The Region

A nation's commercial banks and central bank are reflections of each other

Gary Stern presented the following overview on the relation between a central bank and commercial banks recently in Moscow, where he participated in the International Conference on Russian Banking with other banking professionals from around the world.

Gary H. Stern - President, 1985-2009

Published December 1, 1994  |  December 1994 issue

The issue of the relation between commercial banks and the central bank is a broad, general one which, if I adhere to it, risks a lack of focus in my remarks this morning. Nevertheless, I intend to adhere to it because, as I reflected upon this subject, it became clear that the relation is an important and far-reaching one, with potentially significant implications for a country's economic performance.

My "theme" this morning, in fact, is that a nation's commercial banks and central bank are reflections of each other. They are likely to succeed or fail together. While this theme may have some intuitive appeal in the arena of bank supervision and regulation—where there are clearly overlapping if not common interests—it may be less obvious in other areas of central bank responsibility and of commercial bank activity. It is, however, my firm conviction that the conduct of monetary policy (macroeconomic stabilization responsibilities) and payment system responsibilities are also critical components of central bank-commercial bank relations.

In market economies, the banking system plays a critical role in gathering funds from the public—mobilizing savings—and in channeling these credit resources to their most effective uses. Economies with minimal or underdeveloped banking systems will typically find capital formation, productivity and growth inhibited. An effective banking system can contribute over time to economic growth.

Payments processing

The banking system is also a major processor of payments—frequently the backbone of the payments system of a country. The role of an efficient, reliable, smoothly functioning payments system, as a contributor to economic prosperity, often is overlooked or at least underestimated because it is taken for granted in many industrial countries. We assume, when depositing funds with currency or check, that appropriate credit will occur, and the counterparty's account correctly debited. And we assume the same scenario with the electronic movement of funds. In countries geographically vast, for example the United States and Russia, timely movement of balances and account information is no small accomplishment. Yet the effective conduct of commerce, at a high and sustainable level, depends on it. Businesses and consumers need to be confident that funds are transferred timely and accurately; if not, the economy has to rely too heavily on cash and/or barter, inherently less efficient means of payment.

Integral to a smoothly functioning payments system, are intangibles which, as experience demonstrates, are critical in virtually all aspects of banking. These intangibles are concepts such as confidence, trust, integrity and stability. In the United States, consumers and businesses worry little if at all about the mechanics of payments. They that know with confidence that the system can and will move funds and information routinely, within specific deadlines, and rarely give it a thought. This is what I meant about underestimating the importance of a payments system.

Similarly, there is a good deal of confidence—trust, if you will—that the financial institutions doing business today will be there tomorrow. It has not always been so, but today's system is reasonably stable.

The Federal Reserve System, through the 12 district Reserve banks, is a major provider of payments services. The Fed is active in check clearing, electronic funds transfer, securities transfer, currency provision and destruction, and the accounting of commercial bank reserve balances that coincide with payments. Commercial banks, of course, are also major providers of payments services, and in general deal with a much broader range of customers than the central bank. In the United States, the Fed provides payments services directly only to insured depository institutions.

The Federal Reserve is also a regulator of payments system practices and provides a safety net under the U.S. payments system, explicitly with regard to movement of large dollar funds by wire and implicitly under other payments in times of instability and disruption. It should be emphasized that large dollar payments systems, where banks exchange claims on each other, are vulnerable to major disruption should a participant fail. Such systems handle a large volume of payments for goods, services and financial transactions, and failure of a participant could be highly disruptive to the financial system and, potentially, to the economy. Because of the magnitude of these consequences, the central bank has a role to play in assuring the integrity of the system.

To be sure, there is tension from time to time between commercial banks and the central bank over payments issues, due to the Federal Reserve's dual role as regulator of, and participant in, the payments system. We in the Federal Reserve System have dealt with this tension by establishing a barrier between our regulatory responsibilities on the one hand, and our participatory activities on the other. Nevertheless, some tension remains.

I believe most would agree that, both through regulation and provision of the safety net, the Federal Reserve has contributed to the reliability of the payments system and has helped to provide and to strengthen those intangibles—trust, confidence, stability—which I earlier emphasized. Our direct participation in the provision of payments services has contributed as well, particularly in times of stress in the banking system when direct, hands-on experience is of particular value in resolving problems.

Supervision

As these comments imply, an effective banking system requires a high degree of trust and confidence. It is here that a central bank's supervisory and regulatory responsibilities are particularly valuable because, if carried out thoroughly and well, they can provide assurance that banking institutions are conducting their affairs in a safe and sound manner, and in a manner consistent with international banking standards. This helps to give customers, domestic and foreign, confidence that they can count on the performance of the institutions in question. I am convinced that effective supervision and regulation is in the interest of commercial bankers. It helps to make their institution credible, internationally and domestically, so that they can participate fully in global markets and with a diverse base of customers.

