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How monetary policy can benefit from integrating banking supervision in a central bank
The banking union will strengthen the governance framework supporting the Single Market and EMU. Obviously, its primary purpose is not to support monetary policy. In fact, as the short history of EMU suggests, price stability can be maintained without the ECB being responsible for banking supervision.
But integrating the SSM in the ECB also creates some new opportunities for the conduct of monetary policy and other functions closely related to it. I particularly see four areas in this respect: the state of the macro-economy; monetary policy options; interactions with supervisory policies; and the management of the central bank balance sheet. I will argue that these opportunities are greater in turbulent times than in quiet times.
Broader information basis for assessing monetary policy options
Given Europe’s bank-based financial structure, monetary transmission channels through the banking sector are particularly important in understanding the effects of monetary policy actions, standard and non-standard. A thorough understanding of banks’ behaviour and health across jurisdictions facilitates the design and implementation of non-standard monetary policy measures and will also facilitate the exit from these measures when the time is right.
Better consideration of the interactions between monetary, supervisory and regulatory policies
Monetary policy interacts with supervisory and regulatory policies, be they micro-prudential or macro-prudential in nature. If the monetary policy objective and the supervisory objective are distinctly defined and separate instruments are assigned to each of them, then a single institution could take the interdependencies better into account than separate authorities. Interactions can be expected to occur in particular with macro-prudential policies, which increase in importance due to the lessons from the crisis, and operate through channels closely related to monetary policy transmission. The allocation of macro-prudential regulatory instruments under the SSM is therefore an important design feature of the draft legislation.
Better management of the creditworthiness of counterparties in monetary policy operations
Monetary policy operations expose the central bank to credit (and other) risks, which are controlled through adequate collateral and other risk management techniques. Good banking supervision and prompt corrective action ensure the soundness of counterparties in these transactions and a central bank therefore has particular incentives to make sure its supervision is rigorous. Rigorous supervision, in turn, protects the central bank’s balance sheet and gives it greater control over it, also safeguarding the central bank’s independence and credibility.
How to design monetary policy and banking supervision under one roof
At least three types of challenges and risks need to be managed when integrating supervision in a central bank alongside monetary policy. They relate to potential conflicts of interest, reputational risks and central bank independence.
Avoiding conflicts of interest
There is one situation in which the distinction between supervisory and some monetary policy instruments is less clear cut, namely, in the case of certain non-standard monetary policy actions in the midst of a financial crisis. However, in such a situation, the outlook for the economy and prices has considerable downside risks, so the direction of financial stability and price stability actions (e.g. to repair a broken monetary transmission mechanism) typically go in the same direction and a conflict between both policy branches is rather unlikely.
The draft legislation also confirms that the other statutory tasks and objectives of the ECB remain unaffected by the SSM, implying that monetary policy will continue to be conducted by the Governing Council in full independence, with the primary objective of maintaining price stability over the medium term. With our quantitative definition of price stability, it will be easy to verify every month that inflation expectations remain well anchored, as they are today. It is hard to see how financial stability dominance over monetary policy could occur if such precautions are taken.
Managing reputational risks
In order to ensure the success of banking supervision, competencies and policy instruments need to be assigned to the new SSM which would allow it to perform its tasks effectively. Otherwise, reputational risks could arise that might negatively affect the institution as a whole. The current draft legislation would grant the SSM an appropriate mixture of micro- and macro-prudential instruments for it to conduct supervision effectively. For example, on the micro-prudential side it would have all the relevant powers, ranging from bank authorisation to administrative sanctions, from the control of capital levels to compensation issues, through to structural issues such as business models and mergers.
Ensuring central bank independence
Bank failures and financial fraud often affect small savers or have an impact on public budgets, and lead to the involvement of democratically elected governments and Parliaments. While indeed, the highest standard of democratic accountability needs to be ensured, history shows that political interference can also constrain the effectiveness of banking supervision. In particular, if there is political interference to avoid costly bank restructurings or closures and it undermines supervisory rigour, then the beneficial effects in terms of control over the central bank’s balance sheet and the avoidance of financial or fiscal dominance risks might not accrue. There should therefore be a strict separation between the supervisor and a resolution authority.
Against this background it is reassuring that the transfer of supervisory responsibilities to the SSM will not have any implications for the independence of the ECB in performing all its tasks. By implication, the necessary internal precautions against political interference in supervisory matters adversely affecting the ECB’s independence in conducting monetary policy have been taken