Financial innovations and their implications for monetary policy: an international perspective

Introduction

This paper attempts to provide a broad and long-term perspective on recent changes in the banking system and financial markets and on their major implications for monetary policy in the larger industrial countries. The financial changes or innovations reviewed here cover a broad spectrum. Frequently, the term financial innovation is limited to new or altered financial instruments (i.e. deposit and cash management instruments) issued by banks and other deposit-taking institutions. In this paper the discussion of financial changes includes these types of innovations as well as issues of securities in money and capital markets and also changes in the market structure and institutions. Both the development of markets for new financial instruments and the expansion and deepening of markets for the pre-existing instruments are relevant in considering changes in the workings of the financial system. However, no attempt is made to be comprehensive in terms either of detailed changes or of country coverage. Rather, the study intends to provide a general perspective on those changes that are broadly based across countries and entail potentially significant consequences for policy.

The discussion is carried out in terms of five broad categories of financial changes which seem to reflect the major long-term trends in the financial systems of industrial countries. These categories are:

1. the increasing use of interest-sensitive funds by banks and other financial institutions;
2. variable rate lending or borrowing and maturity shortening;
3. the growth of financial markets and of marketable financial instruments;
4. (4) the changing shape of retail banking;
5. the diversification of sources of financial services.

These "super" changes subsume a myriad of changes in financial instruments and other innovations constituting the significant medium-term trends in the financial system. Needless to say, these trends are relevant for in varying degrees.

The process of financial change exerts significant influences on the empirical definition of money, the money supply process, the demand for money and the role of interest rates in the transmission of monetary influences to the rest of the economy. More generally, changes in the financial system raise questions about the meaningfulness of monetary and financial aggregates and may lead to shifts or (further) instability in the relationship of those aggregates to economic activity. This paper discusses these issues and the problems created by them for monetary policy targeting and monetary control. The paper also considers, albeit briefly, some implications of the changing financial environment for financial regulations and their relevance for monetary policy.

At the outset, it should be noted that the following analysis does not deal explicitly with changes in international financial markets. It would appear that a consideration of those changes would strengthen many of the conclusions regarding trends in various groupings discussed below. For example, interest-sensitive funding and variable rate lending/borrowing are very common features of the Euro-markets. Indeed, some of the new practices originated in those markets and were subsequently adapted by domestic financial markets.