Chapter 1: Introduction

Xunhua Su

Contents

1 The Banking System - Main Players 2

1.1 Various “Banks” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Various Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 What Is a Bank in Our Course? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4 Increasing Importance of The Financial Sector . . . . . . . . . . . . . . . . . . . . . . . . 6

2 The 2007-2009 Financial Crisis 8

2.1 Increased Riskiness of U.S. Home Mortgages: 2000-2006 . . . . . . . . . . . . . . . . . . . 9
2.1.1 The Low Federal Funds Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1.2 Government Housing Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.1.3 Soaring Risk from Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 The Financial Crisis in 2007-2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.2.1 Bust of the Housing Bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.2.2 Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.2.3 The Collapse of Lehman Brothers and Market Crash . . . . . . . . . . . . . . . . . 17
2.3 Government Interventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

3 New Developments in the Banking Sector - FinTech 20

3.1 The History of FinTech . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 “Banking Is Necessary, Banks Are Not” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

4 Topics of the Course 24

4.1 The Economic Role of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.2 Debt and Agency Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.3 The Economic Role of Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4.4 Bank Run, Financial Crises and Bank Regulations . . . . . . . . . . . . . . . . . . . . . . 25
4.5 Financial Innovation and Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.6 New Developments: Disintermediation and FinTech . . . . . . . . . . . . . . . . . . . . . 26
1 The Banking System - Main Players

Figure 1: Main players in the banking system

1.1 Various “Banks”

Central Bank. Federal Reserve System (Fed), European Central Bank (ECB) and Norges
Bank. A central bank is an institution that manages a state’s currency, money supply, and inter-
est rates. Central banks also usually oversee the commercial banking system of their respective
countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing
the monetary base in the state, and usually also prints the national currency, which usually
serves as the state’s legal tender. The main objective is to maintain a certain level of stability
within the country’s financial system. The primary function of a central bank is to control the
nation’s money supply, through active duties such as managing interest rates, setting the reserve
requirement, and acting as a lender of last resort to the banking sector during times of bank
insolvency or financial crisis. Central bank has three main policy tools:

• Open market operations: buy and sell government bonds.

• Lender of last resort - discount window lending: central bank lending to commercial banks.
• Minimum reserve requirements: commercial banks saving in the central bank.

Commercial banks. DnB, Nordea, Citi, BOA, UBS, etc. A commercial bank is a financial
institution that provides services, such as accepting deposits, giving loans and basic investment
products like savings accounts and certificates of deposit. The traditional commercial bank is
a brick and mortar institution with tellers, safe deposit boxes, vaults and ATMs. However,
some commercial banks do not have any physical branches and require consumers to complete
all transactions by phone or Internet. In exchange, they generally pay higher interest rates on
investments and deposits, and charge lower fees.

• In some definitions, commercial banks mean only banks that focus on business customers. In
contrast, retail banks focus on consumers (or the general public) as customers, managing indi-
viduals checking and savings accounts, and offering credit cards and loans, with numerous branch
 locations in populated areas. In this course, we consider these retail banks also as commercial
banks.
• You may also heard about credit unions or mutual banks, which are not-for-profit organizations
that offer many of the same products and services as banks. The experience of using those services
is roughly the same. There are two key differences between a bank and a credit union. Ownership is
the main difference between banks and credit unions. Credit unions are member-owned (customers
at credit unions are called “members,” so the customers own the credit union). Banks are owned by
investors, who might not be account holders or community members. When you open an account
at a credit union - no matter how small - you become a partial owner of the institution. All
members have the right to vote for credit union leadership (the board of directors). Taxation is
another difference. As a not-for-profit organization, a credit union doesn’t pay the same taxes that
banks pay. However, credit unions are not charities. They must make sound financial decisions,
collect revenue, pay salaries, and compete with other institutions.

Investment banks. Morgan Stanley, Goldman Sachs, etc. An investment bank is a finan-
cial institution that assists individuals, corporations, and governments in raising capital acting
as the underwriter and/or agent in the issuance of securities. It may also assist companies in-
volved in mergers and acquisitions (M&As), etc. For example, In 2007, Statoil and Hydro were
merged. Morgan Stanley and Goldman Sachs were two investment banks assisting the merger.
Unlike commercial banks, investment banks do not take deposits. After the 2007-2009 crisis,
the U.S. requires full institutional separation of investment banking services from commercial
banking.

Question: What is the key difference between commercial banking and investment bank-
ing? Investment banking and commercial banking are two primary segments of the banking
industry. Investment banks facilitate the buying and selling of investments, while commercial
banks manage deposit accounts. (Investopedia)

• Investment banks are institutions that function mainly to serve businesses. They aid companies in
the process of purchasing and selling bonds, stocks and a variety of other investments. Investment
banks also aid companies in going public by facilitating their initial public offerings, or IPOs.
These banks are allotted higher risk tolerances, in part because of their general business model and
because they are somewhat more loosely regulated by the Securities and Exchange Commission,
or SEC, granting them substantial freedom in strategic decision making.
• Commercial banks are responsible for managing deposit accounts, such as checking and savings
accounts, for both businesses and individuals. Using money held on deposit enables them to make
loans available to the public and to companies. There is a significantly higher level of government
regulation with these institutions. Commercial banks are federally insured to protect customers
and are governed more stringently than investment banks by federal authorities such as the Federal
Reserve and the Federal Deposit Insurance Corporation, or FDIC. Commercial banks are much
more sensitive to risk due to the fact they deal directly with the public.
• Combination Institutions. In 1933, the Glass-Steagall Act mandated a separation of all investment
and commercial banking. It was repealed over six decades later in 1999. Since then, major banking
institutions have been permitted to operate in the investment and commercial arenas. However,
 while there are some blended institutions, most U.S. banks have chosen to remain as either in-
vestment banks or commercial banks. There are a number of potential benefits to combination
investment/commercial banks. For example, acting as an investment bank, an institution can aid
a company in selling its IPO, and then utilize commercial banking to extend credit to the new
company, thereby simplifying the company’s financing needs.

