Current Legal Issues Affecting Central Banks, Volume IV.

18A. Some General Considerations

Robert Effros
Published Date:
April 1997
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[The banking regulatory system is] a crazy quilt of conflicting powers and jurisdictions, of overlapping authorities and gaps in authorities. . . .

—Board of Governors of the Federal Reserve System

Twenty-Fifth Annual Report (1938)


This chapter evaluates the merits of a country’s having an independent agency to supervise banks, compared with housing the banking supervisory function in the central bank or the finance ministry. Independence, the chapter argues, is in the best interests of depositor safety and bank efficiency. It also leaves the central bank free to concentrate on its proper function, monetary policy. However, the U.S. experience demonstrates the difficulty of attaining the ideal of an independent agency. Where there is a serious risk of the bank supervisor’s task becoming politicized, the supervisory task should be housed wherever it can be most shielded from the pressures to compromise its principal task, maintaining the soundness of the banking system.

At the risk of oversimplifying, one can divide a government’s interest in the banking system into three public policy objectives: implementing monetary policy, preserving the integrity of the banking system, and allocating credit. The function of the supervisor of banks can, in most cases, best be fulfilled by segmenting its role from those of the central bank and the ministry of finance because each institution has a distinct purpose in mind in regulating banks, and attempting to achieve two or more goals with one instrument ensures that there will be conflicting priorities. To understand this idea more fully, the optimum allocation of the three goals to each of the three agencies must be explained, and the extent to which the goals are both interdependent and conflicting must be examined.

Three Roles of Bank Regulation

All arguments for government intervention in financial markets in general, and the banking system in particular, fall within one or more of the three basic categories of objectives.

Controlling the Volume of Liquidity

First, it is generally agreed that it is a legitimate responsibility of government to control the volume of liquidity in a currency-based banking system. Payments are usually made in this kind of system by transferring the ownership of demand liabilities in commercial banks. This control is necessary if for no other reason than to keep the growth of the money supply from fueling excessive price inflation. Mandatory reserve requirements on the deposit liabilities of banks and the open market purchase and sale of (public sector) securities are the major traditional means used by monetary authorities to achieve this goal.1 A related set of policy tools are those that aim at fixing exchange rates through official intervention—the buying and selling of foreign currencies by the central bank. These activities all aim at achieving the above-mentioned public policy objective of implementing monetary policy.

Preventing Bank Failure

The second objective of regulating the behavior of banking institutions is to prevent bank failures, for the sake of both depositors and the financial system in general. The collapse of a bank, because it holds the means of payment and liquid balances of business firms and households, can have a disproportionately disruptive effect on a community and even on the whole financial system if failure (or the fear thereof) leads to a banking panic. This function, which corresponds to the objective of maintaining the integrity of the banking system mentioned above, is explored in more detail later in this chapter.

Ensuring the Availability of Credit

The third objective of government intervention in the banking system is to ensure the availability of credit for certain economic activities, groups, and institutions. In effect, this means that the government allocates credit to groups to whom the private market will not grant sufficient funds or provides favored sectors with credit at below-market terms.

Division of Labor

These three objectives can be associated with the core roles or functions of the three agencies: the central bank, the bank supervisor, and the finance ministry.

Central Bank

The role of the central bank is to monitor and control the adequacy and value of the national currency through monetary policy instruments. In addition, because the central bank serves as banker to banks, it is the ultimate vehicle through which banks transfer payments to one another. Hence, a secondary duty of the central bank is to ensure the smooth, continuous operation of the payments system. Finally, because the central bank is the producer of money, it must serve as the lender of last resort to the banking system as a whole.

Banking Supervisor

The function of the agency supervising banks is to preserve the integrity of the banking system. Its function does not stem from anything to do with the implementation of monetary policy, but from the explicit or implicit insurance of bank deposits that is required to allow the unimpeded transfer of bank liabilities as the means of payment.

