Monetary policy and banking supervision: still at arm's length? A comparative analysis.

• Author: Masciandaro, Donato

1. Introduction

   In terms of central banking the most interesting innovation to have taken place in the two decades preceding the 2008 Crisis was the progressive split between responsibility for monetary policy and responsibility for banking supervision (1). By the early 2000s an increasing number of countries had adopted a well-defined central bank framework, whereby the monetary agency becomes increasingly specialized in achieving monetary policy goals, and consequently its traditional responsibilities in pursuing financial stability seem to be progressively less important. The fundamental effect was that central bank involvement in supervision (hereafter CBIS) generally decreased.

   But now a significant number of reforms are currently taking place concerning the central bank's role in the structure of supervision as a consequence of the financial meltdown (hereafter the Crisis).

   In 2010, the US legislature passed the Dodd-Frank Act, rethinking of the role of the Fed as part of the general overhaul of financial supervision. Even if during the discussion of the bill US lawmakers debated the possibility of restricting some of the Fed's regulatory powers, as well as increasing political control over the central bank, the Dodd-Frank Act actually ended up increasing the responsibilities of the Fed as prudential supervisor (2). In Malaysia, the 2009 Central Bank Law provided for greater involvement in supervision by the central bank (3). In the current evolution of the Basel Capital Accord, the activation of countercyclical prudential measures is being put in the hands of central banks (4).

   In Europe, policymakers are moving to finalize reforms concerning the involvement of central banks in supervision both at the regional and national levels. In 2010, the European Systemic Risk Board (ESRC) was established to provide macro-prudential supervision, and the new institution has been dominated by the European Central Bank (ECB) (5). On June 2012 the heads of state and government of the Eurozone declared that the European Commission would have to present proposals in order to establish an effective single supervisory framework, one which should involve the ECB.

   Concerning individual EU members, in 2011, with the new Banking Act, the German government dismantled its unified financial supervisor (BAFIN) in favor of the Bundesbank, which is now the main banking supervisor. In 2010, the UK government put the key prudential functions of the Financial Services Authority (FSA) within the purview of the Bank of England. In 2010, the Irish Financial Services Regulatory Authority was legally merged with the central bank. Further, an analysis of the reforms undertaken in Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Poland and Slovakia reveals that the trend towards supervisory consolidation has definitely not resulted in smaller central bank involvement (6).

   In this respect, it is interesting to note that before the Crisis the central bank was the main prudential supervisor in less than half of EU countries (13 out of 27) (Figure 1). After the Crisis, with the establishment of new supervisory regimes in Belgium, France, Germany and United Kingdom (7), the central bank has now become the main prudential supervisor in more than half of them (17 out of 27) (Figure 2).

   Do these episodes signal a sort of back to the future for central banking regimes, given that before the Crisis the direction of changes in supervisory structures had been characterized by the move of central banking away from supervision (8)? Therefore the main research question is: how is CBIS now moving?

   This article offers two contributions, organized as follows. Section Two reviews the economics of the pros and cons of central bank's involvement in supervision, reaching the result that what really matters is the role of the policymaker with his own cost and benefit analysis. The result is used in Section Three to evaluate the evolution of the role of the central banker as supervisor in 88 countries worldwide, before and after the Crisis. Section Four concludes.

2. Review of the Literature

   In this paragraph, we discuss the economics of the central bank as supervisor, trying to be at the same time systematic in our presentation and parsimonious in our comments. The aim is to show that the most relevant contributions of the huge literature dealing with the issue of CBIS provide contrasting recommendations.

   Two main consequences will follow. First of all it will be not surprising to note that from time to time and from country to country the distance between central banking and prudential supervision--CBIS--has varied. Therefore in order to analyze the evolution of the CBIS it will be necessary to complement economic analysis with political economy, zooming on the costs and benefits for the policymaker, who is the ultimate player defining the CBIS.

   From a theoretical point of view, the CBIS can be evaluated under two different points of view: macro supervision and micro supervision. Nowadays the central bank is generally considered the monetary authority, i.e. the agent designated by society to manage liquidity in order to pursue monetary policy goals. Being sources of liquidity and acting as lenders of last resort, central banks are naturally involved in preventing and managing systemic banking crises (9) (macro supervision) (10), in close coordination with government agencies entrusted with responsibility for financial stability (11).

   But should central banks also be in charge of pursuing financial stability through prudential oversight of individual banks (micro supervision)? The question is a long standing one.

   On one side, micro supervision is a task that historically has not always been assigned to central bankers (12). Furthermore the last two decades (the age of Great Moderation (13)) have been characterized by the move towards a decrease in CBIS (14). On the other side, in the decades before the Great Moderation several central banks were actively and deeply involved in pursuing tight structural controlling activities (15), which were considered thoroughly integrated in the overall responsibility of the central bank for managing liquidity.

   But going beyond historical cyclical patterns and focusing on the economics of the relationship between monetary and supervision policies, is it possible to disentangle the pros (integration view) and cons (separation view) of merging monetary and supervisory functions (16) (Table 1)?

   The central bank's high involvement in supervision (integration view) is usually supported by arguments related to the informational advantages and economies of scale that derive from bringing all functions under the umbrella of the authority in charge of managing liquidity (17). One additional argument is that human capital employed by the central banks is presumably better equipped also to deal with supervisory issues (18). Having access to all information would help the more highly skilled central bankers to act as more effective supervisors. In other words, setting up a supervisory authority different from the central bank is not efficient, i.e. greater CBIS brings potential gains.

   At the same time the economic literature acknowledges that central bankers involved in supervision can produce greater costs in terms of policy failure (separation view), i.e. a smaller CBIS is better. The crucial argument supporting this point of view is that when the central banker--i.e. the liquidity manager--also acts as the supervisor the risk of policy failure is greater. It is important to highlight that the risk of policy failure is endogenous with respect to the distribution of power: it exists only if the supervisor is the central bank, acting as liquidity manager. The risk of policy failure can be differently motivated, shedding light on the various sources of the policy failure risk.

   First of all, if the supervisor can discretionally manage liquidity, the risk of moral hazard in supervised banks can increase (19) (moral hazard risk). If the supervisor is not the liquidity manager this source of moral hazard doesn't exist.

   Secondly, the discretionary action of the central bank can increase uncertainty in supervised markets, as the recent on-again/off again rescues of financial firms in the US have demonstrated (20) (uncertainty risk). If the supervisor is the liquidity manager greater moral hazard and greater uncertainty are likely to be produced.

   Thirdly, it has been highlighted that monetary policy responsibilities can negatively affect the central bank's behavior as supervisor (21), given the existence of reputational risks (22), as well as conflicts of interest between monetary policy and supervision management (23) (distorted incentives risk).

   Fourthly, the central banker can use his/her powers in liquidity management to please the banking constituents, instead of pursuing social welfare. In this respect, the central bank can be the most dangerous case of a supervisor being captured by bankers (24), given that the banking industry may be more willing to capture supervisors which are powerful (25) (capture risk)

   Finally, the unification of banking supervision and monetary policy in the hands of the central bank can create an overly powerful bureaucracy with related risks of misconduct (26) (bureaucratic overpower risk).

   Therefore the comparison between the integration and separation views is inconclusive: the optimal CBIS cannot be defined.

   The same conclusion is confirmed on empirical grounds, acknowledging that available analyses are rare and very recent. The integration view finds empirical support in a study (27) where the degree of compliance with Basel standards is used to investigate the possible relationship between the compliance capacity of each country and the way these countries have organized the role of the central bank as main banking supervisor. The separation view seems to be...