Week 9 Lecture Slides

BEE2037- MONEY AND BANKING
Financial innovation and inclusivity
Week 9
Outline
1 Introduction
2 Financial innovation
3 Securitisation and shadow banking system
4 Mobile banking and financial inclusivity
5 Financial innovation and the decline of traditional banking
6 Summary
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Last week
Define and recognise the importance of a nominal anchor.

Six basic goals of monetary policy with price stability being the
primary goal.
Inflation targeting, its advantages and disadvantages.
Lessons from the global financial crisis and their implication for
inflation targeting.
Monetary policy should lean against credit booms but not asset price
bubbles.

Introduction
Introduction
Figure 1: Some recent financial innovations Source: Atz and Bholat (2016), Banco Central do
Brasil (2023), Payment cards & mobile (2020), P2P Reviews (2020), Starling (2023)

Introduction
Introduction
These financial innovations have revolutionised how transactions are

conducted today.
Therefore, this week we address the following questions:
1 What is financial innovation?
2 How has financial innovation led to the growth of the shadow banking
system?
3 How can mobile banking promote financial inclusivity?
4 What has been the impact of financial innovation on traditional
banking?
5 What happens when financial innovation turns toxic or is mismanaged?

Financial innovation
What is financial innovation?

» the introduction or creation of new financial products, services or
processes.
Financial innovation is driven by the desire to earn profits.
Financial innovation vs financial engineering.
» What is the difference between the two?
» The process of researching and developing new financial products and
services (innovations) that meet customer needs and are likely to be
profitable: financial engineering.

Recent financial innovations
Some recent financial innovations include:

» Mobile banking financial services e.g. M-Pesa in Kenya.
» Digital currencies e.g. cryptocurrencies and CBDCs*.
» Remittance technology e.g. Remitly, WorldRemit.
» Investment crowdfunding.
opens up and enables the process of raising equity capital more
democratic.
» Peer-to-peer (P2P) lending.
Direct lending between lenders and borrowers online outside traditional
financial intermediaries like banks.
UK has the largest P2P lending market in Europe.
P2P platforms in the UK include: Zopa, Funding Circle UK etc.

Recent financial innovations
Figure 2: Cumulative total value of loans via P2P consumer lending platforms in
the UK as of June 2019, by platform. Source: Statista 2022
Types of financial innovation
1. Responses to changes in demand conditions: interest rate volatility.

» Adjustable-rate mortgages
Flexible interest rates keep profits high when rates rise.
Lower initial interest rates make them attractive to home buyers.
» Financial derivatives
Payoffs are linked to previously issued (i.e., derived from) securities.
Ability to hedge interest rate risk.

2. Avoidance of existing regulations.

» Loophole mining and innovations occur to avoid regulation.
Reserve requirements act as a tax on deposits.
Restrictions on interest paid on deposits led to disintermediation.
» Money market mutual funds
Bruce Bent and the Money Market Mutual Fund Panic of 2008.
» Sweep accounts: any balances above a certain amount in a
corporation’s checking account at the end of the business day are
removed and invested in overnight securities that pay the corporation
interest.

3. Responses to changes in supply conditions: information technology.

» Bank credit and debit cards
Improved computer technology lowers transaction costs.
Contactless cards.
» Electronic banking
ATM.
Home banking.
Mobile banking - M-Pesa.
Virtual banking - Monzo, N26, Starling, Revolut etc.
Mobile (digital) wallets - Wechat pay, Alipay. Alipay vs Wechat pay,
who is leading the market?
» Junk bonds.
» Commercial paper market.
» Securitisation

Time for task 1.

Task 1
You will see the task as you watch the lecture recordings.

Securitisation and shadow banking system
Securitisation is:
» A financial innovation that entails lumping together of a large number
of financial instruments.
» For instance, mortgages, autoloans then dividing them into smaller
different pieces that appeal to different types of investors.
Transforms otherwise illiquid financial assets into marketable capital
market securities.
loan origination ⇒ servicing ⇒ bundling ⇒ distribution
Due to process involved, securitisation is also known as
originate-to-distribute business model.
Main objective of securitisation is to diversify risk.

3 key financial instruments used prior to the GFC as part of

securitisation.
1. mortgage-backed security (MBS)
Financial asset secured by mortgages, returns are generated from the
interest on mortgages
Credit risk from mortgage default is mitigated using diversification and
‘tranching’
Diversification: Mortgages for the MBS are taken from different
geographical regions in the US.
‘Tranching’: The ’junior’ tranche absorbs default losses before the
‘senior’ tranche, hence is riskier and yields a higher return.

2. Collateralized debt obligation (CDO)

» Similar to MBS but backed by a bundle of loans (tranched).
» Originally developed as instruments for the corporate debt market.
» CDO risk comes from the ‘correlation’ of the underlying loans: high
correlation ⇒ defaults occur together ⇒ high risk.
» A CDO can be based on a MBS (2000s).
Dangerous: difficult to evaluate correlations of underlying MBSs.
3. Credit default swap (CDS).
» ‘Super-senior’ tranche from the above CDOs had low returns were
kept by banks themselves.
» AIG sold insurance on these CDOs in the form of CDSs (full repayment
should the ‘super-senior’ tranches ever default).


