Challenges faced by national and international financial regulators

Jean-Armand Figeac 1

What are the major challenges for financial regulators nationally and internationally? Give some examples of recent actions taken by

regulators

Jean-Armand Figeac

February 2015


Table of Contents

I. Introduction .................................................................................................................................... 3

II. Major financial regulators and their core purposes ................................................................. 4

III. What are the main purposes of regulation ........................................................................... 4

IV. Challenges................................................................................................................................. 5

IV.I NATURE OF THE BANKING SECTOR .......................................................................................... 6

IV.II FINANCIAL INTERMEDIATION POLICY ...................................................................................... 7

IV.III CONSUMER AND INVESTOR PROTECTION ............................................................................. 9

IV.IV COST OF REGULATION .......................................................................................................... 10

IV.V GENERAL GLOBAL COMPLIANCE ........................................................................................... 10

V. Conclusion ................................................................................................................................... 11

VI. Bibliography............................................................................................................................. 13


Introduction I.

Almost a decade from now, several countries‘ economies entered a severe

recession caused by the financial crunch. The underlying reasons and regulatory

policy relevance of such an unfortunate event were seriously questioned by

academics and finance professionals (OECD, 2010). Even though much ink has

been spilt over this theme, financial regulation appears to be the epicentre of this

recurrent debate.

After the famous UK Big Bang of 1987, deregulation of financial markets was

beneficial at various scales. Indeed, it created many jobs, increased UK GDP and

made London as a global financial center (BBC, 2013). The creation of financial

conglomerate was thus well established and its leadership among other worldwide

financial centers had to sustain.

Yet, new financial instruments and complex larger-scale banks became more

challenging to supervise and monitor. Since then, ―regulators have struggled to come

up with a system that maintains competitiveness while maintaining sufficient

surveillance‖ (ibid).

To decipher financial regulations challenges this essay will analyse the enforced acts

and actions implemented by authorities and governing bodies at a national (U.S.A,

U.K. and Europe) and international scale. Subsequently, various examples of recent

actions taken by regulators will illustrate financial regulation scope.


Major financial regulators and their core purposes II.

In the U.S., after the markets plummeted in 1929, the congress passed a law

and created the Securities Exchange Act of 1934 aimed to restore investor

confidence in U.S. capital markets (Securities and Exchange Commission, 2013).

Across the pond, UK developed in 1997 an independent financial regulatory body,

the Financial Service Authority (now FCA). Its core purposes are to provide

prudential supervision and to ensure markets integrity (Financial Conduct Authority,

2015).

In France, the Autorité des Marchés Financiers (AMF) was created in 2003 as an

independent public body. Its scope of action includes but is not limited to the

monitoring of financial markets, the investors‘ insurance to receive correct

information and the safeguard of investment (AMF, 2013).

Various other institutions have been created with macro prudential oversight

at the center of their objectives such as the Bank for International Settlements (BIS),

the G20 and the Financial Stability Board just to mention a few (Denters, 2009).

What are the main purposes of regulation III.

The importance of financial markets and institutions is crucial for a country.

Indeed, these entities are responsible for massive amounts of investors‘ money

which can have a severe economic and social impact if put at risk (Forbes, 2014).

Thus, the core purpose of regulation is to effectively tackle the negative externalities

of such failures.

Pilbeam (2010) reports four categories of market failure in which government play a

major:

the externalities problem

the problem of asymmetric information

the moral hard problem

the principal-agent problem


Furthermore, Andrews (2007) states two others financial regulation goals: one being

the reduction of information asymmetries between economic agents and financial

institutions and the second one as the reduction of negative externalities and

information‘s asymmetries.

In turn, Brunneimer et al., (2009) summarized financial regulation in three parts.

Firstly, there is a need in monitoring the use of monopoly power and distortion to

competition. Secondly, finance regulation should focus on protecting ordinary people

as errors will affect welfare. Thirdly, there is an essential need of financial regulation

when ―costs of market failure exceed both the private costs of failure and the extra‖

(ibid p. 34).

Challenges IV.

To critically analyse financial regulation challenges, one should understand

the changes that occurred for the past two decades in this sector. Indeed, finance

landscape hasn‘t changed overnight but rather through deregulation, liberalization

supported by technological advances (Kansas Federal Reserve, 2005). Finance

developments such as financial services diversity, portfolio diversification for risk

reduction or the collecting information process, deeply contributed to more efficient

flow of resources (Fitzgerald, 2006). None the less, a multitude of intricate

challenges arose hand in hand with financial development, both of them evolving

over time.

