Current Developments in Monetary and Financial Law, Vol. 5

Chapter 3 Should a Central Bank Also Be a Banking Supervisor?

International Monetary Fund
Published Date:
November 2008
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This chapter examines the tension between ensuring a stable monetary system and supervising commercial banks, with specific focus on the Latin American experience. It addresses the key question of whether the banking supervisory function should be located within a central bank, whose first obligation is price stability, and presents the arguments both for and against separation of the functions.

The Latin American Experience

As late as the second half of the nineteenth century, banks in Latin America were not under state regulation. The financial systems existed basically for commercial transactions, and currency was issued by many banks. Because central banks did not exist at the time, the functions that would otherwise be exercised by central banks were decentralized.

Eventually, currency instability and its consequent impact on the means of payment made it clear that it was necessary to regulate both issuing and credit. Although several countries centralized their issuing in the late nineteenth and early twentieth centuries, until World War I the only central bank in the region was the Central Bank of Uruguay, created in 1896. It was only after World War I that the region improved regulation and control of its monetary systems by institutionalizing central banks.

The Brussels International Financial Conference, convened by the League of Nations in 1920, played a decisive role in the creation of central banks in Latin America. At the conference, countries that did not yet have their own central banks were advised to constitute one. The central bank would be both the basis upon which the monetary systems of the post-war world would rise and the mechanism that would facilitate a country’s financial relationships. A central bank’s autonomy from the direct influence of its national government was considered a key force in opposing budgetary deficits and, consequently, in preventing inflationary surges.

From 1923 on, central banks were founded in several Latin American countries: Colombia (1923), Chile (1925), Guatemala (1925), Mexico (1925), Ecuador (1927), Bolivia (1929), Peru (1931), El Salvador (1934), Argentina (1935), Costa Rica (1936), Venezuela (1939), Nicaragua (1941), Paraguay (1944), Dominican Republic (1947), Cuba (1949), Honduras (1951), Brazil (1964), and Haiti (1979). In contrast to the Central Bank of Uruguay, which had been inspired by the English model, most of those institutions were influenced either by the Federal Reserve System (Fed) of the United States or by the past experience of the region.

The process of determining which functions should be assigned to the nascent central banks was more the result of political decisions than a response to economic necessity. In the natural course of events, banking supervision was added to the list of central bank responsibilities due to each country’s legislative policy and governmental structure.

Latin American central banks have evolved to adapt themselves to macroeconomic environments that are in constant change. This experience has, in turn, played a key role in determining how the financial systems have developed. Central banks in the region have become vital actors in supporting economic development as well as decisive instruments in rebuilding the financial stability once missing during episodes of monetary expansionism. Yet in the 1970s they still had to face external disturbances resulting from severe instabilities in world economy. And in the 1980s, having become established institutions, national central banks possessed the capabilities to withstand the external debt crisis that damaged countries like Mexico and Brazil.

Monetary Policy and Banking Supervision

In general, there are two complementary views in regard to governmental structures for monetary policy and banking supervision. The first would diminish a central bank’s role as a banking supervisor in order to strengthen the central bank’s autonomy. The second view, which is increasingly being followed, defends the combination of banking, securities, and insurance supervision in a single entity, distinct from the central bank, as the way to improve consolidated supervision of financial groups.

The latter trend argues that banking supervision should not be among a central bank’s responsibilities, so that the principal objective of the institution—price stability—is emphasized. Thus, assembled in a different entity, the supervision of banking, securities, and insurance would make the activity of supervising groups that act in every segment more efficient.

Reasons for the Separation of the Functions

Central bank autonomy is a powerful argument for removing the monetary authority’s responsibility for banking supervision. The need to protect a central bank’s monetary functions has justified the political choice of locating banking supervision in another entity.

Central bank and monetary policy are relatively recent concepts. Until the midst of the 19thcentury, currency was a piece of commonly accepted merchandise (gold or silver). The concept of monetary policy only became relevant with the appearance of banknotes and bank money, when currency became a sort of security (banknote) or a bank account balance (bank money) instead of a sort of good.

