(Research Handbooks in Financial Law) Peter Conti-Brown, Rosa Maria Lastra - Research Handbook On Central Banking (2018, Edward Elgar Publishing)

CONTI-BROWN 9781784719210 PRINT.
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Research Handbook on Central
Banking
Edited by
Peter Conti-Brown
Assistant Profess01; The Wharton School, University of Pennsylvania,
USA
Rosa Maria Lastra

Professor of International Financial and Monetary Law, Queen Mary
University of London, UK
RESEARCH HANDBOOKS IN FINANCIAL LAW
� Edward Elgar
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Contents
List of figures vii

List of tables viii
List of contributors ix
1 The central banking century: an introduction to institutional central banking 1

Peter Conti-Brown
2 Central banking and institutional change in the United States: punctuated
equilibrium in the development of money, finance and banking 6
Peter Conti-Brown
3 The development of the Bank of England’s objectives: evolution, instruction
or reaction? 34
Forrest Capie and Geoffrey Wood
4 Central banking in Japan 53
Hideki Kanda and Toshiaki Yamanaka
5 Reserve Bank of India 68
Raj Bhala
6 The Bank of Russia: from central planning to inflation targeting 94
Juliet Johnson
7 Specific challenges to the People’s Bank of China in a new wave of financial
reforms 117
Zhongfei Zhou
8 An evolutionary theory of central banking and central banking in China 128
Xiangmin Liu
9 New tasks and central bank independence: the Eurosystem experience 155
Chiara Zilioli and Antonio Luca Riso
10 A central bank in times of crisis: the ECB’s developing role in the EU’s
currency union 184
René Smits
11 Monetary policy and central banking in sub-Saharan Africa 208
Christopher Adam, Andrew Berg, Rafael Portillo and Filiz Unsal
12 The Reichsbank and the Bundesbank: the legacy of the German tradition of
central banking 229
Harold James

vi Research handbook on central banking
13 Central banking in Australia and New Zealand: historical foundations and

modern legislative frameworks 245
Frank Decker and Sheelagh McCracken
14 Central banking in Latin America: past, present and challenges ahead 274
Luis I Jácome H
15 The institutional path of central bank independence 296
Rosa María Lastra
16 Central bank accounting 314
David Bholat and Robin Darbyshire
17 International aspects of central banking: diplomacy and coordination 333
Robert B Kahn and Ellen E Meade
18 Central bank psychology 365
Andrew G Haldane
19 Banking regulation and supervision: a UK perspective 380
Kern Alexander and Rosa María Lastra
20 Unconventional monetary policies: a re-appraisal 398
Claudio Borio and Anna Zabai
21 Central banks and payment system risks: comparative study 445
Benjamin Geva
22 Digital currencies, decentralized ledgers and the future of central banking 474
Max Raskin and David Yermack
23 Central banks, systemic risk and financial sector structural reform 487
Saule T Omarova
24 The role of macro-prudential policy 508
Charles Goodhart
25 Transparency of central banks’ policies 518
Christine Kaufmann and Rolf H Weber
26 The lender of last resort: regimes for stability and legitimacy 535
Paul Tucker
27 Concluding observations 553
Rosa María Lastra
Index 555

Figures
4.1 Call Rate, Current Deposits and the ‘Monetary Base’ 59

16.1 Accounting frameworks adopted by select central banks 317
16.2 A hypothetical central bank balance sheet 318
16.3 Hypothetical central bank income statement split by function 325
17.1 Trade-weighted US Dollar Index 343
17.2 The twin deficits 344
17.3 Asian financial crisis, selected exchange rates (index5100 on 1 July 1997) 350
20.1 Central bank assets 402
20.2 Central bank liabilities 403
20.3 Central bank deposit rates sink into negative territory 422
20.4 Government bonds trade at negative yields 424
20.5 An illustration of equilibrium in the market for bank reserves 436
vii

Tables
14.1 Inflation in Latin America in the 1960s and 1970s (average annual
percentage rate for the period) 283
14.2 Key parameters of inflation targeting regimes in the LA5 288
20.1 A taxonomy of monetary policy implementation measures 401
20.2 Balance sheet policies by selected central banks since the Great Financial
Crisis 405
20.3 Large-scale asset purchases and forward guidance since the Great Financial
Crisis: a timeline 406
20.4 Impact of balance sheet policies on domestic yields and the exchange rate 411
20.5 Impact of liquidity support measures by the Fed and the ECB on financial
markets 414
20.6 Impact of recent forward guidance on market beliefs and the yield curve 419
20.7 Impact of large-scale asset purchases on output and inflation 426
20.8 Some evidence about the external impact of US monetary policy 432
25.1 Central bank accountability: stakeholders and audiences 522
viii

Contributors
Christopher Adam, Oxford University

Kern Alexander, Zurich University
Andrew Berg, International Monetary Fund
Raj Bhala, The University of Kansas School of Law
David Bholat, Bank of England
Claudio Borio, Bank for International Settlements
Forrest Capie, Cass Business School, City, University of London
Peter Conti-Brown, The Wharton School of the University of Pennsylvania
Robin Darbyshire, RV Darbyshire
Frank Decker, University of Sydney Law School
Benjamin Geva, Osgoode Hall Law School, York University
Charles Goodhart, London School of Economics
Andrew G Haldane, Bank of England
Luis I Jácome H, International Monetary Fund
Harold James, Princeton University
Juliet Johnson, McGill University
Robert B Kahn, Council on Foreign Relations
Hideki Kanda, Gakushuin University Law School and University of Tokyo
Christine Kaufmann, University of Zurich
Rosa María Lastra, Queen Mary University of London
Xiangmin Liu, People’s Bank of China
Sheelagh McCracken, University of Sydney Law School
Ellen E Meade, Federal Reserve Board
Saule T Omarova, Cornell University
Rafael Portillo, International Monetary Fund
Max Raskin, New York University School of Law
Antonio Luca Riso, European Central Bank
ix

x Research handbook on central banking
René Smits, University of Amsterdam; Queen Mary University of London

Paul Tucker, Harvard Kennedy School
Filiz Unsal, International Monetary Fund
Rolf H Weber, University of Zurich
Geoffrey Wood, Cass Business School, City, University of London
Toshiaki Yamanaka, University of Tokyo and Yale Law School
David Yermack, New York University Stern School of Business; National Bureau of
Economic Research
Anna Zabai, Bank for International Settlements
Zhongfei Zhou, China Executive Leadership Academy, Pudong
Chiara Zilioli, European Central Bank

1. The central banking century: an introduction to
institutional central banking
Peter Conti-Brown
Historians are at the early stages of making sense of what historians call the long
twentieth century, dating roughly from the late nineteenth century through the global
financial crisis of 2008. It has been an extraordinary period, a time consumed by war, hot
and cold; terrorism, in the skies and on the ground; successive revolutions in travel and
communications; and the depths of multiple depressions and the heights of unparalleled
prosperity. Trying to make sense of this history over the longue durée will be a consuming
project for the foreseeable future.
It is not an exaggeration, however, to put central banks at the center of the dizzying
highs and exhausting lows. In many ways, the twentieth century was the century that
central bankers built, for better and for worse. The advent of the modern, bureaucratised,
mostly publicly controlled central bank was born not in seventeenth century Sweden, but
in twentieth century America. And the concept of ‘central bank independence’, a defining
concept, has echoes in earlier eras, but didn’t come into its maturity until well into the
twentieth century. Central banks’ behavior during the 2008 crisis represents an apotheosis
for this vision, not an exception.
The open question, then, isn’t whether central banks and central bankers were at
the center of things in the twentieth century. It is whether they will survive, intact, the
twenty-first. Reports of populist uprisings representing the end of the technocratic
consensus of the 1990s are greatly exaggerated; the populist enthusiasms that stand so
starkly against the vision of central banking as an autonomous enterprise are hardly
stable. But the fall of 2008 brought seismic shifts in the central banking landscape, both
inside and outside those banks.
This volume represents an effort by a diverse set of scholars to make sense of where
central banks stand at the end of that long twentieth century. It is, my co-editor Rosa
Lastra and I believe, the most diverse set of disciplinary commitments brought to bear
on the questions of what central banks are, have been, and might become. The study
of central banks is a venerable one, albeit largely dominated by practitioners, academic
economists, and, if we are honest, fringe conspiracists. This volume represents something
different. Some of the most interesting contributions come from the first two categories—
Charles Goodhart and Andy Haldane, for example, bridging those two gaps. But we
have also included historians, legal scholars, political scientists, an accountant and an
anthropologist. This multidisciplinary effort was self-conscious. We viewed the puzzle of
central banking as one that can only be clarified from multiple angles. It is the proverbial
elephant, the disciplines of the proverbial blind men trying to describe what they feel. If
this volume is successful, it is because we have tried to take a broader view of the elephant
than is normally possible through just one disciplinary lens. (Although, to be clear, we
didn’t include the fringe conspiracists.)

2 Research handbook on central banking
The central idea behind the volume is that central banks are institutions in multiple
senses of the word. It is an institution as that term is used by economists like Douglass
North, as ‘humanly devised constraints that structure political, economic and social
interaction’ that ‘consist of both informal constraints (sanctions, taboos, customs, tradi-
tions, and codes of conduct), and formal rules (constitutions, laws, property rights).’1
It is a set of rules, laws, norms that arise to respond to the identified needs of a nation
or system. But they are also institutions as organizations, a set of buildings, a culture,
governed by laws but also subject to non-legal and extra-legal devices that shape who they
are and where they will go. The institutions of central banking, then, are about both the
US Federal Reserve System and broad thinking about price stability, the Bank of England
and reactions to financial panic.
To get at this institutional framework, we divide the volume in two. The first half deals
with individual case studies; the second with broad themes that will affect most if not all
central banks in the twenty-first century. Our canvas of the world is broad and nearly
comprehensive. I give an overview of the highly historically contingent nature of central
banking in the United States, focusing on the uneven institutional evolution of the US
Federal Reserve. Forrest Capie and Geoffrey Wood provide a capsule history of the Bank
of England and highlight a theme we see throughout the volume: the institutions of
central banking did not arrive fully formed, but have evolved unevenly through the years
and, in the Bank of England’s case, the centuries. Hideki Kanda and Toshiaki Yamanaka
take us through the Bank of Japan (BOJ), long considered one of the least independent
of central banks, but one that has not suffered from runaway inflation as models of
central bank independence might suggest. Indeed, the Japanese experience has been just
the opposite: Japan has struggled with historically low levels of inflation. Kanda and
Yamanaka’s treatment of the Bank of Japan illustrates what we hope to accomplish in
this volume. It is a historical, legal and institutional treatment that explores, accessibly,
how an important institution like the BOJ has changed over time. Raj Bhala provides a
similar overview of the Reserve Bank of India.
Juliet Johnson, a political scientist, opens the hood on a fascinating set of institutions:
central banks in post-Soviet Russia. Johnson explores another theme that is prominent in
the volume: how do politically dominated central banks function as anything other than
governmental functionaries? The answer, for the Bank of Russia, is reputational: even
if Vladimir Putin (or the many other governments without strong independent central
banks) dominates the political scene, there is potential for some kind of autonomy to
develop.
Given its prominence, we have two chapters on the People’s Bank of China (PBOC).
Zhongfei Zhou describes the challenges and opportunities for the PBOC with the develop-
ment of the Shanghai Free Trade Zone, a kind of credible commitment that functions
similarly to governmental commitments to independent central banks. The PBOC’s own
Xiangmin Liu provides a deeper, more historical account of the PBOC, emphasizing
again—as with Conti-Brown and Capie and Wood—the evolutionary nature of central
banking change.
1
North, Douglass C. ‘Institutions’. The Journal of Economic Perspectives 5, no 1 (1991),
97–112.

The central banking century: an introduction 3
In separate chapters, Rene Smits and Chiara Zilioli and Antonio Riso describe the
European Central Bank (ECB), focusing variously on the ECB’s legal structure and how it
has sought to thread the needle between technocracy and accountability during the crisis
of the twenty-first century. Chris Adam, Andy Berg, Rafael Portillo and Filiz Unsal take
on most of an entire continent to describe central banking institutions in sub-Saharan
Africa. Adam et al. focus especially on the success story of sub-Saharan Africa via infla-
tion targeting, while also discussing what happens when governments seek not to trim the
sails of central banks, but to add to their functions.
Harold James, an eminent historian of central banking, takes a look into the German
Bundesbank. The choice to focus on the German example may seem out of place in a
volume about central banking in the twenty-first century, given the dominance of the ECB
in Europe. But as James shows, the institutional solution of the Bundesbank continues to
resonate in contemporary discussions of European central banking.
Sheelagh McCracken and Frank Decker provide a similar historical and institutional
overview of central banking in Australia and New Zealand, a fascinating story about
commonwealth institutions finding their footing in the shadow of the Bank of England,
and then as innovators that set the standard for the rest of the world. The two percent
inflation target, for example, is a New Zealand export. Luis Jacome of the International
Monetary Fund (IMF) concludes part I by providing a detailed overview of central bank-
ing in Latin America, demonstrating another key reason for this geographically-focused
effort: there is much that we see in the development of these institutions around the globe,
but also much that is deeply local.
The second half of the book develops more concretely some of the themes addressed
in the first. It begins with Rosa Lastra exploring perhaps the defining question in central
banking, central bank independence. This elusive concept has dominated discussions of
central banking since roughly the 1980s, but, as Lastra explains, that conceptual under-
standing rests on an incomplete foundation. And in any case, the 2008 financial crisis and
its policy aftermath have introduced challenges to an old framework that was dominated
by the concern to prevent political mismanagement of inflation.
Anthropologist David Bholat and accountant Robin Darbyshire write about an
often overlooked but still essential component of central banking practice: account-
ing. Accounting can seem to be a dry concept for low-level employees, but Bholat and
Darbyshire demonstrate that accounting is at the core of understanding central banks,
their work, and the political relationships that guide them. The authors also put the dis-
cussion of ‘auditing’ central banks into a more rigorous conversation than is customary
for that perennial topic.
This handbook is global in scope and ambition, but often comparative. Robert Kahn
and Ellen Meade introduce ‘international coordination’ as a reality, both as a policy
challenge and a policy tool for major central banks. In this nuanced chapter, Kahn and
Meade discuss how diplomacy and coordination differ, and then take readers on a guided
tour through recent central banking history, discussing how much central banks rely on
each other in accomplishing most of their major goals.
Most of this chapter is focused on central banks; Andy Haldane, chief economist
of the Bank of England, refocuses our attention on central bankers. Haldane’s chapter
brings into conversation behavioral economics and monetary policy, two threads in
economics that don’t often have much to say to each other. Exploring the central banker

decision-making processes—including their limitations—helps us unpack exactly how

central bankers will confront their challenges, old and new.
A key component of central banking practice, arguably since the late eighteenth century
and certainly throughout the twentieth century, is central banks’ role not only in regulat-
ing monetary policy but in supervising banks. Kern Alexander and Rosa Lastra discuss
this ever-changing concept to explain how central banks can and should engage in bank
supervision, and how supervision can facilitate and interfere with the institutions’ other
mandates.
The financial crisis of 2008 looms large over this volume, and rightly so. The crisis
changed so much about how we think about central banks and how central banks think
about themselves. Perhaps most importantly, the post-crisis monetary response was,
to use a term of art, ‘unconventional’. Claudio Borio and Anna Zabai, both of the
Bank for International Settlements, provide the most thorough, empirical account of
unconventional monetary policy of which I am aware. In their treatment, we learn that
unconventional monetary policy has been largely effective, a view that counters some of
central banks’ leading critics. But we also learn that the benefits of these unconventional
policies are unlikely to remain and should be, as a result, used only in emergencies.
The next two chapters, on payment systems by Benjamin Geva and on digital currencies
by Max Raskin and David Yermack, touch on another core issue: how money functions
through the global system. Geva covers the legal architecture of central banks in supervis-
ing the payment system, while Raskin and Yermack dig deeply into what the future may
hold at the intersection of currency and technology. Saule Omarova takes a deep dive into
financial stability and systemic risk regulation, a central banking mission at the core of
the nineteenth-century model that became key again after the financial crisis. Omarova
approaches the question by looking at competing conceptions of financial stability
reform, especially focusing on reforming the structure of the financial industry versus the
more bureaucratic approach taken in the US and EU.
Charles Goodhart, the dean of central banking scholars, explores macroprudential
regulation, as distinct from systemic risk regulation. Goodhart gives a detailed account
to answer four related questions: why did macroprudential regulation attain its near ubiq-
uitous status in discussions of central banking, what macroprudential regulation actually
means, who should be in charge of it, and how has this been accomplished in recent
history. As is typical of Goodhart’s work, the chapter is both innovative and accessible,
providing a new take on an important issue that will engage experts and newcomers alike.
Christine Kaufmann and Rolf Weber discuss what they take as a tension with central
bank independence: transparency. Central banks have not had a reputation for transpar-
ency through much of their history, although this has slowly been changing for many
(though they have not always received credit for this). Kaufmann and Weber argue that
transparency is essential to the functioning of central banks, despite the challenges that
transparency can bring.
Paul Tucker, former Deputy Governor of the Bank of England, concludes the book by
summarizing his influential views on central banks as lenders of last resort, a question he
knows well as a scholar and practitioner. Tucker argues that the key problem for central
banks as lenders of last resort is about delegation and legitimacy, a thorny reality that has
focused the minds of central bankers the world over in the aftermath of the 2008 crisis.
Research handbooks are meant to be snapshots of a zeitgeist, the state of the research

The central banking century: an introduction 5
art for those who will be joining the conversation midstream. This book aims at that
important tradition, but it is also different than this tradition. While research is sum-
marized, it is not a collection of literature reviews. Sometimes the work presented comes
from other publications, but for the most part the essays ahead are original, theoretical,
conceptual, historical and empirical work. As a result, while the spirit of 2017 permeates
the volume, the chapters are aiming at something more enduring than this. Central banks
are experiencing a generational transition. These curious institutions, at the intersection
of government and markets, dominated economic policy-making in the long twentieth
century. It is still too early to predict with confidence the direction that a long twenty-
first century will take, but there is little doubt that central banks will play a dominant, if
ever-changing, role. Research like that presented and summarized in this volume will help
guide that debate.
A note of thanks to the Bank of England, the Wharton School of the University of
Pennsylvania, and Queen Mary, University of London for their logistical support in
gathering these scholars, and to Laura Mann at Edward Elgar for her patience in guiding
the book’s long incubation through to publication.
Let me conclude, too, with a personal note of thanks. Rosa María Lastra has become,
through this project so much more than a collaborator. As one can imagine, editing a
group of authors this diverse—from so many countries and disciplinary backgrounds, at
various stages in their careers and active with their own busy schedules—could have been
a laborious chore. It wasn’t, in part because of the caliber of authors we have recruited.
But the lion’s share of the credit belongs to Rosa, my mentor and friend. It is rare that
someone of her professional stature maintains a deep sense of humanity, but Rosa is a
rare person. I count it a singular privilege to have undertaken this project at her invitation
and will treasure the friendship for decades ahead.
Philadelphia, PA, June 2017

2. Central banking and institutional change in
the United States: punctuated equilibrium in the
development of money, finance and banking
Peter Conti-Brown* 1
In debates about the origins of central banking, no one puts the United States at the
cutting edge. Those garlands belong to either the Swedish Riksbank or the Bank of
England. But this is a mistake. Central banking in the US has had a tumultuous ride,
but the notion of a modern, technocratic, essentially (though incompletely) public
central bank has been significantly influenced by institutional change in the United
States.
In this chapter, I trace some of that history, noting the nodes of institutional change.
The point is to emphasize key moments in the history of central banking in the United
States, especially in the history of the US Federal Reserve System. In writing this
necessarily abbreviated history, I focus on three aspects of institutional change: structure,
functions and perhaps especially personalities. The history of central banking isn’t a
history of nameless agents doing what central bankers do. It is a story of big personali-
ties making bureaucratic war with other big personalities, inside and outside the central
banking system. Sometimes that war would come in the form of legislative action. But
often it would not. The key to understanding US central banking history is to understand
law’s importance, but also its limits.
The chapter has six parts. In Part I, I explain the context of central banking in the
long nineteenth century, including the rise and fall and rise and fall of the Banks of the
United States. In Part II, I discuss the creation of the Federal Reserve System. Part III
outlines how the Fed changed during the Roosevelt Administration and especially under
the leadership of Marriner Eccles. Part IV is about the Fed-Treasury Accord of 1951, seen
by some as creating the modern independent Federal Reserve, but in fact much more of
a tentative understanding at the time. In Part V I discuss the various dynamics between
US Presidents and Fed Chairs, perhaps the most important relationship in determining
what kind of central bank the US will have. Part VI discusses how the 2008 crisis and
subsequent legislation radically changed what the Fed became, and where it is today. A
brief conclusion speculates about the future.
* I thank Alan Blinder, Harold James, Naomi Lamoreaux, Rosa Lastra, Nicholas Parrillo,
Sean Vanatta, and Julian Zelizer for helpful comments on the draft. I have adapted sections of this
chapter from my book, The Power and Independence of the Federal Reserve (Princeton University
Press, 2016).

Central banking and institutional change in the US 7
I. CENTRAL BANKING WHIPLASH IN THE LONG

NINETEENTH CENTURY
Writing the history of central banking is difficult for many reasons, not least the basic
institutional argument that motivates this dissertation: what ‘central banking’ meant
was constantly changing. At the outset of the American Revolution, the concept,
referred to by Hamilton as a ‘National Bank’, was essentially homage to the Bank of
England and referred to a bank with a formal, legal connection to the public-fisc, given
some form of quasi-monopoly in that relationship, and usually modeled after the Bank
of England.1
It was in this context that Alexander Hamilton, that polymath West Indian emigrant,
entered the fray. During his service in the Revolutionary War as General Washington’s
aide-de-camp, Hamilton observed first-hand the sorry state of colonial finances. The
problem was one of political theory as much as economics, and the system of continental
currency led to a hyperinflation during the Revolutionary War that called into question
the very financial well-being of the new Republic.2
Hamilton described his solution to the new nation’s problems in his Second Report
on the Public Credit, written to the House of Representatives at its request in December
1790. He had alluded to the need for a national bank to accomplish the goals of a federal
assumption of state debts incurred in the conduct of the Revolutionary War, but he put
off the full plan for nearly a year.3 By the Second Report, Hamilton described a ‘national
bank’ that would ‘be of the greatest utility in the operations connected with the support
of the public credit.’4 To accomplish those goals, the new bank—eventually called the
Bank of the United States—would be chartered as a private corporation, but by federal
rather than state legislation.
Hamilton’s conception of the Bank of the United States was met with only limited
opposition in the House and Senate, where his proposal passed by strong margins.
Once the bill reached President Washington, however, the debate was joined as an
intra-administration affair: the Secretary of State, Thomas Jefferson, opposed the
very existence of this kind of concentrated authority and sought the President’s veto.
The debate defending the constitutional legitimacy of the Bank of the United States
was intense, and portended the beginning of the party system in the early Republic.
Eventually, Hamilton’s blizzard of arguments carried the day and the Bank opened for
operations in 1791.
Hamilton’s time bomb on the charter went off in 1811. By then, Jefferson was President
of the United States. Some aspects of presidential prerogatives had changed once
Jefferson took residence in the White House, but his hostility to Hamilton’s banking
system remained firmly in place. It was ‘one of the most deadly hostile [institutions]
1
For overviews of banking and central banking in the US and beyond, see Desan (2014),
Wood (2005).
2
For more on the state of American finances at the end of the Revolutionary War, see
Bezanson (1951). Hamilton’s background comes from Chernow (2004).
3
See Hamilton, First Report on the Public Credit, 14 January 1790. For more discussion, see
McCraw (2012, 111–21).
4
Hamilton, Second Report on the Public Credit, 13 December 1790.

existing against the principles and form of our Constitution’, one to be feared as a
political manipulator.5
When the recharter debate did finally come to a head, the new President, Jefferson’s
protégé James Madison, was noncommittal. He didn’t maintain Jefferson’s implacable
opposition to the Hamiltonian system, but nor would he be its champion. Old divides
and the political tensions of 1811 meant that ‘the bank’s near indispensability and its long
record of brilliant success did not guarantee its recharter.’6 After a spirited debate, the
Bank’s recharter died by a single vote in both houses. The proposal never made it to the
President’s desk.7
1. The Second Bank of the United States and the Bank Wars
The War of 1812 convinced these Jeffersonian Republicans of the error of their
ways. They had longed to retire the debt, but the war prevented it, causing other
‘embarrassments’ in Madison’s term.8 A proposal for a new Bank of the United States
sailed through Congress, but with another 20-year charter, pushing the question of
permanence to a future generation.
That rechartering provision, however, proved again to be the Bank’s undoing,
this time at the hands of the leader of the Democracy, Andrew Jackson. ‘That the
modern twenty-dollar Federal Reserve Note should bear Andrew Jackson’s portrait
is richly ironic’, writes historian Daniel Walker Howe. ‘Not only did the Old Hero
disapprove of paper money, he deliberately destroyed the national banking system of his
day.’9
The problem came on three fronts that are a constant source of tension throughout
central banking history in the United States: structure, functions and personalities.
Jackson’s foe in the ordeal was Nicholas Biddle, a Jeffersonian Republican appointed
by Madison in 1816 as one of the first Republican directors of the new Bank.
Functionally, the Bank thrived on various features of its system. It issued notes, like
any bank, but its notes were deemed legal tender and could be exchanged for gold
and silver. It also received the government’s tax receipts, marketed the government’s
debt, and was responsible for almost all foreign exchange transactions in and out of
its currency. Eventually, the bank became the largest corporation in the country.10
And structurally, Jackson opposed the Bank both as a private corporation and as the
recipient of public largesse.
Biddle sought to outsmart the President, and very nearly succeeded by launching the
rechartering debate several years earlier than the statute required. Congress sided with
Biddle, passing the recharter by large margins. Jackson was ready: ‘The bank is trying to
kill me, but I will kill it!’ he declared to Martin Van Buren.11 Despite the large margins of
5
As quoted in McCraw (2012, 290).
6
McCraw (2012, 294).
7
McCraw (2012, 295–96).
8
Howe (2007, 81).
9
Ibid at 373.
10
Ibid.
11
As reported in Van Buren’s memoirs. Van Buren (1857/1920, 625).

victory in the Congress, there was not enough support to override Jackson’s veto, what
Howe called ‘the most important presidential veto in American history.’12
The veto message is an extraordinary document, 8000 wide-ranging words in its
multi-faceted rejection of structure, functions and constitutionality of the Bank of the
United States. The veto message is a statement of political philosophy, a conservatism
that urged the country to return to the ‘legitimate objects of Government by our
national legislation’, not those espoused by the wealthy interests in Congress.13 The
President critiqued the structure of the bank, too. ‘Is there no danger to our liberty
and independence in a bank that in its nature has so little to bind it to our country?’
he asked.
It was also a call to class-based arms. The denouement would reverberate in future
discussions of the Federal Reserve well into the twenty-first century. ‘The rich and power-
ful too often bend the acts of government to their selfish purposes’, he wrote.
[W]hen the laws undertake . . . to grant titles, gratuities, and exclusive privileges, to make the rich
richer and the potent more powerful, the humble members of society— the farmers, mechanics,
and laborers— who have neither the time nor the means of securing like favors to themselves,
have a right to complain of the injustice of their Government.
Andrew Jackson heard or invented their complaints, and acted.14 So it was that Jackson
not only abandoned the Bank of the United States, but also reinforced institutions of
federalism, local autonomy and small-market private control that would dominate the
discussions of the Federal Reserve.
2. Interregnum: Free Banking and Bimetalism
After the collapse of the Second Bank of the United States, the US saw the rise of
what has been called ‘free banking’. The term itself has been used in a variety of ways.
Economists like Lawrence White, George Selgin or Richard Timberlake view free bank-
ing in the same way they view free markets generally, not with money as an exception to
free market principles but as providing a good or service much like any other.15 Under
this theory, free banking stood as the antithesis of the institutionalized money discussed
in this dissertation: that is, the structure and functions of money would be anything the
market said they could be, so long as governmental coercion was not in play.
Free banking as an institutional historical phenomenon, not as an intellectual historical
phenomenon, is something different. Free banking in this context is ‘generally used to
refer to a very specific set of legal conditions for opening a bank defined by New York
state law of 1838’, and widely adopted thereafter, as a kind of ‘Madisonian polity in which
state governments ceded as little power to the federal government as seemed practicable.’16
Free banking in that sense answered the twin questions of institutionalized money in this
12
Howe (2007, 379).
13
Jackson, Bank Veto Message, 10 July 1832.
14
Ibid.
15
Timberlake (1984), Selgin (1988). For a recent survey, see White (2014).
16
Bodenhorn (2003, 5).

way: money would be defined by the state, and would be managed by small private banks
chartered by the states.
The debate about the efficacy of free banking continues to the present, but the
prominence of the free-banking movement away from centralized, federal charters and
towards the decentralized proliferation of state banks played an important role in shaping
how the Federal Reserve Act would eventually be debated. The role of states—or better,
of non-national actors—would be paramount in this conception.
If the free banking era from 1836–64 represented an entrenchment of regional interests,
the Civil War experience marked the extension of national interests. Under the two
National Bank Acts of 1863 and 1864, the federal government sought to provide ‘national
banks’—note both the common usage between Hamilton’s conception, and the step away
from ‘central banks’—that could provide the financing needs of the country, in both
private and public sectors alike. These new private banks would have a federal charter
and be subject to federal regulation and supervision, through the clumsily named Office
of the Comptroller of the Currency. But the banks themselves were motivated entirely
by private purposes, with charters extended almost at whim. They had few features of
central banks.17
3. Paul Warburg’s Confusion, Paul Warburg’s Solutions
This was the state of American finance when Paul Warburg, a German financier from
the Warburg family of Hamburg, Germany, moved to New York City to begin a career
in banking. When he arrived in the US, there were roughly 20 000 banks with ‘no organic
cohesion’ among them. ‘Individualism in banking was the gospel of the country.’ The
problem with this kind of patchwork, from Warburg’s view, was that any minor exogenous
shock would send the entire system reeling as indeed had occurred throughout the
nineteenth century. American industry had not stayed so ‘provincial’, in Warburg’s view.
American economic life by the start of the twentieth century was ‘a lively and intimate
daily exchange of goods and funds began to develop, not only between the several sections
of the country, but between ourselves and all the rest of the world.’ In this environment,
‘the national banking system, with the state banking system superimposed upon it, was
bound to show the fatal consequences of its inadequate structure.’18
Warburg’s vision of banking reforms was thus about the structure of institutionalized
money, about who would control the money supply, and to what ends. The battles over
currency had ended: Warburg was profoundly committed to the gold standard. But it
wasn’t simply about an organizational commitment to a central bank, but about the
provision and regulation of bank reserves with an eye toward stemming the risk of panic.
Warburg also wanted a financial system in his adopted country that could compete with
the global financial juggernauts of the Old World.19
17
For more on the era, see Hammond (1970).
18
Warburg (1930, 11–12).
19
Ibid at 445. Warburg’s enthusiasms for central banking in America owed much to his view
that the financial system could not keep pace with the overall economy absent the development
of a secondary market in international banker acceptances. For more on this important point, see
Broz (1997).

II. FOUNDING THE FEDERAL RESERVE
1. The Panic of 1907
In the usual retelling of the Fed’s history and its links to the 1907 panic, the Fed came as
Congress’s answer to the problem of JP Morgan’s mortality. The 1907 panic was a dark
one, but luckily for the US financial system, Morgan—the great Jupiter of American
banking—saved the day, stemmed the panic, and the system lived to fight another day.
Congress recognized that it couldn’t count on Morgan forever, so it got its central banking
act together after nearly a century in the wilderness and passed the Federal Reserve Act
of 1913. The US has had a central bank ever since.
The problem with that story is that while some of the bare facts are true, the arc of the
narrative is not.20 There was a financial panic in 1907, Morgan was involved, and the
Federal Reserve Act was passed in 1913. What the story misses is just how much the gov-
ernment was involved in that crisis response, and how much activity intervened between
the Panic of 1907 and the signing ceremony on 23 December 1913.
The nature of Morgan’s participation, though, is exaggerated. Some historians repeat
the dramatic scene of an ‘indispensable’ Morgan rising to the occasion.21 After days of
panic, Morgan took his collection of bankers into a library adorned with his collections
of art and rare books. Morgan, it was reported by his associates at the time, was ‘the
man of the hour’, whose pronouncements—bland and obvious in retrospect, such as
‘[i]f people will keep their money in the banks everything will be all right’—assumed
talismanic significance. A sleepless night of Morgan’s banking associates, locked by
Morgan in his smoky library, led to the salvation of the US financial system. It may have
been sleepless for his associates, but Morgan himself was able to doze a little. At one
point, as a banking associate of Morgan’s reported, Morgan’s sleep caused everyone to
wait respectfully: ‘We sat quietly, saying nothing. The only sound that could be heard was
the breathing of Mr. Morgan.’22
The idea that Morgan stood alone to save the financial system is balderdash. In fact,
the Secretaries of the Treasury under William McKinley, first, and Theodore Roosevelt,
second, provided significant infrastructure and liquidity to combat precisely these
kinds of panics. The Panic of 1907 was not a new kind of phenomenon; there had been
devastating banking panics for years after the Jacksonian Bank Wars, including in 1837,
1857, essentially throughout the Civil War, 1873, 1884, 1893, 1895 and 1901. Not all were
created equal, but 1907 was hardly a once-in-a-century event.23
In response to these panics, Secretary of Treasury Leslie Shaw had used the
20
I’m not the first to attempt to debunk these links. See Goodhart (1969).
21
Lowenstein (2015, 65).
22
Herbert Satterlee—Morgan’s son-in-law, business associate and attendant to the events of
that fateful fall—was an early chronicler of the Morgan mythos. Satterlee (1939). The memoirs of
others, like Frank Vanderlip (from whom the quote about a sleeping Morgan is drawn) also helped
cement the view. Vanderlip (1935, 174–75). Newspapers widely reported Morgan’s involvement at
the time. For example, The Washington Post, ‘How and Why J. Pierpont Morgan Stopped the Panic
of 1907’, 10 November 1907.
23
For more on the banking panics of the era, see Wicker (2000) and Hammond (1957).

‘independent treasury system’ to deploy funds in precisely a fashion envisioned by

Bagehot—to stave off panics and reassure a jittery business public that the govern-
ment had things well in hand. And during the Panic of 1907, Shaw’s successor, George
Courtelyou, deployed millions of dollars to support the failing trusts and worked hard to
coordinate with Morgan and other New Yorkers.24
Whatever the reason, when the Panic of 1907 came, Courtelyou was skittish about
taking responsibility for his provisions of liquidity and policy. This reticence may
explain why so little contemporaneous newspaper coverage included the Roosevelt
Administration in its praise of containing the panic, focusing instead on the role of
Morgan and his associates.
There are two points, then, to note about the Panic of 1907 and the Federal Reserve.
First, that Morgan’s role in preventing catastrophe has been oversold, including at the
time. And second, as far as we’ve come in discussing the institutional context of the Fed’s
legislative beginning, there is still much more story to tell. The direct link between the
Panic and the Fed has also been grossly oversold.
2. The National Monetary Commission and the Creature from Jekyll Island?
There was a piece of legislation that came in the immediate aftermath of the Panic of
1907, however. The Aldrich-Vreeland Act of 1908 that, among other things, created the
National Monetary Commission (NMC) to study the questions related to the weakness
of the US financial system. Senator Nelson Aldrich, a Republican from Rhode Island
and close confidante of leading industrialists and bankers of the day, himself chaired the
NMC. The commission issued 30 volumes of original research from various scholars that
covered banking and central banking from every major global jurisdiction and several
different epochs of US history. Most of these volumes have not been widely consulted, but
the point may have been to give the Commission’s final proposals the patina of expertise:
as Roger Lowenstein writes, ‘Aldrich sensed that an ambitious project required a proper
foundation, a bibliographic heft, to be treated with the requisite gravitas.’25
Aldrich’s political strategy appeared to be delay. He wanted to stay above the political
fray and let the NMC do its work while emotions following the panic and the presidential
election of 1908 died down. But as attention moved from the currency question, so too did
Aldrich’s popularity. He had been the subject of scathing reporting regarding the nature
of his fortune, all earned through close contacts in industry while he was a sitting member
of the Senate. Aldrich, at the helm of the plan, appeared more and more like a liability
rather than a highly placed asset.
It was in this context that Aldrich, Warburg and others in banking made their fateful trip
to Jekyll Island, an island off the coast of Georgia frequented by the wealthy. Sometimes,
it seems, conspiracy theories are true. The meeting on Jekyll Island was one such meeting,
where participants traveled in disguise and under pseudonyms, taking an oath of silence
until decades later. Warburg described it in his 1930 memoir only as ‘a small group of
men who, at Senator Aldrich’s request, were to take part in a several days’ conference
24
That Treasury would act this way was controversial at the time. See Andrew (1907).
25
Lowenstein (2015, 79).

with him, to discuss the form that the new banking bill should take.’26 No mention of
the secrecy, location, or the rest—that would only come from subsequent memoirs.27 The
secrecy was to prevent the press from getting wind of their plans for a central bank, still
an anathematized concept in American political life, by their calculations. It has become
yet another instance of one institutional moment defining the perceived character of the
institution long after the fact.
The proposal that emerged from the Jekyll Island meeting became known as the
Aldrich Plan. The centerpiece was the ‘National Reserve Association’ (NRA), a national
association with local branches that allowed individual banks to pool reserves under
common control of a purely private governance structure. It wasn’t a central bank in
the sense of total control by a single central bank governor, nor was it just the National
Banking System redux, nor private clearing houses. It would have government support,
and the US President would appoint the NRA governor, but only from a list of 40
directors. It was, as Warburg put it, ‘strictly a banker’s bank.’28
Unfortunately, no amount of secrecy or international travel or banker enthusiasm
could dictate the political process and the swirl of events that had overtaken the nation
since the 1907 panic. By measuring his time in years rather than months, Aldrich had lost
momentum: the Democrats were on the rise, and wanted nothing to do with Aldrich or
his plan.
3. The Election of 1912
Time continued its march, with two developments adverse to Aldrich’s ambitions for his
National Reserve Association. First, what came to be called the Money Trust hearings on
whether banks—and JP Morgan & Co in particular—had a chokehold on the provision
of national credit that these bankers abused. And second, the election of 1912. Few
presidential elections in US history match it for its drama (however close the Trump versus
Clinton contest of 2016 comes). Gone was the staid front porch campaigns between two
senior partisans. Instead, the election pitted two US presidents, Theodore Roosevelt and
William Howard Taft, against Woodrow Wilson, a college president who had entered
politics just two years before. On the edge, but not the fringe, was the most popular
socialist in American history, Eugene Debs, who captured five percent of the vote. In John
Milton Cooper’s words, the 1912 election ‘verged on political philosophy.’29
That political philosophical moment in American history intervened between the 1907
panic and the Federal Reserve Act in ways that were essential in shaping the System’s curi-
ous governance structure. Conspiracy theorists get close to their target in noting the exist-
ence and significance of the Jekyll Island meeting, but they don’t quite hit it. The reality
is that the ‘creature’ established in that fateful meeting and sponsored by the Republicans
in 1910 had much in common with respect to the functions of institutionalized money,
but very little with respect to the structure of institutionalized money. That is, what the
26
Warburg (1930, 58).
27
Vanderlip (1935).
28
Warburg (1930, 59–60).
29
Cooper (1983, 141). For a modern example of attention to the 1912 election, see Goodwin
(2014).

bankers and politicians agreed about the ways that money should be regulated largely
survived unscathed in the eventual passage of the Federal Reserve Act. Who would
govern that process, on the other hand, did not.30 The final bill was indeed Wilsonian in
its conception, thoroughly Democratic in its partisan support.
4. The Legislative Debate: The Functions of Institutionalized Money
The path of the Federal Reserve Act was a tortured one, as Roger Lowenstein ably
documents in his account of it. What is remarkable is the nature of the legislative fight
over ontology: the very stuff of money became part of the contest. Intriguingly, it was
only a smaller part of that contest, largely because the previous generations’ debates along
these lines had already satisfied so much. When Bryan lost the 1896 (and 1900 and 1908)
elections, the quest for bimetallism was over. Gold had won, at long last.
When the Federal Reserve Act was passed, then, the idea of a silver currency—to
say nothing of a ‘fiat currency’—was anathema to the system’s legislative sponsors.
Supporting this currency, all agreed, must be both the gold standard and what came to
be known as the ‘real bills doctrine’, or the idea that the new Federal Reserve Banks
could only support loans based on trade that had already been transacted. Indeed,
the very accusation that the new Federal Reserve Notes would be anything less than
bona fide was a fighting one. Nothing seemed to provoke Carter Glass, one of the
congressional sponsors of the bill, more than this claim. ‘Fiat money!’ he bellowed from
the House floor. ‘Why, sir, never since the world began was there such a perversion of
terms.’ The notes that issued from Glass’s beloved Federal Reserve Banks would be
made of sterner stuff.31
5. Wilsonian Compromise
That the new Democratic Administration had seemed to embrace the Republican plan
so completely created some dissonance for some Democrats. Their party platform had,
after all, rejected the Aldrich bill, and now it seemed the Democratic Congress was poised
to enact it. Largely through obfuscation and rebranding, Wilson (and Carter Glass)
convinced the new Democratic majority that the new bill was in fact wholly Democratic.
This would lead to a battle of memoirs in the 1920s about who could lay claim to this
innovation.32
What proved much more difficult—and was indeed an innovation—wasn’t the
functional nature of the new legislation, but its structural basis. That is, the question
of who should control the new system was of paramount importance and a question
of intense, partisan, and ultimately uncertain character. The question became oriented
toward two poles: whether the structure would be private or public, and whether it would
be centralized or decentralized. Paul Warburg, focused as he was on the provision of
liquidity throughout the system in case of panics, feared public influence over what he,
30
Berg (2013, 298–315).
31
Congressional Record 51, no 17 (December 22): 563.
32
See especially Glass (1927) and Warburg (1930) for the lines of this debate.

a private banker in the old-school European banking tradition, viewed as an inherently

private function.33
Wilson’s proposal, demanded by few: a Washington-based, government-controlled
supervisory board that he preferred on top of the essentially private, decentralized central
banks flung by Carter Glass throughout the country. Glass retells the key story of how
Wilson came to embrace this ‘capstone’ event in the legislative discussions. When bankers
and Glass both protested the idea that a public board should govern the private reserve
banks, Wilson imperiously asked, ‘Will one of you gentlemen tell me in what civilized
country of the earth there are important government boards of control on which private
interests are represented?’ Hearing no objection, he followed up: ‘Which of you gentlemen
thinks the railroads should select members of the Interstate Commerce Commission?’
While the bankers continued to protest, Carter Glass was ‘converted to Wilson’s position
before they had even exited the office.’34 For all his love for Walter Bagehot, Wilson had
clearly not looked very carefully at this question: had he done so, he would have known
more about the structure of central banks in other jurisdictions, including the Bagehotian
view of central bank governance. Why the bankers didn’t correct him is not recorded in
Glass’s memoir.
And so the Wilsonian Compromise of 1913 was born. The product of his experiment
in institutional design was the leanly staffed Federal Reserve Board, based in Washington.
The Board would include Secretary of the Treasury as the ex officio Chair of the
System, with the Comptroller of the Currency—until then, the exclusive federal banking
regulator—also serving on the Board. In addition to these two political appointees, the
Board consisted of five presidential appointees, serving ten-year terms each. The rest
of the system consisted of ‘eight to twelve’ Reserve Banks—the initial legislation didn’t
set the definitive number. These Reserve Banks would each have a ‘Governor’ and a
nine-person board of directors. They would be the private features of the System.35
According to Wilson’s intent, then, the Federal Reserve System would not be dominated
by either Board or Bank. The emphasis, at least to some of these early legislative framers,
was on the Federal in the Federal Reserve System. That meant that the balance of power
was between local and national figures, much as the US Constitution had done with states
and national governments. That balance was at the core of Glass’s conception of the new
System. ‘In the United States, with its immense area, numerous natural divisions, still more
numerous competing divisions, and abundant outlets to foreign countries’, he said, ‘there
is no argument, either of banking theory or of expediency, which dictates the creation
of a single central banking institution, no matter how skillfully managed, how carefully
controlled, or how patriotically conducted.’36 To that end, the Federal Reserve System
was ‘modeled upon our Federal political system. It establishes a group of independent
33
Perry Mehrling usefully highlights these polar tensions in his book on the Fed’s history,
Mehrling (2010).
34
Glass (1927, 112–16).
35
For the statutory details, see House Report on Glass Bill (reprinted in Glass 1927). Note that
in the Glass Bill that passed the House of Representatives, the Secretary of Agriculture would also
be an ex oficio member, with each member of the Board serving six years. The House version would
have set the floor at twelve, and put no limit on the final number. Glass (1927).
36
Glass House Report, HR 7837, reported H Rpt 63–69 at 12 (1913).

but affiliated and sympathetic sovereignties, working on their own responsibility in local
affairs, but united in National affairs by a superior body which is conducted from the
National point of view.’ To drive the point home: ‘The regional banks are the states and
the Federal Reserve Board is the Congress.’37
III. THE SECOND FOUNDING OF THE FEDERAL RESERVE
Wilson’s design, however, proved more brilliant in political design than institutional
clarity. As Allan Meltzer noted, tensions ‘between the Board and the reserve banks
began before the System opened for business.’ Because the statute left room for divergent
interpretation for competing factions, the legislative authors of the Federal Reserve Act
never defined a number of key terms and largely did not specify the power relationship
between and among the Federal Reserve Board and the Reserve Banks. In the two places
where the Fed exercised the most power—the proactive purchase of securities in the open
market and the reactive discounting of securities brought to the doors of the Reserve
Banks—rivalries arose immediately, both between the Board and the Banks and among
the Banks themselves. Indeed, in one of the most interesting footnotes in Fed history, two
Reserve Banks opened competing branches in Havana, Cuba, as a way to extend their
international reach.38
Despite the federalist design of the system, the center formed in short order in New
York City in the person of Benjamin Strong, the Governor of the Federal Reserve of
New York. According to his biographer, Strong was ‘one of the world’s most influential
leaders in the fields of money and finance’, an assessment that subsequent research
hasn’t contradicted. From the founding of the Federal Reserve System until his death
in 1928, ‘his was the greatest influence on American monetary and banking policies; he
had no close competitor.’39 Unfortunately, Strong died in 1928; had he lived, in the view
of many historians, the Fed’s actions during the Great Depression might have come out
very differently.40
Space constraints prevent me from discussing the Fed’s many failures during the Great
Depression, and fortunately there is a robust literature on this that readers can consult.41
For this chapter’s argument about how central banking changed in the United States, it
is important only to note that after Strong died and even before, the decision-making
apparatus in this curiously governed institution was in disarray. Strong succeeded in guid-
ing the Fed’s policies during his life by dint of personality, not law: nothing in the statute
37
Glass (1927).
38
Meltzer (2003, 75). For discussions of how, for example, the US Constitution created similar
power vacuums, see Rakove (1997). For more on the indeterminacy of the Federal Reserve Act, see
Clifford (1965, 103–09). On competing Cuban branches, see Warburg (1930).
39
For more on this tumultuous period and Strong’s role in it, see Ahamed (2009), Eichengreen
(1992), and Meltzer (2003, 110–21). For the quote, see Chandler (1977, 3).
40
Eichengreen (2015).
41
The literature on what caused the Great Depression is massive. See Bernanke (2000).
For continued modern relevance in public and scholarly debates, compare Shlaes (2008) with
Eichengreen (2015). An excellent new addition to this debate is Sumner (2015).

gave New York pride of place. Outsiders to the System—including, ironically, Herbert
Hoover himself—knew it wielded power, but didn’t know exactly how it did or by whom.42
1. The Federal Reserve and the New Deal
Such was the state of things when Franklin Roosevelt’s team of economic experiment-
ers arrived on the economic scene. During the 1932 campaign, he argued that ‘[t]he
country needs and, unless I mistake its temper, the country demands, bold persistent
experimentation. It is common sense to take a method and try it: if it fails, admit it frankly
and try another. But above all, try something.’ Roosevelt lacked a consistent theory of
regulatory response; the pride of place following his 1932 election was for fast reaction,
not necessarily legal or institutional coherence.
Despite the Fed’s centrality to the banking system, institutional reform of the Fed was
not high on the initial list of priorities. Just as the Federal Reserve Act cannot truly be
considered crisis legislation, given the separation between the 1907 Panic and the 1913
statute, the Fed wasn’t radically reshaped in response to the Great Depression, whether
in the international legislative changes under Hoover or in the first burst of reform
under Roosevelt. There came adjustments in the first round of economic legislation, to
be sure. In the Glass-Steagall Act of 1933, Congress created the Federal Open Market
Committee (FOMC) as the central body that would make proactive decisions about
the purchase of market securities, including government securities. But that structure
reinforced the Wilsonian vision: the FOMC as initially created included only the
Governors of the Federal Reserve Banks; no one from the public Federal Reserve Board
participated.
Nibbling around the edges of the Wilsonian federalist central bank might have
remained the order of the day had it not been for Marriner S Eccles, perhaps the most
intriguing figure in Federal Reserve history. Eccles’s father was a Scottish immigrant, a
Mormon convert, a bigamist (Marriner’s mother was his father’s second wife), and, in
time, one of the wealthiest men in the state of Utah. Eccles thrived in his father’s business
and expanded it into mining, timber and especially banking. He was a millionaire by the
age of 22.43
Eccles rose to national prominence because of his astonishing success as a banker
during the height of the banking crises of the Great Depression largely due to his savvy
in managing his own banks in the face of unprecedented national failure. He was also
more radical an economic visionary than most of his fellow bankers, becoming Keynesian
arguably before Keynes in his advocacy for government activism in borrowing and
spending as the only viable cure for the ails of the Depression.
This advocacy put Eccles on the radar of Roosevelt’s Brains Trust and he was eventually
considered for the position of ‘Governor’ of the Federal Reserve Board, not then a
particularly prestigious position. (To give a sense of how the Board Governor position
was then perceived, the post became vacant when Eugene Black resigned—to take the
42
Hoover (1952).
43
Eccles’s biographical details can be found in his memoir, Eccles (1951) and biography,
Hyman (1976).

position of Governor of the Federal Reserve Bank of Atlanta.44) Eccles refused the
offer. In response to inquiries of his availability, he responded that he ‘would not touch
the position of governor [of the Federal Reserve Board] with a ten-foot pole unless
fundamental changes were made in the Federal Reserve System.’
Roosevelt invited him to propose his view of what those changes should be. Eccles
narrowed his sights on the Reserve Banks: ‘Although the Board is nominally the supreme
monetary authority in this country’, he wrote in a memo to Roosevelt, ‘it is generally
conceded that in the past it has not played an effective role, and that the system has been
generally dominated by the Governors of the Federal Reserve Banks.’ As an ‘unfortunate
result’, he continued, ‘banker interest, as represented by the individual Reserve Bank
Governors, has prevailed over the public interest, as represented by the Board.’ Eccles’s
position was notable: Eccles was himself a banker whose views were represented by the
Federal Reserve Bank of San Francisco, and yet he sought the Banks’ exclusion from
national policy. The problem was not only one of inappropriate banker influence on the
System; it was also one of governance. ‘With such an organization’ as the Federal Reserve
System, wrote Eccles’s assistant and partner in Fed reform, Lauchlin Currie, ‘it is almost
impossible to place definite responsibility anywhere. The layman is completely bewildered
by all the officers, banks and boards. Even the outside experts know only the legal forms.’
Eccles proposed a radical legislative overhaul to resolve both the problems of governance
and banker influence.45
2. The Second Founding of the Federal Reserve: The Banking Act of 1935
Roosevelt was sold on the proposal. He committed the Presidency to the passage of
Eccles’s bill, and Eccles accepted the Governorship so that he could more effectively
lead the legislation through Congress from inside the Fed. The New York Evening Post
summarized the point perfectly: ‘Marriner S. Eccles is a unique figure in American
Finance—a banker whose views on monetary policy are even more liberal than those
already embraced by the New Deal.’46
Eccles’s timing was impeccable: the New Deal experimenters were embarking on a
legislative frenzy that has come to be called the Second New Deal. In a single legislative
session, Congress passed five major pieces of legislation, including the Social Security
Act, the Wagner Act (which reshaped American labor law), the Public Utilities Act,
the Banking Act and the Revenue Act—a controversial tax bill known by critics and
defenders alike as the ‘Soak the Rich’ bill. Eccles’s Banking Act of 1935 was the ‘least
controversial’ of the five, according to historian David Kennedy.47 Least controversial,
perhaps, but in some sense also one of the most consequential. The Act created a system
that represented a dramatic departure from every other experiment in central bank
design in US and indeed world history. It abolished the Federal Reserve Board created in
1913 and replaced it with the Board of Governors of the Federal Reserve System. (The
44
Eccles (1951, 84).
45
Hyman (1976, 155).
46
Hyman (1976, 161).
47
For more on the Second New Deal, see Kennedy (2001).

term ‘Federal Reserve Board’ remains in wide if anachronistic use to refer to the Board
of Governors.) It also demoted the heads of the Federal Reserve Banks, who would no
longer carry the name ‘governor’. That title would be reserved for the members of the
Board of Governors. At the Reserve Banks, the head would be the ‘president’. This was
an intentional demotion: unlike in politics, in banking lingo, a ‘Governor’ was an august
title reserved to the central bank; a mere ‘president’ could be any joe from the corner
savings and loan.
There was one hitch to Eccles’s sweeping reform: Carter Glass, that jealous guardian of
the Federal Reserve System, its original sponsor in the House, Fed Chair under Woodrow
Wilson, and now Fed caretaker as the senior Senator from Virginia. Eccles’s proposals
irked Glass greatly, who retaliated by holding up Eccles’s confirmation hearings as the
old Federal Reserve Board’s Governor. Glass was also, in his core, deeply conservative
and hated almost everything about the New Deal, despite lending his name to one its
signature achievements, the Glass-Steagall bill. In fact, ‘[h]is record of opposition to the
New Deal, based on a study of thirty-one bills on which he voted, 1933–1939, was 81
percent opposed—easily the highest of all Democratic senators of the period.’48
Since the Reserve Banks were essential to Glass’s view of what the Federal Reserve
System must be, their continued participation as power centers within the System became
a point of compromise in getting Glass to endorse Eccles’s bill. As a result of that
compromise, the Reserve Banks’ role in formulating policy wasn’t eliminated entirely.
They therefore became a presence on the newly reformed FOMC, which consisted of the
seven-member strong Board of Governors, plus five Reserve Bank presidents on a rotating
basis.49 As a result, while Glass’s sponsorship allowed the Reserve Banks to continue to
give the System hints of federalism, Eccles had undone the Wilsonian Compromise of
the first Federal Reserve.
As historian David Kennedy has written, after the 1935 Act, ‘the Fed now had more
of the trappings of a true central bank than any American institutions had wielded since
the demise of the Bank of the United States in Andrew Jackson’s day.’ It was more than
that: the new Federal Reserve System had the trappings not only of a ‘true central bank’,
but was the beginning of what economic historian Charles Goodhart has called central
banking’s ‘evolution’ from private banks running a private banking policy with public
benefits to a public central bank in the modern sense of the word. The Fed didn’t join
the fold of central banks at last in 1935; Eccles and FDR had created a new institution
altogether.
IV. THE FED-TREASURY ACCORD OF 1951
And then came war. Eccles’s views on fiscal-monetary coordination during economic
depression were born of the fear of deflation: that is, he believed government was the
only force capable of stopping the economic freefall. His views on fiscal-monetary
48
Patterson (1967, 20).
49
The permanent presence of the president of the Federal Reserve Bank of New York didn’t
get added until 1942.

coordination during war came to the same conclusion, via a different path: war on the
nation’s mortal enemies was no time for anything but full-throated support of all within
the democracy.
Soon after the Japanese attack on Pearl Harbor, the Eccles Fed declared that it was
‘prepared to use its powers to assure that an ample supply of funds is available at all times
for financing the war effort and to exert its influence toward maintaining conditions in the
United States Government security market that are satisfactory from the standpoint of
the Government’s requirements.’ In practice, this meant that interest rates for government
debt were ‘pegged’: 90-day bills at less than 0.5 percent, one-year bonds at less than one
percent, and long-term debt at 2.5 percent. Despite the Fed’s refounding in 1935 as an
agency unto itself, the War brought it squarely under presidential control.50
The war’s end also coincided with the end of the long Roosevelt Administration. The
relationship between the Fed Chair and the new President Harry Truman was never the
same. Whether because of differences in personality, policy perspectives or no shared
history, Eccles did not remember his time as Truman’s Fed Chair with warm regard. They
were ‘years of frustration and failure, as I tried, in my limited capacity, to influence public
thought and governmental policy.’51
Part of the problem was not only that times had changed, but that Eccles had changed,
too. From his early days as a proto-Keynesian in 1933, Eccles became what we would call
today an inflation hawk. He saw risks of runaway inflation in continuing the ‘peg’ he had
established in 1942. Here, with others inside the Federal Reserve System (especially New
York Fed president Allan Sproul), Eccles began an effort to subvert the subordination of
monetary policy that Eccles’s own policies had created.
Truman was not impressed and had no patience for this kind of posturing. In 1948, in
a unique instance in Fed history, Truman refused to reappoint Eccles to the Chair he had
held since 1935. Instead, Truman offered him the Vice Chair, presuming that such a public
and obvious demotion would cause the proud millionaire to return to his business inter-
ests in Utah. Instead, Eccles expressed his interest in the offer; outfoxed, Truman ignored
Eccles’s acceptance, and appointed industrialist Thomas McCabe as the new Chair. The
President pointedly never filled the Vice Chair, which stayed vacant until 1955.52
Eccles embraced his new role on the Fed’s Board of Governors as the Administration’s
gadfly. He made full speeches on something of a crusade to warn the country of
the dangers of the inflationary pressures that were building. The peg had caused
rampant inflation. The risks were dire. The depression and war-time justifications no
longer applied. Eccles advocated a policy that would end the Fed’s domination by the
Administration.
Eccles’s insubordination quickly reached the headlines. As the hostilities of what
would come to be called the Korean War began, concerns about the conflict’s inflation-
ary consequences became a source of ‘“open speculation” as to whether the Federal
50
Chandler (1977, 408) provides an excellent overview of the Fed’s war-time policies. See also
Meltzer (2003, Chapter 7). For the 1942 announcement, see Federal Reserve System Annual Report
(1941, 1).
51
Eccles (1951, 397).
52
For more on the Vice Chair battle, see Eccles (1951, 437–42); Meltzer (2003, 655–56),
Clifford (1965, 208–11), and Kettl (1986, 63–64).

Reserve would continue to support the long-term government bonds’ at the 1942 peg.53
Truman fought back and called the new Chair, Thomas McCabe, at his home and gave his
subordinate the President’s instructions. As McCabe presented to the Board at their next
meeting, ‘the Federal Reserve Board [sic] should make it perfectly plain . . . to the New
York Bankers that the peg is stabilized.’ The alternative, the President warned, would be
for the Board to ‘allow the bottom to drop from under our securities.’ Truman concluded
with an ominous warning: ‘If that happens that is exactly what Mr. Stalin wants.’54
A war of public speeches followed. Treasury Secretary John Snyder spoke implying that
the Fed had committed to the peg; New York Fed president Sproul countered days later;
Eccles drew attention to the Fed’s subtle but clear signal that the peg was not a guarantee.
Truman had had enough, and summoned—for the first and last time—the Federal Open
Market Committee to the Oval Office for a presidential lecture. Immediately thereafter,
he issued a press release that presented the (false) view that the ‘Federal Reserve Board
[sic] has pledged its support to President Truman’, and ‘the market for government
securities will be stabilized at present levels and . . . these levels will be maintained during
the present emergency.’55 Eccles hit back hard, leaking the internal memorandum the
Board had prepared, on behalf of the FOMC, to summarize what had occurred at the
Oval Office meeting to two major newspapers, directly and publicly disputing the Truman
Administration’s account of the meeting. What became known as the ‘Treasury-Federal
Reserve dispute’ was now litigated in the public eye. As Eccles put it in his memoir, ‘the
fat was in the fire.’56
Cooler heads on the staffs of both the Treasury and the Fed intervened to come to grips
with this internal dispute. They decided to resolve the issue once and for all by hammering
out a durable compromise that would honor the Fed’s desire to respond to inflationary
pressures as they arose and the White House’s fear that uncertainty in interest rates would
make it impossible to fight Communism in Asia. From the Fed staff, Winfield Riefler led
the way; from the Treasury, the Assistant Secretary of the Treasury William McChesney
Martin. After agreeing to the terms, both sides announced that they had accepted the
compromise, which came to be known as the Fed-Treasury Accord. The problem? There
was nothing more to the compromise than the awkwardly worded announcement itself.
Here it is, in full:
The Treasury and the Federal Reserve System have reached full accord with respect to debt
management and monetary policies to be pursued in furthering their common purpose to assure
the successful financing of the Government’s requirements and, at the same time, to minimize
monetization of the public debt.
Even a reasonably well informed citizen or lawyer of the day could not have recognized the
extraordinary import of this dense sentence. And in fact, there was more to the deal than
this inscrutable announcement. Shortly after the release, Chair McCabe resigned from the
Board; Marriner Eccles followed in July. They were replaced with two Treasury insiders:
53
Kirshner (2007, 144).
54
Federal Reserve Board, Minutes, 31 January 1951, 9–12.
55
See Kirshner (2007, 144).
56
Eccles (1951, 496).

William McChesney Martin as Chair, and James Robertson, former First Deputy of the
Comptroller of the Currency. Senator Douglas also saw the almost immediate resignation
of the two senior members of the Board of Governors, and their replacement by two
Treasury insiders, as something of an unofficial deal that the ‘truce’ declared in the Accord
just meant Treasury domination, as usual. Truman certainly hoped so: to enforce the
uncertain terms, Truman was sending what he hoped would be his Trojan Horse.57
It didn’t turn out that way. To the chagrin of his patrons in the Truman Administration,
this former Truman insider quickly established that the Fed-Treasury Accord did not
mean what Truman thought it meant. As a result of Martin’s appointment, the Accord
has come to be seen as ‘the start of the modern Federal Reserve System’,58 and a ‘major
achievement for the country.’59 It has become Fed’s third founding, after the Federal
Reserve Act of 1913 and the Banking Act of 1935. Unclear though it may be, written with
an intent to conceal though it may have been, this sentence forms the basis in perception
and in fact of the idea that the Fed’s monetary policy is institutionally separate from the
economic policies of the President and the Secretary of the Treasury. And it comes from
a sentence almost completely devoid of content.
The Accord reached its stature in large part because of the determined leadership of
Martin, among others, including Truman’s successor in office, Dwight Eisenhower. It
was not a legal change, but a change in personnel. Nevertheless, this personnel change
did much to alter the structure of central banking functions. Personnel changes at the
Federal Reserve often do.
V. THE INCESSANT POLITICAL DANCE BETWEEN

PRESIDENTS AND FED CHAIRS
After the Accord, Martin began a process of consolidating power and creating the modern
figure of the Fed Chair that still persists today. The Martin model is one where the Fed
Chair is the public face of the Federal Reserve, which is in turn the face of monetary policy
to the world. And while Martin had his good years and bad years alike—if Eisenhower
deferred to him on monetary policy, Lyndon Johnson did not—the subsequent history
of the Fed showed a multitude of models of how to run the Federal Reserve System. The
key relationship for determining the course of the Federal Reserve’s future has always
been that of the Fed Chair and the US President. History suggests that there is nothing
permanent about this relationship; it will depend on the character and personalities of the
women and men who occupy those big chairs.
1. Control by Domination: Richard Nixon and Arthur Burns
After Martin came Republican Arthur Burns, economic adviser to Eisenhower, but
confidante to Richard Nixon. Burns was an eminent economist at the time; he was, for
57
Kettl (1986, 74). Clifford (1965, 267–68).
58
Hetzel and Leach (2001, 53).
59
Meltzer (2003, 712).

example, an early mentor to Milton Friedman and a long-time member of the economics
faculty at Columbia University. But Nixon knew him better through his Republican
loyalties, and made no secret about his affection for Burns’s partisan commitments rather
than his intellectual ones. For example, in Nixon’s famous book, Six Crises, published in
1962 as a sort of political manifesto outlining Nixon’s approach to politics and leadership,
the former Vice President and future President recalled that Burns reached out to him in
the spring of 1960 with warnings that economic deterioration could interfere with Nixon’s
electoral prospects. To remedy this, Burns urged the Eisenhower Administration, through
Nixon, to do ‘everything possible . . . to avert this development.’ As Nixon recalled, Burns
‘urgently recommended that two steps be taken immediately: by loosening up on credit
and, where justifiable, by increasing spending for national security.’ Ten years later, at
Nixon’s first opportunity, he knew who he would get for the Federal Reserve.60
Burns’s tenure is widely regarded as a failure, in large part due to Great Inflation
already under way when he began his tenure, but overwhelming the nation by the end
of it. Burns also represents a specific model of the Fed Chair/President relationship:
presidential domination. Burns’s diaries are filled with references to a close personal and
emotional proximity between Burns and Nixon that raise modern eyebrows about the
policy proprieties of that relationship. A few examples illustrate the point. Nixon told
Burns about his appointment of prominent Democrat John Connolly as Secretary of
Treasury before announcing it publicly, and then told Burns that Connolly—a politician,
not an economist or businessman—would learn the ropes of his new position from Burns.
Burns attended cabinet meetings; had his speeches vetted by Nixon’s staff; cleared his
talking points with the President ahead of a meeting with other central bankers in Basel,
Switzerland; advised Nixon on tax, wage and other fiscal policy; and made pledges to
remain the President’s ‘true friend’ on economic policies before the public.61
But we could make a similar list of Eccles’s proximity to Roosevelt. What made the
Nixon-Burns relationship so unusual was Nixon’s paranoid leadership style and the
pressure that it brought to bear on Burns. One of the most confusing and intriguing parts
of the Burns chapter in Fed history is that even while he was being bullied by the Nixon
Administration, he intoned regularly on the importance of the ‘independence’ of the
monetary authority. This declaration of independence was a thorn in the side of Wright
Patman, a member of the House of Representatives from Texas and constant scourge of
the Federal Reserve. Burns’s insistence that the Fed was and should be independent, even
after he had coordinated monetary policy for Nixon’s electoral ends, gave Patman even
more fodder for his multi-decade assault on the Fed. Burns’s duplicitous assertions of Fed
independence was an ‘arrogance we must not tolerate. No one man or institution should
have this unbridled power. The people did not elect Dr Burns, and he is not our king.’62
Patman shouldn’t have worried. Burns’s attachment to Nixon, in spite of abuse and
cognitive dissonance, was supreme. In one long journal passage, Burns records a conversa-
tion he had with Nixon late in the President’s first term, as he prepared for reelection—a
time when we would hope the Fed would have the most independence from the President.
60
Nixon (1962, 309–10).
61
Ferrell (2010, 32–49).
62
See Conti-Brown (2016).

Burns was there to reassure him, however, that their friendship ‘was one of the three that
has counted most in my life and that I wanted to keep it if I possibly could’ and ‘that
there was never the slightest conflict between doing what was right for the economy and
my doing what served the political interests of RN.’ Even if there were a conflict, Burns
‘would not lose a minute in informing RN and seeking a solution together.’63
In terms of presidential control of the Fed, the Nixon era was a success for the
President, a failure for the Fed and Arthur Burns. But it does illustrate an important point
of the reality of political influence on the Federal Reserve: a politician can control the
Fed by sheer force of personality. It’s the anti-example that Fed Chairs should consider
in their relationships with the executive.64
2. Volcker: The Giant that Slew Inflation
Richard Nixon’s downfall came about four years before Burns would not be reap-
pointed on a cross-partisan basis, something Burns deeply regretted. The newly-elected
Democratic President, Jimmy Carter, didn’t make an impressive first appointment in
G William Miller, but he made up for this deficiency in his second. Few people tower—
figuratively and literally, as Volcker stands at 6’7”—over late twentieth-century financial
history like Paul Volcker. Volcker’s contributions to central banking practice are many,
but the most important is the view that the Fed was the ‘only game in town’ when it came
to combatting inflation.65
This development is itself a strange one. At the time, the fiscal fight against inflation
was entering at least its tenth year, but the political momentum behind it was much
older. Truman was obsessed by the fight against inflation, which he imbued with moral
overtones. Eisenhower agreed, including the fight in his first State of the Union address.
Richard Nixon had campaigned in 1968 on a promise of price stability and, in an effort
to control inflation by executive fiat, had instituted a 60-day price freeze in 1973. Soon
after taking office, Gerald Ford had promised to make inflation America’s ‘public enemy
number one’ and started distributing ‘Whip Inflation Now!’ buttons to members in the
public to encourage them to do everything they could (whatever that was) to control it.
Carter continued the tradition by invoking its specter as part of the reason the American
people felt so dissatisfied with their government, economy, even society. But none of
this seemed to take root, and inflation remained a highly public and highly publicized
scourge.66
Volcker’s successful effort to stop inflation stemmed from a safe theoretical but radi-
cally practical approach to monetary policy: rather than aiming its monetary policy at
interest rate targets, as the Fed had done historically, Volcker began—cautiously, almost
reluctantly—to target the amount of money in the system and let the interest rates sort
63
Woolley (1986, 110–13). Some Senate Democrats even thought Burns might have been
involved in assisting the Watergate burglars, although this was never direct evidence of these
rumors. See Meltzer (2010, 837–38).
64
As cited in Kane (1974, 750).
65
Silber (2012, 202–16).
66
Meltzer (2010). For more on how inflation altered the American political landscape, see
Samuelson (2010).

themselves out. Explaining the difference in approaches can get technical quickly, but
the gist of these approaches is that an interest-rate approach doesn’t look too much at
how much money is flowing through the system: it wants to keep interest rates relatively
stable, and then move them one direction or another. In the interest-rate climate at the
time, however, the benchmark interest rate was already almost 11 percent. Tweaking
interest rates in the traditional way meant playing a constant game of catch-up with
the financial markets and the individuals, households, labor unions and companies
making decisions in the anticipation of what the dollar would be worth. Some of
them did this using intuition, some using econometrics, and some with pure panic. In
an environment where the inflation rate was galloping away, the Fed’s central bankers
were doing nothing to combat inflation and doing a great deal to help it. The result
was an inflationary period throughout the world that economists have called The Great
Inflation.67
The alternative favored by some influential economists was to engage in monetary
targeting. With monetary targeting, the central bank lets interest rates float according
to the quantity of money in the system, crudely measured. A central bank facing
inflation could dramatically restrict the amount of money circulating in the economy,
thereby allowing interest rates—the ‘price’ that banks and soon everyone must pay
to get money—to float where they would as a market-based reaction to the central
bank’s decisions. This scarcity of money would have dire consequences to the health
of the economy. Millions would lose work as consumers stopped financing purchases,
businesses close, and the economy enters recession. But inflation would stop. This is
what economist Milton Friedman meant by his famous dictum, ‘inflation is always and
everywhere a monetary phenomenon.’ A central bank caught in an inflationary spiral
has an easy exit, according to Friedman and his fellow monetarists: starve the economy
of money, and inflation will cease.68
Volcker himself took some convincing to make this regime change. He was opposed to
monetary targets while on the FOMC as president of the New York Fed, and expressed
misgivings later. But under his leadership, monetarism became the official policy of the
FOMC. Interest rates climbed above 22 percent in 1981, and only came permanently
below ten percent in 1984, causing a recession but ultimately slaying the inflation dragon.
Doing so left a lasting legacy.
The Volcker FOMC’s strategy—and it was the strategy of the entire FOMC, under
Volcker’s leadership—was dramatic, untested, damaging to the economy, and ultimately
successful. Over the course of several years, millions of jobs lost, and skyrocketing interest
rates, inflation came down to a manageable level, something the previous three Fed Chairs
could not accomplish. And with that success, costly though it was, came the conclusion
that reinforced the vision of the Fed as a chaperone: despite constantly channeling
anti-inflation rhetoric, the political branches were not up to the task of managing the
value of the nation’s currency. It not only took a central banker to perform the task;
67
For more on the interest rate climate of the time, the Fed’s mistakes, and the consequences of
the Great Inflation, see Bordo and Orphanides (2013), especially Orphanides and Williams (2013).
For some skepticism of the centrality of Volcker to this narrative, see Blinder and Rudd (2013).
68
For more on monetarism and the Great Inflation, see Meltzer (2010). The Fed formally
abandoned monetary targets in 1993. See Blinder and Reis (2005).

other central bankers of course knew about monetarism and its potential for combatting
inflation. It took Paul Volcker and his associates on the FOMC.
3. Greenspan the Oracle
If Paul Volcker was the embodiment of a central bank as inflation’s master, Alan
Greenspan came to be the icon of the central bank as the all-powerful deity of the
economy.
Greenspan came to the Fed as Volcker’s preferred successor. Very soon, Greenspan
began putting his mark on the Fed by governing monetary policy under ‘the
Greenspan standard’, a style of central banking that meant, two economists quipped,
‘whatever Alan Greenspan thinks it should be.’69 This extraordinary authority came
because it seemed to work, and because it worked, Greenspan’s received adulatory
attention from the public. Though it can be difficult to see it through the din of the
financial crisis of 2008, the image of the Federal Reserve during the Greenspan era
was unlike anything in Fed history. Few if any figures in US history enjoyed the
heights of fame and prestige that Greenspan enjoyed during his tenure.
How did Greenspan achieve this extraordinary reputation? The short answer is,
again, his record of low inflation and steady economic growth, where recessions were
mild and infrequent. But the more comprehensive answer, and the key to the rise in the
power of the Federal Reserve generally, is on two factors: maximal flexibility and discre-
tion for the Fed policy and the reassurance to the financial markets that the Fed will
provide whatever liquidity necessary to maintain stable market conditions, sometimes
called the ‘Greenspan Put’.
The idea that the Fed would retain maximal flexibility was not Greenspan’s;
almost all central bankers have sought to preserve their discretion to greater or lesser
extents. But it came at a time when economists began a systematic challenge to the
desirability of discretionary central banking policy as a good way to organize economic
policy. In a 1977 article that eventually won its authors a Nobel Prize in economics,
economists argued that economic policy-makers (including, principally, central bank-
ers) who have complete discretion to determine future policy are going to do it badly.70
What is fascinating about the Greenspan Era is how much these theories did not
predict. As two economists assessing the Greenspan Fed near the end of Greenspan’s
tenure put it, ‘the Fed brought inflation down dramatically under Paul Volcker and has
controlled both inflation and real fluctuations well under Greenspan. In the process, it
has built up an enormous reservoir of trust and credibility. And it has accomplished all
this without rules or even any serious pre-commitments.’71 Even in his very own words,
Greenspan sought to retain full tactical control of the levers of central bank authority.
As he famously said shortly after his appointment as Fed Chair, ‘Since I’ve become a
central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to
69
Blinder and Reis (2005, 5).
70
The foundational rules-based ideas in economics come from Friedman and Schwartz (1963),
Kydland and Prescott (1977), and Taylor (1993). But this is a growing literature. For a more recent
review, see Bilbiie and Straub (2013).
71
Blinder and Reis (2005, 7).

you, you must have misunderstood what I said.’ Greenspan gathered power to himself
and to the Fed through maintaining a freedom of movement that became one of his
most important legacies.72
Policy discretion by itself isn’t enough to send policy-makers to the pantheon; it depends
on what the policy-maker does with that discretion that matters. With Greenspan, an
important use of his discretion was the perception and fact that he was committed to
giving financial markets a soft landing amidst national and international turmoil. The
idea here is that the Fed, embodied by Alan Greenspan, would always be there to put
the bottom to the market and to keep that bottom within investors’ reach. This is the
infamous ‘Greenspan Put’. As a report in the Financial Times put it in 2000, ‘when
financial markets unravel, count on the Federal Reserve and its chairman Alan Greenspan
(eventually) to come to the rescue.’ This perception—widely shared among market
participants—was built on repeated assurances from the Greenspan Fed. This occurred
when the stock market experienced the largest sell-off since the Great Depression, in
October 1987, during the Mexican peso crisis in 1995, the East Asian financial crisis of
1997–98, the failure of the hedge fund Long-Term Capital Management, in response to
the implosion of equity markets after the dot-com crash in March 2000, and in response
to the attacks on the World Trade Center and the Pentagon on 11 September 2001.73
4. Reverse Control: Bill Clinton and the Greenspan Fed
Greenspan’s reputation also produced one of the strangest relationships between a

US president and central banker in US history. The relationship between Bill Clinton
and Alan Greenspan is not of presidential control of the Fed, but Fed control of the
president. The Clinton-Greenspan years were marked by one of the most noticeable
periods of central bank and presidential cooperation in the nation’s history. This is all
the more remarkable because of the fact that there was no domestic financial crisis that
required close coordination that we would expect from central banks and the Treasury.
Instead, the Greenspan Fed and the Clinton Administration worked hand in glove to
battle international financial crises and, perhaps even more important, domestic fiscal
policy. The Fed reigned not only over money and banking, but over the entire economy.
Indeed, when Clinton was first elected, he actively sought Greenspan’s advice on
Clinton’s domestic economic agenda and deficit reduction in particular. Greenspan
saw the key to Clinton’s reelection prospects and the key to economic growth was get-
ting the Administration’s fiscal house in order. This fiscal conservatism matched the
recommendation from influential parts of Clinton’s Administration and was part of his
political image as a centrist Democrat. Clinton was sold.
It is not terribly surprising that a libertarian central banker and a fiscally conserva-
tive Democrat would agree on the need to constrain governmental spending. It is more
surprising that Clinton’s political calculation included making use of that central banker’s
72
Ibid. For a first-rate overview of the power of words, and especially the change in central
banking practice in their use, see Holmes (2013).
73
Financial Times. ‘“Greenspan Put” May Be Encouraging Complacency’. Financial Times, 8
December 2000. For a survey of market participants on the Greenspan Put, see Miller et al (2002).

personal prestige. Clinton’s very first address to a joint session of Congress in February
1993 was on the economy, with deficit reduction featured prominently in that discussion.
Clinton didn’t say a word about the Fed or monetary policy. But Alan Greenspan was
central to that speech: in front of a televised audience, Clinton had invited Greenspan
to hear this important address as the President’s personal guest. He sat between Hillary
Clinton and Tipper Gore, a symbol of the Greenspan and Clinton partnership.74
Greenspan was more than a passive partner in this relationship. Just a week after
Clinton’s inauguration, Greenspan had testified before the Senate on behalf of the
President’s deficit reduction plan. Clinton had convinced Greenspan that he was seri-
ous about this issue, the ‘by far the most pressing concern’ that Greenspan had from
his perch at the Federal Reserve. They had committed to a joint enterprise. This joint
commitment extended deep into the Administration’s economic policies for the full eight
years. Time Magazine eventually dubbed Greenspan and Clinton’s top economic policy
advisers, Secretary of the Treasury Bob Rubin and Deputy Secretary of the Treasury
Larry Summers, the ‘Three Marketeers’ and the ‘Committee to Save the World’ for their
financial crisis response management. Notably, the magazine cover put Greenspan, not
the Secretary of the Treasury, in the central role.75
The point of reciting this history in Part V is two-fold. First, the role of the Fed Chair
has continued to increase in public attention and institutional power. While the Fed
is a system, a complex set of individual and institutional relationships, the Fed Chair
has exercised outsized influence within that system since William McChesney Martin.
Second, the terms of engagement between Fed Chairs and the politicians who must
ultimately support them are not clearly defined. Central bankers and their defenders often
regard central bank independence as a sacred, legal institutional arrangement designed to
shield technocrats from political intermeddling. But those relationships are always up for
debate. How the Fed will play out will depend on the personalities of those who occupy
these important positions, on both sides of the central banking line.
VI. DURING AND AFTER THE CRISIS
The world that central bankers like Martin, Volcker and Greenspan built no longer exists.
The financial crisis of 2008 killed it and created another.
This book will be published approximately ten years after the initial tremors of the crisis.
In that decade, an extraordinary amount of research, analysis, reporting, memoirs and
history has been written to cover what will amount to a defining event in the twenty-first
century.76 The question for our purposes is this: what did the crisis, and the subsequent
legislative response, do to the functions, structure and personalities of the Federal Reserve
System?
74
Greenspan (2007, 144).
75
Ramo, Joshua C ‘The Three Marketeers’. Time, 15 February 1999. For more on this coop-
eration, see Rubin (2004).
76
For journalistic accounts, see Sorkin (2009) and Wessel (2010). For some of the key memoirs,
see Bernanke (2015), Geithner (2014), and Paulson (2010). For the second draft of history, see
Blinder (2013).

The Fed’s self-conception as the light-touch regulator of the macroeconomy has

fundamentally changed, perhaps forever. The Fed, under Chair Ben Bernanke espe-
cially, pushed its authority to the limits of precedent. Beginning in March of 2008,
the Fed used its little-understood emergency lending authority under Section 13(3) of
the Federal Reserve Act to facilitate JP Morgan Chase’s rock-bottom acquisition of
a failing Bear Stearns. It used this authority again and again throughout the fall and
winter of 2008 and 2009, though infamously refused to do so in sufficient quantity
to stave off the collapse of Lehman Brothers. On the monetary policy front, the Fed
inexplicably kept interest rates too tight through the summer and early fall of 2008,
only to push up to the zero-lower bound and beyond through several rounds of
unconventional monetary policy (a question that Claudio Borio and Anna Zabai ably
discuss in their contribution to this volume). And politically, Bernanke navigated the
largest net expansion of the Fed’s authority since at least the 1950s and arguably since
the Great Depression.
It has been quite the decade for the Fed.
What can we learn from these experiences? I think there are three lessons, one each
for the three focal points of this chapter. Functionally, the Fed may have crossed a
Rubicon with respect to its use of emergency authority and the greater role for systemic
risk under the Dodd-Frank Act. Long gone are the days when we think of the Fed as
the entity that nudges interest rates in one direction or another, 25 basis points at a
time. The elastic of history can often snap back into equilibrium, of course. Perhaps it’s
early yet to declare the old model dead and buried. But just as the Great Depression
shaped central banking thought for 40 years, and the Great Inflation for the next 30,
for at least a generation central bankers at the Fed will be reliving the successes and
failures of the crisis response. The Fed might be faulted for fighting the last war, but
it’s hard to imagine another approach. If the academic and policy discussions of the
Great Depression are any guide, the 2008 crisis will loom as a topic of intense debate
and planning for decades to come.
Structurally there have also been important changes, in at least two respects. The Fed
has found an uneasy place in international coordination after the crisis, a topic discussed
by Kahn and Meade in this volume. In regulatory and supervisory matters, the Fed is at its
cosmopolitan best. But with respect to monetary policy, there is much less of a globalist
orientation, much to the chagrin of the Fed’s foreign counterparties in major economies
like India, China or Brazil. The structure of international decision-making is thus divided.
It’s hard to predict the future of those relationships, particularly in a world still digesting
the populist spasms of 2016.
Second, the Federal Reserve System itself now plays a more coordinated role in domes-
tic regulatory policy. The Dodd-Frank Act created a number of new structures that either
removed the Fed’s authority or required it to do more power sharing. The Consumer
Financial Protection Bureau (CFPB) consolidated authority granted by Congress to a
number of agencies, but the Fed is the biggest loser in that turf battle (for which the Fed
will also pay: the CFPB’s budget is taken from the Fed, as well). The Financial Stability
Oversight Council (FSOC) is designed to put the Fed not as the first among equals in
crisis prevention and response, but on a committee of all relevant regulators, led by the
US Secretary of the Treasury, to ensure a more robust conversation. Critics and defenders
of this new structure argue about a number of different aspects of its new bailiwick, but

it remains mostly a theoretical exercise. Indeed, the future for both the CFPB and FSOC
is uncertain: it remains to be seen whether the 2016 election and its aftermath will retain
them, at least in current form.77
This leaves personalities. Bernanke wrote in his memoir that he sought to walk
back the imperial model of central banking and devolve the Fed’s substantial author-
ity back to its legal basis: the Board of Governors and the Federal Open Market
Committee.78 But events proved otherwise, and Bernanke quickly deployed the
Fed’s powers working with a small group of advisers, including Fed Governors Don
Kohn and Kevin Warsh and Federal Reserve Bank of New York President Timothy
Geithner. Bernanke, a Republican, also became a lightening rod for political backlash
to the ‘bailouts’ of 2008–09. Presidential candidates in 2012 accused him of treason,
even vaguely threatening him with bodily harm. Candidates in 2016 launched their
campaigns on commitments to substantially abridge the Fed’s discretion. Bernanke,
despite his desires to the contrary, became the public face for the Fed and not in the
best way.
The true test of personalities, as of this writing, is imminently before us. Janet Yellen,
Bernanke’s successor as Chair, will face reappointment as Fed Chair in the fall of 2017,
before this book’s publication date. If she is not reappointed, as is widely predicted, she
will be the first single-term Fed Chair in the Fed’s modern history. (Both Thomas McCabe
and G William Miller served less than a full term; the first resigned as part of the Fed-
Treasury Accord, the second was fired by promotion by Jimmy Carter, who elevated him
Secretary of the Treasury.) She will also break the cross-partisan appointment tradition
that dates to 1978 and extends to 1951 if we exclude Carter’s failure to reappoint Arthur
Burns. Regardless, there is an open question as to whether she will remain on the Board
of Governors, as Marriner Eccles did, to protect the Fed from political interference.
President Barack Obama took a decidedly hands-off approach to the Fed, more hands-
off than any of his predecessors. Will President Trump do the same?
VII. CONCLUSION
As mentioned in this volume’s introduction, the twentieth century was the century for
central banking. But we are at an inflection point. The future is not simply unknown,
generically; it is unknown because the present is so volatile. We are not in a period of
significant deference to technocratic decision-making, a deference that has come to define
central banks’ modus operandi. History, though, does present at least this much of a
guide: the Fed has endured dramatic changes to its functions and structure, and has had
personalities of all kinds leading it, attacking it, defending it. And through it all, unlike the
nineteenth century experimentation with central banking in America, it has only grown
in prominence and authority. How that has happened is a question for another day. That
it has happened is indisputable.
77
See Schwarcz and Zaring (2017).
78
Bernanke (2015). See Conti-Brown and Johnson (2013) for a discussion of the Board of
Governors.

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3. The development of the Bank of England’s
objectives: evolution, instruction or reaction?* 79
Forrest Capie and Geoffrey Wood
I. INTRODUCTION
When the Bank of England was founded in 1694 it was not founded as a central bank.
The concept of a central bank did not exist in the seventeenth century. It differed from
other banks of the time only in that it had been given special privileges in return for
undertaking to raise funds for the government. It was set up as a joint stock company, a
corporate form not generally available and granted in individual (and few) cases by the
crown. (All banks could at that time issue their own notes, a right that did not start to
disappear until 1844 when the Bank was given the monopoly.)
It arrived at being what is now called a central bank by a process of evolution. Like all
evolutions it took place in a particular environment. The environment affected the Bank,
and the Bank affected the environment. We therefore examine this joint evolution. Doing
so leads to an understanding of how the Bank of England became what is now called a
central bank, and how its current ‘core purposes’, the maintenance of monetary stability
and of financial stability, developed. Whether the most recent developments have been
entirely satisfactory is discussed towards the end of this chapter.
II. ORIGINS
After a naval defeat by France in 1690 the government of William III wished to build a
strong navy and needed to borrow to do so. Its credit however was not good. To encourage
taking up of the loan, all who did so became members of the Bank of England (formally
known as the Governor and Company of the Bank of England), following a scheme devised
by William Paterson and carried out by Charles Montagu, First Earl of Halifax, in 1694. In
addition to simply lending the money and being paid interest (at eight percent per annum)
the subscribers thus incorporated received certain privileges—in particular, they became
the government’s banker, and were the only joint stock corporation allowed to issue bank
notes.
That the right of the shareholders to have limited liability was a special privilege
usefully highlights that other banks at that time had to be unlimited liability partnerships.
That plays an important part in our subsequent analysis.
A de facto bimetallic standard obtained at the time. But by the early years of the
eighteenth century there was a de facto gold standard. As the Bank grew steadily to the
* This chapter draws in part on earlier papers by the authors. See particularly Capie (2002),
Lastra and Wood (2011), and Wood (1999).
34

The development of the Bank of England’s objectives 35
point where it dominated the financial system a prime responsibility was to maintain the
standard. The standard in the early part of the period was not strictly defined. That had
to await the 1844 Act at which point a fiduciary issue was specified and further note issue
was tied to one-to-one relationship with gold.
This standard maintained price stability by linking the note issue to the stock of gold,
which, while it could and did change, could change only slowly. Inspection of the record
of the price level from then to the beginning of the twentieth century confirms how
successful that standard was. There were fluctuations in the price level, but so long as
Britain was on the gold standard these fluctuations were modest, and were followed by
reversion to the trend.1 The only departures from that state of affairs were when Britain
temporarily left the gold standard—suspended it, to use the technical term.
One could therefore say that from an early date the Bank of England slowly, almost
imperceptibly, acquired one of the functions of a modern central bank, the maintenance
of monetary stability. In the first stage, that was done by protection of the metallic
standard. The current definition is (for the Bank of England—the details of the definition
differ from one central bank to another) inflation in low and positive single figures.
The extension of its functions to include the one now called financial stability followed
developments in the banking system at large.
1. The Bank of England and Financial Stability
The banks that comprised the banking system when the Bank of England was founded
had changed little since banks emerged from being mediaeval goldsmiths. Whatever other
activities they engaged in, their key business was borrowing and lending. When engaged
in that business they are crucial in two ways. They supply a part—in modern economies,
by far the greater part—of the stock of money. And they transfer funds from lenders to
borrowers—they act as financial intermediaries. When engaged in borrowing and lending,
banks such as those considered here need both capital and liquidity.
Capital comprises funds the bank actually owns. It can have been provided by the
bank’s shareholders, or, depending on the corporate form, the partners in the bank or
even by its sole owner. Such funds are needed because however well run the bank is, and
regardless of how well it treats its customers and of the extent to which it is aware of its
responsibilities to them, now and again it will lose money on a loan. Some or all of what
it has lent will not be paid back. That is, though, no excuse (in either morality or law) for
not repaying the people who have lent the bank money; so the bank needs some funds
of its own to make up what is needed to repay depositors. But although such capital is
necessary, it was at the time at which we are currently writing, no concern of the central
bank’s—it was a matter for the bank’s owners and managers.
Liquidity is in some ways a trickier concept. It can most easily first of all be thought of
as cash the bank keeps in its own vaults. Some cash is needed because while most of the
time payments in match withdrawals, sometimes they fall short. Again, the bank is obliged
1
The fluctuations were the result of factors such as large changes in the price of grain, and
changes in the behavior of the cash holdings of the public and of banks other than the Bank of
England. There is further discussion of the behavior of these other banks below.

to pay out what its customers demand, so to avoid default and consequent closure they
need some cash in hand.
This system is known as fractional reserve banking because in it a bank’s cash reserves
are less than the total of the bank’s liabilities that are repayable on demand. There are
two principal views as to how such a system can prosper. One is that an entirely free
system—‘free banking’ with each bank in charge of its own note issue and there being no
central bank—would solve any problems that arose, deal with any shock to the system
for example. The alternative view is that the system requires a central bank. In England
a central bank emerged. Bagehot for one would have preferred free banking but accepted
that the system should remain as it had evolved.
There was certainly fractional reserve banking in England before there was a central
bank, although cash reserves were a large fraction of deposits. The argument, that the
system requires what is now called a central bank before it can grow, was first articulated
by Francis Baring in 1797. In 1793 war had been declared between France and Britain.
That dreadful calamity is usually preceded by some indication which enables the commercial and
monied men to make preparation. On this occasion the short notice rendered the least degree of
general preparation impossible. The foreign market was either shut, or rendered more difficult
of access to the merchant. Of course he would not purchase from the manufacturers; . . . the
manufacturers in their distress applied to the Bankers in the country for relief; but as the want
of money became general, and that want increased gradually by a general alarm, the country
Banks required the payment of old debts . . . In this predicament the country at large could have
no other resource but London; and after having exhausted the bankers, that resource finally
terminated in the Bank of England. In such cases the Bank are not an intermediary body, or
power; there is no resource on their refusal, for they are the dernier resort.2
The Bank was, in other words, the only bank that could still lend—small banks had turned
to bigger banks, these to the big London banks, and these in turn to their banker, the
Bank of England.3
Very soon after Francis Baring’s 1797 coining of the term ‘dernier resort’, Henry
Thornton (1802) provided a statement of what the lender of last resort was, why it was
necessary, and how it should operate. His statement was made in a particular institutional
context, and it is as well for the sake of subsequent clarity to consider what this context was.
There were many banks in England all (except the Bank of England) constrained to
being partnerships of six or fewer. (The joint stock form was not generally allowed until
1826, and limited liability not until 1858.) Even with the care unlimited liability surely
brought, failures were common. It is here, Thornton points out, that the Bank of England
comes in. ‘If any bank fails, a general run upon the neighbouring banks is apt to take
place, which if not checked in the beginning by a pouring into the circulation of a very
large quantity of gold, leads to very extensive mischief’.4
2
This quotation comes from pages 19–23 of the 1967 facsimile reprint by Augustus Kelly
of the 1797 edition of Francis Baring’s Observations on the Establishment of the Bank of England
and on the Paper circulation of the Country. Baring, as well as importing the term, used it in a new,
metaphorical, way. In France it referred to the final court of appeal.
3
That the Bank of England acted as banker to banks makes clear why some central banks,
that of New Zealand for example, go by the title ‘Reserve Bank’. Other banks use them as bankers,
and, like anyone else, hold the bulk of their cash reserves with their banker.
4
Thornton (1802, 182).

And who was to ‘pour in’ this gold? The Bank of England. ‘. . . if the Bank of England,
in future seasons of alarm, should be disposed to extend its discounts in a greater degree
than heretofore, then the threatened calamity may be averted.’5 This was, he emphasized,
not incompatible with allowing some individual institutions to fail. Concern should be
with the system as a whole.
And the reason a ‘pouring into the circulation’ (to use Thornton’s phrase) would stop
a panic and thus protect the system was described with great clarity by Walter Bagehot
in 1873.
What is wanted and what is necessary to stop a panic is to diffuse the impression that though
money may be dear, still money is to be had. If people could really be convinced that they would
have money . . . most likely they would cease to run in such a herd-like way for money.6
In the kind of banking system which Britain had by the mid to late nineteenth century,
a system based on gold but with the central bank the monopoly supplier of notes, the
responsibility for diffusing ‘. . . the impression that . . . money is to be had’ clearly rested
with the central bank.
That summarizes nineteenth century theory on the subject. Because the central bank
was the monopoly note issuer it was the ultimate source of cash. If it does not, by acting
as lender of last resort, supply that cash in a panic, the panic will continue, get worse,
and a widespread banking collapse ensue, bringing along with it a sharp monetary
contraction.
What was nineteenth century practice? Sterling returned to its pre-war gold parity in
1821. The first subsequent occasion for emergency assistance from the Bank was in 1825.
Monetary ease and abundant credit lay behind a developing boom. The Bank tightened
money. The stock market crashed. Some banks failed in the late summer. Panic developed;
there were runs on banks. The type of bills the Bank would normally discount soon ran
out and the panic continued. If a wave of bank failures were to be prevented, the banks
would have had to borrow on the security of other types of assets. On the 14 December
1825 the Bank of England suddenly deviated from its normal practice, and made advances
on government securities instead of limiting itself to discounting commercial bills. The
panic was ended.
There were further steps on the way to the well-developed system, steps taken in the
crises of 1847 and 1857. But the next important step was taken in 1866, with the Overend
and Gurney Crisis. Overend, Gurney and Co originated with two eighteenth century
firms, the Gurney Bank (of Norwich) and the London firm of Richardson, Overend and
company. By the 1850s the combined firm was very large; its annual turnover of bills of
exchange was in value equal to about half the national debt, and its balance sheet was ten
times the size of the next largest bank. It was floated during the stock-market boom of
1865. By early 1866 the boom had ended. A good number of firms were failing. Bank rate
had been raised from three percent in July 1865 to seven percent in January 1866. After
February, bank rate started to ease, but on 11 May Gurney’s was declared insolvent.
To quote the Bankers’ Magazine for June 1866, ‘a terror and anxiety took possession
5
Ibid, 188.
6
Bagehot (1873, 64–65).

of men’s minds for the remainder of that and the whole following day’. The Bank of
England for a brief time made matters worse by hesitating to lend even on government
debt. The Bank Charter Act (which among other things restricted the note issue to the
extent of the gold reserve plus a small fiduciary issue) was then suspended, and the panic
gradually subsided.
The failure in 1878 of the City of Glasgow Bank was much less dramatic. It had started
respectably, was managed fraudulently, and failed. There was fear that the Bank Charter
Act would have to be suspended again (see Pressnell, 1968), but no major problems
appeared: ‘There was no run, or any semblance of a run; there was no local discredit’
(Gregory, 1929). Other Scottish banks took up all the notes of the bank; Gregory
conjectures that they acted in that way to preserve confidence in their own note issues.
Then in 1890 came the (first) ‘Baring Crisis’. Barings was a large bank of great
reputation; in 1877, when Treasury bills were introduced, Bagehot praised them as
being ‘as good as Baring’s’. It nevertheless became involved in a financial crisis in
Argentina. The Argentine government found difficulty in paying the interest on its
debt in April 1890; then the National Bank suspended interest payments on its debt.
This precipitated a run on the Argentinean banking system, and there was revolution
on 26 July. Barings had lent heavily to Argentina. On 8 November it revealed the
resulting difficulties to the Bank of England. The Bank (and the government) were
horrified, fearing a run on London should Barings default. A hurried inspection of
Barings suggested that the situation could be saved, but that £10 million was needed
to finance current and imminent obligations. A consortium was organized, initially
with £17 million of capital. By 15 November the news had leaked, and there was some
switching of bills of exchange into cash. But there was no major panic and no run
on London or on sterling. The impact on financial markets was small. Barings was
liquidated, and refloated as a limited company with additional capital and new (but
still family) management.
Why the great difference between the first, second and third of these episodes? The
Bank of England had both learnt to act as lender of last resort (LOLR) and had made
clear that it stood ready so to act.
Much has been written about the lender of last resort. The activity purportedly covers
everything from supplying liquidity to the market to recapitalising or otherwise rescuing
non-bank firms. It seems to us that precise definition and careful use of the term are
important. The key is in the phrasing. It is the lender when there is no other source of
funds. And that points to the provider of the notes and cash on which the system runs—
commonly the central bank but not necessarily or invariably so. The liquidity should be
supplied to the market as a whole and not to individual banks.
To summarize, we can now see the ‘core responsibilities’ of a central bank, the two
tasks that no other organization can carry out and are essential for the functioning of a
modern banking system. These two tasks are the maintenance of monetary stability in
the sense of stable prices somehow defined, and acting as a lender of last resort when
required.7 The Bank of England had the first task from an early date. By the third quarter
7
We have it will be observed taken for granted that price stability is desirable. That was the
view at the time of the Bank’s foundation. In combination with maintaining the gold standard that

of the nineteenth century it had, through the combination of events and the pressure and
arguments of individuals, adopted the second.
III. FINANCIAL STABILITY ACHIEVED
But it had not adopted the responsibility of being the lender of last resort regardless of
developments in the banking system with which it was concerned.
Fractional reserve banking had become established in England in the late seventeenth
century.8 However, while the principle was implemented the extent was limited. The banks
continued for a long time to hold very high cash ratios—the banking multiplier remained
low, barely above one for the following hundred years. Gradually, over the course of the
eighteenth century the banks learned this business. But it was the end of that century
before there was any real growth in the multiplier and hence the possibility of financial
crisis remained low.
By the early nineteenth century however, the possibility was clearly there. The banking
multiplier was of the order of 2.5 and growing. There followed several crises over the next
decades: in the 1820s, 1830s, 1840s, 1850s and 1860s.
How was it that these crises occurred at regular intervals and then stopped? There
were three parts to the solution. The Bank of England learned how to perform the role
of lender of last resort. The banks learned how to behave and found their own way
to prudence. And third, government provided what it believed to be the appropriate
regulatory environment.
1. The Commercial Banks
At the beginning of the nineteenth century banks were generally small and without
branches. Any shock to the system that cast doubts over the security of deposits could
result in a run, and the nature of a bank’s balance sheet meant even well-behaved banks
could fail.
They had to find their way to the most suitable capital/asset, cash/deposit, and liquid/
asset ratios that were consistent with acceptable profitability. The ratios, as might be
expected, all started out fairly high and gradually came down as banks found what could
work. Caution was learned and by mid-century was essentially the bye-word. A major
contribution to this was made by George Rae from Aberdeen. He learned his trade as a
banker there and in the 1830s he joined a Liverpool bank, the North and South Wales
Bank, and did well before he was embarrassed in the crisis of the 1840s.
Rae then went on to write the handbook for bankers that was still being used in the
twentieth century, The Country Banke (1885), and indeed editions of which were produced
in 1930 and again in 1976. It had also gone through several nineteenth-century editions.
Rae covered every aspect of banking but central to his instruction was caution. He
task was imposed on the Bank of England ab initio. A good explanation of its desirability can be
found in Friedman (1992).
8
Quinn (1997).

wrote: ‘There is . . . a possibility of being over cautious; but in banking that is one of the
cardinal virtues, compared with the opposite evil and mischief of being over credulous.’
(Rae, 3). Bagehot agreed: ‘Adventure is the life of commerce, but caution, I had almost
said timidity, is the life of banking’.9
Nevertheless, even the best behaved banks could still be embarrassed when a shock hit
the system, and the second part to the maintenance of banking system stability was the
lender of last resort. The banks learned caution, and they were supported by the lender
of last resort.
2. The Bank of England
At the end of the eighteenth century and the beginning of the nineteenth there were
many contributors to a developing literature in the changing financial and monetary
environment. And many of these addressed the question of the role of a lender of last
resort. Henry Thornton gave a comprehensive treatment. He described how the Bank
should behave in normal times letting the money supply ‘vibrate only within certain limits’
(Thornton 1802, 259) but that in times of liquidity squeeze the Bank should relieve the
pressure. However, ‘It is by no means intended to imply, that it would become the Bank of
England to relieve every distress which the rashness of the country banks may bring upon
them: the Bank by doing this might encourage their improvidence’. Others such as Thomas
Joplin contributed too, exhorting the Bank how to behave in the middle of the crisis of
1825. The Bank he said should increase its note issue to offset the loss of circulation.
But the Bank of England learned its role as lender of last resort slowly. It resisted for a
long time the advocacy of theorists. Any commercial bank may, from time to time, extend
loans to customers who are illiquid or even insolvent. They may do so even when the present
expected return from the new loan itself is zero or negative; if the wider effects on their own
reputation for commitment, or the knock-on effects of the failure of the first customer on
others, warrant it. By the same token, a nascent central bank—an institution still some way
short of maturity as a central bank—may ‘rescue’ some client or correspondent bank, just as
the commercial bank may support its business customer. But we would not want to describe
such ad hoc exercises as involving a conscious assumption of a systematic lender of last
resort function. We emphasize this as we wish to make clear that the practice of sometimes
bailing out a commercial bank which is about to fail can not by any degree of ingenious
sophistry be described as a natural extension of the classic lender of last resort role.
Nor, indeed, would we want to see a mature central bank endeavouring to rescue
individual banks. There is simply too much moral hazard involved.
No central bank would want to pre-commit itself to giving special support to any
individual bank that was running into liquidity problems. A bank liquidity problem that
is not caused by some technical problem is likely itself to be a reflection of some deeper
suspicions about solvency. Consequently, an unqualified pre-commitment to provide
assistance to an individual firm would involve too much moral hazard.
The central bank should provide liquidity to the market as a whole, and not bail-out
individual firms (banks). It can provide liquidity without limit, but should do so at an
9
Bagehot (1873, 232).

increasing price. It is the knowledge in the markets that the supply cannot run out that
serves to assure the market and allay the panic. In its ideal form this should be done
anonymously. There should be no commercial rivalry that might deflect the bank from its
task, or involve a conflict of interest. If it is known in advance that this is how the bank
will behave (pre-commitment) then the picture is complete.10
It is worth pausing to consider what could reasonably be meant by ‘bail-out’, an
action frequently now confused with lender of last resort. Central banks in general do
not have the capital resources to salvage single-handedly an institution of any significant
size—significant in the sense that it could have damaging consequences for the rest of the
system. If the central bank discounted at face value the inferior assets of an individual
institution in difficulty then if these assets were subsequently marked to market their
values would appear much lower on the bank’s balance sheet. Thus the central bank would
be seen to be damaging its own balance sheet since it has parted with cash and exchanged
that for lower value assets. If this in turn required government assistance in the raising
of more capital, the central bank would in effect have taken a fiscal decision. Thus, in the
case of an individual institution, all the central bank can really do is oversee or organize a
rescue operation, perhaps putting pressure on others to subscribe new capital. (As it did
in the case of Barings in 1890.)
How, then, can the ideal operation of lender of last resort be achieved? The lender of
last resort supplies funds to the market in times of need; it does not supply individual
institutions. It should not engage in bailing-out firms of any kind, be they banks or non-
banks. Indeed, if the operation could be carried out where the identity of those seeking
funds was not known to the Bank that would be ideal (Hawtrey, 1932). Institutions
holding good quality assets will have no difficulty in getting hold of the funds they need.
Institutions with poor quality assets are likely to suffer. In times of panic the interest rate
would rise.
By something of a happy accident this was in effect the system that developed in
England. At the beginning of the nineteenth century the Bank’s monopoly offended the
rest of the banks. Such was the antipathy that the new joint stock banks preferred to keep
a distance. Discount brokers emerged who transacted business between the commercial
banks and the Bank of England. These discount brokers gradually acquired the capital
base to finance their own portfolios and by the third quarter of the nineteenth century
had developed into their modern form, the discount house.
When the commercial banks were under pressure in a liquidity squeeze their first line
of defence was to call in their loans to the discount houses; this in turn sent the discount
houses off to the Bank of England. If the commercial banks had to cash in bills they
would do this at the discount houses and the latter would in turn take them to the Bank.
In this way the central bank never needed to know from whence the great bulk of the
demand was coming. The precise source of the demand was largely an irrelevance. Good
bills get discounted.
Some confusion in the discussion over the nature of the lender of last resort function
10
Vera Lutz Smith in The Rationale of Central Banking (1946) described sound banking and
safe money (in the modern terminology financial/banking stability and price stability) as key
central banking objectives.

may have arisen from too cavalier a treatment of this model. Central banking was more
advanced in Britain than in other countries, and the British model of central banking
was often adopted elsewhere. But the actual mechanism did not always exist elsewhere.
Thus a key feature of the British system, its in-built protective device for anonymity, was
ignored. This meant that in most other countries the institutions themselves went to the
central bank, losing their anonymity by so doing. Difficulties were exacerbated when
the government’s bank and the commercial banks were in competition for commercial
business. This seems to have been ignored in most of the literature, and it may be this that
accounts for the way in which bailing out has been treated by some as a normal central
banking activity, with its being close to axiomatic that some banks were so important that
they were ‘too big to fail’, and had to be bailed-out as a matter of course.
It is worth pausing here to consider the recent ‘too-big-to-fail doctrine’ as it might have
applied to Overend, Gurney. Overend had become banker to the London and country
banks and on the day it failed The Times said it ‘could rightly claim to be the greatest
instrument of credit in the Kingdom’ (11 September 1866). Overend’s appeal to the Bank
for help was refused: ‘The Governor took the view that the Bank could not assist one
concern unless it was prepared to assist the many others which were known to be in a
similar plight’ (King 1936, 242). The refusal to help Overend, although possibly in part
motivated by animosity between it and the Bank, can clearly be seen as a further step on
the road by which the Bank came to see its function as coming to the aid of the market as
a whole rather than bailing out imprudent and insolvent institutions. The panic of 1866
was huge. But in spite of Overend’s size and apparent centrality to the system, the panic
passed and the system went on to become strong and stable.
The Bank of England had learned how to do all this over a long period beginning with
the crisis of 1825 and continuing until the crisis of 1866, and then putting it in to action if
ever the need appeared to be arising.11 There followed over 100 years of financial stability;
banks failed as they should indeed be allowed to, but there were no financial crises. And
that was across a long period of alternating fortunes of growth and recession, of war and
different exchange-rate regimes, deflation and inflation.
3. Regulatory Environment
The third element in the story is the role of government and regulation. The striking thing
to a modern eye about all this evolution is that it occurred in a period of laissez faire,
and banking followed that course. The preceding period that ran through the eighteenth
century was that of mercantilism—the supremacy of the state in commercial matters. And
in that century banking in England was severely circumscribed. But the reaction to the
inefficiency and corruption in government that mercantilism produced was to seek small
government, free trade and sound money. And so in that new climate of laissez faire, after
each financial crisis the authorities deregulated further.
The first stage in this process came with relaxation of the usury laws, at least for the
Bank of England. The laws had been in force for centuries. In 1825 when the crisis blew
up the Bank did lend but it could not lend at a rate above five percent which in the context
11
Ogden (1991); and Capie (2002).

of the times was hardly high enough. After the crisis the usury laws were relaxed and at
the next crisis the Bank raised its rate above five percent.
At the same time the restrictions on banks being limited to partnerships of no more
than six was also abandoned and joint stock banks were allowed to form. Initially, they
could only operate away from London—outside a radius of 65 miles. But a few years later
in the 1830s they were also allowed to operate within London.
The gold standard had been more strictly defined in the 1844 Act but it proved too
restrictive and when the 1847 crisis developed it was clear that the Bank could not hold
to the law and do what was required for financial stability. The Chancellor then wrote to
the Governor and relieved him temporarily of the need to stick to the requirements of the
Act and so limitless lending (at a high rate) could take place.12
There was a growing discussion on the merits and demerits of limited liability in the
second quarter of the nineteenth century and after the 1857 crisis the laws were relaxed
and limited liability was available for those who chose to avail themselves. Not all did but
it was an option.
After that banking was extremely lightly regulated and everything was then in place that
would allow the Bank to act as a lender of last resort. Generally speaking it did so though
on occasions it might have blurred the issue.
There followed a period of more than 100 years when there were no financial crises
in Britain. Financial stability became so entrenched that it was, very reasonably, taken
for granted. There were episodes when individual banks failed, occasionally quite large
banks, but no financial crisis. All the elements of a crisis were present in 1914 but the
circumstances were extremely unusual. In the interwar years there was no banking crisis
in Britain. When much of the rest of the world was in deep depression between 1929 and
1932 Britain was not. There was a downturn. There was a recession. But there was no
financial crisis, no banking crisis. In fact the banking system remained remarkably robust
throughout the period. There was an exchange-rate problem but that was resolved by
severing the link with gold and allowing the rate to float.
IV. POST WORLD WAR II DEVELOPMENTS
In the aftermath of the Second World War the international order changed substantially.
The US, which had not sustained significant economic damage in that war, leapt to
being the largest and most influential economy. World trade started to take place to a
significant extent in the US dollar13 and the Bretton Woods system of ‘fixed but adjust-
able exchange rates’, with its associated international financial institutions, was put in
place.14
Despite all these changes, indeed in some respects turmoil, the British banking system
12
Those who claim that Bagehot urged a ‘penalty rate’ misrepresent him. His recommendation
was that the rate be ‘high’, in the sense of clearly above the normal run of rates, a narrow and well
defined range at the time. The aim was not to impose a penalty on borrowing, but to ensure the
borrowing was repaid as soon as the crisis was thought to be over.
13
See Carse, Williamson and Wood (1980) for a discussion of this and for further references.
14
There is an extensive examination of this system and its institutions in Steil (2013).

remained stable. It would not be unfair to say that its stability was taken for granted and
there was a considerable degree of complacency about its operations.
This complacency revealed itself in the behavior and treatment of bank capital. Capital
had always been important to British banks. Indeed, it was considered so important that
the government and the Bank of England accepted the public interest argument that
allowed the concealment of true profits and capital until as recently as 1970.
Banks have always experienced a tension between having too much capital and too
little. Strong capital positions are designed to give depositors confidence—indeed, in the
nineteenth century, they were on occasions used as a competitive weapon to attract deposits.
But the greater the capital the lower will be the return on capital and so there is a trade-off
between depositor confidence and shareholder satisfaction. And of course the quality of
the assets, the quality of what the bank has lent against or bought, is key to any calculation.
It is important to note, in view of later developments, that right up until well after the
Second World War the amount of capital banks held was entirely their own decision.
There were no regulations as to what proportion of the balance sheet their capital or
any other liability or asset might be. The banks each had to find their own way to the
appropriate balance sheet shape for each individual institution.
Nonetheless, despite this freedom, by the beginning of the last quarter of the nineteenth
century, the published capital ratios had settled at around 15 percent with little variation
across banks, and by the end of the century that figure had slipped to around ten to 12
percent. In the inflationary conditions of the First World War the ratios fell further, as
much of the bank lending which led to the expansion of bank balance sheets was secured
on government debt, then believed to be completely secure. In the years between the two
world wars there continued to be remarkable stability in the banking sector, and, no doubt
in consequence, the ratios slipped slightly further. In the 1920s and 1930s they had settled
at around seven percent.
In the Second World War the banks’ capital ratios fell further and fell sharply, to around
three percent. The banks’ balance sheets expanded with government debt, while private
lending fell away. But as the ratios fell so too did the risk since the bulk of the balance
sheet was made up of gilts. This continued to be the case in the long period of adjustment
following the war. In fact the ratios reached their all-time lows in the 1950s when they were
down to between two and three percent.
Raising capital after the war was not easy, with restrictions placed by the Capital
Issues Committee (a committee which restricted access to capital markets by private
sector borrowers so as to ensure there was always ready finance for the government). This
particular restriction on the banks began to be troublesome and bank chairmen spent a
lot of time in the 1950s lobbying the Bank of England for support in allowing them to
raise new capital. A note for the Chief Cashier made the problem clear:
. . . it will be seen that the capital structure of the Clearing Banks is far from sound . . . At present
it is clear that in times of trouble they must either put footnotes in their balance sheets – which
we deplore – or lean on us for financial aid which would be disastrous . . . The banks, [if] freed
from restriction, should pursue energetically the implementation of a programme which, for
good reasons, is long overdue.15
15
Quoted in Billings and Capie (2007, 145).

Observe that the banks themselves were keen to hold more capital. It was government
regulation that restricted the issuance of more capital. And the Bank was a spectator.
The Bank’s lack of involvement in deciding or supervising capital reflects the view that
no bank was, in twenty-first century terms, ‘too big to fail’. This had been demonstrated
by the Bank’s actions in the Overend Gurney crisis, and so long as no bank really was too
big to fail, and there was a lender of last resort to preserve the system in the face even of
a large individual failure, whether a bank failed or not was a matter for the bank’s own
good management to prevent.
However, there was a crisis in the secondary banking sector in the mid-1970s and that
led to legislation in 1979. The Banking Act passed that year placed limits on individual
exposures to ensure appropriate diversification. Exposures exceeding 25 percent of
capital required prior approval of the Bank of England. That marked the beginning
of interference in bank operations. And soon after that, in the 1980s, the rules of Basel
took over. Capital regulation had started in Britain, and rapidly expanded in complexity
under the tutelage of the Basel Committee.16 This was not supplemented by an increased
emphasis on the banks being responsible for their own actions. How, indeed, could it be?
The banks were being instructed on how they should behave.
There was a natural consequence. It was one that ultimately led to substantial changes
in the Bank of England’s responsibilities.
1. The Socialization of Risk
The seeds for this were planted in the nineteenth century but the process was to build
steadily in the twentieth. In the interwar years, although economic performance was
mixed, the banking system remained essentially robust. Even in 1931 when events are
sometimes misleadingly referred to as a financial crisis, the banks performed well. Their
profits were subdued but there were no grounds for concern over stability. There was a
currency crisis and the mistake of 1925 had to be corrected but apart from that the system
was undisturbed. But the Bank had imperceptibly become an overseer of, and intervener
in, the banking system. When a bank got into difficulty the Bank would suggest to
another bank that it might take it over and the Bank of England might indeed on occasion
itself provide that bank with an indemnity against loss in the process. One example was
Williams Deacon’s in 1929, when Montagu Norman operated behind the scenes to save it
and preserve the appearance of stability.
Although when war broke out in 1939 there was an immediate rise in Bank Rate in fact
there was no need for it and there was no drama. Then after the Second World War the
banking system continued to remain strong and any talk of financial stability in England
would have sounded strange. Financial stability was taken for granted.
But then, as is frequently the case, after a period of increased competition from
1971–73 and of expansionary monetary policy, there was a huge growth of the
secondary or shadow-banking sector. This sector lay outside the main banks, which
were subject to credit controls, and in many ways was a consequence of seeking to avoid
the controls. Its business model was to borrow in the short-term money markets—the
16
See: Bank for International Settlements (2015).

inter-bank market—and lend on property. A great property boom developed with all the
accompanying dangerous practices that are commonly found at such times. When the
monetary authorities then tightened policy in the face of spiralling inflation the market
turned down, the euphoria turned to gloom, property companies failed and then the
secondary banks got into difficulties.
There were fears that the difficulties might spread to other parts of the banking system
and the Bank launched a rescue operation that came to be called the lifeboat. This should
properly be called crisis management of the kind that was organized for Barings in 1891.
The question that arises is: why not rely on that former stabiliser, the lender of last resort,
if indeed it were needed? Any bank in difficulty that held good assets could have gone
to the Bank and got the necessary liquidity. If they did not hold the appropriate assets
then that might be considered poor management and they could be left to fail. If they
were thought of as sufficiently good risks then a clearing bank might well have thought
it worthwhile rescuing them.
Instead of doing so the Bank became involved in a long process (many years in some
cases) of propping up or winding down a large number of institutions at considerable cost
in terms of resources devoted and in some case in substantial losses. And that does seem
to have been the Bank’s approach thereafter, to bail out quietly or otherwise arrange the
affairs of banks in trouble no matter how small and insignificant they were. In the Less
Developed Countries (LDC) debt crisis of the early 1980s and in the small bank crisis at
the beginning of the 1990s, and again from year to year across the last third of the century
that was the practice. It gradually became accepted that no financial institution would be
allowed to fail. How much moral hazard was being stoked up is hard to say.
It is clear that important lessons that had been learned in the past had been forgotten.
The Bank still stood ready to act as lender of last resort, but the high capital ratios and
individual responsibility which had contributed so much to the stability of the British
banking system had not so much been set aside as allowed to drift out of sight. Problems
had been stored up for the future.
2. Drift to Inflation Targeting
Meanwhile, changes had also been taking place to the Bank’s other core responsibility.
When these changes started is hard to state precisely; but it is reasonable to argue that
they started in the 1970s.
Throughout a good part of its history, certainly since the Bank Charter Act of 1844 (as
modified in 1847), the Bank had been charged not with price stability but with adherence
to a rule, that of keeping sterling on gold. This rule had to change when the standard was
suspended, and the consequences had been inflation. But gold was returned to after every
suspension, including that of the First World War.
Between the end of the War and 1925 the Bank had been conducting monetary policy
with the aim of returning to gold at the old parity. That was government policy and was
an objective that was shared by almost all.17 But the return of 1925 was achieved only
17
There was of course some dissent from this view, most famously that of Keynes. See Keynes
(1925), and Capie, Mills and Wood (1986).

briefly. Shortly after Britain left gold in 1931 the USA followed, and in the run up to the
Second World War the Bank operated by maintaining the external value of sterling steady
against the US dollar. While the departure from gold was a government decision, there
seemed just to be a feeling thereafter that maintaining stability against the dollar was a
sensible thing to do. As so often, it is not clear who decided.
After the Second World War a new international monetary system, the Bretton Woods
System, was established. While this retained, at least so far as central banks and govern-
ments were concerned, a residual link to gold, its practical basis was the US dollar. Under
this system, the Bank’s monetary ‘instruction’ was to keep sterling within bounds around
an exchange rate for the US dollar. The rate was a matter for the government, and the
Bank’s role in the choice of it was at most advisory. From the point of view of maintain-
ing price stability this system proved much inferior to the gold standard. But how big a
change was it for the Bank? It was still following a rule for holding sterling pegged to an
external target. The difference was that while the gold peg could have been changed by
government, it was not; in contrast, the exchange-rate peg was changed by government,
and more than once, albeit never willingly.
The really big changes to the ‘monetary stability’ part of the Bank’s task came with
the floating of sterling in 1972, after the 1971 breakdown of the Bretton Woods system.
There was no longer a clear external target, no longer an obvious descendant of the gold
standard rule, and sterling initially appreciated modestly after the float. This lack of a
clear goal was soon followed by sharply rising inflation, peaking at around 27 percent in
1975; the dangers of the lack of an anchor had been exposed by the 1973 oil crisis. The
incoming government of 1976, whose Prime Minster was James Callaghan, soon went to
the International Monetary Fund (IMF) for a loan, one condition of this being a squeeze
on public spending and another being limits on domestic credit expansion.18 This repre-
sented the first domestic target for monetary policy in the Bank’s history. The Callaghan
government fell in the election of 1979, and was replaced by a conservative government
with Margaret Thatcher as Prime Minister. This government adopted targets for the
growth of a monetary aggregate, Sterling M3.19 This target was forced on a reluctant
Bank by a not particularly enthusiastic treasury. Accounts of this episode can be found
in Griffiths and Wood (1984), and Lawson (1992). For a variety of reasons sterling soared
and it eventually became clear that this first attempt at a domestically chosen domestic
target had not been a success. In 1988 there was a return to an external target—monetary
policy was now guided by what was known as ‘shadowing the deutschmark’. That is to
say, sterling was kept within an informal band around the deutschmark. But this external
target caused problems in turn, first leading to interest rates so low that inflation acceler-
ated, and then, after German reunification in 1990, interest rates too high for the then
state of the British economy.
In that year the government decided that sterling would join the European Exchange
Rate Mechanism. This system was one of pegged exchange rates within the European
18
This is a concept developed primarily at the IMF, and comprised the domestic components
of money supply growth. See Foot (1984) for details.
19
This was a broad measure of the money supply, and comprised, in addition to notes, coin
and bank deposits at the Bank of England, primarily current and deposit accounts at the clearing
banks.

