As a central banker myself for over 22 years, I have some familiarity with the internal and external control structures of central banks around the world, but I am obviously more familiar with the United States. So while I’ll talk sometimes in general terms, I’ll also be focusing very much on the U.S. model.

As a central banker myself for over 22 years, I have some familiarity with the internal and external control structures of central banks around the world, but I am obviously more familiar with the United States. So while I’ll talk sometimes in general terms, I’ll also be focusing very much on the U.S. model.

I’ll first talk about external controls, that is, what external structures have been established over and around the central bank to ensure accountability. Then I’ll explain how these external control structures result from the cultural preferences of U.S. society.

I’ll focus particularly on the risks faced by central banks, which are also faced by many other financial institutions. I’ll describe how the New York Federal Reserve Bank is evolving by learning from the private sector and from international and national standards.

One of the private sector tools being implemented at the Federal Reserve Bank of New York is called COSO, which stands for the Committee of Sponsoring Organizations. It was a committee of 30 international organizations, including accounting standards boards, conferences of securities regulators, banking supervisors, and so on, who produced a report in the late 1980s proposing standards for controlling operational risk, a major source of risk for financial institutions and for central banks.

Let me first describe the U.S. model. Accountability within the Federal Reserve System is complex. It is diffused and it reflects the quasi-governmental nature of the system. The Board of Governors is an agency of the federal government, created by Congress. Its major responsibility is oversight of the 12 Federal Reserve Banks. The Federal Reserve Banks themselves are private corporate entities. Legally, they are private banks. In fact, they are national banks chartered by the U.S. Comptroller of the Currency, although there has been no involvement by the Comptroller of the Currency since the chartering of the Federal Reserve Banks.

The Federal Reserve was established as an independent, decentralized central bank to ensure that its policies would remain free of governmental influence. The first source of this independence is the 14-year staggered terms of the Board of Governors’ members. A second source of independence lies in the very nature of the whole system. Its body is a collection of legally separate corporate entities and its conscience is a government instrumentality. A third important source of its independence is financial. Not only is it self-funding in that it earns money from the U.S. government securities held in its portfolios, but it also is self-funding in the sense that it provides, as many central banks do, monetary policy and bank supervision, as well as payment system services, without having to obtain government budget appropriations.

The Federal Reserve Banks’ payment services are required, specifically, by an Act of Congress, to be self-funding. Not only is the Fed required to charge prices for its financial services, but it is required to recover full costs plus the profit it would have earned if it were a private organization and the taxes it would have paid if it were a real, independent private organization. So while that income is not so significant, it is still very important for central bank independence. The Fed’s bank supervisory responsibilities must also recover full cost. In fact, the language in the laws applicable to bank supervisory costs is almost identical to the language that requires full cost recovery for payment system services.

Under this decentralized structure, the Board’s function is to oversee or provide general supervision to the Reserve Banks. However, the supervision is not very well defined. There is very little in the Act, other than a reference to an annual financial examination, to suggest how that oversight might be interpreted. Over time, obviously, it has been interpreted extensively, but one stipulation in the laws requires an annual financial examination conducted by the Board of the Reserve Banks. The structure is not as simple as it may sound and becomes terribly complicated with all 12 banks involved.

This is not the whole picture. An Act of Congress in 1978 stipulated that government agencies were to be inspected by an outside, independent, governmental watchdog agency. That agency is the Office of Inspector General. So the Board of Governors, as a government agency, is itself subject to review by this Office of Inspector General. At the Federal Reserve Board, the Inspector General is accountable to one person, Alan Greenspan, the Chairman of the Federal Reserve Board. However, the Inspector General is also accountable to Congress and reports to Congress twice a year on its findings about the efficiency and effectiveness of the Federal Reserve Board.

The Office of Inspector General is not permitted to examine directly the Federal Reserve Banks. However, in examining the way that the Board of Governors executes its responsibilities, the Office of Inspector General looks at audits and reviews Board programs, including programs for examining and overseeing the activities of the Reserve Banks. It also audits programs delegated to the Reserve Banks, such as bank supervision.

The Office of Inspector General follows the Generally Accepted Government Auditing Standards (GAGAS). Every entity within the Federal Reserve, including the Office of Inspector General, the Board, and all the Reserve Banks, is additionally subject to the review of the General Accounting Office (GAO), another watchdog agency created by Congress to look into the effectiveness of government.

