Should BOT be a watchdog?

First published by The Nation, Thailand on 5 December 2003.

Dr Chodechai Suwanaporn of the Ministry of Finance's Financial System Policy Bureau examines the current trend in financial supervision. This is the first of a two-part series.

Should a country's central bank be involved with banking supervision?

In recent years, there has been a clear trend towards separating the supervision function from the central bank, whose primary focus is developing monetary policy.

Canada and the Scandinavian countries - Sweden, Denmark, Finland and Norway - are the pioneers of this approach.

In the late 1990s, several European countries, among them Britain, Germany, Hungary and Turkey, opted for this model as well.

Recently countries in Asia, including China and Indonesia, have converted to this supervisory framework.

Other countries that have changed their regulatory approach are Australia, Mexico and several Latin American nations. What are the pros and cons of switching from the central bank-as-bank-regulator model to central bank-not-as-regulator model?

Let us first look at the advantages.

First, separating the supervisory function from the central bank is expected to eliminate the possible conflict of interest arising from having dual authority and decision-making on monetary policy and banking supervision, which can sometimes be at odds with each other.

For example, the central bank may be afraid to raise interest rates for fear that it may have adverse effects on bank performance and loan portfolios, even if it is sound monetary policy.

But at the same time, the central bank may be forced to loosen or relax its supervision and inspection on banks to allow more credit extension and to help support its monetary policy.

Second, discharging the central bank from banking-supervision responsibility can help lessen its moral-hazard behaviour. When the central bank is charged with supervising banks, the public perception is that it stands firm behind the commercial banks and is ready to pump in money to rescue banks in times of trouble.

Depositors, creditors and investors may thus loosen their guard and may not be careful in their investments in the commercial banks.

Moreover, the management of the commercial bank will take for granted that their bank cannot fail by presuming that the central bank would not allow this to happen and bail them out. Thus, disconnecting the central bank from a banking-supervision role will help mitigate the problem of moral hazard.

Third, the central bank may put itself and its monetary policy at risk in terms of independence, reputation and credibility when it has supervisory responsibility.

Banking supervision necessitates that the central bank gives carrots and sticks to motivate the commercial banks.

In this situation, the central bank may become too close to the commercial banks. Due to the large business interests, large sums of capital and politics involved, doubts or questions of ethics may be raised in regards to the independence of the central bank.

Moreover, its is impossible to prevent the banking sector from having any banks fail.

If the central bank props up banks based on business or political interest rather than sound policy, this will certainly ruin its reputation and undermine its credibility.

Fourth, it is said that the central bank requires employees who are good at macroeconomic management, that is, having macro views or a broad picture mindset.

Therefore, the central bank tends to hire mainly economists. However, banking supervision requires various skills in business, finance, accounting and law.

Thus, the issue is one of having different skills sets required of the two different functions. Having dual responsibility does not help to foster specialisation of skills.

Having explained the advantages, let me now turn to the disadvantages of separating the bank-supervision function from the central bank.

First, there is an argument that by conducting bank supervision, the central bank can gain direct access to information from the bank - for example, the health of the bank and its operation - which may be useful for conducting monetary policy.

Second, it may be more costly to separate the supervisory function from the central bank.

However, we should keep in mind that the cost to the taxpayer may be greater if supervision is ineffective and leads to bank failures or inappropriate monetary policies.

The second part in the series will ask whether there should be single supervision or multiple supervisors.