B. Principle 2: Systemic supervision must be under the purview of the central bank

The role of the central bank is the major issue at stake in this organizational structure, in particular, whether supervision should be a responsibility of the central bank. With or without direct supervisory responsibilities, a central bank has a responsibility for financial stability, because of its lender-of-last-resort role.

The debate about the supervisory responsibilities ofcentral banks is linked to the discussion of the goals and history of central banks. The Federal Reserve System was set up in 1913 ‘to establish a more effective supervision of banking’,35 following the banking crises of the 19th and 20th centuries. The Fed conceives of its monetary policy as having been largely grafted onto its supervisory functions, and regards its supervisory and regulatory functions as a prerequisite and complement to its monetary policy responsibilities. These origins, as well as the experience regulatory goals because of lower ‘frictions’ in deciding and implementing resolutions, see Briault, above n 23, and see Llewellyn, above n 23, and Larry D. Wall and Robert A. Eisenbeis, ‘Financial Regulatory Structure and the Resolution of Conflicting Goals’, 16(2) Journal of Financial Services Research 223 (1999), accountability (a single regulator will be more transparent and accountable than multiple regulators, and may find it more difficult to ‘pass the buck’ if it makes a mistake), see Briault, above n 23, see Llewellyn, above n 23, and see Abrams and Taylor, above n 23 and transparency (a system with a single regulator is simpler for financial institutions and consumers to understand, see Llewellyn, above n 23); while worrying that a single regulator may have excessive power (Michael Taylor, ‘Twin Peaks: a Regulatory Structure for the New Century’, Centre for Financial Innovation, London, 1995, EdwardJ. Kane ‘De Jure Interstate Banking: Why Only Now?’, 28(2) Journal ofMoney, Credit and Banking 141 (1996); see Briault, above n 23, and see Llewellyn, above n 23).

  • 33 James R. Barth etal., ‘An International Comparison and Assessment of the Structure of Bank Supervision’, Working Paper, February 2002, (visited 10 May 2010).
  • 34 Our recommendations in this regard have found support in recent proposals of the Economic and Monetary Affairs Committee of the European Parliament, suggesting that the EBA, the EIOPA and the ESMA, working together through an improved joint coordinating committee, should all be located in Frankfurt so as to achieve much closer collaboration among them. See Press Release of the Economic and Monetary Affairs Committee, ‘MEPs Vote to Beef up Financial Supervisory Package’, (visited 10 May2010).
  • 35 See Introduction to the Federal Reserve Act of 23 December 1913.

of the Great Depression, help explain the decisiveness and extensiveness with which the Fed has reacted to the financial crisis from the summer of 2007 to date.

The more recent emphasis on stable money as the primary objective ofmonetary policy—the driving force of central bank independence in many countries around the world in the 1980s and 1990s—was often accompanied in some countries (such as the UK and Australia) by a move away from supervisory functions. While there are important grounds for the creation of a separate agency, we believe that the reasons for combining both functions are more important.

First, and most importantly, the lender-of-last-resort function can only be undertaken by a central bank. The involvement of central banks in financial stability originates in their role as monopolist suppliers of fiat money and in their role as bankers’ banks.[1] Only the ultimate supplier of money can provide the necessary stabilizing function in a nationwide scramble for liquidity, as the financial crisis has amply evidenced, with conventional and non-conventional monetary policy operations (quantitative easing and others). This is a clear lesson of the crisis in the UK, where the problems of Northern Rock caught the Bank of England by surprise: having timely information is particularly crucial during financial crises and the best way to ensure access is to have daily supervision by the central bank, as the literature has noted.[2]

Second, we have learned in this crisis that monetary policy not only affects inflation rates, but the price (and thus the amount) of risk-taking. An excessively accommodating Fed convinced actors that they would be saved from their folly (the famous ‘Greenspan put’) and led to excessive risk-taking. Thus, those in charge of monetary policy need to know the amount of risk and instability in the system. Moreover, the absence of stable prices harms the stability of the financial system, while financial fragility, in turn, negatively affects monetary stability.

Third, the prestige and independence of central banks enhances their ability to enforce actions,[3] as well as to recruit and retain the best staff.

Of course, extracting synergies never comes without organizational costs. One key problem with combining tasks has to do with the difficulty in providing adequate incentives and measurement on the stability task. The measurement of the success of a bank on its central banking functions is pretty straightforward. There is one goal, price stability, one instrument, monetary policy. There are also a relatively small number of people (the governor/chairman and the members of the executive board/monetary policy committee)[4] in charge of that task. In contrast, regulation and supervision try to achieve multiple goals (financial stability, protection ofinvestors and consumers, conduct ofbusiness and others), with a wide range of instruments: licensing requirements, macro- and micro-prudential supervision, financial stability reviews, lender-of-last-resort operations and other crisis-management procedures, and there are multiple agencies involved: the central bank, the ministry of finance or treasury, the supervisory agency or agencies. Moreover, supervision typically relies on a large number of staff to perform examinations and other tasks.