Oversight provided to the Reserve Banks by the Board of Governors is exercised through various operating divisions of the Board. Each year the Division of Reserve Bank Operations and Payment Systems evaluates all the operational areas of the Reserve Banks. These evaluations are based on unit costs to determine whether or not the Reserve Banks are sufficiently thrifty and whether, in fact, they meet the mandate to recover full cost where the law requires this, and whether they adhere to laws and accounting standards.

Performance ratings are issued by the Board of Governors to evaluate the presidents and first vice-presidents of the Reserve Banks. Even though those presidents and first vice-presidents report directly to independent boards of directors, their salaries are affected, or, perhaps you could say, capped, by the evaluations made by the Board of Governors of their effectiveness. No central banker is paid what the market will bear. Central bankers are not generally paid as well as they should be, according to market comparisons. So this particular control of the Board over the Reserve Bank presidents and first vice-presidents is somewhat toothless, because the salary structures are already rather constrained, making the increases that they can effect so marginal that there is very little real bite. A narrow margin exists between the reward for doing well and for doing poorly.

Until recently, the Division of Reserve Bank Operations was also responsible for conducting the annual financial examinations of the Reserve Banks. However, in 1997 the Office of Inspector General’s review of the Board concluded that the Board’s financial examination program for reviewing the Reserve Banks, as it was then organized and conducted, presented the appearance of not being fully independent and thus violated the generally accepted government auditing standards that the Office of Inspector General holds sacred. As a result, the responsibility for this particular examination program was taken out of that division and the examiners now report directly to the Board itself.

All these divisions of the Board conduct operations reviews, looking for efficiency and effectiveness in the Reserve Banks. As far as possible, the operations reviews are modeled on private sector practice. Even if the examiners do not look outside the Federal Reserve System, in most areas of examination they have 12 examples of institutions in the same business, and they can certainly identify practices that appear to be more effective or more cost efficient. There has been a lot of pressure from the examined Reserve Banks to improve the quality of Board supervision.

The Division of Reserve Bank Operations, which is the largest of these divisions, routinely conducts operational reviews of the check processing, cash processing, fiscal agency functions (in which the Fed acts as the bank for the government of the United States and its agencies), automated clearinghouse operations, and electronic processing of funds transfers and securities transfers, as well as physical securities, such as federal savings bonds. My current responsibilities at the Federal Reserve Bank of New York make me responsible for all those payment system operations.

A second and probably less clearly governmental level of oversight of Reserve Bank operations is conducted through separate but coordinated internal and external audit processes. Each Reserve Bank has a general auditor and an audit staff, which reports to the independent board of directors, through the directors’ Audit Committee, on the operations and the financial stability of the Reserve Banks.

The internal auditors examine everything from internal controls to compliance with laws and policies. They also evaluate the reliability of our financial statements, which are a matter of public record in the United States. Starting in 1995, the Board of Governors initiated a contract with an independent public accounting firm to help it conduct the financial examinations of the Reserve Banks. Since then, the Reserve Banks have been subjected to the same kind of financial audit as are other financial institutions in this country.

Part of the published record, in addition to the financial statements and notes, is an opinion from the external auditors stating that the statements, unless they find otherwise, were prepared in a fair and honest manner and were subject to a reliable accounting. A private financial institution in the United States would have a GAAP (generally accepted accounting principles) statement of compliance from the external auditors. But the Reserve Banks have been receiving an OCBOA (other comprehensive basis of accounting) statement of compliance from the outside auditors, meaning that the statements meet the standards of an accounting basis other than GAAP.

We are considering the possibility of having the outside auditors give us a GAAP statement. This will probably be arranged in a few years, because we have been modifying our accounting principles to meet GAAP requirements. We are conscious of how the public views the central bank, and an OCBOA opinion is something that those who read financial statements have never seen and don’t understand. There is some suspicion that it is something mysterious. We would like to move in the direction of receiving an opinion that we are subject to GAAP, because GAAP is widely understood in this country and in Congress. It should help us to increase the transparency of our operations, and so we think it’s desirable.

We have a rather complex series of oversight structures, many of which overlap. Congress can look at any of those institutions and ask to see all their records, as can external auditors. The Office of Inspector General can look only indirectly at the Reserve Banks, but can see a lot.

The GAO can look at just about everything except monetary policy decisions. The Federal Reserve’s complex accountability structure has been recently criticized by the GAO. The GAO contends that the Federal Reserve’s structure could give rise to a situation in which the audits or operations reviews of one of these entities might not be shared with others and therefore the other entities would be operating blindfolded. This is a legitimate issue that has to be examined. The GAO has called for stronger and more comprehensive oversight; however, they themselves have recognized that the Federal Reserve’s strange hybrid structure makes oversight difficult. For example, each of the Reserve Banks has a separate board of directors to which its auditors report. Sharing of audit information is not formally required. I think the GAO has raised an interesting question.

