Notes on Mishkin Chapters 11 and 12: Part B
(Financial Innovation and Bank Restructuring in the U.S.)
Econ 353: Money, Banking, and Financial Institutions

Last Updated: 28 March 2015
Latest Course Offering: Spring 2011

Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT
Econ 353 Home Page:

  1. Financial Innovations and U.S. Banking
    1. Inducements to Financial Innovation
    2. Four Recent Financial Innovations
    3. Effects on U.S. Banking
  2. Current Restructuring of U.S. Banking
    1. Seven Distinct Types of U.S. Banking Regulations
    2. U.S. Government Safety Net Provisions
    3. U.S.Restrictions on Asset Holdings and Capital Requirements
    4. U.S.Chartering and Bank Examination
    5. U.S.Disclosure Requirements
    6. U.S. Consumer Protection Legislation
    7. U.S. Restrictions on Competition
    8. U.S. Separation of Banking and Securities Activities
  3. Basic Concepts and Key Issues from Mishkin Chapters 11/12: Part B

I. Financial Innovations and U.S. Banking

Note: The following Section I notes are primarily based on Mishkin Chapter 12, but some related materials from Mishkin Chapter 11 are also incorporated.

I.A Inducements to Financial Innovation

Since the 1960s, many changes that have occurred in the U.S. economy have had significant implications for U.S. financial markets. Three of these key changes are as follows:

These changes have stimulated a search by financial institutions for new financial products and services likely to be profitable in the new environment -- a process called financial engineering.

For example, the increased volatility of interest rates has led to the development of adjustable-rate mortgages (ARMs) -- that is, mortgage loans on which the interest rate changes when some specified market rate changes. The rapid development of computer technology has led to the development of financial products specifically dependent on this technology, such as bank credit cards and electronic banking facilities.

Also, financial institutions making use of new computer technology have been increasingly successful in their efforts to get around regulations perceived to restrict their ability to exploit profit opportunities -- a process aptly referred to as loophole mining.

For example, under the Glass-Steagall Act of 1933, banks were prohibited in most states from paying interest on checking deposit accounts, and maximum limits were imposed on the interest that could be paid on time deposit accounts (regulation Q).

In 1970, however, a mutual savings bank in Massachusetts found a loophole in this legislation. Specifically, by calling a check a Negotiable Order of Withdrawal (NOW), any account on which NOWs were written was not legally a checking account and so was not subject to the Glass-Steagall Act prohibitions on interest.

NOW accounts rapidly spread throughout New England. Finally, in 1980, legislation was enacted (the Depository Institutions Deregulation and Monetary Control Act) that included among its many provisions the authorization of NOW accounts nationwide for savings and loans, mutual savings banks, and commercial banks, with similar types of accounts ("share draft accounts") authorized for credit unions as well.

As this example demonstrates, details matter when it comes to regulation and supervision of the banking industry (or any industry for that matter). Earnings-driven individuals are continually trying to think of new ways to generate profits. Thus, subtle differences in the details of a regulation may have large unintended consequences, such as permitting profit-seeking individuals to find legal means to evade the regulation altogether.

I.B Four Key Financial Innovations

In Chapter 12, Mishkin discusses four financial innovations that have played a particularly important role in the decline of traditional banking practices in the U.S.:

  1. money market mutual funds;

  2. junk bonds;

  3. the rise of the commercial paper market;

  4. securitization.

These four financial innovations are briefly described below.

1. Money Market Mutual Funds

Money market mutual funds issue shares, redeemable at a fixed price (e.g., $1 per share), that effectively function as interest-earning checking accounts. Each shareholder is entitled to periodic interest payments and is also entitled to withdraw funds by check (up to the redemption value of his shares) subject to certain restrictions. Since money market mutual funds are not legally checking deposit accounts, however, they are not subject to reserve requirements or other prohibitions placed on checking deposit accounts.

2. Junk Bonds

Junk bonds are corporate bonds that are rated below Baa (by Moody's rating system) or below BBB (by Standard & Poor's rating system). Standard & Poor's describes bonds rated below BBB as "predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation."

For many years prior to the late 1970s, marketed bonds rated below Baa were predominantly bonds that had been rated higher at original issue but had fallen on hard time ("fallen angels"). In 1977, Michael Milken -- in charge of bond activities at the investment banking firm Drexel Burnham -- began to issue new junk bonds ("original junk issue") primarily to finance highly leveraged acquisitions (i.e., leveraged buyouts (LBOs)) of large companies either by another company or by its management.

