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1 CENTRAL EUROPEAN UNIVERSITY DEPARTMENT OF ECONOMICS MONEY, BANKING AND FINANCE Term paper on topic No.6: Should Central Banks Supervise the Banking System, and if so, Should they Supervise Non-Bank Financial Institutions as well? Professor: Jacek Rostowski Prepared by: Hristo Valev and Grigor Stoevsky 1 st year, MA students Spring Semester, 2004, Budapest


3 Introduction The importance of the central bank s monetary policy function has been very rarely questioned in academic disputes, while the responsibilities of the central bank (CB) for supervision of the banking sector are subject of intensive debate, mostly in the last five to ten years. The event that possibly amplified the rigour of this debate was the formal stripping of the supervisory function from the Bank of England in 1997, followed by the same move in Australia in 1998 and Ireland in There is no clear pattern among the OECD 2 countries for the type of bank supervisory regime they have established whether bank supervision is combined with the monetary policy function within the CB or is separated in a specialist agency outside the CB (Goodhart and Schoenmaker, 1995). Rather, a mixing of the two extremes combination and separation is quite often observed (Haubrich, 1996). As a main pillar of the debate on whether the CB should regulate 3 the banking sector always have been serving the arguments about the importance of the supervisory function for conduct and performance of monetary policy. The seminal study of J.Peek, E.Rosengren and G.Tootell (1999) indicates a presence of information synergies between the bank supervision function and the monetary policy function, but it does not give an adequate answer as to why the CB needs to undertake supervisory responsibilities. On the other hand, in historical retrospect there is no convincing evidence that bank supervision has played a large role in CB s activities (Goodhart, 2001). In this paper we review major recent studies in the framework of the debate combination versus separation of the monetary policy function and the bank supervision function with respect to CB s activities. We argue that the question whether the CB should supervise the banking system could be answered both positively and negatively depending on what the country-specific conditions are. The ambiguity of this answer rests certainly on the wide variety of regimes seen in practice. Probably it is clearer for developing economies where the CB s independence crucially favours the quality of the bank supervision process. We also argue that the CB should not supervise non-bank financial institutions since it risks overlapping with the tasks of other specialist supervisory agencies. This paper is structured in four sections, the first of which introduces definitions of the types of supervisory regime, gives a necessary general background on bank supervision for the purpose of analysis that follows, and highlights the features of bank supervision in the USA, Japan, major European countries and the eurozone as a whole. The second section reviews the main findings of the study of Peek et al. (1999, 2001) on the information synergies between monetary policy and bank supervision. The third section discusses the arguments in support of combining monetary policy with bank supervision and contrasts them with the arguments in favour of separation. The fourth one looks at the topic s questions from the perspective of 1 Ireland could be regarded as a special case. Following the enactment of the 2002 Central Bank and Financial Services Authority of Ireland Bill, the Irish Financial Services Regulatory Authority (IFSRA), an autonomous body within the Central Bank, took over the responsibility for bank supervision on 1st of May The IFSRA is now the supervisory authority for all financial institutions in Ireland (Country Report 2004, HSBC, p.2) 2 OECD Organization for Economic Cooperation and Development. Groups 30 industrialized countries. 3 We will use supervise and regulate as synonyms here since we emphasize on the involvement of the CB in the organizational process of the banking system. However, the supervision and the regulation might not necessarily accompany each other as functions performed by given agency. Similar approach is used in the literature we review in this paper. 3

4 developing economies taking into account their specific economic and political characteristics. Our possible answers are given in the conclusions at the end of the paper. 1. General Background In this section we provide definitions of the types of bank supervisory regime, along with a useful illustration of their practical implementation. We also present the essentials of a theoretical concept for the two distinct areas in the supervision the prudential and the business supervision, known as the Twin Peaks. Then we will briefly introduce the case for consolidated bank supervision. Our short trip in the theory begins with the formal distinction of the types of supervisory regime with respect to the degree of involvement of the CB in the supervisory process of the banking sector. Thus, we define the following types: Combined (C) Monetary policy function and bank supervision function are both performed by the CB. Put differently, bank supervisory agency and monetary policy agency are one and the same body the CB (Goodhart, 2001) Separated (S) Bank supervision function is performed by a separate from the CB specialist agency. In other words, the bank supervisory agency and the monetary policy agency are not one and the same body. This specialist agency may have the function to regulate only the banking system or it may be given broader responsibilities to supervise banking system as well as the securities market (which is the case in Finland and Luxembourg), and even the insurance business (which is the British and the Australian regime). This last subtype of the separation is called integrated financial supervision (Taylor and Fleming, 1999) Mixed (M) The regulation of the banking sector is not a proper function of the CB but the latter retains some supervisory responsibilities or helps (controls) the supervisory process, which is mainly conducted by a separate specialist agency (this is the practice in Germany and Japan, for instance), (Haubrich, 1996) The combined regime could be illustrated by the case of USA where the CB the Federal Reserve is responsible for supervision of more than 75% of all banks in the country, representing over 90% of all bank assets, including most large entities. However, the US model of bank supervision has its own peculiarities. There are three separate regulators of the commercial banks at federal level in USA, along with each state s banking supervisor (Peek et al., 2001). Thus, if an individual bank is a national-chartered one it falls primarily under the regulations of the Office of the Comptroller of the Currency (OCC), which is a part of the US Treasury Department. If the bank is state-chartered, but does not participate in the Federal Reserve System (FRS), it is regulated by the Federal Deposit Insurance Corporation (FDIC), which is an independent federal agency, and by the respective state banking supervisor. Conversely, if the bank is state-chartered but also a member of FRS it automatically falls into the regulation authorities of the Federal Reserve, and is also watched over by the respective state banking supervisor. Additionally, all bank holding companies are necessarily supervised by the Federal Reserve. A potential problem for this system is the overlap of the supervisory functions. In a very extreme case, a state-chartered bank, non-member of FRS, in a holding company, would be under the jurisdiction of three different regulators the state banking supervisor, the FDIC, and the Federal Reserve. 4

