Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Banking crises—and therefore banking system soundness and supervision of banks—have become the “issue du jour”—to use an expression that the First Deputy Managing Director of the IMF, Stanley Fischer, used in a recent roundtable discussion. This has brought the importance of supervision and prudential regulation (of banks) to the forefront of monetary and financial management, as predicted two years ago on the occasion of the Sixth Seminar on Central Banking on Frameworks for Monetary Stability with remarkable prescience by Manuel Guitián, Director of the IMF’s Monetary and Exchange Affairs Department.

At this stage in the seminar proceedings—with earlier presentations having established without any doubt the macro/micro linkages of monetary policy and banking supervision—it is fitting that there should be a paper that focuses on the controversial issue of who should be responsible for banking supervision.

Indeed Pierre Duquesne’s paper, which analyzes where the locus of responsibility for banking supervision should lie from the perspective of the overall efficiency of monetary policy and banking supervision—and whether institutional responsibilities for each function should be independent, answerable to some joint authority, or to one body, that is, the central bank—is a thoughtful and well-crafted presentation that is interesting, instructive, and timely. It presents the theory and then the reality. There is not much to disagree with, except to raise a few questions at the end of my comments. In my remarks, I would like to focus on and expand a few issues that underpin Duquesne’s analysis, including reference to an IMF paper prepared two years ago that compliments his work. The following points are worth considering:

  • Duquesne’s opening remarks refer to the former Federal Reserve head, Paul Volker, and his comments that some central banks were founded more out of concern about banking stability than ideas of monetary policy as we know them today. Indeed, one could extend this notion to some of the instruments of monetary policy, such as reserve requirements and liquidity ratios, which have their genesis in prudential regulation and concern for the soundness of banks (this was certainly the case in the United States in the early days of the Federal Reserve System).

  • The point above and many of Duquesne’s other comments—such as those refuting the assumption of banking neutrality and highlighting the shared task of monetary policy and banking supervision functions in monitoring liquidity in the money market—strengthen his we11-marshaled case against the two classic arguments for keeping monetary policy and banking supervision functions separate, that is, concerns about conflict of objectives and the need for market discipline, including constraining moral hazard. On the market discipline issue, a real challenge is to contain systemic risk while minimizing moral hazard. Duquesne’s point on the shortcomings of deposit insurance compared to the lender of last resort in this respect is well taken.

  • His justification for central bank involvement in banking supervision based on the necessity to ensure security of the payments system through the management of bank liquidity and the need to prevent systemic risk through the lender-of-last-re sort facility are consistent with best practices and recent trends in banking systems. In this case, he recognizes the imperfections of the credit market, particularly, the maturity transformation role of banks and their risk exposure in interbank markets, as well as the growing role that central banks are obliged to exercise in promoting sound and safe payments settlement arrangements. Indeed, these points were also forcefully made by Eddie George in his paper presented earlier in this volume (see Chapter 11) in substantiating why banks are special and in justifying the macro-prudential supervisory role of central banks over banks. This view was also endorsed by Donald Brash in his presentation (see Chapter 16).

  • In sum, Duquesne’s line of argument logically supports and leads to his conclusions that no one institutional model of banking supervision is superior to all others, and there are no grounds in theory for claiming the superiority of the argument that the banking supervisory authority should be strictly independent of the monetary authority. I would have little difficulty in agreeing that the case he makes “tips the balance in favor of central bank involvement in the management of the banking system in collaboration with the banking supervisory bodies.”

  • Having established his case for central bank involvement in banking supervision, Duquesne seems satisfied to let it rest on the conclusion that there are no theoretical arguments to support institutional independence between the monetary policy and banking supervision authorities.

This latter approach may be wise, especially in light of the fact that there is no single all-embracing institutional model. But his statement that this conclusion is contrary to the most widely held view nowadays is somewhat surprising given that the majority of the world’s central banks are involved in banking supervision. Jose” Tuya and Lorena Zamalloa in their paper, “Issues on Placing Banking Supervision in the Central Bank” show that, in over 60 percent of IMF member countries, banking supervision is conducted by the central bank.1 This is not a significant point for debate, however, because in comparing the French system of banking supervision with those of a range of other industrial countries in the final section of his paper, Duquesne amply illustrates that institutional interdependence between monetary policy and banking supervision functions is more common than might appear to be the case—a point which Eddie George also makes.

