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Supervisory independence and accountability

Speech by Kerstin af Jochnick, Member of the Supervisory Board of the ECB, at the IMF High-Level Regional Seminar in Sub-Saharan Africa

Frankfurt am Main, 1 March 2022

Introduction

It is a pleasure to be here, and I would like to thank the organisers for inviting me. I have spent over thirty years of my career in central banking and supervision. I was head of banking supervision at Finansinspektionen (the Swedish Financial Supervisory Authority), and a monetary policymaker for Sveriges Riksbank (the Swedish central bank). I now serve on the Supervisory Board of the European Central Bank. With that in mind, it should come as no surprise to you that today I would like to discuss an important precept of modern central banking: institutional independence and accountability.

And I would like to address this issue in the context of supervision. While central banks often – but not always – perform a supervisory function, far more attention is given to the need for accountability and independence in their monetary policy function. That is why I hope to persuade you that the question of supervisory independence and accountability, while less discussed, is certainly no less important. To anticipate the thrust of my argument, I would like to highlight four key messages.

First, while the principle of supervisory independence has been broadly accepted for many years now, it has been more difficult to apply in practice than the classical independence of central banks in the monetary policy domain. Supervisory independence should therefore continue to be “nurtured” so it can make up ground. However, policymakers and legislators should be aware of the specificities of the banking supervision function when designing independence and accountability frameworks.

My second message is that independence and accountability are two sides of the same coin – one cannot exist without the other. While it is sometimes suggested that accountability is a necessary “counterweight” to independence, I believe that framing this question as a zero-sum game essentially amounts to a false dichotomy. Rather than seeing independence and accountability as mutually exclusive, they should be seen as mutually reinforcing.

However, for this to be the case, independent and accountable frameworks need to be underpinned by clear institutional mandates and well-defined reporting and oversight structures. This is my third message. The more clearly defined institutional mandates are through measurable objectives, the easier it will be for the supervisor to explain whether it has delivered on its goals. There may still be some room for improvement for both supervisors and legislators in this regard, even if the ultimate policy goals of banking supervision are more difficult to measure than those of monetary policy. In addition, having adequate reporting and oversight structures in place makes it easier for legislators and the public to hold the supervisor to account, as well as enhancing the supervisor’s ability to communicate in a transparent and effective manner. Coupled with clear institutional mandates, this means that sound accountability structures are supportive rather than detrimental to the supervisory function.

The fourth message concerns the potential governance modalities around the supervisory function and whether this authority should be vested with the central bank or elsewhere. While each model has advantages and disadvantages, my personal view is that the synergies arising from combining under one roof the monetary policy and supervisory function outweigh the potential downsides of this option, and that adequate safeguards could be put in place so that both functions smoothly co-exist. This view is also influenced by my experiences as a policymaker, not least during the coronavirus (COVID-19) crisis, during which monetary policy and banking supervisory measures taken by the ECB have worked in the same direction to alleviate the economic fallout from the pandemic.

Let me elaborate on these key messages, while also drawing on the practices and arrangements in Europe regarding the ECB.

Central bank and supervisory independence: one and the same?

Central bank independence is nowadays widely accepted as an essential tenet of modern central banking, also thanks to the advocacy role played by institutions such as the International Monetary Fund (IMF) for many years. As is well known, the baseline case for central bank independence stems from the “time inconsistency problem” inherent in monetary policy – or that policymakers might be tempted to use monetary policy in a distortionary way. This is because money creation will have short-term positive effects on growth and employment, while the costs in terms of higher inflation will only accrue over the medium to long term. Shielding the central bank from direct political interference under a rules-based approach towards monetary policy in pursuit of price stability is thus seen as an efficient way of keeping this policy trade-off at bay.

The idea of central bank independence for the conduct of monetary policy was first floated in academic circles during the early 1960s, gaining traction in official policy circles during the late 1970s and early 1980s[1] as many advanced economies struggled with the problem of stagflation. During the 1990s, the policy consensus around this idea firmed, and by the end of that decade central banks in almost all advanced economies and in many emerging economies had been granted independence, albeit in varying degrees[2], coupled with policy accountability.