1.2 Various Markets

The interbank market. Debt market among banks. Banks use the interbank market to
manage liquidity and satisfy regulations such as reserve requirements. Most interbank loans are
made at the interbank rate (also called the overnight rate for overnight loans) for maturities of
one week or less, the majority being overnight. The interbank rate could be the federal funds
rate (USA), the LIBOR (UK), and the Euribor (Eurozone). Interbank loans are also called
repos: short-term secured debt. Repo run was a major contributing factor to the financial crisis
of 2007.
The Libor Scandal. The Libor (London Interbank Offered Rate) is an average interest
rate calculated through submissions of interest rates by major banks in London. The banks
are supposed to submit the actual interest rates they are paying, or would expect to pay,
for borrowing from other banks. The scandal arose when it was discovered that banks
were falsely inflating or deflating their rates so as to profit from trades, or to give the
impression that they were more creditworthy than they were. In June 2012, multiple criminal
settlements by Barclays Bank revealed significant fraud and collusion by member banks
connected to the rate submissions, leading to the scandal. Six banks were fined $2.3 billion
by EU.

The commercial & industrial (C&I) loan market. Commercial and industrial loans
are loans made to a business or corporation either to provide working capital or to finance major
capital expenditures. This type of loan is usually short-term in nature (usually with maturity
less than 10 years) and is almost always backed with some sort of collateral. Commercial loans
usually charge flexible rates of interest that are tied to the bank prime rate or else to the LIBOR.
There are two main types of C&I bank loans: revolving credit lines and term loans. C&I loans
will be the key type of loan contacts we discuss in this course.

Revolving credit or lines of credit:

• A revolving credit is a line of credit where the customer pays a commitment fee and is
then allowed to use the funds when they are needed. It is usually used for operating
purposes, fluctuating each month depending on the customer’s current cash flow needs.
• In a bank lines of credit, the credit can be taken out by both corporations and in-
dividuals. The bank that is in agreement with the customer guarantees a maximum
amount that can be loaned to the customer. Along with the commitment fee there are
also interest expenses for corporate borrowers and carry forward charges for consumer
accounts.
 The mortgage loan market. A mortgage loan, also referred to as a mortgage, is used by
purchasers of real property to raise funds to buy real estate; or by existing property owners to
raise funds for any purpose while putting a lien on the property being mortgaged. The loan is
“secured” on the borrower’s property. This means that a legal mechanism is put in place which
allows the lender to take possession and sell the secured property (“foreclosure” or “repossession”)
to pay off the loan in the event that the borrower defaults on the loan or otherwise fails to abide
by its terms. The word mortgage is derived from a “Law French” term used by English lawyers
in the Middle Ages meaning “death pledge”, and refers to the pledge ending (dying) when either
the obligation is fulfilled or the property is taken through foreclosure. Mortgage can also be
described as “a borrower giving consideration in the form of a collateral for a benefit (loan)”.
Main types of mortgages:

• Interest: Interest may be fixed or flexible, and change at certain pre-defined periods.
• Term or maturity: The number of years after which an amortizing loan will be repaid.
• Payment schedule: The amount paid per period and the frequency of payments.
• Prepayment: Some types of mortgages may limit or restrict prepayment of all or a portion
of the loan, or require payment of a penalty to the lender for prepayment.

Question: What is subprime lending? Subprime lending means making loans to people
who may have difficulty maintaining the repayment schedule, sometimes reflecting setbacks,
such as unemployment, divorce, medical emergencies, etc. Historically, subprime borrowers were
defined as having FICO scores below 600, although this has varied over time and circumstances.
(Wikipedia)

Question: People say “the housing price in Norway will drop is the Norges Bank increases
the policy interest rate”. Can you understand the underlying logic of this statement? (Answers
will be given in Section 2.)

Deposit. Funds held in an account from which deposited funds can be withdrawn at any
time without any advance notice to the depository institution. Demand Deposit are insured by
the government. Certificate of deposit: one type of deposit that has a specific, fixed term (often
monthly, three months, six months, or one to five years), and usually a fixed interest rate.

1.3 What Is a Bank in Our Course?

When we say “banks” in this course, we mean commercial banks. The main functions of a
commercial bank is as a financial intermediary to accept deposits from savers and grant loans to
borrowers. A commercial bank’s balance sheet looks like the following table. 1 (We will discuss
in details bank’s balance sheet in Topic 5.)

1
Balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity
at a specific point in time. These three balance sheet segments give investors an idea as to what the company
owns and owes, as well as the amount invested by the shareholders. It is called a balance sheet because the two
sides balance out.
 Bank Balance Sheet

From the balance sheet, we can see that banks’ main products are loans (the bank owns in
the asset-side) and deposit (the bank owes in the liability-side). This reflects the main functions
of a commercial bank as a financial intermediary. However, bank in practice provide a large
number of various products and services, some of which are even very complicated. Here is a
incomplete list of bank products:

• Individual Banking - Banks typically offer a variety of services to assist individuals in

managing their finances, including checking accounts, savings accounts, debit & credit
cards, insurance, wealth management, etc.

• Business Banking - Most banks offer financial services for business owners who need to
differentiate professional and personal finances. Different types of business banking services
include business term loans, business lines of credit, checking accounts, savings accounts,
debit and credit cards, cash management (payroll services, deposit services), etc.

• Digital Banking - Banks will typically offer digital banking services including online, mo-
bile, and tablet banking, text alerts, eStatements, online bill pay, etc.

These products and services are reflected in the key value chain of banks: financing, asset
management, payment, Insurance, and Advice. Banks also provide authentication services that
guarantee that only the right persons are given access to information and functions.

1.4 Increasing Importance of The Financial Sector

In traditional economics theory, financial intermediaries such as banks have no role. To see
evidence, just think about the economic theory (such as the product or technology functions)
and courses that you learnt. Do banks play a role in the theory? However, the past 2007-
2009 financial crisis provides strong evidence against the traditional view. The subprime crisis
starting in the banking sector caused the global Great Recession finally: GDP shrinks, raising
the unemployment rates in almost all western counties to unprecedentedly high levels. That is,
the financial sector has real effects and cannot be ignored.
 The history of banks can trace back to thousands of years ago, but banks as we know today
is a more recent industry which was forged during the 12 century and early Italian Renaissance
to facilitate commerce and manage personal wealth for rich families in Florance and Venice. The
oldest bank, Monte dei Paschi di Siena (BMPS) operates continuously since 1472. During the 17-
18 centuries, Amsterdam and London took the lead, fostering systematic innovations like central
banking. Yet, only after the 20th century and especially after the industry deregulation in the
1980s, which saw New York and London emerge as world leading financial centers, has financial
innovation enabled banks to stretch their balance sheets anf grow at the level of international
independence to the point of becoming a potential systematic threat to the stability of morden
economies.