Although critical issues are centred on the nature of the banking sector, financial

intermediation policy is severely tackled as well (Claessens, 2006). Additionally,

consumer protection, cost of regulation and a more general global compliance are

key components for a successful financial regulation (ibid).

The following part of his essay will synthetize the above challenges by providing an

overview of each of them and stress on the recent actions taken by regulators.


IV.I NATURE OF THE BANKING SECTOR

In the finance industry, the banking sector has been by far the most regulated.

In 2000, right after the Asian crisis, Eatwell & Taylor (2000) emphasized two majors‘

strengths of the banking system which paradoxically, were potential sources of

weaknesses: intermediation and leverage.

Intermediation can be defined as the process of collecting/lending deposits while

leverage is based on making loans of a substantial amount from the deposit (Eatwell

& Taylor, 2000). ―The Oracle‖ once argued: with leveraging and the simultaneous

risk entailed, the possibility of chain reaction is very high (Greenspan, 1997). Thus,

to minimize any possible burden and to prevent irrecoverable losses, safety net

schemes and deposit insurance were introduced. Their aims are to protect

depositors and banks shareholders (Oatley, 2001). One can inferred the dramatic

consequences that could occurred if a financial insolvency was spread to, first a

certain state and at a further stage, to a whole nation.

Given the wide usage of such convenient set of tools, it unfortunately implies a

certain form of free insurance for the banks and subsequently a necessary structure

of financial supervision to be implemented. Indeed, a certain paradox can be defined:

this safety net being established, it can create an incentive for banks to take

additional risks (ibid).

Banks can then provide liquidity with high interest to risky borrowers to generate a

high leverage. At a macro perspective, this burden can be transferred to the whole

society who in turn, may pay for the consequences when borrower defaults.

This particular shift of activity within the banking sector has reshaped the nature of

banks. ―Many large banks have become risk managers, rather than traditional

providers of financing and liquidity services‖ (Claessens, 2006 p. 6).

A classic example which perfectly illustrates this challenge in the UK, is undoubtedly

the failure of Northern Rock Bank. The FCA (FSA prior to 2013), aside with the

government guaranteed arrangements and made it public ownership in 2008. Such

an act reduced the risk of loss of confidence in the domestic bank system, and

minimise the financial risk to taxpayers (National Audit Office, 2009).


In Europe, the European Commission published an adjustment of the regulation EC

No. 1126 which came into force on October 2008. The intent of this amendment was

the possibility ―to reclassify financials assets and liabilities from categories with fair

value measurement to categories with amortised cost measurement‖ (Balling, 2011 p.

221). This doubled edged sword was a great opportunity for some banks to take

advantages of the latter and managed their disclosed figures (ibid).

On the other side of the pond, regulations in the financial sector occurred as well as

a response to the economic recession coupled with financial crash. Signed by B.

Obama and enforced in 2010, the 1,099 pages Dodd-Frank Act and Consumer

Protection Act (DFA) designed new rules for banks and complex financial derivatives

(Financial Times, 2011). The Financial Stability Oversight Council was henceforth

established to overlook the financial risk that could affect the nation‘s economy. A

major component of the DFA was undoubtedly the Volcker rule which prevent banks

from ―owning, investing, or sponsoring hedge funds, private equity funds, or any

proprietary trading operations for their own profit‖ (Koba, 2012).

IV.II FINANCIAL INTERMEDIATION POLICY

The multifunction banking system is another important facet of the challenges

regulators has to monitor. Previously prohibiting commercial banks from engaging in

the investment business, some important measures of the Glass-Steagall Act (1933)

were repealed under the Act of 1999 (Gramm-Leach Bliley Act) and had disastrous

consequences in the US financial industry. Zamanian pinpoints this ―evolutionary

process […] as an opportunity for larger banks to reap the benefits of the smaller one‖

(2007, p. 20).

In an article, The New York Times (2008) quotes Byron Dorgan, a Democratic

senator, forecasting disastrous consequences by voting -almost unanimously - this

act, and argues that no lessons have been learnt from the past. The causal chain

resulted in the well-known and prominent example of the end of Lehman Brothers.

