Central Bank Regulation and the Financial Crisis

A Comparative Analysis

Miao Han

• Publisher: Palgrave Macmillan
• Year: 2015
• Print ISBN:
  9781137563071
• eBook ISBN:
  9781137563088
• Topic: Business
• Subtopic: Business General
• Index: Business

The respective legal frameworks that control central banks are shaped by whether they are market oriented or government controlled. However such stark distinction between these two categories has been challenged in view of the varying styles of crisis management demonstrated by different central banks during the crisis. This book uses comparative analysis to investigate how the global financial crisis challenged the role played by central banks in maintaining financial stability. Focusing on four central banks including the US Federal Reserve System, the Bank of England, the Bank of Japan and the People's Bank of China, it illustrates the similarities between the banks prior to the crisis, and their similar policy responses in the wake of the crisis. It demonstrates how each operated with varying levels of independence while performing very differently and facing different tasks. The book identifies some central explanatory variables for this behavior, addressing the mismatch of similar risk management solutions and varying outcomes. Central Bank Regulation and The Financial Crisis: A Comparative Analysis explores the legal challenges within central bank regulation presented by the global financial crisis. It emphasizes the importance of, and the limitations involved in, legal order and argue that in spite of integration and globalization, significant differences exist in central banks' approaches to risk management and financial stability.

1

Introduction

1.1 The global financial crisis as a challenge to central banks

The first central bank was established in Sweden in 1668, and since then most countries, whether developed or developing, have set up their own central banks.¹ The inception of central banks has often been linked with certain tasks delegated to them by their governments, but the role of those banks in stabilising financial markets has been far from clear. This conundrum – how central banks contribute to financial stability – has come under the spotlight again because of the far-reaching effects of the global financial crisis (GFC). Through the mechanism of a comparative study, this book will examine how the GFC has challenged the role played by central banks in maintaining financial stability; it argues that this crisis has, amongst other things, changed central bank regulation² to strike an improved balance between government and the market.

In theory, there are a number of explanations concerning how central banks deal with financial crises, and as illustrated later in the historical review, some central banks were established for the very purpose of dealing with stability problems. However, it is still a matter of debate as to how their role in maintaining financial stability is to be defined. This unanswered problem has in part been attributed to conceptual confusion, and also to an unclear relationship between monetary stability and financial stability.

The meaning of ‘financial stability’ has itself evolved over time, but without a great deal of consensus being reached. For example, the expression has been defined as the ability of the financial system to facilitate and enhance economic processes, manage risks and absorb shocks; it was also seen as a continuum, changeable over time, and consistent with multiple combinations of financial elements (Schinasi, 2006). At the very least, financial stability precludes financial crises – though not necessarily change per se – and thus it could roughly be regarded as a period of time without such crises. Three main approaches may be taken to the conceptualisation of financial crisis: the monetarist approach, the asymmetric information perspective, and the financial instability hypothesis (Crockett, 1996). For example, cyclical excess could disturb market participants: a financial crisis is a disruption to financial markets where adverse selection and moral hazard problems become more intensive, so that the financial sector fails to channel efficiently the most productive investment opportunities (Mishkin, 1991). To monetarists, errors in monetary policy lead to instability in the financial system, or produce far-reaching negative influences by causing minor disruptions (Friedman and Schwartz, 1971); this approach has linked the conduct of the central banks more directly to financial stability. Recently, different theories have been employed to understand financial crises, including game theory and the use of asymmetric information (Ferguson, 2003). Overall, therefore, it is clearly difficult to define a financial crisis as such, but financial markets have previously developed as a consequence of crises; such crises can be prompted by different causes and can also take varying forms (Kindleberger and Aliber, 2011). Alternatively, if a positive correlation can be established between monetary and financial stability, it is not hard to determine the role played by a central bank in maintaining financial stability. However, such a link has not yet been proved, nor any convincing evidence found, especially with continuing controversy about the synergies or trade-offs between monetary and financial stability (Padoa-Schioppa, 2002).

It can be challenging to posit a clear-cut link between central banks and financial stability, but the GFC exposed some leading issues. This crisis arose from the subprime mortgage risk that had become evident in the US housing market in 2007, and caused global financial upheavals from 2008 onwards.³ While many factors triggered and/or intensified this crisis (Shiller, 2008), central banks have been criticised for providing excessive liquidity in the years running up to the GFC, and also for their inability to mitigate systemic risk (Taylor, 2009a). Moreover, major central banks launched unprecedented monetary expansion in the early 2010s, having themselves moved to the centre of crisis management. It is thus argued that central banks have assumed particular responsibility for dealing with financial stability. It has been said that: ‘[t]he overall framework [of financial stability] does not appear to have been fully conducive to achieving its objectives, often leaving ill-defined the responsibilities and tools of central banks in their pursuit of financial stability’ (Nier, 2009).

