I came across this excellent paper from David Andrew Singer and Mark Copelovitch. It is easily one of the best papers I have read on political economy of Central Banking.
The paper tries to answer this question- if central banks are given the responsibility of bank supervision as well, how do they perform in terms of inflation management? The reasons for Central banks being given bank supervision role (or not given) is because of historical reasons and the institutional set-up in the economy. Read the paper for some excellent examples.
The next question is why should central banks face problems by doing bank supervision as well? Say a Central Bank raises rates to manage rising inflation, it would impact the banks as well:
Banks are particularly vulnerable to changing financial market conditions because they must commit to loan terms in advance. More specifically, banks that issue fixed-rate loans, such as mortgages and certain corporate loans, will face declining profits as increasing interest rates force them to raise their own deposit rates. Bank customers might also withdraw their money in favor of higher -yielding money market accounts or other investments.
The overall increase in the cost of funds, in turn, cuts into banks’ profits and increases the likelihood of bank failures (OECD 1992). Increasing interest rates also leads to a greater risk of default by bank customers with flexible-rate loans, which also increases the potential for bank failures (OECD1992; Tuya and Zamalloa 1994).
So, what the paper says is if central banks are banks supervisors as well, they would also be looking at bank balance-sheets and not just inf lation. The findings:
All else equal, countries in which the central bank does not regulate banks have inflation rates that are 0.81 % lower than in countries that regulate banks.
This is an important finding. In this crisis, there are suggestions that Central banks should be made responsible for bank supervision as well (or should have a larger role to play). Now, if they are made bank supervisors as well how will they balance the risks of inflation? The study looks at Bank of England and shows how seperation of bank supervision tasks from Bank of England led it to focus on inflation. And in this crisis, there is criticism that Bank of England was not aware of the problems in UK banking system. So clearly, the problems have come full circle. The paper would have been more interesting if it had also seen how central banks that are bank supervisors as well, fared in manging banking/financial crisis? Did they have more information. Then this cost of high inflation vs benefits of managing the crisis could have been analysed. There is a huge scope for further research.
And what should developing economies do? The developing economies have weaker institutions and do not have the expertise as well. So as a result, in developing economies one usually sees Central banks doing the role of both- monetary management and bank regulation. Should they give up the role of bank supervision to get better control on inflation? Then what happens to banks? Who will supervise them? I think developing economies need to wait to seperate the regulation from central banks.
There are numeorus papers that assess whether Central Bank Independence has led to lower inflation or not. But very few papers look at the regulation function of Central Banks and how it effects their performance. This paper throws a lot of light on this matter and also the political economy of central banks.