Ministry of Finance

The proper function of the ministry of finance is to fund and manage the nation’s budget. Thus, the ministry must administer a system of taxes, fees, and other means of raising funds, as well as administer the allocation of resources in a way that seems fit to the nation’s polity. One way to allocate resources is through the banking system. If it is the job of the finance ministry to oversee the nonmarket disposition of resources, including credit, this aspect of banking should in principle be separated from the other two aspects, namely, implementing monetary policy and preserving the soundness of the banking system.

Banking Supervision and the Central Bank as Lender of Last Resort

Things tend to go awry when the supervisory and the lender-of-last-resort functions are confused. This section examines specifically the purpose of banking supervision. The starting point is the central bank’s lender-of-last-resort function.

As noted above, banking occupies a special place in public policy because bank liabilities, notably demand deposits, serve as the principal means of payment for the economy. The central bank’s role as a lender of last resort is to avert the consequences of a run on these deposits. Such an event usually begins with the erosion or disappearance of a bank’s equity position as a result of sudden and excessive loan losses. Depositors concerned about the safety of their funds in a particular bank will place them in institutions considered safer. Even worse is when the failure of one bank casts doubt about the soundness of other institutions, leading depositors to demand currency. In monetary theory, the sudden demand for currency relative to demand deposits is equivalent to a drastic increase in reserve requirements, because currency in circulation, together with the demand liabilities of the central bank to commercial banks, constitutes the reserve base, or high-powered money. If the bank is fully loaned up, it cannot draw on the reserves that it must hold with the central bank when it experiences (net) deposit withdrawals. The bank must instead sell marketable securities and call in loans. If these actions are not sufficient, and often they are not, the bank can go out and borrow funds in the interbank or money markets. If the withdrawal of deposits was caused by concern about the soundness of the bank, such attempts will be unsuccessful, and the institution will have to close its doors. It is here that the central bank enters the picture as the lender of last resort: because it can create domestic money essentially without limit, it can without difficulty make funds available in the form of either currency or central bank liabilities.

In a modern banking system, the mere knowledge that the central bank is willing and able to supply additional funds to banks experiencing liquidity problems (a euphemism for these banks’ inability to satisfy the requests of depositors for the return of their funds) will suffice to prevent sudden shifts out of demand deposits into currency.

Deposit Insurance and the Need to Counter Moral Hazard Incentives

Most nations limit the damage of possible bank failures by employing some form of deposit insurance, either by explicitly insuring or implicitly backing up deposits. In many countries, auxiliary institutions insure deposits and assure depositors that their funds are available without undue delay, thus preventing runs on banks from occurring in the first place. Some countries do this through their private banks, arranging mutual insurance or “lifeboats” in which sound banks agree to support or absorb banks in trouble.

A system of deposit insurance and explicit or implicit promises by the central bank to come to the rescue of depositors involves a “moral hazard” that has long been recognized: when depositors become impervious to risk, it is in the interest of shareholders that their agents, that is, management, undertake investments that yield higher returns but carry more risk. One approach to capturing this effect more formally has been developed by Robert Merton.2 By using option theory, he showed that the insurance in essence permits the operators of a financial institution to “put” the claims of the depositors to the central bank or another (government) insurance institution whenever the market value of the assets is less than that of the deposit liabilities. The value of a depository institution to a bank’s operators is greatest when the net worth is zero, that is, when the option is “at the money.” Without deposit insurance, the operators of the bank must pay a default risk premium in order to attract funds. If that premium were to be priced fairly, it would approximate over time the difference between the net worth (exercise price) and the value of the option. The nature of the option also suggests the nature of the assets that the bank will buy, if unconstrained: higher-risk, higher-return assets. The higher the risk, the more value the bank has for the operators, as any upside gain benefits them directly, while the downside risk is absorbed by the institution that bails out the failing bank. Furthermore, when the bank has large negative net worth, the incentive for reckless transactions or even fraud is enhanced. While these values are not without cost in terms of possible regulatory scrutiny and probability of damaged managerial reputations, the potential for gain is also considerable. In any case, the discipline of creditors (depositors) to monitor the firm’s activities very closely in such circumstances is greatly diminished.

