The Evolving Role of Central Banks

5 Prudential Supervision and Monetary Policy

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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Central banking and the supervision and regulation of financial institutions and markets are key governmental functions in any modern economy. In general, the government reserves for itself the right to issue money—a privilege that is often enshrined in the constitution itself. But in a modern mixed economy, monetary functions tend to be shared by the central bank and commercial banks, be they public or private institutions.

Typically, the country’s central bank is given the exclusive authority to determine the quantity of currency in circulation. It also exercises authority over other types of money, such as demand deposits, that represent liabilities of other financial institutions. These financial institutions play important roles as depository institutions, sources of credit, and as financial intermediaries. In addition to being creditors and debtors to the rest of the economy, the financial institutions also perform payment services.

It is therefore appropriate to describe the financial system as the nerve center of a modern nation, without which it could not prosper. Given this key function of the financial system, it is not surprising that governments take a keen interest in the health of financial institutions and markets as well as the payments system.

The fundamental question to be addressed in this paper is whether the central banking function and the supervisory and regulatory functions should be combined in one institution, such as the central bank or the monetary authority, or whether supervisory and regulatory functions should be delegated to a separate supervisory agency. Posing the question as a simple choice between the need for one or two institutions to exercise the central banking and supervisory and regulatory authority is an oversimplification of a complex set of problems and issues. A modern economy needs a broad range of financial institutions and markets, and the question as to which institutions should exercise, regulate, and supervise these functions is also complex. It is therefore no surprise that in a modern economy several regulators exercise these disparate functions. The search for a simple, all encompassing framework will be difficult at best and lead to endless frustration at worst.

Policy Functions

First among the various financial functions that need to be exercised in a modern economy is the monetary policy function. Monetary policy encompasses the issuance of currency and the control of the monetary aggregates. Because liquid liabilities of depository institutions serve as money, the control over the aggregate amount of such monetary liabilities is a core element of monetary policy. Given the institutional structure of modern banking systems, this implies the need for control over reserve requirements and the total amount of reserves in existence. Without pursuing the point any further at this juncture, it is clear that whatever institution stipulates the required reserve ratio of depository institutions, it will be involved in the monetary policy-making process as well as the bank regulatory process.

Second is the lender-of-last-resort function. In a two-tier banking system, some institution has to be the banker’s bank, by standing ready to supply high-powered money to the depository institutions. This function is tied intimately to the central bank’s role as the issuer of a nation’s currency. In nations without their own currency, the lender-of-last-resort function may be exercised by the central bank of the currency-issuing country or a large private bank of unquestioned standing.

Traditionally, the central bank performs this lender-of-last-resort function through the discount window. By setting the discount rate, a monetary policy function, the central bank sets the terms at which the individual banks have access to the central bank’s resources. If the discount rate is set below the market rate at which reserves are traded in the free market, a need arises to administer the discount privilege. In turn, this may necessitate a need for information to verify that this below-market discount rate privilege is not abused. If the discount rate is set above the market rate, such a need will not normally arise as banks have an incentive not to use the discount window, except as a true last resort. Under such circumstances, the fact that a bank actually utilizes the discount window may be an important indicator for the supervisory agency.

Of course, if the discount window privilege is used not only for liquidity purposes, but also to hide the insolvency or impending insolvency of an institution, this would be cause for concern. If the central bank lends only against sound collateral, the danger is minimized because under the circumstances the act of liquifying an illiquid asset cannot help to hide insolvency. As long as the central bank lends only on the basis of sound collateral, the need for direct supervision to prevent the abuse of the discount window is thereby minimized.

Third is the role of the central bank as the government’s bank. As such, it serves as depository for liquid funds owned by the finance ministry or the treasurer and manages and disburses these funds at the behest of the government. While these functions could also be exercised by private banks, governments need an institution of unquestioned integrity and reputation as their bank.

Fourth is the payment systems function, which encompasses the clearing and settlement of checks and electronic payments. Typically, central banks play an important role in the payment system, with transfers on the books of the central bank constituting final and irrevocable payment.