Supervision alone will not accomplish such participation, however. A comprehensive financial infrastructure, encompassing the foundations of law, accounting and regulation, is needed for the success of a market-based banking system. More specifically, a legal framework that protects private property rights and that supports debt recovery, liquidation and bankruptcy is essential. Adoption of accounting and auditing standards comparable to those accepted internationally, which will measure the conditions of banks consistently and accurately, is also critical.

It is instructive to note that over its history the United States has experimented with both banking structures and approaches to banking supervision. For example, during the Free Banking Era, roughly a 25-year experiment in the middle of the 19th century, US banks were restricted by law and regulation much less than ever before (or since). Allowing such freedom in banking did not work well: Many free banks closed, and many of the notes they issued lost value. Thus, customers of the free banks were losers. One explanation for this performance is that little government oversight encouraged dishonest bankers to form so-called "wildcat banks" whose purpose was to defraud the public.

A more careful reading of the evidence on this period suggests a different explanation, however. Bank problems, rather than attributable primarily to fraud, resulted from declines in the prices of bank assets, leading to impairment of bank capital and to runs on banks and in some cases to insolvency and/or closure. Many of the banks opened in the free banking states, although initially reasonably well capitalized, had asset portfolios that were insufficiently diversified and insufficiently liquid to weather the economic shocks of the period. Whatever the cause, it is undeniable that free banking did not work well.

The Federal Reserve System was established in 1913 after a series of financial problems and panics which had characterized the second half of the 19th century and the early years of the 20th. There were several problems with which banking systems of the time seemed unable to cope:

  • Money and credit did not, at times, grow commensurately with the needs of the economy. Economic expansion thus was constrained by financial shortages.
  • There were sharp seasonal fluctuations in the cost and availability of credit, which were disruptive to sectors of the economy.
  • There were impediments to the flow of credit to its most effective uses, thus interfering with the efficient allocation of resources.

Not only were financial institutions and their immediate customers affected by these problems, but also such disruptions frequently spilled over to adversely affect the level of employment and output in the economy more generally. Part of the problem, as during the free banking era, was that bank asset portfolios were insufficiently diversified, in terms of both type of credit and geographic location of the borrower, so that, once a "shock" depressed values, the effects on particular institutions could be very large.

In response to these problems, the new central bank was to prevent or at least contain banking panics, to provide for growth in money and credit in line with the needs of the economy, and to smooth out seasonal fluctuations in credit availability. These objectives are still with us today, 80 plus years after formation of the Federal Reserve.

As demonstrated particularly by the Depression of the 1930s, achievement of the original objectives of the Federal Reserve Act did not come easily and, indeed, central banking in our country is still evolving. The difficult experience of the 1930s led to changes in the Federal Reserve's structure which remain in place today.

Significantly, legislation of the 1930s also expanded the safety net underpinning banking, with the establishment of deposit insurance. Deposit insurance changed the financial landscape profoundly by making the banking system far more stable and less subject to runs by nervous depositors. It also altered incentives for bankers, leading to a tendency to excessive risk taking in their portfolios and practices, although it took some time for this tendency to appear.

Deposit insurance creates a "moral hazard" problem. When insured, depositors have little if any incentive to care about the calibre of the institutions with which they do business. Hence, risk taking is priced too low, and as a consequence too much risk is assumed. Some remedies that have been suggested are to limit or eliminate insurance; to raise bank capital requirements, so owners have more at stake; and to regulate and supervise bank activities so as to avoid excessive risk taking.

The rationale for the supervision and regulation of banks by the Federal Reserve and other regulatory organizations is to offset the tendency for excessive risk taking as a consequence of deposit insurance and other elements of the safety net. Deposit insurance is a valuable subsidy to banks, but the cost is that the institutions are subject to regulation and supervision of activities, essentially a quid pro quo.

Thus, despite commitment in the United States to market determined outcomes, the banking system has been deemed "special," sufficiently special so that at least some of its creditors (depositors) are protected by a safety net of deposit insurance. In addition, banks have access to the Federal Reserve discount window to meet short-term and seasonal needs for liquidity. All such borrowing from the Federal Reserve is fully collateralized. The United States has made the public policy choice to enhance the stability of the banking system with the safety net; many other countries have made the same decision. Once such a decision is made, supervision and regulation of banking logically follow.

The focus of supervision is to assure banks are well managed, with strong earnings and capital positions, ample liquidity to satisfy increases in loan demand or deposit withdrawals, and high-quality assets well diversified by borrower, economic sector and geography. Banks that fail to display these characteristics are subject to supervisory actions to strengthen their position.