The adoption of fiduciary currencies (legal tender and inconvertible) did not happen entirely peacefully or without traumas. Public opinion, governments, and politicians from the developed world did notice the episodes of hyperinflation that occurred in Germany and other Eastern Europe countries in the 1930s. These events led to a last attempt to keep international monetary rules under the Bretton Woods system, according to which the North American currency was convertible into gold, whereas the remaining currencies were convertible into American dollars.

The post-war period was a time of economic progress and transformation, in part because of the strong influence of the economist John Maynard Keynes. At that time, two distinct schools of economic thought appeared in the debate over the role of currency in the economy. Keynesians understood that variations in the money supply affected the real economy, and accordingly they supported the discretionary conduct of monetary policy. On the other hand, monetarists argued that currency caused little impact on real economy, at least in the long run. Consequently, monetarists insisted on the management of monetary policy according to strict rules.

It was also a time when the debate on central bank autonomy fueled the controversy over regulation versus discretion of monetary policy. With the gold standard abolished in the early 1970s, what would be chosen to replace it: a new system or the discretion of an autonomous central bank? The truth is that economists do not have a clear and unequivocal answer to this question. There are theoretical arguments that favor the establishment of a rule for monetary policy (inflation targeting, currency boards, etc.), but there is no consensus on the design of such a definitive rule. There is also empirical evidence favorable to central bank autonomy, but there is no consensus on the precise institutional format of this autonomy.

The trend that seems to prevail today is to maintain a discretionary monetary policy in which the money supply is set according to economic necessities. Moreover, it is important to mention that most democratic societies do not seem to be willing to confer this discretionary power to the government, but prefer delegating it to an autonomous central bank. This view reflects what has become a consensus among economists: monetary stability is a precondition for long-term growth and inflation is a socially regressive tax.

When discussing the subject of central bank autonomy, two aspects must be highlighted. First, the desired autonomy of the central bank is basically restricted to monetary policy. Second, once it is not possible for a central bank to have absolute control over the economy, the right degree of autonomy is a matter of political decision. There is also concern about how a governmental institution can have a mandate—in this case for monetary policy—that may, when exercised, conflict with other areas of the government. A central bank that is autonomous from the government is better able to make decisions aimed at preserving stability of prices.

Because central bank autonomy is justified by its important role in determining monetary policy, the imposition of other aims and functions, such as banking supervision, is seen as harmful to the central bank’s autonomy because it weakens and compromises the main objective of price stability. The more singularly the objective of a central bank to maintain monetary stability is defined, the greater its autonomy. If the central bank is also a banking supervisor, it can be vulnerable to political pressure to act in a way that is beneficial to banks but not to monetary stability.

Despite the importance of the opinions according to which banking supervision should not be one of the functions of an autonomous central bank, there is no consensus that monetary policy would actually be better if the central bank were not a supervising entity. The last two chairmen of the U.S. Federal Reserve were eloquent defenders of the maintenance of its power in the area of banking supervision. The arguments of this defense are normally related to macro-economic concerns about price stability and sound payments systems, as well as to the rediscount window, since the information obtained in the course of supervisory actions can also be used for purposes of monetary regulation. For example, in 1994 the Fed chairman Alan Greenspan, in a statement before the Committee of Banking, Housing and Urban Affairs of the U.S. Senate, asserted that joint responsibility produces better results for supervision and monetary policy than would be obtained by a supervisor that had no macroeconomic responsibilities or an executor of macroeconomic policy with no involvement in overseeing banking transactions.

The argument is that if the central bank has better information on commercial banks’ health, it will avoid providing rediscount to insolvent banks, in order to protect monetary policy. Furthermore, the access to confidential information derived from the activity of supervision may help monetary policy, not only because of the important role that banks play in the economy but also because problems in banks usually precede other economic problems. There is clear evidence that a central bank’s privileged access to confidential information can be substantially useful.

Reasons Against the Separation of the Functions

Once the two objectives (price and banking system stability) are seen as complementary, there are strong reasons, mainly based on the fact that the central bank is the lender of last resort for commercial banks, not to separate the functions.

