Current Legal Issues Affecting Central Banks, Volume IV.

17A. The Role of the Central Bank

Robert Effros
Published Date:
April 1997
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This chapter addresses the general issues associated with the role of the central bank in bank supervision and regulation and the question of why it is important that central banks should be involved in these matters. Chapter 17B addresses how bank supervision and regulation are implemented and practiced in the Group of Seven countries.

Maintaining Monetary and Financial System Stability

It is the fundamental responsibility of central banks to ensure monetary stability and the stability of financial markets. Each central bank has a somewhat different mandate and objectives; broadly speaking, however, these two objectives apply to all central banks. The two aspects of this responsibility are also distinct, that is, one can talk about what it takes to ensure monetary stability separately from financial market stability. The distinction to be made is between (i) monetary stability, which involves stabilizing the price level and the value of the currency (essentially a macroeconomic set of issues), and (ii) the stability of financial markets, which has to do more with the institutions in the financial sector, the players, the structure and infrastructure of the financial markets, and financial market prices. These two areas are obviously closely related.

In order to implement the two objectives, central banks conduct a range of functions, one of which is (or certainly could be) banking supervision and regulation. That function clearly has a direct impact on financial market stability. The focus in this chapter is on the indirect aspects of the supervisory or regulatory role of central banks, namely, how that function interrelates with or reinforces the other central bank functions.

One central bank function is the monetary policy function itself. In order to carry out a reasonable monetary policy, central banks need to understand its transmission mechanism, that is, how a change in the instruments of monetary policy affects the economy and its various components. While the structure of financial markets varies from country to country, the transmission mechanism in all countries is likely to involve banks. Therefore, it is important in conducting monetary policy to have as full an appreciation of how banks operate as possible. From the point of view of monetary policy, the central bank does not have to play a supervisory role. Even without access to examination reports, one can learn how banks operate. However, it is helpful and has been important in the United States for the central bank to play a supervisory role.

Some people have discerned the possibility of a conflict between monetary policy objectives, on the one hand, and concern about the stability of the banking system, on the other. In a world in which a central bank might want to tighten its policies and raise interest rates, might it be restrained from doing so out of fear of the implications of such actions for the banking system? This is a possibility, but it would arise regardless of whether those two functions were combined in the central bank. Those charged with monetary policy have to take account of the implications of their actions for the financial system and everyone affected by it, regardless of whether they are supervising that system.

The monetary aggregates represent one channel for the transmission of monetary policy. In the United States, for example, various narrow and broad aggregates affect the economy. The broad aggregates have managed liabilities as important components. These liabilities are deposits of the banking system that are induced by banks’ activities, rather than accumulated passively. To understand movements in money, therefore, it is important to understand the extent to which banks are aggressively bidding for deposits.

In the United States, the slow growth of some of the broader aggregates has been linked to the recent spate of bank mergers. In the wake of the savings and loan crisis, banks not only acquired considerable deposit liabilities (so that they did not need to go out and seek more), but they also sought to enhance their financial strength and build up their capital positions. Accordingly, they were less anxious to build up their balance sheets and, therefore, bid less aggressively for deposits. It is important for central banks to understand such processes in order to assess the growth of monetary aggregates.

Transmission of Monetary Policy Through the Credit Channel

The credit channel is another mechanism for the transmission of monetary policy. Much has been said about the “credit crunch” in the United States in the past few years. This phenomenon, which has been seen in other countries as well, describes a shift in the supply schedule for credit generated by the risks, interest rates, and other variables that enter into the calculations, that makes banks less likely to extend credit than they would otherwise. The effect of the credit crunch was not fully appreciated early in the current cycle; it was through its examination process that the Federal Reserve discovered that banks’ behavior was, in fact, changing in line with their desire to improve their financial condition and build up their capital positions. The Federal Reserve would not have gained that supervisory insight if it did not have a role to play in the examination process. The Federal Reserve was induced, at the time, to lower interest rates, in order to offset the effect of the restriction on the supply of credit by the banking system.