5 Table 1 below provides an illustration of the current preferences of type of bank supervisory regime in twenty OECD countries. Attention should be paid to the eurozone states where the CBs are no longer independent monetary policy agencies after the creation of the European Central Bank (ECB) in In this sense their regimes of supervision should be regarded clearly as separated. But as far as there is large variety among these states in terms of the involvement of the CB (though it does not conduct its own monetary policy) in the supervisory process the above definitions could be reasonably applied and thus the distinctions be identified. Table 1: MONETARY POLICY AND BANK SUPERVISORY AGENCIES Country Monetary Policy Agency Bank Supervisory Agency Regime Australia Reserve Bank of Australia Australian Prudential Regulation Authority S Austria* National Bank of Austria Ministry of Finance, National Bank M Belgium* National Bank of Belgium Banking and Finance Commission S Canada Bank of Canada Office of the Superintendent of Financial Institutions S Denmark Danmarks Nationalbank Finance Inspectorate S Finland* Bank of Finland Financial Supervision Agency S France* Banque de France Banque de France, Commission Bancaire M Germany* Deutsche Bundesbank Federal Banking Supervisory Office, Bundesbank M Greece* Bank of Greece Bank of Greece C Ireland* Central Bank of Ireland Financial Services Regulatory Authority S Italy* Banca d'italia Banca d'italia C Japan Bank of Japan Ministry of Finance, Bank of Japan M Luxembourg* Luxembourg Monetary Institute Commission for Supervision of the Financial Sector S Mexico Banco de Mexico National Banking and Securities Commission S Norway Norges Bank Banking, Insurance and Securities Commission S Spain* Banco de España Banco de España C Sweden Sveriges Riksbank Swedish Financial Supervisory Authority S Switzerland Swiss National Bank Federal Banking Commission S United Kingdom Bank of England Financial Services Authority S United States Federal Reserve System Federal Reserve System, OCC, FDIC, State governments Legend: C combined regime; S separated regime; M mixed regime. * All the asterisk-marked countries belong to the eurozone and their central banks do not directly conduct monetary policy. Source: Updated and modified 4 from C.Goodhart and D.Schoenmaker, "Should the Functions of Monetary Policy and Banking Supervision Be Separated?" (1995). C 4 We updated the table from the original source with information valid to the current moment (June, 2004). Modifications were made in column regime and in length of the table (four countries excluded). 5

6 In the European Monetary Union (EMU) as a whole, bank supervision is entrusted to institutions that have no independent monetary policy functions (even if they are CBs) and the Eurosystem 5 has neither direct responsibility for supervising banks nor for banking system stability. Moreover, in three countries in the eurozone Belgium, Finland and Luxembourg the national CB is not directly involved in bank supervision. The Maastricht Treaty, however, insists on the Eurosystem to contribute to the smooth conduct of policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system (cited in Duisenberg, 2000). Along with this, the ECB must be consulted on any community or national draft legislation in the fields of banking supervision and financial stability, and the ECB, on its own initiative, can provide advice on the implementation of the related community legislation. But as the former ECB President Willem Duisenberg puts it in his speech of May 2000: The main risk entailed in this institutional setting is the potential absence of an area-wide perspective of the banking and financial sector for the eurozone (Duisenberg, 2000, p.3) For the countries embarked on the mixed regime differences are also identifiable. In Germany, for example, the Federal Banking Supervisory Office (Bundesaufsichstant) is the primary regulator for the banking sector and is even physically removed from the CB (Bundesbank) its headquarters are in Berlin, while the CB is based in Frankfurt. At the same time large part of the inspections on the individual banks are done by the CB s regional member banks and Bundesbank maintains a special department in charge of supervisory issues. In Austria, the Financial Market Authority (FMA) supervises the banking sector, but the CB (National Bank) co-ordinates and analyses bank reporting on the FMA s behalf. In France, the specialist bank supervision agency (Commission Bancaire) retains close institutional links to the CB (Banque de France). In Japan, the main regulator of the banking sector is the Ministry of Finance, but it alternates the inspections with the CB (Bank of Japan). A better understanding of the nature of bank supervision inevitably requires making a distinction between the so-called prudential regulation and the business regulation. Such an entirely theoretical distinction is made by M.Taylor (1995) and builds the foundation of his Twin Peaks concept. The prudential regulation (or systemic stability supervision) is one of these peaks and deals mainly with the payments system, as well as with certain aspects of the banking or, more generally, with the financial markets. The other peak the business regulation (or customer (investor) protection) is in charge of the control for obeyance of the rules of business and business ethics by the financial firms. Taylor s concept requires two different bodies to conduct these two functions, and if adopted in practice the systemic stability supervision most naturally would have remained within the CB s activities. But Twin Peaks might lead to potential overlap and duplication between the two separate bodies, and probably this is the major reason why its implementation could not be found in the practice (Goodhart, 2001). The US model slightly approximates it with the Federal Reserve coming close to a systemic stability (prudential) supervisor, and the Securities and Exchange Commission undertaking the conduct of business regulation. Practically used comprehensive approach to banking supervision, aiming to assess the strength of an entire holding group, to which given bank belongs is the so-called consolidated supervision of banks (MacDonald, 1998). It takes account for all risks which may affect the bank, regardless of whether they come from the bank s own activities or from other parts of the holding. In the context of the consolidated bank supervision could be distinguished three 5 The European System of Central Banks (ESCB) consisting of all 15 central banks in the EU and the ECB itself. 6

