Financial innovation describes the changes in the types of institutions or services offered in the financial marketplace. Here are some financial innovations that have occurred recently:
- The expansion of insurance companies into banking (e.g., Travelers Insurance merged with Citibank to form Citicorp)
- The expansion of automated teller machines
- The invention of online payment systems (e.g., Paypal, Apple Pay, etc.)
- The expansion of investment banks into commercial banking ( e.g., Goldman Sachs now offers checking accounts and other services.)
- The creation of completely online banks (e.g., SoFi) and completely online insurance companies (e.g., bestow.com)
As we discussed before, depository institutions are known as financial intermediaries. They accept deposits on which they pay interest and make loans on which they charge higher interest, making a profit on the difference. The loans they make include credit cards, mortgage loans, personal loans, and business loans. All are set at different interest rates.
The difference between the average aggregate rate financial intermediaries pay on their total deposits and the average aggregate rate they charge on their total portfolio of loans is called the net interest margin. This must be enough to pay for the overhead plus make a profit for their stockholders. The net interest margin can vary, so here is a snapshot going all the way back to the 1980’s:
Figure 10.1. Federal Financial Institutions Examination Council (US) and Federal Reserve Bank of St. Louis, Net Interest Margin for all U.S. Banks (DISCONTINUED) [USNIM], retrieved from FRED, Federal Reserve Bank of St. Louis; September 30, 2021.
Note that there is a lower limit to the net interest margin, and this gives us an insight into the business banking model. If the net interest margin for a bank gets significantly below 3%, the bank will likely be unable to meet its overhead costs, putting it into serious financial trouble. Similarly, according to the National Credit Union Administration, the net interest margin on credit unions have also been running about 3% for the last decade.
The prime rate, or the rate that banks give to their most creditworthy customers, is always exactly 3% above the Federal Funds Rate. Of course, most commercial bank customers do not get the prime rate on their loans, but it is the benchmark against which commercial loans are priced. Most customers pay 1% to 2% above prime on their short-term loans.