Banking Soundness and Monetary Policy

18 The Supervisory Role of the Central Bank

Charles Enoch, and J. Green
Published Date:
September 1997
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It is quite naturally assumed nowadays that responsibility for monetary policy devolves upon the central bank. The question of who should be responsible for banking supervision, however, is much more controversial despite the historical backdrop concerning institutional responsibility. As Paul Volcker, former chairman of the Federal Reserve System, pointed out on the occasion of the one hundredth anniversary of the Banca d’ltalia, some central banks, like those of the United States and Italy, were “founded much more out of concern about banking stability than out of ideas about monetary policy as we know it today.”1

The controversy over the role of the central bank centers on a basic question: is it preferable, for the effectiveness of monetary policy and banking supervision, that the institutions responsible for monetary policy and banking supervision be independent or come under the same joint authority, even be one and the same institution? The many different systems in existence reflect the history of individual institutions and the particular circumstances in each country. Neither economic theory nor an analysis of the institutional arrangements suggests that one particular model is objectively more effective than all others.

If one looks at the special features of the French system and compares them with the general principles underlying other countries’ arrangements, the wide range of possible approaches becomes apparent. But the French system seems to mix the advantages of having a banking supervisory function closely related to the central bank with those of it having a legal independent status. A further model (the planned European System of Central Banks, or ESCB) will add another element to this already complex picture.

Theoretical Issues in Banking Supervision

Theoretical analysis does not suggest that one institutional model for banking supervision is superior to all others.

Strategic Roie of Banks

Banking supervision is needed because of the strategic role that banks perform and because they are vulnerable to a crisis of confidence. A sound banking system is essential given the importance of the functions that banks perform in the economy: intermediation, maturity transformation, the creation and management of means of payment, and lending. Modern theoretical analysis identifies two particularly important services that banks perform in market economies, namely providing information and ensuring liquidity.

Banks also display two features that distinguish them from other businesses and are a source of fragility:

  • The highly asymmetrical structure of their balance sheets—in a simplified model, they have liquid liabilities whose value in nominal terms is fixed and claims that tend to be illiquid and difficult to value;2 and
  • The importance of interbank operations—a large proportion of transactions takes place among the banks themselves.

The first of these features makes the bank vulnerable in the event of a crisis of confidence, particularly if there is a “run on the banks” (as Milton Friedman, for example, has shown). The second feature can result in individual bank failures posing the threat of a systemic crisis.

Among the main tools of banking supervision policy, the monitoring of liquidity has implications for monetary policy.

Principally, the authorities supervise the banking system by controlling the activities of the banks (licensing, regulation, definition of the scope of banking activity, and so forth); by monitoring solvency (such as setting and supervising prudential ratios); and by monitoring liquidity (regulation of the money market so as to ensure it remains sufficiently liquid). It is in this third area that banking supervision impinges on monetary policy. In most countries, the monetary policy authorities pursue goals of internal (price) and external (exchange rate) stability primarily via the influence they exert on bank liquidity. The banking supervisory authorities, for their part, see it as their task to monitor movements in the banking system’s liquidity. This takes two very different forms. First, they need to ensure that the banks are supplied with an adequate amount of liquid resources, which are essential for the smooth operation of the payments system. Second, they must try to prevent liquidity crises that could be generated by the failure of individual banks.

Separating Monetary Policy and Banking Supervision

The arguments in favor of keeping monetary policy independent of banking supervision are frequently discussed.

The main argument in favor of preserving a separation between monetary policy and banking supervision is that combining them can lead to a conflict of objectives. For example, in its capacity as lender of last resort to banks in difficulty, the central bank could inject excessive liquidity into the system, thus endangering monetary stability. Such a conflict of objectives can also arise in the area of interest rate policy. A reduction in key interest rates may seem desirable to reduce the cost of resources to a banking system in temporary straits, but inflationary conditions in the economy as a whole may require interest rates to be kept high. This was the dilemma faced, and eventually overcome by, U.S. monetary authorities in the late 1980s during the savings and loan crisis. Finally, the requirements of external monetary stability can present another source of conflict. A sharp hike in interest rates may be used to protect the currency, but it may negatively affect banks’ profits.

The structure of a country’s financial system largely determines how serious these conflicts will be. In those countries where banks engage in maturity transformation, which results in a high degree of asymmetry in banks’ balance sheets, the conflicts are likely to be greater. The competitive conditions in the banking market also play a role. The more competitive the market, the more the banks are “price takers,” the less control they have over their lending and borrowing rates, and the more vulnerable their earnings are to changes in interest rates. Generally speaking, the effects of interest rate changes depend on how interest rates are determined (especially the relative importance of fixed and variable rates).

Charles Goodhart and Dirk Schoenmaker have pointed out a paradox here.3 The desire to separate the functions of monetary policy and banking supervision has been strongest in Germany, a country with perhaps the least risk of a conflict arising. The German financial system is dominated by powerful banking groups, most of whose resources are raised at fixed rates of interest. This means that their costs are not particularly sensitive to interest rate changes initiated by the monetary authorities. As a result, the latter can largely discount the effects of their decisions on banks’ earnings.