As would be expected, tension can arise from time to time between commercial banks and the central bank in the supervision and regulation area. From one perspective, this is as it should be, for the regulator's responsibility is not that of advocate of, or spokesperson for, the industry. Rather, the regulator must keep public policy objectives at the forefront, objectives which will benefit the economy as a whole rather than banking or any other specific industry.

Nevertheless, many bankers no doubt see considerable value in supervision. It acts as an objective outside check on their policies and practices, "certifying" their soundness and integrity. Further, it adds to banks' credibility, assuring customers, domestic and foreign, that the institution meets solid prudential standards. This assists the bank, and the system as a whole, in attracting and retaining resources, to the long-range benefit of the economy.

Increasingly, regulations, and in particular requirements for bank capital, have become standardized internationally under the auspices of the Bank for International Settlements. The advantages of such an approach are clear. When banks adhere to such standards, they and their customers can be reasonably confident of the quality of the institutions with which they are dealing. Uncertainty is reduced. Moreover, the playing field for banks competing in the international arena is leveled.

Stabilization policy

The third major area of responsibility of the US central bank is monetary policy. While this function may at first seem far removed from the banking issues and concerns I have previously discussed, it is in fact integrated with these other matters. It is very difficult to have an effective, smoothly functioning, sound banking system in an unstable macroeconomic environment.

An unstable economy may have several unfavorable consequences. The health of particular sectors of the economy will ebb and flow, in the process imposing losses on creditors (banks) and possibly on their depositors as well. I've commented previously on the need for diversification of a bank's asset portfolio, but even extensive diversification may be insufficient if the economy swings sharply between boom and recession. There is no doubt that bank balance sheets are healthier in a sound economy. Conversely, there is no practical way for banks to avoid all the effects of dislocations in their domestic economy.

Instability marked by rapid inflation undermines the value of the currency and can contribute to a flight from deposits in the home currency. Rapid inflation also can make it difficult for bankers to judge the creditworthiness of various business enterprises, thus interfering with sound credit extension practices. Inflation may also spur a return to barter, a highly inefficient transactions mechanism.

Inflation adversely affects economic performance—resource allocation, growth, productivity—because price signals are distorted. Decision-makers have difficulty distinguishing between a general rise in the price level and a change in relative prices. The latter should shift resources to the activity where prices have risen, while the former has no such implications for resource allocation.

A good deal of evidence has now been accumulated which demonstrates that countries with low inflation generally outperform economies with high inflation. Similarly, evidence demonstrates that, over time, the economy of a given country performs better, in terms of employment, growth, and so on, in periods of low inflation. There is even a school of thought that says the severity of the Depression of the 1930s in the United States was in part a consequence of flight from the dollar—because of fear that it would depreciate in value relative to other currencies—rather than a run on US banks, because of fear of their failure.

It is widely acknowledged that an overly expansive monetary policy is the root cause of persistent inflation. The central bank may simply permit money and credit to grow too rapidly. On the other hand, the central bank may be responding to a variety of pressures: pressure to finance large fiscal deficits, pressure to achieve unrealistically low unemployment targets, pressure to provide short-term support for faltering business enterprises, to name a few.

At least in the United States, and I suspect in many other countries, banks are central to the transmission of monetary policy to the economy at large. It is the banking sector that is among the first to feel the effects of changes in monetary policy, as reserve conditions are directly and promptly affected by Federal Reserve actions.

Banks, in turn, transmit policy changes to at least some of their customers. Borrowers with floating rate obligations may be affected almost immediately, and other customers may well find conditions changed when they come to roll over loans or to obtain new credit.

While large, international businesses frequently have direct access to domestic and foreign financial markets at competitive terms, medium and small-sized businesses tend to rely much more heavily on banks, and other intermediaries, for financing. It is such businesses, as well as consumers, that typically are most significantly affected by policy changes. For even if all borrowers face the same general change in interest rates, customers of banks and other intermediaries may experience a change in creditor attitudes which can magnify the effect of the change in rates, for better or for worse.

Summary

Let me conclude by summarizing the points I have attempted to make this morning. It is my view that commercial banks and the central bank of a country are reflections of each other. A healthy, efficient banking system goes hand-in-hand with a dependable, independent central bank. The activities of both are inextricably intertwined, and the institutions undeniably share a commonality of interests.

Central bank supervision of commercial banks, helping to assure maintenance of standards and sound banking practices, contributes to the health of the industry and to the trust and confidence upon which banking depends. The safety net contributes to this objective as well.

Similarly, effective central bank stabilization policy provides an environment in which banks can thrive; one in which they can go about the business of meeting the legitimate needs of their customers without undue concern for capricious fluctuations in economic conditions or asset values.

Further, as I have noted, a reliable and efficient payments system in which both commercial banks and the central bank participate enhances economic activity, encouraging smooth exchange of goods and services and of financial claims, and efficient allocation of resources.

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