How Central Banks Can Succeed as Systemic Risk Regulators

In response to the financial crises in the United States and Europe, policymakers have significantly increased the regulatory authority of central banks.

The most recent move in this direction was the European Union's agreement to empower the European Central Bank as the supranational bank regulator across the continent. This follows a change in the United Kingdom, where the Bank of England was charged with overseeing financial stability, wresting that power away from the bank regulatory agency, the Financial Services Authority. In the United States, the Dodd-Frank Act empowered the Federal Reserve to become the "systemic risk regulator," granting it broad power to regulate any financial institution deemed systemically important (so-called SIFIs).

Clearly, a global shift is underway. Central banks are operating under an additional mandate beyond that of setting monetary policy:  to regulate the largest, systemically important institutions.

There is a reason why central banks have seen their authority grow. Having tamed inflation, central banks around the world have enjoyed increased political independence and respect from elected officials. The initial success of the Euro currency upon its launch in 1999 and the structure put in place granted the ECB power and authority that other supranational European organizations lack. Despite protests against the ECB in Europe and the rise of a prominent U.S. presidential candidate who called for an end to the Fed (the third central bank in U.S. history), these institutions have emerged from the financial crises of the last five years with enhanced legal authority and regulatory responsibility.

Whether this is a wise choice or not, time will tell. Instead of wading into that debate, let's just posit that our global financial system will depend heavily on the central banks' ability to properly regulate a broad range of financial institutions, which they previously did not regulate. In the United States, that includes institutions such as investment banks, insurance companies, and exchanges. In Europe, the ECB is still finding its way as a systemic overseer. 

The question is, how can they do this job well? Here are five simple principles that central bankers may want to consider as they ramp up their new regulatory regimes:

1. Avoid overdependence on models. Models are more useful in setting monetary policy than regulatory policy. Regulation inherently focuses on real-world issues, in which certain facts such as imperfect information, high transaction costs and legacy systems cannot be assumed away.
2. Empower bank regulators. Don't listen exclusively to monetary economists. Institutional culture is difficult to change. Historically, PhD economists specializing in monetary policy have ruled the roost at central banks. However, in regulating financial institutions, there is no substitute for experienced regulators who have first-hand knowledge of how financial institutions operate. If central banks are going to treat their regulatory responsibilities as equal to their monetary policy responsibilities, then regulators and monetary policy specialists should enjoy equal respect.
3. Embrace the diversity among systemically important financial institutions. Just because an institution is large and interconnected does not mean its business model is the same as other financial institutions of the same size. For example, commercial banks are fundamentally different from insurance companies. A one-size fits all regulatory approach will not work.
4. When reality conflicts with theory, go with reality. Former Federal Reserve Chairman Alan Greenspan acknowledged this in discussing why the housing bubble occurred. Said Greenspan, there was a fundamental "flaw in the model that I perceived is the critical function structure that defines how the world works." Sound monetary policy requires taking away the punch bowl once the party gets going. Similarly, sound regulatory policy requires stepping in when people on the ground detect unsustainable practices, while the party is going (preferably at the very beginning).
5. Work cooperatively with other regulators. There can be only one central bank responsible for monetary policy in any economy. However, there can be, and often are, multiple financial regulators, as in the United States. Sharing information, ideas and strategies for tackling problems can greatly improve outcomes. Regulatory infighting, stalemates, and obfuscation of information can lead to disaster.

Central banks' ability to adhere to these five simple principles may well determine their success in their expanded missions. Regardless of whether one was in favor of that mission to begin with, we all should hope for their success.
Aaron Klein was a deputy assistant secretary of Treasury under President Obama and is the Project Director for the Bipartisan Policy Center's Financial Regulatory Reform Initiative.