Governments, central bankers, and banking supervision reforms: Does independence matter?

Lucia Dalla Pellegrina, Donato Masciandaro, Rosaria Vega Pansini, 12 September 2010

a

A

In response to the global crisis, many countries are implementing – or at least considering – reforms concerning the role of the central bank in banking supervisory regimes.

  • On July 2010 US President Barack Obama signed into law the so-called Dodd-Frank Act.

The Dodd-Frank Act increases the role of the Fed as a banking supervisor. This is despite the fact that during the discussion of the bill US lawmakers debated whether to restrict some of the Fed’s regulatory responsibilities.

  • In Europe policymakers moved to finalise reforms of the central bank involvement in supervision both at international and national levels (Phillips 2010).

In 2009 the European Commission enacted a proposal for the establishment of a European System Risk Council for macro prudential supervision.

  • In 2008 the German government expressed its willingness to dismantle the unique financial supervisor (BAFIN) in favour of the Bundesbank.
  • In June 2010 the UK government unveiled a reform of the bank supervisory system aimed at consolidating power within the Bank of England.
  • In the Summer 2010 the Irish Financial Services Regulatory Authority was legally merged with the central bank.

Is the trend reversing?

These episodes seem to signal a sort of “great reversal”. Before the crisis, the trend in supervisory structures was in the opposite direction, i.e. towards the specialisation of central banks in order to pursue monetary policy as a unique mandate (Masciandaro and Quintyn 2009).

In light of the recent financial turmoil, it is unquestionable that decisions concerning how to assign supervisory tasks should pay strong attention to interactions between the responsibility in monitoring banking activity and the role of the central bank. Yet the economic literature has not provided any clear-cut indications of the optimal way of assigning supervision. Indeed, central banks may face conflicts related to financial stability (see among others Pomerleano 2009).

The main argument in favour of the involvement of the central bank in supervision is linked to the positive effect stemming from information gains. But these considerations go against another argument, often made in the literature, that the intertwined implementation of monetary policy and banking supervision can be costly for different reasons.

  • First of all, any extension of the central bank powers in the field of supervision can increase endogenously the moral hazard risks and consequently the risks of accommodative monetary actions. If a central bank is empowered with excessive discretion to monetise financial distress, a systemic risk will be more likely to emerge, derailing both monetary and financial stability.
  • Secondly, the risk of reputational losses may be likely to increase if the central bank is deeply involved in supervision, while the reputational benefits are less likely to emerge, given the nature of the supervision policies, where failures are more visible than successes. In order to avoid reputational losses the central bank is more likely to accommodate bailout pressures using the liquidity tools.

Unravelling the trade-off

In other words the cons of the central bank involvement in supervision are crucially based on the view that the temptation of relaxing monetary policy standards in order to mitigate financial sector problems may in turn exacerbate both financial and monetary instability. Policymakers therefore face a trade-off between expected benefits and costs in determining the central bank involvement in supervision.

In a recent empirical analysis (Dalla et al. 2010), we investigate under which institutional framework policymakers are more likely to choose to involve the central banks in banking supervision. We focus our attention on the key feature of the monetary regime which crucially shapes the relationship between the governments and the central banks, i.e. the degree of central bank independence.

From its origins the central bank independence has been considered a significant determining factor for macroeconomic performances and monetary policy choices (for complete and recent surveys see Cukierman 2008 and Alesina and Stella 2010). The literature also highlights the political and institutional factors which can influence the effectiveness of the central bank independence (Acemoglu et al. 2008). Recently the debate has focused on how the financial crisis can threaten central bank independence itself (see Buiter 2007 and Baldwin 2008). Now, we believe, is the time to study the effect of the central bank independence on the policymakers’ choices in other fields.

Operational independence, supervision, and statutory goals

Our empirical study sheds light on two basic facts.

  • First, the econometric analysis shows that stronger central bank’s operational independence implies fewer supervisory powers, while political independence – intended as the pure absence of government members in the central bank’s board of directors – has no effect on task assignment. We explain our result through the willingness of benevolent governments of not assigning supervision to central banks because these could make an instrumental use of monetary policy as a means to hide supervisory mismanagement.
  • Second, we provide evidence that a peculiar feature of political independence, namely the presence of clearly measurable statutory goals, can affect the way central banks tie their own hands in terms of the use of monetary policy and therefore provides more supervisory power assignment to the latter. Assigning supervision to highly operationally autonomous agencies might be a risk for policymakers. Having a statutory goal which ties central bank’s hands thus minimising operational liquidity mismanagement could help mitigating this trade-off.

