iBusiness, 2013, 5, 63-68
http: //dx.doi.org/10.4236/ib.201 3.53B014 Published Online September 2013 (http://www.scirp.org/journal/ib) 63
Study on Financial Management Innovation
and Currency Policy
Xingang Wang, Shangzhi Yue
Graduate School of Northeast Forestry University.
Email: 920028102@qq.com, yueshangzhi@126.com
Received June, 2013
The thesis analyzes the role of transform risks caused by innovation tools, the extent to which financial innovation tools
have an influence on risks of financial system, the extent to which financial innovation has an influence on financial
statement and macro monetary policy, the extent to which financial innovation exerts influences on classification of
monetary, government’s requirement for monetary, the degree to which financial innovation exerts an influence on con-
trol of money supply. This thesis studies the alternative and significance of monetary aggregates, a new perspective of
financial innovation and general money supply. Financial innovation can enhance the efficiency of the whole financial
market and proactively promote economic development. Financial innovation is charactered by anteriority and financ-
ing, also can erase inflation.
Keywords: Financial Innovation; Monetary Policy; Exchange Rate
1. The Influence and Significance of
Financial Innovation
The appearance of financial innovation follows the de-
velopment of commodity economy, including emergency
of monetary, growing up of commercial banks and the
wide use of bill of exchange, which are defined as main
achievement of financial innovation in the history of fi-
In the middle of 1980s, the wave of financial innova-
tion has dispersed in international financial area. The
increasing emergency of new financial tools and financial
institutions and financial services overwhelms us. As
Professor James C. Van horme of Stanford University
said, “the foundation of our financial system is financial
invention, which is assimilated as a gust of fresh blood in
our effective and acute financial systemAlthough we
pay careless attention to the recent changes caused by
financial service, we will be taken aback by these
changes. [1] “With the growing development of financial
invention, the tide, so far, remains unfolding.
Historically, financial invention has greatly given im-
petus to social progress and promoted several leaps, so it
receives welcome from not only micro -units but also
managers[2]As we all know, technology has greatly
enhanced welfare of humans, in the same way, financial
invention also plays an critical role in human’s living
standards and economic developmentfinancial invention
reflects decrease which can stimulate financial invention
in trade cost caused by technology advancefinancial
invention makes financial tools shift risks to stabilize
monetary markets
This thesis analyses the influence financial invention
and deregulation exert on monetary policy and domestic
macro-economy, [3] in addition, monetary policy greatly
promotes domestic macro-economy
2. Influence of Financial Invention on
Financial Market Stability
2.1. Roles of invention tools in shifting risks
For most people, the use of new financial tools aims to
evade risks, because they hate risksFor individual cli-
ents, the ability endowed by innovation tools of shifting
isks is showed in Table 1. r
Table 1. Balance Sheet
Risk exposure
of interest rateRisk exposure
of exchange rate
of credit
Note issuance
facilities strong 0 strong strong
Currency swap
of capital marketweak strong weak weak
Interest rate swapstrong 0 weak weak
Currency option 0 strong Weak/0weak
Interest rate optionstrong 0 Weak/0weak
Forward rate
agreement strong 0 weak weak
asset strong 0 strong strong
Copyright © 2013 SciRes. IB
Study on Financial Management Innovation and Currency Policy
a. Underlying market prices increase by two percentage
points, and such effects are long-lasting phenomenon.
b. The reduction of yield variance.
c. Systemic risk is not affected.
Detemple and Jorion (1990) investigated a large
sample which was about the introduction of option
(1973-1986).[4]Their conclusion was similar to Conrad.
The similarity is on the following topics:
a. Price of underlying market stock roses about 3
percentage points.
b. Underlying stock volatility decreases.
c. Cancelling option has the opposite effect with the
introduction of options, that the stock price falls and
volatility increases.
d. The price and effect of volatility would not change
obviously after 1982.
e. Systemic risk is not affected
Conrad, Detemple and Jorion's findings are in a
dominant position. Though, theoretically their ideas are
inconsistent. More about the credit period, other
derivative instruments for native volatility affects are
rarely addressed. If derivative markets are more volatile
than the native market, it is also no conclusive empirical
analysis. But people often say "The paradox between
innovation and volatility." Innovation is a reaction to
market volatility and av oidance, however only the market
volatility can attract participants, have a large volume of
transactions and make profits, a large number of
speculators may expect more volatility , mayb e exchange
also do the same thing.