The clarity of the metrics used to measure success by central banks in their inflation-fighting mission makes it hard to combine these tasks with the supervisory task. As Holmstrom and Milgrom[5] have pointed out, in an environment with multiple tasks that are observable with different levels of difficulty, the setting of clear performance criteria in the tasks that are easily measurable deflects agents’ efforts away from the tasks that may be valuable but are more difficult to measure. That is, we can expect a central bank with a clear inflation-target objective to subordinate success on its financial supervision mission to its inflation targeting performance. Conversely, a financial system without a target, but with political pressure on stability, may pursue monetary policy that is too expansionary in order to minimize the adverse effects on bank earnings and credit quality.[6] A final negative spillover between both tasks is reputational. If the central bank is responsible for bank supervision and bank failures occur, public perception ofits credibility in conducting monetary policy could be adversely affected. A related reputational risk concerns its independence, the wider the role of the central bank, the more subject it could become to political pressures, thus threatening its independence.[7]

Early empirical research into these questions generally supported the argument that there were important organizational and incentive costs of combining both tasks and suggested that central banks should adopt a narrow focus and not undertake bank supervision.[8] The recent crisis, however, decisively shifts the argument against the previous consensus. We saw, again, in the Northern Rock debacle which caught the Bank of England completely unprepared, that the central bank’s absence from supervision or closer involvement in the pursuit of financial stability has enormous costs. The problem is, however, that extracting the clear synergies between supervision and monetary policy requires finding solutions that reduce these organizational costs.

The recent consensus points to an intermediate solution, which bundles macroprudential supervision with monetary policy and segregates micro-prudential supervision. According to the House of Lords’ Report on the Future of EU Financial Regulation and Supervision:44

macro-prudential supervision is the analysis of trends and imbalances in the financial system and the detection of systemic risks that these trends may pose to financial institutions and the economy. The focus of macro-prudential supervision is the safety of the financial and economic system as a whole, the prevention ofsystemic risk. Micro-prudential supervision is the day-to-day supervision of individual financial institutions.

In our view, splitting macro-prudential supervision and allocating it to the central bank makes it possible to capture the main synergies while avoiding most of the organizational costs.45 The multitasking, informational economies of scope and reputational issues that we have discussed above apply typically to micro-prudential supervision.46 On the other hand, the arguments against separation, namely the central bank’s lender-of-last-resort role (especially in the case ofsystemic failure), its oversight function concerning the payment system and the need for consistency

Banking Supervision and Monetary Policy Tasks be Given to Different Agencies?’, Universitat Pompeu Fabra Department of Economics and Business Working Papers 411, October 1999, (visited 10 May 2010), use cross-country data to find a positive correlation between the rate of inflation and the central bank having responsibility for both monetary policy and supervision. Goodhart and Schoenmaker, above n 41, ‘Should the Functions of Monetary Policy and Banking Supervision be Separated?’, note that independent central banks, which are generally better at fighting inflation, are also more likely to not have responsibility for banking supervision. Vasso Ioannidou, ‘Does Monetary Policy Affect the Central Bank’s Role in Bank Supervision’, 14(1) Journal of Financial Intermediation 58 (2005), focuses solely on the USA, where the central bank is one of three federal-level bank supervisors. Using data on formal actions taken by federal bank supervisors against banks, this article suggests that the Federal Reserve’s monetary policy responsibilities affect its supervisory behaviour. In particular, when the federal funds rate increases, it relaxes its supervisory posture as a form of compensation to the banks. Ron J. Feldman, Jan Kim, Preston J. Mille and Jason E. Schmidt, ‘Are Banking Supervisory Data Useful for Macroeconomic Forecasts?’, 3(1) Contributions to Macroeconomics, Article 3 (2003), use data forthe US banking system to test the hypothesis that a central bank with direct access to confidential supervisory data can enhance its macroeconomic forecasting ability, and thereby bolster its monetary policy efforts. However, they find little empirical support for the ‘access to information’ argument.

  • 44 Above n 1. One of the authors, Rosa M. Lastra, acted as Specialist Adviser to the House of Lords during the inquiry and contributed to the writing of the Report.
  • 45 The distinction between macro-prudential supervision (the supervision of the financial system at large) and micro-prudential supervision (the supervision of individual financial institutions) has been adopted inter alia by the de Larosiere Report, above n 2; and by Brunnermeier, Crockett, Goodhart, Persaud and Song Shin (eds), The Fundamental Principles of Financial Regulation (11th Geneva Report on the World Economy), above n 6.
  • 46 See Goodhart and Schoenmaker, ‘Should the Functions of Monetary Policy and Banking Supervision be Separated?’, above n 41.

between monetary policy and prudential supervision, are more related to macroprudential supervision. Thus combining only the macro-prudential supervision tasks with central banking seems to provide important benefits while avoiding the main costs identified above.

