The Risk of Impairing Central Bank Independence: The Cases of Peru and Chile

Central bank independence implies a constitutional operation for two major reasons: separation of powers and the guarantee of economic rights. There is a separation of powers because of the reattribution of monetary sovereign powers in favor of a sole specific body—the central bank—not being part of the government. There is an actual separation of functions in the sense that most constitutions and treaties that recognize independent central banks split the state’s fiscal activities (taxation as the major source of public revenues) from the state’s ability to create money. In fact, a constitution necessarily implies a division of powers, as was proposed in France in 1789: “Any society in which the guarantee of the rights is not secured, or the separation of powers not determined, has no constitution at all.”¹² Thus, to assure the effective separation, many constitutions and central bank laws prohibit central banks from financing governments.¹³ In this constitutional order, central banks’ actions to preserve monetary stability will never be confused with the search for resources to finance fiscal policies (Monteagudo 2010a, 496–498).

The second reason for the constitutionality of central bank independence is even more classical, as the reattribution of competences has as a primary goal to preserve or guarantee individuals’ right to monetary stability. Monetary stability allows all individuals to exercise fully their economic rights by the use of a monetary instrument as a stable vehicle for trading and saving. That is why for German ordoliberals, monetary stability should be listed among fundamental rights and, therefore, part of the economic constitution (Tietmeyer 1999).

As mentioned, many independent central banks have unique or primary objectives to preserve monetary stability, without interference from other public goals that remain in the hands of the representative government or its agencies. In that context, how is it possible to attribute to an independent central bank a new goal or functional responsibility related to financial stability without impairing such status of independence? Even more, macroprudential policy in the hands of financial stability councils—constituted by the government, the central bank, and financial regulators—might imply the approval or recommendation of regulations that interfere with the management of monetary instruments. An example is the introduction of rules pertaining to liquidity requirements as a means to curb systemwide credit growth (IMF 2013). In fact, ab initio, there is not an evident conflict between monetary goals and macroprudential goals, but at some critical point the conflict could arise between assuring price stability and adjusting credit to secure adequate liquidity for financial institutions (financial stability). One key question is whether creating institutional arrangements that might produce some interference of functions between the central bank and government or financial regulators is consistent with a constitutional order supposedly ensuring the independence of central banks from government.

The proposed problem seems not to have the same intensity in countries where central banks are also in charge of banking or financial regulation or supervision (Argentina, Brazil, and Uruguay), as long as macroprudential policy is not far from the central bank’s explicit goals and functions. However, even in these cases the presence of the government in financial stability councils could produce a constitutional inconsistency with central bank independence.

In any case, the classical debate about whether the central bank should also assume banking and financial regulation responsibilities could provide some interesting elements to address the more complex problem of central bank independence and financial stability councils. Those who oppose the concentration of powers have claimed that a banking regulation bias could make central banks more relaxed regarding monetary policy and the use of liquidity instruments, to the detriment of the monetary stability goal. Defenders respond that for an effective monetary policy and payment system to function, central banks should not only have hard information on bank solvency (as banks are the primary intermediaries of money creation), but also the powers to impose prudential rules.¹⁴ What happens in legal reality is that, even before the period of multiplication of financial stability councils, legislation in different countries and integrated zones provided central banks with different levels of power and functions in the area of banking prudential regulations. For example, the original version of Article 127.6 of the Treaty of the European Union Function already established that the European Council could assign prudential supervision functions to the ECB.¹⁵ This provision has also given legal support to ECB’s engagement on macroprudential policy responsibilities.¹⁶

There are no doubts about the direct connection between monetary policy and financial stability and the need to establish some level of regulatory consistency or communication between both bodies of law and regulations. It could even be proposed that if money multiplication is an action of the banking and financial industry, the monetary stability goal naturally includes financial stability. However, economic reasoning is not always translated automatically into law. Constitutions and treaties are usually interpreted under the principle of attribution to determine the scope of jurisdiction and powers of public bodies; that is, it is necessary to find in law the basis of regulatory powers and the capacity to impose obligations to individuals and moral persons. One example of this is the power of central banks to impose the constitution of legal reserves.¹⁷

Let us see the consistency problem that may arise in Peru’s constitutional system and how Chile resolved a similar experience. According to Peru’s Constitution, the central bank is an autonomous public entity within the framework of its organic law. Its goal is to preserve monetary stability, and its functions are regulating money and credit in the financial system, managing international reserves, and other functions provided by the Central Bank Charter.¹⁸ Peru’s constitution also establishes that the central bank is governed by its board of directors, thereby creating—at the constitutional level—a self-government regime.¹⁹ Additionally, the Constitution entitles the Superintendence of Banks, Insurance Companies, and Private Pension Funds to supervise (“control”) those financial participants, leaving to legislation the determination of its functional autonomy and organiza-tion.²⁰ As mentioned, the level of constitutional independence of the Superintendence of Banks, Insurance Companies, and Private Pension Funds is not the same as the central bank’s, as the Constitution only refers to functional independence to be determined by the Congress. In that constitutional order, how is it possible to create, by law, a financial stability council where an independent central bank shares macroprudential regulatory responsibilities with government and the Superintendence of Banks, Insurance Companies, and Private Pension Funds, to the point that those common responsibilities could generate the imposition of monetary regulations?