2.2. Concentrations in risk
New financial instruments which previously described
could avoid the risk. Moreover, the introduction of new
tools can reduce the original volatility or at least it is no
evidence of increasing volatility, it appears that systemic
risk will decline. However, the problem is that the
concentration of risk and large numbers of excessive
speculation will bring big risks. The financial system is
very fragile.
This part of the exposition mainly refers to the
balance-sheet business, and especially in derivatives. The
risk posed by derivatives which leads to losses and the
impact on the system, theoretically discussed a lot
Reports in this regard is often apparent. This part only
gives briefly introduction.
Derivatives are leveraged, it can win over a large, this
feature enables easy centralized risk. Speculative
purposes will bring great risk.
Derivative financial instruments are price risk,
operational risk, settlement risk, liquidity risk, legal risk,
credit risk, etc.
Statistical evidence shows that with the development
of new financial instruments, most of the transactions (in
particular OTC) concentrated in a few large banks and
securities firms, in 1991 eight to p largest banks of Un ited
states accounted for 86% interest rate derivative
transactions and 88% foreign exchange derivative
transactions. According to the 1993 Federal Reserve
Bulletin, six major U.S. banks accounted for 90% of the
derivatives market, by the end of 1991 the largest trading
volume eight proprietary stores had occupied 58% of the
market. The level of risk concentration had been
Undoubtedly the most sensational event was collapse
of Barings Bank. Barings Bank was the oldest merchant
bank in Britain, it always had been the top among
merchant banks in Britain and later relegated to second
place. But Riesen bought a large number of Nikkei
futures bulls in Janu ary and February 1995, from the end
of January to 23 February, he had bought a total value of
over 70 billion dollars in contracts. Unfortunately, stock
market continued to decline in Japan, eventually Bahrain
bank lost eight hundred million U.S. dollars and declared
3. Conduction Causes System Risk
Due to the development of technology, resulting in the
reduction of transaction costs, from 1960s to 1980s,
transaction costs fell more than 90%, in CHIPS and
Fedwire payment system had a large number of
transactions every day, for example, in both two systems
it occasionally reached one trillion in 1985. Such
payment system is overburdened and interrupt redundant
danger, this situation does occur, for example, sometimes
due to the computer fault causes an interrupt.
The problem is not too serious, as the market is
expanded, deepening linkages between markets.
Innovative tools actually spread risk in the financial
system. This risk won’t be spread in the system until a
weak point arrives. From a number of financial storms
Federal Reserve Bank of New York drew the following
"Inter-agency, inter-linkages between markets has
become increasingly complex in the new environment.[5]
In a market the first vibration (or shock) will contact be
quickly spread in the contact network, until it reaches an
unrelated place and finds a breakthrough, these
breakthroughs regulatory responsibility is often
weakened, or chaotic place, in fact, there is such a trend:
more and more market contacts join these breakthroughs.
For example, a U.S. savings and credit association may
carry out fixed-rate mortgage loan, if it obtains funds in
the federal funds market, interest rate fluctuations will
obviously be affected, however, it can be an interest rate
swap, thus, it transfers the risk to this commercial bank.
The interwoven relationship in the financial market has
been growing closely, so has the relationship between
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Study on Financial Management Innovation and Currency Policy 65
different markets. Because of the diversification of the
management, some countries allow the financial institu-
tion participate many trades include banking, security,
futures and share option at the same time. Therefore no
mater which part has crisis, it will affect the others and
cause a larger chain reaction.
It is the same in the international financial market.
Some international financial institutions and corporation s
encounter the damage or bankrupt by trading derivative
instruments will make the financial market rise and fall
fiercely. The traders are connected with each other by
financial trade in the financial market. The deficit will
bring chain reaction and spread rapidly. Especially in
global financial times, it may endanger th e stability of the
whole financi a l mark et .
