koetter roszbach spagnolo: financial stability and central bank governance

Michael Koetter (Frankfurt SFM)Kasper Roszbach (Riksbank, U. Groningen)

Giancarlo Spagnolo (SSE-SITE, EIEF)

Financial Stability and Central Bank Governance

DNB conference on Corporate Governance of Financial Institutions

8-9 November 2012

The views expressed in this presentation are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Executive Board of Sveriges

Riksbank.

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Koetter Roszbach Spagnolo: Financial Stability and Central Bank Governance

Origin of project

Interest in the governance (characteristics) of central banks

Why is central banking organized as it is?Enormous variation in way in which central banks are organized;

know relatively littlePerceived objectives, institutional features, wages, other

measures of independenceSupervisory incentives, checks and balancesSurvey

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The central banking agenda

Financial crisis has economists and policy makers thinking about:Institutional organization of micro-prudential

(bank)supervisionSpillovers from monetary policy to financial stability

policy (incl. bank resolution)What the main objective of a CB should beToolboxWhether there is scope for macro-prudential supervision

as a complement to micro-prudential supervisionWhat MPS is and how it should be conducted

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Future institutional arrangements

Should new tools and mandates for prudential regulation and systemic financial stability should be given to Central Banks?

Does this have consequences for the allocation of micro-prudential supervision?

If so, then how to regulate the inevitable conflicts between monetary policy, macro-systemic stability, and micro-supervisory objectives

UK recently "reversed" the 1997 separation between a micro-prudential supervisor and the BoE

More or less with same arguments: supervision of Northern Rock vs Barings/BCCI considered ineffective.

Perception: assigning bank supervision to the Central Bank is a poor institutional arrangement was widespread before the crisis

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But opposing views

Some notable commentators recently suggested that this widespread perception was wrong

Other at least as prominent observers (Goodhart, Buiter): suggest opposite

Independent bank supervision authority preferableOnly the new macro-systemic stability tasks and tools should be

assigned to Central Banks"

Reasonable theoretical arguments exist in support of both views =>

Important question: which institutional arrangement performs better in terms of preventing financial distress, particularly in wake of a financial crisis

Micro supervision to a specialized authority or to the Central Bank?

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This paper

Do differences across Central Banks in terms of their objectives, supervisory mandate, and relevant governance features help to explain banking system fragility prior and during the crisis?

Use a new dataset with detailed information on central banks' governance characteristics

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Ingredients

• Survey data on central bank governance characteristics (objectives, budgetary freedom, allocation of profits)

• Measure of financial fragility: average fraction of non-performing loans in jurisdiction

• Can CB governance characteristics, institutional features for supervision, country controls and CB objectives explain variation in fragility?

• Pre-crisis and during-crisis

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Limitations!

No panel data on governance and institutional structure Number of jurisdictions (homogeneity) Measure of financial stability

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Findings

Country controls, like legal origin, income dispersion, historical levels of credit risk, and OECD membership explain most of fragility

Objectives: only currency stability exhibits a consistently negative relationship with credit risk prior to the financial crisis

Possibly some relation to IMF programs?

Institutional separation (or unification) of prudential and monetary policy has no significant impact on financial fragility

Governance characteristics of central banks do not influence NP

For the crisis period, most links break down!

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Data

•Survey on central bank governance

• Collected information on Board composition, appointment rules, meeting frequency, investment rules, budget rules, et cetera

• Conducted between 2004 and 2006

• BIS, World Bank, Laeven and Valencia (crisis variable), Shleifer (legal origin, creditor protection), World Value Survey (trust), market structure variables HHI, Panzar-Rosse)

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Variables of interest

•Objectives of central bank: MP, FS, Forex•Separated or integrated bank supervision

•Age of CB•Budgetary freedom•Freedom to allocate profits

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• Select regressors from very large set of country controls, CB governance characteristics and institutional features

• Keep variables that display univariate relation and add a few other governance controls

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Pre-crisis results

•Macroeconomic differences across countries most relevant to explain financial fragility

•Neither more frequent crises in the past nor banking market structure affect NPL

•Higher income dispersion and high historical levels of NPL explain most of cross-country variation; correlate positively with pre-crisis NPL

•OECD Membership and a UK style legal system reduce NPL

•Monetary policy objectives exhibit no significant relation•Central bank governance characteristics have no impact •Pursuing external stability as a prime objective correlates most significantly, negatively, with pre-crisis NPL

•Differences in the prudential supervisory architecture have no significant impact

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Mean NPL and country controls pre-crisis (2004-2006)

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Mean NPL and CB characteristics pre-crisis (2004-2006)

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Crisis results

•Ability of covariates to explain NPL shares vanishes almost entirely.

•Pre-crisis monitoring equally (in)effective prudential architecture

• Number of currency crises post 1970, higher banking market concentration, and more recent foundation of the Central Bank exhibit statistically weakly evidence in favor of lower NPL ratios

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Mean NPL and CB characteristics in crisis (2007-2009)

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Mean NPL and CB characteristics in crisis (2007-2009)

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Can we explain role of foreign exchange objectives?

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Do foreign exchange objectives reflect learning from crises?

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Conclusions

•Country specific conditions, past experiences a best at explaining different fragility levels

•Consistent with the negative findings of Hasan and Mester (2008)

•Only governance characteristic that matters is foreign currency objective; potentially related to previous currency crisis experience

•Relationships break down in crisis

•Debate on whether to centralize prudential supervision, the potential role of Central Banks versus alternative authorities, appear less relevant

•For future research: do countries learn from experiences and/or IMF programs?

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koetter roszbach spagnolo: financial stability and central bank governance

Documents

central bank governancebut

financial stability

systemic financial stability

koetter roszbach spagnolo

bank resolutionwhat

eieffinancial stability

financial distress

macroprudential supervision