Union, with the deutschmark the de facto anchor; Britain joined at an exchange rate of
DM2.95 to the pound. Maintaining that then became the Bank’s monetary policy objec-
tive. But maintaining that proved impossible, at any rate over a politically acceptable time
horizon. British inflation did fall as intended, but the squeeze, because of the monetary
policy of Germany having to deal with an economy in a different cyclical phase from
that of Britain, remained tight well beyond the time when British inflation had fallen.
Other countries in the European Exchange Rate Mechanism (ERM) experienced similar
problems, and on September 1992 Britain left the ERM.
This then led to the return of a domestic target for monetary policy. In October 1992
the then Chancellor of the Exchequer wrote to the Treasury Committee of the House of
Commons.
I believe we should set ourselves the specific aim of bringing underlying inflation in the UK,
measured by the change in retail prices excluding mortgage interest payments, down to levels
that match the best in Europe. To achieve this, I believe we need to aim at a rate for inflation in
the long term of 2% or less.
The details involved gradually falling inflation targets until below two percent was
achieved. (This last, it should be noted, was soon given up.) So the target was chosen by
the government, and, at this time, interest rate decisions were taken by the Chancellor in
the light of advice given by the Governor at their monthly meetings.
This system continued until 1997, with some changes in the intervening years. These
changes led, perhaps unintentionally, to more power accruing to the Bank over what
should be done to achieve the target. In February 1993 the Bank started to publish an
‘Inflation Report’, which contained inter alia the Bank’s inflation forecasts. Also from
1993, the Bank was given a little discretion over when to make any interest change—the
constraint was that the change had to take place before the next Chancellor/Governor
meeting. Then in April 1994 the minutes of the Chancellor/Governor meetings started
to be published. These were to be published two weeks after the meeting subsequent
to that to which the minutes related. In 1995 there were further modest changes to the
target—called a ‘restatement’ by the then Chancellor, Kenneth Clarke.20 Interest rate
decisions remained a matter for the Chancellor, and the target remained a matter entirely
for the government.21
After this period of what might reasonably be called turmoil, it is useful to pause and
reflect on a matter that has been implicit throughout much of this account.
It is not always straightforward to establish the source of an objective. It might come
from the state. It appears that most, perhaps all, monetary stability objectives have arisen
there. This does not however mean that the Bank objected to the choice, and nor does it
mean that the Bank had no input in the choice. Indeed, it may have been suggested by the
Bank. There is simply not the information on that, for many such discussions were, and no
doubt still are, informal. It is however true that the actual decision lay with government.
20
Underlying inflation was to be kept at 2.5 percent or less, and the Chancellor suggested that
this would mean inflation was in the range of 1 percent to 4 percent most of the time.
21
How free the Chancellor actually was to decide on interest rates when the advice from the
Governor started to be published is not at all clear, of course.

In contrast, concern over financial stability seems more often to have originated in
the Bank and/or with outside commentators (such as Thornton, Joplin, and so on) who
addressed their concerns and recommendations to the Bank. Equally, where cautious
behavior evolved in the financial institutions it was then on occasion formalized by the
Bank. The liquid assets ratio and the cash asset ratio that the commercial banks moved
to in the late nineteenth century and used in the twentieth century are illustrations of this
point. After the Second World War the Bank formally agreed with them that certain ratios
should be adhered to. Later the Bank took it upon itself to introduce new arrangements
in 1971.
To summarize, up to almost the late 1990s the Bank had been in charge of the financial
stability objective, including how to achieve it. The monetary stability objective in
contrast was formally always the decision of government, although it seems likely that
the Bank was involved in deciding it some of the time, and always was in the attempts to
achieve it.
There were some fundamental changes very soon after the election of a Labour
government in May 1997. The Bank was given responsibility for setting interest rates;
to decide on rates, a Monetary Policy Committee was established, comprising both
Bank staff and others appointed from outside the Bank. These appointments were by
the Chancellor, but were a minority on the committee. What had happened, then, was
that responsibility for the conduct of policy had shifted entirely to the Bank, while the
choice of objective remained entirely with the government. From the constitutional
point of view, it was very close to the situation under the gold standard. But at the
same time the government interfered substantially in the Bank’s financial stability
responsibilities.
Prior to 1997 the Bank had assumed responsibility for financial stability. The Banking
Act of 1987 gave the Bank formal responsibility for both monetary and financial stabil-
ity. Thereafter the Bank spoke of having these two core purposes. But while monetary
stability was easily stated and a simple numerical target for inflation laid down, no such
definition was available for financial stability. And with the creation of the Financial
Services Authority at the same time and the formal removal of supervision from the
Bank, confusion on the question of where responsibility for financial stability lay
prevailed.
V. CRISIS AND POST-CRISIS
This lack of clarity led to problems when Northern Rock ran into difficulties in 2007.
The Bank no longer supervised banks either formally or informally, so, unless someone
told them, which the Financial Services Authority (FSA) did not, they had no way
of knowing the peculiar nature and high risk of Northern Rock’s business model. In
addition, their eye was off the ‘financial stability ball’. Inflation had been the primary
concern for some time, and there had been no financial stability problems for many
years. And finally, even had other banks been willing to support Northern Rock (which
their behavior in markets had clearly indicated they would not be enthusiastic about)
events happened so quickly that there was no time to ask, and the call had to be on the
government. The Bank had to go to its owner and ask for funds, and this had to be done

in an ad hoc manner, and in haste.22 As the report of the Treasury Select Committee of
the House of Commons made clear, there was plenty scope for things going wrong and a
serious banking run starting at many stages in the process. Indeed, some have argued that
the behavior of the Bank made this much more likely.23
The crisis thus not only made it necessary for the Bank to call on government support.
It also brought to light inadequacies in the previous set of instructions laid down by the
government. It became necessary to reconsider central bank mandates.24
Nothing was changed in the UK so far as the inflation mandate was concerned.
It was however recognized after the crisis that it was clearly necessary to ensure that
market information and financial stability are both recognized as important. This can
follow in part from the Bank’s mandate, but internal structure also matters. When
the Bank of England, for example, dealt in the money markets it did so through
the discount office, so called because it dealt with the Discount Market, the market
which had developed both as an intermediary between commercial banks, and as an
intermediary between them and the Bank of England. These discount houses were
small, and very highly geared. One precaution they took against failure was to know
their customers well. The Bank of England in turn gained from them information
about their customers through regular meetings between the discount houses and the
discount office of the Bank.
The crisis exposed weaknesses in the mandate given to the Bank of England, as well as
defects in how the Bank (and the FSA) responded to the crisis. This inevitably required
not only action from the government to deal with the crisis, but also changes in the man-
date. The changes have concentrated authority in the Bank. At the same time, regulation
of the banking sector became (still more) detailed, with still higher capital ratios and
instructions on the risk weights that should attach to various assets.
One point and one implication leap out of that survey of the years after 1997. That was
the first period that the government had interfered in the Bank’s financial stability respon-
sibilities, and it was the first time since 1866 that something had gone seriously wrong
in that area of responsibility. The risk continues; for in the wake of the Global Financial
Crisis (GFC) of the early twenty-first century (a crisis which started at different times in
different countries but which can be dated as around 2007/2008) there were some that can
best be called interjections into this process of change. The Bank became responsible for
‘Macro Prudential’ and ‘Micro Prudential’ policy, and became the resolution authority
for the sector.
The Financial Policy Committee (FPC) was legislated for in the Financial Services Act
2012. That committee was responsible for ‘macro prudential’ stability. Even before that
date, during 2011, an interim FPC was set up; the FPC itself was formally established
22
Why it was decided to support Northern Rock rather than follow the nineteenth century
course and let it fail, and then providing liquidity to the market as needed to prevent a contagious
run, is discussed in detail in Milne and Wood (2009).
23
Congdon (2015).
24
The implications for the conduct of monetary policy with regard to inflation are obvious.
Central banks should not rely exclusively or primarily on measures of the output gap and of infla-
tion expectations in making their forecasts and the subsequent policy decisions. How to get them
to do so is a different matter.

in April 2013.25 The Prudential Regulatory Authority (PRA), responsible for ‘micro
prudential’ stability was also legislated for in the Financial Services Act 2012; the so-called
‘Legal Cut-Over’ (when the micro-prudential functions legally transferred across from the
FSA to the PRA) was also in April 2013. As will be clear, ‘micro prudential policy’ is more
usually termed supervision.
The Bank’s legal powers as a resolution authority are legislated for in the Banking Act
2009.26
How well these various additions will actually work is far from clear. It may, for exam-
ple, seem odd that a body responsible for the stability of the system is also responsible
for the liquidation of individual members of it. A body responsible for the first might in
some circumstances wish to exercise forbearance; a body responsible for the second might
wish prompt closure.
It could well be thought that these tasks ended with the Bank because there was no
other existing institution where they could go with any appearance of plausibility. It is
also far from clear to us that all these new functions are actually useful. But, be that as it
may, we suspect that the experience of the operation of these ‘interjections’ could be as
unhappy as those of previous direct interventions by the government of the day in the
Bank’s financial stability responsibility.
VI. CONCLUSION
A question was posed in the title of this chapter. Did the Bank’s objectives emerge from
evolution, instruction or reaction? A brief answer could in fact be ‘yes’: all three were
involved. The monetary objective evolved from the Bank’s initial obligation to be able to
convert its notes into gold on demand. This was formalized in 1844, and changes since
then although numerous have done no more than changed the form of the monetary
objective. The financial stability objective was adopted by the Bank in response to outside
argument and the pressure of events; but it had from time to time stabilised the system
before that, on an ad hoc basis and without formal explanation or justification. It then
drifted into being involved in the workings of the banks which comprised the British
banking system, and then through legislation acquired increasingly formal and detailed
responsibilities for the conduct of these banks.
And to all this a further complication must be added. The ideas which guided the
Bank’s actions may appear to have come from the private sector or government, but there
may well often have been discussion and flow of ideas, before a mutually satisfactory
conclusion and policy was reached. There is little information on this. A long history does
not always allow a simple and clear-cut story to be told.
25
See http://www.bankofengland.co.uk/financialstability/Pages/fpc/default.aspx.
26
Links to the various acts are available at: http://www.bankofengland.co.uk/about/Pages/gov
ernance/default.aspx.

REFERENCES
Allen, William and Geoffrey Wood (2006) ‘Defining and achieving financial stability’ Journal of Financial
Stability, vol 2: 152–72.
Bagehot, Walter (ed) (1848) The Collected works of Walter Bagehot (Norman St John Stevas, London: The
Economist).
Bagehot, Walter (1873) Lombard Street (Brighton: Henry King and Company).
Bank for International Settlements (2015) Basel Committee on Banking Supervision: A Brief History of the Basle
Committee. October.
Billings, Mark and Forrest Capie (2007) ‘Capital in British banking, 1920–1970’ Business History, vol 49(2)
March: 139–62.
Broz, Lawrence and Richard Grossman (2004) ‘Paying for privilege; the political economy of Bank of England
Charters’ Explorations in Economic History, vol 41(1): 48–72.
Capie, Forrest (2002) ‘The emergence of the Bank of England as a mature central bank’ in Donald Winch and
Patrick K O’Brien, The Political Economy of British Historical Experience (Oxford: Oxford University Press).
Capie Forrest H, Terry C M Mills and Geoffrey E Wood, (1986) ‘What happened in 1931?’ in F Capie and
G Wood (eds), Financial Crises and the World Banking System (London: Macmillan).
Carse, Stephen, John Williamson and Geoffrey Wood (1980) The Financing Procedures of British Foreign Trade
(Cambridge: Cambridge University Press).
Congdon, Tim (2015) ‘How Mervyn King got Northern Rock wrong’ Standpoint, November 2015.
Foot, MDKW (1984) ‘Monetary targets: their nature and record in the major economies’ in Brian Griffiths and
Geoffrey Wood (eds), Monetarism in the United Kingdom (London: Macmillan).
Friedman, Milton (1992) ‘The cause and cure of inflation’ in Money Mischief: Episodes in Monetary History
(San Diego, CA: Harcourt Brace and Co).
Gregory, TE (1929) The Gold Standard and Its Future (Boston, MA: E P Dutton and Co).
Griffiths, Brian and Geoffrey Wood (eds) (1984) Monetarism in the United Kingdom, (London: Macmillan).
Hawtrey, Ralph (1932) The Art of Central Banking (London: Frank Cass and Co).
Joplin, Thomas (1832) An Analysis and History of the Currency Question (Reprinted in DPO’Brien, Foundations
of Monetary Economics, William Pickering 1994 Vol VI).
Keynes, John Maynard (1925) ‘The economic consequences of Mr Churchill’, Essays in Persuasion (London:
Macmillan).
King, WTC (1936) History of the London Discount Market (London: Frank Cass).
Lastra R and GE Wood (2011), ‘Causes of the recent crisis – an economic and legal evaluation’ Journal of
International Economic Law, vol 13(3): 531–50.
Lawson, Nigel (1992) The View from Number 11: The Memoirs of a Tory Radical (New York: Bantam).
Milne, Alistair and Geoffrey Wood (2009) ‘Oh what a fall was there: Northern Rock in 2007’ in Robert R Bliss
and George G Kaufman (eds), Financial Institutions and Markets: 2007–2008—The Year of Crisis (London:
Palgrave Macmillan).
Ogden, Tessa, (1991) ‘An analysis of the Bank of England discount and advance behaviour, 1870–1914’ in
J Foreman-Peck (ed), New Perspectives on the Late Victorian Economy (Cambridge: Cambridge University
Press).
Pressnell, Leslie (1968) ‘Gold flows, banking reserves and the Baring crisis of 1890’ in CR Whittlesey and JSG
Wilson (eds), Essays in Money and Banking in Honour of RS Sayers (Oxford: Oxford University Press).
Quinn, S (1997) ‘Goldsmith banking: mutual acceptance: interbanker clearance in restoration London’
Explorations in Economic History, vol 34: 411–32.
Rae, George (1885) The Country Banker (London: John Murray).
Steil, Benn (2013) The Battle of Bretton Woods (Princeton: Princeton University Press).
Thornton, Henry (1802) An Inquiry into the Nature of the Paper Credit of Great Britain (Reprinted, Augustus
M Kelley: Fairfield 1978).
Wood, G (1999) ‘Great crashes in history’ Oxford Review of Economic Policy, vol 15(3) Autumn: 98–109.

4. Central banking in Japan
Hideki Kanda and Toshiaki Yamanaka
I. INTRODUCTION
It was once said that the Bank of Japan (‘BOJ’), the central bank in Japan, was one of the
least independent central banks in the developed world, and trailed even many developing
countries. Professor Geoffrey P Miller, who made this statement, presented a puzzle in
the following way:
On top of this puzzle is a related anomaly. Political theory predicts, and the empirical research
confirms, that at least in the developed world, the legal independence of a country’s central
bank tends to correlate with lower inflation. The intuition is that an independent central bank
will be able to resist the demands of political actors that it print money to pay the government’s
debts or that it engage in simulative monetary policy in order to enhance the governing party’s
re-election prospects. On this theory, Japan ought to have high inflation. But it doesn’t. Japan’s
inflation rate is one of the lowest in the developed world, and has been at the low end of world
inflation rates for many years.1
Professor Miller then offered two interesting theories regarding the role of the BOJ:
The first draws on the remarkable political stability that characterized Japanese politics between
the end of the Second World War and the recent past, a stability based largely on a commitment
by the ruling party to pursuing policies designed to foster rapid economic growth. The second
draws on a model of bureaucratic decision-making at the BOJ that appears to be richer and
more complete than the model implied by the simple ‘independent-dependent’ measure of
central bank independence. I argue that the BOJ’s decisions on monetary policy questions are
arrived at through a process of ‘preclearance’ in which decisions are thoroughly vetted and
discussed by the relevant actors—who may include officials of the Ministry of Finance as well
as the BOJ—before they are publicly announced. Preclearance allows the Bank to maintain a
substantial degree of control over the decision-making process while at the same time subjecting
the Bank to influences from without that render it accountable to the political system.2
In this chapter, we do not pursue an academic inquiry along the lines examined by
Professor Miller. Suffice it to say that, as a matter of fact, the Bank of Japan Act, which
provides the legal foundation for the BOJ, was significantly amended in 1997. Our focus in
this chapter will be on the basic governance structure of the central bank and the related
institutional setting for the BOJ’s monetary policy and prudential policy, in accordance
1
Geoffrey P Miller, ‘Decision-Making at the Bank of Japan’ (1996) 28 Law and Policy in
International Business 1, at 3 (notes in the original sentences are omitted) [hereinafter Decision
Making]. See also Geoffrey P Miller, ‘The Role of a Central Bank in a Bubble Economy’ (1996) 18
Cardozo Law Review 1053 (examining the role of the Bank of Japan against the origin and the burst
of the bubble economy in Japan).
2
Decision Making, supra note 1, at 3–4.
53

with the current legal regime applicable to the BOJ. We will examine in particular the
unconventional monetary policies adopted by the BOJ since 1999 to present and the BOJ’s
contract-based powers concerning on-site examinations, a feature which is unique to the
Japanese banking supervisory system.
The chapter is divided into five sections, following this introduction. Section II
describes the legal regime applicable to the BOJ. Section III examines the BOJ’s uncon-
ventional monetary policy from 1999 to present. Section IV discusses the BOJ’s on-site
examinations. Section V provides a brief conclusion.
II. INSTITUTIONAL SETTING OF THE BOJ: THE BANK OF

JAPAN ACT3
1. Independence
The BOJ was founded in 1882 as the central bank of Japan. The BOJ’s purposes and
organization are stipulated in the Bank of Japan Act. The 1942 Bank of Japan Act (Act
No 67 of 1942) replaced the 1882 Act. The 1942 Act was substantially amended and
modernized by the 1997 Act (Act No 89 of 1997, effective from April 1998) based on
two principles: respecting the autonomy of the BOJ and ensuring transparency of its
monetary policy and business operations.4 According to Article 1 of the 1997 Act the
purpose of the BOJ is to issue banknotes, to carry out currency and monetary control,
to ensure the smooth settlement of funds, thereby contributing to the maintenance of the
stability of the financial system. Article 2 stipulates that currency and monetary control
shall be aimed at achieving price stability, thereby contributing to the sound development
of the national economy.
Article 3 of the BOJ Act provides that the BOJ’s autonomy regarding currency and
monetary control shall be respected and that the BOJ shall endeavor to clarify to citizens
the content of its decisions, as well as its decision-making process, regarding currency and
monetary control. Article 4 of the BOJ Act requires coordination with the government by
providing that the BOJ shall—taking into account the fact that currency and monetary
control is a component of overall economic policy—always maintain close contact with
the government and exchange views sufficiently, so that its currency and monetary control
and the basic stance of the government’s economic policy shall be mutually compatible.
It should also be noted that Article 5 of the Public Finance Act (Act No 34 of 1947)
prohibits the BOJ from directly underwriting Japanese government securities.
3
This section of the chapter draws on Hideki Kanda, ‘Reform of the Bank of Japan Act’
(1997) 1119 Jurisuto 16 (in Japanese). A comprehensive explanation of the BOJ and its functions
is found in English at Institute for Monetary and Economic Studies, Bank of Japan (ed), Functions
and Operations of the Bank of Japan (2nd edn, 2012) (available at: https://www.boj.or.jp/en/about/
outline/data/fobojall.pdf).
4
English translations of major statutes in Japan, including the Bank of Japan Act, are avail-
able at the ‘Japanese Law Translation’ website (http://www.japaneselawtranslation.go.jp). In the
following text, article numbers to be cited refer to those of the current Bank of Japan Act, unless
otherwise noted.

Central banking in Japan 55
The notion of autonomy enshrined in the BOJ Act is in line with the literature on
central bank independence.5 To ensure autonomy, the BOJ Act provides a general rule
and specific measures. As a general rule, the Act provides that in implementing the
Act, due consideration shall be given to the autonomy of the BOJ’s business operations
(Article 5(2)). Specific measures include three aspects. First, under the regime before the
amendments in 1997, the government had power to issue orders to the BOJ regarding
various operations. Under the new 1997 regime, such power does not exist. Also, the
Governor and other members of the BOJ’s Policy Board cannot be removed from office
unless there are reasons specified under the Act, and in no case can a difference in
opinions between the government and the BOJ be the reason for removal (Article 25(1)).
Second, the amendments in 1997 made for complete renewal of the BOJ’s Policy Board, as
described later. Finally, the amendments introduced measures limiting the government’s
control over the BOJ’s budget (Article 51), thereby ensuring the autonomy of the BOJ.
2. Policy Board
Under the new regime, the Policy Board (the ‘Board’) is the only decision-making body
at the BOJ, and its powers are specified under the Act (Articles 14 and 15). Under the old
1942 regime, the Board consisted of seven members: the Governor, four members, and
two representatives of the government. Under the new 1997 regime, the Board consists
of nine members: the Governor, two Deputy Governors, and six members (Article 16).
The term of office is five years (Article 24). Under the new scheme, representatives of the
government are not included in the Board. Rather, the BOJ Act provides a new measure
for coordination between the government and the BOJ. Specifically, the Act provides, in
essence, that the Minister of Finance may, when necessary, attend and express opinions at
Board meetings for monetary control matters, or may designate an official of the Ministry
of Finance to attend and express opinions at such meetings (Article 19(1)). The Minister
of Finance (or its delegate) may, when attending the Board meetings for monetary control
matters, submit proposals concerning monetary control matters, or request that the Board
postpone votes on proposals on monetary control matters submitted at the meeting until
the next Board meeting for monetary control matters (Article 19(2)). When a request has
been made to postpone a vote as prescribed above, the Board shall decide whether or not
to accommodate the request, in accordance with the Board’s practice for voting (Article
19(3)).6
Note that the Board makes decisions not only regarding monetary control but regarding
other important matters as well (Article 15(1) for monetary control and Article 15(2) for
5
Literature on central bank independence abounds. See, eg, Rosa M Lastra, ‘The Independence
of the European System of Central Banks’ (1992) 33 Harvard International Law Journal 475; Rosa
M Lastra, International Financial and Monetary Law (2nd edn, Oxford, Oxford University Press,
2015) [hereinafter Monetary Law] at 64–82; Christopher Crowe and Ellen E Meade, ‘Central
bank independence and transparency: Evolution and effectiveness’ (2008) 24 European Journal of
Political Economy 763; Stanley Fischer, Central Bank Independence (remarks at the 2015 Herbert
Stein Memorial Lecture National Economists Club, Washington, DC, 4 November 2015) (available
at: https://www.federalreserve.gov/newsevents/speech/fischer20151104a.pdf).
6
This request was made in 2000 as described later in Section III.

other important matters). Disclosure of the outline of each Board meeting and its minutes
is required only for meetings regarding monetary policy (Article 20).
The BOJ’s Board meetings for monetary policy are called Monetary Policy Meetings,
and those meetings took place about 14 times a year until the end of 2015. Beginning in
2016, they take place, in principle, eight times a year,7 which is similar to practice in the
US and Europe.
3. Governance
Aside from the Policy Board, the BOJ has other officers: executive directors, counsellors
and auditors. Auditors are appointed by the Cabinet (Article 23(3)), while executive
directors and counsellors are appointed by the Minister of Finance based on the Policy
Board’s recommendation (Article 23(4)).
Under the 1942 regime, the government had supervisory power over the BOJ and
sent a supervisor to the BOJ. Under the 1997 regime, this system was abolished, and the
government’s supervisory power became limited to matters concerning compliance of the
BOJ’s business operations with laws and regulations. Under the new regime, the govern-
ment can request the BOJ to take necessary actions (Article 56) and auditors to audit and
report them (Article 57) where violations of laws or regulations are likely to exist.
Thus the BOJ’s autonomy, or independence, from the government is ensured as much
as possible under the current BOJ Act. Recent literature emphasizes the importance of
governance of central banks, and the key elements of governance include independence,
accountability and transparency.8
4. Other Central Bank Activities
The BOJ undertakes other activities and operations besides monetary policy. These are
briefly analyzed in the ensuing paragraphs.
Stability of financial system

In Japan, the power to regulate financial institutions is given to the government, not
the BOJ. The BOJ, however, has been given the following three powers. First, the BOJ
has power to make ‘special lending’, which is generally known as the central bank’s
lender of last resort. Under the BOJ Act, this lending can be made in two contexts.
One is temporary lending to individual financial institutions in response to liquidity
7
Article 9(1) of the Bank of Japan Act Implementation Ordinance (Ordinance No 385 of
1997, as amended in 2015). See Bank of Japan, New Framework for Monetary Policy Meetings (19
June 2015) (available at: https://www.boj.or.jp/en/announcements/release_2015/rel150619a.pdf).
8
See Bank for International Settlements, Issues in the Governance of Central Banks: A report
from the Central Bank Governance Group (2009) (available at: https://www.bis.org/publ/othp04.
pdf); Bank for International Settlements, Central Bank Governance and Financial Stability: A
Report by a Study Group (2011) [hereinafter Central bank governance] (available at: https://www.
bis.org/publ/othp14.pdf). See also Ellen E Meade, ‘The Governance of Central Banks’, in David
Levi-Faur (ed), The Oxford Handbook of Governance (Oxford, Oxford University Press, 2012) at
401; Gerard Hertig, ‘Central Bank Governance’ (2012) 84 Swiss Review of Business and Financial
Market Law 486.

shortage, which can be done at the BOJ’s judgement only, that is, without consultation
with the government in advance (Article 37). The other is special lending to individual
financial institutions upon a request by the government (Article 38). This lending is
also intended to deal with liquidity problems, but not with the solvency of individual
financial institutions.
Second, upon authorization from the government, the BOJ may engage in the business
of contributing to the smooth settlement of funds among financial institutions under
certain conditions (Article 39). In fact, the BOJ operates a payment and settlement system
and a settlement system of government securities.
Finally, the BOJ undertakes on-site examinations of financial institutions. The BOJ
Act did not have any explicit provision regarding this before the amendments in 1997,
and the amendments introduced a new provision, Article 44. Article 44 is a product
of a compromise that was reached after lengthy discussions in the legislative process
immediately before the amendments to the BOJ Act in 1997, and reads as follows:
(1) The BOJ may, for the purpose of appropriately conducting or preparing to conduct the
business prescribed in Articles 37 through 39, conclude a contract with financial institutions,
etc. which would be the counterparty in such business (‘counterparty financial institutions,
etc.’ in this Article) concerning on-site examinations (examinations which the Bank carries out
regarding the business operations and the state of the property of the counterparty financial
institutions by visiting the premises thereof) (such contract shall meet the requirements specified
by Cabinet Order including those whereby the Bank shall notify and obtain prior consent from
the counterparty financial institutions when carrying out on-site examinations).
(2) The BOJ shall consider the administrative burden incurred by counterparty financial institu-
tions when carrying out on-site examinations.9
The BOJ’s on-site examinations are legally carried out based on a contract between the
BOJ and each financial institution. In other words, the BOJ’s legal power of on-site
examination arises from a contract, not the BOJ Act. The Act purports to provide certain
conditions. In Section IV, we will further discuss the BOJ’s on-site examinations.
International finance
The BOJ’s operations regarding international finance includes three categories outlined
in Articles 41 and 42 of the 1997 Act. The first is banking operations such as deposit
taking from foreign central banks in Japanese currency, which can be done based on the
BOJ’s judgement only. The second is international rescue measures, which can be made
at a request or upon the approval of the Japanese government (the Minister of Finance).
The third is foreign exchange control, which is decided solely by the government and
implemented by the BOJ (Articles 36(1) and 40).
Issuing banknotes
The BOJ issues banknotes, which are legal tender (Article 46).
9
Article 44(3) reads as follows: ‘(3) When a request has been made from the Commissioner of
the Financial Services Agency, the BOJ may submit the documents describing the results of on-site
examinations and other related materials to the Commissioner or have officials of the Financial
Services Agency inspect them.’

III. THE BOJ’S UNCONVENTIONAL MONETARY POLICY

FROM 1999 TO PRESENT10
In this section, we summarize how the BOJ’s unconventional monetary policy has been
adopted and implemented under the new BOJ Act. We also briefly review theoretical and
empirical aspects of this monetary policy.
1. An Overview of the BOJ’s Unconventional Monetary Policy
Under the new BOJ Act, the BOJ has been implementing an unconventional monetary
policy from 1999 to present.11 Over this period, the nominal interest rate in Japan has
been consistently nearly zero, and the BOJ adopted several tools of an unconventional
monetary policy—which include increasing the amount of current deposits of financial
institutions with the BOJ or the ‘monetary base’—in order to maintain price stability (see
Figure 4.1 below).12
Specifically, the BOJ’s unconventional monetary policy includes the following three
types of measures: (i) ‘zero interest rate policy’ (ZIRP) from 1999 to 2000, (ii) ‘Quantitative
Easing Policy’ (QEP) from 2001 to 2006, and (iii) ‘Quantitative and Qualitative Monetary
Easing’ (QQE) from 2013 to present. Under the QQE policy, the BOJ decided to introduce
‘QQE with a Negative Interest Rate’ on 29 January 201613 and ‘QQE with Yield Curve
Control’ on 21 September 2016.14
Zero interest rate policy (ZIRP): 1999–2000

Japan’s economy experienced a decade of economic stagnation in the 1990s.15 In February
1999, the BOJ decided to ‘provide more ample funds and encourage the uncollateralized
overnight call rate to move as low as possible.’16 This is called ‘zero interest rate policy’
(ZIRP). Furthermore, in an interview in April 1999 after the Monetary Policy Meeting of
10
This section is partly based on Toshiaki Yamanaka, Bank of Japan’s Unconventional
Monetary Policies: A New Approach for Verifying Their Effectiveness (unpublished, MPA thesis at
Columbia University, 2012).
11
As of 4 December 2017.
12
In other words, the primary means of monetary policy has changed from a traditional
adjustment of the nominal interest rate to a use of the central bank’s balance sheet. For a theoreti-
cal perspective, see Vasco Cúrdia and Michael Woodford, ‘The central-bank balance sheet as an
instrument of monetary policy’ (2011) 58 Journal of Monetary Economics 54.
13
Bank of Japan, Introduction of ‘Quantitative and Qualitative Monetary Easing with a
Negative Interest Rate’ (29 January 2016) (available at: http://www.boj.or.jp/en/announcements/
release_2016/k160129a.pdf).
14
Bank of Japan, New Framework for Strengthening Monetary Easing: ‘Quantitative and
Qualitative Monetary Easing with Yield Curve Control’ (21 September 2016) (available at: http://
www.boj.or.jp/en/announcements/release_2016/k160921a.pdf).
15
For the background, see Fumio Hayashi and Edward C Prescott, ‘The 1990s in Japan: A
Lost Decade’ (2002) 5 Review of Economic Dynamics 206 (pointed out that the problem is a low
productivity growth rate).
16
Bank of Japan, Announcement of the Monetary Policy Meeting Decisions (12 February
1999) (available at: http://www.boj.or.jp/en/announcements/release_1999/k990212c.htm/).
The BOJ’s assessment on the economy was as follows:

trillion yen ZIRP QEP QQE %
5 00 9
450 8
4 00 7
350 6
3 00 5
25 0 4
200 3
15 0 2
100 1
50 0
0 –1
19 9 0
19 9 1
19 9 2
19 9 8
2000
2001
2002
2008
2010
2011
2012
19 9 3
19 9 4
19 9 5
19 9 6
19 9 7
19 9 9
2003
2004
2005
2006
2007
2009
2013
2014
2015
2016
2017
‘Monetary Base’ minus Current Deposits
Current Deposits
Call Rate, Uncollaterized Overnight (right scale)
Source: BOJ Time-Series Data Search at the BOJ website (http://www.stat-search.boj.or.jp/

index_en.html). The names of time-series are; (1) ‘Call Rate, Uncollateralized Overnight/Average’
(series code: FM02’STRACLUCON), (2) ‘Monetary Base/Average Amounts Outstanding’ (series code:
MD01’MABS1AN11), and (3) ‘Monetary Base/Current Account Balances/Average Amounts Outstanding’
(series code: MD01’MABS1AN113).
Figure 4.1 Call Rate, Current Deposits and the ‘Monetary Base’
the BOJ Policy Board, the Governor of the BOJ announced that the Bank would continue
the ZIRP until ‘deflationary concern is dispelled’17,18
In August 2000, despite the request from the government to postpone the vote,19 the
‘[C]orporate and household sentiments remain cautious and private sector activities stagnant.
Prices are on a downward trend. Clear prospects for rebound of the economy have yet to emerge.
With respect to financial developments, tight conditions once observed in inter-bank transactions
and corporate funding have subsided. However, long-term interest rates have risen considerably, and
the yen has been appreciating against the dollar. Stock prices, on the whole, have been weak. Such
market developments could have an adverse impact on the future prospect of our economy.’ Ibid.
17
Bank of Japan, Sousai Teirei Kisha Kaiken Youshi (Outline of the regular interview by the
Governor) (made on 13 April 1999 and published on 14 April 1999) (available at: http://www.boj.
or.jp/announcements/press/kaiken_1999/kk9904a.htm/) (in Japanese).
18
Regarding this announcement, Professor Bernanke commented that ‘[a] problem with the
current BOJ policy, however, is its vagueness.’ Ben S Bernanke, ‘Japanese Monetary Policy: A Case
of Self-Induced Paralysis?’ in Ryoichi Mikitani and Adam S Posen (eds), Japan’s Financial Crisis
and Its Parallels to U.S. Experience, Special Report 13 (Washington, DC, Institute for International
Economics, 2000) at 149, 159.
19
The Policy Board rejected this request by a majority vote. Bank of Japan, On the Request

BOJ lifted the ZIRP and decided to ‘encourage the uncollateralized overnight call rate to
move on average around 0.25%’ with the view that ‘Japan’s economy has reached the stage
where deflationary concern has been dispelled.’20,21
Quantitative Easing Policy (QEP): 2001–06

In March 2001, the BOJ decided to change its primary target for money market operations
from the uncollateralized overnight call rate to the outstanding balance of the current
accounts at the BOJ and set consumer price index (CPI) guidelines for the duration of this
policy—‘[t]he new procedures for money market operations continue to be in place until
the consumer price index (excluding perishables, on a nationwide statistics) registers stably
a zero percent or an increase year on year.’22 This is called ‘Quantitative Easing Policy’
(QEP). This quantitative easing (QE) is often referred to as large-scale asset purchases
(LSAPs). It is a tool first deployed in 2001 by the BOJ, and then used more widely since
the financial crisis by the US Federal Reserve, European Central Bank and the Bank of
England.23
The BOJ retained this policy until March 2006 when it decided to change again the
target of money market operations back to the uncollateralized overnight call rate with a
view that the core CPI growth is expected to be positive and thus ‘the conditions laid out
in the commitment are fulfilled.’24
from the Government to Postpone the Vote (11 August 2000) (available at: http://www.boj.or.jp/en/
announcements/release_2000/k000811b.htm/). See supra note 6.
20
Bank of Japan, Change of the Guideline for Money Market Operations (11 August 2000)
(available at: http://www.boj.or.jp/en/announcements/release_2000/k000811.htm/).
21
For an explanation of the ZIRP and the transmission mechanism under it by one of the
Board members at that time, see Kazuo Ueda, ‘Japan’s Experience with Zero Interest Rates’ (2000)
32 Journal of Money, Credit and Banking 1107; Kazuo Ueda, ‘The transmission mechanism of
monetary policy near zero interest rates: the Japanese experience, 1998-2000’ in Lavan Mahadeva
and Peter Sinclair (eds), Monetary Transmission in Diverse Economies (Cambridge, Cambridge
University Press, 2002) at 127.
22
Bank of Japan, New Procedures for Money Market Operations and Monetary Easing (19
March 2001) (available at: http://www.boj.or.jp/en/announcements/release_2001/k010319a.htm/).
The BOJ’s assessment on the economy is as follows: ‘Japan’s economic recovery has recently
come to a pause after it slowed in late 2000 under the influence of a sharp downturn of the global
economy. Prices have been showing weak developments and there is concern about increase in
downward pressures on prices stemming from weak demand.’ Ibid.
23
See Arvind Krishnamurthy and Annette Vissing-Jorgensen, The Ins and Outs of LSAPs,
Federal Reserve Bank of Kansas City Symposium on Global Dimensions of Unconventional
Monetary Policy (2013) at 57, 57 (available at: https://www.kansascityfed.org/publicat/symp
os/2013/2013Krishnamurthy.pdf).
24
Bank of Japan, Change in the Guideline for Money Market Operations (9 March 2006)
(available at: http://www.boj.or.jp/en/announcements/release_2006/k060309.htm/).
More specifically, the BOJ had the following understanding: ‘Concerning prices, year-on-year
changes in the consumer price index turned positive. Meanwhile, the output gap is gradually
narrowing. Unit labor costs generally face weakening downward pressures as wages began to rise
amid productivity gains. Furthermore, firms and households are shifting up their expectations for
inflation. In this environment, year-on-year changes in the consumer price index are expected to
remain positive. The Bank, therefore, judged that the conditions laid out in the commitment are
fulfilled.’ Ibid.

Quantitative and Qualitative Monetary Easing (QQE): 2013–present

The BOJ decided to set the price stability target at two percent in terms of the year-on-year
rate of change in the CPI—‘Price Stability Target’—and to adopt the ‘Open-Ended Asset
Purchasing Method’ in January 2013.25 In order to achieve this target, the BOJ decided
to enter into ‘a new phase’ of monetary easing both in terms of quantity and quality in
April 2013; ‘[i]t will double the monetary base and the amounts outstanding of Japanese
government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more
than double the average remaining maturity of JGB purchases.’26 This is called the QQE.
On 29 January 2016, the BOJ decided to adopt ‘QQE with a Negative Interest Rate.’27
Effective 16 February 2016, the BOJ applies a negative interest rate of minus 0.1 percent to
a certain portion of the current accounts that financial institutions hold at the Bank.28,29
Theoretical aspects
Several significant features—which are common today among central banks in major
countries—had been observed earlier in Japan. The BOJ confronted the situation of ‘the
liquidity trap’ where the nominal interest rate became nearly zero and the central bank’s
conventional monetary policy had lost its effectiveness.30,31 As early as the late 1990s, the
25
Bank of Japan, Introduction of the ‘Price Stability Target’ and the ‘Open-Ended Asset
Purchasing Method’ (22 January 2013) (available at: http://www.boj.or.jp/en/announcements/rele
ase_2013/k130122a.pdf). Bank of Japan, The ‘Price Stability Target’ under the Framework for the
Conduct of Monetary Policy (22 January 2013) (available at: http://www.boj.or.jp/en/announce
ments/release_2013/k130122b.pdf).
26
Bank of Japan, Introduction of the ‘Quantitative and Qualitative Monetary Easing’ (4 April
2013) (available at: http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
27
Bank of Japan, supra note 13.
28
Ibid. More specifically, ‘the Bank will adopt a three-tier system in which the outstanding
balance of each financial institution’s current account at the Bank will be divided into three tiers, to
each of which a positive interest rate, a zero interest rate, or a negative interest rate will be applied,
respectively’. Ibid. For the details, see Bank of Japan, Framework for a Negative Interest Rate on
Current Accounts at the Bank (attachment of the same document, ibid.).
29
For ‘QQE with Yield Curve Control’ on 21 September 2016, the BOJ announced that ‘[t]he
new policy framework consists of two major components: the first is ‘yield curve control’ in which
the Bank will control short-term and long-term interest rates; and the second is an ‘inflation-
overshooting commitment’ in which the Bank commits itself to expanding the monetary base until
the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price
stability target of 2 percent and stays above the target in a stable manner.’ Bank of Japan, supra
note 14.
30
In this situation, standard Taylor-type feedback rules become inappropriate. See John
B Taylor, ‘Discretion versus policy rules in practice’ (1993) 39 Carnegie-Rochester Conference
Series on Public Policy 195; Paul R Krugman, ‘It’s Baaack: Japan’s Slump and the Return of
the Liquidity Trap’ 1998(2) Brookings Papers on Economic Activity 137. See also Jess Benhabib,
Stephanie Schmitt-Grohé and Martín Uribe, ‘Avoiding Liquidity Traps’ (2002) 110(3) Journal of
Political Economy 535; Lars EO Svensson, ‘Escaping from a Liquidity Trap and Deflation: The
Foolproof Way and Others’ (2003) 17(4) Journal of Economic Perspectives 145; Gauti B Eggertsson
and Michael Woodford, ‘The Zero Bound on Interest Rates and Optimal Monetary Policy’ 2003(1)
Brookings Papers on Economic Activity 139.
31
For recent theories by the BOJ economists, see Ippei Fujiwara, Tomoyuki Nakajima, Nao
Sudo and Yuki Teranishi, ‘Global liquidity trap’ (2013) 60 Journal of Monetary Economics 936
(considering the problem of optimal monetary policy in a two-country world where both countries

BOJ was put under pressure for inventing a tool to attain its monetary policy objective of
fighting deflation.
Academic studies submitted theoretical arguments to obtain a better understanding of
the transmission channels of monetary policy, and examined the optimal commitment by
the central bank.32 As a theoretical framework, however, the New Keynesian model was
influential during the late 1990s, and the model typically assumed that the ‘zero lower
bound’ was not a constraint on monetary policy.33 Subsequent studies thus endeavored
to generalize the specific situation and experiences in Japan, and develop a theoretical
framework for such generalization.34,35 Recently, new theories have been presented to
better explain the channels through which unconventional monetary policy affects asset
prices and the real economy.36
may fall into a liquidity trap simultaneously); Takushi Kurozumi, ‘Optimal sustainable monetary
policy’ (2008) 55 Journal of Monetary Economics 1277 (examining a policymaker’s strategy in the
best sustainable equilibrium as ‘optimal sustainable’ policy and showing that such a policy becomes
consistent with the optimal commitment policy in sufficiently later periods). See also Taehun
Jung, Yuki Teranishi and Tsutomu Watanabe, ‘Optimal Monetary Policy at the Zero-Interest-Rate
Bound’ (2005) 37 Journal of Money, Credit and Banking 813 (addressing a central bank’s intertem-
poral loss-minimization problem in which the non-negativity constraint on nominal interest rates
is considered in order to clarify what should central banks do when they face a weak aggregate
demand under the zero lower bound).
32
For the view of the BOJ economists, see Kunio Okina and Shigenori Shiratsuka, ‘Policy
commitment and expectation formation: Japan’s experience under zero interest rates’ (2004) 15
North American Journal of Economics and Finance 75 (analyzing the behavior of the yield curve and
examining the effectiveness and limitations of monetary policy commitment under zero interest
rate from March 1998 to February 2003). See also Hiroshi Fujiki, Kunio Okina and Shigenori
Shiratsuka, ‘Monetary Policy under Zero Interest Rate: Viewpoints of Central Bank Economists’
(2001) 19(1) Monetary and Economic Studies 89.
33
Richard Clarida, Jordi Galí and Mark Gertler, ‘The Science of Monetary Policy: A New
Keynesian Perspective’ (1999) 37 Journal of Economic Literature 1661, at 1702.
34
See, eg, Takeshi Kimura and Takushi Kurozumi, ‘Endogenous nominal rigidities and
monetary policy’ (2010) 57 Journal of Monetary Economics 1038 (considering the flatter Phillips
curve theoretically).
35
After the sub-prime loans crisis in the US that commenced in August 2007 and led to a
global financial crisis in 2008, unconventional monetary policy in the form of QE or LSAPs
has been deployed globally, first in a crisis time and then in ‘normal’ times. Correspondingly,
new models have been presented. See, eg, Mark Gertler and Peter Karadi, ‘A model of
unconventional monetary policy’ (2011) 58 Journal of Monetary Economics 17. See also Mark
Gertler and Peter Karadi, ‘QE 1 vs. 2 vs. 3 . . .: A Framework for Analyzing Large-Scale
Asset Purchases as a Monetary Policy Tool’ (2013) 9(1) International Journal of Central
Banking 5.
36
See, eg, Krishnamurthy and Vissing-Jorgensen, supra note 23 (pointing out three distinctive
channels of LSAPs’ operations in normal times: signaling, capital constraints and scarcity chan-
nels). See also Arvind Krishnamurthy and Annette Vissing-Jorgensen, ‘The Effects of Quantitative
Easing on Interest Rates: Channels and Implications for Policy’ 2011(Fall) Brookings Papers on
Economic Activity 215.

Empirical analyses
Empirical analyses on the BOJ’s monetary policy abound.37,38 We note that for the analysis
of monetary policy in Japan, there are peculiarities. In general, the Vector Autoregression
(VAR) methodology is popularly deployed for examining the effectiveness of a monetary
policy, and VAR in its standard form assumes that time-series data regarding the economy
have stationarity.39 In Japan, however, structural changes in the economy during the 1990s
probably made this condition unsatisfied.40
For this reason, empirical studies often adopted a research design other than VAR.41 For
37
Representative empirical studies include the following. Bennett T McCallum, ‘Japanese
Monetary Policy, 1991–2001’ (2003) 89(1) Federal Reserve Bank of Richmond Economic Quarterly
1; Shigeru Iwata and Shu Wu, ‘Estimating monetary policy effects when interest rates are close
to zero’ (2006) 53 Journal of Monetary Economics 1395 (estimating the effects of exogenous
monetary policy shocks under the zero lower bound in Japan in a nonlinear VAR for the period
from 1991 to 2001); Günter Coenen and Volker Wieland, ‘The zero-interest-rate bound and the
role of the exchange rate for monetary policy in Japan’ (2003) 50 Journal of Monetary Economics
1071 (quantifying the effect of the zero bound on stabilization performance in Japan from 1980 to
1998); Ryuzo Miyao, ‘The Effects of Monetary Policy in Japan’ (2002) 34 Journal of Money, Credit
and Banking 376 (analyzing the policy period from January 1975 to April 1998 with a recursive
VAR methodology); R Anton Braun and Etsuro Shioji, ‘Monetary Policy and the Term Structure
of Interest Rates in Japan’ (2006) 38 Journal of Money, Credit, and Banking 141 (finding that the
response of the yield curve depends on the maintained hypotheses, namely, the liquidity effect
maintained hypothesis and the costly price adjustment maintained hypothesis).
38
For recent empirical studies in Japan, see Kazuo Ueda, ‘The Effectiveness of Non-Traditional
Monetary Policy Measures: The Case of the Bank of Japan’ (2012) 63 The Japanese Economic
Review 1; Nobuyuki Oda and Kazuo Ueda, ‘The Effects of the Bank of Japan’s Zero Interest Rate
Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach’
(2007) 58 The Japanese Economic Review 303. For the analyses by the BOJ economists, see,
Naohiko Baba, Motoharu Nakashima, Yosuke Shigemi and Kazuo Ueda, ‘The Bank of Japan’s
Monetary Policy and Bank Risk Premiums in the Money Market’ (2006) 2(1) International Journal
of Central Banking 105 (by using the interest rates on negotiable certificates of deposit issued by
individual banks, showing that the levels of money market rates and the dispersion of rates across
banks fell to near zero during the BOJ’s ZIRP and QEP periods). See also Shigenori Shiratsuka,
‘Size and Composition of the Central Bank Balance Sheet: Revisiting Japan’s Experience of the
Quantitative Easing Policy’ (2010) 28 Monetary and Economic Studies 79.
39
For introduction to VAR, see James H Stock and Mark W Watson, ‘Vector Autoregressions’
(2001) 15(4) Journal of Economic Perspectives 101. For VAR in general, see Christopher A
Sims, ‘Macroeconomics and Reality’ (1980) 48 Econometrica 1; Lawrence J Christiano, Martin
Eichenbaum and Charles L Evans, ‘Monetary Policy Shocks: What Have We Learned and to What
End?’ in John B Taylor and Michael Woodford (eds), Handbook of Macroeconomics (Amsterdam,
Elsevier, 1999) 1A, 65.
40
See, eg, Tomoo Inoue and Tatsuyoshi Okimoto, ‘Were there structural breaks in the effects of
Japanese monetary policy? Re-evaluating policy effects of the lost decade’ (2008) 22 Journal of the
Japanese and International Economies 320 (employing block recursive structural VAR with Markov
Switching for modelling monetary policy and showing that a major break in Japan’s economy
happened around 1996).
41
It can also be possible to take this into account by adopting Marcov Switching Vector
Autoregressions (MSVAR). There are some empirical researches along these lines. See Fumio
Hayashi and Junko Koeda, ‘Exiting from QE’ (2014) NBER Working Paper, No 19938. See also
Inoue and Okimoto, supra note 40; Ippei Fujiwara, ‘Evaluating monetary policy when nominal
interest rates are almost zero’ (2006) 20 Journal of the Japanese and International Economies
434 (estimating three identified Markov Switching VAR models for the period from January

example, Professor Kazuo Ueda, using a non-VAR approach, examined unconventional

monetary policy measures by the BOJ during the period from 1999 to 2011, and pointed out
that many of those measures have moved asset prices in the expected direction, but most of
them failed to make yen (currency in Japan) weak.42 Furthermore, Professor Ueda pointed
out that although those measures had some effects on asset prices, they failed to stop the
deflationary trend in the Japanese economy.43 Also, Professors Arvind Krishnamurthy
and Annette Vissing-Jorgensen present an interesting explanation with a new theory and
evidence of the channels through which LSAPs affect asset prices and the real economy.44
4. Future Issues
We note two issues for future research and consideration. First, independence of the
central bank is more important where the central bank’s balance sheet is expanded
through implementing its unconventional monetary policy; such expansion is often made
by means of purchasing government bonds by the central bank. In this setting, the success
of monetary policy depends on the central bank’s credibility and the effectiveness of its
strategy regarding announcements and communications.45,46 Central bank independence
in the world of democracy would thus be more important than ever, and it must be
ensured legally and institutionally.47 How exactly the current legal and institutional setting
1985 to December 2003 and clarifying the less effectiveness of the BOJ’s monetary policy after
the structural break). For MSVAR, see James D Hamilton, ‘A New Approach to the Economic
Analysis of Nonstationary Time Series and the Business Cycle’ (1989) 57 Econometrica 357.
See also Hans-Martin Krolzig, Marcov-Switching Vector Autoregressions: Modelling, Statistical
Inference, and Application to Business Cycle Analysis (Berlin, Springer, 1997).
42
Ueda, supra note 38, at 9–17.
43
Ibid, at 18–21.
44
Krishnamurthy and Vissing-Jorgensen, supra note 23.
45
Under the recent new framework for Monetary Policy Meetings, the BOJ ‘will provide, with
higher frequency, more detailed forecasts for Japan’s economy and prices, which serve as the basis
of policy decisions.’ More specifically, this includes; ‘(1) forecasts for the economy and prices are
released on a quarterly basis, (2) meetings on monetary policy are held eight times a year, that
is, four meetings for forecasts and four other meetings in between them, and (3) a summary of
discussion at each MPM is released quickly’ as widely adopted by major central banks. Bank of
Japan, supra note 7.
46
See, eg, Alan S Blinder, Michael Ehrmann, Marcel Fratzscher, Jakob De Haan and
David-Jan Jansen, ‘Central Bank Communication and Monetary Policy: A Survey of Theory
and Evidence’ (2008) 46 Journal of Economic Literature 910. See also, Ippei Fujiwara, ‘Is the
central bank’s publication of economic forecasts influential?’ (2005) 89 Economics Letters 255
(showing that while a central bank’s economic forecasts are not significantly influenced by those of
professional forecasters, the latter are notably affected by the former); Kozo Ueda, ‘Central Bank
Communication and Multiple Equilibria’ (2010) 6(3) International Journal of Central Banking 145
(constructing a model for communications between a central bank and money-market traders, and
found that too-much transparency in central banks is not desirable); Yoshiyuki Nakazono and
Kozo Ueda, ‘Policy commitment and market expectations: Lessons learned from survey based
evidence under Japan’s quantitative easing policy’ (2013) 25–26 Japan and the World Economy 102
(by using individual survey data on interest rate and inflation expectations, the authors estimated
the effects of the BOJ’s policy commitment on market expectations by focusing on the QEP).
47
For a traditional perspective, see Alan S Blinder, ‘Central Banking in a Democracy’ (1996)
82(4) Federal Reserve Bank of Richmond Economic Quarterly 1. See also supra note 8.

for the BOJ under the BOJ’s Act affects the BOJ’s unconventional monetary policy has
not been studied in much depth yet and waits for future research.
Second, despite the vast amount of empirical studies, the transmission mechanism
of announcements by a central bank and how they affect expectations in the market
place have not been sufficiently clear. Accordingly, these should also be considered in
the future.
IV. PRUDENTIAL POLICY: ON-SITE EXAMINATIONS BY THE

BOJ48
The BOJ carries out a prudential policy which has a unique aspect in developed countries.
Specifically, the BOJ undertakes examinations of financial institutions, and checks their
business operations and the state of their assets by visiting their premises. However, the
power to conduct on-site examinations is not explicitly provided in the 1997 Act, and
they are done on the basis of contracts between the BOJ and each financial institution.
Literature regarding the BOJ’s on-site examinations is scarce.
1. An Overview of On-site Examinations
In Japan, regulatory power over financial institutions is given to the government, and for
most financial institutions, the Financial Services Agency (FSA) is the national regulator.
Prudential policy in Japan thus is implemented by both the FSA and the BOJ.
The FSA’s supervisory powers (including inspections) are based on the Banking Act
(Act No 59 of 1981) and other laws. As a regulatory authority, the FSA exercises power
to carry out on-site inspections and to make mandatory requests for financial institutions
to provide materials.
In contrast, on-site examinations by the BOJ have been based on private contracts
(known as ‘on-site examinations agreement[s]’)49 between the BOJ and its counterparty
financial institutions since their inception as early as 1928.50 Accordingly, the BOJ
obtains consent of the financial institutions from phase to phase in carrying out on-site
examinations. There was no explicit provision regarding this under the old BOJ Act, but
the new BOJ Act in 1997 introduced Article 44 (see subsection ‘Stability of financial
system’ above).51
48
This section is based on Toshiaki Yamanaka, ‘On-site Examinations by the Bank of Japan:
Recent research development and future issues’ (2011) 33 Kinyu Kozo Kenkyu 1. For an official
explanation of on-site examinations by the BOJ, see Institute for Monetary and Economic Studies,
Bank of Japan, supra note 3, at 160–72.
49
The model of this ‘on-site examinations agreement’ [hereinafter, referred to as ‘the
Agreement’] was determined in February 1998 (available at: http://www.boj.or.jp/en/finsys/exam_
monit/kei01.pdf).
50
See Yamanaka, supra note 48, at 3 and 10 (note 8).
51
Before Article 44 was introduced, on-site examinations had been understood as based on a
general provision under the old BOJ Act.

2. Legal Framework and Enforcement
Under the on-site examinations agreement (‘the Agreement’), two steps must be taken
before on-site examinations are conducted. First, the BOJ must make an offer to
the financial institution; ‘[i]n the event that it deems it necessary to conduct on-site
examinations of the Financial Institution, the BOJ shall first present the objectives, scope
and dates of the on-site examinations to the Financial Institution, and ask for its consent
thereto.’ (Article 3(1) of the Agreement). Second, the financial institution must respond
to the offer; ‘[u]pon receipt of the offer from the BOJ to conduct the on-site examinations
pursuant to the preceding Article, the Financial Institution shall respond to the BOJ as to
its consent or refusal in a timely manner.’ (Article 4(1) of the Agreement).
In the course of the on-site examinations, the BOJ has the right to request information
from the financial institution; ‘[i]n the course of the on-site examinations the BOJ
may request the Financial Institution to explain its business operations and financial
condition in order to achieve the objectives of the on-site examinations.’ (Article 8(1)
of the Agreement). The financial institutions may refuse to provide information if
there is a ‘legitimate reason’; ‘[t]he Financial Institution may refuse the provision of
information pursuant to Article 8 or Article 9 for legitimate reasons.’ (Article 10 of
the Agreement).52
Where a breach of obligations by the financial institution is found, the BOJ may take
two actions. First, the BOJ may publicly announce the breach, which includes the breach
of the obligation to provide information (Article 13(1) of the Agreement).53 Second, the
BOJ may terminate its current account deposit relationship with the financial institution
in the event that the financial institution breaches the obligation to provide information
or other obligations (Article 19(2) of Touza Kanjo Kitei (‘Current-account Agreement’)54
and Article 13(3) of the Agreement).55
3. Future Issues
In the above, we have briefly introduced core legal aspects of on-site examinations by the
BOJ.56 We note three issues for future consideration.
52
The notion ‘legitimate reason’ may be unclear. ‘In such circumstances, the Financial
Institution shall consult with the BOJ in the event that the BOJ requests consultation with the
Financial Institution regarding other applicable methods, etc. in lieu of the said provision of
information.’ (Article 10 of the Agreement).
53
In practice, 13 cases were published by the BOJ for the period from 1 April 1998 to 4
December 2017. Bank of Japan, Kousa Kinyu Kikan Keiei (available at: http://www.boj.or.jp/fin
sys/exam_monit/index.htm/) (in Japanese).
54
Bank of Japan, Touza Kanjo Kitei (available at: http://www.boj.or.jp/paym/torihiki/touyo
08.htm/) (in Japanese).
55
The right to publish the fact that the BOJ terminated current account deposits on the basis
of the breach of the Agreement is not stipulated in the Agreement.
56
There are other aspects of on-site examinations. The BOJ started publishing ‘On-site
Examination Policy’ at around the end of every previous fiscal year from 1999—the initial title
used to be ‘Principles for On-site Examination and Off-site Monitoring’ for Fiscal 1999 and
Fiscal 2000. Bank of Japan, ‘On-Site Examination Policy’ (available at: https://www.boj.or.jp/en/

First, in theory, the wisdom that the BOJ—or central banks generally—carry out
prudential policy is not entirely clear.57 Second, in the same vein, it is important to clarify
the essential role and functions of on-site examinations, in connection with the lender
of last resort and/or their macroprudential function. Finally, power to undertake on-site
examinations should be recognized by statute rather than by contract.58
V. CONCLUSION
World financial markets today are in a state of flux. As a result, the environment sur-
rounding central banks changes constantly. The activities and functions of central banks
around the world are highly contingent on their historical, political and macroeconomic
landscape.
Professor Raghuram Rajan, former Governor of the Reserve Bank of India, stated:
Political economy is embedded in everything we do, though much of our work is based on a
technical framework, with models, forecasts and a very specific mandate. I’ll argue that there is
a reason for our techno-centric emphasis, but the reality of central banking is that our historical
experience, as well as the current political environment, does influence the emphasis we place on
various aspects of our framework.59
How legal and institutional settings for the central bank and its governance structure
interact with the bank’s monetary policy and on-site examinations in Japan as well as
in other regions continues to be a meaningful academic inquiry, and calls for further
research.
finsys/exam_monit/exampolicy/index.htm/). These contributed to transparency regarding on-site

examinations under the 1997 Act.
57
Discussions abound on this issue. See Central bank governance, supra note 8; Charles AE
Goodhart, The Regulatory Response to the Financial Crisis (Cheltenham and Northampton MA,
Edward Elgar, 2009) at 34–44; Monetary Law, supra note 5, at 111–146. More recently, see, eg,
Stephen G Cecchetti, ‘On the separation of monetary and prudential policy: How much of the
precrisis consensus remains?’ (2016) 66 Journal of International Money and Finance 157 (showing
that the pre-crisis consensus—monetary policymakers and prudential authorities had clearly
defined tools and goals with little or no conflict—remains largely intact after the financial crisis).
58
See Kanda, supra note 3, at 21–22.
59
Raghuram Rajan, Remarks at the Jackson Hole Economic Policy Symposium, Federal Re-
serve Bank of Kansas City (29 August 2015) (available at: https://www.kansascityfed.org/~/media/
files/publicat/sympos/2015/econsymposium-rajan-remarks.pdf ?la5en) (also available at: https://
www.kansascityfed.org/~/media/files/publicat/sympos/2015/2015rajan.pdf ?la5en).

5. Reserve Bank of India* 60
Raj Bhala** 61
I. RESERVE BANK OF INDIA IN PRE- AND POST-PARTITION

INDIA
1. Reserve Bank of India Act, 1934
Essential to an efficient capitalist banking is a defined, respected system of Contract

and Property Law. India had such a system in ancient times, with an oral agreement
being a matter of individual and social honor, and a clear separation of private and
public property, and proscriptions against arbitrary seizure of private property by a
* This chapter forms part of a larger book project, Business Law of Modern India, to be
published by Carolina Academic Press, and will appear in that forthcoming book. Like the book,
the present chapter draws on sources from India, thus introducing and highlighting the work of
Indian legal scholars and practitioners. In other words, the article and book rely on what Indians
say about their legal system. Their voice generally has been neglected in the American legal
academy.
This chapter draws principally on the following sources from India and/or by Indian authors:
(1) Dr RK Bangia, Banking Law & Negotiable Instruments Act (New Delhi: Allahabad Law
Agency Publishers, 5th edition, 2013). [Hereinafter, Bangia.]
(2) Rahul Saraogi, Investing in India: A Value Investor’s Guide to the Biggest Untapped
Opportunity in the World (Hoboken, New Jersey: John Wiley & Sons, Wiley Finance Series:
2014). [Hereinafter, Saraogi.]
(3) ML Tannan, Tannan’s Banking Law (Gurgaon: LexisNexis, 1st student edition, 2015).
[Hereinafter, Tannan.]
(4) The Reserve Bank of India, Volume 4, Parts A and B, 1981–1997 (New Delhi: Academic
Foundation, 2013). [Hereinafter, The RBI.]
(5) Supreme Court of India Cases concerning the Reserve Bank of India. (Cited below.)
To be sure, working with these sources is not always easy, whether getting them or interpreting
them properly. Further, their quality is uneven. Some do little more than regurgitate Indian statutes
and cases, while others provide helpful insights and analysis. Additionally, this chapter draws on
an earlier piece, Raj Bhala, ‘Design and Challenges of Banking and Foreign Exchange Regulation
in India’ (2015) 16 Asian Business Lawyer 27–72. Of course, I am responsible for any errors or
omissions.
** Associate Dean for International and Comparative Law, Rice Distinguished Professor, The
University of Kansas, School of Law, Lawrence, Kansas, USA International Legal Consultant,
The Al Ammari Law Firm, Bahrain and Saudi Arabia, in association with Blake, Cassels
& Graydon LLP, Canada, https://en.wikipedia.org/wiki/Raj_Bhala. Author, TPP Objectively:
Law, Economics, and National Security of History’s Largest, Longest FTA (Carolina Academic
Press, 2016); International Trade Law: An Interdisciplinary, Non-Western Textbook (2 volumes,
LexisNexis, 3rd edn, 2015); Modern GATT Law (2 volumes, Thomson Sweet & Maxwell, 2013);
Trade, Development, and Social Justice (Carolina Academic Press, 2003); Understanding Islamic
Law Sharī‘a (LexisNexis, 2nd edn, 2016). Monthly columnist, BloombergQuint (India), http://
www.bloombergquint.com/.
68

Reserve Bank of India 69
government.1 Thus, when British Colonialists came to India with English Contract
Property Law concepts, they found a receptive venue, one fertile for modern bank-
ing. They introduced features of modern banking to India, and the Reserve Bank
of India (RBI)—India’s Central Bank and bank regulator—was established through
colonial-era legislation.2 It has remained in that position after the 15 August 1947
British Partition of India.
The key legislation establishing the RBI is the Reserve Bank of India Act, 1934. The
Act (with all its post-1934 amendments) spans 92 pages, five Chapters, 58 Sections and
two Schedules.3 The RBI has provided stability in the banking system across decades
characterized by domestic and international booms and busts.4 At times the RBI has been
excessively conservative, yet it rightly wins high (if a bit exaggerated) praise:
The RBI is like a clean lotus growing in the muck of India’s politics and bureaucracy. It is a
spotless organization that is completely meritocratic and professional and does not experience
corruption at any level.5
Recently, especially since the early 1980s, however, it has pushed for modernization and
liberalization.
2. Core RBI Functions
The core functions of the RBI are:6
(1) Note issuing authority

(2) Purchase and rediscounting of notes and bills
(3) Serve as Bank to the government
(4) Serve as Bank to the banks
(5) Regulate banks.7
The first two functions involve standard monetary policy matters. So, too, does the third
one, which also implicates standard fiscal policy implementation, namely, government
expenditures and taxation. The fourth and fifth functions involve quintessential bank
regulatory matters.
In defining and elaborating these functions, a second key statute is the Banking
1
The Buddhist Story of Anathapindika’s Monastery and Jeta’s Gove. (Anathapindika being
the wealthy merchant who paid most, but not all of Prince Jeta’s price in gold coins to cover
the garden in preparation for Buddha and the Sangha, with the Prince forgiving the remainder,
illustrates the points about contract negotiation and performance, and individual versus collective
property rights, along with debt forgiveness for a special reason.) Saraogi, Case Study: Prince Jeta’s
Grove, at 83.
2
Saraogi, at 82; Tannan, at 2–8.
3
Bangia, at 425–33.
4
Saraogi, at 91.
5
Saraogi, at 92.
6
Bangia, at 3–10; Tannan, at 13–14, 77–152, 153–67.
7
See Sajjan Bank (Private) Ltd v Reserve Bank of India, All India Reports 1961 Mad 8.

Regulation Act, 1949. One notable feature of the 1949 Act is its proscription on Islamic
banking. The Act requires payment of interest on deposits, and forbids banks from taking
an ownership interest in commercial assets.8 Consequently, Islamic financial instruments
are forbidden: payment of interest would constitute ribā (under a strict definition of that
term), and ownership interests in assets are associated with legal fiction (h.iyal) devices,
particularly murā bah.a (cost-plus pricing).
Recently, there have been calls to remove this proscription. Doing so might attract
significant capital from the Persian Gulf, which seeks Sharī‘a-compliant vehicles, and
which could help finance India’s US $1 trillion dollar need for infrastructure development.
3. Statutory Liquidity and Capital Adequacy Ratios
In respect of the fifth function, one of the most important rules in Indian Banking Law
concerning the RBI’s core function to regulate banks is the Statutory Liquidity Ratio, or
‘SLR’. To understand the SLR, it is necessary first to understand basic points about the
balance sheet of a bank, and another—equally important—regulatory tool, the Capital
Adequacy Ratio (‘CAR’).
On the balance sheet of any bank, the following equation holds true: Assets5 Liabilities
+ Capital. A bank puts its liabilities to work by buying assets. So, when a depositor puts
funds in a bank, those funds are a current liability of the bank. The bank must pay the
depositor the funds if and when the depositor seeks to withdraw them. Because Assets
must balance with Liabilities plus Capital, and because a deposit does not affect Capital
directly, the bank must make a corresponding entry on the Asset side of its ledger (or ‘T
account’, or ‘books’) to match the deposit liability. ‘Cash’ is the corresponding entry. In
sum, ‘Liabilities’ are what a bank owes to others. ‘Assets’ are what others owe to the bank.
What, then is ‘Capital’?
Regulators are concerned that banks operate on a safe, sound basis. Suppose the value
of a bank’s assets falls. That could occur because the portfolio of the bank falls in value.
That portfolio might consist of investment securities, such as government treasuries,
corporate bonds, stocks, derivatives (eg, forwards, futures, options and swaps), and for-
eign exchange. The trigger event could be idiosyncratic problems with the issuer of those
securities, deteriorating national or regional market conditions, or a global crisis. Indeed,
a problem with an issuer can create systemic risk and lead to a cross-border debacle, as
the problem of debt issued by the government of Greece showed in the summer of 2015.
Holders of that debt, which included banks across many countries, worried they might
never get paid full value (‘100 cents on the dollar’), as Greek public sector finances were
in such poor shape the government could not easily make timely payment of principal
and interest.
Capital is the cushion to absorb such losses. ‘Capital’ consists of the safest of all
financial vehicles: cash (such as retained earnings), and other cash-like instruments.
Thus, one tool of bank regulators to promote safety and soundness is a Capital
Adequacy Requirement.
Essentially, using a formula that involves a percentage of the assets of the bank, the
8
Tannan, at 60–68; Canara Bank v PRN Upadhyaya & Ors, 6 SCC 526 (1998).

regulator requires banks to maintain a certain amount of capital. For example, a simple
formula would be to require a bank to maintain eight per cent of the value of its assets
as capital. More complex formulas take account of the market reality that not all assets
are equally risky, so it is reasonable to demand higher capital against high-risk assets (eg,
derivatives), and lower capital against low-risk assets (eg, letters of credit). Such formulas
are ‘risk weighted’, hence the term ‘risk adjusted CAR’.
The Basel Committee on Banking Supervision (headquartered in Basel, Switzerland)
has published three versions of CARs. Beginning in July 1988, it championed a
straightforward eight percent risk-weighted Ratio, called ‘Basel I’. Later, in the mid-1990s,
it allowed banks to value the risk of their asset portfolios using computer models that
banks devised. The new ratio, Basel II, was known as a ‘Value at Risk’ (‘VAR’) way of
setting the CAR. However, financial crises thereafter suggested the VAR models were
not as effective in capturing accurately the risk in the asset portfolios of banks. Indeed,
some of those models were self-serving, as banks tend to prefer low capital requirements.
They do not want to tie up cash and other cash-like equivalents as capital. So, especially
following the 2008 global financial crisis, the Basel Committee proceeded with Basel III’.
India has generally followed the Basel CAR requirements. In contrast, the SLR is not
a Basel-driven mandate or recommendation. The RBI views the SLR as another, equally
important, safety and soundness requirement. What distinguishes it from a CAR is that
it is based on the liabilities, not assets, of a bank, and as its name suggests, its purpose
is to assure a bank has sufficient liquid assets to cover liabilities. For example, suppose
(as occurs during many banking crises, including the summer 2015 Greek crisis), a bank
experiences a ‘run’, meaning that depositors queue up to withdraw their funds. Does the
bank have sufficient cash to meet depositor withdrawal demands?
The SLR is an answer to this question. The RBI requires banks to maintain a percent-
age of their deposits and other liabilities in the form of government securities, gold, or
both. The figure, which the RBI sets, has varied over time, from 20 percent to 38 percent
of liabilities.9 (In 2014, it was 23 percent.)
Is assurance of adequate liquidity the only policy rationale for the SLR? The answer is
no. In truth, the government of India benefits from the SLR.10 By defining government
securities as an acceptable way to meet the SLR, the government effectively enhances
the market for buyers of those securities—namely, by requiring banks to buy them.
That means India can fund its fiscal deficits by issuing securities, knowing banks must
buy those securities to meet the SLR rule. Much of India’s budget deficits are financed
not by international portfolio investors, which may be skeptical of the risks associated
with Indian securities and thus demand higher interest rates, but by the captive domestic
audience the RBI enjoys.
Yet, the benefit to the Indian government comes at a cost to the banks.11 First, the
banks must dedicate more of their treasury operations to investing in official bonds than
they otherwise might.
Second, the SLR is an artificial incentive to invest, and possibly over-invest, in
9
Saraogi, at 85.
10
Ibid at 85.
11
Ibid at 85.

government securities. If allowed to operate on free market principles, banks might prefer
a more diverse portfolio. When properly managed, banks match their assets and liabilities
in terms of (1) interest rate risk, (2) maturity risk and (3) currency risk. No bank wants
significant mismatches, for example, assets consisting of fixed rate, long-term and/or
rupee ( or Rs) denominated instruments, as against liabilities comprised of floating rate,
short-term and/or dollar-denominated instruments. But, the SLR compels banks to buy
Indian government bonds, thus not only exacerbating their interest rate risk, but also the
chances of balance sheet mismatches.
II. RBI AND PAYMENTS SYSTEM REGULATION

1. Bank-driven Computerization
Starting in the late 1980s, the RBI encouraged—indeed, mandated—computerization of

banking. That was a natural evolution of its mandate in the early 1980s that all banks
use Magnetic Ink Character Recognition (MICR) technology on their checks, so as to
improve security and accelerate check clearing.
The RBI also pushed the introduction of ATMs.12 There are 120,000 of them (as of
2014), up from 16,000 in 2005. This strong growth is a consequence of another RBI
mandate: in 2007, the RBI forbade banks from charging a usage fee on their ATMs when
a customer uses a debit card from another bank (up to the first five transactions in a
month), and no ATM usage fee could exceed 20 rupees. Demand for ATM services surged.
The success also is a result of the RBI allowing third party firms to operate ATMs and
earn a fee therefrom, in effect allowing out-sourcing of ATMs to non-bank operators.
Such ATMs are called ‘white label ATMs’, and because they are often in rural areas, they
help advance financial inclusion.
Computerization is essential for electronic payments, of course, and thus to move India
away from its overwhelming dependence on cash payments. Thus, in 2007, India enacted
the Payments Act, which governs electronic payments. In keeping with other aspects of
Indian banking law and regulation, the drive was bank-led, meaning banks were and con-
tinue to be the primary players in computerization. That makes sense, ie, to work through
the existing infrastructure, given the enormous number and array of banks in India, but
to leverage off of it and allow for branchless banking using information technology (IT).
2. RTGS
Further, the RBI spearheaded the innovation of two nationwide electronic payment
systems.13 One is called ‘Real Time Gross Settlement System’ (RTGS), which is for high-
value transactions between banks in real time. The other, ‘National Electronic Funds
Transfer System’ (NEFT), is for small-value payments (less than 200,000 rupees), which
processes payments in hourly batches.
12
Saraogi, at 92–93; Tannan, at 153–67.
13
Saraogi, at 92–93; Tannan, at 153–67.

Electronic payments systems like RTGS and NEFT are vital pillars for a modern finan-
cial system to support efficient, secure, clearing and settlement of underlying transactions
in goods, services and investments. No developed country lacks such systems. The RBI
has promoted usage of RTGS and NEFT by compelling banks to cut their usage charges
(akin to its strategy to bolster demand for ATM services). Still, RTGS are almost by
definition financially exclusive: the rich have the money to use them, so they have little to
do with the poor. Even access to the NEFT presumes a considerable amount of wealth.
3. 2007 Payments Act, Mobile Banking and Mobile Payments
To what extent do they have access to the payments system? To be sure, cash settlement
is the dominant payment system in India. Still, the RBI created the National Payments
Corporation of India (NPCI) to consolidate India’s multiple retail payments systems
into a single, nation-wide one with standardized procedures.14 The NPCI developed an
‘Immediate Payments Service’ (IMPS) that allows a bank account holder to transfer
funds right away from one account to another. The NPCI operates a ‘National Unified
USSD Platform’ whereby a bank customer can input a USSD code on her mobile device
and instantly check her balances and transfers.15 This Platform cuts across all telecom-
munications carriers, linking all of them to the mobile banking services of any bank. Of
course, usage of the IMPS and USSD code presumes an individual holds an account.
Moreover, in May 2014, the NPCI created the RuPay card (discussed below) as a vehicle
to make domestic payments across banks and non-bank financial institutions, that is, an
inter-operable card. The government has provided over-draft protection.
Under the 2007 Payments Act, and regulations specific to each, both ‘mobile banking’
and ‘mobile wallets’ are permitted.16 ‘Mobile banking’ is a generic term covering any
system that allows a customer of a financial institution to engage in financial transac-
tions using a mobile device, typically a mobile phone or tablet.17 Though mobile banking
presumes an individual has a bank account, it can facilitate access to the banking system
of the poor and marginalized, who may not have easy, everyday access to physical banks:
their transactions costs are lower by using a mobile phone to make and receive payments,
or deposit, withdraw or transfer funds. Moreover, there is a diverse array of mobile pay-
ments systems. Not all are bank-centric, meaning that third-party entities (eg, Google,
PayPal, or a telecommunications company that serves as the mobile operator) may
14
2015 Brookings Financial Inclusion Project Report, at 62.
15
16
2015 Brookings Financial Inclusion Project Report, at 61 (quoting International Finance
Corporation, IFC Mobile Money Scoping Country Report: India, 8 (June 2013), available at http://
www.ifc.org/wps/wcm/connect/49a11580407b921190f790cdd0ee9c33/India+Scoping+report+06301
3+for+publication. pdf ?MOD5AJPERES [hereinafter, 2013 IFC Mobile Money India Report].
17
Wikipedia, Mobile Banking, available at https://en.wikipedia.org/wiki/Mobile_banking. As
of 2012, the top five countries in terms of mobile banking usage (the percentage of people who
used mobile banking, other than via SMS) are South Korea (47 percent), China (42 percent), Hong
Kong (41 percent), Singapore (38 percent), and India (35 percent). The United States ranked 7th
(32 percent). Ibid. For a bank to offer mobile banking on any kind of mobile phone or tablet,
that is, inter-operability, which is secure against cyber-crime, available on a 24x7x365 basis, and
personalizes services, is technically challenging.

provide the service, notwithstanding the existence of a relationship between an individual

payor/payee and a bank.
Indeed, whether such a relationship must exist is a legal question: depending on the
nature of the mobile transaction, a full account may be required. That is the case in India
with respect to a full service mobile money account from which the account holder can
make withdrawals. RBI regulations consider this account to be akin to a normal physical
account, and thus require the customer to deposit funds in a normal account, before using
mobile services associated with that account.
The terms ‘mobile wallet’, ‘mobile money’, ‘mobile money transfer’ or ‘mobile pay-
ment’ are synonymous, and refer to a specific type of mobile banking, namely, paying for
goods or services using a mobile device (again, typically a mobile phone or tablet), rather
than using cash, a check, or a credit or debit card.18 Indian law treats a ‘mobile wallet’ as
a pre-paid payment instrument.19 Mobile wallet transactions are limited to transferring
funds from one mobile phone to another (assuming both phones use the same telecom-
munications operator network), supplement pre-paid mobile phone air time, and pay
utility bills.20
There are at least three legal impediments to expanding mobile banking and mobile
payments services to the under-banked and unbanked in India.21 First, because the Indian
model is bank-led, non-bank entities such as telecommunications companies either
cannot provide services for which there otherwise would be a demand, or they can do so
only under unappealing constraints. For example, they cannot contract with third party
agents of their choice. Second, regulations applying to bank and non-bank entities are not
harmonized. Different rules may apply to the same type of mobile banking or mobile pay-
ment transaction, not based on economic logic, but simply on the nature of the provider.
Those differences may create an un-level playing field. Third, the financial incentives to
provide services may be limited. For instance, interest cannot be paid on funds stored in
an electronic wallet (‘e wallet’). Consequently, customers have an incentive to keep e wallet
balances low, which in turn means the scale of mobile wallets—from the perspective of the
provider—is small. In turn, the provider cannot realize economies of scale, ie, declining
costs with rising balances and transaction values, precisely because they remain small.
4. Small Banks, Payments Banks and Banking Correspondents
Perhaps to mitigate in part these concerns, in 2014, the RBI liberalized rules regarding
entities that could provide payments facilities, namely, by publishing guidelines allowing
‘small banks’ and ‘payments banks’ to be established to offer deposit accounts and serve
18
Wikipedia, Mobile Payment, available at https://en.wikipedia.org/wiki/Mobile_payment.
19
Reserve Bank of India, Master Circular – Policy Guidelines on Issuance and Operation of Pre-
paid Payment Instruments in India (1 July 2014, updated 3 December 2014), available at https://www.
rbi.org.in/scripts/NotificationUser.aspx?Id58993&Mode50; National Payments Corporation of
India, (undated), available at http://www.npci.org.in/pro_over.aspx.
20
21
2015 Brookings Financial Inclusion Project Report, at 59 (quoting 2013 IFC Mobile Money
India Report, 36, and Leo Mirani, ‘Why Mobile Money Has Failed to Take Off in India’ Quartz, 20
June 2014, available at http://qz.com/222964/why-mobile-money-has-failed-to-take-off-in-india/).

as payments platforms.22 The rubrics are indicative of the difference between these two
types of entities.23 A ‘small bank’ may offer a wide range of services, including taking
deposits in different kinds of accounts, and lending. But, it is limited to a particular
geographic area. In contrast, a ‘payments bank’ may operate nationwide, including in
remote areas, via its own branch network or networks of other financial institutions, or
through Business Correspondents (BCs). But, it is limited in the range of products it may
offer, namely, to accepting demand deposits and remitting funds. EKO is an example of
a BC: it is a financial services company providing mobile services.
Contemporaneously, the RBI also struck out its own rule that any banking correspond-
ent be located within 30 kilometers of a bank branch. As a result, small and payments
banks can provide such platforms, in competition with Government Owned Banks
(GOBs), which have extensive branch networks. In turn, they can provide access to the
payments system to the poor. Whether this move, along with newly licensed payments
banks and small banks, will alter significantly the cash-based settlement system used by
India’s poor, remains to be seen.
However, within the framework of bank-led infrastructure, it is clear the RBI is trying to
develop BCs as instruments of financial inclusion. A ‘BC’ is defined by the International
Finance Corporation (IFC) of the World Bank as a ‘representative authorized to offer
services such as cash transactions where the lender does not have a branch.’24 In effect,
they are in a legal agency relationship with a principal. In India, a BC may own or enter
into a contract with a so-called ‘customer service point’. That ‘point’ is a retail unit, or
individual, which or who ‘collect[s] account opening documentation, offer[s] cash-in/
cash-out services, and receive[s] payments.’25
That is, RBI regulations allow BCs to receive deposits, make small loans, offer
third-party mutual and pension funds, and micro-insurance, funds and pensions, and
provide small-value remittance services.26 BCs receive a one-time fee when they open an
account on behalf of a bank, and are compensated for transactional services they provide.
What types of entities can be a BC? In the interests of financial inclusion, the answer
has expanded. Initially in 2006, the RBI permitted a (1) NBFC that does not take deposits,
(2) non-governmental organization (NGO) or a microfinance institution (MFI) that was
registered under the applicable Societies Act or Trusts Act, and (3) post office. In 2009,
the RBI issued a Circular adding the following:
22
2015 Brookings Financial Inclusion Project Report 62–63 (citing Rishabh Khosla and
Vikas Raj, ‘The Implications of India’s 2014 Budget for Financial Inclusion’, Center for Financial
Inclusion Blog, 24 July 2014, available at http://cfi-blog.org/2014/07/24/ the-implications-of-indias-
2014-budget-for-financial-inclusion/; Kumar E Sharma, ‘PM Narendra Modi Kicks Off Phase 1
of Financial Inclusion Program on Independence Day’ Business Today, 16 August 2014, available
at http://businesstoday.intoday.in/story/pm-narendra-modi-financial-inclusion-drive-independen
ce-day/1/209251.html).
23
Press Release, Reserve Bank of India, RBI Releases Draft Guidelines for Licensing of
Payments Banks and Small Banks, 17 July 2014, available at http://rbi.org.in/scripts/BS_PressRel
easeDisplay.aspx?prid531646.
24
2014 World Bank, Global Financial Development Report 2014, at 58–59.
25
2015 Brookings Financial Inclusion Project Report, at 59 (quoting 2013 IFC India Mobile
Money Report 32).
26
Ibid (quoting 2013 IFC India Mobile Money Report, 36).

(i) Individual kirana/medical/fair price shop owners; (ii) Individual Public Call Office (PCO)
operators; (iii) Agents of Small Savings schemes of Government of India/Insurance Companies;
(iv) Individuals who own Petrol Pumps; (v) Retired teachers; and (vi) Authorized functionaries
of well-run Self Help Groups (SHGs) linked to banks.27
In 2010, the RBI permitted any bank to engage an individual as a BC, as long as the
bank performed due diligence and put in place appropriate safeguards.28 In 2014, the RBI
allowed all NBFCs (regardless of whether they take deposits) to be a BC.29
These progressive liberalizations by the RBI have created a hodgepodge of entities that
can be BCs. But, the rationale seems to be that no one type of entity, nor a small handful
of types, can serve India’s vast population and territory. Put simply, the RBI has created
a system of branchless banking by using India’s existing array of diverse entities and
individual entrepreneurs.
5. November–December 2016 Demonetization Crisis
In November 2016, the Government of India demonetized all large denomination bank
notes in the ‘Mahatma Gandhi Series’.30 The affected rupee notes were 500 (roughly
US $7.40) and 1,000 (US $15), and accounted for 86 percent of the cash in circulation.
These notes were used by terrorists, narcotics and human traffickers, counterfeiters, in
prostitution and child labor rackets, in the black market economy (which itself accounts
for upward of 20 percent of India’s GDP), and to avoid taxation.31 Hence the purpose
for declaring them no longer to be legal tender—fighting illegal activities, and bringing
transactions into the open transparent economy—was laudable. But, the demonetization
came without warning. So, ‘the most cash-dependent country in the world — suddenly
found itself without enough cash to run its economy.’32
Prime Minister Narendra Modi announced it in an unscheduled television address at
10 pm Indian Standard Time (IST) on the evening of 8 November.33 Indians had just
two hours—until midnight—to use their 500 and 1,000 rupee notes, or exchange them by
27
Reserve Bank of India, Circular on Financial Inclusion by Extension of Banking Services –
Use of Business Correspondents, 30 November 2009, available at http://www.bu.edu/bucflp/
files/2012/01/Circular-on-Financial-Inclusion-by-Extension-of-Banking-Services-Use-of-Business-
Correspondents.pdf.
28
Reserve Bank of India, Circular on Financial Inclusion by Extension of Banking Services – Use
of Business Correspondents (Amendment), 26 April 2010, available at http://www.bu.edu/bucflp/
files/2012/01/Circular-on-Financial-Inclusion-by-Extension-of-Banking-Services-Use-of-Business-
Correspondents-amendment.pdf.
29
30
Reserve Bank of India, Press Release, Withdrawal of Legal Tender Status for 500 and 1000
Rupee Notes: RBI Notice (Revised), 8 November 2016, https://rbi.org.in/Scripts/BS_PressReleaseDi
splay.aspx?prid538520.
31
‘The Dire Consequences of India’s Demonitisation Drive’ The Economist, 3 December 2016,
http://www.economist.com/news/finance-and-economics/21711035-withdrawing-86-value-cash-circu
lation-india-was-bad-idea-badly.
32
Wade Shepard, ‘After Day 50: The Results From India’s Demonetization Campaign Are In’
Forbes, 3 January 2017, http://www.forbes.com/sites/wadeshepard/2017/01/03/after-day-50-the-
results-from-indias-demonetization-campaign-are-in/#38b026f5552e.
33
Shruti Singh, ‘Here is What PM Modi Said About the New Rs. 500, Rs. 2000 Notes and

the end of the year as promised by the Prime Minister for 500 and 2,000 rupee notes in a
‘Mahatma Gandhi New Series’:
As the clock ticked down to midnight on November 8th, a huge portion of Indian society
instantaneously found themselves stripped of the ability to interact economically. Up to that
point, upwards of 95% of all transactions in India were conducted in cash and 90% of vendors
didn’t have the means to accept anything but.34
Naturally, tens of millions of Indians flocked to banks and automated teller machines
(ATMs) to exchange the old for new notes. Long queues caused not only inconvenience,
but deaths, and the misery was exacerbated by cash withdrawal limits and the breakdown
of roughly half of the ATMs.35 The poor and women were particularly afflicted, as they
had conducted many of their routine, lawful transactions in the old, demonetized notes.
Fifty days after the demonetization, when the redemption period ended on 30 December
2016, the RBI had recovered almost all of the demonetized notes.36 India remained short
of cash, and withdrawal limits persisted, but whether the long-term policy goals would be
achieved remained to be seen.
III. RBI AND FX REGULATION
1. 1947 and 1973 Severe Regulation
The largest market in the world, in terms of the value of average daily turnover, is the
buying and selling of currencies—the foreign exchange (FX) market. That also is true
in India.37 India has a long history of maintaining controls on its currency, the rupee,
with respect to both the current and capital accounts of its balance of payments (BOP).
‘Exchange Control in India dates back to 1939, when for the first time it was introduced
as a war measure under the Defence of India Rules, and subsequently placed on statutory
basis by the Foreign Exchange Regulation Act, 1947’ (1947 FERA).38
In 1973, before the 21-month Emergency Period of 1975–77, Prime Minister Indira
the government of Prime Minister Indira Gandhi (1917–84, Prime Minister 1966–77,
1980–84) pushed through Parliament the Foreign Exchange Regulation Act, 1974 (1973
FERA), which entered into force on 1 January 1974. The purpose of the FERA was to
regulate payments in rupees and the exchange rate of the rupee against foreign currencies
Black Money’ India Today, 8 November 2016, http://indiatoday.intoday.in/story/live-pm-narendra-

modi-addresses-nation/1/805755.html.
34
Shepard, supra note 32.
35
Supra note 31.
36
Shepard, supra note 32.
37
Wikipedia, Foreign Exchange Management Act, available at https://en.wikipedia.org/wiki/
Foreign_Exchange_Management_Act (citing Raj Kumar, International Economics at 307).
38
Reserve Bank of India, Report on Exchange Control Relating to Individuals, (Section III, The
Genesis of Exchange Control and Its Impact on Customer Service, Paragraph 3.1), 25 May 2004,
available at https://rbi.org.in/scripts/PublicationReportDetails.aspx?ID5377. [Hereinafter, May
2004 RBI Report on Exchange Controls.]

(especially hard ones, such as the US dollar and British pound). The Act was draconian,
with a long list specifying transactions directly or indirectly relating to the exchange
rate of the rupee that were subject to control. India’s FX reserves had fallen to low
levels. Hence, it was thought FERA would help India replenish its precious reserves by
conserving them, regulating their outflow, and ensuring they were used wisely to promote
economic growth and development. The Act itself declared its aims as:
regulating certain payments, dealings in foreign exchange and securities, transactions indirectly
affecting foreign exchange and the import and export of currency, for the conservation of foreign
exchange resources of the country.39
The RBI was the key authority administering FERA, which it did so partly through a
lengthy Exchange Control Manual.
For example, on the current account, payments for many imports were regulated. On
the capital account, FX trading in the rupee, and investments in foreign securities, were
regulated. In effect, any type of transaction that affected the importation (inflow) of
rupees into India and corresponding export (outflow) of foreign currencies, or vice versa,
were regulated. The Act even required multinationals, particularly Coca-Cola, to dilute
their ownership interests in local Indian subsidiaries.40 Shockingly, violations of the 1973
FERA were criminal offences.
Both the 1947 and 1973 Acts presumed guilt on the part of a transactor in FX:
In FERA, 1947, [the] burden of proof that a person had requisite permission, or the foreign
exchange acquired by him had been used for the purpose for which permission was granted,
rested with him (Section 24). With the emphasis on conservation of foreign exchange in FERA
1973, the burden of proof (Section 71) was reinforced by the ‘presumption of culpable mental
state’ (Section 59). As a consequence, till FERA 1973 was in force every person was presumed
to be guilty till he proved innocence. Therefore, the two statutes, viz. FERA, 1947, as well as
FERA, 1973, started with a negative presumptive approach that everybody is guilty unless
proved innocent.41
To overcome this presumption, transactors—both underlying economic agents and deal-

ers in FX—had to make onerous declarations.
The Foreign Exchange Regulation Act, 1947, contained Section 3, sub-section (4):
an authorized dealer [AD] shall, before undertaking any transaction in foreign exchange on
behalf of any person, require that person to make such declaration and to give such information
as will reasonably satisfy him that the transaction will not involve, and is not designed for the
39
May 2004 RBI Report on Exchange Controls (Section III, The Genesis of Exchange Control
and Its Impact on Customer Service, Paragraph 3.1).
40
Wikipedia, Foreign Exchange Regulation Act, available at https://en.wikipedia.org/wiki/
Foreign_Exchange_Regulation_Act. This fact, along with the Indian government demand that
India reveal its secret ‘7X’ formula, led Coke to quit the country. It did not return until 1993, when
it (along with Pepsi), were wooed by the First Generation Reforms that commenced in 1991. Ibid.
These events are vividly recalled by the Author, who (with his family) was in India in 1974, 1976,
and 1979.
41

purpose of any contravention or evasion of the provisions of this Act or of any rule, direction
or order made thereunder, and where the said person refuses to comply with any such require-
ment or makes only unsatisfactory compliance therewith, the authorized dealer shall refuse to
undertake the transaction and shall, if he has reason to believe that any such contravention or
evasion as aforesaid is contemplated by the person, report the matter to the Reserve Bank.
Similar provisions were also contained in Section 6, sub-section (5), of the Foreign
Exchange Regulation Act, 1973.42
Such declarations added to the cost of trade and investment deals, and created oppor-
tunities for evasion and corruption.
To be sure, neither the RBI nor ADs had to make declarations of specific compliance
with all FERA provisions. Rather, ADs had to apply to the RBI for release of FX, and
await its approval. By stamping and signing the requisite RBI form, an AD certified the
accuracy of the contents of the form and the bona fide nature of the application for
release.
Here, then, was the high (or low) point of India’s post-Independence FX regulatory
regime: consistent with Socialist economic planning, every transaction was presumed pro-
hibited unless otherwise exempt by permission of the RBI. The underlying presumption
of the 1974 FERA was that any foreign currency earned by a resident of India ‘rightfully
belonged to the Government of India, and had to be collected and surrendered to the . . .
RBI.’43
2. 1993 Market-determined Exchange Rate
Dr Manmohan Singh, whose party, the Indian National Congress, had led the Quit India
Movement and governed India for most of the post-Partition period, understood the need
for reform.44 He came to the position of Finance Minister in 1991 under Prime Minister
PV Narasimha Rao (1921–2004, Prime Minister, 1991–96), and became Prime Minister
in 2004. As Finance Minister, he faced the 1991 BOP crisis: FX reserves were so low India
needed a $2.2 billion emergency loan from the International Monetary Fund (IMF) and
had to airlift 67 tons of gold as collateral.45
Dr Singh was well prepared, and saw the ignominious situation as the justification
for dramatic changes in economic policy that were long overdue. He had trained as an
economist, culminating with a dissertation he wrote at Oxford entitled ‘India’s Export
Performance, 1951–1960’, under the supervision of renowned development economist
IMD Little (1919–2012). The dissertation became a book in 1964, India’s Export Trends
and Prospects for Self-Sustained Growth.
In 1991, Singh—with Atal Bihari Vajpayee (1924-, Prime Minister, 1996, 1998–2004),
42
43
Wikipedia, Foreign Exchange Regulation Act, available at https://en.wikipedia.org/wiki/
Foreign_Exchange_Regulation_Act. The author vividly recalls these events, as he (with his family)
was in India in 1974, 1976 and 1979.
44
This discussion draws on Raj Bhala, International Trade Law: An interdisciplinary, Non-
Western Textbook, Chapter 12, ‘Trade Policy in Modern India’ (LexisNexis, 4th edition, 2015).
45
Saraogi, at 95.

as his Prime Minister—did the needful (to use an Indian expression), ushering in the
dramatic, First Generation Economic Reforms.46 They were dramatic in that they were
46
Anne O Krueger and Sajjid Z Chinoy, ‘Introduction’ in Anne O Krueger and Sajjid Z Chinoy
(eds), Reforming India’s External, Financial, and Fiscal Policies (Stanford, California: Stanford
University Press, 2003) [Hereinafter, Krueger and Chinoy]. As intimated above, the term ‘First
Generation Reforms’ covers a wide ranging set of changes away from Nehruvian Socialist-style
central planning, toward free market economics. Many of changes were designed to boost India’s
participation in international trade, and attract FDI. In addition to foreign exchange convertibility
(discussed above), the First Generation Reforms that affected the external sector included the
following five key changes:
1st: Average Tariff Levels
India cut its applied (as distinct from bound) most favored nation (MFN) tariffs on industrial
goods from an overall average of 15 percent to an average of 12.5 percent. In 1990–91, across
all merchandise categories, the average Indian import-weighted tariff was 87 percent, and 164
percent on consumer goods. Krueger and Chinoy, 2; TN Srinivasan, ‘Integrating India with the
World Economy: Progress, Problems, and Prospects’, in Anne O Krueger and Sajjid Chinoy
(eds), Reforming India’s External, Financial, and Fiscal Policies (Stanford, California: Stanford
University Press, 2003) 18–20 [hereinafter, Srinivasan]. But, by 1996–97, the average imported-
weighted tariff tumbled to 24.6 percent.
2nd: Tariff Peaks
In these reductions, India addressed its tariff peaks (extremely high tariffs on particular prod-
ucts). In 1990–91, the highest duty level hit 355 percent. Srinivasan, 20. In 1997–98, the highest
duty level was 45 percent.
3rd: Tariff Dispersion and Escalation
India dealt with its problem of tariff dispersion (the spread of tariffs across large wide numerical
ranges), which created a bias against the use of imports in domestic agriculture and manufactur-
ing, distorted incentives in resource allocation, and ultimately discouraged exports. India did
so by slashing the standard deviation of tariff levels to one quarter of their 1990–91 levels on
intermediate and capital goods, and one third of those levels on agricultural goods. Srinivasan,
18–21.
In so doing, India also began to address the problem of tariff escalation, whereby tariffs on
merchandise increase with the degree of processing, with lower tariffs on raw materials, higher
tariffs on intermediate items, and the highest tariffs on finished goods. (Escalation is designed to
promote vertically integrated manufacturing, and higher value added production, domestically.
It provides a higher level of effective protection for finished manufactured goods in comparison
with the simple tariff on those goods, because of the tariffs at each earlier stage of processing.)
4th: Simplification
By 2000–01, India had simplified its tariff schedules, and narrowed the duty levels, to just
four categories: 35 percent; 25 percent; 15 percent; and five percent. Srinivasan, 20. India also
cut the number of exemptions, also called use-based concessions, on tariff rates. Ibid. To be
sure, most merchandise fell into the 35 percent and 25 percent categories. Nevertheless, after
decades of protectionism, the change was remarkable—and, it may be added, one for which
American trade negotiators in the Doha Round rarely if ever publicly credited India, choosing
instead to castigate it for not doing enough. (For a critical analysis of this Round, see The

‘structural’, dismantling many post-Partition Socialist-style policies. The changes aimed

to unshackle Indian firms and entrepreneurs from red tape, foster competition, and open
India to the global economy. One key change was establishment of a market-determined
exchange rate.
The Indian government had allowed the rupee to depreciate against hard currencies
(such as the US dollar and British pound sterling) ever since the Bretton Woods fixed
exchange rate system ended in 1971.47 Official devaluation was part of the 1991 reforms:
in July of that year, India reduced its value by 22.8 percent against a basket of currencies
where each currency was weighted by Indian exports to the country of that currency.48
India also dismantled the dual exchange rate system it had created to cope with the 1991
BOP crisis, and eliminated FX licensing and requirements concerning export-based
imports and import compression.49
By 1993, and since then, the rupee was freely convertible for all current account transac-
tions (ie, for purposes of Article VIII of the Articles of Agreement of the International
Doha Round Trilogy, Raj Bhala, ‘Poverty, Islamist Extremism, and the Debacle of Doha
Round Counter-Terrorism: Part One of a Trilogy – Agricultural Tariffs and Subsidies’ (2011)
9 University of Saint Thomas Law Journal issue 1, 5–160 (Annual Law Journal Lecture); Raj
Bhala, ‘Poverty, Islamist Extremism, and the Debacle of Doha Round Counter-Terrorism:
Part Two of a Trilogy – Non-Agricultural Market Access and Services Trade’ (2011) 44 Case
Western Reserve Journal of International Law issues 1 and 2, 1–81 (War Crimes Research
Symposium on International Law in Crisis); and, Raj Bhala, ‘Poverty, Islamist Extremism, and
the Debacle of Doha Round Counter-Terrorism: Part Three of a Trilogy – Trade Remedies
and Facilitation’ (2012) 40 Denver Journal of International Law and Policy issues 1–3, 237–320
(40th Anniversary Symposium Festschrift in Honor of Professor Ved P Nanda, ‘Perspectives
on International Law in an Era of Change’), posted on various databases and websites,
including Gateway House – The Indian Council on Global Relations, www.gatewayhouse.in/
poverty-islamist-extremism-and-the-debacle-of-doha-round-counter-terrorism-a-trilogy/).
All the more remarkable was the price tag: In 1990–91, government revenue from import tariffs
equaled 3.6 percent of Indian GDP, and total tax revenue accounted for 9.5 percent of GDP.
Srinivasan, 19. India had taken the difficult step of starting to wean itself off customs duties as
a key source of government financing.
5th: License Raj
India began to dismantle the License Raj system and expose the country not to complete free
trade, but freer trade. For most categories of merchandise, India abolished many import licens-
ing requirements. Krueger and Chinoy, 3; Srinivasan, 18–21. By 1998, seven years after the
launch of the First Generation Reforms, roughly 32 percent of all Indian tariff lines were subject
to import licensing. World Trade Organization, Trade Policy Review Body, Trade Policy Review
for India, 1998 , available at http://www.wto.org/. That figure, while still too high, was significant,
because Indian import licensing had functioned in practice as an import ban.
The aforementioned external sector reforms did not occur all at once, in 1991. Srinivasan, 19.
India did not choose the shock therapy treatment that Poland used in 1989. Rather, it deferred
tariff cuts and quantitative restriction (QR) elimination on consumer goods until the mid-1990s.
47
Srinivasan, at 17–20.
48
Ibid at 19–20. India also withdrew most of its subsidies to exports, so the devaluation of the
real effective exchange rate for exporters was 16.3 percent, ibid at 20.
49
Ibid at 20.

Monetary Fund).50 The RBI does not peg the rupee to any other currency. That stands in
contrast to the pegged or tightly regulated currencies of China, Hong Kong and the Gulf
Arab states. To be sure, the rupee float is a managed one, but that hardly is peculiar to India.
Many central banks in developed as well as developing countries do what the RBI does:
intervene (directly or indirectly) during times of crisis to calm markets or extreme volatility
to smooth out fluctuations, and indicate a directional preference or benchmark level.
Predictably, the result of exchange rate regime changes was positive. Indian exports
(in terms of volume) grew faster than the world average after 1973, though still small in
overall world trade.51 What was significant was India’s success in rebuilding its reserves
of hard foreign currency.52 It did so with difficulty, particularly in the late 1990s and the
rounds of nuclear tests vis-à-vis Pakistan, and the imposition by the US of sanctions
against both India and Pakistan in response to those tests. Yet, by July 2015, FX reserves
were healthy again, with the RBI holding foreign currency assets and gold valued at
roughly $355 billion.53
3. 1999 Paradigm Shift
The 1947 and 1973 ERA regimes hardly inspired interest in India among the world trade
and investment community, and it discouraged Indians themselves from investing in their
own economy. So (as indicated above), in the late 1980s, India began to close the chapter
on its history of severe FX controls. It started to liberalize FX controls on both the current
and capital accounts.54 Seeing Non-Resident Indians (NRIs)—the world wide Indian
diaspora—as assets to cultivate, and seeking to stem resident Indians from engaging in
unlawful capital flight, the government reversed course.
It did—that is pursue financial sector liberalization—so despite a turbulent 1991
(BOP) crisis.55 A key element of the First Generation Reforms was repeal of the 1974
FERA in 1998. A new statute, containing 87 Sections, replaced it: the Foreign Exchange
Management Act, 1999 (1999 FEMA).56 It entered into force on 1 January 2000, and its
purpose was to liberalize restrictions on both FX transactions and FDI:
[The 1999 FEMA] was a paradigm shift in the philosophical approach to Exchange Control, in
as much as the object of the statute, inter alia, is [‘to consolidate and amend the law relating to
foreign exchange with the objective of’]:
‘facilitating external trade and payment and for promoting the orderly development
and maintenance of foreign exchange markets in India.’
50
Ibid at 20.
51
Ibid at 17.
52
Ibid at 57.
53
‘India’s Foreign Exchange Reserves Crosses $355 Billion for the First Time’ The Economic
Times, available at http://articles.economictimes.indiatimes.com/2015-06-27/news/63886190_1_for
eign-exchange-reserves-gold-reserves-foreign-currency-assets. Roughly $330.7 billion was in cur-
rency, and $19.3 in gold.
54
The RBI, Volume 4, Part A, at 193–232; Part B, at 969–91.
55
Ibid Part A, at 417–42, 493–536; Part B, at 969–91.
56
Act Number 43 of 1999 (29 December 1999), available at http://www.dor.gov.in/sites/
upload_files/revenue/files/Foreign Exchange Management Act 1999.pdf.

. . . Clearly, from regulating transactions and conserving foreign exchange the intent now is on
facilitating trade and payments. The new approach to the Control is reflected in the Statute
by the absence of provisions relating to burden of proof and presumption of culpable mental
state.57
Significantly, liability for violations no longer was criminal, but reduced to civil, and cor-
respondingly, the presumption of guilt changed to one of innocence. Transactions were
presumed lawful unless specifically forbidden, rather than the control-oriented negative
presumption of the 1947 and 1973 FERAs.
The new approach the 1999 FEMA ushered in also was reflected in a change in docu-
mentation required of ADs:
Like the previous two Statutes, however, FEMA in sub-section (5) of Section 10, provides that:
‘An authorised person shall, before undertaking any transaction in foreign exchange
on behalf of any person, require that person to make such declaration and to give such
information as will reasonably satisfy him that the transaction will not involve, and
is not designed for the purpose of any contravention or evasion of the provisions of
this Act or of any rule, regulation, notification, direction or order made thereunder,
and where the said person refuses to comply with any such requirement or makes only
unsatisfactory compliance therewith, the authorised person shall refuse in writing to
undertake the transaction and shall, if he has reason to believe that any such contraven-
tion or evasion as aforesaid is contemplated by the person, report the matter to the
Reserve Bank.’
. . . [But,] [i]n line with the changing economic realities, including convertibility on current
account transactions, the RBI decided that it:
‘will not prescribe the documents which should be verified by the authorised
dealers while permitting remittances for various transactions, particularly of
current account.’
{Annexure I, paragraph 8, A.D. (M.A. Series) Circular No.11 dated May 16, 2000}
Therefore, the ADs who till that time were being guided by the detailed guidelines from the
RBI were given the freedom and responsibility of deciding what documents should be obtained
before allowing a remittance for current account transactions.58
To provide certainty for ADs as to appropriate documentation, the Foreign Exchange

Dealers’ Association of India (FEDAI) provides guidance. Note then, another aspect
of the paradigm shift: the private sector FEDAI works with its members, the ADs, and
collaborates in a ‘bottom up’ manner with the RBI, rather than the RBI imposing ‘top
down’ documentation mandates.
The paradigm shift of the 1999 FEMA followed India’s active participation in
the Uruguay Round (1986–94) of multilateral trade negotiations (MTNs) under the
57
58
and Its Impact on Customer Service, Paragraph 3.6). For recommendations on documentation
and the nature of declarations by FX transactors, such as shifting from statements about what a
transactor is not doing to what it is doing, in the interests of alleviating liability for rules or matters
about which the transactor may be unaware, see ibid, Paragraphs 3.7–3.8.

General Agreement on Tariffs and Trade (GATT), and birth on 1 January 1995 of
the World Trade Organization (WTO). The FX liberalization paradigm of FEMA
synchronized well with the trade liberalization paradigm of the Uruguay Round agree-
ments and mission of the WTO. For much of its post-Independence existence, India
had pursued Import Substitution and Export Promotion. FX regulation—specifically,
the conservation of hard currency to limit imports and support exports—facilitates
those strategies.
In the 1990s, India shifted not to pure free trade, but at least freer trade. FEMA
provided the necessary statutory basis for the Indian government to pass liberalizing
rules consistent with Indian foreign trade policy. Indeed, under FEMA, current account
transactions—that is, FX for imports and exports—do not require RBI permission.
FEMA thereby liberalized FX on the current account. In sum, FEMA dispensed with
the ‘regulation’ of FX associated with the FERAs, and created a flexible ‘management’
approach to FX.59
In what way does the RBI ‘manage’ FX under FEMA? First, it does not do so on the
current account. There are no restrictions on buying or selling rupees against foreign
currencies for import and export transactions. So, any profits, dividends or other
payments that qualify as remittances classified as current account transactions can be
freely repatriated.60
Second, there are almost no restrictions on the rupee for capital account purposes. In
particular, on direct foreign investment in India:61
(1) Rupee denominated profits earned in India are freely repatriable to the home country
of the investor (or third country), in the home country (or third country) currency
of that investor.
(2) Such profits may be subject to restrictions if they come from certain sectors in which
special sectoral policies apply.
(3) Such profits may not be repatriated by an NRI who chooses to invest under a scheme
that is specifically designated as non-repatriable.
With respect to portfolio investment (ie, securities) in India:62
(1) Dividends from investments in India may be repatriated freely to the home country
of the investor (or third country) by remitting them through an AD.
(2) An NRI may sell shares on an Indian stock exchange without prior approval from
the RBI, and freely repatriate proceeds from such sales, so long as the NRI held those
59
Wikipedia, Foreign Exchange Management Act, posted at https://en.wikipedia.org/wiki/
Foreign_Exchange_Management_Act (citing Biswajit Dhar and Mritiunjoy Mohanty, ‘FEMA:
A Closer Look’ XXXIII Economic & Political Weekly number 40 (4 July 1998), available at http://
www.epw.in/commentary/fema-closer-look.html).
60
Consulate General of India – Shanghai, Foreign Exchange Regulations, available at http://
www.indianconsulate.org.cn/page/display/141/137/95. [Hereinafter, Shanghai Consulate General
FX Regulations.]
61
Shanghai Consulate General FX Regulations.
62
Ibid.

shares on a repatriation basis, and have a tax clearance certificate from the Indian
Income Tax authorities.
(3) If shares in an Indian company are sold through a private arrangement, then the RBI
must grant permission for recognised units of foreign equity in that company under
its guidelines issued pursuant to FEMA, and the sale price of those units must be
based on those guidelines.
As to immovable property in India (ie, obtaining rupees to buy real estate, or converting
rupees into foreign currency from a real estate sale):63
(1) Any foreign national residing outside India with authorization from the RBI to
establish a place of business (eg, an office such as a branch, but not a liaison office)
thereby has general permission from the RBI to buy property in India that is neces-
sary for, or incidental to, their business. They must declare to the RBI within 90 days
any such acquisition.
(2) Any foreign national who is not of Indian origin, ie, an NRI, who acquires property
in India with RBI approval, cannot transfer that property without prior RBI
permission.
(3) An NRI may buy property in India, other than agricultural land, a plantation, or
a farm house, and may transfer that property to another NRI (that is, a person of
Indian-origin not residing in India), or to a person residing in India.
Note that the second point appears designed to avoid a property ‘bubble’ created by
speculation among absentee foreign owners. Dramatic run-ups in property prices
exacerbate India’s serious shortage of adequate, affordable housing for the middle and
poor classes, and more generally are antithetical to inclusive development. Similarly, the
exception for farmland in the third point not only helps combat absentee foreign owner-
ship that would worsen India’s problem of the landless poor, but also indirectly enhances
India’s food security.
To summarize:
India has liberalized its foreign exchange controls. [The] [r]upee is freely convertible on
current account. Rupee is also almost fully convertible on capital account for non-residents.
Profits earned, dividends and proceeds out of the sale of investments are fully repatriable
for FDI. There are restrictions on capital account for resident Indians for incomes earned in
India.64
All in all, set in the context of the history of economic policy of post-Partition India, the
liberalizations are remarkable.
63
Ibid.
64
Ibid.

IV. BANK TYPES
1. Government Owned Banks
Until 1955, all banks in India were 100 percent privately owned.65 In that year, the State
Bank of India (SBI) was created. Fifteen years thereafter, the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1970 (sometimes called the Bank
Nationalization Act) nationalized 14 banks, with effect from 19 July 1969. The Act
establishes Government Owned Banks (GOBs). Given its purpose and effective date,
this Act sometimes is called the Bank Nationalization Act 1969. Those banks occupy
the ‘commanding heights’ of the Indian banking sector.66 In 1980, under the Banking
Companies (Acquisition and Transfer of Undertakings) Act, 1980, the central govern-
ment nationalized six more banks.67
GOBs, then, are Public Sector Banks, and thus also are known by the acronym
‘PSBs’—not to be confused with Private Sector Banks (discussed below). However, every
one of them is listed on an Indian stock exchange. Thus, none is 100 percent state owned.
Rather, under the 1969 Act, the central government must maintain a 51 percent stake in
each GOB, but the remainder may be in private hands.
Over 75 percent of all bank assets in India are in GOBs.68 That fact is incongruous
with the country’s increasing market orientation, but reflects a history of deliberate policy
choices associated with Nehruvian-style economic planning.
2. Private Sector Banks
The other 25 percent of bank assets in Indian banks are held in private banks, cooperative
banks and foreign banks. Thus, with GOBs, there are four broad categories of commercial
banking institutions in India.
There is a distinction between old and new generation private banks, namely, pre-1970
Old Private Sector Banks (OPSBs) and New Private Sector Banks (NPSBs).69 OPSBs
existed before 1969. When the government nationalized banks in that year, it opted not
to nationalize OPSBs for one of two reasons: they were too small, or they catered to a
niche market (such as a distinct community or region).70 Some OPSBs have a sustained
record of strong returns on capital, high quality loan portfolios and clean governance.
Others do not.
Thus, an OPSB the government nationalized became a GOB (or PSB). Any bank
arising in the private sector after 1969, and in particular after the 1991 First Generation
Reforms, is a NPSB. Of course, the RBI regulates all banks—OPSBs, NPSBs and GOBs.
In 1993, as part of the financial sector reforms of Prime Minister Manmohan Singh
(1932–, Prime Minister, 2004–14), the RBI announced major liberalizations for the
65
Saraogi, at 84.
66
Bangia, at 13–16; Tannan, at 22, 34.
67
Bangia, at 16–17; Tannan, at 22, 34.
68
Saraogi, at 83.
69
Ibid at 83.
70
Ibid at 83–84.

establishment and management of new private banks. The provisions took the form
of amendments to the Reserve Bank of India Act, 1934, and Banking Regulation Act,
1949.71
V. BRANCHING
1. Significance of Branches
Overall (as of 2014), there are in excess of 80 000 bank branches in India. SBI (including
its subsidiaries) boasts the largest number of branches—13 000.72 These staggering figures
must be juxtaposed with India’s massive population. With roughly 1.25 billion people,
there is one bank branch per 15,000 Indians. Put differently, the IMF reported that (as of
2013), India has just 12 bank branches per 100 000 people.73 And, only about 50 percent
of Indians have a bank account, whereas roughly 80 percent of them have a mobile phone.
Much of India, then, remains under-banked.
Thus, from the 1970s to the 1990s, until the 1991 First Generation Reforms, Indian
banking regulations mandated that every time a bank opened one new branch in an urban
area, it had to open four branches in rural areas. This ‘Branch Development Program’ was
a clear manifestation of a hallmark of Indian Banking Law, namely, financial inclusion
(discussed below). The result was 30 000 branches in rural areas, a feature of the rural
landscape that some travelers to India observe. The Program was judged a success by two
scholars, who said it had a ‘substantial impact on poverty reduction.’74
India ended this ‘Branch Development Program’ in 1991 because many rural branches
could not operate profitably. They lacked economies of scale in comparison with urban
branches, even ones in low-income areas of cities. Trying to be successful, they extended
high-credit risk loans, and experienced high loan default rates.
Of course, branching remains important in the Indian context. As in other countries,
Indian banks tend to expand their commercial presence and transactional activities partly
by building branch networks. Except for a bank that fears competition and seeks to pro-
tect its local market by restricting the expansion of others, most banks ideally would like
71
Tannan, at 22–24.
72
Saraogi, at 87.
73
International Monetary Fund, Financial Access Survey (2013) – India (Washington, DC:
International Monetary Fund, 2014), posted at http://fas.imf.org/Default.aspx. [Hereinafter, 2013
IMF Financial Access Survey.]
74
The World Bank, Global Financial Development Report 2014: Financial Inclusion, 43
(Washington, D.C.: 2014), available at http://siteresources.worldbank.org/EXTGLOBALFINREP
ORT/Resources/88160961361888425203/9062080-1364927957721/GFDR-2014_Complete_Report.
pdf (citing a 2005 study by Burgess and Pande) [hereinafter, 2014 World Bank Global Financial
Development Report], quoted in John D Villasenor, Darrel M West and Robin J Lewis, The
2015 Brookings Financial and Digital Inclusion Project Report: Measuring Progress on Financial
Access and Usage, 58 (Washington, DC: The Brookings Institution, 26 August 2015), available
at http://www.brookings.edu/~/media/Research/Files/Reports/2015/08/financial-digital-inclusion-
2015-villasenor-west-lewis/fdip2015.pdf ?la5en [hereinafter, 2015 Brookings Financial Inclusion
Project Report].

the legal ability to establish and operate a branch anytime, anywhere, with no regulatory
hassle. From the regulator’s perspective, however, that license would be an invitation to
unsafe, unsound expansion.
2. RBI Branching Rules
Traditionally, the RBI has mitigated the tension between excessively lax and overly
zealous branching restrictions by classifying Indian cities into ‘Tier 1’ and ‘Tier 2’.
(Cities not classified as such are, in effect, ‘Lower Tier’, and the rules to Tier 2 generally
apply to them.) The RBI uses the distinction to regulate the extent to which a domestic
scheduled commercial bank can establish branches.75 The RBI has two sets of procedures,
‘Automatic’ and (in effect) ‘Non-automatic’. A bank may branch at its discretion via the
Automatic Route in any Tier 2 city. To set up a branch in a Tier 1 city, however, a bank
needed advance permission via the Non-automatic Route.
In the mid-2000s, via policy announcements, the RBI eased restrictions on branching
in Tier 1 cities. The RBI allowed banks to use the Automatic Route to branch in those
cities, but subject to a key condition: the number of branches that may be opened in a
Tier 1 city depends on the number of branches existing in areas in which that bank has
no presence.76
For example, assume Mumbai is a Tier 1 city and a domestic scheduled commercial
bank seeks to open a branch there. Assume further other banks have opened branches in
areas in which that bank has no presence. The RBI may determine that operating a branch
in Mumbai is important for the diversification of revenue for this bank, given the extant
competition in other areas that the bank might otherwise have had a branch.
VI. FOREIGN BANK ENTRY
1. RBI Regulation and GATS Commitments
Foreign banks have operated in India since the British Raj. They have done so through
branches, and until 2004, the RBI strictly regulated their activities.77 Again the policy
paradigm was Nehruvian: foreign banks should not be allowed to take over Indian ones,
and engage in a kind of financial re-colonization, taking Indian depositor funds and
investing them outside the country, and volatility from overseas should not be transmitted
to India. But, in 2004, the RBI permitted foreign banks to establish 100 percent owned
subsidiaries, and to hold up to a 74 percent equity stake in an OPSB or NPSB.78 However,
as a general rule, the RBI does not permit foreign banks to establish branches using the
Automatic Route.79
The RBI regulates foreign bank entry in keeping with India’s commitments under the
75
Saraogi, at 83.
76
Ibid at 83.
77
Ibid at 83.
78
Ibid at 83.
79
Ibid at 83.