7 general corporate groupings: banking group (when a bank establishes or acquires subsidiary companies in order to carry out other financial activities), mixed-activity group (one controlling commercial and industrial companies together with banks), financial conglomerate (group of companies, being commonly controlled, which provides services in at least two of the three different financial segments (banking, insurance, securities). As MacDonald (1998) points out, there is a considerable overlap between the issues relating to supervision of the financial conglomerates and the consolidated supervision of the banking groups. The blurring boundaries in the financial sector are the main reason for this overlap, which on its own favours the idea for integrated financial supervision, i.e. a unified supervisory body for the entire financial sector. Having built the necessary theoretical footing and glanced at the practice of bank supervision we may comfortably continue with a more thorough exploration of the relation between bank supervision and monetary policy. 2. The Information Synergies Our next step is to present the main results of the 1999 study of J.Peek, E.Rosengren and G.Tootell, elaborated later in 2001, which demonstrates the empirical existence of synergies between bank supervision and monetary policy. The basic finding of the study is that information from bank supervision improves the conduct of monetary policy. Before sketching the framework of the study, however, we need to make a small digression with a brief introduction to the CAMELS system for rating banks in USA, which plays an important role in the mentioned study. Peek et al. (1999, 2001) use as a proxy variable for the confidential data from bank supervision namely a ratio based on CAMELS and we will turn to this in a while. CAMELS rating system is used by the three federal banking supervisors in USA (the Federal Reserve, the FDIC, and the OCC) as well as by other financial supervisory agencies to provide a convenient summary of bank s health when an examination takes place. CAMELS is acronym of Capital, Assets, Management, Earnings, Liquidity, Sensitivity to market risk. These six categories of the bank s health are each given a rating, and then a composite rating is assigned to the bank. The rating scale is from 1 (the highest), to 5 (the lowest). The meanings of the composite ratings are as follows: 1 sound in every aspect; 2 fundamentally sound; 3 flawed performance; 4 potential for failure (impaired viability); 5 high probability of failure (severely deficient performance). In their study, Peek et al. approximate the bank supervision data by the share of banks with CAMEL rating of 5, i.e. the worst performers in the banking sector. It is CAMEL, and not CAMELS rating, because the sampling period of the study (quarterly data) is from the first quarter of 1978 till the second quarter of 1996, and the category S in the rating system has been introduced since the beginning of The study examines the one-, two-, three- and four-quarter-ahead forecast errors of inflation and unemployment rates of the Federal Reserve s own forecasts (the Greenbook) and three major commercial (private) forecasters: Data Resources Inc., Georgia State University, and the University of Michigan. The authors try to find whether the confidential supervisory information reduces significantly the forecast errors of the private forecasters who do not have access to this data. Besides, they are interested whether the type of the regulated financial institution affects substantially the value of the supervisory information that is available to Federal Reserve. 7

8 Peek et al. run the following regression: t+ i 0 1 t, j t+ i t, j 2 CAMEL5 t X = α + α E X I + α + ε, [ ] where: - X t + - the realised future value in period t+i of the macroeconomic variable being i forecasted (inflation; unemployment); - t, j t+ i t, j E X I - the expectation of that variable by forecaster j at time t conditioned on I publicly available information ( ) when the forecast is made; t, j - CAMEL5 - a proxy variable for the confidential supervisory data available to bank supervisors at time t (the percentage of banks with CAMEL rating of 5). The authors anticipate that weaker bank health, measured as higher CAMEL5, would mean that private forecasters overestimate the strength of the economy, and thus underpredict the unemployment (equally said, the slope coefficient α 2 to be positive) and overpredict the inflation ( α2to be negative). Indeed, the estimated effect turns out to be statistically significant (the results of their regression are given in Table 2 below) and in the expected direction at all four horizons for the unemployment rate forecasts and at three- and fourquarter-ahead horizons for the inflation rate. Table 2: OUTPUT OF REGRESSION [ ] Unemployment Inflation Variable Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Constant (0.30) (0.44) (0.46) (0.62) (1.66) (1.08) (1.22) (1.18) Forecast 0.979** 0.948** 0.923** 0.900** 0.935** 0.929** 0.934** 0.892** (87.59) (25.65) (14.12) (11.34) (26.26) (10.68) (7.22) (5.70) CAMEL ** 0.165** 0.233* 0.255* * * (4.90) (3.00) (2.47) (2.26) (1.52) (1.47) (2.44) (2.44) # of observ R Note: The standard errors in the forecast equation are corrected for the appropriate moving average error terms and for contemporaneous correlation across forecasters. Numbers in parentheses are absolute values of t-statistics. ** - Significant at 1% level * - Significant at 5% level Source: Peek, J., Rosengren, E. and G.Tootell, Synergies between Bank Supervision and Monetary Policy: Implication for the Design of Bank Regulatory Structure, from Prudential Supervision: What Works and What Doesn t, ed. F.Mishkin, NBER and Chicago University Press, Chicago, 2001, p.283. As Peek et al. explain: the coefficients are both economically and statistically significant; for example, an increase in CAMEL5 of 1 percentage point, roughly 1 standard deviation, would account for an underestimation of the four-quarter-ahead unemployment rate of approximately 0.25 percentage points (2001, p.282). 8

