Financial Supervision and Central Banking: The Improvements Which Backfired

THE EFFECTS OF THE MOST ADVANCED SUPERVISION ARRANGEMENTS ON ECONOMIC RESILIENCE HAVE BEEN NEGATIVE, A NEW IMF PAPER BY MASCIANDARO, QUINTYN AND VEGA PANSINI SHOWS. THE CASE FOR CENTRAL BANKS-MANAGED MACRO-PRUDENTIAL SUPERVISION

The 1997 Asian financial crisis sparked a worldwide effort to improve financial supervision, as a complement to the changes in financial regulation. Albeit several studies in the pre-2007 years showed some, weak evidence of the positive impacts of supervision unification and better governance arrangements on financial sector stability and soundness, the global financial crisis that started in 2008 pricked this balloon of hope, as supervisory failures have been deemed a contributing factor to its emergence.

Donato Masciandaro (Department of Economics and Paolo Baffi Centre on Central Banking and Financial Regulation), in The Economic Crisis: Did Financial Supervision Matter? (IMF Working Paper No. 11/261, with Marc Quintyn, IMF, and Rosaria Vega Pansini) now shows that supervision unification and better governance arrangements are negatively associated with economic resilience, that the same is true for the quality of public sector governance and the degree of financial liberalization, while the involvement of the central bank in supervision did not have any significant impact. The authors, then, argue that “conducting supervision through two separate agencies (one for macro- and one for micro-prudential supervision) could introduce the necessary checks and balances in the supervisory process that could potentially strengthen governance”, and that the central bank should be involved in the macro-prudential supervision, but not in the micro.

In the wake of the Asian crisis, Masciandaro and his co-authors argue, two trends emerged in supervision architecture, towards a single supervisory agency, with a central bank specialized in monetary policy, or towards a multiplicity of agencies, with the central bank deeply involved in the supervisory process. Independence, accountability, transparency and integrity were the pillars of the new, proposed supervision governance, in order to withstand the various sources of capture (political, industry and self-capture) supervisors face. Scholars, though, agreed on the fact that, in supervision, incentives alignment is impossible to reach through an effective principal-agent contract and that mechanisms to foster market discipline are therefore needed.

For the empirical analysis the authors employ a database on supervisory architecture and governance for 102 countries, which allows them to disentangle the relative effects of these dimensions of supervision on resilience. Their model uses two indicators for the degree of supervisory consolidation (the unification of the different kinds of supervision under the same roof) and of central bank involvement in supervision as for the architecture, and an indicator of supervisory independence and accountability as for the governance. Both consolidation and quality of the governance prove to have a negative impact on economic resilience. Also the market friendliness of the economy (proxied by the quality of public sector regulation and by the degree of financial deregulation) has a negative effect, while the effect of central bank involvement in supervision is negligible.

The authors respond to the widespread call for new proposals in the field recommending a supervisory architecture in which macro-prudential supervision is established as a supervisory activity distinct from micro-prudential supervision (the twin peak model) and suggesting that the central bank should play a major role in this new field, which needs the same information the bank already collects to accomplish its tasks in monetary policy. The existence of two distinct agencies, the authors argue, could also provide the checks and balances which would reduce the possibility of capture, raising the transaction costs of collusive activities and thus offsetting the need for an improbable air-tight contract.

by Fabio Todesco