WTO General Agreement on Trade in Services (GATS).80 That means the RBI permits
foreign banks to enter India by establishing branches, but based on reciprocity.81 India will
grant branch access to the extent the home country of a foreign bank allows Indian banks
to branch in that country. So, for example, in a WTO Member that prohibits Indian banks
from branching, India would forbid banks from that Member from branching. Similarly,
India would restrict branches in number, and to designated locations, from a Member that
treated Indian banks that way in its territory.
2. Subsidiary Preference
The RBI prefers foreign banks to enter India by establishing a 100 percent owned subsidi-
ary. Among other benefits, that ensures the RBI there are sufficient assets and capital
to meet liabilities and cover losses, if need be, and to ring fence the assets, capital and
liabilities of the subsidiary from those of its foreign parent, in the event of turbulence or
insolvency. (At least in theory, a branch, which is unincorporated, has not assets, capital
or liability of its own; rather, it is part of its parent.) However, foreign banks often prefer
flexibility in their form of entry abroad, be it representative office, agency, branch or
subsidiary.
In an effort to induce foreign banks to convert their unincorporated branches to
wholly-owned, incorporated subsidiaries, the RBI altered its rules following the 1991 First
Generation Reforms. If they do establish a subsidiary, then the RBI grants them national
treatment, meaning the RBI treats them like domestic scheduled commercial banks (for
all but a few minor purposes).82 Foreign banks took note though, that conversion meant
their new subsidiaries would be subject to India’s Priority Sector Lending requirements,
and its Statutory Liquidity Ratio (both discussed below).
3. Foreign Acquisitions
One attractive mechanism for foreign banks to enter India is acquiring a well-performing
OPSB.83 The RBI treats OPSBs as a full scheduled commercial bank, and they are likely to
have an extensive branch network (even if it is concentrated to serve a particular commu-
nity or region). So, in 2002, the Dutch bank ING acquired an OPSB, The Vysya Bank, to
form ING Vysya Bank. For Indian bank acquirers, OPSB targets have the same appeal. So,
for instance, in 2005, Centurion Bank merged with Bank of Punjab (which in turn in 2008
was taken over by HDFC Bank), and in 2006 IDBI Bank bought United Western Bank.
Non-banking Financial Companies (NBFCs) (discussed below) are another attractive
vehicle by which foreign capital enters the Indian financial sector. That is for three reasons.
First, the RBI limits the extent to which foreigners can invest directly in commercial banks.
There are no such limits for foreign direct investment (FDI), or portfolio investment, in
80
For a treatment of GATS, see Raj Bhala, International Trade Law: An Interdisciplinary,
Non-Western Textbook Vol 1, Part II, Chapters 44–46 (New Providence, New Jersey: LexisNexis,
4th edn, 2015).
81
Saraogi, at 83.
82
Saraogi, at 83–84.
83
Saraogi, at 84.

an NBFC. Second, foreigners can deploy capital into the special transactional areas, and
toward the targeted consumers, in which NBFCs specialize. They may regard commercial
banks, by contrast, as less agile, and also as relatively less agile. Third, assuming an NBFC
is run safely and cleanly, its leveraged position provides an opportunity for high returns
with minimal up-front investment.
VII. NBFCS
1. Activities
Non-bank entities that perform bank-like functions have existed in India for centuries.84
Money lenders and money transmitters (hawala bankers) are examples. NBFCs are
another example. They are distinct from banks in three respects: they do not accept
demand deposits from retail customers; they are not components in the payments or
clearing and settlement system; and they focus on lending to special sectors.85
But, they fill a vital niche banks are unwilling or unable to service, such as lending for
used trucks. For example, Shriram Transport Finance is a multi-billion dollar NBFC in
financing the used trucking business. Along with vehicle finance, housing finance and
emergency personal loans are examples. In filling these niches, NBFCs are instrumental
in advancing the key Indian banking policy goal of financial inclusion.86
2. 1993 RBI Recognition
In 1993, the RBI formally recognized Non-bank Financial Companies (NBFCs), which
had grown from 7000 in 1981 to 50 000 by 1996.87 This recognition came following failures
of many NBFCs, and in 1997–98, the RBI Act was amended to give the RBI full powers
to regulate NBFCs. That expansion of jurisdiction was important: in some countries,
including the United States, non-bank entities have skirted regulatory supervision of
the Federal Reserve because of their formal status, even though they engage in bank-like
activities and pose systemic risks.
The American savings and loan (S and L) crisis of the 1980s is a case in point. In such
countries, turf battles among regulators and their individual political champions preclude
broad reform that would premise regulatory jurisdiction on the substantive activities in
which an entity is engaged, not merely the form of organization of that entity.
3. Illustrations
NBFCs are especially important as vehicles for financial inclusion (discussed below),
that is, for providing financial services in special sectors and/or to relatively poorer or
84
Saraogi, at 85.
85
Ibid at 85.
86
Ibid at 85.
87
Ibid at 85.

marginalized communities. An illustration is Kotak Mahindra Finance (KMF), which

commenced operation in 1986 as an NBFC.88 Noticing commercial banks failed to pro-
vide trade finance to businesses in a speedy manner, and were not adept at bill discount-
ing, the entrepreneur Uday Kotak focused KMF on these areas. KMF then expanded to
two other specialties banks served poorly, financing purchases of automobiles, and hire
purchases. With the 1991 First Generation Reforms, Kotak created distinct companies for
securities brokerage and investment banking, and soon thereafter ones for mutual funds
and life insurance, and set up private equity and venture capital funds.
KMF illustrates another point: the origins of a commercial bank can be in an NBFC.
In 2003, the RBI granted Kotak a license for a scheduled commercial bank. Kotak
consolidated all of the KMF and allied businesses under the ‘Kotak Mahindra Bank’,
(KMB), in which he held a 50 percent stake. KMB is a leading NPSB.
To be sure, not all NBFCs are successful. Some are highly leveraged, ie, they borrow
large amounts to fund their activities, creating risks with respect to their ability to service
their liabilities (their indebtedness) if their assets fail or underperform. Some of them
engage in fraud, such as Ponzi schemes (covering payment demands with inflows).
Under-serviced sectors and communities thus are vulnerable to NBFCs that are poorly
managed or corrupt, and in that sense the NBFCs undermine the policy of financial
inclusion, that is, efforts to provide banking services to the poor.
VIII. SYNOPSIS
In the post-British Raj Era, financial liberalization has been a hallmark of Indian bank-
ing regulation. The RBI has been integrally involved in change. The pace of change has
been measured thanks to the legacy of Nehruvian Socialist-style controls, and to the
complexity of Indian bank structure. Both payments and FX regulation exemplify this
cautious approach to legal and policy reform.
Underlying recent changes are long-held suspicions in India about unchecked Western-
style banking markets. Reflecting concerns across the Indian Subcontinent, the RBI seeks
to develop a modern banking system while ensuring the poor and emerging middle class
are not financially excluded from that system. That means the cautionary approach to
reform that has characterized the RBI will continue.
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6. The Bank of Russia: from central planning to
inflation targeting1
Juliet Johnson
Russians describe the 1990s with the telling word bespredel—without limits. Fortunes
were made and lost, corruption and criminality ran rife, uncertainty reigned, and
indeed, everything and anything seemed possible. These years saw the rise of the
so-called oligarchs, the band of commercial bankers who loomed so large over the
political system that prominent academics and policy makers spoke of Russia as a
captured state. Both wealth and political power became concentrated quickly and jokes
about the ‘New Russians’ of Moscow with more money than taste, empathy or ethics
proliferated.
Yet amid the thievery, the venality, the political instability, and the Soviet-era norms
and practices that made Russia nearly the last place one might expect to find Western-
style institution building, the Bank of Russia seemed to be changing faster than it had
any right to under the circumstances. Already by the end of that tumultuous decade, the
massive bureaucratic heir to the Soviet Gosbank had developed a reputation as one of the
least corrupt and most professional Russian government institutions. One international
advisor put it well, saying that, ‘I trust the Central Bank of Russia much more than any
other Russian institution, although this is because everything is relative.’2
The careers of two long-time Russian central bankers, Viktor Gerashchenko and
Andrei Kozlov, epitomize the multi-layered and contradictory transformation of the
Bank of Russia. Gerashchenko, a wily Soviet-era operator nicknamed ‘Gerakl’ (Hercules)
for his resilience and seeming ability to do the impossible, first served as head of
the Soviet Gosbank before becoming Bank of Russia governor from 1992 through
1994 and again from 1998 through 2002. Battered by challenges from all sides, he fought
to maintain the Bank of Russia’s political autonomy while at the same time initially
remaining skeptical that it should concentrate on fighting inflation. In frustration, US
advisor Jeffrey Sachs notoriously and unfairly labeled him the ‘world’s worst central
banker.’3
In contrast, Kozlov represented the new generation of Russian central bankers who
quickly adopted the principles of the international central banking community. Elevated
to the board while only 30 years old, he forged close ties with central bankers abroad
during the development of the Russian treasury bill market in the 1990s and led the
Russian division of the Financial Services Volunteer Corps while between posts at the
Bank of Russia. Upon returning to the Bank in 2002 he took on the immense challenge
of overhauling banking supervision. Unfortunately, both of Kozlov’s major professional
1
This chapter is drawn from Johnson (2016).
2
Author’s interview with a senior international technical assistance provider, November 2001.
3
The Economist, ‘The World’s Worst Central Banker’ 16 October 1993, 78.
94

The Bank of Russia 95
efforts ended badly. The first Russian treasury bill market collapsed in 1998, destroyed
by a government that turned the market into a pyramid scheme and by a misplaced
effort to maintain the ruble’s value in the face of the Asian financial crisis and collapsing
commodity prices. Kozlov’s banking reform efforts came to an even more devastating
conclusion. After closing down a number of shady banks and introducing a deposit
insurance system in Russia, contract killers gunned Kozlov down outside a Moscow
sports stadium in 2006.
This chapter begins with the Bank of Russia’s origins, from the waning days of the
Soviet Union through the passage of the revised Law on the Central Bank in 1995. It
then explores the international central banking community’s pivotal role in the Bank’s
transformation, focusing on monetary policy and banking supervision. The Bank
of Russia’s embrace of central bank independence, price stability and commercial
banking reform emerged sequentially, based on both persistent community exposure
and adverse experience. I end by discussing how the Bank of Russia has dealt with the
fallout from the global crisis and the Russian government’s financial nationalist turn,
particularly since the Crimean annexation and the imposition of the Western sanctions
regime.
I. ORIGINS OF THE BANK OF RUSSIA
The Russian Republic’s government founded the Bank of Russia and introduced its first
central banking law in 1990 during a bitter sovereignty battle with the central Soviet
government during the waning days of the USSR. Only in 1994 were political conditions
stable enough to begin drafting a post-Soviet Russian central banking law with interna-
tional assistance. The resulting 1995 law more fully enshrined central bank independence
in Russia, despite a parliament, government, financial sector, and even a few central
bankers who did not agree with or understand the stability mandate that justified this
independence internationally. As Tompson aptly observed in 1998, ‘External lenders have
played a key role in sustaining central bank independence in the absence of any strong
societal coalition in favor of it.’4
Soviet leader Mikhail Gorbachev’s perestroika (restructuring) program in 1987 was the
USSR’s first meaningful flirtation with market economics since Lenin’s New Economic
Policy of the early 1920s. Gorbachev’s key economic advisors did not intend to create
a Western-style market economy, and instead looked to Hungary’s New Economic
Mechanism and to Chinese economic reforms as potential models.5 Nevertheless, a few
Western-oriented economists such as Yevgenii Yasin, Grigorii Yavlinskii, Yegor Gaidar
and Boris Fedorov did emerge in the late Soviet period. Fedorov, who would play a key
role in crafting both the 1990 and 1995 Russian central banking laws, became a relative
expert in Western finance while working at the State Bank of the USSR (Gosbank)
in the 1980s. In his memoirs, he wrote that ‘my economic outlook in great part was
formed under the influence of the Quarterly Bulletin of the Bank of England—one of
4
Tompson (1998).
5
Abalkin (1987).

the most professional banks in the world.’6 Fedorov, Gaidar and their compatriots were
further impressed by the design and initial successes of Polish finance minister Leszek
Balcerowicz’s ‘shock therapy’ plan for economic transformation in 1990.7 When Russian
President Boris Yeltsin brought these economists into his government, they became the
leading advocates for monetary and fiscal conservatism in the early 1990s.
Soviet central bank reform began with a Council of Ministers decree in July 1987
creating a two-tiered banking system. As of 1 January 1988, Gosbank USSR became the
central bank, while five specialized banks (or spetsbanki) would serve different sectors
of the Soviet economy. The USSR Supreme Soviet appointed Viktor Gerashchenko, a
former executive of Vneshekonombank USSR (the Bank for Foreign Economic Affairs),
to head Gosbank in August 1989. Despite Gerashchenko’s best efforts, as the barely
controlled Soviet economic decentralization progressed Gosbank had an increasingly
difficult time managing the spetsbanki and maintaining monetary sovereignty over the 15
Soviet republics. After the election of the Russian Congress of People’s Deputies in March
1990 and Yeltsin’s ascension as its head, the Russian Republic declared its sovereignty on
12 June 1990. Immediately afterward the Russian Supreme Soviet adopted a resolution
calling for the creation of an independent Central Bank of Russia and declared the
spetsbanki on Russian territory to be Russian property.8
Over Gerashchenko’s bitter protests, the newly appointed Bank of Russia governor
Georgii Matiukhin, an academic economist, managed to take over the Russian Republic’s
main Gosbank branch.9 The Bank of Russia then began to pick the Soviet banking
system apart bit by bit, persuading individual Russian spetsbank branches to re-register as
independent commercial banks under its jurisdiction. Influential Russian banker Garegin
Tosunian remembered this time as
a political moment . . . [Gosbank and the Bank of Russia] competed with each other . . . so banks
had the opportunity to choose—if I prefer the instructions of Gosbank, I will place myself under
its jurisdiction. If I prefer the instructions of the Central Bank, then I will choose it . . . It was
complete chaos.10
This dual power culminated in the Soviet and Russian parliaments passing conflicting
central banking laws within days of each other in December 1990.
The Law on the Gosbank adopted by the USSR Supreme Soviet ostensibly created
a Federal Reserve-style system with Gosbank USSR at the center. Gerashchenko had
pushed for this law earlier, and his influential support ensured the law’s smooth passage.11
The law made Gosbank accountable to the USSR Supreme Soviet and independent of
6
Fedorov (1999).
7
Yasin (1998).
8
‘O gosudarstvennom banke RSFSR i bankakh na territorii respubliki [On the State Bank of
the RSFSR and the banks on the territory of the Republic]’, decree of the Supreme Soviet of the
RSFSR, 13 July 1990.
9
Matiukhin (1993). For more detail on the war of the banks, see Johnson (2000).
10
Author’s interview with Technobank president Garegin Tosunian, Moscow, Russia, July
1995.
11
Ivan Zhagel interview with Viktor Gerashchenko, Izvestiia, June 26, 1990. Translated as
‘Gosbank Head Claims Changes Needed in Banking’, FBIS-SOV-90-129, 5 July 1990.

the executive and administration.12 For the first time in Soviet history it also set limits on
Gosbank funding of the Ministry of Finance, a radical change.13
The Russian law, on the other hand, granted independence to the Bank of Russia
without acknowledging any Soviet central authority.14 Boris Fedorov drafted the law with
Western standards in mind. Although modified from his original version, the resulting law
made the Bank of Russia independent of the government and accountable to parliament,
limited Bank of Russia lending to the Ministry of Finance to six months, gave the governor
a five-year term, allowed the president to nominate the governor and the parliament to
confirm, and ensured that all board members came from within the Bank of Russia itself.
As Fedorov remembers it, Bank of Russia governor Georgii Matiukhin and Supreme
Soviet speaker Ruslan Khasbulatov pushed the law through an uncomprehending
parliament ‘in record time . . . Matiukhin laid the foundation for our Central Bank and
its independence.’15 This Russian legislation, drawn up in haste to strike a blow against
the Soviet Union, formalized the independent Bank of Russia as a symbol of Russian
sovereignty. This political battle for sovereignty provided few incentives (and indeed, some
significant disincentives) for the central bankers to increase their technical capabilities or
to stop funneling cheap credits to state enterprises. Instead, Gosbank and the Bank of
Russia competed to offer easier registration and lighter regulation to the rapidly prolif-
erating commercial banks. As a result, when the Soviet Union collapsed and the Bank of
Russia swallowed Gosbank in late 1991, Russia had a relatively independent central bank
but one whose institutional framework, internal culture, and technical capabilities had
otherwise changed little.
Freed of the need to coordinate with Gorbachev, Gaidar and Yeltsin prepared to intro-
duce radical economic reform in Russia at the beginning of 1992 and the Russian Supreme
Soviet granted them temporary powers to conduct economic policy by decree. However,
other Soviet successor states still used the ruble as currency and their central banks could
directly issue ruble-denominated credits, making it nearly impossible for the Bank of
Russia to control the money supply. When the Russian government’s price liberalization
and macroeconomic stabilization program faltered within weeks of its January inception,
the Bank of Russia came under fire from both the Yeltsin administration and the Russian
Supreme Soviet. Beyond the confounding effects of the ruble zone, the fundamental
problem was a lack of agreement among the Russian government, parliament, and central
bank on the proper course and speed of reforms, exacerbated by the painful consequences
of Russia’s ‘shock therapy’ attempt.
This conflict preserved the Bank of Russia’s autonomy despite the protestations of
the government that it was under parliament’s sway and vice-versa, but at the cost of
uncoordinated and contradictory policy making.16 The Bank of Russia’s power in the
12
S Chugaev, ‘On the Eve of the Congress—Izvestiia Parliamentary Correspondent Reports
from the Kremlin’, Izvestiia, 12 December 1990, 1–2, translated in Current Digest of the Soviet
Press 42, no 50 (1990).
13
Barkovskii (1998).
14
Law of the Russian Soviet Federated Socialist Republic ‘O tsentral’nom banke RSFSR
(Banke Rossii) [On the Central Bank of the RSFSR (Bank of Russia)]’, 2 December 1990.
15
Fedorov (1999).
16
Tompson (1998), Gaidar (1999), Johnson (2000).

triad increased when an embarrassing financial scandal forced Matiukhin from office
and Gaidar chose Viktor Gerashchenko to replace him. The conflict led to a string of
initiatives by both president and parliament to further formalize the Bank of Russia’s
independence, even as each tried and usually failed to undermine the Bank regarding
specific policies. This battle gave the Bank wide latitude to implement its own preferred
policies until Yeltsin forcefully disbanded the Supreme Soviet in October 1993.
Immediately afterward, Yeltsin passed a decree subordinating the Bank of Russia to
the executive until elections for a new lower house of parliament, the State Duma, could
be held in December. Although Gerashchenko had supported the Supreme Soviet in its
battle with Yeltsin, Yeltsin reappointed him as Bank of Russia governor after he agreed to
abide by the presidential decree.17 The December 1993 elections restored the Bank’s legal
independence, as anti-Yeltsin forces won a plurality in the State Duma and Russia’s new
constitution, written by Yeltsin’s team, came into effect. The constitution guaranteed the
Bank of Russia’s independence, declared its main goal to be protecting the stability of
the ruble, and gave the president the power to appoint the Bank of Russia governor with
the Duma’s confirmation.18 Yeltsin’s team and its International Monetary Fund (IMF)
advisors enshrined the Bank of Russia’s legal independence in the constitution despite
their deep suspicions of its work in practice. Boris Fedorov in particular had a strong
personal antipathy toward Gerashchenko and his policies.
The 1995 Law on the Central Bank of the Russian Federation, Russia’s first post-Soviet
central banking law, reflected this combination of Fedorov’s mistrust, Gerashchenko’s
defense of central bank independence, the Yeltsin team’s commitment to Western ideals,
and the influence of international advisors. Fedorov had been elected to the State
Duma in December 1993 and drafted the law in early 1994 in his capacity as head of
the Duma subcommittee on monetary and financial policy.19 Gerashchenko, although
cautioning that the law should ‘pay attention to Russian specifics rather than blindly
copying foreign legal acts’, supported a new law that would flesh out the Bank of Russia’s
powers as enshrined in the constitution.20 During the process Fedorov called on Bank of
Russia officials to testify to parliament, Gerashchenko worked hard to convince Duma
deputies to accept the finalized law, and both invoked IMF demands as a justification
for passing it.21 Although the upper house of parliament rejected the bill for giving too
much independence to the Bank of Russia, the State Duma overrode the rejection and
Yeltsin signed the bill on 15 April 1995.22 The resulting law reduced the governor’s term
to four years from five, but in every other way strengthened the Bank of Russia’s legal
independence and gave it a firmer foundation for its operations.
The Bank of Russia subsequently defended its independence and regularly invoked
international practice in doing so. Yet it was independence with two unusual characteristics.
17
Oleg Roganov, ‘Tsentrobank gotov finansirovat prezidenta [The Central Bank is ready to
finance the president]’ Kommersant, 23 September 1993.
18
Articles 75 and 83 of the Constitution of the Russian Federation, ratified 12 December 1993.
19
Fedorov (1999).
20
Gerashchenko (1994).
21
Tompson (1998), Fedorov (1999).
22
Aleksandr Lin’kov, ‘Strasti vokrug Tsentrobanka [Passion concerning the Central Bank]’
Rossiiskaia gazeta, 22 March 1995.

First, the Bank’s leadership initially acted in the service of its traditional mission,
providing funds for enterprise activities. Western advisors like Jeffrey Sachs mistook such
policies as indications of political subordination because they assumed that independ-
ent central banks would be natural inflation hawks. But as Yegor Gaidar pointed out
in his memoir, the Bank of Russia’s behavior accurately reflected its own institutional
preferences.23 Second, the Bank of Russia sought to protect its autonomy in ways that
did not always follow the Western playbook. Its initial wariness regarding transparency
and advice, its embrace of capital controls during the 1998 Russian financial crisis, and
its use of a Jersey-based bank called FIMACO to hide Russian hard-currency reserves
from foreign creditors in the 1990s reflected a willingness to defy international actors as
well as domestic ones. The Bank of Russia wanted to be part of the international central
banking community, but on its own terms.
II. TRANSFORMING THE BANK OF RUSSIA
The international community devoted extensive time and resources to transforming the
Bank of Russia, especially in the 1990s. The IMF made Russia its top priority in the 1990s
and continued regular consultation after its active lending programs ceased in 2001. It
prioritized Russian membership in 1992, granting Russia an individual, constituency-free
seat on the IMF executive board and an unusually large three percent quota given Russia’s
relatively weak economic position.24 The IMF set up a full-time staff in Russia; through
2001 the IMF sent five or six high-level missions to Russia each year—with monthly
missions in 1995–96—and provided 63 person-years of technical assistance, much of
which went directly toward transforming the Bank of Russia.25 The IMF also worked with
the EU’s TACIS (Technical Aid to the Commonwealth of Independent States) program
to coordinate several major training projects that brought foreign experts to the Bank of
Russia and sent Russian central bankers abroad.
The Joint Vienna Institute, the Centre for Central Banking Studies (CCBS) at the Bank
of England, and the IMF Institute each trained more central bankers from Russia than
from any other post-communist country, with the CCBS leading the way.26 According to
the Bank of Russia, in the late 1990s it was sending at least 200–300 staff per year for
training courses outside Russia; many IMF and national central bank experts came to
Russia to give courses at the Bank’s own training centers as well.27 The Bundesbank did
its most intensive work with Russia in terms of both training and technical assistance.28 In
23
Gaidar (1999).
24
Momani (2007).
25
Odling-Smee (2004).
26
The JVI trained 552 Bank of Russia staff from 1992–2013, the CCBS 993 from 1990 through
2005, and the IMF Institute 209 from 1989 through 2006. Data provided by the JVI, CCBS and
IMF Institute.
27
Manukova (2001).
28
By mid-2001 the Bundesbank had ‘held 49 seminars in Russia attended by over eleven
hundred participants. In addition, 243 Russian specialists have visited the Bundesbank on study
trips’, Bundesbank president Ernst Welteke, ‘Speech to the Central Bank of Russia’, March 2001,
Moscow, Russia. From January 2000 through November 2007, the Bundesbank conducted 188

fact, the Bank of England and the Bundesbank both started working with Russian central
bankers as early as 1990, well before the IMF arrived.29 The Banque de France had a
special relationship with the Bank of Russia as well, sending numerous long-term advisors
through the IMF and conducting regular seminars for the Bank, including at the Bank’s
own training facilities. Many smaller national central banks were involved in training and
technical assistance too, as was the World Bank, the European Bank for Reconstruction
and Development, and other international agencies.
The United States, perhaps naturally given its Cold War history, paid more attention to
Russia than to any other post-communist country, and the Russian government returned
the compliment. Even before the Soviet collapse Yeltsin sought out US officials, arranging
to meet quietly with US Federal Reserve Board chairman Alan Greenspan, former
chairman Paul Volcker, and New York Federal Reserve president Gerald Corrigan at the
White House in June 1991 in order to learn more about the Federal Reserve.30 Yeltsin and
Corrigan formed a quick bond, facilitating early cooperation between the two sides. The
US Federal Reserve, the Financial Services Volunteer Corps (FSVC), the US Treasury,
and USAID worked closely with the Bank of Russia, especially in the 1990s. In sum,
Western central bankers and financial experts came in droves to help transform the Bank
of Russia.
The Bank of Russia was not an easy partner, especially in the early years. Many
community members referred to the Bank of Russia as an ‘imperial’ central bank; tellingly,
with the Bank of Russia they used the phrase technical cooperation instead of technical
assistance so as not to offend. Bank of Russia leaders often refused to delegate key tasks,
creating bottlenecks that made change more difficult even when it was desired. The
Bank also had a hierarchical, bureaucratic and secretive culture, the so-called Gosbank
mentality. Reflecting upon his start at Gosbank in 1989, Andrei Kozlov remembered
internalizing the Gosbank mind-set and how hard it had been afterward to change it,
despite his relative youth.31 Some staffers resisted that change. The Bank also experienced
extensive turnover in the late 1980s and early 1990s as many of the best-qualified staff
left to make their fortunes in the newly lucrative commercial banking system. This had
a short-term negative effect as the most knowledgeable officials abandoned the Bank;
however, it also gave central bankers in their twenties and early thirties the chance to rise
quickly to important positions.
Beyond Russia’s own imperial history, the Bank of Russia was an empire unto itself.
The largest central bank in the world, it had between 60 000 and 80 000 employees,
over 80 assorted regional offices, and nearly 500 cash settlement centers during the two
decades after the Soviet collapse.32 This unwieldy, immense structure resulted in a status
separate activities for the Bank of Russia ranging from short-term technical assistance to larger
training programs. Data supplied to the author by the Bundesbank TZK.
29
Author’s interview with a former senior official in the Bank of Russia, Moscow, Russia, June
2006.
30
Author’s interview with a senior official of the Federal Reserve Bank of New York, New
York City, December 2001.
31
Author’s interview with Andrei Kozlov of the FSVC and Bank of Russia, Moscow, Russia,
March 2002.
32
See www.cbr.ru/today/Default.aspx?PrtId5tubr. In 2014 the Bank of Russia opened two

and cultural division between the Bank’s headquarters and branches. The headquarters
on Neglinnaya street in Moscow had only 2000–4000 employees in total, much closer
to the size of a typical post-communist central bank. The regional branches, however,
had thousands of employees dispersed across Russia who were responsible for banking
supervision and cash operations in their territories. The Bank of Russia also had its
own central personnel training center, a network of 14 banking schools, an interregional
training center in Tula, and three regional centers providing training to branch staff. Few
in either headquarters or regional branches read or spoke English, as Russian had been
the dominant language of Soviet finance and key specialist journals such as the Bank’s
own Den’gi i kredit (Money and credit) and the domestic academic journal Voprosy
ekonomiki (Questions of economics) were published in Russian.
These characteristics colored the relationship between the community and the Bank
of Russia, making its transformation lengthier and more complicated than those of
the central banks of Eastern Europe. The Bank’s size, needs, assertiveness and internal
divisions encouraged it to make unfocused, overlapping, numerous and ongoing demands
for training and technical assistance programs from multiple sources. The Bank of Russia
staff took little the community said on faith; its international advisors repeatedly told me
that Russians needed to see and experience practices concretely before they were willing
to adopt them. The Bank of Russia could engage in bricolage as well, borrowing slightly
different technical practices from various central banks and putting them together to
create a ‘Russian’ version, often to ill effect.
The Bank of Russia staff’s initially weak English meant that training programs and
materials had to be translated for many years, while the Bank’s importance meant that
community members often did provide this service. Still, many courses and networking
opportunities took place in English and thus excluded non-English-speaking Bank of
Russia officials. The Bank of Russia’s size exacerbated the effect, as headquarters staff
could regularly take advantage of community programs abroad while the more numerous
and far-flung regional officials could not. Over time this solidified the Bank of Russia as
two central banks in one—a transformed headquarters integrated into the community
network and its more distanced regional affiliates.
Nevertheless, despite these barriers, energetic Bank of Russia officials and the intensive,
persistent and consistent efforts of the community eventually did substantially reform
the Bank along international lines. Despite the challenges and the frustrations, in the end
the Bank of Russia earned a strong international reputation as a technically skilled central
bank that took inflation fighting seriously. Yet as always with Russia, the story is more
complicated than initial analysis might make it seem. To see why, I turn to the transforma-
tion of monetary policy making and banking supervision in the Bank of Russia between
the Soviet collapse and the global financial crisis.
additional branches in Crimea. For staff and branch numbers, see the Bank of Russia annual
reports.

III. THE BANK OF RUSSIA AND MONETARY POLICY
In the 1990s, the Bank of Russia’s international advisors concentrated on convincing

its leadership to focus on inflation reduction and on helping the Bank to develop
new tools of monetary policy. Both of these efforts succeeded. However, community
members at the time, particularly in the IMF, did not fully appreciate the Bank’s
limited control over the money supply, the weakness of monetary policy transmis-
sion mechanisms, or the implications of the poor coordination between the Bank
of Russia and the government. This led to advice on the ruble zone that would
make it impossible for the Bank to fight inflation, to the development of a securities
market that turned into a government pyramid scheme, and to the introduction of
an exchange-rate regime that cost the Bank of Russia billions to defend. More than
anywhere else in the post-communist world, early community advice had unexpected
and adverse consequences in Russia.
From the IMF’s perspective, its main success from 1992 through 1995 was persuading
the Bank of Russia to take inflation seriously. In January 1992 the Russian government
of President Boris Yeltsin and Prime Minister Gaidar liberalized prices, unleashing a
predictable wave of hyperinflation. People quickly spent down the monetary overhang
accrued in Soviet times when scarcity rather than price had rationed consumption.
Russian companies raised prices and granted each other increasingly larger, unrepayable
credits, creating what became known as the inter-enterprise debt crisis.33 Achieving
macroeconomic stabilization would have required Russia to starkly limit new government
spending and money creation. Two barriers to this plan became immediately apparent:
Bank of Russia governor Viktor Gerashchenko did not agree with the strategy and the
Bank could not fully control the flow of money.
Even though Gaidar himself had nominated Gerashchenko to succeed Grigorii
Matiukhin in mid-1992, Gerashchenko and Gaidar were at loggerheads over policy
almost immediately. As Gaidar explained:
Once confirmed by the Supreme Soviet, Gerashchenko promptly showed himself to be a

highly qualified manager and a forceful organizer . . . But a single negative factor canceled all
this out, and this was that Viktor Vladimirovich was unable to comprehend what should have
been axiomatic for bank management during an inflationary crisis. He sincerely believed that
accelerating the growth of the money supply by issuing more currency would straighten out the
economy . . . Changing the mind of someone with deeply rooted, firmly fixed notions about the
interconnections within a free market economy is not easy . . . Pursuing a stabilization policy
when the head of the country’s chief bank does not accept the very essence of that policy is a
remarkably unproductive business.34
For his part, Gerashchenko argued that the ‘young reformers’ substituted book knowl-
edge for a substantive understanding of the Russian economy, saying ‘I considered the
liberalization of prices – [a policy] that Gaidar lifted from Poland – to be fundamentally
wrong . . . Poland is not Russia. They could carry out the process much more easily. In
our country . . . leaving enterprises without credit in conditions of ever-increasing prices
33
Ickes and Ryterman (1992).
34
Gaidar (1999).

was suicidal.’35 The government and Bank of Russia traded accusations of sabotage as
government spending began to increase after an initial pause and after Gerashchenko
in effect created 1.2 trillion rubles of new state credit in July 1992 by wiping out the
inter-enterprise debts that had accrued. After canceling the debt the Bank of Russia
eliminated the Soviet-era accounting mechanism that had allowed it to build up in the
first place, but continued to use its autonomy to issue credits faster than the IMF or
government preferred. Gerashchenko defended his actions by declaring that a cash
shortage did in fact exist and that enterprises needed to be financially supported during
the transition.
Just as significantly, the existence of the ruble zone made it impossible for the Bank
of Russia to bring inflation down rapidly even if it had wanted to do so. At the time of
the Soviet break-up the newly independent post-Soviet states still used the ruble, and
the others were not on board with Russia’s price liberalization and macrostabilization
plan. Even though the Bank of Russia controlled the printing presses, the other central
banks could—and did—increase the money supply by granting ruble credits to their
state-owned enterprises. They could—and did—also issue parallel currencies to circulate
with the ruble. The Bank of Russia supported retaining the ruble zone, but only if Russia
could gain sole authority over the money supply. The IMF initially not only wanted to
maintain the ruble zone, but to do so in a way that would grant ruble-zone members
shared decision-making power over emissions.36 Only once the Bank of Russia began
to assert its monetary sovereignty in November 1992 by refusing to accept non-Russian
credit rubles to settle Russian accounts did the IMF’s position move in favor of independ-
ent currencies.37 The Bank of Russia unilaterally dealt the final blow to the ruble zone
in July 1993 by circulating new ruble notes within Russia while invalidating the old ones.
The ruble-zone break up would likely have been earlier, less costly and more coordinated
if the IMF had assisted rather than delayed the process in Russia. The IMF’s reputation
suffered in Russia because of this mistake.
Between 1993 and 1995 a potent combination of community socialization, IMF
conditionality, and policy learning through adverse experience led to macroeconomic
stabilization in Russia. Bank of Russia officials such as Dmitrii Tulin, Andrei Kozlov
and Tatiana Paramonova, influenced by Western economic theories and community
advisors, began to express more inflation-averse views. Even Gerashchenko himself
gradually moved in that direction as well. Successive emission-related economic shocks,
in particular ‘Black Tuesday’ when the ruble’s value fell almost 30 percent on 11 October
1994, solidified opinion within the central bank that too-loose monetary policy did in fact
have a negative impact on the economy. Gerashchenko acknowledged his responsibility
for Black Tuesday by tendering his resignation in November 1994, to be replaced as
acting director by his protégée Paramonova. International advisors reported a significant
35
Interview with Viktor Gerashchenko, ‘Viktor Gerashchenko: Iz-za togo, chto ia postoianno
rugal Kudrina, mne ne dali personal’nuiu pensiiu’ [Viktor Gerashchenko: ‘Because I constantly
berated Kudrin, I was not given a personal pension’], Odnako, 21 March 2011, www.odnako.org/
almanac/material/viktor-gerashchenko-iz-za-togo-chto-ya-postoyanno-rugal-kudrina-mne-ne-dali-
personalnuyu-pensiyu-1/.
36
For pointed critiques of the policy, see Granville (2002), Aslund (2002).
37
Odling-Smee and Pastor (2002).

transformation in the Bank of Russia through 1994–95 under Paramonova and then
under new governor Sergei Dubinin, as its staff began to understand open market opera-
tions, grasped the role of monetary policy committees, and learned to read Bloomberg
data screens. Kozlov, remembering this time, remarked that the IMF and other commu-
nity advisors pushed the Bank of Russia to analyze monetary policy in ‘Western ways’.
For example, the IMF asked the Bank of Russia staff to draft Russia’s monetary policy
memoranda themselves, but insisted that it be done using Western standards and meth-
ods. In sum, Bank of Russia officials both began to accept the community’s principles
and to learn its technical practices.
At the same time, the IMF, the FSVC, the Federal Reserve Bank of New York and
USAID consultants worked with the Bank of Russia and other Russian officials to
create new short-term treasury instruments known as GKOs (short for gosudarstvennye
kratkosrochnye obligatsii). Kozlov’s team visited New York and Chicago to learn how to
create the technical infrastructure for a securities market and then applied these lessons
in Russia. First introduced in 1993, GKOs allowed the government to raise revenue
without tapping the Bank of Russia and gave the Bank a new instrument for open-market
operations. By 1995 the government was financing the lion’s share of the budget deficit
through GKOs and inflation had stabilized at moderate levels. With the IMF’s encourage-
ment the Bank of Russia then introduced a ‘ruble corridor’ in July 1995 that promised to
lock the ruble-dollar exchange rate within a tight band. The Bank of Russia’s credibility
rose and it was better able to hire strong economists. As one community member
observed, by 1997 the Bank of Russia had ‘caught up with the times’, was eager to learn
how to do things, and was not surprised by change.38
However, the initial success of the GKO market and ruble could not be sustained.
Russian government spending vastly outstripped tax revenue, and Yeltsin’s team began
to rely on ever-increasing sales of high-yielding GKOs to fill the gap. For their part, the
leading Russian commercial banks enjoyed preferential access to the GKO market and
came to rely on it for profits, resulting in GKOs crowding out enterprise lending and
stifling financial deepening while the non-cash economy (barter and corporate IOUs
called veksels) increasingly dominated Russian economic activity outside the financial
sector.39 Once the government opened the GKO market to foreigners in 1996, specula-
tive capital rushed in as well. Scandal then shook the GKO market in spring 1997 when
USAID admitted that its securities-market consultants from the Harvard Institute for
International Development had improperly used their insider positions for personal
financial gain.40
The Asian financial crisis and falling world oil prices finally brought the GKO pyramid
and the ruble corridor crashing down together. In November 1997 about $5 billion
fled the GKO market in the wake of the Asian crisis; the GKO and stock markets both
continued to tumble in subsequent months.41 The Bank of Russia attempted to restore
confidence by guaranteeing the ruble corridor through at least the year 2000. For the
38
Author’s interview with a senior international central banker, November 2001.
39
Woodruff (1999).
40
Wedel (1998).
41
Dmitry Zaks, ‘Russia’s Biggest Stories of 1997’ Moscow Times, 30 December 1997.

Russian government, the flight from GKOs threatened its solvency and raised the yields it
had to offer, while the drop in commodities prices cut into its already meager tax revenue.
Meanwhile, the Bank of Russia introduced capital controls and spent down its reserves
trying to maintain the ruble’s value. An emergency IMF stabilization loan in July 1998
could not stem the tide. In August, the ruble corridor collapsed and the government
defaulted on its GKOs. Russia had lost the GKO market, its foreign exchange reserves,
and its ruble corridor all at once.
As Gerashchenko complained later, ‘It was unreasonable and unrealistic to announce
a three-year trading band in late 1997. This decision was sheer stupidity.’42 The IMF later
admitted the folly of the fixed exchange-rate regime and may even have been advocating its
loosening by late 1997. Nevertheless, the regime had originally been introduced based on
IMF advice and the resulting exchange-rate stability in 1995–97 shaped market behavior
and expectations such that the Bank of Russia would have incurred significant costs even
if it had abandoned the corridor earlier. The crisis experience in Russia and elsewhere also
forced the IMF to rethink its previously strong line against capital controls.43 Far from
causing trouble, capital controls had shielded countries like Russia and Malaysia from
experiencing even worse damage from the crisis.
Finally, as the IMF’s Martin Gilman noted in retrospect:
[T]he whole opening of the GKO market to nonresidents in 1996 was intended to provide the
government with a deep and broad financial capital market to lower the yield so that it could
have access to less expensive capital. But it was all predicated on the idea that the budget was
going to be brought under control.44
On this point Gerashchenko agreed with the IMF, writing after his post-crisis return to
the Bank of Russia that ‘the fundamental problem’ with the GKO market had been the
government’s exploitation of GKOs to avoid solving its budgetary dilemmas.45 They were
right, but given Russia’s underdeveloped tax collection infrastructure, barely restructured
enterprises, parasitic commercial banks, endemic corruption, political infighting and
social services commitments, serious budget reductions were not in the cards in the 1990s.
Moreover, earlier reforms had done little to address the Russian state’s heavy reliance
on oil and gas revenues, leaving Russia vulnerable to budget catastrophe when world
oil prices fell. In sum, while the IMF and the rest of the international central banking
community did much to transform the Bank of Russia and get inflation under control in
the 1990s, certain core policy prescriptions proved misguided, premature or inappropriate
for Russian conditions.
Nevertheless, the Bank of Russia bounced back from the 1998 crisis and reaffirmed
its commitment to working with the international central banking community. It
ramped up its demands for training and technical assistance in the monetary policy
42
Interview with Viktor Gerashchenko, ‘Vokrug rublia [Regarding the ruble]’ Argumenty i
fakty 39, 1999.
43
Abdelal (2001), Chwieroth (2009).
44
Martin Gilman, ‘Russia’s Challenges in the 1990s: An Interview with Martin Gilman of the
IMF’ Washington Profile News Agency, 3 December 2002. Martin Gilman was the IMF senior
resident advisor in Moscow from 1997 to 2002. See also Gilman (2010).
45
Gerashchenko (1999).

realm less than a year after the crisis occurred and re-declared its allegiance to the twin
principles of independence and price stability. Through successive training programs with
multiple community members, Bank of Russia staff became highly skilled in modeling
and inflation forecasting.46 The Bank of Russia also adopted measures to increase its
transparency, including better and more regular publications as well as moving toward
international financial reporting standards. Comparing Bank of Russia publications
from the mid-1990s and the mid-2000s is like comparing a single AMC Gremlin to a
fleet of Toyota Corollas. The difference in quantity and quality is simply astonishing,
and reflected systematic modeling of techniques and styles (even, in some cases, fonts)
from IMF and other central bank publications. Meanwhile, the 1998 crisis and Vladimir
Putin’s rise to power in 1999 had tamed the oligarchs, rebounding world oil prices filled
the government’s coffers, and Gerashchenko’s contested departure in 2002 led to a less
independent central bank but better coordination among the Bank of Russia, the Finance
Ministry and the Putin government.
Between the 1998 and 2008 crises, the Bank of Russia’s main monetary policy challenge
was to balance its increasingly orthodox desire to fight inflation with the government’s
insistence that it maintain a stable ruble. High oil prices and US dollar depreciation
began to put upward pressure on the ruble, threatening Russian exporters. Following the
government’s orders, the Bank of Russia began to buy dollars and print rubles, running
its foreign exchange reserves up to record levels and spurring moderate annual inflations
of ten to 12 percent. From 2002 on the IMF complained regularly about the Bank of
Russia’s attention to ruble stability and blamed the government for pressuring the Bank.
The Bank of Russia indeed would have preferred to focus more on inflation and less on
the exchange rate, but direct requests from President Putin, the absence of meaningful
domestic support, and the government’s disinterest in listening to IMF advice once it had
no need for loans forced the Bank to compromise. Central banker Oleg Vyugin revealed
the Bank’s frustration with its incompatible inflation and exchange rate mandates as soon
as he left to head the Federal Financial Markets Service in March 2004, denouncing the
‘protectionist’ monetary policy that he himself had so recently been in charge of carrying
out.47
The Bank of Russia had few tools with which to square the circle of lowering inflation
and maintaining exchange-rate stability. Its refinancing rates had little impact as they
were well above interbank rates, commercial banks already complained about its high
reserve requirements, and significant ruble appreciation might attract more outside
capital to Russia and exacerbate the inflation problem. In addition, the government itself
boosted inflation on a regular basis through its spending, through raising administered
prices, through trade protectionism, and through monetizing benefits, meaning than even
moderate ruble appreciation might not lower inflation. Dollar depreciation in the run up
to the global financial crisis put pressure on the ruble as well, making the situation even
more complicated for the Bank of Russia.
Under these conditions, throughout the decade the Bank of Russia regularly declared
46
Author’s interview with a senior Bank of Russia official responsible for monetary policy,
June 2006.
47
Alex Fak, ‘Vyugin Raps Central Bank’s Ruble Policy’ St Petersburg Times, 16 April 2004.

its intention to pull inflation down to the single digits and then failed to do so. This
increased its interest in moving toward a formal inflation-targeting regime, with director
Sergei Ignatiev declaring as early as 2005 that the Bank of Russia had already introduced
elements of the policy.48 In pursuing inflation targeting the Bank of Russia worked closely
with IMF economists and with the Bank of England, and translated CCBS director
Gill Hammond’s 2006 handbook on inflation targeting into Russian to help guide its
transformation. By the time the global financial crisis hit in 2008, the Bank of Russia
had declared its intention to allow greater ruble volatility in its first official steps toward
inflation targeting.49
IV. THE BANK OF RUSSIA AND BANKING SUPERVISION
Although nearly everything that could go wrong did go wrong with banking supervision
in Russia, any discussion must first acknowledge the enormity of the Bank of Russia’s
post-Soviet challenge. The Soviet break-up left Russia with 1360 commercial ‘banks’ of
various sizes, shapes and solvency, a number that grew to nearly 2000 in the next few years.
These banks made their money primarily through political patronage, connected lending,
currency trading, and other speculative and downright illicit activities. The introduction
of national, regional and local elections allowed Russia’s bankers to enter the political
system as campaign financiers, lobbyists and even candidates. Institutional deficiencies,
such as the lack of a treasury system, encouraged state agencies to place their funds in
commercial banks in a process that became heavily politicized. The cash-strapped Yeltsin
government turned regularly to the banking system for funds. The government could
even justify these policies by arguing that its support for (and dependence on) the banks
contributed to the development of capitalism in Russia. Russia’s commercial banks thus
enriched themselves in the 1990s while simultaneously becoming estranged from both
enterprises and households.
Supervising such a banking system would test central bank officials even in an advanced
market economy. In Russia, the Bank of Russia’s numerous regional offices bore the
primary supervisory burden. Bank of Russia leadership and banking supervisors on
the ground inherited a Soviet-era attitude toward supervision, insisting on paperwork,
formalities and deference while the banks engaged freely in rapidly evolving, creative
and risky activities. At the same time, before the Asian crisis the international central
banking community did not make supervision a top priority. USAID stepped in to offer
a supervisory training program from 1994 through 1996, but as a contractor hired to
carry it out admitted, ‘it was not designed the way it should have been designed, but it was
what the Russians were willing to accept.’50 Beginning in 1996 the Bank of Russia became
more open toward having international advisors work with supervisors on the ground, so
at that point the US Federal Reserve and FSVC started sending short-term advisors to
consult on specific aspects of banking regulation and supervision. The EU sponsored a
48
Kommersant, ‘Central Bank Sees a Drop in Inflation’ 15 October 2005.
49
Catrina Stewart, ‘Inflation Threatens an Era of Growth’ Moscow Times, 30 May 2008.
50
Author’s interview with a senior consultant, Washington, DC, November 2001.

TACIS program for banking supervisors in the 1990s as well, with a similar model to the
unsuccessful USAID one. Program evaluations noted the mismatch between the Western
concepts taught and the reality of Russian conditions.51
These years saw the Bank of Russia step up its regulatory and supervisory efforts, but
often in ham-handed ways. To give just one example, the IMF suggested that the Bank
of Russia reduce the commercial banks’ lending limit for single borrowers, and it did so.
But as one FSVC veteran told me
The handling of existing loans had not been discussed with the IMF. If it had been, IMF
advisors would have had no problem making accommodation for loans already on the books.
However, the central bank went ahead forcing banks to cancel loans already made, with serious
consequences to the borrowers and the banks’ credibility with their customer base.52
In 1995 Bank of Russia officials began to pull licenses from troubled banks, but considered
that the end rather than the beginning of the resolution process. A long-time Russian
auditor concurred that the Bank of Russia ‘took its regulations from international text-
books, but without any real understanding’, and pointed out that its directives included
text translated directly from the Basel accords.53
This approach encouraged commercial bankers to evade and undercut the central bank.
When I asked commercial bankers in the 1990s about their attitudes toward the Bank
of Russia, many just shrugged their shoulders and gestured toward impressive mounds
of directives piling up on their desks. For their part, Bank of Russia supervisors often
became cynical in the face of endemic corruption and political pressures. Community
members mentioned Russian supervisors who were educated and knew all of the Basel
principles, yet felt powerless to do anything in their country. The Bank of Russia had
promulgated many and overlapping regulations in its efforts to mimic international
practice, but had yet to develop a cadre of effective supervisors and received little political
support for sanctioning troubled yet well-connected banks.
The August 1998 crisis forced the Bank of Russia, the Russian government, and the
international central banking community to focus more serious attention on bank regula-
tion and supervision. This crisis hit Russia’s commercial banks hard. Between July 1998
and December 1998, the list of the top 50 Russian banks by assets changed by one-third.
By threatening the political power of the largest banks, shaking up the financial system,
and boosting the competitiveness of domestic enterprises through ruble devaluation,
the crisis provided an opportunity to restructure the commercial banking system. It
also brought Russia full circle as the banking system once again came predominantly
under state control. Not only did the Bank of Russia put several banks under its own
administration, but Sberbank also resumed its earlier position as Russia’s near-monopoly
savings bank. International and domestic pressures eventually led the Bank of Russia
to gradually divest itself of most commercial bank ownership. It retained control over
Sberbank, though, both because Sberbank represented an immense asset (its nickname
51
For example, see US General Accounting Office (2000).
52
Author’s correspondence with an FSVC volunteer and former Federal Reserve official,
August 2001.
53
Author’s interview with a Russian audit firm director, Moscow, Russia, June 2006.

was the Ministry of Cash) and because a botched privatization or restructuring could
destabilize the Russian financial system. This is an instance in which the Bank of Russia
acknowledged the international norm—central banks owning commercial ones is a
conflict of interest—and simply defied it as not appropriate for Russia at the time.
Initial reform efforts after the 1998 crisis seemed unpromising, as the Bank of Russia
and Russian government failed to prevent commercial bankers from inappropriately
shifting assets and spent millions bailing some out. Vladimir Putin’s rise to power in
1999 and subsequent taming of the remaining defiant oligarchs, however, completed
what the crisis had started and for the first time lent the Bank of Russia political support
for undertaking banking reform. In December 2001 the Bank of Russia and the Putin
government adopted, after much disagreement and political maneuvering, a joint five-
year strategy for banking sector development.54 The departure of Viktor Gerashchenko
(again) in March 2002 ushered in a new leadership team and brought Andrei Kozlov
back to the Bank of Russia. With Kozlov in charge of reforming the commercial banking
system, things started moving more quickly. Kozlov arrived determined to introduce a
deposit insurance system, force banks to switch to International Financial Reporting
Standards (IFRS), and to consolidate the banking system by cracking down on problem
banks.
Kozlov drew on his international connections and two major community assistance
projects in conducting his campaign. First, the IMF conducted a Financial System
Stability Assessment (FSSA) of Russia in 2002–03. The report backed Kozlov’s plans to
create a deposit insurance system, to introduce IFRS, to tighten capital requirements and
to move toward risk-based supervision.55 The Bank of Russia and the FSSA team jointly
devised a stress testing methodology for Russian banks, and the team’s recommendations
helped Kozlov push through a deposit insurance law in December 2003. Its passage had
been preceded by lengthy hearings during which the FSVC brought in top officials from
the US Federal Deposit Insurance Corporation and the Hungarian Deposit Insurance
Fund to give testimony to Russia’s parliamentary banking subcommittee and to visit
government agencies to answer questions.56
Second, the EU’s TACIS program funded a two-year, European Central Bank
(ECB)-coordinated banking supervision training program for Russia that ran from
November 2003 through October 2005.57 Nine European central banks and three
European supervisory authorities officially partnered on the project and officials from
12 European central banks, two supervisory authorities, the EU, the IMF and the Bank
of Russia sat on the project steering committee. The project trained roughly 800 Russian
banking supervisors through 33 one-week overview courses and another 29 specialized
54
‘O strategii razvitiia bankovskogo sektora Rossiiskoi Federatsii [On the strategy for the
development of the banking sector of the Russian Federation]’ Kommersant daily, 14 January
2002.
55
‘Russian Federation: Financial Stability System Assessment’ IMF Country Report No
03/147, May 2003, prepared by the Monetary and Exchange Affairs and the European II
Departments.
56
Author’s interview with Andrei Kozlov of the FSVC and Bank of Russia, Moscow, Russia,
March 2002.
57
Olsen (2005).

courses, in addition to eight European study visits for supervisory managers and four
high-level seminars in Moscow. The project partners gave the courses at the Bank of
Russia’s training centers. The Bundesbank took on the largest role, offering the basic
course 14 times. The project also produced a book designed to disseminate the core train-
ing materials and messages more broadly throughout the Bank of Russia.
While the ECB insisted that the project was intended to share ideas and not tell the Bank
of Russia what to do, the content and tone of the book (complete with quizzes to test
readers’ comprehension) indicated otherwise. Kozlov and the Bank of Russia contributed
their own chapter at the book’s end, one that emphasized the Bank’s plans to develop
risk-based supervision and acknowledged that the ‘corrective actions’ its branches applied
to noncompliant banks ‘are often untimely and inadequate’. The chapter also noted
several times that Russian law did not give supervisors enough or the right powers to act
in key situations. This kind of complaint had been a bone of contention with the Bank
of Russia’s international advisors, who saw the legal framework as largely acceptable and
politely accused the Bank of using it as an excuse not to act. Underlying tensions also
appeared when the Russians’ chapter noted that although the Bank of Russia intended to
implement Basel II and considered it ‘authoritative’, successfully doing so would require
an improved legal framework, better data, economic stability, and ‘a highly developed
general economic and banking culture’ in Russia.
Indeed, backlash from commercial banks and the difficulties involved in transforming
the Bank of Russia’s immense supervisory apparatus made progress slow and uneven
despite Kozlov’s leadership and the international community’s attention. For example,
commercial bankers and auditors I talked with in Moscow in May 2006 claimed that the
Bank had botched the introduction of IFRS.58 They also criticized the ECB-supported
introduction of ‘dedicated supervision’, which assigned each bank a dedicated coordinat-
ing supervisor with whom to work. They accurately observed that while the system might
have advantages elsewhere, in Russia’s regions having each bank answer to a single lead
supervisor opened the door to corruption.
These critiques came from within the small circle of Western-oriented financial
professionals in Moscow, and paled beside the antagonism that the more questionable
commercial banks directed toward Kozlov’s efforts. The Bank of Russia had intended to
use its new deposit insurance law as a tool of consolidation, protecting the strongest banks
while weeding out others. In the end, however, the Bank admitted nearly 75 percent of
applicants into the system, and even this meager cull spawned vicious press and lawsuits
from those left out.59 The same problems occurred when the Bank of Russia tried to
invoke its new anti-money laundering law to crack down on criminal banks. In May
2004 Kozlov announced that the Bank of Russia had revoked its first license under the
law, sanctioning Sodbiznesbank for engaging in illicit activities. The bank fought back,
barring the Bank of Russia from its premises, organizing demonstrations, and ultimately
sparking multiple bank runs when its media campaign implied that many other banks
58
Author’s interviews with the deputy director of a leading Moscow audit firm and with two
high-ranking Moscow commercial bank officials, Moscow, Russia, May 2006. For an exhaustive
account of the initial transition to IFRS in Russia, see McGee and Preobragenskaya (2005).
59
See, eg., Guy Chazan, ‘Blood Money: Murdered Regulator in Russia Made Plenty of Enemies
Targeting Illegal Cash Flows’ Wall Street Journal, 22 September 2006.

would be sanctioned in the near future. Although the Bank of Russia leadership and the
Russian government stood by Kozlov, his public reputation took a beating.
He pressed forward, and the government introduced its second, upgraded Strategy
for the Development of the Russian Banking Sector in the same month.60 Among other
internationally inspired reforms, the four-year strategy promised to liquidate banks with
less than five million euros in capital. The Bank of Russia continued to withdraw banking
licenses and tighten conditions for commercial banks. Kozlov told commercial bankers
that the Bank was determined to introduce Basel II norms and that ‘in order to under-
stand what we do and how we are viewed, it is necessary to examine ourselves from the
point of view of international practice.’61 Unfortunately, he paid for this persistence with
his life. Kozlov’s murder in September 2006 shocked the Russian financial community.
Investigations revealed that Alexei Frenkel, the disgruntled owner of Sodbiznesbank,
VIP-Bank, and two others whose licenses the Bank of Russia had withdrawn, had ordered
the contract killing. Banking reform limped along more slowly after Kozlov’s death, with
the Bank of Russia not making a serious push to reform commercial banking again until
after the global financial crisis.
V. THE BANK OF RUSSIA AND THE GLOBAL FINANCIAL

CRISIS
In the decade after Russia’s 1998 crisis, Russian politicians and financial markets had
grown steadily more confident. Oil prices rose and the Bank of Russia conducted more
restrained monetary policies, leading to several years of seven to eight percent annual GDP
growth and moderate but stable nine to 15 percent annual inflation. Russia accumulated
foreign exchange reserves of nearly $500 billion and created a $225 billion stabilization
fund to protect again future oil price volatility. But by late 2008, the global financial crisis
had plunged Russia’s economy into turmoil once again. Russia faced declining terms of
trade, capital flight and a rapid drop in international oil prices. The ruble’s value declined
steadily, sparking a domestic rush to convert rubles to US dollars and euros. Russia’s
stock exchanges repeatedly halted trading during autumn 2008 in the face of collapsing
share prices. Russian banks and companies with foreign-currency loans were squeezed,
and credit dried up. The crisis deepened through 2009, a year in which Russia’s GDP fell
by 7.9 percent. The swing from nearly 8.5 percent GDP growth in 2007 to −7.9 percent in
2009 was among the largest in the world.
The Russian government viewed the global financial crisis as the failure of the
prevailing international economic order. The crisis in the euro zone reinforced both the
urgency of reform and the perception that the system’s traditional leaders in the United
60
‘Strategiia razvitiia bankovskogo sektora Rossiiskoi Federatsii [Strategy for the development
of the banking sector of the Russian Federation]’ interview with first deputy governor of the Bank
of Russia AA Kozlov, Garant, 7 May 2004, www.cbr.ru/today/publications_reports/print.asp?file
5kozlov_garant.htm.
61
Andrei Kozlov, remarks to the XIII Congress of the Association of Russian Banks in
St Petersburg, 3 June 2005, http://www.cbr.ru/today/publications_reports/print.asp?file5kozlov_
XIII_mbk.htm.

States and Europe were unable to respond constructively to its problems. In response, the
Russian government—tentatively under President Dmitrii Medvedev and then decisively
after Vladimir Putin returned to the presidency in 2012—adopted a financial nationalist
policy that envisioned Russia as not only financially sovereign at home, but as the rightful
leader of an alternative regional economic order.62
As Russia’s politicians proclaimed themselves in the vanguard of a new world financial
order, Russian central bankers behaved much like the rest of the international central
banking community: they uncomfortably adapted to new demands while attempting to
defend independence and price stability to the best of their abilities. The Bank of Russia
announced in October 2008 that it would adopt a formal inflation-targeting regime as of
2014. As with central banks around the world, the financial crisis forced the Bank to lower
interest rates, provide emergency funds and bailouts to domestic banks, and spend foreign
exchange reserves to support the currency. The crisis hit its reserve funds heavily and
increased the already high level of state ownership in the banking system. Nevertheless, the
Bank of Russia pursued its inflation-targeting goal persistently in the ensuing years, even
after the Russian government gave it new financial regulatory roles and added a growth
mandate to its original price stability mandate. The Bank began building its monetary
policy model in 2007, announced its first informal inflation target in 2010, improved its
monetary policy tools and communications strategies, and gradually increased exchange
rate flexibility.63 It established new monetary policy and statistics departments in August
2013. The IMF supported the Bank’s transition, providing technical assistance and
applauding its preparations for adopting inflation targeting, as did other central banks
like the Bank of England.64 In January 2014 the Bank of Russia announced that it would
seek to refrain from daily interventions in the foreign exchange market and seemed on the
path to adopting its first formal inflation target.65
While it may seem unusual to introduce inflation targeting just as that regime came
under fire internationally, from the Bank’s point of view it made perfect sense. The Bank
of Russia, by this time well integrated into the international central banking community,
had struggled with its previous monetary policy regimes. In an economy dependent on
natural resource revenues, with volatile capital flows, and with a high percentage of state
ownership and control over the economy, the Bank had difficulty reducing inflation
to its preferred level. The discipline and transparency of an inflation target naturally
appealed. As the Bank’s monetary policy chief Ksenia Yudaeva wrote, inflation target-
ing ‘at the start of the 21st century has become one of the most widespread models of
monetary-credit policy in the world.’66 She referenced the 2 to 2.5 percent target as the
62
Johnson and Kőstem (2016).
63
For a description of the early phases in building the Bank’s New Keynesian monetary policy
model, see Borodin et al (2008). For a summary of the model as of early 2015, see ‘Monetary Policy
in the Bank of Russia’s Forecast’ in the Bank of Russia’s March 2015 Monetary Policy Report.
64
‘IMF Executive Board Concludes 2012 Article IV Consultation with the Russian Federation’
Public Information Notice (PIN) No 12/90, 2 August 2012, www.imf.org/external/np/sec/pn/2012/
pn1290.htm.
65
Tom Bowker, ‘Russia “Welcomes” Weaker Currency as Central Bank Sticks to Float Plan’
Central Banking, 30 January 2014.
66
Yudaeva (2014).

standard in ‘developed countries’ and said that given Russia’s more complicated status
as an emerging market the Bank had selected four percent as its planned target rate. She
wrapped up by approvingly citing former Bundesbank president Otmar Emminger’s
famous quote that ‘If you flirt with inflation, you’ll end up marrying her.’
Meanwhile, the Russian government’s desire to promote the ruble internationally
meant that it had a newfound interest in reducing inflation in order to build confidence
in the currency. The Bank of Russia’s early progress toward inflation targeting took place
under the presidency of Dmitrii Medvedev, in the midst of an economic modernization
campaign. Inflation targeting fits the model of a more modern Russian policy focused
on economic diversification and combating corruption. Once Putin returned to the presi-
dency in 2012 and adopted his more nationalist, interventionist economic strategy, the
Bank of Russia had already progressed substantially toward its inflation-targeting goal.
Of course, the Bank of Russia’s increasing focus on price stability irritated many govern-
ment officials and business leaders who argued that a looser monetary policy would
reinvigorate economic growth and bank lending. The Bank responded by pointing out
that easing policy would lead to inflation, not to growth.67 The IMF supported the Bank,
noting that the Russian economy was already operating at full capacity and so expansion-
ary policies would lead to inflation and exchange-rate volatility.68 Bank of Russia officials
further pointed out that the government itself had compromised monetary policy by
hiking prices for commodities controlled by government ‘natural monopolies.’69
Pressures on the Bank increased in 2013 as governor Sergei Ignatiev’s term neared its
end. Ignatiev had established a good international reputation and had championed the
Bank of Russia’s move toward inflation targeting. When Ignatiev stepped down in June
2013, Putin chose his economic adviser Elvira Nabiullina as the next governor, sparking
concerns that the Bank would become even closer to the government and neglect its price
stability mandate. Nabiullina turned out to be a strong defender of the Bank of Russia’s
policies, though, aided by the continuity of the expert staff. Putin further boosted the
Bank by naming deputy governor Aleksei Uliukaev to head the Ministry of Economic
Development, putting an inflation-targeting supporter in charge of a ministry that
traditionally had preferred looser monetary policies.
At the same time, the government formally expanded the Bank of Russia’s legal man-
date to include supporting economic growth and gave it significant new regulatory and
supervisory powers. As per legislation passed in July 2013, the Bank of Russia acquired
the responsibilities of the former Federal Financial Markets Service in addition to its
existing bank supervisory role. Uliukaev admitted during a November 2012 parliamen-
tary hearing that ‘the Bank of Russia is completely happy with the responsibility that it
has now, and probably my colleagues and I don’t really want to expand this sphere of
responsibility, because this is difficult, major, additional work’, but acknowledged that
67
Bank of Russia deputy chairman Aleksei Uliukaev quoted in ITAR-TASS, ‘Fighting
Inflation Is CBR’s Main Contribution to Stimulating Russian Economy-CBR Deputy Head’ 22
May 2013.
68
‘Russian Federation: 2013 Article IV Consultation’ IMF Country Report No 13/310,
October 2013, www.imf.org/external/pubs/ft/scr/2013/cr13310.pdf.
69
‘Easing CBR Monetary-Lending Policy More Likely to Produce Inflation Than Economic
Growth—Shvetsov’ Interfax, 29 March 2013.

the proposed merger would address a real regulatory problem.70 The Bank of Russia had
already engaged in an upgrade of its supervisory capacities through an ECB cooperation
program in 2008–11 focusing on the transition to Basel II standards. Bank of Russia
deputy governor Sergei Shvetsov pointed out that after the global financial crisis world
practice had turned toward establishing consolidated regulators, and that doing so
would strengthen Moscow’s development as an international financial center.71 He also
acknowledged the potential for conflict of interest issues to arise, but insisted that such
conflicts would be manageable. Confirming the post-crisis trend toward consolidated
supervision, the IMF praised the move as one that could better monitor systemic risks.72
Bank of Russia officials deflected concerns about the new growth mandate as well,
insisting that it would not interfere with their pursuit of price stability because achieving
price stability itself would be the best driver of economic growth.
VI. THE UKRAINIAN CHALLENGE
So far so good for the Bank of Russia—it had defended its pursuit of inflation targeting as
its government simultaneously called for a transformation of the international economic
order, and had dealt with its expanded mandate and regulatory powers without further
compromising its autonomy. However, the Russian government’s takeover of Crimea in
March 2014 and the subsequent battle over Ukraine presented a more significant threat.
In November 2013 Putin had encouraged Ukrainian president Viktor Yanukovych to
refuse to pursue an association agreement with the European Union, suggesting that
Ukraine would be better off moving closer to Russia and the nascent Eurasian Economic
Union. Demonstrations in Kyiv ensued after Yanukovych rebuffed the EU, leading
through a complex series of events to Yanukovych’s ouster, the installation of an interim
government in Kyiv, and the Russian government’s decision to annex Ukraine’s Crimean
peninsula. This in turn led to Western economic sanctions, a ratcheting up of interna-
tional tensions to levels not seen since the Cold War, and economic instability in Russia.
The Bank of Russia, which had so recently declared its intention not to intervene in the
foreign exchange market, had to sell $11 billion and raise its key rate by 1.5 percent on 3
March in order to stem a rapid decline in the ruble’s value. There were also credible rumors
that it withdrew over $100 billion in US Treasury bills from the Federal Reserve in the days
before the Crimean independence referendum in anticipation of possible sanctions.73 At
the same time, the Bank of Russia provided over $27 million in cash to sanctions-targeted
SMP Bank, owned by close associates of President Putin.74 The Bank of Russia became
70
Quoted in ‘CBR Has Enough Responsibility without FFMS, but Reasons for Merger
Exist—Ulyukayev’ Interfax, 12 November 2012.
71
‘CBR willing to radically change management structure in 3 years in FFMS merges with it’
Interfax, 6 November 2012.
72
‘Russian Federation: 2013 Article IV Consultation’.
73
‘Russia May Have Withdrawn 105bn Dollars from USA Ahead of Sanctions—Paper’ BBC
Monitoring, 20 March 2014.
74
‘CBR Injects $27m of Cash in Sanctions-Hit SMP Bank’ RosBusinessConsulting, 24 March
2014.

responsible for introducing the ruble and shutting Ukrainian banks in Crimea, while the
ruble advanced in war-torn parts of eastern Ukraine as well.
Most consequentially, after Visa and MasterCard briefly denied service in March
2014 to Russian banks under US sanctions, the Russian government passed legislation
mandating the creation of a separate national payments system and demanding that Visa
and Mastercard deposit millions of dollars with the Bank of Russia in order to continue
operations in the country. The Bank of Russia established the National Card Payment
System in June 2014, an expensive proposition that was justified in the name of national
financial autonomy and security.75 Then, when crisis and sanctions led international
ratings agencies to downgrade Russia’s sovereign credit rating to junk level, the Russian
government started its own national ratings agency instead, adopting legislation in July
2015 that charged the Bank of Russia with creating the new Credit Rating Agency of the
Russian Federation.76
The Ukrainian crisis disrupted the Bank of Russia’s activities as much or more than had
the global financial crisis. Bank of Russia governor Nabiullina reiterated the Bank’s com-
mitment to inflation targeting and insisted that ‘the implementation of structural reforms
should not in any way be tied to sacrificing macroeconomic stability.’77 Yet the Bank of
Russia spent over $125 billion in foreign exchange reserves to slow the ruble’s fall in 2014,
then hiked its key interest rate to a startling 17 percent after the ruble’s value crashed in
December 2014 in an effort to staunch the bleeding. Throughout 2015 the Bank of Russia
found itself actively intervening to moderate volatility in the ruble-US dollar exchange
rate while simultaneously affirming its commitment to its inflation-targeting goal.
Despite continuing support from Putin and the international central banking community,
significant swaths of the Russian elite, press and public blamed the Bank of Russia for
choking the economy with its high interest rates and with destabilizing the ruble, decrying
it as a ‘foreign agent’. The Putin government’s alienation from Western Europe and North
America, its heightened determination to pursue a more financial nationalist path, and
the resulting uncertainties have increasingly put the Bank of Russia in a position where its
liberal, internationalist inclinations and its national responsibilities clash.
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75
Ruslan Krivobok, ‘Central Bank of Russia Establishes National Card System Operator’
RIA-Novosti, 19 June 2014.
76
See ‘Federalnyi zakon ot 13.07.2015 g. No. 222-F3 O deiatel’nosti kreditnykh reitingovykh
agenstv v Rossiiskoi Federatsii [Federal law of 13.07.2015 No. 222-F3, On the activities of the credit
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5_122628if2015-07-24T12_23_34.htm.
77
Quoted in Grigory Sisoyev, ‘Structural Reforms Should Not Sacrifice Economic Stability—
Russian Central Bank’ RIA Novosti, 23 May 2014.

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Voprosii ekonomiki 9: 1–9.

7. Specific challenges to the People’s Bank of China
in a new wave of financial reforms
Zhongfei Zhou1
The launch of the China (Shanghai) Pilot Free Trade Zone (hereinafter Shanghai
FTZ)2 marks a milestone in China’s economic reforms, evidencing its openness to the
rest of the World. Shanghai FTZ is intended to develop replicable and promotable
systems and rules with respect to transforming government functions through shifting
the government’s focus from ex ante approval to on-going and ex post surveillance
and enhancing transparency, facilitating trade through employing the ‘negative list’
and national treatment prior to market access, and widening financial reforms through
the liberalization of the capital account and the internationalization of Renminbi
(hereinafter RMB).3 The People’s Bank of China (hereinafter PBOC) and its Shanghai
Head office have issued a series of rules covering the expansion of RMB cross
border use, RMB’s convertibility under the capital account, interest rate liberalization,
etc.4
The establishment of Shanghai FTZ sets off a new wave of financial reforms in China,
as a pilot in RMB’s convertibility under the capital account, interest rate liberalization,
financial holding companies and other financial innovations. In this context, the PBOC
will face various challenges and its capacity will be tested.
1
This chapter does not represent the views of China Executive Leadership Academy,
Pudong.
2
Shanghai FTZ, located in Pudong New Area in Shanghai, was the first free trade zone in
China, officially launched in September 2013. In December 2014, three more free trade zones
were approved by the State Council, located in Tianjin, Guangdong and Fujian, respectively.
Guangdong FTZ aims to speed up economic integration with its neighboring Hong Kong and
Macao. Fujian FRZ focuses on further integration of the industries of Taiwan and Mainland.
Tianjin FTZ is to better coordinate the development of Tianjin and nearby Beijing and Hebei
province.
3
Among the financial innovations in Shanghai FTZ, the ‘free trade account’ deserves credit.
Free trade accounts are opened by resident and nonresident businesses in Shanghai FTZ in domes-
tic or foreign currency. Funds flowing between free trade accounts and overseas accounts are not
subject to the restrictions that apply to other capital movements.
4
The internationalization of RMB is a national strategy carried out by the Chinese govern-
ment firmly but in a gradual way. Any prudential measure taken against the illegal capital outflows
and inflows should not be considered as tightening capital controls. For example, the regulatory
policies regarding overseas investments in the end of 2016 were intended to clamp down on Chinese
companies and individuals who made false outbound Merger and Acquisition and other overseas
investments which were still prohibited.
117

I. CENTRAL BANK INDEPENDENCE AND

ACCOUNTABILITY
Central bank independence (from the government) has received a great deal of attention
in literature and in practice. Central bank independence can be measured by various
variables, eg, political independence and economic independence.5 Political independence
is the ability of the central bank to select its policy objectives without influence from the
government, measured based on such factors as the institutional relationship between the
central bank and government, while economic independence is the ability to use instru-
ments of monetary policy without restrictions, measured based on the extent to which the
central bank is required to finance government deficit.6 Professor Rosa Lastra developed a
framework for assessing legal guarantees of central bank independence from organic and
functional dimensions.7 Applying Professor Lastra’s framework to the central bank law
of China, it may be concluded that the PBOC seems to only enjoy limited independence.
Under the 2003 PBOC Law, the PBOC is delegated to formulate and implement monetary
policy under the leadership of the State Council.8 Measures related to the money supply,
interest rates, exchange rates and other important matters are determined by the State
Council; the PBOC can implement its decision after obtaining the prior approval of the
State Council.9 The PBOC can use the monetary policy instrument determined by the
State Council.10 The Monetary Policy Committee within the PBOC is not an independent
and only an advisory institution in formulating monetary policy.11
However, the conclusion that the PBOC is not an independent central bank may be
superficial and overhasty without taking into account the Chinese political system. A fear
inherent in central bank dependence on the government is that the central bank would
be subordinate to the dictate of the political authorities who have strong incentives for
monetary expansions for the purpose of short term economic growth, in particular in
the election year. As a matter of fact, such a fear does not emerge under the Chinese
political system. The government never needs to win votes by creating more employment
and higher economic growth rate with inflationary policy. As part of the State Council,
the principal-agent relationship between the State Council and the PBOC truly reflects
the nature of their relationship: they share common interests in terms of monetary policy
objective; they work together to maintain monetary stability and in the way to facilitate
economic growth. The term ‘leadership of the State Council’ does not mean arbitrary
5
Alberto Alesina and Lawrence H Summers, ‘Central Bank Independence and Macroeconomic
Performance: Some Comparative Evidence’ (1993) 25(2) Journal of Money, Credit and Banking 153.
6
See ibid.
7
See Rosa Maria Lastra, Central Banking and Banking Regulation, Financial Markets Group,
1996, at 27–48. Professor Lastra reconsiders the legal articulation of central bank independence
from the following elements: (1) declaration of independence; (2) organic guarantees and profes-
sional independence; (3) functional or operational guarantees; (4) the ‘economic test of independ-
ence’; (5) financial autonomy; and (6) regulatory powers. See Rosa Maria Lastra, International
Financial and Monetary Law (2nd edition, Oxford, Oxford University Press, 2015) at 70–75.
8
2003 PBOC Law, art 2.
9
Ibid art 5.
10
Ibid art 23(6).
11
Regulations on Monetary Policy Committee of the PBOC, art 2.

Specific challenges to the People’s Bank of China 119
interference of the State Council with the PBOC’s monetary policy deliberations. In
practice, the annual monetary policy, released whether by the PBOC, or the State Council
or the Political Bureau of the Communist Party of China, is discussed between the State
Council and the PBOC, based largely on the PBOC’s decision. From the legislature’s
perspective, ‘leadership of the State Council’ can be more interpreted as holding the PBOC
accountable to the State Council rather than making the PBOC subservient to the State
Council. Since the central bank and the government share a common monetary policy
goal, central bank independence is less significant in China than in Western countries.
When a central bank is delegated authority, it must be subject to checks and balances;
it must be made accountable. Given that price stability is a public good, the central bank
is accountable, in the broadest sense, to the public at large, represented by parliament.
To hold a central bank accountable, parliament requires the central bank to establish
institutionalized contacts with itself, most often in the form of law, so that parliament has
the opportunity to review and assess the performance of the central bank on a regular
basis. Under the 2003 PBOC Law, the PBOC shall submit to the Standing Committee of
the National People’s Congress (hereinafter NPC) its reports with regard to monetary
policy and the operations of the financial system.12 The PBOC, as a matter of practice,
reports the implementation of monetary policy to the special committee on finance and
economy of the NPC on a quarterly basis. Although none of the laws require that the
PBOC attend the inquiries of the NPC, a common practice is that the Governors of the
PBOC answers the ad hoc inquiries made by the representatives or the special committee
of the NPC.
Traditionally, central banks have been accountable to the government. It has been
argued that an overriding mechanism of the government, including the right to issue
instructions, the right to approve, suspend, annul or defer decisions, and the right to
censor decisions on legal grounds,13 would enhance central bank accountability. In
China, the State Council can, according to the central bank law, be involved heavily in the
determination and implementation of monetary policy and other important central bank
activities. In the sense of enhancing accountability, in my opinion, the central bank law
must clearly provide not only for the details of an overriding mechanism, but also for the
conditions and procedures for applying the overriding mechanism. Legal certainty on the
overriding mechanism can provide guarantee for the mechanism not to be used as a tool
for political intervention by the government, but rather as a tool for holding the central
bank more accountable.
Those who are affected by the agency’s decisions and activities should have the right of
legal redress in court. In central banking, accountability to the Judiciary serves to ensure
that a central bank takes action consistent with its governing statutes and observes the
due process requirements. However, some central bank activities are essentially non-
reviewable. In China, under the Law of Administrative Procedure, the court only accepts
the lawsuit against specific administrative acts of an administrative agency, while abstract
administrative acts fall outside the jurisdiction of a court. It is generally accepted that an
12
Ibid art 6.
13
Jakob de Haan et al, Accountability of Central Banks: Aspects and Quantification (manu-
script, May 1998), at 6.

abstract administrative act is one done by an agency with a general binding force against
unspecific persons and matters while a specific administrative act is one with a specific
binding force against specific persons and matters. Obviously, the PBOC’s decisions and
activities on monetary policy fall within the category of the abstract administrative acts
and are thus non-reviewable. In addition to monetary policy, the PBOC is authorized
to perform some specific administrative acts, eg, to issue permits to trade in bond and
foreign exchange markets. In the event that a person challenges the PBOC’s decision in
this regard, he can sue the PBOC with the court.
Transparency is a mechanism that facilitates central bank accountability. Without
transparency, the effectiveness of other arrangements concerning central bank account-
ability is diminished. To enhance transparency, the central bank law should prescribe
the requirements for the publication of the reports on central bank performance and
of the minutes of central bank meetings. Under the 2003 PBOC Law, the PBOC shall
prepare and publish its annual report.14 In practice, the PBOC publishes the report on
the implementation of monetary policy on a quarterly basis. According to the PBOC, the
report focuses on how the PBOC implements monetary policy to achieve the monetary
policy objectives, which are determined by the State Council. The report contains five
parts: a summary of monetary credits, monetary policy operations, financial market
operations, macro-economy and monetary policy trends.
Some have argued that transparency will be improved if the minutes of the central bank
meetings are made public. The reason is that the publication of the minutes enables the
public to follow the course of debate among the central bank members and understand
why decisions are made,15 to facilitate holding central bank members to account. The
2003 PBOC Law does not require the PBOC to publish the minutes of its meetings. As
a matter of practice, the PBOC publishes the summary of its meetings shortly after its
meetings. For example, the PBOC publishes a brief of the quarterly meetings of the
monetary policy committee soon after the meetings. This type of brief usually contains
the achievements made, a summary of current economic situations, and the actions to be
taken in the implementation of future monetary policy. Although only those who have
expertise in economy and finance could catch different, perhaps important, information
between the lines of the briefs, these briefs do provide a comparative means for the public
to assess the PBOC’s performance.
II. INSTRUMENTS TO MAINTAIN FINANCIAL STABILITY
The PBOC is explicitly mandated to maintain financial stability.16 However, the PBOC is
only provided with limited and somewhat flawed instruments to carry out this role. These
instruments include supervisory powers, information collection, lender of last resort
(hereinafter LOLR) and deposit insurance scheme.17
14
15
Jürgen von Hagen, The ECB: Transparency and Accountability (manuscript, December
1998), at 7.
16
17
Deposit insurance will be discussed in detail in part IV.

The PBOC has been stripped of financial regulation and supervision powers since the
establishment of the China Banking Regulatory Commission (hereinafter CBRC) which
is now generally responsible for regulating and supervising banking financial institutions,
while the PBOC is granted only limited financial regulatory powers in some specific areas
and under specific circumstances. Under article 32 of the 2003 PBOC Law, the PBOC
has the power to conduct supervision of financial institutions, entities and individuals
in terms of carrying out the PBOC’s rules. In an extreme case, the PBOC has an overall
supervisory power. In the event that a banking financial institution runs into payment
difficulty which would thereby cause financial risks, the PBOC, subject to the approval
of the State Council, has the power to conduct an overall examination of the institution
concerned for the purpose of maintaining financial stability.18 In this case, the PBOC’s
supervisory power is extended to cover every aspect of a problem banking financial
institution.
Without having a complete knowledge of the financial condition of the financial
intermediaries in the country, the PBOC cannot perform effectively its financial stabil-
ity function. According to the 2003 PBOC Law, the PBOC has the power to require
banking financial institutions to report their balance sheets, profit statements, and other
financial accounting and statistical statements and materials.19 However, the flaw here is
the PBOC’s limited information collection coverage, only extending to banking institu-
tions. As a matter of global practice, information such as bank and non-bank debts,
transaction volumes by type, defaults by type and region, consumer stress indicators and
systemic problems are essential for any central bank to pursuit the financial stability role.
Moreover, in the event that a banking institution fails to report, the 2003 PBOC Law does
not grant the PBOC authority to punish such violation. The PBOC does not have any
priority over other financial regulatory agencies in collecting data. There have been cases
in which other agencies refused the PBOC’s request to provide financial data. All these
weaknesses should be removed if the central bank law is revamped.
There is no question about the PBOC’s role as LOLR, although the 2003 PBOC Law
does not explicitly so designate. As one of the monetary policy instruments, the PBOC
may provide loans to a bank.20 With the approval of the State Council, the PBOC may also
provide loans to specific non-banking financial institutions as an exception to the general
prohibition as to the provision of loans to non-banking financial institutions, other enti-
ties and individuals.21 In addition, the 2003 PBOC Law creates a new vehicle—specific
purpose loan—which is defined as a loan determined by the State Council and issued
by the PBOC to financial institutions for the specific purpose.22 It is natural to conclude
that the PBOC’s emergency assistance to recover the liquidity of a bank falls within the
specific purpose stipulated by the law. When exercising the role of LOLR, in practice, the
PBOC focused to a great extent on an individual bank failure, whether it was illiquid or
insolvent, and whether it was an isolated failure or systemic risk based failure. It is appar-
ent that China lacks a certain degree of legal clarity in terms of LOLR. It is proposed
18
2003 PBOC Law art 34.
19
Ibid art 35.
20
Ibid art 23 (4).
21
Ibid art 30.
22
Ibid art 32.

that a rule-based approach to LOLR assistance may be highly desirable in preventing the
abuse of LOLR support facilities.23 In other words, the central bank law needs to empower
explicitly the PBOC as a LOLR and establish the criterion (eg, illiquidity but solvency
criterion) for providing LOLR assistance. In addition, discretion may be granted by the
law to the PBOC in determining (not in advance) the amount, term and interest rate of
last-resorting lending and whether collateral is required or, if necessary, eligible.24
Given the central bank’s overall role of financial stability and the close links between
monetary stability and financial stability, the central bank is ideally placed to assume the
role of macro-prudential regulation.25 The PBOC is regarded as assuming the role of
macro-prudential regulation under article 31 of the 2003 PBOC Law where the PBOC has
responsibility to monitor the operations of financial markets and conduct macro-control
of financial markets. Whether the central bank can directly and successfully counter wider
systemic instability depends on the policy tools available.
The PBOC has developed some macro-prudential tools, such as the dynamic adjust-
ment of differentiated reserve requirements, window guidance guiding bank lending on
a countercyclical basis.26 In 2016, the PBOC introduced a system of macro-prudential
assessment (hereinafter MPA) into its macro-prudential toolkit. Under MPA, the PBOC
focuses on seven factors, including capital, leverage, assets and liabilities, liquidity,
pricing, asset quality, foreign debt risks and credit policy implementation. Based on a
comprehensive assessment, the PBOC will enhance countercyclical adjustments and pre-
vent financial systemic risks. Capital adequacy requirement on a macro-prudential basis
is at the core of MPA, which will still be the most important one applied by the PBOC to
control credit expansion. In MPA, lending will be expanded to include bond investment,
equity investment and other investments, and reverse repos. MPA is conducted on a
quarterly basis but supplemented with on-going surveillance.
Despite these developments, the PBOC’s macro-prudential instruments are rather
limited. This points to the necessity that a law-based, separate set of macro-prudential
regulatory instruments needs to be developed for the specific purpose of maintaining
financial stability. The central bank law of China should equip the PBOC with a set
of macro-prudential instruments at its disposal. Macro-prudential instruments include
23
Before the global financial crisis, only a few central bank laws, eg, the Bulgarian National
Bank Act and the Bank of Korea Act, have general provisions with respect to LOLR. See Dong
He, Emergency Liquidity Support Facilities, IMF Working Paper No 00/79, April 2000, at 27–32.
The US legislation is an exception, which provides detailed provisions regarding the LOLR’s opera-
tions. See Rosa Maria Lastra, International Financial and Monetary Law, supra note 7, at 152–53.
After the global financial crisis, a rule-based approach to LOLR is adopted by some countries, eg,
the UK.
24
See eg, the Financial Services Act 2012 of the UK, Section 9O and part 4, providing greater
clarity with respect to LOLR.
25
See also Luis Garicano and Rosa Maria Lastra, ‘Towards a New Architecture for Financial
Stability: Seven Principles’ (2010) 13(3) Journal of International Economic Law, at Principle 2
(arguing that splitting macro prudential supervision and allocating it to the central bank makes it
possible to capture the main synergies while avoiding most of the organizational costs).
26
The CBRC has also developed a wide range of macro-prudential tools, including higher
capital requirements and leverage ratio, forward-looking loan loss provisioning, loan to value, and
loan to income.

countercyclical capital requirements, leverage limits, collateral requirements, quantitative

credit controls and reserve requirements as well as the power to collect data from and
on the banking and non-bank sectors. In addition, the PBOC should be granted the
following macro-prudential powers: (i) risk surveillance via the collection of market
data; (ii) risk identification and assessment through the review of the data collected; (iii)
enhanced supervision of systemically important financial institutions, shadow banking,
local government financing platforms, real estate market, and mutual guarantee of
enterprises; (iv) assessment of systemic risks conducted by the Financial Stability Bureau
of the PBOC; and (v) risk mitigation by improving counter-cyclical macro adjustment
mechanisms and developing cross-border capital flows and management.
III. FINANCIAL REGULATORY STRUCTURE
There is no optimal financial regulatory structure uniformly applied to all countries.27 The
regulatory structure change in a country depends much on its political culture, historical
path, financial size and structure, response to financial crisis, etc.28 Despite these, the
importance of regulatory structure in the efficiency and effectiveness of financial regula-
tion has been increasingly acknowledged across countries, with emphasis being given to
the question of whether and to what extent the achievement of regulatory objectives is
influenced by the particular institutional structure within which regulatory agencies oper-
ate. In China, the fragmented regulatory structure faces challenges. A number of financial
holding companies have emerged, although there is neither financial holding company law
nor a specific regulatory agency responsible for supervising financial holding companies.
With financial innovations and legal avoidance, more and more financial products and
even shadow banking activities are developed. Financial institutions are increasingly
moving out of their own turf into other sectors. The distinctions between financial prod-
ucts, and between banks and non-bank institutions are becoming increasingly blurred,
the result of which is growing cross-sectoral risks and systemic risks.29
In China, each financial regulatory agency as well as the PBOC develops its
macro-prudential tools in the name of maintaining financial stability which is explicitly
or implicitly mandated to them.
The PBOC, the CBRC, the China Securities Regulatory Commission (hereinafter
27
For the arguments for and against separating monetary and supervisory functions, see eg,
Charles Goodhart and Dirk Schoenmaker, Should the Functions of Monetary Policy and Banking
Supervision Be Separated, Oxford Economic Papers, Vol 47, No 4, October 1995. They claim that
there are no overwhelming arguments for separation or combination model. See ibid at 556.
28
Goodhart and Schoenmaker argue that the question of the appropriate design of regula-
tory system may need to be answered against the particular financial/banking structure of each
country. See ibid. Lastra claims that the debate about the supervisory responsibilities of central
banks is linked to the discussion of the goals and history of central banks. See Rosa Maria Lastra,
International Financial and Monetary Law, supra note 7, at 125.
29
Min Liao, Tao Sun and Jinfan Zhang, China’s Financial Interlinkages and Implications
for Inter-Agency Coordination, IMF Working Paper WP/16/181, August 2016 (evidencing that
Corporations, households, governments, and financial institutions have become more financially
interconnected, particularly since the early 2000s in China).

CSRC) and the China Insurance Regulatory Commission (hereinafter CIRC) all perform
top-down stress tests for their supervised firms either at a macro level or for targeted
sectors. The PBOC also conducts on-site reviews of banks with the purpose of financial
stability. The CBRC has developed a systemic risk early warning system, while the CSRC
has introduced a capital markets risk index monitoring system. However, due to a lack of
enforceable mechanisms for information sharing and coordination in the application of
macro-prudential instruments, sectoral responsibility for maintaining financial stability
will not form a full picture of financial systemic risks.
On 15 August 2013, the State Council agreed to establish Coordination Meeting
System led by the PBOC and with the participation of the CBRC, CSRC, CIRC and
SAFE. The Coordination Meeting System coordinates between monetary policy and
financial regulatory policies; between financial regulatory policies, laws and regulations;
between financial stability maintenance and regional systemic financial risk prevention;
between cross-financial products and cross-market financial innovation; and between
financial information sharing and financial statistics system. It should be noted that
the Coordination Meeting System neither changes the existing financial regulatory
system, nor replaces the existing regulatory division. However, it is doubtful whether
the Coordination Meeting System is sustainable as it is set up more on an administrative
order basis rather than on a law basis. Its soft nature may be unable to provide it with
sufficient authority to coordinate between sectoral regulators to address systemic risk
and fill in the loophole of regulatory arbitrage. Therefore, coordination would be
costly but inefficient and ineffective, in particular when there exist unclear task sharing
and demarcation between sectoral regulatory agencies. Apart from the Coordination
Meeting System, China’s tripartite regulatory system fails to identify the problems that
are building up in individual financial sectors and would be eventually developed into
systemic risks.
Since the global financial crisis, an independent body responsible for macro-prudential
supervision has been established in a number of countries to ensure that risks develop-
ing across the financial system as a whole are identified and responded to in time and
effectively. The macro-prudential bodies in the US, UK and EU have different functions.
But common to them are the functions of collecting and analyzing information and
data, issuing warnings, directions or recommendations with respect to systemic risks, and
coordinating regulatory agencies and other parties which have a stake in systemic stability.
Following the international experience, it is recommended that China’s Coordination
Meeting System be legally upgraded to become a financial stability oversight committee,
established within the PBOC. The committee shall be a collaborative body chaired by the
governor of the PBOC that brings together the expertise of central and local financial
regulatory agencies and even independent experts in relevant fields. The committee should
have a statutory mandate to monitor and identify risks to financial stability. To fulfill
its mandate, it must have authority to collect and analyze information and data on the
financial industry, issue recommendations in response to systemic risks, and coordinate
actions to maintain financial stability among regulatory agencies.
The financial stability oversight committee recommended above has a function of
analyzing and identifying financial systemic risks, but has no regulatory and supervisory
function with respect to cross-sectoral risks created by financial holding companies and
cross-sectoral innovative activities. Given that any of the specialist regulatory agencies

do not have a whole picture about systemic risks, it is recommended that the PBOC is
mandated with regulatory and supervisory responsibility regarding financial holding
companies and systemically important financial and non-financial institutions.
In the longer term, China may adopt an integrated regulatory structure in which
monetary policy, micro-prudential and macro-prudential regulation are conducted under
the same roof of the PBOC. Macro- and micro-systemic risks are often correlated.
Without micro-prudential regulation, the PBOC may not have a holistic view of the
conditions of the whole system and therefore macro-prudential regulation would become
ineffective. In addition, an integrated approach to financial regulation can place financial
holding companies and systemically important financial institutions under supervision,
eliminating regulatory coordination costs across sectoral lines.
IV. DEPOSIT INSURANCE SCHEME
With the Regulations on Deposit Insurance coming into force in May 2015, the gap in
financial safety net in China was filled. The scheme is government-run and administered
by the deposit insurance scheme administration (currently the PBOC). The deposit
insurance fund is contributed by ex ante periodic (per six months) premium payments
from the insured depository institutions, assets allocated from liquidating a failed insured
depository institution, proceeds from deposit insurance fund investments and other
legal proceeds.30 The insured depository institutions pay the premiums according to
the rates determined by the PBOC. The premium rates consist of the basic rate and the
risk-adjusted rate.31 Insured deposits are employed as the assessment base.32 The deposit
insurance fund is only limited to invest in low risk, highly liquid assets such as deposits
in the PBOC and government bonds, central bank notes and other highly rated bonds.33
As a compulsory scheme, the deposit insurance scheme applies to all deposit-taking
institutions, except for branches established in foreign countries or foreign branches
established in China.34 The maximum insurance coverage per depositor is currently set at
RMB 500 000,35 with 99.63 percent of all China’s depositors being fully protected. The
coverage limit is applied to the sum of the deposits including principal and interest that a
depositor holds at the same failed insured depository institution.36
Unfortunately, the Regulations on Deposit Insurance do not define ‘deposit’, only
generally to cover all deposits, whether denominated in RMB or foreign currencies, that
natural persons and entities place with the insured depository institution, except for
inter-financial institution deposits, senior management personnel deposits of the insured
depository institution and other deposits that do not qualify for insurance.37
30
Regulations on Deposit Insurance, arts 6, 10.
31
Ibid art 9.
32
Ibid art 10.
33
Ibid art 11.
34
Ibid art 2.
35
Ibid art 5.
36
Ibid.
37
Ibid.

The deposit insurance scheme administration, currently the PBOC, is granted several
responsibilities such as issuing rules relating to deposit insurance operations, premium
rates, collecting premiums, deposit pay-off, taking early corrective actions and risk
resolution measures, and sharing information with other financial regulatory agencies.38
The mandates reflect that the deposit insurance scheme is not only a pay box, but also
granted with banking supervisory functions. In other words, the PBOC makes use of
the deposit insurance scheme to acquire more banking supervisory powers than those
stipulated by the 2003 PBOC Law.
However, the implementation details of the deposit insurance scheme remain undis-
closed. Because detailed financial institution resolution arrangements are not ready, what
responsibilities the deposit insurance scheme will assume are unclear. Addressing this
should be a central objective as part of putting in place an effective financial stability
framework. Despite this, the Regulations on Deposit Insurance of China are consistent
with international standards in many respects. In the area of deposit insurance, we have
long been perplexed by how to strike a balance between reducing moral hazard and increas-
ing market discipline. In my opinion, the primary objective of deposit insurance is to
prevent destructive bank runs as well as protect depositors. In theory, bank runs should not
occur because the existence of deposit insurance, full and explicit deposit insurance in par-
ticular, would discourage depositors from withdrawing their deposit from a failing bank.
The adverse impact of explicit and full deposit insurance is that insured depositors do not
have incentive to exercise market discipline. But I argue that this is the price (ie, decrease
in market discipline) that a deposit insurance scheme has to pay for preventing bank runs.
In my opinion, a deposit insurance scheme is to achieve the objective of preventing runs
at the cost of sacrificing a certain degree of market discipline. Therefore, in the trade-off
between preventing runs and limiting moral hazard, priority should be given to preventing
runs, and the moral hazard consideration should be secondary to preventing runs.
In a world with less than 100 percent deposit insurance, runs will still develop, so
the most effective way to prevent runs is to provide all depositors with 100 percent
protection.39 As soon as they believe that they would suffer some loss, depositors will run
as quickly as if there were no deposit insurance.40 For this reason, limiting the number
of accounts per depositor and co-insurance are not workable.41 However, 100 percent
protection for all depositors is prohibitively expensive and would completely eliminate the
38
Ibid art 7.
39
See Charles Goodhart, ‘Bank Insolvency and Deposit Insurance: A Proposal’ in Philip
Arestis (ed), Money and Banking: Issues for the Twenty-First Century (Basingstoke, The Macmillan
Press Ltd, 1993) at 84 (full and explicit deposit insurance means that the depositor need no longer
try to withdraw his deposit in the face of perceived bad news).
40
Jack M Guttentag and Richard Herring, ‘The Lender of Last Resort Function in an
International Context’ (May 1983) 151 Essays in International Finance 23.
41
See ibid at 24; Zhongfei Zhou, Chinese Banking Law and Foreign Financial Institutions
(Alphen aan den Rijn, Kluwer Law International, 2001) at 177. In September 2008, the UK abol-
ished co-insurance based on the lesson from the UK’s events that coinsurance created incentives
for depositors to withdraw their funds at the first sign that a bank was in difficulties. See UK HM
Treasury, Financial Stability and Depositor Protection: Strengthening the Framework, January 2008,
para 5.6. In March 2009, the EU revised its Directive on Deposit Guarantee Schemes to abolish co-
insurance. See Directive 2009/14/EC of the European Parliament and of the Council of 11 March

role of market discipline. So it is desirable that the insurance coverage is set at a level that
the overwhelming majority of depositors will be provided with 100 percent protection,
leaving a small percentage of depositors uninsured.
China’s deposit insurance scheme is in compliance with international standards by
renouncing co-insurance and providing 99.63 percent of the depositors with full protec-
tion.42 Compared to other approaches to reforming deposit insurance, the risk-adjusted
premium approach is no doubt the most appealing in reducing moral hazard.43 This
approach increases the incentive for banks subject to potential penalty premium to control
risk-taking and for depositors to carefully select banks according to banks’ risk exposure
while the deposit insurance scheme’s function of preventing runs is still working.
It is wise that China adopts the risk adjusted approach to calculating insurance
premiums, although the approach would present a number of practical problems; for
example, the difficulty of assessing in an objective, precise way the relative degree of
riskiness of the different banks, and of reflecting the relationship between the premium
and actual bank risk. These problems should be addressed by the PBOC in setting forth
the implementation details of the deposit insurance scheme.
V. CONCLUDING REMARKS
The past decade has witnessed the evolving role of the central bank across countries.
The pursuit of longer-term price stability and financial stability remain the two primary
objectives, while there continues to be significant disagreements as to whether financial
regulation and supervision should be put under the same roof of the central bank. With
the coming of the new wave of financial reforms forced by China’s greater integration
in the global financial markets and the internationalization of the RMB, China’s new
generation of central bank law should take into account the changing roles of the central
bank. In addition to the traditional roles, fostering financial stability must be a crucial part
of the PBOC’s mandate, supplemented with a set of macro-prudential instruments which
should be explicitly stipulated by the central bank law. Although it seems to have not put
into agenda to unify all financial regulatory agencies under the PBOC’s roof, a law-based
financial system oversight committee established within the PBOC is needed in order to
address systemic risks. Crucially, to fulfil its mandate, the PBOC must be independent and
accountable, which are guaranteed legally.
2009 Amending Directive 94/19/EC on Deposit-Guarantee Schemes as regards the Coverage Level
and the Payout Delay, Preamble, para (14) and art 1 (3)(c).
42
Press Conference by Legislative Affairs Office of the State Council of China and the PBOC
on the Regulations on Deposit Insurance, on 31 March 2015, available at http://www.gov.cn/
xinwen/2015-03/31/content_2840896.htm.
43
For a detailed discussion, see Zhou, supra note 41, at 175–76; see also The Research and
Guidance Committee of International Association of Deposit Insurers, General Guidance for
Developing Differential Premium Systems, October 2011, at 6 (addressing that the primary objec-
tive of most differential premium systems is to provide incentives for banks to avoid excessive risk
taking); Financial Stability Board, Thematic Review on Deposit Insurance Systems: Peer Review
Report, February 2012, at 22 (addressing that a risk-adjusted premium system may help to mitigate
moral hazard by having banks pay for adopting a higher risk profile, but it is also more procyclical).

8. An evolutionary theory of central banking and
central banking in China
Xiangmin Liu* 44
This chapter tries to understand and explain the development of central banking from
an evolutionary perspective, to develop an analytical framework based on evolutionary
theory, and to use China’s experience in central banking, as well as major central banking
practices around the world, to validate this theory. I present China’s practice of central
banking and its evolution, with a focus on the period after 1984, when People’s Bank of
China received its mandate as the nation’s designated central bank. The understanding
and practice of central banking in China has undergone a sea change since then, not
only largely in line with and in support of the overall economic development and reform
agenda, but also, and more so in the most recent period, to promote further reform and
development of the financial system and the larger economy. I think that China’s practice
of central banking could best be explained by an evolutionary theory, rather than by
any strand of economic, legal or political theories, because the Chinese model of central
banking does not fit neatly with any of these existing theories, and central banking in
China is still fast evolving and open to any theory, model, practice, or elements thereof,
as long as they are proven elsewhere and fit for China’s reform and development needs.
This chapter does not intend to refute or contradict any theories, practices or models of
central banking described in this book. Rather, it intends to develop a general framework
to understand the changing nature of central banking that takes into account the vari-
ations in both theory and practice across jurisdictions and how a change or a common
shock (such as a global financial crisis) in the environment the central banks operate
in induced paradigm shifts and how a new paradigm takes root with new variations in
different jurisdictions. Indeed, this whole idea of evolution and natural selection, which
is the core of modern evolutionary theory since Charles Darwin, could shed new light on
the understanding of central banking both in China and beyond.
I. AN EVOLUTIONARY THEORY OF CENTRAL BANKING
Perhaps one of the most misunderstood concepts of modern science and one of the
most contentious concepts in pop culture is the idea of evolution. The word ‘evolution’
depicts a process of change and development, and projects an image of progress, of
something changing for the better. In fact, humans, animals, plants and all living creatures
on earth, including bacteria and viruses, evolve through a three-step process: variation
(differentiation), natural selection and amplification. We do not evolve on purpose to fit
* The views expressed in this article are the author’s personal views only and do not represent
those of the People’s Bank of China.
128

An evolutionary theory of central banking and central banking in China 129
any desired values or preferences. We evolve because there are variations or differentiation
within and across species, and these variations or differentiations could be either random
(in the realm of the non-human biological world) or human designed (in the realm of
human-made technologies or organizations). The natural or social environments then
select those that are fittest to their particular environment. Those variations or attributes
with a survival advantage would tend to propagate themselves through the larger popula-
tion, and thereby increasing their frequency in the population. Thus the amplification.
Like the laws of gravity govern the entire physical world, the laws of evolution apply
to the entire biological world. However, can we directly apply this simple logic of evolu-
tion to explain the emergence and changes in central banking? Since central banks are
part of the larger economic system, we need to answer first whether an evolutionary
theory could be applied to study economic systems. We are used to treating evolution as
either belonging to the realm of biology, therefore it has little to do with the discipline
of economics, or as another version of Social Darwinism, which we already rejected.
But modern evolutionary theory views evolution as something much more general. As
outlined earlier, at its core, evolution is a three-step process—differentiation, selection
and amplification. This process is the same for both natural and human worlds. For
the natural world, differentiation happens randomly through tiny genetic mutation and
random distribution, selection is through natural selection such as climatic and environ-
mental change, and amplification is through survival, reproduction and propagation of
the fittest. For the human world such as an economy, differentiation occurs through both
random and conscious design, selection through markets or the interaction of millions of
consumers and households, and amplification in the form of market success and spread
of fashion and widespread adoption of a new product, brand or business model. Modern
evolutionary theorists believe that, like gravity, evolution is a universal phenomenon, a
general algorithm and information processing mechanism that differentiate, select and
amplify new products, new ideas, new technologies, new business models, new institutions,
new modes of governance, and yes, new ways of conducting central banking.
So here is a simple evolutionary theory of central banking: from the emergence of
modern central banks to the contemporary world of post-global financial crisis, there
have been variations in the design of central banking arrangements to serve the needs of
their respective and particular political authorities or economic realities, and over time
successful models got selected and amplified through widespread adoption in different
jurisdictions in like circumstances. However when the underlying political and economic
conditions underwent substantial or radical change, such as a war or financial crisis or
a revolution in the political regime, old models may no longer work and new designs
emerged to cope with the new environment. And sooner or later, new models got selected
and became dominant. This process is also what we call ‘paradigm shifting’, which to
some bear the look of a revolution but in fact is a process of evolution. The key to this
process is the selection mechanism. Unlike in the natural world, the selection mechanism
is the natural environment, including any climatic and environmental changes, in the
human world, the selection mechanism is humans themselves. In a market economy, a suc-
cessful technology, product, company or business organization is selected by the market
and the amplification is in the form of market shares. Central banks, however, are not (or
no longer are) business organizations and their successes are not, or at least not entirely
or even primarily, selected by markets. Central banks are created to serve the political and

economic needs of a society, and whether they are fit or not for their purposes, they are
selected by the political and economic needs of that particular society. Although even if
they fail, the institution of central banking is not going to go away, or at least not going
away anytime soon, the governors can be replaced and modes of central banking can be
changed. To sum up, in the realm of central banking, the differentiation part is played
by human design, and manifests itself through different institutional arrangements and
practices of central banking. Selection is the political and economic needs of that country.
Amplification is the dominant model or paradigm of central banking across jurisdictions
over a certain period.
II. THE EVOLUTION OF CENTRAL BANKING AROUND THE

WORLD
Central banking has undergone three distinct paradigm shifts, each can be explained
under this evolutionary framework. The first paradigm, of course, is the establishment
of central banking as an institution integral to modern market economy. The history of
central banking is quite short and its beginning only dates back to the seventeenth century,
with the establishment of the Bank of Amsterdam (1609–1819), the Swedish Riksbank
(1668) and the Bank of England (1694). They started off as private institutions with
some sort of state backing to support state finance (including war finance) and economic
development. Over the following two centuries, all major economies established central
banks or central bank-like institutions, including Bank de France (1800), Nederlandsche
Bank (1814), First and Second Banks of the United States (1791–1811 and 1816–36
respectively), German Reichsbank (1876–1945), Bank of Japan (1882) and Banca d’Italia
(1893). Over time, these early central banks acquired two critical functions of modern
central banking: monopoly in note issue and lender of last resort, with other functions
such as state financing or sovereign debt management gradually transferred to state treas-
uries. Similarly, direct support of economic development by central banks largely ceased,
after the spectacular collapse of John Law’s Banque Generale and the successful populist
refusal to renew the charter of the Second Bank of the United States. Establishing the
institution of central bank to manage the nation’s currency based on gold standard and
to provide emergency liquidity support to the banking system, and later the consensus
of central banking as a public function (especially with the establishment of the Federal
Reserve System of the United States in 1913), emerged as the first paradigm in central
banking. It is clear from history that central banks emerged as an evolutionary response
to the political (state finance, war, enhancing power of the sovereign, etc) and economic
needs (supporting economic development through infrastructure financing, maintaining
a stable currency, and containing disruptive impact of financial panics, etc). It was not
designed from top down. Rather, it was a spontaneous innovation to address challenges
to manage a much more sophisticated industrial economy and market-based financial
system, and the fiscal needs of its governments, be they waging wars or promoting
domestic development. Once it passed the selection test of the political and economic
needs of the time, its effectiveness and necessity became obvious, and the institution got
copied around major industrializing economies and as a result, the amplification process
was underway.

This classical paradigm of central banking was shattered by two world wars and the
first global financial and economic crisis (the Great Depression). The gold standard and
serious policy mistakes committed by central banks (most notably the hyperinflation
created by the German Reichsbank and the severe tightening of money supply as well as
the failure to stop the banking system collapse by the Federal Reserve) played their critical
parts in inducing the Great Depression. The war financing needs also greatly undermined
the established separation between central banking and treasury functions.
The post-crisis retrenchment, the establishment of modern financial regulatory
framework, and the Bretton Woods System of fixed exchange rates and closed capital
accounts ushered in an extended period of financial market moderation and stability
from the end of Second World War all the way up to the start of this most recent global
financial crisis. The post-war period can be further divided into the Bretton Woods and
post-Bretton Woods periods. During the Bretton Woods period, capital accounts were
largely closed, financial markets were tightly regulated, and central banks were situated in
a cushy position of maintaining the dollar peg and focusing on post-war reconstruction
and managing domestic business cycles through the use of interest rates along the lines of
Keynesian economics, with the International Monetary Fund (IMF) playing the role of
international policy coordination. In the post-Bretton Woods period, and especially after
the ‘Reagan-Thatcher revolution’, laissez-faire was ascendent, de-regulation and liberali-
zation became the norm, Chicago School of economic thought won over and Keynesian
economics was cast aside. The second paradigm of central banking emerged based on
this new economic and ideological foundation: inflation targeting became the main focus
of monetary policy, which became the core mission of central banks, which either spun
off their supervisory functions, or relegated them to a secondary role. To effectively carry
out this new mission, better to insulate monetary policy from political pressure and to
have central bank independence. Despite the bad omens revealed by several regional crises
(from the Latin American debt crisis to the Asian financial crisis), the 1990s witnessed the
completion of this paradigm shift, and the new paradigm of central bank independence
and inflation targeting dominated the developed economies up until 2008.
The underlying political and economic needs of the time again spawned this second
paradigm shift. The stagflation of the 1970s brought the failings of Keynesian economic
policies and the excesses of post-war welfare state into sharper focus and set the stage
for de-regulation and liberalization policies and supply-side economics to take center
position. Freer markets ushered in a new age of prosperity and globalization, which
increased calls for further liberalization. Free markets and flexible exchange rates, open
capital accounts and free flow of capital, less state meddling of the market dominated
political and policy dialogues, and a more libertarian strand of economics became the
dominant economic ideology. The political and economic mainstreams of this era selected
the new central banking paradigm: the technocratic stewardship of the economy by an
independent monetary authority narrowly focused on maintaining monetary stability.
The new and the third shift of paradigm in central banking, of course, has emerged
recently in the aftermath of the global financial crisis. In a Bank for International
Settlements (BIS) tabulation, central banks with some form of explicit financial stability
or macroprudential mandate increased from 2/3 to 4/5 after the crisis. More importantly,
financial stability or macroprudential supervision has become an equally important
mandate for central banks as monetary policy. As compared to the classical model of

central banking when maintaining financial stability was primarily linked with stopping a
banking panic through emergency lending, current understanding of financial stability is
much broader and more sophisticated: financial stability is first and foremost a macro and
systemic concept, achieved through macroprudential policies that are counter-cyclical
in nature and takes into account the systemic issues in the broader economy, financial
markets, and the global factors. It not only requires the traditional lender of last resort
function, but also calls for a coordinated and comprehensive framework that integrates
monetary and prudential policies. Monetary and financial stabilities can no longer be
treated and accomplished separately. Central banks can no longer afford to maintain their
narrow focus on inflation targeting. Under the new paradigm, they are responsible for
overseeing the monetary, prudential, and all the systemic factors in the financial system
(including key financial infrastructures).
This latest paradigm shift is taking place because of the lessons learned from the global
financial crisis. You cannot have globalized finance, free flow of capital, and liberalization
and deepening of financial markets, which brings not only unprecedented prosperity
and wealth creation but also drastically increases the scale, sophistication and intercon-
nectedness of risks, with nobody responsible to oversee and manage the interconnected
and systemic risks. The specialized microprudential regulators, with their narrow focus
on safety and soundness of individual institutions and inadequate grasp of the macro
economy and the financial system as a whole, and most importantly, without the firepower
of money creation and lender of last resort, are ill-equipped to handle such a herculean
task. The underlying financial and economic development again outstripped the earlier
generation model of the separation of central banking and supervision and rendered it
obsolete. The change in the financial and market environment induced by recent decades
of development, innovation and liberalization, has proved the inadequacy of the old
model and created the need for a new paradigm. Central banking has just undergone a
new round of differentiation, selection and amplification, and the new paradigm, that
of the dual mandate of monetary and financial stability for central banks, has emerged.
III. EVOLUTION OF CENTRAL BANKING IN CHINA
Now let’s turn to China’s experience in central banking and examine whether that experi-
ence also supports the evolutionary approach this chapter advocates.
1. The Pre-reform Era
China’s first central bank or central bank-like institution was established as early as 1908,
in the twilight of its 2000-year-long dynastic rule. The bank was set up by the treasury
of the imperial court to support state finance, manage royal treasury, and unify national
currency. Aptly named the Great Qing Bank, the bank obtained an imperial charter and
a modern joint stock corporate form, with half its shares contributed by the imperial
treasury and the other half subscribed by private shareholders. The bank acquired a
monopoly in note issue and the privilege to manage imperial treasury, but also had the
right to engage in normal commercial banking business. Within a short three years of
its founding, however, the imperial dynasty was toppled and the Republic of China was

founded. The Great Qing Bank was forced to shed its official central bank status and
was relegated to become Bank of China, the predecessor to its contemporary entity, as
a commercial bank. The first Central Bank of the Republic of China was founded in
Canton, where Sun Yat-Sen headquartered his first republican government, in 1924 to
support war finance of the Republican government to launch its northern campaign.
As the republican forces expanded its territories, a second Central Bank was founded in
Wuhan at the end of 1926, with a similar purpose to finance the government’s war efforts
by issuing a government-backed currency. As Chiang Kai-shek consolidated his power
and moved the Republican capital to Nanking, a third Central Bank was established in
Shanghai in 1928 to try to unify national currency through a series of currency reforms.
The Nationalist government was weak and had trouble enforcing its policy nationally.
The warlords across China issued their own bank notes. Through great efforts over many
years, the number of note-issuing banks got reduced from over 40 to four in 1935. As the
country came under full-scale Japanese invasion after 1937, while at the same time still
troubled by internal strife, the Central Bank devalued its currency repeatedly and switched
back and forth between gold and silver standards or no standards at all, in a desperate
effort to shore up war finance and win the anti-Japanese war and later the civil war. This
era of financial and monetary chaos only ended with the victory of the Communists and
the retreat of the Nationalist government, including its central bank, to the island of
Taiwan.
The People’s Bank of China (the PBOC) was founded on 1 December 1948, on the eve
of Communist victory. The Bank was commissioned as a state bank that assumed the
functions of issuing a national currency, managing state treasury, managing the nation’s
finance, stabilizing the financial markets, and supporting economic recovery and post-war
reconstruction. The ‘state bank’ model was further consolidated when China formally
chose the Soviet-style planned economy as the path to fast industrialization and national
strength, and when China launched its first Five-Year Plan in 1953. As the state bank,
the PBOC not only served the functions of note issue and financial supervision, but also
engaged directly in financial intermediation along the planning principles: mobilizing
savings and concentrating them in the PBOC, which then allocated the savings to different
parts of the economy according to a central credit plan. Under the command system,
the PBOC was neither a central bank in its true sense, nor a real commercial bank in a
market-based economy. The business of financial intermediation essentially consisted of
mobilizing savings across the nation and channel them through a centralized institution
(the PBOC) to different uses in the command economy based on a central credit plan, the
drafting and execution of which was the primary focus of the PBOC during the planned
economy era (1953 to 1978).
This short survey of history reveals something very simple but basic to understanding
the evolution of central banking: central banks were set up with its functions designed to
serve a country’s dominant political and economic needs of the time. When such needs
change, the form and functions, or even the necessity of the central banks, also change.
Prior to the founding of the People’s Republic, several central banks were set up by the
successive Nationalist governments to support their war effort to unify China, to defeat
the competing political factions, and later to fight the war against Japanese aggression.
The mission focus was war finance and therefore under a bi-metallic standard, inflation-
ary policies became the norm as the government needed to mobilize and deploy precious

metals to finance the war and there was always insufficient reserves left to back the paper
currency. Direct financing of the national debt was also the norm, not unlike those central
banks in their infancy at the other end of the Euro-Asia land mass. After the founding
of the People’s Republic, China soon abandoned the market-based economy in favor of
the command system. The classical central banking model clearly would not fit the needs
of the new system and a centralized, Soviet-style state bank took over the entire financial
system and took care of the credit needs of the entire economy. It is therefore obvious
that as part of the economic governance framework, different central bank models (or
the lack thereof) got selected by the dominant political and economic system, to serve the
dominant political and economic needs. China’s state bank model served the needs of
its planned economy era, and the model operated well into the beginning of the reform
era. When a state decided to forgo markets, the need for a modern central bank also
disappeared.
2. The Reform Era
The monumental Party plenum meeting in the fall of 1978 opened a new era in Chinese
history. After three decades of failed planned economy experiment, China switched
course and embarked on a new journey. In the process, its financial system has undergone
dramatic changes and growth, and the People’s Bank of China shedded its credit alloca-
tion functions and became the nation’s designated central bank. The evolution of PBOC
from a planned era state bank with heavy command legacy to a modern central bank
along the lines of major market economy central banks has been ongoing, and in the
process its functions and forms changed dramatically. Such evolution took place in the
larger context of the country’s reform and opening up, and clearly points to the evolution-
ary need to fit the new political and economic environment in the reform era.
1978–84: beginning of reform and birth of China’s financial system

The Third Plenum of the Eleventh Party Congress that took place in December 1978
was a watershed event in modern Chinese history. The Plenum decisively refocused the
country’s efforts on economic development and reform under the post-Mao leadership of
Deng Xiaoping. As is widely known, the reform efforts began spontaneously in the rural
sector even before the Third Plenum, and a ‘household responsibility system’ emerged in
some rural areas to allow farmers to keep the agricultural surplus after meeting the state
production quotas, greatly incentivizing agricultural production and opening the door to
unprecedented prosperity in rural China. The Third Plenum formally acknowledged the
positive outcome of such reform, legitimized it, and replicated it nationwide. Reforms
soon after trickled to the urban sector, when state factories and enterprises were allowed
to keep a share of their profits to incentivize management and employees. The results of
such a small change in the incentive structure were almost magical: shares of national
income that went into firms and households increased dramatically, and in turn, the
demand for basic banking services such as deposit and lending also increased exponen-
tially. The highly centralized state banking system could no longer meet the needs of a fast
commercializing economy. To support the overall economic reform and development, the
state introduced the first round of financial reforms: re-establishing financial institutions.
With PBOC serving as China’s sole state bank, this essentially meant splitting off PBOC’s

non-central bank functions and incorporating them into different financial entities. So it
happened.
In January 1979, the PBOC submitted to the State Council a plan to re-establish
the Agricultural Bank, and the Agricultural Bank of China (now known as the ‘ABC’)
formally opened for business on 14 March 1979.1 In March 1979, the State Council
approved a PBOC proposal to separately incorporate Bank of China (BOC) to take
over foreign exchange business from it, and to establish State Administration of Foreign
Exchange (SAFE) as a subsidiary of PBOC to supervise foreign exchanges. The China
Construction Bank (CCB) was initially a department within the Ministry of Finance
since the 1950s, mainly responsible for allocating and supervising construction funds.
It acquired its independent corporate entity in August 1979, and was later subjected to
PBOC supervision.2 During the same period, PBOC’s insurance business was separated
out into the People’s Insurance Corporation of China (PICC), the forerunner of China’s
insurance industry. Although the process of peeling off non-central bank functions from
PBOC started as early as 1979, PBOC remained the country’s primary source of credit
for China’s state-owned commercial and industrial sectors up until September 1983, when
the State Council formally designated PBOC as the nation’s central bank and established
the Industrial and Commercial Bank of China (ICBC) to take over its commercial and
industrial credit business.3
The early reforms of the financial sector accomplished two key objectives: first, China
rebuilt the foundation of its financial system, with the ‘Big Four’ banks at the core,
specializing respectively in agriculture, construction, foreign exchange, and commerce
and industry. A big number of rural and urban credit cooperatives, non-bank financial
institutions, and the insurance industry also emerged, which together with the Big Four,
formed a basic structure of financial system to serve the financial needs of the early
reform economy. Second, the PBOC became the nation’s central bank, exited the com-
mercial banking business, and started to concentrate its minds on macro and policy issues.
1984–92: socialist commercial economy and central banking

The Third Plenum of the Twelfth Party Congress in 1984 for the first time clearly stated
that the goal of economic reform was to develop a ‘commercial economy with planning
and based on public ownership.’4 At the Thirteenth Party Congress convened in 1987,
this new direction was further clarified and consolidated into the ‘basic route of the
Party during the preliminary stage of socialism’, which focused the Party’s mission during
this ‘preliminary socialist stage’ squarely on economic development, and announced an
ambitious three-step target for the economy: first, doubling the 1980 GDP and satisfying
people’s basic needs; second, doubling the GDP again by the end of the century and
increasing people’s living standards to ‘moderately well-to-do’; and third, increasing per
capital GDP to the level of the ‘medium developed countries’, raising further people’s
1
People’s Bank of China (ed), A History of Financial Development Under the Chinese
Communist Party（中国共产党领导下的金融发展简史）(China Finance Press, 2012) 205.
2
Ibid, 206.
3
Ibid, 210.
4
Decision of the Central Committee of the Communist Party of China on Economic System
Reform adopted on 20 October 1984.

living standards to ‘well-to-do’, and basically completing modernization.5 In line with this
ambitious development plan, reform focus transitioned from rural to urban sectors, and
all-rounded economic reforms began. Over this period, the highly centralized economic
structure greatly decentralized and diversified. To service an increasingly diverse and
sophisticated commercial economy, the highly centralized financial system also needed
to change. Reforming and further liberalizing China’s tightly controlled financial sector
thus became the first priority for PBOC after it formally obtained the central bank status.
On 17 September 1983, the State Council issued an important decision (the Decision)6
designating the PBOC as China’s central bank, and prescribed ten specific functions
to be exercised by the PBOC. In January 1984, the PBOC formally started exercising
central banking functions, with maintaining monetary stability as its core mission and
a focus on drafting and implementing macro policies in the financial arena. The macro
policies of this era showed a strong focus on the quantitative control of aggregate credit
and money supply, a legacy carried over from the planned era. After operating on the
basis of the Decision for two years, the PBOC’s central bank status and functions were
consolidated formally in a Provisional Banking Regulation, which prescribed the follow-
ing specific functions for the PBOC: drafting and implementing guidelines and policies
of the financial sector; drafting rules and regulations; issuing money, regulating monetary
circulation, and maintaining monetary stability; setting deposit rates and lending rates,
as well as foreign exchange rates; drafting national credit plan, centrally managing credit
funds and working capital of state-owned enterprises; managing foreign exchange, gold
and silver, and their reserves; licensing ‘specialized banks’ and other financial institutions;
leading, managing, coordinating, supervising and examining specialized banks and other
financial institutions; managing state treasury and underwriting government bonds;
supervising securities and financial markets; conducting international financial activities
on behalf of the government. This job description accurately depicts a ‘command and
control’ model of central banking in China during this period: the main tools PBOC
used to carry out its mission included direct quantitative control of money and credit
supplies and centralized credit allocation. It also directly controlled prices in the financial
sector: deposit rates, lending rates, foreign exchange rates were all centrally fixed. As the
sole licensing and regulatory authority, PBOC also controlled the entry and exit of the
full spectrum of financial institutions, and directed their day-to-day business operations.
This ‘command and control’ model of central banking generally fitted well with the
early reform era needs of the Chinese economy. As described earlier, the economic model
established in the initial stage of reform could be characterized as a ‘planned commercial
economy’, and later a ‘socialist commercial economy’, in which market forces were
allowed to play an expanding role in allocating agricultural products and most day to day
consumer goods and services. The key parts of the economy (manufacturing, finance, and
all others) were still heavily controlled. Since finance was state-owned and state-operated,
and financial resources still largely allocated pursuant to planning principles to support
the state-owned sector, there was no need for the central bank to deviate from this com-
5
Report of the Thirteenth Communist Party Congress on 25 October 1987.
6
Decision on that the People’s Bank of China Only Exercising A Central Bank’s Functions
issued by the State Council on 17 September 1983.

mand and control model in finance. The political and economic needs of the early reform
period ‘selected’ the command and control model for PBOC. This should not overshadow
the importance of the key achievements in this period: by becoming the designated central
bank and shedding its commercial operations, PBOC was better positioned to serve an
increasingly commercial and diverse economy, and the reforms it undertook spawned the
emergence of a much needed and vibrant financial sector.
Financial sector reforms: laying the foundation The financial reform over this period
unfolded along the following lines.
First, reforming the foreign exchange regime to support foreign exchange needs of the
first special economic zones, a fast expanding trade sector and facilitating foreign direct
investments. Second, developing and reforming the banking sector. After setting up the
Big Four, China introduced more competition to the banking sector by re-establishing and
creating new joint-stock banks. The overall reform objective for the state banking sector
was to make state-owned banks into true commercial banks operating on commercial,
rather than planned economy, principles. To support financial reforms, then paramount
leader Deng summed up the reform agenda nicely in his own words: ‘We should take
bigger steps of financial reform. We need to make banks into real banks. Our banks in
the past were money issuing entities, were treasuries, but not real banks.’7 The commercial
principle was formalized in the 1986 Provisional Banking Regulation: ‘Specialized banks
are independent budgeting economic entities, carrying out their missions and business
independently according to the state’s laws and regulations.’ This was a big step forward
indeed as in the past, banks were treated as part or an extension of the government and
were supposed to follow command, rather than commercial principles. PBOC imple-
mented this reform vision, granting banks more decision-making power in operations
and business decisions, while at the same time enlarging the business scopes of each bank
to allow overlap and encourage competition. Along similar lines, rural credit coopera-
tives were encouraged to become operationally and financially independent entities that
provided credit support to agricultural production on a cooperative basis.
Third, establishing more non-bank financial institutions to meet increasingly diverse
financial needs of a fast commercializing economy. The trust industry was gradually
re-established. Other non-bank entities including financial leasing companies, finance
companies, a nation-wide postal savings system and a pawn shop industry all emerged
and expanded during this period.
Another important development was the re-establishment and growth of the insurance
industry. As of the end of 1980, the newly re-established PICC had set up branches in
most provinces. After that, PBOC licensed six more insurance companies, including
the first joint-stock insurance company Ping An Insurance in 1988. In 1992, Shanghai
welcomed its first foreign insurance companies including a subsidiary of AIG.8
Fourth, the founding and development of capital markets and other financial markets.
This is probably the most important and far-reaching development in modern Chinese
7
Selected Works of Deng Xiaoping (邓小平文选), Vol III, (People’s Publishing House, 2001)
193.
8
People’s Bank of China, supra note 1, 226.