It has been seen that the conduct of the central banks allowed the build-up to the GFC; at the same time, they were required to provide solutions for it. With the radical changes that took place in the early 2010s, they were challenged to develop better mechanisms to achieve financial stability. As one leading commentator observed:

Following the on-going financial crisis, Central Banks are now probably on the verge of a further, fourth, epoch, though the achievement of a new consensus on their appropriate behaviour and operations may well be as messy and confused ... Indeed the financial stability authority would then, de facto, become the true Central Bank. (Goodhart, 2010)

All these issues have provided a focus for this book’s discussion on how the GFC challenged central bank regulation and on the efforts of those banks to maintain financial stability.

1.2 The significance of the question of stability

In contrast to other theoretical and statistical studies which focus more upon the economic effects of central banking, this book will employ a more basic theory to identify key legal considerations relevant to central bank regulation aiming at achieving financial stability. As paper currency replaced metallic currencies, the central banks became involved in stabilising the financial markets. Through their involvement in the money supply, their engagement has been further enhanced. The need to maintain currency values necessitated the establishment of an agency to maintain public confidence; at the same time, banks as deposit takers began to participate in the wider monetary cycle. So, after being established as an important intermediary between the banking system and the wider economy, the central bank has gradually developed its core values: at the same time serving as the government’s banker and as the bankers’ bank (Goodhart, 1995, pp. 205–215). Starting from this core orientation, a central bank is located within a two-tier relationship, one that simultaneously involves both the government and the financial markets. The theoretical and legal framework used here will revolve around these two tiers, and four case studies will illustrate how the GFC specifically challenged central banks and their relationships with the government and the financial markets. It is clear that central bank crisis management is affected by each specific two-tier relationship.

Central banks were first set up in developed countries in the 17th century, including the Bank of England (BOE) in 1694; more recently, the Bank of Japan (BOJ) was established in 1883 and the Federal Reserve System of the US (US Fed) in 1913. After World War II, new central banks were established in other (often semi-colonial) countries, including China. However, only limited written materials are available to help classify them. In this book, four central banks will be examined from the perspective of their respective two-tier relationships, and these banks will be categorised according to the nature of their market or government orientations.

It is necessary to set out some key concepts before the specific propositions are examined. For example, the concepts of ‘state’ and ‘government’ might, in different academic studies, have different meanings and also have been used interchangeably. Then in international law there is a close relation between ‘government’ and ‘statehood’. The best known formulation of the basic criteria for ‘statehood’ is laid down in the Montevideo Convention on the Rights and Duties of States: ‘The State as a person of international law should possess the following qualifications: (a) a permanent population; (b) a defined territory; (c) government; and (d) capacity to enter into relations with other States’.⁴ It has also been argued that ‘government’ or ‘effective government’ is the basis for the independence of states in regard to their internal and external affairs.⁵ At the very least, ‘state’ is seen as different from ‘government’: an effective government is one prerequisite for statehood, and central government is the main – and for most purposes the only – organ through which the state acts in international relations. In any event, international law distinguishes between changes of state personality and changes of the government of the state (Crawford, 2006, pp. 31–33, 55–61). In this book, in distinguishing between the two groups of central banks, ‘government’ will be used in contrast to ‘market’.

The GFC put many different issues into the spotlight. Amongst other things, the dominance of the prevailing neo-liberal ideology has been questioned; for example, it has been said that: ‘the onset of the global financial crisis in 2008 has been widely interpreted as a fundamental challenge to, if not crisis of, neoliberal governance’ (Peck, Theodore and Brenner, 2009). Between the 1970s and the 1990s, neo-liberal market-oriented reform became widespread in the US, the UK, Japan and beyond.⁶ In principle, classic neo-liberalism incorporates privatisation, minimal regulation, depoliticisation, and liberalisation (Megginson and Netter, 2001). It has been expected that market principles enable economic units to maintain a temporary imbalance between incomes and expenditures, adjust the types of claims with diversifying assets and liquidity, and achieve a sounder payment system to make a wider range of transactions feasible. Such a market economy cannot be effective without certain pre-conditions, including: open financial markets; information closure; no anticipation of bailouts; and a proper set of response mechanisms (Lane, 1993). Furthermore, since market-oriented institutions claim a positive association with economic development, market disciplines are also employed to reform those institutions, including central banks (Haan, Lundstrom and Sturm, 2006). In addition, during the period of market-oriented reform, the government was hard-pressed to balance its welfare and its market-making roles (Sbragia, 2000). However, neo-liberalism did not develop evenly (Peck, Theodore and Brenner, 2009), and varies even within East as against West (Wade, 1990); for example, in Japan it was a tight nexus of government, financial markets (mainly banks) and firms that achieved industrialisation and economic modernisation, while China explicitly saw its government as the maker of the markets from the very start of its economic reform.