At the theoretical level, the existence of these conflicts can be explained by the fact that monetary policy is supposed to have a countercyclical effect, whereas banking supervision policy has procyclical effects. As a consequence, it is more difficult for the banks to observe solvency ratios in a period of recession, when profits are low and their level of indebtedness high.4 In cases where monetary policy and banking regulation are not separated, the banking supervisory authorities would come under considerable pressure to enable monetary policy to be eased—that is, make it less costly for banks to comply with the prudential regulations. In such circumstances, a complete separation of the two functions would appear to be the only way to resist such pressures.

Another argument in favor of separating the functions of monetary policy and banking supervision revolves around the role of market discipline. Ensuring the soundness of a bank is first and foremost the responsibility of its shareholders and managers. The principles of corporate governance, based on the sanction of the market, apply in full to the banks. In accordance with this approach, internal controls at the banks are the best way to avoid difficulties and bank failures. The main role of the banking supervisory authority should be to “monitor the internal controls in place at banks” so as to ensure that they are effective and operate properly. It is also accepted that the banking supervisory authority should be responsible for preventing the systemic risks that are associated with the interdependence of banks and that are ignored by the internal control systems designed to manage risk at individual banks.

To ensure that the discipline of the market is not prejudiced by any action taken by any supervisory authority, the latter must be independent. The effectiveness of the authority will be greatest if the banks are convinced that it will resist their pressure. If the supervisory authority is separate from the central bank, it cannot act as lender of last resort and cannot create liquidity to meet the demands of a bank in difficulty. Similarly, such an independent institution does nothave the power to manipulate interest rates to help the banks.

The independence of the supervisory authority, therefore, is a means of eliminating moral hazard, which considerably reduces the credibility and effectiveness of the authority. If the supervisory authority is not independent and banks believe that the central bank will come to their aid if they are in difficulties, they have no incentive to abide by the prudential rules and the discipline of the market. The greater the size of the bank in trouble, the greater will be the moral hazard, since senior executives at the bank know that their failure could have disastrous effects on the banking system as a whole. This is the “too big to fail” argument.

Thus, there may be cases where liquidity assistance to an individual bank may be needed to guard against systemic risk. However, rather than the lender of last resort facility, another solution is often applied, namely a guarantee of deposits by an institution that is independent of the central bank. Unfortunately, this solution does not entirely resolve the problem of moral hazard, as discussed later.

Arguments Against the Total Separation of Monetary Policy and Banking Supervision

Those arguments are less familiar, but just as important. There are two lines of argument against strict separation and in favor of coordinating the functions of the authorities responsible for monetary policy and banking supervision.

First, payments systems play a strategic role in the operation of a decentralized market economy. The considerable volume of same-day payments that pass through most large-value payments systems give rise to major potential risks of failure that could rapidly degenerate into systemic risk. During the past decade, the question of payment risk has become a major concern to the supervisory authorities, as evidenced by the Lamfalussy report and the Padoa-Schioppa report.5

The central bank’s role in managing, underwriting, and supervising the national payments systems is fundamental: it is one of the main arguments made by Chairman Alan Greenspan when defending the role of the Federal Reserve in the 1993–94 debate on a would-be Federal Banking Commission.6 Of course, the nature and scope of this role depend on the nature of the payments system concerned.

In net settlement systems and in gross settlement systems with overdrafts, operators are exposed to counterparty risk, which is greatest in net settlement systems where payments can be revoked (as with SAGITTAIRE in France). Failure on the part of a participant may involve a partial or total loss for counterparties (depending on the operational rules). The repercussions of such a loss can result in the settlement default spreading in a way that could destabilize the banks involved. In such circumstances, action by the central bank as lender of last resort would be needed to safeguard the system’s credibility.

The counterparty risk is minimized in gross (or real-time) settlement systems without overdrafts, since an operator’s standing is determined immediately; payment orders are issued and settled on a synchronized basis. On the other hand, such a system requires a higher level of intraday liquidity than the systems mentioned above. Operators are exposed to a continuous risk of illiquidity, which may hinder the operation of the settlement system. As a result, central banks need to monitor movements in liquidity and in some cases require operators to hold reserves in their books. Such a system is more secure, but the opportunity costs are correspondingly higher.

The security of payments systems tends to increase as the technology advances (real-time and synchronized gross settlements). However, not all the risks have been eliminated, and the settlement systems of different countries still present a varied picture. In the long run, once settlement systems are secure, the supervisory authority can be confined to a monitoring role. Until this ideal is realized, however, the central bank will still need to act as lender of last resort and in an operational capacity.