9 The results also imply that the underprediction of unemployment and the overprediction of inflation by the private forecasters increase over the time horizon. This can be seen by the rise of the magnitude in the coefficients for CAMEL5 (their absolute value, precisely said) from first through fourth quarter. However, the robustness of the point estimates slightly declines at the same time (the significance level changes from 1% to 5% for the unemployment, while inflation is better predicted using CAMEL5 only at three- and four-quarter-ahead at 5% level). Peek et al. conclude that the measure of confidential supervisory information makes a significant contribution to the reduction of forecast errors for both unemployment and inflation rates. But, as they also admit, it is yet unclear why Fed needs hands on supervisory responsibilities, since the information could be transferred to the Federal Reserve from another bank supervisory agency? (1999, p.3). To answer this question Peek et al. run the same regression equation but with different subsets of banks, thus disaggregating the information content in CAMEL5. Their crucial finding is that the greatest information synergies with monetary policy for the Federal Reserve come from the state-chartered banks. Since the latter typically tend to be small, the evidence suggests that the set of institutions that pose systemic risks may not substantially overlap with the set of banks for which supervisory information is most valuable for improving unemployment and inflation rate forecasts (2001, p.286). Thus, the difference in the objective functions of the CB and a separate specialist supervisor may reflect in collection of information which is not of great value for the conduct of the monetary policy. The policy implication therefore, according to the authors, is that any refocusing of the regulatory powers of Fed only towards the bank holding companies or the large internationally active banks, let alone stripping of the supervisory function, may sacrifice some information useful for the monetary policy. The results of the study indicate that, at a minimum, the conduct of monetary policy requires full access to supervisory information. Furthermore, for the CB to exploit this important source of information in the conduct of monetary policy, it must have timely and reliable data (1999, p.20). The authors give two main explanations why supervisory information improves the economic forecast accuracy and thus contributes to effective monetary policy. First, problems in the banking sector may serve as an early indicator of deteriorating conditions in the whole macroeconomy. Second, the information could provide in advance notice of changes in the bank lending behaviour, which could affect the macroeconomy to the degree the lending channel is operative in it. Peek et al. refrain form discussing which of these two reasons is most important but highlight the striking fact that despite the high correlation of bank supervisory data with forecast errors the Federal Reserve s internal staff does not seem to take advantage on it. However, the members of the Federal Open Market Committee the policy-making body of Fed use this information to correct the staff forecasts when they vote on certain decision (p.2, 1999). In his testimony before the Senate Committee on Banking, Housing, and Urban Affairs, in March 1994, the Chairman of the Federal Reserve, Alan Greenspan, puts best in one sentence the whole motivation behind the study we have already reviewed: Without the hands on experience of regulation and supervision, and the exposure to the operations of banks and markets provided by such experience, the Federal Reserve s essential knowledge base would atrophy (Greenspan, 1994, p.88). However, a number of criticisms could be raised regarding the research of Peek et al. One and perhaps most important is, that if the supervisory information truly improves the predictions, why do the Federal Reserve economists actually not use this data in their forecasts? Besides 9

10 this, the authors are likely to be biased in their statements, since they are professionally connected with the Federal Reserve System, working also as researchers there. A well-known fact is that CB insiders tend to claim optimality of the status quo or that increased responsibilities for the CB are required. Apart from these research-specific critics, the finding of information synergies (whatever form they might take) is still one that deserves attention. Even far from being conclusive at this relatively early stage in our investigation, we may reasonably acknowledge that the existence of information synergies between monetary policy and bank supervision being more effective the more timely and reliable the banking data is serves in favour of having a combined supervisory regime. Though this argument is strong viewed in isolation, it may happen to be rather insufficient to justify the CB s involvement in the supervisory process when we take into account other circumstances as well. 3. Weighting the Pros and Cons In this section we articulate and evaluate the main arguments, which are widely discussed in the literature, and are usually put forward in favour of one or the other of the two extremes of supervision the combined and the separated regime. In what follows, we outline briefly the causes and the roots of the debate and we also summarise the variety of factors that have to be considered in addressing this question. Then in the first two of the subsections we discuss the strengths and the weaknesses (pros and cons) of the two extremes, while in the third subsection we turn separately to the question of reputation because of its special place in the debate and the controversies it displays. The final subsection presents the empirical results of a study on the relation between supervisory regime and bank failures. In our view the dilemma combination or separation is the most important with respect to the regulation and the supervision of the banking and the non-banking financial institutions by the CB. Actually, one may regard the integrated supervision as a distinct regime such as the number of intermediate practices belonging to the broader category mixed are. However, since the integrated regulator is almost always different from the CB institution, and therefore emerges as a subtype of the separated regime, we present its benefits and shortages simultaneously with the basic two extremes. Before turning to the technical aspects we may ask the natural question, why is there an academic debate in this field at all? What causes its existence and where the roots of it are. The simplest answer would be, because of the wide variety in the practice and the history of financial supervision among countries. Furthermore, the theory in the field (as we already discussed in the first section) is highly inconclusive and there is no straightforward and definite prescription. Whereas the conduct of the monetary policy is clearly a CB s function and its first priority, the assignment of supervising responsibilities to this institution might not be justified by many criteria. The changes that took place in the financial sector in the last few decades complicate the answer of the question even further. Some among them are: blurring of the boundaries of the financial businesses; emerging of financial conglomerates and new financial intermediaries; development of new products and financial innovations. Other aspects of central importance with respect to the supervising responsibilities are: whether the country is developed (DC) or less developed (LDC) and what are the specific consequences of that; whether the financial sector and its players are big and mature or they are small and less complex; what are the structure of the financial sector; the legal, political and economic system and tradition of the 10

