Über die Autorin bzw. den Autor

Howard Davies is director of the London School of Economics and Political Science. Previously, he was chairman of the United Kingdom's Financial Services Authority and deputy governor of the Bank of England. David Green has worked for almost forty years as a central banker and financial regulator, principally at the Bank of England and the Financial Services Authority. Davies and Green are the authors of "Global Financial Regulation".

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"Not long ago, national central banks were endowed with wide-ranging authority, enormous prestige, and a high degree of independence. Today, in the aftermath of the global financial crisis, rethinking their functioning and their modus operandi is both natural and needed. Howard Davies and David Green write on this issue with authority, reflecting their practical experience, political sensitivity, and high analytic skills."--Paul Volcker, former chairman of the U.S. Federal Reserve and current chairman of the U.S. Economic Recovery Advisory Board

"Banking on the Future provides the most comprehensive and lucid analysis of the pressing challenges faced by central banks. The book clearly shows how monetary policy and financial stability concerns have drifted apart in recent years and the crucial role this dichotomy has played in the run up to the crisis. Davies and Green put forward precise, cogent, and practical recommendations for the future. It is urgent and important that policymakers ponder and act on these proposals."--Jacques de Larosière, chairman of the Strategic Committee of the French Treasury and former governor of the Banque de France

"An indispensable book for practitioners and students alike. The authors write from a depth of central banking experience, and have witnessed at close hand the disastrous consequences of separating monetary policy from financial regulation. They provide a convincing plan for reuniting the two."--William Keegan, senior economics commentator,Observer

"The great credit crisis of 2007-9 begs the question: how much do we need to rethink central banking? The explosive issues include whether central banks should lean against asset bubbles, whether inflation targeting needs to be reconsidered, and whether strong independence is compatible with the expanding responsibilities assumed by central banks. There is no one more reliable than Davies and Green for guiding us through this minefield."--Barry Eichengreen, author ofThe European Economy since 1945

"An extraordinary book that asks all the right and very difficult questions, and manages to suggest some of the answers."--Guido Tabellini, Università Commerciale Luigi Bocconi, Milan

"This is a timely book on an important subject. It represents a significant contribution to the literature on central banking, and draws on historical, political, economic, business, and sociological considerations."--Rosa M. Lastra, Centre for Commercial Law Studies, Queen Mary University of London

"In the wake of recent financial disturbances, there have been many papers and books on what went wrong, and on what changes there have to be in the private financial sector and the behavior of regulators. There has, however, been very little written on the implications for central banks. This is an excellent, clear, and important book."--Geoffrey E. Wood, Cass Business School, City University London

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"Not long ago, national central banks were endowed with wide-ranging authority, enormous prestige, and a high degree of independence. Today, in the aftermath of the global financial crisis, rethinking their functioning and their modus operandi is both natural and needed. Howard Davies and David Green write on this issue with authority, reflecting their practical experience, political sensitivity, and high analytic skills."--Paul Volcker, former chairman of the U.S. Federal Reserve and current chairman of the U.S. Economic Recovery Advisory Board

"Banking on the Future provides the most comprehensive and lucid analysis of the pressing challenges faced by central banks. The book clearly shows how monetary policy and financial stability concerns have drifted apart in recent years and the crucial role this dichotomy has played in the run up to the crisis. Davies and Green put forward precise, cogent, and practical recommendations for the future. It is urgent and important that policymakers ponder and act on these proposals."--Jacques de Larosière, chairman of the Strategic Committee of the French Treasury and former governor of the Banque de France

"An indispensable book for practitioners and students alike. The authors write from a depth of central banking experience, and have witnessed at close hand the disastrous consequences of separating monetary policy from financial regulation. They provide a convincing plan for reuniting the two."--William Keegan, senior economics commentator,Observer

"The great credit crisis of 2007-9 begs the question: how much do we need to rethink central banking? The explosive issues include whether central banks should lean against asset bubbles, whether inflation targeting needs to be reconsidered, and whether strong independence is compatible with the expanding responsibilities assumed by central banks. There is no one more reliable than Davies and Green for guiding us through this minefield."--Barry Eichengreen, author ofThe European Economy since 1945

"An extraordinary book that asks all the right and very difficult questions, and manages to suggest some of the answers."--Guido Tabellini, Università Commerciale Luigi Bocconi, Milan

"This is a timely book on an important subject. It represents a significant contribution to the literature on central banking, and draws on historical, political, economic, business, and sociological considerations."--Rosa M. Lastra, Centre for Commercial Law Studies, Queen Mary University of London

"In the wake of recent financial disturbances, there have been many papers and books on what went wrong, and on what changes there have to be in the private financial sector and the behavior of regulators. There has, however, been very little written on the implications for central banks. This is an excellent, clear, and important book."--Geoffrey E. Wood, Cass Business School, City University London