In U.S., the financial sector accounts for around 8.3% of GDP in 2010, while assets managed
by the financial sector is close to 500% of GDP. The sector has an essential role to play with
respect to the allocation of funds to the most profitable investment opportunities. The former
British Prime Minister William Gladstone expressed the importance of finance for the economy
in 1858 as follows: “Finance is, as it were, the stomach of the country, from which all the other
organs take their tone.”
 Information technology (IT) has facilitated the harnssing of economies of scale in the banking
industry. For many decades, banks have been front runners on IT spending - a digitalization
shift. Technology is not the only force in motion to transform financial services. Regulation is
clearly the other major driver. One major financial innovation before the Great Financial Crisis
is the explosion of complex instruments through securitization, as we will see in the next section,
which largely brings new sources of finance but may contribute much to the financial crisis.

2 The 2007-2009 Financial Crisis

The global financial crisis (2007-2009) is considered to have been the worst financial crisis
since the Great Depression of the 1930s. It threatened the collapse of large financial institutions,
which was prevented by the bailout of banks by national governments, but stock markets still
dropped worldwide. In many areas, the housing market also suffered, resulting in evictions,
foreclosures and prolonged unemployment. The crisis played a significant role in the failure of
key businesses, declines in consumer wealth estimated in trillions of U.S. dollars, and a downturn
in economic activity leading to the 2008-2012 global recession and contributing to the European
sovereign-debt crisis. Although Norway did not feel much about the 2007-2009 financial crisis
and the following Euro-zone debt crisis, the crisis significantly changed the world in 2007-2014.
 • Video for the 2007-2009 financial crisis: Youtube Click Here.
• Video for the global debt crisis: Youtube Click Here.

What are the reasons for the past financial crisis? “U.S. government actions and interven-
tions – not any inherent failure or instability of the private economy – caused, prolonged and
dramatically worsened the crisis.” “We should let the large banks, as well as the Wall Street,
to fail. It is the greedy Wall Street bankers who created the financial crisis. They should be
punished.”

2.1 Increased Riskiness of U.S. Home Mortgages: 2000-2006

2.1.1 The Low Federal Funds Rate

After the dot.com bust in 2000 (Nasdaq:

from 5000+ to 2400 within the year, and fur-
ther to 1140 in 2002), concerned about the
deflation and the Japanese stagnation of
the 1990s, the Federal Reserve Bank (Fed)
abruptly lowered its funds rate from 6.5% to
under 2% in 2001 and then kept it at 1% un-
til 2004. The inflation rate was around 2% in
this period, resulting in a negative real rate.
This negative interest rate has a significant ef-
fect on the real economy. Borrowing by both
households and businesses was greatly stimulated, especially in the real estate markets.

For most households, the largest and most heavily debt-financed purchase they will ever
make is to buy a home - so demand for housing, which is particularly rate-sensitive, responded
strongly to the monetary stimulus. With plentiful and cheap liquidity, some of it also coming
from the trade surplus investments of the Asian export economies, a steady increase in household
debt and house prices was the result. (The situation seems similar in Norway in 2012-2016.
The policy rate is around 1%, while the inflation rate is about 2-3% - negative real interest rate
actually. If you do not borrow, you lose money! )

However, the low federal funds rate is only one contributor to the soaring housing prices.
There are many other factors, including the government housing policy that supports home
ownerships and the boom of the securitization market that makes home properties more liquid
and eases financing. We discuss them in the following.

2.1.2 Government Housing Policy

Fannie Mae and Freddie Mac. U.S. housing policy has for some time been to encourage
home ownership, and a number of government agencies were formed from the 1930s on to support
housing finance. Most notably, the Government Sponsored Enterprises (GSEs), Fannie Mae and
Freddie Mac, have insured residential mortgages that met their standards for a fee. They have
also bought the loans and put them into pools that have then been sold to private investors,
thereby providing funds for additional purchases from banks and mortgage originators. In so
doing, these GSEs led the way for the development of a securitization market for conventional
mortgages. Securitization makes the credit market more efficient, but more complex and risky.
When the GSEs securitize mortgages, they essentially pool all of the mortgages they have bought
and repackage them into securities called mortgage-backed securities (MBSs). For an investor
who has purchased a MBS, the GSEs guarantee the payment of principal and interest to the
investors. By doing so, they are taking on the risk that the borrower may default, making these
securities very popular among investors.
 Lending to Minorities (LMIs). From about 1977 on Congress embarked on a program
to expand mortgage lending to minorities and low and moderate income groups (henceforth
“LMIs”). It began modestly with the Community Reinvestment Act, which aimed to prevent
“redlining” of certain urban areas in which a bank was allegedly refusing to lend at all, but shifted
in 1995 to measuring the volume of loans to LMI borrowers by banks and then to establishing
ever-growing “targets” (starting at 30% and ultimately reaching 55%) for the percentage of
“affordable housing” loans among all those bought or guaranteed by the GSEs. The goal was
to push home ownership rates ever higher... but it also involved pushing credit standards ever
lower.

Subprime Loans. The process reached its zenith after the creation and promotion of
“subprime” loans - loans to borrowers with poor credit scores (less than 660), multiple recent
mortgage delinquencies or foreclosures, debt-service-to-income ratios above 50%, and the like.
With a somewhat better credit score, the loans were called “Alt-A.” Conventional down payment
requirements of 20% dropped to as low as 3.5% for the GSEs (and to zero for some private
originators) because significant down payments were viewed as “barriers” for low-income families.
New products were invented to make mortgages more “affordable” for buyers with very limited
income or resources, and for owners drawing out their equity in refinancing. Adjustable rate
mortgages (ARMs) evolved into “hybrid” ARMs with low initial rates that would reset to market
rates after two or three years, or “option” ARMs in which the buyer could chose the monthly
payment. Interest-only (IO) loans involved no amortization of principal for a period of ten or 15
years. Downpayments could be borrowed through a second mortgage. Approval processes were
automated; income statements were not verified, and such “no-doc” loans became commonplace.
The private sector entered subprime lending in a big way, selling the mortgages not only to
the GSEs, but into the private securitization market. Private (non-GSE backed) subprime and
Alt-A securities amounted to around $560 billion in 2004, $830 billion in 2005, $840 billion in
2006, and $470 billion in 2007 (but only $4 billion in 2008), for a total of about $2.7 trillion.

Questions:
• Do you know ‘securitization”?
• What is the role of Fannie Mae and Freddie Mac in the U.S. home mortgage market?
• Why does low-down-payment loans or interest-only loans raise the banks’ risk?

