Subprime Series, part 3: Why central banks should be financial supervisors

Central bankers regularly describe price stability as an essential foundation for maximum sustainable growth. Well, financial stability is another one. In fact, without a stable, well-functioning, financial system, there is no way that an economy can flourish. A well-functioning financial system is like the plumbing. When it works we take it for granted; when it doesn’t, watch out. But, as we have seen recently, financial markets and institutions can malfunction on a moments notice. To prevent this, governments regulate and supervise financial institutions and markets. And best practice dictates that financial stability is one of the primary objectives of the central bank.

Central banks and financial supervision

For over a decade there has been a debate over how to structure government oversight. What responsibilities should reside in the central bank? Different countries resolve this question differently. In places like Italy, the Netherlands, Portugal, the United States and New Zealand, the central bank supervises banks. By contrast, in Australia, the United Kingdom, and Japan, supervision is done by an independent authority. Is one of these organizational arrangements better than the other? Does one size fit all?

The events of the summer and fall of 2007 shed new light on this question, and my conclusion is that there is now an even stronger argument for placing supervisory authority inside of the central bank. As events unfolded through August and September, it became increasingly clear that having the bank supervisors separated from the liquidity provider placed added stress on the system.1

Pros and cons of separation

To understand this conclusion let me very briefly summarize the traditional arguments for and against separation of the monetary and supervisory authorities.2 Starting with the former, the most compelling rationale for separation is the potential for conflict of interest. The central bank will be hesitant to impose monetary restraint out of concern for the damage it might do to the banks it supervises. The central bank will protect banks rather than the public interest. Making banks look bad makes supervisors look bad. So, allowing banks to fail would affect the central banker/supervisor’s reputation.

In this same vein, Goodhart3 argues for separation based on the fact that the embarrassment of poor supervisory performance could damage the reputation of the central bank. Monetary policy-makers who are viewed as incompetent have a difficult time achieving their objectives.

Turning to the arguments against separation, there is the general question of whether a central bank can deal effectively with threats to financial stability without being a supervisor. There are a variety of reasons that the answer might be no.

First and foremost, as a supervisor, the central bank has expertise in evaluating conditions in the banking sector, in the payments systems, and in capital markets more generally. During periods when financial stability is threatened, when there is the threat that problems in one institution will spread, such evaluations must be done extremely quickly.

Importantly, the central bank will be in a position to make informed decisions about the tradeoffs among its goals, knowing whether provision of liquidity will jeopardize its macroeconomic stabilization objectives, for example. They are in the best position to evaluate the long-term costs of what may be seen as short-run bailouts. Put another way, appropriate actions require that monetary policymakers and bank supervisors internalize each others objectives. Separation makes this difficult.

Second, separation can lead central bankers to ignore the impact of monetary policy on banking system health. A simple example of this is the potential for capital requirements to exacerbate business cycle fluctuations. Granted, this seems unlikely, but regardless, the argument goes as follows: when the economy starts to slow, the quality of bank assets decline. This, in turn, reduces the level of capital, increasing leverage. Banks respond by cutting back on lending, slowing the economy even further. Combating this requires that monetary policymakers take explicit account of banking-system health when making their decisions. And, without adequate supervisory information, there is concern that they might not.

Most relevant to the recent experience is the fact that in their day-to-day interactions with commercial banks (and other financial institutions) central bankers need to manage credit risk both in the payments system and in their lending operations. In the United States, for example, the Federal Reserve allows banks what are known as “daylight overdrafts” on their reserve accounts. That is, the Fed extends very short-term credit to banks that makes payments with insufficient balances.4

As the lender of last resort, central banks worldwide take on credit risk. To do so responsibly requires information about the borrower. The evidence suggests that this is nearly impossible without having fast and complete access to supervisory information. An example will help to illustrate the problem policymakers’ face.

An example

On 20 November 1988 a computer software error prevented the Bank of New York from keeping track of its US Treasury securities trading.5 For 90 minutes orders poured in and the bank made payments without having the funds as normal. But when it came time to deliver the bonds and collect from the buyers, the information had been erased from the system. By the end of the day, the Bank of New York had bought and failed to deliver so many securities that it was committed to paying out $23 billion that it did not have. The Federal Reserve, knowing from its up-to-date supervisory records that the bank was solvent, made an emergency $23 billion loan taking the entire bank as collateral and averting a systemic financial crisis. Importantly, only a supervisor was in a position to know that the Bank of New York’s need to borrow was legitimate and did not arise from fraud.