The shadow banking system, estimated at not less than US$ 67 trillion, is

another area in which financial regulation and international agreement should be

conducted (Gertz & Jones, 2013). Yet, many problems arise when it comes to


precisely define this expanding financial sector that has almost tripled in less than a

decade. The Financial stability Board (FSB) highlights in its Shadow Banking

Monitory Report (2012) this expansion: US$ 25 trillion in 2002 and US$ 67 trillion in

2011 (cf. figure).

To counteract this shift, the Volcker rule was then proposed focusing on the

intersections of bank activities in the US (Brown, 2013). Nonetheless, this growing

sector outside the US might encounter difficulties of international co-ordination

(Financial Times, 2010).

Another example of financial intermediation policy is the European Markets

Infrastructure Regulation (EMIR). Similar to the DFA in the US, the European Union

regulation recently designed this new regulatory reform to impose requirements on

entities with the aim of improving transparency and reduces risk in the derivatives

markets (FSA, 2013).

On the other hand, speculative funds (hedge funds), a largely criticized

investment vehicle that ―did not cause the financial crisis‖, may benefit from

alleviated regulation structure (Banziger, 2009). In his economic journal, Rameix

(2008) aligns his researches and works on this specific position by stipulating that

hedge funds positively contributed to financial market mechanism expansion since

the high-tech bubble of 2001. Nevertheless, he further stated financial regulation

Figure 1 Growth of Shadow Banking, Source: FSB, 2012


challenges arose as this sector faced exponential growth including stronger systemic

risk, potential market abuse, misuse of shareholders activism, possible cases of

misspelling and a lack of risk management and internal controls (ibid).

IV.III CONSUMER AND INVESTOR PROTECTION

Dr. De Caria (2011) reports in his Hayekian approach journal a third challenge

of financial regulation: the investor/consumer protection. Undeniably, this challenge

faced by financial regulation increased over time as financial instruments became

more and more complex (Herring & Schmidt, 2011). In Europe, the European

Commission intends to regulate mortgage market by harmonizing a set of rule which

aim to provide better information for consumers (European Credit Research Institute,

2011). In the US, the creation of the Consumer Financial Protection Bureau was

funded with the same goals.

Another regulatory response after the credit crunch of 2007 was the Housing

and Economic Recovery Act signed in 2008 by George W. Bush. In response to the

subprime mortgage crisis, the purpose of this amendment was to restore confidence

in the two main government sponsored enterprises (Fannie Mae & Freddie Mac)

(Federal Housing Finance Agency, 2008).

Lastly, addressing the issue of moral hazards that credit rating agencies have

is another crucial milestone for financial regulators. ―They are the first line of defence

of investors against unnecessary credit risk exposure‖ (Božović et al., 2011 p. 220).

An article in The Guardian (2012) reported that AIG & Lehman Brothers were rated

respectively AAA and AA by the ‗‘creditworthiness‘‘ Big Three rating agencies

minutes before they collapsed (Kingsley & Nasiripour, 2009 and 2012). This example

strongly illustrates the degree of failure of the financial ratings services.

To prevent the occurrence of such an unfortunate outcome, subtitle C-Title IX

sections 901-991 of the Investor Protection and Securities Reform Act of 2010, firmly

emphasized the importance of improvement of credit rating agencies and stringent

regulations of those entities (Public Law No: 111-203, 2010).


IV.IV COST OF REGULATION

―Everything comes with a price‖, and in the financial world, this proverb makes

sense too. In the case of new ―international standardized regulation‖ implementation

to financial intuitions, drastic costs of such enforcements shall be highlighted. The

Government Accounting Office (2013) reported that out of the 400 Dodd-Franck

rules established, the cost of implementing only half of them raised up the bill to

approximately $US 2 billion (Atkinson et al., 2013).

From a macro perspective, looking at the solution of increasing banks capital

requirements has been argued to have positive effects as it will maintain the

probability of bank failure very low. The consequences of this latter can be beneficial

as well for the national output which will not be thrown out with bank failure but

instead may remain stable. Nevertheless, negative outcomes can emerge from such

a requirement; Barrell et al., (2009) pinpoints that increasing bank capital

requirement will lead to an increase as well of the cost of borrowing which in turn

may reduce national output.

IV.V GENERAL GLOBAL COMPLIANCE

Harmonization monitored by authorities, government bodies and financial

market political leader is required for the elimination or reduction of barriers and

avoid regulatory arbitrage (Claessens, 2006).