By 1987, junk bonds accounted for nearly 25 percent of all new corporate bond issues. This changed dramatically in the late 1980s. A number of highly publicized leveraged buyouts financed by junk bonds failed, others came close to defaulting on their interest payments, and significant abuses in the issuance and trading of junk bonds were reported. In particular, Drexel Burnham failed and Michael Milken was convicted for fraud.

In recent years, junk bonds have again come into common use, in more modest volume, as a vehicle for financing risky corporate ventures.

3. Commercial Paper

Commercial paper is a short-term debt security issued by large banks and corporations.

Improvements in information technology since 1970 making it easier for investors to screen out bad from good credit risks have contributed to a tremendous growth in the commercial paper market.

This growth has also been aided by the concurrent growth in money market mutual funds, pension funds, and other large funds that invest in liquid, high-quality, short-term assets and so provide a ready market for commercial paper.

4. Securitization

Securitization is the process of transforming otherwise illiquid financial assets (e.g., residential mortgages, automobile loans, credit card receivables,...) into more marketable securities.

Securitization was initiated in 1970 by the Government National Mortgage Association ("Ginnie Mae") with the introduction of mortgage-backed securities. With reductions in transactions costs due to improved computer technology, Ginnie Mae found that it could profitably bundle together a diversified portfolio of mortgages, collect the interest and principal payments on the mortgages, and then -- for a fee -- pay out these collections to third parties who had bought standardized shares of this mortgage portfolio.

Ginnie Mae guaranteed the interest and principal payments on these shares, and the diversification of the underlying mortgage portfolio reduced their risk. Consequently, these mortgage-backed securities were highly liquid. Mortgage-backed securities remain the most common form of securitized financial asset in the U.S. today.

I.C Effects on U.S. Banking

Traditional banking business in the U.S. -- that is, lending funded with deposits -- has declined in both size and profitability as a result of the competitive pressures introduced by these and other financial innovations. For example, as seen in Figure 2 (Mishkin, Chapter 12, page 287), commercial banks' share of total credit advanced declined from 1974 through the mid-1990s, and has been fairly stagnant in recent years; and the share of thrifts (S&Ls, mutual savings banks, and credit unions) in total credit advanced has fallen dramatically since about 1977 and is now well below 10 percent.

The response of banks to this decline in traditional banking services has been to seek out other sources of profit. One strategy has been to expand into new areas of lending, such as commercial real estate loans. A second strategy has been to expand into nontraditional off-balance-sheet activities, including loan sales, trading positions in futures and options, foreign exchange trades on behalf of customers, servicing of mortgage-backed securities, debt security guarantees, provision of credit line backup, and other specialized services to customers. Both of these strategies have generated concern from financial rgulatory agencies because of their perceived higher riskiness.

The decline in traditional banking that has occurred in the U.S. is now also occurring in many other countries of the world as well. Because of increased international integration of financial markets, banks everywhere are facing more difficult competitive environments. The next section focuses more carefully on the way in which U.S. banking has been restructured in recent years.

II. Current Restructuring of U.S. Banking

Note: The following Section II notes blend materials from Mishkin Chapters 11 and 12.

As seen in previous notes, banking in the U.S. has been regulated almost since its inception, and it remains one of the most highly regulated industries in the U.S.

Banks have not been allowed to own businesses that are not closely related to banking. They have been effectively barred from any meaningful participation in the securities industry. And they have been further limited by frequently changing rules regarding exactly what kinds of investments they are permitted to make.

In 1994, however, President Clinton signed into law the Riegle-Neal Interstate Banking and Branching Efficiency Act that permits banking across state lines. This act represents a critical step in the restructuring of the U.S. financial system, a process that began back in the 1970s and continues today. Together with the Federal Reserve's liberal merger and acquisition policy, the Riegle-Neal act fueled a significant movement towards bank consolidation within the U.S. and increased political pressure for the further liberalization of the regulations that restricted banking activities.

II.A Seven Distinct Types of U.S. Banking Regulations

Mishkin (Chapter 11) identifies seven distinct types of banking regulations that have at one time or another been imposed on the U.S. banking industry:

In the following sections, each type of regulation is taken up in turn. For each case, a brief discussion is given of the most important forms this type of regulation has taken in the U.S., and the extent to which these regulations have been modified or even eliminated in recent years.

II.B U.S. Government Safety Net Provisions

Principal Forms of U.S. Government Safety Net Provisions:

In the U.S., government safety net provisions have taken two principal forms: lender-of-last resort provisions; and the provision of deposit insurance backed by tax revenues.

The Fed stands ready to provide discount loans (or advances) to U.S. banks who are short on reserves. Since such borrowing is generally interpreted by the public and the Fed as a sign of distress or liquidity mismanagement, however, banks usually only resort to discount loans in times of emergency and for short periods of time. Consequently, the Fed essentially functions as a lender-of-last-resort for banks in distress.

