Christian Noyer: Financial innovation, monetary policy and financial stability
Speech by Mr Christian Noyer, Governor of the Bank of France, at the Spring Conference of the Bank
of France/Deutsche Bundesbank, Eltville, Germany, 27/28 April 2007.
* * *
Ladies and gentlemen,
- It is a privilege and a real pleasure to open this conference, which is the first one to be jointly
organised by the Banque de France and the Deutsche Bundesbank. And I look forward,
together with President Weber, to many other events of the same kind to be held either in
France or in Germany.
- This conference addresses a topic which I believe is of utmost importance. Indeed, central
banks extensively collect and analyse micro-data, mainly on banks and firms. Such information
is used in an extensive way in order to assess the economic situation and short-term prospects
for output, demand and prices. It also provides inputs to macroeconomic models for forecasting
and policy evaluation; and finally, it helps identifying possible threats to the stability of the
financial system. At a time when financial innovation is developing rapidly, micro-data analytical
research is particularly useful in helping central bankers meeting the challenges we face for
maintaining price stability and financial stability.
Financial innovation, defined as the emergence of new financial instruments and services, and of new
forms of organisation in more sophisticated and complete financial markets, has many well-known
positive effects:
•
by creating more complete markets, it improves resource allocation, thereby supporting
longer-term growth prospects1;
•
financial innovation even appears to reduce growth volatility, as has been shown in the case
of the US2 and confirmed on a sample of 25 countries3. As regards firms, this seems to
result from a more flexible financial structure. With respect to households, this appears to
stem from relaxed collateral constraints on borrowing4 allowing households to better smooth
consumption in the face of temporary changes in their income5. Moreover, deregulation and
innovation on the housing finance markets enable households to purchase houses whose
values are consistent with their long-term income prospects, as shown e.g. in the case of the
US using data from the Panel Study of Income Dynamics.
Financial innovation does not follow a regular pattern, as some periods are more active than others
especially those of financial liberalisation and increased use of IT in financial related activities. It is
clearly the case of the last few years with the rapid development of credit derivatives, securitization,
hedge funds and private banking that has led to a situation where most credit risk are no longer in the
form of loans, held to maturity on the balance sheets of banks, but where much of the credit risk is
now held by nonbank financial institutions that can take on substantial leverage. It has occured in
Europe in the context of a major financial innovation, the introduction of the Euro, and poses new
challenges for central bankers: it makes monetary analysis more complex, modifies the monetary
policy transmission mechanisms and, in some cases, may endanger financial stability.
1. Financial innovation is a challenge for the interpretation of developments in the
monetary aggregates and for the best use of our second pillar
It is clearly not a surprise, at a time of burgeoning financial innovation to observe signs of instability in
money demand. New products and new intermediaries tend to blur the distinction between monetary
and non-monetary assets and to modify the financial behaviour of economic agents. And indeed, the
demand for M3 in the euro area has shown clear signs of instability since 2001 and a break in the
income velocity of M3 occurred at the same time. Most remarkably, instead of delivering some erratic
pattern, a new velocity trend seemed to emerge with liquidity expanding much more rapidly6. It is fair
to say that the precise role of financial innovation in this regard is still unknown but we have all the
reasons to believe that, taking it into account should help explain this change in money demand, and
better gauge its consequences for future inflationary pressures. Let me elaborate further.
First of all, the introduction of the euro in itself a major financial innovation, had many effects on the
financial behaviour of economic agents.
The introduction of the euro immediately resulted in:
•
the removal of any exchange rate risk between participating countries;
•
the introduction of a new system of remunerated reserve requirements;
•
and the creation of an integrated money market - thanks in particular to the setting up of a
new large-value payment system (TARGET).
Furthermore, thanks to the introduction of the euro and to the successful monetary policy conducted
by the ECB, all member countries now benefit from an environment of well-anchored inflation
expectations and, as a result, low interest rates.