2.1.3 Soaring Risk from Securitization

Mortgage securitization had begun simply with the bundling of conventional mortgages in-
sured by a GSE into a pool. Shares of the pool were then sold to investors as reasonably
safe securities in part because the borrowers were diversified across geographical regions and
economies. But with the increasing volume of subprime mortgages, things became more com-
plicated. Investors wanted higher returns, but they also wanted safety. So, to simplify, claims
on the cash flow of the residential mortgage-backed pools (RMBS) were divided into tranches
or levels of seniority, with those at the bottom first to take losses or shortfalls in payments and
those at the top holding first claims viewed as quite secure, with relatively low contractual return
entitlements and AAA ratings.

It was not difficult to sell the AAA tranches, but there was less demand for those with
lower ratings. The solution: put the lower tranches into a new pool and combine them with the
tranches of a hundred other pools, and create a new hierarchy of claims on a pool of collateralized
mortgage obligations (CMO). Then repeat the process, and add in some other kinds of consumer
debt and perhaps some commercial loans, and form a pool of collateralized debt obligations
(CDO). But the process of creating asset-backed securities (ABS) need not, and did not, stop
there. It continued into CDO2 pools.

As you went down this securitization chain, the actual original loans underlying it all were
becoming farther and farther removed from the securities held by investors. So various forms
of credit enhancement were used to provide some reassurance and maintain the AAA ratings.
Municipal bond insurers ventured into insuring these new kinds of bonds; and credit default
swaps (CDS) were purchased to shift some of the credit risk off investors. Reliable estimates are
hard to come by, but aggregate issuances from 2004-2008 of MBS securitizations (agency and
private) may have amounted to something on the order of $9 trillion, purchased to their current
regret by institutional investors all around the globe.

The creation of securitization is called financial innovation. Financial innovation refers to

the ongoing development of financial products designed to achieve particular client objectives,
such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with
obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage
(ARM); the bundling of subprime mortgages into mortgage-backed securities (MBS) or collater-
alized debt obligations (CDO) for sale to investors, a type of securitization; and a form of credit
insurance called credit default swaps (CDS). The usage of these products expanded dramatically
in the years leading up to the crisis. These products vary in complexity and the ease with which
they can be valued on the books of financial institutions. The boom in innovative financial prod-
ucts went hand in hand with more complexity. It multiplied the number of actors connected to
a single mortgage: mortgage brokers, specialized originators, the securitizers and their due dili-
gence firms, managing agents and trading desks, and finally investors, insurances and providers
of repo funding. With increasing distance from the underlying asset these actors relied more
and more on indirect information (including FICO scores on creditworthiness, appraisals and
due diligence checks by third party organizations, and most importantly the computer models of
rating agencies and risk management desks). Instead of spreading risk this provided the ground
for fraudulent acts, misjudgments and finally market collapse.

Financial innovation such as securitization does make the financial markets more efficient,
e.g., by financing mortgages that were not able to be financed otherwise, but it makes financial
products more complicated and more difficult to price and monitor (regulate) - hence the financial
markets are more risky. For a variety of reasons, market participants did not accurately measure
the risk inherent with financial innovation such as MBS and CDOs or understand its impact on
the overall stability of the financial system. For example, the pricing model for CDOs clearly
did not reflect the level of risk they introduced into the system. Banks estimated that $450bn of
CDO were sold between “late 2005 to the middle of 2007”; among the $102bn of those that had
been liquidated, JPMorgan estimated that the average recovery rate for “high quality” CDOs
was approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO was
approximately five cents for every dollar.

Question: In the past ten years, the housing prices in Norwegian main cities have increased
over 200%. Many people think they are rich now, because their houses have a equity value of
several millions. They hence increase their spending (e.g. buying a Tesla car) through cashing
out some of their house equity. Do you think there is any risk for the country’s economy?

2.2 The Financial Crisis in 2007-2009

2.2.1 Bust of the Housing Bubble

Six years or so of constantly accelerating house price appreciation could not go on forever.
The bubble burst at the end of 2006. House values quickly fell below the amount of the mortgage
debt and many of these subprime loans went into default and foreclosure. This process inevitably
affected the values of subsequent pools down the chain, but by how much? In a given MBS
pool, one could observe the defaults and at least in theory use the information on thousands
of borrowers to try to model future performance. But for subsequent pools, the information on
the underlying original loans was lacking and the complexity made credible estimates of risks
and losses nearly impossible. The rating agencies saw that trouble was coming, and in 2007
they started downgrading more and more ABS issues. Their values became indeterminate and
trading in them dried up, which eliminated external market prices, and their acceptability as
collateral diminished accordingly.

Making the situation even worse was the

poor disclosure of the positions held by the
various investors in subprime loans and secu-
rities based on them, particularly commercial
and investment banks, and some hedge funds.
Those who had created these securities were
among the largest holders. They were at the
heart of the credit markets in the financial
system, and they were with great reluctance
announcing writedowns in their positions. It was widely believed that both agency downgrades
and bank writedowns were significantly lagging the actual loss of economic value, and hence
there was a spreading concern about the solvency of counter-parties among participants in the
inter-bank and prime brokerage markets.

The growing appreciation of the seriousness of the problem throughout 2007 was accelerated
in July when the rating agencies downgraded hundreds of mortgage-backed bonds. Then in 2008
the auction-rate securities market shut down in February and Bear Stearns collapsed in March,
followed by the dramatic failures of September. The GSEs Fannie and Freddie, which owned
or guaranteed $5.4 trillion of mortgage debt, were taken over and put into conservatorships on
September 7; Merrill Lynch was forced into acquisition by Bank of America on the 14th; Lehman
filed for bankruptcy on the 15th; and the Fed made an $85 billion bailout loan to AIG on the
16th. On September 19th, the Treasury Secretary announced a “bold approach” to “remove
these illiquid assets that are threatening our economy” and requested a massive appropriation to
forestall a complete collapse; the effect on the equity and interbank loan markets was immediate.
Contrary to popular lore, the Lehman failure and refusal to bail it out was not the principal
cause, but one in a series of signals, of the mounting magnitude of the mortgage losses.