There are two initial difficulties with this combination. First, the critical question is the extent to which this ‘macro’ role would be sufficient to avoid the next financial crisis. This crisis is also a micro-crisis, after all—knowing how AIG and some of the mono-line insurers were operating required an intimate knowledge of their behaviour that could only come from being their (micro-prudential) supervisor. On the other hand, there may be some tools (such as extended monetary type aggregates, the volume of repurchase agreements outstanding, the amount of shortterm commercial paper), that could give advanced warning of ‘frothy’ conditions.

Second, there is a specific problem in Europe: that ofjurisdictional domain. Not all the countries in the EU belong to EMU.[9] The purview of any EU financial supervisor must be Europe wide, but the European Central Bank only includes some ofthe countries in Europe. The recently created ESRB responsible for macroprudential oversight follows the recommendation of the de Larosiere Report and includes on its General Board the Governors of the national central banks of all EU Member States. The jurisdictional issue, however, continues to effect European efforts to implement systemic supervision. The UK as Europe’s key financial centre is particularly important and relations between the UK and the rest of the EU have become increasingly strained following Prime Minister Cameron’s veto of a new EU Treaty in 2011.[10]

  • [1] Cf. Baltensperger and Cottier in Ch 20 of this volume.
  • [2] See Charles Goodhart and Dirk Schoenmaker, ‘Institutional Separation between Supervisory andMonetary Agencies’ in Charles Goodhart (ed), The CentralBank andthe Financial System (Cambridge,MA: MIT Press, 1995) 333—414 and Charles Goodhart, ‘Price Stability and Financial Fragility’ inCharles Goodhart (ed), The Central Bank and the Financial System (Basingstoke: MacMillan Press,1993) 263—303. Joseph G. Haubrich, ‘Combining Bank Supervision and Monetary Policy’, FederalReserve Bank of Cleveland Economic Commentary, November 1996. See Briault, above n 23, seeLlewellyn, above n 23, and see Abrams and Taylor, above n 23. Joe Peek, Eric S. Rosengren andGeoffrey M. B. Tootell, ‘Is Bank Supervision Central to Central Banking?’, 114(2) Quarterly Journal ofEconomics 629 (1999).
  • [3] Ian H. Giddy, ‘Who Should be the Banking Supervisors?’ (Paper presented at the seminar onCurrent Legal Issues Affecting Central Banks, International Monetary Fund, 10 May 1994, on filewith authors); Rosa M. Lastra, ‘The Independence of the European System of Central Banks’, 33(2)Harvard International Law Journal 475 (1992); and See Abrams and Taylor, above n 23.
  • [4] Although the central bank also needs a team of economists to do the forecasting, to study thetransmission mechanisms of monetary policy, etc.
  • [5] Bengt Holmstrom and Paul Milgrom, ‘Multitask Principal-Agent Analyses: Incentive Contracts,Asset Ownership, and Job Design’, 7 Journal of Law, Economics, & Organization 24 (1991) (specialissue) and Bengt Holmstrom and Paul Milgrom, ‘The Firm as an Incentive System’, 84(4) AmericanEconomic Review 972 (1994).
  • [6] See Goodhart and Schoenmaker, above n 37. Charles Goodhart and Dirk Schoenmaker,‘Should the Functions of Monetary Policy and Banking Supervision be Separated?’, 47 OxfordEconomic Papers 539 (1995). See Haubrich, above n 377 See Briault, above n 23, and Abrams andTaylor, above n 23.
  • [7] See Haubrich, above n 37. See Briault, above n 23, and Abrams and Taylor above n 23. Indeed,one ofus [RosaM. Lastra, CentralBanking andBanking Regulation (London: FMG, 1996)] has arguedthat the Bundesbank (German Central Bank) was not given direct responsibility for prudential bankingsupervision in order to remove any possible threat to the credibility of its price-stability target.
  • [8] For instance, see Goodhart and Schoenmaker, above n 41, ‘Should the Functions of MonetaryPolicy and Banking Supervision be Separated?’ and Carmine Di Noia and Giorgio Di Giorgio, ‘Should
  • [9] See de Larosiere report, above n 2, and the House of Lords’ Report, above n 1.
  • [10] The veto by Prime Minister David Cameron on a new EU treaty and the subsequent abstentionof the UK in joining almost all Member States (the Czech Republic is the only other member not toratify but has indicated it may) in ratifying the ‘treaty on stability, coordination and governance in theeconomic and monetary union’, see (visited 6 March 2012) has led to concerns that the UK may have caused a split in the union seeFinancial Times ‘Cameron Frozen out after wielding veto’, (visited 6 March 2012).
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