Allocating Lending of Last Resort and Supervision in the Euro Area
The Maastricht Treaty created the European System of Central Banks and the European Central Bank to head this system. The Treaty entrusted the European Central Bank with the responsibility for monetary policy, but it did not give this institution supervisory powers or an explicit mandate for providing emergency liquidity support to individual banks. National authorities remained responsible for financial stability. As a result, in the euro area some bank regulatory functions are centralized, while others are allocated to not one, but multiple, competing national regulators. Previous researchers have discussed the potential implications of this institutional allocation of regulation on the financial stability of the region. In this chapter, we investigate instead the potential efficiency implications. We focus on the consequences of the allocation of the lender of last resort and supervisory functions for the degree of forbearance in closing distressed banks and for the level of diligence in bank supervision. We conclude that the integration of banking markets without the integration of regulatory functions increases forbearance and decreases supervision. Centralizing regulatory functions will tend to reverse this decline. If only one of the two functions is centralized, then it will be more effective to centralize the supervisory function.
Institutional Separation between Supervisory and Monetary Agencies
This paper investigates whether monetary policy and banking supervision should be separated, or not. It starts with an account of the historical evolution of the Central Banks micro-function (banking supervision). The role of the lender of last resort and the introduction of deposit insurance is discussed. There is currently a diversity of institutional arrangements, but the differences are found to be greater in appearance than in reality. The main argument of divorcing the monetary from the regulatory authority is that the combination of functions might lead to a conflict of interest. This conflict can arise in different ways. The most important instance is that interest rates are held down because of concern with the ¶health¶ of the banking system, when purely monetary considerations suggest higher rates. It is argued that this conflict between ¶regulatory¶ and ¶monetary¶ objectives depends to some extent on the structure of the banking and financial systems (i.e. whether banks are dependent on wholesale or retail markets for short term funding). A First argument against separation is the role of the Central Bank in the payment system, in particular with respect to preventing systemic risk. The massive intra-day credit exposures in large value payment systems could give rise to settlement failure(s), which in turn could generate a systemic crisis. Settlement risk is therefore increasingly an area of supervisory concern for Central Banks. In so far as the Central Bank as lender of last resort is likely to support a failing participant, it is assuming the risks and effectively becoming the implicit guarantor of the system. Although Central Banks implement risk reduction policies, some risks originate beyond the settlement system, e.g. in foreign exchange trading, securities transactions and interbank transactions. It is argued that Central Banks should have a regulatory and oversight role in the payment system, although it does not follow that they should also operate them. Turning to the broader concern of the Central Bank of systemic stability, it is claimed that the Central Bank usually has to use its lender of last resort function not only in cases of liquidity difficulties, but also where the solvency of banks is uncertain. A cross-country survey of 104 bank failures is assembled in an appendix. We focus on the provision of funding for rescues: central bank, deposit insurance, government or other banking system should lie with the agency which pays if, and when , banks are to be rescued. So long as rescue and insurance is undertaken on an implicit Central Bank basis, then the Central Bank would naturally want to undertake regulation and supervision. However, there is a trend towards using tax-payer money for bank rescues which strengthens the case for separation of the monetary and supervisory functions and establishment of a government agency for the latter. It would, however, be difficult to have a complete division, since the Central Bank would generally remain the only source of immediate funding.
Deposit Insurance and Lender of Last Resort Functions
We consider issues concerning the design of a banking system "safety net" when both a deposit insurer and a lender of last resort are present. In our model both entities have a role to play. Moreover, issues related to deposit insurance pricing are relatively unimportant in this context, whereas issues related to discount window access and pricing are not. We discuss when and why (or why not) a lender of last resort should lend liberally but charge high rates of interest. And, we raise the possibility that discount window policy may enhance or reduce the scope for multiplicity of equilibria.