lending possible

What is commercial paper?

Short-term debt issued by firms

Why did commercial paper grow?

Easier credit evaluation + demand from institutional investors

What is disintermediation?

Movement of funds out of banks into markets

What causes disintermediation?

Higher market interest rates than bank deposits

What is regulation avoidance ("loophole mining")?

Innovation to bypass regulations

How do reserve requirements act like a tax?

Banks lose interest on required reserves

What are deposit rate ceilings?

Restrictions on interest banks can pay

What happens when market rates exceed ceilings?

Deposits leave banks (disintermediation)

What is a money market mutual fund?

A fund offering deposit-like services with interest

Why are MMMFs attractive?

Higher returns than bank deposits

What is a sweep account?

Automatically transfers funds into interest-bearing assets

How do sweep accounts avoid regulation?

Funds are not classified as deposits

What is traditional banking?

Borrowing short (deposits) and lending long (loans)

Why has traditional banking declined?

Loss of cost and income advantages

Why did banks lose liability advantages?

Competition from higher-yield alternatives

Why did banks lose asset advantages?

Firms can borrow directly via markets

How does securitization reduce banks’ role?

Loans are sold instead of held

How have banks responded to declining profits?

Shift to off-balance-sheet activities

What is a key risk of new banking activities?

Increased risk-taking

Why must regulators be more vigilant now?

Complex and riskier bank activities

What is the structure of Canadian banking?

Highly concentrated (Big Six dominate)

What share of assets do the Big Six hold?

About 97%

What are Schedule I banks?

Domestic Canadian banks

What are Schedule II banks?

Foreign-owned subsidiaries

What are Schedule III banks?

Foreign bank branches

What is the main difference between Schedule II and III?

Subsidiary vs branch structure

What is unique about Canadian banking?

Highly concentrated but competitive

How has technology affected banking competition?

Enabled new entrants and innovation

What is the U.S. banking structure like?

Highly fragmented (thousands of banks)

Why are there many small banks in the U.S.?

Historical branching restrictions

What was the McFadden Act?

Limited interstate branching

How did branching restrictions affect competition?

Protected small banks

What is a bank holding company?

A corporation that owns banks

How do holding companies bypass regulation?

Control multiple banks without branching

What is an ATM’s role in regulation avoidance?

Expands access without being a branch

What was the four-pillar system in Canada?

Separation of banking, insurance, brokerage, trusts

What is convergence?

Blurring of boundaries between financial sectors

What caused convergence?

Innovation + deregulation

What are economies of scale?

Cost advantages from larger size

What are economies of scope?

Cost advantages from offering multiple services

Why has consolidation increased?

Technology + economies of scale/scope

What is universal banking?

Banks offer all financial services

What is British-style universal banking?

Some separation via subsidiaries

How does Canada’s system compare globally?

Closer to British-style universal banking

What are trust companies?

Provide fiduciary services

What are loan companies?

Specialize in mortgage lending

What are credit unions?

Member-owned cooperative financial institutions

How do credit unions differ from banks?

Non-profit and member-focused

What is deposit insurance for credit unions?

Provided provincially (not CDIC)

What are government savings institutions?

State-run deposit-taking institutions

Why do banks operate internationally?

Serve global clients and earn profits

What are Eurocurrencies?

Deposits held outside their home country

What are Eurodollars?

U.S. dollar deposits outside the U.S.

Why are Eurocurrencies attractive?

Less regulation and restrictions

What is the Eurocurrency market size?

Over $10 trillion

Why do Canadian banks operate abroad?

Access markets and serve multinational firms

Why do foreign banks enter Canada?

Profit opportunities and trade growth

What is financial market integration?

Increasing global interconnectedness

What are Basel Accords?

International bank capital standards

What was the 2001 Bank Act reform?

Modernized Canadian financial regulation

What did the reform introduce?

Holding companies, new ownership rules, more competition

What is the advantage of holding company structure?

Flexibility and reduced regulation

What are permitted investments changes?

More flexibility in technology and services

How did ownership rules change?

Increased allowable ownership stakes