finance. In November 1982, a Shenzhen-based Bao’an Joint Investment Company

became the first corporate entity to publicly issue stocks. In July 1984, Beijing Tianqiao
Department Store became the first state owned enterprise to publicly issue stocks and suc-
cessfully raised three million yuan in equity. After that, many more joint stock companies
came into being in major cities. Over the following year, the State Council promulgated
a Circular on Strengthening Supervision of Stocks and Bonds, and Shanghai enacted a
local regulation on Over-the-Counter (OTC) securities trading and a provisional measure
on stocks. With the rudimentary rules in place, stock trading volume expanded.
In December 1989, under the leadership of then mayor Zhu Rongji, Shanghai munici-
pal government set up a task force to plan the nation’s first stock exchange. In September
1990, the government of Shanghai and PBOC’s Shanghai branch jointly submitted a
proposal to formally establish Shanghai Stock Exchange. In December, the first formal
stock exchange of modern China opened for business.9 Shenzhen followed suit and set up
the Shenzhen Stock Exchange in December 1990.10
With central government’s blessing, more financial markets came into existence and new
products got created: the foundation of the futures market was laid when the wholesale
grain market in Zhengzhou opened and introduced futures trading; the first standardized
commodity futures contracts was born at a Shenzhen metals exchange; the first financial
future was born in the form of a treasury future at Shanghai Stock Exchange; investment
funds emerged and their shares became tradable on multiple markets. In the process,
securities firms emerged and the securities industry was born.
The debt securities market was born in 1981, when the central government for the first
time after 22 years issued treasuries, mainly to enterprises and other entities but also
included individual subscribers.11 Corporate bonds appeared at about the same time as
treasuries. Offerings were initially targeted mostly at issuer’s own employees, but public
issue soon followed in 1985. Money market also emerged both in commercial papers and
interbank lending.
Over a short decade since economic reform was launched, the foundation of China’s
modern financial sector was laid, the powers of economic freedom and markets were
already in full play, propelling further liberalization and financial deepening over the
next decade. Market demand drove development of financial products and markets,
households, firms and financial institutions innovated to meet their increasing and diverse
financial needs. Finance, economy and the supervisory structure co-evolved into a new
mix that reflected the features of a more commercial and fast industrializing economy.
The ‘emerging’ nature of the algorithm of evolution was evident.
Taming inflation A recurring problem with China’s economic transition during the early
reform era was the issue of inflation. The reasons were not only cyclical, but structural.
First, due to its long legacy of planned economy, there was persistent shortage of supply
from everyday consumer goods to capital goods and other factors of production. Second,
decentralization created thousands of economic engines driven by local governments
9
Ibid, 235–36.
10
Ibid, 236.
11
Ibid, 232–33.

that were incentivized to ramp up local growth to win promotion as well as to expand
local revenue base. On top of that, state enterprises faced the ‘soft budget constraint’
problem and tended to expand without regard to market demand. With rising income
and an optimistic future, urban and rural residents also demanded more and better food
items and consumer goods. As a result, demand often tended to outstrip supply. And
third, in a planned economy, prices were set by the government and tightly controlled.
They did not represent the equilibrium prices set by demand and supply. The price effect
of liberalization was usually a price hike. Hence the transition period has been fraught
with inflationary pressure, and PBOC’s number one priority in terms of macro economic
management has been taming inflation.
The period between 1984 and 1988 was an episode of particularly virulent inflation,
structural imbalance and financial instability. The fast expanding investment and
consumption demands led to very high inflation, and the growth of retail prices reached
an annualized rate of 18.5 percent at the end of 1988.12 Industrial output grew by 20.8
percent in 1988, and fixed investment grew by 23.5 percent, aggravating shortages in
energy, primary materials and transport.13 Agricultural output failed to keep up with
domestic demand, further contributing to inflation and social frustration. The central
leadership underestimated the inflationary impact of price reforms and wanted to finish
the job in a big-bang, resulting in runaway inflation and inflationary expectation. Major
cities rushed to liberalize prices for grain, cooking oil and staple foods, resulting in higher
price expectations and a nationwide rush to hoard staple goods. As if these were not
bad enough, in the rapid financial sector liberalization and growth as outlined above,
non-bank financial entities multiplied and supervision lagged far behind, and financial
markets in many provinces became the wildest west (especially with trust investment
industry). Bank loans grew by 16.8 percent in 1988, and currency supply increased by 68
billion yuan, resulting in an increase of 46.7 percent in notes in circulation by year end.14
As in the last round, the government and PBOC reined in, severely tightening credit
across the board, including the interbank market, and cracking down on the trust invest-
ment industry. Other parts of the government also pulled back the investment lever. In
1989, industrial output growth lowered to 6.8 percent, fixed investment 11 percent, growth
of bank loans fell to 17.5 percent and new note issue to 9.1 percent. Retail prices leveled
out and decreased to 17.8 percent.15
1992–2003: socialist market economy and further reforms to central banking

Globally, the end of the 1980s and early 1990s marked the start of the era of deregulation,
liberalization and a new round of globalization that lasted to this day. It was the end
of the Cold War and the start of a new chapter in global capitalism. It was within this
broader context that China redoubled its reform effort and committed itself unwaveringly
to building a modern market economy. The Fourteenth Party Congress in the fall of
1992 stated clearly to the world that ‘the objective of our country’s economic reform is to
12
Ibid, 238.
13
Ibid, 238.
14
Ibid, 238.
15
Ibid, 238.

establish the system of socialist market economy.’16 The Third Plenum in 1993 outlined
key measures to deepen reforms, and the State Council issued the Decision on Financial
System Reforms (the ‘Financial Reform Decision’) in December 1993, initiating all-round
reforms of the financial sector as a key step to establishing the socialist market economy.
Key elements of this reform blueprint could be summed up as follows: establishing a
system of macroeconomic management with the central bank at the core; separating
commercial banking and policy banking and establishing a system of financial institu-
tions with state-owned commercial banks as the main component but with a diverse
body of other financial institutions; and establishing an open, competitive and effectively
supervised system of financial markets.
Reforms to central banking The Financial Reform Decision clarified PBOC’s main
mandate as: first, conducting monetary policy and maintaining monetary stability;
second, carrying out financial supervision, to ensure safe and efficient operation of the
financial system. To fulfill this dual mandate, PBOC introduced fundamental governance
reforms: (1) centralizing monetary policy functions, including note issue, credit aggregate
management, management of base money, and fixing benchmark rates; (2) establishing
an independent finance and budgeting system and strengthening internal control; (3)
centralizing management of provincial PBOC as branch offices rather than independent
entities with primary responsibilities for financial supervision, economic and statistical
analyses, treasury management, interbank margin management, and clearing and set-
tlement; (4) strengthening financial supervision over banks, non-banks, and insurance
entities; (5) clarifying boundaries between monetary and fiscal policies. In 1994, PBOC’s
direct financing of the treasury stopped, and the treasury could no longer borrow directly
from PBOC after 1995. Direct monetary ties between PBOC and Ministry of Finance
were severed; (6) clarifying boundaries between monetary and investment policies. Except
for loans to finance fixed investment, PBOC stopped allocating credit to finance invest-
ment projects, and ordered banks to stop lending to projects with no capital backup and
no working capital arrangements. Bank loans could no longer be used as enterprises’
own capital or own funds; (7) PBOC’s policy banking functions were transferred to three
newly established policy banks. In March 1995, the Law on the People’s Bank of China
(the PBOC Law) was promulgated and for the first time in its history, PBOC’s status and
functions as the nation’s central bank acquired a firm legal basis.
Monetary Policy Tools The PBOC Law of 1995 clearly provided that the monetary
policy objective is to ‘maintain monetary stability, and thereby promoting economic
growth.’ This squarely put monetary stability, and therefore price stability, as the core
objective of monetary policy and clearly spelled out the relationship between monetary
stability and economic growth. Prior to reform, the omnipotent monetary policy tool
was the credit plan, which carried over into the early days of reform and became the
loan aggregate and cash plan. Having studied the modern monetary policy tools, the
1993 Financial Reform Decision prescribed that the monetary policy tools PBOC should
employ in the new era included ‘required reserve ratio, central bank loans, discount rate,
16
Report of the Fourteenth Communist Party Congress on 12 October 1992.

open market operation, foreign exchange operation, loan quota, and deposit and lending
rates.’ Along these lines, PBOC started to modernize its monetary policy armory.
Beginning in 1994, PBOC gradually phased out loan quotas, and in 1995 introduced
money supply, especially M2, as the main intermediate target of monetary policy.
Liberalization of interest rates proceeded along the sequence of ‘money market and
bond market first, deposit and lending rates second’; and within the latter, ‘foreign cur-
rency rates first, RMB rates next; lending rates first, deposit rates next; longer term, large
amount deposit rates first, short term, smaller amount deposit rates last.’ The process was
completed in about two decades’ time, with the deposit rate cap finally removed in 2015.
The Required Reserve Ratio (RRR) system was established in 1984, but the required
reserves couldn’t be used for payment and clearing purposes, and banks were required to
maintain a separate payment account at the central bank with sufficient funds, resulting in
a high combined reserve ratio of around 20 percent. In 1998, PBOC consolidated the two
accounts, unified the reserve requirement, and lowered the RRR ratio to eight percent.17
Central bank lending used to be the main channel of issuing and managing base money.
Over this period, central bank lending as a key monetary policy tool gradually shrunk
in prominence, and its role as a structural policy tool and a tool to maintain financial
stability gained more attention. For example, PBOC earmarked funds for rural credit
institutions, city commercial banks and credit cooperatives to support agricultural and
SME lending. During the financial risk resolution in 1999, PBOC extended emergency
lending to local governments, distressed financial entities and the newly established asset
management companies (AMCs) to stamp out panic, facilitate risk resolution, and
protect retail investors.
Prior to 1995, PBOC discounted commercial bills to encourage the growth of a
commercial paper market. Once a commercial paper market emerged, PBOC developed
a discount window for banks and developed discount rate into a key benchmark rate.
In April 1996, PBOC experimented with open market operations in the treasuries
market. In May 1998, open market operation was further institutionalized, with the
participant base expanded from 14 to 29 banks, and target securities expanded to include
treasuries, central bank notes and policy bank bonds. In a short period, open market
operation had become the main instrument for PBOC to manage money supply, with 52
percent of base money injected through this channel in 1999.18
Macro Economic Management Between the second half of 1992 and first half of
1993 and shortly after Deng’s Southern Tour, another round of overheating became obvi-
ous, and the Chinese-style business cycle was again in full swing. As usual, leading the
charge was fast-expanding investment, which drove up bank lending and money supply.
In 1992, M2 grew 31.3 percent year over year and the trend continued in 1993. Consumer
Price Index (CPI) reached 14.7 percent in 1993 and 24.1 percent in 1994.19 Unregulated
financial entities sprouted up all over the country, unlicensed lending and illegal financ-
ing schemes were rampant, exacerbating the over investment problem. Artificially cheap
17
People’s Bank of China, supra note 1, 275–76.
18
Ibid, 278.
19
Ibid, 279.

funding available within the formal banking system created strong incentives for insiders
to collude and broker funding schemes that channeled cheap bank funds to eventual
borrowers at multiples of bank rates. Money flowed in high volumes from inland to
coastal areas where returns were much higher under the speculative fever. Some smaller
banks in inland provinces came under severe distress. In response, PBOC carried out a
two-pronged strategy, significantly tightening up monetary policy and cracking down on
illegal financial activities. In 1996, CPI fell back to 8.3 percent and GDP growth lowered
to 9.7 percent (from the 1992 high of 14.2 percent).20 A soft landing was engineered.
Soon after, however, the Asian Financial Crisis hit. In 1998, the consumer price level
turned negative, and the biggest threat to Chinese economy changed from inflation to
deflation in a short two years. PBOC had to quickly reverse its policy stance and loosened
money supply, which, together with an expansive fiscal policy, stabilized aggregate
demand. In the meantime, China pledged not to devalue the currency, removing the big-
gest cloud hanging over investor confidence worldwide. The battle against deflation lasted
well into 2002, when increasing net export as a result of China’s new WTO membership
became an important driving force of economic recovery that ushered in a new decade-
long boom cycle.
Further financial sector reforms Building on the foundation from the prior period, the
financial sector was further liberalized and developed. First were the important reforms
to the foreign exchange regime. Fast growing trade deficits and high inflation during the
1980s and early 1990s created strong depreciation pressure on the RMB, resulting in big
divergence between official and market exchange rates. In May, 1993, China announced
at a General Agreement on Tariffs and Trade (GATT) meeting that it would within five
years establish a single, unified, managed float system based on market forces. Soon
thereafter, PBOC intervened in the foreign exchange market and stabilized the exchange
rate. In November 1993, the Third Plenum of the Fourteenth Party Congress announced
China’s intention to ‘build a market-based managed float foreign exchange regime’ and
to ‘gradually make RMB into a convertible currency’.21 In December 1993, PBOC issued
implementing measures to establish a single, managed float based on market demand and
supply. On 1 January 1994, a single exchange rate system was established, and fixed the
initial rate at a weighted average of 31 December market rates of 8.72 yuan for a dollar.
Through a series of steps in 1996, China eliminated restrictions on the current account,
satisfied the requirements under Article VIII of the IMF Charter, and achieved current
account convertibility.
Second was further deepening banking sector reforms. Without a market-based
commercial banking sector, not only monetary policy lacked an effective transmission
belt, but more importantly, a modern market system cannot be established because
firms cannot become true market players due to the problem of persistent soft budget
constraint when financing was not conducted on commercial and arm’s length basis,
20
Ibid, 281.
21
Decision on Several Issues Relating to Establishing Socialist Market Economy System by the
Central Committee of Communist Party of China adopted by the Fourteenth Communist Party
Congress on 14 November 1993.

and financial resources cannot be allocated efficiently according to market principles. In

December 1993, the Financial Reform Decision made clear that the objective of banking
sector reform was to transform state specialized banks into modern commercial banks.
In 1995, the Commercial Banking Law was enacted to formalize the Big Four as wholly
state-owned commercial banks. Under the new legal framework, the Big Four introduced
governance reforms to centralize credit and funding decisions, clarified legal entity con-
cept and rationalized head office-branch relationships, thus ending the era of thousands
of autonomous local entities captured by local political and economic establishments.
New accounting rules, banking tax rates, Non Performing Loan (NPL) coverage and
setoff rules were introduced. The law also strengthened requirements for banks’ balance
sheet management. In June 1998, China recapitalized the Big Four, injecting fresh capital
in the amount of 270 billion yuan, effectively improving their capital adequacy.
In addition, more joint stock banks were set up, with a more modern corporate govern-
ance structure. City credit cooperatives were reorganized into joint stock city commercial
banks in accordance with the 1995 Commercial Banking Law. In the rural area, rural
credit cooperatives continued to proliferate, but due to a combination of loose internal
control, lack of professional management, and local interference in credit decisions,
40 percent of them were facing a loss. Many credit cooperatives deviated from their
cooperative nature and essentially engaged in unregulated commercial banking business,
ie, taking deposits and lending with no membership, geographic or sector restrictions. In
1996, PBOC led the reform to restore their cooperative nature, but as acknowledgement
to reality, also started incorporating some rural cooperative banks on a pilot basis. At the
same time, credit cooperatives were placed under direct supervision of PBOC branches.
In an effort to separate policy banking from commercial banking, China established three
policy banks in 1994: State Development Bank, China Export Import Bank and China
Agricultural Development Bank, which collectively took over policy lending functions
from the Big Four. As China’s banking sector grew and diversified, the credit support to
the non-state sector also grew. At the end of 2000, 48 percent of the total outstanding loan
balance (4.8 trillion yuan) went to the non-state sector.22
Third, capital markets and other financial markets grew quickly. As Shanghai and
Shenzhen were contemplating China’s first stock exchanges, conservatives in the Party
voiced their opposition and it was Deng himself, during his famous Southern Tour, spoke
decisively in favor of the new capital markets.23 Following the establishment of the two
exchanges, it became obvious that there should be a dedicated securities regulator. In
October 1992, China Securities Regulatory Commission (CSRC) was established, and
the stock-offering experiments extended from Shanghai and Shenzhen to nationwide. In
September 1995, the proposal on the Ninth Five Year Plan specifically mentioned that
China should ‘appropriately expand direct financing’ and ‘proactively and prudently
develop bond and stock financing’. On 1 July 1999, China’s first Securities Law was
enacted.
The money market emerged and expanded. Between 1994 and 1996, PBOC took steps
to establish an organized inter-bank lending market and liberalized the inter-bank rates
22
23
Ibid, 270.

on 1 June 1996, and CHIBOR became a new benchmark rate for short-term lending.
In 1995, China passed a Commercial Paper Law and PBOC promoted the formation of
several regional commercial paper markets. As the treasury primary market liberalized,
PBOC also encouraged the development of a repo market, using treasuries as collateral.
Reforming the supervisory framework At the beginning of the reform, PBOC was the
only financial supervisor for the entire financial sector, which at the time was a simple
bank-dominated system with an inactive inter-bank money market and a capital market in
the cradles. After the founding of organized stock markets, China established a dedicated
securities regulator to supervise the capital markets, and PBOC’s supervisory focus shifted
to banking and financial institutions. Within the PBOC, separate departments were set
up along the functional lines of banking, non-banking financial institutions, insurance,
agricultural credit cooperatives, etc. Later in 1997, supervision of securities firms was also
handed over to the CSRC, and PBOC’s supervisory functions were further consolidated
into two banking supervision departments, a nonbank department, and a credit coopera-
tives department. With the founding of China Insurance Regulatory Commission (CIRC)
in November 1998, a new supervisory structure emerged that was divided along functional
lines of banking, securities, and insurance. In 2003, China established the China Banking
Regulatory Commission (CBRC), taking over day-to-day banking supervision from the
PBOC, and a ‘one bank, three commissions’ supervisory structure emerged. Also during
this period, China adopted Basel standards and started to implement them in earnest.
Resolving failed financial institutions In the period leading up to 2001, and without a
legal resolution regime, China successfully resolved and closed a large number of failed
financial institutions. Examples include the purchase of BOC Trust Investment Company
by Guangdong Development Bank (24 September 1996), closure of China Agriculture
Trust Investment Company (4 January 1997) and placing remaining assets in the trust of
CCB, closure of Hainan Development Bank and placement in the trust of ICBC (21 June
1998), closure of China New Technology Venture Capital Company and the receivership
by PBOC (22 June 1998), closures of 18 rural credit cooperatives and two city credit coop-
eratives in Guangdong and receivership by Guangdong Development Bank (7 December
1998). The biggest closure was Guangdong International Trust Investment Company with
an unpaid debt totaling 14.6 billion yuan, much of it owed to foreign investors. The entity
was declared bankrupt on 16 January 1999. Over the 1998–2001 period, a total of 28 000
rural cooperative funds and over 1700 city credit unions were closed. Another 110 high
risk trust entities, two finance companies, five financial leasing companies were liquidated
as of the end of 2002.24 Building on this period of intense resolution experience, China
enacted its first Regulation on Liquidating Financial Institutions in November 2001,
providing for capital injection, debt-equity swap, receivership, purchase and assumption,
merger, closure and bankruptcy as legal means to resolve a distressed financial institution.
Through forceful action and effective protection of retail investors, financial and social
stabilities were preserved.
24
Ibid, 288–89.

2003–present: modernizing central banking and the financial sector

In December 2001, China joined the World Trade Organization (WTO), another
watershed event that committed China irreversibly to an open economy and further
market-based reforms. The decade following China’s WTO accession witnessed unprec-
edented growth and prosperity, including the trade sector, and the economy’s ascension
to the global number two status and the biggest exporter of manufactured goods. In the
financial sector, China fulfilled its WTO commitments and opened up its banking, securi-
ties, insurance industries and financial markets for foreign competition according to its
schedule of commitments. Under the leadership of a new and visionary governor, PBOC
pushed forward with comprehensive financial reforms and transformation of PBOC into
a modern central bank, opening a new chapter in China’s financial history.
Modernizing monetary and exchange rate policy framework Accompanying the supervi-
sory reorganization of 2003, China amended PBOC Law to formalize the separation of
banking supervision from central banking, but at the same time and with great foresight,
added financial stability as a new mandate for PBOC. Equally important, the law affirmed
PBOC’s jurisdiction over interbank financial markets, especially the bond market. Both
functions were added after the arrival of the new governor Zhou Xiaochuan, who had
moved to head the central bank from the chairmanship of the CSRC and with a deep
repertoire of financial and economic expertise and leadership experience in economic
and financial reforms. This is an important contribution to central banking in China.
From early on and building on China’s experience in resolving several episodes of sys-
temic financial risks, Governor Zhou firmly believed in PBOC’s central role in financial
stability and financial reform and development in China. Under his leadership, PBOC
created a financial stability bureau to focus on both financial stability and key reform
efforts, because he knew true stability could only be achieved through further reform and
development of the financial sector. PBOC also added a financial markets department
to promote the development of financial markets, especially the interbank bond market
which would prove to be a huge success because of the more market-friendly policy
environment PBOC created. Both new functions, financial stability and reform and
development of the financial sector, would in turn contribute to the core mission of PBOC
as a modern central bank in promoting price stability and economic growth.25 In August
2005, to signify the central bank’s new focus on monetary policy and financial markets,
PBOC upgraded its Shanghai branch to head office level in an effort to turn it into the
center for open market operations. It was also a significant step to help Shanghai with its
ambition to become an international financial center.
Traditionally, target securities for open market operation consist mostly of treasuries.
China’s treasuries market was not well developed, however, and PBOC faced a shortage
of treasury securities especially with short tenors, making the treasury yield curve incom-
plete. As PBOC started to focus on open market operations as its main monetary policy
tool, this shortage became more obvious and PBOC was forced to adapt and innovate. In
April 2003, PBOC began to issue central bank notes to fill the void. Since then, central
25
Zhou Xiaochuan, The Global Financial Crisis: Observations, Analysis and Countermeasures
（国际金融危机：观察、分析与应对）(China Finance Press, 2012) 258–60.

bank notes have become an important supplement to the sovereign debt market and
greatly facilitated the operation of monetary policy and helped with the formation of a
more complete sovereign debt yield curve with the addition of key short term maturities.
In December 2003, PBOC started to pay interest on RRR and surplus reserves. In March
2004, it introduced a more market-based flexible rate system on central bank loans. In
April 2004, PBOC introduced a differentiated RRR system based on safety and sound-
ness of individual banks, credit policy, and other macroeconomic factors, as an early
attempt at macroprudential supervision of banking activities.
Money supply, especially the new bank loan aggregates or growth, used to be the main
intermediate policy target for monetary operations. PBOC realized early on that that
needed to change to a more market-based system and to reorient monetary policy opera-
tion to influencing market interest rates. To do that, and more importantly to support
the transition to a more full-fledged market economy, China needed to liberalize interest
rates and make them market-determined. PBOC implemented the earlier mentioned
roadmap to interest rate liberalization with art and determination. Building on earlier
efforts, PBOC liberalized the lending rate ceiling in October 2004, but kept the lending
rate floor at 0.9 times the benchmark rate. At the same time, it abolished the floor on
deposit rates but kept the ceiling. After that, only two restrictions on rates remained: a
ceiling on deposit rates, and a floor on lending rates. Banks were otherwise free to set their
own rates. In August 2006, the lending floor for mortgages was loosened to 0.85 that of
the benchmark, which was further loosened to 0.7 times in October 2008. In June 2012,
the deposit rate ceiling was loosened to 1.1 times base rate, and all lending rate floor was
loosened to 0.8 times base rate which was further loosened to 0.7 times base rate in July
2012. In July 2013, the lending floor was removed for good. The final decisive step toward
interest rate liberalization was taken in October 2015, when the deposit rate ceiling was
finally removed. In a series of incremental but determined steps, China’s interest rate
regime has been liberalized and set the stage for further modernizing PBOC’s monetary
policy operations.26
On the exchange rate front, in July 2005, PBOC announced a managed float system
whereby the rate is to be set based on market demand and supply and a reference basket
of currencies, thus opening a new round of market-based reforms to the exchange rate
regime. In January 2006, a bid-ask system was introduced to replace the earlier matching
method to encourage more market-based pricing behavior, and the median price was
determined by a weighted average of price quotes reported by main foreign exchange
dealers. In May 2007, the RMB/Dollar trading band was expanded from 0.3 percent to
0.5 percent. After that, the exchange rate system became more market-based and more
elastic, with increasing emphasis on market demand and supply and the reference of
a currency basket. In April 2012 and March 2014, the RMB/Dollar trading band was
further enlarged from 0.5 percent to two percent, and the deviation from the median
price that banks were allowed to trade for their clients was expanded to two percent from
the previous one percent in April 2012 and became fully open in July 2014. As market
forces were allowed to play a bigger role in setting the exchange rate, RMB embarked on a
26
Financial Stability Analysis Group of the People’s Bank of China, China Financial Stability
Report 2016 （2016中国金融稳定报告）(China Finance Press, 2016) 133.

gradual appreciation path, with cumulated appreciation of around 35 percent against the
dollar as of August 2015 since 20 July 2005. On 11 August 2015, PBOC announced a more
market-based price formation system for RMB/dollar exchange rates. The key determin-
ing factors have shifted to focus more on the following market indicators: previous closing
price, market demand and supply, and the movement of major currencies. There was a
one-off depreciation of RMB against dollar of two percent, and a further 1.6 percent
depreciation on the second day. Despite some short-term market overreactions to this
important reform, the RMB exchange rate has remained largely stable against both the
BIS basket of currencies and Special Drawing Rights (SDR) basket of currencies. Equally
important, PBOC has clearly spelled out its intention to transition to a more market-
based, flexible managed float system, with the eventual goal of further transitioning to
a ‘clean float’. In the meantime, PBOC extended the trading time of the onshore foreign
exchange market, and welcomed more foreign entities into this market, with the clearly
stated goal of achieving price unification onshore and offshore. By changing its previous
practice of pegging primarily against the dollar, this shift to a more market-based and
basket-based approach made RMB’s exchange rate more market-determined and more
flexible in both directions, effectively ending the one-way appreciation path that started
with the 2005 exchange rate reform. With a more flexible exchange rate in place, PBOC’s
room for independent monetary policy has increased significantly, and China’s balance
of payments position has become more balanced.
Strengthening Financial Stability and Macroprudential Policy Framework

Following the formalization of a financial stability mandate in the 2003 law, PBOC
established its central role in dealing with systemic financial risks and promoting financial
reform and development. And since the global financial crisis, PBOC has been quick to
absorb the key lessons from the crisis and has developed a new macroprudential policy
framework to more effectively maintain financial stability.
The first round of state banking reforms earned China more time to carry out more
fundamental banking reforms. Over the couple years since the 2000 financial reorgani-
zation and capital injection, the balance sheets of the Big Four again worsened and
NPL ratio again crossed the safe line. After all, the underlying governance and incen-
tives structure have not fundamentally changed and it was just a matter of time before
the next crisis broke out. In March 2003, the new government under Premier Wen
Jiabao put banking reform on top of its policy agenda. At his first press conference
as the Prime Minister, Wen stated that ‘the fundamental solution to banks’ problems
lies with reform, with establishing modern corporate governance and modern financial
enterprise system, and creating conditions to implement the joint stock system.’ PBOC
quickly took action and implemented a four-step strategy of banking reform: writing
off bad assets, capital injections (this time directly by PBOC from its vast foreign
exchange reserves due to central government’s tight fiscal constraints), introduction
of international strategic investors (with a view to modernize internal governance and
bring in outside expertise), and public listings both on shore and off shore (so the banks
are permanently subject to capital market discipline). The reform of the Big Four was
a resounding success, and China’s state banking sector was effectively reborn and its
financial health restored and corporate governance improved. They have become the
world’s largest banks by asset and remained financially strong, which enabled them to

weather the shocks of the global financial crisis and to continue serving the needs of
the real economy.
In addition to the Big Four, other medium and small sized banks multiplied and grew in
number, market share, ownership diversity and competitiveness. Both foreign and private
capital flew into this sector. As of the end of 2011, 42 percent of joint stock banks’ equity
and 54 percent of city commercial banks’ equity were privately owned. 92 percent of
rural credit institutions’ equity was privately owned.27 Major international banks became
important stakeholders in China’s banking industry, with HSBC’s acquisition of Bank
of Communications’ strategic stake, Citi Group’s stake in Pudong Development Bank,
Hangseng Bank’s investment in Xingye Bank, etc. In terms of market share, as of end
of 2011, joint stock banks’ assets reached 18.37 trillion yuan, a 16.2 percent share of
total banking assets. City commercial banks’ assets were close to ten trillion yuan and
8.8 percent, respectively.28 Contrary to the international trend since the financial crisis,
China’s banking sector has become less concentrated and the market share of small to
medium sized banks rose and continues to rise. Many of these banks have also listed on
major stock exchanges, and adopted differentiated business strategies and developed
competitive advantages in serving the small to medium enterprises, retail banking, wealth
management, rural finance, etc, further promoting the healthy diversification and growth
of China’s banking sector and contributing to banking sector stability.
There were huge amounts of risks accumulated in the rural credit cooperatives sector, due
to a similar set of factors of weak governance and risk control, government interference of
lending decisions and lack of professional management. The sector was technically insol-
vent at the end of 2002. In 2003 and 2004, PBOC drafted and State Council approved plans
to reform this sector. To fully restore its financial health, PBOC issued special notes to help
fund half of the cooperatives’ capital shortfall in the total amount of close to 170 billion
yuan. The funding was preconditioned on governance and performance benchmarks, creat-
ing an incentive-compatible dynamic that successfully turned the sector around shortly
thereafter. PBOC also utilized its lending, discount window, and differentiated RRR tools
to lower the financing costs and incentivize more credit support to the agricultural sector.
In addition to banking risk resolution and banking sector reforms, PBOC took the
lead to successfully resolve the systemic risks developed in the securities and insurance
industries. In the securities industry, PBOC led the reorganization of nine large securities
firms through a three-step process: capital injection by major shareholders, liquidity
support and introduction of strategic investors. Most of these reorganized firms went
on to become listed companies. In a period of rapid growth and loose regulation, many
securities firms engaged in risky business practices and misused customer money for
speculative purposes, resulting in severe capital and liquidity shortfalls. PBOC and CSRC
jointly resolved 28 high risk securities firms and provided funds to help repay retail inves-
tors’ customer money, and at the same time closed institutional loopholes, introducing
governance reforms, setting up an investor protection fund, and segregating customer
funds in separate bank escrow accounts. In the insurance industry, PBOC and CIRC
jointly resolved high risk insurance entities including China Re, Xinhua Life and China
27
28
Ibid, 301.

United in 2006 and 2007, executing the now proven strategy of reorganization, governance
reform, capital injection, introducing strategic investors, and eventually public listing.29
Similarly, an insurance guarantee fund was set up in 2008 to institutionalize policyholder/
consumer protection on a more market-based and sustainable basis.
A key pillar of the modern financial safety net was added in 2015, when PBOC
announced the long expected deposit insurance scheme based on an enabling legislation,
the Deposit Insurance Regulation. The scheme incorporated the latest developments in
international best practices, including higher levels of protection, mandatory participa-
tion of all deposit-taking institutions, risk-based premia, the authority to monitor risks
and take early remedial actions, and the power of risk resolution.
Taking a key lesson from financial crisis to its heart, in 2009 PBOC incorporated macro-
prudential considerations into its macro policy and financial stability framework. In 2011,
PBOC introduced a dynamic adjustment program for the differentiated RRR, combining
monetary policy and macroprudential considerations. In early 2016, PBOC upgraded
this program to a Macro Prudential Assessment framework, employing the differentiated
RRR based on capital, leverage, balance sheet, liquidity, pricing behavior, asset quality,
foreign debt risk and credit policy factors. The purpose is to strengthen countercyclical
management of the financial sector and the economy and prevention of systemic risks.
International Cooperation With the ongoing globalization of financial markets and

free capital flows, there is heightened need for global cooperation and policy coordina-
tion by major central banks and international financial institutions. PBOC has embraced
such efforts. It has become an active participant in major international organizations
including G20, Financial Stability Board (FSB), BIS and IMF. It also strengthened
regional financial cooperation such as Executives’ Meeting of East Asia-Pacific Central
Banks (EMEAP), ASEAN+3, and its most recent membership in the European Bank
for Reconstruction and Development. Currency swap lines have been arranged between
PBOC and many central banks around the world, and an emergency reserve arrangement
has been set up for BRICS countries. With the rapid internationalization of RMB since
2009 and the admission of RMB into the SDR basket of reserve currencies in November
2015, China’s economy and finance is now more closely integrated than ever with the rest
of the world.
A More Open and Market-Based Financial Sector From its humble beginning a
little over three decades ago, PBOC has transformed itself into a more modern central
bank and a major player in international finance and monetary policy. In the process,
China’s financial sector has undergone fundamental changes and has emerged as one of
the world’s largest banking, securities and insurance markets. At the end of 2015, China’s
banking sector assets reached 199.3 trillion yuan, one of the world’s largest. Weighted
average tier one core capital adequacy ratio of the commercial banking sector stood
at 10.91 percent, and weighted average capital adequacy ratio was 13.45 percent, both
among the world’s highest. Despite downward pressure and concerns over asset quality,
29

NPL ratio remained low at 1.67 percent, and Return on Equity (ROE) was a respectable
14.98 percent. The industry’s concentration level continued its downward path, with large
state owned banks taking up a market share of 39.2 percent on the asset side and 39.1
percent on the liability side.30 The stock market, despite the burst of a leverage-induced
bubble during the summer months of 2015, still held a market capitalization of over 53
trillion yuan by the end of 2015, an increase of 42.63 percent year-on-year, with 2827
listed companies on two exchanges.31 The insurance industry had total assets of 12.4
trillion yuan by the end of 2015, an increase of 21.7 percent year-on-year, which were
invested in bank deposits, stocks, bonds, investment funds and alternative investments.32
Insurance firms have become important institutional investors globally. The bond market
reached a size and depth as one of the world’s largest bond markets, with total debt
securities outstanding at 47.9 trillion yuan at the end of 2015 and a new issue of 22.3
trillion yuan for the year, up by 34.6 percent and 87.5 percent year-on-year respectively.33
China’s capital account has also become more open and China has committed itself to
gradually removing the remaining restrictions and to eventually achieving an open capital
account on an orderly basis. After China opened its current account in 1996, Chinese
government announced its intention to achieve capital account convertibility in a gradual
and controlled manner. Over the intervening years, cross border direct investment has
been fully liberalized. For portfolio flows, a qualified foreign institutional investor (QFII)
and qualified domestic institutional investor (QDII) program have been launched. In sync
with increased cross border use of the RMB since 2009, a RQFII program was added,
and domestic firms have been allowed to borrow offshore. In November 2014, a Hong
Kong-Shanghai Stock Connect program became operational, and a similar connect pro-
gram between Hong Kong and Shenzhen stock exchanges got approved in August 2016
and is expected to become operational late this year. Other exchange connect programs
could be launched in the future. In July 2015, PBOC fully opened the interbank bond
market for sovereign foreign investors. On 30 October 2015, PBOC and other financial
regulators jointly published financial reform policies for the Shanghai Free Trade Zone,
centered around freer capital accounts anchored with a system of ‘free trade accounts’.
(For details please see Annex 1 by Zhou Zhongfei.) In February 2016, it further opened
the bond market for all foreign financial institutions and other medium and long-term
institutional investors without quota limits. With few items remaining fully closed, it is
fair to say China’s capital account is very close to ‘basically’ open.
IV. LESSONS AND RESPONSES
With the above tour d’horizon of China’s history of central banking, and the accompa-
nying analysis, it is clear that an evolutionary perspective that employs key elements in
30
China Banking Regulatory Commission, Annual Report 2015 （中国银行业监督管理委员会
2015年报） (China Finance Press, 2016) 24–26; 168–69.
31
32
Ibid, 65.
33
Ibid, 84.

modern evolutionary theory, namely, differentiation, selection and amplification, could

be used to explain the past and even predict the future of central banking. Prior to the
financial crisis, the world of central banking converged on the dominant paradigm of
single-minded focus on monetary policy and separation of financial supervision from
central banking. The epitome of that old paradigm was the Bank of England with its
supervisory function removed entirely to the Financial Services Authority (FSA) and no
clear mandate for financial stability. The pre-crisis European Central Bank also embodied
the old paradigm. Fortunately, variations in central banking remained. Once the global
financial crisis hit, it was immediately clear that the financial crisis was the most powerful
selection mechanism at work, just like a sudden climatic change or the arrival of the
industrial age created a powerful selection process to eliminate the previous dominant
traits and to favor new variations or even new species. The result of a sudden and
dramatic environmental change often results in mass extinction of pre-existing species
and emergence of entirely new species. The violent impact of the once in a lifetime global
financial crisis acts in ways similar to a big change in our physical environment. The crisis
has proven the unfitness of the old central banking paradigm and selected a previously
unpopular variation: a model that focuses on both monetary policy and financial stability.
Specifically, the crisis has taught us the following four lessons.
First, deregulation and financial liberalization breeds systemic risks. Since the end
of World War II, the financial world has gone through a regulation–deregulation–re-
regulation full circle. In the period leading up to the crisis, the dominant central banking
model was monetary stability and single-minded focus on inflation targeting, accompa-
nied by deregulation and financial liberalization, backed by the economic laissez-faire
philosophy as championed by the Chicago School. The blind belief in an efficient market
led to financial deregulation and relegation of financial supervision to a secondary
function of the central bank and then to separate it out entirely from the central bank.
This financial crisis, just like the one that triggered the Great Depression more than
eight decades ago, has proven yet again that in the financial world, liberalization without
supervision is a formula for disaster. While the lesson is still fresh, people are willing to
adjust the institutions to reflect the new cognitive reality. When memories fade, however,
animal spirits may again triumph over rationality and disaster may strike again. It’s best
to introduce changes while memories and pains are still fresh.
Second, microprudential regulation cannot ensure financial stability. Prior to the crisis,
the belief was that the safety and soundness of individual institutions would automati-
cally bring about financial stability. Therefore central banks should focus on monetary
stability and otherwise leave financial markets alone. The markets would always take care
of themselves in the absence of government interference. Now we know how wrong that
view was and how individual rationality could be compatible with group irrationality,
herd behavior and panic. It is therefore imperative to have a systemic supervisor who is
responsible for overseeing the entire financial system, including the connections between
key institutions and markets, as well as the connection between the financial system and
the real economy, and the inter-temporal connections across all of them. It’s a herculean
task for any single institution to accomplish, to be sure. But it’s better to have such a
designated institution with all the requisite powers and face up to the challenge than to
‘extend and pretend’. Central banks are uniquely positioned to conduct macroprudential
supervision of the entire financial system due to its macro perspective and expertise,

its vast resources as the issuer of legal tender and the key financial market participant,
its central role in clearing and settlement, and its lender of last resort functions. Other
regulators should work in tandem with the central bank and help it accomplish the goal.
Third, separation of monetary policy and supervisory functions undermined financial
stability. Under the old paradigm, the dominant view was supervision and monetary
policy inherently conflict and in order to maintain monetary stability, it would be better
for central banks to shed supervisory function and focus entirely on monetary policy and
jealously guard its independence. The crisis has proven that wrong as well, because finan-
cial stability cannot be achieved by a separate microprudential supervisor, and monetary
stability would not guarantee financial stability. On the contrary, financial instability
would definitely threaten monetary stability. As many of the tools necessary for macro-
prudential supervision, such as leverage, liquidity and capital, are essentially the same
used in routine microprudential regulation, it is even harder to separate macroprudential
and microprudential functions without duplication, regulatory overlap and even conflict.
Fourth, a fragmented supervisory structure not only creates room for regulatory
arbitrage and incentives to ‘race to the bottom’, it also leaves significant regulatory gaps
and seriously hampers crisis response. The fact that not one single agency even sounded
an alarm during the lead-up to financial crisis strongly indicates significant regulatory
gap and lack of accountability. In both the US and UK, no single agency, including
the central bank, had the full view of the financial sector risks on an integrated basis,
because the regulatory authority was too fragmented and the inter-departmental sharing
of information proved to be highly unreliable and inefficient. Ex post, it was even hard
to pinpoint who was responsible for financial stability and agencies were free to play the
blame game. The lessons from financial crisis call for a significant consolidation of the
supervisory structure and integrated approach to financial regulation, with central banks
at the core.
In China’s case, although China’s financial sector performed strongly and weathered
the storm relatively well through the global financial crisis, this was largely due to the
happy coincidence of timing, that is, the most recent round of banking sector reforms
and financial risk resolution put Chinese financial sector’s health at a strong footing on
the eve of the global financial crisis. The fragmented supervisory structure and PBOC’s
lack of effective regulatory tools, however, if left unamended, would surely breed the
next financial crisis in China. In fact, a mini crisis already broke out in plain sight last
summer with the dramatic boom and bust of a credit-fueled stock market bubble and its
aftermaths. Nobody, be it the securities regulator or the banking regulator and even the
central bank, had a clear view of where the leverage came from and how much leverage
was involved. The crisis response was like fighting a war with a blindfold. As if these were
not bad enough, toward the end of 2015 and beginning of 2016, a few large internet-based
illegal financial schemes collapsed, triggering a closer look at the massive shadow banking
system developed under the eyes of financial regulators who claimed to have no authority
over such activities because these activities were unlicensed (by them) and therefore not
subject to their supervision. The fast erosion of traditional business lines in finance, the
increasingly diverse body of financial entities and their ever more sophisticated products
and services, the digital revolution, and a more open financial system that’s increasingly
integrated with the rest of the world, have made China’s current fragmented supervisory
structure obsolete and untenable going forward. Taking the lessons from China’s own

financial market turmoils and the global financial crisis to heart, President Xi in his
remarks on the Party’s proposal for the new five-year plan stated clearly:
[S]ince the international financial crisis, major economies have introduced important reforms
to their financial supervisory systems. Main measures included consolidating the supervision
of systemically important financial institutions and financial holding companies, especially
the prudential supervision of these entities; consolidating supervision of financial market
infrastructures, including important payment, clearing, and registry and custodian systems and
institutions, to maintain their safe and efficient operation; consolidating financial statistics, and
through financial data’s full coverage, strengthening and improving financial macro supervision
and maintaining financial stability. All these practices are worthy of our studying and learning.
This has pointed out the direction of China’s new round of financial regulatory reform
and where the evolutionary forces would take PBOC in the next step.
V. CONCLUDING REMARKS
The reform era financial history is rich and fast-paced. As the leader of such fast-paced
changes and an institution central to the entire financial system, PBOC transformed and
even reinvented itself several times through its short history as a central bank. The only
thing that hasn’t changed is change itself. An evolutionary theory of central banking
would help us understand such changes as the institution’s conscious effort to constantly
adapt itself to fit the new and fast evolving political and economic environment and in
the process, induced further changes and evolutionary responses in the economic and
financial markets, which stimulated further evolutionary pressure on the central bank,
thus forming a complex co-evolutionary system between the central bank and the market
and political environments it operates in. From its early years as a state monopoly bank
during the planned economy era, to the early reform years when it first became a central
bank but retained planned methods to manage money supply and the financial system,
to the more recent periods when it tried to modernize its organization, governance, core
functions and major tools, to become more market-oriented and international, PBOC
has kept pace with the country’s overall economic reform agenda, and more in recent
years, even started to spearhead and lead key reforms and used financial reforms to
create a more favorable financial market environment to support and stimulate overall
economic reforms. In this process of metamorphosis, PBOC also differentiated itself
from its international peers in important ways: the early realization of the importance
of a financial stability mandate based on China’s own experience, the financial sector
reform and development function that’s critically important for PBOC as a central bank
in a large transition economy, the quick development of a macro prudential function, and
its direct supervision of the world’s third largest bond market. All these local variations
suited China’s unique needs well and some may have broader implications to enrich the
world of central banking practices. With China firmly integrated with the rest of the
world, China’s central banking practice is also converging with major international trends
and standards. A most important trend is the new paradigm of central banking emerged
since the global financial crisis, the paradigm of dual mandates of monetary and financial
stabilities. Fortunately for China, PBOC already acquired a dual mandate in 2003. But

it’s critically important how that mandate could be further strengthened amid the wave
of international regulatory reforms and in light of both international best practices and
Chinese experiences.
REFERENCES
Arner, Douglas and Zhou Zhongfei (2015) A Comparative Study of Central Banking in the Post-Crisis World,
Project Number SC 104773 PRC, Asian Development Bank.
Beinhocker, Eric (2006) The Origin of Wealth (Cambridge MA: Harvard Business School Press).
PBOC, The People’s Bank of China Annual Report, various years.
PBOC, China Financial Stability Report, various years.
People’s Bank of China (2012) A History of Financial Development Under the CCP (共产党领导下的金融发展
简史) (China Finance Press).
The Proposal for the Thirteenth Five-Year Plan on National Economic and Social Development by CCP Central
Committee （中共中央关于制定国民经济和社会发展第十三个五年规划的建议）(People’s Press, 2015).
Xiaochuan, Zhou (2012) The Global Financial Crisis: Observations, Analysis and Countermeasures (国际金融危
机：观察、分析与应对) (China Finance Press).
Xiaochuan, Zhou (2008) Systemic Institutional Transformation: Research and Exploration in the Process of
Reform and Opening Up (系统性的体制转变—改革开放进程中的研究与探索) (China Finance Press).

9. New tasks and central bank independence: the
Eurosystem experience
Chiara Zilioli and Antonio Luca Riso1
INTRODUCTION
During the recent global financial crisis that started in 2007 central banks across the
world performed a very important role in ensuring the provision of liquidity, thereby
limiting the consequences of financial instability and granting the relevant authorities
the time to introduce fundamental institutional reforms and start with more thorough
structural reforms. The authoritativeness of their advice and the competence and
efficiency demonstrated at this critical time by central banks earned them a lot of
respect from governments and citizens. Central bank actions and communications
acquired a much higher visibility and impact than in the past. Independence and
high level expertise were the key ingredients for the quality of their advice in difficult
times.
The high appreciation of the general public for the central banks’ contribution to
tackling the financial crisis materialized in the assignment of new public tasks to central
banks: this expression of trust was an acknowledgement of the success of these institu-
tions in pursuing their objectives and of the synergies between the classic monetary policy
functions and other functions related to the control of the banking system. However, the
assignment of new tasks entails a challenge for the model of central bank as we know it
and for its independence.
This chapter is divided into two parts. The first part briefly recalls the underlying
rationale for the principle of central bank independence,2 as a generally acknowledged
practice of good governance which best supports the central bank objective to preserve
price stability. While this principle has widely spread across the world, the focus will be
1
The views expressed are those of the authors and do not necessarily reflect those of the
ECB.
2
The theoretical framework supporting central bank independence has been discussed
since long and has intensified at the end of the 1980s. Cfr; R Lastra, ‘The Independence of
the European System of Central Banks’ (1992) Harvard International Law Journal 475–519, R
Lastra, Central Banking and Banking Regulation (Financial Markets Group, London School of
Economics, London, 1996) 9–68; A Alesina, V Grilli, ‘The European Central Bank: Reshaping
Monetary Politics in Europe’, Centre for Economic Policy Research Discussion Paper
Series 563 (1991); C Samm, ‘Die Stellung der Deutschen Bundesbank in Verfassungsgefüge’
(1967), DM 43,60; A Alesina, L Summers, ‘Central bank independence and macroeconomic
performance: some comparative evidence’ (1992) Journal of Money, Credit and Banking 151–62;
M Castello-Branco, M Swinburne, ‘Central Bank Independence: Issues and Experience’,
IMF Working Paper 91/58 , 1991; A Cukierman, Central Bank Strategy, Credibility and
Independence: theory and evidence (Cambridge/London, The MIT Press, 1992), and many
others.
155

on the case of the European Central Bank (ECB) and Eurosystem and on the relationship
between independence and accountability. The second part focuses on the way the trend
of conferring new tasks to independent central banks during the crisis has materialised
in the European experience, and on how the legal framework of the European Union has
reacted to such a trend.
PART I
1. General Principles on Central Bank Independence
In general, granting regulatory power to independent institutions is considered compat-

ible with democratic principles provided that three basic criteria are complied with: first,
that the allocation of powers to a non-majoritarian institution is based on precise reasons;
second, that the conferred powers are restricted within a well-defined scope, normally
related to technical competencies and pursuing clearly stated objectives; and third, that
there are instruments of accountability, ie that the powers are counterbalanced by obliga-
tions of transparency and dialogue with democratic institutions and citizens. Central
banks are no exceptions to this understanding.
Reasons for independence

In a democratic society, granting independence to an institution must be based on solid
reasons.3 The most obvious reason to confer to an independent institution the task to
decide and implement a public policy to achieve a pre-set objective, is to shelter such
institution from the short-term bias of politicians driven by political cycles.4 This is
classically the case of monetary policy, which is primarily aimed at achieving price
3
See: M Selmayr, ‘Wie unabhängig ist die Europäische Zentralbank? Eine Analyse
anhand der ersten geldpolitischen Entscheidungen der EZB’ (1999) WM 2429 ff; R Lastra,
‘The Independence of the European System of Central Banks’, above note 2, 476–77;
R Lastra, H Shams, ‘Public Accountability in the Financial Sector’, Chapter 12 in E Ferrán,
C Goodhart (eds), Regulating Financial Services and Markets in the XXIst Century (Oxford, Hart
Publishing, 2001) 165–88; C Zilioli, ‘Accountability and Independence, Irreconcilable Values
or Complementary Instruments for Democracy – The Specific Case of the European Central
Bank’, in G Vandersanden (ed), Mélanges en hommage à Jean-Victor Louis (Brussels, ULB,
2003) 395–422. G Majone, ‘Independence vs. Accountability? Non-Majoritarian Institutions and
Democratic Government’ in EUI WP SPS 94/3; F Amtenbrink, The Democratic Accountability
of Central Banks: A Comparative Study of the European Central Bank (Oxford, Hart Publishing,
1999).
4
See: WD Nordhaus ‘The Politycal Business Cycle’ (1975) 42(2) Review of Economic Studies
188; M Quintyn, M Taylor, ‘Robust Regulators and their Political Masters: Independence and
Accountability in Theory’, in D Masciandaro, M Quintyn (eds), Designing Financial Supervision
Institutions (Cheltenham and Northampton MA, Edward Elgar, 2007) 4; A Alesina, G Tabellini,
‘Bureaucrats or Politicians’, NBER WPS n. 1024 (2004); F Kydland, E Prescott, ‘Rules rather
than discretion: the inconsistency of optimal plans’ (1977) 85 Journal of Political Economy 473–90;
R Barro, D Gordon, ‘Rules, discretion and reputation in a model of monetary policy’ (1983) 12
Journal of Monetary Economics 101–21; C Walsh, ‘Optimal contracts for central bankers’ (1995) 85
American Economic Review 150–67.

New tasks and central bank independence: the Eurosystem experience 157
stability, by definition a long-term goal.5 A second reason is because of the high level of
technical complexity of the task.6
A third reason for granting a high degree of independence to the ECB,7 and the
European System of Central Banks (ESCB) as a whole, is connected to the institutional
design of the European Union (EU), ie to protect the conduct of the single monetary
policy at the European level from national and local interests in order to pursue the
common interest of the euro area as a whole.8
Scope of central bank independence

The limitation of the scope of central bank independence can be achieved through two
sets of rules clearly defining respectively: (i) the concrete requirements to be complied
with to ensure central bank independence; and (ii) the scope of the competences assigned
to the central bank, for the exercise of which independence is granted. In the case of
the ECB, these rules are established directly in the Treaty9 in a very detailed manner,
which is unusual for provisions at a constitutional level.10 Since the ECB’s establishment,
enhanced independence under the Treaty on the Functioning of the European Union
(TFEU) has sparked a debate between those who are concerned that monetary policy
decisions have been taken out of democratic control, thus not complying with the basic
principles of a democratic society,11 and those who argue that only a central bank that is
independent from political power will be able to pursue the common good of maintaining
a stable currency12 and that the ECB’s accountability is ensured by a number of measures
provided for in the TFEU.
5
The case for a price stability oriented independent central bank, see J Tinbergen, On the
Theory of Economic Policy, (North-Holland Publishing Company, Amsterdam, 1952); M. Friedman,
A Program for Monetary Stability (New York, Fordham University Press, 1959); R. Lastra,
‘International Financial and Monetary Law’ (Oxford, OUP, 2015) 9–68.
6
See A Stone Sweet, M Thatcher, ‘Theory and Practice of Delegation to NonMajoritarian
Institutions’ (2002) 25(1) West European Politics 1–22.
7
See C Zilioli, M Selmayr, The Law of the European Central Bank (Oxford, Hart Publishing,
2001), 13 ff.
8
This feature is common to other EU institutions and, being enshrined in the TFEU, it
has constitutional level. Pursuant to Article 245 TFEU, Member States are required to respect
the independence of the members of the Commission and not to seek to influence them in the
performance of their tasks. According to Article 253 TFEU, Judges and Advocates-General of the
CJEU must be chosen from persons whose independence is beyond doubt. Also, under Article 283
TFEU, members of the Court of Auditors must be completely independent in the performance of
their duties in the Union’s general interest.
9
By using the term ‘Treaty’ (or ‘Treaties’), reference is made to the highest source of law in the
legal system of the European Union, also referred to as ‘primary law’.
10
This applies both to the Treaty Articles relating to monetary policy, and even more so to the
Articles of the Statute of the European System of Central Banks and of the European Central
Bank (hereinafter the ‘Statute of the ESCB’).
11
J De Haan, F Amtenbrink, ‘The European Central Bank. An independent Specialized
Organization of Community Law. A Comment’ (2002) 39(1) CMLR 65–76.
12
O Issing, ‘Central Bank Independence – Economic and Political Dimensions’ (2006) 199
National Institute Economic Review 66–76.

Accountability
‘Accountability’ can be defined as the diversified interaction13 between the holder of power
(the ‘accountable institution’) and the authority to which account is owed (the ‘accountee’),
whether ex ante or ex post.14 The ECB accountability arrangements15 are also regulated
directly by Treaty provisions: the ECB independence and accountability have thus the same
ranking and level of importance within the constitutional framework of the European
Union. Indeed, independence does not mean isolation: an independent central bank needs to
interact, without being instructed, with the other democratic institutions. This relationship
needs to be regulated in the law, to make sure that accountability is ensured but independence
is not violated. Independence and accountability are complementary concepts,16 which have
been defined as two sides of the same coin17 or the opposite ends of a continuum.18
2. ECB Independence in the Constitutional Framework of the Union
The reasons for ECB independence in the Treaty

The Court of Justice of the European Union (CJEU) stated in a seminal decision that
independence is ‘functional’19 to achieving the primary objective of price stability,
established in Articles 127(1) TFEU and Article 2 of the Statute of the ESCB.20 The ECB
independence is thus not an end in itself, but a tool.21 The CJEU held that the Treaty
principle of independence ‘seeks, in essence, to shield the ECB from all political pressure
in order to enable it effectively to pursue the objectives attributed to its tasks, through the
independent exercise of the specific powers conferred on it for that purpose by the EC
Treaty and the ESCB Statute’.22
13
F Amtenbrink, R Lastra ‘Securing Democratic Accountability of Financial Regulatory
Agencies – A Theoretical Framework’, in R De Mulder (ed), Mitigating Risk in the Context of
Safety and Security – How Relevant Is a Rational Approach? (Rotterdam, Erasmus University, 2008)
115–32. See also Lastra, Shams, above note 3, 165–88.
14
Lastra, Shams, above note 3 and Zilioli, above note 3, 405.
15
ECB, ‘The accountability of the ECB’, ECB Monthly Bulletin, November 2002, 45, <http://
www.ecb.europa.eu/pub/pdf/mobu/mb200211en.pdf> accessed 22 July 2016.
16
A formal concept of accountability can amount to full control, with the possibility of over-
riding, suspending and annulling decisions. Obviously this is incompatible with the concept of an
independent institution. The accountability of independent institutions does not mean control
over them or power to revoke their decisions.
17
Zilioli, above note 3, 413.
18
R Lastra, Legal Foundations of International Monetary Stability, (Oxford, OUP, 2006)
70–71.
19
Judgment in OLAF, C-11/00 [2003] ECR I-7147, ECLI:EU:C:2003:395, paragraph 126, See
also F Elderson, H Weenink, ‘The European Central Bank redefined? A landmark judgment of
the European Court of Justice’ (2003) 2 Euredia 294. Judgment in OLAF, ECLI:EU:C:2003:395,
paragraph 134.
20
Price stability is not only the primary objective of the ESCB central banks, as set out in
Article 2 of the Statute of the ESCB, but it is also one of the objectives of the Union pursuant to
Article 3(3) of the TEU. Zilioli, Selmayr, above note 7, 467–91.
21
The German Constitutional Court has held that the constitutional justification of the
independence of the European Central Bank is limited to a primarily stability-oriented monetary
policy and cannot be transferred to other policy areas: BVerfGE 89, 155, 208 and 209; 97, 350, 368.
22
Judgment in OLAF, ECLI:EU:C:2003:395, paragraph 134.

The principle of central bank independence23 is enshrined directly in Article 130

TFEU,24 directly at the constitutional level:25 therefore, the Union legislator cannot
amend it without a Treaty change (thereby avoiding that short-term preferences of politi-
cians prevail over long-term interests of the polity).
Scope and limits of the ECB independence in the Treaty

Article 130 TFEU prohibits the ECB, the national central banks (NCBs) and the members
of their decision-making bodies from taking or seeking instructions from any Union
institutions, offices or agencies, from any government of a Member State or from any other
body.26 In addition, it prohibits the Member States as well as the Union institutions and
bodies from seeking to influence the ECB and the NCBs.27 The intensity of protection is thus
higher for ECB independence than for the independence of other EU institutions such as
the Commission,28 the Court of Auditors29 or the CJEU,30 but also of other central bank.31
To ensure independence in practice and not only in the law, several aspects of independ-
ence (personal, institutional, functional and financial independence) have been identified
and are monitored by the ECB through its convergence reports and its opinions.32
The ECB accountability in the Treaty

The ECB accountability arrangements for its monetary policy activities are regulated
directly by Treaty provisions. A first category of accountability arrangements includes
minimum transparency obligations.33
23
For a history of the principle, CCA Van Den Berg, The Making of the Statute of the
European System of Central Banks – an Application of Checks and Balances (Amsterdam, Dutch
University Press, 2004) 23–32, 37 and 51–71.
24
This provision is repeated in identical terms in Article 7 of the Statute of the ESCB. In
Judgment in OLAF, ECLI:EU:C:2003:395, the CJEU referred to the independence of the ECB as
being ‘strictly functional’.
25
The Treaty of Maastricht was a major step forward for the principle of independence. For
the first time in history, the independence of central banks became a legal requirement enshrined in
provisions with constitutional authority. C Zilioli, M Selmayr, La Banca centrale europea (Milan,
Guiffre, 2007) 73–81.
26
Lastra, ‘The Independence of the European System of Central Banks’, above note 2,
475–519, was the first to address in depth the need for accountable independence of the ESCB and
to mention the lack of supervisory responsibilities as a major drawback of the ESCB/ECB design.
27
Article 130 TFEU imposes a direct obligation on national and European Union political
authorities to comply with the principle of independence and to refrain from conduct that would
jeopardize it, see below.
28
Article 245(1), first paragraph, TFEU.
29
Article 285 TFEU.
30
Article 253(1), first paragraph, TFEU.
31
See by comparison the further aspects of independence granted to the Deutsche Bundesbank,
which was the paradigm of an independent central bank, at the time of the start of the monetary
union.
32
C Zilioli, ‘The Independence of the European Central Bank and its new Banking Supervisory
Competences’, in D Ritleng (ed) Independence and Legitimacy in the Institutional System of the
European Union (Oxford, OUP, 2016) 143–55.
33
Article 284(3), first sentence, TFEU and Article 15 of the Statute of the ESCB. The ECB
also applies higher standards of transparency than strictly required, for example by holding regular

A second category of accountability arrangements relates to exchange of information

and dialogue34 with other institutions.35
A third category of accountability arrangements relates to the controls performed by
other authorities on the ECB activities. This includes: the checks performed by external
auditors on ECB’s accounts;36 the auditing of operational efficiency by the Court of
Auditors;37 the jurisdiction of the CJEU on ECB’s acts and omissions;38 as well as the
ECB controls to which all other Union institutions are also subject.39
3. NCBs Independence in the Constitutional Framework of the Union
The reasons for the NCBs independence in the treaty

The independence of the ESCB established in Article 130 of the Treaty is not only more
intense than for other Union institutions but broader in scope, as it applies not only to the
ECB but also to the NCBs of the Member States, including the NCBs of those Member
States which are not part of the Euroarea: independence is functional to the overarching
principle of price stability, which is an objective for the whole Union.40
press conferences, issuing press releases and disseminating statistics and forecasts. The addressee of
this enhanced transparency can be considered the public at large. This enhanced transparency thus
increases accountability and provides the basis for a democratic dialogue.
34
A distinction must be made between the expression of opinions and requests for clarification
by accountees, which are allowed, and the ability to compel the ECB (or an NCB) to follow such
opinions or requests, which is not allowed. H Siekmann, ‘Artikel 130’, in H Siekmann et al. (eds),
Kommentar zu Europäischen Währungsunion, (Tübingen, Mohr Siebeck, 2013) paragraph 114.
35
According to Article 284(1) TFEU the President of the Council and a Member of the
Commission may participate, without voting rights, in Governing Council meetings, and the
President of the Council may even submit a motion for deliberation to the Governing Council.
Likewise, according to Article 284(2) TFEU the ECB President may be invited to Ecofin meet-
ings. Article 284(3) provides the possibility for the ECB President and the other members of the
Executive Board to be heard, by the competent committees of the European Parliament, upon
invitation or on their own initiative. Remarkably, the European Parliament is perhaps the most
neglected institution in this respect. While the Council and the Commission are invited to partici-
pate in the meetings of the ECB Governing Council (subject to strict confidentiality obligations),
this is not the case for the Parliament.
36
Article 27.1 ESCB Statute.
37
38
Article 35.1 of the ESCB Statute.
39
See, eg the controls of the European Data Protection Officer, the Office for the Fight Against
Fraud and the Ombudsman.
40
Article 3(3) of the Treaty on European Union. The introduction of this provision should
have solved the apparent contradiction between Article 139(2)(c) TFEU, according to which the
objective of price stability does not apply to non-participating Member States, and Article 42 of
the Statute of the ESCB, according to which this objective applies to them. This inconsistency
has indeed been used to argue that the independence principle should not extend to NCBs that
are not part of the Eurosystem: see U Häde, ‘Unabhängigkeit für die Ungarische Nationalbank?
– zum Status der Zentralbanken von Mitgliedstaaten mit Ausnahmeregelung’ (2005) 22 EuZW
679–82. This interpretation however contradicts the letter of the Treaty, according to which
Article 130 applies to all NCBs. In addition, the NCBs of Member States with a derogation have
to prepare for their Member State’s adoption of the euro, which is an obligation for all Member
States. This would also explain the exception of the United Kingdom, which is exempted from

The Treaty does not normally interfere in the legal status of national authorities; in the
case of the NCBs this is necessary as NCB Governors are members of a decision-making
body of a Union institution, the ECB Governing Council41 or the General Council,42
in their personal capacity,43 rather than as representatives44 of their respective NCB or
Member State.45
Scope and limits of the NCBs’ independence

The scope of the NCBs’ independence is not as broad as the ECBs’ independence:
this is also due to the double nature of the NCBs as part of the ESCB and as part of
national administrations. First, when performing Eurosystem tasks, the NCBs are not
independent from, but rather subject to the instructions46 of the ECB and the decisions
of its decision-making bodies.47 Second, as part of national administrations, NCBs may
perform functions other than those specified in the Statute of the ESCB:48 however,
according to Article 14.4 of the Statute of the ESCB such functions are performed under
such obligation under Article 7 of Protocol No 15 to the Treaties. An additional reason exists
for those NCBs which are part of the Eurosystem, as their respective Member State is part of
the Euroarea According to Article 8 of the Statute of the ESCB, the ESCB is governed by the
decision-making bodies of the ECB, and according to Article 14.3 of the Statute of the ESCB
the NCBs have to act in accordance with the ECB guidelines and instructions. Article 282 TFEU
clarifies that the task of conducting the monetary policy of the Union is entrusted with the
Eurosystem, which consists of the ECB and of the NCBs of the Member States whose currency
is the euro.
41
The Governing Council is one of the decision-making bodies of the ECB which, according
to Article 8 of the Statute of the ESCB, govern the ESCB and of the Eurosystem. The Governing
Council is composed of the members of the Executive Board, appointed by the European Council
and performing their duties on a full-time basis, and the governors of the NCBs of the Member
States whose currency is the euro.
42
All the governors of the EU Member States central banks, plus the ECB President and Vice-
President, are members of the General Council.
43
The governors do not act as representatives of their countries and become members of
the Governing Council in their personal capacities as experts on monetary policy in Europe. See
J-V Louis, L’Union européenne et sa monnaie, Commentaire J Mégret (Bruxelles, Editions de
l’Université de Bruxelles, 2009), paragraph 245, 178.
44
As a term of comparison, also the members of the Commission according to Article 18
TFEU are required to be independent and do not represent the Member State of provenance in
their office.
45
NCBs Governors act in a double capacity as members of the decision-making body of a
Union institution subject to Union law, and as governors of their NCBs which are governed by
national law. See C Zilioli, M Selmayr, above note 7, 147, fn. 107.
46
Articles 8, 9.2, 14.3 and 35.6 of the Statute of the ESCB clearly show that the NCBs are not
independent from the ECB when performing Eurosystem tasks; on the contrary, they are hierarchi-
cally subject to the ECB and must follow its instructions. When the NCBs perform residual national
competences they are subject to national law (which, among other things, also defines the extent of
the protection of the NCBs’ independence).
47
On the contrary, NCBs Governors in their capacity as members of the Governing Council
are independent from NCBs instructions. Governors are not representatives of their NCB. They
are members of the Governing Council on the basis of a personal mandate, which is incompatible
with seeking or receiving instructions from the NCB decision-making bodies. See also H Siekmann,
above note 34, paragraph 114.
48
According to Article 14.4 of the Statute of the ESCB, when the Governing Council finds, by

the responsibility and liability of the NCBs. The performance of these tasks is subject to
national law, thus the independence principle as set out in Article 130 TFEU does not
apply.49
The protection of Article 130 applies to the NCBs when they perform Eurosystem
activities. The features of the scope of the principle of independence were classified in
199550 by the European Monetary Institute (EMI) as consisting of personal independence,
functional independence, institutional independence and financial independence.51 The
ECB has continued to follow such classification52 in its Convergence Reports and
Opinions.
With regard to the personal independence of NCB Governors,53 it is not easy
to apply the rules in a differentiated way, distinguishing whether a national or an
ESCB function is at stake: such distinction could open a crack in the protection of
the Governors from governmental interference in the ESCB functions.54 Personal
independence has been defined as the ‘hard core’ of central bank independence in
the Union framework,55 due to the level of detail of the safeguards provided by the
Treaty in case of non-compliance. The Treaty provides in particular safeguards to the
office of NCBs’Governors56 including the duration of their mandate,57 changes to their
a majority of two thirds of the votes cast, that these fuctions interfere with the objectives and tasks
of the ESCB, the NCBs may not perform these functions.
49
Article 14.4 of the Statute of the ESCB specifies that these functions shall not be regarded as
being part of the functions of the ESCB. Central bank independence in the Treaty is functional to
properly perform the tasks assigned to the ESCB by the Treaty.
50
European Monetary Institute (EMI), Progress Towards Convergence: Report prepared in
accordance with Article 7 of the EMI Statute, November 1995. The EMI was the predecessor of
the ECB.
51
See also Lastra, ‘The Independence of the European System of Central Banks’, above
note 2.
52
In the legal literature a number of slightly different classifications can be found. For a sum-
mary, see Lastra, Shams, above note 3, 165.
53
See in detail the ECB Convergence Report of 2016, see ECB Convergence Report of May
2016, <https://www.ecb.europa.eu/pub/pdf/conrep/cr201606.en.pdf ?a91977931874a7c6c63d80305
b651394>, accessed 22 July 2016, page 23.
54
55
This ‘hard core’ concerns both the NCBs’ Governors under Article 14.2 of the Statute, and
the members of the Executive Board under Article 11.2 and 4 of the Statute of the ESCB. See C
Zilioli, above note 32, 137 ff and 146 ff. While NCBs Governors are heads of national institutions,
they are also members of a European institution and thus granting their personal independence is
primarily aimed at protecting the performance of ESCB and Eurosystem tasks from from outside
interference or undue influence. See generally R Smits, The European Central Bank – Institutional
Aspects (The Hague, Kluwer Law International, 2000).
56
Members of the decision-making bodies of NCBs other than governors are not expressly
referred to in Article 14.2 of the Statute of the ESCB. However, Article 14.2 is to be read in
conjunction with Article 130 TFEU and Article 7 of the Statute of the ESCB do not refer to NCB
governors only, but to ‘any member of their decision-making bodies’. This is the interpretation
followed in the ECB’s convergence reports: see ECB Convergence Report of May 2016, above note
53. See also ECB Opinions CON/2006/44, CON/2004/35, paragraph 8; CON/2005/26, paragraph
8; CON/2006/44, paragraph 3.3; CON/2006/32, paragraph 2.6; and CON/2007/6, paragraphs 2.3
and 2.4.
57
The term of office of NCB governors must be no less than five years. See Article 14.2,

terms of office,58 the limitation of the possibility of dismissal59 and the judicial review of
dismissal decisions.60
Functional independence61 relates to the NCBs’ statutory objectives, tasks and
instruments.62
Institutional independence63 relates to the influence of third parties on central bank
decisions.64
Financial independence65 relates to the need66 for the NCBs to rely on sufficient means
first paragraph, of the Statute of the ESCB. The misalignment with the term of Executive Board
Members has been criticised in the doctrine as it may expose NCBs Governors to undue pres-
sures connected to national electoral cycles, which have a periodicity closer to five than to eight
years; see J Endler, Europäische Zentralbank und Preisstabilität (Stuttgart, Boorberg, 1997), at
440–41.
58
The minimum term of office provided for in Article 14 of the Statute of the ESCB
has precedence over any conflicting national law on a compulsory retirement age. See ECB
Opinion CON/2012/89, paragraph 7, and the ECB Convergence Report of 2016, above note 53,
page 23.
59
Dismissal is possible, according to the Treaty, only on two grounds: where the perfor-
mance of a NCB Governor’s task is prevented over a prolonged period of time and in cases
of ‘serious misconduct’, not further defined in the Treaty. The Treaty is instead silent on the
appointment of NCBs Governors, as opposed to the detailed provisions on the appoinment
of Executive Board members, pursuant to Article 283(2) TFEU and Article 11 of the Statute
of the ESCB. See Lastra, ‘The Independence of the European System of Central Banks’,
above note 2, 475, 483; L Bini Smaghi, ‘Central Bank Independence in the EU: From Theory
to Practice’ (2008) 4 European Law Journal 446, 451–52); P Athanassiou, ‘Reflections on the
Modalities for the Appointment of National Central Bank Governors’ (2014) European Law
Review 27.
60
To avoid any abuse or unlawful application of the grounds for dismissal, the Treaty provides
the possibility of a direct action before the CJEU. See C Zilioli, M Selmayr, ‘Recent Developments
on the Law of the ESCB’ (2006) Yearbook of European Law 78. It is up to the national legislator
to provide for independent judicial review of the removal of the other members of an NCB’s
decision-making body.
61
See in detail the ECB Convergence Report of 2016, above note 53, page 20.
62
The principle of functional independence in particular requires that the main objectives of
the NCBs need be clearly and precisely defined in national law, in line with the provisions of the
TFEU.
63
See in detail the ECB Convergence Report of 2016, above note 53, 21.
64
Article 130 TFEU rules out the possibility of a governmental or parliamentary body, or
one of their representatives, approving, suspending, annulling or deferring an NCB’s decisions, or
giving parties other than independent courts the possibility of censuring an NCB’s decisions on
legal grounds. See C Zilioli, above note 32, 142.
65
See in detail ECB, Convergence Report 2016, above note 53, 25.
66
The Eurosystem and each NCB must always have sufficient resources to carry out their
tasks. For the ECB, this is explicitly provided for in Article 282 TFEU.The Statute of the ESCB
also contains specific rules to ensure that the ECB remains able to perform its functions. NCBs
may in theory operate with negative capital: ECB Convergence Report of 2016, above note 53, 25.
However Articles 28.1, 30.4 and 33.2 of the Statute of the ESCB provide for the possibility of the
ECB to request the NCBs to make further contributions to increase its capital, to make further
transfers of foreign reserves and to resort to monetary income to cover any losses: therefore,
NCBs should always be sufficiently capitalised. See ECB Convergence Report of 2016, above,
note 53, 25.

to perform their tasks67 and to be capitalized appropriately at all times,68 and includes the
treatment of profits69 and losses.
The NCBs accountability

Protecting independence from political instructions cannot mean, in a democratic society,
isolation from politics and political institutions: the prohibition of ‘not seeking or
taking instructions’ under Article 130 TFEU cannot encompass a prohibition of inter-
institutional dialogue, for instance, and each case needs to be evaluated on its merits to
see where the borderline lies. It is important to maintain a dialogue between institutions
and the exchange of information and debates provided for by the Treaty.70 It is thus
necessary to distinguish between, on the one hand, expressions of opinions and requests
for clarification, which are allowed, and, on the other hand, the ability to compel the ECB
or an NCB to follow an opinion or comply with a request (coercive capacity), which is
not allowed. This distinction, which requires constant interpretation of the substantive
content of the independence principle, is carried out by the ECB. When it is consulted71 on
proposed changes to laws affecting NCBs,72 the ECB monitors how the protection of these
four features of independence is implemented in national law and practice.73
67
NCBs must be and their financial strength should be assessed from the perspective of their
ability to resist the direct and indirect influences of third parties and to ensure their capacity to
comply with their mandate, both in operational and human resources terms. The ECB has clarified
that, to protect the financial independence of the NCBs, the accounting policies of NCBs must
either be those generally applicable, or specific policies to be defined by or in agreement with the
decision-making bodies of the relevant NCB; it has further stated that if an NCB is subject to
national audits, the scope of the audit must be clearly defined by law and must be conducted by
external auditors, without interfering with the NCB’s functions that are related to its participation
in the ESCB; the ECB Convergence Report of 2013, at: <http://www.ecb.europa.eu/pub/pdf/
conrep/cr201306en.pdf>, 25, accessed 22 July 2016. ECB Opinion CON/2002/16, paragraph 6.
68
To ensure that an NCB is always able to fulfil its mandate, the ECB has referred to the
obligation of the Member States to recapitalise an NCB whenever necessary. However, an NCB
can also operate temporarily with negative capital and this has happened on few occasions. See
the specific case of Česká národní banka; ECB Convergence Report of 2012 at: <http://www.ecb.
europa.eu/pub/pdf/conrep/cr201205en.pdf>, at 235. See also the ECB Convergence Report of 2013
at: <http://www.ecb.europa.eu/pub/pdf/conrep/cr201306en.pdf>, at 25, where it is clearly stated
that this is also a requirement for the non-participating NCBs.
69
ECB Opinion CON/2009/26, paragraph 2.3 on the accounting of profits. ECB Opinion
CON/2009/63 and ECB Opinion CON/2009/59 on the tax treatment of notional profits. On the
need to consult the NCB prior to any change of the framework, ECB Opinions CON/2009/83 and
CON/2009/53.
70
Article 284 TFEU. F Amtenbrink, ‘On the Legitimacy and Democratic Accountability
of the European Central Bank: Legal Arrangements and Practical experiences’, in A Arnull, D
Wincott (eds), Accountability and Legitimacy in the European Union (Oxford, OUP, 2002) 149.
71
On the ECB’s consultative tasks, A Arda, ‘Consulting the European Central Bank: Legal
aspects of the Community and national authorities’ obligation to consult the ECB pursuant to
article 105(4) EC’ (2004) Euredia 111 ff.
72
The ECB is concerned about any signs of pressure being applied to the members of the
decision-making bodies of NCBs, which would be inconsistent with the spirit of the TFEU on
central bank independence even if it is in line with its letter (section 2.2.1 of the ECB Convergence
Report of May 2007). ECB Convergence Report of May 2008, 16.
73
Opinions on national legislation are thereafter systematically summarized in the ECB’s

PART II
1. The Principle of Central Bank Independence and New Legal Developments
New institutional developments in Europe as a reaction to the events of the financial crisis
The global financial crisis, which started in 2007, has had a profound impact upon the
institutional structure of the Economic and Monetary Union of the European Union
(EMU). The legal framework of the EMU was not conceived to cope with large asym-
metrical but concomitant shocks affecting the financial, fiscal and economic sector at the
same time. The changes in the legal framework following the crisis represented in fact a
paradigm shift for the constitution of the EMU.74 Given the importance of these changes,
they would have probably deserved to be in most cases included in an amendment of
the Treaty. However, already before the start of the crisis,75 prior attempts to amend the
Treaty had not been very positively received. Member States had thus to resort to more
creative solutions to update the constitutional framework of the EMU. This approach
was reflected in the fact that these changes, rather than being part of a coherent system,
have taken place in the form of a complex patchwork which has evolved over time. Since
the beginning this evolution has implied the attribution of new tasks to the ECB76 in
the field of microprudential supervision and in the field of crisis management, and also
at national level to the NCBs. Immediately after the beginning of the crisis, a high-level
Group chaired by Mr De Larosière was established to explore the necessary changes in the
legal framework to enhance the EU financial legislation and supervision,77 including the
role of the ECB.78 In the end a new body, the European Systemic Risk Board (ESRB),79
was established80 and the ECB was conferred specific tasks concerning the functioning
of the ESRB, and in particular the provision to the latter of a Secretariat.81 In line with
convergence reports, which however only deal with non-participating Member States. In serious
cases in which there is a clear breach of the rules on NCB independence, it is always possible for the
Commission to initiate infringement proceedings against the Member State.
74
The EMU legal framework was initially focused on risk reduction and crisis prevention. The
crisis was a reality check for the framework, calling for the need to have in place also rules for crisis
management. Cfr JV Louis, ‘The EMU after the Gauweiler Judgement and the Juncker Report’
(2016) MLJ 56.
75
See the referendums in France on 29 May 2005, Netherlands on 1 June 2005, Ireland on 12
June 2008 [and 7 June 2001, as well as Denmark on 2 June 1992].
76
See bibliographic references in Zilioli, above note 32, 126, fn 4. The inadequacy of the
supervisory design had also been mentioned in 2003 by R Lastra, ‘The Governance Structure for
Financial Supervision and Regulation in Europe’ (2003) CJEL 49.
77
Report by the High-Level Group on Financial Supervision in the EU chaired by Jacques
Delarosière (the ‘Delarosière Report’), 2009, in particular 69, ‘Annex I’ <http://ec.europa.eu/inter
nal_market/finances/docs/de_larosiere_report_en.pdf> accessed 22 July 2016.
78
Delarosière Report, 42 to 46.
79
G Napoletano, Legal aspects of macroprudential policy in the United States and in the European
Union (2014) 76 Quaderni di Ricerca Giuridica della Consulenza Legale, Banca d’Italia <https://
www.bancaditalia.it/pubblicazioni/quaderni-giuridici/2014-0076/Quaderno_n-76_solo_inglese.pdf>
accessed 22 July 2016.
80
Regulation No 1092/2010 of the European Parliament and of the Council on European
Union.
81
Council Regulation No 1096/2010.

the proposal of the High-level Group, three European Supervisory Agencies (the ESAs)
were established instead in the field of microprudential supervision.82 The choice to recur
to Article 114 TFEU as a legal basis, rather than Article 127(6) TFEU, was not however
immune from limitations and legal risks.83
Less than three years after the ESAs’ regulations were approved, the possibility to recur
to a more solid legal basis, Article 127(6) TFEU, certainly played a role in the decision
to finally confer, through the adoption of the Single Supervisory Mechanism (SSM)
Regulation, microprudential supervisory tasks on the ECB.84
In addition, the absence of specific legal basis in the Treaty has been a distinctive ele-
ment of the legal framework developed to manage the financial crisis. Starting from 2010,
the ECB was conferred new roles in this field on ad hoc bases.85 In particular the ECB
was mandated to negotiate and monitor the implementation of adjustment programmes
attached to loans to Member States, together with the Commission and the IMF (the so
called ‘troika’). This role was initially enshrined in acts of private law such as bilateral
loan agreements86 and even the framework agreement of a private company, the European
Financial Stability Facility (EFSF), albeit the latter was owned by Member States.87 Later
on such role was enshrined in an instrument of public international law,88 and in a Council
regulation.89 Other acts of secondary Union law90 contributed to shape in a more complex
and comprehensive manner the role of the ECB in the new economic governance.91
Both the attribution of supervisory tasks and the new roles in crisis management are
82
Regulation (EU) No 1093/2010 of the European Parliament and of the Council of 24
November 2010.
83
Judgment of 22 January 2014, UK vs Parliament and Council, Case C-270/12, EU:C:2014:18.
84
Council Regulation (EU) No 1024/2013. On Article 127(6) as a legal basis, and on the
comparison with the legal bases used for the ESAs, AL Riso, G Zagouras, ‘Single Supervisory
Mechanism (SSM)’, in S Grieser, M Heemann (eds), Europäisches Bankaufsichtsrecht (Frankfurt
School Verlag, 2015) 106–10.
85
On the new roles of the ECB, C Zilioli, ‘The ECB’s Powers and Institutional role in the
financial crisis, A confirmation from the Court of Justice of the European Union’ (2016) 23(1)
MLJ 178–79.
86
This was eg the case for the first loan to Greece in 2010.
87
Article 2(1)(a) of the EFSF Framework Agreement.
88
Article 13(3) of the ESM Treaty.
89
Article 3(3) of Council Regulation (EU) No 407/2010 of 11 May 2010.
90
In particular, the ‘Six pack’ and ‘Two pack’, including respectively: Regulation (EU) No
1173/2011 of the European Parliament and of the Council of 16 November 2011, Regulation (EU)
No 1174/2011 of the European Parliament and of the Council of 16 November 2011, Regulation
(EU) No 1175/2011 of the European Parliament and of the Council of 16 November 2011,
Regulation (EU) No 1176/2011 of the European Parliament and of the Council of 16 November
2011, Council Regulation (EU) No 1177/2011 of 8 November 2011 amending Regulation (EC) No
1467/97, Council Directive 2011/85/EU of 8 November 2011, and Regulation (EU) No 472/2013
of the European Parliament and of the Council of 21 May 2013, Regulation (EU) No 473/2013 of
the European Parliament and of the Council of 21 May 2013.
91
In the field of resolution Article 18(1), Regulation No 806/2014 of the European Parliament
and of the Council of 15 July 2014 (the so-called SRM Regulation). According to Article 18(1) of
the SRM Regulation, it is the role of the ECB to make the determination that an entity is failing or
likely to fail. It may be argued that such task could have been conferred on the ECB on the basis of
Article 127(6) TFEU, but the legal basis of the SRM Regulation is Article 114 TFEU.

clear indications of the ECB being perceived as a successful and reputable institution.
Nonetheless, the conferral of new tasks outside the existing system of checks and balances
enshrined in the Treaty has triggered some concerns about the independence of the ECB.
The involvement of the ECB in the new EU economic governance: challenge to

independence?
In the Pringle case,92 the European Court of Justice addressed for the first time the con-
cern that having responsibility in the crisis management procedures could put the ECB
independence at risk. The applicant had complained that the Treaty establishing the
European Stability Mechanism (ESM Treaty), as well as the related Decision 2011/199
amending Article 136 TFEU, would impinge on the exclusive competences of the Union
in the field of monetary policy. The Court engaged in quite an extensive analysis of the
role of the ECB93 and concluded that since the duties conferred on the ECB within the
ESM Treaty, albeit important, did not entail any power to take decisions on its own,94
they did not alter the essential character of the powers conferred on it by the Treaties.95
The Court also provided some interpretative criteria to distinguish monetary policy from
economic policy.96
The Gauweiler Case97 gave the Court the possibility to scrutinise more closely the poten-
tial interference on the ECB independence of its new role in the economic governance of
the Union. The Court focused on the distinction between monetary policy and economic
policy. In a nutshell, the applicants in this case claimed that the ECB, by announcing
the Outright Monetary Transactions (OMT) programme had exceeded its competence,
since the OMT programme pertained to the field of economic policy,98 which is reserved
by the Treaty to the Member States.99 The Advocate General, in his Opinion on the
92
Judgment of 27 November 2012, Pringle vs Government of Ireland, Case C-370/12,
EU:C:2012:756.
93
Ibid, paragraphs 155 to 169.
94
Ibid, paragraph 161. In the same paragraph it is noted that the activities pursued by the ECB
within the ESM Treaty solely commit the ESM.
95
Ibid, paragraph 162. The Advocate General went further to hold that the ESM Treaty did not
allocate any task to the ECB, but rather acknowledged—by using the wording ‘in liaison with the
ECB’—‘a qualified right [of the ECB] to be consulted’. See also the View of the Advocate General
Kokott, in Pringle, ECLI:EU:C:2012:675, paragraph 179.
96
Such criteria are based on the pursued objectives and on the instruments used to pursue these
objectives. See Judgment in Pringle, EU:C:2012:756, in particular paragraphs 56, 57 and 93 to 98.
97
Judgment of 27 November 2012, Gauweiler vs Deutscher Bundestag, C-62/14, EU:C:2015:400.
98
On the nature of the OMT programme and its qualification as a monetary policy instrument,
AL Riso, ‘An analysis of the OMT case from an EU law perspective’, in H Siekmann, V Vig, V
Wieland (eds), The ECB’s Outright Monetary Transactions in the Courts – IMFS Interdisciplinary
Studies in Monetary and Financial Stability (2015), 19, available at <http://www.imfs-frankfurt.
de/fileadmin/user_upload/Interdisc_Studies/IMFS_Interdisc_Studies_2015_1_OMT_webversion.
pdf> accessed 1 January 2018.
99
One of the arguments raised by the applicants was that the purchase by the ECB of govern-
ment bonds in the context of the OMT programme was linked to the existence and adherence
to economic assistance programmes of the EFSF or of the ESM (the so-called ‘conditionality’):
according to the applicant these purchases should have hence been considered as a functional
equivalent of an assistance measure of the EFSF or the ESM. Order of 14 January 2014 – 2 BvR
2728/13 of the Federal Constitutional Court of Germany, paragraphs 74 to 78.

Gauweiler case, held that ‘the ECB’s role in the design, adoption and regular monitoring
of those programmes is significant, not to say decisive’.100 Therefore, in the Opinion of
the Advocate General, the purchase of debt securities subject to conditions may become
another instrument for enforcing the conditions of the financial assistance programmes,
ie an instrument which serves macroeconomic conditionality.101 To remain independent in
the exercise of its monetary policy tasks, the ECB should have thus detached itself from
all direct involvement in the monitoring of the financial assistance programme applied to
the Member State concerned in case of activation of the OMT programme.102
The reasoning underlying the Advocate General’s Opinion was that the principle
of independence, as enshrined in the Treaty, only represents the negative dimension of
independence, shielding central banks from interferences of politics, which should be
complemented by a positive dimension, compelling central banks to abstain from actively
participating in politics.103
The Court did not follow the opinion of the Advocate General: on the contrary the
Court highlighted several reasons to consider that making the OMT programme condi-
tional to compliance with an adjustment programme, is fully compliant with the Treaty
and thus indirectly that the new role of the ECB in the economic governance is also fully
compliant with the principle of independence. First, the independent decision of the
ECB to subject the implementation of its action to an adjustment programme ensures
that monetary policy measures do not work against the effectiveness of the economic
policies followed by the Member States.104 Secondly, such approach ensures compliance
with a guiding principle which the ECB is obliged to follow in accordance with Article
127(1) TFEU, read together with Article 119(3) TFEU, namely that public finances must
be sound.105 Finally, such feature of the programme contributes to reducing the risk of
losses for the ECB,106 thereby protecting the ECB financial independence.
The Judgment of the Court seems to have thus excluded any further doubt on the
fact that the Treaties do not warrant the extension of the principle of independence to a
positive dimension which would prevent the ECB from any interaction with, and support
to, the political arena. On the contrary, the Court has confirmed that independence does
not mean isolation from politics and political institutions. The instances where the Treaty
provides for dialogue with political institutions, through mechanisms which do not imply
any undue interference of polical institutions into the policy discretion of the ECB, are
put in place to achieve a proper level of mutual consultation and information.107 These
100
Opinion of 14 January 2015 of Advocate General Cruz Villalón in Gauweiler,
ECLI:EU:C:2015:7, paragraph 143.
101
Ibid, paragraph 145.
102
Ibid, paragraph 150.
103
D Sarmiento, ‘The Luxembourg “double look” – The Advocate General’s Opinion and the
Judgement in the Gauweiler Case’ (2016) 23 MLJ 1. For a wider analysis of this view of central
bank intervention in Member State economic policy making, T Beukers, ‘The new ECB and its
relationship with the Eurozone Member States: between central bank independence and central
bank intervention’ (2013) 50 CMLR 1579.
104
Judgment in Gauweiler, Case C-62/14, EU:C:2015:400, paragraph 60.
105
Ibid, paragraphs 60, 111 and 120–21.
106
Ibid, paragraphs 124 to 126.
107
Smits, above note 55, 170.

are now complemented by new forms of dialogue and technical support, established by
secondary legislation, such as the ECB participation in the so-called troika, which do
not imply any undue interference of the ECB into politics and the policy discretion of
political institutions.108 Since interdependence between monetary and other (economic,
fiscal, financial) policies is unavoidable, a strong framework, of which central bank
independence is a part,109 is required to manage these relations. The performance of an
advisory function by the central bank in the context of economic policy is in line with
such framework.
The limits of the principle of independence as regards possible interferences of the ECB
in the politics of Member States and of the EU are rather to be found in the principle
of conferral: the ECB should not be asked to take decisions which require democratic
legitimation,110 but it has been endowed with the power to take technical decisions.
The conferral on the ECB of supervisory tasks111

A widespread opinion is that prudential supervision is inextricably linked to the central
banking function,112 and that the conferral to the ECB of tasks in the field of prudential
supervision would not undermine its independence or mandate.113 This interpretation is
however not unanimously shared: some indeed highlight the potential risk of a conflict
of interests between the two functions,114 and that this may endanger the independence
of the central bank.115 The existence of these two ‘schools of thought’ is the reason
why, when the Maastricht treaty was drafted, the competence for prudential supervision
108
109
See speech by B Cœuré, Lamfalussy was right: independence and interdependence in a mon-
etary union, Budapest, 2 February 2015, <https://www.ecb.europa.eu/press/key/date/2015/html/sp1
50202.en.html> accessed 22 July 2016.
110
Ibid.
111
For a more extensive analysis on the conferral of supervisory tasks to the ECB, Riso,
Zagouras’, above note 84, 106–54.
112
See C Goodhart, D Schoenmaker, ‘Should the Function of monetary policy and bank-
ing supervision be separated?’ (1995) 47 Oxford Economic Papers 539–60; C Goodhart, The
Organisational Structure of Banking Supervision, available at http://www.bis.org/fsi/fsipapers01.pdf
accessed 22 July 2016; T Padoa-Schioppa, ‘EMU and Banking Supervision’, in C Goodhart (ed),
Which Lender of Last Resort for Europe? (Central Banking Publications, 2000) 15 and 29.
113
Since the ECB forms part of the ESCB, Article 127(1) TFEU applies, whereby the primary
objective of the ESCB is to maintain price stability. As a consequence, it may be argued that other
tasks (including supervisory tasks) also have to be conducted with the ESCB’s overriding objective
in mind. Smits, above note 55, 187.
114
T Brandi, K Gieseler, Vorschläge der EU-Kommission zur einheitlichen Bankaufsicht in der
Eurozone (2012) 43 Betriebs-Berater, 2646, 2648; M Lehmann, C Manger-Nestler, ‘Einheitlicher
Europäischer Aufsichtsmechanismus’Bankenaufsicht durch die EZB’ (2014) 2 ZBB 1.
115
Especially the German Council of Economic Experts (‘Sachverständigenrat Wirtschaft’)
criticized that a central bank that also assumes supervisory functions may ‘shy away’ from raising
interest rates if this could cause banks’ financial situation to deteriorate. According to this view,
this would undermine the independence of the central bank and could lead to a situation in which
monetary policy is used for supervisory and thus essentially for fiscal goals. See the annual report of
the German Council of Economic Experts of 2012/2013, 172. An English translation of the report
is available at <http://www.sachverstaendigenrat-wirtschaft.de/fileadmin/dateiablage/Sonstiges/ch
apter_three_2012.pdf> accessed 22 July 2016.

was not conferred on the ECB, and rather a provision was introduced into the Treaty
which allowed at a later stage to transfer, by unanimity, prudential supervisory tasks
to the ECB by means of secondary legislation. When the financial crisis required the
establishment of a supervisor at the EU level and the SSM Regulation was adopted,
those concerned with housing the monetary policy and the supervisory competences
under the same roof turned to criticise Article 127(6)116 as a suitable legal basis117 to
confer upon the ECB tasks in the field of prudential supervision. However, short of
a Treaty change, Article 127(6) is the only legal basis available to confer at the Union
level tasks in the field of prudential supervision, but it pre-determines the ECB as the
institution in charge for these tasks: the SSM Regulation thus complies with the limits
of Article 127(6) TFEU.118
The drafters of the SSM regulation took the concerns on the risk of possible conflict
of interests and of danger for the monetary policy independence very seriously, and
embedded in the SSM regulation a series of institutional arrangements aimed at
minimising this risk. These arrangements are the expression of a new ‘principle of
separation’ introduced in the ECB by the SSM regulation.119 The principle of separa-
tion may however be considered as an extension of the principle of independence to a
new, deeper level: we are witnessing the independence from each other of two policy
functions, monetary policy and prudential supervision, within the same institution, the
ECB.120
The actual risk that a conflict of interest materializes should however be solved by a
safeguard which is embedded in the Treaty, the hierarchy among the different ECB objec-
tives. Price stability is clearly identified as the primary objective of the ECB and should
in case of conflict always prevail. This does not mean that the objectives of supervision
should be disregarded; the prevalence of the primary objective should be understood as
a guiding principle, to evaluate all the options which would pursue the supervisory objec-
tives, and select the one which best suits the primary objective.121
Besides the need to preserve the independence of the two policy areas from each other,
which is specific of an institution—like the ECB—in charge of both policies, there are
specific reasons for safeguarding the independence of supervisors in their own rights122
116
According to this interpretation of Article 127(6) TFEU, its wording refers to specific tasks
only, thus it would neither allow the transfer of a number of tasks encompassing the whole of
prudential supervision nor the conferral of powers, also in view of Article 25 ESCB Statute. Riso,
Zagouras, above note 84, 109.
117
A lawsuit has been filed with the German Constitutional Court to claim that the conferral
of supervisory tasks to the ECB would be unlawful under German law. In Germany a law has been
passed (BGBl. II 2013, 1050) to authorise the German representative to vote for the adoption of
the SSM Regulation.
118
See Riso, Zagouras, above note 84, 109.
119
Article 25 SSM Regulation.
120
C Gortsos, The Single Supervisory Mechanism (Athens, Nomiki Bibliothiki, 2015) 262 to
269.
121
Smits, above note 55, 187.
122
See Lastra, ‘The Independence of the European System of Central Banks’, above note 2.
See also M Quintyn, M Taylor, ‘Robust Regulators and their Political masters: Independence and
Accountability in Theory’, in D Masciandaro, M Quintyn (eds), Designing Financial Supervision
Institutions (Cheltenham and Northampton MA, Edward Elgar, 2007) 4.

and clear standards on the required level of independence for supervisors which are set
at international level.123 Similarly to central banks, supervisors’ independence is aimed
at shielding them from undue interferences of politicians influenced by the interests of
specific electoral constituencies and by short-term electoral cycles, rather than by the
common good in the long-term. In addition, supervisors need to be also safeguarded
by undue influences of the supervised entities, the so-called regulatory capture by the
industry.124 At the same time, the operational independence125 of supervisors potentially
has a bigger impact on the general policies of a democratically elected government, as the
latter will have to ultimately bear the consequences and the costs of a crisis, in case public
intervention is called for to rescue a credit institution.126 This calls for more intrusive
accountability arrangements,127 requiring in particular that governments are informed
when the prospect of a state rescue, or a resolution, becomes likely.128 The level of protec-
tion granted to the personal independence of Supervisory Board members is thus lower
if compared to that granted to Governing Council Members. In addition, with regard
to the functional independence of NCAs, the instruments for accountability are more
developed if compared to the situation of central bank activities,129 as higher potential
redistribution effects of supervision, in comparison to monetary policy, call for a higher
degree of accountability.130
Supervisory tasks and the call for tighter accountability arrangements

According to international standards, supervisors’ accountability mainly relates to the
concept of functional independence.131 In the SSM, the accountability framework appli-
cable is more complex as it also includes reference to other aspects, such as the financial
123
In particular core principles 1 and 2 in: BCBS, Core Principles for Effective Banking
Supervision, September 2012 (the ‘Basel Core Principles’), available on the website of the Bank for
International Settlement (BIS).
124
Essential Criterion 1 for Principle 2 in the Basel Core Principles, page 22: ‘There is no
government or industry interference that compromises the operational independence of the
supervisor’.
125
This is the term used in Principle 2 in the Basel Core Principles.
126
J Westrup, ‘Independence and Accountability: Why Politics Matters’, in Masciandaro,
Quintyn, above note 122, 145–46.
127
Amtenbrink, Lastra, above note 13, 132; L Garicano, R Lastra, ‘Towards a new architecture
for financial stability: Seven Principles’ (2010) 3 JIEL 597 ff, suggest having recourse to input or
process monitoring accountability; R. Lastra, ‘Accountability and Governance – Banking Union
Proposals’, DSF Policy Paper No 30, 8.
128
129
For an analysis of the provisions for the independence of the ECB when exercising its
supervisory functions and of the NCAs on the basis of the SSM Regulation, Zilioli, above note
32, 166–73.
130
However, in the case of supervision and crisis management, ‘due to the stigma effect of
publicising overt assistance and the nature of bank runs (the belief in a panic is self-fulfilling)’,
the benefits of transparency are less clear. Garicano, Lastra, above note 127, 597 ff, suggest
having recourse to input or process monitoring accountability. Lastra, Amtenbrink, above note
13, 132.
131
Essential Criterion 3 for Basel Core Principles 2: ‘the supervisor publishes its objectives and
is accountable through a transparent framework for the discharge of its duties in relation to those
objectives.’

independence mentioned above.132 The scope of the ECB accountability obligation in the
SSM context is dynamic, as room is left to the institutional interlocutors of the ECB to
adapt the content of the accountability obligation to the needs of the moment. The list of
‘institutional interlocutors’ of the ECB deserves a first consideration: in accordance with
Article 20(2) SSM Regulation, the ECB has to submit an annual report to the European
Parliament, to the Council, to the Commission and to the Eurogroup.
The Eurogroup133 and the European Parliament are the two main interlocutors of the
ECB in its accountability obligations for its supervisory tasks: both have the possibility
to request a hearing of the Chair and Vice Chair of the Supervisory Board,134 and
to submit to the ECB questions in writing that the ECB has to reply.135 In particular
the SSM Regulation conferred a certain prominence to the role of the European
Parliament: the European Parliament has also the prerogatives to request the Chair of
the Supervisory Board to hold ‘confidential discussions behind closed doors’ with the
Chair and Vice-Chairs of the competent European Parliament committee,136 and to
launch investigations for which the ECB is requested to cooperate sincerely.137 As both
these prerogatives are rather intrusive, the SSM Regulation requires for their practical
implementation the conclusion of appropriate arrangements between the ECB and the
European Parliament,138 which are set out in detail in an inter-institutional agreement
between the two institutions.139
The most remarkable innovation which the SSM Regulation has brought about in
terms of accountability is that for the first time the ECB has to be accountable to national
institutions, ie national parliaments, in accordance with Article 21 SSM Regulation.140
Accordingly, national parliaments receive also the ECB reports like the European
Parliament, the Council and the Euro Group; they may address reasoned observations
on such reports, and request the ECB to reply in writing to any observations; they may
132
G Ter Kuile, L Wissink, W Bovenschen, ‘Tailor-made accountability within the Single
Supervisory Mechanism’, (2015) 15 CMLR 155.
133
The Eurogroup started as an informal meeting of the finance minister of the Member States
of the European Union whose currency is the euro. The Eurogroup is now referred to in Article 137
TFEU, and is disciplined by Protocol 14 to the TFEU.
134
Articles 20(4) and (5) SSM Regulation.
135
Article 20(6) SSM Regulation.
136
137
Article 20(9) SSM Regulation. Such provision refers to the conditions set out in the TFEU.
Such reference should be understood as a reference to Article 226 TFEU.
138
The SSM Regulation does not require similar arrangements necessarily to be in place
between the Council and the ECB, since the powers conferred to the Council are more limited and
directly regulated in the SSM Regulation itself. Nonetheless the Council and the ECB decided to
put in place similar arrangements to regulate their relationship: Memorandum of Understanding
between the Council of the European Union and the European Central Bank on the cooperation
on procedures related to the Single Supervisory Mechanism (SSM).
139
Interinstitutional Agreement between the European Parliament and the European Central
Bank on the practical modalities of the exercise of democratic accountability and oversight over
the exercise of the tasks conferred on the ECB within the framework of the Single Supervisory
Mechanism (2013/694/EU), OJ L 320, 30.11.2013, 1.
140
Cfr however in the TFEU Protocol No 1 on the Role of National Parliaments in the
European Union.

also invite the Chair or another member of the Supervisory Board to participate in an
exchange of views in relation to the supervision of credit institutions in that Member State
together with a representative of the relevant NCA.141
From a systematic perspective this new form of accountability to the national level is
difficult to square with the nature of the ECB as an European Institution, for which the
Treaty sets out a mandate and an accountability at the European level.142 The reason
could be the ECB’s double mandate, to contribute to the safety and soundness of credit
institutions and the stability of the financial system both within the Union and each
Member State.143 However, the national accountability may impair the principle accord-
ing to which all members of the Supervisory Board should act in the interest of the Union
as a whole.144 This precarious equilibrium is the byproduct of an incomplete transfer of
competences to the European level,145 as supervisory functions were centralised at Union
level, but potential costs of bank failures have been left at the national one:146 the resources
of the newly established single resolution fund may not be sufficient or available in all
cases of resolution of a credit institution,147 and in those cases recourse may be given to
fiscal support arrangements.148 The instrument of ESM direct recapitalisation, which was
meant as the complement of the SSM to sever the link between banks and sovereign, does
not exclude national fiscal responsibilities, as it passes through lending to the relevant
Member State, and requires the latter’s direct involvement.149 The fiscal responsibility of
Member States is even clearer in the case of potential liabilities for the activation of the
deposit guarantee,150 where no centralization has been achieved yet at European level.151
141
In addition, national parliaments maintain their prerogatives as set out in national law for
the accountability of NCAs: Article 21(4) SSM Regulation.
142
A different explanation would be that the balance between independence and accountability
is different in the case of monetary policy than in the case of supervision, since supervision of
troubled institutions can quickly turn into actual crisis manangement, and national governments
have a great interest at stake, given their potential competence for bank renationalization: therefore
the need for national accountability is paramount and the balance between independence and
accountability tilts towards the latter.
143
144
145
If this is the reason, accountability arrangements should perhaps change, and be centralised
at European level, once a similar centralisation process will have been concluded also for the
potential liabilities of banking crises. Article 32(e) and (m) of the SSM Regulation.
146
Recital 56 SSM Regulation.
147
Articles 27(7)(b), 27(9) SRM Regulation.
148
Articles 56 to 58 BRRD.
149
ESM direct bank recapitalisation instrument – Main features of the operational frame-
work and way forward, Luxembourg, 20 June 2013 <http://www.consilium.europa.eu/council-eu/
eurogroup/pdf/20130620-ESM-direct-bank-recapitalisation-instrument/> accessed 22 July 2016.
Accordingly, ‘the requesting ESM Member will be required to make a capital contribution along-
side the ESM, equivalent to 20% of the total amount of the public contribution in the first two
years after the entry into force of the instrument and to 10% afterwards’.
150
Article 6(1) of the Directive 2014/49/EU of the European Parliament and of the Council.
See also the Judgment of the EFTA Court in Case E-16/11 of 28 January 2013.
151
The Commisison has presented on 24 November 2015 a Proposal for a Regulation of the
European Parliament and of the Council amending Regulation (EU) 806/2014 in order to establish
a European Deposit Insurance Scheme (EDIS) (COM(2015) 586 final).

The saying according to which banks are ‘European in life but national in death’,152 even
if less than in the past, still holds true.
Conferral of supervisory tasks and preservation of the principle of independence

As mentioned above, as a consequence of the recognized need for tighter democratic
accountability, the international standards of personal153 and financial154 independence
for supervisors tend to be narrower than for central banks: in the case of the ECB,
however, the ECB as supervisor benefits to a great extent of the application of the
independence principle to the ECB as a whole,155 which is warranted in provisions having
a constitutional status.156
From the perspective of the external dimension of institutional independence, Article
19(1) SSM Regulation to a vast extent mirrors the content of Article 130 TFEU, with
some significant differences: Article 19(1) SSM Regulation in particular refers the specific
obligation not to take instructions for the members of the Supervisory Board, but not for
the ECB and the NCAs, which are only required to ‘act independently’: while the ECB is
‘covered’ by such obligation as set out in Article 130 TFEU, the same does not hold true
for NCAs.157 Since the obligation for the Supervisory Board members does not extend to
their NCAs, the risk is that such obligation could thereby be circumvented.158
152
The saying, originally ‘Banks are international in life and national in death’, is commonly
attributed to the Governor of the Bank of England at the time, Mervin King.
153
Essential Criterion 2 for Principle 2 in the Basel Core Principles, page 22.
154
Essential Criterion 6 for Principle 2 in the Basel Core Principles, page 22.
155
It can be maintained that Article 19 has a declaratory function, clarifying that the inde-
pendence granted by Article 130 also applies to the ECB’s supervisory function (which was not
the case before the SSMR in NCBs that are also supervisors and whose independence for this
function was granted by national law). According to the case law of the CJEU (Judgment in OLAF,
ECLI:EU:C:2003:395, paragraph 134) the independence bestowed by Article 130 TFEU is intended
to enable the ECB effectively to pursue the objectives attributed to its tasks. The ‘activation’ of the
ECB micro-prudential tasks, although conditional to the adoption of a Regulation by the Council,
was directly provided in Article 127(6) TFEU. There is thus no apparent ground in the Treaty to
differentiate scope of application of Article 130 TFEU with regard to these tasks. See also Zilioli,
above note 32, 165. Contra, the German Federal Constitutional Court (Bundesverfassungsgericht)
considers that ‘The constitutional justification of the independence of the European Central Bank
is, however, limited to a primarily stability-oriented monetary policy and cannot be transferred
to other policy areas’: BVerfG, 2 BvR 2728/13 of 14.1.2014, para 59, <http://www.bverfg.de/
entscheidungen/rs20140114_2bvr272813en.html> accessed 22 July 2016.
156
To be noted that Essential Criterion 1 for Basel Core Principle 1 only requires responsibili-
ties and objectives of each of the authorities involved in banking supervision are clearly defined
in (ordinary) legislation, thus their definition in constitutional provisions implies per se a higher
degree of protection than the internationally agreed standard. R Lastra, ‘Banking Union and
Single Market: Conflict or Companionship?’ (2013) Fordham International Law Journal 1189. On
the applicability of Article 130 TFEU to the new supervisory powers of the ECB, Zilioli, above
note 32, 165.
157
Or at least those NCAs which are not also NCBs. The application of Article 130 TFEU to
the NCAs which are also NCBs is however not fully clear, considering that the tasks conferred on
the ECB pursuant to article 127(6) are conferred on the ECB only, rather than on the ESCB.
158
Some NCAs are eg subject to the overriding power of a ministry, and the obligation not
to take instructions does not extend to the staff members of the NCAs, other than the respective
representative in the Supervisory Board. Zilioli, above note 32, 166.

From the perspective of the principle of separation, or of intra-institutional independ-

ence, the main innovation of the SSM Regulation has been the establishment of a new
internal body, the Supervisory Board, which is in charge for the planning and execution
of the new tasks conferred on the ECB in the field of prudential supervision,159 without
prejudice to the competences of the ECB decision-making bodies.160 Specific organisa-
tional and procedural arrangements have been put in place to grant the maximum possible
degree161 of independence of the decision-making process relating to the two policy areas.
In particular, the SSM Regulation has assigned to the Supervisory Board an exclusive
‘right of initiative’ with regard to supervisory decisions, ie the prerogative to propose to
the Governing Council complete draft decisions to be adopted by the latter,162 pursuant
to the so-called ‘non-objection procedure’.163 In terms of the relationship between the
objectives of the two policies, the Supervisory Board is in charge of identifying the
options which best suit supervisory objectives, while the Governing Council can object, in
particular if the proposed option is not the most suitable for the purposes of price stabil-
ity. In such cases a Mediation Panel, composed of members of both bodies, works on
the identification of the most suitable option.164 The non-objection procedure illustrates
however in a plastic manner the hierarchy among objectives: the Governing Council, in
its capacity of representative of the primary objective, always has the last say. Also, the
Governing Council165 is required to maintain strictly separated meetings and agendas for
each of the two policies.166 The separation at the level of the decision-making bodies is
complemented by the organisational separation of the policy areas at staff level.167
159
160
Article 13 of the Decision of the European Central Bank of 19 February 2004 adopting
the Rules of Procedure of the European Central Bank (ECB/2004/2) (2004/257/EC). The relevant
provisions in primary Union law (Articles 8, 10 and 12 of the Statute) acted as a bar to conferring
to the Supervisory Board any final decision-making competences. E Ferran, V Babis, ‘European
Single Supervisory Mechanism’ (2013) 10 University of Cambridge Faculty of Law Research Paper
14, fn 138.
161
According to Article 25 (3) SSM Regulation, the ECB is obliged to adopt and make public any
necessary internal rules, including rules regarding professional secrecy and information exchanges
between the two functional areas. Moreover, the ECB is obliged to take ‘all necessary measures’ to
ensure separation between the two ECB functions: Article 13k(2) of the ECB Rules of Procedure.
162
A particular and specific implementation of the principle of separations regards draft
supervisory decisions which entail the imposition of an administrative penalty by the ECB,
where a further layer of separation is provided between the investigation and the decision-making
phase: Articles 123–27 of the SSM Framework Regulation, Regulation (EU) No 468/2014 of the
European Central Bank of 16 April 2014 (SSM Framework Regulation) (ECB/2014/17). AL Riso,
‘The power of the ECB to impose sanctions in the context of the SSM’ (2014) 63(4) Bančni vestnik
32, 35, <http://papers.ssrn.com/sol3/papers.cfm?abstract_id52526380> accessed 22 July 2016.
163
A draft decision shall be deemed adopted unless the Governing Council objects within a
period to be defined in the procedure mentioned above but not exceeding a maximum period of ten
working days. Article 26(8) SSM Regulation.
164
Article 25.5 of the SSM Regulation.
165
On the side of the Supervisory Board, its members are prevented from performing duties
directly related to the monetary policy function. Article 13b(6) of the ECB Rules of Procedure.
166
Riso, Zagouras, above note 84, 141.
167
Such organisational separation includes separate reporting lines, professional secrecy
requirements for the two policy areas as well as defining the scope of exchange of information

Financial independence is a key aspect of the independence of supervisors according to

international standards.168 The overlap between this dimension and the intra-institutional
independence within the ECB, ie the separation between the two policy areas, is perhaps
clearer in the case of financial independence169 than in other cases. Indeed, Article 28 SSM
Regulation, by requiring the ECB to devote the necessary financial (and human) resources
to exercise its supervisory tasks, provides a safeguard to the financial independence of
supervision from monetary policy. On the other hand this provision is mirrored by Article
30 SSM regulation, which instead empowers the ECB to levy an annual supervisory fee
from the supervised credit institutions, calculated on the basis of the annual expenditure
on supervision,170 thereby protecting the financial independence of monetary policy
from the costs of supervision. Such protection may however not be complete, as the
SSM Regulation is not clear on how potential additional costs, deriving eg from judicial
liabilities,171 would be allocated. The provisions on the financial separation of the two
policy areas are indeed completed by Article 29 SSM Regulation, which requires the
ECB’s expenditure for its supervisory tasks to be separately identifiable within the budget
of the ECB: however the ECB is a single institution with a single balance sheet, and the
general rules on its balance sheet apply, including on the allocation of losses.172 The way
costs of supervision are transferred onto the supervised entities was of particular concern
for the legislator: Article 20(2) indeed specifically mentions the amount of the supervisory
fees as an element which needs to be included in the annual report as part of the account-
ability obligation for the ECB relating to its supervisory functions.
NCBs are assigned new tasks: is there any impact on central bank independence?
Following the recent global financial crisis, there has been a renewed interest in regulating
the financial sector. In parallel to the attribution of new supervisory tasks on the ECB at
the European level, a similar phenomenon took place at the national level, where NCBs
appeared as best placed to implement newly introduced financial regulation. Indeed,
NCBs are at the same time national institutions and integral parts of the ESCB; as
national institutions they can carry out national tasks: however, if these national activities
interfere with the objectives and tasks of the ESCB, the Governing Council can prohibit
these activities.173
The question has arisen, whether these new tasks may endanger the independent
performance of the traditional central banks activities, for two reasons.
First, independence as foreseen by Article 130 TFEU, and also by Article 19 of the
SSM Regulation, does not apply to the performance of these national activities: national
between them. See more in detail the Decision of the European Central Bank of 17 September 2014
(ECB/2014/39) (2014/723/EU).
168
Essential Criterion 5 for Basel Core Principles 2.
169
See Judgment in OLAF, ECLI:EU:C:2003:395, above note 19.
170
Regulation (EU) No 1163/2014 of the European Central Bank.
171
P Athanassiou, ‘Financial Sector Supervisors’ Accountability – a European Perspective’
(2011) 12 ECB Legal Working Papers Series; M Andenas et al, ‘To Supervise or to Compensate? A
Comparative Study of State Liability for Negligent Banking Supervision’, in M Andenas et al (eds),
Judicial Review in International Perspective (The Hague, Kluwer Law International, 2000) 333.
172
See in particular Article 33.2 ESCB Statute.
173

provisions regulate the accountability and the independence of NCBs when performing
these tasks. There is therefore a risk of ‘contagion’ or ‘spillover’ effect of these looser
standards of independence on the performance of ESCB tasks.
Secondly, the prohibition of monetary financing, as laid down in Article 123 TFEU,
acts as a bar to the financing of government activities by the NCBs. Since these national
activities are new, it is important to check whether they belong to what can be considered
a central bank responsibility, or whether they are in reality a responsibility of the govern-
ment, and the financing of these activities needs to be born by the State not to violate the
prohibition of monetary financing.
The prohibition of monetary financing is of essential importance in the construction of
the economic and monetary union, first to ensure that the primary objective of monetary
policy, to maintain price stability, is not impeded; and, secondly, because central bank
financing of the public sector lessens the pressure for fiscal discipline.174 The wording of
the Treaty refers to a prohibition of overdraft facilities and any other type of credit facili-
ties, as well as direct purchases of debt instruments.175 In the teleological interpretation
applied by the ECB, the scope of such prohibition is extended to include any form of
funding, that is without the obligation to repay.176 The ECB opinions on national legisla-
tion provide a sufficiently reliable guidance on the ECB’s understanding of how national
law should be designed to comply with the prohibition of monetary financing as well as
with the principle of financial independence.
The freedom of democratically accountable Parliaments and Governments to establish
new public functions and organise the administration of the State accordingly needs to be
respected, also when these new public functions are assigned to the central bank. However,
this freedom cannot run counter central bank independence or violate the prohibition of
monetary financing, as set out in the Treaty.
To ensure that the independence granted to central banks to perform their monetary
policy tasks is not jeopardized by the assignment of new tasks, the ECB has strived to
distinguish new tasks that are compatible with these principles from those that are not.
The development of ECB tests to qualify new NCBs tasks To ensure a consistent
approach regarding the assessment of such newly conferred tasks, the ECB has developed
tests to assess the ‘competence’ for these tasks. In the first place, these tests are aimed at
identifying ‘traditional’ government and central bank tasks, as they fall in the field of
competence of governments and central banks, respectively.
In some occurrences the ECB has determined that a task qualifies as a government task
174
AG Cruz Villalón, in his Opinion in Gauweiler, C-62/14, ECLI:EU:C:2015:7, paragraph
219, stated that ‘the prohibition in question “assumes the status of a fundamental rule of the
constitutional framework that governs economic and monetary union, exceptions to which must be
interpreted restrictively”’. ECB, Convergence Report 2016, above note 53, 30.
175
The monetary financing prohibition is laid down in Article 123(1) of the Treaty and its
precise scope of application is clarified by Council Regulation (EC) No 3603/93 of 13 December
1993 specifying definitions for the application of the prohibitions referred to in Articles 104 and
104b (1) of the Treaty. The prohibition includes any financing of the public sector’s obligations
vis-à-vis third parties. ECB, Convergence Report 2016, above note 53, 30.
176
Ibid, 30.

due to its nature. In particular, the ECB draws a line177 between the temporary provision
of liquidity,178 which is a central banking task, and solvency support, which is always a
State task.179 The concept of solvency support has been in particular extended to include
also cases such as: the funding of a bank recapitalized by a State with its government
bonds under certain conditions;180 the provision of Emergency Liquidity Assistance
against a State guarantee, when certain strict conditions are not complied with;181 the
financing beyond the short term provision of liquidity of deposit guarantee schemes,182
investor compensation schemes and resolution funds.183
In addition, when a task was previously performed by another national public institu-
tion and it is transferred to the NCB, this is considered to be a government task: to comply
with the prohibition of monetary financing the ECB requested in these cases that the
NCB should be insulated from financial obligations resulting from the prior activities of
the public body previously in charge for the transferred tasks.184
In general, for the ‘traditional’ tasks the ECB has distinguished between ‘central bank
tasks or tasks which facilitate the performance of such tasks’ on the one hand, and ‘tasks
linked to a State task and performed in the interest of the State’ (ie government tasks) on
the other hand. Consistent with this distinction, tasks belonging to the second category
would need to be remunerated in advance by the Member State, to comply with the
monetary financing prohibition.185
A decisive element to qualify functions performed by NCBs as ‘ESCB-related tasks, or
traditional central bank tasks’186 is whether a task had been traditionally allocated to the
NCB in the specific national context.187 This check is clearly performed ‘in recognition of
the different Member States’ legal frameworks, central banking traditions and national
set-ups’.188 Examples of tasks which have not been considered as ‘atypical’ include: the
application and enforcement of the rules implementing the payment accounts directive
consumer protection,189 the administration of resolution tasks,190 the supervision over
177
Ibid, 29 ff.
178
See eg, to temporary illiquid but solvent credit institutions. ECB Opinion CON/2013/5,
paragraph 3.1.1.
179
The distinction between illiquid (but solvent) and insolvent bank is a thin one, but central to
the very same role of central banks, and their function of lender of last resort. See H Thornton, An
Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802); W Bagehot, Lombard
Street: A Description of the Money Market (1873); Goodhart, The Evolution of Central Banks,
(Cambridge/London, The MIT Press, 1985), 35.
180
ECB Opinions CON/2012/50, CON/2012/64, and CON/2012/71.
181
ECB Opinion CON/2012/4, in particular footnote 42.
182
ECB Opinions CON/2011/83, paragraph 9, and CON/2011/84, paragraph 8.
183
ECB Opinion CON/2011/103 paragraph 4.
184
ECB Opinion CON/2010/4, paragraph 3.5.
185
186
187
ECB Opinion CON/2013/29, paragraph 3.
188
ECB Opinion CON/2015/21, paragraph 2.2.1.
189
Ibid, paragraph 3.1.
190
ECB Opinions CON/2016/28, paragraph 3.2.5.3; CON/2016/5, paragraph 3.4.3; CON/2015/54,
paragraph 3.4; CON/2015/35, paragraph 3.2.4; CON/2015/33, paragraph 3.1.4; CON/2015/22, para-
graph 3.2.4; ECB Opinion CON/2016/19, paragraph 3.1.4.

financial leasing companies,191 the operation of deposit guarantee schemes.192 Even for
the ‘traditional tasks’ a ‘review clause’ is included in ECB Opinions, to warn Member
States that the ECB may review its assessment if tasks currently discharged by NCBs are
subject to substantive changes.193
As new public functions have been established in the context of new financial sector
regulations, new tasks have been added to the traditional central bank tasks and it has thus
become necessary to develop a set of common criteria to assess the compatibility of these
new tasks with central bank independence and the prohibition of monetary financing.194
This categorisation would eventually lead to a harmonization of the treatment of tasks
across the board among ESCB NCBs, beyond national traditions.195
The criteria developed by the ECB to assess new tasks assigned to central banks The first
criterion identified by the ECB clarifies the scope of the ESCB- (or Eurosystem-) related
central banking tasks, which are by definition excluded from an assessment of compli-
ance by the ECB: these are the tasks listed in Article 127(2), (5) and (6) TFEU.196 ECB
Opinions have eg considered the application and enforcement of the rules implementing
the payment accounts directive197 as related to the task conferred in Article 127(2) TFEU;
consumer protection,198 administrative resolution tasks,199 supervision over financial leas-
ing companies,200 as related to the task laid down in Article 127(5) TFEU; the operation
of deposit guarantee schemes as related to the tasks laid down in Article 127(5) and (6).201
The second criterion is that, for NCB tasks other than ESCB tasks, it should be ensured
that NCBs continue to have sufficient financial resources to carry out their ESCB- or
Eurosystem-related tasks.202
191
192
193
‘The tasks currently discharged by an NCB as central banking tasks are not reviewed and
re-categorised, but may be reassessed if they are subject to legislative amendments of substance’.
194
Starting with the ECB Opinion CON/2015/21, paragraph 2.2.1, first subparagraph.
Curiously it may be noted that many following Opinions however track back to ECB Opinion
CON/2015/22 as the first of the series: ECB Opinions CON/2016/19, footnote 4, or CON/2015/46,
footnote 2.
195
The new sets of criteria have been consistently implemented since their introduction by
ECB Opinions, with few exceptions. In the case of ECB Opinions CON/2016/21; CON/2016/14;
CON/2016/4 and CON/2016/3, the consultation regarded traditional tasks of the relevant NCBs,
relating to IMF participation, monetary policy operations in overseas territories, and mint of coins.
In the case of CON/2015/43 the ECB Opinion followed up to a previous opinion (CON/2015/3)
adopted prior to the introduction of the new criteria. In the case of CON/2015/25, while the
criteria were not systematically applied, their spirit was to a large extent followed.
196
ECB Opinion CON/2015/21, paragraph 2.2.1, third subparagraph.
197
198
199
ECB Opinions CON/2016/28, paragraph 3.2.5.2; CON/2016/5, paragraph 3.4.2; CON/2015/54,
paragraph 3.3; CON/2015/35, paragraph 3.2.3; CON/2015/33, paragraph 3.1.3; CON/2015/22,
paragraph 3.2.3.
200
201
202
ECB Opinion CON/2015/21, paragraph 2.2.1, second subparagraph.