Timeline of the financial crisis

• Jul. 2007: Bear Stearns discloses losses on two subprime hedge funds; start of the subprime
crisis
• Aug.-Sep. 2007: run, U.S. subprime originator Countrywide; run, U.K. bank Northern Rock
• Mar. 2008: JP Morgan Chase bought Bear Stearns
• Sep. 2008: Black Month - Fannie Mae, Freddie Mac nationalized; Lehman Brothers bankrupted;
AIG bail-out; etc.
• Oct. 2008: stock markets crash (from 14000 to 6627 finally); financial crisis spreads to Europe;
TARP
• Autumn 2008: credit markets collapse; liquidity injection
• Oct. 2009: U.S. unemployed rate peaks at 10%
 • 2011-2012: Euro-zone debt crisis

Time Line of Events 2007/2008

2.2.2 Bank Runs

The bust of the housing market bubble is followed by bank runs: a situation that occurs
when a large number of bank or other financial institution’s customers withdraw their deposits
simultaneously due to concerns about the bank’s solvency. As more people withdraw their funds,
the probability of default increases, thereby prompting more people to withdraw their deposits.
In extreme cases, the bank’s reserves may not be sufficient to cover the withdrawals. A bank run
is typically the result of panic, rather than a true insolvency on the part of the bank; however,
the bank does risk default as more and more individuals withdraw funds - what began as panic
can turn into a true default situation. There had been a list of bank runs.

In early August 2007, the American firm Countrywide Financial suffered a bank run as a
consequence of the subprime mortgage crisis.

On September 13 2007, the British bank

Northern Rock arranged an emergency loan
facility from the Bank of England, which it
claimed was the result of short-term liquid-
ity problems. Northern Rock became the first
bank in 150 years to suffer a bank run after
having had to approach the Bank of England
for a loan facility, to replace money market
funding, during the credit crisis in 2007. Hav-
ing failed to find a commercial buyer for the business, it was taken into public ownership in 2008,
and was then bought by Virgin Money in 2012.

On Tuesday, March 11 2008, a bank run began on the securities and banking firm Bear
Stearns. While Bear Stearns was not an ordinary deposit-taking bank, it had financed huge long-
term investments by selling short-maturity bonds (Asset-backed Commercial Paper), making it
vulnerable to panic on the part of its bondholders. Credit officers of rival firms began to say
that Bear Stearns would not be able to make good on its obligations. Within two days, Bear
Stearns’ capital base of $17 billion had dwindled to $2 billion in cash, and Bear Stearns told
government officials that it saw little option other than to file for bankruptcy the next day. By
07:00 Friday, the Federal Reserve decided to lend Bear Stearns money, the first time since the
Great Depression that it had lent to a nonbank. Stocks sank, and that day JPMorgan Chase
began an effort to buy Bear Stearns as part of a government-sponsored bailout. The deal was
arranged by Sunday in an effort to calm markets before overseas markets opened.

On July 11 2008, U.S. mortgage lender IndyMac Bank was seized by federal regulators. The
bank relied heavily on higher cost, less stable, brokered deposits, as well as secured borrowings,
to fund its operations and focused on stated income and other aggressively underwritten loans
in areas with rapidly escalating home prices, particularly in California and Florida. A highly
stressed institution, IndyMac’s capital was being lost to downgrades as the poor quality of their
book was revealed. On June 26, Senator Charles E. Schumer released to the media letters he
sent to the regulators, which warned the bank might not be viable. In the days following the
release, depositors pulled out approximately 7.5% of the bank’s deposits.

On Sep. 25 2008, the Office of Thrift Supervision was forced to shut down Washington
Mutual, the largest savings and loan in the United States and the sixth-largest overall financial
institution, on a Thursday due to a massive run. Over the previous 10 days, customers had
withdrawn $16.7 billion in deposits. This is currently the biggest bank failure in American
financial history.

On Sep. 26 2008, Wachovia, the fourth-largest bank in the United States, lost $5 billion
in deposits - about 1% of its total deposits - when several large customers (mostly businesses
and institutional investors) drew down their accounts below the $100,000 limit for FDIC deposit
insurance. The Office of the Comptroller of the Currency and the FDIC were both concerned
that Wachovia wouldn’t have enough short-term funding to open for business on 29 Sep. -
which would have resulted in a failure dwarfing that of WaMu just a day earlier. They pressured
Wachovia to put itself up for sale over the weekend. Initially, Wachovia was to sell its commercial
banking operations to Citigroup, but eventually the entire company was sold to Wells Fargo.

On Oct. 6 2008, Landsbanki, Iceland’s second largest bank, was put into government re-
ceivership. The Icelandic government used emergency powers to dismiss the board of directors
of Landsbanki and took control of the failed institution. Prime Minister Geir Haarde also rushed
measures through parliament to give the country’s largest bank, Kaupthing, a £400m loan. In
addition, Iceland pleaded with Russia to extend 3bn in credit as western countries refused to
help. With over 5bn in savings held by Britons in Landsbanki, the Icelandic collapse threatens
private citizens in the United Kingdom as well as companies in Iceland.

2.2.3 The Collapse of Lehman Brothers and Market Crash

On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets
and $619 billion in debt, Lehman’s bankruptcy filing was the largest in history, as its assets far
surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the
fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide.

Lehman’s high degree of leverage - the ratio of total assets to shareholders equity - was
31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to
deteriorating market conditions. On March 17, 2008, following the near-collapse of Bear Stearns
- the 2nd-largest underwriter of MBS - Lehman shares fell as much as 48% on concern it would
be the next Wall Street firm to fail. Confidence in the company returned to some extent in April,
after it raised $4 billion through an issue of preferred stock that was convertible into Lehman
shares at a 32% premium to its price at the time. However, the stock resumed its decline as
hedge fund managers began questioning the valuation of Lehman’s mortgage portfolio.

On June 9, Lehman announced a second-quarter loss of $2.8 billion, and reported that it
had raised another $6 billion from investors. The firm also said that it had boosted its liquidity
pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure
to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to
about 25. However, these measures were perceived as being too little, too late. Over the summer,
Lehman’s management made unsuccessful overtures to a number of potential partners. The
stock plunged 77% in the first week of Sep. 2008, amid plummeting equity markets worldwide,
as investors questioned CEO Richard Fuld’s plan to keep the firm independent by selling part of
its asset management unit and spinning off commercial real estate assets. Hopes that the Korea
Development Bank would take a stake in Lehman were dashed on Sep. 9, as the state-owned
South Korean bank put talks on hold. The news was a deathblow to Lehman, leading to a 45%
plunge in the stock and a 66% spike in CDS on the company’s debt. The company’s hedge
fund clients began pulling out, while its short-term creditors cut credit lines. On September
10, Lehman pre-announced dismal fiscal 3rd-quarter results that underscored the fragility of its
financial position. The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion,
and also announced a sweeping strategic restructuring of its businesses. The same day, Moody’s
Investor Service announced that it was reviewing Lehman’s credit ratings, and also said that
Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating
downgrade. These developments led to a 42% plunge in the stock on Sep. 11.