Moreover, the 1933 Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) to oversee the federal provision of insurance on deposit accounts up to a certain size, currently set at $100,000.

Weaknesses Revealed by 1980s U.S. Financial Crisis (Mishkin pp. 265-267):

Proponents of these two government safety net provisions point to the increased stability of the U.S. banking system since their institution.

Critics agree that, up until the 1980s, lender-of-last-resort protections and federal deposit insurance worked exceedingly well in reducing bank failures in the U.S. relative to earlier time periods. Nevertheless, they argue that this optimistic scenario changed dramatically during the U.S. financial crisis in the 1980s.

Specifically, critics argue that financial innovations such as NOW accounts, money market mutual funds, junk bonds, the rise of commercial paper, and securitization (see above) were beginning to seriously erode the profitability of traditional bank lending arrangements by the early 1980s.

At the same time, the increasingly liberalized regulatory environment of the 1980s permitted a wider latitude for the activities of banks and thrifts. For example, the Depository Institutions (Garn-St. Germain) Act of 1982 permitted thrifts to have up to 40 percent of their assets in commercial real estate loans whereas previously they had been restricted almost entirely to home mortgage loans.

Given federally provided lender-of-last-resort protections and deposit insurance, bank and thrift managers thus had strong incentives to engage in new forms of higher-risk lending in an attempt to increase their profitability -- for example, real estate lending, and lending to assist corporate takeovers and leveraged buyouts. These managers knew that reserve shortfalls could be covered by discount loans from the Fed, and that deposit losses would be covered by tax-payers in case of bankruptcy (moral hazard behavioral effects). Moreover, insured depositors had little reason to monitor the managers' activities because their deposits were protected by insurance.

Risk-taking entrepreneurs -- in particular, real estate developers, and merger and acquisition moguls -- were in turn encouraged to seek out more loans from banks and thrifts, because they knew that the managers of these banks and thrifts were now more willing and able to engage in high-risk lending (adverse selection pool effects).

Unfortunately, bank and thrift regulators lacked both the expertise and the funds needed to provide effective oversight and control of these new and more risky forms of lending.

More cynically, some critics argue that regulators (as well as politicians) also deliberately chose to ignore the crisis early on, practicing regulatory forbearance -- i.e., permitting insolvent banks and thrifts to stay in business -- in the hopes that the situation would either improve or stay hidden until after they had left office. In previous editions of his textbook that included a more detailed discussions of the U.S. financial crisis in the 1980s, Mishkin argues that this regulatory forbearance arose from an intrinsic and serious principal-agent problem that exists in the U.S. between taxpayers (the principals) and the regulators and politicians (agents) who are supposed to act in their interest.

The result, say critics, was predictable. Bank and thrift managers took on excessive risk, loans went bad, and institutions crashed.

According to U.S. Commerce Department estimates in 1995, over 1031 federally insured banks and thrifts with deposits of over $199.2 billion were either reorganized or closed in the U.S. during 1980-1994 due to financial difficulties. Compare Mishkin (Chapter 11, Figure 1, page 266).

The final cost of these reorganizations and closures to U.S. taxpayers was on the order of $150 billion. Consequently, the damage to the U.S. economy was substantial.

Moreover, critics argue that those in charge of reorganization adhered to a too big to fail policy, so that the assistance that was provided to depositors by the FDIC during this crisis was not fairly applied. Depositors at large institutions were much better protected than depositors at smaller institutions. For example, the FDIC arranged for the purchase and assumption of the failed Bank of New England in 1991 at no cost to its depositors while allowing the much smaller Freedom National Bank to fail in 1990 with a loss of 50 cents on the dollar for deposits in excess of $100,000.

Subsequent Reforms in U.S. Government Safety Net Provisions:

As a result of the U.S. financial crisis in the 1980s, and the ensuing criticisms of government safety net provisions, important legislation was enacted by the U.S. Congress that introduced major changes in existing government safety net provisions.

First, Congress in 1989 enacted the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), one of the most significant pieces of legislation affecting thrifts since the Great Depression.

For example, under FIRREA, additional funds were provided to reorganize or close insolvent thrifts, and S&Ls were essentially re-regulated to the asset choices permitted them before 1982 (e.g., no junk bond purchases allowed). FIRREA also substantially enhanced the enforcement powers of thrift regulators.

Second, in 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA) to revitalize and reform the bank regulatory system.