Chile, which has “one of the most independent central banks in the emerging market world,”²¹ offers a very innovative solution. The Financial Stability Council of Chile was created by the Supreme Decree No. 953 of 2011 but consecrated at the law level by Law No. 20.789 of 2014²² and is chaired by the Minister of Finance. The Financial Stability Council is also composed of the three financial supervision agencies (for banks, securities and insurance, and pensions). The two key institutional arrangements of the council are the following: (1) the central bank participates in the council only as an advisor to the chairman (who is not a member with voting power), and (2) the council’s powers “are not above the legal mandate of their members.”²³ In fact, the council only has the capacity to make regulatory recommendations²⁴ and, when considering recommendations that may have any effect over central bank powers, Article 2 of Law 20.789 provides a suspension procedure at the request of the Minister of Finance, established in Article 19 the Central Bank Law.²⁵

The Chilean solution has left central bank independence almost unharmed and reinforced its protection in case regulatory recommendations from the Financial Stability Council may interfere with monetary policy. In addition, it must be taken into account that advisory powers or the authoritative production of nonbinding measures has become a centerpiece of the evolution of international economic law. Soft law has become an efficient “regulatory” instrument for implementation purposes.

Classical Carve-Out and Macroprudential Exemptions

Since the beginning of the 1990s, many Latin American countries have liberalized international trade, foreign investment, and financial services through bilateral investment treaties and free trade agreements.²⁶ Many aspects of the free trade agreement model formerly promoted by the United States have prevailed in negotiations with Latin American countries; for example, the prudential exemption provided in the Chapter of Financial Services, which basically mirrors the prudential carve-out (or prudential exemption) provided in the Annex on Financial Services of the General Agreement on Trade and Services (GATS) of 1994. Paragraph 2 (a) of the Annex establishes:

Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system. Where such measures do not conform with provisions of the Agreement, they shall not be used as a means of avoiding the Member’s commitments or obligations under the Agreement. . . .

As remarked by Matsushita and others, “the prudential carve-out ensures that other economic and societal objectives, such as consumer protection and financial stability, can be protected. If the Global Financial Crisis (GFC) has shown that this has not happened sufficiently in the past, it was certainly not the World Trade Organization (WTO) parameters which limited the right sensibly to regulate the financial services industry.”²⁷ These authors also remark that the current prudential carve-out exemption “would accommodate the new focus of central banks and regulators in addressing systemic risk.”²⁸ However, it is difficult to imagine that GATS writers had in mind macroprudential measures in the actual sense of the concept when they designed the carve-out exemption. Even though the examples of prudential measures proposed by Paragraph 2 (a) are not precisely typical macroprudential measures (“measures for the protection of investors, depositors, policy holders”), the reference to “ensure the integrity and stability of the financial system” amplifies the scope of the exemption with a visionary perspective. In addition to that, the annex provision employs the term “prudential reasons” and does not refer to specific types of measures.²⁹

In the Peru—United States Free Trade Agreement, signed on April 12, 2006, and entered into force in February 2009, the prudential carve-out transposes GATS’ text in Article 12.10 (1).³⁰ However, it adds an explanation of what prudential reasons may mean, stating that “it is understood that the term ‘prudential reasons’ includes the maintenance of the safety, soundness, integrity, or financial responsibility of individual financial institutions or cross-border financial service suppliers” (footnote 4). It is clear that in this example of “prudential reasons” there is a more classical micro approach than a macro one, referring to “individual financial institutions” and regulatory objectives (“safety, soundness, integrity, or financial responsibility”) associated with Basel Committee and Anti—Money Laundering/Combating the Financing of Terrorism standards, as well as social responsibility principles.

The language of the footnote of Article 12.10 (1) does not use examples more related to the era of macroprudential policy. However, there is no doubt that these “examples” are not part of numerous clausus or a closed list of prudential reasons. The text starts by saying that the term “prudential reasons” includes the referred examples and also Article 12.10 (1), as used in the text of the GATS, including to exemplify the measure for prudential reasons, ending with a general expression that expressly refers to measures “to ensure the integrity and stability of the financial system.” Therefore, it is clear enough that, according to the text of the treaties, macroprudential measures are among the carve-out exemptions.