The GAO has suggested that the Reserve Banks be subject to direct review by the Office of Inspector General. However, the Reserve Banks contend that this review would be inconsistent with their private, corporate nature and have reminded the GAO that this is the way Congress wanted it.

In 1935, the Treasury and its Comptroller of the Currency, which reports to the Secretary of the Treasury, were members of the Federal Reserve Board, but that is no longer the case. That connection has been severed to enhance the independence of the central bank. Some external controls are the result of cultural preferences. The history of banking in the United States helps to explain some of the complexity and the diffusion in formal oversight. Americans tend to distrust concentrations of power and exalt free access to information.

The unique design of the Federal Reserve System, with all of these oversight bodies, therefore reflects the response of Congress to these cultural preferences for accessible and clear information, and for a separation of powers to prevent concentration. For example, intentional tension has been built into the Federal Reserve System’s structure. The powers that resided in Washington versus the powers that were given to the Reserve Banks, and most particularly to the Federal Reserve Bank of New York, were carefully crafted to prevent any entity from having total control. That is very much valued in the Fed System and in U.S. society.

Over time, Congress felt the need for more information for itself on the workings of the Federal Reserve and for more oversight of the system. That we are now working toward having our financial statements presented on the same basis as private financial institutions exemplifies this desire for clarity and accessibility of information.

Other significant values have formed the culture of the Federal Reserve from within. One is the seriousness in which officials of the Federal Reserve hold the public trust. We incessantly question our actions by saying, “This may sound like a good idea, but is it in the public’s best interest?” A high value is also placed on continuing the independence of the central bank and keeping it free from the heavy influence of government.

But this heavy layering of oversight bodies by itself is not enough. From within we impose on ourselves additional discipline to limit the risk that might weaken the trust that the public places in the central bank and the independence that the Congress has given it. The Reserve Banks have instituted strict codes of conduct that place restrictions on our activities, our financial holdings, and the information available about our past and current activities.

Another risk is that Reserve Bank policies or actions may be unpopular. That is not to say—and certainly it’s not to say in the area of monetary policy or bank supervision or even in payment systems—that we are unwilling to take actions that might be unpopular. What it means is that when we have to do something unpopular, such as raise interest rates (which is never terribly popular as a public issue, except with banks, which don’t always represent the interests of the public), we try to avoid little decisions that add to unpopularity. We try to keep a low profile. Because when it matters, we want the authority to be able to take action with the confidence that we are not going to be undermined by an outpouring of distrust.

Another serious concern for us is that some action we might take might weaken market discipline. This is called moral hazard risk. We are cautious in taking actions in the markets, or in our lending activities, or in how we design our payment systems, to be certain that we are not creating a moral hazard. The classic case is that large financial institutions or other players might assume that they can do whatever they want because at the end of the day the central bank will come in and save them from their own mistakes. We can’t allow that.

Those are general concerns of central banks. However, a good number of risks faced by central banks are also faced by every financial and many nonfinancial institutions. These risks—credit risk, market risk, operational risk, legal and reputational risk—also exist in the private sector. The tools used by the private sector to manage these risks are also appropriate for central banks.

The Federal Reserve Bank of New York has responsibilities that other Federal Reserve Banks do not, and that makes the Federal Reserve Bank of New York, of all of the 12 banks, much more like the other central banks of the world. Many of its activities parallel the private sector. It recognizes this and is able to understand the private sector position.

Let me talk a little bit about kinds of risk. Operational risk is the risk of loss resulting from processing a transaction or booking a transaction. It could be a settlement error, or a breakdown in the systems. It’s a very “nuts and bolts” kind of risk. It’s the sort of back-office risk that may occur in any business.

Credit risk is the risk of loss from default of a counterparty. That includes settlement risk. All financial institutions have that risk, and it extends to central banks. Central banks do have credit risks. Even if you collateralize a transaction, you may still have residual credit risk.

Market risk is the risk of loss resulting from adverse movements in interest rate markets or foreign exchange markets. It includes presettlement risk in open market or foreign exchange transactions. Again, this risk can be mitigated. Central banks sometimes operate in the markets as the central bank; but other times central banks operate in the markets with the same intent as a private sector institution. Should there be different rules or measures, or different ways of controlling the risk? I’ll talk more about that later.

Another important risk is portfolio concentration risk, whether it be too much exposure to one counterparty, too much of one instrument, and so on. This risk is present if a portfolio is not sufficiently diversified. Central bank portfolios tend, however, to be highly concentrated. Therefore, if an outside auditor is looking at a central bank portfolio and knows little about the nature of central banks, he might regard that heavily concentrated portfolio as risky.