Relationship between MBSs, CDOs and CDSs

Financial innovation and the growth of the shadow

banking system
Securitisation played an prominent role in the development of a new

financial innovation:
» The subprime mortgage market in the mid 2000s.
» Subprime mortgages: new class of residential mortgages offered to
borrowers with less than good credit records.
Shadow banks such as investment banks were highly leveraged
financial institutions.
» When the Fed raised the Fed rate what happened to these banks’
balance sheet?
In the UK, the size of the shadow banking sector has grown over time
as shown by Figure 3.


banking system
Figure 3: Percentage of assets held by various financial subsectors in the UK. Source:
Atz and Bholat
Week 9 (2016) BEE2037- MONEY AND BANKING 18 / 43

banking system
Time for Task 2

Task 2
You will see the task as you watch the lecture recordings.

Progress so far
Remember the questions that we are looking at this week...

1 What is financial innovation? ✔
2 How has financial innovation led to the growth of the shadow banking
system? ✔
3 How can mobile banking promote financial inclusivity? Next slides...
4 What has been the impact of financial innovation on traditional
banking? Next slides...
5 What happens when financial innovation turns toxic or is
mismanaged? Tutorials...

Mobile banking and financial inclusivity
Banks and financial intuitions channel money from savers to

borrowers who need it the most.
BUT, there are people without bank accounts today.
» Therefore are financially excluded in many countries.
Mobile banking is a financial innovation that can greatly help improve
financial inclusivity in societies.

Figure 4: Geographic mapping of mobile money services in emerging and developing

countries. Source: Pelletier et al. (2020)

Mobile banking vs internet

banking using a mobile
phone.
What is the difference?
Task 3
You will see the task during the lecture.

The most well known mobile

banking system in the world is
M-Pesa.
M-Pesa launched by Safaricom
in March 2007.
Safaricom established in 1993 is
the leading mobile network
‘M’ stands for mobile while ‘Pesa’ is provider and most profitable
Swahili for money. company in East Africa.

Apart from M-pesa, there are 3 other mobile banking services in

Kenya.
» Airtel Money provided by Airtel Kenya.
» T-kash provided by Telkom Kenya Ltd.
» Equitel run by Equity Group (a bank).
96% of households and 72% of people have a mobile money account
in Kenya as of 2020.

Prior to mobile phones becoming widespread:

» People in rural Kenya had very few options to manage their money.
» Only option for rural dwellers was cash transactions.
» Payment systems in Kenya were inefficient.
With mobile phones becoming cheaper and M-Pesa being launched:
» the financial inclusivity of rural population and the unbanked in cities
greatly improved.
» Payment systems landscape in Kenya was revolutionised.


How does M-Pesa work?

M-Pesa is a telecom-led model.
» In its basic form no bank account is required.
» M-Pesa is text messaging based.
» To deposit or withdraw cash from M-Pesa account, the mobile money
system uses human agents (M-Pesa agents).
» Users have access to saving and credit through their M-Pesa accounts.
» Currently, M-Pesa is a fully-fledged financial service.

What is the evidence of M-Pesa promoting financial inclusivity in

Kenya?
» By November 2007, M-Pesa had just over 1 million active users in
Kenya.
» By 2012, it had 15 million active users and more than 30,000 M-Pesa
agents.
» By mid 2022, M-Pesa had over 51 million users & 600,000 M-Pesa
agents.
» Basic formal financial services taken for granted in some advanced
economies, have been provided to million of Kenyans using mobile
banking.

Figure 5: Financial access in Kenya Source: Finaccess Household Survey, Central bank of
Kenya (2021)
Figure 6: Expanding formal financial inclusion in Kenya Source: Finaccess Household Survey,
Central bank of Kenya (2021)
Figure 7: Mobile money accounts usage in Kenya Source: Finaccess Household Survey,
Figure 8: Decline of traditional banking in Kenya Source: Finaccess Household Survey,

Figure 9: Who is driving mobile banking in Kenya? Source: Finaccess Household Survey,

Key lesson from M-Pesa:

‘Simple financial technology & innovations (mobile money & banking)
can solve basic financial exclusion’
Formal Informal only Excluded
Seychelles (2016) 95 2 3
South Africa (2019) 91 3 6
Kenya (2021) 83.7 4.7 11.6
Nambia (2017) 73 5 22
Rwanda (2020) 77 16 7
Tanzania (2017) 65 7 28
Cameroon (2017) 49 15 36
Uganda (2018) 58 20 22
Nigeria (2018) 48.7 14.6 36.8
Table 1: Kenya’s ranking of financial inclusion in Africa (values in percent) Source: Finaccess
Household Survey, Central bank of Kenya (2021)

Figure 10: Cash vs non-cash usage in percent in Kenya Source: Finaccess Household Survey,
Some open ended questions worth considering:

» What are the risks associated with mobile money (mobile) banking?
» What is the future of digital money and traditional banking in Kenya?
» What can the rest of the world learn from Kenya about financial
inclusion?
» What can other monetary policy makers learn from the Kenyan
monetary policy maker?