Clearly, some, or all, of these functions can also be performed by private sector financial institutions. Special precautions must be taken, however, to safeguard the system against the possible failure of a financial institution and the potential need to recast, or unwind a settlement. But while a nation’s central bank can well serve as the backbone of a national payment system, the issues involved are not at all clear when it comes to the international payment system. Nations are by nature reluctant to let official agencies of other countries perform this function and hence there is an important role for the private sector or an international agency.

So far, we have discussed the functions of a central bank as they are more narrowly construed. We will now turn to the regulatory functions that may be exercised by the central bank or a supervisory and regulatory agency.

Bank Supervisory and Regulatory Functions

Rule-making authority is the broadest regulatory function that can be delegated to a bank supervisory agency. The legislature is the ultimate regular, rule-making authority in the country—save for a constitutional convention or the constitutional amendment process. Owing to the complexity of modern financial institutions and the everpresent need to adapt the regulatory environment to small institutional changes and market innovations, legislatures often find it convenient to delegate limited rule-making authority to regulatory bodies. This authority is generally confined to well-defined, narrow problem areas, but on occasion disputes regarding the legislative intent of the limits to an agency’s rule-making authority may emerge. Rule making tends to follow a framework and set of procedures that are not unlike the legislative process itself. Typically, draft proposals are put out for public debate and comment and are implemented only after long and searching scrutiny.

In contrast, cases brought before the regulatory agency by various parties are handled in a manner that more closely resembles judicial procedures. Cases are brought either by regulated entities that wish to engage in additional activities or be relieved of restrictions imposed by previous regulatory decisions, or by other parties that wish to enjoin the regulated entities from engaging in certain activities or force them to offer additional services. By their very nature, cases are more closely related to the supervisory process and frequently arise out of the supervisory process itself.

Both rule making and case decisions can influence profoundly a country’s banking structure. Over time, the cumulative effect of changes that are in and of themselves only marginal can be substantial, and the regulatory agency can thereby exercise quasi-legislative functions.

Key areas of regulatory activity are in defining the charter provision for banks and the granting of charters under these provisions; the ongoing administration of banking institutions, including capital adequacy, liquidity, and related balance sheet requirements; the authorization to engage in specified activities; and the approval of expansions, mergers, and acquisitions. Finally, the ultimate supervisory responsibility rests in the authority to withdraw the charter and force the dissolution of the banking organization.

Competing Interests

In addition to the regulatory and supervisory functions, financial institutions may also have to adhere to the rules and regulations established by other regulatory bodies. In particular, this may include the insurance funds for deposits in financial institutions. The interest of the insurance fund in regulatory issues will be heightened if the financial institutions to be insured have the option of seeking a charter from any one of several different supervisory and regulatory agencies. Under these circumstances, the insurance fund must make certain that the institutions are properly supervised and are adhering to certain minimum risk standards. This problem is less likely to arise in those countries where one single regulatory agency imposes a uniform set of standards upon all insured financial institutions. In that case, the insurance fund becomes a mere risk-pooling device rather than an agency that is concerned with the establishment of uniform standards.

Also, in many countries, a whole panoply of governmental agencies exists, such as the tax authorities, the securities and exchange commission (or its equivalent), and labor and employee health and safety commissions that also have a role in regulating financial institutions. It is therefore not surprising that in complex modern economies with sophisticated financial systems and high degrees of innovation, competing regulatory interests exist and maybe even a degree of tension and competition among various regulatory bodies. It is not surprising that competition is particularly evident in large countries with a federal structure and in countries that have a complex and differentiated financial system.

An extreme example is the United States, where competing regional and sectoral influences are further exacerbated by a governmental structure that emphasizes checks and balances at the federal level and the preservation of state’s rights at the regional level. This has resulted in a web of regulatory agencies that has resisted numerous attempts at reform designed to produce a more unified and coherent structure. It would be interesting to speculate to what extent a unified Europe might eventually resemble the complex U.S. regulatory structure a few decades from now.

