A measure of the independence of financial regulatory agencies
We can find a great deal of academic work on central bank independence, and central bank governors tackle this issue at every opportunity.
Most academic research, and all conservatives, argue that a high degree of independence is associated with lower inflation and monetary stability. Some of these academic studies question the direction of causation, wondering whether countries whose citizens hate inflation most - Germany being the most obvious example here - tend to favor strong independence. But it is not without widespread support for the general assumption that taking politicians out of the interest rate-setting process is associated with lower and more stable inflation. There is also a lot of evidence indicating that the electoral cycle has previously influenced interest rate decisions, with dire consequences.
Much less attention has been directed at the independence of financial regulators, especially the bodies overseeing banking. Of course, many of the bodies overseeing banking are part of central banks, but certainly, not all of them are.
Much less attention has been directed at the independence of financial regulators, especially the bodies overseeing banking. Of course, many of the bodies overseeing banking are part of central banks, but certainly, not all of them are.
About a third of the countries with weighted banking systems work with supervisors outside the central bank. This is true of Sweden, Japan, and Australia, for example. In some cases, different independent systems apply to monetary policy and supervision, even when both are attached to the central bank. The question of the independence of bank supervisors is more than just theoretical importance. Regulatory and supervisory independence is one of the basic principles of the Basel Committee on Banking Supervision. Nevertheless, according to the International Monetary Fund, this principle has the lowest level of compliance in the various countries reviewed by the Fund.
Banking supervisors ’perceived lack of independence in some eurozone countries was one of the reasons behind the creation of the European Union’s banking union. There is evidence indicating that banks whose work involves a direct link with the world of politics were subject to lax supervision, and they performed poorly, especially in the global financial crisis that erupted in 2008. Their bad debts were higher than all expectations.
More recently, questions arose about the proximity of German supervisors to the German Finance Ministry. After the accounting scandal that caused the bankruptcy of Wirecard to process payments and financial services, the European Securities and Markets Authority pointed to a growing risk of increased influence by the Ministry of Finance, given the repeated and detailed reporting in the Wirecard case.
Against this background, the Bank of England has produced new research in a timely manner, on the link between regulatory independence and financial stability. The authors of this research are creating a new independence index similar to those used in the area of monetary policy, but with differences in some areas.
The Bank of England research includes the procedures for appointing the head of the regulator: is there a degree of independence in the process? How long is the president's term? How easy is it to be fired?
Researchers also study a supervisor's ability to enforce regulatory controls without gaining political approval, and they examine the budget process. It is possible that some supervisors can finance themselves through the power to impose fees on the regulated companies, and others need to go obediently to the government or the legislature to obtain the money, which leads to the possibility of political pressure from banks to deprive the regulator of funds
Following the creation of the financial regulatory index, the authors examine whether supervisory independence is positively correlated with financial stability, compared to monetary stability. Financial stability is an elusive and unclear concept. We tend to discover its absence very painfully, but attempts to develop indications for its presence have proven extremely difficult. Several indicators explain the recent crisis well but are somewhat less helpful in predicting the next. As an expression of financial stability, the Bank of England study chooses the level of non-performing loans in the banking system. It may not be a perfect metric, but it has the distinction of being available on a widely comparable basis, across a range of countries, and for a large number of years.
Mapping the two sets of data against each other leads to powerful conclusions. Over the last 20 years, we have seen a steady increase in supervisory independence. In the words of the authors: “Reforms that achieve greater regulatory and supervisory independence are associated with a decrease in the volume of bad loans on bank balance sheets. On the whole, our findings show that increasing the independence of regulatory and supervisory bodies is beneficial to financial stability.”
Moreover, the authors provide evidence that stricter supervision is associated with independent supervisors and does not adversely affect the efficiency or profitability of the banking system. It might be reasonable to be bothered by the fact that more stringent supervision may impose costly restrictions, yet this does not appear to be the case. Reality: A bank's efficiency, if defined as its cost-to-income ratio, tends to improve as supervisors become more independent. This is not accompanied by any negative impact on bank profits.
What might not be desirable then? Are we in the free lunch area?
not exactly. It is not without one flaw that may confuse politicians. The correlation between independence and the amount of bank lending is clearly negative. In other words, if independent supervisors are more stringent, banks tend to reduce lending somewhat. The size of the effect may not be dramatic, but it is negative and this is important.
This effect is likely to be transitional and may fade as more disciplined supervision is maintained. Moreover, the lending that did not happen may have gone to unsustainable companies or exhausted consumers. It is not clear that such lending is particularly beneficial for growth and productivity.
In the public sphere at least, regulatory and supervisory independence has not earned the reputation for central bank independence. It is not referred to by an acronym commonly used, for example. If we use the acronym RSI Regulatory and Supervisory Independence, the listener's mind will deviate from the term "Repetitive Strain Injury", meaning "injury resulting from repetitive stress." Truth: The research conducted by the Bank of England is a strong case in favor of changing this situation.