For example, the above-mentioned Bahrain bank
bankrupt event has made the world’s financial market a
mess. England bank announced that the Bahrain bank
bankrupt on 26th February, 1995, then the Asian stock
market down in different degree on 27th, Nikki index
dropped 664.24 point; the range of price drop is 3.8 per-
cent, the stock market of Taipei dropped 3.1 percen t. The
British stock market has also been affected, 100 kinds of
stock index of London Financial Times dropped 0.19
percent. [6] On the same day in foreign exchange market,
the Pound and Lira are devalued while the Mark and
Franc are increased in value. That day, the exchange rate
of Pound to Mark dropped to 2.3000, the important sup-
porting point, becoming the low point for more than two
years. The exchange rate of Lira to Mark dropped to
116.7, the record low.
The world’s crisis of stock market in 1987 was caused
by derivative instrument market and spread to the spot
Due to the centered risk, the big financial institutions
have more possibility to be bankrupt. Meanwhile, be-
cause the market connection has been closer and the
conduction effect has been stronger, the crisis of the
whole financial institutio n has been increased. Th e author
point out that the financial crisis like the one in 1929 is
not occurred due to the enhancement of safeguard and
insurance system by each management authority. The
public’s confidence has been strengthened. On the other
hand, it is easier to raise huge capital than before as long
as you have a good reputation, so it is easier to loan and
merger and acquisitions, and avoid the further chain im-
3) The influence of financial innovation on financial
There are many financial approaches, the adoption of
approaches of balance sheet and the complicated of the
measures present a new problem of transparency. Some
hedge technology is complex on math and some trades
promise has no precedent.
The problem of accounting management
How to express the specific instrument business in fi-
nancial statement, different accountant in different bank
and institution has different ideas. Different institutions
continue to use the differen t conv en tio ns and it can not be
compared among institutions. Some people think we
should adopt historical cost method, while some think
current market method is better. Some accountants think
the process should be reflected in the sheet, some think it
should be made a footnote out of the sheet.
In a word, there in no unified accounting convention to
handle these businesses. So the institution s and banks can
not be compared, the result may widely divergent.
These problems cause two common anxieties: firstly,
the transparency of position statement. Secondly, the
actions are taken to assume the risk of banks and enter-
One result of Off-Balance Sheet Activities is the spe-
cific risk can not be explained clearly. The banking
manager must ensure the degree of the relationship be-
tween the whole and specific risks that Off-Balance Sheet
Activities are taken and the Balance Sh eet Activities, and
also ensure the proper standard of risk comparison to
determine the capital rate, at last to determine the capital
level of bank management. The bank situation is more
salient compared with corporation, the materials should
be provided to stockholders and borrowers. But with the
development of Off-Balance Sheet Activities, the tradi-
tional financial statement is always imperfect or clear,
and it makes clients of banks and institutions different to
know the whole business. But credit should be estimated
on the basis of financial statement which published regu-
larly at intervals. However, with the influence of
Off-Balance Sheet Activities, it is more difficult to un-
derstand the communiqué which has been published, and
so is the estimate of risk and credit.
Risk taking
Due to the lack of unified accounting conventions, es-
pecially the Off-Balance Sheet, the financial statement
that published lack credit, it also cau ses a problem that is
the corporation bank may take more risks.
3 The choice and significance of monetary aggregates
The influence of financial innovation on M1
M1 is a very important monetary definition. It was re-
garded to be the most important monetary policy index
by western economist and currency authorities. That is
because the M1 held the following three characteristics
for a long time: firstly, M1 include the main exchange
medium, secondly, the relationship between M1 and sta-
bility and forecast of national economy, thirdly, M1 is
easier to control by the monetary authority.
The significance of broad money
Copyright © 2013 SciRes. IB
Study on Financial Management Innovation and Currency Policy
Because the disappearance of stability between M1 and
national economy index. The US Federal Reserve has no
longer paid much attention to M1 since 1993, while the
M2 and M3 attract more attention.
M2 and M3 are popular instead of M1. Many econo-
mists think that the relationship between broad money
and the final economic index is more stable, and it has
less influence from financial innovation; because of the
large capacity of broad index. The broad index will not
be affect when the public change account in RPs and
MMDAs which has the similar functions in M1 and M2.
However, the problems of M1 gradually appear in gen-
eral indices.
Redefining and dividing money
In 1996, the repor t of Bank of Eng land stated: [7 ] “The
problems of defining money become more acute for the
fact of developing innovation and modernization. At pre-
sent, there is a series of financial products of little differ-
ence. As a matter of fact, monetary and non-moenytary
cannot be divided wit h speci fic and accurate standards.”
