Most political constitutions try to disperse power. In financial regulation the fashion is to concentrate it. America’s Federal Reserve is accumulating huge control over the economy and banks. Similarly,Britain’s Conservative Party,likely to form the next government,wants the Bank of England to be in charge not just of interest rates,but also the two big tasks of regulation: guarding the overall system’s stability (“macro-prudential regulation”,as it is known) and the “micro” supervision of individual firms. Does that make sense?
It is not hard to see why the central banks are being given more clout. Regulatory credibility is scarce and the central bankers often have more of it than other financial policemen. In times of disaster the mess ends up with them: the boundary between,say,the Bank of England lending to HBOS and testing its solvency,supposedly the job of the Financial Services Authority (FSA),became academic when the system seemed hours from blowing up. Above all,central bankers now know that they ignore macro financial stability at their peril.
For years most central banks concentrated on using a single tool,interest rates,to achieve a single goal,price stability. They ignored or failed to spot huge asset bubbles and banks’ kamikaze behaviour. Now,it is clear central bankers should consider not just the economy but the state of the financial plumbing behind it. By using tools like bank-capital rules and credit controls,they can try to prevent excesses building up again.
If they are to be responsible for stability,the central banks must have the power to act. That means the authority to swoop on individual firms that pose a threat to the system or are failing. As Mervyn King,the governor of the Bank of England,puts it,it would be hopeless “if we can do no more than issue sermons”. So it makes sense for the central banks to be in charge of the macro-prudential bit. The harder question is the micro one: who should do day-to-day supervision of firms?
Being close to banks should allow regulators to get better information. But it also raises the risk that supervisors will be “captured” by bankers. This newspaper has argued that the Fed should cede responsibility for the micro management of American banks. In Britain,the situation is different. The existing supervisor,the FSA,has an impressive new boss in Adair Turner but in the past it has suffered something close to Stockholm syndrome,exempting Northern Rock from regular examination,and allowing Royal Bank of Scotland to buy ABN AMRO. And unlike America’s finance,British banking is now concentrated in four big firms,blurring the distinction between general rules and regulation of individual companies. On balance,the Tories are probably right to return day-to-day supervision to the Bank of England.
Reap the reward: the hate of those you guard
That regulatory argument,however,is dwarfed by three worries. First,where the financial policemen sit matters less than hiring competent ones. Second,no matter how good those people are,central banks are bound to fail eventually: the banking system is huge and complex,and now enjoys a taxpayer guarantee that both encourages risky behaviour and is hard to withdraw. Thus,third,central banks will be on the hook more explicitly than ever before. When times are good they will struggle to take the punchbowl away: a central bank that tried to stop subprime lending in 2003 would have faced a political firestorm. When times are bad,they will be blamed.
That plainly raises the spectre of political intervention. But central banks need not be helpless. One priority should be to counter the impression that they are acquiring their new empires by accident. Their mandates need to be refined to include clear responsibility for both price and financial stability. One group of decision-makers should be responsible for both. Sometimes they will conflict,but having separate committees,as the Tories propose,does not resolve this.
And central banks should lead efforts to reform banking,so that it poses less risk to taxpayers. They can prod banks with taxpayer guarantees to shrink their risks and to build up capital buffers to absorb losses. It will be difficult,but unless the industry is reformed,the future will consist of banks that are too important to fail and central banks that are destined to do so.
© The Economist Newspaper Limited 2009