Although central banks were already heavily involved in banking supervision at the time, the idea of extending independence to the bank supervisory function per se (or granting independence to the banking supervisory authority if different from the central bank) took longer to come to fruition than it did for monetary policy. For example, in the run-up to the global financial crisis of 2008, there was still no clear provision for supervisory independence in the Treaty on the Functioning of the European Union, nor about what this would mean or require in concrete terms.[3] This contrasts with the well-defined provisos for central banks in the monetary policy domain which already existed at the time, with the Treaty stipulating that the primary objective of the European System of Central Banks (including that of the ECB) was to maintain price stability and granting those institutions independence in achieving that goal.[4]

However, to be fair we should also note that as far back as 1997, the Basel Committee’s core principles for banking supervision[5] already highlighted that supervisors required “operational independence” to effectively carry out their tasks. I am pleased to say that this concept is now broadly accepted, and here again institutions such as the IMF and the World Bank have been instrumental in promoting compliance with best practices across their membership. However, my point is that, even when independence was recognised as an important organising principle of supervision during the period before the global financial crisis, its relatively generic formulation at the time meant that the interpretation of what this concept entailed in practice could vary from country to country. In this respect, it is important to keep in mind that the Basel Committee’s concept of operational independence was first developed when banking supervision in some key G10 jurisdictions was housed at the ministry of finance.

Moreover, despite the progress made since then, recent studies suggest that compliance with this principle is still not widespread at a global level[6]. In a European context, a recent report by the European Banking Authority suggests that while the concept of supervisory independence has been heavily influenced by authorities being housed within, or with close ties to, central banks that have long-established independence requirements, there is still scope for greater clarity on personal independence as well as further consideration of what is required to ensure the independence of financial and staff resources while ensuring accountability[7].

Factors weighing on supervisory independence and accountability

Overall, there have been at least two probable factors explaining why progress towards supervisory independence has lagged behind that of monetary policy. The first is that there tend to be significant political interests in banking supervision, especially in relation to the potential consequences of bank failure, and the potential impact of supervisory borrower-based measures on households. In turn, this may also give rise to “time inconsistency” issues in supervisory decision-making. As is the case for monetary policy, this would support shielding supervisors from the vagaries of the political cycle.

At the same time, however, as bank failures may have a negative impact on the public balance sheet, domestic political authorities have a legitimate interest in supervisory affairs. In turn, this might have a bearing on how supervisory independence and accountability frameworks are implemented in a practical sense. Coupled with governments being key stakeholders in financial stability (including in a direct sense through publicly-owned banks), this also helps to account for the constellation of supervisory arrangements which persist to date around the world, whereby some central banks are also bank supervisors, some are not, and some have a relationship with a separate authority tasked with banking supervision.

The second factor which has likely impinged on the question of supervisory independence stems from the nature of banking supervision itself. From a public policy point of view, banking supervision can be seen as a means to help attain a public good, in this case, financial stability. This focus on maximising public welfare is akin to the role attributed to monetary policy in order to achieve price stability.

However, a key difference with monetary policy is that banking supervision requires taking decisions on individual entities and on measures directly affecting individual citizens, which might entail distributional effects. While this still supports the argument that supervisors must be shielded from groups which might seek to influence their decisions, it is also true that such decisions may have an impact on individual rights and liberties (for example through sanctions on legal or natural persons) and should therefore be subject to judicial review. The need to strike a careful balance among these different elements might thus influence the modalities of supervisory independence and accountability.

Overall, the balance of these arguments suggests that while central banks were often involved in supervision, granting them independence for their supervisory function and establishing proper oversight structures was more difficult than for monetary policy, especially because the provisos governing monetary policy independence could not simply be replicated for the supervisory function without some adaption.

