2. The Central Banks and their function in:

Stanyo Dinov

Central Banks as a Bank Supervisor, page 19 - 28

A Comparison of the Function of the Bank of England, the Federal Reserve and the European Central Bank

1. Edition 2017, ISBN print: 978-3-8288-3993-9, ISBN online: 978-3-8288-6765-9,

Series: Wissenschaftliche Beiträge aus dem Tectum Verlag: Rechtswissenschaften, vol. 90

Tectum, Baden-Baden
Bibliographic information
The Central Banks and their function Originally the function of the banks1 in any society was one of custody and safe keeping. The role of the banks are to be financial intermediaries which carry out a number of key functions in the market economy.2 Although there is disagreement with regard to the number and relative importance of each of these functions, they are generally based on concepts of saving, credit and payment. CBs differ from the other banks due to the fact that naturally some of them become more influential and they also acquired the function to exercise states control over 2. 1 The terminus "bank" is defined in the UK through statutory law: s 2, 91 BA 2009, and Case Law United Dominions Trust v Kirkwood [1966] 2 QB 431. Lord Denning defined "bank" through three characteristics: accepting money, collecting cheques for customers and placing these at the credit of the customers’ accounts; honouring cheques or orders drawn on bankers by the customers when presented for payment, and debiting their customers’ accounts; keeping running accounts for customers in which debits and credits were entered. 2 Charles Goodhart, The Evolution of Central Banks, (Press Classic 1988), 86. For instance, they provide transactions, accounting services and portfolio management. 19 the domestic banking system.3 Beside these common features the historical evolution of the CBs is different from those of other banks.4 For instance, Bank of England (BoE) was a private bank and latter become a CB,5 in opposite to the Federal Reserve (Fed) and the European Central Bank (ECB) which were set up as a publicly directed institutions. The Fed wanted to differ from the centralised model in Europe6 and avoiding the name "Central Bank" a system was 3 Cf. Charles Goodhart (2), 2, 73. The transition of the BoE from profit-maximizing, competitive bank to CB did accrue naturally. Some CBs were set up as such ab inito. There are two different approaches, for instance, F. A. Hayek, Denationalisation of Moneythe Argument Refined, 3rd ed., (London Institute for Economic Affairs 1990, 77, 101 f.) argued that society does not need CB, but competition from banks. In opposition, M. A. Friedman, A Program for Monetary Stability, (Fordham University Press 1960), 6 f., supported the idea of the CBs as a banking regulator. Moreover, (F. Hirsch, The Bagehot Problem, (1977) Manchester School of Economic and Social Studies, Vol. 45, No. 3, 252) described that these approaches can be quite similar in either case. The voluntary club approach involves cartels. By the legalistic approach, ‘the regulatory bodies will feel some need to allow badly run banks to collapse, in order to avoid moral hazard, but will come under pressure to support larger banks in order to avoid system crises’. Therefore, the depositors will prefer larger banks as safer, which will lead to oligopoly. 4 Cf. European Central Bank, The role of Central Banks in prudential supervision, 8. CBs may benefit from their traditional focus on systemic risk, and from the knowledge of area-wide developments in money and securities market and in market infrastructure. 5 Charles A. E. Goodhart and Dimitri P. Tsomocos, Changes in Central Banking, (Cambridge University Press 2010), 122. The Riksbank in Sweden was also a private bank and later in 1668 become the first CB. 6 After the unsuccessful attempts to be created the First and the Second Bank of the United States. 2. The Central Banks and their function 20 created of twelve important US banks in the most powerful US states. Differently, the ECB was formed using the US federal model but with the idea to be a central and independent bank of sovereign EU-Member States (MSs). CBs are important institutions, because they have helped to guide the development of modern financial and monetary system and they play a major role in the economic policy.7 The adoption of CBs regulatory and supervisory role8 was founded in the nineteenth century.9 Regulation is distinguished systematically between two dimensions: in the narrower and the broader sense. Regulation in the narrower sense includes selected instruments of state economic law to create and enable safe competition on markets.10 Regulation in the broader sense is related to any form of governmental influence on the economy and com- 7 Ben S. Bernanke, The Federal Reserve and the Financial Crisis, (Princeton University Press, Princeton and Oxford 2012), 2. 