11 country. Due to our particular interest with the LDCs we devote the fourth section of this paper to analysis of their specifics. Finally, a group of main factors could be outlined, which determine the broad debate on the problem whether the CB should supervise the banking system or not. Among the most commonly considered, as presented by Goodhart (2001), Taylor and Fleming (1999), Haubrich (1996) and others, are: Structure of the financial system: players, services, innovation Efficiency, risk and crisis management Information: synergies, content, sufficiency and flow Conflict of interests Balance of powers This list is only indicative, as the relevant aspects are usually discussed on the positive and negative sides of the two supervisory extremes. In compliance with this approach, we present in subsections 3.1 and 3.2 the two regimes separately and elaborate on their respective advantages and disadvantages Combination Turning to the combined regime of monetary policy and bank supervision, we consider the following main pros and cons to be: Pros: Information synergies Regulatory efficiency: smooth and fast flow of information, timely provision of the lender of last resort (LOLR), economies of scale Easier crisis and risk management Cons: Conflict of interests: the CB, having objectives other than maximising the social welfare, may abuse its given power in favour of the banking system and in damage of the taxpayers Moral hazard problems Insufficiency of information: according to the Adversarial System Theory, contending sides produce the best information. Therefore the combined regime may not produce enough due to the lack of competition Balance of powers: the more independent is the CB the less regulatory responsibilities it should possess (trend in the developed economies) One of the main arguments on the positive side, usually discussed and empirically tested, is the possibility of realisation of information synergies when the CB carries out both functions. As we have already shown in the second section of this paper, the main finding of Peek et al. (1999, 2001) is that statistically and economically significant synergies do exist, at least in the USA. But these synergies could be eventually lost due to the loss of regulatory powers by the CB only if the information were no longer easily transmitted to the policy makers (Peek et al., 2001). The efficiency-related issue is also highly favourable for the combined regime. However, the argument is not supported empirically and relies somehow on common knowledge. The reasoning is that, within a single institution, the flow of information is easiest and fastest, the 11

12 appropriate measures could be taken in a timely manner, and significant economies of scale could be achieved. Turning to the first aspect, it is not obvious why the information flow should be distorted by a physical separation. Given the rapid development of the information and communication technologies and the fact that, wherever the supervisors institutionally are separated they have to work closely with the CB experts, some additional sources of distortion are needed as a justification. As Goodhart (2001, p.80) argues, an independent supervisory body may be jealous of its own independence. This may hurt the communication between the agencies and the information quality, depth and timely provision. It can also affect adversely the proper implementation of the CB s LOLR function. The economies of scale aspect is most convincing in terms of costs reduction. The unified institution uses common support infrastructures, such as administration, information and security facilities. It also builds up more easily its reputation and attracts and retains qualified personnel. As Taylor and Fleming (1999, p.43) describe it, this economies-of-scale argument might also be referred to as the small-financial-system rationale for integration. The other pro-combination factor usually analysed in the literature is that related to crisis and risk management. This argument is logically related to the previous ones, namely that in times of crises the information losses due to separation and the inefficient LOLR operation are magnified. On one hand, this could lead to a misjudgement from the CB of the current economic situation resulting in wrong policy directives and measures. The CB could also underestimate the effect of its policy on the banking system (Haubrich, 1996). On the other hand, fundamentally solvent banks could be bankrupted due to the lack of adequate CB financing. The risk management issue should be considered in the light of the two different purposes that the supervision serves. On one hand, it is the systemic stability, which is the main concern of the CB and requires prudential supervision. On the other, it is the customer protection, which is also called business supervision (we discussed this duality of the supervision in the first section). In order to prevent a considerable overlap between different supervising bodies each having its own focus and with the presence of deposit insurance bearing some of the customer protection, it is argued that the prudential supervision should be given a higher weight and should be part of the CB. This reasoning is reinforced by the macro (prudential) micro (business) approach stating that a separate supervisor might devote much of its efforts to the latter and thus to neglect the former. Further on, if it happens the consequences at the aggregate level will be undoubtedly harmful. Being a strong advocate of the combined regime, Roger Ferguson, Jr., a Governor of the Federal Reserve Board summarises these factors in a Conference speech 6 as follows: The intelligence and know-how that come from our examination and regulatory responsibilities play an important at times, critical role in our monetary policy making. No less relevant, our economic stabilization responsibilities contribute to our supervisory policies In short, I think the Fed s monetary policy is better because of its supervisory responsibilities, and its supervision and regulation are better because of its stabilization responsibilities (2000, p.301). The possible negative effects from the combination, however, are also important and largely discussed. A central place on this side of the argumentation holds the conflict of interests. In essence, it says that the monetary policy conduct and the supervisory responsibilities could sometimes result into conflicting and controversial measures needed from the CB. Such a 6 The source of the quotation is Goodhart (2001) 12

13 situation becomes apparent when a restrictive monetary policy is required but some of the banks are particularly vulnerable due to insufficient reserves. Obviously, one consequence from having both functions under one roof is their mutual influence. In a rather extreme manner Haubrich (1996) writes, the central bank might view its primary function as protecting banks, not the public interest. The CB could either relax its monetary policy measures under the pressure of the large banks or tighten (soften) its supervision in order to meet its monetary policy objectives. Further on, as Goodhart (2001) describes, the supervisory work is time-consuming and thankless. Given the limited managerial time and reputational concerns, having a single focus through separation might be preferred. As a proponent of this argument, the Shadow Financial Regulatory Committee in the USA states 7 : Indeed, it is the Committee s view that the Fed should not retain responsibility for both monetary policy and the prudential regulation of banks or bank holding companies. There is at times a clear conflict of interest inherent in the Fed s carrying on roles as both a promoter of stability in the domestic and international financial markets and as e supervisor of banking organizations (1998). Goodhart (2001) argues, however, that the macro and the micro focuses of the two tasks could naturally complement rather than conflict each other. Nevertheless, he admits that under some conditions, such as a monetary policy with primary external objectives, a conflict may arise. Another problem from the combination is the possibility of moral hazard induction. If the CB bails out the banks too often they may expose themselves to a higher than optimal risk. As Duisenberg (2000, p.4) argues in this regard, central bank interventions should be limited and the crisis prevention mechanisms need to be in good shape : In general, the crucial issue is that the risk management systems of individual institutions guarantee their safety and soundness, and the supervisors should assure themselves of this fact (Duisenberg, 2000, p.4) One more argument on the negative side is the insufficiency of information. As Haubrich (1996) presents it, separate agencies with differing agendas will each search for evidence supporting their own position, whereas a combined agency might not. The theory behind is that of the Adversarial Legal System contending institutions produce the most information. Further on, he writes, proponents of separation believe that in relatively stable economies, where policymakers concern is justifiably less with crises and more with understanding the market, this argument can be decisive. Finally, the concentration of power in the CB is usually considered as a major drawback of the combined regime. Achieving a balance of powers among the institutions is a primary goal of every democratic society. There is a common trend in the developed economies that the more independent is the CB the less regulatory responsibilities it should be given. The reason is that normally the CB is an unelected body having at least operational independence from the executive institution (the Government), and as such it may become too powerful under the combined regime without direct public accountability. Goodhart (2001) presents the argument in the following way: Democratically-elected governments are sovereign. An element of such a sovereign, say the Minister of Finance, is unlikely to want to delegate so much power to another body (the central bank) that it might be seen as a separate (and competing?) centre of influence. (Goodhart, 2001, p.89) 7 Statement No.153 of the Committee issued on 7 December 1998, as quoted by Goodhart (2001) 13