An example of international regulation is the Basel Accord (BA). The first BA,

enforced in 1988, was a review of capital adequacy provision of banks from the G10

countries (Pilbeam, 2010). Less than two decades later, the Basel committee

introduced a new regulatory framework, viz. Basel II, intended to ―strengthen the

soundness and stability of the international banking system‖ as Basel I was

insufficient (Bank for International Settlements, 2004).

Even though this more sophisticated approach aimed at improving bank safety, the

Financial Times reported that the US never implemented it (Jones, 2011). According

to JP Morgan‘s CEO, it was ―blatantly anti-American‖ (Dixon, 2011). After the

financial crash, the G20 recognized the importance of a stronger global regulation

and coordinated supervision (Denters, 2009). The challenges here relied on the little


understanding of the products created by complex financial engineering to which

domestic supervisors were not able to control nor couldn't fathom (ibid). The new

Basel III framework was then introduced focusing at increasing level of capitals,

liquidity and stress testing (BCBS, 2010).

Upon closer scrutiny, Goodhart (2008) argues that one of the major Basel

conventions failings is to take into account contra-cyclical instruments needed to

offset major fluctuations and liquidity conditions (p. 12).

Even though it couldn‘t prevent nor forecast the financial collapse, the EU

designed half a decade ago an approach called ―Lamfalussy process‖ composed of

four distinctive levels ―aimed at creating a new regulatory system which would allow

the European legislation to respond rapidly and flexibly to developments in financial

markets‖ (Inter-institutional Monitoring Group, 2006).

These international settlements were indeed needed as the interaction among

financial institutions increase and idiosyncratic risk could have severe importance

transmitting the risk of a foreign bank to a domestic one. Furthermore,

countercyclical instruments should

Conclusion V.

Throughout this essay, the conducted analysis identified both the continuous

obstacles national and international financial regulators are confronted to and

simultaneously, the significant role financial regulation has to play to maintain sound

economy. The appropriate balance of efficiency and stability are in fact the main

faced challenges (OECD, 2010).

As the recent crisis demonstrated few years ago, the systemic risk was the risk

financial regulation failed to monitor. Rather than a micro prudential policy, a larger-

scale approach should be implemented: a macro prudential policy should be the

correct measure for a global supervision. Nevertheless, this policy involves different

types of measures banks have to take such as adjusting their capital ratios or

imposing ceiling on a certain amount of debt a borrower can take (Financial Times,

2014). The Bank for International Settlements General manager argues macro

prudential policy can be a very useful tool but banks should not entirely rely on this

―new shiny weapon‖ (Fleming, 2014).


Central banks should play a major role as well in regulating and supervising financial

services. The Economist argues that:

“Central Banks should lead efforts to reform banking, so that it

poses less risk to taxpayers..[otherwise].. the future will consist of

banks that are too important to fail and central banks that are

destined to do so”

(The Economist, 2009).

Eventually, it seems that having implemented different acts and enforcements to

counteract the negative externalities of the financial market, many banks and other

financial institutions spend a huge amount of efforts to circumvent the laws. This led

researchers, scholars and professionals to underpin the special need for better

regulation rather than more regulation (Bank of England, 2012).

Greenspan once stated: ―you can have huge amounts of regulation and I will

guarantee nothing will go wrong, but nothing will go right either‖ (Goodman, 2008)

which says it all.


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Conventional and unconventional tools of Central Banks (1994-2014).

Current challenges

Jean-Armand Figeac

November 2014


Table of Contents

I. Introduction .................................................................................................................... 3

II. Which conventional tools Central Banks possess? ........................................................ 4

II.I The target federal funds rate......................................................................................... 4

II.II Discount rate ............................................................................................................... 6

II.III Deposit rate (DR) ........................................................................................................ 7

II.IV Minimum Reserve ...................................................................................................... 9

III. Second range of tools ................................................................................................. 9

IV. Current challenges faced by Central Banks .............................................................. 11

IV.I Lender of Last Resort ................................................................................................ 11

IV.II Regulatory and Supervisory role .............................................................................. 12

IV.III Transparency, accountability, credibility and independence .................................... 12

V. Conclusion ............................................................................................................... 12

VI. References ........................................................................................................... 14


I. Introduction

Central Banks (CB) play a major role in a nation‘s economy as their primary goal is

to control inflation and monitor price stability; consequently, most of the worldwide

countries adopted this system (Bordo, 2007). It is important to highlight that their

roles, functions and tools have considerably widened up for the past two decades.