Prudential Regulation: Asset Side Versus Liability Side

The function of banking supervision is to prevent banks from exercising the incentive to buy higher-risk, higher-return assets. When the authorities (or other market participants, in the case of a mutual insurance scheme) underwrite a portion of a bank’s debt, they will invariably have to constrain the asset allocation decisions of the individual financial institution, either directly or through liability-side incentives. It is easily shown that liability-side prudential regulation, such as deposit insurance fees or capital requirement related to risk, is more desirable.

Asset-side prudential regulation entails the involvement of the supervisor in a bank’s business decisions. The goal is to ensure that the bank’s funds are prudently invested and that these investments are properly diversified. Statutory and administrative limitations are put on the bank’s freedom to conduct business in certain strategic areas (for example, insurance, commodities trading, and underwriting). Assets cannot be too concentrated in any one borrower or industry. Restrictions on the pricing of funds (interest ceilings) and the detailed examination of individual loans are part of the regulatory bag of instruments used in asset-side prudential regulation.3 Certain investments are generally taboo (in the United States, corporate bonds4 and equities); others are required.

Virtually everywhere, the public regulation of commercial banks includes restrictions on entry into the banking business—restraints that cover both the establishment of de novo institutions and expansion through branching—on the theory that competition must be limited to prevent it from becoming “ruinous.” Such measures, intended to assure the soundness of banks, are often anticompetitive and, therefore, may deprive the public of differentiated and least-cost banking services.

The question thus arises as to where the government’s responsibility to preserve the soundness of financial institutions ends and where the obligation to foster competition begins. Similarly, the dividing line between the objectives of prudential banking supervision and of credit allocation becomes blurred under asset-side prudential regulation. Which investment policy might better appear to promote the stability and soundness of financial institutions than that of keeping a large proportion of their assets in government paper? The reality is that asset-side prudential regulation is easily transmuted into indirect credit allocation.

Because credit allocation is, almost by definition, highly political, a direct and open approach is avoided whenever possible. Instead, existing private financial institutions are induced, by various means and pressures, to take into consideration reasons other than expected return and risk when deciding where to invest funds. Thus, indirect credit allocation always makes the portfolio composition of a financial institution inferior to that which its management might choose; otherwise, it would not be necessary to apply pressure. In the United States, for example, banks are expected to channel funds into local businesses, particularly small ones, and into community institutions, such as school authorities and municipalities. In particular, the Community Reinvestment Act5 is intended to ensure that the credit needs of the entire community, including low- and moderate-income neighborhoods, are met.6 Likewise, the provision of cheap credit to home buyers and farmers has also been a preferred objective for U.S. banking regulation. In Western European countries, such policies are even more widespread, although different criteria prevail;7 in some developing countries, the financial systems appear to be completely paralyzed by extensive networks of credit allocation.8

Liability-side prudential regulation seeks to get the supervisor out of the business of second-guessing bank asset decisions. Instead, it says to banks, in effect, “buy whatever assets you choose, but focus on maintaining an adequate capital position while restricting the composition of assets: reserves, liquid investments, and loans.” Control is exercised through the establishment of balance sheet ratios, consisting of maximum and minimum relations between different categories of assets and liabilities. Since the Basle Capital Accord9 on capital requirements was adopted, many countries have shifted to liability-side regulation.

A variant of this approach is risk-based deposit insurance fees, which are being introduced in a tentative fashion in the United States. Under this approach, premiums are based on “the probability that the deposit insurance fund will incur a loss with respect to the institution.”10 The differential between the average assessment rate and that imposed on the most risky institutions must be at least 10 basis points.11 Effective January 1, 1993, the Federal Deposit Insurance Corporation (FDIC) adopted an interim deposit insurance system, with premiums ranging from 23 to 31 basis points on deposits and an estimated average premium of 25.4 basis points. Under this interim system, banks are classified according to both supervisory evaluations and capital categories similar to those used for capital-based supervision. Again, there is no direct need in this system to constrain asset-side decisions.

In short, an independent agency to supervise banks, concentrating on liability-side regulations and free of pressures to allocate credit or serve other public policy objectives, will do the best job of ensuring the soundness of the banking system. Realism, however, demands that one recognize that no agency can operate outside the political system. Moreover, regulators themselves are subject to moral hazard incentives, which can be explained in the context of economic incentive theories explaining the relationship between the regulator and the regulated.