Commercial banks are not only part of payments systems but, together with other financial institutions, they also intermediate currency and credit of economic agents, performing operations in which interest rates are formed. Thus there is a strong correlation between macroeconomic stability and the health of financial systems. A country’s macroeconomic difficulties affect the solvency and liquidity of the banking system. Banks and financial institutions in insolvency jeopardize both the sound functioning of the economy and the government’s economic policy.

In general, banking insolvency is caused by bad management, assumption of excessive risks, fraud, and unexpected changes in the economy that negatively affect the returns of loans and investments. There is a saying that the financial system is always a highly sensitive thermometer of a country’s economy, for changes in the economic environment have a direct influence in the solvency of banks and financial institutions due to their operations with clients and the quality of their loans.

Similarly, economic policy is affected by a fragile and debilitated financial system, principally because of budgetary and monetary impacts caused by bankruptcy of banks and financial institutions. In effect, insolvent financial institutions do not respond to stimulations from the market or the government’s economic policy, especially from monetary policy. A fragile banking system is an obstacle to a contracting monetary policy as well, impeding the rise of interest rates.

Supervision of Cross-Border Institutions

With exponential increases in international financial and economic transactions, the preoccupation with stability and solvency of financial systems has also become an international issue. Because economic and financial markets have become interdependent across national boundaries, there is a risk that local problems will become contagious.

The creation of an international supervising entity is not viable. But at the end of 1974 the Bank for International Settlements (BIS) created the Committee on Banking Supervision, commonly called the Basel Committee. Its purpose is to promote the adoption of certain mechanisms and to exchange information among national supervisory bodies, with the goal of controlling the international financial system by influencing national banking systems. The Basel Committee also promulgates qualitative standards for banking supervision and recommends the autonomy of supervising institutions, though without taking a position about the location of the supervising body (whether within the central bank or outside of it).

Nonetheless, the great concern of several countries in regard to supervision is in fact related to banking insolvency. There is little disagreement about the traditional supervisory instruments of the banking safety net: licensing, regulation, and supervision of financial institutions. The conflicts occur in regard to the remaining instruments of the safety net, e.g., the rediscount window, the mechanisms of intervention and liquidation of banks, and deposit insurance. In this case, the classical discussion regarding deposit insurance—the problem of moral hazard—might be invoked.

Deposit Insurance and Moral Hazard

The protection of depositors by means of deposit insurance is frequently condemned under the argument of moral risk, mainly when the protection is limitless. However, in the absence of deposit insurance the negative effect of moral hazard can be worse if large depositors and banks themselves are certain that government will always intervene in these situations, saving everyone. A proper deposit insurance mechanism, besides preventing the government from reimbursing depositors, eliminates much of the discretion in dealing with these cases, thus reducing the moral hazard caused by the repetitive governmental practice of stepping in to save all.

In sum, the prudential policy is to foster cooperation between the supervising and the monetary authorities, precisely because the central bank has the duty to be the banks’ lender of last resort, one of the classic instruments of the banking sector’s safety net. In this regard, there is legitimate concern (well explored in the specific literature on deposit insurance) about the danger of moral risk, which recommends avoiding loan authorizations by the central banks to insolvent banks.

Advantages and Disadvantages of Supervision

A frequent argument for separating banking supervision and monetary policy is that there can be a conflict of interest between the two activities. The basis of this argument is the importance of protecting the autonomy of the central bank in its role of preserving the stability of prices. The pressure to rescue a bank through the rediscount window may sometimes be excessive, compromising the monetary policy. Under pressure from bankers or politicians, the central bank may be tempted to give priority to the protection of banks, to the detriment of public policy.

The more important conflict is related to the setting of interest rates. A central bank that also performs the role of supervisor might resist raising interest rates to curb inflation because the measure could harm the financial health of the very banks it supervises. Usually, the greater the dissimilarities between the level of a commercial bank’s short-term or fixed-rate borrowing and its long-term or pre-fixed-interest-rate lending, the greater the potential harm to the institution as a result of a rise in interest rates.

On the other hand, the same argument of potential conflict can be used to support the maintenance of supervision within the central bank. The reasoning from this point of view is that a central bank without responsibilities of supervision would tend to neglect the impacts of monetary policy on the banking system and, consequently, on the economy as a whole. In response, the defenders of central bank autonomy argue that most difficulties the banking system faces are not caused by monetary policy but, among other factors, by assets of bad quality, capital insufficiency, and fraud.