However, the advent of the global financial crisis hastened developments for both central bankers and bank supervisors. In a fundamental sense, that crisis showed that two key relationships needed to be revisited. For central bankers, it was the relationship between price stability and financial stability; for supervisors, it was the relationship between microprudential bank supervision and systemic risk. For both groups, the interactions between monetary and financial policies suggested that standard microprudential banking supervision needed to be complemented with an analysis of interrelations across banks and transmission channels to and from the broader economy, in what became known as the “macroprudential approach” to financial regulation.[8]

Taken together, the recognition that the implementation of both microprudential and macroprudential policy had obvious synergies with monetary policy meant that central banks emerged as key stakeholders in the post-crisis institutional and regulatory landscape. Some central banks, such as the ECB, were also given formal microprudential and macroprudential mandates as a result. These developments brought the question of supervisory independence and accountability back to the fore, an aspect which also received prominent attention in the Basel Committee’s revision of its core principles in 2012.

The importance of well-defined institutional mandates and oversight frameworks

The additional responsibilities often entrusted to central banks either directly or indirectly in the aftermath of the global financial crisis placed new demands on accountability and transparency, at a time of low trust in both banks and the public institutions which oversaw them.[9] So I think it’s important to discuss the elements which should ideally underpin a sound independence and accountability framework, drawing on the ECB’s experience where necessary.

The first element concerns the relationship between independence and accountability. While it is sometimes suggested that accountability is needed as a counterbalance to independence, I believe that framing advances in one domain as necessarily coming at the expense of the other is tantamount to a false dilemma. The standard dictionary definition of these concepts illustrates this point: independence in a political sense is defined as “the freedom to make laws or decisions without being governed or controlled by another party”, while accountability is defined as “the fact of being responsible for what you do and able to give a satisfactory reason for it”.[10] It follows that one cannot be held to account for decisions unless these were taken in an independent manner in the first place. As I said earlier, it is more useful to see independence and accountability as two sides of the same coin, which are mutually reinforcing rather than mutually exclusive.

However, a number of conditions need to be fulfilled for this to be the case. For an authority to satisfactorily discharge an independent function, its performance needs to be measured against a clear objective – that is, a well-defined mandate. This will facilitate both the assessment of the authority’s performance by third parties, as well as its own external communication efforts to that end. By contrast, unclear or complex institutional mandates open the door to authorities needing to rely on discretionary policy choices or being possibly confronted with conflicting policy objectives. Insofar as the resulting actions may be more difficult to explain and be assessed by outsiders, the credibility of the independent function itself may be ultimately undermined.[11]

Moreover, a lack of clarity in institutional mandates may lead to excessive discretion attributed to the independent function, which might be particularly scrutinised by other stakeholders (such as regulators) in times of crisis. This is why I also believe that such provisos are essential for the sustainability of the independent function over time. Accountability should thus be exercised through transparency towards the public, as well as through regular reporting to those parties that have delegated responsibilities to the independent function.

Relative to what is typically the case with monetary policy, institutional mandates in the bank supervisory domain tend to suffer from it being more difficult to measure the stated policy objective. For example, whereas the EU Treaty clearly mandates the ECB to maintain price stability, and the ECB Governing Council has adopted a numerical objective in that regard (aiming for 2% inflation over the medium term), the EU Regulation conferring supervisory tasks on the ECB says that it does so “with a view to contributing to the safety and soundness of credit institutions and the stability of the financial system”.[12] This formulation thus leaves ample room for interpretation. Evidently, such a wording cannot be understood to mean that the banking sector should be free of risk, since by its very nature, banks’ main activity is maturity transformation and involves a degree of risk-taking. Nor can it be construed as a policy where no banks will ever be allowed to fail, since this would fuel moral hazard in the system precisely through higher risk-taking. Between these two extremes, however, reasonable people may disagree on what such a mandate implies for policy prioritisation. The ECB is hardly alone in this predicament, since other supervisory authorities have adopted similar definitions and the Basel Committee also refers to “safety and soundness” in its core principles for banking supervision. This is why it is important for supervisors to have a limited number of concrete priorities which could be monitored by third parties as a way to increase accountability. More fundamentally, I share the view, expressed by others before me[13], that supervisors and legislators have more collective work to do in the future so as to achieve a better common understanding of what a “safe and sound” or “stable” financial system entails in practice.