The Federal Reserve and other central banks are not subject to liquidity risk. The obvious reason is that central banks are the ultimate source of liquidity and, therefore, even though they may be temporarily affected by the seizing of a market or the inability of a market to clear prices, they are not limited in their liquidity.

However, central banks are conscious of and susceptible to—perhaps more so than private companies—reputational risks and legal risks. These risks tend to feed into other types of risks. Reputational risk is embedded in other types of risk, as are legal risks. Of course, we are cautious about these risks because we fear that a blot on our reputation could affect how the public perceives our operations and how independent we can remain.

In most countries, financial firms are subject to supervisory or regulatory oversight authorities, such as central banks. In industrial countries, unless they are nonpublic financial firms, these firms are typically also subject to internal and external auditors. All these supervisory and auditing bodies are, at least in the industrial countries, increasingly focusing not only on independent types of risk, which can be measured on a transactional basis, but on the overall processes and systems, which can be used together to manage risk.

As a central bank, our tolerance for risk and our perspective on risk must differ from that of the private sector. Let me give you an example from our payments system. Our tolerance for the risk—and this is an operational risk—that our Fedwire funds transfer system and securities transfer system would be disrupted is close to zero. We have almost no tolerance for a disruption in the systems that transfer trillions of dollars of funds and securities every day and which are the end point for clearance for many global markets. We just cannot allow disruption.

On the other hand, in designing those payment systems, we have not designed systems that eliminate our own exposure to credit risk. There is credit risk in the funds system. When funds are sent out, they are final. It is as if I hand you a dollar bill. You have the money. I don’t. I cannot get it back. So we have built systems that—at any time—carry heavy risk exposures. But in this case, we are willing to accept quite considerable credit risks on an intraday basis.

During the day, financial institutions may be in what we call a daylight overdraft position. In other words, they owe money to the Fed, because they have not yet collected balances in their account, and yet the Fed allows them to transfer money that they don’t have. A daylight overdraft position may be worth billions of dollars. We allow that, because it allows the system to be liquid and to clear smoothly. We don’t allow it at night, but during the day, we are willing to take that risk. Risk is not an all-or-nothing proposition.

In the private sector, the typical financial firm putting together a risk management system is able to apply two philosophies to that system. It is able to balance the risk against return. It wants the risks and the potential costs of the risks to be smaller than the returns.

The second philosophy that a private sector firm might apply is that it would want to not pay more to reduce a risk than the risk might be worth. So, for example, you would not want to spend more of your income to prevent a fire in your home than the total replacement cost of your home. You would be paying more for reducing the risk to zero than it is worth. That, however, is again an area where a central bank may make another decision. For example, recently we had (and this is an unusual occurrence) a shortage in a cash shipment. Newly minted currency from the Bureau of Printing and Engraving was shipped to our vaults in New Jersey. These bills come shrink-wrapped, which means that they are so tightly sealed in their containers that to get money out without being detected is virtually impossible. Yet, one of these packs arrived short about $7,000, which is not a very large amount. Even as a central banker, I assume I can take an occasional $7,000 loss in my operations without having the public pounding on the doors and insisting that I resign. A private sector firm would have written that amount off and simply have made an entry to a difference account.

I could not make that decision, because for me it was not the individual loss. It was the possibility that the system was deficient, that controls either at the Bureau of Printing and Engraving or in my own operation were not adequate to prevent that from happening again. In this case we had to send out investigators. This particular shipment had made a circuitous route, so we actually sent investigators to several countries to find out what happened. We reviewed hours of videotapes of the various operations that had handled this money. We spent far more researching that one $7,000 error than any private firm would have because of the need to assure ourselves that our systems had integrity and were not vulnerable to pilfering.

Conversely, our willingness to accept some credit risk to assure counterparty settlement or the settlement in a payment transaction or to assure liquidity for a major financial institution may be necessary to assure a smoothly functioning payments system. So there are balances to be weighed by a central bank.

My theory, being debated very hotly in New York, is that when the Fed acts like a private sector firm, it should use the same measures and be subject to the same constraints as the private sector firm. But when we are acting as the central bank, we are subject to other constraints.

We are trying to manage and think methodically about our risks. Our current risk management framework is evolving. It is complex because we are a complex institution. It is self-imposed. It is not something that we have been asked by anyone else to do. It’s something that we decided was necessary, and it is modeled on private sector models.