The third criterion clarifies that no further detailed assessment is needed for those tasks
which clearly qualify as ‘government tasks’.203 These are tasks which are either ‘atypical of
NCBs’ tasks’, such as, eg, the supervision of escrow institutions,204 or which are ‘clearly
discharged on behalf of and in the exclusive interest of the government or of other public
entities’: according to ECB Opinions this is the case eg when under national law solvency
support is required to be provided as opposed to liquidity provision,205 and a register of
bank accounts has been established, the exclusive purpose of which is to more efficiently
locate bank accounts which may hold proceeds of crime and thereby protect the financial
interests and security of the State.206
The application of these three criteria is more delicate when we are dealing with tasks
which are either entirely new NCB tasks, such as eg the establishment of a register of
bank accounts,207 or are traditional tasks which have been substantially amended, such as
in a case relating to the operation of a deposit guarantee scheme.208 In these cases further
assessment is needed to properly appreciate the impact of the new tasks on the institutional,
financial and personal independence of the NCB,209 keeping also in mind the objective
of ensuring the consistent application of the prohibition of monetary financing within
the Eurosystem and the ESCB,210 and protecting the independence of the central banks.
This can be done on the basis of the following four elements. First, the absence of
inadequately addressed conflict of interests between the new tasks and existing central
banking tasks211 is a very important element for this assessment. A certain degree of
complementarity between the new tasks and existing central banking tasks (which should
however not lead to an indefinite chain of ancillary tasks) must exist and, in case of a
conflict of interest, sufficient mitigation arrangements (structural arrangements to ensure
operational independence and avoid conflicts of interests, such as structural separation and
subjection of staff to separate reporting lines212) must be in place. As a negative element for
the assessment of this first criterion, ECB Opinions have instead referred to the existence
of reputational risks deriving from the accountability to the public for the new tasks.213
A second criterion requires that the performance of the new tasks is not dispropor-
tionate to the financial and organisational capacity of the NCB without new financial
resources, and may not negatively impact on the NCB capacity to perform existing central
banking tasks.214 The ECB has welcomed the introduction of fees to finance the newly
attributed tasks in its Opinions,215 or the possibility for the NCB to require the payment
203
Ibid, fourth subparagraph.
204
205
ECB Opinion CON/2015/21, paragraph 2.2.1, fourth subparagraph.
206
207
208
209
ECB Opinion CON/2015/21, paragraph 2.2.2, first subparagraph.
210
Ibid, paragraph 2.2.3.
211
Ibid, paragraph 2.2.2, second subparagraph.
212
ECB Opinions CON/2015/35, paragraph 3.2.6, and CON/2015/33, paragraph 3.1.6.1.
213
214
ECB Opinion CON/2015/21, paragraph 2.2.2, third subparagraph.
215
ECB Opinions CON/2016/28, paragraph 3.2.5.1; CON/2015/45, paragraph 3.1.6;
CON/2015/37, paragraph 3.1.1.

ex post of the operating expenditures and costs incurred216 or advance payments217 carried
out in the performance of the new tasks. On the contrary, the ECB has raised concerns in
case of an increase in the workload which may be disproportionate in comparison to the
NCBs core central banking, ESCB-related, prudential supervisory and macro-prudential
tasks.218
In connection to this it is also necessary to assess whether the performance of the new
tasks harbours substantial financial risks.219 A reason for particular concern raised by the
ECB in its opinions has been the increased risk of liabilities connected to the performance
of new tasks.220
Another criterion regards the assessment of whether the performance of the new task
fits into the institutional set-up of the NCB, in the light of central bank independence
and accountability considerations.221 As a negative element for the assessment of the
compatibility of the new tasks with the principle of independence of central banks, ECB
Opinions have referred to the existence of reputational risks deriving from the account-
ability to the public for the new tasks.222 While this is not necessarily seen in the ECB
Opinions as a reason of concern, such Opinions have taken note of the fact that some
new tasks would trigger closer cooperation with the government.223
An additional criterion is aimed at assessing whether the performance of the new
tasks exposes the members of the NCB decision-making bodies to political risks which
are disproportionate and may also impact their personal independence.224 The ECB has
raised concerns in its opinions when, following the attribution of new tasks, it cannot
be excluded that the NCB Governor, or its decision-making bodies, could be exposed to
reputational risks due to the new tasks, and be placed in a difficult position which could
also entail a negative impact on their personal independence.225
The four elements on the basis of which the analysis must be performed coincide
with the four classical limbs of the principle of central bank independence, ie func-
tional independence,226 complemented by their logical companion, ie accountability
considerations,227 institutional,228 financial,229 and personal independence.230 The inherent
capacity of these principles to expand their scope of application and serve a purpose
beyond the goal they were originally meant to achieve is further confirmed by a closer
216
217
ECB Opinion CON/2015/35, paragraph 3.2.7.2.
218
ECB Opinion CON/2015/54, paragraph 3.7 and 4.
219
ECB Opinion CON/2015/21, paragraph 2.2.2, fifth subparagraph.
220
ECB Opinions CON/2016/28, paragraph 3.2.5.7 and 3.2.5.8; CON/2016/5, paragraph
3.4.8 and 3.4.9; CON/2015/54, paragraph 3.8 and 4.; CON/2015/37, paragraph 3.1.7 and 3.1.8;
CON/2015/33, paragraph 3.1.9 and 3.1.10.
221
ECB Opinion CON/2015/21, paragraph 2.2.2, fourth subparagraph.
222
223
224
ECB Opinion CON/2015/21, paragraph 2.2.2, sixth subparagraph.
225
ECB Opinions CON/2015/46, paragraph 3.1.7 and CON/2015/36, paragraph 3.1.7.
226
The first criterion in Opinion CON/2015/21, paragraph 2.2.2, second subparagraph.
227
The third criterion ibid, paragraph 2.2.2, fourth subparagraph.
228
The second criterion ibid, paragraph 2.2.2, third subparagraph.
229
The fourth criterion ibid, paragraph 2.2.2, fifth subparagraph.
230
The fifth criterion ibid, paragraph 2.2.2, sixth subparagraph.

look at the first criterion, where a reference is made to the need to have in place sufficient
mitigation arrangements to prevent conflicts of interests between tasks within the same
institution. This seems to echo the development in the direction of intra-institutional
independence dubbed as ‘separation principle’ in the SSM context and shows not only
the ability of the principle of independence to cope with new developments, but also to
adapt to them, and to use these adaptations in a dynamic manner.
CONCLUSION
Central bank independence has been ‘codified’ in a certain manner in a specific histori-
cal moment,231 when a model of central bank with a high degree of independence had
proven successful to preserve price stability (which mainstream economists had agreed
as the best possible outcome of monetary policy) on the basis of empirical experience in
several countries. This model of central banking moved from the acknowledgement of
a short-term bias of politicians, who would be keen on trading higher levels of inflation
for short term shocks on the aggregated demand, and was based on the carrying out of
a single function by the central bank, monetary policy, to pursue price stability. However
independence from political control was clearly an exception to the general rule in demo-
cratic societies. The counterweight to such exception was the establishment of adequate
accountability arrangements.
As any exception, though, independence had to be narrowly defined. Hence, the diffu-
sion of this model of independent central banking was linked to a gradual ‘purification’
of central banks from tasks different from those relating to monetary policy, or not strictly
functional to such policy. In the case of supervision, interestingly, the retreat of central
banks took place in parallel to the spread of a model of single supervisors for the financial
sector.232 Interestingly, the trend started to be gradually reverted when, after more than 70
years without a major financial crisis, the global financial crisis erupted in 2007. The need
to ensure financial stability gained new importance and many jurisdictions, including the
EU, realized that the institutional framework for prudential supervision and financial
stability in place at the time suffered from various shortcomings which needed to be
fixed. A pattern emerging from these reforms has been that, at least to some extent, the
supervisory function has been brought back to central banking in many jurisdictions. In
some cases also administrative tasks related to resolution have been conferred onto central
banks (eg, the Bank of England).
The conferral of new (and to some extent old) tasks to central banks is an acknowledge-
ment of the success of these institutions in fulfilling their mandate and of the synergies
between their classical task (monetary policy) and other tasks connected to the monitor-
ing or control of the banking system, as well as a recognition of the positive effect of the
independence for taking difficult technical decisions. However the plain extension of the
231
To a certain extent it may be argued that this model was the product of its times. After a
period of hyperinflation the priority was to re-establish price stability.
232
D Masciandaro, ‘Unification in financial sector supervision: The trade-off between central
bank and single authority’ (2004) 12(2) JFRC 151.

sphere of competence of independent institutions would have also implied an extension

of the scope of an exception to the general democratic rule. Therefore, the trend to extend
the sphere of competence of central banks is accompanied by symmetric institutional
arrangements which tend to be more intrusive than the accountability arrangements
to which independent central banks have classically been subject. The original scope of
central bank independence risks to be affected by tighter counterweights, hence this trend
to some extent endangers the model of independent central bank as we know it.
An empirical analysis of the experience in the ESCB can prove useful as a benchmark
to protect central banks from being assigned tasks that would jeopardize their capacity
to properly fulfil their ‘core’ central bank functions (ie, in the European context, ESCB
tasks). Such experience shows in particular that three safeguards may be put in place
to prevent such risk from materializing. First, where new tasks are introduced against a
higher level of accountability, high standards of intra-institutional independence should
be granted, ie separation of monetary policy from other areas within the same institu-
tion. Second, the independence of the policy functions and of the respective objectives
should be complemented by a clear hierarchy of such objectives, to ensure that in case
of conflict the primary objective pursued by monetary policy, ie price stability, prevails.
Third, the financing of such new tasks should follow their qualification as government
or central bank tasks, according to interpretative criteria which the ECB has developed
for this purpose.

10. A central bank in times of crisis: the ECB’s
developing role in the EU’s currency union
René Smits
I. INTRODUCTION
1. Focus of this Chapter
The European Central Bank (ECB) has seen its mandate stretched to the limit in the crisis
that erupted in 2007 and seems to be abating only after a decade. There have been major
developments in its pursuit of price stability through the single monetary policy, on which
this chapter will focus. Major extensions of its role into adjacent or different areas are
beyond its scope, such as the attribution of powers in the areas of, first,1 macro- and, then,
micro-prudential supervision,2 which extended the ECB’s brief squarely into the pursuit
of systemic financial stability, and the soundness and safety of credit institutions. The
ECB’s concerns in the area of economic policy are a recurring theme in the discussion of
its monetary policy mandate. Another hallmark of the crisis years—more transparency
and accountability mechanisms and the ECB’s increased exposure to judicial review—is
beyond the space allotted here.
2. Outline of this Chapter
This chapter provides a critical description of the forays into unconventional monetary
policy measures, including a discussion of the issue of the court case on the ECB’s
competences. Sections II and III describe the non-standard measures and give the legal
bases thereof, critically assessing the latter. Section II gives an overview of the col-
lateral widening and the lower bound, even negative territory, of interest rates, as well
as the longer-term liquidity provision. Section III discusses the ECB’s late conversion
to quantitative easing and touches upon the Gauweiler Case on Outright Monetary
Transactions (OMT). Also, Emergency Liquidity Assistance (ELA) is briefly discussed
as it is closely linked to the issue of the ECB’s competences. Section IV concludes and
looks ahead.
1
Council Regulation (EU) No 1096/2010 of 17 November 2010 conferring specific tasks upon
the European Central Bank concerning the functioning of the European Systemic Risk Board, OJ
L 331/162, 15 December 2010.
2
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 institu-
tions, OJ L 287/63, 29 October 2013 (the SSM Regulation).
184

The ECB’s developing role in EU’s currency union 185
3. Confines of this Chapter
Beyond the above substantive limitations, the reader is reminded that the manuscript
was closed on Europe Day (9 May) 2016. It does not take into account subsequent
developments. All internet searches took place before. The technical nature of the
issues discussed, and their being in a state of constant flux, means that the descriptions
and analyses are an outsider’s.3 As the author does not have day-to-day working experi-
ence in the field of monetary policy, this account is written from an academic perspective.
Assistance received is gratefully acknowledged; all errors and omissions remain mine.
II. MONETARY POLICY MANDATE IN TIMES OF CRISIS:

NON-STANDARD MEASURES
1. General Introduction
Without any formal change to its core mandate of maintaining price stability, the ECB
has seen its monetary policy brief changed thoroughly by the Great Financial Crisis
(GFC), the global severe economic downturn which started in 2007, and the subsequent
European sovereign debt crisis which began in 2010.
Unconventional monetary policy measures were adopted that stretched its mandate as
conceived thus far. Other central banks have had similar experiences and needed to go
to the margins of their legal mandates. For the ECB, the crisis became more existential
because it operates in a multi-national environment, in a continent that became more
divided than unified and amidst an upswell of existential doubt about, and fierce specula-
tion against, the continuity of the currency it is the guardian of.
Apart from generic liquidity support to the financial system, which the ECB started
to provide in August 2007, the unconventional measures consisted in forays into negative
interest rates, providing ‘forward guidance’ on the development of its official interest
rates, the offering of long-term facilities beyond the usual timeframe, the introduc-
tion of a programme of targeted lending, and the introduction of asset purchases
programmes—announced (OMT) or realized. This section discusses the non-standard
measures except for the asset purchase programmes, and ELA, to which section III is
devoted.
All of these measures were adopted against the backdrop of the ECB’s mandate, as
interpreted by the central banking system itself. The Treaty makes the European System
of Central Banks (ESCB) competent ‘to maintain price stability’4 and, ‘without prejudice
to the objective of price stability, [to] support the general economic policies in the Union’.5
3
Disclosure: the author is an Alternate Member of the ECB’s Administrative Board of
Review, the body independently looking into review requests concerning micro-prudential super-
visory policy measures.
4
Article 127(1) TFEU; Article 2 ESCB Statute.
5
Article 127(1) TFEU and Article 2 ESCB Statute add that this support is to be undertaken
‘with a view to contributing to the achievement of the objectives of the Union as laid down in
Article 3 of the Treaty on European Union’. Article 3 TEU states the EU’s aim as ‘to promote

The Eurosystem6 adopted its interpretation of ‘price stability’ as ‘a year-on-year increase

in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%’.7
The perspective is not headline inflation but a medium-term one: ‘Price stability is to be
maintained over the medium term.’
As other central banks, the ECB started to implement unconventional monetary policy
measures, also labelled ‘non-standard’ policy measures.
Naturally, unconventional central bank measures have been the subject of intense
debate, among academics, in the markets and the media, and among politicians. Here,
it is the legal confines of the ECB’s mandate that interest us. This concerns the limits of
the Treaty-given powers of the ECB,8 and the several constraints imposed by EU law,
notably the prohibition of monetary financing (financing of government spending by the
central bank) in Article 123 Treaty on the Functioning of the European Union (TFEU),
the prohibition of privileged access (of the public sector to the financial sector) in Article
124 TFEU and the ‘no bail-out’ clause (the prohibition for the Union or other Member
States to guarantee or take over public debt outstanding) in Article 125 TFEU. Another
constraint is the injunction to ‘act in accordance with the principle of an open market
economy with free competition, favouring an effective allocation of resources’ (Article
127(1), in fine, TFEU).9
2. Negative Interest Rates: ‘The Lower Bound’
The ECB ventured into negative territory for nominal interest rates as the most traditional
method of monetary stimulus. The central bank sought to discourage commercial banks
taking their excess liquidity to the safe haven of the central banks instead of mutual
lending in the money market by, first, lowering the remuneration for deposits and, then,
charging for keeping money at the central bank.10 This should stimulate banks’ lending to
the real economy where banks had previously kept excess liquidity idly at the central bank.
Borrowing from the ECB had simultaneously become cheaper: the rate on the marginal
peace, its values and the well-being of its peoples’, adding objectives which include the internal
market and sustainable development, economic growth and price stability, and ‘a highly competi-
tive social market economy, aiming at full employment and social progress’.
6
By this name the ECB and the National Central Banks (NCBs) of the Member States that
have adopted the euro identify as the monetary authority of the Euro Area, to distinguish them-
selves from the European System of Central Banks (ESCB) in its pan-EU composition (ie, includ-
ing the NCBs of the Member States that have not—yet—adopted the euro). The term ‘Eurosystem’
was introduced in the TFEU (Article 282) by the Lisbon Reform Treaty.
7
See the ECB’s Press Release of 13 October 1998, at: https://www.ecb.europa.eu/press/pr/
date/1998/html/pr981013_1.en.html, its first Monthly Bulletin of January 1999 (page 46), at:
https://www.ecb.europa.eu/pub/pdf/mobu/mb199901en.pdf and the ECB’s website at: https://www.
ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html.
8
Notably, whether the unconventional measures can be based on the powers given in Chapter
IV of the ESCB Statute (Articles 17–24): Monetary functions and operations of the ESCB.
9
And the corresponding Article 2 of the ESCB Statute. See, also, Article 119(2), in fine,
TFEU.
10
The interest rate on the deposit facility went down from a high of 3.35 percent in 2008 to
zero in 2012, and negative in 2014, reaching a level of –0.40 percent in March 2016. See: Key ECB
interest rates, at: https://www.ecb.europa.eu/stats/monetary/rates/html/index.en.html.

lending facility has gone down from a high of 5.25 percent in July 2008 to a low of 0.25
percent in March 2016, whereas the rate charged on refinancing operations tumbled from
4.25 percent in July 2008 to zero per cent in March 2016.
There are no legal qualms about this use of the ECB’s discretion except for the heavily
politicized issue of the ‘expropriation’ of savers and the undermining of pension funds.
In line with the principle of an open market economy, the ECB should guard against
long-term distortions of markets, eg, by favoring certain classes of operators over others.
Yet, when markets are distorted and non-functioning, the blame for ‘perverse effects’ of
a monetary policy that seeks to re-open transmission channels and stimulate lending to
the real economy, whilst re-establishing the level of inflation considered compatible with
price stability, cannot be laid on the central bank. Also, as the ECB has started to explain
extensively11 with independence-threatening dissent by senior German politicians against
its low-cost money policies, the actual, real interest rate is what counts, not the nominal
rate. Corrected for inflation, which is low or absent, the nominal interest rates in the
economy may imply better current remuneration for liquidity than in the ‘good old days’
of high interest rates.
3. Forward Guidance
Another innovative approach to monetary policy is ‘forward guidance’. This is the central
bank leaving behind the usual unpredictability of interest rate movements and announc-
ing that the current level of interest, or a lower one, may be maintained for a prolonged
period of time. The ECB began giving ‘forward guidance’ in July 2013.12 A clear, recent
example is the statement of the ECB’s Governing Council of 21 April 2016: ‘. . . we
decided to keep the key ECB interest rates unchanged. We continue to expect them to
remain at present or lower levels for an extended period of time, and well past the horizon of
our net asset purchases.’13 The asset purchases programme is set to last for another year,
at least.14
11
For instance: Addressing the causes of low interest rates, Introductory speech by Mario
Draghi, President of the ECB, held at a panel on ‘The future of financial markets: A changing view
of Asia’ at the Annual Meeting of the Asian Development Bank, Frankfurt am Main, 2 May 2016,
at: https://www.ecb.europa.eu/press/key/date/2016/html/sp160502.en.html.
12
In the introductory statement to his Press conference of 4 July 2013, ECB President Mario
Draghi said: ‘Looking ahead, our monetary policy stance will remain accommodative for as long
as necessary. The Governing Council expects the key ECB interest rates to remain at present or lower
levels for an extended period of time. This expectation is based on the overall subdued outlook for
inflation extending into the medium term, given the broad-based weakness in the real economy
and subdued monetary dynamics. In the period ahead, we will monitor all incoming information
on economic and monetary developments and assess any impact on the outlook for price stability’
(emphasis added). See: https://www.ecb.europa.eu/press/pressconf/2013/html/is130704.en.html.
13
Introductory statement to the press conference, Mario Draghi, President of the ECB and
Vítor Constâncio, Vice-President of the ECB, Frankfurt am Main, 21 April 2016, at: http://www.
ecb.europa.eu/press/pressconf/2016/html/is160421.en.html (emphasis added).
14
As the introductory statement of the previous month (10 March 2016) specifies: ‘[The
monthly purchases under our asset purchase programme] are intended to run until the end of
March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained
adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but

‘Forward guidance’ ‘provid[es] more systematic guidance on the expected path of future
policy rates’ and aims ‘to ensure that market expectations on future monetary policy
are indeed consistent with the policy intentions of the respective central bank’.15 It was
introduced to enable private agents in the economy to trust the future course of monetary
policy in unsettled times as they cannot infer from the more tranquil conditions of the
past how the central bank would respond to turmoil. Market participants’ expectations of
future interest rates co-determine their economic decisions. The longer-term perspective
of the central bank was also visible through the introduction of Long-Term Refinancing
Operations (LTROs), for periods of up to three years.16
This approach of giving comfort on their intentions over the long-term has been fol-
lowed by other central banks, as well. Legally, for the ECB, this is not a major shift from
the traditional approaches. Its very competence to set interest rates is used in a different
way. The interest-setting competence is part of the first ‘basic task’ entrusted to the
ECB, ‘to define and implement the monetary policy of the Union’.17 This is elaborated
in Article 12.1 of the ESCB Statute which entrusts the Governing Council to ‘formulate
the monetary policy of the Union, including, as appropriate, decisions relating to the
intermediate monetary objectives, key interest rates and the supply of reserves in the
ESCB’. The remuneration of accounts with the central banks in the Eurosystem,18 and
the terms of open market and credit operations19 detail the interest rate at which the
ECB is willing to engage with market parties to channel its monetary policy through the
European economy. All of this concerns the current returns on money, whereas ‘forward
guidance’ is about expected future returns.
4. Collateral Widening
Any lending by the ECB and National Central Banks (NCBs) in the Eurosystem is to
be ‘based on adequate collateral’.20 Prior to the crisis, the ECB had ‘outsourced’ its
appraisal of collateral to a certain extent by relying on the assessment of the issuer’s
creditworthiness as of prime quality by Credit Rating Agencies (CRAs). The sudden and
deep downgrading of debt instruments issued by Member State governments forced it to
reconsider and to accept collateral as adequate without it meeting a high assessment by
CRAs, falling back on ‘investment grade level’ as adequate. Without this reassessment of
the required collateral rating, the ECB would have been unable to pursue its monetary
policy as debt instruments issued by the European official sector dominate the EU finan-
close to, 2% over the medium term.’ See: http://www.ecb.europa.eu/press/pressconf/2016/html/

is160310.en.html.
15
As ECB Executive Director Benoît Cœuré explained in his illustrative speech of 26
September 2013 on the issue: The usefulness of forward guidance, at: https://www.ecb.europa.eu/
press/key/date/2013/html/sp130926_1.en.html.
16
Press Release of 8 December 2011: ECB announces measures to support bank lending
and money market activity, at: https://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.
html.
17
Article 127(2), first indent, TFEU; Article 3.1, first indent, TFEU.
18
Regulated in Article 17 ESCB Statute.
19
Regulated in Article 18 ESCB Statute.
20
Article 18.1, second indent, in fine, ESCB Statute.

cial markets. There would simply not have been sufficient collateral to continue providing
the banking sector with liquidity, with adverse consequences for the real economy where
most citizens and companies rely on bank funding.
A first step was taken in mid-October 2008, when the ECB21 not only enlarged the scope
of eligible collateral to include, eg, non-euro-denominated assets but, also, lowered the
rating level required, from A- to BBB-, announcing with the usual optimism of those days
on the end of the crisis that such measures would last until the end of 2009.22 The ‘tem-
porary expansion of the collateral pool’ was part of a wider package of special measures.
The collateral widening was enacted in an amendment23 to the General Documentation,
which confirmed the announced additional haircut to be applied to collateral below an
A-grade.24
Simultaneously with a further prolongation25 of the inclusion of investment-grade
level instruments as collateral beyond the end of 2010, the ECB announced new, gradu-
ated haircuts to replace the uniform five percent haircut applied before to lower-quality
collateral.26 An overall haircut schedule applied as of 2011 gave a permanent basis for
graduated haircuts for lower-rated collateral.27
Currently, the acceptance of public debt with at least one ‘investment grade’ rating by
an CRA28 is laid down in the General Documentation Guideline for Eurosystem monetary
policy operations.29 The Guideline includes the rating scale and the Eurosystem Credit
Assessment Framework (ECAF),30 which is further explained on the ECB’s website.31
21
Press Release of 15 October 2008: Measures to further expand the collateral framework and
enhance the provision of liquidity, at: https://www.ecb.europa.eu/press/pr/date/2008/html/pr081015.
en.html.
22
In its Press Release of 7 May 2009, the ECB announced that it ‘decided to prolong until the
end of 2010 the temporary expansion of the list of eligible assets, announced on 15 October 2008’,
see: https://www.ecb.europa.eu/press/pr/date/2009/html/pr090507_2.en.html.
23
Guideline of the European Central Bank of 21 November 2008 on temporary changes to the
rules relating to eligibility of collateral (ECB/2008/18), (2008/880/EC), OJ L 314/14, 25 November
2008.
24
Article 5 of Regulation (EC) No 1053/2008 of the European Central Bank of 23 October
2008 on temporary changes to the rules relating to eligibility of collateral (ECB/2008/11), OJ L
282/17, 25 October 2008. See, also, Decision of the ECB of 14 November 2008 on the implementa-
tion of Regulation ECB/2008/11 of 23 October 2008 on temporary changes to the rules relating to
eligibility of collateral (ECB/2008/15), OJ L 309/9, 20 November 2008.
25
Already an extension of an earlier self-imposed deadline of end-2009; see note 22 above.
26
Press Release of 8 April 2010: ECB introduces graduated valuation haircuts for lower-rated
assets in its collateral framework as of 1 January 2011, at: https://www.ecb.europa.eu/press/pr/date/
2010/html/pr100408_1.en.html.
27
Press Release of 28 July 2010: ECB reviews risk control measures in its collateral framework,
at: https://www.ecb.europa.eu/press/pr/date/2010/html/pr100728_1.en.html. For the current valu-
ation haircuts, see: Guideline (EU) 2016/65 of the European Central Bank of 18 November 2015
on the valuation haircuts applied in the implementation of the Eurosystem monetary policy
framework (ECB/2015/35), OJ L 14/30, 21 January 2016.
28
Or, in ECB parlance: external credit assessment institutions (ECAIs).
29
Guideline (EU) 2015/510 of the European Central Bank of 19 December 2014 on the imple-
mentation of the Eurosystem monetary policy framework (General Documentation Guideline)
(ECB/2014/60) (recast), OJ L 91/3, 2 April 2015, notably Article 82.
30
Title V (Articles 119–126) of Guideline 2015/510, as amended.
31
At: http://www.ecb.europa.eu/paym/coll/risk/ecaf/html/index.en.html#ratingscale.

In respect of Greece, Portugal, Ireland and Cyprus, the ECB decided to continue
accepting their public debt as collateral, suspending the minimum credit rating thresh-
olds of the usual eligibility requirements. If the public debt of these States dropped
below ‘investment grade’ level, it continued to be acceptable as collateral as long as
there was a realistic prospect of a return to ‘investment grade’ level. This prospect was
grounded in the pursuit by the government of each State of an economic adjustment
programme that was intended to restore the access to financial markets and, therefore,
their creditworthiness.
These decisions were inspired by the central bank’s concern about the creditworthiness
of its (potential) debtors. By accepting as collateral debt issued by these States even though
graded below ‘investment level’, the ECB had, and still has, an enormous exposure to
them. Legally, these decisions might be considered to constitute undue interference in the
economic policy arena as they give an assessment of the economic adjustment programme
(the ‘conditionality’ for the financial assistance to programme States). The distinction
between monetary policy, an exclusive Union competence conferred on the Eurosystem,32
and economic policy, has been a contested frontier, central to some of the fierce debates
about the appropriate crisis-fighting instruments. Throughout the crisis, the ECB has
been involved in formulating and overseeing economic policies of the programme
States, and has been urging Member States to adopt certain economic policies ever more
vociferously. Assessing the adjustment programmes as appropriate, the ECB expressed its
confidence in the restoration of the creditworthiness of those governments that had lost
the confidence of the markets. Even though its general involvement in economic policy
formulation, and scrutiny, may be considered as legally debatable, I consider the ECB’s
insistence on an adjustment programme as a condition for the continued (or restored)
eligibility of their debt instruments for monetary policy purposes, legally valid. The ECB
simply didn’t have other means to defend its interests as a creditor—often indeed, the
largest creditor—of the debt issuing States, as it is required by law to do. After all, lending
is to be ‘based on adequate collateral’. Whilst having a large discretion in determining the
adequacy of collateral, the ECB cannot shirk its obligation to require adequate collateral.
Continued compliance with conditionality is an awkward aspect of this collateral
assessment approach as it makes economic policy dependent upon the blessing of the
central bank, a situation which defies the usual dividing line between monetary policy and
economic policy that is probably untenable in the long term. In view of the severe crisis
situation, with the ECB the only actor at Union level which was able to implement strong
action, I consider the central bank to have been acting within the limits of its powers
when linking the adequacy of collateral to the continued abiding to conditionality. This
assessment in no way endorses the actual contents of the conditionality: whether the mix
of austerity and structural reforms imposed on programme States has been the economi-
cally correct approach, whether the measures imposed have been legally sound, and in
compliance with constitutional guarantees for human rights, has been sharply contested.
Also, whether the adopted conditionality has been the optimal approach to restore market
confidence and competitiveness to the programme States is the subject of very divergent
views. From a legal perspective, I consider the ECB to have remained within the limits of
32
Article 282(1), second sentence, TFEU, in conjunction with Article 3(1)(c) TFEU.

Economic and Monetary Union (EMU) law by having linked conditionality to collateral
adequacy.
In respect of the Greek public debt, which the ECB was the first to keep accepting as
collateral in May 2010, the ECB expressly referred to this aspect of its decision: its posi-
tive assessment of the programme and the Greek government’s commitment is the basis
for continuing the eligibility ‘also from a risk management perspective’.33 The recitals of
the relevant legal instruments, also in respect of other programme States, reflect this risk
management approach. The exceptional measures in favour of programme States have
been codified in ECB guidelines.34
Beyond the general issue of the continued admissibility of public debt instruments
issued by programme States, two such States faced additional difficulties, as they engaged
in debt restructuring, leading the CRAs to declare them in default of their obligations.
The Private Sector Involvement (PSI), euphemistic jargon for a write-down of Greek debt
owned by private investors, and the restructuring of outstanding Cypriot debt, forced the
ECB to temporarily exempt the debt instruments issued by Greece35 and Cyprus36 from
Eurosystem monetary policy operations.
At the time of writing, both Greek37 and Cypriot38 public debt is not eligible for use in
Eurosystem credit operations. When they become eligible again, debt instruments of both
nations are subject to severe haircuts (write-downs of the nominal value for purposes of
collateral evaluation).
33
Press Release of 3 May 2010: ECB announces change in eligibility of debt instruments issued
or guaranteed by the Greek government, at: https://www.ecb.europa.eu/press/pr/date/2010/html/
pr100503.en.html.
34
See, notably, Article 8(2) of Guideline of the European Central Bank of 9 July 2014 on
additional temporary measures relating to Eurosystem refinancing operations and eligibility of
collateral and amending Guideline ECB/2007/9 (recast) (ECB/2014/31), OJ L 240/28, 13 August
2014. This provision suspends the credit quality threshold for sovereign debt of programme States
unless the ECB finds that the State in question does not comply with the conditionality or the
macro-economic programme.
35
Decision of the European Central Bank of 5 March 2012 on the eligibility of marketable
debt instruments issued or fully guaranteed by the Hellenic Republic in the context of the Hellenic
Republic’s debt exchange offer (ECB/2012/3) (2012/153/EU), OJ L 77/19, 16 March 2012; Decision
of the European Central Bank of 18 July 2012 repealing Decision ECB/2012/3 on the eligibility of
marketable debt instruments issued or fully guaranteed by the Hellenic Republic in the context of
the Hellenic Republic’s debt exchange offer (ECB/2012/14).
36
Decision of the ECB of 28 June 2013 repealing Decision ECB/2013/13 on temporary
measures relating to the eligibility of marketable debt instruments issued or fully guaranteed by
the Republic of Cyprus (ECB/2013/21), OJ L 192/75, 13 July 2013; Decision of the European
Central Bank of 5 July 2013 on temporary measures relating to the eligibility of marketable debt
instruments issued or fully guaranteed by the Republic of Cyprus (ECB/2013/22), OJ L 195/27, 18
July 2013.
37
Decision (EU) 2015/300 of the European Central Bank of 10 February 2015 on the eligibility
of marketable debt instruments issued or fully guaranteed by the Hellenic Republic (ECB/2015/6),
OJ L 53/29, 25 February 2015.
38
Decision (EU) 2016/457 of the European Central Bank of 16 March 2016 on the eligibility of
marketable debt instruments issued or fully guaranteed by the Republic of Cyprus (ECB/2016/5),
OJ L 79/41, 30 March 2016.

A comparative overview of the eligibility requirements for collateral39 shows how wide
the ECB has spanned its net: the Eurosystem is by far the central bank which accepts
most types of collateral, and at the lowest credit standards of the major central banks.
The ECB even went as far as allowing NCBs to have their own additional collateral
acceptance policies, as a temporary deviation of the Euro Area-wide approach. The ECB
approved ‘specific national eligibility criteria and risk control measures for the temporary
acceptance of additional credit claims as collateral in Eurosystem credit operations’40
for seven NCBs that had submitted concrete proposals.41 The risk for such collateral use
in Eurosystem monetary policy operations is not shared, as the applicable rules usually
provide,42 but borne by the NCB itself.43 Thus, bank loans can be accepted by NCBs in
addition to other assets.44
A similar expansion of NCB powers to accept short-term debt instruments as
collateral is included in the ECB’s 2014 Guideline on additional temporary measures
relating to Eurosystem refinancing operations and eligibility of collateral,45 as is the
NCBs’ power to reject as collateral certain government-guaranteed bank bonds.46 The
General Documentation on monetary policy47 was last codified in 2014, effective as of
1 May 2015.
5. Targeted Long-term Refinancing Operations
Like the Bank of England before it, the ECB introduced a programme to stimulate
lending to the real economy, the so-called Targeted Long-Term Refinancing Operations
(TLTROs). This non-standard measure is one of the most innovative: it seeks to directly
influence the behavior of banks by requiring them, on penalty of early repayment, to
on-lend the funds they borrowed.
39
ECB, Collateral Eligibility Requirements – A Comparative Study Across Specific Frameworks,
July 2013, at: https://www.ecb.europa.eu/pub/pdf/other/collateralframeworksen.pdf.
40
Press Release of 9 February 2012: ECB’s Governing Council approves eligibility criteria
for additional credit claims at: https://www.ecb.europa.eu/press/pr/date/2012/html/pr120209_2.
en.html.
41
Press Release of 8 December 2011: ECB announces measures to support bank lending
and money market activity, at: https://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.
html.
42
See, notably, Article 32.5 of the ESCB Statute.
43
The Press Release of 8 December 2011 specifies: ‘The responsibility entailed in the accept-
ance of such credit claims will be borne by the NCB authorising their use.’
44
See Article 4 of Guideline ECB/2014/31, paragraph 1: ‘NCBs may accept as collateral for
Eurosystem monetary policy operations credit claims that do not satisfy the Eurosystem eligibility
criteria.’
45
In Article 5.
46
In Article 6.
47
Guideline (EU) 2015/510 of the European Central Bank of 19 December 2014 on the imple-
mentation of the Eurosystem monetary policy framework (General Documentation Guideline)
(ECB/2014/60) (recast), OJ L 91/3, 2 April 2015. See the announcement of the new General
Documentation in the ECB’s Press Release of 20 February 2015: ECB announces publication of a
new Guideline on the implementation of monetary policy, at: https://www.ecb.europa.eu/press/pr/
date/2015/html/pr150220.en.html.

The original programme was announced48 in June 2014. The ECB Decision49 was ready
at the end of July. As its preamble makes clear, the ECB ‘aims to support bank lending
to the non-financial private sector, meaning households and non-financial corporations,
in [the Euro Area]’.50 Banks are to report51 on net lending to the real economy,52 with the
exception of lending for buying real estate by households.53 Banks are required to repay
their borrowing early if they do not meet a benchmark for credit expansion.54 A further set
of TLTROs was announced in March 2016,55 with the possibility that the lending rate for
banks which exceed a benchmark for on-lending may be set at the same rate as the deposit
rate on the day of the tendering (currently: -0.40 percent), that is at negative interest rates.
This implies the ECB may actually be paying banks to on-lend funds borrowed from the
central bank to the real economy. Critical outsiders have detected another change in the
targeted lending programme, namely the elimination of the requirement for repaying
loans when banks have not achieved their lending benchmark.56 A new legal act underpins
the TLTRO programme.57
As indicated above, the Bank of England introduced the Funding for Lending Scheme58
in 2012.59 A legal issue which arises is whether such a scheme, which restricts cheap
lending to banks for the purpose of onward credit provision within the United Kingdom,
is compatible with the internal market rules which seek to ensure that financial services
providers are free to grant credit to clients across the EU. A similar question does not
48
Press Release of 5 June 2014: ECB announces monetary policy measures to enhance the
functioning of the monetary policy transmission mechanism, at: https://www.ecb.europa.eu/press/pr/
date/2014/html/pr140605_2.en.html.
49
Decision of the European Central Bank of 29 July 2014 on measures relating to targeted
longer-term refinancing operations (ECB/2014/34) (2014/541/EU), OJ L 258/11, 29 August 2014.
50
Recital 2 of the preamble to Decision ECB/2014/34.
51
Article 8 Decision ECB/2014/34: Reporting requirements. Paragraph 8 requires external vali-
dation: ‘an annual examination of accuracy in respect of data reported [which] may be performed
by an external auditor . . .’
52
Meaning: ‘non-financial corporations and households (including non-profit institutions
serving households)’ according to Article 1 sub (3) Decision ECB/2014/34.
53
Article 1 sub (3) Decision ECB/2014/34 specifies: ‘except loans to households for house
purchases’.
54
Article 7(1) Decision ECB/2014/34.
55
Press Release of 10 March 2016: ECB announces new series of targeted longer-term refinanc-
ing operations (TLTRO II), at: https://www.ecb.europa.eu/press/pr/date/2016/html/pr160310_1.
en.html.
56
Silvia Merler, ECB TLTRO 2.0 – Lending at negative rates, Bruegel blog post, 11 March 2016
at: http://bruegel.org/2016/03/ecb-tltro-2-0-lending-at-negative-rates/.
57
Decision (EU) 2016/XX of the ECB of 28 April 2016 on a second series of targeted longer-
term refinancing operations (ECB/2016/10), 3 May 2016, at: https://www.ecb.europa.eu/ecb/legal/
pdf/en_2016_10_f_sign.pdf.
58
The scheme is explained in: Rohan Churm, Amar Radia, Jeremy Leake, Sylaja Srinivasan
and Richard Whisker, The Funding for Lending Scheme, Bank of England Quarterly Bulletin
2012/4, at: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb120401.
pdf.
59
Bank of England, Market Notice, 30 November 2015, at: http://www.bankofengland.co.uk/
markets/Documents/marketnotice151130.pdf. News Release – Bank of England and HM Treasury
announce extension to the Funding for Lending Scheme, 30 November 2015, at: http://www.
bankofengland.co.uk/publications/Pages/news/2015/096.aspx.

immediately arise in respect of the Eurosystem’s TLTROs as these, although implemented

through the NCBs, serve the entire Euro Area economy.60
III. MONETARY POLICY MANDATE IN TIMES OF CRISIS:

ASSET PURCHASE PROGRAMMES AND ELA
1. Asset Purchase Programmes
The ECB introduced two kinds of asset purchase programmes.

One kind was introduced, or announced, to unblock the monetary policy transmission
channels. Here, the ECB acted as a chimney sweeper to ensure that its fire (interest rate
decisions) could reach the open air of the outside world (the real economy, working
through the banking system). The strong variation in interest rates prevalent in different
parts of the Euro Area made the ECB’s monetary policy ineffective in the areas affected.
There, the links between banks and sovereigns meant that both paid risk premiums to
tap liquidity in the financial markets, premiums that—in 2010 and 2012, when these
kind of programmes were started—seemed way off the ‘normal’ spread between debtors
considered low-risk (notably, Germany) and those that were considered high risk (the
sovereigns that had to rely on financing by arrangements with other European States—the
‘programme States’). The rates they had to pay also reflected the convertibility risk that
was perceived to exist: markets prepared for the demise of the euro and its replacement by
legacy currencies that had been abolished. In so far as these premiums were a function of
the market’s lack of faith in the irreversible nature of the adoption of the single currency,
addressing these premiums came within the ECB’s mandate.61
The other sort of asset purchase programme was introduced to rekindle inflation and
bring growth back to the economy. This latter kind of operation seeks to lower long-term
interest rates and to take financial assets out of the market onto the central bank’s balance
sheet, so as to free up resources for the banks to start lending, again: ‘quantitative easing’.
Covered Bonds Purchase Programme 1

In May 2009 the ECB announced a scheme to buy covered bonds, ie, debt instruments
whose repayment is secured (‘covered’) through underlying assets, often mortgages62
60
Although a strict reading of the internal market rules may find limitations to a central
bank’s ‘own’ jurisdiction, even when at Euro Area level, to sit uncomfortably with the fundamental
freedoms in the area of financial services.
61
As ECB President Mario Draghi indicated when he made his intervention in London on
July 2012 saying: ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the
euro. And believe me, it will be enough.’ Verbatim of the remarks made by Mario Draghi – Speech
by Mario Draghi, President of the European Central Bank at the Global Investment Conference in
London, 26 July 2012, at: https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html.
He added: ‘. . . the euro is irreversible . . .’ and: ‘To the extent that the size of these sovereign
premia hampers the functioning of the monetary policy transmission channel, they come within
our mandate.’
62
On its website, the European Covered Bond Council (ECBC), the stakeholder forum of
participants in the covered bonds market, defines these instruments as follows: ‘Covered bonds are

over a one-year period. They were to have ‘a minimum rating of AA or equivalent

by at least one of the major rating agencies (Fitch, Moody’s, S&P or DBRS) and,
in any case, not lower than BBB-/Baa3’.63 This announcement was made simultane-
ously with the introduction of LTROs with a maturity of one year. The stated
objectives of the CBPP were ‘to contribute to: (a) promoting the ongoing decline in
money market term rates; (b) easing funding conditions for credit institutions and
enterprises; (c) encouraging credit institutions to maintain and expand their lending
to clients; and (d) improving market liquidity in important segments of the private
debt securities market.’64 This relatively small-size programme was implemented in the
usual decentralized manner, with an ‘exceptional’ role for the ECB in direct contact
with counterparties.65 The Eurosystem works in a decentralized fashion in accord-
ance with Article 12.1, third paragraph ESCB Statute.66 CBPP1 was terminated in June
2010.

A smaller programme was introduced67 in November 2011 to last until October 2012.
Two of the objectives invoked for CBPP1 were maintained as grounds for the renewed
programme.68 To be eligible for purchase, covered bonds needed to have ‘a minimum
rating of “BBB-” or equivalent, awarded by at least one of the major rating agencies’. The
same exception to decentralized implementation was adopted.

A third covered bonds purchasing programme is still active at the time of writing.
CBPP3 was introduced69 in October 2014 as a complement to the general asset purchase
debt instruments secured by a cover pool of mortgage loans (property as collateral) or public-sector
debt to which investors have a preferential claim in the event of default’, at: http://ecbc.hypo.org/
Content/default.asp?PageID5504. See, for essential features of covered bonds: http://ecbc.hypo.
org/Content/default.asp?PageID5503.
63
Press Release, 4 June 2009, Purchase programme for covered bonds, at: https://www.ecb.
europa.eu/press/pr/date/2009/html/pr090604_1.en.html.
64
Recital 2 of the preamble to Decision of the European Central Bank of 2 July 2009 on the
implementation of the covered bond purchase programme (ECB/2009/16) (2009/522/EC), OJ L
175/18, 4 July 2009.
65
66
‘To the extent deemed possible and appropriate and without prejudice to the provisions of
this Article, the ECB shall have recourse to the national central banks to carry out operations which
form part of the tasks of the ESCB.’
67
Press Release, 3 November 2011: ECB announces details of its new covered bond pur-
chase programme (CBPP2), at: https://www.ecb.europa.eu/press/pr/date/2011/html/pr111103_1.en.
html.
68
Namely: ‘(a) easing funding conditions for credit institutions and enterprises; and (b)
encouraging credit institutions to maintain and expand lending to their clients.’ See recital 3 of the
preamble to Decision of the European Central Bank of 3 November 2011 on the implementation
of the second covered bond purchase programme (ECB/2011/17) (2011/744/EU), OJ L 297/70, 16
November 2011.
69
Press Release, 2 October 2014: ECB announces operational details of asset-backed securities
and covered bond purchase programmes, at: https://www.ecb.europa.eu/press/pr/date/2014/html/
pr141002_1.en.html.

programme and the TLTROs. The legal act70 underpinning CBPP3 mentions several
objectives: enhancing the transmission of monetary policy, facilitating credit provisioning
to the real economy, and ‘positive spill-overs to other markets’. Together, this should
result in easing of the ECB’s monetary policy stance (needed since interest rates are
already at the lower bound) and help rekindle inflation to the ECB’s inflation target71 of
below, but close to two percent. Eligibility is set at the same level as before72 but with an
intention to include the whole Euro Area, including Greece and Cyprus.73
Securities Markets Programme

In 2010 the ECB announced it would engage in ‘interventions in the euro area public and
private debt securities markets’ in what was dubbed the Securities Markets Programme
(SMP). The SMP was meant ‘to ensure depth and liquidity in those market segments which
are dysfunctional.’ The objective was ‘to address the malfunctioning of securities markets
and restore an appropriate monetary policy transmission mechanism.’74 The ECB’s
announcement came shortly after the Euro Group’s announcement75 of a bilateral loans76
package for Greece, the announcement of the establishment of the European Financial
Stability Facility (EFSF) and the establishment of the European Financial Stability
Mechanism (EFSM).77 The SMP was strongly linked to the economic policy adjustments
undertaken by Member State governments: its announcement78 explicitly refers to the
economic policy adjustments to which Member States had agreed.79 The SMP was
70
Decision of the European Central Bank of 15 October 2014 on the implementation of
the third covered bond purchase programme (ECB/2014/40) (2014/828/EU), OJ L 335/22, 22
November 2014.
71
Recital 2 of the preamble to Decision ECB/2014/40: ‘Alongside the ABS purchase pro-
gramme (ABSPP) and the Targeted Longer-Term Refinancing Operations (TLTROs), the CBPP3
will . . . contribute to a return of inflation rates to levels closer to 2%.’
72
Article 2 sub (1) Decision ECB/2014/40.
73
As the Press release of 2 October 2014 states: ‘To ensure that the programmes can include the
whole euro area, ABSs and covered bonds from Greece and Cyprus that are currently not eligible
as collateral for monetary policy operations will be subject to specific rules with risk-mitigating
measures.’ See Article 2 sub (5) Decision ECB/2014/40 for eligibility for outright purchases under
CBPP3 for Greek and Cypriot covered bonds.
74
Press Release of 10 May 2010: ECB decides on measures to address severe tensions in financial
markets, at: https://www.ecb.europa.eu/press/pr/date/2010/html/pr100510.en.html.
75
Statement by the Eurogroup, Brussels, 2 May 2010, at: http://www.consilium.europa.eu/ue
docs/cmsUpload/100502-%20Eurogroup_statement.pdf.
76
From EU Member States plus an IMF facility, totalling € 110 bn; the so-called ‘Greek Loan
Facility’ (GLF).
77
Press Release 9596/10 of the Extraordinary Council meeting Economic and Financial Affairs
Brussels, 9/10 May 2010, at: https://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/
ecofin/114324.pdf. See, also: Council Regulation (EU) No 407/2010 of 11 May 2010 establishing a
European financial stabilisation mechanism, OJ L 118/1, 12 May 2010.
78
The ECB Press Release of 10 May 2010 states (italics in original): ‘In making this decision
we have taken note of the statement of the euro area governments that they “will take all measures
needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit
procedures” and of the precise additional commitments taken by some euro area governments to
accelerate fiscal consolidation and ensure the sustainability of their public finances.’
79
In the summer of 2011, ECB President Jean-Claude Trichet issued a statement welcom-
ing economic policy commitments by Italy and Spain, and calling for their ‘decisive and swift

adopted in ‘exceptional circumstances in financial markets, characterised by severe ten-

sions in certain market segments which are hampering the monetary policy transmission
mechanism and thereby the effective conduct of monetary policy oriented towards price
stability in the medium term’.80 Pursuant to the usual decentralized fashion of operating
but with an operational role for the ECB itself, the Eurosystem would buy debt instruments
issued by public sector of the Euro Area Member States on the secondary market and,
on the primary or secondary markets, private debt issued in these States. The difference
in market operations can be explained by the prohibition of monetary financing81 which
prevents primary market purchases of public debt by the ECB and the NCBs. The SMP
was terminated upon the announcement of the OMT on 12 September 2012.
Outright Monetary Transactions
Announcement of Outright Monetary Transactions After an earlier announcement,82

the ECB decided, on 6 September 2012, to introduce Outright Monetary Transactions
(OMT) as a means to ‘safeguard’ (rather: restore) the transmission channels of monetary
policy and to re-establish the unity of monetary policy across the Euro Area. This
occurred at a time of major upheaval and disbelief in the irreversible nature83 of the
single currency.84 After arguing, in its August monetary policy statement,85 that three
conditions were necessary for these risk premiums to disappear, namely ‘fiscal consolida-
tion, structural reform and European institution-building with great determination’, the
ECB announced that ‘within its mandate to maintain price stability over the medium
implementation’. These, and other economic policy-related developments were stated as enabling
the ECB to pursue the SMP: ‘It is on the basis of the above assessments that the ECB will actively
implement its Securities Markets Programme. This programme has been designed to help restor-
ing a better transmission of our monetary policy decisions – taking account of dysfunctional
market segments – and therefore to ensure price stability in the euro area.’ See the Press Release
of 7 August 2011: Statement by the President of the ECB, at: https://www.ecb.europa.eu/press/pr/
date/2011/html/pr110807.en.html.
80
81
Article 123 TFEU; Article 21 ESCB Statute. This prohibition is elaborated in Council
Regulation (EC) No 3603/93 of 13 December 1993 specifying definitions for the application of
the prohibitions referred to in Articles 104 and 104b (1) of the Treaty [currently, Articles 123 and
125(1) TFEU], OJ L 332/1, 31 December 1993.
82
After the 2 August 2012 meeting of the Governing Council.
83
The irrevocable nature of the transition to the third stage of EMU had been laid down in
primary EU law. The relevant Protocol No 10, attached to the EC Treaty (now: TFEU), has been
revoked by the Lisbon Reform Treaty as, in 2009, the transition was considered complete and the
insistence on its irrevocable nature obsolete. The Euro Area sovereign debt crisis erupted within
months of this revocation.
84
Article 140(3) TFEU also makes clear that adoption of the euro is for good: in respect of
the Ecofin Council decision after establishing a Member State’s compliance with the convergence
criteria, it provides that ‘the Council shall . . . irrevocably fix the rate at which the euro shall be sub-
stituted for the currency of the Member State concerned, and take the other measures necessary for
the introduction of the euro as the single currency in the Member State concerned’ (emphasis added).
85
Introductory statement to the press conference (with Q and A), Mario Draghi, President of
the ECB, Vítor Constâncio, Vice-President of the ECB, Frankfurt am Main, 2 August 2012, at:
http://www.ecb.europa.eu/press/pressconf/2012/html/is120802.en.html.

term and in observance of its independence in determining monetary policy, [it] may
undertake outright open market operations of a size adequate to reach its objective.’
Governments’ efforts were mentioned as necessary conditions for the employment of the
new instrument.86 The announcement of the technical features of OMT87 began by speci-
fying the link to conditionality for activating OMT. These would be considered ‘to the
extent that they are warranted from a monetary policy perspective as long as programme
conditionality is fully respected, and [the ECB would] terminate them once their objec-
tives are achieved or when there is non-compliance with the macroeconomic adjustment
or precautionary programme.’ The Governing Council emphasized its full discretion to
activate or terminate OMTs in the sole context of its monetary policy mandate.
Legal acts only before CJEU No legal acts were adopted to activate OMT. The
announcement alone had the intended effect of bringing interest rates on ‘peripheral’
nations’ markets down to sustainable levels, thereby restoring, at least in part, the
ECB’s monetary policy’s effectiveness throughout the Euro Area. Draft legal acts that
the ECB had prepared for the activation of OMT did play a role before the Court of
Justice of the European Union (CJEU) in preliminary proceedings on referral by the
German Constitutional Court (GCC). The Governing Council’s insistence that OMT
were a monetary policy instrument had not been unanimously agreed. The Bundesbank
disagreed. When a case was brought before the GCC in which the mandate of the ECB
to adopt the OMT decision was challenged as ultra vires, and the alleged exceeding of
its competences as flouting against the German act of conferral of sovereign powers to
the EU, the Bundesbank submitted a brief opposing the measure. The German central
bank argued that the extreme interest rate differentials between Member States could
not be qualified as impediments to the monetary policy transmission mechanism. They
are attributable to differentiated market assessment of the creditworthiness of the
sovereigns.88 The ECB took a diametrically opposite position, explained by its German
Executive Board member.89 The question whether openly opposing a decision taken by
the Governing Council amounts to an attack on the central bank’s independence has been
raised by former ECB Executive Director Bini Smaghi.90
86
‘The adherence of governments to their commitments and the fulfilment by the EFSF/ESM
of their role are necessary conditions.’
87
Press Release of 6 September 2012: Technical features of Outright Monetary Transactions, at:
http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html.
88
See Deutsche Bundesbank, Stellungnahme [im OMT-Verfahren], at: http://www.han
delsblatt.com/downloads/8124832/1/stellungnahme-bundesbank_handelsblatt-online.pdf, and
Eingangserklärung anlässlich der mündlichen Verhandlung im Hauptsacheverfahren ESM/EZB,
Dr Jens Weidmann, Präsident der Deutschen Bundesbank, beim Bundesverfassungsgericht in
Karlsruhe am 11 June 2013, at: https://www.bundesbank.de/Redaktion/DE/Kurzmeldungen/
Stellungnahmen/2013_06_11_esm_ezb.html.
89
Introductory statement by the ECB in the proceedings before the Federal Constitutional Court,
Jörg Asmussen, Member of the Executive Board of the ECB, Karlsruhe, 11 June 2013, at: https://
www.ecb.europa.eu/press/key/date/2013/html/sp130611.en.html.
90
Lorenzo Bini Smaghi, The ECB is doing the right thing, Financial Times, 14 June 2013.
Moreover, one may question the compatibility of such an open revolt in court against a collective
decision with the principle of sincere cooperation (Gemeinschaftstreue, literally: loyalty to the

Main features of the CJEU decision The legal battle before the GCC led it to make its
first-ever reference to the CJEU, asking specific questions on the legality of the OMT
programme. In its judgment91 of 16 June 2015, the CJEU held that the ECB acted within
its mandate. Several observations of the European Court merit a closer look.
As previously in the Pringle case,92 which concerned a question of a preliminary
ruling from the Supreme Court of Ireland on the ratification of the ESM Treaty, the
delimitation between monetary and economic policy was a prime issue. Monetary
policy is the exclusive competence of the Union for Member States whose currency is
the euro,93 whereas economic policy is a shared competence, even though it is not listed
among the shared competences in the relevant TFEU provision94 but in a separate
one.95 After finding that the selective nature of the OMT programme (implying only the
purchase of bonds issued by selected States) does not imply that the measure qualifies
as an economic policy instrument,96 and specifying that monetary policy may be single
but not necessarily uniform across the currency area,97 the Court concludes that ‘it is
apparent that in view of its objectives and the instruments provided for achieving them,
[the OMT programme] falls within the area of monetary policy’. Linking its activation
to economic policy conditionality does not overstep the boundaries of the divide
between monetary policy, on the one, and economic policies, on the other hand. The
Court acknowledged that the OMT programme may be an incentive to comply with
the adjustment programme that a State needs to undertake as a condition for receiving
financial support, but considered such indirect effects did not overstep the boundary
between the two policy areas, arguing that Articles 119(2), 127(1) and 282(2) TFEU
require the ESCB ‘without prejudice to the objective of price stability, to support the
general economic policies in the Union.’
The Court’s appraisal of the ECB’s discretion to adopt policy measures it sees appro-
priate for the situation confirms its general approach to allow the institutions to make
technical decisions on complex economic issues. The proportionality test applied allows
the ECB broad discretion. Judicial review of compliance with procedural guarantees is
fundamental, yet the announcement and the draft legal acts that were brought before
the Court but that citizens and academic writers have not been able to access, met such
Community [Union]), laid down in Article 4(3) TEU, as loyalty towards EU decisions by State
agencies is to be the norm.
91
In Case C-62/14 (Gauweiler and Others vs Deutscher Bundestag), ECLI:EU:C:2015:400.
92
Judgment of 27 November 2012 in Case C-370/12 (Thomas Pringle v Government of Ireland,
Ireland and The Attorney General), ECLI:EU:C:2012:756.
93
Article 3(1)(c) TFEU.
94
Article 4 TFEU.
95
Article 5 TFEU.
96
Paragraph 55 of the judgment in the Gauweiler Case: ‘. . . it should be borne in mind that the
programme is intended to rectify the disruption to the monetary policy transmission mechanism
caused by the specific situation of government bonds issued by certain Member States. In those
circumstances, the mere fact that the programme is specifically limited to those government bonds
is thus not of a nature to imply, of itself, that the instruments used by the ESCB fall outside the
realm of monetary policy.’
97
In the same paragraph 55, the CJEU adds: ‘Moreover, no provision of the [TFEU] requires
the ESCB to operate in the financial markets by means of general measures that would necessarily
be applicable to all the States of the euro area.’

procedural requirements. The Court sides with the ECB and does not superimpose
its own analysis on that of the central bank when it considers that the OMT were
introduced on the basis of ‘an analysis of the economic situation of the euro area,
according to which, at the date of the programme’s announcement, interest rates on the
government bonds of various States of the euro area were characterised by high volatil-
ity and extreme spreads’ which ‘according to the ECB . . . were not accounted for solely
by macroeconomic differences between the States concerned but were caused, in part,
by the demand for excessive risk premia for the bonds issued by certain Member States,
such premia being intended to guard against the risk of a break-up of the euro area.’
This ‘special situation severely undermined the ESCB’s monetary policy transmission
mechanism in that it gave rise to fragmentation as regards bank refinancing conditions
and credit costs, which greatly limited the effects of the impulses transmitted by the
ESCB to the economy in a significant part of the euro area.’ Thus, the Court found
that the adoption of the OMT programme ‘was not vitiated by a manifest error of
assessment.’ The monetary policy transmission mechanism is described with utmost
clarity by the CJEU.98
Although the question of the delimitation of economic and monetary policy was
broached by the Court, it did not go as far as the Advocate General (AG) who, in
his Opinion,99 fully underwrote the ECB’s discretion and the monetary nature of the
OMT but considered that the ECB, when activating OMT, was to withdraw from
the troika overseeing compliance with the conditionality for financial assistance
provided by the EFSF and the ESM. The AG argued that making compliance
with third parties’ conditionality for loans a requirement for activating the OMT
was acceptable for the avoidance of moral hazard for the Member State whose bonds
the Eurosystem would purchase. Yet, the ECB’s own role in adopting and overseeing
that very conditionality made it imperative for the central bank to withdraw from
its oversight function once OMT were activated in respect of an individual Member
State.
The AG’s contextual interpretation avoids that the central bank would come to occupy
a place in policy-making that would transcend the boundaries between monetary policy
and economic policy, to the detriment of the accountability of policy-makers for their
separate spheres. In my mind, the AG rightly qualifies OMT as a monetary policy instru-
ment but, also, found that activating it would have to imply the ECB’s withdrawal from
its economic policy overseeing role.100 The Court, while also concluding that OMT are
98
Paragraph 78: ‘Thus, it is undisputed that interest rates for the government bonds of a given
State play a decisive role in the setting of the interest rates applicable to the various economic actors
in that State, in the value of the portfolios of financial institutions holding such bonds and in the
ability of those institutions to obtain liquidity. Therefore, eliminating or reducing the excessive
risk premia demanded in respect of the government bonds of a Member State is likely to avoid the
volatility and level of those premia from hindering the transmission of the effects of the ESCB’s
monetary policy decisions to the economy of that State and from jeopardising the singleness of
monetary policy.’
99
Opinion of Advocate General Cruz Villalón delivered on 14 January 2015 in Case C-62/14,
ECLI:EU:C:2015:7.
100
Paragraph 151 of the AG’s Opinion: ‘. . . I consider that the OMT programme is to be
regarded as a monetary policy measure, provided that the ECB refrains — once the time has

a monetary policy instrument, assessed the legality of the OMT’s announcement differ-
ently by finding that the requirement of compliance with conditionality serves the ECB’s
secondary objective of support for the economic policies in the Union,101 and by finding
further arguments102 to distinguish purchases of government bonds on the secondary
market subject to compliance with conditionality by the ESM from similar operations in
respect of government bonds by the Eurosystem.103 To reach this conclusion, the Court
finds the different objectives between the two instruments decisive: maintenance of price
stability for the OMT and safeguarding the stability of the euro area for the interventions
of the ESM.
Asset-backed Securities Purchasing Programme

Three further sets of measures have been actually implemented since 2014. The first is
the Asset-backed Securities Purchasing Programme (ABSPP), announced in September
and enacted104 in November 2014. The ABSP has the same objectives105 as the CBPP3.
The ECB’s website adds the following: ‘The ABSPP also helps banks to diversify
funding sources and stimulates the issuance of new securities. Asset-backed securities
can help banks to fulfil their main role: providing credit to the real economy’.106 As in
the CBPP3, eligibility criteria include special provisions for Greece and Cyprus.107 The
ABSPP forms part of the larger expanded asset purchase programme (APP) which
combines the CBPP3, the ABSPP and the public sector purchase programme (PSPP).
The intention is for the APP to withdraw € 80 billion per month in purchases until
March 2017 (€ 60 billion per month in the first year of operation: March 2015–March
2016).
come to put that programme into effect — from any direct involvement in the financial assistance
programmes of the ESM or the EFSF.’
101
Paragraph 59 of the judgment in the Gauweiler Case.
102
The Court, in paragraph 61 of its judgment, refers to the guiding principle of sound public
finances of Article 119(3) TFEU to which the ECB is subject, to conclude that the condition of
compliance with the adjustment programme does not take OMT from the realm of monetary to
that of economic policy.
103
The Court in paragraph 63: ‘. . . the fact that the purchase of government bonds on
the secondary market subject to a condition of compliance with a macroeconomic adjustment
programme could be regarded as falling within economic policy when the purchase is undertaken
by the ESM [referring to Pringle] does not mean that this should equally be the case when that
instrument is used by the ESCB in the framework of [the OMT] programme . . .’
104
Decision (EU) 2015/5 of the European Central Bank of 19 November 2014 on the
implementation of the asset-backed securities purchase programme (ECB/2014/45), OJ L 1/4, 6
January 2015. Subsequently amended by Decision (EU) 2015/1613 of the European Central Bank
of 10 September 2015 amending Decision (EU) 2015/5 on the implementation of the asset-backed
securities purchase programme (ECB/2015/31), OJ L 249/28, 25 September 2015.
105
Recital 2 of the preamble to Decision ECB/2014/45 is similar to recital 2 of the preamble to
Decision ECB/2014/40 on CBPP3.
106
FAQs on the ABSPP, at: https://www.ecb.europa.eu/mopo/implement/omt/html/abspp-faq.
en.html.
107
Article 2 sub (8) Decision ECB/2014/45.

Public Sector Purchasing Programme

In January 2015, the ECB announced108 a widening of the scope of the APP, to include
public sector securities.109 For two years, the Eurosystem is to engage in purchases of
bonds issued by central governments and agencies of the Euro Area and EU institutions.
Adding to the purchasing programme in respect of private sector assets, the ECB seeks
‘to address the risks of a too prolonged period of low inflation.’ Although the purchases
are part of the wider asset purchasing programme, the PSPP entails operations on the
secondary market only. Buying public-sector bonds in primary markets is prohibited by
Article 123 TFEU. In order to allow primary market price formation, the ECB’s PSPP
legal act imposes ‘black-out periods’.110 As usual, an eligibility test is applied: only securi-
ties whose issuer meets the ‘investment grade’ level rating are eligible.111 Debt instruments
issued or guaranteed by States under a financial assistance programme are only eligible112
if the minimum eligibility criteria have been suspended in respect of these States under
Guideline ECB/2014/31.
The idea behind the PSPP is that ‘the institutions that sold the securities can use [central
bank money received by selling securities] to buy other assets and extend credit to the real
economy.’ In line with the decentralisation principle, the purchases are effected by NCBs,
‘in proportions reflecting their respective shares in the ECB’s capital key’,113 but also by
the ECB itself.114 This relates to a specific issue of the PSPP, the limitation of loss-sharing.
The loss-sharing arrangement may be seen as evidence of a decrease in cohesion of the
Eurosystem.
Corporate Sector Purchase Programme

The latest addition to the asset purchase programmes is the Corporate Sector Purchase
Programme (CSPP). It was announced115 on 10 March 2016, with details coming six
weeks later.116 At the time of writing, no legal act specifying the CSPP is available so it is
on the detailed press release that the following is based. CSPP purchases are to start in
June 2016.
108
Press Release of 22 January 2015: ECB announces expanded asset purchase programme, at:
https://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html.
109
Decision (EU) 2015/774 of the European Central Bank of 4 March 2015 on a secondary
markets public sector asset purchase programme (ECB/2015/10), OJ L 121/20, 14 May 2015.
110
Article 4 (Limitations on the execution of purchases) Decision ECB/2015/10.
111
Article 3(2)(a) Decision ECB/2015/10.
112
Article 3(2)(c) Decision ECB/2015/10. Article 5(2) Decision ECB/2015/10 provides that a
different cap applies to purchases of these debt instruments than to those issued or guaranteed by
other Member States.
113
Recital 3 of the preamble to Decision ECB/2015/10. NCBs purchase bonds issued by their
own State’s government.
114
For 8 percent of all purchases, the remaining 92 percent to be undertaken by NCBs: Article
6(2) Decision ECB/2015/10.
115
See point 5 of the Press Release of 10 March 2016: Monetary policy decisions, at: https://
www.ecb.europa.eu/press/pr/date/2016/html/pr160310.en.html: ‘Investment grade euro-denominated
bonds issued by non-bank corporations established in the euro area will be included in the list of
assets that are eligible for regular purchases.’
116
Press Release of 21 April 2016: ECB announces details of the corporate sector purchase
programme (CSPP), at: https://www.ecb.europa.eu/press/pr/date/2016/html/pr160421_1.en.html.

A notable feature is the decentralized and concentrated implementation117 of these pur-

chases. Only six NCBs will effect purchases under this leg of the APP, namely the central
banks of Belgium, Germany, Spain, France, Italy and Finland,118 with ‘each NCB . . .
responsible for purchases from issuers in a particular part of the euro area’, and the ECB
coordinating these purchases. The eligibility criteria are in line with those established
for other elements of the APP, namely ‘at least credit quality step 3 (rating of BBB- or
equivalent)’.119 In line with the prohibition of monetary financing, it is specified that no
primary market purchases will be undertaken in respect of bonds issued by undertakings
which may be considered to belong to the public sector.120
2. Emergency Liquidity Assistance
The provision of Emergency Liquidity Assistance (ELA), also referred to as Lender of

Last Resort (LOLR) assistance, has been a focal point of attention. Its direct impact
on the liquidity of banks in programme States made ELA decisions a headline item.
The acceptance of bonds issued by programme States, or by States whose ratings had
fallen below the usual eligibility level, also had an ELA consequence. Neither the general
provision of liquidity to the banking system, which the ECB was the first to engage in
when the GFC erupted in 2007, nor the provision of liquidity to individual solvent com-
mercial banks, has been exhaustively regulated at ESCB level. This is because the ECB,
in a remarkable act of auto-limitation, qualified ELA as a ‘function other than those
specified [in the ESCB Statute]’ that NCBs perform.121 Such ‘national tasks’ may continue
to be performed unless the Governing Council, by a two-thirds majority, finds that they
‘interfere with the objectives and tasks of the ESCB’. Such remaining ‘national tasks’ are
for the account of the NCB which undertakes them.
This allocation of responsibilities, applicable since 1999, has been explained122 in
2007 and clarified in 2013.123 In its 2007 publication, the ECB highlighted that ELA124
117
The approach of several NCBs acting for the entire Eurosystem is not novel: the pan-Euro-
pean gross settlement payment system through which euro payments are channelled (TARGET2) is
operated by three NCBs: Bundesbank, Banque de France and Banca d’Italia. See: https://www.ecb.
europa.eu/paym/t2/html/index.en.html.
118
Nationale Bank van België / Banque Nationale de Belgique, Deutsche Bundesbank, Banco de
España, Banque de France, Banca d’Italia, and Suomen Pankki/Finlands Bank.
119
See the Press Release of 21 April 2016.
120
Press Release of 21 April 2016: ‘The purchases will be conducted in the primary and second-
ary markets, but no primary market purchases will involve debt instruments issued by entities that
qualify as public undertakings.’
121
122
In an article in the Monthly Bulletin of February 2007 which explained the crisis manage-
ment arrangements in the EU that were to fail so miserably just months later: The EU arrangements
for financial crisis management, notably pages 80–81. See: https://www.ecb.europa.eu/pub/pdf/
mobu/mb200707en.pdf.
123
ELA Procedures, 17 October 2013, at: https://www.ecb.europa.eu/pub/pdf/other/201402_
elaprocedures.en.pdf ?10cc0e926699a1984161dc21722ca841.
124
Defined as: ‘providing liquidity support in exceptional circumstances to a temporarily
illiquid credit institution which cannot obtain liquidity through either the market or participation
in monetary policy operations’.

constituted ‘exceptional and temporary liquidity provision’, which should respect the
prohibition of monetary financing. Emphasising the very exceptional nature of ELA, the
ECB declared that a ‘private sector solution is preferable whenever possible’.125 It further
elaborated that ‘the provision of ELA is within the discretion of the national central bank,
which will consider the relevant factors that may justify the access to this lending of last
resort’. Its insistence that ‘automatic access to central bank liquidity’ may not be assumed
constitutes the much-heralded ‘constructive ambiguity’. This is the approach whereby
commercial banks are left in the dark about whether they can rely on the central bank’s
liquidity support in times of need. Such uncertainty is considered to enhance a bank’s
reliance on market operations and its self-sufficiency. The only glimpse of the ESCB-
internal approach to ELA given was that ‘the Eurosystem also has procedures in place
regarding the provision of ELA to individual credit institutions in the euro area, which are
under the responsibility of NCBs’.126 In its 2013 publication, the ECB provided extensive
insight into the information that an NCB is to provide for the Governing Council to give
its assessment of the provision of ELA, quantifying the levels of assistance beyond which
there will be deeper scrutiny.
Without going into the many legal ramifications of ELA, such as their qualification as
state aid,127 the experience gained during the crises has taught that the ECB is to decide
on the appropriate level of liquidity assistance to commercial banks, on the basis of a
set of rules concerning its assessment of possible interference with the Eurosystem’s
monetary policy. Even if this allocation of responsibilities has worked during the crisis, it
seems natural for the ECB to assume an ELA function of its own now that banking union
has attributed to the ECB direct supervisory functions in respect of significant credit
institutions.128 Such a direct role would certainly be natural in respect of the significant
institutions it directly supervises.
125
‘Central bank liquidity support should not be seen as a primary means of managing
financial crises, since it is limited to the temporary provision of liquidity in very exceptional
circumstances. Hence if, despite preventive arrangements, a crisis at a financial institution occurs,
a private sector solution is preferable whenever possible.’
126
‘These procedures are aimed at ensuring an adequate flow of information within the
Eurosystem to the decision-making bodies of the ECB. In this way, the impact of an ELA interven-
tion on aggregate liquidity conditions in the euro area can be managed in a manner consistent with
the maintenance of the appropriate single monetary policy stance.’
127
In its 2013 Banking Communication, the Commission declares ‘ordinary activities of
central banks related to monetary policy, such as open market operations and standing facilities
to fall outside the scope of the state aid rules.’ Paragraph 62 of this Communication from the
Commission on the application, from 1 August 2013, of State aid rules to support measures in
favour of banks in the context of the financial crisis (‘Banking Communication’), OJ C 216/1, 30
July 2013.
128
These are credit institutions that meet a number of thresholds set out in Article 6(4) SSM
Regulation.

IV. APPRAISAL AND OUTLOOK
1. Economic Policy Involvement
As many central banks do, the ECB has issued policy advice to governments in the past.
Its secondary objective of supporting economic policies in the Union, and the need for
some kind of alignment between monetary and economic policies129 make this a valid
exercise of its mandate. The crisis led the ECB to hammer on economic policy adjust-
ments and step over the dividing line between the two policy areas in several manners.
First, the ECB’s exhortations to governments and EU institutions became louder
and more focused. Suffice it to here cite two instances: the ECB’s clear ‘line in the sand’
concerning the strengthening of economic governance of the Euro Area130 and the most
recent (at the time of writing) introductory statement of the ECB President to his monthly
press conference.131
Second, the ECB obtained an informal role in the drafting of economic adjustment
programmes for Member States that needed to rely on financing by their peers, acting
jointly through the ‘bail-out’ funds, as market funding became prohibitively costly.
As discussed before in the context of the case on OMT, its troika role made the ECB
intimately involved in policy-setting and compliance testing together with the EU
executive and the IMF.
Third, this latter informal role became institutionalized in the rules adopted to
strengthen economic governance and the charter of the ESM.132 Notably, the regulation
instituting ‘enhanced surveillance’ for Member States with serious financial-stability
difficulties, confers a prominent role to the ECB as co-overseer of adjustment.133
Fourth, the ECB gave intrusive economic policy advice to at least two Member States
by way of letters addressed to their governments. In the case of Ireland, the exchange of
129
For which Article 284(1) and (2) TFEU provides an inter-institutional setting, with mutual
representation in decision-making bodies and the Ecofin President’s power to submit a motion for
deliberation to the Governing Council.
130
An enumeration of 11 elements that the ECB considered essential in the economic govern-
ance changes. See: The reform of economic governance in the euro area – essential elements, Monthly
Bulletin, March 2011, 99–119, notably at 117–19, at: https://www.ecb.europa.eu/pub/pdf/mobu/
mb201103en.pdf.
131
Introductory statement to the press conference (with Q&A), Mario Draghi, President of the
ECB, Vítor Constâncio, Vice-President of the ECB, Frankfurt am Main, 21 April 2016, at: https://
www.ecb.europa.eu/press/pressconf/2016/html/is160421.en.html.
132
The Commission is to negotiate, in liaison with the ECB, ‘an MoU detailing the condition-
ality attached to the financial assistance facility’ the ESM may provide (Article 13(3) ESM Treaty).
The same tandem is to ‘be entrusted with monitoring compliance with the conditionality attached
to the financial assistance facility’ (Article 13(7) ESM Treaty). In both instances, the tandem
becomes a troika by the involvement of the IMF as they are to act ‘wherever possible, together with
the IMF’. The role of the two institutions in the ESM was an issue in the Pringle case, notably in
paragraphs 153–69.
133
See, notably, Article 7(3) of Regulation (EU) No 472/2013 of the European Parliament and
of the Council of 21 May 2013 on the strengthening of economic and budgetary surveillance of
Member States in the euro area experiencing or threatened with serious difficulties with respect to
their financial stability, OJ L 140/1, 27 May 2013.

letters became public after exhortations from the European Ombudsman;134 in the case
of Italy, the letter to the Prime Minister was leaked.135 These specific cases must be seen
against the backdrop of the ECB becoming a major creditor of these sovereigns and their
banking systems. Concerns about the creditworthiness of its debtors may have justified
these transgressions into the field of economic policy formation. Besides, the ECB was
the only institution at federal level with the authority to act, with the crisis resolution
instruments being crafted at the height of the crisis and subject to decision-making by
the Euro Area Member governments which had reserved for themselves the role of fire
brigade. If no-one seems to act decisively whilst market forces are about to deconstruct the
European currency union project, which is the ECB’s to guard and defend, there is more
room for finding competence than in quieter times. Moreover, the ECB had the means to
enforce its views as it was operating the levers of finance.
Therefore although, in normal times, such an exercise of economic-policy discretion
would not seem to be within the confines of its competences,136 I consider the ECB’s
actions to have remained with its mandate for the double reasons mentioned: legitimate
concern for its exposure to individual sovereigns137 and their connected banking systems,
and the need for decisive action at the central level in the perfect storm raging.
2. Future Challenges
What the future holds is uncertain but our current actions and approaches mould the
future. As humans we are shaping our own reality, whether individually or acting in
groups or organizations. At the ECB, people have shown a remarkable resilience in
the face of crises, and a strong willingness to address a backlash against the euro that
seemed overwhelming. Legally, these actions are, in principle, within the mandate of the
Eurosystem. As stated before, this finding does not amount to an endorsement of the
actual policies pursued, about which valid disagreements are entertained. I see three major
challenges ahead.
First, combining the monetary policy task with prudential supervision will give rise
to issues. Measures taken in one field may have repercussions in another that are not
134
Press Release of 6 November 2014: ECB publishes letters from 2010 on Ireland, at: https://
www.ecb.europa.eu/press/pr/date/2014/html/pr141106_1.en.html, and https://www.ecb.europa.eu/
press/html/irish-letters.en.html.
135
Letter to Government of Italy, August 2011, ahead of large-scale bonds purchases under the
SMP: http://www.reuters.com/article/us-italy-ecb-idUSTRE78S4MK20110929, and http://www.cor
riere.it/economia/11_settembre_29/trichet_draghi_inglese_304a5f1e-ea59-11e0-ae06-4da866778017.
shtml?fr5correlati.
136
And hence ultra vires.
137
This concern was clearly visible in the exchange of letters with Ireland and has later been
repeated on several occasions. In the context of the provision of ELA to the Greek banks, the
extent of the Eurosystem’s exposure to Greece was emphasized by ECB President Mario Draghi
during his press conference on 16 July 2015, just after agreement on the third Greek assistance
package: ‘So, as I said several times, ELA has increased from zero to almost € 90 billion, and now
the Eurosystem has a total exposure to Greece of about € 130 billion, which makes the Eurosystem
the largest depositor in Greece.’ See Introductory statement to the press conference (with Q and A),
Mario Draghi, President of the ECB, Vítor Constâncio, Vice-President of the ECB, Frankfurt am
Main, 16 July 2015, at: https://www.ecb.europa.eu/press/pressconf/2015/html/is150716.en.html#qa.

necessarily welcomed from the latter policy perspective. The impact of low interest
rates on the business of banks under supervision comes to mind. Another example is
the treatment of holdings of government bonds by banks, which are subject to a zero
risk weighting. This is on the agenda for prudential reasons in Brussels, Frankfurt and
Basel. Any change to the current treatment of this phenomenon that exemplifies the
banks-sovereign doom loop,138 even if introduced with smooth transition periods, will
have monetary-policy repercussions as public-sector bonds are major instruments in
monetary policy operations. In spite of the legally mandated ‘full separation’ between
these policy areas, the added advantage of a central bank operating prudential control
in a given jurisdiction is that the necessary balancing of conflicting considerations can
take place within the same house. This prevents the inter-institutional tussle that separate
organizations with different briefs would entail. Yet, the balancing act is a delicate one, as
it also involves the tension between the ‘centre’ (the ECB) and the ‘periphery’ (the NCBs
and NCAs) that characterizes the Eurosystem as a whole.
Second, the further development of EMU will require a strong role for the ECB to
be continued and combined with a stronger economic counterpart. An EU Treasury, as
proposed by Jean-Claude Trichet,139 may provide the focal point of discussions between
the monetary authority and the overseer of economic and financial policies at Euro Area
level. Further mechanisms to align monetary and economic policy and more robust instru-
ments of accountability and transparency that are equal to stronger integration and more
effective governance for the Euro Area are called for. The role of the ECB in helping to
define and oversee economic policy deserves to be reconsidered when, on the occasion
of the transition into Union law proper of the Treaty on Stability, Coordination and
Governance in the Economic and Monetary Union, (TSCG, or ‘Fiscal Compact’ Treaty),
the economic governance provisions of the TFEU are amended. This author would argue
that, apart from the TSCG and the Agreement on the Single Resolution Fund (SRF), the
ESM Treaty should be incorporated into Union law proper, as well.
Third, there is the need for unity. Naturally, among European citizens and their
governments. But, foremost, for the institution with the single most effective power and
the willingness to use it: the ECB, acting together with the NCBs (and, in the Single
Supervisory Mechanism (SSM), the National Competent Authorities (NCAs)). We have
seen disagreements spill over into the public arena, and before courts. Mechanisms for
loss-sharing that deviate from the usual rules had to be introduced for the adoption of
the PSPP, with exposure to national governments remaining with ‘their’ NCBs. The
option of State-specific collateral was introduced. These may be signs of stress within the
Eurosystem. The cohesion of the Eurosystem and its ability to act in unity will be further
tested. Meeting these tests successfully is crucial for the success of the Eurosystem, and
of the single currency in Europe.
138
Which the banking union is supposed to break. See the Euro Area Summit statement of 29
June 2012: ‘We affirm that it is imperative to break the vicious circle between banks and sovereigns.’
139
Building Europe, building institutions, Speech by Jean-Claude Trichet, President of the ECB,
on receiving the Karlspreis 2011 in Aachen, 2 June 2011, at: http://www.ecb.europa.eu/press/key/
date/2011/html/sp110602.en.html.

11. Monetary policy and central banking in
sub-Saharan Africa
Christopher Adam, Andrew Berg, Rafael Portillo and
Filiz Unsal
I. INTRODUCTION
Central Banks in sub-Saharan Africa (SSA) have made great progress over the past two
decades in stabilizing inflation, to single digits on average, in the context of greater central
bank independence, support from fiscal-based stabilization efforts, and more sustained
and stable growth. Central banks (CBs) did so by relying on monetary policy arrange-
ments centered, at least de jure, on money targets. These economies have now largely
stabilized and grown and their financial systems have become more developed. With these
developments, policymakers are beginning to ask more of central banks than (broadly)
stabilizing inflation, and in many cases existing regimes have not provided clear and
effective frameworks for formulating and implementing monetary policy. In recent years,
this affected CBs’ ability to steer financial conditions, respond appropriately to shocks,
and avoid policy misalignments. Fully aware of these limitations, many central banks are
therefore in the process of modernizing their monetary policy frameworks.
In this chapter we provide an overview of the issues facing central banks as they
modernize. For the most part, we draw on our own work on this subject, as well as on
recent efforts at the International Monetary Fund (IMF) to develop a view on this issue
(efforts in which several of us were directly involved).1 We also briefly review the ongoing
debate on the role of central banks in dealing with financial stability, and how it applies
to Africa, as well as the possibility of CBs in the region taking on other responsibilities.
Our coverage of central bank functions is not exhaustive; for example, we do not cover
issues related to the management of payment systems.
In terms of regional coverage, our focus is on SSA countries excluding South Africa.
Monetary policy challenges in the latter country differs enough from the rest of the
continent to warrant a separate treatment; fortunately in general its challenges are those
of many commodity-dependent emerging market economies about which there is a
voluminous literature. For the most part we concentrate on countries with some degree of
exchange rate flexibility, though we also briefly discuss the main challenges facing central
banks in countries with hard pegs.
The chapter is organized as follows. Section II presents a list of principles that embody
the consensus view on monetary policy and serve as a benchmark for assessing the state
of affairs in SSA. Section III reviews the history of monetary arrangements in SSA.
Section IV describes the current monetary landscape in Africa, while section V discusses
1
See IMF (2015b).
208

Monetary policy and central banking in sub-Saharan Africa 209
issues in hard pegs and currency unions. Section VI discusses recent efforts to modernize
policy and the challenges that remain and section VII analyzes other issues relevant for
monetary policy. Section VIII discusses other roles for central banks and Section IX
concludes.
II. A PRINCIPLES-BASED BENCHMARK FOR SSA CENTRAL

BANKS
In the decades prior to the global financial crisis there was a revolution in the practice
and thinking of monetary policy, which started in small advanced economies and then
spread to other countries. IMF (2015b) recently summarized these lessons into seven
principles. First, central banks should have a clear mandate, set in the law, and the opera-
tional independence to pursue it. Second, price stability should be the primary objective
of monetary policy, at least over the medium term. Third, central bank should have a
numerical medium term inflation objective to operationalize the price stability mandate
and guide policy actions. Fourth, the central bank should nonetheless take into account
the implications for output and financial stability when making policy decisions. Fifth,
the central bank should have an effective operational framework centered on the control
of short-term interest rates. Sixth, delivering on price stability requires a forward-looking
strategy that maps objectives into policy decisions. And finally, a central element of the
monetary policy framework is clear communications, to help explain policy decisions and
outcomes and provide guidance about the future.
It should be clear that inflation targeting best embodies these principles, as it was the
historical development of this regime that helped clarify these desirable properties of
monetary policy. In policy debates in Africa however, and in other countries as well, the
term ‘inflation targeting’ has at times been a source of controversy. Some have interpreted
it as implying a strict and exclusive concern with inflation, and therefore inappropriate for
low-income countries. Others feel that central banks can only adopt inflation targeting
after a long sequence of reforms. The focus on principles, with which few people could
disagree, is a way of moving the debate forward.
The global financial crisis has not fundamentally changed this consensus, which if
anything has strengthened along certain dimensions. For example, inflation targeting
countries performed better during the financial crisis than non-targeting countries.2
Moreover, the prospects of deflation have underscored the importance of medium-term
numerical inflation targets to help anchor expectations. In addition, the crisis served
to reinforce the importance of central bank communications, in particular the use of
forward guidance as a monetary policy tool.
One notable change relative to the pre-crisis consensus has been greater experimenta-
tion with new instruments in advanced economies, mainly quantitative easing. We see
little scope for the use of these tools in SSA CBs, given the lower likelihood of short-term
interest rates hitting the zero lower bound. This does not imply that SSA CBs limit them-
selves to one instrument. CBs in the region, and other developing counties, do (and will
2
See de Carvalho Filho (2011).

continue to) rely on sterilized foreign exchange interventions, which should be thought
of as a separate tool from short-term interest rates, and used for different purposes. We
discuss this issue in more detail below.
The crisis did reveal however the limitations of price stability as the sole focus of
central bank actions, and the importance of financial stability. Financial crises cannot be
completely eliminated and when they do occur they are often very costly in terms of lost
investment and output. Central bank policy should try to minimize the risks of financial
crisis but tools other than conventional interest rates, most notably macroprudential
measures, are better suited for this task. Much of the recent discussion has focused on how
to incorporate these new responsibilities and tools within central banks. This debate is
important, and its implications for Africa have yet to be fully fleshed out. However, we see
the new focus on financial stability and macroprudential tools as refinements to pre-crisis
arrangements, rather than a complete overhaul. Modernizing policy frameworks along
the lines described earlier should remain the priority for SSA central banks, even as they
pay greater attention to financial stability issues.
We now review the history of monetary policy arrangements in SSA, which can be
interpreted as a succession of efforts to bring monetary policy and central banking in
line with best practices.
III. A BRIEF HISTORY OF MONETARY POLICY

ARRANGEMENTS IN SSA
1. 1970s: From Currency Boards to Developmental Central Banking
Central banks in Africa began to emerge in their modern form in the 1950s and 60s as the
countries regained their independence from European colonial powers. Pre-independence
monetary arrangements were tightly managed by a set of currency boards anchored
to British pound sterling, the French franc and, to a lesser extent, the Spanish peseta
and Portuguese escudo, and monetary policy was tightly controlled by the respective
European central banks. British colonies were covered by three currency boards: the
West African Currency Board covering modern day Nigeria, Ghana, Sierra Leone, the
Gambia and British Cameroon; the East African Currency Board consisting of Kenya,
Uganda, Tanzania and Zanzibar along with Somalia, Ethiopia and Yemen; and the
Southern Rhodesian Currency Board covering modern Zambia, Zimbabwe and Malawi.
Francophone African countries of West and Central Africa came under the Communauté
Financière Africaine (CFA) Franc Zone which had been established in 1948,3 while
similar currency board arrangements existed for the handful of Spanish, Belgian and
Portuguese colonies. In Southern Africa, the small British protectorates of (modern-day)
3
The Franc Zone consists of two unions, UEMOA (Union Économique et Monétaire Ouest
Africaine) and CEMAC (Communauté Économique et Monétaire de l’Afrique Centrale) and two
central banks BCEAO (Banque Centrale des États de l’Afrique de l’Ouest) and BEAC (Banque des
États de l’Afrique Centrale). The two central banks issue their own currencies, the West African
CFA franc and the Central African CFA franc. These are theoretically separate but because of the
guaranteed convertibility to the Euro the two CFA franc currencies are effectively interchangeable.

Lesotho, Swaziland, Botswana and Namibia came under the aegis of the long-established
Rand Monetary Area anchored by South Africa.
The post-colonial era saw these groupings follow distinctly different trajectories.
The Rand Monetary Area and the CFA Franc Zone structures remained intact even as
their members attained political independence and both continue to operate today with
almost the same institutional structures they inherited at Independence. We discuss these
institutions in Section IX below.. The British government and the Bank of England had
similar expectations that the Sterling currency board arrangements would persist—in
part because of concerns that independent central banks in new colonies would struggle
to resist the political pressures that they would inevitably face—but in the face of growing
opposition amongst emergent nationalist movements, these currency board arrangements
were dismantled and gave way to a set of independent central bank institutions. The
Central African Currency Board was thus abolished in 1956, the West African Currency
Board folded over the subsequent years as first Ghana then Nigeria and Sierra Leone
ceded and (the unified) Cameroon joined the CFA Franc Zone. Most of the discussion
in this chapter concentrates on this latter group of central banks that were established
as notionally independent national institutions principally because it is their history that
has shaped the ideas and structures that underpin contemporary central banking on the
continent that only really began to emerge at the end of the 1990s.
Established at a time where the dominant intellectual climate in economics favored
strong and centralized development planning, the role of these fledgling central bank
institutions was very different from today. Along with other visible manifestations of the
state such as a national army, an airline and a seat at the UN, a national currency and a
national central bank, independent from colonial legacy, were seen as a tool of national
development geared to but very much subsidiary in supporting such goals.
2. 1980s: Financial Repression and Fiscal Dominance
This distinctive character began to emerge particularly after the collapse of the Bretton
Woods system of fixed exchange rate in the early 1970s. Central banks found themselves
administering heavily managed exchanged rates (often in situations of severe rationing so
that parallel markets in foreign exchange were widespread); setting administered interest
rates, typically far below market-clearing values; directing the allocation of domestic
credit between sectors, in many cases through a state-dominated and highly oligopolistic
banking system whose operations were often limited to mobilizing private savings for
on-lending to government and Small Open Economies (SOEs) at highly repressed rates;4
and—crucially—providing direct monetary financing of the budget deficit.
By the early 1980s it was clear that many central banks were being asked to do too much
and were failing to deliver on most if not all of these multiple objectives, including the
core monetary objective of providing an effective nominal anchor for prices.5 While many
countries across the continent certainly faced extremely difficult external circumstances,
including from low prices for primary export commodities to the challenge of external
4
Collier and Gunning (1991).
5
Honohan and O’Connell (1997).

and civil conflict and the associated burden of high external debt, the highly distorted
macroeconomic and monetary policy regimes also exerted a serious drag on economic
growth and welfare. High and variable inflation became pervasive and parallel markets
for foreign exchange flourished which badly distorted incentives for investment and
encouraged widespread rent-seeking across the continent.
Central to this failure was the pressure on central banks to finance fiscal deficits from
their own balance sheets. In environments where domestic asset markets were relatively
under-developed and there were tight controls on capital flows so that financial repression
was widespread, the demand for money was relatively inelastic presenting governments
with the scope to mobilize substantial seigniorage revenues, an attractive option where
traditional tax revenue mobilization capacities were limited.6 But as controls weakened,
and the velocity of circulation rose, inflation began to rise sharply and fiscal balances
worsened, thereby confronting central banks with serious problems of fiscal dominance
which rendered ineffectual any formal distinction between fiscal and monetary policy.
3. 1990s: Fiscal Based Stabilization Efforts and Disinflation
In these circumstances, the IMF’s reserve money programmes offered the appeal of a
monetary policy framework anchored on the control of money-financing of the fiscal
deficit. Reserve money programming in Africa combined a diagnosis of the stabilization
problem that located the fundamental macroeconomic weakness in a lack of fiscal control
within a transparent operational framework that targeted domestic credit from the
central bank to government. Embedded within broader reform programmes aimed at the
liberalization of domestic prices, interest rates and the exchange rate, bolstered in some
cases by explicit fiscal ‘cash budget’ rules7 and supported by substantial donor assistance
to government budgets (including through large scale official debt relief in the form of
the Heavily Indebted Poor Countries (HIPC) and Multilateral Debt Relief (MDRI) initia-
tives), reserve money programmes of this kind played a major role throughout the 1990s
and early 2000s in restoring macroeconomic stability across the continent.
By the early 2000s countries such as Ghana, Nigeria, Uganda, Kenya, Zambia and
Tanzania were beginning to enjoy sustained growth with low and stable inflation (see for
example, Kessy et al 2016) Macroeconomic stability was increasingly accompanied by
the deepening and development of domestic asset markets and, in some cases, by moves
to liberalize the capital account in order to encourage greater private capital inflows,
including into sovereign debt.
4. 2000s: New Challenges
Reserve money targeting served these countries very well in containing fiscal dominance
and supporting the restoration of macroeconomic stability. And yet, in the last ten to 15
years, many central banks have started to make important changes to their frameworks.
The reasons behind these changes, and their implications going forward, are discussed next.
6
Adam et al (1996).
7
Stasavage and Moyo (2000).

IV. THE CURRENT MONETARY POLICY LANDSCAPE
The reduction in inflation and improvements in macro outcomes in SSA over the last
20 years should not mask the significant gaps that remain, both in the institutional
arrangements that delineate central bank actions and in existing policy arrangements.
The main issue is that central banks do not have effective frameworks for formulating and
implementing policy. We now assess the current state of affairs, using the principles-based
benchmark described earlier.
1. Legal Frameworks and Operational Independence
As previously discussed, the stabilization efforts post-1980s were supported by the adop-
tion of new legal charters in many central banks in SSA. Assessments of central bank
independence however show very modest improvements over time, and SSA countries
lag behind their peers.8 Ghana provides a case in point. A new Act adopted in 2002
established price stability as the central bank’s primary objective, granted operational
independence and created a monetary policy committee. The Act did not, however,
prohibit the CB from lending to the government, nor did it provide monetary policy
committee members with sufficient tenure protection. These two issues have come into
focus during the recent period of high inflation in that country.
Adherence to the existing legal framework has also been uneven. Though measures
of de facto independence are more difficult to estimate, there is plenty of anecdotal
evidence. In Zimbabwe the adoption of a new charter granting greater independence to
the CB preceded the complete loss of monetary autonomy and the rise in inflation—and
subsequent hyperinflation—in that country. Even in countries with more stable inflation,
deviations from legal limits to direct central bank financing are common, which attests to
the pressures that central banks continue to face.
The cost of monetary operations is another issue that often hampers the operational
independence of SSA CBs. This is a source of contention with the government, particu-
larly in cases where the financial system is in a situation of structural liquidity surplus,
for example due to sizeable interventions in FX markets, and a legacy of past quasi
fiscal operations have left the central bank with low or negative net worth. In this case
sterilization operations, which are necessary to maintain an appropriate policy stance,
can have sizable effects on central bank profits (seignorage). In principle, this can be
resolved simply by recapitalizing the central bank, for example through the transfer of
government bonds. But concerns with the Treasury using the opportunity to look into
the CB’s operating expenses, or the mistaken belief that the central bank should not make
losses, can often result in a monetary policy stance that is more accommodative than
required.9
8
Indices of central bank independence combine assessments of tenure protection of central
bank’s senior management, operational independence, clearly legally defined objectives for mon-
etary policy, and limits to central bank lending to the government.
9
Another type of pressure on operational independence occurs when the central bank does
not tighten policy as aggressively as it would like to out of concern for the effect of that policy on
fiscal solvency. Pressures of this type are likely to materialize in regimes, such as IT, in which the

2. Price Stability, the Medium-term Inflation Target, and the Pursuit of Other
Objectives
SSA CBs have bought into the idea that price stability is the primary goal of monetary
policy, at least de jure. In many countries however, the primacy of price stability remains
to be established. Many CBs continue to pursue other objectives, for example supporting
growth, financial deepening, or external competitiveness. This multiplicity of objectives
and lack of clear hierarchy among them typically results in erratic policies, although to a
smaller degree than in the past: the monetary stance is loosened, for example to support
financial deepening, only to be tightened later once inflationary pressures appear.
This state of affairs is most visible in the central role that the exchange rate plays in
policy frameworks of many SSA countries, including those with de jure exchange rate
flexibility. Though some attention to the exchange rate is inevitable given its importance
for inflation dynamics, in some countries exchange rate stability often takes precedence
over price stability. The exchange rate serves as the de facto anchor, at least temporarily,
and operations aimed at influencing the exchange rate end up determining the stance of
policy, for example through the use of unsterilized interventions in the FX market. The
resulting disconnect between the de jure and the de facto frameworks undermines the
credibility, transparency and effectiveness of policy.
There are several related factors that account for the policy confusion. First, with
the exception of inflation targeting countries, most central banks in the region lack an
explicit, medium-term, inflation objective that can discipline policy and operationalize
the pursuit of price stability.10 In its absence, policy is more likely to be driven by
political pressures, recent events or the pressing issue of the day. Second, even if the
primacy of price stability is recognized, central banks typically lack a strategy for
mapping objectives into policy decisions or for taking other objectives into account
in a way that does not undermine price stability. Third, operational frameworks are
not in line with international best practice, which obscures the actual stance of policy
and facilitate deviations from policy intentions. We discuss the last two points in more
detail below.
3. Operational Frameworks in SSA CBs
Reserve Money Targeting (RMT) remains the de jure operational framework of choice
in SSA, in contrast with the now standard practice of setting operational targets on
(and controlling) very short-term interest rates adopted by most advanced and emerging
market central banks.11 This reflects in part the legacy of IMF-supported programs,
which emphasize targets on central bank balance sheet items as part of their conditional-
central bank takes direct responsibility for short-term interest rates. Avoiding this type of pressure
may be one possible reason why many central banks in SSA have yet to adopt interest-rate-based
frameworks, and why those that do often implement changes to the policy stance without changing
the (more visible) policy rate. This is discussed below.
10
To the extent there is an inflation objective, it is more akin to a short-term inflation forecast,
which is revised to account for short-term pressures and does not guide policy in a meaningful way.
11
See IMF (2015b).

ity, and which played an important role in the stabilization of inflation in SSA. In practice
most CBs practicing RMT display considerable flexibility.12 Targets on reserve money
are missed frequently, in part as CBs accommodate changes in money demand. More
recently, many CBs have introduced policy rates to signal the stance of policy, though
deviations between policy and actual rates are common, and tensions between money
targets and interest rate policy are inevitable.
In practice, RMT makes the stance of policy noisier and difficult to interpret, both
by financial market participants and the central bank. Not all money demand shocks
are accommodated so that interest rates are volatile and a noisy indicator of the current
and expected stance of policy. Greater de facto flexibility vis-à-vis money targets reduces
this volatility but at costs of greater discretion and opacity about the true operational
framework. Of course not all deviations from target represent accommodation of money
demand, but it is very hard to tell in any particular situation. The effectiveness of the
operational framework is hampered as a result.
Moreover, RMT breaks the important separation between policy design and policy
implementation. In most CBs, the former is typically determined by the monetary policy
committee, following input from the research staff, whereas the latter is done by the trad-
ing desk. Under RMT, it is typically the operations staff which decide whether to hit or
miss targets based on technical reasons, for example not to disrupt money markets. And
yet the decision to miss targets has implications for the stance of policy, even if there is
no consultation with the monetary policy committee. This adds a lot of confusion about
the division of labor and governance structure within CBs.
An additional layer of complexity is brought about by recurrent interventions in FX
markets, which are the main tool for managing the exchange rate in most SSA countries.
There is often insufficient coordination between interventions in FX markets and other
operations. As a result, interventions influence the stance of policy in unintended and
undesired ways.
Some of this opacity may be desired by central banks aiming to avoid public respon-
sibility for policy decisions (‘We are not setting interest rates so high; it is the markets.
We are just following our monetary program.’). In some particular instances this may be
a ‘second-best’ response to political pressures, whereby technocrats can hide behind the
obscurity of the regime to conduct policy.
4. Forward-looking Strategy and Communications
As central banks have increasingly focused on the medium-term inflation outlook a

forward-looking strategy that guides policy decisions and communications has become
the defining feature of policy. To a large extent, such a strategy is missing in many SSA
CBs. This is not surprising, given the lack of numerical medium-term inflation objectives
and the limitations of the operational framework.
12
Targets on reserve money are part of a broader monetary programming exercise in which
targets are also set for broad money, which is considered an intermediate target of policy. With
a few exceptions however (eg, Tanzania), targets on broad money play a smaller role in policy
discussions in practice.

The lack of clear strategy is most visible when thinking about how to respond to large
external shocks, for example the international food and fuel commodity price surge of
2007–2008. Policy has long settled on the adage that central banks should accommodate
first round effects but prevent spillovers from these shocks into broader wage and price
setting (second round effects). However, it is far from clear what the above policy advice
implies for money targets. Should these be missed, and if so, in which direction? And how
is the missing of money target meant to influence wage and price dynamics in response
to these shocks?
In practice, the framework itself becomes a handicap for articulating a clear policy
response. For instance, in Zambia, concerns with money targets in the aftermath of the
global financial crisis resulted in excessively tight monetary policy at a time when domestic
banking systems were under stress (Baldini and others, 2015). These policies were later
reversed, but it can be argued that the policy framework amplified the initial impact of
the crisis.13
An additional and related factor is insufficient internal analytical and forecasting capac-
ity in many central banks, which limits the staff’s ability to provide senior management
with an assessment of the state of the economy, sound macroeconomic forecasts and
policy recommendations. Most SSA CBs have yet to develop in-house modern macro
models that are standard in most advanced economies and emerging market CBs, though
the issue of which models to use for these countries is an open question, as we discuss
below. The absence of models adds to the lack of a clear quantitative view within central
banks on how monetary policy is transmitted to the economy.
Communication policy is yet another area of modern monetary policy in which SSA
central banks have much catching up to do. This is reflected in the low score most African
CBs have in measures of central bank transparency.14 For example, very few CBs publish
a medium-term inflation outlook or provide a forward looking assessment as a basis
for their policy decisions. Again, the lack of a clear communication strategy goes hand
in hand with the lack of clear monetary policy frameworks. Perhaps not surprisingly,
CBs that have adopted inflation targeting regimes, such as Ghana, have made important
progress in clarifying their policy announcements.15
V. HARD PEGS AND CURRENCY UNIONS IN SSA
Our discussion so far has focused on SSA countries with some degree of exchange rate
flexibility and therefore scope for independent monetary policy. But what about central
banks in countries with hard pegs? A sizable share of SSA economies are members of the
two monetary unions in the CFA Franc Zone (16 countries in total), with their currency
13
Zambia had also experienced unintended changes in its policy stance during 2005–06, again
related to the monetary framework, as increases in money demand that were not accommodated
resulted in higher interest rates and exchange rate overshooting.
14
See Dincer and Eichengreen (2014).
15
On Ghana, see MPC Press Release May 2016: https://www.bog.gov.gh/index.php?option
5com_content&view5article&id52557:mpc-press-release-may-2016&catid547:press-releases&It
emid5120.

pegged to the Euro, while others are members of the Common Monetary Area (Namibia,
Swaziland, Lesotho) and have their currencies pegged to the South African Rand.16 Other
African countries are not part of monetary unions but have hard pegs, eg, Cape Verde.
We briefly review the main issues for these central banks, with a focus on the CFA zone.
Hard pegs to strong currencies offer countries a strong nominal anchor, which typically
results in low inflation. The CFA zone is no exception, as countries in that region have
lower average inflation than their SSA peers.17 In this sense, CBs in countries with hard
pegs are importing the credibility of the monetary institutions they are pegging to (the
European Central Bank (ECB) in this case).
The cost is twofold. First, central banks lose much control over monetary policy. In
the case of the CFA zone central banks retain some monetary control due to limited
capital mobility in that region, but maintaining the peg, among other things by preserving
a sufficient level of international reserves, still takes precedence over all other consid-
erations. Other policies are therefore necessary to achieve macro stability (fiscal, or even
macroprudential).
Second, under a hard peg adjustments to the equilibrium real exchange rate can
only come about through changes in the price level, which implies that variations in
inflation are to a large extent necessary for external adjustment and beyond the control
of the monetary authorities. In addition, not all real exchange rate adjustments are
equal. Achieving large real depreciations is very costly and difficult, given the need for
prolonged deflation, and in most cases countries are forced to abandon or adjust their
peg. The CFA zone was confronted with such a scenario in January 1994 when, after a
prolonged period of real exchange over-valuation, the CFA franc was devalued by 100
percent, the first and, so far, only nominal adjustment to parity since 1948. The resulting
devaluation of the CFA franc is still remembered to this day. Preventing overvaluation
of the currency is therefore of the utmost importance, which puts additional onus on a
stable fiscal policy.
The above discussion does not imply however that central banks in the CFA zone
cannot benefit from improvements to their frameworks. This is particularly the case of
their operating procedures. For example, while the BCEAO has a transparent interest-
rate-based corridor system, which makes it easy to assess the stance of policy (and the
deviation from interest rates in the Euro zone), the BEAC’s system is considerably opaque,
with no clear policy target. These central banks also face important issues of market
segmentation, which result in unintended variations in the policy stance across their
member countries.18
While the Common Monetary Area (CMA) and CFA Franc Zone pre-date
Independence, the idea of common regional currencies (and even a continental currency)
16
It is important to note that neither the CMA nor the CFA are entirely conventional hard peg
arrangements since in both cases the hegemon (the Reserve Bank of South Africa in the former
instance and the French Treasury—not the ECB—in the latter) provides support to the exchange
rate peg.
17
See IMF AFR Regional Economic Outlooks, for example IMF (2008).
18
See IMF (2015a, 2015b, 2015c). CFA central banks face other important issues, most notably
difficulties with the pooling of international reserves across member countries and governance
issues over the management of CB assets.

has long been a goal of various regional groupings, including the Africa Union.19 Of
these, the putative East African Monetary Union (EAMU, consisting of Kenya, Uganda,
Tanzania, Rwanda, Burundi and, possibly, South Sudan) is at the most advanced stage.
The enabling legislation—the equivalent of Europe’s Maastricht Treaty—was ratified
in December 2013 with currency union scheduled for 2024. Unlike the CFA or CMA
arrangements, the ambition of EAMU is to create a monetary union between a com-
munity of equals with a common currency that is guaranteed by neither a regional nor an
international hegemon. As with the Eurozone, the plan is that the common currency will
float so that the nominal anchor will be provided by the credibility and commitment of
the supra-national central bank’s monetary policy. It remains to be seen if this monetary
union will be realized.
VI. MODERNIZING MONETARY POLICY IN SUB-SAHARAN

AFRICA
SSA central banks are well aware of the limitations of their existing frameworks and are
looking to improve along the various dimensions we have discussed. First, several central
banks have announced the intention to adopt inflation targeting regimes, for example
Uganda. Ghana was an earlier adopter of inflation targeting (IT), though the experi-
ence there has been mixed. Several other central banks, including Kenya, have explicitly
discussed the possibility of adopting IT, even if they have yet to formally commit. Many
other countries, while not explicitly considering the move to IT, are working to improve
their operational framework by giving more prominence to policy interest rates, and
improving on the design and use of open market operations and standing facilities. And
many central banks are investing in their internal capacity, for example through technical
assistance programs developed jointly with the IMF.20 SSA CBs are also increasingly
exchanging views on these and other topics through peer-to-peer events and regional fora.
Although there is no one-size fits all approach to monetary policy modernization,
the central banks can learn from the experience of many countries outside SSA, as well
as from early movers within the region. One key lesson is that progress is not possible
without sufficient operational independence nor with a sufficiently clear central bank
mandate for price stability, even if adherence to these two principles is always work in
progress. Building and maintaining political commitment is therefore critical. The central
bank has a leading role to play in building the necessary consensus for reform.
Another lesson is that central banks can make progress in a number of areas simultane-
ously. Progress can be self-reinforcing: the development of analytical capacity is more
likely to impact policy making if it is consistent with the way policy is designed and
implemented, which requires clarity about the strategy and the operational framework.
The adoption of an explicit numerical objective can provide an impetus to investing
19
A common currency for Africa was a stated objective of the Organization of African Unity
when it was founded in 1963 and was endorsed at the founding of the successor body, the African
Union, in 2002. (See Masson and Pattillo, 2005).
20
See IMF (2015b). Countries that are investing in their analytical capacity include Ghana,
Kenya, Mauritius, Mozambique, Rwanda and Uganda.

in analytical capacity and the communication strategy; while an effective operational

framework can make central banks more comfortable about explicitly committing to an
inflation objective. These synergies call for a comprehensive approach to reform.
A related issue is whether to explicitly adopt a new regime, namely IT, and if so whether
to do so at a specific stage of the modernization process. What the international evidence
corroborates, and the above discussion implies, is that countries do not need to satisfy a
strict number of preconditions before they can adopt IT.21 If anything the opposite is true.
A clear framework is more conducive to reform.
There are other considerations. Central banks are naturally conservative institutions,
and some may be concerned with their ability to deliver on their inflation objectives, in
which case both reforms and the adoption of new regimes may be very gradual processes.
The risk with gradualness is that the reform process may stall. Other CBs may wish to
benefit from announcement effects: you can only announce the adoption of inflation
targeting once so you may wish to be prepared before you announce. The evidence here
is mixed though, as countries that have announced inflation targeting do not necessarily
yield immediate benefits, for example in terms of better anchored inflation expectations.
Announcing the intention to adopt inflation targeting at a specified date in the future, is
one reasonable way of navigating between these various concerns, both to stir reforms
while at the same time giving central banks some flexibility.
1. What Role for Exchange Rate Management and FX Interventions Going Forward?
The international experience shows that countries that modernize their monetary policy
frameworks also move towards more exchange rate flexibility. The de facto anchoring
role of the exchange rate is diminished in favor of a more explicit focus on price stability.
Foreign exchange interventions do not disappear, however, as can be seen in their wide-
spread use in many central banks in emerging markets with explicit inflation targeting
regimes. These countries are attempting to influence the real exchange rate and external
financial conditions facing their country, while maintaining their inflation objectives.
Given these trends, it is very likely that some degree of exchange rate management will
endure in sub-Saharan Africa.
There has been growing interest in understanding how foreign exchange interventions
fit in emerging market monetary policy frameworks.22 The focus is on sterilized interven-
tions, which ensure that the central bank retains control of short-term interest rates as the
monetary policy instrument used for domestic stabilization. For sterilized interventions
to serve as a separate instrument, they must operate through a different channel, in this
case the portfolio balance channel (Benes et al (2015)).
In addition, interventions in inflation targeting countries are guided by a different con-
cept of exchange rate stability. Rather than stabilizing the exchange rate so that it serves
as an anchor, the objective is to respond to large and costly deviations of the exchange
rate from its medium-term equilibrium value, for example because of risk-on risk-off
episodes (associated with sizeable capital flows) or other temporary factors unrelated to
21
See Batini and Laxton (2007).
22
See Ostry et al (2012) and Benes et al (2015), among others.

fundamentals. Given the uncertainty associated with the assessment of these deviations,
central banks lean against the wind, that is intervene when the exchange rate is appreciat-
ing or depreciating more rapidly than usual but without targeting a specific level.
The possible benefits of an active FX intervention policy will have to be weighed
against the need for price stability. This is especially important early on in the moderniza-
tion process, when central banks are building credibility, often painstakingly. Finding
the right role for the exchange rate will continue to be an unsettled and evolving issue in
many SSA countries.
VII. KEY CHALLENGES FOR MODERN MONETARY POLICY

FRAMEWORKS IN AFRICA
The domestic and external environment in SSA will continue to shape monetary policy
in important ways, even as central banks bring greater clarity to their regimes. We now
briefly discuss some of the issues that are relevant for monetary policy in the African
context.
1. The Monetary Transmission Mechanism
CBs must have a view of the monetary transmission mechanism, even if that view is evolv-
ing and subject to considerable uncertainty, in order to calibrate their policy decisions.
There are reasons to think that transmission may be quite different in SSA from emerg-
ing markets or advanced economies. The overall magnitude of the effects on aggregate
demand and inflation from monetary policy decisions is likely to depend on the extent of
financial deepening. African countries have shallow financial markets, so that changes in
financial conditions brought about by monetary policy may directly affect a smaller share
of the population. Moreover, the history of fiscal dominance may reduce the ability of
monetary policy to affect demand, as there may be little room for accommodative policies,
say to address a recession, before inflationary expectations ratchet up. In addition, the
pervasive management of the exchange rate may reduce the exchange rate channel of
transmission.
Policymakers and researchers often conclude from this assessment that the transmis-
sion mechanism is weak and unreliable. Mishra, Montiel and Spilimbergo (2012) find
that the correlation between short-term interest rates and bank lending rates is weaker in
SSA than in higher-income regions, which they interpret as a sign of weak transmission.
Mishra and Montiel (2012) argue that the impulse responses to monetary policy shocks
derived from structural VARs, the tool of choice for identifying the effects of monetary
policy shocks, are typically too weak and statistically unreliable in low-income coun-
tries. If this is the case, then monetary policy is not a reliable tool for macroeconomic
stabilization.
In our view, this evidence is not conclusive. Li et al (2016) show that short data samples,
measurement error and high-frequency supply shocks, all of which are pervasive features
in the African context, substantially reduce the power of VAR-based inference on the
monetary transmission mechanism. Other approaches focusing on different techniques
yield different results. For example, Berg et al (2013) and Abuka et al (2015), the latter

using loan level data, find clear evidence of a working transmission mechanism in some
SSA countries using an event study approach. Bulir and Vlcek (2015) derive similar
conclusions using a yield curve model.
In addition, the previous discussion suggests that the shortcomings of existing policy
regimes should also account for part of the weak empirical evidence. Monetary policy
relies on a clear understanding from financial market participants of central bank actions,
both current and likely future (the expectations channel). Such a clear understanding is
likely not to be the case under existing arrangements in SSA: the combination of money
target misses, noisy short-term interest rates, and incipient communications make it
difficult to assess policy makers’ intentions. Under these conditions, Portillo and others
(2018) show that monetary policy decisions have a smaller impact on longer term rates,
inflation, and output, compared to interest-rate based frameworks, even when policy
intentions are the same. This is confirmed in the findings of Berg et al (2013), whose
evidence of functioning transmission mechanism is strongest in countries where the
stance of monetary policy was communicated clearly, as well as in the work of Bulir and
Vlcek (2015) for the case of countries with credible IT regimes.
We conclude from this discussion that the SSA features need not invalidate the effective-
ness of monetary policy, even if it may affect the required magnitude of monetary policy
decisions.23 In addition, the monetary transmission mechanism is likely to evolve with the
policy regime. More research is needed however to develop a better understanding of the
various channels through which policy influences inflation.
2. Shocks and Macroeconomic Volatility
Many SSA countries face frequent, large shocks that raise the volatility of inflation and
output and can pose difficult trade-offs for monetary policy. We briefly review the types
of shocks and the challenges they pose to central banks.
Most SSA countries are commodity exporters, and shocks to their terms of trade are
an important source of macroeconomic volatility given the lack of diversification in
their export base. Though all countries are affected, SSA countries with de jure flexible
exchange rate regimes do a better job of shielding their economies from the effects of
these shocks, thanks to the shock-absorbing role of the exchange rate (and in spite of the
exchange rate management). The challenge in these countries is to prevent the fluctua-
tions in nominal exchange rates from spilling over into inflation, especially when a large
nominal depreciation is required. On the other hand, hard pegs tend to display larger
economic fluctuations (and movements in inflation) following these shocks.
Shocks to international food and fuel prices pose an additional set of challenges. It is
well understood that supply side shocks create difficult trade-offs between inflation and
output stabilization because efforts by the central bank to offset inflationary pressures will
also affect output. In the African context, food makes up a large share of the consumer
basket, so the direct impact of food price shocks is larger. In addition, SSA countries
23
Policy interest rates in SSA CBs are often changed by several hundred basis points in
one single policy decision, which reflects erratic policies (the correction of large previous policy
misalignments) but also the fact that larger policy changes are likely needed to stabilize inflation.

are net food importers on average, and many are net oil importers, so the inflationary
impact from higher international prices may be compounded by the real and nominal
depreciation required for external adjustment.24 These shocks have therefore been a
source of inflationary pressures, especially during 2007–08 and 2010–11. One complica-
tion however is that the direct effect of these shocks often masks underlying monetary
policy misalignments, which then amplifies the overall inflationary effect. This was the
case in Kenya during the 2011 period (Andrle et al (2015)).
Domestic supply shocks are an even larger source of inflation volatility. This is because
the agricultural sector is heavily exposed to weather-related shocks. One implication is that
inflation is inevitably more volatile in low income countries—SSA countries included—
with the larger volatility reflecting supply side changes to relative food prices (Portillo et
al (2016)). Some of this volatility is unlikely to disappear even as countries modernize
their policy frameworks.
Capital flows are an additional source of external shocks, though their impact is lower
given the more limited integration with global capital markets (see Berg et al (2011)). For
example, during the global financial crisis, SSA countries did not experience large and
sharp capital flow reversals similar to those observed in many emerging markets, given
the tight financial links of those countries with advanced economies. SSA countries are
becoming more integrated however, as can be attested in the growing number of countries
that have tapped international bond markets, many for the first time, in recent years.
3. Fiscal Policy as a Source of Volatility
In the previous section we have reviewed various channels through which fiscal pressures
hamper operational independence. A related issue is that central banks in Africa must
contend with highly volatile and pro-cyclical fiscal policy. Sometimes the source of fiscal
volatility is the reliance on taxation of the commodity sector (or on royalties or profits
from that sector) as a primary source of fiscal revenue, and the lack of binding fiscal
rules to ensure inter-temporal smoothing. In other cases fiscal pro-cyclicality stems from
the political cycle. Certain features of African economies, for example the large share
of the population that lives on their current income, amplify the effects of these shocks
on aggregate demand, so that larger changes in interest rates are required to stabilize
output.25 This adds to the challenges of monetary policy, and further stresses the by
now obvious point that price stability requires the broad support of the overall macro
framework.
4. Management of External Revenues and the Coordination of Fiscal Policy and Central
Bank Operations
In addition to inflation stabilization, central banks play an important role in the manage-
ment of external revenues, such as aid or commodity windfalls. Berg et al (2007) document
how, during aid surge episodes in several African countries with managed floats (Ghana,
24
See Adam (2009).
25
See Berg et al (2010).