Finally, beyond their supervisory role, central banks may find it necessary to retain functional links with the payments system, since they need the latter for the purposes of regulating bank liquidity. Here, too, a potential conflict of objectives can arise if the volume of liquidity required to enable a payments system to function does not necessarily coincide with the volume required for the conduct of monetary policy.

A second argument against total separation of monetary and supervisory function relates to the central bank’s role as lender of last resort. There are two opposing theories regarding the lender-of-last-resort function as a means of eliminating systemic risk. According to orthodox theory, central banks should intervene only to assist banks that are illiquid but solvent and they should charge a penalty rate of interest (above the market rate) for such assistance. This argument was first set forth by Walter Bagehot in his famous book Lombard Street (1873) and has been adopted and developed by a number of later writers.7

A more recent approach supported by a growing number of economists, especially Goodhart and Baltensperger, suggests that the role of lender of last resort is necessary because of imperfections in the credit market.8 These mean, first, that the survival of an individual bank may be threatened in the event of a liquidity crisis and, second, that the failure of a bank may have destabilizing effects on the banking system as a whole. The starting point for this argument is the fact (mentioned above) that banks are potentially vulnerable because of the structure of their balance sheets. There is also an asymmetry of information between the bank and its clients. For example, it is difficult for the depositor to assess the quality of the bank’s assets. Given such an uncertainty the slightest doubt concerning a bank’s solvency could trigger a series of bank runs, and such a process could weaken, via the interbank market, other banks that had no liquidity problems at the outset.

In practice, this orthodox view of the central bank’s lender of last resort role is not in all circumstances adhered to. This is illustrated by the results of a recent survey of bank failures in 24 countries in the 1980s and early 1990s.9 Out of the 104 bank failures recorded, 73 were the subject of rescue operations in which the central bank was involved. The remaining 31 went into liquidation, 4 of them after unsuccessful attempts to rescue them.

Central banks see fit to intervene for various reasons. First, the difference between a liquidity crisis and a solvency crisis is difficult to discern in the short term. In principle, solvency is measured by comparing (actual or potential) losses with equity resources. But such an assessment takes time. Central banks usually have to act quickly to maintain the confidence of depositors and to stop any risk of the problem spreading or infecting the banking system as a whole.

Second, issues of moral hazard may motivate central bank intervention. As we have seen, there are two main ways of supplying liquidity to failing banks (excluding direct intervention by the government): intervention by the lender of last resort or a deposit insurance scheme. The latter option, which is often advocated by the orthodox school, is by no means clearly superior to the lender-of-last-resort facility. Deposit insurance schemes are usually slow to pay out compensation, because of complicated bureaucratic and legal procedures involved, and depositor confidence may suffer as a result. Moreover, the knowledge that depositors will be compensated in the long run does not encourage banks to improve their risk management. The lender-of-last-resort option is, it would appear, less subject to such criticisms. Not only can action be mounted very rapidly with the immediate restoration of depositor confidence but the central bank can also apply the doctrine of “constructive ambiguity” by creating a climate of uncertainty over whether or not it will intervene and to what extent. This is one way of discouraging banks from neglecting their responsibilities for sound risk management. Experience seems to show (see the above-mentioned survey) that direct intervention by the government (and hence the use of taxpayers’ money) is more frequent where a deposit insurance scheme is in existence. This could be taken as an indication that such a system is less efficient.

Linking Monetary Policy and Banking Supervision

The need for a link between monetary policy and banking supervision is thus established.

All in all, there appear no theoretical grounds for claiming the superiority of a banking supervisor that is strictly independent of the monetary authority. The different positions on whether banking supervision should be assigned to an independent body simply reflect differing conceptions of the role of the banks in the economy. Those in favor of an independent institution assume that banks are neutral, in the sense that their behavior has no impact on the functioning of the economy. This view is supported by those who claim to belong to the school of “new classical economics,” which dominates at the present time.10 Once banks are assumed to be neutral, there is no longer any reason to link banking supervision with the other objectives of economic policy.

If one rejects this assumption of banking neutrality, however, then the question of the links between monetary policy and banking supervision arises, since the smooth operation of the banking system becomes a real economic policy issue. Three lines of argument can be pursued against neutrality.

(1) Monetary stability seems to be closely linked to the stability of the banking system, and this relationship seems to work in both directions. The banking system is the main channel for the transmission of monetary policy and so a poorly functioning banking system diminishes the effectiveness of monetary policy. Likewise, a banking system can work properly only in a stable monetary environment (absence of inflation and relative stability of interest and exchange rates).

(2) Banking crises can have important repercussions on the operation of the real economy. This has been amply demonstrated by the theoretical analyses, often based on the study of historical experience, of, among others, Kindleberger and Minsky.11

(3) The economic and social cost of a banking crisis is usually greater than the macroeconomic cost of an injection of liquidity, especially since central banks have the means of neutralizing this liquidity, at least partially (through offsetting measures to freeze liquidity).

