Alternative Models of Systemic Stability Regulation

4.1 Global Practices of Central Banks in Financial Stability

The role of a country's central bank is critical to promote financial stability. There is a view that the central bank should be responsible for financial stability in addition to the usual responsibility of price stability. There are several reasons for making such a recommendation. First, in the US, full employment and price stability are the dual mandates conferred by Congress on the Federal Reserve in the conduct of monetary policy. Financial stability is an essential element in achieving those objectives. Second, there are important synergies between the systemic stability regulation and monetary policy, as insights garnered from performing one of those functions inform the performance of the other. Third, close familiarity with private credit relationships, particularly among the largest financial institutions and through critical payment and settlement systems, enables the central bank better able to anticipate how its actions could affect the economy. Finally, the lender of last resort function of the central bank is a natural link between the central bank and the emergence and reduction of systemic risk.

Table 2 [ PDF 55.9KB | 1 page ] summarizes information on the structure of financial supervision and regulation and the role of central banks in prudential supervision. Of the 84 countries listed in the table, 30 have an integrated prudential supervisor, 20 have supervisory agencies in charge of two types of financial intermediaries, and 34 have multiple sectoral supervisors. The central banks of 48 countries (57% of the total) have the authority of banking supervision, and of these 48 countries 39 (81%) are developing and emerging economies. It is informative to note that in countries with multiple sectoral supervisors, central banks almost always have this supervisory authority.

Table 3 [ PDF 56.6KB | 1 page ] summarizes the central bank mandates of the G20 members and a few Asian economies. In all cases the central bank is in charge of price stability as well as payment system stability, and in some cases it is in charge of supervising and regulating securities and insurance firms—in addition to banks. Close to half of the central banks have financial stability committees and most of them do publish financial stability reports, suggesting the presence of their analytical capacity to conduct macro-financial surveillance. Also the central banks of Saudi Arabia and Singapore hold the responsibility of macroprudential supervision, and the majority of the world's central banks do not.

4.2 Reform Proposals in the US, the UK, and the European Union

National efforts to address systemic risk and promote financial stability are proceeding in the US and the UK, while regional efforts are under discussion in the European Union (EU).

4.2.1 US Stability Reform Plan

In the US, the Obama administration has proposed that the Federal Reserve become the nation's financial stability overseer. The central bank would gain both the power to monitor risks across the financial system and the authority to examine any firm that could threaten financial stability, even though normally the Federal Reserve would not supervise the institution. The nation's biggest and most interconnected firms would be subject to heightened oversight. The Fed would more tightly regulate systemically important financial institutions (“Tier 1 institutions”), even if they are not banks in the traditional sense (such as General Electric). The administration's proposal calls for a “rapid resolution plan.” It mandates that systemically important financial firms be required to file a “funeral plan” regularly—a set of instructions for how the institution could be liquidated in an orderly and timely fashion should the need to do so arise. Finally, a new insolvency regime to be introduced will cover all such firms, modeled on the scheme run by the Federal Deposit Insurance Corporation (FDIC) for ordinary banks.

Against this Federal Reserve-led model there is a competing view that a “Financial Services Oversight Council” should be created to provide macroprudential oversight of the system, that is, to oversee systemic risk issues, develop prudential policies, and mitigate systemic risks. This council would include the Fed, regulators/supervisors, FDIC and the Treasury. This model could become effective if the council could clarify its objectives and mandates and acquire sufficient resources and implementation tools. Also the fragmentation of financial regulation and supervision would have to be eliminated by consolidating these functions into a single authority. This would help harmonize prudential regulatory standards for financial institutions, products and practices to prevent regulatory arbitrage and, hence, systemic risk.

4.2.2 UK Stability Reform Plan

The UK Treasury has proposed regulatory reforms as well. A “Council for Financial Stability” would be created to bring together the Bank of England (BOE), Financial Services Authority (FSA) and the Treasury. The FSA would be in charge of both macroprudential and microprudential supervision and address systemic risks, such as rapid credit surges, for example by requiring more bank capital. The BOE would have statutory responsibility for financial stability and would be given new powers to deal with troubled banks. However, the BOE objects that it does not have the tools it needs to maintain financial stability.