With the increasing of financial products and new
components in the definition of broad money, the defini-
tion of money has to be changed constantly to keep up
with innovation. Meanwhile, it is a hard work to divide
money because of the addition of new tools and changing
of old tools. Monetary must be analyzed carefully, di-
vided and classified accurately and rationally, so it is
very diffic ul t to define broad money.
The Adjustment of Broad Money Indices
Broad Money M2 may be replaced by M3,
M4……with stronger and broader explanatory ability
over time.
For instance, in 1997, the report of Bank of England
stated, gradually there is no difference between the
Housing Association savings and bank savings, therefore
the central bank should attach much more importance to
The research of Weale (1996) also showed that the
savings of the Housing Association and banks have
higher substitutab ility, which means it is improper for the
central bank to pay attention to M3 only for the control of
As a matter of fact, it cannot be solved by only focus-
ing on changing M3 to M4, for it is not for good and all,
and the indices need to be modified with the development
of financial innovation, which all hinder the control of
The Significance of Broad Money Indices
Even though the instruction of the controlling indices
of the monetary aggregates has broadened, the problems
still exist.
If one index of monetary aggregates control in imple-
ment of money supply strategy, it’s better to keep a stable
connection between money aggregates and ultimate tar-
get. The motive of owning money should be synchro-
In this way, the growth rate of money aggregates can
exactly reflect the growth level of expenditure. The sig-
nificance of monetary control is the reduction in money
means the reduction in money available for spending, so
there will be a stable and close relationship between
money aggregates and nominal incomes. But according
to the communiqué of Bank of England, it seems that the
financial innovation has changed the quantity of money
--- the connection among incomes. Since 1990, the rela-
tionships between M3 and nominal incomes and between
M4 and nominal incomes have changed greatly: from
1984 to 1989, in contr ast to rate flow of incomes, M3 and
M4 have descended in 1990s; the experience of
1980w shows that there was two years’ time-lag during
the period of the increasing of M3 and ensuing inflation
--- there was a high monetary growth in 1983, and there
was a high inflation in 1985 afterwards; The high mone-
tary growth in 1988 also r esulted in the inflation in 1990.
However, there was no such connection since 1990. From
1993, M3 increased constantly, but the rate of inflation
decreased, which shows no clear connection between
money aggregates and inflation.
4. The Effects of Financial Innovation on
Monetary Supply
R. W. Haver and Scott E. Haine[8] have studied the fluc-
tuation of American monetary supply, and they point that
the fluctuation of monetary supply is mainly caused by
money multiplier, not by the instability of provisions.
Garcia considers that money multiplier will change
greatly in following conditio ns: in different levels of con -
trolled money aggregates, in unequal condition of legal
reserve ratio and in the same level of different reserve
The regulations of different reserve ratio can promote
financial innovation, such as MMMF, for reserve is like
tax. It will cause the instability of money multiplier. As
assets of different reserve ratio can be converted and
these assets have similar functions, all of which cause the
final change of money multiplier.
Take ATS Account as example. ATS is typical, for it is
functioned as checking account, but only deposit reserve
requirement is paid.
C: Currency in circulation held by the public
CD: Checkable Deposits
K: the ratio of C and CD (that is, C=kCD)
T: Savings Deposit and Term Deposit
rt: term deposit reserve requirement ratio
DD: demand d e po si t
rd: demand deposit reserve requirement ratio
Supposedepository institutions don’t have excess
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Study on Financial Management Innovation and Currency Policy 67
reserves, only demand deposit and ATS are checkable
deposits and d is used to represent the ratio of ATS bal-
ances in checkable deposits, the ratio of demand deposits
is (1—d), that is ATS=dCD DD=(1—d)CD
If t is used to represent the ratio of term deposit and
checkable deposit, that is T=tCD,
Total reserve of the deposit system R can be expressed
also can be expressed as:
so R=[rd+rtt—d (rd—rt)]CD=RCD
R is the average ratio of reserve requirement.
Monetary amount is the product multipling the mone-
tary base by the currency multiplier.
Monetary base is sum of currency held by the public
and reserves existed by depository institutions.