Considering the conceptual basis of the carve-out exemption, it should be taken into account that its basic idea is that—in the context of liberalizing trade, investment, and financial services—the states and regulators keep the regulatory capacity in some specific areas such as the banking sector.³¹ The carve-out exemption is not provided in the GATS or free trade agreement as a domestic policy exemption that should be “necessary” in special circumstances; in fact, as a principle, all prudential measures are exempted.³²

Future free trade and investment agreements may amplify the list of examples to avoid unnecessary discussion on this issue. However, it is interesting to observe the evolution of financial regulation and liberalization treaties that might need to be revisited occasionally with a view to ensuring their consistency.

The Implementation of Macroprudential Policy without an Institutional Arrangement: Peru’s Experience

Peru is an example of a country that, though not having set a formal financial stability council and explicit macroprudential legislation, has been able to implement some macroprudential measures. As already explained, the Central Reserve Bank of Peru has as a unique goal the preservation of monetary stability, whereas the Superintendence of Banks, Insurance Companies, and Private Pension Funds is the actual banking regulator. However, this separation of functions between monetary policy and banking regulation admits, in the field of legislation, some sort of joint regulatory coordination. This is because the central bank has a consulting role for approving some banking regulations and licenses (such as for organizing and managing banks and financial institutions),³³ establishing autonomous banking equities,³⁴ providing previous opinion for the liquidation of banks,³⁵ providing previous opinion for bank rehabilitation plans,³⁶ providing previous favorable opinion on the Superintendence’s definition of “exceptional circumstances” for justifying an increase in bank equity,³⁷ providing previous favorable opinion for the constitution of bridge banks,³⁸ and providing previous opinion for the authorization of operations not explicitly considered in the banking law.³⁹ This common experience between the central bank and the banking regulator⁴⁰ has permitted an important level of coordination between both entities.

One primary action of the central bank (also implemented by some African central banks)⁴¹ is the publication of periodical financial stability reports since 2007. The Central Bank of Peru publishes the report “with the objective of identifying the risks that affect the functioning of financial markets, financial stability, and payment systems.”⁴² The report is justified because “financial shocks can diminish the efficiency of monetary policy.”⁴³ It covers an assessment of risks for banking, financial, and payment systems. Peru’s Constitution also establishes that the central bank has the function of informing the country, “accurately and periodically” about the state of national finances.⁴⁴ This general provision, which does not distinguish between the public sector and banking finances, serves also as a foundation for the central bank’s financial stability reports.

The Peruvian economy still confronts financial dollarization as one of the long-term effects of the 1980s hyperinflation episode. In March 2016 the ratio of dollarization of banks loans was 35 percent, from above 60 percent at the beginning of the century.⁴⁵ In that scenario, dollarization in a context of exchange rate volatility becomes a macrorisk, especially for the banking system. This special circumstance has led the Central Bank of Peru to adopt measures—mostly in the area of reserve requirements—to create incentives for gradual dedollarization. Mercedes García-Escribano concludes that “the findings confirm that Peru bank de-dollarization has been the result of a three-prong approach. Macroeconomic stability, proxied by inflation, different measures of exchange rate changes, and sovereign credit risk (EMBI), had a significant impact on dedollarization. Prudential measures, such as the introduction of asymmetric reserve requirements and provisions for currency-induced credit risk, had an impact on banks’ incentives to borrow and lend in soles” (García-Escribano 2010, 5). The main measures adopted include the following:

• A legal reserve regime of differentiated reserve requirements by currency;⁴⁶

• The imposition of additional reserve requirements for housing mortgages and car loans in US dollars, aimed at reducing the risk of excessive indebtedness in foreign currency;⁴⁷

• The imposition of additional reserve requirements to banks that do not reduce their credits in foreign currency, aimed at reducing the risk of excessive indebtedness in foreign currency;⁴⁸ and

• The offer of substituting repos to enhance the substitution of foreign currency loans for local currency loans.⁴⁹

The Superintendence of Banks, Insurance Companies, and Private Pension Funds has also approved prudential regulations for limiting banks’ foreign exchange positions.⁵⁰ Whereas all these measures have been approved under exclusive competences with some level of informal coordination, international experience shows the positive effects of interagency councils, with the eventual participation of government taking into account the specific legal and political realities of each country. However, Peru’s experience shows that, even in the absence of explicit mandates and formal arrangements, central banks and banking regulators are able to respond to some of the challenges of financial stability.