Pending such collective reflections, the main consequence of this relatively broad mandate for bank supervisors is that communication with outside stakeholders becomes more challenging than it would be otherwise. Let me give you two examples, again drawing on experiences at the ECB. First, a few years ago, the ECB’s power to set supervisory expectations for prudential provisioning of non-performing exposures was challenged by the European Parliament, on the grounds that setting provisioning calendars for such a purpose was akin to rules and thereby impinged on the prerogatives of the European legislator. Second, more recently, the ECB’s recommendation that banks should refrain from distributing dividends during certain phases of the pandemic (from March 2020 to September 2021) was also met with criticism in some quarters as being excessive or unwarranted relative to the prevailing circumstances at the time.

While the ECB has been adamant that these actions fell within the remit of its supervisory mandate, these instances showed the value for supervisors of having multiple and dedicated communication channels with different stakeholders which could be intensified when necessary precisely to make such a case. Insofar as those communication channels are underpinned by statutory accountability mechanisms for regular reporting, as is the case with the ECB and the European Parliament, for example, these cases also showed that dialogue to reach a common understanding between both parties is facilitated. Let me build on this point by briefly reviewing the independence and accountability provisos which the ECB is bound by in its banking supervisory role.

Independence of and accountability by the ECB as supervisor

When conferring microprudential tasks on the ECB, the European legislator granted it a high degree of protection. The legislator stipulated that both the ECB and the national supervisors of participating countries, which together constitute the Single Supervisory Mechanism (SSM), “shall act independently”, that the members of the ECB Supervisory Board “shall also act independently and objectively in the interest of the Union as a whole”, and that they “shall neither seek nor take instructions from the institutions or bodies of the Union, from any government of a Member State or from any other public or private body”. The EU Regulation conferring supervisory powers to the ECB also underlines that “the institutions, bodies, offices and agencies of the Union and the governments of the Member States and any other bodies shall respect that independence”[14].

While this formulation is virtually identical to the protections in the EU Treaty afforded to the ECB in its monetary policy function[15], the accountability mechanisms governing the ECB supervisory function are somewhat different. The main difference between the two functions relates to the degree of oversight exercised by the European Parliament which, in the case of the ECB, is somewhat higher for its supervisory function, particularly regarding access to information. The specific provisos to this end are covered under an Interinstitutional Agreement between the European Parliament and the ECB[16].

Elsewhere, and similar to what applies for the monetary policy function of the ECB, there are three main channels of accountability for the ECB as supervisor. First, hearings and exchanges of views, with the Chair of the Supervisory Board attending regular hearings and discussions in the European Parliament, and in the Eurogroup in the presence of all Member States participating in the SSM. Second, through written questions which Members of the European Parliament and the Eurogroup can address to the Chair of the Supervisory Board. Third, the annual report on supervisory activities, which the ECB submits to the European Parliament, the EU Council, the Eurogroup, the European Commission and the national parliaments of participating Member States.[17]

Concluding remarks on central banks as supervisors

To conclude, let me share some thoughts with you on the relationship between monetary policy and banking supervision and whether it is good idea to combine both functions in a central bank. As you may know, in Europe the decision to establish the SSM with the ECB at its core was part of a wider project to establish a banking union, foreseen to include a Single Resolution Mechanism, which is now in place, and a common European Deposit Insurance Scheme (which is still pending). The main rationale behind the banking union project, put forward in the aftermath of the global financial crisis, was to create distance between commercial banks, the sovereign states of their home jurisdictions, which also supervised those banks, and domestic taxpayers, who were frequently called on to shoulder the cost of bank failures. While this emerged from a rather specific context, the expansion of central banks’ mandates to include microprudential or macroprudential powers in the aftermath of the great financial crisis was more broad-based in nature.

As I mentioned, there are different supervisory arrangements around the world which co-exist to the present day. Also within the SSM, we have participating countries in which supervision is partly or fully tasked to a separate agency, rather than to the central bank. This being said, I believe that the advantages of combining the monetary policy and supervisory function in one entity outweigh the potential downsides. This is mostly on account of the synergies this creates and the ease with which informational asymmetries can be internalised. This view is also influenced by my experiences in recent years as a policymaker. I have observed the ECB’s monetary policy and supervisory measures working in tandem to alleviate the economic fallout from the COVID-19 shock. Prudential supervision is important for ensuring resilient financial institutions and financial stability. And financial stability is a prerequisite for the implementation of monetary policy. I also believe that, as is also the case at the ECB, potential drawbacks arising from tasking central banks with supervisory functions could be limited through adequate safeguards.[18]

However, insofar as institutional independence and accountability are concerned, this combined model also means that specific provisos might need to be developed for the supervisory function which may be different to those applying to the central bank in its monetary policy role. Central bankers and legislators should thus keep in mind this challenge, as well as the additional communication efforts this option would entail.

