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Symposium 2013

Proposal - Why banking supervision and monetary policy must be separated

The Challenge

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established m ...

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established microprudential policies, macroprudential policies aimed at increasing the stability of the financial sector as a whole are imperative. But an active debate has emerged over what role the central bank should play with this augmented set of policies.

The global banking crisis exposed the inability of current microprudential policies to prevent systemic financial failure. We urgently need new policies and new institutions to safeguard the overall stability of the financial sector. Policymakers agree that the need for macroprudential regulation is imperative but disagree on who will implement it.

The core of the current debate is what role the central bank should play within this augmented set of policies and instruments. Should monetary policy and banking supervision be conducted by separate institutions? Or should both tasks be assigned to the central bank?

In our view, the arguments in favor of institutional separation are much more convincing. Suppose that the central bank – in addition to its price stability mandate – is responsible for the supervision of the banking sector as well. Several conflicts of interest are inevitable.

First, the central bank will face an important tradeoff when insolvent financial institutions need to be closed down, and at the same time, those institutions have previously borrowed from the central bank against collateral whose value has fallen. How likely is it that the central bank will take action and incur potentially large losses on its balance sheet? It seems more likely that the central bank will practice forbearance to avoid those losses. That, however, will keep insolvent institutions alive and ultimately hamper the necessary reallocation of scarce capital.

Another important tradeoff for the central bank will arise when macroeconomic fundamentals, e.g. inflationary pressures, call for interest rate increases, which would push financial institutions that have relied too heavily on low interest rates into insolvency. If, again, the central bank practiced forbearance and refrained from the necessary interest rate increases, then price stability and the credibility of the central bank to maintain it would be endangered.

To ensure an effective enforcement of banking regulation free of conflict of interests, monetary policy and banking supervision must be assigned to separate institutions. Firewalls between monetary and supervisory departments of the central bank would always remain artificial as the crucial decisions would always have to be taken by the central bank’s top management.

Separating monetary policy and banking supervision is not the same as saying that the central bank shouldn’t have access to information about the state of the banking sector. In fact, the central bank should collect all the information that is needed for fulfilling its role as lender of last resort by giving emergency liquidity assistance to illiquid but solvent financial institutions only. The fact that the central bank is also in need of information about the banking sector is not an argument in favor of assigning it with the task of banking supervision.

Of course, providing the supervisory authority with the necessary information about the banking sector is not free of cost. But the benefits of an effective bank regulation enforcement that reduces the probability of bail-outs by the taxpayer will outweigh those costs in the long-run.

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