Indeed, not limited to act during slump and recession time, they work closely with

financial services and commercial banks (Cecchetti & Schoenholtz, 2011). From a

semantic perspective, a CB is defined as the institution located at the centre of

payment systems ensuring the regulations and monitoring the rate of monetary

expansion. CB being nowadays independent, they fully participate and are entire

liable on monetary policy (Goodhart,1987). In addition, they are responsible for the

security and long term stability of the entire payment system (Banque de France,

1999). One of the most notorious monetarist stipulated that «inflation is everywhere

a monetary phenomenon» (Friedman, 1963). Nevertheless, Romer (2011)

emphasises that CB attempts to follow monetarist policy recommendations had

catastrophic outcomes over a decade ago and, as a result, the implementation of

inflation targeting was conducted through interest rate setting policy. Taylor & Meyer

(2001) researches entitled this new macroeconomics model as New Concensus also

known as New Keynesian synthesis.

Having identified that the interest rate and thus inflation targeting is CB‘s main goal,

we shall now determine their monetary policy instruments and applications.

The aim of this research paper is to analyse concisely and magnanimously the

conventional and unconventional tools entailed by CB while demonstrating a strong

critical understanding by discussing the current challenges those monetary

authorities are facing. The core ideas will be put into perspective with academic

theories and material support will demonstrate their applications.


II. Which conventional tools Central Banks possess?

The Federal Reserve has four major conventional tools, in other words monetary

policy instruments, to efficiently tackle monetary economy.

• The target federal fund rate

• The discount rate

• The deposit rate

• The reserve requirement

(Cecchetti & Schoenholtz, 2011)

II.I The target federal funds rate

Monetary base (MB), in other words, high powered money, is the total currency in

circulation (C) plus the total reserves in banking system (R). It can be algebraically

expressed as:

MB = C or (Fed Reserve notes + Treasury currency - coin) + R

(Mishkin, 2004)

It is monitored by central banks through diverse range of conventional tools.

Figure 1The Market for Bank Reserves


To achieve efficient monetary policy, CB focus on inflation targeting through interest

rate also called Federal Fund target rate in the United States. Taking account central

banks do not target money supply anymore, they use a « corridor system » (Yilmaz,


2013) also called a « channel » or a « discount window » (Ireland, 2014). In practice,

Central Banks, here the Fed, sets a target for the federal funds rate –generally short

term rates- defined a minimum deposit rate (bottom of the graph) and a ceiling, also

known as discount rate (top). Within this corridor, the interest rate will fluctuate,

enabling the interbank lending market to flourish and reach the required target rate.

Open Market Operations (OMO) are used by the Fed to monitor and control the

federal fund rate. We defined OMO here as a purchase or sale of existing

governments securities in the private market such as mortgage back securities,

notes, bonds…The sale and purchasing of such has a direct impact on the

monetary base and thus on the money supply as a whole. The open market

purchase will increase the monetary base and open market sales will have the

opposite effect.

Figure 2 Money Market and Loan Interest

(Palley, 2013)

As per Mishkin (2011), the advantages of OMO are several and can be listed as

follow:

• while having a complete control over their volume, they occur only at the

initiative of the Fed

• they can be implemented very quickly and are easily reversed

• they are flexible and precise


Although ECB has some identical monetary policy tools, it differs from the Fed on

few points. Indeed, its main goal is price stability within the eurozone consisting of

not less than 18 European Union member states (Official Journal of the European

Union, 2008). Regarding ECB, OMO are quite similar to the Fed; they can be divided

into four categories as following:

• main refinancing operations

• longer-term refinancing operations

• fine-tuning operations

• structural operations

(ECB, 2011)

II.II Discount rate

Discount rate, also known as discount lending is the secondary tool controlled by the

Fed as a monetary policy tool. « The discount rate is the interest rate charged to

commercial banks and other depository institutions on loans they receive from their

regional Federal Reserve Bank's lending facility--the discount window » (Federal

Reserve System, 2014). Depository institutions are offered three «discount window »

programs with their own interest rate, namely primary credit, secondary credit, and

seasonal credit. These programs are accessible to commercial banks facing

temporary shortage of liquidity due to internal or external disruptions. Allegedly, the

reader can expect this conventional instrument to have been used recently as

financial markets faced a severe recession. Nevertheless, Armantier et al. (2011)

argue that banks barely had access to such tool once the slump emerged; this lack

has been attributed to stigma. Bernanke (2009) assimilated this reaction as « it might

lead market participants to infer weakness ». The following graph shows the target

for the federal funds rate and the discount rate curve for the past two decades. The

two critical downwards slopes illustrate the 2000 stock market crash and the recent

recession we entered in.


