Separating Banking Supervision

In this article, published in 1998, I argued that there is no evidence to suggest that separation of banking supervision from central banks will enhance the effectiveness of either supervision or monetary policy. On the contrary, it could be detrimental to both. The article was published in the Op-Ed page of Economic Times dated 5 October 1998. In 1997, banking supervision was separated from the Bank of England. This was done when it was decided to make the Bank of England more independent in the conduct of monetary policy. At the same time, it was decided to combine supervision of all financial markets and sectors in the Securities and Futures Authority which was then renamed the Financial Services Authority. This model was followed by many other countries especially those have more developed economies.

In this context, a demand arose in the media in India that supervision be separated from the Reserve Bank of India also. A recommendation to the effect was also made in the Narasimham Committee Report on Banking Sector Reforms. This article argued against separation of banking supervision from central banks. It concluded that there is no evidence that separation will enhance the effectiveness of either supervision or monetary policy while putting both at the risk of becoming weak. In fact, I had separately argued that this step could be reversed around a decade later, as it eventually happened in the UK. Many other countries have also since followed suit.

As this article is not available in soft copy form in the public domain, and in view of its continuing relevance, I am reproducing the text below as it appeared in Economic Times.

Banking: Separating Supervision

There is no evidence to suggest that separation will enhance the effectiveness of either supervision or monetary policy, says G Sreekumar

“… regulation and supervision is a thankless task. The best that can be hoped for is not to be noticed. Failures become immediate public knowledge and engender heaps of blame, whereas successes are unknown, unrealised and unappreciated.”

C.A.E. Goodhart et al., Financial Regulation: Why, How and Where Now?, Routledge, 1998.

Bank supervisors, world over, have been taking a lot of flak in recent times. The Bank of England’s alleged lapses in the failure of BCCI and the collapse of Barings may have contributed to the recent separation of supervision from it. Though this was primarily due to a decision to combine several regulators in one, it has prompted demands that India also follow suit even though the context of banking and its practices do not merit comparison.

The Reserve Bank of India was modelled on the Bank of England in many respect. But, when it came to supervisory practices, it rightly preferred the American emphasis on on-site examination to the informal methods of the British. The regulatory and supervisory systems depend on the banking structure it seeks to serve as well as a host of historical and cultural factors that tend to shape the development of institutions.

Conflict between monetary policy and supervisory compulsions is the oft-cited argument in support of separation. Thus, increase in interest rates may be deferred considering the fragility of sections of the banking system. Or, a supervisor’s decision to keep a bank afloat may raise fears of adverse monetary effects. But, the social and economic costs of banking crises far outweigh the effects of injecting liquidity which can in any case be offset by open market operations.

Monetary policy is said to have a counter-cyclical effect while supervisory strategies could be pro-cyclical. This need not always be the case. Supervisory interventions usually coincide with economic downturns, which increase the probability of banking problems. These are also periods when the monetary authorities attempt to raise the level of economic activity.

The likely conflict between monetary policy and supervisory concerns itself provides the main rationale for combining the two functions. If they were with different institutions, which pull in different directions, it would be detrimental to both monetary stability and banking soundness. The advantages of separation can be had by the creation of ‘Chinese walls’ between the departments of the central bank charged with the two functions.

Conflict is only one side of the coin. Recent experience in Asia and elsewhere underline the interdependence between the two. Monetary stability is closely linked to banking soundness since the banking system is the main channel through which monetary policy signals are transmitted. Inefficient financial intermediation can blunt monetary policy initiatives apart from causing inefficiencies in the real economy. Similarly, banking efficiency is affected by unstable monetary conditions.

‘Separatists’ argue that the credibility and prestige of a central bank, which are crucial to the success of its monetary policy, are likely to suffer whenever there are banking crises. Such crises are bound to occur. In fact, it is neither feasible nor desirable to ensure that no banks fail whether supervision is with the central bank or not. Combining has several synergistic effects, not easily discernible. Oversight of the payment system helps tracking money laundering activities and transactions beyond prudential limits. Combining enables smooth switch-over to real time gross settlement systems, which require the central bank to extend intra-day limits to participants. It also facilitates penalising errant bankers and avoids duplication of reporting requirements and associated regulatory costs.

Stressing the monetary policy function along gives an incomplete picture. Eminent writers on central banking such as Thornton, Bagehot and Hawtrey have highlighted lender of last resort as a central bank’s main function. Such assistance has to be quick so that temporary liquidity problems do not aggravate into insolvency cases. This requires that the central bank be satisfied as to the solvency of the institution. The lack of such information had once prevented the RBI from extending assistance to the Travancore National and Quilon Bank, which failed in 1938 leaving a banking crisis in its wake. Non-extension of timely assistance has been the cause of most banking crises. This perhaps explains why countries with separation have had a much higher level of bank failures.

For central banks, which evolved from being commercial banks, interest in banking soundness was consequent to their role as overseers of the payment system. Monetary policy was a subsequent addition. According to Paul Volcker, some central banks were “founded much more out of concern about banking stability than out of ideas about monetary policy as we know it today.” Patrick Downes of the IMF extends the argument further: “…some of the instruments of monetary policy, such as reserve requirements and liquidity ratios, …have their genesis in prudential regulation and concern for the soundness of banks…”

In India, the lack of provisions in the RBI Act, 1934, for detailed regulation of commercial banking was soon recognised as a lacuna. This was addressed partly in 1936 when the Indian Companies Act was amended. A comprehensive legislation, which among other things provided for the SLR as a supervisory tool, came in 1949. This followed the failure of nearly 600 banks in the preceding decade. The Indian supervisor’s performance, post-1949, has not received a detailed and dispassionate analysis. However, the first volume of the RBI History records that the fact that “bank failures were few bears testimony to the success of the Bank’s regulatory efforts.”

Supervision is with the central bank in more than 60 per cent of the IMF member countries. Taking the Asian, African and West Asian countries alone, it is over 80 per cent. In other countries, supervision involves varying degrees of central bank involvement. In Germany, Japan and France, though supervision is separated, the supervisory bodies rely heavily on the staff and other resources of the central bank. How far such coordination is replicable elsewhere would depend on the level of institutional development, banking structure, legal systems and even certain cultural specifics.

Alan Greenspan, Chairman, Federal Reserve Board, has gone on record that the experience and capability provided by the Fed’s supervisory functions is essential for it to respond effectively to future financial crises. In developing countries, which are more susceptible to economic swings, the information generated by a supervisor is all the more crucial to the central bank. It is thus rightly said that banking supervision is an extended, but often neglected, arm of monetary policy. Banking soundness is being increasingly recognised as an additional dimension to monetary management. As an objective, it is almost on par with price stability. Discussions on separation are usually inconclusive. Even the Narasimham Committee, while recommending separation, has observed that there is no overwhelming international experience in favour of either separation or combining. To conclude, there is no evidence that separation will enhance the effectiveness of either supervision or monetary policy while putting both at the risk of becoming weak. Experimenting with separation in India, given the present state and structure of its banking system, is therefore not called for.

(The author is a faculty member (AGM) with the Zonal Training Centre of the RBI. The views expressed here are personal.)

© G Sreekumar 2021

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