Central Banks as Bank Regulators

12/27/2012 12:00:00 PM
John Cochrane makes a good point, though as he often does, not necessarily with the right reasoning. The Eurozone recently reached an agreement that would make the European Central Bank a regulatory authority over banks across the Eurozone to try to prevent systemic risks like those that caused the 2007 recession. According to the Wall Street Journal:
"...the European Central Bank would start policing the most important and vulnerable banks in the eurozone...the ECB will be able to force banks to raise their capital buffers and even shut down unsafe lenders."
Cochrane has some suggestions on the type of regulating they need:
"...it should protect the banking system from sovereign default. It should declare that sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.
 Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization. Greece needs a national banking system as much as Chicago (same population) does..."

To be honest, this verymuch confuses me. Cochrane seems to feel that regulation is only needed to protect banks from the risk of sovereign debt--shouldn't banks be just as cautious (or reckless) buying government bonds as they are with private assets? At any rate, Cochrane goes on to explain why he thinks it is a bad idea to put the ECB in charge of this:
"The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt."
That's the crazy part of his argument. For one, the ECB can't force the banks to increase their risk exposure to sovereign debt--it can certainly induce them to buy the bonds by offering guarantees that reduce the risk, but that means they aren't being exposed to that risk. But the bigger point is this: I doubt it matters whether the banks are exposed to the risks directly. The risks from sovereign default are just as harmful if the investors were individuals that own and deposit in the big banks, or if they were the big banks themselves. Or to put this differently, governments are way more systemically more important than any of the banks.

Moreover, Cochrane's argument is a strawman. He's invented a function he wants the ECB to carry out, and then criticized the results of a regulatory regime that exists only in his mind. In reality, the regime will empower the ECB to regulate capital requirements and nationalize (internationalize?) failing banks. The problem with this, which Cochrane failed to mention, is that central banks rely on cozy relationships with private banks. This is clearest with the Federal Reserve in the US, where much of the policy-making body is actually chosen by the private banks, who appoint the boards of directors of each of the Federal Reserve banks, and indirectly pick their presidents, who sit on the FOMC. The ECB has a similar problem since its governing council consists mostly of the heads of the 17 national banks within the European central bank system. But, in Europe, this problem is muted by the fact that these bank heads are usually (perhaps always?) political appointments rather than chosen by the banking industry itself.

However, even so, the central banks are actively involved in private bank markets, often making loans to banks, buying and selling assets to and from them, and serving as their clearing house. The result, established in much economic research, is that central banks often relax regulations at the request of private banks. The perfect example is the Federal Reserve's steady reduction of reserve requirements, which studies have shown to be a response to pressure by private banks.

For most of what the central bank does, this cozy relationship with private banks is entirely appropriate. The banks want low inflation and low unemployment as much as everyone else. But it means that the central bank is incapable of serving as a bank regulator, which requires enacting regulations that banks don't want to accept. For that purpose you need an outside agency that has no stake in the private banks, and who can take a dispassionate look at their balance sheets.

That conflict of interest is the reason I oppose portions of Frank-Dodd financial reform that expanded the Fed's regulatory role, as well as this new European analogue. I fully expect the ECB to lower, not raise, capital requirements, in response to pressure from banks. I expect them to prop up rather than nationalize failing banks. And the Fed will do the same.

In my view, the regulatory regime should consist of a central bank that uses monetary policy alone--buying assets and serving as lender of last resort--to keep all banks out of bankruptcy, and an independent regulator (like the FDIC) to swoop in and nationalize those that are being kept alive by the central bank's monetary lifesupport.