Once it has been accepted, for the reasons above, that the functions of monetary policy and banking supervision should be linked in some way, any institutional arrangements based on the complete independence of the authorities responsible for these two functions appear suboptimal, since independence provides the least favorable conditions for coordination. The chosen organizational structure must prudently divide responsibilities between the monetary and banking authorities, as well as coordinate their two functions and ensure they are carried out according to precise rules. Such an approach may take several different forms. For example, the responsibilities may be assigned to two separate departments within the central bank (as in the Banca d’Italia and the Bank of England until the reform) or to two separate but coordinated institutions (as in France, where the Commission Bancaire operates in close conjunction with the Banque de France). An intermediate option was adopted in some recent central bank laws by giving banking supervision a special, semi-independent status while maintaining the function within the central bank.12

The institutional arrangements proposed for the future economic and monetary union (EMU) embody an original approach to this question of separation. The two functions will be carried out at two different levels within the future European System of Central Banks. Monetary policy will be the responsibility of the European Central Bank, while banking supervision will be decentralized at the national level in accordance with the principle of subsidiarity, which does not rule out the most appropriate forms of cooperation: exchanges of information and views among the national banking supervisors, the national central banks (NCBs), and the European Central Bank.

Within this new institutional environment it therefore becomes less important whether or not the national banking supervisory authorities are independent, especially since the institutional process initiated in preparation for EMU has brought independence for the NCBs. In the past, when the NCBs were not independent, there was a danger that governments would put pressure on the monetary authorities to pursue permissive banking policies. Once the NCBs became independent, the danger disappeared. Thus, paradoxically, this new institutional environment creating supervisory bodies that are independent of the NCB could make banking policy more vulnerable to banking pressure groups and to political pressure. The credibility of banking supervision policy depends more on independence with respect to these operators than with respect to the central bank, as is underlined in international surveys.13

Moreover, independence from external pressures—and above all from political pressures—is one of the key requisites for efficient banking supervision. This tenet should be complemented by adequate coordination of banking supervision and monetary policy and by the appropriate staffing and resources.

All in all, contrary to the prevailing view, there are no conclusive theoretical arguments to support institutional independence between the monetary policy and banking supervision authorities. Instead, the recent trend in banking systems—and particularly payments systems—favors central bank involvement in the management of banking systems in collaboration with the banking supervisory bodies. The variety of experience among the different countries suggests that there is no single all-embracing model.

How Common Is Institutional Interdependence?

In practice, institutional independence is more common than might appear to be the case. It is common practice to distinguish between the U.S. and the European models of “universal banking.” In reality, there are at least three European models of “universal banking,” found respectively in Germany (where all banking activities, including market operations on behalf of clients, are combined in a single balance sheet), the United Kingdom (where market activities are delegated to subsidiaries), and France (where the banking groups are universal). The banking model has important implications for the supervision setup.


The French system conforms to the principles underlying the more general organization of banking regulation and supervision in France. The French Banking Act of 1984 (which has since been marginally extended) basically applies to the French version of the universal bank. It therefore covers almost all operators in France engaged in financial intermediation. The institutional framework established under the Banking Act is based on a strict separation of functions and bodies. It confers responsibility for supervising credit institutions on the Commission Bancaire, which replaced the former Commission de Controle des Banques, which was set up in 1941.

This system thus follows an approach (already 50 years old) embodied in an independent commission acting for the state, without formal legal personality or resources of its own, but fulfilling a quasi-judicial function. The French system of banking supervision is idiosyncratic. It is a three-tiered system, an essential feature of which is the very close relationship between the Commission Bancaire (responsible for supervision) and the Banque de France. The Commission Bancaire is the main body conducting banking supervision, notably through its general secretariat. Six members serve on the Commission Bancaire: the governor of the Banque de France, or his representative, as chairman; the directeur du tresor, or his or her representative; plus four other members appointed for a term of six years by the minister of economic affairs and finance. Of the latter, one is a member of the Conseil d’Etat, one a judge at the Cour de Cassation (thus representing two of the highest courts in the country), and the remaining two are appointed for their knowledge of banking and finance and are generally retired bankers. The chairman casts the deciding vote in the event of a tie.

The Commission Bancaire meets every two to three weeks. It has three essential tasks: verify compliance with banking laws and regulations and punish any breaches; examine the terms on which banks conduct their business and make sure that their financial situation remains satisfactory; and ensure that the rules of good professional conduct are followed. It thus exercises both administrative and quasi-judicial powers. Its role extends well beyond ensuring that credit institutions comply with the prudential standards.

The Commission Bancaire has a general secretariat (Secretariat general de la Commission bancaire, SGCB), to which it issues instructions on the supervision of institutions. Generally speaking, the secretariat drafts and implements the directives and decisions issued by the commission. Most of its staff are Banque de France employees seconded under the terms of a joint agreement. This ensures the consistency needed to conduct sound supervision.