14 The discussion so far revealed the complexity and the importance of the arguments both in favour and against of the combined regime. It brought a major and essential part of the reasons in support of our strong conclusion that a universal prescription with respect to the supervision simply does not exist. At the other pole of the supervisory practices is the complete separation, so we turn to it next Separation In this subsection we consider the major factors usually presented on the positive and the negative side for the regime of separation, i.e. when the regulatory responsibilities are stripped from the CB. Apart from the arguments already given in the previous subsection, which taken with a reversed sign are directly applicable here as well, some more are: Pros: Supervision moves closer to the banking business: better knowledge of the business More adapted to the differences in risk profiles, clear focus on objectives and rationale of regulation Financial services are getting more and more complex, and the boundaries between different types of business are blurring Cons: Overlap of functions may hurt the efficiency of supervision Over-regulation: single micro-level regulator, without macroeconomic responsibilities, would be more likely to over-regulate and stifle innovation and risk-taking It is worth noting that many of these aspects are also discussed in the light of the integration choice. Namely, whether the supervision, once stripped from the CB, should overlook all financial players or there should be separate agencies for the banking, investment and insurance businesses. The first two of the benefits from the separation listed above rely on the well-known notion for the positive effects that stem from specialisation. This sphere of the debate is actually applicable to both types of a separated regime. Either the striping from the CB results in an integrated financial supervisor or the outcome is distinct regulatory agencies. The argument finds its grounds in the idea, that a specialised institution would have a clear focus of its work and a clear mandate, it would be easier to manage and thus more effective. As Lannoo (1999), points out, the supervisor would also move closer to the business and would have a better knowledge of it. As a consequence of that, the regulatory institutions would be more adapted to the differences in risk profiles and nature of the respective financial businesses. So, the specialisation argument encompasses the first two positive factors we outlined above. The third argument, and perhaps the most important one, is actually pro-stripping the supervising functions from the CB and pro-integration of the regulation into a single institution. The rapid financial innovation in the past decades and the development of the financial intermediaries lead to blurring of the previously clear boundaries between businesses. Banks started to offer insurance and assurance services, and both with the insurance companies engaged in fund management and stock exchange investment operations. Building separate regulatory institutions with a different functional focus would result in a considerable overlap of their work. The need of integrated supervision mixed with the balance of powers argument results naturally in a separation of the banking supervision from the CB. As Goodhart (2001, p.84) describes it, if efficiency and cost saving implied the 14

15 unification of financial supervision, this suggested placing such a unified body outside the central bank. One obvious factor already mentioned, on the negative side of the separated regime is the possibility of a considerable overlap of functions resulting in inefficiency at the aggregate level. On the one hand, the CB experts need to have the detailed micro-level information that comes from the supervision. Even if they do not carry the responsibilities for the regulation directly, they should be actively engaged in the process, either with individual or joint bank inspections. On the other hand, the financial institutions would face higher costs if they have to deal with two different sets of inspectors. The second drawback of the separation regime, namely the possibility of over-regulation, is even more important. It takes us back to the different macro-, micro- focus of the two activities. In essence it says, that a single micro-level regulator with no macroeconomic concerns would be more likely to over-regulate the industry and stifle innovation and risktaking. These considerations are expressed by the Chairman of the Federal Reserve System, Alan Greenspan, who argues that a reasonable level of risk-exposure of the banks should be encouraged and is actually beneficial for the macroeconomy and the sustained long-term growth. Indeed, a single regulator with a narrow view of safety and soundness and with no responsibility for the macroeconomic implications of its decisions would inevitably have a long-term bias against risk-taking and innovation. It receives no plaudits for contributing to economic growth through facilitating prudent risk-taking, but it is severely criticized for too many bank-failures. The incentives are clear (Greenspan, 1994, pp ). 8 Therefore, the discussion focused on the case of separation is once again inconclusive. The arguments are strong and having significant implications with respect to both, the advantages and shortages of this regime. The issue we address in the following subsection the reputation concerns for the CB is even more frustrating because it is not easily placed on either side of the debate. Reputation, however, is an important factor for every institution and that is why it deserves separate attention in the light of the supervisory responsibilities dispute Reputation concerns Reputation concerns are yet another major factor usually discussed in the literature. This aspect is particularly complicated, because a combination of the monetary policy and bank supervision can both help and hurt the CB s reputation. Haubrich (1996) is one of the authors who address this issue. It is common sense that the commercial banks take fewer risks if they face a regulator known to play hardball. But under a combined regime an interesting question arises: Does letting a bank fail mean that central bankers are incompetent, and therefore soft on the inflation as well? Or does it mean that they are tough all around? And the Haubrich s answer is that, depending on the context, either interpretation makes sense. As we mentioned already, the conduct of supervision is a thankless task. A supervisor is visible only when the things go wrong, i.e. a major bank is threatened by failure or the 8 As quoted in Haubrich (1996) 15