Under the FDICIA, the FDIC (which was nearly bankrupt) was recapitalized, and restrictions were placed on the ability of the FDIC to invoke the "too big too fail" policy. The FDIC was also required to take earlier and more substantive corrective actions when insured institutions showed signs of financial difficulty.

The FDIC was also required to charge increased insurance premiums to banks that had increased risk exposure. This risk-based premiums policy was to replace the previous policy of charging a flat fee to all banks (e.g., 10 cents per $100 of deposits) without regard for risk exposure.

Moreover, under the FDICIA, real estate lending was restricted, increased bank examinations and reporting requirements were imposed, and securities firms were given access to Fed discount lending during a financial crisis.

II.C U.S. Restrictions on Asset Holdings and Capital Requirements

Bank regulations can restrict the extent to which banks can hold risky assets such as real estate and common stocks, thus directly limiting the extent to which bank managers can engage in high-risk activities.

Such restrictions were imposed on U.S. banks and thrifts until the early 1980s. As detailed above, the relaxation of these restrictions in legislation enacted in the early 1980s is thought to have contributed substantially to the subsequent U.S. financial crisis. Tighter control of risky asset holdings were reimposed on S&Ls under legislation (FIRREA) enacted in 1989.

In addition, bank regulations can discourage bank managers from engaging in high-risk lending by requiring each bank to maintain its net worth ("bank capital") at or above some specified minimum level, so that the bank has more to lose should the bank go bankrupt.

Throughout most of the 1980s, U.S. banks were simply required to maintain a specified minimum "(capital) leverage ratio", defined to be the total amount of bank's net worth divided by the total amount of the bank's assets. Increased regulatory restrictions were automatically triggered if a bank's net-worth-to-assets ratio declined toward the minimum level.

Important Note on Terminology: There are many different definitions for "leverage ratio" used in the financial literture. As earlier seen in the html notes for Mishkin Chapter 10, one of the most commonly used meanings of this term is the debt-to-equity ratio, defined as the ratio of a firm's total liabilities to its total net worth. Care must be taken to understand which meaning of "leverage ratio" is being used in any given context.

Since the late 1980s, however, additional capital requirements have been imposed on larger banks in proportion to the riskiness of their trading activities. In addition, under legislation passed in 1991 (FDICIA), a carrot-and-stick approach is now used to encourage banks to hold more bank capital. Well-capitalized banks receive valuable privileges, while less-well-capitalized banks are subject to increasingly onerous regulation.

In addition, by international agreement among industrialized nations (the June 1988 Basel Accord, or "Basel 1"), additional types of bank capital restrictions are now imposed on banks engaging in significant off-balance-sheet activities. See Mishkin (Chapter 11, Global box discussion of "Basel 2", p. 256) for a discussion of ongoing attempts to reform the original 1988 Basel Accord.

II.D U.S. Chartering and Bank Examination

As noted in previous discussion of the dual nature of the U.S. banking system, anyone wishing to establish a bank in the U.S. must first apply for and obtain a charter -- i.e., a license to operate -- either from the Federal Government (specifically, the Comptroller of the Currency) or from a state banking agency.

Whether at the federal or state level, the chartering agency evaluates the anticipated financial soundness of a bank applicant by examining factors such as the quality and experience of the applicant's intended management, the applicant's projected earnings prospects, the applicant's qualification for deposit insurance, and the amount of the applicant's initial capitalization.

Once chartered, a bank must file periodic financial statements with the chartering agency, and it must also submit to regular examinations by a bank regulatory agency to ensure it remains in compliance with all charter provisions.

Chartering thus restricts entry into the U.S. banking industry. While providing protection against unqualified entrants, chartering also reduces the intensity of competition. Consequently, chartering reduces the likelihood that inefficient banks will fail.

Since 1993, chartering restrictions in the U.S. have been significantly eased in some respects and tightened in others. For example, chartering agencies are now less concerned with the prevention of harm (competition) to already existing banks. On the other hand, chartering agencies now place much greater emphasis on risk management.

II.E U.S. Disclosure Requirements

As discussed above, legislation enacted subsequent to the U.S. financial crisis in the 1980s imposed far more stringent reporting requirements on banks and thrifts. In particular, traditional disclosure requirements regarding balance sheets and income statements were supplemented with additional disclosure requirements focusing on risk exposure and risk management practices.

II.F U.S. Consumer Protection Legislation

One form that consumer protection legislation has taken in the U.S. is truth in lending laws -- that is, laws designed to force lenders to disclose to potential borrowers the true total costs of their borrowing, including a standardized annual interest rate and total financial charges.

Another form that consumer protection legislation has taken in the U.S. is laws to prevent discrimination in credit markets on the basis of age, gender, marital status, age, or national origin.