The opposition party makes a very different proposal. It advocates the abolition of the FSA and the enlargement of the BOE mandate to absorb all of the FSA's supervisory functions. Essentially this would transform the BOE into a key systemic stability regulator, signifying a return to the pre-1998 financial services regulation in the UK. Prior to 1998, responsibility for banking supervision was with the BOE, and the supervisory functions were transferred to the newly established FSA beginning in 1998.

4.2.3 European Union Reforms

In Europe, forging a robust approach to coordination is a big challenge, in particular on issues related to regional financial and macroeconomic stability. A high-level expert group headed by Jacques de Larosière (2009) proposed establishing two supra-national structures to deal with cross-border aspects of financial stability:

• A European System of Financial Supervisors, which would bring together existing national supervisors with three new sectoral EU-level authorities (for banking, insurance, and securities markets), and
• A European Systemic Risk Council, which would monitor systemic risks and address them through coordinated policy responses from EU member states.

The European Commission favors a systemic risk board to sound the alarm when it perceives a critical buildup of risk. It has drafted a proposal to establish a European Systemic Risk Board (ESRB) that is in charge of EU-level macroprudential regulation and supervision. It would be headed by the president of the European Central Bank (ECB). Although the ESRB would identify risks with a systemic dimension, issue risk warnings, and, if necessary, recommend specific actions to avoid the buildup of wider problems, it would not have any binding power to impose measures on member states, that is, its recommendations would not be legally binding. In addition, the role of monetary policy in financial stability is not clearly specified particularly when the demands of price stability and financial stability clash. These limitations could significantly weaken the role and performance of the ESRB as Europe's regional systemic stability regulator.

The EU recognized a second problem as well: the system for supervising cross-border banks is flawed, and the question of who should be in charge of Europe-wide bank oversight remains unanswered. The European Commission has drafted a proposal to establish a European supervisory authority to carefully monitor large cross-border financial institutions. Finally, new European Union laws are likely to require banks to strengthen capital cushions, liquidity, and counter-cyclicality.

4.3 Alternative Models

There are several models for systemic stability regulation, including a fully integrated model, a la Singapore; a central bank-led model as in the pre-1998 UK; and a coordinated “council” model. Although the fully integrated model could be ideal from the perspective of promoting financial stability, its establishment is now increasingly difficult due the rising demand for central banks to be independent from the government and political process. The central bank-led model is also possible, but it bears the risk of government interference particularly at the time of crisis management and resolution, threatening the independence of the central bank. However, in countries—particularly in many developing and emerging economies—where the central bank is not independent, this model will likely remain viable.

A realistic approach for most developed countries would be to establish a workable “council” approach, where the national financial authorities (the central bank, supervisor(s), and finance ministry) work collectively, as if they formed a single systemic stability regulator, to perform the stability regulation function. There exist frameworks for financial crisis management in the US, the UK and Japan (see Table 4 [ PDF 50.1KB | 1 page ]). The “council” approach would be, in a sense, an expansion of this framework to address broader issues of crisis containment, including crisis prevention. But this should not be a mere expansion of the existing frameworks.

For such a “council” approach to function successfully, the collective objectives and mandates as well as the division of labor among the authorities should be clearly defined, sufficient capacities and resources should be provided collectively, and all the necessary macroprudential tools should be made available for use. Most importantly a culture of sharing information should be developed and there should be intensive dialogue among the financial authorities.

The central bank has a comparative advantage in macro-financial surveillance and may or may not have macroprudential authority (particularly tools). If the central bank does not have macroprudential authority, then it could still suggest the supervisor(s) to take certain macroprudential actions (such as an increase in capital adequacy ratios, a reduction of loan-to-value ratios, etc) to contain a buildup of systemic risk. Similarly, the supervisor(s) can suggest that the central bank alter monetary policy to contain systemic risk.

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