28 June, 2022


Why Financial System Stability Should Be A Function Of Central Banks

By W.A Wijewardena –

Dr. W.A. Wijewardena

Dr. W.A. Wijewardena

Central banks to produce inflation free worlds

Traditionally, central banks have been mandated to attain two objectives. One is to keep the value of money it has issued at a stable level known as ‘the price stability objective’. In the laymen’s language, this objective is known as maintaining an ‘inflation free world’ but in actual practice, it means maintaining an inflation rate at a very low level, say around 2 to 3%, so that it would not discourage people to save, invest and plan their activities taking a long term view of what they will do in the next five to ten years.

How this objective relates to Sri Lanka was discussed in a previous article in this series titled “Central Bank’s mandate is to attain both ‘economic and price stability’” (available here ).

Supervision of banks to be overridden by monetary policy objectives

The other is to maintain the financial system of the country – the institutional setup consisting of banks and other institutions that provide financial services to people – with no failure or disruption of the system known as ‘the financial system stability’ objective. In many central banks and even in Sri Lanka’s Central Bank before 2002, the price stability objective was the ‘supreme objective’ of the Bank meaning that it always overrode the financial system objective if the latter stood in the way of a central bank’s realisation of the price stability objective.

There is a valid economic reason for elevating the price stability objective to this supreme position. That is the conflict that arises when a central bank tries to attain both these objectives at the same time forcing it to seek to attain only one at a time. If a central bank has to sacrifice its ‘inflation-free-world objective’ simply because it had to support the banks and other financial institutions, it would be criticised later for having failed the main job it is supposed to do in an economy. That main job is to maintain the value of the money it has produced at a stable level.

Compromising the price stability objective

To attain economic and price stability, a central bank is required to keep the money supply of the country at an appropriate level so that the total demand for goods and services, known as the aggregate demand, is just equal to the total supply of goods and services, known as the aggregate supply. If the aggregate demand is higher than the aggregate supply creating an excess demand and generating pressures for inflation to rise, the central bank is required to cut down the money supply to a lower level. But if banks are in trouble and the central bank concerned has to bail them out by giving them temporary loans, it amounts to printing new money leading to an increase in money supply and thereby making it difficult for the central bank to keep inflation at a low level.

Since the prime responsibility of a central bank is to keep inflation at a low level, it has been argued that a central bank should not compromise its price stability objective with the financial system stability objective. This is the reason for allowing the price stability objective of a central bank to override its financial system stability objective when inflation has become the more pressing problem in an economy and the central bank has been taking measures to cut down the money supply to tame it.

The rush to separate bank supervision from central banks

When many countries in the world were hit by high inflation in 1970s and 1980s, a concern was expressed as to whether a central bank should have the financial system stability objective as one of its policy goals at all. The argument was that if inflation was the ‘public enemy number one’ and has to be defeated at all costs, keeping financial system stability as an objective of a central bank will frustrate its inflation fighting efforts.

This is particularly true when it comes to supervising and regulating individual banks and financial institutions. That is because when they are in trouble due to lack of enough cash with them to pay out to depositors – the so called problem of liquidity – the supervisor will have to ensure that they get enough cash to prevent a general banking failure. But if a central bank has to supply liquidity to an illiquid bank as the regulator and supervisor, then, the central bank is reduced to the awkward position of being the judge, supplier of money to pay the fines and bail-out agent.

Clearly, a single institution cannot perform all these three functions without giving a bad example to customer banks in the form of encouraging wrong practices among them – a problem known as the ‘moral hazard problem’ among economists.

German example of having a separate supervision authority to be followed by many others

Germany, long before these issues were brought to focus, had separated bank supervision and regulation from its central bank, Bundesbank. There was reason for Germany to do so because it had been very badly hit by hyperinflation during 1920s, inflation running at around one million percent per annum. Frightened by this dreadful experience, the German leaders did not want to do anything that will interfere with their central bank’s attempt at killing inflation. Thus, Bundesbank was made independent charged with only the inflation fighting objective which it has to achieve whatever the ground conditions prevailing in the country. Accordingly, the function of supervising and regulating banks was handed to a separate authority which was colloquially known as BAKred.

This German example was followed by the UK many decades later when it separated the supervision and regulation of banks from the Bank of England and set up a separate authority called The Financial Services Authority or FSA in 1998. After the East Asian financial and banking crisis of 1997-98, many countries in East Asia and the Pacific followed the British example and separated the bank supervision and regulation from their central banks. Australia (1998), South Korea (1999) Japan (2000), China (2003) and Taiwan (2004) are examples.

“Today, two aspects of financial system stability have to be handled by a central bank. The first is to introduce a system to ensure the overall financial system stability, known as macroprudential regulation of the financial system. The second is the implementation of the microprudential supervision and regulation of financial institutions. Since the financial system consists of individual financial institutions, the safety of each one of them will help central banks to ensure the safety of the whole financial system”

Central Bank of Sri Lanka rejects the separate authority idea

When the Central Bank of Sri Lanka underwent its modernisation phase during 2000-5, a proposal was made to the Bank too that it should shed its bank supervision function and set up a separate financial services authority to handle the subject, following the example set by its colonial master, the UK. This writer recalls that this proposal was examined in detail within the Central Bank and finally, A.S. Jayawardena, the incumbent Governor, chose not to follow the colonial master. He had several reasons to substantiate his decision.