Two main reasons are posed by supporters of maintaining banking supervision within the monetary authority. The first is associated to the strategic role of payments systems, through which systemic risk is transmitted in the economy. This was the argument of Alan Greenspan in 1994, when he defended the role of the Fed in banking supervision before the U.S. Congress. The second is related to the solution of systemic crises, for the central bank is the lender of last resort to the banking system. The practical issue consists of identifying the moment when the rediscount window must be used to aid banks, considering that supervision utilizes other mechanisms to prevent undesired behaviors deriving from moral hazard.

Rediscount is not an absolute right of a commercial bank. The monetary authority must be aware of the danger of lending to a bank that is in an illiquidity situation but is not insolvent. This rule is valid for the liquidation of small and medium banks but not for bigger banks, because their bankruptcy can eventually produce systemic risk. Nevertheless, how can the central bank know that a bank is insolvent, if it is not the supervising agency? How can a situation that is not likely to represent systemic risk be identified?

These questions constitute the basis of the argument by those who defend the importance of a central bank having supervisory powers. They maintain that the central bank assumes vital importance in moments of crisis because it can quickly obtain information if it is also the banking supervisor. It would be impossible to transmit the needed information and analysis in a timely way if it had to come from another entity. Moreover, supervisory powers enable more efficient action by a central bank than coordinated action between two distinct entities.

On the other hand, the defenders of separation argue that better information is acquired when different institutions hold those two functions. Supporters of central bank autonomy also argue that in crisis situations the central bank, invested in the role of banking supervisor, would be more vulnerable to political pressure. In order to protect the reputation of the central bank, the defenders of central bank autonomy further argue that the monetary authority should not be involved with intervention and liquidation of banks.

An important argument for the separation of monetary and supervising authorities into two distinct institutions is market regulation, particularly in regard to deposit insurance and the danger of moral hazard. If rediscount regulation were more difficult, making it harder to access central bank credit, it is probable that banks (and the banking supervisor itself), even in moments of crisis, would act more correctly and efficiently because they would be liable for their occasional economic shortcomings.

Nonetheless, diminishing the role of the central bank in banking supervision does not necessarily mean that the moral risk problem is eliminated. Even without deposit insurance, the supervising authorities and banks can still believe that they will always be helped by the central bank and still neglect supervision or market regulation. Such moral hazard can be as great as the size of the bank in difficulty (“too big to fail”), which may compel central bank intervention as a way to prevent systemic risk. This problem can be minimized by a deposit insurance mechanism not managed by the central bank, but it does not entirely solve the problem.

In the past decade, economic theory has paid considerable attention to the issue of market regulation. There is evidence that fewer bank bankruptcies occur in countries in which the central bank is invested with banking supervision powers. There is also evidence that in these countries less public resources are used in the assistance of insolvent banks because bank insolvencies are dealt with mainly by means of resources of both the central bank and banking institutions. One possible explanation is that a central bank with supervisory powers can more quickly recognize and respond to banking problems, therefore not allowing them to assume great proportions.

The international trend, however, seems to be towards removing banking supervision from central banks and committing it to a specialized institution, as demonstrated in the attached comparative tables1 on the institutional organization of central banks and agencies of supervision of the banking system.

The Basel Core Principles of Consolidated Supervision

One of the main contributions of the Basel Committee on Banking Supervision is its recommendation of consolidated supervision over financial conglomerates. As a response to the concern about the soundness of bank financial groups, the Committee asserted the principle of consolidated supervision over international financial groups. The issue is so important that it was included in the Basel Core Principles for Effective Banking Supervision. Core Principle 20 states:

An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.

This recommendation comprises nonbanking activities, since these activities can expose banking activity to risks.

Evidently, this concern is not directed exclusively at banking financial activities. It also reaches other sectors of financial systems, such as securities and insurance markets. Because of that, in 1996 the Joint Forum on Financial Conglomerates was established under the aegis of the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS).

