Thursday, February 25, 2010

Central banks and banking regulation

The sub-prime crisis and the the Great Recession have prompted calls for a radical restructuring of the extant financial market regulation architecture. One of the most important issues being debated involves the role of Central Banks in banking supervision.

On the one side are those who see monetary policy and financial market regulation as distinct and independent activities and therefore favor a separate regulator, different from the central bank, to supervise the banking sector. However, there are others like Mark Thoma and Paul De Grauwe who point to the difficulty of separation of these two activities into distinct and independent functions, and feel that the central bank should be the primary regulator of the financial system.

Central Bank governors including Ben Bernanke and D Subba Rao argue that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined and therefore advocate an important role for the Fed in regulation and supervision of banking sector.

I am inclinced towards an opinion that while the central banks should have an adequate level of control over systemic risk through macro-prudential regulation, a separate regulator for individual firm specific risks may not be a bad idea.

In a Vox article, Hans Gersbach proposes "a new policy framework whereby the central bank chooses short-term interest rates and the aggregate equity ratio while banking regulation and supervision, including the determination of bank-specific capital requirements, would be left to separate bank-regulatory authorities". This approach seeks to reconcile the need to expand the role of the central bank by giving it greater control over the banking sector while at the same time giving individual bank regulation to a separate regulator.

The aggregate equity ratio of the banking sector, defined as the ratio of total end-borrower lending (credit for non-financial firms, households, and governments) plus other non-bank assets to total equity in the banking sector, is a measure of the capital cushion of the banking sector. Gersbach advocates an aggregate equity ratio rule, which "relates the required equity ratio of the banking system in the next period to the current aggregate equity ratio and to the state of money and credit". He concedes that "while it is impossible to find a fixed aggregate equity ratio rule, it will be essential that such a rule is as systematic, transparent and accountable as traditional monetary policy regimes". He writes,

"The state of money and credit indicates how strongly consolidated and unconsolidated balance sheets of banks or financial intermediaries expand or contract in comparison with average growth. It is often useful to concentrate on sub-aggregates such as total credit to non-banks or total short-term debt liabilities of banks to non-banks and among banks themselves. The latter measures include both traditional monetary aggregates such as household deposits and other liabilities such as commercial papers and repurchase agreements which provide signals about the price of risk and other financial-market conditions.

All remaining activities for the regulation and supervision of banks are executed by separate and less independent bank-regulatory authorities. These authorities act under the aggregate equity ratio constraint set by the central bank. They determine bank-specific capital requirements that may require upward and downward adjustments of capital requirements, depending on whether a particular bank holds a high-risk or low-risk asset portfolio... Those separate authorities also regulate shadow-banking, operate the deposit insurance scheme and may intervene to restructure or close banks."

He feels that the setting the interest rate and the aggregate equity ratios enables central banks "to conduct flexible inflation targeting and to moderate booms and busts as a system regulator". This rule can be deployed as an effective counter-cyclical adjustment mechanism - lower the ratio to enable banks to write down equity as asset prices decline or credit losses mount so as to moderate the bust, and "lean against the wind" and raise the ratio when the balance sheet assets and liabilities (and thereby leverage) start exploding during a boom.

Update 1 (18/4/2010)
Thomas Hoenig of the Kansas Fed makes the point that Fed should supervise all banks (and not just the large banks, which pose systemic risk, as in the current Bill before Senate) and that all insolvent large banks should be placed into receivership and resolved in an orderly fashion just as smaller banks (currently the decision to close a large financial firm that is failing would depend on the Treasury Department’s petitioning a panel of three United States Bankruptcy Court judges for approval to place the firm in receivership with the Federal Deposit Insurance Corporation. The panel would have 24 hours to make a decision, and if it turned down the petition, the Treasury could re-file and subsequent appeals could be considered. So a decision to put the firm in receivership might not be timely enough under the circumstances).

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