Similarly, the multiplier m2 can be launched M2
Clearly, m1 and m2 are an increasing function of d. It
means opening check deposit will result in increasing of
the multiplier m1 and m2 when it is in the proportion of
larger, so that M1 and M2 increases, and vice versa
counter to it. The reason is very simple, as ATS prepara-
tion is low, so it increases the proportion of the total re-
serve ratio decreased, causing the multiplier increases.
5. “New Ideas” of Financial Innovation and
Broad Currency Supply
Considering the broad currency supply, financial innova-
tion in the currency supply and asset supply performance
in this area are these non-bank assets of monetary greatly
improved while the non-bank deposit-taking financial
assets greatly improved among the financial assets held
by the public of the whole society, and it has been able to
easily convert to bank deposits. Advanced science and
technology greatly reduces the lower cost of conversion
between the two, improving the liquidity of non-banking
assets. That is, in broad currency Conceptu ally, monetary
expansion existed not only in commercial banks create
credit but also other financial institutions such as trusts,
savings loan associations, housing associations, insurance
company, etc. They are also carried out of the expansion
of financial assets, in essence, they also involving in
monetary creation. Therefore, from the perspective of the
broader currency, monetary authorities should consider
how to put them into the control of the total currency
supply. This is called the “new ideas” of currency su pply
theory. As early as 1959, The Radcliffe Report pointed
out that it is not just in the traditional sense, but of the
whole social mobility to really impact on the economy’s
currency supply. The decision of the currency supply is
not only for commercial banks, but also for the entire
financial system including commercial banks and
non-commercial bank financial institutions. Subsequently,
Gurleyheshaw also pointed out: [9] “There are many
similarities between currency system and non-monetary
system agencies, and these similarities more important
than those differences. These two types of financial in-
termediaries have created financial claims, and they have
created specific liabilities based on certain assets which
held by them...... Moreover, they can create loadable
funds, can cause excess amount of currency.” They em-
phasized the identities among financial institutions, cre-
ated some form of evidence of financial claims, played
the role of credit creation. Tobin further elaborated the
“new ideas”, and stressed the identity of intermediaries as
financial institutions and the identity of currency and
other financial assets. At that time, “new idea” was criti-
cized by mainstream economics, but there is a very real
sense in financial innovation-driven financial services
cross tendency for homogeneity today. It can be seen as
the test of the “new ideas”. For example, in 1987 the
Bank of England proposed a new currency aggregates M4
and M5, which take full account of the economic role of
debt in the non-bank financial institutions.
In summary, the currency supply has also been im-
pacted by financial innovation. Base currency less af-
fected, while currency multiplier larger varied. Thus,
while the central bank reduced the base currency, the
public may pass among different asset reserve ratio ad-
justment, the conversion to aug ment the multiplier so that
the currency supply can not to achieve the desired ef-
[1] T. F. Kargil and J. L. G. Garcia: Financial Reform Eight-
ies, 1990.
[2] C. James, “Van Horne of Financial Innovations and Ex-
cesses,” The Journal of Finance, July 1985.
[3] W. A. Silber, “The Process of Financial Innovation,”
American Economic Review, May 1983.
[4] Thomas Mayer Financial Innovation—the Conflict be-
tween Micro and Macro Optimality, American Economic
Review, 1982.
[5] Donald, Monetary Policy in an Era of Change Federal
Reserve Bulletin Feb, 1989.
[6] Donald, Policy Targets and Operating Procedures in the
1990s Federal Reserve Bulletin Jan, 1990.
[7] L. Zhang, “Conduction from the Financial Analysis of the
Monetary Policy Transmission Mechan ism,” Reforms and
Strategies, Vol. 1, 2009, pp. 70-73.
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Study on Financial Management Innovation and Currency Policy
Copyright © 2013 SciRes. IB
[8] M. K. Lewis, Monetary Economics, Beijing: Science
Press, 2008, pp. 98-99.
[9] Y. H. Su and Z. Ding, “Basket of Currencies Exchange
Rate Regime Research,” Shandong Finance College, Vol.
6, 2008, pp. 20-26.
[10] Donald “Policy Targets and Operating Procedures in the
1990s,” Federal Reserve Bulletin Jan, 1990.