From a policy perspective, recent months seems to show an increasing involvement of central banks in supervision, in general using the “new” formula of the macro-supervision given the existing levels of central bank independence. An explanation can be found in the effects of the financial crisis on the policymaker’s perception of the pros and cons of the central bank involvement, and the level of central bank independence can represent a case by case a factor which facilitates or restricts the final political decision.

The financial crisis has stressed the importance of overseeing systemic risks. In order to carry out macro prudential supervisory tasks, information on the economic and financial system as a whole is required. The view is gaining momentum that central banks are in the best position to collect and analyse this kind of information, given their role in managing monetary policy both in regular and in exceptional times (through lending of last resort).

From the policymakers’ point of view, the involvement of the central bank in the macro supervision area means greater potential benefits in terms of information. They can also presume that the potential costs of central bank involvement are smaller compared to those related to micro supervision. In other words, the separation between micro and macro supervision can be used to reduce the arguments against central bank involvement.

How does the level of central bank independence come into play?

Both in the EU and the UK, independent central banks are committed to monetary stability. Hence, central bank independence is likely to represent a facilitating factor in increasing central banks' involvement in supervision. The same reasoning can be applied to the cases of Germany and Ireland, which both belong to the Eurozone. On the one side, their central banks no longer have the full responsibilities for monetary policy, yet on the other side they are members of a monetary regime with an independent central bank committed to monetary stability. Both elements go in the same direction, i.e. to facilitate the political solution toward a greater central bank involvement in banking supervision.

In the US however, we have an operationally independent central bank without any clearly measurable statutory goal. Our view suggests that the risks of policy misallocation are higher in this case. The behaviour of US lawmakers can be classified either as outliers – i.e. benevolent politicians which underweight the potential cons of a deeper involvement of the Fed in the banking supervision – or alternatively as grabbing hand politicians who are in favour of a regime where a discretionary and powerful Fed can accommodate the financial difficulties using monetary tools – i.e. the politicians are captured by the financial constituency and/or by the Fed.

We therefore argue that the recent episodes of greater central bank involvement in supervision through the macro responsibility assignment seem to be more of an evolution of central bank specialisation as a monetary agent rather than a reverse trend towards de-specialisation.

References

Acemoglu, Daron, Simon Johnson, Pablo Querubín, and James A Robinson (2008), “When does policy reform work? The case of central bank Independence”, VoxEU.org, 25 June.

Alesina A and A Stella (2010), “The Politics of Monetary Policy”, Discussion Paper Series, Harvard Institute of Economic Research, n.2183.

Baldwin, Richard (2008), “Buiter’s warning: Who is the recapitaliser of last resort for the ECB?”, VoxEU.org, 17 May.

Buiter WH (2007), “Seignorage”, NBER Working Paper 11919.

Cukierman A (2008), “Central Bank Independence and Monetary Policymaking Institutions: Past, Present and Future”, European Journal of Political Economy, 24:722-736.

Dalla Pellegrina L, D Masciandaro, and R Pansini (2010), “Governments, Central Banks and Banking Supervision Reforms: Does Independence Matter?”, Paolo Baffi Centre Working Paper 74.

Masciandaro D and M Quintyn (2009), “Reforming Financial Supervision and the Role of the Central Banks: a Review of Global Trends, Causes and Effects (1998-2008)”, CEPR Policy Insight 30, 1-11.

Phillips, Leigh (2010), “Deal reached on pan-European financial supervisors”, euobserver.com, 3 September.

Pomerleano Michael (2009), “What international experience tells us about financial stability regulatory reforms”, VoxEU.org, 21 December.

Topics: Global governance, Monetary policy
Tags: Central Banks, financial regulation, global governance, monetary policy

Lucia Dalla Pellegrina

Assistant Professor, University of Milan-Bicocca

Donato Masciandaro

Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University

Rosaria Vega Pansini

Post-doctoral Research Fellow at the Economics Department, Bocconi University