With only $1 billion left in cash by the end of that week, Lehman was quickly running out
of time. Last-ditch efforts over the weekend of Sep. 13 between Lehman, Barclays PLC and
Bank of America Corp. (BAC), aimed at facilitating a takeover of Lehman, were unsuccessful.
On Monday Sep. 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its
previous close on Sep. 12.

Market crash: The collapse of Lehman Brothers (Sep., 2008) triggered a run on repos
in the interbank market and a run on stock market. Both markets collapse in the following two
months, starting the most serious financial crisis since the Great Depression in the 1930s. The
following figures show the collapse of the stock market, the LIBOR rate (interbank market rate),
and the increased collateral requirement (“haircut”) in the interbank repo market.
U.S. Stock Markets (S&P 500 Index)

The 3-month Libor -Treasury Bill Spread

Average Repo Haircut on Structured Debt (Gordon and Metrick, 2012)

2.3 Government Interventions

Too big to fail: the spill-over effect of bank failures hurts the economy. The too big to fail
theory asserts that certain corporations, and particularly financial institutions, are so large and
so interconnected that their failure would be disastrous to the greater economic system, and that
they therefore must be supported by government when they face potential failure. Proponents
of this theory believe that some institutions are so important that they should become recipients
of beneficial financial and economic policies from governments or central banks.

In general, government interventions include

• Liquidity Injection through Asset Purchase, Debt Guarantee or Direct Debt:

during the last quarter of 2008, central banks purchased US$2.5 trillion of government
debt and troubled private assets from banks. This was the largest liquidity injection into
the credit market, and the largest monetary policy action, in world history.
• Equity Injection: central banks raised the capital of their national banking systems by
$1.5 trillion, by purchasing newly issued preferred stock in their major banks.

There are some well-known examples of Government Interventions.

Northern Rock, encountering difficulty obtaining the credit it required to remain in busi-
ness, was nationalised on 17 February 2008. As of 8 October 2008, United Kingdom taxpayer
liability arising from this takeover had risen to £87 billion ($150 billion). The remaining bad
bank was merged with Bradford & Bingley and is now NRAM plc. As of October 2014 around
£44 billion in loans remain outstanding.

IndyMac Bank, America’s leading Alt-A originator in 2006 with approximately $32 bil-
lion in deposits was placed into conservatorship by the Federal Deposit Insurance Corporation
(FDIC) on July 11, 2008, citing liquidity concerns. A bridge bank, IndyMac Federal Bank, FSB,
was established under the control of the FDIC.

The GSEs Fannie Mae and Freddie Mac were both placed in conservatorship in September
2008.[7] The two GSE’s guarantee or hold mortgage-backed securities(MBS), mortgages and
other debt with a Notional value of more than $5 trillion.

AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve,
which AIG is expected to repay by gradually selling off its assets. In exchange, the federal
government acquired a 79.9% equity stake in AIG. AIG may eventually cost U.S. taxpayers
nearly $250 billion, due to its critical position insuring the toxic assets of many large international
financial institutions through credit default swaps.

In Nov. 2008, the U.S. government announced it was purchasing $27 billion of preferred
stock in Citigroup, a USA bank with over $2 trillion in assets, and warrants on 4.5% of its
common stock. The preferred stock carries an 8% dividend. This purchase follows an earlier
purchase of $25 billion of the same preferred stock using Troubled Asset Relief Program (TARP)
funds.

Government interventions raised Credit Availability. How?

• Removing poisonous assets
• Debt guarantee
• Relaxing the requirement of collateral
• Increase borrowers’ net worth

3 New Developments in the Banking Sector - FinTech

NHH Forum 2017: two speeches by Nordea.

• Snorre Storset, CEO Norway, “Future Banking”

• Ewan MacLeod, Chief Digital Officer, “Partnership, Open Banking”

3.1 The History of FinTech

(Forbes: Falguni Desai) FinTech is short for financial technology and involves usage of mod-
ern technology to support, enhance and innovate services and products offered from traditional
financial services institutions, hereby banks, insurance companies, real estate companies and
investment funds. We mainly in this course study FinTech within the banking sector: tech-
nologies, products and services that take out smaller components of the traditional banks’ value
chain and make them more user-friendly, more efficient, cheaper and digitized. As such, FinTech
gives rise to new business models, applications, processes and products.

While the focus on FinTech has increased significantly in the past decade, particularly in
the aftermath of the financial crisis in 2008, the technological infusion in the financial sector
begun as long as sixty years ago. In the 1950s, credit cards were introduced to ease the risk and
burden of carrying cash only, and in the 1960s the first ATM was installed to replace physical
tellers and bank branches. In the 1970s, electronic stock trading began on exchange trading
floors. The 1980s saw the rise of bank mainframe computers and more sophisticated data and
record-keeping systems. In the 1990s, the Internet and e-commerce business models flourished.
The result was the introduction of online stock brokerage websites aimed at retail investors,
replacing the phone-driven retail stock brokering model.

These five decades of developments have created a financial technology infrastructure which
most people never think about, but use almost everyday. It’s also important to note that
throughout that 50 year period, FinTech developments were also creating more sophisticated risk
management, trade processing, treasury management and data analysis tools at the institutional
level for banks and financial services firms. While these systems are not apparent to retail
banking customers, they make up a multi-billion industry aimed at supporting the needs of the
financial services sector. Bloomberg and Thomson Reuters are just a few of the players that make
up the existing set of large FinTech companies that have built this institutional infrastructure.

The commercial internet and the dotcom boom resulted in large numbers of startups trying
to capitalize on the banks’ business, but only a minor part of them survived - one of them
PayPal. What is striking about the last 65 years of development in these technologies is that
while they became mainstream and widely used by banks and their customers, the banking
sector was not threatened. On the contrary, banks grew. In looking at the U.S.’s FDIC data,
from 1950 to 2014, the number of bank branches in the country grew from approximately 18,000
to over 82,000. In general, banks have historically been one of the most resistant institutions,
and many of them have been robust due to governmental support and ownership.

Now, in the early part of the 21st century, retail financial services are being further digitized
via mobile wallets, payment apps, robo-advisors for wealth and retirement planning, equity
crowdfunding platforms for access to private and alternative investment opportunities and online
lending platforms. These FinTech services are not simple enhancements to banking services,
but rather replacing banking services completely. So, FinTech can be thought of in two broad
categories, consumer-facing and institutional. It is these consumer-facing FinTech services which
are quickly gaining customers and competing with banks.