However, adjustments have to be made to take account of either possible systemic risk or more risk than a private firm would take on. Or we might want to refuse to take any risk at all, because we are the central bank and we don’t want to create a moral hazard risk. Similarly, if we intend to move the market, we will not take the cautious approach that a private sector trader would. We have tried to design a risk management framework to help us to identify, to measure, to monitor, and to report to senior management on the risks so that we can manage them. All the pieces are not yet in place. It is a work in progress.

Where do you think about risk? You probably think about risk at all levels of the organization. The most basic thinking about risk really occurs on the business level. At the business level, a decision has to be made about what risks are tolerable in the business. What makes sense? How far do I want to go?

The next level is at the institutional level. A particular business might have, for example, a counterparty credit risk to a particular financial institution. But another business might have another exposure to the same institution. It is a very complex structure. At the institutional level, we have to be aware of all the exposure in the family of that institution. There might be affiliates. They might be similarly funded, so that if one of them goes down, the other is going to be threatened. We have to review these risks at a much higher level.

These multiple perspectives on risk are very common in the private sector as well. They are what we see when we examine how financial institutions look at risk. They put responsibility for risk controllable by the business in the hands of the business. But then they ask a more senior group in the institution to take responsibility for all of the risks that the institution incurs.

Our current system is not all in place. In some of our business areas we are having healthy debates about the applicability of private measures. In others, there is not as much debate as there should be. In the area of operational risk, where business managers have tremendous control, there is a common understanding of what the risk responsibility of the business manager is.

We do not yet make regular formal reports to our board of directors about the risks that we undertake. We are measuring them, but we are not yet sharing them outside the organization. There is a debate as to what extent we should. We do, however, have periodic discussions, usually of a general nature, with our board of directors about some of the risks that we undertake. We don’t always share with them the specifics, in some cases because the board includes people who are competitors of institutions that we might have lent funds to. We don’t get into discussions of the details. If we look at a private sector model, there would certainly be regular and more specific reporting to the board of directors, so we are still working out what the correct balance ought to be.

The Reserve Banks are all organized somewhat differently in terms of risk management, but tend to have a similar view of what is covered. Within the Federal Reserve System is a group called the Conference of Presidents, a committee formed of the 12 Reserve Bank presidents who discuss broad common policy issues. In the last couple of years, they have focused heavily on these issues of risk management. In 1996 they established a committee of themselves and a subcommittee of Federal Reserve executives who were asked to develop and introduce, in all the Reserve Banks, a common risk management approach.

I chaired the subcommittee at its formation and proposed to the presidents what they should do. My basic argument was that the institutions that we supervise have certain procedures. Why are we different? Are we so different that we should not take a comprehensive look at the risks that we undertake? If we want information and transparency, why shouldn’t we be open to evaluating our own procedures?

In 1996, that same Conference of Presidents approved a private sector process for evaluating one kind of operational risk, the risk of unintended disclosure of information using electronic means. We, therefore, put in place at all the Reserve Banks a computer security standard.

All other operational risks are being looked at using the methodology called COSO. As I noted earlier, this methodology was developed by a committee of 30 organizations from around the world trying to provide guidance to financial institutions on managing operational risks.

Now, although these things may seem slightly unrelated, they are not. The charge of the Conference of Presidents to look comprehensively at risk, the small adoption of the security of information standards, and now an effort at broadening that adoption to cover all operational risks are each pieces of a longer-term plan to get a focused and integrated risk management philosophy in place at the Reserve Banks.

The COSO methodology, including the information security standards, is consistent with and based upon this broader risk-management framework. The implementation of COSO will lead each Reserve Bank to identify and evaluate operational risks that each of the businesses poses.

Next, the Reserve Banks, through the business managers, will assess the controls that are needed to reduce or possibly to increase the operational risks in each business. I am also looking to the private sector to see what kinds of risks they are willing to take. It may be that in some of our businesses we have, through caution and conservatism, layered on so many controls that they are making us less cost-efficient.

Right now we are going through a debate about whether in some of these businesses there may be too much control and whether we might be willing to take a little bit more risk. The process is intended to achieve a better balance of control over the inherent risk.

Once it’s fully implemented, COSO should address risks in all our operations. However, the broader risk management framework includes other kinds of risk. Once you have put in place operational controls, you have already reduced the business risks. So that any credit risk, any market risk, any portfolio concentration risk that remains is a residual risk that has already been reduced by controls. Reputational risk and legal risk are embedded in each of the other four categories of risk.

Once controls are in place, you have to announce them. You then have to inform people. You have to communicate what you have done and why you have done it. You have to be able to articulate how much risk you are actually taking on and that you are comfortable with it. Then a comprehensive process can start to measure and report across the institution and across businesses.