Transmission of Monetary Policy Through the Interest Rate Channel

Monetary policy also affects the economy through the interest rate channel. Consider, for example, how interest rates are set. Central banks set the official rates at which they lend to the banking system and, by controlling the supply of reserves, influence the federal funds rate. However, the spreads that the banks impose between those interest rates, deposit rates, and lending rates are functions of a number of variables that the central bank needs to understand. Once again, the insights gained from the examination process enable the Federal Reserve, as the nation’s central bank, to do that.

Management of the Payment System

A second broad function of a central bank is management of the payment system. While the role of a central bank in the payment system varies from country to country, central banks typically play a role in large-value payment systems. In a sense, this situation is almost inevitable. Private banks hold deposits at the central bank. These deposits, as they are central bank money, are unlike other deposits. There is no credit risk associated with them. These deposits constitute an important element of the financial market structure.

While providing the opportunity for commercial banks to hold balances at the central bank, the central bank must also provide a means of transferring these balances from one account to another. Although these transfers are relatively few in number, they are very large in value. The need for credit might arise in such a system when the outflows from one account do not exactly match the inflows. In these contexts, there may be a need for the central bank to provide credit—intraday, at least, if not overnight. The central bank need not be the entity that runs a large-value payment system. However, because of the unique nature of the central bank—the lack of credit risk and the infinite liquidity that is available—it offers a degree of certainty to the financial system that private participants cannot provide.

In any event, the central bank plays a role in supervising such a system. If the central bank itself runs the system, it must know the participants: to be able to extend credit on very short notice, it must have a feel for the financial condition of each participant in the system. If the central bank does not manage the overall payment system, it must oversee at least the privately run, large-value payment systems. The Bank for International Settlements (BIS) considered this issue a few years ago. The result has now become known as the Lamfalussy standards,1 according to which countries agree that central banks will oversee large-value payment systems and ensure that these systems adhere to a set of standards and principles.

Lender of Last Resort

The lender-of-last-resort function is key to any central bank. Central banks may well be in a position of having to extend liquidity support to a bank that is in trouble. This process involves setting the discount rate and the other terms and conditions of the liquidity support. Once again, the need often arises to respond quickly to a situation that could otherwise get out of hand. The central bank must make a judgment as to whether the problem facing a troubled institution is one of illiquidity or insolvency. In the U.S. system and in most lender-of-last-resort structures, liquidity support is not provided to an insolvent institution. The judgment is not easy to make; it certainly is not easy to make quickly. Once again, the closer the central bank is to the supervisory process, the more it knows about that process. Similarly, the more central bank staff there are who are accustomed to evaluating the financial condition of the banks, the better able the central bank is to make those judgments properly and promptly.

Responsibility for examining or supervising all banks in a system will not necessarily enhance a central bank’s ability to make these judgments. Even if a troubled bank is supervised by some other entity than the central bank, (which can easily happen, given the fragmented structure in the United States), the presence of experts accustomed to dealing with these issues on the central bank’s staff is quite beneficial and important.

Crisis Management

While the functions of maintaining monetary stability, managing the payment system function, and acting as the lender of last resort all benefit from being combined with the supervisory function, the strongest argument for a central bank role in bank supervision has to do with crisis management. Central banks are necessarily involved in reducing the likelihood that systemic crises might arise and resolving those crises that do arise. Systemic crises can arise from disturbances to financial markets and firms. These disturbances could spill over to other firms, or to the markets as a whole, and cause consequences for the real economy.

Central banks are necessarily involved because they alone can provide enough liquidity to deal with crises of systemic proportions. Beyond that, they are also the only participants with the broad knowledge of financial markets (and of the interactions among financial markets) that is needed to resolve such situations. Unlike the problems of an individual troubled bank, which can usually be dealt with through liquidation or merger, a systemic crisis by its very nature involves a wide range of entities, not just banks. Increasingly, as the world evolves, banks and other financial market participants (institutional investors, securities firms, insurance companies, or hedge funds) have become so interrelated that one needs this breadth of experience and knowledge that central banks can best supply. This is not to say that this knowledge could not be embodied in some agency outside the central bank; however, it is most likely to be found in the central bank.

