In nearly every major financial crisis of the past decade - from East Asia to Russia, Turkey, and Latin America - political interference in financial sector regulation helped make a bad situation worse.
Political pressures not only weakened financial regulation generally, they also hindered regulators and the supervisors who enforce the regulations from taking action against banks that ran into trouble. In so doing, they crippled the financial sector in the run-up to the crisis, delayed recognition of the severity of the crisis, slowed needed intervention, and raised the cost of the crisis to taxpayers.
Increasingly, both policymakers and policy analysts are recognising the need to shield financial sector regulators from political pressure to improve the quality of regulation and supervision with the ultimate goal of preventing financial crises. Surprisingly, however, few analyses have systematically discussed why independence for the financial regulatory agency might be desirable and how it might best be achieved.
This pamphlet investigates why financial sector regulators and supervisors might need a substantial degree of independence - not only from the government but also from the financial services industry - to fulfil their mandate to achieve and preserve financial sector stability. It also looks at the need for keeping regulators accountable as they exercise the (often) far-reaching powers delegated to them by their government.
RATIONALE FOR REGULATION: Regulators and supervisors in nations around the world are charged with managing the health of banks and other financial institutions and preserving the stability of the financial system. Governments regulate financial institutions for two main purposes. The first is consumer protection.
This is much the same reason they regulate public utilities and telecommunications: to provide a framework of rules that can help prevent the excesses and failures of a market left entirely to its own devices. Second, regulation in the financial sector has the additional goal of maintaining financial stability, a clear public good that justifies a more elaborate framework of regulation and supervision.
Financial sector supervision, in particular, is more rigorous and intensive than supervision in other regulated sectors. Banking supervisors engage not only in off-site analysis of banks' performance but also in extensive on-site inspections, and they intensify their monitoring and may intervene when banks fail to meet minimum requirements designed to ensure their financial soundness. Supervisors can even, in extreme cases, take ownership rights away from the owners of failed or failing financial institutions.
Banking regulation developed out of the concern of central banks to ensure financial stability. In many parts of the world, the central bank is the agency responsible for regulating banks, while, in others, it is a separate agency. In the nonbank financial sector, such as securities markets, insurance, and pensions, regulation has usually been conducted either by a central government ministry or by a specialist agency answerable to a ministry. The need for independent regulatory agencies has not, however, featured very strongly in public debates. In recent years, this has begun to change, driven by two important reasons.
LACK OF INDEPENDENCE WORSENS FINANCIAL CRISES: In many of the world's recent financial crises, policymakers in the countries affected have sought to intervene in the work of regulators - often with disastrous results. It is now increasingly recognised that political meddling has consistently caused or worsened financial instability.
In her account of the Venezuelan banking crisis of 1994, former central bank president Ruth de Krivoy cited ineffective regulation, weak supervision, and political interference as factors weakening the banks in the period leading up to the crisis. In her book, Collapse, published in 2000, de Krivoy emphasised the need for lawmakers to "make bank supervisors strong and independent, and give them enough political support to allow them to perform their duties."
In East Asia in 199798, political interference in the regulatory and supervisory process postponed recognition of the severity of the crisis, delayed action, and, ultimately, deepened the crisis. In Korea, for example, a lack of independence impeded supervision.
While the country's commercial banks were under the authority of the central bank (the Bank of Korea) and the Office of Banking Supervision, Korea's specialized banks and nonbank financial institutions were regulated by the ministry of finance and economy. The ministry's weak supervision encouraged excessive risk taking by the nonbanks, which helped lead to the 1997 crisis. Korea subsequently reformed its supervisory system, both to give it more autonomy and to eliminate the regulatory and supervisory gaps.
In Indonesia, banking sector weaknesses stemmed from poorly enforced regulations and from supervisors' reluctance to take action against politically well connected banks, especially those linked to the Suharto family. When the crisis hit, central bank procedures for dispensing liquidity support to troubled banks were overridden, it has been claimed, on the direct instructions of the president. Even after Suharto's fall, political interference continued in the bank restructuring effort. Indonesia's Financial Sector Action Committee, which was composed of several heads of economic ministries and chaired by the co-ordinating minister, intervened intrusively in the work of the Indonesian Bank Restructuring Agency and undermined the credibility of the agency's restructuring effort.
The lack of independence of financial supervisors in Japan's ministry of finance weakened the Japanese financial sector and contributed to prolonged banking sector problems. Although there was probably little direct political pressure on the ministry to allow weak banks to continue operating, the system lacked transparency, and implicit government guarantees of banking sector liabilities were understood to be widespread. Following a decline in the ministry's reputation in the late 1990s, the Japanese government created a new Financial Services Agency to oversee banking, insurance, and the securities markets, in part as an attempt to improve the independence of supervision.
THE EXAMPLE OF CENTRAL BANK INDEPENDENCE: A second development that has encouraged interest in regulatory independence is the success achieved by independent central banks in fighting inflation. Since the late 1980s, more and more countries have freed their central banks from political control because evidence was growing that independent central banks had a successful record of achieving monetary stability-in other words, controlling inflation.
Central bank independence is seen as essential to counter the natural preference of politicians for expansionary economic policies that promise short-term electoral gains at the risk of worsening inflation in the long run. Making central banks independent frees them from political pressure and thus removes the inflationary bias that could otherwise unsettle monetary policy.
The incentives for politicians to rescue failing banks are similar to those for inaction in the face of inflation. The decision to close a failing bank is usually unpopular.
Politicians eager to avoid a necessary closure may be tempted to pressure bank supervisors to organise a bailout or to excuse the failing bank from regulatory requirements, even at the risk of worsening the problem and increasing the long-term costs of resolving it.
This similarity strengthens the case for regulatory and supervisory independence in the financial sector. Bank regulatory independence is to financial stability what central bank independence is to monetary stability, and the independence of the two agencies can be mutually reinforcing. Both agencies also provide a public good-financial stability-which sets them apart from other sector-specific regulatory agencies.
Still, banking supervisory authorities differ from central bank authorities in one important way. When banking supervisors revoke a failing bank's license, they are using the coercive power of the state against private citizens. When central banks conduct monetary policy, they have no such coercive power. However, the unique power enjoyed by financial regulators should not be used as an argument against granting them independence. Instead, governments should fully accept and take the implications of that power into account-both by establishing strong accountability mechanisms to prevent abuse and by recognising the need to employ highly qualified supervisors of demonstrable integrity and to pay them adequately.
POTENTIAL PROBLEMS WITH AGENCY INDEPENDENCE: Growing recognition of these factors, together with a growing trend toward the creation of "integrated" financial supervisory agencies that regulate banks, securities markets, and insurance companies - which forces policymakers and legislators to rethink institutional arrangements - has focused attention on the case for agency independence.
To be continued