A framework for central banks and bank supervision

A framework for central banks and bank supervision

A fresh policy framework

Under this framework, monetary policy and the regulation of banks aim at stabilizing both inflation and the true economy. Stabilisation of the true economy consists in stabilising output fluctuations due to macroeconomic shocks and by financial instability. In the latter case, stabilisation of output fluctuations is attained by avoiding or reducing financial instability itself.

The central bank could have two instruments at its disposal:

(a) the short-term interest and

(b) the aggregate equity ratio of the banking sector thought as the ratio of total end-borrower lending (credit for non-financial firms, households, and governments) plus other non-bank assets to total equity in the banking sector. The aggregate equity ratio may be the measure of the administrative centre cushion of the banking sector.

As a result, there are two policy rules for the central bank: mortgage loan rule and an aggregate equity ratio rule. The former is a normal interest rule (see for instance Gali (2008, Chapter 3)) that can include yet another variable capturing the existing state of money and credit, as discussed below. The latter relates the mandatory equity ratio of the bank operating system within the next period to the present aggregate equity ratio also to the state of money and credit. Although it is impossible to locate a fixed aggregate equity ratio rule, it’ll be essential that such a rule is really as systematic, transparent and accountable as traditional monetary policy regimes.

The state of money and credit indicates how strongly consolidated and unconsolidated balance sheets of banks or financial intermediaries expand or contract in comparison to average growth. It is useful to focus on sub-aggregates such as for example total credit to non-banks or total short-term debt liabilities of banks to non-banks and among banks themselves. The latter measures include both traditional monetary aggregates such as for example household deposits and other liabilities such as for example commercial papers and repurchase agreements which provide signals about the cost of risk and other financial-market conditions (see Adrian and Shin (2009) for an analysis of the usefulness of broader monetary aggregates like these). 1

All remaining activities for the regulation and supervision of banks are executed by separate and less independent bank-regulatory authorities. These authorities act beneath the aggregate equity ratio constraint set by the central bank. They determine bank-specific capital requirements that may necessitate upward and downward adjustments of capital requirements, based on whether a specific bank holds a high-risk or low-risk asset portfolio. Effectively, bank-specific capital requirements are dependant on the banking-on-the-average approach examined in Gersbach and Hahn (2009). Those separate authorities also regulate shadow-banking, operate the deposit insurance scheme and could intervene to restructure or close banks. 2

An illustration of the brand new policy framework

The framework enables a central bank to conduct flexible inflation targeting also to moderate booms and busts as something regulator. Both setting of the interest and of the aggregate equity ratios need to be chosen so they are mutually consistent. Below are a few examples illustrating this aspect.

In a low-inflationary downturn, when banks need to jot down equity as asset prices decline or credit losses occur, both aggregate capital requirements and short-term interest levels could be lowered to moderate the bust. After such a poor shock, the central bank can (and must) raise the required aggregate equity ratio when the liabilities (or assets) of the banking sector start growing strongly again, so as to raise the aggregate buffer of the bank operating system.

In boom periods, central banks can "lean against the wind" with a combination of short-term interest increases and raising the mandatory aggregate bank-equity ratios. For example, in a boom with low inflation and rapid growth of the banking sector’s balance sheet, raising the aggregate equity ratio may be the principal vehicle for moderating the boom, putting a lesser weight on interest hikes. If the boom is accompanied by higher inflation, increasing short-term interest levels can be used as well as higher aggregate bank-equity requirements to moderate inflation also to avoid the build-up of excessive leverage in the complete banking sector, thus lowering the chance of another banking crisis.

As a result, a lot of the drawbacks of Basel II (see Hellwig (2008)) could be avoided. For example, regulatory capital in a boom reaches least partially a buffer against negative macroeconomic shocks. Moreover, raising the aggregate equity ratio in booms can put a damper on the build-up of high leverage for most banks. This might curtail the vulnerabilities of the bank operating system. Furthermore, banking regulation authorities can ensure the soundness of individual banks. For example, bank-specific capital requirements could be made reliant on the relative riskiness of banks’ asset portfolios.

This policy framework has an response to how macroprudential and microprudential supervision could be organised so they are mutually consistent (e.g. Borio (2003)). Our suggestion to create capital charges countercyclical shares the spirit of Brunnermeier et al. (2009), who suggest using above-average growth of credit and leverage, and the mismatch in the maturity of assets and liabilities to regulate capital adequacy requirements over the cycle.

Of course, it’ll never be possible to tell apart precisely between a boom fuelled by high total factor productivity growth and one which can’t be justified on fundamental grounds. Moreover, constraining bank expansion during euphoric upswings can induce disintermediation to less controlled channels. These considerations reinforce the necessity for the consistency of interest-rate and aggregate-equity policies if they are used jointly, to lean – strongly or gently – against the wind.

Moreover, there are two alternative institutional arrangements for implementing the guidelines. Either bank regulation and supervision authorities manage both macroprudential and microprudential activities, or they are executed in two different institutions and separated from the central bank. Such arrangements would shield central banks from pressure by interest groups when equity ratios must be raised. However they would only be viable if aggregate equity rules allow little discretion for the regulatory agencies.

This principle of targeting aggregate equity may be put on liquidity requirements if targeting aggregate bank equity will not make such requirements superfluous. Moreover, if the downturn is severe and is connected with banking instability, further unconventional measures could be necessary, such as for example emergency liquidity assistance, guarantees, recapitalisation of banks, or restructuring and liquidation of individual banks. The framework proposed here is aimed at minimising the probability of such events.

The formal framework

The formal resource for examining this new policy framework is actually a mix of the leading models for flexible inflation targeting using its microfoundation (Woodford (2003)) and flexible bank equity targeting, as suggested by Gersbach (2009) and Gersbach and Hahn (2009), in addition to the balance sheet model for the banking sector outlined by Shin (2009). 3


The existing proposal is aimed at separating the responsibilities and instruments regarding capital requirements and bank supervision. The proposal places a considerable burden on the shoulders of central banks in regards to to inflation and financial stability. As well as current events, the function of central banks as a lender of final resort indicates that burden can’t be avoided. Accordingly, it creates common sense to equip the central bank with two instruments (short-term interest levels and aggregate equity ratios of the bank operating system) to greatly help them bear this burden, while leaving detailed bank regulation and supervision activities to split up authorities.


1 Moreover, other the different parts of systemic risk such as for example inter-connectivity and derived network risk could be included to spell it out the state of the economy.

2 It ought to be noted, however, that the central bank must keep its monopoly as a lender of final resort. Hence, liquidity support to the banking sector beyond what will be possible through government bonds can only just be supplied by the central bank.

3 An initial attempt is available upon request.


Adrian, Tobias and Hyun Song Shin (2009), "Money, Liquidity and Monetary Policy", forthcoming in American Economic Review Papers and Proceedings.

Brunnermeier, Markus, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin, THE ESSENTIAL Principles of Financial Regulation, Geneva Reports on the World Economy 11, ICMB and CEPR, Geneva and London, 2009.

De Larosière, Jacques, Leszek Balcerowicz, Otmar Issing, Rainer Masera, Callum McCarthy, Lars Nyberg, José Pérez and Onno Ruding (2009), Report by the High-Level Group on Financial Supervision in the EU, 25 February.

Gerlach, Stefan, Alberto Giovannini, Cédric Tille and José Viñals (2009), Will be the Golden Days of Banking Over? The Crisis and the Challenges, Geneva Reports on the World Economy, 10.

Gersbach, Hans and Volker Hahn (2009),“Banking-on-the-average Rules”, CER-ETH Working Paper 09/107.

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