Mozambique, Tanzania, Uganda), concerns about real appreciation resulted in large

accumulations of reserves. This policy response may have helped contain the appreciation
pressures. But it also resulted in a peculiar situation in which the authorities tried to use
the aid twice: once to increase government spending, and once to increase the stock of
reserves. The private sector was crowded out as a result, mainly through higher interest
rates (when the accumulation was sterilized) and in some cases also through the inflation
tax (when otherwise).26
The above raises the issue of whether greater coordination of reserve policy with
fiscal policy could help improve macroeconomic outcomes. It is difficult to see how this
coordination can take place without affecting central bank independence however.
Other issues of coordination arise naturally given the central bank’s role as the govern-
ment’s bank. For example, it is often argued that the challenges with monetary policy
implementation in SSA stem from the difficulty in forecasting government transactions,
which then have a direct implication on liquidity in the banking system. We believe this
issue is largely overblown however—the problem can be avoided under interest rate based
floor systems that automatically withdraw liquidity when needed.
5. What Models for Monetary Policy Analysis in SSA?
There is great need for models to undertake policy analysis in SSA CBs. In our view, these
models must meet two criteria. First, they must reflect modern thinking on monetary
policy, drawing on both state of-the-art macro theory and current practice in central
banks in advanced and emerging markets. Second, they must be tailored to address key
low-income-country specific issues. Despite the importance of the topic, there has been
very little work in the academic and policy literature tailored to low-income countries. We
briefly review some recent work in this area here.
Andrle et al (2013, 2015) develop an analytical framework for low income countries,
with two applications to Kenya. In Andrle et al (2015), the authors extend the standard
framework used in central banks in advanced and emerging economies to study food and
non-food inflation. They find that imported food price shocks accounted for part of the
inflationary spike in 2011, but more importantly, that accommodative monetary policy
also played an important role. Andrle et al (2013) focus on the implementation of flexible
money targeting and provide a model-based interpretation of target misses, eg, whether
they reflect policy or money demand shocks.
Alichi et al (2010) develop a model of endogenous policy credibility to study the opti-
mal path of disinflation and the attainment of an inflation target, and apply it to Ghana.
They find that the output inflation trade-off is more severe at earlier stages of credibility,
and policy needs to be geared toward achieving its target, at the expense of output.
Baldini et al (2015) develop a dynamic stochastic general equilibrium (DSGE) model
with a banking sector to analyze the impact of the financial crisis on Zambia. They find
that monetary policy added unnecessarily to macroeconomic volatility, for reasons related
to the money targeting framework. They also argue however that even well-designed and
26
See Berg et al (2010, 2015), Adam et al (2009), and Buffie et al (2008, 2010) on the pros and
cons of various policy responses in this context.

implemented policies may not be able to do much to resist the volatility associated with
the sorts of shocks encountered by Zambia during the crisis.
Central banks in the region are gradually making use of these types of models. This
is part of a broader effort to develop in-house forecasting and policy analysis systems
(FPAS), drawing on best practices that have emerged from the experience of central banks
in other regions.27 For the most part, the focus has been on simple models that focus
exclusively on monetary policy.
VIII. OTHER ROLES FOR CENTRAL BANKS

1. SSA Central Banks and the Pursuit of Financial Stability
SSA has not been immune to greater experimentation with financial sector policies
following the global financial crisis. Several SSA central banks have recently implemented
macroprudential measures, often in the context of large external shocks (eg, capital
inflows and commodity price shocks). For example, following the decline in oil prices in
2008, the liquidity ratio in Nigeria was decreased to address concerns over banks’ liquidity
and asset quality. The authorities also reduced limits on net FX open position in 2009, and
put a limit on capital market lending as a proportion of a bank’s balance sheet in 2010
(IMF, 2014). In Uganda, a limit on the ratio of FX loans to FX deposits was set in 2010
in response to a sharp increase in foreign currency lending, partly reflecting capital inflows
(BoU, 2010). This trend is likely to continue going forward, as CBs address emerging
financial stability concerns in the context of greater financial sector development and
integration to international financial markets.
Greater emphasis by CBs on financial sector policies presents a number of challenges in
SSA. Developing appropriate governance structures, which ensure operational independ-
ence of monetary and macroprudential policy functions while maintaining an effective
coordination between them, is difficult anywhere. However, in SSA there is an even greater
risk that this additional role may impinge on monetary policy, given the lack of clear
frameworks.
In most SSA countries banking supervision and regulation is also within the remit of
the central bank.28 This provides the central bank direct access to supervisory informa-
tion and direct control over traditional microprudential policy tools that can be used for
macroprudential purposes. There has been little progress however on the delineation of
micro and macroprudential policies within CBs.
The capacity to assess financial stability and implement financial policies may also
be limited. Analytical frameworks for financial stability analysis can be quite complex
27
See Laxton, Rose and Scott (2009) for a thorough description of FPAS.
28
As in other regions, the role of the central bank in institutional arrangements for financial
sector policies vary in SSA (Masson, 2014). In some countries, the central bank is the sole regula-
tor of the financial system (Ghana, Kenya, Lesotho, Malawi, Seychelles, Tanzania), in some it
only regulates the banking system (Angola, Mauritius, Morocco, Tunisia, Uganda, Zambia,
Zimbabwe), and in some other it shares responsibilities with supervisors (Nigeria, CEMAC, and
UMOA).

and lack of well trained staff in this area is likely to be even more of an issue than with
monetary policy modeling. More broadly, there are severe capacity constraints in SSA
to develop and effectively implement financial sector policies, including the availability
of high-frequency data and capacity to monitor systemic financial stability, and limited
supervisory capacity of the supervisory agencies.29
SSA central banks have so far chosen approaches that are simpler and more suitable to
their needs, mostly with a micro-prudential focus (Griffith-Jones and Gottschalk (2016),
IMF (2014)). Most of the low and lower-middle income SSA countries are still adherent
to Basel I, but bank regulation in many countries set higher minimum capital adequacy
requirements than international standards.30 For this reason, African regulators argue that
the proposed reforms under Basel III on raising both relative and absolute capital ratios
(the latter through introducing leverage ratios) may have little effect in SSA (Bagyenda
et al, 2011). There has also been a broader range of restrictions on the composition of
banks’ assets and liabilities. For example, most countries have rules in place to limit banks’
ability to lend to a single borrower or to a group of inter-related borrowers (Gottschalk,
2014). However, SSA central banks may need to do more to address adequately systemic
risks. What is ultimately needed is a more robust analysis and understanding of the links
between the macroeconomy and the financial sector.31
2. Central Banks as Custodians of Natural Resource Wealth
In addition to the issues of monetary policy modernization and the pursuit of financial
stability, there has been another Africa-specific debate on the role of central banks. In
particular, Paul Collier and others have called for a greater involvement of central banks
in the management of natural resource revenues in African countries.32 We briefly review
this argument here.
How to use resource wealth for development is a central policy question facing African
countries. In principle, such wealth can help finance much needed public investment needs
(in infrastructure, education and health) and serve as a boost to the productive capaci-
ties of these countries. This is the argument behind the creation of sovereign wealth or
development funds. Moreover, as large increases in investment can quickly run against the
absorptive capacity constraints of these economies, these funds should also be invested in
external assets, which would then be drawn down over time.33
Whilst the management of sovereign wealth funds often falls within the purview of
government, the lack of strong fiscal institutions however, raises the possibility that these
29
See Gottschalk (2014).
30
For example, a higher regulatory ratio is imposed in Uganda (10.5 percent for Tier 1 and 14.5
percent for total capital under Basel 3 from January 2015), and in Tanzania (12.5 percent for Tier 1
and 14.5 percent for total capital under Basel 1 from March 2014) (IMF, 2014). This is in contrast
to the macroprudential approach in most advanced and emerging economies where policy settings
are continuously recalibrated.
31
There are also important regulatory issues related to the emergence of Pan African banks
and the importance of greater coordination across national supervisors.
32
See Collier (2011a, 2011b), among others.
33
The initial focus of these funds was on the accumulation of foreign assets, but the development
needs of many resource-rich countries has led to a rethinking of this issue, including at the IMF.

revenues will be mismanaged, or that excessive commodity-driven fiscal expansions will

add to real exchange rate over-valuation, greater macroeconomic volatility, and possibly
political instability (the so-called resource curse). Insulation from political pressures is
therefore necessary if resource wealth is to contribute to development and macro stability.
Rather than create new institutions, such as a statutorily independent sovereign wealth
fund, for this task, which are likely to be unable to resist the political pressures involved,
Collier’s proposal is that the management of these funds be delegated to central banks.
In his view, several factors make this an ideal arrangement. First, de jure independence
vis-à-vis the government makes it less likely that central banks would cave in to political
pressures. CBs would ensure the use of the funds in accordance with properly designed
fiscal rules, while also making sure that the funds themselves are managed in line with
international best practice. Second, central banks are staffed with technocrats, which are
otherwise scarce in developing countries, and are therefore better equipped for a relatively
sophisticated task such as the management of potentially very large development funds.
Finally, central banks’ emphasis on communications makes them ideally suited for educat-
ing the public about the importance of resource wealth management.
Collier’s proposal falls within the broader call for central banks to take on more
responsibilities, under the argument that central banks’ independence and technocratic
nature make them ‘the only game in town’ (Marcus (2016)). The risk of such a move is that
central banks may lose their hard-won independence as they take on more responsibilities.
Pressures on central banks have been increasing, including in advanced economies. The
more fragile nature of central bank autonomy in SSA, which remains a work in progress,
makes this risk higher. In addition, the lack of clear frameworks for monetary policy
raises the question of whether resource wealth management could influence the stance
of policy in unintended ways. In sum, it remains to be seen whether central banks in SSA
will take on these new responsibilities.
IX. CONCLUSION
Central banks in SSA have come a long way. They played a critical role, though perhaps
subordinate to fiscal policy, in stabilizing macroeconomies and thereby helping set the
stage for the growth resurgence that much of the continent has enjoyed since roughly
the mid 1990s. The challenges, however, seem to be getting tougher. Perhaps foremost
is the difficult global economic environment: will SSA countries be able to keep growth
going in the face of shocks related to China’s growth slowdown and swings in commodity
prices? Are monetary policy institutions strong enough? Have central banks achieved
effective enough monetary policy frameworks to adjust to these shocks, keep expectations
anchored, and resist political pressures? Much progress has been made and much more
is underway. Will pressures expose weaknesses that spur further reforms or rather derail
them?
Many of these challenges lie in the domain of fiscal policy and more broadly still in the
resilience of a broad range of institutions both public and private. Most of the shocks
are ‘real’, not nominal: real commodity prices, resource output, FDI flows, and foreign
demand, and fiscal policy. However, in our view the agenda for central banks that we have
outlined here can play a critical supporting role.

Central banks can work to implement clear forward-looking policy regimes that
respond coherently to the full range of shocks. This will help avoid macroeconomic and
financial crises and keep expectations anchored while avoiding unnecessary swings in
interest rates, inflation, exchange rates, and output. All this can keep bad times from
exploding into vicious circles of macroeconomic disarray and allow policymakers time to
address the full range of challenges. The central bank agenda itself is of course broader,
encompassing payments systems and financial regulation. And the lessons of the global
financial crisis for monetary policy regimes themselves are still being digested. But in our
view all of this broader reform is better built on the solid foundations we have discussed
here.
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World Development 2105–22.

12. The Reichsbank and the Bundesbank: the legacy
of the German tradition of central banking
Harold James
Germany’s central banks have played a key role in shaping a much wider approach to
best practice in central banking. Central banks—at least after the establishment of the
Bank of England—have often been shaped on the basis of lessons and experiences drawn
from other central banks. Indeed, even the Bank of England may have in part been based
on the Genoese Casa di San Giorgio. The design of the first German central bank, the
Deutsche Reichsbank (Imperial Bank), was heavily influenced by the Bank of England
after the reform of the 1844 Peel Act. In turn, the Reichsbank served as a model for the
Bank of Japan, and then after 1908 in the discussions of the US National Monetary
Commission as a prototype for a US central bank. After severe German policy failures in
the interwar period, lessons from the Federal Reserve System were applied when it came to
a redesign of German central banking after 1945. The new institution eventually became
the Deutsche Bundesbank, which was widely celebrated (along with the Swiss National
Bank) as a successful model of resistance to inflation, and as a strong argument for central
bank independence. In particular, many features were transferred from the Bundesbank
to the European Central Bank (ECB). After his appointment as the third President of the
ECB, Mario Draghi gave an interview to the populist Bild Zeitung in Germany (which
had previously dismissed an Italian candidate on the ground that inflation goes with Italy
as tomato sauce with pasta). The newspaper asked ‘Germans want a central bank head
who is strictly against inflation, independent of politics, and in favor of a strong Euro.
How German are you?’ Draghi replied: ‘These really are German virtues. But every central
banker in the Eurozone should have them.’1
The German central bank has always been an instrument for managing the links
of Germany to an international world of money; but over time there have been quite
different experiences with respect to political independence, and to issues such as lender
of last resort actions with regard to the domestic banking system as well as to price
stability. In the 1870s, the Reichsbank had been part of an economic policy regime that
linked Germany to the international currency order, the gold standard. After the disaster
of the German hyperinflation, a new and independent Reichsbank, whose autonomy
was guaranteed by international treaty, recreated a stable and convertible currency, the
Reichsmark, with a gold parity fixed by law. In the 1930s, the legal independence of the
central bank was again eroded, and after 1945 the Allied Military authorities regarded
the German financial record with the highest suspicion. They established a new version
of an independent central bank, which gradually developed its own mythology. The
Bundesbank—the new German central bank—was termed by one long-term President,
1
Bild, ‘Interview mit EZB-Chef Mario Draghi’ 22 March 2012.
229

Karl Otto Pöhl, as ‘a kind of state within the state – an economic policy counterweight
to the government.’2
Germany’s central bank played a dismal role in the worst moments and in the greatest
crimes of twentieth century history; and then after 1945, the central bank was transformed
into the symbol of German success and German rectitude.
I. IMPERIAL GERMANY
The Deutsche Reichsbank was established in the aftermath of German unification

(1871) and of a dramatic real estate and railroad book that collapsed in 1873. The aim
of the new institution was in part to tame the chaotic state of German banking, where
problematic note-issuing banks had produced uncertainty and a proclivity to panic; and
in part to provide an orderly mechanism for managing the international flow of specie,
and in particular the outflow of gold that hit Germany in 1874. The first President of
the Reichsbank, Hermann von Dechend defined the institution’s ‘principal task’ as ‘for
the currency and sustaining monetary circulation in the country.’3 It was in the context
of protecting German gold from flowing out that the phrase ‘guardian of the currency’
was first used.
Like the Bank of England, the Reichsbank was a privately owned institution, with
annual meetings of shareholders, who were represented by a Central Committee of 15
members, mostly resident in Berlin, and meeting monthly. Three deputies appointed by
the Central Committee participated in the meetings of the Directorate. Profits were shared
between the shareholders and the German Empire. The Reichsbank was also supervised
by a Bank Curatorium, consisting of the Reich Chancellor (Otto von Bismarck) as chair-
man, and four members, meeting quarterly, and representing the federal German states.
The management of the bank consisted of a Reichsbank Directorate, under a President,
following the general principles of conduct set by the Reich Chancellor. It could thus on
occasion be subjected to direct political commands, as on the famous occasion in 1887
when, for foreign policy reasons, and at Bismarck’s insistence, the Reichsbank forbade
the use of Russian bonds as collateral.4 This semi-public and semi-private character of
the Reichsbank may appear puzzling in historical retrospect. But in the Reichstag debates
on bank reform, the balanced character of the institution was depicted as critical to its
successful operation. The balance was actually a neat expression of the new Empire, a
mixture of private interest and the order provided by the state.
The two predominant economic concerns of the Reichstag debates of the 1870s
on the establishment of the Reichsbank—the preservation of the gold stock and the
appropriate response to financial distress—were fully reflected in its early practice. It
was always prepared to act as lender of last resort to the German banking system,
2
Die Zeit, ‘Die Bundesbank, gefesselt von Europa’ 40, 25 September 1992.
3
Quoted in Harold James, ‘The Reichsbank 1876–1945’ in Deutsche Bundesbank (ed), Fifty
years of the Deutsche Mark: central bank and the currency in Germany since 1948 (Oxford: Oxford
University Press, 1999) 7.
4
George F Kennan, The Decline of Bismarck’s European Order: Franco-Russian Relations
1875–1890 (Princeton: Princeton University Press, 1979).

The Reichsbank and the Bundesbank 231
even when such support became increasingly problematical in the years preceding the
First World War. ‘The Reichsbank is the last support of the German home market’,
argued an official commemorative volume in 1900.5 The Hamburg banker and monetary
theorist Friedrich Bendixen in 1909 concluded: ‘we Germans arc so lucky to have an
ideal solution to the problem of a central bank constitution, and intelligent observers
abroad envy us.’6
But the Reichsbank seemed unprepared for the major international financial crisis
of 1907, and many bankers—including especially the influential Hamburg banker Max
Warburg, the older brother of Paul Warburg, one of the intellectual begetters of the
Fed—urged a reform that emphasized the capacity to respond speedily to international
diplomatic and security crises. The newly appointed President, the reformer Rudolf
Havenstein, soon became colloquially known as the ‘Generalgeldmarschall’, the General
Monetary Marshal, who provided a ‘worthy counterpart of the Schlieffen plan.’7
II. THE GREAT INFLATION AND THE STABILIZATION
The Reichsbank played a starring role not only in war finance during the World War,
directly monetizing government debt, but also in the Great Inflation that started in the
War but then shaped the first years of the Weimar Republic. The German inflation and
hyper-inflation is one of the most notorious, and most studied, monetary catastrophes in
human history. By November 1923, the Mark had sunk to one tenth of its pre-war value
against the dollar. In the last months of the German inflation the central bank believed
that it needed to respond to the real fall in the value of currency by producing more
currency at faster rates. The Reichsbank even boasted of the efficiency of its 30 paper
factories and 29 plate factories producing 400 000 printing plates to be employed by the
7500 workers in the Reichsbank’s own printing works, as well as by 132 other printing
firms temporarily working to satisfy the need for currency.
Germany’s inflation experience is best described in modern terms as fiscal dominance.
In 1920, 12 percent of central government expenditure went to finance deficits in the post
and railroad systems, where employment was judged a social and political necessity. The
deficits rose in subsequent years, as the government in effect adopted a full employment
program. Similar political considerations also guided tax policy, with weak coalition
governments finding tax rises impossible in the face of militant opposition from business
interests.
The Reichsbank also continued to discount private commercial bills, at negative real
interest rates: the policy rate (discount rate) was held at an amazingly low five percent
until July 1922. This policy was highly controversial at the time and has remained so sub-
sequently. Contemporary critics, including the Italian economist Costantino Bresciani-
Turroni (a member of the Allied Reparation Commission who wrote the first major study
5
Translated as The Reichsbank 1876–1900, Washington D.C: Government Printing Office
(National Monetary Commission), 41.
6
James, above note 3, 10, 12.
7
Gerald D Feldman, The Great Disorder: Politics, Economics and Society in the German
Inflation 1914–1924 (New York: Oxford University Press, 1993) 31–32.

of the German inflation, thought that the discount policy represented an illegitimate
subsidy to that part of the business community having access to the Reichsbank.
As the inflation accelerated, in 1922, the Allies successfully demanded a change in
legislation to make the Reichsbank independent, but the move did not really affect the
central bank’s thinking or policy in any way. Indeed, the Reichsbank consistently argued
that it had taken treasury bills by choice, to discharge its ‘duty’ to the German economy,
and not because it had been instructed to do so by the Reich Chancellor.
In stabilizing the currency after the dramatic highpoint of the inflation in November
1923, when Germany faced civil war as well as currency chaos, the initiative lay with the
Finance Ministry, not the central bank. Foreign advice—especially that of the influential
Bank of England Governor Montagu Norman and Benjamin Strong, Governor of the
New York Federal Reserve Bank—played a key role in reshaping central banking.
It was the government that needed to provide a basic mechanism for fiscal stabilization
and an end to the ‘fiscal dominance’ that had produced inflation. In this new environ-
ment, monetary policy mattered again, and thus the question of who would succeed the
discredited Reichsbank President Havenstein became central; but so did the fundamental
issue of the design of a new currency and a new Reichsbank. The foreign central banks
had pressed for the dismissal of Havenstein, who had refused ironically citing the law on
bank independence that the Allies had insisted on. Eventually the government had named
a left liberal critic of the Reichsbank, Hjalmar Schacht, as Currency Commissioner. When
Havenstein died of a heart attack at the height of the German inflation, Schacht was
appointed as his successor. The opposition of the Reichsbank Directors to his appoint-
ment (and their advocacy of the candidature of the nationalist wartime Reich Treasury
Secretary Karl Helfferich) helped to convince the foreign central bankers that the German
government had made a very wise choice in Schacht.
After the stabilization of 1923–24, monetary policy was set by a rule, that of the gold
standard with the requirement of currency convertibility; and in the new institutional
arrangements of the Reichsbank, the rule was secured by the institution of a General
Council imposed at the London Conference on which half the members were representa-
tives of the creditor powers. The Reichsbank Law of 30 August 1924, specified that the
Council was to appoint the President and could dismiss him on ‘important grounds’
(Article 6). Article 25 limited lending to the government to a short term operational credit
of a mere 100 million Reichsmark.
An essential component of the practice of central bank cooperation in the 1920s was
not only the legal autonomy, but also their practical independence from national pres-
sures, both political and commercial. Schacht dealt with the poisonous historical legacy
by fierce criticism of those relationships which had brought so much trouble during the
inflation-with public authorities, and with the banking system. At first, he directed most
of his attention to the rationalization of public finance, and began to criticize public
spending. He also tried to control borrowing on foreign markets by German banks, and
tried to restrain credit growth. Schacht always made sure that his central bank colleagues
in other countries heard about his criticism, since that helped to build the credibility of
the Reichsbank. In the end, the conflict with the government escalated, and in March
1930 Schacht resigned.

III. THE GREAT DEPRESSION AND THE NAZIFICATION OF

THE REICHSBANK
The precarious stability that followed the currency stabilization was shaken by the Great
Depression, and was intensified by a banking and currency crisis in July 1931. The
convertibility of the Reichsmark was ended by decree legislation. In the development
of economic policy and the move away from liberalism and toward control, the decisive
break with the international world of the gold standard was 1931. The political caesura
of 1933 then decisively accelerated the development of economic nationalism. The
Reichsbank played a crucial part in the administration of Nazi economic policies, above
all in the financing of rearmament, in the economic exploitation of the victims of Nazi
racial persecution, and in the economic reshaping of occupied Europe. It also served to
camouflage Nazi policy in that between 1933 and 1938—under the renewed presidency
of the brilliant but controversial Schacht—the Reichsbank publicly opposed some aspects
of Nazi policy, and gave in consequence a quite false impression of the extent of political
pluralism prevailing in Germany.
The crisis of 1931 and the imposition of exchange control severed the link of the cur-
rency to a gold or foreign exchange rule. After that, Reichsbank policy had no consistent
guideline, although of course there were some policy priorities. At first, it tried to provide
a stimulus to economic recovery, and later in the 1930s it aimed at price stability. But it
never consciously adopted any operational equivalent of the gold standard rule, such as
would have been represented for instance, by the adoption of a monetary target. Only
such an impersonal rule (the currency parity, or a quantitative target) could have served as
a way of isolating policy from political influences. After all, questions such as the best way
to attain economic recovery, or what was meant by price and wage stability, could quite
legitimately and plausibly be answered in a large number of ways, reflecting divergent
political views and interests. Instead of a rule, the Reichsbank and its political masters
saw matters in terms of the credibility attached to particular personalities.
The reappointment of Schacht was a vital move for Hitler, intended to build economic
confidence in the new regime both internationally and domestically. Internationally, he
could be trusted with the complicated negotiations on the frozen German short-term
debt, and on reduction of payments on long-term debt. Domestically, Schacht as ‘Savior
of the Mark’, appeared as a guarantee against inflation. He had consistently hammered
away at an anti-inflationary theme, especially in the decisive years at the end of the Weimar
Republic. At the meeting of the National Opposition in Bad Harzburg on 11 October
1931, Schacht criticized the Reichsbank as managed by Hans Luther, who had succeeded
him in office, not for its deflation, but rather for taking risks with the currency and bring-
ing too many ‘frozen’ (illiquid) bills into the portfolio.8 After the appointment of Hitler
as Chancellor in January 1933, Luther resigned; and, at Hitler’s urging, the Reichsbank’s
General Council appointed Schacht as his successor. The incident demonstrates how even
an apparently cast iron legal autonomy of the central bank is not inevitably a guarantee
against political intrusion.
8
Henry Ashby Turner, German Big Business and the Rise of Hitler (New York: Oxford
University Press, 1985) 167–68.

If Hitler thought that the magic of Schacht’s name would prevent panic or loss of
confidence, Schacht in turn believed that the ‘Führer’s’ personality would hold the key to
a new economic recovery. He had met Hitler for the first time on New Year’s Day 1931,
and had rapidly associated himself politically with National Socialism and its charismatic
leader. But he never joined the party, and always remained more impressed by Hitler
personally than by the movement or its ideology, and he intensely distrusted its populist
rhetoric. For a long time Schacht saw Hitler as a statesman of ‘genius’. After 1945, he was
still happy to state that ‘I thought Hitler was a man with whom one could cooperate.’9
Throughout the 1930s, even as he became increasingly disenchanted with National
Socialism, Schacht treated Hitler obsequiously. From the beginning of his association
with the new political movement, Schacht regarded it as his mission to harness the
charisma, and to protect private ownership against the socialist claims of the National
Socialist German Workers’ Party (NSDAP). His greatest success in this regard was as
chairman of the Bank Inquiry of 1933—a commission established to determine what
had gone wrong in the crisis of the Great Depression, and to provide remedies. He turned
the commission into a relatively harmless opportunity for some of the more ideological
National Socialists to appeal for a greater control of banking. The eventual outcome of
the Inquiry, the bank law of December 1934, reflected almost nothing of Nazi criticisms
of finance capital. It laid out instead a regulatory framework for the banking industry
that was surprisingly unideological and which lasted into and helped to shape Germany’s
post-1945 banking experience. Further measures helped the Reichsbank control the
money market. From October 1933, open market operations—the buying and selling
of Treasury bills with the purpose of supplying or absorbing excess liquidity—were
permitted.
In addition to financing through borrowing, Germany’s armament drive was paid
through the device of the Mefo-Wechsel: a bill drawn by the munitions supplier on the
Metallurgische Forschungsgesellschaft m.b.H. Since these were six month bills, they were
ineligible for Reichsbank discounting in the first half of their life, but were taken by a
subsidiary institution of the Reichsbank, the Golddiskontbank. Half of the Mefo-bills
issued were never presented to the Reichsbank or the Golddiskontbank for rediscount,
but were held by the private sector. The major intention of the device was to take some
military expenditure off-budget. Though the Mefo-Wechsel and the extent of their usage
were kept secret, in fact they proved of little use in camouflaging German rearmament. It
was quite possible for other countries to deduce what was happening in Germany.
As in the 1920s, financial and economic policy tensions developed between the
Reichsbank and the government, over the increased pace of German rearmament, the
expansion of the public sector, the growth of the public sector debt, and the orientation
of German trade policy. It became increasingly clear that the expansion of the state-led
economy was not just an attempt to give an initial pump priming to a market economy,
but that it was developing a logic and a dynamic of its own. New elites in the party and
also in business had an interest in the new state-led development. By emphasizing the need
for limits on government spending, the Reichsbank kept any opposition fundamentally
9
Institut für Zeitgeschichte archive, ZS 135/2, 20 July 1945 CJ Hynning interrogation of
Schacht, and ZS135/6, 11 July 1945 CJ Hynning interrogation of Schacht.

within its limited and technical sphere of responsibility: but it confronted the powerful
interests of the new elites.
Throughout the first years of the National Socialist dictatorship, Schacht had repeat-
edly insisted on Germany’s need to find export markets. In practice, however, he presided
over an increasingly tight control of external trade. ‘Schachtianism’, as the system of
blocked debts and politically managed trade was known abroad, came to be regarded
as a new philosophy of economic management. The vigor of the economic recovery in
1933–34 endangered the last scarce German reserves, and prompted first a reintroduc-
tion of very radical exchange controls, and then, with the New Plan of September 1934,
a move to bilateralization of foreign trade. Within the context of exchange control,
different rates were applied for different countries and products. Such controls were
explained by Schacht as a counterpart to the refusal of creditor countries to write down
German debt.
In 1936, Schacht resisted a more extensive push for control of the heavy industrial
suppliers to the armaments industry in the Four Year Plan; and responsibility for German
rearmament was transferred to Prussian Minister President Hermann Göring and the
Four Year Plan administration. In the following year, Schacht tried, but failed, to enlist
the support of the Rhine-Ruhr steel elite in fighting Göring’s plans for a state steel sector
using very costly domestic ores, the Reichswerke Hermann Göring.
In practice a new inflation began already during the peacetime years of the Nazi
dictatorship. The government, obsessed by the damage that inflation might do to popular
confidence, tried to use price controls as an anti-inflationary instrument. Hitler boasted:
‘I had to also make it clear to Schacht that the first cause of our currency stability is
the concentration camp: the currency is stable when anyone who demands more is dealt
with.’10 The price controls brought unintended consequences, notably a steady deteriora-
tion of quality. And the official cost of living statistics undoubtedly understate the extent
of German price inflation during the economic recovery in the peacetime years after the
Great Depression and before the outbreak of war in 1939.
In 1938 and 1939 the Reichsbank’s conflict with the government reached a climax.
The Reichsbank insisted that the volume of Mefo-bills outstanding should be reduced.
The fourth Reich bond issue of 1938 for 1500 million RM was the first dramatic failure
of the government on the capital markets: a substantial part of the issue needed to be
taken up by the underwriters. In December 1938, the Reichsbank refused a request from
the Finance Ministry for a special credit of 100 million RM. On 7 January 1939, Schacht
addressed a dramatic letter, signed by the entire Directorate, to Hitler, demanding a
limitation of expenditure to the extent that it could be funded through taxation or long-
term loans. The letter raised the specter of inflation. ‘Our responsibility is to point out
that a further use of the Reichsbank, either directly or indirectly, cannot be justified from
the standpoint of the currency, and must lead straight to inflation . . . The Führer and
Chancellor has always in public rejected inflation as stupid and useless.’11 The letter led
to the dismissal, first of Schacht, Vice-President Friedrich Dreyse and Ernst Hülse, and
10
Werner Jochmann (ed), Adolf Hitlers Monologe im Führerhauptquartier 1941–1944: Die
Aufzeichnungen Heinrich Heims (Hamburg: Orbis, 1980) 88.
11
German Bundesarchiv Berlin, R43II/234.

then of other members of the Direktorium (including both Karl Blessing and Wilhelm
Vocke, who headed the central bank in the Federal Republic).
On 15 June 1939, a new Reichsbank law subordinated the bank directly to the ‘Führer’
and abolished the Central Committee. Instead, an advisory committee (Beirat) composed
of leading business figures, and divided into various sub-committees, was constituted.
The ‘Führer’ was to determine the limit of the operating credit that could be extended to
the Reich, and the maximum volume of treasury bills. The Reichsbank was now redefined
as the ‘Main Bank of the Government’, a completely subservient part of the bureaucratic
machinery of totalitarian control. These measures in fact converted the Reichsbank back
into a perfect machine for inflation: a role in which its officials felt most unhappy. The
gold coverage rules, which were in any case wholly redundant at this stage, were abrogated.
The application of the Nazi ‘leadership principle’ (Führerprinzip) to the management
of the Reichsbank meant the abolition of majority voting by the Direktorium, and the
vesting of sole responsibility for policy in the President. Rather perversely, but quite
characteristically for National Socialist politics, this apparent move toward an authoritar-
ian principle meant little in practice. For the new President, unlike his predecessor, was
a nonentity.
Walther Funk had already been Schacht’s successor as Economics Minister; and in fact
he spent most of his working time at the ministry, not the bank. Schacht regarded Funk
with a contempt that appears to have been widely shared by Reichsbank officials, and later
told Allied interrogators. ‘Mr Funk is certainly stupid and in fact has no knowledge of
finance.’12 Funk actually (perhaps surprisingly) continued to preach about central bank
independence, regardless of the politicized realities of rearmament and war.
Like the First World War, Hitler’s war was fiscally ruinous. There were tax rises and
in 1942 an effort to siphon off excess business profits; but ordinary revenues were barely
sufficient to pay for the cost of the state’s civilian expenditure. The war was managed
through the ‘silent financing’ of private savings channeled by the banks and savings banks
into state paper, just as they had been through the 1930s. Some part of the war was paid
through impositions on occupied countries. But these sources were inadequate, and as the
war progressed, its cost was increasingly met through the use of the printing press. With
an increasing pace after 1943, the treasury bills and treasury certificates ended directly
in the Reichsbank’s portfolio. As a consequence, the currency in circulation rose from 11
billion RM at the outset of the war (12 percent of GDP) to 73 billion RM by the time of
the German defeat, a 663 percent increase.
The extension of rationing, with price and incomes controls, rather than monetary
limitation, was the primary weapon against inflation. From the beginning of the War, the
Reichsbank’s economists had tried to refute some of the arguments made already in the
previous war, according to which monetary policy had an insignificant role in wartime
policy. They correctly reasoned that only monetary discipline, not more controls, could
limit the damage done by the blossoming of the black market. Most of the German
official mind did not share this view.
One of the major tasks of the Reichsbank in the early stages of the war lay in providing
a blueprint for the New Europe. After the military successes of May and June 1940, with
12
James, above note 3, 40.

Great Britain left as Germany’s only military opponent, Funk launched a major initiative.
On 20 June 1940, a Reichsbank paper ‘Problems of external economic policy after the
end of the War’ set out the theory that the world would be reordered in economic spheres
of influence (Grosswirtschaftsraum). It then sketched out a German area that would
include Belgium, Holland, Scandinavia and South-East Europe, as well as colonies from
the Belgian, British and French empires. The paper was discreetly silent about the future
of France (the French armistice was signed on 22 June). Within the German area, there
would be fixed exchange rates, facilitating the later move to a currency and customs union.
On 25 July 1940, these plans culminated in a very well publicized speech by Walther
Funk, and the theme was repeated again in a speech on 11 August at the Königsberg
fair. Funk ridiculed the idea of a gold-based currency as an American system. Instead
the European economy would be tied together through long-term trade agreements, and
a multilateralized clearing in place of the bilateral agreements which in the 1930s had
restricted commercial development. ‘By concluding long-term agreements with European
countries, it is intended that the European economic systems shall adapt themselves to the
German market by a system of production planned far into the future.’13
The European schemes developed in the Reichsbank have a very obvious interest to the
present-day analyst, since they resemble both some aspects of the postwar international
monetary order, as well as postwar plans for European economic and currency unions.
The spectacular propaganda initiatives with which the Funk plan was launched indeed
played some part in pushing Britain and the United States to draw up their own currency
plans for the postwar world. In this way, the 1940 plans stood at the origins of the Bretton
Woods agreements of 1944. Aspects of the Bretton Woods regime were then deliberately
used in the late 1970s in the construction of a European Monetary System. Such an
intriguing historical retrospective may give greater significance to Funk’s plan than
existed at the time. These European currency schemes were a flash in the 1940 pan, which
faded as it became clear that there would not be a short European war followed rapidly
by a new peace settlement. As the war went on, the practical objections to the realization
of the European currency union increased.
In the large-scale business of planning a postwar monetary order, gold played an
increasingly insignificant role. Funk again and again rejected ‘the international rules of
the game of gold automatism which make us unfree.’14 But in the day-to-day running
of the war economy, gold still mattered greatly. It was used to pay for strategic imports,
such as chrome and iron ores, that could not be obtained elsewhere. As a consequence, it
became clear that gold was a vital wartime raw material. Gold would also eventually be
needed to settle Germany’s increasingly large clearing debts. In wartime Europe, gold no
longer played a role as international economic regulator: it reverted to its much earlier
role as a strategic good, needed to keep armies in the field.
This gold was sold to foreign central banks, mostly to the Swiss National Bank. In addi-
tion, the Reichsbank sold substantial amounts to Swiss commercial banks. Three quarters
of the gold sold abroad went through Switzerland. But Switzerland was fundamentally a
13
Walther Funk, The Economic Future of Europe (Berlin: Deutsche Reichsbank, 1940) 9, 11.
14
Walther Funk, Wirtschaftsordnung im neuen Europa: Rede gehalten vor der Südosteuropa-
Gesellschaft am 12. Juni 1941 (Vienna: Südost-Echo Verlagsgesellschaft, 1941) 22.

financial intermediary. Gold sold there was used to make payments on German account
to countries which would not allow the buildup of clearing balances: Yugoslavia in 1940,
and right up to the moment of the German invasion on 6 April 1941; Romania after 1942;
and Spain and Portugal throughout the War. Portugal too was an intermediary for the
vital trade in wolfram and industrial diamonds from South America. The last German
sale of gold to the Swiss National Bank occurred as late as 6 April 1945.
Most of this gold was a result of German military action, but the Reichsbank also
involved itself in the sinister and criminal business of taking and realizing gold from the
victims of the concentration and annihilation camps. When the main Reichsbank vault
was evacuated at the beginning of 1945 to a salt mine at Merkers, it contained not only
4173 bags with gold bars, but also 207 containers of gold jewelry and silverware looted
by the SS. Other looted goods were held in the local branches of the Reichsbank: the
Regensburg office for instance had in its safe the tabernacle of a Russian orthodox church.
A substantial amount of gold was derived from the killings of ‘Operation Reinhard’
in occupied Poland. This gold was delivered by Hauptsturmführer Bruno Melmer, the
head of Amtskasse-Hauptabteilung A/II/3, to the Reichsbank for the account of ‘Max
Heiliger’. It amounted to 2578 kg, sent in 76 deliveries between 26 August 1942 and 27
January 1945. Part of this amount was derived from dental gold, broken out from the
mouths of dead or sometimes living Jews and other victims in German concentration
camps. The complicity of the Reichsbank and its officials in the criminal acts of the
regime formed the basis of the indictments after 1945. Walther Funk was sentenced
at Nuremberg to life imprisonment; and Emil Puhl to five years’ imprisonment at the
subsequent ‘Wilhelmstrasse’ trial. Schacht, who had been dismissed from the Reichsbank
in January 1939, was acquitted of all charges at Nuremberg.
IV. ECONOMIC REFORM AND THE BANK DEUTSCHER

LÄNDER
Central banking was reestablished after 1945 first on the basis of the individual states
(Länder), and according to the design of the occupying military authorities. The British
had wanted to keep the centralized Reichsbank organization; the Americans pushed for
decentralization, and the Soviets created a monopoly central bank structure as a basis for
Soviet-style planning. France had originally lined up with the British, but then accepted
the American vision of decentralized central banks, analogous to the district Reserve
bank system. There was no more private ownership: the new Land central banks were
owned by the Länder. They managed the circulation of money, did discount operations,
and also controlled banking in their areas through a minimum reserve system based
on the US precedent. In March 1948 the British and American military governments
issued decrees creating a coordinating Bank deutscher Länder (BdL) to supervise and
coordinate the Land banks, and settle inter-Land transactions. This was a precondition
for the currency reform. The President of the Board of Managers was elected by the Land
central bankers, not obviously by any German government (as there was none at that
time). The man initially chosen, Hermann J Abs, had been a director of Deutsche Bank,
was well liked by the British authorities but regarded with great suspicion (as a result of
his wartime role) by the Americans. The Allied Bank Commission rejected the election

results, and a second candidate was chosen, Wilhelm Vocke, who had been in the prewar
Reichsbank but had been sacked by Hitler in 1939.
The currency reform enacted in June 1948, which introduced the new Deutsche Mark
and also finalized the division between Western and Eastern zones, was also a largely
American affair, based on a plan originally presented by three US economists, Gerhard
Colm, Joseph M Dodge and Raymond Goldsmith in 1946 (Colm and Goldsmith
had both been born in Germany, but fled the Nazi dictatorship). The only German
currency plan, the Homburg Plan, had a Currency Office that reported directly to the
bizonal Administrative Board (or to a later German Chancellor). The leading German
economist involved in the discussions, Hans Möller, described his creation as a ‘sort of
superminister’, and later concluded that the Americans—who were suspicious of German
proclivities for inflation and government control—were quite right in their insistent rejec-
tion such a construction.15 As it was, the BdL was substantially independent and built the
foundation for the construction of the independent Bundesbank.
The legacy of the 1946–48 discussions also had an impact on the attitude of the
Bundesbank to the controversial question of reform strategies in other European coun-
tries. In particular, Germans began to believe that very painful reforms could sometimes
not really be developed internally, but required an external intervention: the US military
government in Germany in the 1940s, but Germany or the European Union in the debates
of the twenty-first century.
V. THE BUNDESBANK
The Bundesbank Law of 1957 established the Deutsche Bundesbank in the place of the
Bank deutscher Länder. The central governing authority was the central bank council
(Zentralbankrat) which determined the currency and credit policy of the bank (article 6);
on this council, the presidents of the Land central banks were represented. A directorate
(Direktorium), whose members were also members of the council, was responsible for
carrying out the policy determined by the council. (This looks in other words like the
structure of the ECB Governing Council, where the heads of National Central Banks sit,
with the Executive Board the equivalent of the Bundesbank Direktorium.) The President
of the Bundesbank, and other members of the Direktorium, were nominated by the
Federal President on the suggestion of the Federal Government, and had the status of
public officials (Beamte). The Bundesbank was obliged (Article 12) to support, while
keeping to its mandate, the ‘general economic policy of the Federal Government’. But in
the exercise of its functions it was to be ‘free from direction by the Federal Government’.
Credit to the government (monetary financing) was strictly limited under Article 20,
though not completely prohibited (as German mythology sometimes suggests): a three
billion DM credit to the government, as well as small sums for the publicly owned
railroads and postal system, were allowed. In practice, however, the room for monetary
15
Christoph Buchheim, ‘The Establishment of the Bank deutscher Länder and the West
German Currency Reform’ in Deutsche Bundesbank (ed), Fifty Years of the Deutsche Mark:
Central bank and the currency in Germany since 1948 (Oxford: Oxford University Press, 1999) 83.

autonomy was limited by the government’s choice of a foreign exchange regime, the par
value system, in which parity changes were cumbersome, rare, and resisted by the govern-
ment and by influential industrial pressure groups.
The practical implications of Bundesbank independence were bitterly fought out in
the late 1950s. The Chancellor, or other government ministers, might attend meetings of
the central bank council. There were some dramatic conflicts, the most defining of which
took place before the transition from BdL to Bundesbank. On 7 November 1955, the
veteran Chancellor Konrad Adenauer wrote to the President of the BdL, Wilhelm Vocke,
when boom conditions indicated that an interest rate hike might be appropriate (though
an election was in the offing, in 1957): ‘I would be grateful to you if the BdL would not
propose or implement incisive measures in the field of credit policy without prior consul-
tation with the Federal Government.’ To which Vocke promptly (on November 8) replied,
‘may I point out that incisive credit policy measures are part of the responsibility of the
Central Bank Council.’16 In May 1960, after another incident in which the Bank had
pushed up rates, Adenauer delivered a speech criticizing the Bundesbank for having dealt
a ‘heavy blow’ to the German economy (‘and it is the little ones who will suffer most.’)17
The speech was counter-productive, and convinced many Germans—including members
of the government—that the 84-year-old Chancellor was really losing his touch, and he
stepped down after failing to maintain his absolute majority in the 1961 general election.
Along with the setting of domestic interest rates, a sore issue—it became the sore
issue—for Bundesbank policy lay in the connectedness of Germany with the international
economy. Many figures in the Bundesbank—though not the President in the 1960s—were
hostile to the fixed exchange rate regime of Bretton Woods, and regarded the tie to the
dollar as a mechanism through which inflation was imported. The economist Otmar
Emminger (who eventually became President, from 1977 to his sudden death in 1979)
was one of the very first supporters in Europe of Milton Friedman and his advocacy of
flexible rather than fixed exchange rates.
Adenauer’s successor, Ludwig Erhard, and a later Chancellor, the social democrat
Helmut Schmidt, tried to tame the Bundesbank by appointing figures as President who
they thought would be sympathetic. But the strategy misfired. Erhard’s appointee, Karl
Blessing, presided over a rate increase which slowed the economy down and forced
Erhard’s government out of office.
After 1973, the Bundesbank was free of the constraints of the par value (Bretton
Woods) system, and almost immediately set about following a monetary target that it
regarded as a key to maintaining effective price stability. But it never followed a strict
Friedman-style target, and always emphasized pragmatism, believing that the announce-
ment of a target would influence the expectations of unions and employers in wage-
setting, as well as financial markets. The bank was always worried that undertaking some
new foreign policy commitment might undermine the monetary stability that it hoped
its targets would guide. The German experience raises the question of whether a good
16
Manfred JM Neumann, ‘Monetary Stability: Threat and Proven Response’ in Deutsche
Bundesbank (ed), Fifty years of the Deutsche Mark: central bank and the currency in Germany since
1948 (Oxford: Oxford University Press, 1999) 290.
17
Ibid, 291.

anti-inflationary policy follows from institutional design (the independence of the central
bank), or whether a broad social anti-inflationary consensus is the essential element, as
Adam Posen suggested.18
Helmut Schmidt, like all his predecessors in the Chancellor’s Office of the Federal
Republic, found the Bundesbank’s stance frustrating. He wanted to have someone who
thought along his lines as a sympathetic presence in Frankfurt. So he appointed as Vice
President his former press spokesman who had subsequently been state secretary in the
Finance Ministry, Karl Otto Pöhl. Schmidt believed that Pöhl, unlike the Bundesbank
traditionalists, would fully understand the international framework within which German
monetary action needed to occur, and in particular the need for a European monetary
agreement.
In practice, however, the appointment of Pöhl soon looked like the famous story of
the English King Henry II who appointed his friend and minister, Thomas à Becket, as
Archbishop of Canterbury when he was locked in a conflict with the English church.
Pöhl, like Becket, quickly reproduced the priorities of his new institution, not his original
political patron.
The Bundesbank in fact shaped the European Monetary System in one crucial
respect, by insisting on an exit clause if German monetary stability were to be endan-
gered. Emminger had written that the central bank council had agreed ‘under the
precondition that the government and central bank agree on the legal basis and also on
the future possibility of opting out in particular circumstances.’ Schmidt checked the
memorandum with the letter ‘r’ for richtig, correct, and returned it to the Bundesbank.
Germany agreed to a currency mechanism, but only to one that had a readily useable
escape hatch.
In a historic appearance before the Bundesbank Council on 30 November 1978,
Schmidt then pleaded for the bank to accept the European scheme. He cast his message in
a very broad historical context. He said: ‘There are bad exaggerations around when each
views it through national spectacles. One side prattles about an inflationary community,
the others, English and Italians in particular, prattle about a deflationary community
which would be accomplished there and would disrupt their whole national economy.’
He also referred to the more fundamental dilemmas of German foreign policy: ‘We are
doubly vulnerable and will remain so far into the next century. Vulnerable on account
of Berlin and also on account of the open flank to the East, on account of the partition
of the nation, symbolized by the insular position of Berlin, and secondly we remain
vulnerable on account of Auschwitz.’19
In the end the Bundesbank—and particularly Pöhl as President—did play a prominent
role in European monetary integration. By the 1980s, central banking was becoming more
internationalized, the cycle of regular meetings in Basel at the Bank for International
Settlements (BIS) and in Washington and elsewhere brought a new solidarity of what
was sometimes called the ‘fraternity’ of central bankers. Other central bankers wanted to
18
Adam Posen, ‘Central bank independence and disinflationary credibility: a missing link?’
(1998) 50(3) Oxford Economic Papers 335–59.
19
An English translation of the transcript of this meeting, courtesy of David Marsh, is avail-
able at http://www.margaretthatcher.org/document/111554.

be more like the Germans—and they admired the idea of independence. And Pöhl was
subject to foreign pressure as well.
When the Italian economist and Director-General of Economic and Financial Affairs
at the European Commission, Tommaso Padoa-Schioppa, visited Pöhl in his Frankfurt
office on 1 March 1982, the Bundesbank President explained his opposition to further
institutionalization of the EMS, but also laid out his position (that he had also explained
in the German Central Bank Council) that intellectually the better solution would be a
complete monetary union. Already before that, Padoa-Schioppa had explained in a letter
to Pöhl that:
To couple the defence of monetary orthodoxy with that of the institutional status quo may
lead to defeat in terms of both monetary stability and independence. Your ‘monetary constitu-
tion’ has been too successful on the fight for stability. It will now either become the monetary
constitution for Europe or be contaminated by the sins of the others. That is, by the way, a very
‘deutsches Schicksal’.20
The germ of the idea of monetary union thus lay in the Bundesbank’s feeling that the
early experience of the EMS was deeply unsatisfactory.
By the late 1980s, there was a mood of greater international cooperation. The G-7
finance ministers’ Louvre meeting in 1987 agreed to lock their exchange rates into a
system of target zones (with the Bundesbank President saying that there had been no such
agreement). In practice, nothing came of that global plan, but then Edouard Balladur,
the French finance minister who had largely been responsible for the Louvre proposal,
came up with a tighter European scheme. When German foreign minister Hans Dietrich
Genscher appeared sympathetic, Europe’s central bankers were asked by the president of
the European Commission, Jacques Delors, to prepare a timetable and a plan for currency
union: that was the origin of the Committee that produced the detailed blueprint for
monetary union. The German Chancellor, Helmut Kohl, agreed, and Pöhl was furious,
but then worked to transform the committee into a committee of central bankers. The
skeptical British Prime Minister Margaret Thatcher agreed to let the Governor of the
Bank of England participate and even encouraged him with the words, ‘You can sign
anything that Karl Otto Pöhl will sign’, because she was so sure of the Bundesbank’s
opposition to the project of monetary union.
After the report of the Delors Committee laid out a blueprint for monetary union,
and what would be the framework for the Maastricht Treaty, Pöhl continued to play an
active and energetic role. He was chairman of the Basel-based Committee of Governors
of the Central Banks of Member Countries of the European Community, and dominated
the institutional design of the new central banking system. In April 1990, Pöhl made a
proposal at the Committee of Governors for draft statutes on the objectives, organization,
functions, instruments, and voting system of a new bank.21 The Governors were resistant
to any hint of political supervision, and believed that any measure of political control
20
27 May 1981, Tommaso Padoa-Schioppa to Pöhl, quoted in Harold James, Making the
European Monetary Union (Cambridge Mass: Harvard University Press, 2012) 293.
21
CCA van den Berg, The Making of the Statute of the European System of Central Banks:
An Application of Checks and Balances (Amsterdam: Dutch University Press.an den Berg, 2004) 6.

would in practice mean pressure to inflate. They also largely wanted to escape from any
obligation to accept quantitative inflation targets—a view which was beginning to have a
strong impact among policy-oriented academic economists.22
Pöhl presented this outcome to the European finance ministers’ meeting (ECOFIN) on
8 September 1990, making clear the high importance that price stability would have for
the new regime: ‘there should be no misunderstanding: in the event of a conflict between
price stability and other economic objectives, the governing bodies of the System will have
no choice but to give priority to its primary objective. There can be no compromise in
this respect.’ This was the solution eventually adopted in the enumeration of ECB tasks
in Article 2, and it seemed to strengthen the emphasis on price stability in comparison
to the US system, where the concept only appeared in 1977 and was qualified by a dual
mandate which also referred to high employment.
Pöhl also insisted on the ECB not being categorized as an EC institution. The odd
result, that the ECB’s institutional position in the European Union had no political
anchor was only resolved by the Treaty of Lisbon (in Article 1(14) producing the new
Article 9); it was thus only on 1 December 2009, in consequence that the ECB became
an EU institution—to the dismay of the Bundesbank, at exactly the moment that ECB
decisions were becoming highly politicized in the wake of the global financial crisis. But
the ECB was also skeptical, and its President, Jean-Claude Trichet, was quoted as arguing
‘Because of its specific institutional features, the ECB needs to be differentiated from
the union’s institutions’. He implied that governments were trying to impose a political
control on the ECB.23
In many vital areas, then, the ECB looked as if it was a replica of the Bundesbank; the
primacy of price stability; the prohibition of monetary financing of government debt
(Article 123 of the Maastricht Treaty); the institutional guarantee of independence; as
well as the provision that the National Central Banks should also be independent (Article
14 of the ECB statute). It even looked as if the relationship between the ECB and the
National Central Banks (NCBs) was a mirror of that between the Bundesbank and the
Landeszentralbanken. The ECB’s policy approach also follows that of the Bundesbank,
with two pillars, on the one hand economic indicators on the real side, and on the other
monetary aggregates.
The ECB statute echoes many parts of the Bundesbank statute in the question of the
relationship to the government or governments in Europe: in the draft prepared by the
European Central Bank Governors Article 2 stated that the ECB ‘shall support the general
economic policy of the [European] Community with a view to contributing to the objec-
tives of the Community.’ This however raised a problem: the Community did not have
any mechanism for defining a single economic policy to go alongside the single monetary
policy of the new central bank. Consequently, the phrase was altered by the government
negotiators into the much less intellectually satisfactory obligation to ‘support the general
economic policies in the Community.’ As in the case of the Bundesbank, exchange rate
22
Ben S Bernanke et al, Inflation Targeting: Lessons from the International Experience
(Princeton, NJ: Princeton University Press, 1999).
23
Financial Times, 11 August 2007, ‘ECB independence threatened by treaty text, Trichet
warns EU chiefs’.

policy was to be the domain of the politicians (Article 109.2 of the Maastricht Treaty).
The Bundesbank had just experienced an extreme version of the tensions that could be
created over this issue, when Helmut Kohl as part of the negotiations over German unity
announced a 1:1 conversion rate between the Deutsche Mark and the East German Mark,
although the Bundesbank had warned (almost certainly correctly) about the deleterious
consequences, which would price East Germans out of jobs. That conflict was one of the
issues that led Pöhl to resign as Bundesbank President.
At the time, in the early 1990s, some influential figures in the Bundesbank, such as
Helmut Schlesinger, who succeeded Pöhl as President, liked to make the argument that
a Treaty was a stronger embodiment of the principle of independence than a simple
national law, like the Bundesbank law, which could always be easily reversed by a parlia-
mentary vote. Was it really that easy? The Bundesbank had often emphasized the way that
it was backed not just by law but by a strong, almost immutable, public sentiment about
stability culture, Stabilitätskultur.
Until the 2008 Global Financial Crisis, the Bundesbank could think that it had
successfully Europeanized its vision. During the Euro crisis, after 2010, however, ECB
policy diverged from the line of the Bundesbank. In May 2010, the central banks of the
Eurosystem were allowed for the first time to purchase government bonds on secondary
markets on a big scale, a move that was criticized in Germany as ‘monetary financing’
and which led to the resignation of Bundesbank President Axel Weber. Then in 2012,
ECB President Mario Draghi announced the Outright Monetary Transaction program
for bond purchases of countries that would conclude a rescue program. At that moment,
in the summer of 2012, when the existence of the Euro was at stake, the German govern-
ment backed Draghi and the ECB rather than the Bundesbank. Within the ECB Council,
the Bundesbank appeared more and more isolated, and its President, Jens Weidmann,
complained that the ECB was behaving like a Politburo. Unlike the US Federal Open
Markets Committee, where the New York Fed always has a vote, the Bundesbank had
no guaranteed vote in the large ECB Council (after the expansion of the ECB Council
to include 19 NCBs when Lithuania joined the currency union in January 2015 and the
voting rules were reconfigured). Faced with a radical policy shift, and once more at odds
with the German government, the Bundesbank explained its policy by drawing on its
history and on the tradition of Stabiltätskultur.

13. Central banking in Australia and New Zealand:
historical foundations and modern legislative
frameworks*
Frank Decker and Sheelagh McCracken
I. INTRODUCTION
Australia and New Zealand are geographically proximate and share a political history as
well as a common law heritage. In recent years they have worked closely on strengthening
their economic ties.1 However, the history of central banking in each country, and hence
the development of legislative frameworks, differs. Parallels can nonetheless be drawn at
various stages.
The existing literature, especially for the earlier years, is fragmented and, we would
argue, incomplete. Hence in sections II to IV of this chapter we reconstruct the develop-
ment path for both countries, commencing in section II by exploring how a free-banking
system operated in Australasia in the nineteenth century and how financial crises were
resolved without resort to central banks.
In sections III and IV, we trace the evolution through the course of the twentieth
century of each central bank—the Reserve Bank of Australia (‘RBA’) which started life
as the Commonwealth Bank of Australia, and the Reserve Bank of New Zealand (‘RB
NZ’). We examine in particular the impact of the introduction of state notes; foreign
exchange dealings; the set-up of command economies during both world wars; and the
subsequent deregulation in the 1980s. Contrary to common interpretations, we show that
the rise of central banking in Australia and New Zealand was triggered by the break-up
of a common £ sterling currency area; a much more significant event for the monetary
structures than is generally assumed. Core institutional structures of both central banks
were also intimately connected with the establishment of the war economies in World War
II. As a result of this war legacy, the RBA and RB NZ were for a long time viewed as pure
instruments of government policy. Institutional structures based on direct controls and
the monetisation of government deficits were only unwound in the mid-1980s.
Throughout this chapter we show how these economic developments shaped the
legislative framework of both the RBA and the RB NZ, a framework now formed by the
Reserve Bank Act 1959 (‘RBA Act’) and the Reserve Bank of New Zealand Act 1989
(‘RB NZ Act’).2 In section V we focus on two aspects of that framework which are of
*
Sheelagh gratefully acknowledges the research assistance of Onur Saygin.
1
See generally Australian Government Productivity Commission and New Zealand
Productivity Commission, Strengthening trans-Tasman economic relations, a Joint Study, Final
Report November 2012.
2
For the most recent consolidated versions, see Reserve Bank Act 1959 (‘RBA Act’),
Compilation No 29 dated 14 April 2015, available at www.legislation.gov.au and Reserve Bank of
245

particular interest in light of the banks’ economic history: the ownership structure and
the powers which might typically be described as ‘core central banking powers’. Our
analysis indicates that common labelling of the banks as government-owned does not
accurately reflect the legal position. It also discloses an extensive range of powers vested
in the banks, albeit subject to varying degrees of political control. The first proposition
points towards a level of institutional independence on the part of the central banks, while
the second ultimately points in the opposite direction. Both hint at the legislative ease at
which controls over the economy could be resumed through the central banks in the event
of changes in political will.
In our discussion we draw on the detailed statutory rules from each country. New
Zealand is a unitary jurisdiction, while Australia has multiple jurisdictions, with eight
State and Territory jurisdictions3 in addition to the federal jurisdiction. Central banking
has, however and perhaps not surprisingly, fallen within the scope of the federal legislature
since federation in 1901.
II. FREE BANKING IN AUSTRALASIA
The British Colony of New South Wales was established as a convict settlement in 1788,
while the efforts of a colonising company, the New Zealand Company of 1838, trans-
formed various whaling and sealing outposts into the colony of New Zealand in 1840.
From this developed what was described, at the turn of the nineteenth century, as the
‘seven colonies of Australasia’4—New South Wales (NSW), New Zealand, Queensland,
South Australia, Tasmania, Victoria and Western Australia. They were closely connected
economic units of the British Empire. A concept of national boundaries developed
only later, following the Australian Federation in 1901 and New Zealand becoming a
Dominion in 1907. It is a remarkable fact that this geographical area operated under a
free banking system for more than half of its 230-year history and was dominated by
competing private-note issuing banks. No central bank operated until the early 1930s in
Australia and 1934 in New Zealand.5
By contrast to New South Wales, the colony of New Zealand experienced several state
note issues. In 1844, a local ordinance6 authorised the government, then in financial
difficulties, to issue debentures in small denominations and to declare these legal tender.
The ordinance was later disallowed by the Colonial Office in London. A more thorough
New Zealand Act 1989 (‘RB NZ Act’), Reprint as at 1 January 2016, available at www.legislation.
govt.nz.
3
The States are: New South Wales, Queensland, South Australia, Tasmania, Victoria and
Western Australia. The Territories are: Australian Capital Territory and the Northern Territory.
4
Coghlan (1902).
5
Australasia’s first bank was the Bank of New South Wales founded in 1817 as a private note
issuing bank. Bank notes were preceded by merchant notes and notes issued by individuals: Decker
(2010, 2011). New Zealand’s first bank was the Port Nicholson (Wellington) branch of the Union
Bank of Australia established in 1840: New Zealand Gazette 18 April 1840; Butlin (1961) 154. The
central bank functions of the Bank of England did not extend to the colonies of Australasia.
6
An Ordinance to authorise the Governor of New Zealand to issue Debentures and to make
the same Legal Tender (passed 18 May 1844).

Central banking in Australia and New Zealand 247
attempt was the creation of the New Zealand Colonial Bank of Issue,7 which opened
in 1850. Notes were legal tender, convertible on demand and fully backed, as they were
issued in return for coin only. The Bank was, however, unsuccessful. A Parliamentary
Committee concluded that the monopolisation of the note issue by the government bank
had prevented the expansion of the Colony’s currency in line with commercial needs as
the property of the colony could not be sufficiently monetized.8 In 1856 the Bank was
wound up.9
In the absence of a central bank, money10 was created in the form of bank notes or
deposit entries when banks advanced credit by making loans or discounting promissory
notes or bills of exchange. At the turn of the nineteenth century Australasia had 22 trad-
ing banks, of which five had offices in New Zealand and the majority in London.11 Bank
charters and private Acts of Parliament, which trading banks required for the privilege of
limited liability, imposed a form of regulation. They specified capital requirements, note
backing and areas of operation.
Bank notes were legally redeemable in gold coin on demand. Important assets to finally
settle obligations (‘settlement assets’),12 were the English and Australian sovereign and
half sovereign gold coins with the nominal value respectively of £1 and 10s (legal tender in
Australasia and England). The Australasian unit or money of account was then the pound
sterling. To ensure an adequate level of gold reserves in each branch location, regular gold
coin and bullion shipments took place, including to and from London.
Private banks set monetary policy, including deposit and lending interest rates,
and selling/buying rates for bills on London and other locations. At times, rates were
determined by agreements between banks, which often acted as a ‘cartel’. Credit policy
was decided by reference to expected development of business and economic prospects.
Lending was tightened through interest rate rises, rationing and qualitative controls
in anticipation of economic downturns. In this way banks safeguarded liquidity and
attempted to contain loan losses.
Private banks also provided banking services to the colonial governments. They held
government cash balances and revenue proceeds as deposits, provided overdrafts and
became intermediaries for raising funds in the London capital markets. They regularly
monetised government debts, typically by overdraft. However, the scale of lending to
governments was limited by the terms of specific loan agreements and the banks’ need
to maintain their solvency, ie their ability to settle with other banks and redeem their
notes.
By far the most important issue that shaped the early development of central banking
in both Australia and New Zealand was what is today referred to as ‘foreign exchange’.
Unfortunately, there appears to be little clarity about how monetary transactions between
the colonies and London in the nineteenth and early twentieth centuries should be
7
Paper Currency Ordinance 1847, 11 Vic 16.
8
Bedford (1916) 274.
9
New Zealand Colonial Bank of Issue Winding-up Act 1856.
10
See Decker (2015) and (2017) for a discussion of the various forms of money and a classifica-
tion of monetary systems.
11
Coghlan (1902) 775.
12
Decker (2010) 175; (2015) 938.

characterised. Tocker,13 in a pioneering work on Australian and New Zealand monetary

standards, assumes a nineteenth century ‘gold standard’ that transitioned, at least in New
Zealand, to an exchange standard after 1914. On the other hand, Butlin14 assumes both
countries had always been on a ‘sterling-exchange standard’.
The characterisation of nineteenth century monetary arrangements as gold or
exchange standards is, however, in conflict with the fact that buying and selling rates
for bills of exchange on London typically stayed within narrow limits and that quoted
discount and premiums were largely interest and commissions.15 Moreover, gold points
were not formally recognised16 and banks operating in Australia and New Zealand never
distinguished between different types of pounds in their balance sheets.17 For these rea-
sons, we believe that the arrangement connecting England and Australasia during most
of the nineteenth century and at the beginning of the twentieth century is more accurately
described as a common currency area. The latter was maintained by independent, private
note-issuing banks that used a common money of account and cleared balances through
a common settlement asset (legal tender gold coin), which was denominated in the same
money of account, thereby reducing all debts to the same common currency unit. This
meant that transactions were first and foremost concerned with ‘debts due in different
places’,18 which were accepted by banks at par value (after accounting for interest and
commission).19
The nineteenth century free banking system was severely tested in the eastern Colonies
of Australia during major depressions in the 1840s and 1890s. The 1840s depression was
clearly recognized as a monetary event at the time and the NSW Legislative Council
passed the Monetary Confidence Bill, with a view to creating a de facto central bank in
NSW.20 The Colonial Governor however withheld his assent.21 National or state bank
proposals continued to be debated throughout the later part of the nineteenth century
but none were implemented.22
The 1890s crisis extended from mid-1891 to late 1893. Of Australia’s 22 trading banks,
13 suspended trading in April–May 1893.23 There were three important legislative
responses: voluntary insolvency regulations, legal tender provisions and state-issued
notes.
13
Tocker (1924) 565.
14
Butlin (1961) 397.
15
Hawke (1997) 31–35; Holder (1970) 525.
16
Commonwealth of Australia (1937) 40.
17
Plumptre (1940) 335.
18
Hawtrey (1923) 105; emphasis original.
19
The system relied on the management of the volume of bank advances and the free move-
ment of gold coin (or bullion) across locations. The latter was a frequent occurrence in the nine-
teenth century. Our argument builds on Stadermann (1992) 363, where he shows how a common
European currency could have been created by an association of national central banks without a
European central bank.
20
Decker (2008) 166; (2009).
21
This was prior to the establishment of responsible government in NSW. More successful was
the introduction of the Lien on Wool and Stock Mortgage Act 1843 (NSW); see Decker (2008).
22
Gollan (1968) 19–26.
23
Butlin (1961) 301.

Under voluntary liquidation legislation,24 trading banks under pressure could suspend
operation and reopen after a few months, reconstructed as a new company under schemes
whereby creditors accepted conversion of parts of their deposit claims into shares and
deferment of the repayment of their residual deposit claims, generally for a minimum of
four years.25 The option for reconstruction avoided the wholesale liquidation of many
banks and proved significant in mitigating the impact of the crisis.26
On 3 May 1893 the NSW government passed legislation to make bank notes a first
charge on a bank’s assets27 and to enable notes of solvent banks to be declared temporar-
ily as legal tender.28 With the situation deteriorating, the latter measure was invoked
with respect to the four remaining NSW banks for six months from 16 May 1893.29 This
stopped the panic.30 On 26 May the Current Account Depositors’ Act 1893 was enacted
to deal with the issue of frozen deposits. It allowed the monetization of frozen deposits
by the issue of Treasury notes redeemable in gold within five years against a certificate
stating the credit amount in frozen accounts in suspended banks.
The Queensland National Bank suspended trading on 15 May. It was Queensland’s
most important bank and also held the government account. The Queensland govern-
ment introduced legislation on 25 May to place a prohibitive tax of ten percent on private
bank note issues,31 which forced their substitution by Treasury notes payable in specie on
demand at the Treasury.32 This was to become the prototype for the first Australian note
issue in 1910.
When the banking crisis in NSW and Victoria peaked in May 1893, it created some
nervousness in New Zealand but its direct impact was not significant.33 Nevertheless,
in light of the NSW banking legislation of May 1893 making bank notes legal tender,
preparations were seemingly made to introduce new banking legislation in New Zealand,
permitting banks to procure New Zealand legal tender treasury notes on the security
of debentures.34 These speculations were confirmed by the accidental release of a draft
‘Banks and Bankers Bill’.35 However, the government did not pursue the Bill in the belief
that there was no longer a fear of a financial panic in New Zealand.36
New banking legislation was triggered by a bank run that occurred on 1 September
1893 on the Auckland Savings Bank based on unfounded rumors that it was implicated
24
This had just been revised under the Companies Act Amendment Act 1892 (Vic) and the
Joint Stock Companies Arrangement Act 1891 (NSW).
25
Holder (1970) 454; Fitz-Gibbon and Gizycki (2001) 23.
26
Merrett (2013) 20.
27
Bank notes had previously been declared to be a first charge on a bank’s assets in Victoria
(The Banks and Currency Amendment Statute 1887 (Vic)) and South Australia (Bank Notes
Security Act 1889 (SA)).
28
Bank Issue Act 1893 (NSW).
29
Butlin (1961) 304.
30
Coghlan (1969) 1678.
31
Stamp Duties Act Amendment Act 1893 (Qld).
32
Treasury Notes Act 1893 (Qld). The Queensland government had issued treasury notes in
1866 to overcome its financial difficulties: Holder (1970) 324–5.
33
Butlin (1961) 312.
34
Otago Daily Times, 4 July 1893.
35
Evening Post, 21 August 1893.
36
Evening Post, 22 August 1893.

in the suspension of the New Zealand Loan and Mercantile Agency Company. On the
same day the government introduced the Bank Note Issue Bill.37 By contrast to the
previous draft Treasury note proposal, the Bank-note Issue Act 1893 declared bank notes
a first charge on a bank’s assets and provided the government with the power to declare
bank notes legal tender. The provisions were relied upon when the Bank of New Zealand
encountered financial difficulties in 1895 and was rescued by the New Zealand govern-
ment, which injected capital and became a shareholder.38
Consequently, neither the 1840s nor the 1890s financial crises resulted in the estab-
lishment of a central bank as a lender of last resort and a ‘banker’s bank’39 in either
Australia or New Zealand. Nor did clearing house associations, such as the Associated
Banks in Melbourne, develop into last resort lenders as had happened in the US. Instead,
reconstruction schemes, legal tender provisions and treasury note issues helped stabilize
the situation and resolve the crisis. With the exception of Queensland, the system of
private note issuing banks continued with little change. Nevertheless, the events had
highlighted that the banking system in the Australasian colonies required a degree of
government intervention in a crisis, raising the question of how these measures should
best be institutionalized. This paved the way in both countries for legislation to introduce
state-issued notes.
III. CENTRAL BANKING IN AUSTRALIA
1. Australian Notes and State Banking
On federation in 1901, the Constitution40 conferred legislative power for banking and
issue of paper money on the newly established Commonwealth parliament.
In 1910 an early measure of the incoming Labour government under Andrew Fisher
was the Australian Notes Act 1910, authorising the Commonwealth Treasurer to issue
‘Australian Notes’ and Treasury bills. Notes were legal tender payable in gold coin at
the Melbourne Treasury on demand. The Treasurer was to hold a gold coin reserve of
not less than 25 percent of the amount of Australian notes issued and a reserve of 100
percent for note issues in excess of £7 million. This latter constraint was removed in the
Australian Notes Act 1911. Effective July 1911, the government imposed an annual tax
of ten percent on private bank notes,41 thereby forcing them out of circulation. The Acts
financed the trans-continental railway, privately-held land in the federal capital territory,
37
New Zealand Herald, 2 September 1893.
38
Chappell (1961) 199, 204–5. The Bank of New Zealand was nationalized in 1945: Chappell
(1961) 361.
39
Hawtrey (1970) 116.
40
Commonwealth of Australia Constitution section 51 confers the power to: ‘make laws for
the peace, order, and good government of the Commonwealth with respect to: (xiii) banking,
other than State banking; also State banking extending beyond the limits of the State concerned,
the incorporation of banks, and the issue of paper money; . . .’. The federal legislative power also
extends (see section 51(xii)) to ‘currency, coinage, and legal tender’.
41
Bank Notes Tax Act 1910 section 4.

land and buildings in London and other activities.42 By 1914, interbank settlement had
transitioned to clearing in Australian notes rather than gold, avoiding some of the cost
of storing and moving coins.43
The Fisher government also established the long debated state bank through the
Commonwealth Bank Act 1911 as a statutory body corporate.44 It functioned as a trading
and savings bank and managed the Commonwealth government account. Like the private
banks, it lacked the right to issue its own notes, which remained Treasury’s monopoly. It
had no special powers over the private banks.
An important structural change to the Australian monetary system occurred as the
result of World War I. From July 1915 a prohibition was placed on the export of gold.
This remained in place until April 1925 when Australia, New Zealand and England
returned to the gold standard. While Australian notes were legally still convertible into
gold, the government suspended the convertibility of notes, albeit attempting to conceal
the fact. The Treasury did not allow banks to redeem notes for gold. However, no official
statement in relation to the inconvertibility of notes was made and the responsibility for
refusing gold for notes was shifted to the banks. Australian notes became, for practical
purposes, inconvertible.45
The government significantly increased the issue of Australian notes by various credit
facilities during the war, when the bank holdings of Australian notes increased from about
£5 million in 1914 to £35 million in 1920.46 This monetization of state debt resulted in
significant consumer price inflation.
In 1920 legislation was passed to transfer the Australian note issue from Treasury to
a newly created Note Issue Department of the Commonwealth Bank, which was to be
kept distinct from all other departments within the Bank.47 One political motive was
apparently a desire to avoid potentially controversial and unpopular actions arising
from the note management being associated with the government.48 The note issue was
controlled by a Board of Directors constituted by the governor of the Bank as ex officio
chairman, an officer from Treasury and two persons unconnected with the Bank or
Treasury. The Act did not articulate policy goals, although the Board reportedly pursued
a strong anti-inflationary policy,49 which created liquidity constraints in Australia as the
Board refused to lend on the security of the banks’ London funds. These had reached
the highest ever reported level but could not be repatriated due to the embargo on gold
42
Butlin (1961) 347.
43
Holder (1970) 553.
44
The Report of the Royal Commission on State Banking, Victoria (1895), which is regarded
as the most exhaustive assessment of the need for state banking in the mid-1890s (Gollan (1968)
60), recommended the creation of a state bank in 1895 in order to improve credit conditions for
farmers. State control of currency and state banking remained important planks of Labour party
election platforms in the 1890s (Gollan (1968) 43) and later of the Australian Federal Labour
movement.
45
Commonwealth of Australia (1937) 43; Holder (1970) 575; Butlin (1961) 357–58.
46
47
Commonwealth Bank Act 1920 section 7, inserting section 60C into the Commonwealth
Bank Act 1911–1920.
48
Coleman (1999) 162, quoting Polden (1977).
49
Coleman (1999) 165.

exports from England.50 Consequently, the buying rate for bills on London in Sydney fell
by October 2014 to £96 10s per £100 of sales proceeds in London.51 This represented a
loss to primary producers.
By the end of 1923, the Notes Issue Board’s economic management attempts had
antagonised both trading banks and primary producers. Deciding to abolish it,52 the
government enacted the Commonwealth Bank Act 1924, enabling the Bank to take over
its function and empowering the newly created board of the Bank to issue notes to banks
in Australia on the security of their London funds,53 a facility the Notes Issue Board had
refused to provide.
2. Foreign Exchange
On 30 April 1925 Australia, New Zealand and England returned to the gold standard.
This differed, however, from the pre-war standard. Gold coin remained out of circulation.
In Australia, the prohibition on gold exports was lifted, but Australian notes remained in
practice inconvertible.54 More than half of Australian banks’ settlement assets were now
in the form of Australian notes, which were generally not accepted in payments outside
Australia. Although the money of account of Australia, New Zealand and England was
still identical in name, the underlying basis of the currency systems had permanently
diverged and no longer fulfilled the attributes of a common currency area.
This divergence was only fully recognized in 1930. In 1929, at the beginning of the Great
Depression, Australian export prices severely declined and the London market for long-
term government borrowing ceased. Drastic steps had to be taken to meet public debt and
import commitments. This was facilitated by the Commonwealth Bank Act 1929, which
empowered the Bank, on instruction of the Treasurer, to require the exchange of gold coin
and bullion holdings for Australian notes (exercised in January 1930). Further steps were
taken in August 1930, when the banks agreed to establish a voluntary mobilization pool
of their London funds so that priority could be given to overseas interest payments of
Australian governments.55 Further amendments to the Commonwealth Bank Act in 1931
included the temporary reduction of the note issue reserve below 25 percent to enable a
further release of gold for export.56 Significant amounts of gold were exported over this
period, depleting the banks’ gold holdings from £27 million in 1929 to £3 million in 1931.57
Despite these efforts, by January 1931 the banks’ buying rate for £100 payable in
London had been raised by the Bank of New South Wales to £130. This devaluation
had become necessary to compete with the outside market.58 Other trading banks and
the Commonwealth Bank fell into line. From December 1931, the Commonwealth Bank
50
Giblin (1951) 9–10; Gollan (1968) 157.
51
Giblin (1951) 7.
52
Coleman (1999) 168.
53
Commonwealth Bank Act 1924 section 18.
54
55
Giblin (1951) 70.
56
57
58
Viz: dealings between importers and exporters outside the banking system.

undertook the obligation to buy and sell London funds at a fixed rate, set at £125 Sydney
for £100 London in December 1931.59
The changes to the Australian monetary system were further institutionalised in the
Commonwealth Bank Act 1932. The Act widened the assets able to be held as note-issue
reserves to gold and ‘English sterling’.60 The obligation to redeem Australian notes in
gold coin was dropped61 and the notes were also formally rendered inconvertible.62 This
marked the end of gold coins as settlement assets. Australia had formally transitioned
from a common currency (£ sterling) to a sterling-exchange standard with the £ Australian
pegged to £ sterling at a fixed rate.63
For the Commonwealth Bank the events of 1929–32 marked what has been described
as the ‘first advance towards the status of an operative central bank’.64 The Bank became
more of a ‘banker’s bank’, insofar as it provided the balance of domestic settlement assets
(Australian notes and Commonwealth bank deposits) and managed the exchange rate on
behalf of the system.
3. Command Economy
Following the outbreak of World War II, the Commonwealth Bank began to play a
central role in restructuring the Australian economy into a command system capable of
mobilizing and directing activities towards the war effort and attained unprecedented
powers over the trading banks. In September 1939 the National Security Act 1939 came
into force and the government implemented capital controls65 and export and import
licensing. All purchases or sales of foreign exchange had to be approved by the Bank and
trading banks acting as its agents.66 National Security Banking Regulations were issued
in November 1941.67 These required banks to be licensed and to comply with the advance
policy laid down by the Bank. Moreover, banks had to lodge surplus investable funds68
in a special account with it, by selling government securities to it or by drawing on their
deposit account with it. Trading banks earned interest on surplus funds at a rate set by
the Treasurer. The surplus fund mechanism allowed control of trading bank profits and
contained the inflationary impact of war-related government expenditure.69
59
Giblin (1951) 128.
60
Commonwealth Bank Act 1932 section 2. ‘English Sterling’ included credits at the Bank of
England, bills of exchange payable in the UK, advances secured by bills of exchange payable in the
UK in UK legal tender, and UK Treasury bills.
61
62
Australian mints had ceased to mint coins from September 1931 (Commonwealth of
Australia (1937) 26).
63
Hence, Butlin’s (1961) 397 comment that the ‘century old . . . sterling-exchange standard’
devised by the London-based banks had been superseded is misleading. The year 1931 marks the
formal start and not the end of the sterling-exchange standard.
64
Plumptre (1940) 94.
65
Including postal censorship to control the movement of securities.
66
Giblin (1951) 265–66.
67
Ibid, 357–59.
68
Surplus investable funds were defined as £20m plus any increases in the trading bank’s assets
in subsequent years.
69
Giblin (1951) 285–87.

Resources and activities were redirected towards war efforts through the monetization
of government debt by the Commonwealth Bank and trading banks. For instance, the
sum of Commonwealth Bank holdings of government securities and all outstanding
Treasury bills increased four-fold from £117 million in 1939 to £502 million in 1945. By
1945, more than half of the trading banks’ assets were related to government lending.70
With the National Security legislation due to expire after the war and monetary control
deemed important to maintain full employment and low inflation, the Labour govern-
ment prepared legislation to replace the Commonwealth Bank Act with new legislation
embodying the principles of the war regulations. The Banking Act 1945 provided for a
continuation of the special accounts procedures and wide ranging powers, such as control
over the trading bank’s advance policy, profits (through interest on special accounts),
interest rates, foreign exchange and London funds. While this may appear unusual, the
legislation was broadly consistent with the recommendations made by the 1937 Banking
Commission71 and reflected the desire to manage the economy with a full employment
objective in the post-war years.
The Act also reshaped some governance arrangements. The Commonwealth Bank was
to be managed by a Governor, supported by an Advisory Council rather than a Board
of Directors.72 The requirement of the 1932 Act to hold a reserve of one-fourth of the
note issue in gold or English sterling was omitted.73 The Act also sought to clarify the
relationship between the Bank and government.74 If Bank and Treasurer could not reach
agreement on monetary and banking policy, the Bank had to adopt the government’s
policy. The latter had to take responsibility for its adoption. This provision has been
described as the ‘Chifley overwrite provision of 1945’.75 It was introduced by the Labour
Prime Minister and Treasurer Ben Chifley to avoid situations such as those encountered
during the Great Depression when the Bank had declined government requests to directly
finance relief for wheat growers and employment relief programs.76 For the first time,
the Commonwealth Bank Act 1945 defined the aims of central banking. These were
formulated in line with a broad macro-economic management agenda.77
The Commonwealth Bank Act 1951 reintroduced78 governance through a Board and
amended79 the clauses dealing with policy disagreements between Treasurer and Bank.
If irresolvable, disagreements about monetary policy had to be laid before Parliament.80
70
Ibid, 318, 355; Holder (1970) 864-5. There was no secondary market for Treasury bills.
71
Commonwealth of Australia (1937).
72
Commonwealth Bank Act 1945 sections 23, 25, 29.
73
Giblin (1951) 337–41.
74
Commonwealth Bank Act 1945 section 9. See now RBA Act section 11.
75
Bell (2004) 153.
76
Schedvin (1970) 241–42.
77
Commonwealth Bank Act 1945 section 8, requiring the Bank to exercise its powers so as
to best contribute to ‘(a) the stability of the currency of Australia; (b) the maintenance of full
employment in Australia; and (c) the economic prosperity and welfare of the people of Australia’.
See now RBA Act sections 10, 10B.
78
Commonwealth Bank Act 1951 section 7. See RBA Act Pt II, Div II, under which there is
now a Payments System Board in addition to the Reserve Bank Board.
79
80
Schedvin (1992) 150. See now RBA Act section 11.

The subsequent 1953 Act created greater separation between the trading and central
banking functions of the Bank81 amidst ongoing criticism from the trading banks that its
central bank powers and functions conflicted with its role as a competitive trading bank.82
However, under continuing political pressure and lobbying from the trading banks the
central bank functions were segregated into a separate institution in 1959 to be known
as the ‘Reserve Bank of Australia’. This was effected through a series of Acts, namely
the Reserve Bank Act 1959, the Commonwealth Banks Act 1959 and the Banking Act
1959.
The Banking Act 1959 provided the RBA with the previous war powers over advance
policy, interest rates and foreign exchange control.83 The special accounts regime was
replaced by a statutory deposit regime, requiring each trading bank to maintain a mini-
mum amount in a Statutory Reserve Deposit Account with the RBA.84 This system of
banking controls originating in World War II provided the key instruments of monetary
policy to the 1980s.85
4. Deregulation
By the mid-1970s the economic conditions had deteriorated, with the rate of inflation
reaching 17 percent in 1975 (June quarter CPI) and unemployment rising from 1.6 percent
in 1970 to 4.9 percent in 1975. Attempts to control inflation in 1974 by applying liquidity
constraints via increased statutory deposit ratios were abandoned, given the serious
financial difficulties they created for local businesses. An effective strategy for controlling
inflation was no longer in place.86
Another concern was the rise of non-bank financial intermediaries (‘NBFI’) such as
building societies and finance (hire-purchase) companies and a steady decline of the regu-
lated trading banks’ share of total assets.87 NBFI were not subject to banking controls and
could offer higher interest rates and provide lending facilities outside the controlled sector.
81
Schedvin (1992) 165.
82
A previous attempt to separate the central banking functions into a stand-alone entity was
the Central Reserve Bank Bill of 1930, which was subject to criticism by a Senate Select Committee.
Concerns included the exclusive state ownership structure of the proposed design; provisions allow-
ing unlimited and unsecured advances to government; and the poor timing of the Bill. These points
were largely consistent with the observations on the Bill by Otto Niemeyer (Bank of England), who
had been invited by the committee to comment on the Bill: see Select Committee Report upon the
Central Reserve Bank Bill, Commonwealth of Australia (1930). At the time, central bank theory
stressed the importance of independence from political pressures. Best practice designs included
private joint stock ownership structures and restrictions on lending to government: see Kisch and
Elkin (1930) 16–41, 43. The Bill was abandoned in 1931.
83
See division 5 of the Act.
84
Statutory Reserve Deposit (SRD) system: Schedvin (1992) 289; Cornish (2010) 33. The
SRD system was complemented by a voluntary Liquid Assets and Government Securities (LGS)
Convention, whereby banks held cash or Commonwealth Government securities above a certain
percentage of their deposit liabilities: Schedvin (1992) 196, 289; Commonwealth of Australia
(1981) 75.
85
Cornish (2010) 33.
86
Schedvin (1992) 513, 524.
87

This also limited the scope and effectiveness of monetary policy.88 Interest rate controls
had become counter-productive.89 Legislation was passed in 1974 to extend controls to
the non-bank sector as part of the Financial Corporations Act 1974, but Part 4 dealing
with extended controls was not declared due to waning support for direct controls.90
Instead, interest rate ceilings on bank deposits were removed in December 1980. This was
consistent with recommendations of the Campbell Inquiry into the Australian Financial
System,91 which had been important in achieving a consensus for change. Interest rate
ceilings on new housing loans were removed by 1986. Qualitative lending controls had
already begun to be discontinued in the 1950s.92 Quantitative lending guidelines were
removed in 1982.93
In line with the deregulation of interest rates, the issue of treasury bills and treasury
bonds was transitioned from a system with government predetermined rates to a tender
system with market determined rates in 1979 and 1982, respectively.94 Under the old
arrangement, government securities could be sold at below market rates because legisla-
tion had created a group of captive buyers such as trading banks, savings banks and
insurance companies, which were legally required to hold a large part of their assets in
government securities.
As a consequence, monetary policy came to rely on market operations rather than
minimum deposit requirements via the Statutory Reserve Deposit (SRD) mechanism.
Market operations were in the first instance conducted through sales/outright purchases
or repurchase agreements involving Commonwealth Government securities in the short-
term money market for same day/exchange settlement funds held as deposits by the
RBA.95 The SRD system was last used as an instrument of monetary policy in 1981.96
Another area of deregulation was foreign exchange. The Australian pound (and later,
after decimalization, the dollar) had been pegged against the English pound, US dollar
and later a trade-weighted index since formal recognition of the exchange standard in
1931. With exchange rate management becoming increasingly difficult, the decision was
taken to float the Australian dollar in December 1983.97
In the late 1980s, the Australian inflation rate was still higher than most other
Organisation for Economic Co-operation and Development (OECD) countries.98 A
wage-accord based strategy was used to contain inflation. However, added pressure
to reduce it was mounting from the New Zealand model, which had now a statutory
goal of reducing inflation. Moreover, in the context of a speculative boom in the late
1980s, the RBA began to realize that inflation was distorting investment decisions and
88
Reserve Bank of Australia (1991) 4.
89
90
Cornish (2010) 37.
91
92
93
Reserve Bank of Australia (1991).
94
Commonwealth of Australia (1981) 170; Macfarlane (1998) 8.
95
Reserve Bank of Australia (1985).
96
Reserve Bank of Australia (1991) 15. Prudential regulation was subsequently separated from
the RBA and transferred to the Australian Prudential Regulation Authority (‘APRA’).
97
Bell (2004) 25–27.
98
Ibid, 59.

creating structural issues.99 High inflation favored investments in property and other real

assets.
The floating of the dollar removed undesired money supply injections or withdrawals
from the RBA’s foreign exchange transactions, which had previously been required to fix
the rate. This provided the opportunity to tackle inflation.100 However, significant money
supply injections from government financing also had to be addressed. These were caused
by shortfalls in public borrowing that were traditionally met by loans from the RBA,
‘colloquially known as “printing money” or “monetizing the deficit”’.101
The principle of fully funding the government deficit by public tender of securities
was agreed in 1986 between Treasury and the RBA. Treasury bills were no longer
issued to the RBA to meet short term funding needs.102 This is to be considered an
historic step in Australia’s more recent monetary history. For the first time, fiscal
and monetary policy were separated. As the two ‘leakage’ points of foreign exchange
liquidity injections and government ‘money printing’ had been removed,103 the RBA
was finally able to restrict liquidity and influence economic activity via the supply of
settlement assets.
With the new framework in place, the RBA prolonged the 1991/92 recession to
bring down inflation.104 Subsequently, an inflation target of two to three percent was
developed by the RBA as a new nominal anchor of monetary policy105 following the
pioneering New Zealand model. This provided a much needed alternative to the previ-
ous monetary targeting regime and checklist approaches, which had been unsuccessful,
and brought the bank in line with other jurisdictions. The RBA approach to inflation
targeting was more flexible than that of the RB NZ (see below)—the RBA made clear
that inflation was not the only policy consideration and deliberately took a medium
term view, with the objective of achieving the target ‘on average, over the course of the
cycle’.106 Critically, this initiative for bringing down inflation was taken by the RBA. The
inflation target was adopted unilaterally by unelected officials.107 RBA independence
was subsequently reconfirmed by the Statement on the Conduct of Monetary Policy
99
Bell (2004) 67–68.
100
Both the Swiss National Bank and the German Bundesbank had demonstrated in the 1970s
that central banks could rapidly regain the ability to impose restrictions on the domestic money
supply and attain improved inflation outcomes once flexible exchange rates were introduced:
Baltensperger (2012) 229; Deutsche Bundesbank (1995) 26. Legislation limits or prohibits direct
and indirect loans to governments in both countries.
101
Macfarlane (1998) 8. This was an even bigger issue before the tender system for govern-
ment securities was introduced as the RBA had to make up the shortfall if sales proceeds were
insufficient: Reserve Bank of Australia (1993) 1. See already the Campbell inquiry: Commonwealth
of Australia (1981) 103, 110, 156, 160 on this issue.
102
The agreement was by an exchange of letters: Reserve Bank of Australia (1993) 3. While
the RBA continued to provide overdraft finance to manage mismatches in cash flows, additional
Treasury notes would be issued to discharge the overdraft in the next weekly tender: Reserve Bank
of Australia (1993) 4.
103
Macfarlane (1998) 7–8.
104
Bell (2004) 71.
105
Cornish (2010) 28–29; Macfarlane (1998) 14–16.
106
Stevens (1999) 48.
107
Bell (2004) 123.

in 1996.108 Significant institutional changes had been achieved, largely initiated and
implemented by the RBA, without changes to the RBA Act.
IV. CENTRAL BANKING IN NEW ZEALAND
1. New Zealand Notes and State Banking
The question whether New Zealand should have a state bank was formally revisited in a
Parliamentary committee in 1910. The State Bank and State Paper Currency Committee
concluded that a permanent partnership with the Bank of New Zealand, or an acquisi-
tion of the shareholders’ interests in it, was the preferred option109 and that a state paper
issue was inadvisable. Despite the Committee’s findings, the government announced in
October 1911 that it would give the state the sole right to issue notes and introduced the
New Zealand Notes Bill. The bill resembled the Australian Notes Act 1910,110 but was
abandoned following a change in government.111
The private banking system was again subject to emergency regulations at the begin-
ning of World War I when the bank notes of New Zealand’s six private banks were
declared inconvertible legal tender. The export of gold was prohibited.112 The legal tender
provisions under the Act were renewed and stayed effective until 1934 when RB NZ—the
Reserve Bank of New Zealand—started operations.113 Additional legislation extended the
note issue limit to the total of coin, bullion, government securities and other advances
such as war loans, Soldiers’ Settlement loans and wool advances.114 This was to incentivize
the six banks to make substantial investments in war loans and monetize state debt. As
a result of World War I, the underlying foundation of the New Zealand note issues had
significantly diverged from the pre-war common £ sterling system.
2. Foreign Exchange
The issue of a common state currency as an alternative to private bank notes was raised
again within the context of the 1930s exchange crisis. As we have noted in section III(1)
above, by the 1930s Australia had transitioned to a sterling exchange standard. A similar
system had been established in New Zealand via the control of London funds.115 However,
New Zealand and Australian systems were interdependent and relied on the joint actions
of the New Zealand, Australian and London-based banks (operating in Australia and
108
The Statement referred to ‘independence, as provided by the Act’. There is however no
formal declaration of independence in the RBA Act. The Statement thus appears in this respect to
add little to the legal position.
109
Chappell (1961) 268; New Zealand Herald, 25 November 1910.
110
See section III(1) in this chapter.
111
Chappell (1961) 268–69.
112
Banking Amendment Act 1914, Chappell (1961) 277.
113
It was established under the Reserve Bank of New Zealand Act 1933, as discussed in text
below.
114
Finance Act 1916, Finance Act 1917, Finance Act 1920; Ashwin (1930) 195.
115
Tocker (1924); Ashwin (1930).

New Zealand) as London funds were not separately accounted for or divided between
national boundaries.116 Following the lead of the Bank of New South Wales and pressure
from the non-bank market, the selling rate for £100 London funds in New Zealand was
raised by the banks from near parity in 1928 to £105 in April 1930.117
This perceived loss of sovereignty and the increased overseas borrowing costs, associ-
ated with a depreciated New Zealand currency,118 created a new rationale for the creation
of a central note issue. The establishment of a Note Issue Board was proposed by a New
Zealand Treasury official in 1930.119 In that same year, the New Zealand government
sought advice from Otto Niemeyer of the Bank of England, who recommended formal
adoption of a sterling exchange standard and management of a fixed exchange rate
through a central reserve bank rather than a note issue board.120
The Bank of New South Wales raised the exchange rate to £110 in January 1931 and
was followed by other banks operating in New Zealand.121 Faced with unfavorable condi-
tions on the London market for New Zealand government loans, a system for licensing
exports was introduced in December 1931. Banks joined an exchange pool and undertook
to provide London funds to the government to enable it to meet its sterling obligations.
This system also pegged the exchange rate at 110. In January 1933, with the depression
worsening, the government requested the Bank of New Zealand to fix the exchange
rate at NZ£125 5 £100 within the framework of the Banks Indemnity (Exchange) Act
1932–33.122 The measure had resulted from pressures from rural interest groups, who had
suffered from a fall in the value of exports during the depression123 and sought to benefit
from a higher premium on sterling. Similar to Australia, exchange rate management was
now used to mitigate the impact of the depression.
The Reserve Bank of New Zealand Act (‘RB NZ Act’) was passed in 1933 and the
bank began operations on 1 August 1934.124 Largely following Niemeyer’s design,125
the concept for the bank was that of an independent private concern, a bankers’ bank,
being the sole provider of legal tender notes for the country. A reserve of 25 percent
116
Holder (1970) 752; Ashwin (1930) 198–99. Ashwin, a New Zealand Treasury official, had
correctly observed that exchange for transfers between New Zealand and London had been fixed
at the same rate for at least ten years before 1914 and had been independent of marked variations
in the trade balance, which had occurred at the time. He concluded, based on that evidence, that
New Zealand had always been on an exchange standard: Ashwin (1930) 194. We argue that this is
correct for the period after 1914, but that New Zealand was part of a common £ sterling currency
system with Australia and England prior to that time, having similar attributes to those observed
by Ashwin.
117
Hawke (1973) 19; Holder (1970) 750.
118
The price for selling for £100 sterling of London funds in New Zealand as set by the banks
increased from £100/15/0 (15 Oct 1928) to £105/0/0 (3 Apr 1930) and £125/0/0 (20 Jan 1933): Hawke
(1973) 19.
119
By Ashwin (1930) 204; see also Hawke (1973) 20–25.
120
Niemeyer (1931). Niemeyer is seen as the originator of the central bank idea for New
Zealand: Hawke (1973) 29.
121
Sinclair and Mandle (1961) 190.
122
See Chappell (1961) 319, 324. This was the same exchange rate as the Australian rate.
123
Ibid, 318.
124
Hawke (1973) 50.
125
Ibid, 41.

was to be held126 against note and deposit liabilities in the form of gold coin, bullion,
sterling exchange and net gold exchange (non-sterling central bank balances and bills
of exchange payable in gold). The RB NZ was responsible for setting the price of the
sterling exchange as expressed in its notes.127 It kept the government account but the
level of government advances were restricted,128 limited to one-half of the estimated
yearly revenue in the case of the Treasury. It was to publish a discount rate and
discount, rediscount, buy and sell bills of exchange.129 The Act placed restrictions on
trade130 and, unlike the Commonwealth Bank of Australia, the RB NZ was actually
constituted as a bankers’ bank. Under the Act the banks had to hold deposits with
RB NZ of no less than seven percent of demand liabilities and three percent of time
liabilities.131 The Act provided that all gold coin and bullion holding had to be trans-
ferred to the RB NZ, for which banks received notes.132 In this way the New Zealand
gold reserves were centralised.
In practice, the powers of the RB NZ and its direct influence on the money supply
in New Zealand were rather limited.133 The bank could not vary the minimum
deposit requirements and discount facilities were rarely used.134 Moreover, minimum
deposit requirements stipulated in the Act were lower than the banks typical reserve
holdings of gold coin, bullion and government securities, and London funds prior to
the Act.135
The government’s influence over RB NZ was strengthened by the overhaul of the
legislation by the new Labour government through the Reserve Bank of New Zealand
Amendment Act 1936. The Act’s clear objective was to make the bank an instrument of
government policy.136 Its private ownership structure was abolished and its powers to lend
to government were expanded.137 The Act also allowed variation of the minimum deposit
balances held by banks.138 Foreign exchange powers were extended to include controls
over money transfers to and from New Zealand.139 Disagreements over the maintenance
of low interest rates and foreign exchange resulted in a further amendment in 1939, which
directed140 the bank to give effect to any decisions of the government.141
126
RB NZ Act 1933 section 17.
127
Ibid, section 16.
128
Ibid, section 14.
129
Ibid, section 13.
130
Ibid, section 14.
131
Ibid, section 45.
132
Ibid, section 15(2).
133
Hawke (1973) 58.
134
Sinclair and Mandle (1961) 212; Hawke (1973) 138–9.
135
Plumptre (1940) 118.
136
Graham and Smith (2012) 30.
137
Reserve Bank of New Zealand Amendment Act 1936 sections 2, 12, 14, 15.
138
Ibid, section 23.
139
Ibid, section 10(1).
140
Reserve Bank of New Zealand Amendment Act 1939 section 2.
141
Graham and Smith (2012) 30.

3. Command Economy
Despite the wide-ranging powers under the 1936 and 1939 legislation, the RB NZ only
became fully involved in the monetary policy when New Zealand established a command
economy during World War II. This involvement included the introduction of selective
controls for various classes of trading bank advances in 1942, which were executed
through the bank.142 Import control regulations requiring all imports to be licensed had
been put in place in 1938143 and the first systematic interest rate controls were introduced
during the Great Depression and continued during World War II.144 The government
controlled capital issues of all firms, making them more dependent on bank finance. Price
controls were also implemented.145
After the war, these controls became part of the structure of New Zealand economic
management. Wide-ranging controls over interest rates, bank advances policy and
foreign exchange were codified in the Reserve Bank of New Zealand Amendment Act
1960 and the consolidated Reserve Bank of New Zealand Act 1964. The Reserve Bank
of New Zealand Amendment Acts of 1970 and 1973 extended the scope of controls
to a broader range of financial institutions, including savings banks, building societies,
life insurance companies and other persons acting as financial intermediaries. These
controls included the requirement to hold government securities. Changes to section
8(4) as part of the Reserve Bank of New Zealand Amendment Act 1973 sought to
clarify the issue of direct loans to government, which had not been addressed in the
1964 Act. The added paragraph (4) in section 8 empowered the bank to make loans to
government ‘to ensure the continuing full employment of labour and other resources
of any kind’. General powers of direction were left with Parliament, with the govern-
ment’s monetary policy communicated to the bank for implementation, ‘promoting
the highest level of production and trade and full employment, and . . . maintaining
a stable internal price level’.146 In 1973, a reserve asset ratio system was introduced,147
requiring banks to hold a specific proportion of their deposit liabilities in the form
of Treasury bills and government securities. This also created a captive market for
government securities, which could therefore be issued at below market rates. Open
market operations were seldom used.148 Key elements of the Reserve Bank of New
Zealand Amendment Act 1982 were updates to interest and lending controls, updated
requirements for the holding of balances with the RB NZ as well as for the holding
of specified assets. This included their application to financial institutions other than
trading banks.
142
Hawke (1973) 141; Sinclair and Mandle (1961) 213–14.
143
Pritchard (1970) 364–65.
144
Chappell (1961) 310, 341; Quigley (1992) 221.
145
Chappell (1961) 342; Hawke (1997) 191.
146
Reserve Bank of New Zealand Amendment Act 1973 section 5, inserting a new section 8,
and in particular section 8(2) into the Reserve Bank of New Zealand Act 1964.
147
The variable reserve ratio was discarded in 1969.
148
Deane (1972) 13–14, 34; Reserve Bank of New Zealand (1981a); Hawke (1973) 164.

4. Deregulation
The regulatory system based on direct controls that emerged from the command economy
established in response to World War II meant that banks were significantly constrained.
However, the same constraints initially did not apply to other NBFI. This meant that
the share of trading bank assets in New Zealand markedly declined in the period from
1945 to 1965.149 By contrast to Australia, the legislators responded to this trend by
extending the monetary controls to NBFI, as is reflected in the Reserve Bank of New
Zealand Amendment Acts of 1970 and 1973. The Interest on Deposit Regulations of
1972 imposed comprehensive controls on deposit interest rates in NBFI. However, by
the mid-1970s it was recognized that interest rates controls ‘were creating serious impedi-
ments to the effective and efficient functioning of financial markets’.150 In March 1976,
the government decided to introduce a flexible interest rate policy. The Interest on Deposit
Regulations were revoked; the control of interest rates on, for instance, trading bank
deposits and overdrafts were removed.151 Nonetheless, the deregulation of interest rates
was incomplete. While rates on government securities had been increased, rates payable on
newly issued stock were still below market rates and below the rate of inflation. Moreover,
the continuation of credit rationing continued to push lending into unregulated channels.
In the year to March 1981, private mortgage lending via solicitors was estimated to
account for 25 percent of all registered mortgages. This meant that a substantial propor-
tion of lending activities had shifted to virtually unregulated but legal channels.152
The average annual rate of inflation over the quarters of the 1980–82 calendar years
was 16.2 percent. In a number of Bulletin articles (October 1982, March 1983 and
September 1983) the RB NZ began to take a position on the monetary effects of the
government budget deficit. It argued that the absolute size of the budget deficit was less
important than the methods adopted to finance the deficit, highlighting the fact that
direct government borrowings from RB NZ, trading banks, other M3 institutions and
overseas transactions were effectively monetising the budget deficit and increasing the
liquid reserves.153 This type of financing resulted in less control over money and credit
and ultimately a higher rate of inflation.154 The RB NZ estimates indicated that over the
1975–83 period on average about 46 percent of budget deficits (adjusted for transactions
without domestic impacts) had been monetized, at up to 5.9 percent of GDP. By contrast,
the bank argued that funding government deficits from non-financial institutions via
tenders at market rates did not create liquidity injections and were thus the preferred
method of financing the deficit.155 Similar to the Australian situation, liquidity injections
149
Holmes (1999) 14.
150
Quigley (1992) 223.
151
Reserve Bank of New Zealand (1981b).
152
Grimes (1998) 296–97.
153
For instance, by financing government deficits via overdraft on the government account
with the RB NZ: Reserve Bank of New Zealand (1982) 414.
154
Reserve Bank of New Zealand (1982) 411; (1983a) 71–72. Monetary financing is identified
as the major cause of inflation in a broader theoretical context by Heinsohn and Steiger (2013)
91–8.
155
Reserve Bank of New Zealand (1983a), (1983b) 387 including borrowing from trading
banks and other ‘M3’ institutions. At the time, the projected (unadjusted) 1984 deficit under a

through ‘money printing’ were identified by central bank officials as a major cause of the
high rates of inflation.
The government announced in March 1983 that it would transition to a tender system
where the volume was set by the government and the market determined the rates.
Tendering began in September 1983, but not all bids were accepted as the government was
not willing to pay more than 11 percent on conventional bonds.156
Efforts to put government financing onto a sounder basis overlapped with the reintro-
duction of comprehensive economic controls. Alarmed by inflation projections, labour
unrest and a predicted continuation of the wage-price spiral, the conservative government
under Prime Minister Robert Muldoon announced in June 1982 a 12 month wage and
price freeze and the reintroduction of interest rate controls.157 The return to controls was
not well received. The government was defeated in the July 1984 election.
The incoming Labour government initiated a sweeping set of reforms removing interest
rate regulations, credit ceilings, foreign exchange controls, ratio requirements for the hold-
ing of government securities and other interventions.158 The key instrument of monetary
policy became open market operations based on a regular government securities tender
program, later shifting to daily operations to manage settlement cash balances.159 An
important plank of the reform and stated objective of monetary policy became the
principle of fully funding the government deficit via the market to achieve better control
over the money supply. In post-election tenders the government accepted market rates.160
The New Zealand dollar was floated in March 1985, further enhancing the RB NZ’s
ability to restrict the money supply. After the float, the New Zealand government had
closed the two main money supply ‘leakages’161—money printing and foreign exchange
liquidity injections—that had constrained monetary policy in the past. Inflation peaked
at 18.9 percent in the June quarter of 1987 but reduced to single digits in December 1987.
In April 1988, in order to reduce inflation expectations, the government indicated it would
not be content with inflation settling at around five percent. By contrast, it was looking
to emulate countries like Japan, Switzerland and West Germany, which at the time were
the OECD countries with the lowest level of inflation. A notional inflation target of
around zero to one percent was indicated by the Finance Minister, Roger Douglas, in a
television interview.162 This was the origin of the inflation target. Import price reductions
due to an appreciated exchange rate163 and a consistently tight policy while the economy
was sliding into recession in 1988 brought the inflation rate down to one percent in the
Muldoon government was unusually large and projected at 9.5 percent of GDP. Funding included
a job program aimed at providing 3000–4000 jobs and tax relief for low income families.
156
Reserve Bank of New Zealand (1985) 437; Singleton (2006) 1453.
157
Singleton (2006) 1401. Consequently, the Reserve Bank of New Zealand Amendment Act
1982 includes updates to interest rate and lending controls.
158
Deane (1985) 368; Reserve Bank of New Zealand (1984a); Grimes (1998) 299.
159
Singleton (2006) 2576; Reserve Bank of New Zealand (1987) 201.
160
Reserve Bank of New Zealand (1985) 438. The November 1984 Bulletin could state that
‘given current institutional arrangements’ the government was no longer resorting to ‘the “printing
of money” as the residual means of financing its deficits’; Reserve Bank of New Zealand (1984b) 537.
161
Macfarlane (1998) 7.
162
On 1 April 1988; Reddell (1999) 67.
163
Hodgetts and Clemens (1989) 213.

December quarter of 1991. The Employment Contracts Act 1991 brought increased
flexibility into the labour market.
All major reforms were achieved without any further amendment to the then existing
legislation (as amended up to 1982). The Reserve Bank of New Zealand Act 1989 was
therefore not as radical as commonly perceived. It only formalised the essential elements
of these reforms.164 The main objective of the 1989 Act was to ‘Muldoon proof’ the
system; ie, to ‘implement a new institutional structure for monetary policy that would
prevent the misuse of the monetary printing press’.165 Section 8 was changed to focus
monetary policy on achievement and maintenance of price stability. The government
ultimately determines monetary policy but must do this in an accountable, open and
transparent manner. The mechanism is that the government specifies economic outcome
targets for monetary policy, which must be recorded in writing. The first formal Policy
Target Agreement (PTA) was agreed by the Minister of Finance and the Governor of the
Bank in March 1990. It specified the reduction of the CPI inflation rate to within zero
and two percent by December 1992.166
New Zealand’s monetary reforms were highly influential and the approach became
known as ‘inflation targeting’, which developed, formally or informally, into the de facto
standard for central banks around the world. Canada adopted inflation targeting in 1991
and the UK in 1992. Sweden, Finland and Australia followed in 1993. It has been argued
that the New Zealand model also had some influence on the design of the monetary policy
regime of the European Central Bank. The need to create an alternative to the Muldoon
regime of economic management became the platform for major public sector reforms, of
which the RB NZ formed an integral part. It should be noted that the RB NZ’s approach
to monetary policy was ‘eclectic’ and it did not advocate simplistic monetarism.167 An
inflation target was chosen because it appeared to be the best outcome-based measure
available and consistent with output objectives assigned to other public sector agencies as
part of New Zealand’s public sector reforms.168
V. LEGISLATIVE FRAMEWORKS
1. Ownership
Both the RBA and the RB NZ are constituted as bodies corporate by their own specific
Act. In each case, the Act continues in operation169 a body corporate established under
164
The 1986 amendment to the Reserve Bank of New Zealand Act 1964 had introduced
prudential supervision.
165
Singleton (2006) 3171.
166
The more recent 2012 and 2017 Policy Target Agreements set a target CPI inflation outcome
of one percent to three percent on average over the medium term, with a focus on keeping future
average inflation near the two percent midpoint. This widening of the target range demonstrates
some of the limitations of the inflation targeting approach. Central bank influence over prices is
indirect and limited (see also Decker (2017) 351, 353).
167
Singleton (2006) 2243–7.
168
Wood (1994) 68.
169
RBA Act section 7; RB NZ Act section 5.

earlier legislation.170 Neither the RBA nor the RB NZ have, in technical legal terms, an
‘owner’—no person holds shares in the body corporate.171 Yet it is common for each to be
described as ‘owned’. In fact, the banks themselves use that description. The RBA states
that it is owned by the ‘Commonwealth of Australia’; the RB NZ, by the ‘New Zealand
Government’.172
Much of course depends on the meaning attributed to ‘ownership’. If understood
in a looser sense than holding a legal ownership interest, characteristics pertain-
ing to ownership can be identified in the legislation. In Australia, for example, the
Commonwealth receives the annual net profits of the RBA,173 and is ‘responsible for
the payment of all moneys’ due by the RBA.174 In New Zealand, an annual dividend
is payable by RB NZ to the Crown.175 Application of a looser interpretation risks,
however, viewing other statutory rights, such as rights of Ministers to give directions,
as indicative of ownership rather than as potential restraints on independence. The two
should not be confused.
The legal structure of both banks can be modified by an amending statute. As sections
III and IV showed, this has happened throughout the development of each bank. The
legal environment is shaped by the will of a democratic parliament. As is typical of a
common law country but unlike some civil law countries,176 there is no constitutional
protection for either bank.177 Nonetheless, the fact that parliamentary control is not
necessarily the same as ‘government’ control signifies at an institutional level, at least in
theory, a degree of independence on the part of the banks from the government of the
day.
2. Powers
Each central bank obtains its original powers to act from its constituting legislation and
potentially additional powers from other statutes. Determining their scope is critical,
both from the technical perspective of precluding an act of the bank being challenged
under the legal doctrine of ‘ultra vires’, as well as from the more general perspective of
understanding the range of the bank’s functions.
170
In Australia, see Commonwealth Bank Act 1911 sections 5, 6 continued by Commonwealth
Bank Act 1945 section 7. In New Zealand, see Reserve Bank of New Zealand Act 1933 sections 3,
7 as amended by Reserve Bank of New Zealand Amendment Act 1936 section 4 and continued by
Reserve Bank of New Zealand Act 1964 section 3.
171
This has not always been the position historically, see section IV(2) ‘Foreign Exchange’.
172
See www.rba.gov.au/qa; www.rbnz.govt.nz ‘Research and Publications’, ‘Factsheets and
Guides’, ‘Ownership of the Reserve Bank of New Zealand’.
173
RBA Act section 30.
174
RBA Act section 77. The heading to that section describes this as a ‘Guarantee by
Commonwealth’, but the provision itself makes clear that no creditor or other claimant can sue the
Commonwealth in respect of their claim.
175
RB NZ Act section 162.
176
See Bank for International Settlements (2009) 59–60.
177
See in Australia, Commonwealth of Australia Constitution Act; in New Zealand, Constitution
Act 1986.

Potential impact of the doctrine of ultra vires

The legislation provides each bank’s capacity to act. Under a long established common law
principle an act done beyond the capacity of a body corporate is ‘ultra vires’ and hence void.178
The Acts differ in how they address this fundamental issue. Little protection is given
in the RBA Act, either for the RBA itself if it were to engage in an ultra vires action or
for third parties involved in that action.179 As a result, the RBA’s powers require broad
expression to counter arguments based on lack of power. A more modern approach
confining (if not wholly eliminating) the operation of the ultra vires doctrine is adopted in
New Zealand, where the RB NZ Act confers on RB NZ ‘the rights, powers, and privileges
of a natural person.’180
Both the Australian and New Zealand Acts describe the banks as a ‘central bank’,181
but neither defines that term. Although each Act confers express powers pertaining to
central banking, the teasing out of the possible scope of ‘central bank’ powers is left to
general techniques of statutory construction. These typically involve construing not only
the text but also the purpose of the legislation.182 Only the New Zealand statute, however,
articulates an express purpose.183
Determination of scope
Differences in legislative approach to conferring powers become evident in comparing the
RBA Act and the RB NZ Act. The latter tends to the more explicit, and arguably conse-
quentially, to the more prescriptive. It certainly imposes some boundaries between RB NZ
on the one hand, and the government on the other. Yet although no equivalent restrictions
on powers are found in the RBA Act, ultimate political control emerges through the
statutory mechanism for resolving differences of opinion between government and board
on policy matters.184
The RBA Act initially confers on the RBA ‘such powers as are necessary’ for the pur-
poses of the Act.185 This is obviously very broad, particularly given the lack of statutorily
178
Attorney-General v Great Eastern Railway Company (1880) 5 App Cas 473 at 481. Decisions
of the House of Lords are persuasive authority in both Australia and New Zealand.
179
RBA Act section 87 which precludes the validity of an act being called into question in legal
proceedings on the basis of non-compliance with the Act does not directly address questions of
ultra vires.
180
RB NZ Act, section 5(3). The risk is not wholly eliminated as there may be acts which a
central bank would do that an individual could not do.
181
RBA Act section 26; RB NZ Act section 7.
182
See Commissioner of Taxation v Unit Trend Services Pty Ltd [2013] HCA 16, (2013) 297
ALR 190, at [47]; in New Zealand, see Strategic Finance Ltd (in rec & in liq) v Bridgman [2013]
NZCA 357, [2013] 3 NZLR 650, at [46].
183
RB NZ Act 1989 section 1A: ‘The purpose of this Act is to provide for the Reserve Bank
of New Zealand, as the central bank, to be responsible for- (a) formulating and implementing
monetary policy designed to promote stability in the general level of prices, while recognising the
Crown’s right to determine economic policy; and (b) promoting the maintenance of a sound and
efficient financial system; and (c) carrying out other functions, and exercising powers, specified in
this Act.’ The Australian Act in its Long Title merely refers to the statute being ‘An Act relating to
the Reserve Bank of Australia, and for other purposes’.
184
RBA Act section 11. See Section III in this chapter.
185
RBA Act section 8.

stated purposes and definition of ‘central bank’. Furthermore, the conferral is also for
those of ‘any other Act conferring functions’ on the RBA. This includes, for example, the
Payment Systems (Regulation) Act 1998;186 Payment Systems and Netting Act 1998;187
and the Corporations Act 2001.188 It also includes the Banking Act 1959, which has
historically provided a statutory framework for controlling dealings in gold and foreign
exchange, as well as advances and interest rates.189
Although the provisions relating to gold ceased operation in 1976 and the Banking
(Foreign Exchange) Regulations were repealed in 2016,190 the Banking Act still contains
several powers which the RBA no longer currently exercises. Banking Act section 36
provides, for example, a power to determine policy for advances to be followed by
authorised deposit-taking institutions such as banks and credit unions. That power is
exercisable where the RBA is ‘satisfied that it is necessary or expedient to do so in the
public interest’.191 Furthermore, while the RBA now influences interest-rates through
determining the movement of the cash-rate, there remains in the Banking Act a power
for the RBA, with approval from the Treasurer, to make regulations for control of
interest-rates.192 These powers’ continued statutory existence leaves the door open for
future action. In fact, that door is capable of being opened very wide (or indeed forced
open on political impetus), given the general power vested in the Governor-General under
both the Banking Act193 and the RBA Act194 to make regulations ‘prescribing all matters
which . . . are necessary or convenient to be prescribed for carrying out or giving effect
to this Act’ and additionally, in the case of the RBA Act, ‘for the conduct of business by
the [RBA]’.
The RBA Act expressly sets out in Part II some nine general powers.195 They are: receiv-
ing money on deposit; borrowing money; lending money; buying, selling, discounting and
rediscounting bills of exchange, promissory notes and treasury bills; buying and selling
Commonwealth and other securities; buying, selling and dealing in foreign currency,
specie, gold and other precious metals; establishing credits and giving guarantees; issuing
bills and drafts and effecting money transfers; and underwriting loans. These general
186
Under the Payment Systems (Regulation) Act 1998 the RBA has power to designate pay-
ment systems and to impose access regimes, make standards, arbitrate disputes and give directions
to participants (see overview of its powers in section 10).
187
The RBA has power under the Payment Systems and Netting Act 1998 to approve on
the satisfaction of specified criteria such matters as payment systems (section 9) and multilateral
netting arrangements (section 12), and to declare that statutory provisions addressing close-out
netting do not apply when it is satisfied that ‘systemic disruption in the financial system’ could
result from a contracting party’s external administration (section 15).
188
Corporations Act 2001 Pt 7.3 in relation to clearing and settlement facilities; Corporations
Act 2001 Pt 7.5A with regard to Derivative Transactions and Derivative Trade Repositories.
189
See McCracken (2001) [109].
190
Formal foreign exchange provisions relating to mobilization of foreign currency are in
Banking Act 1959 sections 32–35.
191
Banking Act 1959 section 36(1).
192
Ibid, section 50.
193
Ibid, section 71.
194
RBA Act section 89.
195
Ibid, section 8(a)–(i). Section 8(j) also grants the RBA power to do anything ‘incidental to’
any of its powers.

powers are again expressed in broad terms and would appear to enable the RBA—were
it so minded—to ‘print money’ in the sense of lending to the government. There is no
prohibition equivalent to that found in German and Swiss legislation.196
As a matter of drafting, the RBA Act separates these general powers from those
contained in two other parts which are more overtly focused on central banking; viz Part
IV entitled ‘Central banking’ and Part V, ‘The note issue’.197 Part IV opens with section
26 which states very plainly that the RBA is ‘the central bank of Australia’, that it shall
‘carry on business as a central bank’ and, subject to the provisions of the Act itself and the
Banking Act 1959, ‘shall not carry on business otherwise than as a central bank’. While
this latter statement may appear to overly emphasise the role, it reflects the historical
concern by commercial banks in Australia that the bank, in its earlier incarnation as the
Commonwealth Bank, was a competitor.198
Only one express power relating to central banking is stated in Part IV of the RBA Act;
namely, the statutory power to ‘act as banker and financial agent of the Commonwealth’
contained in RBA Act section 27. Former more general powers relating to rural credits,
primary production, savings and industrial undertakings, and housing loans previously
contained in either the RBA Act itself or the Banking Act 1959 were gradually removed
from the remit of the RBA.199 Interestingly, although lending through the Rural Credits
Department (‘RCD’) was phased out by 1988,200 there was an unsuccessful attempt in
2013 by a private members bill201 to create a third board for the RBA in the form of an
Australian Reconstruction and Development Board. In its submission to a parliamentary
inquiry into the bill, the RBA contended that the financial markets remained better suited
to meeting the rural sector’s demands.202 Indeed, it maintained that a commercial lending
function remained inappropriate, besides pointing out it lacked ‘the requisite expertise in
regular commercial lending.’203
Adopting a different starting point from the RBA Act, the RB NZ Act sets out in Part
2, RB NZ’s functions and powers under the headings of ‘Monetary Policy’, ‘Foreign
Exchange’, ‘Currency’ and ‘Other functions and powers’. RB NZ’s primary function
is: to ‘formulate and implement monetary policy directed to the economic objective of
196
See section III n 100 in this chapter. Wood notes that legal restrictions were deemed as
‘[u]necessary in view of the PTA and the Government’s “full funding” commitment’ and undesir-
able because they could constrain liquidity management or lender of last resort operations (Wood
(1994) 65).
197
RBA Act section 34 confers power to issue, reissue and cancel ‘Australian Notes’.
198
When the RBA was established under the name of the Commonwealth Bank of Australia
under the Commonwealth Bank Act 1911, it specifically had the power to ‘carry on the general
business of banking’ (section 7(a)). See section III in this chapter.
199
See generally section III in this chapter.
200
See RBA, Submission to the Inquiry into the Reserve Bank Amendment (Australian
Reconstruction and Development Board) Bill 2013, February 2014, 5.
201
Reserve Bank Amendment (Australian Reconstruction and Development Board) Bill 2013.
202
See RBA, Submission to the Inquiry into the Reserve Bank Amendment (Australian
Reconstruction and Development Board) Bill 2013, February 2014, 4–5.
203
RBA, Submission to the Inquiry into the Reserve Bank Amendment (Australian
Reconstruction and Development Board) Bill 2013, February 2014, 5. In any event, the re-
establishment of a RCD would also have complicated monetary policy operations. Direct central
bank loans would have created liquidity injections that would have needed to be sterilized.

achieving and maintaining stability in the general level of prices.’204 In so acting, RB NZ

is required to have ‘regard to the efficiency and soundness of the financial system’.205 The
Act nonetheless makes provision for the bank to be given direction to do so for other eco-
nomic objectives.206 Such direction is given by the Governor-General acting on the advice
of the Minister and is seen as ‘significant’ in ‘uphold[ing] the right of the Government to
determine economic policy’.207 A similar interplay between the statutory roles of bank
and government is evident in the area of foreign exchange. The power to deal in foreign
exchange is granted ‘on such terms and conditions as [RB NZ] thinks fit.’208 The Minister
may, however, ‘for the purpose of influencing the exchange rate or exchange rate trends’
direct the bank to deal within prescribed guidelines.209 The Minister may also direct that
dealings are transacted at specific rates of exchange or within a range of rates.210
RB NZ has an explicit power to act as ‘lender of last resort for the financial system’
where it considers it ‘necessary for the purpose of maintaining the soundness of the finan-
cial system.’211 Leaving aside prudential supervisory powers, other core powers include
the power to issue bank notes and coins212 and ‘in accordance with an agreement with the
Minister’, to undertake the Government’s banking business.213 Interestingly, this latter
power is made subject to the Public Finance Act 1989. Although Part 6 of that Act imposes
restrictions on the Crown’s borrowing powers,214 it permits the Minister to borrow on the
Crown’s behalf if ‘it appears to the Minister to be necessary or expedient in the public
interest to do so’ and to do so from ‘any person, organization, or government’.215 These
explicit powers sit alongside some very general powers conferred by section 39 of the RB
NZ Act. These include carrying on the business of banking, issuing financial products,
giving a charge, entering into arrangements and obtaining assurances for carrying out its
functions and powers and generally carrying on business and exercising powers which can
be ‘conveniently’ carried on or exercised with its functions and exercise of powers.
204
RB NZ Act section 8. Private Member’s Bills in 2012 and 2013 to broaden this function to
include ‘maintaining an exchange rate that is conducive to real export growth and job creation’ were
defeated: Reserve Bank of New Zealand (Amending Primary Function of Bank) Amendment Bill
2012 clause 5, Reserve Bank of New Zealand (Amending Primary Function of Bank) Amendment
Bill (No 2) 2013 clause 5. This would have reintroduced economic management objectives resem-
bling those pursued in the 1980s.
205
RB NZ Act section 10(a).
206
RB NZ Act section 12. The period for which a direction is given must not exceed 12 months:
section 12(1).
207
Stephen Dawe (1990) 33. He observes more generally (at 36): ‘The objective of the legisla-
tion is not to make the Bank independent from the wishes of the Government of the day, but to
ensure that any changes in policy are made in an open and transparent manner.’
208
RB NZ Act section 16.
209
Ibid, section 17.
210
Ibid, section 18.
211
Ibid, section 31.
212
Ibid, section 25. This is stated to be a ‘sole right’.
213
Ibid, section 34.
214
Public Finance Act 1989, section 46.
215
Ibid, section 47.