Recognizing these institutional arrangements for monetary policy and prudential supervision functions very often reflect social and political, historical and cultural factors, two broad conclusions can be drawn on the locus of responsibility issue from Duquesne’s overall presentation and other literature on this subject.

First, regardless of where formal institutional bank supervisory authority is vested in a country, the central bank has to have a close involvement in prudential supervision and monitoring of the financial system—if only to ensure that monetary management, particularly when conducted through indirect instruments, is based on market discipline and leads to competition and efficiency. If the formal locus of such responsibility, especially the micro-prudential aspect, is outside the central bank, then it need not participate directly in making decisions on troubled institutions. While this may keep the central bank from having to take overt actions that might conflict with its well-recognized policy aim of price stability, substantive participation in macro-prudential supervision aimed at containing systemic risk is nevertheless necessary for the effective discharge of lender-of-last-resort and liquidity management responsibilities, especially to maintain market discipline in lender-of-last-re sort arrangements.

Second, the complex institutional arrangements for banking supervision among the list of countries mentioned in Duquesne’s presentation highlight the basic importance—whatever the institutional framework is—of establishing good policies to keep the banking system sound. These institutional arrangements involve the relation to the different concepts of universal banks together with the unevenness of supervision by central banks and other bank regulatory agencies, not to mention the “original” approach to banking supervision responsibilities in the new European central bank. These policies were elaborated in detail in Carl-Johan Lindgren’s presentation earlier in this volume (see Chapter 12), and of course many were highlighted in both Duquesne’s and Artopoeus’s presentations (see Chapter 17).

It is interesting to recall that in the fifth central banking seminar in 1990, which had as its theme the evolving role of central banks, the views on the role of the central bank in prudential supervision and on the locus of this responsibility were somewhat more polarized than nowadays; nevertheless, there was little disagreement between both camps that, when the responsibility for the two functions of monetary policy and prudential supervision on banking is institutionally separate, economies of scale in information gathering and the efficient implementation of monetary and supervisory actions call for close coordination by the supervisory and monetary authorities.

Finally, two questions arose in regard to Duquesne’s presentation. First, the natural mobility of Bank of France staff between monetary policy and supervision areas seemed to be a very practical aspect of interdependence and enhancement of collaboration between the two functions. Yet, it is surprising to note that in its financial market intervention area the Bank of France had no access to inside information on the quality of counterparties. (Paradoxically, the Bundesbank—portrayed as a separation model through the information gathered by its regional network—may have access to more information on the condition of counterparties than the Bank of France.) How then does the Bank of France monitor risk in relation to liquidity management and lender-of-last-re sort transactions?

Second, although best practices can be drawn from countries with well-developed banking systems in relation to standards and guidelines for prudential supervision and regulation of banks, the question remains of just how to advise developing countries and those in transition on how to build and enhance their financial systems. What advice can be given to those developing countries and those in transition about the best institutional framework or model to adopt for licensing, regulation, and examination in their respective countries, particularly in view of the complexity of models and institutional practices in the countries surveyed?

In those countries in which the IMF has provided technical assistance, invariably central banks have taken on oversight responsibilities for banking supervision and payments system reform. This is the situation especially in countries where banks are the dominant financial intermediaries. Where there is a need for consolidated supervision of conglomerates, there may be a strong argument for an umbrella-type supervisory organization incorporating all financial supervision under one roof.

Indeed the Tuya-Zamalloa paper in this respect provides a useful background study on the institutional framework for banking supervision that complements Duquesne’s own analysis. One of its conclusions, for example, is that the decision to place banking supervision within the provence of the central bank should be handled on a case-by-case basis. This is particularly true for developing countries and economies in transition where institutions and legal systems are in the process of development and human capital is scarce, making coordination between institutions often difficult.

In conclusion, it is interesting to note that John Maynard Keynes, in his pre-Bretton Woods drafts, had a view that the IMF Board of Directors should be composed of cautious bankers. I am not sure that his wish was realized, but, if he were alive today, he could take some satisfaction from the increasing importance now being attached to banking and financial system soundness in the IMF’s economic surveillance work of member countries.

José Tuya, and Lorena Zamalloa, 1994, “Issues on Placing Banking Supervision in the Central Bank,” Frameworks for Monetary Stability: Policy Issues and Country Experiences (Washington: International Monetary Fund).

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