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Banking on the Future

PRINCETON UNIVERSITY PRESS

Contents

Preface...........................................................................viiAbbreviations.....................................................................ixIntroduction......................................................................1Chapter One What Is Central Banking and Why Is It Important?.....................9Chapter Two Monetary Stability...................................................23Chapter Three Financial Stability................................................52Chapter Four Financial Infrastructure............................................90Chapter Five Asset Prices........................................................115Chapter Six Structure, Status, and Accountability................................141Chapter Seven Europe: A Special Case.............................................182Chapter Eight Central Banking in Emerging Market Countries.......................212Chapter Nine Financial Resources, Costs, and Efficiency..........................236Chapter Ten International Cooperation............................................252Chapter Eleven Leadership........................................................270Chapter Twelve An Agenda for Change..............................................285Afterword.........................................................................297Notes.............................................................................301Index.............................................................................317

Chapter One

Societies become so used to the availability of stable currency, the ability to make payments both domestically and internationally, and the existence of banks and other financial institutions through which to save and borrow that it is easy to forget that each of these is a purely social construct, fundamentally based on trust, albeit bolstered by legislation. Occasionally, unpleasant reminders resurface abruptly that the financial system is fundamentally fragile. It is rare, fortunately, that currencies lose their value so fast that they cease to function-something that we have recently seen in Zimbabwe and that happened in Germany in the 1930s-or that other payment mechanisms break down so that goods and services can only be traded through barter. That tends to happen only in wartime, as in Afghanistan in the recent past or, briefly, when Iraq invaded Kuwait in 1991 and no one knew who controlled the Kuwaiti central bank.

It is more common for individual banks or other financial firms to fail. Banking is itself a fragile business because a bank depends on the confidence of its depositors that it will be able to repay their deposits whenever they want them, even though it has lent them out at longer terms to borrowers. The maturity transformation that banks carry out is in that sense a confidence trick.

All developed economic activity is dependent on this fragile financial infrastructure, which requires its numerous constituent players to play their parts as expected: the provider of currency must avoid issuing it at such a pace that it is devalued; those making payments must deliver them to the intended recipient ; savings should be made available to sustain investment and loans provided to sustain business activity, house purchase, or consumer spending.

Society looks to central banks to try to prevent these inherent fragilities crystallizing or, if they do, to mitigate their repercussions. The instruments at their disposal are quite limited and, in a sense, not very sophisticated. Their main tool is their own balance sheet, as it is by acquiring and selling assets and liabilities, borrowing and lending, that they can seek to influence prices and interest rates in other markets. The effectiveness of these actions is far from guaranteed-indeed the central bank's own balance sheet may well be constrained-and is dependent on the wider economic climate in which they are operating. So the use of the balance sheet has to be supplemented by suasion or guidance to the markets and to economic agents generally. Indeed it may be as much through persuasion as through economic action that a central bank achieves its aims. The combination of the two determines whether what the central bank does makes any difference at all, given that its armory of tools is essentially very limited. Changes in its balance sheet may be backed up by an array of other controls, for which it may be responsible, on the behavior of economic agents. These may be capital or exchange controls, or controls on bank behavior, such as quantitative or price controls. But in open markets such controls are of limited value in the long term.

Because the economic environment changes constantly, the way the tools are used evolves. Political priorities change over time, sometimes quite markedly and rapidly, with switches, even within a single country, from ensuring credit is available to favored economic sectors to restraining inflation, and then, perhaps, to maintaining a particular exchange rate.

Almost all countries now boast an institution called a central bank. Central banking was not always so widespread, nor were its advantages so widely acknowledged. In the United States, there were two unsuccessful attempts to establish a "central" bank, in both cases called the Bank of the United States, before the Federal Reserve System was set up in 1913. There was a strong strand of thinking in the United States at the time in favor of "free banking," and a fully competitive banking system, without the intermediation of a state-owned or state-backed institution at its center. Indeed, arguments about the merits of free banking still rumble on in some academic and political circles.

Advocates of free banking argue that private monetary systems have in the past been stable and successful, and that a competitive banking system is less susceptible to bank runs, while the existence of central banks has allowed political interference in the banking system, which has had the effect of altering incentive structures and which has created instability. These arguments have not, however, persuaded many governments. The balance of evidence appears to show that free banking leads, instead, to systemic instability. So while arguments continue about the sources of financial instability and, while even before the financial meltdown of 2007-9, the incidence of banking crises remained surprisingly high, both the academic and the political debates now focus more on the appropriate functions and responsibilities of the central bank rather than on whether it should exist at all.

But what exactly do we mean by a central bank? The answer is not straightforward. Indeed the definition of the functions that are appropriate for a central bank has changed considerably through time. As the BIS Central Bank Governance Group points out, in the past central banks "have been understood more in terms of their functions than their objectives."

