Kenneth R. Szulczyk
defaulting on their mortgages. Unfortunately, the housing values were falling since 2007. If a
bank foreclosed on a person’s house, then a bank possesses a home that is losing value. Thus,
the financial crisis caused 140 banks to fail during 2009, causing financial difficulties for the
FDIC. Then the FDIC requires banks to prepay their deposit insurance for 2010, 2011, and
- The FDIC wants banks to prepay $45 billion in deposit insurance after it already doubled
the insurance premiums for 2009.
Financial Innovation
Financial markets and institutions continually change and evolve, and financial innovation
can drive this change. If a new financial instrument lowers risk, increases liquidity, or increases
information, then investors are attracted to the new security. For example, mutual funds are one
financial innovation. A mutual fund pools money from many people together into a fund, and a
fund manager invests the fund in a variety of stocks. Consequently, this method lowers
investors’ risk through diversification of stocks. For example, you manage your mutual fund,
and you bought 30 different corporate stocks. Your Coca-Cola stock rises one day while the
value of your IBM stock declines. Overall, the average of the fund’s 30 stocks could earn a
return for the fund investors. If you bought only Kodak corporate stock, then you would lose
your investment when Kodak filed for bankruptcy.
Regulations can spur innovation. The U.S. and state governments have always heavily
regulated their financial institutions. Consequently, these institutions ingeniously circumvented
these regulations by creating new financial instruments or new financial institutions. First
method to circumvent banking regulations, bank leaders and owners developed bank holding
companies. A bank holding company is one corporation obtains ownership or control of two or
more independent banks. A bank holding company can do three things.
Bank holding company can branch within states or across state lines. For example, a
corporation buys enough common stock of two banks to become the majority shareholder.
Majority shareholder elects the Board of Directors and votes on corporate policy.
Therefore, the holding company can control several banks in several states, circumventing
the McFadden Act. Bank holding companies can buy other non-bank companies and enter other spheres of
economic activity, such as data processing, investment advice, and insurance. Allowing
banks to participate in nonfinancial activities is called universal banking. Bank holding company can raise non-deposit funds. For example, a bank holding company
controls one bank, and this bank needs funds. Holding company issues commercial paper
on itself and diverts these funds to the bank, circumventing the interest rate restrictions on
bank deposits.Second innovation, nonbank bank, allows banks to circumvent federal and state
regulations. Legal definition of a bank is an institution that accepts deposits and makes loans.