10.2 Innovations Galore #Notebook

 10.2 Innovations Galore #Notebook

The competition drives bankers to adopt new technologies and search for ways to reduce the negative effects of volatility. 

Bankers responded to the increased interest rate risk by inducing others to assume it with financial derivatives, like options, futures, and swaps. 

In the 1970s, bankers began to make adjustable-rate mortgage loans. Traditionally, mortgages had been fixed rates. That way, bankers transfer the risks to borrowers. Although, when rates decrease, the borrower pays less to the bank, the interest rate risk still falls on borrowers.

To induce borrowers to take on that risk, banks must offer them a more attractive (lower) interest rate than on fixed-rate mortgages. 

However, fixed-rate mortgages remain popular, because many people don’t like the risk of possibly paying higher rates in the future. 

If mortgages contain no prepayment penalty, borrowers can take advantage of lower interest rates by refinancing, getting a new loan at the current, lower rate and using the proceeds to pay off the higher-rate loan. 

In the 1970s and 1980s, life insurance companies sought regulatory approval for several innovations, including adjustable-rate policy loans and variable annuities. Because policy loans are loans that whole life insurance policyholders can take out against the cash value of their policies. 

Most policies stipulated a 5% or 6% fixed rate and annuities were also traditionally fixed, therefore, life insurance companies, or banks, were adversely affected by event like the Great Inflation. 

If policyholders borrowed the cash values of their life insurance policies at 6%, then re-lent the money at the going market rate, which was often in the double digits. By making the policy loans variable would limit such arbitrage. 

Fixed annuities were a difficult sell during the Great Inflation because annuitants saw the purchasing power of their annual payments decrease dramatically. 

Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.