The Joint Forum has already produced several papers with recommendations. The most important are “Capital Adequacy Principles,” “Principles for Supervisory Information Sharing,” and “Coordinator,” which is a guide for the coordination of joint supervisions over financial conglomerates by different supervisory bodies.2 It is important to emphasize that, except for defending a certain degree of autonomy for the supervisory bodies, the international entities concerned with the supervision of banking, securities, and insurance sectors have avoided making recommendations about the political and institutional organization of member countries and have only dealt with technical and operational aspects of banking supervision.


It is important that each country seek the model of banking supervision that best fits its specific circumstances, whether within the central bank or outside of it. There has been a strong international trend towards a simpler bank model, transferring the role of banking supervision to a specialized supervisory body. Removing the supervisory role from the monetary authority, on its turn, seems to constitute a political choice in favor of autonomy, so that the central bank does not become a fourth branch of the state. Additionally, banking supervision is usually a burden that imposes costs, risks, and responsibilities. It therefore demands different specialization and qualification from those expected of a classical central bank.

The main concern, however, is the costs of bank liquidation, principally of big banks that may bring risks to the system, forcing expenses with the recuperation. Such costs may be high and, if not supported, they may affect the monetary policy. This concern can be partly addressed with the maintenance of an adequate deposit insurance system, although the ultimate responsibility for liquidity would lie with the government and with the central bank, even when the latter is not the supervisory entity, because it will always have the role of lender of last resort to the banking system.

While the trend today is to grant autonomy to central banks, according to the classical model, it is important that central banks which are not yet autonomous perform both the tasks of implementing monetary policy and those of banking supervision. Otherwise, there is a risk of weakening the conduct of monetary policy and the ability to face systemic crisis. As a matter of fact, the joint operation, performed by only one body, through the consolidated supervision of financial conglomerates, is an option to be considered by countries that have not gone through the process of separating monetary policy and banking supervision.