First, the Central Bank had already developed its bank supervision function to a high level having recruited high calibre officers and trained them at the best institutes of training in the world, notably, the Bank for International Settlement, Bank of England and the Federal Reserve Bank in USA. If a new authority is set up, the Central Bank will have to lose its trained officers because the new authority will not be able to function effectively without trained staff. In the intervening years, the whole bank supervision function in the country will fail creating a chaotic situation – creating a hiatus according to A.S. Jayawardena’s words.

Second, A.S. Jayawardena very correctly reasoned that the Central Bank will not be able to perform its function as the ‘lender of last resort’ if the bank supervision function is taken away from it. This is because however much a new authority will be effective in supervising banks, a responsible central bank cannot rely on such an outside agency to support banks financially having compromised its inflation fighting objective. If the central bank is to pump money to fill the liquidity in banks, the whole process of supervising them should be handled by the Central Bank itself.

Third, the financial sophistication which the countries have gone through had made a close connectivity between monetary policy that seeks to establish price stability and financial institutions through which such policy is implemented. The stability in the price level will enrich the financial institutions; similarly, the stability in financial institutions will make monetary policy easier. When the two functions are handled by two different institutions, it was conceived that neither function will be effective. The subsequent events in the global economy especially the financial crisis of 2007-8 that made macroprudential regulation of financial system an essential feature of the regulatory mechanism proved A.S. Jayawardena correct.

Fourth, there was the question of coordination of the work of the new authority with that of the Central Bank. The new authority is to be a bureaucracy and bureaucracies are notorious for protecting their own territorial rights instead of cooperating with each other. Bureaucracies functioning at loggerheads with each other are not the best for a country when it is hit by a serious financial crisis. But if both monetary policy function and financial system stability function are under one roof within the Central Bank, this problem of coordination of the work relating to the two functions will not arise since one Governor can handle both effectively.

Sri Lanka’s Central Bank decides to retain bank supervision function

Convinced by these strong reasons, Sri Lanka’s Central Bank decided that it should not hand over the financial system stability function to a separate authority though many countries in the region had already done so. Accordingly, economic and price stability and financial system stability were made co-objectives of the Central Bank by an amendment made in 2002 to the Monetary Law Act, the legislation under which the Central Bank has been established.

The Bank of England ponders its earlier decision

Though the UK went ahead with separating the bank supervision function from the Bank of England in 1998, the financial crisis of 2007-8 pointed very strongly to the fact that an outside financial services authority cannot function fast enough to save a financial system like a central bank when it is hit by a major crisis. If support is to be given to an ailing bank to prevent it from collapsing, a financial services authority has to secure funds from the government by following the due budgetary processes. This takes time and an ailing financial system cannot wait for such a long time to get the support.

A central bank does not have these financial constraints since it can always fund an ailing bank just by making book entries without having to go through the government’s budgetary processes. Hence, a central bank, unlike a financial services authority, can act fast enough to save a collapsing bank and prevent a general financial system failure. This wisdom made the UK revisit its earlier decision to have a separate financial services authority to regulate and supervise financial institutions in the country.

Bank supervision is returned to the Bank of England in 2013

The result was the abolition of the Financial Services Authority in 2012 and the establishment of two separate supervision outfits in April 2013 called the Financial Conduct Authority to regulate financial services and Prudential Regulation Authority to regulate banking and insurance institutions. The latter authority was placed under the direction of the Bank of England by establishing it as a company wholly owned by the Bank. In this manner, the function of regulating and supervising the banking institutions was returned to the Bank of England after 15 years of unsuccessful experimentation.

Though it is a separate company, it has a close relationship with the other arms and organs of the Bank of England, namely, the Financial Policy Committee that decides on the policies relating to the UK financial system and the Special Resolution Unit that has been charged with the function of finding suitable solutions for ailing financial institutions. Its Board which is accountable to the Parliament consists of senior Bank of England officers including the Governor who is the ex-officio Chairman and some independent directors appointed from outside the Bank.

Macroprudential regulation of a financial system

Today, two aspects of financial system stability have to be handled by a central bank. The first is to introduce a system to ensure the overall financial system stability, known as macroprudential regulation of the financial system. In this exercise, a central bank does not worry itself about the soundness of a particular financial institution but the soundness of the overall system.

If a particular financial institution which has no impact on the rest of the system is in trouble, macroprudential regulatory tactics do not warrant a central bank to intervene and save the financial institution in trouble. A central bank may very well allow such non-systemic financial institutions to close doors and thereby set an example for other financial institutions to follow. This tactic is known as ‘weeding out’ of viral financial institutions to save the whole system.

Microprudential regulation of financial institutions

The second is the implementation of the microprudential supervision and regulation of financial institutions. In this exercise, a central bank will examine, supervise and regulate individual financial institutions within the country. If a particular financial institution is in trouble, the central bank will take appropriate measures to put it into a proper shape. Since the financial system consists of individual financial institutions, the safety of each one of them will help central banks to ensure the safety of the whole financial system.
The general consensus today is that a central bank should handle the financial system stability function rather than handing it to a separate outside authority.

*W.A Wijewardena – Formerly Deputy Governor of the Central Bank of Sri Lanka and presently Visiting Lecturer at PIM, University of Sri Jayewardenepura, Asian Institute of Technology, Bangkok and Naresuan University, Thailand. He can be reached at waw1949@gmail.com

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  • 0

    the issue is when Central bank is managed people like Cabraal it has no credibility even it does the right things.

    This week we saw Anura Dissanayake showing in parliament how the country GDP figures were manipualted from 5.5 to 6 by these people.


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