Who Should Regulate the Banks?

The headquarters of Riksbank, Sweden's central bank, in Stockholm Photograph by Casper Hedberg/Bloomberg

Sweden hasn’t had its banking crisis yet, and household debt in the country continues to grow. This has not gone unnoticed, but now the country’s financial regulator—the Swedish Financial Supervisory Authority—and its central bank are sniping over who gets to do something about it. The financial regulator argues that it’s already on the job and has made changes to ensure stability in the mortgage market. A deputy for the Riksbank—Sweden’s central bank—says financial stability is already discussed during monetary policy meetings, “in the absence of a clear framework.”

The “who” of regulation matters as much as the “what.” Sweden’s conflict, between bank regulator and central bank, mirrors similar debates in the U.S., the U.K., and the euro zone. Right now, everyone in every government is motivated to prevent systemwide bank failure in the future. But fear fades with memory. The next truly destructive financial crisis may come 50 years from now, when the regulators of 2063 remember 2007 only from a course in college. And in 2063 the government institutions best able to prevent a crisis will be the ones with the strongest incentive to do so. If you’re planning for the faraway future, you can’t rely on good intentions.

The United Kingdom has placed this power squarely within the Bank of England, its central bank. Paul Fisher, the bank’s executive director, in March 2012 gave a talk in London explaining that before the crisis, the bank had responsibility for financial stability but “had never had any policy levers it could pull.” It had been stripped of the power to supervise commercial banks in 1997. Had it even wanted to intervene to minimize systemwide risk, the bank had no way to do so other than to warn of problems in its twice-yearly Financial Stability Report. “Issuing carefully crafted sermons,” said Fisher, “isn’t enough to deliver financial stability.”

As a remedy, the Bank of England now houses a Financial Policy Committee. Fisher is a member; the U.K. is still finalizing its powers. It can make recommendations to other regulators, but it will likely also hold the power to compel them to raise capital requirements for commercial banks and investment firms. This is the power, the one the finance industry fears the most. It makes sense as a part of the central bank, Fisher has argued, because understanding systemic financial risk and understanding macroeconomic modeling—what central banks have always done—demand similar skill sets.

Germany has distributed this power among several agencies. Its Financial Stability Committee, launched on Jan. 1 of this year, allows representatives from the country’s central bank, its financial supervisor, and its finance ministry to make decisions jointly. In a speech (PDF) earlier this month in Geneva, Andreas Dombret, member of the executive board of the Bundesbank, Germany’s central bank, praised this system. Long-term systemic stability, he said, draws on the policy instruments of several institutions. Fiscal policy, set by a legislature, can provide tax incentives. Financial regulators can encourage banks to invest in safer asset classes. And so Germany sets capital levels by consensus and committee. Consensus and committees work in Germany.

The U.S. has distributed this power even more. And it’s not certain that it’s even power. The Board of Governors of the Federal Reserve System has created an internal Office of Financial Stability Policy and Research, which is staffed by capable and forward-thinking economists with no power. The Dodd-Frank legislation created the Financial Stability Oversight Council, which is run by the Department of the Treasury. The council numbers among its 10 voting members the Treasury secretary, the Fed chairman, the Comptroller of the Currency, and the chairmen of the Securities and Exchange Commission and the Federal Deposit Insurance Corp. Together they have no power, just the ability to report, designate, and recommend. Should they agree to, they could not compel any bank to raise capital.

This week the Riksbank and the Swedish Financial Supervisory Authority are arguing over the power to regulate banks—to make them raise capital—because it is a real power. The U.K. and Germany have moved at least some of this power to the central bank, but both Bank of England’s Fisher and the Bundesbank’s Dombret fail in their speeches to address the most compelling reason to do so: The central bank has a balance sheet. It actually carries risk, and in a crisis will be the first called upon, before the treasury, to provide capital to failing banks and investment houses. In the U.S., after an exhaustive several years of legislating and rule-making, there’s an oversight council for financial stability. The Fed is one of 10 voting members. And all it can really do is what the Bank of England could do before the crisis: issue sermons.

    Before it's here, it's on the Bloomberg Terminal.