There are three levels at which supervision takes place: continuous supervision by “data analysis” (“off-site” control), supervision by inspection visits (“on-site” control), and general oversight of the banking system. The SGCB is thus divided into three departments, which employ approximately 400 people:

  • microsupervision—permanent oversight of individual credit instituions and investment companies;
  • macrosupervision—legal affairs, European and international affairs, banking analysis, accounting, information technology; and
  • on-site inspections—led by Banque de France inspectors.

These arrangements were confirmed in 1993 when the Banque de France’s statutes were revised (to make the French central bank independent). It was felt by parliament that the combination of an independent commission and a general secretariat whose functions were performed by Banque de France secondees was a sound arrangement, which also maintained the French judicial tradition of separating the functions of investigation and decision making.

The particular characteristic of the French system also derives from the separation of the three functions of regulation, licensing, and practical supervision and the assignment of official responsibility for these functions to bodies that are legally separate from both the central bank and the Ministry of Finance.

But the French system also ensures that there is cooperation between the ministry and the Banque de France in this area. The governor of the Banque de France and the minister of economic affairs and finance, or his representative (the Directeur du Tresor), serve on all three bodies. The Comité de la Reglementation Bancaire et Financiere (CRBF, or Banking and Financial Regulatory Committee), whose name is self-explanatory is composed of six members and chaired by the minister’s representative. The body responsible for granting authorizations (to set up a bank or make significant changes to its basic characteristics, such as the majority shareholder structure), namely the Comité des Etablissements de Credit et des Entreprises d’lnvestissement (CECEI, or Credit Institutions and Investment Companies Committee), is (like the Commission Bancaire) chaired by the governor of the Banque de France. In other words, the Commission Bancaire does not issue regulations or banking licenses but assists the competent authorities in those tasks.

The Commission Bancaire and its general secretariat naturally provide technical assistance to CRBF and CECEI. Moreover, they issue clarifications and elaborate specific regulations to make sure that they are understood and implemented by credit institutions.

The Banque de France is closely involved in the three tiers of banking supervision, particularly through staff links. These three committees are politically independent and formally independent one from the others. However, because of the need for close cooperation among them—after all, they have joint overall responsibility for ensuring that the French banking system is sound—they maintain links at the institutional (or departmental) level so as to operate effectively in tandem and strengthen their relationship with the central bank. Indeed, the catalyst for the permanent collaboration among the committees is the Banque de France. The committees meet to make decisions, but the preparation for these decisions and their implementation are undertaken by Banque de France personnel.

This means that the Banque de France is primarily responsible, on an on-going basis, for staffing the permanent secretariats of these three bodies. In the case of the Commission Bancaire this is stipulated in the Banking Act. Apart from seconding staff, the Banque de France also provides logistical support to the three bodies and access to some of its electronic data files. The SGCB has access to the qualitative information gathered by the Banque de France’s network of branches. These perform a strategic function in the preparation and conduct of banking supervision, although their role is probably more discreet than that of the land central banks in Germany.

The fact that the seconded staff of these committees are recruited and trained in accordance with the same principles and share the same methods and aims is one of the great strengths of the French system. However, to ensure that those working for the banking supervisory body have an understanding of market practices and to stimulate an exchange of views between supervisors and the supervised, an exchange arrangement has been in operation for some years, allowing temporary job swaps between the main banks and the SGCB. This provides an opportunity for supervisors, released by the SGCB for about two years at a time, to learn more about the outside world and for bankers to gain some insight into banking supervision as well as to contribute some of their own expertise. To exploit the full benefits of this system of staff secondments from the Banque de France to the Commission Bancaire, some additional recruitment takes place for specific purposes.

Finally, thanks to the natural mobility of central banking staff, it is possible, for a Banque de France official to alternate several times between departments concerned with the formulation or conduct of monetary policy and the SGCB or the Banque de France’s Direction des Etablissements de Credit, which acts as secretariat for the CECEI. It should be noted, however, that such career switches do not impair the effectiveness of the “Chinese walls” erected between the central bank and the banking supervisory authority. For example, except in the performance of its statutory duties, the Banque de France has no access to information provided by the SGCB on the quality of a given counterparty. The SGCB is bound by the rules of professional secrecy, under the terms stipulated for the sharing of information between bodies with statutory duties in the fields of banking and finance, not to reveal certain details of a bank’s operation.

The special relationship between the banking supervisory body and the Banque de France is particularly important with regard to on-site inspections, which serve to complement off-site controls. The number of visits conducted directly on banks’ premises is increasing in France, as in most other major countries. In addition to their traditional task of conducting comprehensive examinations of individual bank’s activities, inspectors also undertake across-the-board analyses of particular themes covering the whole banking population and specially targeted emergency inspections. This last type of inspection is becoming more common, in line with current trends, for example in the United States.

Those engaged in off-site supervision maintain close contacts with all regulated banks and with those who carry out targeted on-site inspections. As a result, it becomes easier to prevent a banking crisis, or, at least limit the extent of its fallout. To this purpose, the Commission Bancaire employs a wide range of suitable sanctions and may rely on numerous options for intervention.