  1. See, for example, Friedman, M. (1962), “Should there be an independent monetary authority?”, In search of a monetary constitution, Harvard University Press; Kydland, F., and Prescott, E.(1977) “Rules Rather than Discretion: The Inconsistency of Optimal Plans” Journal of Political Economy 85, pp 473-492; Barro, R. and Gordon, D. (1983) “Rules, Discretion and Reputation in a Model of Monetary Policy”, Journal of Monetary Economics; and Rogoff, K. (1985), “The Optimal Degree of Commitment to an Intermediate Monetary Target”, Quarterly Journal of Economics No. 100.
  2. Within the different features of central bank independence, it is its institutional aspect (prescribing that central bank decisions should not be subjected to instructions from other authorities) which tends to capture the limelight in the public discourse. However, it is useful to distinguish between other forms of central bank independence, including its functional and operational aspect (where the objectives to be pursued by the central bank are clearly spelled out, and the prohibition of monetary financing is detailed), its financial aspect (ensuring that the central bank has sufficient resources to perform its tasks), and its personal independence aspect (including appointment and removal processes for central bank officials and safeguards for possible conflicts of interest), respectively. It is also useful to distinguish between goal independence (where a central bank sets its own target) and instrument independence (where a central bank chooses its own instruments to achieve a target set by the government). See Dall’Orto Mas, R., B. Vonessen, Fehlker, C. and Arnold, K. (2020) “The case for central bank independence”, ECB Occasional Paper Series No. 248, October.
  3. See Bini Smaghi, L. (2006) “Independence and accountability of supervision in the European financial market” speech given at the Conference on Financial Regulation and Supervision in Europe, Bocconi University, Milan, March.
  4. See articles 127 and 130 of the Consolidated version of the Treaty on the Functioning of the European Union.
  5. See “Core Principles for Effective Banking Supervision”, Basel Committee on Banking Supervision, September 2012.
  6. See Adrian, T., and Narain, A. (2019), “Let Bank Supervisors Do Their Job”. IMF Blog, International Monetary Fund. Washington DC.
  7. See “ EBA Report on the supervisory independence of competent authorities”, EBA, 18 October 2021.
  8. See Angeloni, I (2017) “Faraway or close? Supervisors and central bankers”, speech given at the Halle Institute for Economic Research (IWH), Halle, February.
  9. See Powell, J.(2018) “Financial Stability and Central Bank Transparency”, speech given at the conference “350 years of Central Banking: The Past, the Present and the Future”, Sveriges Riksbank, Stockholm, May.
  10. See the Cambridge dictionary.
  11. See Bini Smaghi, L. (2007) “Central bank independence: from theory to practice”, speech given at the conference on Good Governance and Effective Partnership, Budapest, Hungarian National Assembly, April.
  12. See Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions .
  13. See Angeloni, I. (2019) “Supervisory independence”, speech given at the ECB colloquium Challenges for Supervisors and Central Bankers, Frankfurt am Main, March.
  14. See Article 19 of Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions.
  15. See Article 130 of the Consolidated version of the Treaty on the Functioning of the European Union, and Article 7 of the ECB Statute.
  16. There is also a Memorandum of Understanding between the EU Council and the ECB.
  17. In addition, Members of the ECB Supervisory Board are subjected to declarations of compliance and interest which are publicly available in the ECB Banking Supervision website, as are the calendars of the Chair and Vice-Chair of the Supervisory Board, and those of the four members of the Supervisory Board who are appointed by the ECB.
  18. For example, in the case of the ECB the SSM Regulation introduces a separation principle establishing that neither of the two ECB policy functions should prevail over the other. Such a principle has been further developed through several internal rules disciplining the interaction between the monetary policy and supervisory functions.
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