As discussed above, the main objectives of central banks is to preserve and promote financial systemic stability. Recent events provide impetus for recognizing a financial stability role for central banks. When a crisis hits, central banks play a predominant role in efficient crisis management and resolution. Even though there are a variety of activities to prevent the crisis, crisis events simply cannot be avoided. The imperfectly functioned financial markets consequently give rise to the potential crises in financial system. In addition, external shocks would also trigger the disimbursement.
How to pick up the pieces when a financial crisis occurs varies from case to case. But there are some general principles (Eichengreen and Portes, 1995), some of which require actions before the onset of the turmoil.
An Extension of Traditional Roles of Central Banks
Traditional Roles of Central Banks
Lender of Last Resort Arrangements
The need for the creation of bridge banks and a Special Resolution Regime (SRR) was brought to light following numerous related proposals which were put forward following the financial woes of banks such as Northern Rock and Hypo Real Estate.
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One of the weaknesses of central banks which was revealed during the Financial Crisis was the inability of the Bank of England to perform its traditional role as lender of last resort for a limited period of time (without such a role being made public) - which created problems that triggered the run on Northern Rock.()
Oversight of payment systems
Furthermore, as observed by Hannoun, central banks are increasingly being put in charge of overseeing systemic risk. Such an innovative role can be considered to be an extension of their traditional role as overseers of payment systems. Hannoun goes on to attribute the delegation of such responsibility for the oversight of systemic risk as owing to their unique positions as ultimate providers of liquidity - which places them in a such a formidable stance to focus on system wide risks (as well as obtaining an integrated view of both the individual financial institutions and the financial system as a whole).
In addition to their unique position as ultimate providers of liquidity, the extensive knowledge possessed by central banks - such knowledge and expertise being attributed to their role as overseers of payment systems, their means of acquiring such knowledge and expertise, places them in a formidable position in matters relating to the responsibility for macro prudential supervision.
The above support the view "the macro prudential approach to supervision should take into consideration the fact that, even when financial institutions appear to be strong on an individual basis, systemic risk could still emerge as a result of the interconnectedness of financial institutions, markets and infrastructures" - the European Systemic Risk Board (ESRB) and the proposed Financial Stability Oversight Council in the United States are recent examples(ibid).
The concept "macro prudential" can be defined as "policy which focuses on the financial system as a whole, and also treats aggregate risk as endogenous with regard to the collective behaviour of institutions."(E.P.Davis and D.Karim, 2009). Macro-prudential regulation is considered as "a missing ingredient from the current policy framework" while there is "too huge a gap between macro economic policy and the regulation of individual financial institutions."(Bank of England, Executive Summary, 2009)
The Banking Reform Act in UK has entitled the Bank of England with "a legal objective to contribute to protecting and enhancing the stability of the financial systems of the UK"formalises the Bank of England's role in the supervision of payment systems." The capacity of the Bank to request data from banks through the FSA is only able to collect data it requires itself, is considered to be "an important innovation" under the Act. These arrangements under the Act are also considered to be an important and vital means whereby the Bank is able to acquire "more detailed understanding of developments about the banking system." On 19.11.2009 the the Financial Services Bill was introduced into Parliament. This Bill reforms financial services regulation and contains provisions to improve redress for consumers, and financial education and awareness. ( E P Davis and D Karim,2009)
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The Act (HM Treasury, "Financial Services Act")includes:
âˆ’ A new statutory financial stability objective for the Financial Services Authority (FSA);
âˆ’ A new independent consumer financial education body, established by the FSA.
âˆ’ Provision for regulations on remuneration transparency, and a duty for the FSA to make rules on remuneration.
âˆ’ A duty for the FSA to make rules requiring firms to produce recovery and resolution plans,i.e."living wills".
âˆ’ Power for the FSA to ban short selling of certain instruments, and establish a permanent disclosure regime; and Greater disciplinary powers for the FSA, including earlier disclosure of investigations.
The new statutory duty conferred on the UK's financial services regulator (the FSA), namely, the new financial stability objective, is aimed at reinforcing the FSA's international focus.Such an aim required not only "a consideration of the importance of re affirming the roles of the Treasury, Bank of England and the FSA, but also the need to establish mechanisms which would help ensure that the tripartite authorities speak with a common voice in international fora." Equally important is the expectation that such a statutory duty would complement the Government and the Bank of England's responsibility.
Hence whilst, greater powers have been transferred to the Bank of England, the FSA has also acquired a new statutory duty - in addition to the previous four statutory objectives.