Basic Tenets

At this juncture it may be useful to establish some basic tenets that may guide us in arriving at an answer to the question of whether supervisory and regulatory authority should be exercised by the central bank or lodged in a separate institution, and—if so—where the dividing line should be drawn. One, the institutional structure of the regulatory, supervisory, and monetary authority should promote a safe and sound, stable financial system. It should also promote the development of dynamic markets. Two, the role of the government supervisory and regulating agency should not be to micro-manage the various financial institutions but to prevent systemic failures and the risk of contagion. Three, the freedom of action of the monetary, regulatory, and supervisory agencies should not be unduly impaired by conflicting goals and purposes.

The goal of a sound and stable financial system is the central focus of all governmental regulatory and supervisory activity, as well as of monetary policy. It should include the activities of the government itself, such as the conduct of the government’s budgetary policy.

A stable financial environment necessitates the existence of a coherent and noncontradictory regulatory policy. Differences in regulatory and supervisory approaches lead to competitive advantages and disadvantages among financial institutions and thereby engender financial instability. For example, regulatory laxity is an aspect of regulatory diversity. It is easy for industry groups to plead that they should be accorded easier regulatory treatment when various regulators can be played off against each other. While the potential for competition in laxity among federal and state banking and regulatory agencies cannot be ruled out, the opposite—namely, competition in stringency—is also a real possibility when the government or even the public at large is looking for scapegoats in difficult times.

But competition on a regional basis, for example, between various state banking regulators, is difficult to control. On the one hand, there is the potential to attract entire branches of the financial service industry to one location by having a relatively permissive regulatory environment. This temptation on behalf of a state regulatory agency is particularly pronounced when the existence of a federal safety net provides protection to depositors lured by high interest rates made possible by a very lax state regulatory environment. On the other hand, the existence of competition among states and state regulators helps to avoid the creation of an overly powerful federal bureaucracy. In small countries, where there is no scope for the maintenance of several regional regulatory agencies, similar considerations may be brought into play by cross-border competition.

In sum, while a fragmented regulatory system may offer certain limited advantages by permitting experimentation and diversity in financial regulation, it is difficult to argue that regulatory diversity promotes stability, safety, and soundness of the financial system. For example, U.S. financial history provides little evidence to suggest that the existence of a multitude of regulatory agencies has served to enhance the safety and soundness of the U.S. financial system.

The potential conflict between macro- and micropolicy objectives is closely related to the question of whether the central bank or a separate bank supervisory agency should be involved in the day-to-day supervision of financial institutions. There are several reasons why one might argue that the central bank should be involved in the day-to-day supervision and regulation of financial institutions. First, the central bank can garner valuable insight into the overall state of the economy by being involved in the day-to-day supervision and regulation of financial institutions. Second, being able to influence bank policy through regulatory pressure might give additional force and impetus to monetary policy measures; however, in exercising this additional power, the central bank might easily cross the line from impartial macromanagement of the economy to credit allocation and micromanagement of individual institutions.

One may well argue that there is also the danger that impartial access to the discount window may not be given by a central bank that also has regulatory powers in case of a regulatory conflict between the central bank and a bank that it supervises. In other words, one can see certain advantages in the existence of the central bank as an independent and neutral lender of last resort, rather than as an institution that can leverage its own policy authority from one policy area to another policy area.

Central banks with supervisory and regulatory responsibilities have traditionally avoided such conflicts of interest by operating separate supervisory and monetary policy departments and have argued that the two functions are being conducted independent of each other. But if such “Chinese walls” exist within the central bank, then the argument that the supervisory and monetary policy functions should be exercised by one institution so as to take advantage of potential synergies does not hold water.

One can also easily envision situations where the monetary policy function and the regulatory function might result in a conflict of interest, for example, in times when the central bank is forced to pursue such a tight monetary policy that the very survival of many financial institutions is threatened. In such a situation, it may be difficult to separate the mandate for a sound monetary policy—which might drive interest rates so high as to threaten the existence of many financial institutions—from the mandate to maintain safe and sound financial institutions. In such a conflict, regulatory and supervisory actions may be delayed or not implemented so as not to exacerbate the impact of the monetary policy actions on the banking industry.