ANNEXAnnex: Institutional Organisation of Central Banks and Supervisory Bodies
CountryMonetary PolicySupervisionComments
BankingPayments SystemInsuranceSecurities
GermanyDeutsche BundesbankFederal Banking Supervisory OfficeFederal Securities Supervisory Office/Federal Supervisory Office for Securities TradingCB independent since its creation, in 1957. At present it is part of the European CB.
ArgentinaBanco Central de la República ArgentinaSuperintendencia de Entidades Financieras y CambiariasBanco Central de la República ArgentinaSuperintendencia de Seguros de la Nación (Ministerio de Economia)Comisión Nacional de ValoresCB independent (currency board). The Superintendencia is directly subordinate to the CB President (Article 43 of Law 24144 of 23.9.1992).
AustraliaReserve Bank of AustraliaAustralian Prudential Regulation Authority (APRA)Reserve Bank of AustraliaAustralian Prudential Regulation Authority (APRA)APRA and Australian Securities and Investments Commission (ASIC)CB independent since 1959. 1998–separation of the banking supervision from the RBA and merger with the Insurance and Superannuation Commission.
BoliviaBanco Central de BoliviaSuperintendencia de Bancos y Entidades FinancierasBCB’s regulatory powerseparatemixedCB independent since 1995. 1987–creation of Superintendencia de Bancos y Entidades Financieras.
CanadaBank of CanadaOffice of the Superintendent of Financial InstitutionsBank of CanadaOffice of the Superintendent of Financial InstitutionsOffice of the Superintendent of Financial InstitutionsCB independent. 1925–creation of Office of the Inspector General of Bank(OIGB). 1987–merger of OIGB with Department of Insurance.
ChileBanco Central de ChileSuperintendencia de Bancos e Instituciones FinanceirasBanco Central de ChileSuperintendencia de Valores y SegurosSuperintendencia de Valores y SegurosCB independent since 1989. 1925—creation of Superintendencia.
ColombiaBanco de la República de ColombiaSuperintendencia Bancaria de Colombia (MF)Banco de la República de ColombiaSuperintendencia Bancaria de ColombiaSuperintendencia Bancaria de ColombiaBRC independent since 1991, but Ministro de Hacienda presides the Monetary Board (Junta Monetaria–7 members, 6 from the BRC).
Costa RicaBanco Central de Costa RicaSuperintendencia General de Entidades FinancierasSeparateSuperintendencia General de ValoresCB is not independent. The Superintendencia General de Entidades Financieras is a subsidiary of CB.
El SalvadorBanco Central de Reserva de El SalvadorSuperintendencia del Sistema FinancieroSuperintendencia del Sistema FinancieroSuperintendencia de ValoresCB is no independent.
EcuadorBanco Central del EcuadorSuperintendencia de BancosBanco Central del EcuadorSuperintendencia de BancosSuperintendencia de Compañias del EcuadorCB is not independent. 1927–creation of Superintendencia de Bancos after CB split-up.
SpainBanco de EspañaBanco de EspañaBanco de EspañaDirección General de SegurosComisión Nacional del Mercado de ValoresCB independent (European CB). 1994–Banco de España independence.
FranceBanque de FranceBanking and Financial Regulatory Committee (BC)/Credit Institutions and Investment Firms Committee/Banking Commission (BC)Banque de FranceBanking and Financial Regulatory Committee (BC)/Capital Markets Council/Stock Exchange CommissionCB independent (European Central Bank). 1996–Banque de France independence.
HondurasBanca Central de HondurasBanking supervisorBanking supervisorBanking supervisorConforme Aguirre (1997).
Hong KongHong Kong Monetary AuthorityHong Kong Monetary AuthorityHong Kong Monetary AuthorityHong Kong Securities and Futures CommissionCB independent (currency board). 1993–merger of supervision with the Central Bank.
EnglandBank of EnglandFinancial Services AuthorityBank of EnglandFinancial Services AuthorityFinancial Services AuthorityCB independent since 1997. 1997 – separation of banking supervision from Bank of England and merger of supervisions.
IrelandCentral Bank of IrelandCentral Bank of IrelandCentral Bank of IrelandCB independent (European Central Bank).
IsraelBank of IsraelBank of IsraelBank of IsraelCB independent.
ItalyBanca d’ltaliaBanca d’ltaliaBanca d’ltaliaCB independent (European Central Bank).
JapanBank of JapanFinancial Supervisory AgencyBank of JapanFinancial Supervisory AgencyFinancial Supervisory AgencyCB is not independent.
LuxembourgLuxembourg Monetary InstituteLuxembourg Monetary InstituteLuxembourg Monetary InstituteCB independent (European Central Bank).
MexicoBanco de MéxicoComisión Nacional Bancaria y de ValoresBanco de México/Comisión Nacional Bancaria y de ValoresComisión Nacional de Seguros y FinanzasComisión Nacional Bancaria y de ValoresCB independent since 1993 (constitutional reform). 1995 – creation of CNBV, by merger of banking supervision with securities supervision.
NicaraguaBanco Central de NicaraguaBanking SupervisorBanking supervisorBanking supervisorConforme Aguirre (1997).
New ZealandReserve Bank of New ZealandReserve Bank of New ZealandReserve Bank of New ZealandReserve Bank of New ZealandCB independent since 1989.
PanamaBanco CentralBanking SupervisorSeparateseparateConforme Aguirre (1997).
ParaguayBanco CentralBanco CentralseparateseparateConforme Aguirre (1997).
PeruBanco Central de Reserva del PerúSuperintendencia de Banca y SegurosBanco Central de Reserva del PerúSuperintendencia de Banca y SegurosComisión Nacional Supervisora de Empresas y Valores (CONASEV)CB is not independent. 1931–creation of Superintendencia. 1979 – administrative and personnel Superintendencia independence.
PortugalBanco de PortugalBanco de PortugalBanco de PortugalCB independent (European Central Bank).
SwitzerlandSwiss National BankFederal Banking CommissionSwiss National BankCB independent.
UruguayBanco CentralBanco CentralBanco CentralConforme Aguirre (1997).
VenezuelaBanco Central de VenezuelaSuperintendencia de Banca y Outras Institui-ciones Finana-cierasseparateseparate1993 – creation of Superintendencia
1See annex to this chapter.
2The papers released by the Joint Forum are available at the BIS website at

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