Time for task 4

Task 4
In this task, I would like you to do the following. Review what we have
covered on M-Pesa. Then answer the following question.
Despite M-Pesa’s success in promoting financial inclusion in Kenya, in your
view, why has this success been difficult to replicate in other countries?

Financial innovation and the decline of traditional banking
Financial innovation and the decline of traditional

banking
As a source of funds for borrowers, market share has fallen.

Commercial banks’ share of total financial intermediary assets has
fallen.
No decline in overall profitability.
Increase in income from off-balance sheet activities.
Decline in cost advantages in acquiring funds (liabilities).


banking
Decline in income advantages on uses of funds (assets).

Banks’ responses:
» Expand into new and riskier areas of lending.
» Pursue off balance-sheet activities.
Decline of traditional banking in many countries.


banking
Time for task 5.
Task 5
In this task, I would like you to do the following. Take 10 minutes to do
some research on P2P lending in the UK. Then answer the following
questions.
1 Why has P2P lending grown in the UK?
2 What has been some of the impacts of the P2P lending sector on the
conventional banking sector in the UK?

Summary
Summary
A change in the economic environment will stimulate financial

institutions to search for financial innovations.
Financial innovation is more than just financial institutions using
financial technologies and artificial intelligence to lower their cost and
providing efficient services to customer.
The securitisation and trading of (sub-prime) mortgages greatly
increased systemic risk.
Mobile banking has greatly promoted financial inclusivity in Kenya
and transformed its financial structure.
Financial innovations has led to the decline of traditional banking in
many countries across the world.

Next week and next topic...
Guest speaker on M-Pesa and financial inclusivity
Tuesday 28 October 2023

Topic of week: Foreign exchange market: an asset approach
The basics of the exchange rate.

The foreign exchange market.
Modelling the exchange rate.
» The uncovered interest parity (UIP) condition.
Reading material and resources:
» Carlin and Soskice (2015), Chapter 9: sections 9.1 - 9.2.1 (only these
sections are relevant to our topic and examinable).

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BEE2037- MONEY AND BANKING

Financial innovation and inclusivity

3 Securitisation and shadow banking system

4 Mobile banking and financial inclusivity

5 Financial innovation and the decline of traditional banking

Week 9 BEE2037- MONEY AND BANKING 2 / 43

Define and recognise the importance of a nominal anchor.

Week 9 BEE2037- MONEY AND BANKING 3 / 43

Week 9 BEE2037- MONEY AND BANKING 4 / 43

These financial innovations have revolutionised how transactions are

Week 9 BEE2037- MONEY AND BANKING 5 / 43

What is financial innovation?

Week 9 BEE2037- MONEY AND BANKING 6 / 43

Recent financial innovations

Some recent financial innovations include:

Week 9 BEE2037- MONEY AND BANKING 7 / 43

Recent financial innovations

Types of financial innovation

1. Responses to changes in demand conditions: interest rate volatility.

Week 9 BEE2037- MONEY AND BANKING 9 / 43

Types of financial innovation

2. Avoidance of existing regulations.

Week 9 BEE2037- MONEY AND BANKING 10 / 43

Types of financial innovation

3. Responses to changes in supply conditions: information technology.

Week 9 BEE2037- MONEY AND BANKING 11 / 43

Types of financial innovation

Time for task 1.

Week 9 BEE2037- MONEY AND BANKING 12 / 43

Securitisation and shadow banking system

Week 9 BEE2037- MONEY AND BANKING 13 / 43

Securitisation and shadow banking system

3 key financial instruments used prior to the GFC as part of

Week 9 BEE2037- MONEY AND BANKING 14 / 43

Securitisation and shadow banking system

2. Collateralized debt obligation (CDO)

Week 9 BEE2037- MONEY AND BANKING 15 / 43

Securitisation and shadow banking system

Week 9 BEE2037- MONEY AND BANKING 16 / 43

Financial innovation and the growth of the shadow

Securitisation played an prominent role in the development of a new

Week 9 BEE2037- MONEY AND BANKING 17 / 43

Financial innovation and the growth of the shadow

Financial innovation and the growth of the shadow

Time for Task 2

Week 9 BEE2037- MONEY AND BANKING 19 / 43

Remember the questions that we are looking at this week...

Week 9 BEE2037- MONEY AND BANKING 20 / 43

Mobile banking and financial inclusivity

Banks and financial intuitions channel money from savers to

Week 9 BEE2037- MONEY AND BANKING 21 / 43

Mobile banking and financial inclusivity

Figure 4: Geographic mapping of mobile money services in emerging and developing

Week 9 BEE2037- MONEY AND BANKING 22 / 43

Mobile banking and financial inclusivity

Mobile banking vs internet

Week 9 BEE2037- MONEY AND BANKING 23 / 43

Mobile banking and financial inclusivity

The most well known mobile

Week 9 BEE2037- MONEY AND BANKING 24 / 43

Mobile banking and financial inclusivity

Apart from M-pesa, there are 3 other mobile banking services in