VI. CONCLUSION
Central banking in Australia and New Zealand has a complex and fascinating history.
Unlike many other jurisdictions, central banks in these countries did not emerge organi-
cally as lenders of last resort.
A remarkable aspect of this history is the profound impact that the two World Wars
had on the monetary systems in both countries. The wars increased the influence of the
state over the monetary systems in each country. This triggered the breakdown of a free
banking system with a common £ sterling currency system, which had prevailed for over
100 years. Both governments used their central banks to establish command economies
that could reallocate and mobilise resources to suit the war effort. The Australian and New
Zealand central banks became effective as instruments of government policy and must
be regarded as ‘creatures’ of the state. As part of this process both central banks, for the
first time in their history, attained dominance over the entrenched and powerful private
banks. It is perhaps for this reason, that the institutional structures established during the
war were maintained well into the 1980s.
The reform efforts in both jurisdictions also provide particularly illuminating case
studies on the inflationary impact of monetising of government deficits. Both banks
made clear in the 1980s that they were ‘printing money’ and that this practice severely
limited their ability to restrict the money supply and led to unsustainable levels of high
inflation. They concluded that the fully funding of government deficits in the open market
at market rates was a necessary precondition for achieving low inflation. Indeed, after
the float of the Australian and New Zealand dollar and the full funding of government
deficits via the market had removed the major source of undesired liquidity injections,
both jurisdictions experienced inflation rates comparable to those of West Germany and
Switzerland. The central banks in the latter countries had led the development to low
inflation environments after the collapse of the Bretton-Woods system of fixed exchange
rates in the 1970s. This confirms the view that monetary systems where central banks
create settlement assets and payment instruments through market based operations and
behave like private note-issuing banks achieve better outcomes than those that rely on the
monetisation of state debt.216
Much has been made of the independence achieved by the RB NZ. The RB NZ became
a role model for other central banks, while the RBA was subject to criticism due to a
perceived lack of independence in the 1980s. However, one could argue that the RBA
has in fact always been more independent than the RB NZ. In Australia, an inflation
target was adopted and implemented unilaterally by unelected central bank officials.
In New Zealand, monetary policy including the inflation target was formulated by the
Finance Minister, which the bank was legally required to execute. The RB NZ is now
bound by a policy target agreement with the government, while the RBA is only subject
to government direction via an escalation procedure under section 11 of the RBA Act,
the ‘Chifley overwrite’. Moreover, the contribution of legislative changes to the economic
reform effort was insignificant. Reforms in both countries were carried out under exist-
ing statutory frameworks, which had their origin in the command economies of World
216
Type VII in Decker (2015) 942.

War II. Both banks retain wide ranging powers to this day. Unlike jurisdictions such as
Germany or Switzerland, a prohibition of lending to governments has, for example, not
been included in the respective central bank Acts. One could conjecture that a return
to monetary policies based on direct controls is still possible under current regulatory
frameworks.
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14. Central banking in Latin America: past, present
and challenges ahead
Luis I Jácome H
I. INTRODUCTION
The history of central banking in Latin America over the last 100 years features episodes
of inflation and hyperinflation, severe banking crises compounded with currency crises
and, in some cases, sovereign crises. This chapter deals with the evolving role of central
banks in the region and discusses the past, the present and the main challenges that lay
ahead.
To examine past and current central banking developments in the region, the chapter
identifies three key periods: the early years; the developmental phase; and the golden
years. The analysis highlights central banks’ institutional arrangements and the monetary
policy framework in place throughout those periods, and how they played a critical role in
the rise and fall of inflation and on periods of banking and currency crises.
The challenges facing Latin American central banks are associated with a legacy of
the global financial crisis that ignited a debate about a new paradigm for central banks.
This debate is taking place primarily in advanced economies,1 but is also gaining trac-
tion in Latin America. In the advanced economies, an increasing number of countries
are expanding central banks’ regulatory and supervisory responsibilities thus assigning
them a major role in preserving systemic financial stability. Also, in the aftermath of
the crisis, central banks in these countries have also been called upon to foster economic
activity amid growing dissatisfaction with the tepid economic recovery. Assigning cen-
tral banks a greater role in preserving financial stability may be well received in Latin
America, as a region that has been historically prone to banking crises. And, since
economic growth remains subdued, central bank policies may be required to also focus
on supporting economic growth. In addition, central banks in Latin America need
to confront regional-specific challenges and looming restrictions on monetary policy
independence in a post-crisis world of enhanced and volatile capital flows.
Following this introduction, the rest of the chapter is organized as follows: Section II
takes a quick historical journey through central banking in Latin America, stressing the
institutional foundations of monetary policy and the evolving policy framework. Section
III highlights central banks’ major achievements in recent years. Section IV gives a flavor
of current and future challenges facing Latin American central banks.
1
See Blanchard and others (2013) and Bayoumi and others (2014).
274

Central banking in Latin America 275
II. THE PAST
This section provides a historical perspective of central banking in Latin America. It

covers about 70 years, starting in the 1920s, when the first group of central banks was
created. Two periods are analyzed: the early years that lasted until the end of the Second
World War, and the developmental phase, which spanned from the post-war period to the
early 1990s.
1. The Early Years
The first group of central banks in Latin America were founded at the time the gold
standard was ruling the international monetary order.2 Most of these central banks were
established based on the recommendations provided by the Kemmerer missions.3 This
first group of central banks comprised the Reserve Bank of Peru, founded in 1922, and
the Bank of the Republic of Colombia, in 1923. They were followed by the central banks
in Chile and Mexico in 1925, and later in Guatemala, Ecuador and Bolivia in 1926, 1927
and 1929, respectively. Kemmerer’s recommendations included the creation of the central
bank with the monopoly of currency issue, the endorsement of the gold standard in
order to stabilize the value of the local currencies, the introduction of bank legislation to
regulate and supervise banks by a separate agency, and a reform of the public finances to
make them consistent with the goal of preserving the stability of the currency.4
Initial institutional arrangements

Central banks in Latin America had an auspicious start. Initially, the first group of
central banks benefited from a mostly favorable external economic environment. The
US—already Latin America’s main trade partner—was growing strongly (more than
three percent on average during the 1920s) while maintaining relatively low inflation (less
than one percent on average in the five years before the start of the Great Depression).5
However, central banks soon went through a bumpy period as they coped with the severe
impact of the Great Depression.
The first central banks in Latin America were designed to fulfill—explicitly or
implicitly—three key objectives: (i) to maintain monetary stability; (ii) to finance the
government on a limited basis; and (iii) to help preserve banks’ stability. Monetary
stability resulted from an orderly currency issuance associated with the rules of the gold
2
The term ‘gold standard’ is used throughout the paper, but it was actually the ‘gold exchange
standard’ that most Latin American countries endorsed. The latter allowed countries to convert
domestic banknotes into bills of exchange denominated in a foreign currency that was convertible
into gold at a fixed exchange rate.
3
Edwin W Kemmerer was an economics professor at Princeton who led missions of experts
to seven Latin American countries between 1917 and 1930 to advise on monetary and financial
sector issues. See Nurske (1985) for further explanations on how the gold exchange standard
operated.
4
For a deeper analysis of Kemmerer’s role on the creation of the first central banks in Latin
America, see inter alia Seidel (1972) and Drake (1989).
5
Some commodity prices, for copper, coffee and wheat, for example, were also performing
well.

BOX 14.1 KEY FUNCTIONS OF CENTRAL BANKS DURING THE EARLY

YEARS
Argentina: Chile: Colombia:

Law 12.155 (1935) Law 486 (1925) Law 25 (1923)
– Issue the domestic – Issue the national currency. – Issue the national currency.
currency. – Conduct rediscount and dis- – Conduct rediscount and
– Regulate the amount of count operations with banks discount operations with
money and credit in line and the general public. banks and the general
with the needs of the – Provide financial assistance public.
economy. to the public sector on a – Provide financial assis-
– Accumulate sufficient inter- limited basis. tance to the public sector
national reserves to moder- – Work as a fiscal agent. on a limited basis.
ate the adverse effects of – Receive deposits from – Work as a fiscal agent.
exports and foreign invest- banks, the public sector, and – Receive deposits from
ments and preserve the the general public. banks, the public sector,
value of the currency. – Provide clearing for and the general public.
– Preserve appropriate condi- payments. – Provide clearing for
tions of liquidity and credit – Define the rediscount rate. payments.
and apply the legislation on – Define the rediscount rate.
the banking system.
– Act as fiscal agent and
advisor for the management
of public debt.
standard, which also secured a stable exchange rate and, ultimately, an environment of low
inflation. Central bank financing of the government, although allowed, was constrained
by legislation. This prevented the repetition of previous episodes of generous—often
forced—financing to the government by private banks that enjoyed the privilege of
issuing local currency. In turn, by requiring commercial banks to be on a sound financial
footing in order to benefit from rediscount operations, central banks contributed to
maintaining financial stability.
Specific functions assigned in legislation included: (i) issuing the national currency;
(ii) discounting and rediscounting commercial paper and maintaining banks’ liquidity;
(iii) receiving deposits from the public sector, banks and the general public; (iv) working
as a fiscal agent and providing credit in limited amounts to the government; and (v)
providing clearance for payments (Box 14.1).
A second group of central banks was established after the collapse of the gold
standard in the early-1930s. This group included El Salvador’s central bank (1934),
Argentina’s (1935), and Venezuela’s (1939). The new central bank laws reproduced many
of the provisions existing in 1920s legislation. However, for the first time, they gave
central banks explicit responsibilities for controlling money and credit in the economy.
In Argentina, the central bank was called on to lean against the wind by accumulating
sufficient international reserves to moderate the adverse effects of external shocks—like
sudden capital outflows and negative terms of trade shocks—and preserve the value of
the currency (Box 14.1). This central bank also was tasked with regulating and supervising
the banking system. This dual responsibility—monetary policy and banking regulation

and supervision—was later replicated in the legislation that created the central banks of
Brazil, Paraguay and Uruguay. In contrast, in Chile, Colombia, Ecuador, Peru—under
the Kemmerer influence—and Mexico, the central bank was tasked only with monetary
policy, and banking supervision was assigned to a separate agency. These distinct insti-
tutional arrangements have been characterized as the ‘Atlantic’ and the ‘Pacific’ models,
respectively (Jácome and others, 2012b).
The initial composition of the central banks’ board of directors and the rules of the
gold standard provided some de facto independence to central banks. The board of direc-
tors included representatives of the government and the private banks. Thus, lawmakers
tried to prevent any single party, public or private, from being able to control central bank
policy decisions. While central banks were not created as politically independent institu-
tions, most did enjoy operational independence due to the policy limitations imposed by
the rules of the gold standard. Specifically, although monetary policy was envisaged to
be part of the government’s broad economic policy, the issuance of currency and, hence,
the expansion of credit, was limited by the requirement to back the new currency with
gold reserves. In addition, the private sector could not have access to unlimited central
bank financing either because the legislation introduced specific operational restrictions
in the provision of credit with the aim of protecting central banks’ financial soundness.
The policy framework during and after the gold standard

Because the exchange rate was kept fixed during the gold standard years, countries
maintained an open capital account to allow capital flows to adjust balance of payment
disequilibria. Countries set their exchange rate based on the rules of the gold standard.
The value of each currency was measured in terms of the amount of fine gold it contained,
and because such value tended to differ across countries, it was possible to establish bilat-
eral exchange rates.6 To support currencies’ convertibility, central banks in Latin America
issued banknotes only if they were backed by international reserves, mostly gold.7
The gold standard system imposed an automatic mechanism for adjusting to balance
of payment disequilibria. When countries were hit by either real or financial shocks and
international reserves declined, money supply also shrank as central banks sold gold. As
a result, the interest rate increased, thereby restricting aggregate demand and attracting
capital inflows, which would restore international reserves and money supply. Raising
interest rates, however, was a procyclical response, as it tended to dampen economic
activity on top of the effect produced by the negative shock.
Preserving the gold standard during the Great Depression imposed severe economic
costs. Thus, Latin America—like the rest of the world—eventually abandoned this
6
For example, because the sucre in Ecuador contained 0.300933 grams of fine gold in 1927
while the US dollar contained 1.504665 grams, the exchange rate was five sucres per US dollar
(Carbo, 1978). Similarly, since the Chilean peso contained 0.183057 grams of fine gold, the
exchange rate was about eight pesos per US dollar (Carrasco, 2009).
7
Legal provisions typically required that 50 percent of the banknotes be backed by the
so-called ‘legal reserves’, which generally included the sum of the central bank’s gold and foreign
currency convertible into gold. For example, the Central Bank of Chile could only issue notes for
as much as twice the amount of its gold reserves. A similar rule existed in Ecuador, Mexico, and
Peru. In Colombia, gold reserves were required to be 60 percent of banknotes.

monetary system in 1931 and 1932 amid deep economic contractions. Monetary policy
was then the only policy available to mitigate the adverse effects of the Great Depression.
Central banks implemented countercyclical policies to counteract the economic slump.
Measures included curtailing interest rates and implementing quantitative easing. Central
banks also expanded liquidity assistance to banks to avoid a financial panic—as it hap-
pened in the US at that time. In addition, central banks increased the financing of fiscal
deficits. This set of countercyclical measures helped Latin America restore economic
activity and bring inflation back to positive territory. However, central banks’ balance
sheets kept expanding, mostly due to persistent government financing, thus sowing the
seeds of higher inflation in the future.8
As countries abandoned the gold standard, central banks in Latin America gradually
acquired control over monetary policy. Countries increasingly imposed capital controls
and banned the exports of gold to help maintain exchange rate stability, and central
banks no longer had formal restrictions in place to ensure the convertibility of domestic
currencies. Countries could adjust the exchange rate as needed although, in practice,
they kept most of the time the exchange rate pegged to the US dollar and made few
discrete devaluations.9 Due to the inception of capital controls, monetary policy became
more controllable, and thus countries expanded their monetary policy toolkits. Changes
in rediscount rates started to loose popularity and, alternatively, pioneered by Mexico,
central banks began to use changes in reserve requirements.10
By the early 1940s, inflation in Latin America was rising slowly—reinforced by
imported inflation, as prices in the war economies were also creeping up—reaching
double-digit rates in several economies.
2. The Developmental Phase
After the Second World War, the Latin American central banks—in particular in South
America—expanded monetary policy as part of the state-led development strategy
of import-substitution industrialization that had gained traction since the late 1930s.
Despite the restrictions imposed by the Bretton Woods system, established in 1944,
central banks gradually turned into development banks, tolerant of inflation and focused
8
In Chile, for instance, financing of the government occurred primarily to tame the economic
contraction stemming from the Great Depression in the early 1930s, followed by the extension of
credit lines to other public sector institutions. In Peru, credit to the government was particularly
large: it increased more than threefold between 1933 and 1938, and rose another 300 percent by
1944 (Jácome, 2015).
9
In Chile, the exchange rate depreciated significantly in 1932 as the value of the peso jumped
from 8.2 to 16.5 per US dollar (Carrasco, 2009). Colombia depreciated the peso 19.1 and 30.4
percent in 1933 and 1934 (Banco de la República, 1990), whereas in Ecuador, the sucre depreciated
several times, from 5.48 to 14.04 per US dollar between 1932 and 1944 (Banco Central del Ecuador,
1997).
10
The Bank of Mexico changed the reserve requirement rate within the range of three percent
and 15 percent from 1936 onward, and between 15 percent and 20 percent from 1941 onward.
Argentina also changed reserve requirements in 1936. An increased use of reserve requirements
was followed by Venezuela in 1940, Nicaragua in 1941, and Costa Rica in 1943, among other
countries.

BOX 14.2 KEY MANDATES OF CENTRAL BANKS DURING THE

DEVELOPMENTAL PHASE
Argentina: Chile: Colombia:

Law 25.120 (1949) Decree-Law 106 (1953) Decree 756DE (1951)
– Regulate the amount of – Encourage the orderly and – Conduct monetary, credit,
money and credit in order progressive development of and exchange rate policies
to secure conditions to the national economy through with the aim of fostering
preserve a high level of credit and monetary policy, the appropriate condi-
employment. avoiding any inflationary or tions for an orderly and
deflationary tendencies, and fast development of the
thus permitting the maximum Colombian economy.
use of the country’s productive
resources.
on economic growth. The result was persistent and increasing inflation, which in some
countries became an endemic problem that eventually reached hyperinflation levels.
New central bank mandates

To reflect the new economic strategies and the new international monetary order, a wave
of central bank reforms took place in Latin America and additional central banks were
created. There was a general sense that the existing legislation was obsolete and imposed
unnecessary constraints on the governments’ economic strategy, which had become more
interventionist. Thus, central banks were called upon to support inward-oriented growth.
While some of the new laws also made references to inflation in general, promoting
economic development was the overriding policy objective of monetary policy (Box
14.2). The Central Bank of the Republic of Argentina was assigned a double objective,
namely to regulate the amount of money and preserve a high level of employment, similar
to the US Federal Reserve. In addition, new central banks were established during the
developmental phase, in Cuba and the Dominican Republic in the 1940s, and in Costa
Rica, Honduras, Nicaragua and Paraguay in the 1950s. In the 1960s, the Central Bank
of Brazil and the Central Bank of Uruguay finally became stand-alone central banks.11
The new legislation also modified the governing structure of some central banks. With the
change in the policy objective and a greater role of governments on monetary policy, the
public sector increased their representation on central bank boards. Moreover, in some
cases, the executive branch became directly involved in monetary policy decisions, beyond
its presence on central banks’ board of directors. For instance, in Chile, starting in 1953,
changes in reserve requirements were approved by the Minister of Finance and, in some
cases, by the President of the Republic. The same happened in Nicaragua and Uruguay
starting in the 1940s. In Argentina, the National Economic Council was assigned from
1947 onward a direct role in formulating credit regulations, leaving to the central bank the
operational responsibility to implement those decisions. Moreover, the 1949 reform to the
11
Until then, state-owned banks—the Banco do Brasil and Banco Republica Oriental del
Uruguay—conducted both commercial bank and central bank responsibilities.

central bank law made the Minister of Finance the President of the Board of the central
bank, which implied that the government took full control of monetary policy. Thus,
during the developmental phase, any vestige of central bank independence disappeared.
Later, in the mid-1970s, two pieces of central bank legislation were passed, which were
part of national political projects. In Argentina a new law put the central bank completely
under government control.12 As a result, the central bank provided credit to the private
sector under specific government guidance that aimed at ‘increasing production and at
securing the highest standard of living and collective happiness’ (Central Bank of the
Republic of Argentina, 1973 Annual Report). It also extended credit to the government,
increasing almost 130 percent in 1973—well above the inflation rate of about 60 percent
in the same year. The central bank reform in Chile also put monetary policy under full
government control as part of an economic reform promoted by the autocratic govern-
ment in power.13
Monetary policy during the developmental phase

While the formulation of monetary policy was broadly aligned with the government poli-
cies during the developmental phase, it was initially restricted by the rules of the Bretton
Woods system. The Bretton Woods system required countries to maintain fixed yet
adjustable exchange rates and to commit to the convertibility of their currencies against
the US dollar, which was the new reserve asset—like gold in the gold standard system.
The new exchange rate regime was the cornerstone of monetary policy across the world.
The exchange rate peg was complemented by a vast array of capital controls, which opened
the possibility for central banks to enjoy an independent monetary policy and, thus, to
potentially manage monetary aggregates. Capital controls allowed domestic interest rates
to deviate from international interest rates—even after factoring in risk premiums.14
The controls were complemented by numerous exchange restrictions, which were used
to allocate scarce foreign exchange to priority sectors, in line with the inward-oriented
growth strategy.15 These restrictions also served to postpone exchange rate adjustments,
as countries preferred to raise tariffs or introduce export subsidies as a way of implicitly
devaluing the currency. Currency devaluations were a last resort measure.
This policy framework established a close link between monetary imbalances and
changes in international reserves. Because countries maintained a fixed exchange rate,
expansionary monetary policy resulted in current account deficits, which had to be
financed with international reserves given that the capital account was virtually closed.
Thus, in order to prevent an excess of money supply that would drain international
reserves, central banks’ credit to the private sector and the government must be kept in
check.
However, due to the influence of governments, the main focus of central bank policies
12
See Law 20.539 from 1973.
13
See Law 1078 from 1975.
14
Capital controls had already been established in the 1930s following the collapse of the gold
standard, but they were expanded during the Bretton Woods regime.
15
Common restrictions included import licenses and advance deposits, quotas, and prohibi-
tions; licenses for payments of services; taxes charged over the exchange rate for different types of
imports; and a surrender requirement of export proceeds to the central bank.

turned away from controlling inflation and toward fostering economic growth. Central
banks extended credit through the banking system to priority sectors selected by the
government. Central banks also became the most important source of government
financing. While monetary instruments were, in theory, aimed at controlling monetary
aggregates to keep external imbalances and inflation in check, in practice, central banks
put more emphasis on financing specific economic activities, in particular, agriculture,
industry and housing.
With a mandate of fostering economic development, central banks expanded their
monetary policy toolkit. Central banks allocated credit by rediscounting commercial
banks’ paper with the aim of financing so-called ‘productive activities’. Interest rate
differentials were also established to promote specific economic activities and to favor
operations of state-owned financial institutions. In turn, central banks used unremuner-
ated reserve requirements, together with quantitative controls on credit to prevent the
buildup of monetary imbalances and, more generally, to contain inflation. Central banks
continued using rediscount operations, but mostly to assign credit to selected economic
activities. Reliance on open market operations was not popular in Latin America until
the 1960s.
Simultaneously, many central banks deepened their financing of the government at
preferential interest rates (often negative in real terms). With monetary policy mostly
focused on channeling resources to specific sectors and financing the government, central
banks’ balance sheets expanded rapidly, in particular in South America. In Argentina,
domestic assets rose more than 200 times, and almost tripled in real terms between 1950
and 1970. Similarly, in Peru, domestic assets multiplied by more than 15 times and more
than tripled in real terms in the same period. The main drivers of this expansion were
rediscount operations to commercial banks in Argentina, and credit to the government
in Peru and in Argentina from the late 1950s onward.
This expansionary monetary policy fueled inflation, which, eventually, became
endemic, especially in Argentina, Brazil, Chile and Uruguay. A stylized explanation of the
money-inflation link points to the policy of abundant credit granted to the private sector
and, specially, the government, which fueled aggregate demand and inflation pressures.
Inflation, in turn, also contributed to the increase in money supply in order to preserve real
money balances, thus creating a mutually reinforcing feedback. The close co-movement
of inflation and money supply in Brazil and Chile during 1946–70 illustrates this point.
The exchange rate was an important channel of transmission of the money-inflation link
during this period because the provision of credit in large scale fed external imbalances,
which, eventually, led to currency devaluations.16 Thus, the use of monetary policy for
development purposes proved to be inconsistent with maintaining the fixed exchange rate
regime required by the Bretton Woods system and, hence, Latin America resorted to the
International Monetary Fund (IMF) to support balance of payment problems. During
1954–70, Latin America requested 132 Stand-by Arrangements from the IMF, most of
them during the 1960s.
By the late 1950s, inflation inertia had become entrenched in this group of countries.
Backward indexation was common in private contracts and wage negotiations. As a
16
See Jácome (2015).

result, countries exhibited hysteresis, as most prices in the economy tended to adjust
based on past information, reinforced by expansionary fiscal and monetary policies, thus
making inflation a persistent process. Exchange rate depreciations became common and
frequent, creating a vicious cycle of inflation-devaluation-inflation. Reducing inflation
in those countries therefore required a comprehensive approach, addressing not only the
lax monetary and fiscal policies, but also the process of price formation and indexation.
This turned out to be a difficult and drawn out process in many countries. Adjustable
peg regimes (crawling peg) were introduced in the second half of the 1960s to cope with
persistent high inflation in countries like Argentina, Brazil and Chile. Crawling pegs were,
however, a passive exchange rate regime in the sense that the rate of adjustment was set
to close the gap between external and domestic inflation to avoid large real appreciations
and to limit the buildup of large current account deficits in an environment of external
financial constraints. Crawling pegs also reinforced inflation inertia.
The collapse of the Bretton Woods monetary system in the early 1970s marked the
beginning of an era when countries were allowed to choose their exchange rate regime.
The multiplication of flexible exchange rate regimes in advanced countries created incen-
tives for a new wave of cross-border capital flows and the enhancement of international
capital markets. In Latin America, countries gradually started to relax capital controls to
become more integrated with the major financial centers. Many countries received fresh
capital inflows, which translated into dollar credits mostly, fostering the dollarization of
the economies and the expansion of fiscal and external disequilibrium.17
At the same time, the surge in oil prices in the mid-1970s pushed up inflation across
the world, including in Latin America. Inflation also rose in the oil-importing economies
fueled by the increase in world energy prices. Even oil-exporting countries that subsidized
the price of energy and were able to maintain a fixed exchange rate experienced higher
inflation as a result of the increase in aggregate demand induced by the windfall gains
(Table 14.1). Argentina and Chile were special cases, as populist macroeconomic policies
pushed inflation to record highs—more than 500 percent in Chile in 1974 and about 450
percent in Argentina in 1975. As inflation soared, these countries turned to stabilization
policies, implementing for the first time some sort of forward-looking monetary policy,
the so-called ‘tablita’ arrangements.18
By the early 1980s, most countries in Latin America suffered a debt crisis, which lasted
until the end of the decade. Most Latin American countries had accumulated large
external obligations to finance fiscal and external imbalances in the second half of the
1970s. In response to the surge in interest rates in the advanced economies, capital inflows
reversed and large devaluations materialized, hitting the dollarized balance sheets of
17
International liquidity had increased, as the so-called ‘petro-dollars’ were recycled from the
oil-exporting countries that had benefited from the surge in the world oil prices.
18
The new policy was aimed at breaking inflation inertia by using the exchange rate as a
nominal anchor. It consisted of pre-announcing a crawling peg, specifying a daily decreasing pace
of devaluation. Despite some initial success, the ‘tablita’ program was ultimately not sustainable.
Neither inflation nor interest rates declined at the same pace as the pre-announced rate of devalu-
ation. As a result, the domestic currency became increasingly appreciated and ultimately large
depreciations took place. For a comprehensive analysis of the ‘tablita’ experiments see Corbo
(1985) on Chile and Fernandez (1985) on Argentina.

Table 14.1 Inflation in Latin America in the 1960s and 1970s (average annual
percentage rate for the period)
1960–64 1965–69 1970–74 1975–79

High-inflation countries
Argentina 23 23 38 228
Brazil 57 31 20 41
Chile 25 25 198 150
Uruguay 27 73 58 60
Commodity-exporting countries
Colombia 12 9 16 24
Ecuador 4 5 12 12
Peru 7 12 9 44
Venezuela 1 1.5 4 9
Low-inflation countries
Costa Rica 2 1.5 12 8
Guatemala 0.1 1 7 11
Sources: Argentina and Chile: Braun-Llona and others (2000); Brazil: IGP-DI, FGV; Colombia: Banco de
la Republica (1990) and IMF, International Financial Statistics; Costa Rica: ECLAC; Ecuador: Central Bank
of Ecuador (1997); Guatemala: ECLAC; Peru: Banco Central de Reserva; Uruguay and Venezuela: IMF,
International Financial Statistics.
firms, banks and the government and thus leading to a triple crisis—currency, banking
and sovereign—that pushed inflation to unexpected heights.
Central banks were at the center of the policy response to the debt crisis. They provided
exceptional monetary support to assist ailing banks, restructure the financial system and
support borrowers. In turn, governments implemented income policy and price controls
with the intention of tackling inflation inertia, as well as fiscal adjustment. However,
fiscal tightening faltered in most cases and, therefore, the exchange rate plunged and
inflation—which initially had declined—eventually rebounded to even higher levels. The
simultaneous currency, banking and sovereign debt crises took a large toll on the Latin
American economies. Economic growth took a hit and became negative in most countries,
such that it took several years for countries to bring back output level to the pre-crisis
long-term trend.19 In turn, inflation accelerated across the region: Argentina, Brazil,
Mexico and Peru reached three-digit inflation. In response, stabilization policies were
implemented, but they went through a stop-and-go cycle, as they were often aborted at
an early stage and followed by new adjustment policies.
In sum, the developmental phase of Latin American central banking proved to be
mostly a dark period. The central banks’ mandate and the formulation of monetary
policy were subordinated to the governments’ developmental goals with no commitment
to fighting inflation. Rather, their actions were geared to financing predetermined eco-
nomic activities, including government spending, and to keeping interest rates artificially
low to favor an orderly development of the economy—a policy objective established in
19
See Jácome (2015).

the central bank legislation. The result was increasing inflation in many countries, well
above that in the rest of the world.
III. THE PRESENT: THE GOLDEN YEARS
Most central banks in Latin America have delivered low inflation during the past 15 years.
This outcome is the result of far-reaching reforms of central banks’ institutional and
policy frameworks, with the support of sound fiscal policies and of decreasing external
inflation. The emerging markets in the region have also kept financial stability in check,
after suffering a number of full-fledged financial crises.
1. Central Bank Independence
The 1990s in Latin America marked a turning point for monetary policy. After more than
50 years of burdening central banks with multiple objectives, they were finally granted
political and operational independence to focus on abating inflation. Countries accepted
that the main contribution of monetary policy to economic growth was to achieve and
preserve low and stable inflation—as it reduced uncertainty in consumers’ and investors’
decisions.
In a region battered by decades of high inflation, a comprehensive monetary reform
was necessary. All Latin American countries except Brazil approved new central bank
laws—starting with Chile in 1989 and throughout the 1990s and early 2000s.20 Central
bank independence was the backbone of this reform as a way to avoid the inflationary
bias stemming from political influences on monetary policy. The structural reforms
implemented from the second half of the 1980s onward bore its fruits, as they helped to
improve resource allocation and to keep inflation low.21
Although the scope of the new central bank legislation varied across countries, it had
four common elements: first, a new central bank remit was established, establishing as
primary objective to fight inflation (Box 14.3). To minimize the chances that a future law
would dilute the focus on price stability, countries like Chile, Colombia, Mexico and Peru
enshrined the new mandate in the constitution. Second, central banks were granted political
independence to formulate monetary policy, with the aim of untying monetary policymak-
ing from electoral calendars; the new laws called for the central banks’ boards of directors
to be independent of the government. In most cases, the reform established restrictions on
the removal of the board members except through procedures whereby the legislative or the
judicial branch approved dismissal on grounds strictly codified in law. Third, central banks
were also granted independence to execute monetary policy, allowing them to increase or
reduce their short-term interest rates to tighten or loosen monetary policy without govern-
20
El Salvador approved new central bank legislation in 1991; Argentina, Colombia, Ecuador,
Nicaragua and Venezuela in 1992; Mexico and Peru in 1993; Bolivia, Costa Rica, Paraguay and
Uruguay in 1995; Honduras in 1996; and Dominican Republic and Guatemala in 2002. Brazil did
not reform the law, but the central bank has enjoyed most of the time de facto independence, as the
government refrained from exerting influence on monetary policy decisions.
21
Jácome and Vázquez (2008) provide empirical evidence of its positive impact on inflation.

BOX 14.3 A NEW MANDATE FOR LATIN AMERICAN CENTRAL BANKS
In the 1990s, all countries in Latin America except Brazil enacted new central bank legislation.
Central banks’ mandate focused on preserving price stability.
Argentina: Chile: Peru:

Law 20.539 (1992): Law 18.840 (1989): Organic Law 26123 (1993):
– Single objective is to Look after the stability of the Preserve monetary stability.
preserve the value of currency and promote the
the currency. normal functioning of internal
and external payments.
Colombia: Bolivia: Mexico:
Law 31 (1992): Law 1670 (1995): Organic Law of 1993:
– Preserve the purchasing – Preserve price stability. Primary objective is to seek the
power of the currency. stability of the purchasing
power of the currency.
Promote sound development of
the financial system and
proper functioning of the pay-
ments system.
ment interference. The new legislation also restricted and even prohibited central banks
from financing government expenditure, historically the chronic source of inflation. Fourth,
central banks were held accountable with respect to their policy objective.22
The reforms granted Latin American central banks broad independence both from
a historical perspective and by international standards. A modified Cukierman, Webb
and Neyapti index of central bank independence23 shows that following the reform of
the 1990s, there was a marked increase in central banks’ independence in Latin America
(Jácome and Vázquez, 2008), taking it to a level that was high compared to other emerging
markets (Canales and others, 2010).
In the years that followed the introduction of central bank independence in Latin
America, inflation declined across most of the region. Yet, contrary to conventional
wisdom, causality from central bank independence to a decline in inflation has not been
established formally.24 Moreover, causality seems to run in the opposite direction, as
inflation was already declining before central bank legislation came into effect in most
countries.
2. Forward-looking Monetary Policy
Monetary policy was gradually transformed in the 1990s and early 2000s. In addition to
approving institutional changes, the monetary policy framework was redesigned to make
22
For a comprehensive analysis of central banks’ reform in Latin America, see Carstens and
Jácome (2005).
23
See Cukierman, Webb and Neyapti (1992).
24
See Jácome and Vázquez (2008).

it more effective to achieve price stability. However, the road to price stability was bumpy.
Financial crises re-emerged, inciting bouts of inflation. Most central banks eventually
managed to anchor inflation expectations, thus achieving the longest period of price
stability ever in Latin America.
During the 1990s, most countries in Latin America relied on some form of
exchange rate anchor to defeat high and resilient inflation. Many central banks
preferred to target the exchange rate to break inflation inertia, which would minimize
output costs typically associated with using monetary-targeting schemes. Crawling
pegs and crawling bands (mostly forward-looking against the US dollar) were the
most popular exchange rate regimes.25 Only a handful of countries, most notably
Mexico (since 1995) and Peru, had a flexible exchange rate.26 When supported by
fiscal adjustments, exchange rate-based stabilization policies helped reduce inflation
in Latin America from close to 500 percent on average in 1990 to about 40 percent in
1995.
Operationally, since money and interbank markets deepened and financial markets
were more competitive and more integrated internationally, open market operations
became the preferred monetary policy instrument. Some central banks also started to
conduct liquidity management in order to steer short-term interest rates and maintain
control over monetary aggregates, and often intervened in the foreign currency market to
preserve the exchange rate anchor.
However, targeting the exchange rate also created vulnerabilities, in particular
in the financial system. Foreign capital had returned to Latin America in the
early 1990s following the restructuring of external debts. Capital inflows appre-
ciated real exchange rates, boosted banks’ credit, and led to new—and often
risky—financial transactions. Prudential standards were not adjusted to cope with
financial innovations and the heightened risks incurred by banks, so financial vulner-
abilities grew unchecked. The combination of financial and capital account liberaliza-
tion and weak prudential regulation and supervision sowed the seeds of systemic
banking crises.
A new wave of banking crises hit Latin America during the mid-1990s to the early
2000s, putting at risk the progress achieved in reducing inflation. In most cases, these crises
were preceded by ‘boom and bust’ cycles, as large capital inflows stopped and reversed
due to internal political factors, exogenous shocks or external contagion, thus triggering
systemic banking crises. Emerging markets were affected worse, especially if they had
in place a soft exchange rate peg, were financially dollarized, and featured a weak fiscal
position.27 Once again, the Latin American countries did not have in place the appropriate
institutional arrangements to respond effectively at an early stage and prevent the crises
from unraveling or mitigating their adverse effects. In this institutional vacuum, central
bank money was used in large scale to pay depositors and bail out banks amid fears of
systemic contagion and even the collapse of the payments system. However, pouring
25
Countries like Brazil, Chile, Colombia, Costa Rica, Ecuador and Uruguay had these policy
regimes in place.
26
See the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, 1995.
27
See Jácome (2008) for a detailed analysis of these Latin American crises.

central bank money into the financial system created an excess of money that eventually
fueled simultaneous currency crises, and thereby exacerbated banks’ instability.28
The ‘monetized’ resolution of the banking crises took its toll on the Latin American
economies. After major progress in decelerating the pace of inflation, currency deprecia-
tions across most countries inevitably led to bouts of inflation. Also, as had happened
before, the higher interest rates brought about by the rise in inflation, together with the
impact of devaluations, made it impossible for some countries to service their external
debt. In particular, Argentina, the Dominican Republic, Ecuador and Uruguay under-
went triple crisis—banking, currency and sovereign crises.
Latin American central banks drew important lessons from this new wave of banking
crises. They learned that exchange rate pegs tended to intensify the severity of crises, as
they eventually ended up in a currency crush, thus stoking runaway inflation and a surge in
interest rates, and adversely affecting the already weak financial system. Central banks also
learned that high levels of international reserves were an insurance policy that helped deter
or battle attacks on the currency. Equally important, countries recognized the importance
of enacting appropriate financial legislation and equipping supervisory authorities with
legal powers to conduct bank resolution at an early stage, before the crisis unravels.
3. Moving to Inflation Targeting
As countries in Latin America abandoned exchange rate targeting—in most cases, in

the midst of systemic banking crises—they looked for another anchor for inflation.29
In the late 1990s and early 2000s, Brazil, Chile, Colombia, Mexico and Peru—the
so-called LA5—introduced inflation targeting.30 Since the experiences have been analyzed
extensively in the literature, only key aspects of inflation targeting in Latin America are
highlighted below.31
The new policy framework was based on four pillars: (i) a clear mandate for achieving
price stability; (ii) monetary policy formulation based on a forward-looking approach,
which directly targets a medium-term inflation target; (iii) the use of policy rate as a
short-term interest rate, whose changes signal the stance of monetary policy; and (iv)
accountability and monetary policy communication. Inflation targeting proved to be
simple and easy to understand by the general public and the markets, as it was based
on a single policy objective (a medium-term inflation target with a tolerance above and
below the target), which could be achieved using a single policy instrument (a short-term
interest rate).
A distinct feature in most inflation targeters in Latin America is that they were assigned
28
See Jácome and others (2012a) for an empirical analysis of the impact of using central bank
money in large scale to cope with banking crises in Latin America.
29
While in 1995 five countries in Latin America had in place some form of floating regime, by
2005 this number had doubled (IMF’s Annual Report on Exchange Arrangements and Exchange
Restrictions).
30
In Latin America, Guatemala also introduced inflation targeting in 2005, whereas Costa
Rica, Dominican Republic, Paraguay, and Uruguay are gradually heading in the same direction.
31
See, for example, Schmidt-Hebbel and Werner (2002) on Brazil, Chile, and Mexico; Gómez
and others (2002) on Colombia; and Armas and Grippa (2005) on Peru.

Table 14.2 Key parameters of inflation targeting regimes in the LA5
Inflation Who decides Revisions of Time span Report to the

target the target inflation for bringing Congress
(in percent) target inflation back
to target
Brazil 4.5 ± 2 G + CB a/ Every year c/ 1 year Yes
Chile 2–4 CB b/ No revisions d/ 2 years Yes
Colombia 2–4 CB + G Every year 1 year Yes
Mexico 3±1 CB No revisions 1 year Yes
Peru 2±1 CB No revisions 1 year Yes
Source: Central bank websites.
Note: G 5 Government, CB 5 Central Bank.

a/ The National Monetary Council (NMC), headed by the Minister of Finance and where the central bank
governor is one of four members, decide the target.
b/ The Board of the Bank of the Republic, headed by the Minister of Finance, decides the target.
c/ The NMC sets the inflation target for the end of each year (t) by end-June two years in advance (t-2).
d/ The Bank of the Republic of Colombia has a long-run inflation target and reviews annually the target for
the following year.
not only instrument independence, but also goal independence. Allowing the central bank
to set the inflation target on its own—known as goal independence—is uncommon in
advanced economies, where such a target is agreed on with the executive power. In Latin
America, this institutional attribute reflects its history of heavy government influence on
monetary policy formulation and the record of high inflation. Operationally, the target
for inflation has remained the same for some time in Chile, Colombia, Mexico and Peru;
in Brazil, in contrast, the inflation target is revised or confirmed every year (Table 14.2).
In all these countries, the key policy instrument is a short-term interest rate, which the
central bank adjusts depending on the expectations about inflation.32
The credibility of the LA5 inflation-targeting regimes increased over time as central
banks fulfilled their promise and inflation remained within a target range most of the
time. The deviations of inflation with respect to the target were smaller than in most
emerging market inflation targeters (see Jácome, 2015).33 Building up credibility has had
a reinforcing effect on the effectiveness of monetary policy, as market participants tend
to align inflation expectations with central banks’ targets, thereby creating a virtuous
circle. Communication and transparency about how monetary policy is formulated and
implemented have allowed market participants to anticipate and understand monetary
policy decisions, and have also reinforced central banks’ accountability.
32
Changes in the policy rate are supported by systemic liquidity management and open market
operations in order to keep the short-term interbank rate close to the policy rate. Central banks also
use standing and lending facilities, below and above the policy rate, to offer liquidity absorption
and liquidity provision if needed. Reserve requirements are still used in some countries (in particu-
lar, in Brazil, Colombia and Peru), but as a capital flow management measure or a macroprudential
policy instrument.
33
A similar result is obtained when deviations are calculated with respect to the target range.

The LA5 countries attained and maintained low and stable inflation in the 2000s.
Their previous history of endemic inflation makes this a major achievement. In fact,
the period since 1994 has been the longest period of price stability in the LA5 since the
1950s. Inflation not only has been more stable than in the past, but even more stable than
in the US. Admittedly, low and stable inflation was only possible because these countries
introduced and maintained over time sound macroeconomic policies, in particular fiscal
policies, and also strengthened their financial systems.
4. The Global Financial Crisis and Its Aftermath
The global financial crisis of 2007–08 tested the preparedness of Latin American
central banks to manage large financial shocks. Based on macro-financial fundamentals
that were stronger than in the past and on buffer mechanisms put in place over several
years, the Latin American economies, in particular the LA5, successfully handled the
impact of the global financial crisis. Supported by solid institutional underpinnings,
central banks weathered the reversal of capital inflows well and made an important
contribution to stemming subsequent deflationary pressures. The credibility gained by
central banks in the preceding decade was critical for this achievement. The relatively
modest impact of the financial crisis on the LA5 was in stark contrast to previous
crisis episodes.
From 2010 onward, Latin America started to grow again while inflation was kept in
check. Because of easy monetary conditions in the advanced economies and low returns
in financial and securities markets, investors focused mostly on buying stocks domesti-
cally, and turned to emerging market economies to invest in search for higher yields. The
large capital inflows received by the LA5 countries, in tandem with high commodity
prices, helped economic growth to pick up. Yet, large capital inflows created pressures for
a nominal exchange rate appreciation and also fueled credit expansion, in particular in
2010 and 2011, thus feeding potential financial vulnerabilities.
Most LA5 central banks were ready to cope with the potential adverse effects from large
capital inflows and the subsequent outflows. The central banks in Brazil, Colombia and
Peru introduced or tightened capital flow management measures (CFMs) and/or macro-
prudential policies to discourage speculative capital inflows and prevent excessive credit
growth.34 By using CFMs and macroprudential tools, the LA5 countries departed from
the trilemma hypothesis, as maintaining a flexible exchange rate proved to be insufficient
to keep control over monetary policy while preventing financial vulnerabilities. Later,
the US Federal Reserve announced the imminence of monetary policy normalization,
and this triggered sudden capital outflows that once again put pressures on exchange
rates and international reserves in emerging markets. The ‘safe to heaven’ behavior of
global investors and the deceleration of global economic activity caused the US dollar to
appreciate and the commodities supercycle to end. This induced several Latin American
34
Brazil used a wide range of policy measures, such as increases in the tax rate on financial
operations for some foreign exchange transactions, higher reserve requirements, higher risk weights
for some sector loans, and lower loan-to-value ratios in the housing market. Colombia and Peru
mostly tightened reserve requirements.

central banks to tighten monetary policy to avoid second-round effects on inflation from
large currency depreciations.
IV. THE WAY FORWARD
Central banks have become the symbol of Latin America’s macroeconomic stability.
With a few exceptions, they have been widely praised for their actions and for keeping
institutional strength in a region prone to political and economic volatility. Yet, the central
banks cannot be complacent. They face the challenges that come with an enhanced role
in preserving financial stability and fostering economic activity. Other challenges are
associated with the need of improving the effectiveness of monetary policy.
1. Toward Expanded Responsibilities?
The severity of the global financial crisis is tearing down economic paradigms including
the mandate and primary functions of central banks. Central banks have been blamed as
being partially responsible for not having acted to prevent the crisis. The apparent inaction
of central banks has been linked to their narrow mandate, which assigned them limited
duties for preserving financial stability. In turn, the aftermath of the financial crisis has
raised the question of whether central banks should be more concerned with growth and
employment. In response, a consensus seems to be emerging about the need of expanding
the responsibilities of central banks in order to address these concerns. However, this
notion is to some extent akin to going ‘back to the future’ in Latin America.
A macroprudential policy function

Central banks in Latin America might be called upon to play a more active role in
supporting financial stability—as is already happening in other advanced and emerg-
ing economies. This request may gain traction in a region with a history of recurrent
banking crises. The additional mandate would likely require that central banks develop
a macroprudential policy function and become responsible for monitoring the buildup
of systemic financial vulnerabilities and for taking decisions to prevent crises. This new
responsibility would have different implications for central banks operating under the
‘Atlantic model’ (Argentina, Brazil, Paraguay and Uruguay) compared to those operating
under the ‘Pacific model’ (Chile, Colombia, Peru and Mexico, among others). The former
group already has banking regulation and supervision responsibilities. The new mandate
would order central banks to monitor and make decisions—individually or as part of
financial stability committees—applicable to the rest of the financial industry, including
insurance companies, securities firms, pension funds and other financial institutions. For
central banks operating under the ‘Pacific model’, the mandate would imply expanding
their power to regulate banks and other financial institutions, which is already in the
hands of separate institutions.
However, assigning enhanced financial stability responsibilities to Latin American cen-
tral banks has pros and cons, and thus its implementation should be carefully balanced.
Assigning macroprudential policy to central banks would allow countries to harness
central banks’ expertise in assessing macroeconomic and financial risks, and ensure

coordination with monetary policy. Central banks have the appropriate skills to assess the
performance of financial cycles and their interplay with macroeconomic developments.
Moreover, housing macroprudential policy in the central banks has merit because it would
facilitate coordination between macroprudential and monetary policies. These two poli-
cies have reinforcing—and sometimes conflicting—effects, as changes in macroprudential
instruments affect not only financial stability but also aggregate demand, and the same
happens with interest rates, which can have a bold impact on financial stability.35
However, fully assigning macroprudential functions to central banks can put their
hardly won independence at risk. For instance, the high credibility of the LA5 central
banks is supported by the clear and measurable objective of low and stable inflation.
These central banks have enjoyed not only de jure independence—except Brazil—but
also de facto independence to achieve price stability. But policy measures that aim at
preserving financial stability affect a wide range of economic activities and market
participants. For instance, tightening loan-to-value ratios in mortgage loans may
hinder access to housing for low- and middle-income families. In these circumstances,
central banks may face the public perception that they enjoy excessive economic power
that can potentially diminish people’s wellbeing, despite not being run by publically
elected officials. Therefore, the ‘democratic deficit’ raised years ago with respect to the
inflation-unemployment trade-off would be exacerbated. This has already been hinted
at in relation to macro-prudential policies.36 Against this backdrop, central banks could
lose credibility, including for monetary policy, if a financial crisis were to materialize,
and the banks’ independence could come under scrutiny if their performance were to
falter under this dual mandate. Central bank independence could be in greater jeopardy
if central banks receive the mandate to manage crisis resolution, with the authority to
spend taxpayers’ money. In this case, the government could require greater oversight
of policy decisions and even sit on relevant decision-making committees. As a result,
central banks would have to give up instrument independence for the financial stability
mandate.
A wider mandate that includes financial stability may also risk eroding central banks’
accountability. The reason is that financial stability is difficult to measure. What is
measurable, instead, is instability—exactly what central banks would seek to avoid. Thus,
contrary to monetary policy, where the rate of inflation is a quantifiable measure against
which central banks’ actions can be gauged, the absence of such an indicator for financial
stability makes accountability a difficult process.
The challenge therefore is to design institutions and policy frameworks for preserv-
ing financial stability that do not undermine monetary policy credibility. Some Latin
American countries (namely Chile, Mexico and Uruguay) have recently established
financial stability committees, headed by the Minister of Finance, to oversee financial
systems as a whole and prevent financial crises, but the mandate of central banks has not
been modified.37 However, if the mandate were expanded, because of the leading role
35
The interaction between monetary and macroprudential policies is discussed in IMF (2012).
36
See Blanchard and Summers (Central Banking, 2013): http://www.centralbanking.com/
central-banking/news/2257620/blanchard-summers-warn-on-central-banks-democratic-deficit.
37
Jácome and others (2012b) describe the structure of these committees and their responsibilities.

of the government in the financial stability committee, this arrangement could create
noise on central banks’ independence and accountability. Thus, in case a dual mandate is
adopted, it would be advisable to dissociate decision-making settings for monetary policy
and financial stability so that performance could be evaluated separately. Moreover, it
would be necessary to ring-fence monetary policy decision-making structures, so that
central banks were not influenced by external pressures—often associated with financial
sector issues—or alternative objectives. As for the use of instruments, ideally countries
should legislate that interest rates are the preferred instrument to target price stability and
affect aggregate demand, whereas macroprudential instruments should aim at preventing
system-wide financial crises.
Central banks and economic activity

Should central banks in Latin America get involved in promoting economic activity,
and even employment, by using unconventional monetary policies? Since inflation is not
a major source of concern anymore in most countries in this region, once again these
responsibilities may appear appealing for some policymakers. However, whether central
banks can effectively achieve these policy objectives should be considered.
In the aftermath of the global financial crisis, central banks in major advanced econo-
mies have provided monetary accommodation to mitigate the recession, and later to make
the recovery less protracted. Whether or not to prolong accommodation and preserve
unconventional instruments as part of the monetary policy toolkit during normal times is
currently being discussed, because the Phillips curve does not seem to be relevant anymore
in advanced economies (IMF, 2013). Central banks in Latin America have turned to this
policy option only as a last resort and to a modest degree, but they did so extensively in
the past, unfortunately with very negative results.
In Latin America, monetary policy is not likely to be a very effective instrument to
spur growth and employment. Economic activity is highly dependent on external factors
in the short run, and hinges on structural changes to enhance productivity in the long
run. To incorporate growth or employment as an objective for central banks is likely
to overburden their mandate, and may put monetary policy credibility at risk. This
mandate may also make it difficult to hold central banks accountable when inflation and
growth become conflicting objectives. As an alternative, some Latin American central
banks have already assigned more weight to output in their policy reaction function
and have become flexible inflation targeters, without any explicit broadening of their
mandate.
Although less likely, it would be more worrisome if Latin American central banks
were to finance economic activity indirectly, including through the government, using
an enhanced toolkit of instruments to purchase public and private sector securities—the
so-called ‘helicopter money’ policy. Argentina already employed this policy during
the developmental phase, analyzed in section III, and more recently during the 2010s.
However, with a historical record of financing to the government in Latin America and
in today’s world, where market participants anticipate changes in the stance of monetary
policy, financing the government and the private sector would be interpreted as fiscal
dominance thus undermining central bank independence. As a result, an inflation bias
would likely emerge, necessitating monetary policy to increase interest rates more than
usual in order to achieve the same stabilizing effect.

In sum, Latin American leaders would need to carefully balance the costs and benefits of
expanding central banks’ mandates. The costs could surpass the benefits if central banks
were required to achieve too many goals. While future developments would not necessarily
replicate past events—for example going back to high inflation or hyperinflation—central
banks’ credibility could suffer if they were unable to deliver on their expanded policy
mandate. Policymakers should be cautious and avoid overburdening central banks with
multiple mandates, as this could end up eroding their hard-won monetary policy cred-
ibility and, therefore, their ability to preserve price stability.
2. Living with Unsynchronized Global Cycles and Monetary Policy Effectiveness
Central banks in the financially integrated economies of Latin America also face the
challenge of preserving their capacity to effectively conduct monetary policy in a world
of unsynchronized global cycles. In addition, they still need to refine their inflation
targeting frameworks to achieve a policy impact similar to that in other advanced small
open economies.
Is monetary policy independent in a world of unsynchronized global cycles?

The impact of increasingly powerful global financial cycles is complicating domestic
monetary policymaking in Latin America. In particular, the economic cycle in the US is
not in sync with economic cycles in Latin America. As a result, monetary policy decisions
by the US Federal Reserve put pressure on the Latin American central banks to move in
the same direction, regardless of considerations about domestic inflation expectations
and output gap.
Whether Latin American central banks enjoy independence to control monetary
policy—from spillovers coming from US monetary policy decisions—as contended by the
trilemma hypothesis, is an open question that has to be answered empirically. Until now,
the empirical analysis has provided conflicting evidence when addressing this question.
Rey (2015) suggests that the trilemma has been replaced by a dilemma, as monetary policy
remains independent only if countries manage the capital account directly or indirectly,
regardless of the exchange regime in place. This conclusion is at least partially contested
by, among others, Obstfeld (2015), who finds that those emerging market economies with
a flexible exchange rate are in a better position to maintain an independent monetary
policy than those that feature fixed exchange rates. In addition, IMF (2015) highlights
the importance of flexible exchange rates, and also the negative impact of financial
dollarization and the lack of central bank credibility.
Monetary policy decisions in the group of commodity exporters in Latin America might
also face pressures coming from developments in the Chinese economy. Specifically, the
economic cycle in some countries in Latin America (mainly Argentina, Brazil and Peru)
is more associated with China’s cycle than with the US cycle. Therefore, the economic
deceleration in China leads to a deterioration in terms of trade and a reduction in export
volumes from Latin America, resulting in lower economic growth and disincentives to
increase interest rates, in circumstances that the normalization of US monetary policy
put upward pressures on domestic interest rates.

Refining inflation targeting frameworks

Latin America faces the challenge of improving the effectiveness of inflation targeting
regimes. There are three main areas to work on. The first is to deepen the mechanisms for
the transmission of monetary policy. In almost all economies in the region, these transmis-
sion mechanisms are weaker than they are in advanced economies, most often because
of Latin America’s smaller financial systems. This points to the importance of financial
deepening and inclusion as policies that would promote growth and, as a byproduct, allow
for more effective monetary policy implementation.
A second pending task is to ensure that one-year or two-year inflation expectations
converge with the central banks’ inflation target in order to strengthen the anchoring of
those expectations. Ideally, inflation expectations should fluctuate around the inflation
target as they capture the effects of temporary supply shocks. The problem arises when
deviations persist in a single direction, since this suggests that there is a short-term bias in
the credibility of the target. Achieving greater convergence between inflation expectations
and the official inflation target probably would require improved central bank communi-
cations and more systematic achievement of the official target.
The reliability of the measurement of the output gap is no less important, but this is a
concept that is difficult to measure. In many cases, a comparison of real-time measure-
ments of the output gap and estimates made some years later using more complete data
could even change the sign of the output gap, and its order of magnitude could vary
considerably. The data available when monetary policy decisions are taken could thus
lead to suboptimal results. This does not mean that central banks should abandon the
use of the output gap in monetary policy decision-making, but rather that they should
make an effort to improve its measurement and, above all, supplement their information
with more detailed studies and indicators, especially of the countries’ labor markets and
of capacity utilization.
Finally, in a handful of countries in Latin America, central bank independence has
been eroded due to political reasons. Cases in point are Argentina and Venezuela, where
the central banks have been authorized to finance the fiscal deficit and the expenditure
of state-owned enterprises. In those countries, inflation has increased significantly,
reflecting a large deterioration in public finances and fiscal dominance, which is expressed
through government pressures on central banks to finance the fiscal deficit. There are also
countries that feature an inflation ranging between six percent and 12 percent. In these
countries, indexation—particularly of wages—and lax fiscal policies put pressures on the
exchange rate and inflation expectations, thus leading to an inflationary bias.
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15. The institutional path of central bank
independence
Rosa María Lastra*
Central bank independence is a concept that authors in this volume have explored in
depth in specific jurisdictions and as it relates to other topics. The idea of ‘independence’
is one of the most studied inside and outside of central banks, and one of the most
contested. The 2008 crisis has only intensified this phenomenon.1
Despite the recent mini-boom in the study of central bank independence, the idea of
separating central banking functions, in some way or another, from the rest of govern-
ment policy is a very old one. Indeed, the institutionalization of this separation is the
very nature of central banking: creating a ‘central bank’ is an act of declaring that these
functions belong outside the default policy position.
But what is that default position, and what is that separation? In this chapter, I outline
the contours of central bank independence and focus on the rough consensus that
prevailed in the pre-2008 era of legally separating the heads of central banks from the
heads of state for purposes of price stability. This conception of the central bank as the
‘only game in town’2 when it comes to combating inflation was a powerful one, but was
never an accurate description of central banks or their many external audiences, complex
internal governance systems, and multiple functions. That image of the central bank as a
Platonic ideal of institutional technocracy has much to say on its behalf, however, and we
describe the relevant arguments and counter-arguments.
I. LEGAL STRUCTURE OF CENTRAL BANK INDEPENDENCE
The relations between the central bank and the government have always been the subject
of much controversy. These relations involve several aspects: ownership, separate juridi-
cal personality, and dependence/independence (which in turn is related to the issue of
control).
The issue of public or private ownership is of marginal importance these days, though
the ownership of reserves and the allocation of central bank profits can be a source of
contention in privately owned central banks, since the interests of private shareholders
* This chapter draws on earlier publications on the subject (and citations thereof), in particular
Chapter 2 of International Financial and Monetary Law, published by OUP in 2015.
1
See Peter Conti-Brown, The Power and Independence of the Federal Reserve (Princeton NJ,
Princeton University Press, 2016) and José Fernández-Albertos, ‘The politics of central bank
independence’ (2015) 18(1) Annual Review of Political Science.
2
Mohamed A El-Erian, The Only Game in Town (New York, Random House Publishing
Group, January 2016).
296

The institutional path of central bank independence 297
may conflict with the central bank’s public responsibilities. A great number of central
banks were nationalized in the twentieth century (eg, the Bank of England was national-
ized in 1946), while others that were newly created were established as public agencies,
typically endowed with public ownership.3
Most central banks these days enjoy separate juridical personality, which means that
they can sue or be sued, and are the subject of rights and obligations. The attribution of
separate legal personality is different from the granting of independence in the exercise of
some delegated government functions. While the former relates to its nature as a person
under law (exercising rights and obligations), the latter refers to its insulation from short-
term political pressures in order to achieve certain public policy objectives.
The issue of legal personality becomes rather interesting in the case of complex central
banking systems, such as the US Federal Reserve System or the European System of
Central Banks. The nature of the Federal Reserve System is intricate. The primary com-
ponents of the Federal Reserve System are the Board of Governors and the 12 regional
Federal Reserve Banks.4 The Federal Reserve System itself is not an entity; the entities
with legal personality are the Board of Governors, which is a federal government agency
(ie, a public body) created by Congress and accountable to Congress, and which performs
administrative functions5 (central banking functions), and the 12 Federal Reserve Banks,
which are separate legal entities,6 privately owned,7 organized as corporate entities and
with a different legal personality each. The Federal Reserve Banks perform a duality of
functions: central banking functions8 on the one hand (eg, administration of monetary
and credit policies) and corporate functions proper of a bank on the other (eg, managing
depository accounts for other banks).
Complexity also characterizes the European System of Central Banks (ESCB), which is
composed of the European Central Bank (ECB) and the National Central Banks (NCBs).
Neither the Eurosystem (which comprises the ECB and the national central banks of the
Member States that have adopted the euro) nor the ESCB have legal personality, and,
therefore, they are not carriers of rights and obligations. The entities that do have a legal
personality are the ECB and the NCBs.9 Article 13 of the Treaty on European Union
3
The particular proprietary structures used to create central banks or monetary authorities
vary considerably; they can be established as a privately owned institution, a private corporation
that is controlled by the state, a joint venture between the state and private investors, a public law
body created through statute or constitutional provisions or by a treaty. The latter is the case of
the European Central Bank (ECB), as a central bank whose array of functions and jurisdictional
domain are determined by a Treaty instrument, the Maastricht Treaty (today TFEU). See Rosa
Lastra, ‘The evolution of the European Central Bank’ (Spring 2012) Fordham International Law
Journal, Special Issue, ‘From Maastricht to Lisbon: The Evolution of European Union Institutions
and Law’, 1260–81.
4
The Federal Open Market Committee (FOMC), established in 1933, adds another layer of
complexity to the understanding of the System. See Conti-Brown, above note 1.
5
12 USC 241.
6
Section 4 Rules of Organization of the Board of Governors, issued pursuant to 5 USC 552.
7
12 USC 282, 323. See also Article 4 of the by-laws of the FRBNY.
8
The central banking functions are conferred by statute or by express delegation of authority
pursuant to 12 USC 248(k).
9
See Article 13 and Article 129 TFEU, and Articles 9 and 14 Protocol on the Statute of the
European System of Central Banks and of the European Central Bank, annexed to the Treaty

(TEU) clarified the legal position of the ECB, which is listed among the EU institutions.
Pursuant to Article 282, paragraph 3 Treaty on the Functioning of the European Union
(TFEU) ‘The European Central Bank shall have legal personality. It alone may authorise
the issue of the euro. It shall be independent in the exercise of its powers and in the man-
agement of its finances. Union institutions, bodies, offices and agencies and governments
of the Member States shall respect that independence.’ And only the Court of Justice of
the European Union can judge the ECB according to Article 35 of the ESCB Statute.
The independence of the ECB and the interpretation of whether it abides by its
mandate as enshrined in the Treaty have been the subject of much debate in recent years.
The Court of Justice of the European Union defined the limits of the independence of
the ECB in the OLAF case,10 adopting a functional interpretation of the concept. In the
recent Gauweiler case,11 the Court showed deference towards the discretion and independ-
ence of the ECB in the adoption of the necessary monetary policy measures (in this case
the Outright Monetary Transactions), as long as such measures were in accordance with
the objectives of the Eurosystem as set out in the Treaty.
The NCBs act in a dual capacity. On the one hand, they are the operational arms of
the ESCB when carrying out operations that form part of the tasks of the ESCB. On the
other hand, they are national agencies when performing non-ESCB functions.12 For these
reasons, while the law governing the ECB is solely EU law, the laws governing the status
of the NCBs emanate not only from EU sources, but also from their respective national
legislation. Furthermore, there are substantial differences between the range of functions
and responsibilities assigned to each NCB in the various jurisdictions that comprise the
euro area. In terms of capital structure, it should be noted that the NCBs are the ECB’s
sole shareholders.
II. THE QUESTIONS OF INDEPENDENCE
To dissect the notion of independence, let us first consider the question of independence
from whom. In exercising its responsibilities, the central bank can be dependent or inde-
pendent from the political instruction of the government, though in the case of central
banks with supervisory responsibilities it is also independence from the financial institu-
tions to avoid regulatory capture. Dependence implies subordination to the dictate of the
political authorities. Before the advent of central bank independence, the relationship
between the Treasury or Minister of Finance and the Central Bank was a principal–agent
(ESCB Statute). See also René Smits, The European Central Bank, Institutional Aspects (The
Hague, Kluwer Law International, 1997) 92–93.
10
See Case 11/00 Commission of the European Communities v European Central Bank [2003]
ECR 1–7147, para 92. This case is referred to as ‘the OLAF (European Anti-Fraud Office) case’.
The independence of the ECB is further discussed in other chapters in this volume.
11
Case C-62/14 Peter Gauweiler and Others vs Deutscher Bundestag [2014] OJ C129/11.
12
According to Article 14(4) ESCB Statute. ‘National central banks may perform functions
other than those specified in this Statute unless the Governing Council finds, by a majority of
two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such
functions shall be performed on the responsibility and liability of national central banks and shall
not be regarded as being part of the functions of the ESCB’.

type of relationship in which the Treasury or Minister of Finance instructed the Central
Bank what to do, and the latter was subservient to the wishes of the former, whether
that meant to finance government deficits, or to use interest rate policy for a variety of
government objectives. Independence aims to insulate the central bank from short-term
political influences.13
Having answered the question of independence from whom, let us then consider the
question of independence in what. The intellectual edifice of central bank independence
has been constructed upon the conduct of a price-stability oriented monetary policy
(monetary independence). However, the scope of independence can also be extended to
other central bank functions, either because their functioning is intimately linked to the
conduct of a price-stability oriented monetary policy or because the law says so (ie, the
law specifies that the central bank is independent in the conduct of all of its functions).
Independence in the conduct of lender of last resort operations is a necessary corollary
of monetary independence, since the central bank’s discretion in the exercise of this
function is necessary to preserve its effectiveness as a unique and swift crisis management
instrument.
Three observations on the institutional understanding of ‘monetary independence’
ought to be added. To begin, the central bank is necessarily ‘dependent’ in some func-
tions, for instance when it acts as an agent of the Treasury in the carrying out of foreign
exchange operations or when it acts as fiscal agent. Secondly, with regard to the pursuit of
monetary stability, central bank independence is limited to its internal dimension, ie, price
stability. The external dimension of monetary stability (concerning the exchange rate and
the formulation of exchange rate policy) generally rests with the government, even though
its implementation is often entrusted to the central bank.14 Thirdly, the goal constraint
(that is the constraint imposed upon central banks by the mandate specified in a Treaty,
Constitution or Statute) provides a delimitation of the contours of independence.
Central bank independence—in line with the theory of delegated powers—has to be
understood within the context of the goals that the institution is required to pursue, which
are important public goals needed for the proper economic functioning of the state. While
maintaining price stability is a fundamental goal, it is rarely—if ever—the sole objective..
Financial stability is also a key goal for central banks and other agencies. And if public
funds are at stake, central bank independence in the pursuit of financial stability is limited
by the government’s necessary involvement in the destiny of the financial institutions
that have received government assistance (as the old adage says: ‘He who pays the piper
calls the tune’). The issue of supervisory independence—a principle endorsed by the
13
In the words of former French Prime Minister Lionel Jospin (Paris, May 2000) ‘Independence
signifies ignoring pressures, whatever its source. The independence of central banks goes, . . .
beyond independence from political, executive and legislative power. For me it also equates with
independence from private or collective economic interests, autonomy versus the short term
frequently imposed by capital markets and, finally, freedom of action vis-à-vis the monetary policy
of other central banks’, http://www.bis.org/review/r001018b.pdf.
14
Former German Chancellor H Schmidt wrote in his memoirs that he regarded exchange rate
policies as ‘important elements of general foreign and strategic policy’. See Rosa Lastra, Central
Banking and Banking Regulation (London, London School of Economics FMG, 1996) 276. This is
recalled by Michele Frattianni and others in ‘The Maastricht Way to EMU’ (1992) 187 Princeton
University Essays in International Finance 35.

Basel Committee on Banking Supervision—has become the subject of much debate

with the expanded mandates of central banks (notably Bank of England and European
Central Bank) in response to the global financial crisis. As discussed later in this chapter,
supervisory independence is not the same as monetary independence.
III. THE CASE FOR MONETARY INDEPENDENCE
Central bank laws in numerous jurisdictions granted independence or greater operational

autonomy to their central banks with an explicit price stability mandate in the last decade
and a half of the twentieth century. Central bank independence became a kind of ‘gradu-
ation issue’ for countries wishing to exhibit or consolidate their credentials in monetary
stability and fiscal restraint. This was based on the empirical evidence showing an inverse
correlation between inflation and the degree of central bank independence, economic
theory (vertical Phillips curve, time inconsistency and public choice considerations).15
The movement towards enhanced independence for central banks was thus supported
by a nearly overwhelming consensus among scholars and policy makers that independent
central banks were desirable from the standpoint of public policy.
The argument for ‘monetary independence’ (ie, central bank independence in the pur-
suit of a price-stability oriented monetary policy) is relatively straightforward. Inflation
has no long-range welfare benefits. But it does have significant costs. These costs include
distortions in economic activity, the costs of repricing real assets according to a changing
nominal price level, the costs of the effort people have to undertake to avoid losing the
value of their financial claims, and, in cases of very high inflation, the subtle but pervasive
effects of social demoralization.16 Because inflation is unequivocally bad for a society,
everyone would be better off if the political institutions maintained stable prices.
Experience has shown that political institutions often do not maintain stable prices.
They have several powerful incentives to expand the money supply beyond the rate of real
growth in the economy. In non-democratic societies, the control of the money supply is an
important instrument of economic policy that can address various political needs, most
15
See eg, Michael Parkin and Robin Bade, Central Bank Laws and Monetary Policies: A
Preliminary Investigation, Research Report No 7804 (London, Ontario: University of Western
Ontario, November 1977); Vittorio Grilli, Donato Masciandaro, and Guido Tabellini, ‘Political
and monetary institutions and public financial policies in the industrial countries’ (1991) 13
Economic Policy 341; Alberto Alesina and Laurence Summers, ‘Central bank independence and
macro-economic performance: some comparative evidence’ (1992) 25(2) Journal of Money, Credit
and Banking 151; Alex Cukierman, Steven Webb and Bilin Neyapti, ‘Measuring the independence
of central banks and its effects on policy outcomes’ (1992) 6(3) World Bank Economic Review 353.
It is interesting to observe that the empirical studies supporting central bank independence have
contributed a novel feature to the law and economics literature. Rather than applying economic
tools to legal matters (as with cost-benefit analysis applied in the field of torts), those empirical
studies apply a legal index (based upon a number of selected legal provisions/indicators) for the
purpose of developing economic and statistical tests that show a negative correlation between
central bank independence and inflation. See Fernández-Albertos, above note 1, for a summary of
the empirical research.
16
See Geoffrey P Miller, ‘An interest group theory of central bank independence’ (1998) 17
Journal of Legal Studies 433, 436.

notoriously the financing of government needs. In a democracy, political parties try to

appeal to various constituencies and, in their eagerness to increase economic activity, the
incumbent party may engage in inflationary policy in the period immediately before an
election in order to raise employment, and create a strong, if temporary, sense of euphoria
among voters that translates into votes for the politicians then in office.17
It is against this background that independent central banks found their contemporary
justification: monetary independence was conceived as a means to achieve the goal of
price stability.
Making a central bank independent interferes—to some extent—with the sovereign’s
right concerning the creation and regulation of money (lex monetae). Article I, section
8, clause 5 of the US Constitution gives Congress the power ‘to coin money, regulate
the value thereof, and of foreign coin’.18 Congress delegated some powers to the
Federal Reserve System when it enacted the Federal Reserve Act in 1913. It is this first
‘democratic act’ (passage of legislation by Congress) that gives legitimacy to the func-
tions and operations of the Federal Reserve System. The nature of delegated powers is
fundamental to frame independence within the existing system of checks and balances,
and to understand its constitutional scope and the nature of its limitations. Central
bank independence is not absolute, but relative. Central bank independence has an
instrumental nature, as a means to achieve a goal, namely price stability, a goal or set
of goals which are desirable for the economic running of the state and for the welfare
of society.
Central bank independence has been the preferred institutional arrangement to pro-
mote monetary stability since the end of the 1980s and beginning of the 1990s. A number
of factors contributed to this development. In the European Union, the Maastricht
Treaty on European Union made legal central bank independence a conditio sine qua
non to participate in the European Monetary Union, in addition to the four criteria of
economic convergence and the additional requirements regarding fiscal responsibility. In
developing countries and emerging economies, governments were strongly advised and
sometimes compelled (eg, via a ‘recommendation’ of the International Monetary Fund)
to grant autonomy or independence to their central banks.19 Central banks around the
world have become by law less subordinate to the dictate of political authorities.
One problem, however, with the ‘political argument’ in favour of central bank inde-
pendence is that its logic could theoretically justify the ‘depolitization’ of other economic
policies, converting a democracy into a technocracy. Holtham claimed in 1993:
If monetary policy can be taken out of politics, why not take fiscal policy, too? In fact, there is
much more international evidence of fiscal policy being manipulated for electoral ends than in
17
There is another inflation motivation as well: politicians can disrupt interest group deals by
creating unanticipated inflation, which then causes the interest groups to return to the politicians
with more campaign contributions. See Miller, ibid, 436–45.
18
[US] Congress’ right to regulate interstate commerce (Article 1, section 8, clause 3) encom-
passes banking and other financial services as the courts have come to define and interpret this
clause. Congress also has the right to make any law that is ‘necessary and proper’ for the execution
of its enumerated powers (Article I, section 8, clause 18).
19
See Rosa Lastra, ‘IMF conditionality’ (2002) 4(2) Journal of International Banking Regulation
167.

the case with monetary policy. Yet, no one proposes that fiscal policy should be put in the hands
of independent functionaries.20
The phenomenon of ‘independence’ is not unique to central banking. It is a feature

inherent in an administrative law tradition in which certain powers are delegated to
certain agencies, with regulatory powers. This feature of functional decentralization
used to be considered more acceptable in those countries which also favored geographic
decentralization (ie, a federal structure, such as the USA or Germany, with power divided
between the center and the states (länder in the case of Germany). The skills, expertise and
superior qualifications of technocrats (central bankers, energy regulators, etc) compared
with those of politicians with regard to the conduct of their delegated functions, reinforce
the case for independence.
Despite the economic merits of central bank independence,21 the actual decision to
grant independence is a political one. Relations between central banks and governments
have not always been easy. Indeed, quite often they are rather confrontational. The link
between economics and politics is a difficult and complex one, which changes across
countries and over time. This is true both for developed and for developing countries.
Monetary independence is a way of accomplishing a partial depoliticization of the money
supply process, which provides an intermediate solution between full depoliticization, as
advocated in the free-banking proposals, and politicization, in which all economic policy
is under governmental control.
The consensus that surrounded the need to delegate control over the money supply to
an independent central bank in the early 1990s was also a recognition of the importance
given to the function of monetary policy and to the objective of price stability. Under the
Keynesian policy modalities of the 1950s and 1960s fiscal policy had primacy and demand
management policies (goals of growth and employment) were prevalent. In the end, the
trade-off between objectives is often a political decision.22
IV. THE LEGAL ARTICULATION OF CENTRAL BANK

INDEPENDENCE
Legal guarantees concerning the organization and functions of central banks on the one
hand and the integrity and professionalism of central bankers on the other hand are an
20
See G Holtham, ‘No Case for Independent Central Bank’, Financial Times, 3 September
1993. B Hopkin and D Wass (‘The Flows in Central Bank Freedom’, Financial Times, 22 January
1993) also maintain that if monetary policy is to be taken out of the hands of politicians, because
they cannot be trusted to give inflation the priority that it deserves, then other instruments of
policy, which have a bearing on inflation (they cite government borrowing, taxation competition
policy and public sector pay) should also be taken out of their hands.
21
See Lastra, above note 14, 13–24, for a review of the main arguments for (economic, political
and technical) and against independence (the latter include democratic legitimacy, the need for
consistent economic policy, and capture).
22
Financial Times, 19 March 2009, ‘Carney’s central bank for all seasons’. Central bankers
‘cannot be tunnel-vision economists or specialists on the intricacies of bank capital, but need to be
central bankers for all seasons, capable of understanding the big picture’.

important measurement of legal central bank independence. The incentive structure of

independent central bankers is different from that of elected politicians. Political economy
and political science have contributed to the understanding of this ‘incentive structure’.
However, these incentives need to be enshrined in the law in order to be effective and
enforceable.
I have recommended since 199223 that the following elements be included in the law:
(1) declaration of independence; (2) organic guarantees and professional independence;
(3) functional or operational guarantees; (4) the ‘economic test of independence’ (ie, the
central bank’s ability to withstand government pressure to finance government deficits via
central bank credit); (5) financial autonomy; and (6) regulatory powers.
1. Declaration of Independence
A provision declaring that the central bank will be independent or autonomous from the
Government and that interest rate decisions will not be politicized.
2. Organic Guarantees and Professional Independence
A number of provisions regulate the organization of the central bank and its institutional
relationships with the Government. I call these provisions ‘organic guarantees’ of
independence,24 though some of the measures I advocate also protect the scope of ‘pro-
fessional’ or ‘personal’ independence. In particular, a law on central bank independence
should guarantee security of tenure (typically for a period of time longer than that held
by legislators) and well defined appointment and removal procedures for central bank
board members.
3. Functional or Operational Guarantees
The central bank law should include what I refer to as ‘functional’ or ‘operational guar-
antees’ of independence, that is provisions that grant the central bank room for maneuver
with regard to the carrying out of its functions and operations, without government inter-
ference. The law should provide provisions that safeguard the central bank’s decisional
autonomy in the exercise of this fundamental monetary policy function. A dependent
central bank is required to secure prior government approval of its monetary policy
decisions. An independent central bank does not require such prior approval. Therefore,
clear provisions regarding the instruments of monetary control (monetary operations)
available to the independent central bank are needed. Market-related (indirect) instru-
ments of monetary control, such as discount policies and open market operations, are
to be preferred over direct instruments of monetary control, such as credit ceilings or
interest rate controls.
With regard to the proper understanding of ‘functional independence’, it is important
23
Rosa Lastra, ‘The independence of the European system of central banks’ (1992) 33(2)
Harvard International Law Journal 475–519; and Lastra, above note 14, Chapter 1.
24
Ibid.

to bear in mind that most countries’ central banks do not have ‘goal independence’ (ie,
the ability to choose the goal; the Fed does have this type of independence within the
constraints of its statutory mandate), but ‘instrument independence’ (ie, the ability to
choose the instruments necessary to achieve the goal).25 The ‘goal constraint’ as further
discussed below is an important limitation of central bank independence.
4. Economic Test of Independence
The key economic test of independence is the central bank’s ability to withstand govern-
ment pressure to finance government deficits via central bank credit. In this respect, the
central bank law should include provisions prohibiting or limiting the central bank’s
lending to the public sector. A truly independent central bank should be under no obliga-
tion to extend credit to the government.26 This is the rationale behind the prohibition of
monetary financing of Article 123 of the Treaty for the Functioning of the European
Union and related secondary law.
5. Financial Autonomy
An independent central bank should be able to adopt its internal budget, in accordance
with criteria defined in the law so as to ensure that the bank’s expenditures are reason-
able. This criterion of financial autonomy was tested at the EU level in the OLAF case.
The Court of Justice of the European Union clarified that, though the ECB has its own
resources and budget (not included in the Community budget),27 it does not mean that
it is exempt ‘from every rule of Community law’. Hence, the ECB is not exempt from
the anti-fraud investigations conducted by the Commission’s anti-fraud office (OLAF).
Article 282, paragraph 3 TFEU recognizes that the ECB is ‘independent in the manage-
ment of its finances.’
6. Regulatory Powers
The power to issue rules and regulations is a measure of the autonomy (ability to give rules
to itself) of an agency. However, while in the USA this rule-making power of independent
regulatory commissions is consistent with the administrative law tradition of the country,
the legitimacy of rules and regulations issued by the central bank (or by an independent
agency) and not directly by the government was a contentious issue in civil law countries.
In the USA, rule-making is the administrative counterpart of what a legislative body does
when it enacts a statute. In the case of the Federal Reserve System (the Fed), the Federal
Reserve Act gives authority to the Fed to issue rules that are binding on depository
institutions and other institutions under its scope of influence (ie, limited application).
25
See Lastra, above note 14, 36–38, and 44–48.
26
See Latin American Shadow Financial Regulatory Committee, Statement No 4, Montevideo,
18 October 2001, ‘Central Bank Independence: the Right Choice for Latin America’ available at
<http://www.aei.org>.
27
See OLAF case, Case 11/00 Commission of the European Communities v European Central
Bank [2003] ECR 1–7147, paragraph 132.

Such rules are codified in the Code of Federal Regulations (CFR) published in the Federal
Register by the Executive departments and agencies of the Federal Government.28
The EU Treaty gives rule-making powers to the ESCB. Article 132 TFEU states that in
order to carry out the tasks entrusted to the ESCB, the ECB shall issue regulations (with
general application and binding in their entirety and directly applicable in all Member
States), decisions (binding in their entirety upon those to whom they are addressed), and
recommendations and opinions (the latter two with no binding force).
V. THE LIMITS OF CENTRAL BANK INDEPENDENCE

The notion of independence that I advocate is one that I developed in a paper I wrote with
Geoffrey Miller in 1999.29 By an ‘independent’ central bank, we mean a particular kind
of institution that is independent in some respects, but highly constrained in others. In
particular, an independent central bank is relatively free of short-term political pressures:
its officers serve for long periods and may not be removed from office for disagreements
over policy with other government officials, and it does not take orders from any other
institution. In this respect, it enjoys a high degree of autonomy. At the same time, an
independent central bank is constrained by its statutory goal or goals.
1. The Goal Constraint: The Case Against ‘Absolute’ Independence
Independent central banks remained constrained by their statutory objective or objec-

tives. Sometimes the objective is defined in narrow terms as a numerical target and some
other times in broad terms. In some jurisdictions, most notably in the USA, the central
bank’s mandate may encompass several objectives, rather than a single or primary goal.
As mentioned earlier, the Fed is required by law to pay attention to a variety of unranked
targets, including stable prices, growth and employment. Since independent central banks
can seldom choose their goals, the discussion about central bank independence mainly
focuses on the scope of powers delegated to central banks for the achievement of their
statutorily defined objectives.
The independent central bank can be seen as a form of pre-commitment by the political
system to tie its hands, like Ulysses at the mast, to avoid taking destructive actions when
the siren of inflationary temptation appears. If the central bank is truly independent
of the political cycle, and is truly committed to the goal of maintaining price stability
(monetary independence), it will not be subject to the pressures that tend to generate
28
The Code is divided into 50 titles which represent broad areas subject to Federal regulation.
Each title is divided into chapters which usually bear the name of the issuing agency. Title 12 refers
to Banks and Banking and Chapter II of Title 12 refers to rules issued by the Federal Reserve
System.
29
This paper, which was presented at a joint conference in Stockholm in December 1999,
was subsequently published as a book chapter. See Rosa Lastra and Geoffrey Miller, ‘Central
Bank Independence in Ordinary and Extraordinary Times’ in Jan Kleineman (ed), Central
Bank Independence. The Economic Foundations, the Constitutional Implications and Democratic
Accountability (The Hague, Kluwer Law International, 2001) 31–50.

inflation when monetary policy is in the hands of political actors. There is some evidence
that, in fact, this theory has practical merit: in the developed world, at least, independent
central banks tend to have a somewhat better record of achieving price stability than their
non-independent counterparts.30
The case for monetary independence has often been presented as a virtual absolute.
That is, the theory recognizes no limits on central bank independence, so long as the bank
itself is reliably pre-committed to achieving price stability. Taken at face value, the theory
would suggest that central banks should be completely insulated from politics. But this has
not been the case in the real world. Even highly independent central banks, such as the
Federal Reserve Board, the pre-1999 Bundesbank, or the European Central Bank, do not
enjoy this kind of independence. Although they operate with a high degree of protection
from political pressures, they are far from isolated from the political process. And while
maintaining price stability is typically the primary goal of such institutions, it is rarely—if
ever—the sole objective.
As discussed earlier, the charters of these banks often also contain clauses that
permit or require them to consider other objectives, such as maintaining the stability
of the financial system, enhancing employment, facilitating economic growth, and
so on. Moreover, even if the central bank charters purported to establish absolute
independence, they are only pieces of paper. A legislative charter can always be revised
by subsequent legislation; and even if the charter is embodied in a national constitution,
the constitution can always be amended or ignored. It is obvious that there are limits to
central bank independence in the real world, however much the economist’s pure theory
might question the rationale for such limits. Why do we observe, in fact, considerably
less independence than would be suggested by orthodox economic theory? Three answers
suggest themselves.
First, it might be that the observed limits on the independence of central banks around
the world are the results of political compromise. Politicians may recognize that an
independent central bank provides significant benefits. If they are public-spirited, they
will understand and support the role of the independent central bank as a form of pre-
commitment to price stability even in the face of considerable political temptation. The
current cynicism about politics overlooks the fact that some politicians might actually
wish to be in office in order to deliver long-lasting prosperity for the country and that
therefore, they will not sacrifice that long-term goal for the short-term benefits of infla-
tionary policies. But even if politicians are purely self-interested, they may find a degree
of central bank independence to be in their interests, either because an autonomous
bank can be blamed as a scapegoat for failed or unpopular policies, or because the price
stability that an independent central bank can ensure allows the politician to milk interest
groups for larger financial support in the short run.31 However, these motivations that a
politician may have to favor independent central banks are likely, in the real world, to
be counterbalanced by conflicting motivations to acquire, maintain and exercise power.
30
See eg, Alex Cukierman, Central Bank Strategy, Credibility and Independence: Theory and
Evidence (Cambridge MA, MIT Press, 1994).
31
On the rent-extraction motivation for central bank independence, see Miller, above note 16,
at 36.

Control over the price level is one of the most important powers of any government, and
politicians are likely to give up that power only reluctantly—especially because politicians
themselves tend to be people who like and desire power. Thus, some limits of central bank
independence are the result of political compromise.
A second possible explanation for the observed limits on central bank independence
is based on simple necessity. While an absolutely independent central bank may be an
appealing idea from a policy standpoint, in practice, institutions must be able to operate.
For example, the central bank must have officers to direct its operations. These officers
must be appointed somehow. One might suppose that to achieve maximum independ-
ence from the political process, the officers could be appointed through some ostensibly
non-political process—for example, they might be selected by a panel of experts who
are not politicians, or vacancies may be filled by the incumbent officers. Yet it requires
little thought to realize that these alternative selection mechanisms are not themselves
immune from political influence. Members of the nominating panel must themselves be
nominated; and all parties involved in the process are human beings who are subject to
the normal pressures of friendship, loyalty and inducement.
Even if politics in the narrow sense does not play a role, the process of insulating the
officers of the central bank from political influence also removes an important check on
their behavior, and thus allows the bank’s officers greater flexibility to ignore the goal
of price stability in the service of other objectives. As a practical matter, politics has to
play a role in the activities of central banks: the goal of complete insulation from politics
cannot be realized. In an imperfect world, some compromise with the ideal of central bank
independence is a practical necessity.
A third possibility is that the ideal of central bank independence is not an absolute even in
theory, even if we could overcome the political and practical impediments to creating a fully
independent central bank. If central bank independence—and the price stability that such
independence seeks to achieve—were unambiguously good in all circumstances, it would be
good social policy for the central bank to be replaced by a computer that was programmed
to achieve price stability in any and all circumstances, set in motion, and equipped with
fail-safe mechanisms to deter any future tampering with its operations. If such a machine
were to be constructed, as long as prices remain stable, the element of human intervention
would seem to be irrelevant. Such a central bank would be both completely autonomous
and absolutely goal-constrained. This machine, of course, does not exist in reality, but we
can construct it imaginatively in order to investigate the theoretical point.32
Most people would not be comfortable with this level of independence in the central
bank. Even if we generally accept the economists’ view that price level stability is a
good and desirable thing, the idea of committing a central governmental function to a
mechanical operation appears bizarre and undesirable. Intuitively, it is not an appealing
idea. This intuition appears to be supported by observations described above of the
structure of central banks around the world. Although most of the world supports the
concept of independent central banks, no country has attempted to achieve the level of
independence of our hypothetical computer.33 It may be that these limits to central bank
32
Lastra and Miller, above note 29.
33
Ibid.

independence reflect genuine concerns of social policy as well as the influence of politics
or practicality. The increasing complexities of monetary and financial management imply
an expanding two-way flow of consultation and cooperation between the central bank
and the government.
While a very high level of central bank independence is highly desirable, complete
independence is not, even if it could be achieved.
2. Democratic Legitimacy
There are two principal limits on central bank independence that all democratic societies
should maintain. One of these limits of central bank independence principally concerns
the limitations of the goal, ‘the goal constraint’, an issue which I discussed in the first sec-
tion of this chapter. Important as stable prices are in ordinary times, the commitment to
preventing inflation should not impair a nation’s ability to respond to fundamental threats
or basic changes in its identity or extraordinary circumstances. The other limit refers to
the issue of democratic legitimacy, an issue which I survey below, and which is related
to the debate about central bank accountability. A democratic society always retains
the discretion to reinvent itself; and should the people of a country make a considered,
deliberate choice to seek some other goal, the institutions of central bank independence
should respect that decision.34
3. Ordinary Versus Extraordinary Times
In ordinary times, countries do not face profound threats to, or alterations of, their
basic identity. Ordinary times are structured around more limited disputes that do not
go to the identity of the nation or to its basic security. In extraordinary times, when a
country’s basic identity or survival is at stake, as I illustrate below with the example of
Germany, the government may need to raise revenues very quickly and efficiently in
order to provide the necessary funding for the enterprise. One means of raising revenues
quickly is through seigniorage35 (ie, the margin between the nominal value of the notes
and coins issued and the costs of their production), which can be rather substantial in
the current system of fiat money, paper money inconvertible into gold or other precious
metals, as discussed earlier.
Seigniorage can be conceived of as a form of taxation. Like any tax, seigniorage raises
revenues to finance government operations. And like any tax, seigniorage introduces dis-
tortions into economic activity. The utility of seigniorage increases when the demand for
government funds is sudden and unanticipated. There are two crucial differences between
seigniorage and ordinary taxes: the timing of their imposition and the fact that seignior-
age does not require parliamentary approval, while ordinary taxes do. Seigniorage taxes
34
Ibid.
35
Historically, and as applied to money, seigniorage was a levy on metals brought to a mint for
coining, to cover the cost of the minting and to provide revenue to the ruler, who claimed it as a pre-
rogative. In recent monetary literature the term has been revived and applied to the revenue derived
by a note issuing authority. See eg, Cukierman, above note 30, at 47: seignorage revenues are the
amount of real resources obtained by the government by means of new base money injections.

can be imposed very quickly. Conventional taxes, however, require a much longer lead
time. They often require authorization from the parliament or other legislative body.
Such a process can be time-consuming, especially when interest groups enter to seek
advantages for themselves in the tax package being drafted. Even after new taxes have
been imposed, the collection process requires a substantial lead time, since the entities
being taxed must be given notice of their obligations and time to respond. The upshot
is that, if the government needs money quickly, seigniorage is likely to be preferable to
ordinary taxation as a temporary measure.
The cost of obtaining seigniorage revenues through inflationary finance is, of course,
inflation. But some level of inflation may need to be tolerated in order to achieve the
government’s compelling need to raise money quickly in times of crisis. Yet the govern-
ment cannot always be relied on to use the power of inflationary finance only when this
course is indicated by extraordinary circumstances. Seigniorage is a highly tempting
means of raising revenues to finance ordinary government operations, or to subsidize
powerful interest groups. Because its effects are pervasive—felt by the public in the
form of price increases—the actual interests that benefit from the policies can often be
disguised. And because the inflation tax can ordinarily be imposed by the monetary
authorities without the need for parliamentary approval or the consent of other govern-
ment agencies, the inflation tax may be politically easier than conventional taxes. Some
features of central bank institutional design can be understood as attempting to deal
with the problem of how to limit the government to imposing inflation taxes only in
extraordinary times. For example, many central bank laws contain strict prohibitions
against central bank lending to the government (the economic test of independence).
These prohibitions are intended to prevent the government from inflating the economy
during ordinary times.
The problem of institutional design is how to distinguish the ordinary times from the
extraordinary ones. The history of the pre-1999 German Bundesbank in particular during
the period leading to the reunification of Germany illustrates the sacrifices that sometimes
are needed to achieve a greater objective for a nation than price stability. The example
is noteworthy because the pre-1999 Bundesbank is widely regarded by commentators
and policy makers as a bastion of the commitment to price stability.36 The ‘Bundesbank
36
As David Marsh emphasized in his book The Most Powerful Bank: Inside Germany’s
Bundesbank (New York: Times Books, 1992) 13, ‘Stabilitätspolitik [in Germany] transcends the
boundaries between dictatorship and democracy.’ The German visceral hate for inflation and their
unwavering support for monetary stability dates back to the disastrous experience of hyperinflation
in 1923 in an economy already overburdened with onerous war debts and reparations. The heavy
burden of reparations imposed on Germany in 1919 in the Versailles Peace Treaty was criticized
by John Maynard Keynes in The Economic Consequences of the Peace (London, Macmillan, 1919).
Keynes argued forcefully that the reparations payments discussed at Versailles were far too high
and that the peace was to be Carthaginian. See Arminio Fraga, ‘German reparations and Brazilian
debt: a comparative study’ (1986) 163(2) Princeton University Essays in International Finance.
Enormous popular discontent at the time paved the way for the rise of National Socialism, with
its dire consequences for the German nation. Adolf Hitler came to power promising currency
stability to the German people, though he eventually sacrificed it (as well as the independence of
the Reichsbank) because of the needs of the armaments policy first and war thereafter.

model’ of one agency, one objective, one main task (Tinbergen rule) became the ‘model’
of what a price stability oriented independent central bank should be. 37
The fall of the Berlin Wall was an event of tremendous symbolic importance in the
history of Germany and in the history of Europe. Chancellor Kohl seized the historical
opportunity of bringing unity to the German people with courage and decisiveness, as
well as improvisation. The Chancellor had vision, but lacked a coherent blueprint of
how to accomplish unification. This is particularly evident when talking about mon-
etary unification (1 July 1990) which preceded full political reunification (3 October
1990). The timing of it took everybody by surprise, including the Bundesbank. Kohl’s
political instinct cautioned him against long negotiations that could have dragged for
years, and possibly, hampered the prospect of unity. The Bundesbank had expressed
its view that the process of monetary unification could not be rushed. However, the
decision to go ahead was indeed ‘rushed’ and on 6 February 1990 Kohl proposed
‘immediate’ talks on extending the Deutschmark to East Germany. The Bundesbank
opposed the conversion rate of one to one, based on sound economic logic. But the
government did not listen and went ahead with such parity: ‘One for one, or else we
will never be one’. The conversion rate between the Ostmark and the Deutschmark
was fixed at one to one for political imperatives, against the Bundesbank’s advice. In
the case of German unification, the interest at stake was the higher goal of national
identity.
However, the distinction between ordinary and extraordinary times is not always
straightforward. Can the financial crisis that commenced in 2007 and reached its zenith in
September 2008 be considered such an ‘extraordinary time’, one that justifies a departure
from regular principles of central bank operations? I tend to side with those that contend
that in 2008 we were living in extraordinary times, with a real danger that the whole
financial system would implode.38 Hence, central bank actions during that period ought
to be examined under this prism.
Indeed, in order to understand the expansionary monetary policy and unprecedented
liquidity assistance that the Fed provided during the 2007–09 crisis it is important to bear
in mind that Chairman Ben Bernanke, a student of the Great Depression, clearly wanted
to avoid a repeat of the 1930s. Milton Friedman and Anna Schwartz in their authoritative
Monetary History of the United States had advanced the idea that the Great Depression
had been triggered by the central bank’s reduction in the US money supply from 1928
37
The provisions in the 1957 Bundesbank Law that encapsulate the idea of independence for
the sake of monetary stability were Articles 3 and 12 (modified after the ratification of the Treaty
of Maastricht. The wording of these provisions is reproduced in part in Article 127 TFEU and
Article 2 Protocol on the Statute of the European System of Central Banks and the European
Central Bank: ‘The primary objective of the ESCB shall be to maintain price stability. Without
prejudice to the objective of price stability, the ESCB shall support the general economic policies
in the Community.’
38
Martin Wolf, writing in the Financial Times, 5 June 2013 (‘America owes a lot to Bernanke’)
stated: ‘Central banks, including the Fed, are doing the right thing. If they had not acted as they
have over the past six years, we should surely have suffered a second Great Depression. Avoiding
such a meltdown and then helping economies recover is the job of central banks. My criticism,
albeit more of the ECB than of the Fed, is not that they have done too much, but that they have
done too little . . . Exceptional times call for exceptional measures’ (emphasis added).

until the early 1930s.39 Chairman Bernanke’s intimate knowledge of how the policies of the
Federal Reserve System contributed to the crisis and exacerbated the recession following
the stock market crash of 1929 were clearly behind the Fed’s decisive stance against the
great financial crisis of the twenty-first century.
In extraordinary times extraordinary measures are justified and restrictions can be
eased. The problem of course with justifying extraordinary measures is that by definition
such measures must be limited in time. A return to ordinary times—and the abandonment
of such extraordinary measures—is not always easy, as exemplified by the discussion
about ‘QE tapering’ mentioned above. That is also why accountability mechanisms are
particularly important during ‘extraordinary times’.
VI. SUPERVISORY INDEPENDENCE AND ACCOUNTABILITY
Supervisory independence is not the same as monetary independence.40 To begin super-

visory independence can be predicated both with regard to central banks (if they are
endowed with supervisory functions) and with regard to other agencies (if supervision
resides outside the central bank). Monetary independence is almost invariably central
bank independence.
In stark contrast to the relatively simple ‘Bundesbank model’ of monetary independ-
ence, ‘supervisory independence’ presents a much more complex model.41 The conduct of
supervision involves several goals (financial stability, consumer protection, conduct of
business, prevention of money laundering), is related to other instruments (macro super-
vision, competition, crisis management, emergency liquidity assistance, etc) and generally
implicates several entities/authorities nationally (central banks, Treasuries or Ministers of
Finance, supervisory agencies, etc), as well as supra-nationally and internationally.
If public funds are at stake, central bank independence in the pursuit of financial stabil-
ity is limited by the government’s necessary involvement in the destiny of the financial
institutions that have received government assistance.42 This requires a different model of
accountability, with adequate institutional and procedural arrangements.
As regards the forms of accountability, when it comes to monetary policy, central banks
are generally given clear performance objectives (outputs which can be easily measured).
39
See Ben Bernanke, Essays on the Great Depression (Princeton NJ, Princeton University
Press, 2000), and Milton Friedman and Anna Schwartz, A monetary history of the United States,
1867–1960. (Princeton, Princeton University Press, 1963). See also Allan H Meltzer, A History
of the Federal Reserve System, Vol I and Vol II (Chicago, University of Chicago Press, 2009). An
entertaining account of the boom in the 1920s that eventually lead to the bust in 1929 is provided
by Bill Bryson, One Summer. America 1927 (London, Doubleday, 2013) 234–37.
40
See generally Fabian Amtenbrink and Rosa Lastra, ‘Securing Democratic Accountability of
Financial Regulatory Agencies – A Theoretical framework’ in RV de Mulder (ed), Mitigating Risk
in the Context of Safety and Security. How Relevant is a Rational Approach? (Rotterdam, Erasmus
School of Law & Research School for Safety and Security (OMV) 2008) 115–32.
41
See also Marc Quintyn and Michael Taylor of the International Monetary Fund in a paper
on ‘Regulatory and Supervisory Independence and Financial Stability’ published by CESifo
Economic Studies, Vol 49, 2/2003, 259–94 available at http://www.cesifoeconomicstudies.de/.
42
We should remember the adage: ‘he who pays the piper calls the tune’.

However, in the case of supervision, input or process monitoring is preferred, because

performance or outputs on the supervisory activity are often hard to measure.43
The fact that inputs, rather than output monitoring should be chosen also suggests that provid-
ing a monetary authority (with a clear performance objective) with independence is not the same
as providing independence to a supervisor: if delegation and output measurement cannot be
used, then independence must be more restricted with regard to financial supervision than with
regard to monetary policy.44
While central bank accountability with regard to monetary policy is typically ‘explana-
tory’, the accountability of the central bank or the supervisory agency in the field
of prudential supervision and regulation is sometimes ‘explanatory’ and sometimes
‘amendatory’.
Democratic accountability is a process, which involves subjecting the accountable to the
procedures and processes of a democratic society. As such judicial review of the actions or
decisions of an independent agency can function as an instrument of democratic account-
ability. With regard to the regulatory and supervisory function, courts should be able to
review whether and to what extent the agency has observed the rule of law.45 However, the
degree of review will be limited in areas where the agency exercises discretion both in the
context of regulatory and supervisory functions. In such cases the review is limited to
observing whether and to what extent the agency has observed the limits of its discretion.
In order to establish a breach of the rule of law the supervisory authority must be shown
to have (manifestly) disregarded the limits of its discretion.46
In the context of judicial review, the liability of financial regulatory and supervisory
authorities is a contentious issue. The issue of (state) liability for loss caused by the
inadequate supervision of banks,47 in the context of the damages action against the Bank
of England for the failure of Bank of Credit and Commerce International (BCCI)48 and
in the context of the Peter Paul case,49 has raised much controversy.
Another dimension is provided by the relevance of transparency in the framework of
monetary independence in contrast with the framework of supervisory independence.
While transparency in monetary policy is clearly advantageous, the benefits are less clear
43
Luis Garicano and Rosa Lastra, ‘Towards a new architecture for financial stability: seven
principles’ (2010) 13(3) Journal of International Economic Law 597–621.
44
Ibid.
45
Amtenbrink and Lastra, above note 40.
46
Ibid.
47
See Mads Andenas, ‘Liability for supervisors and depositors’ rights: the BCCI and the
Bank of England in the House of Lords’ (2001) 22(88) The Company Lawyer 226–34. See also
M Andenas and D Fairgrieve, ‘To Supervise or to Compensate? A Comparative Study of State
Liability for Negligent Banking Supervision’ in M Andenas and D Fairgrieve (eds), Judicial Review
in International Perspective (London, Kluwer Law International, 2000) 333–60.
48
The case against the Bank of England [Three Rivers District Council v Governor and Company
of the Bank of England (No 3) [2000] 2 W.L.R. 1220; [2000] 3 All E.R. 1; [2000] Lloyd’s Rep. Bank.
235, HL] was abandoned on 2 November 2005, when BCCI liquidators Deloitte Touche Tohmatsu
dropped their claim (against the Bank of England), after receiving a legal ruling that it would not
be in the best interests of BCCI’s creditors to continue with the lawsuit.
49
Case C-222/02, Peter Paul and Others v Bundesrepublik Deutschland, [2004] ECR I-(12.10.2004).

when it comes to supervision and crisis management, due to the stigma effect of publiciz-
ing overt assistance and the nature of bank runs (the belief in a panic is self-fulfilling).50
The reporting requirements prescribed by law are the best way to ensure a regular flow of
information. They can include annual and other regular reports, extensive information of
regulatory and supervisory activities, as well as regular presentations by agency officials.
Similar to what can be observed for central banks with regard to monetary independence,
the difficulties in defining legal obligations in this regard lies in striking a balance between
the need for confidentiality and the need for information to be publicized.
Goodhart observes that providing accountability and transparency for banking super-
visors is particularly difficult, since the information that they get is frequently confidential
and since ‘success’ is often measured by the absence of financial failures (considering also
that the optimal number of failures is not zero!). ‘Supervisory failures have to become
public, but supervisory successes in averting crisis often have to remain secret.’51 This
excludes complete openness in the decision-making process of the supervisory authorities.
VII. CONCLUDING OBSERVATIONS
Independence is economically desirable in some ways, politically impossible to accomplish

in its entirety, legally relevant but tricky, and subject to significant revision in light of the
2008 crisis.
Central bank mandates have been expanded substantially in the aftermath of the
global financial crisis with central banks acting micro and macro prudential supervi-
sors, crisis managers and resolution authorities in addition to their traditional—also
extended—roles as monetary authorities (monetary policy and note issue) lender of last
resort, government’s bank and bankers’ bank. This leads to question both the scope of
discretion—which is exercised within the contours of a rule-based framework—and the
design of adequate mechanisms of accountability. With power comes responsibility. Lord
Acton’s dictum lurks in the background.
One problem in the design of an ‘accountable central bank independence’ lies in the
possible reversal of the intended objective of ‘depoliticizing’ the conduct of monetary
policy and/or supervision. Indeed, if too much independence may lead to the creation of
a democratically unacceptable ‘state within the state’, too much accountability threatens
the effectiveness of independence.
The debate about independence and accountability resembles the philosophical debate
about freedom and responsibility: independence without accountability would be like
freedom without responsibility.
50
Garicano and Lastra, above note 43.
51
See Charles Goodhart, ‘Regulating the Regulator – An Economist’s Perspective on
Accountability and Control’ in Eilis Ferran and C Goodhart, Regulating Financial Services and
Markets in the 21st Century (Oxford, Hart Publishing, 2001) 162–63.

16. Central bank accounting
David Bholat and Robin Darbyshire
I. INTRODUCTION
Accounting is sometimes seen as boring by non-accountants. However, there are at least

six reasons why the accounts of central banks should interest everyone, and certainly the
readers of this research handbook:
(i) Central bank accounts are an important part of accountability and transparency.
Central banks are responsible for a significant amount of public funds and play
a significant role in the economy. However, in many jurisdictions, they are not
subject to the same level of scrutiny as other public bodies in order to protect their
independence. The accounts of central banks are an important medium through
which central banks are open and accountable to the public.
(ii) Central bank financial statements are important because they reflect major policy
interventions. For example, in response to the financial crisis, central banks in
Japan, the US, the UK and the Eurozone expanded their balance sheets by issuing
new liabilities (new money) to purchase assets (Rule 2015).
(iii) Central bank accounting is different from the accounting applicable to other firms.
This reflects the unique role played by central banks. As an example, for every other
individual and firm in the economy, central bank notes and deposits are classified
as assets on their balance sheets. For central banks, these are classified as liabilities.
(iv) Central bank accounting has distributive consequences. For example, how central
banks record their financial results affects the surplus available for distribution to
external shareholders, most often the government.
(v) Central bank accounting is diverse. It varies from country to country because there
are no global standards for central banks.
(vi) Central bank accounts can create or undermine credibility. If the financial strength
of a central bank, as registered in its financial statements, weakens, there may be a
crisis of confidence in the central bank that can impact the whole of the economy.
II. CHAPTER OVERVIEW
Given the importance of central bank accounting for the reasons outlined above, this
chapter seeks to shed light on it. Specifically, it examines the distinguishing factors that
make the financial statements of central banks unique, from both an accounting perspec-
tive and in terms of their larger economic significance. Our commentary is informed by
our practical experience working in and with central banks. The issues we present are
well-known in central bank accounting circles but are not much discussed outside of
them.
314

Central bank accounting 315
Our chapter discusses central bank financial accounts at a high level of analytical
abstraction. In other words, we draw out pertinent accounting issues facing central banks
in general, rather than discuss in-depth the accounts of specific central banks. This could
be considered an unwise tack to take given that there is no international financial report-
ing framework for central banks, meaning that the ways they go about their accounting
is manifold. However, while the solutions adopted vary across central banks, many of
the accounting issues are common. If the accounting issues we discuss have any tilt, it is
towards those facing central banks in the ‘developing’ world simply because these central
banks are more numerous. For example, while some of the most prominent central banks
globally, such as the Bank of England and Bank of Canada, do not hold the foreign
exchange reserves of their countries on their balance sheets, many other central banks do.
Consequently, we discuss the impact of exchange rate movements on balance sheets and
income statements extensively.
In brief, four key accounting issues common across central banks are the following:
(i) Profit is not a measure of policy performance. Central banks do not set interest rates
or conduct policy transactions for their own financial benefit. Indeed, they may have
to undertake operations that adversely affect their financial position and even cause
them a loss.
(ii) Central bank policy operations require balance sheet positions such as open
(unhedged) foreign exchange reserves1 that produce volatility. But the reporting of
this volatility through the income statement (as required by International Financial
Reporting Standards or IFRS) can significantly affect financial results.
(iii) The concept of liquidity for central banks is different from its concept for com-
mercial entities including banks. Here a distinction can be drawn between domestic
and foreign exchange liquidity. In its own currency, a central bank creates money
and so having sufficient liquidity is rarely an issue, at least for large central banks in
developed markets.2
(iv) Accounting issues such as short-term volatility inherent in market price-based
accounting standards may drive central banks to sub-optimal decisions in order to
minimize losses reported to shareholders and the general public.
Our chapter is structured as follows. The next section gives reasons why central banks
produce financial statements. We then discuss a variety of issues in central bank account-
ing. We divide these issues between the balance sheet and income statement.3 With
respect to the balance sheet, we discuss (1) banknotes and (2) shareholders’ equity, on
the liabilities side, and (3) gold, (4) foreign currency, and (5) financial instruments, on
1
The term foreign currency reserves is well known, even though these are not reserves in the
accounting sense, and the term does not commonly appear in central bank financial statements.
2
In less developed markets where there are fewer financial instruments available, central
banks may find practical issues in ensuring that there is adequate liquidity. In these cases, a central
bank’s own expenditure may have a significant impact on liquidity.
3
In reality, the division is artificial as the issues we discuss affect both. This is because flows
recorded in the income statement appear as differences in balance sheet positions between the start
and end of each reporting period.

the assets side. These five areas are the most challenging in central bank accounting. For
many of the other items on a central bank balance sheet, such as fixed assets and pension
liabilities, accounting treatments are similar to the accounting for these items by other
entities, or are of limited relevance to policy operations. Our discussion of the income
statement then centres on the major and all-encompassing issue of profit recognition
and distribution.
III. WHY CENTRAL BANKS PRODUCE FINANCIAL

STATEMENTS
The production of financial statements by commercial enterprises and other organisa-
tions is today an accepted part of their normal accountability to shareholders and other
stakeholders. It follows that similar considerations apply to central banks. Central banks
may also feel the need to show leadership to banks in their jurisdiction on how to produce
high-quality financial statements. And the production of financial statements, even when
the central bank is fully owned by the government, may signal or assist the central bank’s
independence (Sullivan and Horáková, 2014).4
While there are good reasons for central banks to produce their own independent finan-
cial statements, they have to consider the potential policy implications of the information
they disclose. For example, a central bank’s financial strength, as revealed in its financial
statements, can affect its credibility and ability to perform some operations (Bindseil,
Manzanares and Weller, 2004). Indeed, certain accounting procedures could run contrary
to policy aims. For example, disclosing a provision against a particular asset could trigger
further loss in the value of the asset. Alternatively, the disclosure of emergency liquidity
assistance to a particular firm could cause the failure of that firm.
In sum, central banks have to balance openness and accountability with limits on
disclosures and the adoption of special accounting frameworks. That said, most central
banks now publish fairly comprehensive financial statements. Many have also adopted
recognised accounting regimes as this gives added credibility to the financial statements,
particularly to users who may not be familiar with a national accounting regime. The
principal concern is that accounting policies will be chosen selectively, for example, to hide
bad news or increase the distribution to the finance ministry.
The most common framework is IFRS. IFRS are a comprehensive accounting and
reporting framework created by the International Accounting Standards Board to provide
a common global framework for users of financial reports including stock exchanges and
regulators. Comparability between financial reports in different jurisdictions is enhanced
by such common standards and their existence reduces the need for companies to produce
different reports for various jurisdictions, which is expensive and, at times, confusing.
IFRS are primarily intended for large commercial entities. IFRS were introduced in 2001
and have been widely adopted around the world.
While IFRS is used by many central banks—a situation encouraged by the International
4
However, when a government produces a ‘whole of government accounts’, the central bank
is typically included if owned by the government.

National Standards
Accounting Framework
IFRS
ESCB
National GAAP
IFRS with departures
0 2 4 6 8 10 12
Number of Central Banks
Source: Annual Reports by central banks on their websites. The 19 jurisdictions represented above include
the European Union (ESCB); France (ESCB); Italy (ESCB); the United States (National GAAP); the
United Kingdom (IFRS); Canada (IFRS); Brazil (IFRS); South Africa (IFRS with departures); Germany
(National GAAP); Japan (National standards); Australia (National standards); India (National standards);
Russia (National standards); South Korea (National standards); Saudi Arabia (National standards); Mexico
(National standards); Turkey (National standards); Argentina (National standards); and Indonesia (National
standards).
Figure 16.1 Accounting frameworks adopted by select central banks
Monetary Fund—it is by no means universal (KPMG, 2012). For example, the European
System of Central Banks (ESCB) developed its own accounting framework, which
predated IFRS. This framework is adopted by the European Central Bank (ECB) and all
central banks within the Eurozone, as well as some other ESCB central banks, and indeed
some others outside the EU. The ESCB accounting framework deals with a number of
items not fully addressed in IFRS, such as gold and what is meant by a realised foreign
exchange gain. The ESCB framework places great emphasis on the maintenance of capital
buffers5 to maintain the financial strength of the Eurosystem.
IV. BALANCE SHEET
While they have acquired many functions during the twentieth and early twenty-first cen-
turies, and their structures have undergone various changes over the years, central banks
are at root banks, so many of the accounting issues are similar to those facing other banks.
5
This term is used to encompass balances held in the balance sheet to cover against future
losses. It thus includes provisions and reserves. In this chapter the term ‘reserves’ is mainly used in
the accounting sense, that is as part of equity. This approach is consistent with the central bank’s
published financial statements.

Banknotes
Foreign currency/gold
Deposits from banks
Monetary policy assets Deposits from

government
Monetary policy
liabilities
Other liabilities
Other assets
Equity
Assets Liabilities
Figure 16.2 A hypothetical central bank balance sheet
These include applying the appropriate accounting for financial instruments. However,
certain central banking functions mean they hold some items on their balance sheets in
such magnitudes, and for such specific purposes, that their financial reporting requires
variation on general accounting themes. These items include currency in circulation, gold
and foreign exchange.
1. Liabilities—Banknotes
Domestic banknotes are an important asset for banks, businesses and households. But for
central banks, domestic banknotes are not an asset.6 They are a liability to the holders
of the notes. Since the recognition of banknotes as liabilities is largely confined to central
banks,7 there are no international accounting rules for how to do this. Therefore, central
banks have developed their own. Typically, banknotes in circulation are recorded as a
6
Unissued banknotes may be recorded as an asset (an inventory item) at their production
cost. However, many of the larger central banks do not do this on grounds of materiality.
7
In the UK, some commercial banks still issue their own banknotes.

liability on the balance sheet. Notes are in circulation when they are outside the control
of the central bank.
By contrast, stocks of notes inside the central bank are not in circulation. Some central
banks vary this general treatment at the margins by recognising notes in their tills as an
asset, but the value and volume of these are typically negligible.
Technically, banknotes are a liability whose redemption must be honoured on demand.
Redemption happens every day. Although the specifics vary from country to country, the
general operation is the same. Banks often withdraw notes in the morning, exchanging
them for reduced claims on the central bank.8 At the end of the day, the banks may return
any surplus notes to the central bank in exchange for a top-up of their account balances.
Although individual banknotes have a relatively short life, the circulation as a whole has
a permanent nature.9 In fact, while there is seasonal variation in the value of banknotes in
circulation, there is generally an increase across time, in line with the growth of national
income. These facts have led some scholars to suggest that banknotes could be treated as a
component of central bank capital. Such an accounting treatment would look through the
legal form of banknotes as demand liabilities to the economic reality of their permanent
circulation (Archer and Moser-Boehm, 2013: 34). However, banknotes are not available to
absorb losses, which is one of the purposes of capital. Also, the level of banknotes in circu-
lation is not determined by central banks, whilst other components of capital typically are.
2. Assets
Gold
Many central banks hold gold as part of their foreign reserves or, historically, as backing for
the banknote circulation. This means that central banks often have much more gold than
other types of firms. While gold ordinarily is priced in ounces, the quantity central banks
sometimes hold can be measured in tons. Since gold is not widely held as an asset by other
entities, there is little standard accounting for it. IFRS mentions gold only to state that it is
a commodity and not a financial instrument. However most central banks regard gold as
essentially a financial asset (equivalent to an alternative currency). It therefore makes sense
to account for it in a similar way. As a consequence, central banks have adopted a range of
policies to account for gold holdings. Many commonly distinguish between monetary gold,
which qualifies as part of foreign reserves,10 and non-monetary gold. While some central
banks value monetary gold at cost, others value it at market prices. Non-monetary gold is
most commonly valued at cost, or the lower of cost and net realisable value.11
8
The notes may not be returned physically to the central bank. Banks may hold the notes in
their vaults on behalf of the central bank. Book entries are made by the banks and the central bank
to reflect changes in ownership.
9
Most countries keep a series of notes in circulation for a number of years and periodically
change or update the design. Old series are withdrawn from circulation but may remain valid, or
may cease to be valid, after a period.
10
This is gold with purity of 99.99 percent.
11
A further nuance in gold accounting is the price to use. The quoted market price for gold
presupposes it takes the form of London Good Delivery (LGD). This is both a purity criterion and
prescribes the form of the bars. Strictly speaking, the price of gold in other forms should reflect
deductions for getting it into LGD form, as well as transport costs to one of the main gold trading

Revaluing gold at its market price raises the broader issue of how to treat unrealised
revaluation gains and losses. While there is broad agreement among central bank
accountants that unrealised valuation gains should not be distributable because they
do not represent actual extra resources, there are different accounting approaches to
achieving this.12 Some central banks take the revaluation directly to a revaluation reserve13/
account, which may or may not be part of central bank equity. Others take the revalu-
ation through the income statement and then to reserves. Still others only remove the
revaluation effects when computing the distributable profit.
Foreign currency reserves

Many central banks carry their country’s foreign currency reserves on their balance
sheets. Consequently, they are exposed to exchange rate movements. The effects of these
movements can be rather counter-intuitive. A central bank that hits its inflation target and
generally achieves its policy goals may see its currency appreciate accordingly.14 However,
this may result in an exchange rate loss for a central bank with large holdings of foreign
reserves. Conversely, a central bank in a country suffering serious inflation, and economic
and financial system instability, may see its currency depreciate. Counterintuitively, this
results in a financial gain for the central bank. This phenomenon is sometimes described
as an example of ‘good losses and bad profits.’
This is an area where applying IFRS mechanistically may be ill-suited to central
banking. IFRS requires exchange rate gains and losses to be taken through the income
statement. This is appropriate for commercial entities, where the exchange rate position is
a management decision and the consequences in terms of reported income are part of the
performance on which management can be judged. This is not the case for central banks.
They do not manage the exchange rate for their own financial benefit and do not usually
trade currencies for profit. Yet inclusion of exchange rate gains and losses in the income
statement makes them eligible for distribution, potentially reducing the real net assets of
the central bank by the magnitude of the unrealised ‘book’ entry gain.
How to define and measure realised gains and losses on foreign exchange is also an
issue. In practice, three basic approaches are adopted:
(i) All transactions involving foreign currency (eg, transactions in assets and liabilities
denominated in a currency other than the domestic currency) can generate a realised
gain or loss. So, for example, sale of a security denominated in a foreign currency
for cash can result in a currency gain or loss, due to movements in the exchange rate
since the security was purchased, even when no change occurs in the overall currency
position;
cities. However, in practice, few central banks deduct these transaction costs ex-ante, and instead
recognise them as expenses when they arise.
12
The treatment of unrealised losses is less clear-cut. They could be treated in the same way
as gains, with any deficit (after offsetting against previously recognised gains) held on the balance
sheet. Or they could be treated as a reduction in distributable income.
13
The term reserve is used in its accounting sense, commonly, but not always, a part of equity.
14
Of course, the strength or weakness of a currency is not exclusively determined by central
banks.

(ii) A gain or loss arises only when there is a net reduction in the holding of a particular
currency, ie, some currency has been sold for another non-domestic currency. This
involves central banks regarding each currency as a portfolio invested in various
assets. Transactions within the portfolio do not give rise to any currency gain or
loss, unless the total currency position declines. This is the approach adopted by the
Eurosystem.
(iii) A realised gain or loss only arises when a currency is sold for the domestic currency
and is not reinvested in another currency. This may be the most prudent approach,
as there is an actual net increase in domestic currency assets.
The treatment of revaluation deficits is also an issue as it impacts on distributable profits.