8 Pan, Eric J., Challenge of International Cooperation and Institutional Design in Financial Supervision: beyond Transgovernmental Network, (2010) Chicago Journal of International Law, 243, 265 f. Supervision and regulation are different categories. Supervision is a distinctive form of regulation. As the regulation is related to rulemaking and setting rules, the supervision is connected with the monitoring and evaluating how these rules are applied from the financial institutions. 9 Charles Goodhart (2), 8. 10 Alexander Wellerdt, Organisation of Banking Regulation, (Springer 2015), 29. Both, a legislative and an administrative intervention are possible. By banking regulation, regarding statutory capital and liquidity requirements, organisational requirements as well as an administrative supervision and resolution, the state may interfere indirectly and directly in the financial sector. 2. The Central Banks and their function 21 petition on the market.11 The area of banking regulation is a form of regulation in the broader sense.12 Basically, there are two approaches about the main function of the CBs. The first one is the British uniform approach, where the CBs have at the same time the responsibility of monetary policy13 as well as the banking supervision.14 The idea behind this is that the CB have to prevent systemic risk15 and act as a Lender Last Resort (LLR) collecting all necessary information. Arguments in favour of conducting supervision from the CBs are: 11 Ibid. 12 Ibid. 13 Ben S. Bernanke (7), 3. The monetary policy have to achieve macroeconomic stability: stable economical and low and stable inflation. 14 Ibid., 4. CB plays a role in supervising the banking system, assessing the extent of risk in banks' portfolios. 15 Cf. BIS, Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten countries 1999, 6, ˂˃, accessed 18 June 2015. See Benjamin Geva, Systemic risk and financial stability: the evolving role of the central bank, (2013) Journal of International Banking Law and Regulation, 407ff. CBs have to limit the systemic risk in payment systems and financial markets. 2. The Central Banks and their function 22 (1) the use of information from banking policy and supervision, (2) the focus on systemic risk, (3) the technical expertise.16 16 Cf. European Central Bank (4). Yiwei Fang et. al., ‘Institutional Structure and Effectiveness of Central Banks during the Financial Crisis: An Empirical Analysisʼ in Syvester Eijffinger and Donato Masciandaro (edt.), Handbook of Central Banking, Financial Regulation and Supervision, Edward Elgar, Northampton 2011, 185. 2. The Central Banks and their function 23 In order to carry out their obligations independently, the CBs have in this case to separate strictly the function of monetary policy from banking supervision.17 17 Cf. Charles Goodhart/Dirk Schoenmark, Should the function of monetary policy and banking supervision be separated?, (1995) Oxford Economic Paper, 546. Otherwise there will be a conflict of interests. For instance, where the monetary policy aims a higher interest rate in order to maintain an exchange rate or to bear down inflation; the regulatory authority, which is freighted about the adverse effect such as higher interest rate might reflect the profitability and solvency of the banking system. In addition, some part of private sector might expect that the CB are influenced by financial system stability considerations when determining monetary policy. However, in the UK such a conflict of interests is of a magnitude less important than those between purely monetary objectives and political imperatives. See Frederic S. Mishkin, ‘Macroprudential and Monetary Policies’, in Douglas D. Evanoff and others edt., The Role of Central Banks in Financial Stability: How Has It Changed?, 409 f. In the standard view there is a dichotomy between monetary policy and banking supervision where the supervision includes micro as well as macro oversight. The two types of policy have to be conducted separately, where monetary policy must focus on minimizing inflation and output gaps and the prudential regulation and supervision have to prevent excessive risk-taking that could affect financial industry. The lack of equilibrium between these two types of policies led to the financial crisis. See Charles A. E. Goodhart and Dimitri P. Tsomocos, (5), 133. There is a tide of establishing separate universal FSA like in Germany, Japan and Korea. See Claeys S. and K. Schoors, ‘Bank supervision Russian style: Evidence of conflict between micro- and macro-prudential concernsʼ, (2007) Journal of Comparative Economics, 630-657. Empirical evidence of micro- and macro-prudential objectives in the CB of Russia. See Benjamin Born a. al. (16), 252 f. ‘Jackson Hole consensusʼ leading to a common understanding that the two goals should be conceptually separated. 