16 payment system and the financial system stability comes at risk. As Goodhart (2001, p.89) describes, a combination of both tasks within the CB is all too likely to tarnish the reputation of the supervisor as well as of the CB. One clearly dividing line between the monetary policy and the supervision is the transparency of the implementation and the assessment of the achievement of the goals. Nowadays the success or failure of the monetary policy to meet its objectives is widely understood from the general public and reasonably anticipated. However, that is not the case with the supervision, which has as a primary concern the prevention of undesirable events. So, the regulatory tasks can obviously hurt the reputation of the CB. Looking at the question from the other angle, the supervisors themselves need a credible reputation as well. The combined regime offers a way in which the regulatory unit takes advantage from the established independence and authority of the CB per se. Another regime, which also helps the reputation building, is the integrated supervisory agency. The unified institution has better chances for adequate financing and guarantees against political influences. It can also develop a strong human capital through attracting and retaining highly qualified professionalists. However, there are drawbacks as well. As Taylor and Fleming (1999, p.44) write, the reputation of banking supervision may also suffer if it is associated with weaker securities and insurance supervisory agencies. Therefore, the matter of reputation is quite complicated and deserves a special attention in every discussion of the supervisory responsibilities. Having described and evaluated the main factors underlining the institutional regulatory setup, we turn to some empirical evidence. In the subsequent subsection we report the findings of a study of the relation between supervision and bank failures Bank failures and supervision Particularly interesting problem is how the regime of supervision, combined or separated, relates to bank failures. An empirical cross-country study of 104 major bank failures was conducted by Goodhart and Schoenmaker (1995). They address the issue from the point of view of frequency of failures under each regime. The authors examine 24 countries in the period of 1970s, 1980s and early 1990s, concentrating on major bank failures only. Eleven countries from their sample had combined regime and thirteen had separated. Authors argue that they have provided reasonably comprehensive coverage of the larger failures over a wide range of developed countries (1995, p.550). Their results are given in Table 3 below: Table 3: NUMBER OF BANK FAILURES UNDER COMBINED AND SEPARATED REGIMES Sample size: 104 major bank failures in 24 countries. Supervision: 11 countries have a combined regime; 13 countries have separated regime Supervisory regime Number of bank failures Combined Separated Total Observed frequency Expected frequency Note: The cross-country survey covers the 1980s and early 1990s, with a few important cases taken from the 1970s. Source: Goodhart and Schoenmaker, "Should the Functions of Monetary Policy and Banking Supervision Be Separated?" (1995). 16

17 We can readily see that the observed bank failures under the separated regime are more than twice as frequent as under the combined regime. On the other hand, the expected frequencies of bank failures under both regimes are almost equal. This implies possible dependence between the type of regime and the frequency of bank failure. To test the relation Goodhart and Schoenmaker (1995) perform a standard 2 χ -test of goodness of fit, which compares observed and expected frequencies and is used to determine whether a statistically significant difference exists. Their test has 1 degree of freedom and the test-statistic s value is 2 ( f ) 2 o fe χ = = 8.37, whereas the critical theoretical value is χ 2 (1) = 6.63 (at 1% fe significance level). So, χ 2 > χ 2 (1), i.e. the p-value is even less than Therefore they comfortably reject the null hypothesis that the type of supervisory regime and bank failures are independent. According to their data, the bank failures under separated regime are statistically significantly more than those under combined. Nevertheless, the authors point out also some of the limitations of their exercise. Their data selection would undoubtedly lead to severe under-sampling of the occasional failures of small banks (1995, p.550). So, the number of failing banks under each regime in their procedure understates the total population of failing banks in the countries. Further on, the regime with the smaller number of bank failures is not necessarily the better one in welfare terms. The smaller number of fails could be due to the existence of some form of bank cartel, which would ceteris paribus extract rent and decrease the social welfare. The other reason for the observed frequencies could be the supervising manner, which in turn is affected by the legal type of regime through all the aspects discussed in the previous subsections. As an example of this, a system of tight regulation, which could be the result of the separation may produce a higher number of bank failures. Therefore, in spite of the fact that the test is quite informative and interesting for the combination-separation discussion, it is not decisive in terms of social desirability. In the words of the authors, it is not obvious that having such a low frequency of costly bank rescues would outweigh the potential gains from a more permissive regulatory system (1995, p.550). We conclude with the words of Haubrich: So many on one hand and on the other hand arguments bring to mind Harry Truman s wish for a one-handed economist Combination and separation are more like two poles of a continuum than two discrete boxes. Many countries tend to mix the two systems in an attempt to gain advantages of both and produce a superior system (1996). The analysis of the various factors in the framework pros-cons made in this section, left us with no firm judgement on which regime of bank supervision combined with the monetary policy or separated from it is better suited for complex financial systems. We continue to investigate the problem, however, with respect to the less financially and economically developed countries in order to capture any specific reflection. 4. The Developing Economies Case We address in this section the special aspects that should be regarded when one analyses the situation in the emerging economies, either transition or developing. 17