This new context has had several consequences:
•
both inside and outside the euro area, the reputation of the euro as a solid currency has
fostered the holding of euro-denominated banknotes, which has doubled in a few years, now
representing the largest banknote circulation in the world;
•
the so-called "home bias" in asset holdings has decreased further, both inside the euro area
vis-à-vis assets issued in other Member States and outside the euro area vis-à-vis assets
issued in the euro area. This has increased globally the demand for euro-denominated
financial assets;
•
the integration and competition in the banking and financial markets that has been fostered
by the euro speeded up the development and the spreading out of financial innovation
throughout the euro area, affecting money and credit developments in different ways. Let me
just mention some of them.

One is the rapid pace of expansion in the activities of the so-called "other financial
institutions" or OFIs. OFIs are not part of the money-creating sector and are neither
insurance companies nor pension funds. In particular, they include financial vehicle
corporations that purchase, pool and repackage as marketable securities loans that
are "securitised" by banks, thereby reducing the growth rate of loans to the private
sector. The expansion in OFIs' activities is to a certain extent mirrored in the
development of their monetary assets: which is now quite significant and amounts
to around 10.5% of M3. I would submit that, in normal circumstances OFIs' money
holdings are unlikely to be transferred to non-financial agents and to generate an
additional demand for goods and services. The reading of M3 developments, and
its interpretation in terms of the risks to price stability, should, most likely, be
adapted accordingly.

Financial innovation has also affected money and credit developments by making it
easier for banks to hedge credit risk and manage maturity and credit mismatches.
This may have supported the supply of credit, especially long-term loans to
households, in recent years. Indeed, housing loans have grown at a rate of 9.8%
per year in the euro area since the beginning of 1999.

In recent years, two innovations that may have an impact on the interest rate
elasticity of money demand have emerged. One takes the form of high-yielding and
highly liquid deposits accessible via direct banking or internet accounts. The
second, which is still marginal, consists in the introduction of so-called "retail
derivatives", which are usually short-term deposits with embedded derivatives
tailored to the needs of investors.
Taking into account the effects of financial innovation is a clear challenge for monetary analysis.
Meeting this challenge requires regularly updated tools and in-depth research based, in particular, on
sectoral analysis.
2. By affecting the transmission mechanism, financial innovation is also a challenge for
the conduct of monetary policy
A good knowledge of the mechanisms through which monetary policy affects the economy is of crucial
importance for central banks. Financial innovation affects these mechanisms both by altering the
channels through which monetary policy operates and by changing the overall impact of monetary
policy decisions. But the magnitude of the changes and the precise effect due to financial innovation at
a time when other factors such as globalisation are at work are not well known. At the present juncture
research shows that financial innovation tends to strengthen the interest and exchange rate channels
whereas it appears to weaken the credit channel.
- Financial innovation certainly contributes to stronger wealth effects and thus probably also to
strengthen interest rate channel7. This can be explained as follows :
•
Financial innovation fosters faster dissemination of information and its more rapid
incorporation into financial market prices. This is of course particularly true for
monetary policy decisions and can therefore increase the effectiveness of
monetary policy, particularly via the interest rate channel8.
• Financial innovation contributes to an increased holding of financial assets by
lowering transaction costs and facilitating arbitrage, hedging, funding and
investment strategies.
•
Financial innovation often relies on stronger leverage, increasing the effect of
interest rate change by the central bank. One example of this enhanced impact is
provided by the behaviour of hedge funds who customarily borrow short-term funds
to finance their (longer-term) investments9.
- Turning to the exchange rate channel, financial innovation results in greater integration of
domestic and international financial markets, which should also strengthen the exchange
rate channel as exchange rates become more sensitive to interest rate differentials between
currency areas. This has been illustrated by the recent debate about cross-border carry
trades10.
- At the same time, financial innovation has probably weakened the credit channel11. Several
phenomena may be at play :
•
Financial innovation gives firms broader access to securities markets, which may
reduce information asymmetries at the source of the credit channel.
•
More specifically, securitisation by banks has reduced their liquidity constraints and
thus further weakened the credit channel. A recently published research paper by
the New York Fed, using a micro data set of individual loans granted by a sample
of banks between 1997 and 2005, shows that the use of credit derivatives is
associated with a greater supply of newly negotiated loans extended to large
corporate borrowers. Previous research has generally found that banks have used
earlier credit market innovations such as loan sales and securitisation to diversify
credit risk exposures and increase lending.