2. The Central Banks and their function 24 The second approach is the so called German model, which separates the function of the monetary policy belonging to the CBs and the banking supervision which is given to another independent authority.18 In the UK a proponent of this model was the former British prime minister Gordon Brown with his reformative Financial Services and Markets Act (FSMA) 2000. Arguments in favour of separation are: (1) avoiding potential conflict of interest between monetary policy and supervision, (2) the tendency of financial conglomerates to be active at the same time on different banks, security and insurance markets. The supervisory authority could monitor effectively overall risk exposure in these large and complex financial groups, (3) the need to avoid excessive concentration of power in the CBs.19 Following these approaches it could be considered that the CBs' main task is to be a central regulator in the national banking system. For some CBs like: BoE, Fed and ECB this 18 Cf. Charles Goodhart/Dirk Schoenmark (17), 541; Thortnton (1802); Bagehot (1873). The CBs should act in a public good and not as a private competitor for business. 19 European Central Bank (16), 5. 2. The Central Banks and their function 25 involves also carrying out banking supervision.20 However, all CBs contribute to financial stability through their influence on banking regulation relating to liquidity and capital.21 The CB role of banking supervision includes the duties of: (1) investor protection, and the financial institutes' obligations on the issuance and enforcement, conducting business and disclosing information rules, (2) micro-prudential supervision, including all on and offsite surveillance of the safety and soundness of individual institutions aiming to protect depositors and retail creditors, (3) macro-prudential analysis which encompasses all activities for monitoring the exposure to systemic risk and identifying potential threat arising from macroeco- 20 Cf. Group of Thirty, ʻThe Structure of Financial Supervisionʼ 2008, 24 f., 31, ˂ papers/fa0223cb1-837-3-e.pdf˃ accessed 8 August 2015. See Guynn Randall D., Global Financial Crisis and Proposed Regulatory Reform, (2010) Brigham Young University Law Review, 421, 462. G 30 report set out four alternative regulatory approaches regarding the financial supervision: the Institutional (one institution is permitted by its regulators to extend into new business lines within the existed entity); the Functional (supervisor is determined by the business that is transacted by the entity); the Integrated (a single universal regulator conducting both safety and soundness and business regulation); the Twin Peaks (where the supervisory function are separated between two regulators). As well in the UK, this has been adopted in the Netherlands and Australia. Nevertheless, in Australia the prudential regulator is independent from the CB. 21 Howard Davies and David Green, Banking of the Future, (Princeton University Press), Oxford 2010, 69. 2. The Central Banks and their function 26 nomic or financial market development or from market infrastructure.22 Besides these functions, the CBs are responsible for: – advising governments regarding monetary policy, – raising money for the government through managing short-term and long-term funding by issuing bills and bonds, – managing the interest rate, – issuing banknotes, – controlling the payment systems, – lending money with low interest rate to other banks, – controlling the national currency reserves, – acting as a LLR for other banks and creating confidence in the banking system, – liaison with international bodies.23 22 Cf. European Central Bank (16), 3. See Benjamin Geva (15), 409, Macro-prudential regulation focus on risks to financial system as a whole, with a view to protecting the real economy from severe disruptions in the provision of financial services. 23 Cf. Stephen Valdez and Philip Molyneux, An Introduction to global financial markets, 7th edn., (Palgrave Macmillan 2013), 57; Richard Roberts, Inside International Finance, (Orion Business Books), London 1999, 99 f. 2. The Central Banks and their function 27

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As a result of the Global Financial Crisis in 2007, the financial and bank supervision in many countries was reformed. Stanyo Dinov investigates the Central Banks of the three advanced financial systems – the UK, the USA and the EU – and the questions related to their supervisory role. All three banks historically and symbolically represent different legal systems, influenced by each other and comparable to one another. They all represent the model of free market economy, whose roots began with the idea of economic liberalism and wellbeing from Adam Smith. The legislators in the UK, the USA and the EU have chosen solutions that are in some ways similar though in other ways different to reform these financial systems. Therefore, on the basis of their historical development, the author presents and compares the post-crisis reforms by these three systems, with the main focus on the CBs’ role as banking supervisor. Existing problems are discussed and some alternative solutions are presented.