The COSO process emphasizes five activities: control environment, risk assessment, control activities, information and communication, and monitoring. The first focus is on the control environment, whether or not you have competent people. You can have all the wonderful procedures in a book that you want, but if you don’t have people who understand them, it does you no good. You have to make sure that your people have ethical constraints and integrity.

What does risk assessment mean? It means asking yourself, what am I trying to do here? Am I trying just to make money? Am I only trying to recover the costs, as Congress requires, or do I have a larger strategic issue at hand? Why am I in these payment services? Is it because the U.S. Government wants the central bank to provide leadership? Does that sometimes conflict with Congress’ preference that I recover full cost, plus profit, plus imputed taxes?

What is the objective? What obstacles are in the way of your objective? Not knowing your objective means not knowing what your risks are. One risk is that by completely satisfying the congressional requirement that I recover full cost in all operations, I could defeat the larger purpose of providing leadership in the payments mechanism. I have to know what I am trying to achieve before I can really assess the risks that I am facing.

The controlled activities are the policies and the procedures that you put in place to implement directives—the required reviews and approvals—for things to happen. Information and communication in a private sector model is both internal and external. What data need to be shared, with whom, and how timely does the sharing need to be? Monitoring is continuous and ongoing.

We like the discipline of the COSO process because it requires repeating the assessment of risks and questioning what the objectives really are. Since it forces you to go through those exercises year after year, we think it’s a much stronger way to build a risk-management approach.

I believe that we can learn from the private sector, and I am trying to work with my colleagues at the Bank to see that we incorporate as much of the private sector into our approaches as we can. There might be several considerations if you try to provide guidance to your central banks. You do not have to choose a private sector model or any particular model. I am not recommending that you learn about COSO and study our standards on electronic security. That’s not the point of what I am saying.

What I think is important is that you develop a common risk language. You can’t address these issues unless everyone understands what risks you are dealing with. I would think about risk assessment methodologies. As I have said, we have found some private sector approaches useful and are being influenced by them.

It is important that whatever system of measurement you use be integrated. The senior management of the institution needs to be actively involved in the debate and in the decisions on risk taking. It doesn’t mean that they have to make all the decisions at every level, but it means that they have to set the tone. We find that the input from internal auditors and external auditors is valuable. And if you were trying to influence your central bank to think about these things in a different way, you might consider this input as well.



It has become a creed of modern central banking that, in discharging its duties, the central bank should be independent from the political establishment and accountable to the public. As there are limits to the powers of the central bank, however, there are limits to what the central bank may be held accountable for. These comments examine some of these limitations, especially in the pursuit by the central bank of price stability.

In a market economy, price stability depends largely on the public. In a market economy, prices are determined by the relationship between supply and demand with respect to assets and services. Demand is largely driven by the decisions of the public to advance or to postpone purchases. In pursuing price stability, the central bank attempts to change the public attitudes that motivate these decisions. It does so not only by using its monetary policy instruments to change the cost of short-term borrowing but also and especially by addressing the public attitudes that must be changed for monetary policy to take hold.

It is generally recognized that, in conducting monetary policy, the central bank cannot on its own ensure price stability. To be effective, monetary policy requires cooperation from the political establishment in ensuring a proper macroeconomic policy framework, including proper budgetary and wage policies and adequate prudential regulation of commercial banks. Examples abound. For instance, deflationary spirals cannot generally be halted without massive fiscal outlays by the government. For instance, the macroeconomic convergence criteria of European monetary union required of participants in the euro reflect the common wisdom that price stability cannot be achieved or sustained without a proper macroeconomic policy framework. As the public knows this, the central bank’s leadership in maintaining price stability will be credible only if the public believes that the political establishment and the central bank are working together toward this goal.1

Accountability of the central bank for the conduct of monetary policy is an essential condition for gaining and maintaining credibility and public confidence without which monetary policy cannot be successful. However, the central bank cannot account for government policies over which it has no control. The importance of governmental macroeconomic policies for achieving monetary policy goals argues for requiring the government to give a similar accounting of its policy contributions to price stability as is required of the central bank.

The powers of the central bank to ensure price stability, and hence its accountability, are limited not only owing to its dependence on support and cooperation from the government but also because usually not all categories of prices are addressed by monetary policy.

Normally, the monetary policy objective of price stability is understood to address so-called consumer prices measured in terms of changes over time in an index based on standard baskets of consumer goods and services, such as a consumer price index. Normally, price stability as a monetary policy goal does not directly cover other prices, such as the prices of commercial real estate or financial assets (hereinafter “asset prices”). This limitation of the scope of monetary policy is problematic.