As regards the financial sector, after the Bretton Woods System came to an end, fixed exchange rates were gradually liberalised, and government intervention was reduced to necessary regulation (Mascinadaro and Quintyn, 2008). In consequence, while market discipline has become a force whose effectiveness pervades financial policy, it does not exclude government intervention in markets, especially as regards regulation and supervision (Lane, 1993). In this context, central banking should reflect the true relationship between the demand for real cash balances and the level of economic activities; hence, effective market orientation is an outcome of the monetary policies that keep overall prices low, as well as of the sound and stable financial systems which operate to produce positive market rates of interest across the whole range of financial intermediations (Valdepenas, 1994). Market-oriented central banks help keep prices stable by undertaking a programme of actions, including interest rate policies, open market operations (OMOs), quantitative controls, and so forth (Borio, 1997). They make credit and capital allocation more feasible by conducting due regulation and supervision, and they also control oversight of payment and settlement systems (Padoa-Schioppa and Saccomanni, 1994, pp. 235–268). However, financial liberalisation is by no means a guarantee against financial crises, and such liberalisation may even enhance fragility of markets (Demirguc-Kunt and Detragiache, 1998). Financial liberalisation and innovation have blurred the boundaries between financial markets and the jurisdiction of central banks, whilst also blurring the traditional distinctions between banks and non-bank financial institutions; this further challenges the pursuit of financial stability by central banks (Golembe and Mingo, 1985).

Based on the separation of ‘market’ and ‘government’, this research assumes that the four selected central banks have different orientations; the countries earmarked for detailed analysis – especially to determine comparative convergence and divergence – of their central banks include China, Japan, the UK and the US. In theory, central banks are generally in charge of monetary policy and financial regulation to some extent; from their respective two-tier relationships, they are argued to be either market-oriented or government-controlled. Both the US Fed and the BOE were primarily market-oriented; while the former was a consolidated regulator within a rigid legal framework, the latter transferred major micro-prudential regulatory duties to an independent outside agency in the late 1990s. They both represent the diffusion of market-oriented reforms, whereas the BOJ has apparently taken another direction. Due to long-term subordination to its finance ministry, it was still under government control after financial liberalisation, and its oversight was limited to selected but direct monitoring duties at the firm level. China, meanwhile, having not launched economic reform until 1978, was aiming for a shift from a highly centralised planning economy to reliance upon market disciplines. As far as the People’s Bank of China (PBC) is concerned, it remains (at the time of writing) government-owned and works with other responsible agencies to directly control China’s partially liberalised financial markets.

So, until the GFC changed the central banks’ two-tier relationships, the features of these banks can be summarised thus:

•the US Fed: predominantly a market-oriented or laissez faire central bank; it was also a consolidated financial regulator based upon rigid legislation;

•the BOE: predominantly a market-oriented or laissez faire central bank; it had limited prudential regulation role in the tripartite model (involving the BOE, the FSA and HM Treasury);

•the BOJ: a government-guided central bank, and a regulator that relied upon moral suasion with limited functions;

•the PBC: a government-owned politically-dominated central bank, and a proactive regulator as part of China’s financial regulatory regime.

The main question here requires that the above key propositions be examined with reference to our four leading central banks, and I will focus on regulation by China’s central bank. As China was one of the first major countries to recover from the spillover effects of the GFC, it might be assumed that the policy responses from the PBC and beyond were particularly effective. However, this work will show that the GFC challenged the PBC to such an extent that explicit government intervention could threaten China’s continuing market-oriented reform.

1.3 Approach

This study combines logical, explanatory, empirical, hermeneutic, exploratory and evaluative methods of analysis (Hoecke, 2011). In essence, it will involve interdisciplinary comparative research in regard to the four countries selected (Siems, 2014, pp. 7–9).

The study of central banks is inevitably interdisciplinary, drawing upon insights from a variety of intellectual traditions such as economics, finance, mathematics, management, law, social science and so on. Of all the interdisciplinary approaches to research, there is an increasingly close link between law and economics (Arban, 2011; Priest, 1993), and this study will draw on a legal perspective in its approach to the capacity of the selected central banks to deal with financial crises. In general, rulemaking and law reform have d...

Table of contents

• Cover
• Title
• 1  Introduction
• Part I  Theoretical Framework
• Part II  Case Studies
• Part III  Comparative Analysis
• Bibliography
• Index