Financial innovation refers to the surfacing of novel types of institutions and creative financial instruments in the financial market (Noyer 1). According to Kogar, financial innovations create novel technological instruments (such as electronic cards) that enable economic agents (households and business organizations) to carry out investment activities efficiently in the capital markets (1). As a result, financial markets benefit in terms of efficient allotment of portfolio risks as well as better allocation of financial assets (13). Some researchers have previously demonstrated the relevance of financial innovation with respect to monetary policy efficiency. Conversely, others have shown that financial innovations bring about certain risks associated with the implementation of monetary policy (Misati and Lucas 124). It is important to mention that monetary policies can only be executed successfully in the short-run. Nonetheless, there are various setbacks that may emerge when financial innovations are adopted in the financial sector. For instance, the central bank may find it difficult to implement monetary policies in a capital market characterized by the prevalence of financial innovations. In addition, the emergence of novel financial instruments necessitates the enactment of a new set of laws to guarantee the smooth implementation of monetary policies in the financial sector (Misati and Lucas 124).
Financial Innovations and Monetary Policies
Misati and Lucas concur that financial innovations have led to the emergence of new financial products which have attracted new investors in the financial sector (127). In addition, financial innovations have widened the range of investment and funding prospects available to potential investors. These developments have also enlarged the diversification options with respect to portfolio and funding sources. Therefore, financial innovations create novel instruments that facilitate speedy transmission of monetary policies in the economy. Financial innovations also augment the monetary and non-monetary assets of investors while diminishing the bank lending instruments. This happens since financial innovations enable many borrowers move into financial markets as their preferred sources of financial support (Misati and Lucas 127).
Furthermore, Misati and Lucas examined the relationships between financial innovation and the mechanisms of monetary policy transmission (128). They asserted that financial process is basically a monetary policy aimed at specific macroeconomic variables. In addition, the financial system is deemed as the line connecting the real economy and central bank policies via the monetary policy transmission method. According to Misati and Lucas, asset channel, exchange rate channel and interest rate channel are the three major ways through which financial innovations influence monetary policy. For example, economic agents can employ novel financial tools to augment the inter-temporal exchange of income channels, counter variations in the cost of funding as well as preserve the present interest rates for financing future investments. In other words, current outlay is no longer influenced by the present income. Since financial innovations enhance insurance prospect, the inter-temporal replacement of the monetary transmission mechanism is effectively controlled (Misati and Lucas 128).
Furthermore, the emergence of e-money (electronic money) can potentially replace the conventional form of money. In addition, the traditional bank demand deposits could be replaced by electronic payment thereby weakening the relevance of the monetary transmission method. This happens because the connection between alteration in the real sector activities and adjustment in bank deposits is undermined. Therefore, the aggregate sum of reserves held by the central bank on the behalf of commercial banks will reduce if the demand for conventional form of money declines. The widespread use of e-banking is an example of financial innovation that played a critical role in what was initially regarded as a steady relationship between the aggregate nominal income and stock of money (Misati and Lucas 128).
The value of the monetary transmission method is determined by the strength of financial markets as well as the nature of financial diversity. For example, novel financial instruments encourage attract a large number of investors to the capital market because they can utilize these new instruments to achieve their investment goals. In this framework, the introduction of technological innovations in the financial system influences monetary policy effectiveness by escalating or reducing delays from alterations in the monetary policy rate in terms of the cost of funds to economic units. For example, when economic units (households and business) rely on other sources of finance, the rate and strength at which monetary policy rates are conveyed to the real cost of financing may be compromised. For example, the monetary policies of the central bank may be rendered irrelevant (to some level) because the financial structures of these novel instruments may be different (Misati and Lucas 129).
Benefits of Financial Innovation
According to the existing literature, there exist two major approaches that attempt to explain the manner in which financial innovations influence the effectiveness of monetary policies. For instance, the first theory asserts that financial innovations enhance monetary policy in three crucial ways. First, financial innovations reduce the time taken to distribute financial information within the financial sector. Second, financial innovations augment the role of expectations. In other words, real and expected adjustments in interest rates are easily conveyed to various financial assets thereby manipulating long-term interest rates with repercussions on investment and consumption. Third, financial innovations enable shareholders to access a wide array of financial instruments that permit hedging of interest rate risks. As a result, shareholders are able to diversify their portfolios with optimistic presumptions on the pass-through upshots of policy rates (Misati and Lucas 124).
As mentioned earlier, financial innovations not only facilitate rapid distribution of financial information among key stakeholders but also ensure that such information is integrated into financial market prices on time. This is especially true with regard to monetary policy actions since financial innovations augment the efficiency of monetary policy through interest rate instruments. Financial innovations also enable economic agents to invest in financial assets for a longer period since they reduce transaction outlays. In addition, financial innovations facilitate investment, funding and hedging strategies. Finally, financial innovations alleviate information asymmetries since they allow economic agents access to securities markets (Misati and Lucas 128).
Negative Effects of Financial Innovation
The second theory posits that relying on new financial instruments (created via financial innovation) can diminish the magnitude and the rate at which monetary policies are transmitted to the cost of financing. This happens when the central bank policy directives cannot manipulate the new financial instruments due to their dissimilar funding arrangements. In addition, financial innovation can bring about imbalances especially if policy directives deviate from the expectations of the shareholders. If this happens, financial markets may experience disruptions resulting in enhanced volatility in asset prices and liquidity which may bring about inefficiency in policy directives via the interest rate instrument (Misati and Lucas 125).
Financial innovations have also brought about new risks regarding the management and operation of domestic and global financial systems. For instance, financial innovations alleviate the distinction between money markets and capital markets. In addition, financial innovations prevent central banks from pursuing their goals. However, the emergence of financial innovations may prevent central banks from achieving the macroeconomic and structural objectives. In addition, financial innovations make it difficult to analyze financial data thereby preventing the implementation of monetary policies (Kogar 14).
As mentioned above, financial innovations have considerable influence on the operations and structures of financial systems. Misati and Lucas examined the relationships between financial innovation and the mechanisms of monetary policy transmission (128). In addition, the financial system is deemed as the line connecting the real economy and central bank policies via the monetary policy transmission method. As mentioned earlier, financial innovations not only facilitate rapid distribution of financial information among key stakeholders but also ensure that such information is integrated into financial market prices on time. This is especially true with regard to monetary policy actions since financial innovations augment the efficiency of monetary policy through interest rate instruments. According to Misati and Lucas, asset channel, exchange rate channel and interest rate channel are the three major ways through which financial innovations influence monetary policy. Financial innovations also manipulate monetary policies in several positive ways. For instance, financial innovations not only facilitate rapid distribution of financial information among key stakeholders but also ensure that such information is integrated into financial market prices on time. However, financial innovations reduce the magnitude and the rate at which monetary policies are transmitted to the cost of financing. This happens when the central bank policy directives cannot manipulate the new financial instruments due to their dissimilar funding arrangements.
Kogar, Cigdem. Financial Innovations and Monetary Control. Turkey: The Central Bank of the Republic of Turkey, 1995. Print.
Misati, Roseline and Lucas Njoroge. “Financial Innovation and Monetary Policy Transmission in Kenya.” International Research Journal of Finance and Economics 50 (2010): 123-136. Print.
Noyer, Christian. “Financial innovation, monetary policy and financial stability.” BIS Review 42 (2007): 1-6. Print.