Historians of monetary institutions tend to date the introduction of central banking to the foundation of the Swedish Riksbank in 1668 or to the foundation of the Bank of England in 1694. But, as Capie et al. point out, at that time there was no developed concept of central banking. The Bank of England was founded as a private bank to finance a war. Not until Henry Thornton wrote his An Enquiry into the Nature and Effects of Paper Credit in the United Kingdom in 1802 was any theory of central banking as we would recognize it today articulated. Others argue that the modern-day notion of central banking should be dated from the 1844 Act, which effectively gave the Bank of England a monopoly on the issue of banknotes, or even from 1870 when the Bank first accepted the function of lender of last resort. The other main European central banks took on these responsibilities in the last decades of the nineteenth century. Nevertheless, Thornton's enquiry into "paper credit" points to the fact that central banks are seen to address the fundamental problem that financial intermediation is based purely on trust documented in paper or, now, in electronic form. If that trust breaks down, payments cannot be made and savings become worthless. Recent events have provided a very sharp reminder of that risk.

Many central banks, especially the oldest of them, began as private-sector companies; others started as public-sector agencies. The Bank of England is in the former group; the Federal Reserve Board and the European Central Bank are in the latter. The great majority are now state owned, though partial private ownership persists in a few cases. In principle, one can imagine an argument in favor of some private ownership, especially as a stimulus to efficiency, which, as we shall see, is a neglected area. But as the allocation of profits is typically specified in advance, even in partly private institutions, the case is weaker. Central banks are clearly carrying out public objectives, in whole or in greater part, so the case for state ownership is strong. Almost all of the 162 central banks now in existence are state owned. Private-ownership stakes, where they persist, seem more an accident of history than a deliberate policy objective. (In the United States a mixed model is in operation. The Federal Reserve Board in Washington is state owned, while the regional Federal Reserve Banks are statutory bodies that combine public and private elements, and which have boards selected largely from financial and commercial firms in the district.) Private shareholding can entail risks, too. "Rogue" shareholders may challenge a central bank's actions, as has happened in Belgium. Where the shares are quoted there can be inconsistency between stock exchange reporting requirements and policy-driven restrictions on disclosure. There is no strong case, therefore, for retaining private ownership, and a clear trend toward nationalization. Even governments with a strong ideological commitment to privatization have not carried that enthusiasm into central banking. In some cases, though, functions have been contracted out, or sold. The Bank of England, for example, sold off its note-printing works a few years ago.

In terms of their formal responsibilities we can identify a gradual expansion of the range of functions undertaken by central banks up to the 1980s, and then something of an ebb in the last twenty-five years in terms of the breadth of responsibilities, but certainly not in terms of their overall status and influence. The latter part of the twentieth century was a golden age for central banks. While after the foundation of the Swedish and English central banks at the end of the seventeenth century there was a gap of more than 100 years before France established the third central bank, 118 new institutions were established between 1950 and 2000. Every country with a seat at the United Nations wanted its own central bank, and even some jurisdictions that might not normally be regarded as independent countries, like San Marino, set one up. As we shall see, these institutions gradually became more "independent," though independence carries a multitude of meanings in this context. The growing complexity and diversity of the financial sector in most parts of the world, and the rapid increase in government borrowing and in capital movements, gave central banks more and more to do, whether in the form of overseeing payment systems, undertaking basic banking transactions for the government, handling foreign exchange flows, sometimes managing government borrowing, or supervising banks and other financial institutions.

A significant boost to the number of central banks was given by the collapse of the Soviet Union. Each former Soviet state established its own financial system and concluded that a central bank was required to watch over it. Elsewhere, in the Balkans particularly, other new countries have been created. The most recent additions to the central banking ranks have been in East Timor and Kosovo. But it seems probable that the absolute number of central banks has now peaked, and there have been one or two amalgamations in recent years. In some cases a number of countries that share a currency make do with one central bank, as in the East Caribbean or former French West Africa.

And as the number of institutions grew, so did the number of people employed in them. By the end of the last century-if one includes the People's Bank of China, before it was broken up into its component parts-there were almost 600,000 central bankers in captivity. That number has now fallen back to under 350,000, and the trend is now clearly downward, though by no means everywhere. While there are powerful pressures for staff reductions in, for example, national central banks in the European System of Central Banks, there are other places where staff numbers are growing. The People's Bank, in its reduced form, is expanding again, as are some central banks in more unexpected places like Zimbabwe. But in most OECD countries numbers are falling, though by no means as rapidly as they could be, as we will explain when we examine central banks' commitment to efficiency and productivity, which is not as marked as it should be. We will argue that this is partly because of the absence of competitive forces bearing down on the central banking function. It may also be born of uncertainty about just how much "central banking" is enough.