Figure 3 The Target for the Federal Funds Rate and the Discount Rate

(National Council on Economic Education, 2014)

Even though this tool is small aside from recession time, it remains a dominant

instrument to:

« Ensure short-term financial stability,

Eliminate bank panics, and

Prevent the sudden collapse of institutions that are experiencing financial

difficulties. »


Cecchetti (2008) works demonstrate that both of these tools (OMO & Discount rate)

differs in two ways. Firstly, even though any bank is able to borrow to the Fed, there

are actually only nineteen of them, called « primary dealers », which can take part in

OMO. Secondly, a discount loan is allowed by the Fed endorsed by a wide range of

assets but only a few of high quality of them can be repurchased in regular OMO.

II.III Deposit rate

The deposit rate (DR) is the amount of interest rate that CB pay on excess reserves

held by the banks. The Federal Reserve highlights that DR goal is « to satisfy

reserve balance requirements and on excess balances». Furthermore, the Relief Act

of 2006 enable the Fed to « pay interests on balance held by or on behalf of


depository institutions at Reserve Banks, subject to regulations » (Federal Reserve

System, 2014). The institutional body evaluating the settings of the rates constantly

evolve market conditions and adjust when necessary.

Figure 4 Reserves of Depository Institutions

(Federal Reserve Board, 2013)

The previous graph illustrates the increase of the excess reserve that occurred from

mid-2008. This massive spike is due to the Emergency Economic Stabilization Act of

2008 effective on October 2008. Even though it has been said that this action was

taken in recession and slump time, as one of the solution to restrain financial market

disruptions, Anderson (2008) casts doubt upon this action and named it as a « level

of playing field between depository financial institutions subject to statutory reserve

requirements and their not-so-encumbered competitors». Furthermore, Bernanke

(2008) advances that the DR allows the Fed to better control the federal funds rate.

The deposit rate‘s impact is to set a floor under the market fed funds rate. ECB, on

the other hand, uses a conventional tool namely « standing facilities» which purpose

is to provide and absorb overnight liquidity within two ways:

• marginal lending facility

• deposit facility

We shall here analyse and put into perspective, recent events and decisions took by

ECB body. In regards to the considerably expected low inflation (below 2%) for a


long period of time, the Governing Council brought to terms the fact it needed to

lower its interest rates and thus introduced negatives rate interest. « ECB has shown

that interest rates can be pushed into shadow negative territory without the financial

system seizing up. That could encourage their use elsewhere or in future crises »

(Financial Times, 2014). By acting as such, we can then realize the wide and broad

spectrum of instruments CB can refer to for maintaining their goal and thus price

stability. From a different perspective, even though this action should be well

regarded within the financial market, such decisions can generate a high level of

criticism and raising a high level of uncertainty at it occurred very late.

II.IV Minimum Reserve

Finally, both of these institutions share a common conventional tool called the

Reserve Requirement (RR) also known as Minimum Reserve Ratio. Consisting of

fractions of deposit that banks must keep either at their vaults or at the Fed, its

primarily pursue is to stabilize the demand for reserves and creating/enlarging

structural liquidity shortage. It is set in accordance to the balance sheets of each

credit institutions and remunerated at the rate of main refinancing operations. Slavin

(2009) argues that RR is the ultimate weapon used by the Fed even though it occurs

maybe only once a decade. The required reserve of a bank subtracted from its

actual reserve will determine its excess reserves. Table 1 illustrates the different

Reserve requirements from February 2008.

Figure 5 Legal Reserve Requirements for Checking Accounts

(Slavin, 2009)

III. Second range of tools

Strictly speaking, unconventional tools and policy are implemented depending on a

series of considerations all of them related to economic health; they are mostly set


during deflationary pressures. Even though some of them can be risky, others can

present great advantages being easily reversible and offering the required incentives.

On one hand, ECB tried to minimize its own risk and implemented Long Term

Refinancing Operation & Securities Markets Programme, while facing the crisis. On

the other hand, Bank of England and the Fed have done Quantitative Easing (QE).

Financial Times (2014) pinpoints the use of QE as unconventional tools employed by

CB and the problems that it bequeaths. Gros et al. (2012) pointed out in their

Directorate General for Internal Policies report that the very recent and evident

outcome of the unconventional tools used by the CB was the balance sheet size;

undeniably, it has expanded in term of total assets (three times for BoE and the Fed,

and two times for ECB) in less than 5 years and thus creating new challenges for CB.