In the last couple of years, many FinTech sector commentators and watchers have pointed
to the coming demise of banks. Several have questioned whether banks will exist in the future.
As the data shows, retail banking has flourished up until now. But this most recent evolution
in FinTech may change the banking landscape in some markets.

Bill Gates in 1994, “Banking is necessary, banks are not.”

3.2 “Banking Is Necessary, Banks Are Not”

(Forbes: Falguni Desai) In most developed countries, the majority of households have at
least one bank account which they use as their central hub for receiving paychecks, making
payments and saving money. But this isn’t the case everywhere. In under-banked or un-
banked regions, primarily in parts of Asia and Africa, many individuals hold their life savings in
cash, without bank accounts. To capture this distinction more broadly, in developing countries,
banking penetration is approximately 41%, compared to 89% in developed countries. In India
for example, the country has approximately 102,000 bank branches for a population that is
roughly four times that of the U.S., which has approximately 82,000 bank branches.

Fintech startups that offer secure mobile wallets and payment apps are allowing these un-
banked populations to safely store their money and make purchases without having to worry
about storing or carrying large amounts of cash. For example, M-Pesa is probably the most
successful example of such an app. In Kenya, the company touts a very strong user base, and
the mobile wallet has become a daily used utility for purchases. This eliminates the need for
a bank account among those users who don’t have complicated finances. This type of dynamic
allows smaller fintech startups to play the role of banks, by helping people to borrow, spend and
pay using mobile apps and websites, bypassing banks altogether. In these markets, a stagnated
banking landscape is a very real possibility.

In the U.S., fintech apps such as Apple Pay provide convenient and secure payment meth-
ods. They are faster and cheaper than transferring money between bank accounts. Millenials
are habitually paying each other or making purchases with such apps. Lending platforms such as
Lending Club and Prosper, provide lower interest rate personal loans with a maximum limit of
$35,000. Robo-advisors are providing an alternative to traditional financial advisors. Companies
such as Betterment or Wealthfront provide a data driven automatic investment plan for retire-
ment planning and wealth management. All of these fintech companies are strong contenders
who are increasing their market share and competing with retail banking services.

(PWC) Today, FinTech is not only a buzzword. FinTech shows growing influence on Finan-
cial Services. There are a list of fast emerging financial technologies, including P2P lending,
mobile payments, crowdfunding, block chain, cryptocurrency, open banking, robo-advisor, big
data analytics, etc. The pace of change in Financial Services seems only to be increasing - as
does the urge for the industry to react. Mobile money services have proven to be an effective
gateway for financial inclusion among the unbanked, a demographic that could evolve into a
US$3 trillion payments volume opportunity. Tomorrow, your bankers or wealth manager will
coach you throughout your day to take appropriate financial decisions based on a combination
of AI and transaction and contextual data. Frustration and cost will decrease as new busi-
ness models and emerging technologies are being adopted to streamline onboarding processes,
operations and client communication.
 Mainstream Financial Institutions are rapidly embracing the disruptive nature of FinTech
and forging partnerships in efforts to sharpen operational efficiency and respond to customer
demands for more innovative services. In fact, funding is moving from a venture capitalist
dominated field towards more mainstream investments. According to research based on data
from PwC’s DeNovo platform, funding of FinTech startups has increased at a compound annual
growth rate (CAGR) of 41% over the last four years, with over US$40 billion in cumulative
investment. Cutting-edge FinTech companies and financial innovation are changing the com-
petitive landscape, and are redrawing the lines of the Financial Services industry. According
to PWC’s Global FinTech Report 2017, many banks fear losing business to innovators, starting
with payments, fund transfer and personal finance sectors. The vast majority (88%) of partici-
pants indicated that they are worried that part of their business is at risk to standalone FinTech
companies. This business at risk is due to developments in FinTech and has grown to an esti-
mated 24% of revenues. As a response, 82% of incumbents (banks) expect to increase FinTech
partnerships in the next three to five years, and 77% expect to adopt blockchain as part of an
in production system or process by 2020.
 The Case of China. In China, the traditional wallet has been replaced by an electronic
wallet on a smartphone. It’s common to make all of your payments for daily needs through
that smartphone, using one of two main electronic payment providers: WeChat Pay or Alipay.
WeChat Pay is part of the WeChat messaging family, owned by Tencent, and Alipay is affiliated
with Alibaba. It’s not just ease of use. These two tech behemoths have the reach and customer
base to push their payment systems beyond their original e-commerce mission. Noodle shops will
take electronic payments, and even street musicians have QR codes for donations. Whether you
are paying your electricity bill or seeing a doctor, your mobile phone can handle the payment. As
a result, China is today the most cash-free of any of the world’s major economies and that trend
will continue. Already, the numbers are staggering. According to a survey by Ipsos and Tencent,
14% of Chinese people do not carry any cash, while 26% hold less than RMB100 ($16) in their
wallets, day to day. By contrast, in 2016 China’s mobile payments hit $5.5 trillion, almost 50
times the size of America’s $112 billion market, according to consulting firm iResearch.

4 Topics of the Course

4.1 The Economic Role of Financial Markets

The 2007-2009 Great Recession originated from the subprime crisis, and most past serious
economic recessions follow the same pattern (starting from the financial sector and spread to the
real economy). Since financial market collapses or financial crises can induce such big problems
to the society, do we really need financial markets? Why? Nowadays in the U.S., the financial
sector accounts for around 8% of GDP. After the financial crisis, people criticize that the financial
sector is too big, because it produces “nothing”. What is your point?

What is the economic role of financial markets? This is one of the most fundamental questions
for people studying finance. In this course, we will show the economic role of financial markets
using some simple mathematical models - financial markets improve our life through transferring
wealth or money across periods and across states.

4.2 Debt and Agency Problems

The trigger of the past financial crisis is the increasing default of subprime mortgages - a
special type of debt. Actually, the bust of housing bubbles and increasing default of mortgages
were typically the key reason for past financial crises. Then what is debt? What are the
special properties of debt that drive financial crises? We have many types of debt: bank loans,
mortgages, corporate or government bonds, etc. Debt plays a central role in financing business
firms - for most firms, the main external financing source is bank loans (v.s. equity, bond, etc).

Debt is subject to agency problems. If your brother asks you to lend him NOK 100,000,
you may easily accept it. However, if a stranger comes to you and asks for the money, are you
willing to lend to him? If your answer is no, why? Similarly, if a bank lends money to a firm,
credit quality investigation is necessary before lending. After the lending, the bank is sure to
monitor the firm through various techniques during the loan term. Why?