A central bank needs to manage credit risk both in the operation of the payments system and in lending operations. In short-term lending it relies heavily on supervisory information. While this can normally be obtained from the supervisor, when an institution comes under stress it can be essential to have people in the central bank who know what is going on.

We can summarize the argument against separation as being about efficiency in the production and use of timely information on the one hand, and the ability to internalize the tradeoffs on the other. Separation means something akin to the children’s game of “telephone,” where a message is whispered from one child to the next, getting distorted at each step along the way. While internalization of the tradeoffs means that the central bank is best positioned to decide whether actions aimed at calming financial markets today forsake macroeconomic stabilization objectives tomorrow.

I find all of this persuasive. But for those people who do not, recent events add another argument for central banks retaining supervisory powers. Looking at the Northern Rock episode one has to wonder whether individuals would have behaved the way that they did if they had all been working inside the same institution. Recall what happened in mid-September. Shortly after Bank of England Governor Mervyn King sent a letter to the Treasury Committee of the House of Commons,6 the U.K. Financial Services Authority made it known both that Northern Rock was on the verge of collapse, and that supervisors had known this for some time. Contrary to wide-spread perception of the position taken just a few days earlier in the Governor’s letter, the Bank of England was forced to make a substantial emergency loan, substantially tarnishing their public image.

Northern Rock lessons

I have no special knowledge of the merits of this particular case. Should Northern Rock have been extended this loan or forced into bankruptcy? Could the FSA have taken preemptive action to avoid reaching this point? What was in the best long-term interests of the British public in this specific case? It will take some time to sort out the answers to these questions and determine whether specific legal changes are needed. What I will say is that things surely would have gone more smoothly had the Bank of England had supervisory authority so that the officials with intimate knowledge of Northern Rock’s balance sheet would have been sitting at the table on a regular basis with the management of the central bank.

Operations in a midst of a financial crisis are more like maneuvers during a war. And in the heat of a battle, it is essential that a single person be in charge. That is why the military is organized with a clear chain of command. Separation of supervision from the central bank is like having two generals with potentially different objectives giving orders to the same army. It is hard to see how this could possibly work.

So, as I consider the lessons that we should take away from the financial turmoil of 2007, one of them is that it makes sense to place at least some supervisory authority inside of the central bank.

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Footnotes

1 The chronology of events is now well known, so I will not repeat them here. For a discussion of the initial stages, see my description at “Market Liquidity and Short Term Credit: The Financial Crisis of August 2007” available at www.ifk-cfs.de/fileadmin/downloads/events/ecbwatchers/20070907ecb_cecchetti_document.pdf.

2 For a detailed and very thought-provoking discussion see both the text and the references in Ben S. Bernanke, “Central banking and Bank Supervision in the United States,” speech delivered at the Allied Social Science Association Annual Meeting, Chicago, Illinois, 5 January 2007 available at www.federalreserve.gov/newsevents/speech/bernanke20070105a.htm.

3 See Charles Goodhart, "The Organizational Structure of Banking Supervision," Occasional Papers, no.1, Basel Switzerland: Financial Stability Institute, November 2000 available at www.bis.org/fsi/fsipapers.htm.

4 Because reserve balances are not remunerated in the American system – that is, there is no interest paid on the balances banks hold at the Fed – there is an incentive to economize on the level of reserves held. This has created a system in which banks regularly overdraw their accounts early in the day, making payments prior to receiving them. The Fed has announced that starting in 2011 it will start paying interest on reserve balances, at which point the day-light overdrafts seem likely to disappear.

5 At the time, computers could store only 32,000 transactions at a time. When more transactions arrived than the computer could handle, the software’s counter restarted at zero. Since the counter number was the key to where the trading information was stored, the information was effectively erased. Had all the original transactions been processed before the counter restarted, there would have been no problem. See the discussion in Stephen G. Cecchetti Money, Banking and Financial Markets, 2nd Edition. Boston: McGraw-Hill, Irwin, 2008.

6 Mervyn King, “Turmoil in Financial Markets: What Can Central Banks Do?” paper submitted by the Governor of the Bank of England to the Treasury Committee of the U.K. Parliament, 12 September 2007, available at www.bankofengland.co.uk/publications/other/monetary/treasurycommittee/