FSI Studies Involvement of Central Banks in Financial Oversight

The oversight of financial sector involves a number of policy functions aimed to ensure adequate market functioning and the stability and integrity of the financial system. These functions include the monitoring of the solvency and conduct of business of different types of financial institutions. The design of institutional arrangements for financial sector oversight requires these different functions to be assigned to specific agencies. Decisions need be made on how policy objectives should be assigned between different authorities. Traditionally, this question has revolved around identifying conflicts and complementarities between their various remits. Equally important, however, is the question of whether specific policy instruments can be neatly assigned to specific objectives. When a specific policy instrument can significantly influence more than one objective, the case for assigning each of those objectives to a different agency weakens. 

The COVID-19 crisis has shown how different policy instruments could be activated in parallel by different agencies with the aim of stabilizing the economy and the financial system. It also showed the difficulty of making clear distinctions between actions aiming at addressing deflationary risks (and economic instability more generally) and those targeting the availability of credit to the real economy. Moreover, the measures taken reveal that the latter objective cannot be achieved by purely macroeconomic or macro-prudential measures, without adjusting the micro-prudential policy stance. The impact of various policy instruments on differing social objectives constitutes a challenge for the adequate functioning of institutional arrangements based on allocating monetary, macro-prudential, and micro-prudential responsibilities to different agencies. During a crisis, agencies may naturally agree on the need to adopt extraordinary measures. On the other hand, the challenges of a coordinated policy response may become more severe as authorities decide on the pace of normalization based on their own remit but using instruments that may also affect the other objectives of the other agencies.

This paper shows that there is a reasonably sound argument for assigning a financial stability function to central banks. It highlights that, based on the experience with COVID-19 policy response, there would seem to be a clear case for assigning the financial stability mandate to central banks and an even stronger one for including both macro and micro-prudential responsibilities in that mandate. The paper also puts forward the view that the financial stability function should encompass both macro-prudential and micro-prudential responsibilities. These two tasks should ideally be combined within a single policy framework comprising the instruments that would allow an authority to address all the different dimensions (entity-by-entity, systemic) of the financial stability objective. Although this lies outside the scope of this paper, political economy considerations could, of course, be equally important for an adequate institutional design. The accumulation of responsibilities by independent authorities, such as central banks, raises issues of democratic legitimacy and accountability. These need to be satisfactorily managed if the chosen formula is to be socially acceptable and, hence, sustainable.

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Keywords: International, Banking, COVID-19, Macro-Prudential Policy, Micro-Prudential Policy, Financial Stability, FSI