A great deal of discussion is taking place in a number of jurisdictions on the changes needed in regulatory structure so that the probability of financial crises arising again is minimised. The regulatory regimes have to be more effective over the cycle. There is general agreement on the need for putting in place a regime of macro prudential regulation and financial stability oversight. The issue under discussion in different jurisdictions is: Who will do it? Would it be a council of regulators, the central bank or the treasury?
The core concern behind such discussions relates to the location of responsibility for maintaining financial stability. Should central banks be made responsible, and also accountable, for maintaining financial stability?
Macro prudential regulation is increasingly seen to be among the key means for maintaining financial stability. That requires the imposition of prudential regulations in the light of some macroeconomic or overall financial trends that need to be acted on. If the central bank is only a monetary authority and a separate agency, like the Financial Services Authority (FSA) of the UK, is responsible for financial regulation and supervision, how is coordination to be achieved so that such action can be implemented? The US has had a very fragmented regulatory structure, whereas the UK had placed all regulatory responsibilities for all segments of the financial sector in the unified FSA.
In the rest of Europe, monetary policy got centralised in the European Central Bank (ECB) but financial regulation has remained fragmented at national levels.The US Federal Reserve System has had significant regulatory responsibilities but regulatory failures were significant in all North Atlantic financial systems, with the exception of Canada. The ongoing efforts to undertake significant regulatory reform in the US, the UK and in the eurozone illustrate the lack of consensus on what kind of regulatory structure constitutes best practice for promoting financial stability.
The UK is abandoning its experiment of completely separating financial regulation from the central bank and the FSA is now being folded back into the Bank of England. The governor of the Bank of England will now be responsible for monetary policy, financial regulation and financial stability, an arrangement similar to that prevailing in India. Consequent to the crisis, it is felt that the central bank can better exercise its responsibility for financial stability if financial regulation also comes within its purview.
The US Treasury had initially proposed that all banking regulation be unified in a single agency, while placing greater responsibility on the US Federal Reserve for maintaining financial stability. In the reform Bill that has finally been passed, systemic risk will be formally assessed by a new Financial Services Oversight Council, which will be composed of the main regulators and chaired by the treasury secretary. It will focus specially on Systemically Important Financial Institutions (SIFIs) in order to prevent institutions from getting too big to fail. Any emerging SIFIs, including non-banks, will be put under the regulation of the Federal Reserve.
Regulatory jurisdiction has been simplified and clarified, with the Fed handling systemic institutions; the Office of the Controller of the Currency (OCC), national banks; and Federal Deposit Insurance Corporation (FDIC), state banks. The only agency being eliminated is the Office of Thrift Supervision. It is yet to be seen how these new arrangements will function. What is clear, however, is that there is now much greater appreciation of the role of the central bank in maintaining financial stability and in regulating SIFIs of all varieties, not just banks.
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Having worked in both the central bank and the treasury, I really do not believe that effective macro prudential oversight or financial stability oversight can be done without the central bank being at the helm of this activity. Any kind of group can be set up depending on the country’s overall regulatory set up, including the treasury and the heads of the other regulators. The central bank is the lender of last resort, it is also the only agency which has an overall view of the economy, along with exceptional stability in terms of staffing and continuity in thinking, relative to most treasuries. It also has its ear to the ground with respect to evolving developments in all financial markets if it does its job well as a monetary authority.
Our own experience is that the Reserve Bank of India (RBI), as both the monetary authority and the lead financial sector regulator, has been able to supplement its monetary policy very effectively with prudential actions on a consistent basis. It regularly monitors credit aggregates, including movements in sectoral credit. Consequently, it could take macro prudential action when it observed excess credit growth, both on an aggregate basis and in particular sectors like real estate and housing. So, it increased the cash reserve ratio (CRR) to curb overall credit growth and imposed higher provisioning and risk weights for lending to the affected sectors.
As part of its supervisory activities, it also monitors the incremental credit deposit ratio carefully and cautions banks when such a ratio is found to exceed acceptable norms. It is also able to do forward-looking countercyclical capital buffering through increases in loan loss provisioning when needed. Further, when it observed regulatory arbitrage being practised by the lightly regulated non-banking financial companies (NBFCs) during 2005-07, it took measures to tighten their regulation towards reducing their potential ability to do excess leverage. This experience is a valuable example for practising the kind of proposals being put forward for implementing macro prudential polices as supplements to monetary policy as normally practised in a narrow fashion.
I do believe that given different countries with large variations in institutional legacies, traditions and systems, no one size can fit all. But at the same time, I think that the central bank does need to have a lead role as far as financial stability is concerned, within any kind of arrangement that is deemed fit in a particular country.
Extract from R K Talwar Memorial Lecture, Mumbai, July 2008. Full text of the lecture is available at: https://www.business-standard.com/404684/
The author is professor in the practice of international economics and finance and senior fellow at the Jackson Institute of Global Affairs at Yale University, and non-resident senior research fellow at the Stanford Center for International Development, Stanford University