More controversially, the Community Reinvestment Act (CRA) enacted in 1977 was intended to promote community involvement. The CRA imposes reporting requirements on banks to ensure that the banks are lending to certain members of the community from whom they are acquiring deposits -- specifically, to low income community residents and to small businesses in the community. If a bank is found to be in noncompliance with the CRA, regulators can reject the bank's application for a merger, a new branch, or other proposed new activities.

Moreover, under the Gramm-Leach-Bliley Act of 1999, a bank holding company (BHC) cannot become a financial holding company (FHC) -- and hence cannot engage in the various new financial activities permitted to FHCs under this act -- unless all of the BHC's insured depository institutions have a CRA rating of satisfactory or better. See "Notes on the 1999 Gramm-Leach-Bliley Act" for further details.

The strengthening and increased enforcement of CRA provisions leading up to the subprime mortgage crisis 2007-2009 have been the source of a good deal of controversy. Some have claimed that these CRA provisions are in part responsible for this crisis in that they put strong pressure on banks to issue residential mortgages to subprime borrowers.

II.G U.S. Restrictions on Competition

In the past, U.S. banking legislation has frequently included provisions designed to protect banks from competition on the grounds that increased competition can lead to increased risk-taking by bank managers and hence to increased danger of bank failures.

The downside of these protective provisions is that inefficient banks are subject to less pressure to improve, which can result in higher costs to bank customers, suboptimal lending arrangements, and lower economic growth and development.

For example, one key type of protective provision that has been included in past U.S. banking law is branching restrictions. Branching restrictions have led to extensive loophole mining by banks attempting to get around these restrictions, e.g., the formation and reliance on bank holding companies, nonbank banks, and automated teller machines. In effect, branching took place, but by indirect and inefficient means. Legislation enacted in 1994 (Riegle-Neal) finally overturned earlier legislation prohibiting interstate branching.

II.H U.S. Separation of Banking and Securities Activities

As briefly discussed in previous lecture notes on Mishkin (Chapters 11/12:Part A), one of the most contentious aspects of the many-faceted 1933 Glass-Steagall Act has been its provisions requiring the separation of commercial banking and securities activities.

In particular, although the Glass-Steagall Act permitted commercial banks to sell new offerings of government securities (thought to be safe), it expressly prohibited commercial banks from underwriting corporate securities, from selling insurance, or from engaging in brokerage activities. Conversely, investment banks were prohibited from engaging in commercial banking activities.

Advocates justify this separation on the grounds that it reduces risk-taking behavior by commercial bank managers and protects commercial banks from competition. In addition, they argue that this separation also protects the securities industry from unfair "subsidized" competition from commercial banks -- subsidized in the sense that commercial bank depositors receive low-cost federally-provided deposit insurance whereas other firms providing insurance to their customers must do so at market cost.

Critics argue that brokerage and other nonbank firms have been able to pursue banking activities through financial innovations such as money market mutual funds and cash management accounts. Therefore it is unfair to prevent commercial banks from engaging in brokerage and other securities activities. In any case, commercial banks do so indirectly already, through bank holding companies; so retaining these separation provisions simply imposes higher costs on commercial banks without achieving the desired separation outcome in any case.

The benefits and costs of repealing the separation provisions of the Glass-Steagall Act have been under active study in the U.S. Congress since 1995. Representative Jim Leach of Iowa, then-Chair of the House Banking Committee, was a key advocate for repeal of these separation provisions. In Fall 1999 the U.S. Congress finally enacted financial modernization legislation --- the Gramm-Leach-Bliley Act --- that significantly weakened the Glass-Steagall separation provisions.

The key features and effects to date of the Gramm-Leach-Bliley Act are discussed briefly by Mishkin (Chapter 12, p. 297) and at greater length in "Notes on the 1999 Gramm-Leach-Bliley Act". In a nutshell, regarding separation provisions, the Gramm-Leach-Bliley Act eases the way for banks and nonbanking firms to consolidate in some fashion to take advantage of the synergies and cost advantages perceived to result from the ability to jointly undertake commercial banking and securities activities.

Many commentators have pointed to this easing as a key factor in the financial crisis of 2007-2009. As explained in Part A of these notes on Mishkin Chapters 11/12, this weakening of the Glass-Steagall Act has now been partially overturned by the version of the Volker Rule included in the Dodd-Frank Act of 2010.

III. Basic Concepts and Key Issues from Mishkin Chapters 11 and 12: Part B

Basic Concepts from Mishkin Chapters 11 and 12: Part B

Key Issues from Mishkin Chapters 11 and 12: Part B

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