The alternative situation, namely, that monetary policy be conducted with excessive regard for supervisory concerns about the health of one or more financial institutions, would be potentially even more dangerous, as it might perpetuate inappropriate monetary policies that could, in the long run, actually worsen the problems confronting the nation. Of course, a central bank without supervisory responsibilities might also feel that it is limited in its freedom of action in a situation where the banking system is in a precarious situation; under these circumstances, however, the possibility of a direct conflict of interest is not present, and politicians and other observers cannot accuse the central bank of conflict of interest. Thus, it will be easier for the central bank to preserve its most cherished possession: its independence in the realm of monetary policy.

Preserving the Central Bank’s Independence

This brings us to the essential point: preserving the independence of the central bank in monetary policy matters. In most countries, the central bank acts pursuant to authority granted to it by the congress or parliament. Whatever legislative powers the legislature grants, it can also take away.

Bank supervision and regulation is a function closely related to the exercise of general governmental authority, that is, the executive branch. It is not a function that is independent of the government, but governmental agencies—such as the Justice Department—are directly and substantially involved as well. To put the matter differently, monetary policy is a macroeconomic activity that touches individual economic agents only indirectly, while regulatory and supervisory policy involves direct control by governmental agencies.

If the central bank assumes daily regulatory authority, it will get involved in the day-to-day exercise of governmental authority, which may in extreme circumstances involve the central bank in partisan politics—thereby unavoidably endangering its independence. This does not imply that the central bank cannot do an outstanding job in regulating and supervising financial institutions. As a matter of fact, I believe that the Federal Reserve has done an excellent job in that regard and has managed to stay clear of controversy and partisan politics. This has not been true for some other supervisory agencies in the United States. Just imagine the potential damage to the reputation of the central bank that might have resulted if the Federal Reserve had also been the supervisory agency for the thrift industry. At best, its prestige would have been blemished, and at worst, its independence in monetary affairs might well have been challenged.

The Track Record

It may be interesting to compare the track record of central banks that have supervisory responsibilities with that of central banks without supervisory responsibilities in achieving the central goal of monetary policy: a low inflation rate. Table 1 shows the inflation rate, as measured by the average annual increase in consumer prices during the period 1980–87, for central banks without supervisory responsibilities, for central banks that share the supervisory role, and for central banks that have main supervisory responsibilities.

Table 1.Supervisory Responsibility of Central Banks and Inflation Performance(Inflation rates are average annual rates for 1980–87, in percent)
Central Banks Without Supervisory Authority
Japan1.44.9(3.3 excluding Venezuela)
Central Banks Share Supervisory Authority
United States4.3
Central Banks with Supervisory Authority
Ireland10.266.2(9.6 excluding Argentina and Brazil)
South Africa13.8
United Kingdom5.7
Sources: World Bank, World Development Report, 1989; and Price Waterhouse.
Sources: World Bank, World Development Report, 1989; and Price Waterhouse.

Judging from the evidence provided by the limited sample of countries for which the evidence was readily obtainable, one may conclude that central banks without supervisory responsibilities were more successful in attaining a low inflation rate than central banks with shared or full supervisory responsibility. The average inflation rate for 1980–87 for countries with central banks without supervisory responsibility was 4.9 percent (or 3.3 percent if Venezuela, the only Latin American country in the group, is omitted). For the group of central banks that have shared supervisory responsibility, inflation averaged 6.5 percent, while it reached an annual rate of 66.2 percent for countries with central banks that have full supervisory responsibility (9.6 percent if the two Latin American countries in the sample, Argentina and Brazil, are excluded). This evidence supports the notion that central banks that concentrate all their energy on monetary policy tend to be more successful in achieving the goal of price stability than central banks that have major supervisory responsibilities.

