Why the central bank should be a leading supervisor

“Monetary policy and concerns about the structure and condition of banks and the financial system more generally are inextricably intertwined. […]neither monetary policy nor the financial system will be well served if our central bank is deprived from interest in, and influence over, the structure and performance of the financial system.” Paul A. Volcker, March 17, 2010.

Should central banks be a leading supervisor, including supervising systemically important institutions? This is a question that members of the U.S. Congress periodically raise.  Our answer is unequivocally yes. As the lender of last resort, as the monetary policy authority, and as the organization responsible for overseeing the health and stability of the overall financial system—what we could call a systemic regulator—the central bank needs to be a leading supervisor.

The lender of last resort and prudential supervision. Recall that Congress created the Federal Reserve in 1913 in response to a series of banking panics. Financial instability after the Civil War resulted from the absence of a central bank to provide emergency loans to solvent institutions facing sudden deposit outflows. When depositors ran on a few banks, panic frequently spread. To promote stability, Congress mandated that the Fed serve as the lender of last resort—lending against good collateral to solvent institutions.

Operating as the lender of last resort requires two pieces of information: (1) a determination of an institution’s solvency, and; (2) a valuation of the collateral that is being posted to back the loan. Supervisors, with their intimate knowledge of the bank’s operations, usually have both of these.

With regard to solvency, there are three reasons that it is imperative a central bank never lend to bankrupt institutions. First, since the central bank will always require collateral, its loans further subordinate the bank’s long-term creditors. It does this both by allowing short-term depositors to run and by inserting itself ahead of others in the queue for claiming repayment when failure inevitably comes. Second, lending to an insolvent bank does not put an end to that institution’s fragility. Ultimately, it must be liquidated or re-capitalized. Postponing the day of reckoning is usually costly both for the institution in question and, as a consequence of a misallocation of resources, for the economy as a whole. Third, when people find out that the central bank is willing to lend to insolvent banks, any bank that borrows will be suspected of being bankrupt. The resulting stigma will impair the useful function of the lender of last resort as a lender to solvent, but illiquid banks. If only those that are bankrupt borrow, the central bank’s lending facility will become worse than useless (see our previous discussion here).

Even with a solvent borrower, protecting public finances means that the central bank must obtain sufficient collateral. Again, this requires intimate knowledge of the quality of a bank’s assets, something that supervisors routinely assess.

An example illustrates the challenge that a central bank lender faces in maintaining financial stability. On November 21, 1985, a computer software error prevented the Bank of New York from keeping track of its U.S. Treasury securities clearing operations. In line with normal practice, orders poured in and the bank made payments without having received the funds. But when it came time to deliver the bonds and collect from the buyers, the order information had been erased from the system. By the end of the day, the Bank of New York had bought and failed to deliver so many securities that it was committed to paying out nearly $23 billion that it did not have. The Federal Reserve, knowing from its up-to-date supervisory records that the bank was solvent, made an emergency $23-billion loan taking the entire bank as collateral and averting a systemic financial crisis. The amount of the loan exceeded the aggregate reserves in the entire U.S. banking system at the time. Importantly, only a direct and effective supervisor was in a position to know that the Bank of New York was solvent, that it had the necessary collateral, and that its need to borrow was legitimate. (For more on this episode, see here and here.)

So, in order to operate responsibly as a lender of last resort, protecting the public interest, the central bank needs to have timely access to confidential supervisory assessments, knowledge about an institution’s business practices, and the skills to evaluate the collateral a bank is posting to secure a loan. Importantly, this information has to be available to high-ranking central bank officials on very short notice. In some cases, decisions must be made in a matter of minutes, so the quality of the data must be without question and it cannot be in the hands of people who may or may not choose to share it.

It is difficult to overstate the importance of liquidity provision in the prevention and management of financial crises. The Federal Reserve has a variety of methods for injecting liquidity into the banking system on short notice, including the direct purchase of securities through open market operations and the provision of intra-day credit through the payments system. But direct lending to banks is sometimes the most important means to avert panic and contain a crisis. For example, in the aftermath of the terrorist attacks of September 11, 2001, to head off what would have been a financial system collapse, the Fed lent roughly $37 billion that day (and subsequently provided an additional $100 billion through a variety of means). In the aftermath of the Lehman bankruptcy, Federal Reserve lending peaked at $441 billion. Without supervisory information, the Fed would have been flying blind, not knowing if it was lending to insolvent institutions or whether it was accepting good collateral. Not only would this have been bad policy, it would have put taxpayers at risk.