As soon as the Commission Bancaire identifies a problem that is not yet beyond repair (it has not resulted in a net liability position or an overt liquidity crisis), it acts very quickly and discreetly to help restore normality. At the same time, the commission may initiate disciplinary procedures in which the rights of the bank to defend its actions are rigorously protected. The sanctions may range from the issue of a warning to the withdrawal of authorization. (In between these extremes, it may prohibit or limit the conduct of certain operations, levy fines, and temporarily suspend or permanently dismiss senior bank management.) If the Commission Bancaire finds that a bank is no longer adequately managed, it must take appropriate steps by appointing a provisional administrator, who will cooperate with the official receiver. If the situation degenerates to the point where the bank cannot be saved, the commission must withdraw the bank’s authorization and appoint a liquidator. Recommendations to take enforcement action against individual institutions are made by the general secretariat but must be approved by the commission itself. While doing so, the Commission Bancaire acts as an administrative court. Enforcement actions are generally not made public at the time they are taken.

Supervision cannot prevent every bank failure, because, however promptly and effectively the commission acts, its supervision is always carried out after the event and it cannot get involved in the actual management of a bank.14 Besides, when economic conditions are difficult, the situation of individual banks can deteriorate very rapidly. This is why the handling of crisis situations forms an integral part of the Commission Bancaire’s work, while preventing them requires it to liaise more closely with the two other parties involved in the monitoring process, namely the external auditors and the persons responsible for exercising internal controls on behalf of the shareholders.

In France, the position of shareholders is not the same as that of U.S. bank shareholders vis-a-vis the Federal Deposit Insurance Corporation (FDIC). In France a bank shareholder’s financial liability is not limited to his or her share of the capital held.15 For this reason, the governor of the Banque de France, under Article 52, first paragraph of the Banking Act, may, in his capacity as chairman of the Commission Bancaire call upon the shareholders to provide the bank with the support it needs. Moreover, in exceptional circumstances the governor of the Banque de France may, under Article 52, second paragraph of the Banking Act, “arrange for the assistance of the credit institutions as a group with a view to taking the measures needed to protect the interests of depositors and third parties, ensure the smooth functioning of the banking system, and safeguard the reputation of the financial center.”

Such emergency measures are always the result of a long period of discreet consultation. Much of the Commission Bancaire’s work toward crisis prevention and resolution is carried out quietly. Nevertheless, while prudent intervention (which does not seek to prolong the life of an institution with no hope of recovery) costs society less than a series of badly managed failures, the moral hazard that can result from such intervention, despite all threats of external sanctions, makes the authorities extremely cautious about implementing these two provisions of Article 52 (especially the appeal for assistance from regulated banks).

It is important that shareholders should be made aware of their responsibility for ensuring full implementation of statutory, regulatory, and legal provisions strengthening corporate governance at banks and the companies that own them. In particular, the CRBF has recently approved a regulation on internal controls at banks, which encourages setting up audit committees and sets the powers of internal control departments; the latter must be independent of the operational areas and report directly to the bank’s board and shareholders, the banking supervisor in the SGCB, and the external auditors. Moreover, closer cooperation between the latter and the SGCB follows a trend already well established in Europe.

Other Countries

Because they often share the same concerns, banking supervision systems in various countries are developing along similar lines, despite very different institutional traditions. Specifically local elements means, however, that it is not possible to arrive at a single standard “model.” While governments are generally responsible for drafting banking regulations, the authorities responsible for issuing banking licenses vary considerably across countries and a precise classification becomes somewhat irrelevant.

Japan is traditionally cited as an example of a country where regulatory powers are concentrated to a large degree in the Ministry of Finance. Usually the ministry lays down the general principles underlying the regulations, and the supervisory body then operates on the basis of documents that are more technical and specific. As far as the European Union is concerned, Austria, Germany, and, in some respects, France (see above) conform fairly closely to this model. Belgium, Finland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, and the United Kingdom conform to it partially. The Danish Finanstilsynet, whose instructions have the force of regulations, belongs to that country’s Ministry for Industry.

However, when their individual characteristics are taken into account, countries are less easy to categorize. In Germany, for example, under the arrangements governing the drafting of regulations, the Bundesbank, whose consent is required in certain (monetary) matters, must be involved in the regulatory process, and the Federal Banking Supervisory Office (BAK, an independent body) issues instructions that flesh out the regulatory framework laid down by the federal Finance Ministry. In the United Kingdom, because of the flexibility of the legal framework that governs the relationship between the Treasury and the Bank of England (and the latter’s powers), the question of which agency holds the respective powers to issue and to implement regulations becomes less relevant.

