There are proponents “for” and “against” the centralisation of regulation in the financial system and whether it should be managed by Central Banks.
Irrespective of what the argument is the real question is not whether it should happen but when it should happen and how Central Banks should take on these responsibilities?
At the onset of the 2008 financial market crisis swift and decisive action was required from a diverse span of regulators including Central Banks, to stem the collapse of banks and other financial institutions. The coordination of their effort was initially not forthcoming and Central Banks were not key role players in the regulatory process in many jurisdictions.
Regulators who were responsible for different segments of the market struggled to coordinate their efforts and in some instances acted unilaterally to the detriment of other regulators. The need for speedy coordinated action by regulators when institutions and financial markets collapse has focused attention on the need for a central coordination point. Central Banks are ideally positioned to assume this role.
From the outset of the crisis the inter-connectivity between banks and financial institutions caught regulators off guard. There was a perception by regulators that the globalisation of financial markets had taken place, but there was little understanding of the inter-connectivity between market players such as banks and non-bank financial institutions and how quickly matters could spiral out of control because of this inter-connectivity.
Operating in a globally inter-connected market raises issues around the concept of lender-of-last-resort. In particular, which regulator in what regulatory jurisdiction should take on the final regulatory responsibility for intervention to save institutions when the financial system fails, whether they be banks or non-banks. Consider that a regulator responsible for only the efficient operation of banks may not consider or know how their decision to save particular banks would affect other areas of the financial system. Under current conditions of inter-connectivity, a failure within the financial system could originate from anywhere within the financial system and be caused by the activity of various role-players such as Banks, Insurance Firms or Asset Managers. In each instance these role-players are very often regulated by different regulators with Central Banks playing a minimal role in their day-to-day regulation.
If recent international events are taken into account, it is clear that the State in various jurisdictions took responsibility for stabilising failure in their financial system but while they may fulfil the lender-of-last-resort role, they are not a market regulator. In extreme market stress conditions, I believe that the State will always take on the role of lender-of-last-resort. It is never some arbitrarily independent regulatory body like the FSA in the United Kingdom or APRA in Australia who fills this role. Independent regulatory bodies simply do not have the financial resources available to them as Central Banks do to plough into a market failure if needed. As banker to the State, Central Banks on the other hand have access to resources that independent regulatory bodies do not have. Independent regulators must in circumstances of market failure approach Central Banks directly for help because they control these resources in their role as the banker to the State.
The problem often inherent in this arrangement when approaching detached Central Banks is it invariably causes delays. In many jurisdictions Central Banks are removed from the day-to-day process of regulating financial markets due to the creation of independent market-funded regulators that are divorced from the State. In these instances due to the remoteness of Central Banks from the regulatory process, they may need to be convinced first of the necessity to intervene before intervention can actually take place. This all creates delays that may further unnecessarily exacerbate the problem. The image of the Roman Emperor Nero playing his fiddle while Rome burns seems to come to mind.
It follows that because it is the State that ultimately carries accountability for stemming failure in the financial system, that it must be their banker or Central Banks that carry out the duty of lender-of-last-resort on behalf of the State. Because of this duty, it is clearly necessary for Central Banks to stay close to all activities conducted in the financial system. Therefore, there is a strong case for the Central Banks to be involved and to regulate key financial market activity. Central banks are also in an ideal position to become a coordination point for regulating a diverse modern financial market.
Policy setters are aware of the relationship between the State, Central Banks and the financial market and I believe will of course take this relationship into account when setting up whatever regulatory system they decide to carry out.