For regulation of banking institutions,
"In all countries, the activities of government-insured, deposit-taking institutions should be subject to prudential regulation and supervision by a single regulator (that is, consolidated supervision). " The largest and most complex banking organizations should be subject to particularly close regulation and supervision, meeting high and common international standards.(G of thirty,2009)
There is, however, an opposition for this policy.
"Banks existed long before prudential regulation was imposed on them by the government."( George J. Benston and George G. Kaufman, 1996) And this regulation is not required for the banking system to operate effectively (see also the comprehensive review by Selgin and White, I994). Long before government prudential regulation attempted to ensure that banks maintain sufficient liquidity to finance with drawals, the market forces that Dowd discusses performed this task and recent evidence strongly suggests that, at least in the United States, government discipline has been less effective. "few would deny that there have been periods of significant financial instability when banks have been regulated", but we suggest that Dowd's review the evidence taken from U.S. experience (reviewed in Benston, I995), which shows that government regulation has been largely responsible for financial instability. Moreover, Dow mischaracterises the U.S. savings and loan debacle when she states (p. 703) that "many episodes of financial instability can be traced to misguided attempts to use regulatory power to control the money supply". Whether or not the I979-8I run up in interest rates was due to the Fed's attempt to control the money supply or to its inability to keep down interest rates after it had allowed the money supply to expand excessively, U.S. thrifts would not have taken massive capital losses had they not held long-term fixed-interest mortgages that were funded with short-term deposits. They held these mortgages because of banking regulations that largely restricted them to these assets, and could get the funding because deposit insurance fully protected depositors (Benston and Kaufman, I990). Finally, they disagree with the view "it is systemic fragility which accounts for the systemic consequences of such micro [bank] failures." It is not supported by theory or empirical studies. ( George J. Benston and George G. Kaufman, 1996)
Emphasize has been given on keeping close collaboration with other central banks as well as the supervisory authorities by the Financial Stability Forum(FSF). The latest accounting and prudential standards which have been proven to be pro-cyclical increase the necessity of this proximity. And in these standards, liquidity and solvency are interlaced. Based on this, it is essential to keep cross-checking the latest status of banks balance on money market functioning, in order to assess the risks of financial stability. Such an assessment can make it possible to adapt the refinancing policy of central bank as far as needed, so that the tension of the market could be reduced. Otherwise, the tension can exert a negative effect on both financial stability and the effectiveness of the transmission of monetary policy. (Ravi Kumar Singh)
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There are many ways to improve international regulatory and supervisory coorperation."National regulatory authorities and finance ministers are strongly encouraged to adapt and enhance existing mechanisms for international regulatory and supervisory coordination."
The focus of needed enhancements should be to:
(i) better coordinate oversight of the largest international banking organizations, with more timely andopen information sharing, and greater clarity on home and host responsibilities, includingin crisis management; (ii) move beyond coordinated rule making and standardsetting to the identification and modification of material national differences in the application and enforcement of such standards; (iii) close regulatory gaps and raisestandards, where needed, with respect to offshore banking centers; and (iv) developthe means for joint consideration of systemic risk concerns and the cyclicality implicationsof regulatory and supervisory policies. The appropriate agencies should strengthentheir actions in member countries to promote implementation and enforcement ofinternational standards.(Group of thirty,2009)
Balance Between Regulatory authorities and market discipline
Be it a rules- based scheme which stipulates that banks should build up buffers of general provisions, capital conservation rules for stronger capital buffers, or a principles based regime (in which a considerable degree of judgment and discretion will be exercised), "any macroprudential policy framework should seek to be credible, with policy decisions applied consistently and systemically. To be consistent over time, a regime needs to be robust to uncertainty and unforeseen events."(Bank of England,2009)
A main policy issue in regulatory institutions is how to choose the right balance between central banks and regulatory authorities. It's decision of the authority where to strike that balance. It is crucial to fulfill the major objectives of central banks. Beyond the central mission of monetary policy, central banks generally play a role in managing and supporting payments systems, in providing liquidity to banks under presure, and more importantly to sustain financial stability.
An important element of post-crisis reform is to consider which crisis managementactions and innovations developed by central banks should usefully remain part of policymakers' tool kits and which should be strictly limited or eliminated entirely. The pointis that broadly extending the safety net may actually encourage risk taking to the point offacilitating future excesses and carry central banks into areas more appropriately reservedfor political authorities.