As we shall show, there is a remarkable range of central bank sizes in relation to the populations they serve. Only part of this remarkable difference can be explained by economies of scale or by different combinations of function.

All central banks, when asked what their responsibilities are, say that they are responsible for monetary policy, although a few acknowledge that they operate in partnership with the government, or that they advise government ministers on interest rates. But in fact there is a great diversity of practice in terms of who makes interest rate decisions. In many cases, especially in emerging markets, it is clear that governments are closely involved, whether through direct participation in interest rate decision-making bodies within the central bank itself, through the exercise of some veto authority, or by marking the governor's card in private. Of course, where the anti-inflation anchor is essentially provided by an exchange rate target, the central bank's discretion in monetary policy, whether setting interest rates or determining the growth of money, is heavily constrained.

In a study of forty-seven central banks, carried out in 2006, researchers from the Swedish Riksbank asked the banks themselves how they perceived their objectives. Around half responded that price stability was their primary objective, but the rest chose a different aim, or combination of aims (figure 1.1). The study also asked banks to set out what, apart from monetary policy, they saw as their objectives. Roughly half considered that they were pursuing aims in relation to the financial system and financial stability. A smaller proportion cited more general economic objectives, in relation to employment or economic activity more generally. The distinction between those banks with a "dual mandate" along Federal Reserve lines, charged with controlling inflation and promoting economic activity, and those with a narrower inflation target type regime seems clear from the analysis, though the implications for the interest rate policy decisions may not be as stark as the data suggest here.

When asked to describe the exchange rate policies within which they operate, central banks give a range of answers. If we exclude the members of the euro area, and the handful of countries (such as Ecuador, El Salvador, and Montenegro) that do not have a domestic currency of their own and which use the dollar or the euro, roughly 40% describe themselves as operating a floating rate regime. In some cases it would be wrong to describe these as "free floats," and the governments undoubtedly intervene, whether directly in foreign exchange markets or in domestic interbank markets, in order to smooth market movements and reduce volatility. These regimes are often described as "dirty floats." So the borderline between floating and managed exchange rates is not as rigid as these distinctions might imply. But twenty-four countries claim that they are managing a floating exchange rate, while sixty-eight say that their rates are pegged, whether to the dollar or the euro or to some basket of currencies reflecting their trade flows. The contents of those baskets may be disclosed or left deliberately opaque, as in the case of Singapore. It is perhaps surprising that almost exactly the same number of countries now claim to be pegged to the euro as claim to be pegged to the dollar. Eight of these countries are members of the West African franc zone, however, which perhaps exaggerates the euro's impact on other exchange rate regimes.

Since the establishment of the European single currency in 1999 a growing number of other countries, whether on the edges of Europe or outside it, have chosen to use the euro as their nominal anchor. The financial crisis has increased the attractiveness of the euro as a stable store of value. The other pegged currencies are mainly linked to the rand in Southern Africa, which exerts a similar gravitational pull on members of the Southern African Development Community. A subset of member countries takes part in a formalized Common Monetary Area.

Another area in which there is considerable diversity of practice is in relation to the central bank's involvement in financial regulation. We shall discuss the pros and cons of such involvement later (in chapter 4). Around 120 central banks have some direct involvement in hands-on supervision, always of banks, and sometimes of other financial institutions as well, though in a few, mainly small countries, they are the regulators of the financial sector as a whole. In around sixty countries the central bank is not directly involved (figure 1.2). (These numbers are somewhat larger than the number of central banks, as they are disaggregated by country, where the supervision arrangements are invariably national, while those for monetary policy are sometimes pooled between several countries.) But in population terms the ratio is rather different, since banking supervision in China is not carried out by the central bank. A rough breakdown by population suggests that in around 60% of the world central banks supervise banks, while in 40% they do not. In the years leading up to the recent crisis there was a general trend away from central bank involvement in supervision, and in a number of countries, the responsibility was transferred. But it is unlikely that a global consensus on this point will be achieved in the foreseeable future. Indeed the financial crisis has caused a rethink of the optimal role for a central bank in financial stability, and the extent to which that role requires direct involvement in the regulation of individual banks.

There is also little sign of a consensus being reached on the appropriate role for the central bank in consumer protection. When he was governor of the Bank of England, Eddie George liked to say that consumer protection was "not the natural habitat" of the central banker. The ECB has no consumer protection function. Yet at least half of all central banks do play some role in this area. In the United States, the Federal Reserve has been responsible for implementing federal laws on consumer credit. Its performance in that area in the run-up to the crisis has been heavily criticized, and President Obama's reforms envisage a new consumer financial protection regulator to carry out those responsibilities, and more. In the United Kingdom, the Conservatives have also proposed a separate consumer protection agency.

(Continues...)

Excerpted from Banking on the Futureby Howard Davies David Green Copyright © 2010 by Princeton University Press. Excerpted by permission.
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