Thus, in the aftermath of the equity market crash in October 1987, the Federal Reserve and other central banks provided liquidity to the market as an initial response. This action went a long way toward reducing the negative impact of that stock market crash. Beyond that, the Federal Reserve used its familiarity with the banks’ relationships with the security houses, including the credit exposures of those houses, to help coordinate the provision of liquidity from individual banks to individual securities firms. This additional involvement of the Federal Reserve further minimized the negative impact of that systemic disturbance.

The mutually reinforcing nature of the various central bank functions must be stressed. Supervising banks enables the central bank to carry out its other functions more easily and rationally, as better information is available. At the same time, these other functions also bring something to the supervisory process. Central banks are better supervisors because they have this other experience to draw on.

The international aspect of this situation is particularly noteworthy. First, central banks are a close-knit group. They all have contacts with each other in various roles (in connection with monetary policy, payment system, supervisory, and other kinds of functions) and in various forums. These contacts are crucial, especially in the event of a systemic disturbance, because central bankers have developed working relationships with the individuals who will be dealing with the systemic crisis in their own countries. In today’s fast-moving world, these contacts are invaluable. Supervisors by themselves could not have that full range of contacts.

Second, many banks are themselves international in nature. These large, internationally active banks could well be the source of a systemic problem. A disturbance is much more likely to arise from the activities of a large, internationally active bank than from a small bank, or even a large, domestically oriented bank; the nature of international financial markets increases the likelihood that such a disturbance might spread from one country to another and develop into a systemic global crisis. In order to supervise internationally active banks, the supervising agency must have the requisite breadth of knowledge.

When the developing countries’ debt crisis erupted in 1982 (clearly a major international event in financial markets of that decade), the Federal Reserve and some other central banks were well positioned to act promptly. They already knew, on the basis of supervisory reports (not economic research), that a large number of U.S. banks, including the largest, had substantial exposures to countries that could lead to debt-servicing difficulties. These exposures, in many cases, were large relative to their capital. When the crisis did erupt, the Federal Reserve knew which banks were exposed. It was familiar with the risk-analysis process followed by the supervisors and within the banks themselves. It also maintained contacts with the other central banks. The Federal Reserve was therefore able to organize liquidity support on short notice. Prompt action in the initial phase of dealing with the debt problem helped to minimize the macroeconomic consequences.

As the months and years of the debt crisis wore on, a tension developed between the need to protect and restore the financial strength of the banking system and the need to ensure that borrowing countries had at least conditional access (conditional upon policy actions on their part) to funding by the international community, without which they would not have been able to work out the problems in a reasonable way. A trade-off had to be made between the supervisory need to limit banks’ exposures, on the one hand, and the macroeconomic need for funding, on the other. The central banking community was in the best position to make that kind of trade-off. Supervisors without responsibility for the macroeconomic consequences of their actions could not have made that trade-off as well as the central banking community did.

Another more recent example involves derivatives. Ongoing work is aimed at managing the risks associated with derivatives in a wide range of areas. Not only are all of the supervisory bodies in the United States involved in this, but the market itself is also involved. In addition, the matter is of concern to banks, securities firms, and the U.S. Congress.

The range of aspects relevant to this discussion cuts across many different kinds of functions, putting central banks in a good position to deal with this issue. Within the Federal Reserve, a working group of experts on the legal, research, international, payment, and supervisory aspects has been set up to ensure that their various perspectives are not overlooked in making regulatory judgments about the derivatives markets. Supervisors on the Basle Committee on Banking Supervision are also very much interested in derivatives, which they are discussing in the context of market risk and off-balance-sheet risk and the capital charges that need to be placed. Other groups are also discussing derivatives.

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