The situation regarding the licensing rules (issue of an authorization to conduct banking business) varies quite fundamentally. Leaving aside France, European countries are apparently divided between those in which the supervisory authority, whether it is the central bank or an independent body, is also the licensing authority for the banks (Belgium, Germany, Greece, Italy, the Netherlands, Portugal, and the United Kingdom) and those in which authorization is granted by the Finance Ministry, often in consultation with the supervisory authority (Austria, Finland, Luxembourg, Norway, and Spain in the case of banks, Portugal in the case of foreign shareholders, and the Irish Republic).

Japan is one of the countries where the dominant role of the Finance Ministry is most marked. Here, too, a detailed study of the various branches of activity that require authorization serves to highlight the inevitable differences between countries.

In nine of the countries of the European Economic Area (Greece, Iceland, the Irish Republic. Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom), responsibility for conducting day-to-day banking supervision lies directly with the central bank. In only one European country, namely Austria, is the Finance Ministry directly responsible for supervision. The situation seems more complicated in the Scandinavian countries and in Belgium, France, and Germany, where the authority responsible for banking supervision is an independent body, sometimes with its own legal personality. Moreover, in a few countries this body’s competence extends to the financial sector generally, since it supervises the financial markets (as in Belgium) and even insurance companies (as in the Scandinavian countries). However, despite such legal autonomy, this body is usually linked (except in the case of Belgium) to either the central bank or the Finance Ministry (or the Ministry for Industry in the case of Denmark).

The central bank is usually either solely or jointly responsible for the conduct of day-to-day banking supervision, although the practical arrangements may vary significantly from one institutional setup to another. It is important to avoid being too categorical in such classifications. The dangers of such an approach are illustrated by even a cursory glance at Germany, where several organizations are involved in the task of day-to-day supervision. The central bank, particularly through the land central banks, carries out all the initial tasks of off-site supervision and monitors the general financial situation of banks. The professional associations monitor, by means of off-site and on-site controls, the solvency of their member institutions that enjoy their guarantee. Finally, the Federal Banking Supervisory Office is legally responsible for and administers the individual decisions taken under Germany’s banking laws. This offers a good example of the effectiveness of links between the banking supervisory body and an independent central bank.

The relationship between the banking supervisory authority and the central bank raises the issue of how such arrangements are organized, and in this regard a number of extremely interesting issues are worth considering: the practical consequences that could result from a radical reform of the Japanese system of banking supervision, the new arrangements for conducting supervision in the United Kingdom, or the extensive program, undertaken over the past few years, to consolidate the complex system of banking and financial supervision in the United States, In particular, whatever the complexity of the institutional debate in the United States, it is quite interesting to consider that the proposal to replace the current framework with a Federal Banking Commission was eventually abandoned, mostly on the grounds that a stand-alone institution might have lacked the vital contacts with the financial industry and the ability to efficiently tackle signals of potential liquidity crises.

A final element of both monetary policy and banking supervision is safeguarding the interests of depositors.16 The present paper has concentrated on the way that banking supervision impinges directly and immediately on monetary policy, via the monitoring of liquidity. In most countries, however, supervisors are also concerned with safeguarding depositors’ interests and those of the deposit insurance scheme—that is, with monitoring solvency.

There is no need to discuss here whether these two aspects of supervision are naturally separable and should be assigned to different sets of auditors. One might simply note two well-known models of deposit insurance and their supervision: in the United States (via a federal organization) and in Germany (via several professional organizations).

Supervision of depositors’ interests does not necessarily duplicate the work undertaken by other bodies even when the same risks are being analyzed (solvency, concentration of lending, and so on), since the approach, training, and methods needed for the two areas are different. Nonetheless, the question of the additional cost to the banking and financial sector as a whole cannot be overlooked.

Generally speaking, the need to strengthen and adapt the supervision arrangement should be met in three ways.

First, there should be better coordination between the different types of external controls currently exercised. The existing supervisory arrangements should be fully exploited, such as by improved cooperation between banking supervisors and external auditors. Steps have already been taken to this effect in France.

Second, continuous improvements are needed in the professional training given to supervisors. This is one of the basic concerns currently felt by all the major central banks and banking supervisory authorities. More focused and more frequent supervision is needed, requiring staff who, except in a few cases, are not career specialists in a narrow field but who can tackle a variety of problems at a very high level of competence.

Third, internal controls need to become more widespread within each institution.

What sort of link can be established between these “intermediate objectives” of banking supervision and the conduct of monetary policy? It could be found in an attempt to maintain the efficiency of the two central functions of the banking and financial system referred to at the beginning of this paper, namely providing information and ensuring liquidity, at a time when some parts of this system are changing at an ever-increasing rate. These functions also lie at the heart of monetary policy.


An analysis of the role of the central bank reveals a great diversity of approaches both in theory and practice among various countries. No conclusive argument at the theoretical level appears to support the view, which seems to prevail today, that the banking supervisory authority should be entirely independent of the monetary authority. At the practical and institutional levels, different countries’ systems operate according to very different principles but have still proved to be effective.