For example, inflation of asset prices can be damaging to the economy, much like consumer price inflation, for, inter alia, the following reasons. Asset price inflation leads to misallocation of resources and therefore tends to slow economic growth. Asset price inflation gives asset owners an inflated feeling of wealth, inducing them to spend more, fueling consumer price inflation. Often, asset price inflation is accompanied by inflationary monetary growth.2 And, finally, the collapse in asset prices that inevitably follows an asset price boom can be very harmful to the financial system. This last point deserves special attention, because the financial system functions as the transmission mechanism for monetary policy.3

As real estate and financial assets are used to secure loans, their prices are used to set loan ceilings and to measure bank compliance with prudential standards. Uncontrolled inflation of asset prices presents serious systemic risks because asset price bubbles are nearly always resolved in a market crash whose effects cascade through the financial system.

Recent examples of speculative bubbles and their collapse are the meteoric rise and precipitous fall of commercial real estate prices in Japan and Thailand. When, eventually, asset prices collapsed, collateral values decreased to below outstanding levels of loan principal. During the ensuing economic recession, the same economic conditions that contributed to mortgage loan defaults also caused lower demand for commercial real estate, depressing real estate values. Mortgage liquidations increased the supply of real estate and eroded real estate prices even further. This experience supports the worrisome truism that loan collateral that retains its value in good economic times when it is not needed often loses much of its value in bad economic times when it must serve its purpose.

Similar price bubbles arise in respect of financial assets, such as equity shares. Financial history is replete with situations when suddenly, and always unexpectedly, the financial markets turn down to depreciate financial assets, causing their owners to offer the assets for sale simultaneously, swamping the market. When that happens, buyers are difficult to find and reasonable prices are difficult to obtain. The enormous losses that such market turns can produce affect not only the hapless sellers of assets at much lower prices but also others whose fortunes are linked to these assets. For instance, traders using the assets as collateral may have their lines of credit cut, causing them to liquidate the assets and putting further pressure on a market that is already saturated. Banks and brokers providing credit against the collateral of investment securities may witness the failure of their borrowers while the market value of their collateral evaporates. And banks, as owners of foreign assets, may suffer losses due to a sudden depreciation of asset values or of the foreign currencies in which assets are denominated.

For most financial institutions, there are prudential rules that apply to provide protection against such catastrophe. Often, however, the prudential protection so afforded proves to be inadequate. One reason for this is a fundamental flaw in the accounting practices used to value financial assets.

In many countries, financial institutions are required to mark their financial assets to market on a regular basis. Accordingly, their financial assets, such as stocks, bonds, and foreign currency holdings, must be valued in financial statements on the basis of the market values of these assets at the end of the financial reporting period concerned; commercial banks are often required to do this on a daily basis. However, this practice is flawed, as illustrated by the following example.

Assume that on December 31 of a given year 2.5 million shares of IBM were traded on the New York Stock Exchange. The last trade of the day was for a lot of 100 shares of IBM at a price of 95. The mark-to-market practice dictates that the price of 95 be used to value portfolio holdings of IBM shares in year-end financial statements. Thus, the mark-to-market practice requires that the price at which a lot of only 100 shares was traded will be used by thousands of IBM shareholders in their financial statements as of December 31 for the valuation of millions of IBM shares. If, at the time of the last trade on December 31, all these IBM shares would have been offered for sale at the going market price, the IBM share price would have sunk through the cellar floor. The demand in the market at that time for IBM shares would have been too small to accommodate such an enormous supply: without doubt, the exchange would have declared an order imbalance and trading in IBM shares would have been halted.

For a commercial bank, the prudential requirement that financial assets must be marked-to-market serves several pragmatic objectives. The principal objective is to determine the bank’s financial health. For instance, the practice is designed to measure the extent to which the bank’s demand deposit liabilities are covered by assets that could be sold to meet those liabilities on demand. For a bank, the mark-to-market practice functions as a risk measurement tool. Simple logic would dictate that the financial assets of banks be valued in a manner that corresponds to this objective, namely, on the basis of values at which the assets can be sold, or at least could have been sold at the time that the market produced the benchmark values at which the assets are appraised. Unfortunately, this is not what the mark-to-market practice does: normally, the mark-to-market rule appraises assets on the basis of prices for which those assets could not have been sold.4

The principal purpose of the prudential regulation of banks is to ensure their continued financial soundness. It would be prudent to require banks to maintain values for their financial assets that are reliable not only in good times but also and especially in bad times when the assets may have to be liquidated at depressed prices. The mark-to-market rule as applied to banks appears to ignore the possibility of future economic adversity and to paint an unrealistic picture of the financial health of banks; therefore, it should be supplemented with prudential regulations that overcome this problem. The same applies, mutatis mutandis, to liabilities.