The following graph puts forward the total asset spike the three institutions reached

soon after the recession struck.

Figure 6 Total Assets/Liabilities : ECB, FED and BoE

(Gros et al., 2012) Eventually, we can now connect the use of unconventional tools by CB during

particular economical events. We shall now analyse critically the challenges CB were

facing to adopt and put into practice such tools.


IV. Current challenges faced by Central Banks

IV.I Lender of Last Resort

During recession time, CB has the duty to support financial system and thus

intervene for the stability of financial markets, being the lender of the last resort.

Indeed, its intervention is a must as it provides the necessary help to contain

financial instability and thus play a major role in CB‘s policy arsenal (World Bank

Institute, 2012). The action which follows was supplying the market with a huge

amount of quantities of dollars. Although this role has been severely criticized based

on economic reasoning, Bagehot & Thornton (1802 & 1962) already observed this

contingency and argue that it plays a major role in central banking analysis.

Nevertheless, both of them differ on few points as their work was achieved at two

entire different period of economic growth. Though, the question that can be raised

will concern its legitimacy. Tucker works emphasizes three main concepts which

shape the lender of last resort analysis which are time consistency, moral hazard

and adverse selection (2014). For instance, various extremely risky assets have

been recently purchased by CB as they were threatening the rest of the financial

market (Bloomberg, 2014). ECB argues that "We are now in an implementation

phase and will start... within the next days, to purchase the assets foreseen under

our new asset purchase programmes" (Coeuré, 2014). The following graph shows

the tremendous institution‘s expansion of balance sheet from 2008.

Figure 7 Size of Central Bank's balance sheets and the Monetary Base

(ECB, 2014)


IV.II Regulatory and Supervisory role

Having identified unconventional tool used in extreme conditions as crisis, it can be

advanced that CB play a major regulatory and supervisory role in the financial

system. The macro prudential regulation first observed in the ‘70s, strongly rose

awareness about the magnitudes of those catastrophic effects and disastrous

consequences. The Financial Stability Board defined macro prudential policy as « a

policy that uses prudential tools to limit […] financial risk, […] by dampening the

build-up of financial imbalances, building defences […] identifying, and addressing

common exposures, risk concentrations, […]that may jeopardise the functioning of

the system as a whole. » (Financial Stability Board, 2011 p32)

IV.III Transparency, accountability, credibility and independence

Dumiter (2014) identified transparency, accountability, credibility and independence

as the key components, key features and pillars encompassing the effectiveness of

central bank‘s policy. Moreover, independence of CB has brought public scrutiny on

how such actions (lending $1.5Tri. and purchasing $1.25Tri.) have been realized

without the consent of the Chief of State of the Congress (Waller, 2011). He argues

that giving independence to CB « is the best method for governments to tie their own

hands and prevent them from misusing monetary policy for short-term political

reasons» (ibid). Bain & Howell (2011) observe that the fact of increasing CB

independence has a positive correlation between both political independence and

low rates of inflation. Inasmuch independence is a key tool to CB, it is their

responsibility to be fully transparent in term of monetary policy enabling the public to

entrust economic reasoning, a fundamental principle in democracy.

V. Conclusion

It has been demonstrated throughout this essay the different relevant type of tools

monetary authorities can apply as a direct response towards particular economic

circumstances. Bain & Howell (2011) stress that no CB can avoid to be concerned

with the conduct of monetary policy as it is a must to involve the settings of short

term interest rates which is only done by the CB themselves, even though the

decision of the rate can be taken elsewhere. In addition, orchestrating monetary

policy is crucial for the health of the economy as tight monetary policy may lead to


deflation (financial instability) or slump and on the contrary, overly expansionary may

lead to high inflation. Elgar (2005) works, highlights Lavoie and Seccareccia views

on the endogenous role of money. Indeed, rather than focusing on monetary

aggregates, CB target interest rate. Ultimately, if the CB decline to lend to the banks

during severe slump, a credit crunch may occur as a result of a money market fall.

Although CB actions are required, some operations are frequently interrogated. We

can ask ourselves in the midst of doubt if this huge amount of bail-out were

necessary rather picking a winner and a loser in specific institutions. Eventually,

having critically analysed the CB conventional and unconventional tools and having

assessed their current challenges, the reader can allegedly wonder what would be

the last step of CB in terms of interventions. How far would they go to wave again

financial system and finally, what would be the exit strategy to return to normalcy?