It should not really surprise anyone to hear that monetary policy cannot afford to ignore the demands of banking supervision. Likewise, if an ever-widening gap seems to be developing between principle, especially in the matter of strict functional separation, and practice, which is often characterized by a more or less officially acknowledged interdependence between institutions, this is probably inevitable. It may be frustrating to be unable to identify an abstract model that is superior to all the others in terms of preventing crises and minimizing the cost of adapting the banking and financial system to the trends in the underlying economy. But, from a practical point of view, there is no denying that, given the cultural and political framework in many countries (especially emerging countries), entrusting banking supervision to a special department of the central bank may be considered, at least in a first stage, as the most efficient way to address three basic requirements: independence from political pressures, coordination of monetary policy and banking supervision, and logistical reliability.

Most certainly, every national supervisory system is peculiar and cannot be transposed without caution, whatever its own efficiency: for example, the U.S. institutional framework might be extremely complex to manage in a country that lacked the adequate institutional experience of checks and balances and cooperation. The institutional arrangements arising from the EMU represent a new and original response to the question of the relationship between the central bank and banking supervisory authority. While still respecting, in accordance with the principle of subsidiarity and that of efficiency, the differences in the practical arrangements in different countries, the European System of Central Banks aims at a separation between monetary policy (to be decided at the European level) and banking supervision (to be conducted at the national level). The treaty is fairly clear on this point and meets with the political intentions of the economic and monetary authorities in the various countries. However, it is worth noting that the treaty does not rule out exchanges of information and views among national banking supervisors, the national central banks, and the European Central Bank. Nor does it preclude that the European Central Bank should participate in the debates over such general issues as the stability of the financial system and overall banking soundness.

In view of such diversity, there is no one simple answer to the complex question of the relationship between a central bank and the banking supervisory authority. Nor is there a list of criteria to help assess how effective the various countries’ systems of banking supervision are. It is clear, though, that no system places its monetary and banking supervision authorities in watertight compartments, and it is in both their interests to cooperate if they do not already have close institutional or operational ties. Such a pragmatic approach need not necessarily be a source of concern.

1Reported in “The Importance of Central Banks in the Modern World,” International Herald Tribune, January 4, 1994.
2D. W Diamond, and P. H. Dybvig, 1983, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, Vol. 91 (June), pp. 401–19.
3C. Goodhart, and D. Schoenmaker, 1992, “Institutional Separation Between Supervisory and Monetary Agencies,” in Prudential Regulation Supervision, and Monetary Policy, Milan, 1993, ed. by F. Bruni.
4Goodhart and Schoenmaker, “Institutional Separation.”
5Bank for International Settlements, 1990, “Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries” (The Lamfalussy Report) (Basle: BIS), European Commission, 1992, “Payment Systems in EC Member States” (The Blue Book) (Brussels: EC).
6See Wall Street Journal, December 16, 1993, for Greenspan’s comments.
7W. Bagehot, 1873, “Lombard Street: A Description of the Money Market” (London: Kegan, Paul & Co.). T. Humphrey, 1975, “The Classical Concept of Lender of Last Resort,” Federal Reserve of Richmond Economic Review, Vol. 61, pp. 2–3.
8E. Baltensperger, 1992, “Central Bank Policy and Lending of Last Resort,” in Bruni, ed., Prudential Regulation.
9Goodhart and Schoenmaker, “Institutional Separation.”
10New classical economics is based on two central tenets, namely the theory of general equilibrium and the hypothesis of rational expectations. Its chief advocates were the American economists Robert Lucas, Neil Wallace, and Thomas Sargent. One of the main proponents of the theory of banking “neutrality” is Eugene Fama.
11C. P. Kindleberger, 1978, Manias, Panics and Crashes: A History of Financial Crises (New York: Basic Books). H. Minsky, 1982, “The Financial Instability Hypothesis: Capitalist Processes and the Behavior of the Economy,” in Financial Crises, Theory, History and Policy, ed. by C. P. Kindleberger and J, P. Laffargue (New York: Cambridge University Press).
12J. Tuya, and L. Zamalloa, 1994, “Issues on Placing Banking Supervision in the Central Bank,” in Frameworks for Monetary Stability (Washington: International Monetary Fund).
13Tuya and Zamalloa, “Issues on Placing Banking Supervision.”
14For example, the Commission Bancaire does not have the power to issue instructions regarding commercial policy, deposit-taking arrangements, types of lending, and so on. It can do no more than identify, especially in the course of its targeted inspection visits and with the help of precise and rapid reporting, where decisions taken by a bank have led to financial problems. In such cases it will, for example, suggest a more suitable matching of resources to lending or appropriate risk-provisioning measures.
15This is also why an authorization to conduct banking business is, above all, conditional upon there being a “reference shareholder” to which the Commission Bancaire can turn before all other shareholders in the event of a liquidity or solvency crisis.
16This question was briefly touched on when discussing the emergency action that may be taken at the initiative of the governor of the Banque de France.

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