Behavior of Regulators

The modern view of bank regulation espoused by Edward Kane and others12 is based on a correspondence between concepts germane to theories of market behavior, on the one hand, and the manifestations of regulatory activity, on the other. Financial regulatory services are produced and delivered by governmental entities because government sponsorship confers a number of marketing advantages on regulatory entities, and because regulators have the opportunity to redistribute income, a political process by definition. Financial regulatory services consist of efforts to monitor, discipline, or coordinate the behavior of individual financial service providers for a common good or objective. Regulators also compete for market share; the broader their reach, the greater their power, prestige, job satisfaction, and other emoluments.

In exchange for explicit and implicit revenues, producers of regulatory services enhance the confidence of the customers of their regulatory clientele. From the point of view of those regulated, however, the costs imposed on them by regulators explicitly and via constraints on operations reduce the value of regulatory services. This perception represents an incentive to “shop” regulators that involves some transition costs but also acts as a constraint on regulators.13 These ideas are dramatically illustrated in the United States, particularly through the debate on the proper locus for bank supervision that took place in 1993 and 1994.

Where Should Banking Supervisory Authority Lie? The U.S. Debate

The quotation at the beginning of this paper reflects the well-known fact that the U.S. banking regulatory system is a set of overlapping and even conflicting jurisdictions. The patchwork regulatory structure keeps federal examiners from getting a good handle on the industry. For example, a large bank holding firm may own a nationally chartered bank, a thrift, and a state-chartered bank that is not a member of the Federal Reserve. Each of the four regulators—the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, and the Office of Thrift Supervision—examines a part of the firm, but no regulator has responsibility for examining it as a whole. Most worrisome, a multiple-regulator system can be exploited by aggressive bank holding firms. Suppose a firm’s executives are unhappy with the Office of the Comptroller of the Currency’s supervision of one of its banks. They can threaten to change the charter or membership status of the bank—to shop around, in other words, for a more lenient regulator. Because no regulator wants to lose banks to another agency, lawmakers have long warned that the shopping-around threat encourages lax regulation and thus increases the likelihood of bank failures, for which taxpayers are liable.

As part of its plan to reform the structure of government institutions, the U.S. Department of the Treasury proposed in late 1993 that an independent banking supervisory agency be established.14 Initially, the new agency was to be within the executive branch; later, the proposal was amended to make the agency separate and independent. The proposal envisioned five commissioners: the Secretary of the Treasury, a member of the Federal Reserve Board named by the Board, and three members appointed by the President and confirmed by the Senate. The President would designate one of the commissioners as chairperson, subject to Senate approval. Under this scheme, the FDIC would retain its core role as manager of the taxpayer-backed deposit insurance system. Although the Federal Reserve would lose its hands-on examination authority, it would retain other key powers, such as the ability to make direct loans to troubled banks.

The idea was not new. This plan has been discussed in one form or another over the past 30 years. It has always failed because the Federal Reserve, the FDIC, and the Office of the Comptroller have opposed giving up any control over financial institutions, and banks have joined their regulators in opposing a merger because of the uncertainties that would result from being regulated by a new federal agency. The U.S. Congress has always gone along with this consensus; the current round proved to be no exception.

The Federal Reserve was not interested in any arrangement that left it without a substantial supervisory role. It pointed out that supervisory functions predate and are additional to the more purely monetary functions of open market and foreign exchange operations: “A basic [Federal Reserve] responsibility, and the reason for its founding, was to assure a ‘stable and smoothly functioning financial payments system’ and to ‘head off and deal with financial disturbances and crises’ to the extent possible.”15 Chairman Alan Greenspan argued that a hands-on supervisory role is “indispensable” for maintaining the Federal Reserve’s “‘unparalleled knowledge’ of financial systems, markets, institutions and relationships needed to carry out its key responsibilities ‘at the nexus of monetary policy, the payments system, and bank supervision and regulation.’”16 President of the New York Federal Reserve Bank William J. McDonough also “warned that ‘sooner or later there will come a crisis,’ and the [Federal Reserve] will fight ‘with absolute determination and dedication’ to safeguard the economy, but that ‘Congress should not strip us of the weapons we need—it is simply too dangerous.’”17 The Federal Reserve’s counterproposal was to establish two supervisory agencies (one of which would be the Federal Reserve itself).18