VI. References

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European Central Bank (2011) Annual report 2011, The implementation of monetary policy in the Euro area, Retrieved from Internet http://www.ecb.europa.eu/pub/pdf/other/gendoc2011en.pdf? 6d6476996a529c2ea3f6fd6879f94c9d Accessed 8/11/14 European Central Bank (2013) Annual report 2013, Simplified Eurosystem balance sheet: liabilities, Retrieved from Internet http://www.ecb.europa.eu/pub/pdf/annrep/ar2013en.pdf Accessed 8/11/14 Federal Reserve (2014) System Board of Governors, The discount rate. Retrieved from internet http://www.federalreserve.gov/monetarypolicy/discountrate.htm Accessed 7/11/2014 Financial Stability Board (2011), Macroprudential policy tools and frameworks Update to G20 Finance Ministers and Central Bank Governors. Retrieved from Internet http://www.financialstabilityboard.org/wp-content/uploads/r_1103.pdf? page_moved=1 Accessed 10/11/2014 Financial Times (2014). Europe shows negative interest rates not absurd – and might work. Published by Ralph Atkins, London, Retrieved from internet http://www.ft.com/intl/cms/s/0/db1f5da4-3e89-11e4-a620-00144feabdc0.html#axzz3IUV28Gzc Friedman, M., (1963) Inflation Causes and Consequences, Asian Publishing House.. Goodhart C., A., E., (1987) Why do banks need a central bank?, Oxford economic Paper, Oxford University Press, vol. 39(1), pages 75-89, March. Gros D., Alcidi C., Giovanni A., (2012) Directorate General for Internal Policies report, Central Banks in times of crisis. The Fed versus the ECB. PE 475.117 Ireland P., (2014) Money, Banking, and Financial Markets Department of Economics, Boston College, Chapter 17b: Federal Reserve Operating Procedures Retrieved from internet http://irelandp.com/ec261/chapter17a.pdf Accessed 10/11/2014 Meyer, L., H., (2001) ‗Does money matter?‘, Federal Reserve Bank of St Louis Review, 83 (5) (September–October), pp. 1–15. Mishkin, F. S., & Serletis, A. (2011). The economics of money, banking and Financial markets. Toronto: Pearson Addison Wesley.


National Council on Economic Education (2014) Federal reserve, The target rate for he Federal Funds Rate. Retrieved from internet http://www.econedlink.org/lessons/ docs_lessons761_em761_federal_reserve_ppt1.pdf Accessed 7/11/2014 Official Journal of the European Union (2008). On the statute of the European system of central banks and of the european central bank. The European system of central banks. Protocol N°4 C115/230 Palley T., I., (2013) Horizontalists, verticalists, and structuralists: the theory of endogenous money reassessed, P: 406—424 Romer, D. (2000) ‗Keynesian macroeconomics without the LM curve‘, Journal of Economic Perspectives, 14 (2) (Spring), pp. 149–69. Slavin S., L., (2009) Macroeconomics, The Federal Reserve and Monetary Policy Ed. The McGraw-Hill Series, ISBN 978-0-07-336246-5 Taylor, J.B. (2004) Principles of Macroeconomics, 4th edition (Boston:Houghton Mifflin). Tucker P. (2014) Independent agencies in democracies: legitimacy and boundaries for the new central banks, The lender of last resort and modern central banking: principles and reconstruction, Gordon Lecture, Harvard Kennedy School. Yilmaz S., D., (2013) Bubbles, Panics and Crashes: An Introduction to Alternative Theories of Economic Crisis, Endogenous Money, Credit Bubbles and Central Bank Policy, Retrieved from internet http://www.post-crasheconomics.com/wp-content/uploads/2013/10/Bubbles-2013-14-Lecture7-Endogenous-Money-and-Central-Bank-Policy.pdf Accessed 7/11/2014 Waller C., (2011) Federal Reserve Bank of St Louis, Independence + Accountability: Why the Fed Is a Well-Designed Central Bank, , Review, September/October 2011. World Bank Institute (2012) Lenders of Last Resort and Global Liquidity: Rethinking the system. Retrieved from Internet http://wbi.worldbank.org/wbi/devoutreach/article/266/lenders-last-resort-andglobal- liquidity-rethinking-system Accessed 8/11/14

Challenges faced by national and international financial regulators

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