Of course, this apparent association between a good performance in attaining price stability and the absence of supervisory responsibilities may also be caused by other influences. One possibility that comes immediately to mind is the degree of independence of the central bank from the government. It may well be that independent central banks are better in attaining the goal of price stability and that these independent banks also do not tend to have supervisory responsibilities. But in a way, this argument, if found to be true, would support the basic hypothesis, namely, that bank supervisory responsibility is a governmental function that is unlikely to be given to a truly independent central bank. In other words, the supervisory role for a central bank does tend to be associated with significant strings in terms of greater dependence on the government. Of course, exceptions to this general observation, like the highly independent Bank of the Netherlands, which also exercises supervisory authority, exist as well.

While the supervisory and regulatory function may impede the monetary policy function, the reverse is true as well, particularly if the central bank as regulator is empowered with rule-making authority. It is easy to conceive of situations where the rule-making authority of the central bank overlaps or comes into potential conflict with the legislative function itself. In those situations, it is not unheard of that legislators approach directly the central bank and make their views felt.

Once this direct contact is established, two dangers emerge: one, legislators may also attempt to influence monetary policy actions, and two, the central bank may defer regulatory action in order to preserve its monetary independence. Under these circumstances, the regulated entities will not be served as well as they would be served by a regulatory agency for which such considerations do not apply, thereby permitting greater regulatory freedom. Thus, one might conclude that, on balance, a central bank might be able to exercise its monetary policy responsibilities better if it is independent of primary supervisory and regulatory responsibilities. This has also been suggested by most of the task forces that have made recommendations regarding a possible restructuring of the U.S. monetary, supervisory, and regulatory authorities.

Role of the Central Bank in Supervision

Having stated that for various reasons the central bank should not be the primary regulatory agency, I believe that there is still an important role for the central bank in the regulatory process that will enhance and supplement its monetary policy function. One can see this role of the central bank in setting rules that establish appropriate liquidity levels for the financial institutions and in monitoring adherence thereto. This includes the setting of reserve requirements to be held against monetary liabilities of the financial institutions. The role would supplement the central bank’s role as the lender of last resort and a monetary policymaker by extending the central bank’s authority over that part of the bank’s activities that has a monetary impact.

Such a split in supervisory functions between liquidity concerns, on the one hand, and general supervisory and solvency concerns, on the other, exists already in some countries, as well as in the international banking area. Here, the Basle Concordat provides for supervision of liquidity matters by the host country, while the home country, or the country of the bank’s domicile, has general supervisory authority, including solvency matters.

The proposal would extend the international division of labor to the domestic arena, with the central bank in charge of liquidity concerns and the other supervisory agency in charge of solvency and general supervision and regulation. For internationally active banks, this proposal would imply no significant changes, except that the home country supervision and regulation would normally be undertaken by a bank regulatory agency, while the supervision of foreign branches and agencies would be the responsibility of the foreign central bank.


We may conclude that while central banks generally have a good track record as bank supervisor and regulator, a conflict may arise between regulatory and supervisory functions, on the one side, and monetary policy functions, on the other. Such a conflict could result in an inflation rate higher than might be achieved by a truly independent central bank without supervisory responsibilities. Nonetheless, it makes sense to give the nation’s central bank limited supervisory functions in the liquidity area, as management of the money supply is a prime function of monetary policy. The supervisory and regulatory role pertaining to reserve requirements and liquidity ratios—as well as to the obligation of monitoring adherence thereto—can and should be exercised by the central bank.

This framework is similar to that agreed to in the Basle Concordat for international bank supervision, where the supervision of the liquidity position of foreign branches and agencies is delegated to the host country, while general supervision and regulation is performed by the regulatory and supervisory agency in the bank’s home country.

By giving the major supervisory and regulatory responsibilities to a banking agency, while focusing the responsibilities of an independent central bank on monetary policy and supervision of liquidity, a possible conflict between supervisory and regulatory concerns and monetary policy objectives will be avoided and both national goals, the maintenance of a safe and sound financial system and an inflation-free environment, may be realized.

*The author is President of Visa U.S.A.

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