The foregoing is one of the reasons why some years ago the Basle Committee on Banking Supervision adopted new risk-management guidelines requiring banks to measure value at risk by reference to historical price volatilities. One purpose of these guidelines is to ensure that banks, for purposes of meeting their prudential requirements, value those of their assets and liabilities that are traded in financial markets in a manner that takes account of the possibility that assets may have to be sold and liabilities may have to be serviced at values that are significantly less favorable than current market prices indicate. Thus, for instance, liabilities denominated in foreign currency may have to be valued at significantly higher domestic currency values than marking-to-market at current exchange rates would require.

The mark-to-market practice causes similar problems in the valuation of financial assets that serve as collateral for loans made by financial institutions. The same deficiency of the practice threatens the ability of these institutions to enforce their collateral rights at adequate prices in the event of a sharp downturn in asset values. This threat is aggravated by the time lag implicit in the enforcement of collateral rights, as compared with the liquidation of market positions in assets owned outright.

Currently, equity markets in the United States and Europe are experiencing an unprecedented rise in share prices. To avoid having a market collapse affect the financial position of banks that have received investment securities as collateral for loans made by them, bank regulators should tighten prudential ceilings for such loans. For instance, regulators should gradually tighten loan margin and collateral requirements for credit secured by equity positions as the market rises. The tightening should be gradual so as not to precipitate the very market crash that tightening is designed to avoid. The collateral requirements could be relaxed after a meaningful market correction, to be tightened again as the market resumes its bull run.5

Another reason for tightening equity margin requirements and thereby reducing borrowing is that much of the amounts borrowed against collateral of equity investments are applied to fund further equity investments. Increased borrowing to increase equity investments in equity markets that by most traditional standards must be considered significantly overvalued adds to market volatility at a time when prudential supervision should aim at reducing market volatility.

The question is whether central banks should be made accountable for asset price stability.

Maintaining price stability consists not only in avoiding inflation but equally in avoiding deflation. There is convincing evidence that asset price boom and bust cycles are conducive to instability of consumer prices. The deflationary spiral gripping the Japanese economy is but one example. Moreover, although the monetary policy instruments available to the central bank are appropriate for fighting inflation, they have proven to be rather ineffective to stem deflation, as is illustrated by the inability of the monetary authorities of Japan to stimulate economic activity through monetary policy alone, even when interest rates are lowered to zero.

Maintaining asset price stability is an important prerequisite for preserving creditworthy and efficient financial institutions. Even in countries where central banks are not directly responsible for the prudential oversight of financial institutions, they have a vested interest in and should actively promote the continuing health of the financial system, especially where to do so is not only consistent but even supportive of sound monetary policy.

The conclusion is inescapable that central banks should be made accountable for asset price stability and should be required to include asset prices in their monetary policy targets.


Such cooperation is especially important when the country faces an economic crisis. On the negative side, state entities should suspend destructive internecine turf battles. On the positive side, central bank and government should form a united macroeconomic policy front. Sometimes such cooperation between central bank and government is formalized under agreements between them, as for instance in New Zealand and Canada.


A recent ten-year study for the United States by Deutsche Morgan Grenfell in New York shows that a price index composed of consumer and producer prices (about 80 percent), property prices (about 15 percent), and equity prices (5 percent) tracks closely the rapid rise in broad money (M3), even as the consumer price index moved down. This argues for the use of such a broad price index to measure price stability. See The Economist, May 9th–15th, 1998, at 78.


These are some good reasons for including the pursuit of asset price stability under the mandate of the central bank.


The mark-to-market practice uses historical prices. For banks, the practice is designed in part to determine the price at which a particular holding of financial assets could be liquidated to meet their financial obligations. There is inconsistency between this forward looking objective of the rule and the use of historical prices. To meet this objective, the rule should also be forward looking and help determine the price at which financial assets could be liquidated today or tomorrow, instead of only the price at which they could have been liquidated yesterday.


In the United States, code provision 15 U.S.C. § 78g (1994) requires the Federal Reserve Board to prescribe rules and regulations with respect to the amount of credit that may be initially extended and subsequently maintained on investment securities. See Regulations T, U, and X in 12 C.F.R., Parts 220, 221, and 224 (1998), respectively, for details.