• However, credit derivatives might also encourage banks to monitor risks less
carefully than in the past and thus mitigate the aforementioned effects that dampen
the credit channel. To the extent that banks monitor their risks efficiently that
mitigating impact should nevertheless be only partial.
Research conducted within the Eurosystem Inflation Persistence Network has already shown that the
interest rate channel is a prominent channel of transmission in the euro area12. As financial innovation
tends to strengthen that channel, it would be tempting to assert that it makes monetary policy more
efficient. However, countervailing effects make it difficult to draw a general conclusion. Furthermore,
empirical work is lacking on this issue. I would thus strongly encourage researchers to provide
policymakers with further evidence - drawing especially on micro-data.
3. Financial innovation may in some cases endanger financial stability and central banks
should take appropriate action in order to mitigate potential systemic risks
Such issues may arise both at the microeconomic and at the macroeconomic levels.
- Let us first look at the microeconomic level
•
Specific difficulties may arise in the infancy of new products: valuation difficulties,
lack of market liquidity, possible lack of expertise of some traders, and so on.
However, such problems can be regarded as mostly transitory in nature. Indeed,
financial innovation has improved and increased the efficiency of the financial
system. In particular, risks are spread among a greater number of agents, who are
a priori
willing and able to bear them. However, innovations constantly introduce
additional layers of sophistication and complexity13. In this regard, the system of
incentives by which professional asset managers operate should be closely and
permanently aligned with the interests of investors.
• One specific type of financial innovation is the emergence of new unregulated
players whose default might have implications for systemic risk. One such type of
investor are hedge funds. Hedge funds' activities could clearly be the source of
systemic risk since they are now major - often dominant - actors in several market
segments accounting for 40% of the turnover of major stock exchanges and 25% of
the turnover of credit derivatives markets. They are also the main providers of
liquidity in some markets that would dry up very quickly should they withdraw. They
often leverage themselves with very high multiples either directly through borrowing
or indirectly by intensive use of derivatives.
• The importance of hedge funds and more generally of the already mentioned OFIs
illustrates that there may be circumstances in which injecting liquidity into the
banking system - a traditional tool of crisis management used by central banks -
may not be sufficient to prevent major instability. Three main avenues for mitigating
the risks of contagion from hedge fund defaults either through potential losses to
their bank creditors or through adverse market dynamics have been proposed14.
First, appropriate intervention by supervisors vis-à-vis prime brokers to make sure
that they ask for and get broad information from hedge funds and that they put in
place comprehensive risk management of all hedge funds-related exposures is
essential. Second, there may be scope for policy-makers to encourage appropriate
organisation of infrastructure in order to improve the information available on the
markets in which hedge funds operate. Third, a specific information system to be
triggered in the event of a crisis could be established ex ante in order to ensure
that relevant information on exposures and positions could be quickly gathered if
necessary.
- At the macroeconomic level
•
Increased financial asset holding resulting from financial innovation is likely to
result in higher sensitivity of households to asset price booms and busts15. On the
liabilities side of non-financial agents' balance sheets, by facilitating the
management of risk and easing liquidity constraints, financial innovation stimulates
both the supply of and demand for credit, which may lead to higher leveraging and
financial fragility. Note that both effects run counter to the result I mentioned at the
start, i.e. that financial innovation tends to reduce growth volatility. Although this
result may still hold true in normal circumstances, it may thus be reversed in
specific ones, especially in stress situations.
•
Finally, as links between markets are tightened by financial innovation, a shock
occurring on one specific market may be more easily transmitted and possibly
amplified on other markets. This may particularly be the case if the shock is large
and if market participants adopt herd behaviour in the face of incoming information
that is disseminated very fast.
I will not try to conclude these opening remarks, since it is precisely the purpose of the conference to
go into deeper analysis of all the issues I tried to mention briefly, and perhaps of others I forgot. And it
will be up to President Axel Weber at the end, to draw the conclusions. But let me make just one final
remark. Financial innovation brings a lot of progress and should be welcome in principle. It is also a
constant challenge for central bankers. Good knowledge of microeconomic behaviour is of prime
importance in order to better cope with the increased uncertainties and the new types of risks they
bring about. This in turn is a challenge I am sure this conference will endeavour to rise to.
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•
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•
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•
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•
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