At the early stage of the past financial crisis, banks with liquidity (cash or money) held
the money in hand instead of lending it out, though other banks with liquidity shortage were
willing to pay a high interest rate to borrow. This liquidity hoarding made the interbank market
collapse. The market failure was an important feature of financial crises, some time irrespective
of the solvency of banks. It requires the government to intervene. Why can market fail?

4.3 The Economic Role of Banks

A concentrated financial market (where lenders and borrowers trade directly) can ease bor-
rowing and lending by reducing transaction costs. However, it is not obvious whether a bank or
other financial intermediary is better than the financial market in doing so. Then why do we
need banks or other financial intermediaries? In addition, the history of banks is a history of
financial crises:
• The Great Depression (1929-1933).
• Latin American debt crisis: beginning in Mexico in 1982 with the Mexican Weekend.
• Japan financial crisis: Japanese asset price bubble collapsed in 1990.
• Scandinavian banking crisis (1988-1993)
• The 2007-2009 financial crisis
Given that bank failures cause financial crises, why do we need them in an economy? To put it
differently, why do banks exist?

4.4 Bank Run, Financial Crises and Bank Regulations

Financial Crises was typically triggered by bank runs. For example,

• The Northern Rock Bank
• Lehman Brothers

Why is there bank run? How can bank run be linked to the economic role of banks? Bank
run may induce bank failure, but bankruptcy of business firms are common in the real world
(e.g., GM, Arron, etc.). Is bank run or bank failure special for the real economy? We will also
show that bank failures may induce the collapse of the credit market and hence transfer the
crisis to the real economy.
 Financial crises have negative effects on the real economy, e.g., GDP, employment rate,
etc. The central bank has to intervene to reduce the negative effects of financial crises through
monetary policies and other special actions. In addition to these actions after a crisis, central
banks regulate the financial industry in order to reduce bank failures and hence financial crises.
Central bank plays a central role in maintaining financial stability.
• Cash reserve of commercial banks.
• Capital requirements.
• Lender of last resort.

4.5 Financial Innovation and Securitization

Corresponding to the economic roles, banks have various products. For example, deposit,
commercial and industrial loans, mortgages, securitization products, inter-bank market prod-
ucts, etc.
• Deposit
• Commercial and industrial (C&I) loans
• Mortgages
• Securitization products: MBS, ABS, CDS, CDO, etc.
• Inter-bank market: repos.
How can these products link to the roles of banks in the modern economy? In particular we will
discuss the economics of securitization. Securitization is the process through which an issuer
creates a financial instrument by combining other financial assets and then marketing different
tiers of the repackaged instruments to investors. The process can encompass any type of financial
asset and promotes liquidity in the marketplace.

Mortgage-backed securities are a perfect example of securitization. By combining mortgages

into one large pool, the issuer can divide the large pool into smaller pieces based on each
individual mortgage’s inherent risk of default and then sell those smaller pieces to investors. The
process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool.
Using the mortgage-backed security example, individual retail investors are able to purchase
portions of a mortgage as a type of bond. Without the securitization of mortgages, retail
investors may not be able to afford to buy into a large pool of mortgages.

Securitization contributed to the past financial crisis, as the video shows. Financial inno-
vation such as securitization does make the financial markets more efficient, e.g., by financing
mortgages that were not able to be financed otherwise, but it makes financial products more
complicated and more difficult to price and monitor (regulate) - hence the financial markets are
more risky.

4.6 New Developments: Disintermediation and FinTech

Disintermediation is the withdrawal of funds from intermediary financial institutions, such

as banks and savings and loan associations, to invest them directly. Generally, disintermediation
is the process of removing the middleman or intermediary from future transactions. Disinter-
mediation is usually done to invest in instruments yielding a higher return. (Investopedia) The
goal of disintermediation is to lower the overall cost involved in the completion of transactions.
Removing the intermediary may also allow a transaction to go through more quickly.

FinTech refers to the technology that is becoming increasingly important in the world of
financial services. This can include everything from P2P lending, mobile banking, to crowdfund-
ing. Prior to the 2008 global economic crisis, the financial industry was generally accepted as
being one of the least open to innovation and disruption. In some cases, simple tasks like inquir-
ing about your bank balance and withdrawing money were still being performed in a traditional,
offline setting. The rise of FinTech in the last decade or so means this is all changing.

With FinTech, people are becoming less reliant on the providers of traditional financial
services, such as banks. There was a time when we’d visit our local bank branch for any issue
affecting our personal finances. Today we transfer our money using TransferWise, apply for a
student loan through SoFi, file our taxes with SimpleTax, and manage outstanding payments
on Satago. The list goes on. FinTech is cutting out the middle man when it comes to making a
financial transaction of any kind.

This trend has the potential to shake finance to its very core. Peer-to-peer lending, for
example, removes the traditional financial institution from the process altogether, instead es-
tablishing direct lending and borrowing channels between people. In simple terms, people with
money and people in need of money are being connected more efficiently than ever before. The
“marketplace lenders” providing this service typically offer lower rate loans for borrowers and
provide investors with a differentiated, high-yield source of income. Their interest rates are often
algorithm-driven. It’s all making queuing for a loan in a bank seem so outdated.

Perhaps the greatest threat to the established financial sector lies in payment systems and
virtual currencies, gradually removing the need for cash transactions and, eventually, electronic
bank transfers. BitCoin is a well-known example of a “cryptocurrency”, yet to fully mature,
which promises lower transaction costs upfront and a seemingly endless list of revolutionary
possibilities for our financial futures. How Much was 1 Bitcoin Worth in 2010? Bitcoin’s price
never topped $1 in 2010! Its highest price for the year was just $0.39! At the beginning of 2017,
its price was still below $1000. However, in Dec. 2017, its highest price was about $20,000 - a
2000% change in one year! Just remember Laszlo Hanyecz bought the two pizzas in the following
picture for 10,000 bitcoins on May 22, 2010. At the price peak today, that’s $200 million!

Bitcoin could be a bubble, but the technology (blockchain) behind it has the potential to trans-
form the world. Just as the web once promised freedom, so does blockchain. The chain is
self-policing. Anyone who attempts to launch an exchange of data outside the protocols of the
chain will immediately be spotted by the other blocks and the exchange will be aborted. Sud-
denly, the world has acquired a system for the fast, trusted exchange of vast amounts of data
without intermediaries or supervision. (Will Hutton)