As a practical matter, liquidity provision is also the mechanism central banks use to achieve their traditional interest rate objective. During normal times, when aggregate reserves are scarce, the Federal Reserve influences the federal funds rate by adding or draining liquidity from the banking system. This means that there is no operational difference between monetary policy actions and lending operations. In fact, in terms of their impact on the Fed’s balance sheet, the purchase of a security and a loan are identical.

Returning to the issue of governance, operations in the midst of a financial crisis are akin to maneuvers during a war. In the heat of battle, the military relies on a clear chain of command to ensure a consolidated view of the battlefield and effective coordination of resources. Separation of supervision from the central bank would be like having multiple generals with potentially differing objectives simultaneously giving orders to the same army. It is hard to see how this could possibly work. Successful crisis management requires timely and effective coordination.

Monetary policy and prudential supervision. The intimate relationship between monetary policy and prudential supervision is another important rationale for giving the central bank a supervisory role. As a practical matter, the two are inseparable. The Federal Reserve, for example, is set up as a matrix organization, so it is nearly impossible to say where one function stops and another starts. This is particularly true of the Federal Reserve Banks, which bear the day-to-day responsibility of examining and supervising banks. Monetary policy and prudential supervision are not in siloes, but operate in tandem, sharing knowledge, staff and expertise. And, because they work together, they are both more effective.

Prudential supervision provides important inputs into the monetary policy process. The Federal Reserve supervises those parts of the banking system that account for nearly all of its assets. This includes oversight of more than 5,000 holding companies and over 200 foreign banking operations. Through its access to these financial firms, supervisors naturally learn about the health of the borrowers as well as that of the lenders. Put differently, the Federal Reserve knows a great deal about what banks are doing, to whom they are lending, as well as the size and the terms of the loans.

This nonpublic information can be vital for monetary policy. A deep and complete understanding of the state of the financial markets and institutions, including the terms and conditions under which borrowers can obtain financing, is critical for the determination of the appropriate monetary policy stance. That is, the level of the interest rate set by the Federal Open Market Committee depends on supervisory information (see, for example, here).

The events of mid-2008 provide a clear example of a time when the use of banking system information was critically important. Inflation was running a quarter of a percentage point above the Fed’s 2-percent objective. A mechanical rule based solely on inflation and unemployment would have dictated that monetary policymakers raise interest rates to a level exceeding 5 percent. Fortunately, with their understanding of financial fragilities—gleaned in part from access to supervisory information about the deteriorating state of the banking sector—the Federal Open Market Committee judged interest rates at 2 percent consistent with inflation and growth prospects (see the comments of William Dudley on pages 4 to 8 of the transcript of the June 24-25 FOMC meeting). Needless to say, the next few months provided disastrous, dictating further policy easing, not tightening.

Information and skills also flow from monetary policymakers to prudential supervisors. An assessment of the safety and soundness of banking institutions requires an understanding of economic prospects—something that is integral to the formulation of monetary policy. In practice, this means that the economic and financial outlook is an input into supervisory evaluations.

Nowhere is this more apparent than in the case of stress testing. Stress tests today are the most powerful prudential tool we have for safeguarding the resilience of the financial system. They take seriously the fact that when a large common shock hits, there may be no one who will purchase a bank’s assets or provide equity capital. Ensuring that each systemic intermediary can withstand significant stress raises the likelihood that the system can survive. And, importantly, by adjusting the scenarios to reflect changing conditions, prudential authorities help ensure that the system remains resilient. Formulating stress scenarios requires both knowledge about how the entire economy operates and a sense of the financial risks that are not adequately compensated. This is true both for domestic developments, like real estate booms, as well as those that could come from other parts of the world, like the cyclical downturns of major trading partners.

Financial stability and prudential supervision. Finally, there is the relationship between prudential supervision and the maintenance of systemic stability. The second of these is prudential supervision for the financial system as whole. It is clear that the central bank is the locus of that responsibility. The Federal Reserve does not have an explicit financial stability mandate. But without a modicum of financial stability, it would fail to achieve the statutory objectives of maximum employment, stable prices and moderate long-term interest rates.

With that in mind, building on the skills of its staff, its day-to-day access to and knowledge of financial markets, and its supervisory information, the Federal Reserve has created the capacity to monitor the financial system in order to ensure that both monetary and prudential policy are set in a way that enhances resilience.

In sum, prudential supervision and the core functions of the central bank are very clearly complementary. Each requires information from the other. As Paul Volcker put it, they are inextricably intertwined. Separating them would hurt them both.

Note: This is a slightly modified excerpt from Steve’s testimony before the joint hearing of the Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Monetary Policy and Trade of the Committee on Financial Services of the U.S. House of Representatives on September 12, 2017. The full text of his remarks, as well as other information on the hearing, is available here.