18 As we described already, the trend towards CB independence in the developed countries is accompanied, whether due to causality or coincidence, by a trend towards shifting regulatory responsibilities to a separate (unified or not) supervisory agency. In the emerging economies, however, many of the factors presented above have a more specific place and others emerge as more important. Some of these specific aspects are: Institutional independence Quality of the personnel and adequacy of financing Corruption and inefficiency Legal system and coordination Financial structure: complexity and players Banking liberalisation and systemic disturbances The first and the most important aspect, is the institutional independence. As Taylor and Fleming (1999, p.44) argue, in many transition economies, central banks have been established with strong guarantees of their independence. Thus only the CB s independence can protect the supervisors from political and commercial pressures and interference. Further on, if a new institution is constituted in the process of regulatory separation, a dangerous vacuum of authority could be created as the new agency struggles to establish its credibility (ib.). The problems of the quality of the personnel involved in the supervision and of the financing adequacy are also magnified in the developing countries. It is a well-known fact that due to scarcity of these resources, the CB is one of the few institutions in these economies, which can attract and retain the qualified experts as well as to provide sufficient funding. Taylor and Fleming (1999, p.44) write that a real risk of separation is that it may lead to a reduction in banking supervisory capacity, as professional staff opt to leave rather than to lose the pay and status usually associated with being a central bank employee. Addressing these same issues, Goodhart writes: The central bank is, therefore, an institution which can often provide satisfactory levels of expertise, independence and funding in a country where these may be in short supply. If banking supervisors come under the umbrella of the central bank they are more likely to share in the good fortune of better, and more independent, staff and stronger funding. (Goodhart, 2001, p.98) The problems of corruption and the resulting inefficiency are also more pronounced in the emerging economies as they have a greater likelihood within an underdeveloped institutional setup. These could be due to inadequate accounting rules and prudential norms, obsolete regulations and ritualistic execution of the supervision. The legal system and its impact on the coordination between institutions also have a central importance. The type of the system, whether a common law or civil code, the legal enforcement, and the tradition of the laws and the normative acts, determine to a large extent the institutional culture, the inter-agency coordination and the flow of information. In general, the legal and the institutional framework in the developing and the transition countries are rather weak. 18

19 As an example of the practical importance of these aspects, we refer to Ruth De Krivoy, a former Governor of the CB of Venezuela, who writes in her 2000 book, Collapse: The Venezuelan Banking Crisis of 1994 the following 9 : Giving supervisory powers to an independent CB is especially advantageous if public institutions are weak, coordination between different public sector agencies is troublesome, or skilled human resources are scarce. Central banks are usually a country s most prestigious and well-equipped institution, and are in a good position to hire, motive and keep skilled staff. (De Krivoy, R., 2000, p.203) The financial structure is yet another factor that deserves special attention. The system of financial intermediation in the developing and transition countries is less complex and relies more on commercial and universal banking. The banks are the dominant players, whereas the investment and insurance companies are smaller and less influential. Under such conditions it would be more natural the supervising responsibilities to be carried out by the CB. One more argument regarding the specifics of these countries is their higher exposure to systemic disturbances. It is particularly strong for the transition countries, which went through processes of the banking system liberalisation. So, the main focus of the bank regulation in these economies is the prudential supervision and the systemic stability. Goodhart (2001, p.97) explains in this respect, so the connections between supervision and monetary policy, including LOLR operations, are more frequent and evident than in developed countries. An interesting point, deserving particular attention, is the increased desire of the CB to retain as many functions as possible, and particularly its supervising responsibilities, when under some circumstances its role and influence are reduced. One such occasion is the firmly fixing of the exchange rate regime, either through an introduction of a currency board, irrevocable fix or dollarization. The CB s monetary policy functions are greatly reduced in such an event or even completely eliminated and the following question arises: would it be necessary the CB to exist at all in this case if the banking supervision is also separated from it? As Goodhart (2001, p.87) describes, concerns for institutional survival will cause central banks, when stripped of their macroeconomic role, to argue more strenuously for retention of their other activities, notably bank supervision. One can safely argue that even for the developing and transition countries the separation is also good. The factors on this side of the debate rely on the case of an integrated supervision and the small-financial-system rationale. Establishing an integrated financial supervision agency (distinct from the CB) may achieve significant economies of scale. The new institution might build faster its reputation and may achieve the needed expertise through a human capital concentration. Hence, the controversies about the best place of the supervision are once again valid even for the developing economies. However, many of the factors shaping the debate have more specific characteristics when applied to these countries. Conclusions Having discussed the problem of the advantages and disadvantages of central bank s involvement in the process of bank supervision, and based on a review of large body of relevant literature in the field, we are now in a position to draw some possible answers to our 9 As quoted by Goodhart (2001) 19

20 research topic s questions. We sought these answers analytically in each of the four sections and the broad conclusions that emerged are the following: Should the CB supervise the banking system? Unfortunately, there is no straightforward and one-sided answer to this question. Very often it depends on the prevailing conditions: the financial system structure, the political environment, and the preferences of the population. One should carefully apply the analysis of the pros and cons to the specific country in question before judging what s the best prescription. As an example of the no clear answer result, serves the fact that the practice in this field varies widely. Should then the CB supervise the non-bank financial institutions as well? The development of the financial services enlarges the scope for banking, in particular, and financial, in general, supervision. The blurring of the functional boundaries among the different financial businesses calls for integrated financial supervision, and as a consequence, a unified supervisory body, which should be distinct from the CB for reasons of efficiency. Even without an integration, our conclusion is that the CB should not supervise the non-bank financial institutions. Otherwise there would be a considerable overlap with the responsibilities of other supervisory agencies having as a primary focus the insurance and securities companies. However, when it comes to consolidated banking supervision, which is a natural response to the contemporary tendencies in the financial industry, the supervision of the non-bank financial institutions by the banking supervisor is inevitable as far as those are linked to banks (being part of a banking group or financial conglomerate). In this view, the argument for integrated financial supervision is strong and favoring the stripping of the supervisory function from the CB. 20

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