Then Secretary of the Treasury Lloyd Bentsen argued that Germany’s Bundesbank did not have supervisory authority over banks and did not need it to conduct monetary policy.19 He questioned the Federal Reserve’s contention that more than one federal banking supervisor was necessary.20

The industry rallied behind the Federal Reserve. No banker wants to get on the bad side of a regulator. The result is that, at present, reform efforts are at a standstill.

Central Bank Independence

Ironically, the argument in favor of an independent supervisory agency runs along the same lines as the argument for an independent central bank. With the independent Bundesbank playing a powerful role, Germany has greatly strengthened its reputation for resisting inflation and safeguarding the currency. Meanwhile, the United Kingdom is considering fundamental moves toward central bank independence to the end of ensuring the benefits of price stability for its economy.

Indeed, a movement toward greater independence for central banks is sweeping across the globe. In Europe, central bank independence has become a prerequisite for participating in the final stages of monetary union;21 major structural changes for independence are in place or have been proposed in Belgium, Italy, France, and Spain.22 With its reorientation toward open economies and market-based policies following the debt crisis, Latin America has seen major moves toward greater central bank authority or independence in Chile, Venezuela, Mexico, and Argentina.23 The transitional economies of Eastern Europe are experimenting with alternative approaches. Also, New Zealand has introduced an imaginative scheme for targeting inflation, and South Africa has fortified the powers of its central bank.

The independence of the central banks must be continually defended in order to depoliticize the process of money creation and develop the required public determination for monetary stability. Bundesbank Chief Economist Otmar Issing puts the case for central bank autonomy succinctly and fervently:

Resistance to making the central bank independent always reflects the intention of reserving access to money creation to policymakers. This has never been good for the value of money anywhere.24

Statutory independence does not work everywhere. In the United Kingdom, an independent panel decided against recommending a “generalized” mandate of the Bundesbank model, feeling that, as it relied too heavily on the Bundesbank’s unquestioned credibility and the German electorate’s strong support of price stability, it was not appropriate for the United Kingdom.25 The panel chose instead a model with a more precise numerical inflation target, closer to the approach of New Zealand, whose anti-inflation credentials, like those of the United Kingdom’s, were not so firmly established. The panel recommended that “price stability” be the sole statutory objective of the Bank of England and that the bank formulate and announce short-run targets for inflation and control short-term interest rates.26 The Government could in extremis overrule the bank and resume control of monetary policy but only to suspend by parliamentary action for six months the bank’s objective of price stability.27

Conclusion: Implications for Independence of Bank Supervision

In an ideal world, the banking supervisory agency would be separate and independent and have the sole function of administering liability-side prudential regulation. As the U.S. experience indicates, however, neither central banks nor supervisory agencies operate in a political vacuum. The U.S. central bank, similar to those of Germany and Switzerland, is able to maintain its independence because it has a strong constituency. An independent, powerful Federal Reserve is in the interest of the nation’s largest financial institutions, which worry about the health of the national and global economies and have confidence in the Federal Reserve’s ability to provide stable, low-inflation growth. Banks now supervised by the Federal Reserve offer a natural constituency in favor of its continued independence. The implication, it seems, is that a single, federal banking supervisory agency could not in fact maintain the desired independence unless it were able to garner a similar degree of constituent support.

These considerations lead to a second model of bank supervisory independence, one along the lines of the British proposal. Where there is a serious risk of the bank supervisor’s task becoming politicized, the supervisory task should be housed wherever it can be most shielded from pressures to compromise its principal task, maintaining the soundness of the banking system. Instead of focusing the banking authorities’ efforts by segregating the agency, one could place strict limits on the goals and powers of the supervisors, wherever they are housed. The goal would be to ensure the stability of the banking system, and the regulators would not be permitted to engage in activities, such as credit allocation, that were detrimental to this goal.

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