If the deficit is anticipated to be short-lived, then it may be appropriate to maintain the
deficit as a negative balance on (a deduction from) reserves. However, an arguably more
prudent approach would be to deduct the deficit from profit and reduce the amount
available for distribution.15 This is an area where some central bank laws specify the
accounting treatment. Before the widespread adoption of IFRS, it was quite common
to see the negative balance, ie, accumulated revaluation losses, shown on the asset side.
Indeed, for some central banks which have had long-term revaluation losses, the deficit
was a major ‘asset’. The existence of such an ‘asset’ brought into question the relevance
and credibility of the financial statements.
As mentioned, the treatment is not just an accounting issue as it bears on distribut-
able profits. Any distribution to central bank shareholders almost always will be in the
domestic currency. However, a significant part of the income of a central bank could
be denominated in foreign currency. Thus the distribution in itself changes the currency
composition of the central bank balance sheet and could increase the domestic money
stock. Whilst in larger markets the effect may not be material, in smaller countries they
are because the central bank’s profits make up a relatively larger share of government
revenue.16 Volatility due to exchange rate effects may not be appreciated by finance
ministries and can potentially provoke a broader, politically fraught discussion about
whether central banks ought to hold foreign currency reserves at all. This latter point is
outside the scope of this chapter.
Financial instruments and their valuation

Central banks hold many of the same financial instruments as commercial banks and
undertake similar transactions, albeit for different reasons. They therefore encounter
many of the same accounting issues, including the issue of whether to adopt a cost-based
method of accounting or to use fair value.17 This decision is mostly relevant to securities
15
If this results in an overall loss, this would reduce reserves. If the reserves are insufficient,
then there would be negative equity. This is not an immediate financial issue for a central bank but
could cause credibility issues.
16
Hence method (iii) above, which requires the foreign currency to be sold for domestic cur-
rency before the gain is recognised, is probably the most sensible for smaller countries.
17
Under a cost-based method, the financial instrument is recorded at cost and the difference
between this and its nominal or redemption value is amortised over the life of the instrument.
Amortisation is added to, or deducted from, the original cost, and the resulting amount is shown

holdings, as loans and advances (including repos) typically will be held at cost, though the
bright line dividing trading assets from assets held to maturity has been blurred in recent
years by securitisation.
There are two basic approaches to valuation in accounting. One is based on stating
assets and liabilities at their original cost (with amortisation over time). The other is based
on using current values. Both approaches have their advantages and their disadvantages.
Valuation using current values (commonly referred to as fair value) gives more up-to-date
information but may result in greater volatility in the income statement. Conversely, cost-
based accounting is based on a deterministic value in the past and the income statement
tends to be more consistent. However, the relevance of this historic valuation diminishes
with the passage of time. The debate about the relative merits of these valuation approaches
has continued for many years and will probably continue for many years to come.
Most accounting frameworks, including IFRS, adopt a mixed-model approach with
some items at fair value and others adopting cost-based values.18 In general, there are
three key reasons central banks may be wary of fair value accounting, in addition to
the problem of unrealised gains already mentioned. First, fair value accounting tends to
increase balance sheet volatility. Second, central banks have the ability to influence the
market price by their operations. Finally, the valuation of assets by central banks may
have market impact. If a central bank reduces or impairs the value of an asset, it may be
interpreted by readers of financial accounts as the central bank endorsing the weakness
of the institution issuing the asset. This could run contrary to policy aims, especially if
the issuing institution is the central bank’s sovereign.
In practice, central banks adopt a variety of approaches. The Federal Reserve System
adopts a cost-based approach, while the Reserve Bank of Australia (which follows IFRS)
adopts a market valuation approach. The European System of Central Banks has moved
from fair value to cost for its monetary policy securities.
Intangibles
A striking trend in advanced economies in recent decades is that the market capitalisa-
tion of firms has grown to be several multiples of their ‘book’ or accounting value. One
explanation for this is that firms’ balance sheets do not recognise all their assets, especially
intangibles such as brand value. While accounting regimes account for intangibles when
on the balance sheet. Under fair value accounting, financial instruments are regularly revalued
to their fair values (basically the price at which they could be sold on the market). The gains and
losses resulting from the revaluation may be included in income, or taken to a balance sheet account
depending on the approach adopted. IFRS contains criteria for the treatments. For central banks
reporting under IFRS, IFRS9 replaces IAS39 with effect from January 2018. The new standard
may change the treatment of financial instruments between cost and fair value. It also changes the
impairment recognition from incurred loss to expected loss.
18
A simple example, though not of a financial instrument, may illustrate the point. A
company’s premises were bought at cost, possibly several years ago. The cost is probably not a
particularly good estimate of its current value, but is a good basis to spread the cost over the
useful life of the building. In contrast, the current market value (the fair value) is of interest but of
little practical use unless there is a plan to sell the building or to borrow against it. Central bank
premises are normally rather old, sometimes a century or more. The original cost of these is not
very meaningful, particularly when the effects of inflation are taken into account.

acquired from other firms (via goodwill), they are usually not recognised if they are
organically generated (Higson, 2012).
This general observation has particular salience for central banks. In many respects,
the most important ‘asset’ central banks have is their ‘brand’/reputation. In an era of fiat
money unbacked by gold, confidence in the currency at least partly reflects confidence in
the central bank issuing it. Indeed, recent policy interventions in the UK such as forward
guidance have been premised on central banking reputation. However, the central bank
‘brand’ is not recognised in balance sheets as an asset. Nor are other valuable intangible
assets such as the data central banks own, or their research capability. As a result, from
an economic perspective, their balance sheets are incomplete and their equity (assets in
excess of liabilities) is likely understated.
3. Equity
Any firm’s book equity consists of funds contributed by equity investors in the past, plus
the ongoing, undistributed surplus the firm has accumulated over time. This statement
applies to central banks as well. For central banks, capital provides a source of funds
that can be invested to generate income independent of the results of policy operations.
Some central banks explicitly identify this as an ‘own funds’ portfolio’ and have a separate
investment portfolio. In all cases, central bank capital is available to absorb losses. But
when these occur, the capital needs to be replenished in order to absorb future losses.
Besides the initial capital paid up to get a firm started, firms can and do raise additional
equity from investors by issuing new shares. Many firms do so through rights issues,
offering new shares to existing shareholders. However, most central banks are owned by
government. There are two principal mechanisms for government to recapitalise central
banks, both of which have broader impact. First, the government can write a check
against its account with the central bank in exchange for equity. From the central bank’s
perspective, this swaps one government claim on it for another on the liabilities side of
the balance sheet. There is also a potential macroeconomic impact because the stock
of money would fall, leading to possible disinflation. The second mechanism is for the
government to issue new securities in exchange for equity.19 This grows both sides of the
central bank balance sheet. However, this has a fiscal impact because it increases public
debt. This may be undesirable if a financial crisis is coupled with a sovereign debt one,
meaning the government may not be in a position to recapitalise a central bank at a time
when the central bank needs it.
To further complicate matters, a government-owned central bank is not usually in a
position to engage in an open market issue of new equity because a central bank’s aim is
to maximise the common good, not shareholder value. Financial investors are unlikely
to bear risks and losses from policy operations which they cannot influence and where
the entity does not profit maximise. And even if a government-owned central bank could
19
To be effective the security needs to have a fair value, which means it should be interest-
bearing and, ideally, with a known maturity. Best practice is to issue marketable securities which
the central bank can then use in its policy operations. This is not always possible in small countries
that do not have securities markets.

issue shares to private investors, concerns could be raised about potential external influ-
ence in how the central bank operates.20 Given these limitations, a key question is whether,
and, if so, how, central banks can raise external equity.
This question is timely. As a result of recent policy interventions, many central banks
today are highly leveraged and are exposed to greater credit risk because they are lend-
ing against a wider array of collateral. Thus there is a growing academic literature that
discusses the optimum level of equity financing for central banks (Perera, Ralston and
Wickramanayake, 2013; Reis, 2013; Adler, Castro and Tovar, 2012; Stella, 2009; Buiter,
2008; Klüh and Stella, 2008; for earlier reflections see Fry, 1993; Ize, 2005; Bindseil,
Manzanares and Weller, 2004). According to this literature, too little central bank capital
exposes it to balance sheet insolvency and lost credibility. Yet too much has an opportunity
cost if there are higher returns available to shareholders elsewhere in the economy (Milton
and Sinclair, 2011: 6). Getting the quantum of central bank capital just right is challenging.
In theory, central banks can operate with zero or negative capital.21 For example, the
central banks of Chile, the Czech Republic, Israel and Mexico have all pursued their
policy objectives despite at times operating with negative equity (Archer and Moser-
Boehm, 2013: 71). However, the ability of central banks to operate in technical insolvency
applies only to operations in the domestic currency. In foreign currencies, central banks
need to satisfy their counterparts that they can meet their obligations. Also, insofar as
members of the public believe capital matters to the ability of a central bank to conduct
policy operations, then technical insolvency may not inspire confidence in a central bank’s
ability to carry out these functions, even if it still could.
V. INCOME STATEMENT
A central bank’s income statement is dominated by income and expenses arising from
policy operations. These are principally interest income and expenses on the assets and
liabilities used in policy operations, and on foreign reserves, together with effects from the
revaluation of the foreign currency position. Out of this net income, a central bank must
fund its costs, and pay shareholders (ordinarily the government).
At least in theory, a central bank could monetise its expenditures, consuming real
resources by printing additional banknotes and/or increasing the balances of central
bank depositors.22 However, there are real limits to any central bank’s ability to do this.
A central bank behaving in this way over a long period of time and at sufficient scale
could cause the exchange value of its currency to fall, reducing its purchasing power of
real resources from abroad. And domestically, at some point, its banknotes and bank
deposits (ie commercial banks’ reserve and other accounts with the central bank) could
20
Some central banks do have external private shareholders. However, these holdings are typi-
cally few, and largely predate the assumption by the central bank of its modern duties. Examples
where the central bank is not wholly owned by the central government include the US Federal
reserve banks, Belgium, Greece, and Switzerland.
21
Capital includes statutory capital, statutory reserves, specific reserves and undistributed
profits. The treatment of revaluation reserves varies and must be considered carefully in context.
22
This possibility is sometimes referred to as ‘financing from the vault.’

Foreign exchange
Interest on foreign exchange assets
less interest paid on foreign exchange assets
Market operations
Interest
less interest paid
Banking activities
Interest income
less interest paid
Currency circulation
less handling costs
Own funds
Income from securities
Note: Items in black are income. Items in grey are expenses.
Figure 16.3 Hypothetical central bank income statement split by function
cease to function as money, because price inflation would likely encourage people to find
other monetary substitutes, eg other sovereign monies or cryptocurrencies (Stella, 2011).
1. Income
Central banks need an adequate income to be able to fund their operations. This includes
operating expenses such as staff and premises, as well as the cost of policy operations in
terms of interest expense. For large central banks, the operating costs are small relative to
their balance sheets and overall income flows. Thus, they do not usually need to consider
how they will actually fund these costs.23 A payment by a central bank of its invoices, or
payment of salaries to its staff, is an injection of central bank funds into the market in the
same way as a formal policy operation. It is a transfer of liquid resources from the central
bank into the accounts of commercial banks. It is just that it is normally on a much smaller
scale and can be ignored by large central banks. However, for smaller central banks, this is
not the case. Their operating costs may be large relative to their income and indeed quite
large relative to the size of their economies.
Like most banks, a central bank’s income will come mainly from earned interest.
However, there is also scope for central banks to generate income through charges for such
23
Though they should of course have proper budgets and financial control procedures to
demonstrate proper stewardship.

activities as government banking, supervision, foreign exchange transactions, and payment

transactions on behalf of customers. Also, banknotes are an interest-free form of funding
that central banks can invest in interest-bearing assets. The income arising from issuing
notes is commonly called seigniorage. Seigniorage arises not from the notes themselves but
from the assets financed by the note circulation. Central banks issue banknotes in return for
funds, typically claims on commercial banks. These funds are then used to purchase assets,
typically interest bearing securities, or are lent back to the banks. These securities and loans
may then be used in monetary policy operations. The income from these assets produces the
seigniorage.24 The Bank of England exceptionally separates out the seigniorage via a sepa-
rate accounting entity, the Issue Department,25 and all income from the Issue Department
is paid over to the UK Treasury on a regular basis.26 Most central banks do not separate out
their balance sheets in this way. Instead, seigniorage is apportioned out of total income.27
We underscore that seigniorage is income actually earned on the assets matching the
note circulation. The definition of seigniorage as the difference between the face value of
notes and their production costs is not used by central banks. This definition ignores the
fact that the note is a liability of the central bank. Also, the formulation sometimes used
in economic models—taking the note circulation value and multiplying by an interest
rate—is only an approximation. It assumes that the entire note circulation is backed by
interest earning assets and normally uses the short-term interest rate.
Seigniorage is not automatic. It only exists if a central bank holds income-generating
assets against its notes liabilities. Although for central banks in developed countries such
assets normally exist, this is not the case in all countries. In several countries, a major asset
of the central bank is a loan to the government, which may not be performing, or which
pays a low rate of interest. In other cases, the note circulation may be backed by gold
(which generates virtually no income) and foreign exchange. Exchange rate movements
could result in losses, which could make the seigniorage negative. Another case where
seigniorage may not arise is where the note circulation is composed of notes of very low
denomination. Here the income earned on these notes during their lifetime is very low
and insufficient to cover the production costs of the note.
2. Expenses
Central banks are financially leveraged, meaning they fund most of their assets with debt
rather than equity. They are also typically operationally leveraged, meaning that a large
24
The Sveriges Riksbank has included a description of seigniorage in its annual financial
report for several years.
25
The separation of the Issue Department is contained in the Bank of England Charter Act
1844. This Act gave the Bank of England the exclusive right to issue notes in England and Wales.
It required the Bank to identify the assets backing the note issue separately from its other activities.
It was a form of ‘ring-fencing.’
26
The historical justification for distributing seigniorage to the state is that, before modern
times, the monopoly on money-making belonged to government (Desan, 2015).
27
The concept of seigniorage is sometimes extended to include income generated from other
policy related liabilities such as banks’ required reserves. Within the Eurosystem, monetary income
fits this description. It is shared between the member central banks according to a formula based
on relative sizes of national economies and populations.

proportion of total operating costs are fixed and invariant in the medium term.28 As in
most firms, the biggest operational costs for central banks are typically the salaries and
pensions paid to employees. Yet staff costs for central banks are likely to show a different
pattern from most firms in the economy. During economic downturns when revenues fall,
so often do the payrolls of private sector firms. By contrast, during downturns, central
banks often hire additional staff to handle crisis exigencies. In brief, while most firms’
variable costs are procyclical, those of central banks are likely to be counter-cyclical.
Another way central banks differ from other entities is how they make spending
decisions. In most firms, spending is determined according to expectations of future
revenue, using discounted cash flow or other similar capital budgeting methods. However,
in central banks, analytical areas often receive the lion’s share of funding, even though
they often generate no revenue. This is because such analysis is vital to the policymaking
process. Hence if central banks disclosed the profitability of different operating segments,
as is becoming common in the published accounts of other bodies, this could give a
misleading portrayal of the relative value of different parts of the central bank to the
achievement of the organisation’s primary goals.
3. Impairments and Provisions
Like other banks, central banks have to consider impairment issues. Impairment arises
when the amount expected to be repaid falls below the contracted value carried on bal-
ance sheets. When this happens, provisions are made.29 Such provisions are taken as an
accounting deduction from the income statement in the period in which impairments
arise and reduce the carrying value of the assets. This accounting deduction amounts to
the difference between the money borrowers from banks have agreed to repay, and banks’
most current estimate of the amount they will actually receive30 (Bholat et al, 2016).
However, there will be a difference in the nature of the assets that central banks hold.
These will typically be government securities and other low risk, highly rated short-term
paper, and loans to the government.31 A further major class of assets where impairment
can arise is on those assets acquired as part of rescue or support operations, and loans
to banks. In such cases, central banks may acquire many kinds of unusual, or complex,
assets, which may be difficult to value.
Any impairment by a central bank could be interpreted as ‘official’ confirmation that
the issuing entity is weak. In particular, making provision against a loss on government
debt is fraught with difficulty, particularly when it is the central bank’s own government.
It is perhaps easier to make a provision against a government security or loan when the
government is already in default. This is an example of an incurred loss approach. This
28
However, operational costs are small relative to policy income and expenditure for larger
central banks.
29
Under an incurred loss approach, provisions can be made only when a loss manifests. Under
an expected loss approach, provisions can be made in anticipation of probable losses not yet
realised.
30
This is a simplified definition. The actual accounting rules require calculations, some of
which can be complex.
31
Not permitted in the Eurosystem, under the no monetary financing rules.

approach was criticised following the global financial crisis, including by central banks
wearing their supervisory or financial stability hats, as being too reactive and backward-
looking. Consequently, accounting standards are moving to a more forward-looking
expected loss approach. However, having been critical of the old accounting approach,
many central banks may feel obliged to adopt the new expected loss approach. For banks
reporting under IFRS, it will be compulsory since IFRS 9 requires an expected loss
approach, including recognising some credit loss on inception (day one provisions). But
doing this in practice could be challenging. If the central bank, based on its economic
forecasts, thinks that the government will not be able to service its debt, it should make
a provision, but by making of a provision, it could, in an extreme scenario, create a
sovereign debt problem where one did not previously exist.
Some central banks also create large provisions (as a deduction before arriving at
profit) for general risks such as foreign exchange and interest rate losses. Such ‘rainy day’
provisions, recorded as liabilities in the balance sheet, are not allowed under IFRS. Central
banks using IFRS have to create reserves out of profits for such risks.
4. Profit Recognition and Distribution
Unlike other companies, where the distribution of after-tax income is at the discretion of
company directors subject to few restrictions imposed by law, the profit distribution of
central banks may be enshrined in statute, and call for a substantial portion of profits to
be paid out to the government.32 While having profit distribution arrangements prescribed
in law negates the need for ongoing negotiation with government, it may limit the central
bank’s ability to undertake unusual or novel activities and operations (Ize, 2006).33 As a
consequence, expenditure, including policy-related expenditure, may be tightly managed
in order to protect profits. So while profitability is not the main purpose of central banks,
it can still matter.
Income recognition policy will have a direct impact on the amount available for dis-
tribution. This is not just an accounting issue. It has real economic implications. Central
bank distributions automatically increase the domestic money stock, and provide revenue
for shareholders such as government to potentially spend. It is therefore important that
distributed profits represent real income and not just unrealised ‘book’ profits such as
those, for example, which result from the periodic upward revaluation of property, plant
and equipment, or, more significantly, gold and foreign reserves, and domestic securities.
A related issue is that accruals may be included in profit and distributed before the cash
has been received. For example, interest may be accrued on government securities. Yet
these may be paid back to the government as a distribution before the government actually
has paid the interest. This creates additional funds for governments in the short-term.
A further effect of profit rules is that they can act as a constraint on central banks’ abil-
32
For example, the Central Bank of Ireland can only retain a maximum of 20 percent of any
surplus, regardless of its equity position, and the Bank of Japan may only retain five percent of
surplus according to law (Archer and Moser-Boehm, 2013: 37).
33
Central banks are often exempt from corporate income tax because a significant portion
of their profits already go to government as a dividend. Given that, corporate income tax is
superfluous.

ity to undertake unusual or novel activities and operations. Since any losses that result will
affect the distribution, the shareholders, particularly the government, have a legitimate
interest in the activities that cause them. This is, of course, appropriate for an institu-
tion receiving public funds, which should be constrained in its activities, particularly
those that are quasi-fiscal, for which the government should be ultimately responsible.
However, there is the risk that institutional and financial independence could be damaged.
Consequently, central banks may feel the need to build up significant financial ‘buffers’34
to be able to cope with potential losses, without the need to call upon the shareholder for
additional funds.
Central banks address these challenges in various ways. Most consider distribution
effects when choosing their accounting policies. When possible, there will be arrange-
ments to calculate the distributable profit as a separate figure from the accounting profit,
typically excluding unrealised gains. This may be incorporated in law or by contractual
agreement.
VI. CONCLUSION
This chapter has surveyed key features of central bank financial statements which distin-
guish them from those produced by other bodies. We also have pointed out the unique
context in which central banks produce those statements and how that may influence
their nature and presentation. We have described some of the particular accounting
issues applicable to central banks, including those relating to gold, foreign exchange and
seigniorage. It should nevertheless be noted that, these specific issues aside, central bank
accounting should follow the same general accounting principles that apply to other
entities. These include consistency, transparency and prudence.
In summary, some of the ways central bank accounts differ from those of other banks
are as follows:
(i) Profit is not a measure of policy performance. Central banks do not generally set
interest rates or conduct policy transactions for their own financial benefit. Indeed,
they may have to undertake operations that result in financial loss. For example, if
a central bank raises rates to dampen an overheating economy, this could cause the
value of the debt they hold to fall under fair value accounting. However, central
banks may still pay attention to their income statements to ensure their financial
credibility.
(ii) Liquidity has a different meaning for central banks than it does for other banks.
34
The term buffers is used to encompass all the funds that are available to meet potential losses,
including reserves, provisions and other accounts set up for the purpose. The use of the terms pro-
visions and reserves is not standardised across accounting (and in English can have several different
uses) around the world and can lead to confusion. Also, the circumstances in which provisions can
be made differs greatly across jurisdictions. In general, a provision is made before arriving at profit,
whilst a reserve is not. The use of the term buffers means that discussion of the size and the need
for these buffers, where there is a lot of agreement, can be divorced from the discussion of how to
achieve them, where different approaches cause problems.

A central bank usually creates its own domestic currency so liquidity is rarely an
issue, although this statement does not apply to foreign currency operations, where
a central bank is in the same position as other banks.
(iii) The meaning of capital adequacy for central banks also differs. Central banks can,
and some central banks do, operate with negative equity. Other banks in this posi-
tion would be insolvent and out of business without some form of assistance.
VII. AREAS FOR FUTURE RESEARCH
Central bank financial statements evolve over time and their evolution reflects the chang-
ing roles of central banks historically. Looking ahead, there are four potential develop-
ments on the horizon that may impact the nature of central bank financial statements (see
also Barker, Bholat and Thomas, 2017).
(i) The first is that some central banks start to issue digital currency, defined as an elec-
tronic form of central bank money usable by the general public. Currently, central
bank reserves are the only electronic form of central bank money that exists (with
banknotes being the physical form), and only a select number of financial institu-
tions have access to them. Central bank digital currency could potentially provide
the central bank with another tool through which to conduct monetary policy, as
both the quantity and/or the interest rate of central bank digital currency could be
adjusted. However, assuming the rise in central bank digital currency isn’t matched
by a fall in the issuance of banknotes, the issuance of any meaningful quantity
would lead to a significant increase in liabilities for the central bank, requiring them
to buy more assets. Some of these assets might be government bonds, but many
central banks already hold very large quantities of these post-crisis. They may not
want to hold more for fear of distorting bond markets, political worries about
monetary financing, or simply because there are not enough government bonds in
circulation. Although there has been a lot of discussion about how central bank
digital currency could radically change payment systems—and even the financial
sector as a whole—the implication for the assets on central bank balance sheets
could be just as critical.
(ii) A second possible development is that central banks start to make more creative
use of their equity to implement policy. Typically, central bank equity is seen just
as a ‘loss-absorbing buffer’, instead of being actively used to implement policy. For
example, QE has worked, roughly speaking, by central banks creating new reserves
so they can buy financial assets from the private sector. However, in theory, central
banks could achieve the same ends by different bookkeeping means, issuing central
bank shares in exchange for private sector assets. These shares would be different
from conventional shares in a listed company as they wouldn’t give voting rights
on the activities of the central bank, but apart from that, they’d be similar. An
upside of using equity to buy private sector assets is that the central bank would be
strengthening its capital base at a time when it’s taking on more risk.
(iii) A third possibility is that central bank currency swaps (CBCS) continue to increase
in importance. CBCS can be seen as a set of two reciprocal loans in different

currencies; for example, the Federal Reserve supplying the Bank of England with
dollars, and the Bank of England supplying the Federal Reserve with pounds. CBCS
gained prominence in 2007–09 as central banks needed access to foreign currency to
support their domestically headquartered banks with heavy international exposures.
Although originally a temporary crisis measure, many currency swap lines are now
permanently agreed between major central banks. CBCS are off-balance sheet credit
commitments. When exercised, they appear on the balance sheet as a new foreign
currency denominated liability and a new asset in the domestic currency. This
creates a currency mismatch that can be risky if the domestic currency depreciates.
If called on again in the future, CBCS could substantially alter the size and composi-
tion of central bank balance sheets, and the risks facing them.
(iv) Last but by no means least: a central bank could implement a ‘helicopter money
drop’ to stimulate the economy. There are many forms that this policy could take, but
most proposals envision the money being used to monetise fiscal policy—essentially
creating money for the government to either spend or distribute to people. Besides
raising important questions about central bank independence, helicopter money
would involve substantial change to the balance sheet of the central bank. For
example, helicopter money could be implemented by the purchase of a perpetual
zero-coupon government bond issued specifically for this purpose. Unlike bonds
purchased in QE, this couldn’t ever be sold and would therefore provide a com-
mitment never to unwind the policy, leading (arguably) to a larger impact on the
economy. However, economists at the BIS have argued that helicopter drops would
do more harm than good (Borio, Disyatat and Zabai, 2016).
All of the topics above are worthy of future research.
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Archer, D and Moser-Boehm, P (2013) ‘Central bank finances’ BIS Papers 71, April.
Barker, J, Bholat, D and Thomas, R (2017) ‘Central bank balance sheets: past, present and future’ Bank
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accounting treatments of assets’ Bank of England Staff Working Paper 594, April.
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http://voxeu.org/article/helicopter-money-illusion-free-lunch.
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17. International aspects of central banking:
diplomacy and coordination*
Robert B Kahn and Ellen E Meade
I. INTRODUCTION
In this chapter, we discuss the evolution of central bank interactions since the early
1970s following the breakdown of the managed exchange-rate system that was negoti-
ated at Bretton Woods. We focus not only on how central banks interact with one
another in normal times, but also on how they behave during times of crisis. Today,
central banks have more forums in which they interact without finance ministries than
they did in earlier times, reflecting the fact that the focus of interactions has shifted away
from managing exchange rates and toward monitoring and regulating the international
financial system, global financial institutions and cross-border capital flows.1 At the
same time, the rise in statutory independence has given central banks more authority
to shape the response to events, and the rise of new powers and their integration in
markets has resulted in the broadening out of the prominent coordinative groupings to
include countries outside the historically traditional major powers. Within this context,
our main conclusion is that the relationship-building that is inherent in multilateral
interaction has provided a springboard for coordination in times of stress or crisis.2
Moreover, crises matter in that they can be turning points in terms of the actions taken
and the countries included in the dialogue; thus, the groupings themselves are to some
extent endogenous to events.3
Even in the relatively short period during which central banks have been an institutional
mainstay of society, there have been dramatic shifts in how central banks have interacted.
During the gold standard and the Bretton Woods period, central bank coordination was
* The authors thank Tom Connors, Peter Conti-Brown, Charles Goodhart, Randall Henning,
Melanie Josselyn, Miles Kahler, Michael Levi, Steve Meyer, Ed Nelson and Ted Truman for helpful
comments on an earlier draft, and Melanie Josselyn and Ted Liu for excellent research assistance.
The views expressed here are those of the authors and do not necessarily reflect the views of other
members of the research staff, the Board of Governors of the Federal Reserve System, or the
Federal Reserve System.
1
A major theme in Bergsten and Henning (1996) is the increasing role that central banks have
played over time.
2
In our view, relationships are a necessary condition for action during a crisis; of course, this
point cannot be proven definitively because we are not able to observe the outcomes that would
arise in the absence of such relationships.
3
This framing is similar to what Krasner (1984) terms ‘punctuated equilibrium’, in which new
institutions or structures arise during times of crisis and the ‘dynamics associated with a crisis of
the old order and the creation of a new one are different from those involved in the perpetuation of
established state institutions’ (240). The theory of punctuated equilibrium comes from evolution-
ary biology and has been applied in many different disciplines.
333

typically bilateral and involved the provision of liquidity to support the convertibility of
currencies and maintenance of the exchange-rate system.4 Following the end of managed
exchange rates in 1973, central banks shifted their focus to achieving price stability and,
during the 1990s, began to orient their monetary policies around inflation targeting—a
framework which did not require cooperation per se (although central banks continued
to meet and discuss their policies and objectives).5 By the end of the 1990s, inflation
targeting had been adopted not only by advanced economies but by many developing and
emerging market countries as well. Over the same period, with the increase in financial
liberalization and capital flows, central bank cooperation was expanded to include the
codification of standards and rules aimed at ensuring the safety and soundness of
the international financial system. Since the global financial crisis that began in 2007,
much more talk among central banks has been dedicated to discussions of financial
stability.6
It is perhaps no surprise that we have seen such large historical shifts in central bank
interactions. How scholars have interpreted these interactions has changed over time.
Papers on multilateral interactions typically differentiate the types of those interactions
into categories, with no two studies using an identical taxonomy. For example, Bergsten
and Henning (1996: 13) distinguish between cooperation and coordination, where the
former refers to ‘all collaborative activities among governments’ and the latter is the
subset of cooperative activities that involves the ‘mutual adjustment of national economic
policies.’ Cooper (2008) defines central bank cooperation as having six facets: sharing
information; standardizing concepts; exchanging views on global economic developments
and the objectives of central bank policy; discussing the economic outlook; standardizing
concepts with a possible adjustment of regulations; and agreeing to joint actions. James
(2013) sees the progression from collaboration (pure information exchange); to discur-
sive cooperation (discussion of policy objectives or technical issues); to instrumental
cooperation (actions that are made more credible because they are undertaken jointly);
to coordination (an extreme form of instrumental cooperation in which the action would
not have been undertaken in ordinary circumstances but supports a shared longer-term
goal).
In our view, the activities specified by the various taxonomies can be broadly classified
into two types: relationship-building and joint actions.7 Relationship-building, which we
term ‘diplomacy’, includes all forms of public and non-public information exchange—
discussions of: current economic conditions, the economic outlook, statistical models of
the economy, or statistics. Diplomacy develops in international forums that build knowl-
edge, professional relationships and trust. We see joint actions such as standard or rule
setting, foreign-exchange market intervention, and liquidity provision, as ‘coordination’.
4
There are many histories that discuss central bank coordination during the fixed exchange
rate period; see, for example, Eichengreen (2011) and Flandreau (1997).
5
For a description of the inflation targeting framework, see Bernanke and Mishkin (1997).
6
Balls, Howat and Stansbury (2016) discuss the implications of the broadening of central bank
remits for institutional design and independence.
7
Our classification is similar to the one adopted by Borio and Toniolo (2008) who distinguish
between information exchange (which they term ‘low-key cooperation’) and joint decisions or
actions (‘high-profile cooperation’).

International aspects of central banking 335
Although coordination does not necessarily occur only in times of crisis, relationships
built through diplomacy lay the ground work for coordination when a crisis occurs.
Most central bank interactions—whether they be in forums exclusive to central
banks or joint with finance ministries—are an example of ‘minilateralism’ as defined
in Hampson and Heinbecker (2011). In minilateralism, ‘cooperation is promoted and
advanced through smaller group interactions that typically involve the most powerful
actors in the international system’ (301).8 Our study follows this model; therefore, we focus
on central banks in the advanced economies and, more recently, those in major emerging
market economies. The decisions that arise from these minilateral forums can be seen as
a type of ‘soft law’ in that these forums generally have no formal rules of membership,
are granted no specific authority, and have no formal decision-making processes or pro-
cedures for resolution of disputes.9 One example of soft law is the G-5’s Plaza Accord in
1985, which had no binding legal standing, but whose announcement has been interpreted
as a public commitment device to lower the value of the US dollar through concerted
foreign-exchange intervention.10
The chapter is organized as follows: In the next section, we discuss the most important
forums or organizations through which central banks have engaged in diplomacy. We
then discuss the mobilization of coordination through diplomacy using three examples
over the past 30 years: the Plaza Accord in 1985 negotiated by the G-5; the response to
the Asian financial crisis in 1997–98, led by the International Monetary Fund (IMF) with
heavy participation from G-7 finance ministries and central banks; and the response to
the global financial crisis that began in 2007. In each of these examples, we provide the
economic circumstances at the time, discuss how the response was mobilized, and evaluate
its success. An important take-away is that the major diplomacy bodies have tended to
evolve in the aftermath of crises. In the concluding section, we use the lens of diplomacy
and coordination to trace out the path for central bank diplomacy going forward.
II. DIPLOMACY
Diplomacy is the art of telling people to go to hell in such a way that they ask for directions.
(Winston Churchill)
There are a multitude of international forums in which central banks participate, some
of them high-profile (for example, G-7 or G-20 meetings of finance ministers and central
bank governors) and others that are more private and less subject to public scrutiny
8
Hampson and Heinbecker (2011) note that these minilateralist forums tend to be more
decisive and efficient but less broadly accountable compared with large, more representative
forums. ‘Plurilateralism’ might be a better term, as the countries involved can be quite powerful and
large—such forums are ‘mini’ only in the sense that some countries have been excluded.
9
For a discussion of hard and soft law in international governance, see Abbott and Snidal
(2000).
10
Feldstein (1988: 10) argues that the system of government matters in that the separation
of powers in the United States limits the authority of the US Treasury Secretary in international
macroeconomic policy coordination relative to finance ministers from countries with parliamen-
tary systems, particularly with respect to federal spending or taxes.

(meetings at the Bank for International Settlements, for instance). Despite advances in
openness and transparency of central banks over the past two decades, the volume of
central bank interactions and the multitude of forums is greatly underappreciated.
In a recent speech, Ben Bernanke recounted the extensive consultations among central
banks during the time he served as Chairman of the Federal Reserve, including meetings
with about 50 central bank governors six times a year at the Bank for International
Settlements (BIS). He noted that these meetings were ‘of sufficient importance to the
Fed that FOMC meetings are rescheduled to make sure they don’t conflict.’11 In addition
to meetings at the BIS, there were ‘international meetings that involve both central bank
governors and finance ministers, including the G-20, which meets all around the world
several times a year, G-7, the other Gs, and also, of course, the IMF meetings typically
here in Washington and sometimes elsewhere, where you gather together the policymakers
from the finance ministries and central banks from around the world’ as well as ‘many
other forms of consultation, calls, conference calls, bilateral calls, bilateral meetings, staff
meetings, and the like.’ Not only were these consultations extensive, but they also included
a discussion of prospective policies, not just of actions already taken, so that ‘policies are
not made in isolation’—a point that may not be entirely clear to the general public.
Our aim here is to provide an overview of the forums to which Bernanke alludes, those
that historically have been or today are the most important for international dialogue
involving central banks. We leave aside the various regional groupings such as the Centro
de Estudios Monetarios Latinamericos (CEMLA), founded in 1952 to promote policy
dialogue and training in Latin America and the Caribbean; and the Executives’ Meeting
of East Asia-Pacific Central Banks (EMEAP), founded in 1991, which in addition to
the traditional information exchange has several bodies devoted to the discussion of
crisis management, financial stability, and supervisory issues.12 (Given the importance
and idiosyncratic nature of Asian regional cooperation, we address that topic in a later
section.) While these regional groupings are important, particularly for establishing
regional solidarity and providing a counterweight to international institutions and
the world’s most influential central banks, they have not operated at the helm of crisis
response and resolution to date.
1. Working Party Three and the Group of Ten
Working Party Three (WP3), a subcommittee of the Economic Policy Committee (EPC)
at the Organization for Economic Cooperation and Development (OECD) is one of the
oldest forums for finance ministry and central bank dialogue. The OECD, established
in September 1961 as the successor to the Organization for European Economic
Cooperation, is an international institution with 34 member countries that provides
economic analysis and a venue for meetings of government officials. WP3 was founded to
analyze ‘international payments of monetary, fiscal and other policy measures’ and con-
11
Bernanke (2015b).
12
CEMLA is the oldest regional association of central banks; current membership includes
49 central banks. There are 11 member central banks in EMEAP, including the People’s Bank of
China.

sult ‘on policy measures, both national and international, as they relate to international
payments equilibrium.’13 From its inaugural meeting in 1961, WP3 was a macroeconomic
talk-shop for representatives of finance ministries and central banks from ten industrial
countries—the most important forum of its kind until the mid-1970s.14 In 1962, the
members of WP3 met separately as the G-10 to establish the General Arrangements to
Borrow (GAB), a set of bilateral standing arrangements that provided the IMF with
additional resources to lend (initially only to countries in the G-10) in extraordinary
circumstances.15 The BIS hosted that meeting of the G-10 and, according to Borio and
Toniolo (2008: 43–44), central bank governors were already meeting regularly in Basel
and the BIS provided technical and staff support for ‘an increasing number of official
and semi-official “groups”, sometimes made up of both government and central bank
officials’ from the 1950s onward. Baker (2006) reports that finance ministries and central
banks of G-10 countries met regularly from the early 1960s until the collapse of the
Bretton Woods system in 1973.
2. Other G-groupings16
The origin of the G-5 and later G-7 groupings dates to the spring of 1973 when the US
Treasury Secretary met together with the finance ministers of France, West Germany
and the United Kingdom in the library of the White House to discuss the international
financial system after the collapse of the Bretton Woods system of fixed exchange rates.
In calling together the ‘Library Group’, the US was seeking a more candid and informal
grouping less dominated by European countries than the G-10; at another meeting in
the fall of 1973, which included the Japanese finance minister, the G-5 finance ministers
agreed to meet regularly. Federal Reserve Chairman Arthur Burns attended the next meet-
ing and set a precedent for the inclusion of central bank governors. According to Baker
(2006: 24–25), ‘the beginnings of the G-5 (later to become the G-7) process were heavily
informal, somewhat ad hoc and had an incremental and evolutionary dynamic’ that relied
on ‘personal networks and shared understandings.’ The group issued no communiqués
after its meetings until 1985—indeed, its meetings were held in secret. Although the meet-
ings of heads of state or government—known as ‘leaders’ level’ summits—had expanded
to include Canada and Italy by 1975, the grouping of finance ministers and central bank
governors did not meet as the G-7 until 1986.
13
See OECD, http://www.oecd.org/general/2504075.pdf, 39.
14
The original G-10 included: Belgium, Canada, France, West Germany, Italy, Japan,
Netherlands, Sweden, United Kingdom and United States. Switzerland became part of the group
in 1964, although the grouping kept its name as ‘G-10’. See Bergsten and Henning (1996) for a
history of WP3. WP3 is still considered an important talk-shop; for example, the current Federal
Reserve Board Vice Chair heads the WP3, and other US participants include the US Treasury
Under Secretary for International Affairs, a member of the Council of Economic Advisers, and a
Federal Reserve Board Governor.
15
Bergsten and Henning (1996) regard the formation of the G-10 as a victory for the Europeans
who viewed the IMF as a US-dominated institution; extensions under the GAB were not an IMF
decision. Switzerland did not join the GAB until 1964 (http://www.imf.org/external/np/exr/facts/
groups.htm#G10).
16
For background on the assorted G-groupings, see Baker (2013).

A process to expand the club of finance ministers and central bank governors to
include a broader set of countries began in the late 1990s at the behest of Asia-Pacific
Economic Cooperation (APEC) leaders and President Clinton amid a financial crisis in
Asia.17 In 1998, ministers and governors convened a meeting of the G-22 (initially known
as the ‘Willard Group’ because their first meeting took place in the Willard Hotel in
Washington, DC) to discuss prospective reforms to the architecture of the international
financial system.18 Over the course of 1998 and 1999, the G-22 and its various working
groups made a number of proposals, including the creation of a Financial Stability
Forum (FSF). The FSF was established by the G-7 in early 1999 ‘to ensure that national
and international authorities and relevant international supervisory bodies and expert
groupings can more effectively foster and coordinate their respective responsibilities to
promote international financial stability, improve the functioning of the markets and
reduce systemic risk’ and, although initially convened at the G-7 level, was intended to
become more inclusive over time.19 The FSF comprised representatives from not only
finance ministries and central banks but also supervisory authorities and other financial
authorities; a small secretariat for the FSF was housed at the BIS in Basel.
In addition, the G-7 tasked a somewhat larger group of countries with reviewing some
of the G-22’s proposals and this G-33 met twice in the spring of 1999.20 Kharas and
Lombardi (2012) report that efforts then began to transform the G-33 into a smaller, more
manageable and less Asian grouping that would, at the same time, satisfy the need for a
forum broader than the seven industrial powers.21 This was achieved in September 1999
when the G-7 finance ministers and central bank governors announced the formation
of the G-20,22 with their communiqué stating that this new forum would ‘broaden the
discussions on key economic and financial policy issues among systemically significant
economies and promote cooperation to achieve stable and sustainable world economic
growth that benefits all.’23 However, from the start, some were skeptical about whether
the G-7 was using the G-20 to legitimate its discussions.24
17
The G-7 leaders’ summit expanded to eight members with Russia in the mid-1990s, but the
grouping of finance ministers and central bank governors remained unchanged.
18
The G-22 added 15 countries to the G-7: Argentina, Australia, Brazil, China, Hong Kong,
India, Indonesia, South Korea, Malaysia, Mexico, Poland, Russia, Singapore, South Africa and
Thailand. The G-22 was intended from the start to be a temporary forum (http://www.imf.org/
external/np/exr/facts/groups.htm#G22).
19
Communiqué (1999). See Langdon and Promisel (2013) for a history of the FSF and its
work.
20
The G-33 added 11 countries to the G-22: Belgium, Chile, Côte d’Ivoire, Egypt, India,
Morocco, Netherlands, Saudi Arabia, Spain, Sweden and Turkey.
21
There is a rich and interesting debate about global governance surrounding the G-22, G-33
and G-20 groupings. See Kharas and Lombardi (2012) and the references therein.
22
The G-20 comprised 19 countries (Argentina, Australia, Brazil, Canada, China, France,
Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South
Korea, Turkey, United Kingdom and United States) and a representative of the European Union.
23
Canada (1999).
24
Kirton (1999) writes: ‘One doubt arises from the view of some who see the G20 as part of the
“G7-ization” of the world. In this view, the G20 was born to legitimate G7 initiatives to the wider
world, by securing a broader consensus for G7-generated ideas. The G20’s eleven non-G7 members
are thus destined to affect issues merely on the margin, to be informed of G7 initiatives, and to be

After quiet initial years, the G-20 finance and central bank forum began to coordinate
more closely beginning in the fall of 2007 as signs of what was to become the global
financial crisis began to emerge. We defer the discussion of these actions to the next
section, but note that as the importance of the G-20 grew, it began meeting at the leaders’
level in fall 2008 and assumed a central role in the policy response that unfolded over the
course of several summit meetings.
3. The Bank for International Settlements
The BIS is the oldest multilateral central banking institution, unusual in both its history
and the fact that its members are central banks, not governments. Founded in 1930 as
part of the Young Plan, the BIS was established to administer Germany’s World War I
reparations payments consistent with the statutory objective to act as a trustee or agent
for international financial payments.25 In this capacity, the BIS acts as a bank for central
banks.26 However, another statutory objective directs it ‘to promote the cooperation of
central banks and to provide additional facilities for international financial operations.’
Cooper (2008: 82–83) writes that this ‘convening function was exercised at once, as gov-
ernors of the equity-holding central banks gathered once a year, and their representatives
gathered almost monthly from the opening of the BIS in April 1930.’
The BIS has a fascinating early history that is worthy of a brief review. Americans played
a central role in the committee that negotiated the Young Plan and established the BIS, but
the US government was officially opposed to linking Germany’s reparations payments and
the Allied war debt owed to the United States.27 Prominent private financiers—including
JP Morgan—and the Federal Reserve represented US interests in the negotiations.
Although seven countries were involved in the negotiations, only six central banks held
equity when the new institution was created—Belgium, France, Germany, Italy, Japan and
the United Kingdom. The US government would not permit the Federal Reserve System
to occupy its seats on the BIS’s Board of Directors, so the shares were held by a consortium
of private banks.28 (The Federal Reserve System did not take up its seats until 1994.)
given some semblance of participation. The G20 underscores the fact that the G7 does not want to
leave the reform of the international financial system to the IMF or World Bank, where developing
countries have an institutionalized role.’
25
See Article 3 of the statutes: https://www.bis.org/about/statutes-en.pdf.
26
Simmons (1993) notes that Montagu Norman, governor of the Bank of England at the time
of the BIS’ founding, referred to it repeatedly as a ‘club for central bankers’ (390).
27
The Committee of Experts on Reparations—the so-called Young Committee, headed by
American businessman Owen Young—met in 1929 to work out the rescheduling of Germany’s
reparations debt. The Young Committee proposed creating an international bank to ‘commercialize’
the reparations payments. See Simmons (1993) and Toniolo (2005, Chapter 2) for detailed accounts.
By commercializing the payments, reparations would be separated from politics, something that
appealed to private bankers. Simmons (1993: 393) writes that ‘The United States government
opposed any bank that would simply be a funnel for German reparations to pay off American war
loans.’ Toniolo (2005) explains that although there was no formal link between Germany’s repara-
tions payments and the debt the Allied countries owed the United States, a linkage might create a
‘united European front’ that could demand a reduction or repudiate the debt.
28
The first two Chairmen of the BIS’s Board of Directors were American (Gates McGarrah
and Leon Fraser). The head of the Federal Reserve Bank of New York, George Harrison, favored

The reparations function of the BIS did not last long. The onset of the Great Depression
in late 1929 was followed by a breakdown in international trade (spurred by passage of
the American Smoot-Hawley Tariff Act), and a prolonged period of nationalism and
isolation. In 1931, President Hoover issued a moratorium on the payment of World War
I reparations and debts, which were permanently suspended in 1932. Although the BIS
adopted a ‘neutral’ stance during the Second World War, it facilitated the transfer of gold
from the Czech central bank to the Reichsbank29 and accepted looted Belgian, Dutch and
‘victim’ gold deposits in the Reichsbank’s account. At the Bretton Woods conference in
1944, a recommendation called for ‘liquidation’ of the BIS ‘at the earliest possible date.’30
Even though this recommendation was included in the Bretton Woods agreement, it
proved impossible to carry forward. Despite the desire of Americans Harry Dexter White
and Henry Morgenthau to dissolve the BIS, strong support from the central banks in
Europe and John Maynard Keynes prevailed, and the BIS survived.
Since that time, the BIS has facilitated central bank operations and provided the forum
for a wide range of technical discussions about central banking issues. In the 1950s,
the BIS acted as agent for the clearing and settling of intra-European payments in the
European Payments Union (EPU).31 In the 1960s, the BIS was at the center of central
bank efforts to keep the price of gold in the free market trading near its official price in
the Bretton Woods system, provide a line of credit to the Bank of England to prop up the
pound sterling, and monitor developments in the emerging Eurocurrency market.32 As
noted earlier, it was also during those years that the central bank governors of the G-10
countries began to hold regular meetings at the BIS to review economic developments and
monetary policy; the BIS also acted as agent for the G-10’s GAB. In addition, in keeping
with its historically European focus, the BIS played a central role in European monetary
integration, initially by hosting a committee of central bank governors of the European
Economic Community, starting in 1964, and later, beginning in 1993, by housing the
European Monetary Institute, the precursor of the European Central Bank (ECB), which
made the technical and operational plans necessary for Europe’s monetary union.33
keeping private bankers involved given that the US government had blocked Federal Reserve
participation in the BIS. At that time, the Fed’s relationships with foreign central banks and govern-
ments were handled largely by the Federal Reserve Bank of New York. The Banking Act of 1935,
which changed the structure of the Federal Reserve System, explicitly handed those activities to the
Federal Reserve Board of Governors in Washington; see Wheelock (2000).
29
The transfer of Czech gold occurred in March 1939 at the time of the German occupation
of Czechoslovakia and prior to the outbreak of war later that year.
30
This recommendation was submitted by the Norwegian delegation to Bretton Woods; see
Toniolo (2005: 268).
31
The EPU was the first multilateral arrangement for the clearing of payments related to
international trade and was administered by the Organization of European Economic Cooperation
in Paris, set up to assist the European recovery after World War II; see Triffin (1957).
32
These are commonly known as the Gold Pool, the Sterling Group Arrangements, and the
Standing Committee on the Eurocurrency Market, respectively.
33
Siegman (1994) lists the ‘European character’ of the BIS as one of the reasons that the
United States did not assume its seat on the BIS’s Board until 1994 (both the Chair of the Federal
Reserve Board and the President of the Federal Reserve Bank of New York hold seats on the
Board of Directors). In the early 1990s, the institution began expanding to include a number of
non-European central banks. According to Siegman (at 900), America’s decision to take up repre-

With the end of the Bretton Woods system in 1973, the BIS began to shift toward
forums organized to address various financial-sector issues. Borio and Toniolo (2008)
distinguish between crisis response, on the one hand, and work aimed at strengthening
the financial system in order to make it less susceptible to crisis, on the other. The
most prominent example of the latter during this period was the Basel Committee
on Banking Supervision (BCBS), a standing committee established by, and originally
reporting to, G-10 central bank governors.34 The Committee first met in February
1975 following the collapse of a German bank (Bankhaus Herstatt)—an event that
raised concerns about the fragility of fast-growing international financial markets.
Since that time, the committee has evolved into the primary forum for central banks
and regulatory authorities to cooperate on banking supervisory matters.35 Other BIS
committees created during this period addressed payments and settlement systems,
financial market functioning, and international banking statistics. To the extent that
responsibility for these issues extended beyond central banks, the forums were opened
up to other government authorities.
At times shifting from diplomacy to cooperation, these forums have yielded a number
of well-known agreements on minimum capital standards for banks, core principles for
banking supervision, and principles for the operation of settlement systems.36 Borio
and Toniolo (2008: 64–65) point out that the codes and principles for the financial
sector have relied upon ‘non-binding agreements reached by national authorities, imple-
mented largely through peer-group pressure within national jurisdictions, possibly after
adjustments to local law, and with the support of market forces’—that is, soft law. With
regard to crisis response, the BIS has made financing commitments or carried out
operations on a number of occasions to countries experiencing a financial crisis, often
on behalf of the G-10 countries (examples include Mexico and Argentina during the
Tequila Crisis in 1995 and Thailand in 1997, in advance of IMF lending).
Today the BIS has 60 member central banks. In terms of macroeconomic consultations,
governors of 30 BIS members meet bimonthly at the Global Economy Meetings, which is
supported by a smaller group of 18 governors on the Economic Consultative Committee.
As noted earlier, the BIS houses the FSB and also provides facilities for international
associations for insurance supervisors and deposit insurers.
sentation ‘was made in recognition of the increasingly important role of the BIS as the principal
forum for consultation, cooperation, and information exchange among central bankers and in
anticipation of a broadening of that role.’
34
For a history of the BCBS’s early years, see Goodhart (2011). As evidence of the limited
nature of international coordination at the time, Goodhart (45–46) reports that at the first meeting
of the committee, none or hardly any of the participants around the table had met before.
35
See BIS (2016). The Committee expanded its membership in 2009, again in 2014, and now
includes 28 jurisdictions. Today the Committee reports to an oversight body composed of central
bank governors and (non-central bank) heads of supervision from member countries.
36
These were Basel I in 1988 and Basel II in 2004; the Core Principles for Effective Banking
Supervision in 1997; and the Lamfalussy Report on wholesale net settlement systems in 1990.

III. CONVERTING TALK INTO ACTION: THREE EPISODES OF

COORDINATION
Good ideas are not adopted automatically. They must be driven into practice with courageous
patience. (Hyman Rickover)
If the previous discussion lays out the institutional and legal structure of central bank
coordination, what does that coordination look like in practice? We now turn to three
important episodes since the end of the Bretton Woods system in which relationships
created through diplomacy have provided a springboard for action, streamlining our
discussion to focus as much as possible on the role played by central banks.
1. The Plaza Accord
The economic circumstances that propelled the dollar’s exchange value upward in the early
1980s are clear: A substantial tightening in monetary policy from the Volcker-led Federal
Reserve beginning in fall 1979 combined with a doubling of the federal fiscal deficit as a
share of GDP during the first Reagan Administration to push US interest rates higher
(both in level terms and relative to foreign interest rates), attracting flows of foreign capital
into the United States and appreciating the dollar.37 Between July 1980 and June 1984—the
peak of the differential between US and foreign interest rates—the dollar appreciated 36
percent in nominal terms relative to other major currencies (the red line in Figure 17.1).
Thereafter, the dollar continued to rise despite a moderation in the interest differential,
peaking in March 1985 at a level almost 55 percent above its value in the summer of 1980.38
The appreciation of the price-adjusted or ‘real’ dollar mirrored that of the nominal dollar
(the blue line). Williamson (1985) estimates that by late February or early March 1985, the
dollar was more than 40 percent above its fundamental equilibrium value. It is no wonder
then that the US current account swung from near balance in 1981 to a deficit position that
reached nearly 2.5 percent of GDP by 1984 (see Figure 17.2), or that major corporations
and business organizations engaged in international trade called initially for actions to
reverse the dollar’s rise and later on lobbied for protectionist measures.39
The US Treasury made clear from early 1981 that it would take a ‘hands-off’ approach
to exchange-rate policy, consistent with the free-market, noninterventionist beliefs of its
Undersecretary for Monetary Affairs, Beryl Sprinkel.40 There would be no regularized
intervention in foreign-exchange markets; intervention would occur only in the event of
disorderly financial market conditions.41 Furthermore, Treasury officials did not link the
37
Many studies provide detailed accounts of these economic developments; see Frankel (1994)
and Bordo, Humpage and Schwartz (2015).
38
The rise between June 1984 and March 1985 is often viewed as a ‘bubble’, because the
movement in economic fundamentals over that period did not support the dollar’s continued
appreciation.
39
See the accounts in Destler and Henning (1989) and Frankel (1994).
40
For in-depth descriptions of the political climate in the first Reagan Administration, see
Destler and Henning (1989), Frankel (1994), and Truman (2016b).
41
Sprinkel formally communicated this during Congressional testimony in April 1981.
According to Truman (2016a), Volcker had reviewed Sprinkel’s remarks beforehand and ensured

Source: Board of Governors of the Federal Reserve System (US), Real Trade Weighted US Dollar Index:
Major Currencies [TWEXMPA] and Trade Weighted US Dollar Index: Major Currencies [DTWEXM]
retrieved from FRED, Federal Reserve Bank of St Louis; https://fred.stlouisfed.org.
Figure 17.1 Trade-weighted US Dollar Index
dollar’s rise to high interest rates and the growing US fiscal deficit, but rather to the favora-
ble investment conditions created by tax and regulatory changes.42 Although the Federal
Reserve had concerns about the dollar and the twin deficits, Volcker saw exchange-rate
policy as the purview of the Treasury (even though the Federal Reserve has independent
legal authority for conducting foreign-exchange operations) and the Federal Reserve
Chairman preferred to share his concerns privately with Secretary Regan.43 And, as the
that the minimalist approach included the possibility of responding to disorderly market
conditions.
42
Other officials in the Reagan Administration took a different view. Martin Feldstein, head
of the President’s Council of Economic Advisers (CEA) from 1982 to 1984, linked the high interest
rates and fiscal deficit to the dollar’s rise and widening current account deficit—the ‘twin deficits’
view that is widely accepted today (see Frankel, 1994). While Feldstein made his views known,
he had no formal authority over budget or exchange-rate policy. Bordo, Humpage and Schwartz
(2015) observe that before 1985, there were few Administration officials who worried about the
dollar’s appreciation because they viewed the crowding out of exports that resulted as preferable to
the traditional form of crowding out that results from an increase in the fiscal deficit. As evidence,
the authors (at 273) point to the CEA’s 1984 Economic Report of the President as suggesting ‘that
the investment sector contributed more to potential economic growth than the traded-goods sector,
and that higher potential growth eased inflationary conditions.’
43
See Volcker and Gyohten (1992), 238–39; Truman (2016a), 154; Truman (2016b), 143.
Destler and Henning (1989) argue that Volcker was reluctant to criticize the Treasury publicly

Source: Federal Reserve Bank of St. Louis and U.S. Office of Management and Budget, Federal Surplus or
Deficit [-] as Percent of Gross Domestic Product [FYFSGDA188S], retrieved from FRED, Federal Reserve
Bank of St. Louis; https://fred.stlouisfed.org/series/FYFSGDA188S.
Organization for Economic Co-operation and Development, Total Current Account Balance for the United
States [BPBLTT01USQ188S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouis
fed.org/series/BPBLTT01USQ188S.
Figure 17.2 The twin deficits
Federal Reserve’s primary focus was bringing inflation down from double-digit levels, an
appreciating dollar was helpful—at least until the misalignment became extreme.44
In the international arena, the dollar’s value and the U.S. fiscal-monetary policy mix
because the Federal Reserve was being attacked for running a very stringent monetary policy.
Bordo, Humpage and Schwartz (2015, 278–79) claim that Volcker ‘briefly considered, but rejected,
intervening without the Treasury’s participation’, fearing a political backlash. The account in
Volcker and Gyohten (1992) casts doubt on that view and suggests that Volcker would have been
extremely reluctant to intervene without Treasury participation (see 234–35). The legal authority
for conducting foreign-exchange operations is in Section 14(1) of the Federal Reserve Act, which
authorizes Federal Reserve Banks to buy and sell cable transfers in the open market; in its annual
Authorization for Foreign Currency Operations, paragraph 1(A), the Federal Open Market
Committee authorizes and directs the purchase and sale of ‘foreign currencies in the form of
cable transfers through spot or forward transactions on the open market at home and abroad,
including transactions with the U.S. Treasury, with the U.S. Exchange Stabilization Fund . . .’
(Federal Reserve, 2016). When the Federal Reserve Act was drafted in 1913, international currency
transactions were carried out via cable.
44
In his address at a conference on the Plaza Accord, Volcker indicated that by the time the
Accord was agreed, he thought a ‘sizable realignment’ of the dollar was necessary and that he
wanted to avoid a ‘free fall’, which could be abrupt and disorderly. See Green (2016).

received substantial attention. At the 1982 G-7 leaders’ summit in Versailles, the French
argued that foreign-exchange intervention was a useful tool for countering exchange-rate
misalignment—a view quite contrary to that held by the Americans. The Germans must
have concurred with the French because, by this time, the Bundesbank had been inter-
vening heavily to stem the fall in the German mark.45 The leaders agreed to establish an
inter-governmental working group to study the effectiveness of intervention; the report
produced by the group, known as the Jurgensen report, was presented at the leaders’
summit meeting in Williamsburg the following year.46
According to Truman (2016b), the working group, which was composed of finance
ministry and central bank representatives, met ten times and produced more than a dozen
studies on foreign-exchange intervention—many of them written at the Federal Reserve.47
A key question concerned the effectiveness of sterilized intervention—that is, intervention
that does not alter the monetary base.48 The working group’s studies provided evidence
that sterilized intervention can have small, transitory effects on exchange rates and that
coordinated intervention was more powerful than intervention by a single country. Bordo,
Humpage and Schwartz (2015: 277) write that around the time of the Jurgensen report,
‘the weight of the evidence [from the working group’s studies as well as other research]
did not rule out sterilized intervention, but it appeared to shift against a portfolio-balance
channel and toward a narrowly defined signaling channel; that is, intervention as a signal
of future monetary-policy changes.’49 Truman (2016b: 140–43) sees the Jurgensen report
as having ‘contributed to a better understanding in official circles of the distinction
between sterilized and unsterilized intervention’ and set the stage for later cooperation ‘in
particular with respect to coordinated operations and signaling official attitudes to the
market.’50
The Plaza Agreement in 1985 is widely regarded as a success in terms of cooperation—
Paul Volcker writes that it was the ‘most aggressive and persistent effort to guide exchange
rates on both a transatlantic and transpacific scale since floating had begun more than
a decade earlier’—even if there is some controversy about whether or by how much
the announcement contributed to the dollar’s decline.51 Most detailed accounts see the
Plaza Agreement as the culmination of a process that began earlier in the year, following
45
According to Bordo, Humpage and Schwartz (2015), ‘many countries’ had been using
nonsterilized intervention to put upward pressure on their currencies vis-à-vis the dollar.
46
The Report of the Working Group 1983 was written by the Working Group on Exchange
Market Intervention, whose chair, Philippe Jurgensen, was a French Treasury official.
47
Eight of the studies were written by economists in the Federal Reserve System. See
Henderson and Sampson, (1983).
48
This was an important issue because some central banks would have been opposed to
unsterilized intervention, which would have altered the monetary base and had implications for
inflation—for example, selling dollars and buying foreign currencies would have increased the US
monetary base and put upward pressure on inflation at a time when the Federal Reserve was trying
to reduce it.
49
See Dominguez (2008) for a discussion of sterilization and a more recent review of the
efficacy of sterilized intervention; see also Frankel (2016).
50
Frankel (2016: 56) says the Jurgensen Report was ‘not quite as supportive of intervention as
the other countries had hoped.’
51
Volcker and Gyohten (1992), 229.

the change in leadership at the US Treasury.52 The new Secretary, James Baker, in his
confirmation hearing before the Congress in January 1985, signaled a possible change in
attitude toward foreign-exchange intervention, saying that the Administration’s posture
was ‘obviously something that should be looked at because some will argue that that
[intervention] could have a dramatic effect on the value of the dollar’ (quoted in Destler
and Henning, 1989: 42). Even before the formal change in Treasury personnel, however,
G-5 finance ministers and central bank governors met and released a statement indicating
their willingness ‘to undertake coordinated intervention in the markets as necessary.’53
Some coordinated intervention followed from mid-January through early March, with
the German and Japanese central banks selling dollars and the Federal Reserve buying
marks, yen and sterling.54 Frankel (1994) sees the Bundesbank’s large sales of dollars
over two days in late February as having been the trigger for the dollar’s reversal, while
others see the intervention—which on the whole was relatively small—as not having
been particularly noteworthy.55 Whatever the case, the dollar peaked in late February
and began to depreciate fairly steadily, falling nearly 11 percent in nominal terms before
the Plaza meeting.56
The road to the Plaza Accord had begun over the summer, with the deputies in the
G-5 finance ministries and central banks holding several secret meetings in the run-up to
September 22. In recent remarks, James Baker referred to the ‘serious protectionist fever
burning in Congress’ as the impetus for the discussions and indicated that, at the begin-
ning of the secret meetings, the other G-5 governments expressed ‘predictable skepticism’
(Baker, 2016). But Truman (2016b) reports that by the summer of 1985, Secretary Baker
had the support of the US Secretary of State and officials of the other G-5 governments to
take action to bring the dollar down.57 The communiqué issued at the end of the meeting
stated:58
52
See Frankel (1994). Frankel (2016: 57) writes, ‘my view is that it is appropriate to use the
term [Plaza Accord] to include all the elements of the shift in dollar policy that occurred when
Baker became Treasury Secretary, including other meetings, public statements, perceptions, and—
especially—foreign exchange market intervention.’
53
The G-5 met on January 17.
54
The Federal Reserve generally intervened only in German marks and Japanese yen (the Open
Market Desk at the Federal Reserve Bank of New York undertakes all US intervention opera-
tions on behalf of the Treasury and Federal Reserve). Changes in the dollar-mark exchange rate
had ramifications for other currencies—such as the French franc—that were linked to the mark
through the Exchange Rate Mechanism of the European Monetary System. Bordo, Humpage and
Schwartz (2015) characterize the intervention in sterling as a political gesture prior to Margaret
Thatcher’s official visit to the United States.
55
See Bordo, Humpage and Schwartz (2015). Truman (2016a) terms the intervention ‘substan-
tial’, but does not see it as the trigger for the dollar’s reversal.
56
Frankel (1994: 303) writes that ‘German authorities could claim credit for the reversal of
[intervention] policy’, but that Baker got all the credit instead. It should be noted that the dollar did
reverse course and appreciated from late August until the time of the Plaza meeting in September.
57
Volcker reports that he was ‘not in on the ground floor’ but ‘was brought into the discussions
only in August, when the ideas were becoming more operational.’ See Volcker and Gyohten (1992),
242.
58
Announcement (1985). According to Funabashi (1988) and Frankel (1994), the deputies
agreed to a ‘nonpaper’ that specified a 10–12 percent depreciation of the dollar (with up to $18
billion in intervention).

The Ministers and Governors agreed that exchange rates should play a role in adjusting external
imbalances. In order to do this, exchange rates should better reflect fundamental economic con-
ditions than has been the case. They believe that agreed policy actions must be implemented and
reinforced to improve the fundamentals further, and that in view of the present and prospective
changes in fundamentals, some further orderly appreciation of the main non-dollar currencies
against the dollar is desirable. They stand ready to cooperate more closely to encourage this when
to do so would be helpful.
The dollar fell sharply upon the Plaza announcement59 but, by early October, had returned
to the pace of steady, gradual depreciation that it had followed earlier in the year. Judged
in terms of politics and coordination, the Plaza was a great success. If you view the entire
year of 1985 as a ‘Plaza period’, as Frankel does, then the sea-change in US attitudes
and subsequent coordinated actions that put the dollar on a downward path also make
the Plaza a success. But for those who are skeptical that sterilized intervention can have
lasting effects and who view the Plaza as a one-time event in September, then it is more
difficult to see that the agreement produced more than a hiccup in the dollar’s decline.60
Let’s turn now to the Plaza Agreement as an example of coordination built through dip-
lomatic relationships, and the role of central banks in it. First, there is no doubt that getting
to Plaza required coordination and a working network of G-5 relationships. Obviously,
the change in US attitudes at the start of 1985 was fundamental; also fundamental was
the extent of the dollar’s overvaluation and the protectionist climate that it brought out.
Second, as a result of Plaza, the diplomatic grouping of finance ministers and central bank
governors was expanded in 1986 to include Italy and Canada. Baker (2006: 25–26) links the
expansion of the G-5 grouping to the formal announcement of and publicity surrounding
the Plaza Accord, which resulted in pressure to align the membership with that of the
leaders’ grouping.61 Thus, the Plaza produced an evolution—albeit a small one—in a major
diplomatic forum, a point that is central to our view that the forums are elastic to events.
Finally, central banks played a critical role in this episode through their contributions
to the Jurgensen report and the execution of intervention operations, but their involve-
ment in and support for the Plaza Agreement itself is more equivocal. Truman (2016b)
reports that central banks were brought into the secret discussions late—around the
time the deputies began discussing the operational issues associated with the planned
intervention.62 As a result, ‘the Federal Reserve, along with other central banks, did not
have ownership of, and therefore commitment to, the substance of the Plaza Accord.’63
There was no doubt some tension between independent central banks concerned with
price stability (notably the Bundesbank and Federal Reserve) and finance ministries with
other objectives—particularly the US Treasury that favored coordinated interest rate
59
The weighted-average dollar fell four percent on the day after the Plaza announcement.
60
For the skeptical view of Plaza’s effects, see Feldstein (1988); Bordo, Humpage and Schwartz
(2015); and Taylor (2013).
61
Until 1985, the G-5 meetings of finance ministers and central bank governors were not
made public or covered by the press. The 17 January 1985 meeting marked the first issuance of a
statement. Historical information is also provided in Bergsten and Henning (1996), Kharas and
Lombardi (2012).
62
Funabashi (1988) reports that the very early discussions were done on a bilateral basis
between the US Treasury and the finance ministries of Japan and Germany.
63
Truman (2016b), 148.

cuts to fuel economic growth.64 Volcker and Karl Otto Pöhl were both concerned that the
dollar’s decline could be rapid and unruly, and so insisted on the insertion of ‘orderly’
in the Plaza announcement.65 Destler and Henning (1989: 50) write that the ‘consensus
over the desired direction of exchange rate movement evaporated’ well before the end of
1985.66 Secretary Baker continued to pursue an activist agenda of international coordina-
tion during Reagan’s second term.67
2. Asian Financial Crisis and the Road to the G-20
The growing power of emerging markets during the 1990s created enormous strains
for the guardians of the world’s economic architecture. Globalization, combined with
the rapid growth of international financial markets, brought new financial actors to the
table and made diplomacy and coordination with those actors far more complex and
consequential. Further, at times of crisis, these new rising powers would need to be part
of the coordinated international response. In particular, financial rescue packages for
countries in trouble were growing in scale and becoming increasingly likely to outstrip
the capacity of the IMF, acting alone, to address. These developments created new pres-
sures on central banks to broaden their horizons and engage in new forms of diplomacy.
Notably, Truman (2016a) argues that it was primarily the Federal Reserve’s involvement
in external financial crises during the decade—first Mexico in 1994 and then the Asia
crisis—that led the Federal Reserve to become increasingly engaged with countries and
their central banks outside of the traditional circle of the G-10 plus Mexico.68 In the early
1990s, the G-7 was the primary forum where emerging market issues were discussed.
64
Indeed, at the bottom of the statement, each country listed several goals. France, Germany,
the United Kingdom and United States specified stable prices, disinflation, or price stability as an
objective, while Japan specified ‘the flexible management of monetary policy with due attention to
the yen rate.’
65
See Funabashi (1988) and Truman (2016a). In Green (2016), Volcker indicates that he had
not been ‘an enthusiastic proponent’ of the Plaza Agreement; he thought the dollar would depreci-
ate on its own and wanted ‘to avoid a free fall.’
66
Pöhl was quoted in the Wall Street Journal two weeks after the Plaza Accord as saying that
the level of the dollar was ‘acceptable to us’ (Destler and Henning, 1989: 50). Volcker was quoted
in the Washington Post around the same time as saying ‘one could have too much of a good thing’
(Truman, 2016b: 154).
67
Secretary Baker wanted other major countries to stimulate their economies through
monetary and/or fiscal policy, thereby increasing demand for US exports and reducing the trade
and current account deficits; an alternative to stimulative macroeconomic policies was a further
depreciation of the dollar. From 1986, Baker pursued various other initiatives aimed at policy
coordination. These included a set of objective macro indicators announced at the May 1986
G-7 leaders’ summit (with the intention of setting goals for the indicator variables); the Baker-
Miyazawa agreement announced later in 1986 (to stabilize the yen-dollar rate as a quid pro quo
for Japanese fiscal expansion); the Louvre Accord in February 1987 intended to stabilize exchange
rates near then-current levels (and that reportedly included target zones that were agreed but not
announced). See Funabashi (1988), Destler and Henning (1989), and Frankel (1994).
68
The Federal Reserve facilitated the operation of the Exchange Stabilization Fund as part of
the 1995 US Treasury- and IMF-backed rescue package for Mexico, which also led to a rethink of
the international financial architecture that played an important role in the central bank’s response
to the Asia crisis.

Still, the importance of bringing the major emerging market countries more fully to the
table was increasingly recognized, and there were occasional efforts by the leading central
banks to reach out to their emerging market counterparts. The focal point of outreach
was Asia, where rapid growth was raising expectations that the region was set to play a
leading role in the global economy. Still, prior to the onset of the Asia crisis, the primary
forums for central bank communication and diplomacy remained dominated by the
industrial countries.
Among Asian central banks, there was a parallel effort during this period to
strengthen regional cooperation, but the overall effect in terms of developing a
regional voice was limited prior to the crisis. In addition to regional integration efforts
oriented around the Association of South East Asian Nations (ASEAN)69 and the
ASEAN countries together with China, Japan, and South Korea (a grouping known as
ASEAN+3), central bank cooperation was primarily conducted through three bodies:
Executives’ Meeting of East Asian-Pacific Central Banks (EMEAP),70 the South East
Asian Central Banks Research and Training Center (SEACEN),71 and Central Banks
of Southeast Asia, New Zealand and Australia (SEANZA).72 While leaders provided
repeated political support for these initiatives, by the mid-1990s there was a broad
consensus that efforts at regional integration had run out of steam and were inad-
equate to meaningfully address regional economic dislocations. Further, the existence
of overlapping groups, with different country memberships and similar but at times
competing mandates, underscored the difficulty of achieving effective coordination
within the region.
Against this backdrop, the Asian financial crisis was a dramatic challenge to global
policymakers’ capacity to coordinate their responses to crises. The onset of the crisis is
traditionally dated as 2 July 1997, when the Thai government abandoned its peg of the
baht against the US dollar.73 As shocking and unexpected as that move was, in retrospect
it is clear that warning signs had been apparent for some time not only in Thailand but
69
At its founding in 1967, ASEAN was composed of Indonesia, Malaysia, the Philippines,
Singapore and Thailand; by the time of the Asian financial crisis, there were four additional
members—Brunei, Laos, Myanmar and Vietnam; Cambodia joined in 1999. Economic integration
through ASEAN was based on trade integration, but in 1977 was extended to include liquidity
provision when the central banks of Indonesia, the Philippines, Malaysia, Thailand, and Singapore
created the first regional swap arrangement (ASEAN Swap Arrangements or ASA). Originally for
$100 million, it was expanded to $200 million in 1978 and was activated five times in the late 1970s
and early 1980s. See Henning (2002), 14–15.
70
EMEAP was founded in 1991 and consists of Australia, China, Hong Kong, Indonesia,
Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore and Thailand.
71
SEACEN began as an informal annual meeting of seven regional central bank governors
in 1966 (Laos, Malaysia, the Philippines, Singapore, Sri Lanka, Thailand and Vietnam) and com-
menced holding training programs in 1972; in 1982, agreement was reached formally creating the
South East Asian Central Banks Research and Training Center. It now has 20 members, including
notably from outside of the founding countries of ASEAN, China, Korea and India.
72
Created in 1956, SEANZA includes central banks of Southeast Asia, New Zealand, and
Australia, is composed of 20 countries, and focuses primarily on information exchange and
training events hosted by member countries on a rotating basis. In 1984, the SEANZA Forum of
Banking Supervisors was established.
73
The baht closed the day down nearly 17 percent against the US dollar in offshore trading.

110
U.S. dollar / South Korean won
U.S. dollar / Thailand baht
100 U.S. dollar / Malaysia ringgit
90
80
Index
70
60
50
40
1/2/1997 4/2/1997 7/2/1997 10/2/1997 1/2/1998 4/2/1998 7/2/1998 10/2/1998
Source: Board of Governors of the Federal Reserve System (US), South Korea / US Foreign Exchange Rate
[EXKOUS], Thailand / US Foreign Exchange Rate [DEXTHUS], and South Korea / US Foreign Exchange
Rate [EXKOUS] retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org.
Figure 17.3 Asian financial crisis, selected exchange rates (index5100 on 1 July 1997)
throughout the region. A private sector-led investment boom during the 1990s fueled large
increases in current account deficits, rising debt levels (much of it in foreign currencies and
of short duration), and real appreciations that over time raised growing concerns about
sustainability.74 Most of the region had exchange rates that were effectively—even if not
formally—fixed or semi-fixed. This meant that as sentiment turned in late 1996 and early
1997, and capital flows began to reverse, exchange rates came under pressure (see Figure
17.3). Further, close ties between banks and the firms that they lent to and expectations
of state support further distorted incentives.75
Among policymakers, concerns were raised, though not with the strength and focus
needed to mobilize action. Boughton (2012: Chapter 11) argues that, beginning in 1995
and intensifying in late 1996–97, IMF management expressed their concerns privately to
Asian policymakers and, in general terms, in a number of speeches. But such concerns,
while often expressed, were not with the urgency needed to break through. It has often
been noted that Asian policymakers saw little reason for concern. Decades of high growth
rates had bred strong conviction in the success and stability of the ‘Asian economic
74
For example, see Camdessus (1997).
75
In contrast with most developing country debt crises of the 1970s and 1980s, public sector
deficits were not the primary problem in Asia. See, for example, Roubini and Setser (2004).

miracle’, and without the need for IMF resources there was a deep resistance throughout
Asia to adopting IMF recipes.76
Investors began to turn against these countries in the summer of 1996, and the out-
flows of private capital intensified in September 1996, when Moody’s Investors Service
downgraded its rating on Thailand’s short-term external debt.77 Following the decision
by Thailand to borrow from the IMF and float its currency in 1997, shockwaves spread
quickly through the region, and Indonesia and the Philippines also had to turn to the IMF
for financial assistance in the following months. As Truman (2013) aptly comments, ‘few
anticipated that a crisis in Thailand would be as severe as it proved to be or the extent
to which other countries in Asia had their own vulnerabilities and were susceptible to a
change in investor appetites.’78
In the early stages of the crisis, central bank efforts focused on supporting the devel-
opment of adjustment programs and the mobilization of financial support for those
programs. The first line of defense within the region came from financing packages from
governments and central banks intended to complement funds from the IMF and other
multilateral sources. An August 1997 ‘Friends of Thailand’ meeting organized by Japan’s
Ministry of Finance resulted in $9 billion in support from governments in the region plus
financing from a number of central banks including the People’s Bank of China. For
Indonesia, a group of central banks (China, Japan and the United States, as well as some
regional central banks) agreed to a ‘second line’ of assistance should unexpected adverse
developments occur.79 In addition, in the early days of the program, the central banks of
Indonesia, Japan and Singapore conducted large-scale, foreign exchange intervention to
support the rupiah.
In contrast, throughout the crisis, existing Asian central bank emergency swap lines
were not activated, as the amounts available under the programs were small and the pres-
sure to put together large, internationally supported packages led lending countries to rely
on other approaches. Further, to some extent regional policymakers were overwhelmed
by the scale of the crisis confronting them, making policy coordination challenging on a
regional basis.
The next important step forward in central bank diplomacy took place in December
1997, with an extraordinary effort to coordinate a rollover of loans made by banks around
the world to banks in Korea. The Korean crisis had built slowly over the summer as
economic performance deteriorated and markets became extremely skittish over Korea’s
mounting foreign debt and large current account deficit, but it intensified following the
floating of the Taiwan dollar and sharp sell-off in the Hong Kong stock market in mid-
October. By the end of October, Korean equities were down 40 percent from early August,
and the won was falling sharply against the dollar. The rout was on.80
An initial IMF program, totaling $21 billion over three years, was announced on 7
December, and the announcement stressed that, with bilateral assistance, the package
76
See World Bank (1993); for a post-crisis assessment from the IMF, see Kato (2004).
77
See Boughton (2012), Chapter 11, and Blustein (2001). See also the Nukul Commission
report (1998), 43.
78
Truman (2013), 187.
79
That commitment never materialized, as financing needs were met multilaterally.
80
See Boughton (2012), 544–45.

would total $55 billion. Still, the initial disbursement was small—$5.6 billion—and ques-
tions were immediately raised about the overall adequacy of financing; a tightly contested
election campaign in Korea raised questions about the durability of the program. The
Korean central bank’s reserves were falling by nearly $1 billion per day, a pace that would
exhaust them by month-end. In drawing up a replacement program (eventually approved
on 30 December 1997), policymakers decided that the official community was unwilling
to finance the continued rapid outflow of capital.
On 23 December 1997, after a conference call of IMF management with the deputies of
the G-7 finance ministers and central bank governors, it was decided that a standstill of
commercial bank lines would need to be attempted.81 According to Boughton (2012), the
subsequent public announcement indicated that ‘central banks would coordinate the debt
rollovers internationally and make sure that aggregate exposure was being maintained.’
In the following days, US Treasury Secretary Robert Rubin telephoned the heads of the
major international banks,82 and IMF and US government officials met with the banks
in a meeting organized and hosted by the Federal Reserve Bank of New York. This
publicized and carefully orchestrated campaign sent a clear signal of the importance that
the official community placed on the success of the operation.
Through the initial set of meetings, central banks largely remained in the shadows,
concerned about their regulatory role and how such an explicit effort at moral suasion
would be received. But the operation of the rollover was the responsibility of central
banks, which coordinated their efforts to press commercial banks in their jurisdiction
to maintain exposure. The IMF’s role in the standstill was to help the Bank of Korea
develop a real-time monitoring system to track the amount of debt that was maturing
each day, along with the amount that was being rolled over. Once that data was collected
and analyzed, a daily conference call took place to brief central bank representatives.
While the initial data was suspect, within a week the data was strong enough to support
a substantial central bank moral suasion effort, and capital flows quickly stabilized
and rollover rates rose steadily over the next few months.83 In addition, the substantial
package of economic measures that the Korean government undertook contributed to
the restoration of confidence, paving the way for an agreement converting $22 billion in
short-term interbank claims into bonds with maturities of one to three years, which were
fully guaranteed by the Korean government. The exchange normalized Korea’s debt and
allowed the country to return to the debt market in April 1998.
Although we leave aside examples from other regions, Asian efforts at regional coopera-
tion have been highly visible and important; the crisis catalyzed a significant effort among
Asian central banks to expand regional diplomacy. This impetus reflected a number
of factors. Within Asia, there was a belief that a strong regional response was needed
to avoid the sort of contagion that had been experienced during the Asian financial
crisis and ensure that Asian countries ‘never again’ would need to turn to the IMF for
81
In this situation, a standstill involved convincing banks outside Korea to roll over maturing
lines of credit to Korean banks.
82
Blustein (2001), Rubin and Weisberg (2003).
83
Based on Robert Kahn’s recollection of events from his experience as an IMF staffer who
helped to develop the real-time monitoring system. See also Boughton (2012), 564–65, and Blustein
(2001).

emergency support. The crisis had created a new appreciation that shocks affecting one
country could spill over quickly to others in the region. Increased dependence on foreign
capital and bank loans, as well as underdeveloped domestic financial markets, were seen
as creating unique regional vulnerabilities from global swings in capital flows. At the same
time, the strengthening of regionalism around the world, including the launch of the euro
in 1999 and trade integration in the Americas, reinforced the acceptability of regional
arrangements.
This pressure for regional solutions was reflected in a number of dimensions. In the fall
of 1997, Japan’s Vice Minister for International Finance, Eisuke Sakakibara, proposed
the creation of an Asian Monetary Fund (AMF) with an initial $100 billion to provide
trade finance and balance of payments support to the Asian economies.84 This represented
an attempt by Japan to take the lead in creating a new regional financial institution that
would not, at least initially, include the United States. But the effort was poorly prepared
and ran into strong opposition particularly from the United States, which was concerned
that the new agency would undermine the influence of the IMF, and from Germany,
which was concerned about the moral hazard created if financing to avoid balance of
payments adjustment was too readily available.
Following the failure of this effort, subsequent regional coordination initiatives were
more carefully designed to be complementary to, rather than competitive with, existing
international bodies. At a 18–19 November 1997 meeting of Asian-Pacific finance
ministry and central bank deputies,85 agreement was reached on the ‘Manila Framework’
that explicitly acknowledged the central role of the IMF.86 This was to serve as the basis
for regional central bank cooperation following the crisis, including the establishment
of regional liquidity support arrangements through the Chiang Mai Initiative (CMI),
the formation of the Asian Bond Fund (ABF), and the progress toward creation of an
Asian Bond Market Initiative (ABMI).87 These initiatives were developed and moved
forward primarily through regional financial forums, with a central role for ASEAN+3
and EMEAP.
The ASEAN+3 finance ministers endorsed the creation of the CMI at their May 2000
meeting, held on the margins of the ADB annual meeting in Chiang Mai, Thailand.88
In addition to a commitment to strengthened policy dialogue and regional cooperation
in general, the proposal envisaged an expanded ASEAN swap arrangement consisting
of a network of bilateral swap and repurchase agreement facilities among ASEAN+3
countries; the exchange of ‘consistent and timely data and information on capital flows’;
84
This occurred shortly after the ‘Friends of Thailand’ meeting and with the group’s support.
See Kawai (2015).
85
Fourteen countries attended, including from outside Asia, the United States, Canada,
Australia, and New Zealand.
86
The Manila Framework proposed three areas for regional cooperation: (1) a regional surveil-
lance mechanism; (2) technical cooperation to improve domestic regulations and financial systems;
and (3) a financing mechanism called the Cooperative Financing Arrangement (CFA).
87
See Jung (2008). The development of regional financial markets, which were seen as back-
ward and inefficient and leading to dependence on funding from abroad, was the focus of EMEAP
and ASEAN+3 initiatives. While there has been rapid growth in these markets in subsequent years,
some have questioned how much credit should be given to these efforts.
88
See Henning (2002), Chapter 3, for details.

creation of a regional financing arrangement to supplement IMF and other official

lending arrangements; and creation of an early warning system to identify sources of
financial instability on a timely basis.89 The CMI remains the most controversial of the
Asian regional initiatives.
The initial swap lines were small,90 and cognizant of the controversy over the Asian
Monetary Fund, only ten percent of the amount could be drawn without an IMF
review.91 This requirement limited the perceived value for addressing pure liquidity crises,
but reflected the judgement that the CMI lacked the ability to perform independent and
credible surveillance and monitoring. At the same time, an increase in the resources avail-
able to the IMF and new flexibility in its lending rules92 further reduced the need for the
facility. In the end, the CMI has not been drawn upon but remains as a central element of
the regional crisis response mechanism.93
In sum, the Asia crisis resulted in a number of innovations in the way that central banks
communicated and coordinated. First, it brought to the surface growing pressures from
emerging market countries to have a greater voice in policymaking, and as noted earlier,
ultimately led to the creation of the G-20 grouping of finance ministers and central bank
governors. The Korea program led to an intensive use of moral suasion by central banks
in a coordinated effort to stem capital outflows.94 Furthermore, the CMI, while ultimately
ineffective, was an early exercise in creating a swap network and remains a potential base
for future central bank diplomacy in Asia. In each of these cases, the job of furthering
regional cooperation fell primarily to the central banks, albeit with strong political
support from their sovereigns.
3. The Global Financial Crisis
Much has been written about the global financial crisis (GFC), yet the origins of and
lessons to be drawn from the deepest crisis the global economy has seen since the Great
Depression are still being debated. For the purposes of this chapter, one point on which
there is agreement is that the policy response required an extraordinary degree of central
bank coordination, brought forth a comprehensive rewrite of the playbook for dealing
89
Joint Ministerial Statement (2000).
90
Henning (2002: 13) notes that, ‘With ASEAN and South Korea, the total reserves of the “10
plus 3” countries were $729 billion, which did not include Hong Kong or Taiwan’s foreign exchange
reserves, nor ASEAN+3’s noncurrency reserves, such as gold, Special Drawing Rights (SDRs),
and reserve positions in the IMF.’ Table 3.1 indicates that the size of each bilateral currency swap
ranged from $1 to $3 billion.
91
The amount that can be drawn without IMF review has now been increased to 30 percent.
92
In 2002, the IMF introduced ‘exceptional access’ rules allowing lending in excess of normal
lending limits subject to conditions.
93
Since its creation in 2000, the CMI has been enlarged and converted into a multilateral
facility: it was multilateralized—that is, converted into a reserve pooling arrangement known as the
CMIM, with $120 billion in resources. In 2012, CMIM resources were increased to $240 billion and
members are now permitted to draw up to 30 percent of quota without an IMF program.
94
Korea was not the first modern case of central banks exerting moral suasion over financial
institutions. Notably, in 1982, the Federal Reserve led efforts—together with the US Treasury and
IMF—to persuade major banks to rollover their loans to Mexico. See Kraft (1984), Volcker and
Gyohten (1992).

with financial crises, and will have implications for how central banks operate (and relate
to each other) for generations to come.
The onset of the GFC began in summer 2007, when a collapse in confidence by
investors in the value of sub-prime mortgages led to a credit crunch and liquidity
crisis in global capital markets.95 As the crisis deepened and spread—reflecting the
unwinding of a credit boom combined with excessive leverage, underpricing of risks,
and insufficient risk management—central banks responded with increasing urgency,
providing liquidity, slashing interest rates and undertaking asset purchase programs
in order to stabilize financial conditions, restore market functioning, and stimulate
economic activity.96 In this account, we separate the discussion into conventional
monetary policy actions, actions related to market functioning and liquidity provision,
and unconventional policies; we find the functional approach in this case to be more
informative than the chronological narrative we used for outlining the two previous
coordination episodes.
The onset of the GFC quickly led central banks to recognize that cooperation and
coordination among central banks around the world was necessary and needed new
impetus. In terms of policy, actions in early days included a conventional monetary policy
response—a rapid reduction in interest rates by the major central banks as they sought to
offset the shortfall in demand and tightening of financial conditions. While there is little
doubt that there was extensive consultation and communication among central banks,
the early response to the crisis is best described as diplomacy: Central banks exchanged
information and analysis resulting in parallel—but not coordinated—cuts in policy inter-
est rates in response to signs of simultaneous economic slowing.97 Many central banks
began cutting policy rates in August 2007,98 which at the time was seen as unusual and
preemptive given that growth was just beginning to falter and inflation in many countries
95
Many date the start of crisis from 9 August 2007, when interbank markets seized up fol-
lowing BNP Paribas’ announcement that it was suspending redemptions in three of its investment
funds because of a collapse in the liquidity of subprime mortgage assets.
96
See Bernanke (2008), Duke (2012).
97
See Committee on the Global Financial System (2008: 8): ‘The financial market turmoil
prompted central banks to have much more frequent and detailed discussions about market
developments and the technical aspects of their market operations, both bilaterally and collectively.
Such enhanced cooperation took place both at the Governors’ level and at the experts’ level. The
Bank for International Settlements served as a forum in this respect. Communication across central
banks intensified as the turbulent episode evolved over time.’ Bernanke (2008) also discusses this
diplomacy.
98
On 17 August 2007, the Federal Reserve cut the discount rate 50 basis points, narrowing
the spread between the discount rate and the federal funds rate target; in September, the Fed
announced a further cut of 50 basis points in both the discount rate and the fed funds target,
bringing those rates to 5.25 percent and 4.75 percent, respectively. Prior to the collapse of Lehman
Brothers in September 2008, the Fed cut the funds rate target six more times bringing the cumula-
tive easing to 325 basis points; central banks in Canada, New Zealand, and the United Kingdom
also reduced policy rates by 150, 75, and 75 basis points, respectively, over this period. In contrast,
the ECB kept policy rates on hold after June 2007 and increased them by 25 basis points in July
2008 to counter rising inflation; the ECB began a sequence of rate cuts on 8 October 2008, when it
reduced its rates on the deposit and marginal lending facilities by 50 basis points. See Chailloux et
al (2008) and Committee on the Global Financial System (2008) for additional details.

was running above target.99 The pace of rate cuts accelerated and continued through the
end of 2008 as the crisis gathered momentum.
Central banks moved from the realm of diplomacy to coordination in October 2008
when, three weeks after the collapse of Lehman Brothers, six major central banks—the
Bank of Canada, Bank of England, ECB, Federal Reserve, Sveriges Riksbank and Swiss
National Bank (SNB)—jointly announced a reduction in their policy rates of 50 basis
points.100 Such a coordinated monetary policy action is highly unusual. Amid a simul-
taneous economic slowdown, the coordinated action was meant to send a strong signal
to global financial markets of policymakers’ intent to mitigate the effects of the crisis.
Similar language was used by the central banks in their announcements to reinforce the
sense of shared purpose in the policy decisions.101 At the same time, and encouraged by
this move, central banks in major emerging market countries also cut policy interest rates,
and many—notably China—took other measures to boost credit growth. These latter
actions did not come as a total shock to financial markets, but the timing was a surprise
and the cuts were not fully priced in.
In addition to reducing policy rates, the Federal Reserve and other central banks
took measures to deal with liquidity shortages that were developing, providing funding
first to banks and later to other financial institutions—actions consistent with their
role as lenders of last resort. The first coordinated action of this sort took place in
December 2007 when the central banks of Canada, the euro area, Switzerland, the
United Kingdom and the United States jointly announced measures intended to
address elevated pressures in short-term funding markets.102 In addition to efforts to
address domestic liquidity shortages, other measures were needed to address dollar
funding shortages arising from the foreign-currency exposure on the balance sheets
of financial institutions outside the United States—exposure that had been rising
with globalization. These dollar funding shortages added concerns about currency
mismatches on the balance sheets of major financial institutions and led to ‘a more
99
For example, the start of the recession in the United States is dated as December 2007, by
which point the Federal Reserve had already reduced its target for the federal funds rate by 100
basis points.
100
The Bank of Japan expressed its support, and China informally joined in the easing, lower-
ing reserve requirements by 50 basis points; benchmark lending and deposit rates also were reduced
by 27 basis points.
101
Notably, both the Federal Reserve and the ECB began their statements with, ‘Throughout
the current financial crisis, central banks have engaged in continuous close consultation and have
cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in
financial markets.’ See Federal Reserve (2008a) and European Central Bank (2008).
102
The Federal Reserve announced the establishment of its Term Auction Facility (TAF),
which made dollar funding available to depository institutions operating in the United States, and
of temporary currency swap lines with the ECB and SNB; the ECB announced actions to provide
dollar liquidity to Eurosystem counterparties in connection with the TAF. See ECB (2008) and
Federal Reserve (2007). In 2008, the Federal Reserve established a number of other facilities to
provide liquidity to key financial market actors and markets—two examples are the Money Market
Investor Funding Facility and the Commercial Paper Funding Facility (http://www.federalreserve.
gov/monetarypolicy/bst_archive.htm). The communiqué from the November 2007 meeting of
G-20 ministers and governors had acknowledged that ‘an orderly unwinding of global imbalances,
while sustaining global growth, is a shared responsibility.’

internationally coordinated approach among central banks to the lender-of-last-resort

function.’103
The dollar funding strains led to a significant step forward in central bank coordination
with the creation of a network of bilateral currency swap arrangements.104 Led by the
Federal Reserve, the arrangements began with two major central banks in December 2007
(the ECB and SNB), and by the end of October 2008 had been expanded to encompass
12 more.105 As Duke (2012) details:
Under these swap arrangements, in exchange for their own currencies, foreign central banks
obtained dollars from the Federal Reserve to lend to financial institutions in their jurisdictions.
These swap arrangements pose essentially no risk to the Federal Reserve: They are unwound
(with a fee paid by the central bank drawing on the swap arrangement to the Federal Reserve)
at the exact same exchange rate that applied to the original transaction, they are conducted with
major central banks with track records of prudent decision-making, and they are secured by the
foreign currency provided by those central banks.106
The swap lines were renewed on several occasions, becoming a core element of central
bank liquidity support. In December 2008, usage of the Fed’s swaps by foreign central
banks peaked at nearly $600 billion.107
The success of the swap lines in mitigating funding pressures and reducing interbank
borrowing rates is considered one of the major successes from central bank coordination
during the crisis. In addition to easing funding shortages, these swaps also contributed to
an alleviation of market fears and sent a strong signal that central banks were prepared to
move outside of their comfort zone to address financial stress. In this regard, it is worth
noting that three emerging market central banks participated in these arrangements
(Brazil, Korea and Singapore). Notably, Korea drew on its swap line with the Federal
Reserve but not on its CMI swap line. It is generally believed that the existence of the
103
Bernanke (2008), 3.
104
See Fleming and Klagge (2010) and Bordo, Humpage, and Schwartz (2015), 352–56, for a
detailed description of these swap arrangements. The establishment of such swap arrangements
was not unprecedented—the Federal Reserve had set up similar arrangements after the terrorist
attacks on 11 September 2001.
105
These were the central banks in Australia, Brazil, Canada, Denmark, Japan, Mexico, New
Zealand, Norway, Singapore, South Korea, Sweden and the United Kingdom. In addition, in
fall 2008, the ECB established a euro swap arrangement with the Danish central bank and euro
repurchase agreements with central banks in Hungary and Poland; the SNB established Swiss
franc swap arrangements with the ECB and National Bank of Poland. For details on these liquidity
arrangements, see Ho and Michaud (2008).
106
Duke (2012), 3–4. Caruana (2012: 3) notes that ‘The extension of such swaps in unlimited
amounts represents a turn in central bank cooperation that the founders of the BIS would have
found unimaginable.’ Bernanke (2015a) reflects on the political sensitivities of instituting the
swap arrangements (at 163), noting that ‘The ECB, in particular, was sensitive to any aspects of
a currency swap arrangement that might imply that the Fed was riding to the rescue of European
markets. We, in turn, wanted to avoid an incorrect inference that we were lending to potentially
risky foreign private banks rather than creditworthy central banks.’ Broz (2014) discusses the
Federal Reserve’s choice of swap counterparty countries and the congressional response to the
arrangements.
107
Mersch (2010); see Chart 4 in Fleming and Klagge (2010).

lines helped prevent stresses that could have otherwise developed.108 As the financial crisis
receded, the swap lines were allowed to expire in February 2010. However, in May 2010,
in response to ‘the reemergence of strains in U.S. dollar short-term funding markets in
Europe’,109 the Federal Reserve announced that it had reopened temporary swap lines
with the Bank of Canada, the Bank of England, the Bank of Japan, the ECB and the
SNB; in November 2011, these same central banks announced enhancements to the swap
arrangements.
By the time financial markets had begun to stabilize, interest rates in much of the
advanced world were at or quite near zero (at the time, zero was considered the lower
bound on policy rates110). Central banks then began to turn to unconventional monetary
policies—large scale asset purchases and forward guidance about expected future policy
rates—in order to provide additional easing in broader financial conditions. The first
asset purchase program during the GFC, announced by the Federal Reserve in November
2008, was motivated by the desire to provide direct support to the housing sector.111 While
central banks have established a number of subsequent programs targeted to specific
sectors of the economy, most programs have involved purchases of government securities
with the more general objective of easing monetary conditions and restoring monetary
transmission to stimulate economic recovery and expansion.112 In some countries, asset
purchase programs were combined with strong communication about the expected path
of policy interest rates (known as forward guidance).113 Although central banks have not
directly coordinated these unconventional policy actions, they have continued to rely on
diplomacy to inform and discuss these actions in international forums.
Throughout the exploration and expansion of unconventional policies, there was
extensive press coverage of central bank diplomacy, including central bank meetings,
and reporting that highlighted the close communication among central bank governors
and senior staff, and the efforts at the BIS and elsewhere to draw common lessons for the
conduct of monetary policy (for example, on issues such as lending against collateral and
the use of forward guidance). Newspaper articles highlighted the shared backgrounds and
academic training of many central bank heads.114
Extensive asset purchase programs did cause strains among central banks, particularly
108
See Duke (2012).
109
Federal Reserve (2010a), ‘FOMC statement: Federal Reserve, European Central Bank,
Bank of Canada, Bank of England, and Swiss National Bank announce reestablishment of tem-
porary U.S. dollar liquidity swap facilities’, May 9; Federal Reserve (2010b), ‘FOMC statement:
FOMC authorizes re-establishment of temporary U.S. dollar liquidity swap arrangement with the
Bank of Japan’, 10 May.
110
Beginning in 2012, several central banks (in Denmark, the euro area, Japan, Sweden and
Switzerland) have begun to experiment with negative policy rates.
111
In announcing the program, the Fed said: ‘This action is being taken to reduce the cost and
increase the availability of credit for the purchase of houses, which in turn should support housing
markets and foster improved conditions in financial markets more generally.’ See Federal Reserve
(2008b).
112
See Habermeier and Mancini Griffoli (2013) and IMF (2013a, 2013b) for discussion of
these programs and their effects.
113
Canada and the United States are notable examples.
114
For example, see Hilsenrath (2012), Hilsenrath and Blackstone (2012).

in the emerging markets. The most outspoken critic of the effects of unconventional
monetary policies, both during the implementation of the asset purchase programs and as
the time to end them neared, was Bank of India governor Raghuram Rajan, who captured
the concern of many emerging market governments that central banks in advanced econo-
mies were not taking adequate account of the extra-national effects of their policies.115
Although financial supervision and regulation are dealt with elsewhere in this volume,
it is important to note here that there were extensive efforts during this period—including
at the BIS, the FSB and the Financial Action Task Force—to coordinate on central bank
rescues of financial institutions and the creation of a new architecture that, among other
things, would improve the provisions for orderly liquidation of banks.
As we noted earlier, the G-20 forum for finance ministers and central bank governors
garnered a greater role in policymaking beginning in the fall of 2007 as signs of what
was to become the global financial crisis began to emerge. Paul Martin had lobbied for
the original creation of the G-20 in the late 1990s when he was Minister of Finance in
Canada, and had been a long-time advocate of raising the group to the leaders’ level and
giving it a prominent role in crisis governance. There was debate over whether some new
grouping could be created, but the politics of deciding who was in and who was out soon
proved intractable. Further, the G-20, with its established ‘troika structure’,116 provided
the needed infrastructure for bringing together leaders of the major countries quickly, at
a time of crisis. Consequently, following a request from French President Nicolas Sarkozy
and British Prime Minister Gordon Brown to US President George W Bush, the G-20 met
for the first time at the leaders’ level in Washington in November 2008.117 While concerns
were expressed at the time that the summit could fail to deliver on heightened expecta-
tions, it was subsequently seen as successful in establishing an agenda for dealing with
the GFC and assumed a central role in the policy response that unfolded over the course
of several summit meetings. And, in spring 2009, the leaders established the Financial
Stability Board (the successor institution to the FSF) tasked with promoting reform of
international financial regulation and whose membership included all G-20 members.118
IV. LOOKING AHEAD

In this complex and interdependent world there is, and will continue to be, a clear need for
structured, institutionalised central bank cooperation. . . [To] be effective and legitimate, such
115
Rajan (2013).
116
Leadership of the G-20 rotates among countries, and the staff from the prior-, current-, and
next-year host countries form a secretariat that prepares for the ministerial meetings.
117
Some credit that first G-20 leaders’ summit as the impetus behind the coordinated interest
rate cuts. Angeloni and Pisani-Ferry (2012: 15–16) write that the communiqué conveyed ‘a sense
of urgency, focus, and concreteness that could not be found in the traditional G7/G8 declarations.
Instead of broad, often nebulous, open-ended political declarations encompassing a wide range of
topics, it reads like what it is—an extremely focused action plan . . . the language is precise, even
technical—specialised institutions in charge of carrying out work . . . are named and they are given
strict deadlines for implementation.’
118
Langdon and Promisel (2013) discuss the transition from the FSF to the Financial Stability
Board.

cooperation must continuously evolve and adapt to an evolving international monetary and
financial environment, with financial and economic crises serving as catalysts for change. Put
differently, the evolution of central bank cooperation is inherently linked to the challenges
presented by the evolution of the international monetary and financial environment, changes in
institutional frameworks and advances in economic thought. (Jaime Caruana)
The case studies presented in this chapter—the Plaza Accord, the Asian financial crisis
and the Global Financial Crisis—demonstrate clearly that while central bank thinking
evolves and adapts over time to changing global circumstances, financial and economic
crises serve as, in Caruana’s words, ‘as catalysts for change’. Repeatedly during the post-
war period, crises have led to changes in how central banks communicate and act, changes
that can have long lasting effects on the global financial architecture.
There are a number of reasons that this is likely to remain the case. First, at a time of
crisis, there often is a compelling reason that the appropriate central bank policies are
significantly different from what policymakers would choose if they were acting indepen-
dently, due to perceived gains from policy coordination.119 Second, when a crisis does hit,
central banks need to move fast to stay ahead of rapidly developing events in financial
markets.120 Further, statutory independence often affords central banks the capacity to
move ahead of their governments. Maintaining a balance between moving quickly and
being accountable to the public requires that central banks both have appropriate powers
and instruments, and be able to explain their actions to the public.
Getting that balance right has, if anything, become more challenging in recent years.
As noted earlier, central banks were drawn into a wider range of activities during and
in the aftermath of the GFC, some of which had a quasi-fiscal character or involved
unconventional policies that were introduced when policy interest rates neared zero. As a
consequence, central banks have arguably acquired a wider range of powers in the areas
of unconventional monetary policy, crisis response and financial stability. These wider
powers have challenged conventional wisdom about how central banks should operate
and, in some countries, resulted in political backlash.121
While it is a fool’s errand to try and predict the next crisis, there is accumulating
evidence that we are now more interconnected, that financial channels transmit shocks
across national borders more widely and with more power than in the past, and that as a
119
See Obstfeld and Rogoff (2002) for the argument that when credible central banks are
following optimal policies, the gains from policy coordination are small, and Taylor (2013) for why
unconventional monetary policies arising from the GFC have created the potential for additional
coordination gains.
120
A good example is the response to the 2016 British referendum—Brexit—that produced
a majority vote in favor of exiting the European Union. Following the vote on 23 June, central
banks moved quickly and in a clearly coordinated fashion. Bank of England Governor Mark
Carney signaled to financial markets the Bank’s willingness to ‘take all necessary steps to meet its
responsibilities for monetary and financial stability’ and hinted at possible future monetary easing
(see www.bankofengland.co.uk/publications/Pages/calendar/default.aspx). The SNB and a number
of emerging market central banks reportedly intervened in foreign exchange markets. Other lead-
ing central banks including the Bank of Japan, ECB and Federal Reserve signaled that they were
closely monitoring developments in global financial markets and were prepared to address liquidity
needs.
121
See Balls et al (2016) for a comprehensive review.

consequence the spillovers from shocks abroad will become even more consequential.122
This has implications for financial regulation, which is dealt with elsewhere in this volume.
But it also has important implications for monetary policy at the leading central banks
and suggests a potentially more significant role for central bank diplomacy in the years
to come.
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18. Central bank psychology
Andrew G Haldane*
13 September 2007 will be seen as a red letter day in financial history. It was the date news
broke of Northern Rock seeking emergency liquidity from the Bank of England, prompt-
ing the first run on a UK bank in over a century. It also fired the starting gun on what
subsequently became known as ‘The Great Recession’. That very day, the Bank hosted a
conference. In a painful irony, its theme was ‘The Great Moderation’.
The Great Moderation described the long-period of pre-crisis macro-economic calm,
with stable growth, stable inflation and stable banks.1 This view held that central banks,
while not eliminating boom and bust, had moderated macro-economic undulations. It also
held that financial innovation, while not eliminating risk, had scattered it to the four winds.
As Great Recession abruptly replaced Great Moderation, it was clear a grave analyti-
cal and policy error had been made. Economic and financial pride had come before a
momentous fall. Nemesis had duly followed hubris.2 It was the coldest of comforts that
this cognitive lapse was shared by the whole economic and policy-making profession.
Clinical diagnoses of this failure will continue for some time. Was this an example of the
intoxicating effect of power, the anaesthetising effect of success, or the humbling effect of
uncertainty? I do not know. But if nothing else, this episode underlines the importance of
cognitive constraints on decision-making when assessing the robustness of policy.
Over recent years, there has been a huge amount of research on how human decision-
making is affected by various cognitive biases.3 Behavioral economics, the fusion of
psychology and economics, has come of age. There has also been an enormous amount
of research over many years on central bank decision-making.4 Yet the link between the
two—the psychology of central banking—has to date been largely unexplored territory.5
In this chapter, I want to engage in a little amateur psychology by beginning to explore
that terrain. Psychology tells us that behavioral biases, because they are neurologically
* The views are not necessarily those of the Bank of England or the Monetary Policy
Committee. I would like in particular to thank Rashmi Harimohan, Jeremy Franklin, Michael
McMahon and Nick McLaren for assistance in preparing the text. I would also like to thank John
Barrdear, Rob Elder, Bob Gilhooly, Chris Hackworth, Jeremy Harrison and Gareth Ramsey for
their comments and contributions.
1
It was a term first popularised by Ben Bernanke, then-Chairman of the US Federal Reserve
Board (Bernanke (2004)).
2
In Greek mythology, Nemesis was the spirit of divine retribution against those who succumb
to hubris (arrogance before the Gods). The term hubris now typically refers to a loss of contact
with reality and an overestimation of one’s own competence, accomplishments or capabilities.
3
Loewenstein et al (2008), Kahneman (2011), Mischel (2014), Urminsky and Zauberman
(2014).
4
Blinder (2004), Reis (2013) and Friedman and Schwartz (1963).
5
There are some obvious exceptions in research on monetary policy decision-making, dis-
cussed below. Sibert (2006) also discusses the topic of ‘Central Bank Psychology’.
365

hard-wired, are often difficult to detect: they are unconscious biases. Simply recognizing
the cognitive constraints on decision-making is thus a first step towards making policy
robust to them.
So too is institutional design. Indeed, I wish to argue that the evolution of central bank
policy frameworks over recent years can be seen as an attempt to make them robust to
psychological biases. I want to illustrate that by reference to the Bank of England’s policy
framework. And, based on that analysis, I want to suggest some areas where a further
evolutionary ‘nudge’ in those frameworks might be warranted.6
I. BEHAVIOURAL BIASES IN PRACTICE

The literature on behavioral economics has sky-rocketed over recent years.7 This identifies
a long list of cognitive ticks that can affect human decision-making. All of these are likely
to affect policy decision-making to some degree. But from that potentially very long list,
let me highlight four biases which may pose a particular policy-making challenge.
1. Preference Biases
Public policy involves making choices on society’s behalf. Society typically delegates these
choices to an individual or set of individuals, often either politicians or bureaucrats. That
act of delegated authority means that policy decisions usually involve both a principal
(society) and an agent (such as government). The nature of that principal/agent relation-
ship then becomes crucial for effective policy.8
Yet history suggests that this relationship is not always entirely harmonious. One
potential source of friction is that the agent may have preferences which are not perfectly
aligned with society at large. This is human nature. For example, it might arise from the
agent putting personal objectives over societal ones, such as personal power or wealth.9
These problems have been widely studied in political and management science. In their
extreme form, this preference misalignment can manifest itself as autocracy (the pursuit
of personal power at society’s expense) or corruption (the pursuit of personal wealth at
society’s expense). Historically, such ‘extractive regimes’ have had dire consequences for
societal welfare. Indeed, they may explain why nations fail.10
Historically at least, the antidote to these preference problems is typically found in
institutions—property rights, the rule of law, democratic processes. Strong institu-
tions have often laid the foundation on which nations have been built. Typically, these
institutional structures comprise an ex-ante mandate (agreed by society) and ex-post
accountability mechanisms (assessed by society). Colloquially, these are often called
checks and balances.
6
A term first popularised in the Book ‘Nudge: Improving Decisions about Health, Wealth,
and Happiness’ (Thaler and Sunstein (2008)).
7
As discussed in Diamond and Vartiainen (2007).
8
Bergman and Lane (1990).
9
Gailmard (2014).
10
Acemoglu and Robinson (2012).

Central bank psychology 367
For example, electoral democracy is an institutional response to a potential preference

misalignment between the electorate and the polity. Parties publish manifestos ex ante
to set their mandate. And, if successful, they are held accountable for that mandate by
society ex-post through elections.11 Democracy, and its associated institutions, is the
solution to an ageless principal/agent problem.
What is true at the level of the nation state is also true at the level of the firm and
the individual. In firms, principal-agent problems can arise because managers put their
own preferences (for mega-mergers, mega-bonuses, mega-jets) ahead of shareholders.12
They also arise from workers putting their own preferences (say, for an easy life) over
managers.13 Institutional structures—in this case, company and employment law—can
help solve these problems.
Among individuals, preference biases can also have negative societal implications. In
the medical profession, there is research arguing that doctors systematically over-prescribe
drugs and over-admit patients to hospital.14 Neither may be in the patients’, nor societies’,
best interests. This is usually the result of doctors weighing their own preferences (the risk
of reputational or financial loss) over the patient’s (the risk of health problems worsening).
2. Myopia Biases
Psychological experiments show that people differ materially in their capacity to defer
gratification. The classic example is the ‘Marshmallow test’ devised by Walter Mischel
in the 1960s.15 Mischel gave children at Stanford University’s Bing Nursery School the
choice between one marshmallow for immediate consumption or two if the child waited.
Not only did children differ significantly in their ability to defer gratification. As
researchers followed the fortunes of these children as they grew older, a remarkable
pattern emerged: children which had exhibited greater patience in their pre-school marsh-
mallow test subsequently outperformed their impatient counterparts in everything from
school examinations, to salaries, to reported levels of life satisfaction.
Subsequent sociological studies have established a longer list of ways in which impa-
tient or myopic behavior influences human decision-making. Myopic individuals are more
likely to smoke, to suffer alcohol and drug addiction problems, to be obese and to have
credit card debt problems.16 Myopia also differs significantly across countries.17
To explain this, Richard Thaler developed a psychological model based on the ‘two
selves’. In effect, each of us comprises a patient ‘planner’ and an impatient ‘doer’.18
Neuro-scientific evidence has subsequently lent support to Thaler’s model, with different
areas of the brain found to be responsible for patient and impatient behaviors.19
11
Ferejohn (1986).
12
Jensen and Meckling (1976).
13
Ross (1973).
14
Orlowski and Wateska (1992).
15
Mischel (2014).
16
As discussed in Urminsky and Zauberman (2014).
17
Wang et al (2011).
18
Thaler and Shefrin (1981).
19
McClure et al (2004), Figner et al (2010) and Loewenstein et al (2008).

In practice, myopic behavior appears often to hold sway in everyday decision-making.

People appear consistently to discount too heavily future rewards, a property called
hyperbolic discounting.20 This can explain myopic saving behavior by households and
companies, when tomorrow’s consumption is brought forward to today.21 And it can
explain political business cycles, when tomorrow’s GDP is brought forward to today.22
Myopic behavior also appears rife in risk decisions. People appear to exhibit risk
myopia, discounting risk events more heavily the longer the period that passes without
that risk materialising.23 This is the behavior we see from car drivers whose speed gradu-
ally increases after witnessing an accident. It was also the behavior we saw during the
Great Moderation when financial markets suffered progressively greater risk myopia.
3. Hubris Biases
In 1965, psychologist Stuart Oskamp performed a multiple choice test on a group of

psychology students based on a case study. He also asked them to assign a confidence
rating to their answer.24 The students were then given more information on the case study
and asked to answer further questions with a confidence rating.
He found that additional information did nothing to improve the accuracy of the
students’ answers. It did, however, cause the confidence rating they attached to these
answers to rise significantly. The addition of information and experience led students to
become over-precise, to over-estimate their abilities, to over-state their performance.
There is no shortage of casual evidence of such hubris or over-confidence biases. 90 per-
cent of faculty at the University of Nebraska rate themselves as above-average teachers.25
Over 90 percent of US students rate themselves as above-average drivers.26 And over 80
percent of Frenchmen rate themselves to be above-average lovers.27
Over-confidence biases have been widely studied in politics and management. There
is a degree of Darwinian self-selection at work here. Over-confident individuals tend to
outperform in tournaments. This means they are more likely to occupy positions of influ-
ence in the first place, whether Prime Minister or CEO, though not Chief Economist.28
But the same factor that pushes these individuals to the summit may also push them
over the edge. Over-confidence increases the risk of over-reach—for example, pursuing
over-ambitious targets or undertaking over-complex company takeovers, generating an
above-average risk of systemic failure. That is why nemesis is often thought to follow
hubris.
What is true of those managing countries and companies appears to be no less true
of those managing money. Investment managers have consistently been found to over-
20
Ainslie (1975).
21
Laibson (1997).
22
Nordhaus (1975).
23
Kahneman and Tversky (1979) and Thaler, Kahneman, Tversky and Schwartz (1997).
24
Oskamp (1965).
25
Cross (1997).
26
Svenson (1981).
27
Taleb (2007).
28
Goel and Thakor (2008).

estimate their abilities and traders consistently to over-trade their positions. On average,
there is little evidence of either consistently out-performing their peers.29
Over-confidence effects tend to be more acute among individuals than groups, as
groups dilute the influence of hubristic individuals, as well as promoting a greater under-
standing of others’ perspectives. Consistent with that, studies of decision-making by the
US Supreme Court in the US have found benefits from expert, unelected committees.30
4. Groupthink Biases
In 1951, Solomon Asch conducted a series of tests on a group of students. Each was asked
in turn to state which of three lines on a card matched the length of the line on a separate
card.31 The twist came in the fact that all but one of the participants was an actor, primed
to give the wrong answer. The real student, answering last, then responded.
These Asch experiments found something remarkable. The unsuspecting student
conformed to the group’s wrong answers between a third and a half of the time. Their
decision-making suffered a systematic conformity bias. Interestingly, if as little as one
dissenting view was added, this conformity bias was reduced by up to 75 percent.
In 1972, Irving Janis called this tendency for groups to act cohesively ‘groupthink’.32
Janis focused on a number of US political decisions to motivate this concept, the most
celebrated of which was President Kennedy’s decision to invade the Bay of Pigs in 1961.
More recently, groupthink was used to explain the Challenger space shuttle disaster.33
Groupthink is the collective manifestation of confirmation bias—the tendency to
search and synthesize information in ways which confirm prior beliefs. This, rather
than alcohol, is why drunks search for lost keys under the lamppost.34 Confirmation
bias is prevalent in uncertain environments, where popular narratives are used to filter
uncertainties.35
Psychologists such as Janis have identified a number of ways to mitigate groupthink
or confirmation bias. Actively encouraging dissent in groups is one. Seeking alternative
perspectives from outside experts is a second. And having the group chair state their
preferences last is a third.36
II. EVOLUTION OF BANK OF ENGLAND’S POLICY

FRAMEWORK
Let me now describe the evolution of the UK’s macro-economic policy framework over
the past half-century or so. This is a journey whose starting point was a rules-based regime
29
Kahneman (2011).
30
Iaryczower et al (2013).
31
Asch (1951).
32
Janis (1972, 1982).
33
Hughes and White (2010).
34
Kaplan (1964).
35
Tuckett (2011).
36
Janis (1982).

over which the Bank had little discretion and whose finishing line is a regime over which
the Bank exercises significant discretion.
For much of its 320-year history, the Bank of England’s role in UK economic policy
was as operational agent. The role of policy principal was played by government.37 In
the setting of monetary policy, the Bank’s role from the end of the second world war
through to the 1990s was as implementer, not decision-maker. The Bank had little, if any,
independence in the setting of monetary targets or instruments.
That changed progressively in the 1990s and decisively after 1997. Through the
Bank of England Act 1998, the Bank was granted operational independence for
the setting of monetary policy in the UK, to meet an inflation target set by govern-
ment. Specifically, monetary policy came to be set by a nine-person Monetary Policy
Committee (MPC), meeting monthly and comprising five Bank ‘internals’ and four
‘externals’.38
In the light of the crisis, the UK’s policy framework has been further changed. The
Financial Services Act 2012 vested the Bank with further responsibilities, creating a new
ten-person Financial Policy Committee (FPC), meeting quarterly to execute macro-
prudential policy. The FPC sets regulatory policy to ensure the stability of the financial
system as a whole. Like the MPC, it comprises both internals and externals.39
The Financial Services Act also gave the Bank responsibility for micro-prudential
supervision—ensuring the safety and soundness of individual financial firms. This
responsibility rests with the Prudential Regulation Authority (PRA) at the Bank,
specifically its Board. The PRA Board also comprises both Bank insiders and
outsiders.40
From 1694 well into the twentieth century, the Bank of England functioned as the
government’s operational agent with respect to the regulation of money, while also engag-
ing in a strictly private business. Indeed, this schizophrenic institutional role prompted
a grumpy Walter Bagehot to excoriate the Bank for failing to own its public role more
completely, in his magisterial Lombard Street. But over the past 20 years, its degree of
policy discretion has been transformed. It now comprises monetary, macro-prudential
and micro-prudential policy—a ‘3M’ regime. The Bank’s span of responsibilities may well
be unique, at least among advanced economy central banks.
Though there are differences in detail, there are also striking elements of institutional
similarity in the decision-making architecture for monetary, macro-prudential and micro-
prudential policy, as carried out by the MPC, FPC and PRA respectively. Let me mention
four features in particular:
(a) Goal dependence: The policy objectives of all three policy committees are set in
statute by Parliament, reflecting the attitudes of the electorate at large. In the
language of economics, the 3M regime thus exhibits ‘goal-dependence’.41 Though
different in detail, these objectives share some similarities. For example, the MPC
37
Capie, Goodhart and Schnadt (1994).
38
King (2010), Lambert (2005).
39
For more on the FPC, see Tucker, Hall and Pattani (2013) and Murphy and Senior (2013).
40
Bailey, Breeden and Stevens (2012).
41
Debelle and Fischer (1994).

and FPC have a unique primary objective, augmented with a common secondary
objective.42
(b) Instrument independence: The policy instruments of the three policy commit-
tees are delegated, through statute, to them. In other words, the settings of these
instruments on a day-to-day basis are for the Bank of England’s policy committees,
subject to meeting the Parliamentary-set target. The 3M regime thus exhibits
‘instrument-independence’.
(c) Committee-based decision-making: Decisions on monetary, macro-prudential and
micro-prudential policy rest with three Committees, rather than any one individual.43
The Committees themselves vary in size from nine to 11 people. They comprise a
mix of Bank of England ‘internals’ and ‘external’ experts. Decisions are made either
by majority voting (MPC), consensus (PRA) or by consensus with a provision for
majority voting (FPC).
(d) Transparency and accountability: The deliberations and decisions of each Committee
are subject to public scrutiny. The minutes of MPC and FPC policy meetings are
published. All three Committees produce periodic reports, tabled in Parliament,
on their actions and analysis.44 And members of each Committee appear regularly
before Parliamentary Committees. There is individual accountability, as well as
collective responsibility, for policy.
These institutional features are no historical accident. Each serves as a constraint on the
policy discretion exercised either by the Bank as agent or by its principal Parliament.
The 3M policy regime is one of ‘constrained discretion’.45 Each of these constraints
can, in turn, be seen as an institutional response to the behavioral biases discussed
earlier.
III. BEHAVIORAL BIASES IN POLICY
How, then, do these institutional features influence the various behavioral biases?
With elements of this policy framework still fledgling, it is too early to reach definitive
conclusions on some of its features. But in this section I’ll provide some evidence on how
successful these features may have been in leaning against these biases.
1. Preference Biases
The policy frameworks of the MPC, FPC and PRA Board share the feature that targets
are set ex ante in legislation by Parliament acting on behalf of society. The policy
42
For example, for the MPC the remit specifies that the primary objective is to maintain price
stability and, subject to that, the secondary objective is to support the economic policy of Her
Majesty’s Government, including its objectives for growth and employment.
43
Although a single individual—the Governor—chairs all three committees.
44
For MPC, this is a quarterly Inflation Report; for FPC, a semi-annual Financial Stability
Report; for the PRA, an Annual Report.
45
Bernanke and Mishkin (1997) first coined this term in the context of inflation-targeting.

mandates of the MPC, FPC and PRA are those of the principal (society), not the agent
(the Bank). The Bank is not setting its own exams.
Nor, ex post, is the Bank marking its own exams. For example, if the MPC fails to meet
its two per cent inflation target by one percentage point in either direction, it is required to
write an open letter to the Chancellor, setting out why this happened and how the MPC
intends to respond in returning inflation to target. And the Bank’s regular policy reports
set out the MPC, FPC and PRA’s intended actions and are subject to Parliamentary
scrutiny.
These design features—ex ante mandates and ex post accountabilities—are explicitly
designed to ensure the actions of the Bank’s policy committees are well-aligned with soci-
ety’s wishes. They are designed to reduce the risk of the Bank becoming a mono-maniacal
inflation-fighter or risk-slayer, with preferences out of kilter with society’s.
To operate effectively, these institutional checks and balances need to be reasonably well-
specified—for example, the mandate needs to be clear and monitorable. On the monetary
policy side, this is relatively straightforward. The MPC’s inflation target is quantitative
and observable. It also appears to be pretty well-aligned with societal preferences.
The Bank conducts regular surveys of public attitudes towards the inflation target.
They paint a consistent picture. Around half of respondents think the two percent target
for inflation is about right. The minority who disagree are roughly evenly-split between
those thinking it is too low and too high.
There is also a striking correlation between public attitudes towards the Bank and
perceptions of inflation, with the public seemingly strongly averse to above-target
inflation rates. There is little sense that the Bank may be acting like an ‘inflation-nutter’.
This pattern is replicated internationally where inflation targets are centered around two
percent and survey evidence indicates a strong public aversion to inflation.46
Even if public minds are made up on appropriate inflation targets, academics are not.
Since the crisis, a number of countries have operated near the zero bound for interest rates.
It has been argued that targeting a two percent inflation rate results in this zero bound
constraint binding too frequently, inhibiting the effectiveness of monetary policy.47 A
higher target would loosen that constraint. This academic debate may run for some time.
On the financial stability side, the position is less straightforward. There is no single,
easily observable or quantifiable target for systemic risk against which to hold the FPC
and PRA to account. And the public at large often do not have well-defined or strong
attitudes towards financial stability—except, perhaps, when things go wrong.
Since 2012, the Bank has been surveying the general public on how they believe the
Bank has performed in protecting the financial system. Some reassurance can perhaps be
taken from the fact that this has moved from a net dissatisfaction score of 13 in 2012 to
a net satisfaction score of 40 today.48 Nonetheless, by itself this approach falls well short
of having a clear objective against which the FPC and PRA can periodically be assessed.
The FPC has begun publishing a set of financial stability indicators against which it
46
Shiller (1997).
47
Ball (2014).
48
The Bank of England GfK/NOP FPC Survey. Further details available at: http://www.
bankofengland.co.uk/publications/Documents/speeches/2013/fpcsurvey.xlsx.

assesses systemic risk and is held to account. And through the process of stress-testing the
balance sheets of financial institutions, the FPC and PRA are now laying out transpar-
ently the risk standard they are requiring from firms and from the financial system as a
whole and which is the subject of external scrutiny.
But this has not fully allayed occasional criticisms of the Bank’s regulatory policy
choices. At various times, the Bank has been warned against pursuing the stability of the
graveyard or the tendencies of the Taliban. A somewhat better defined financial stability
anchor, set by Parliament and reflecting society’s desires, could over time damp these
criticisms.
Beginning in the 1950s and 1960s and crystalizing in consensus in the 1980s and 1990s,
central banks and academics strove to define an appropriate anchor for monetary policy.
That brought success, with inflation targets and attitudes now well-anchored. This
gives grounds for optimism that financial stability can follow the same path though, as
monetary policy found, the journey is likely to be long and arduous.
2. Myopia Biases
The Bank’s monetary, macro-prudential and micro-prudential policy regimes all exhibit
instrument independence. Decisions are made by Committees of technocrats, operating
at arms-length from the political process. The case for delegation of policy responsibility
is founded on myopia biases within society at large or among its elected representatives.
In a monetary policy context, myopia tends to manifest itself as a desire to bring forward
tomorrow’s income to today, typically by setting monetary policy too loose. As one former
US president is rumored to have put it, ‘I want tight money – and lots of it’. Myopia risks
coming at the expense of higher inflation tomorrow. It imparts an inflation bias.49
What is true of monetary policy is equally true of regulatory policy. A desire to bring
forward income may result in regulatory policy also becoming too loose. As one former
British Prime Minster put it, pre-crisis regulation was ‘hugely inhibiting of efficient busi-
ness by perfectly reasonable companies’.50 Myopia then risks coming at the expense of a
higher incidence of crises tomorrow. It imparts a crisis bias.51
Luckily, these temporal biases also have a potentially straightforward solution. This is
to delegate decision-making over monetary and regulatory policy to an agency less prone
to myopia bias—an agent whose time horizon stretches beyond the political business
cycle. This is where central bank independence comes into the picture.
The inflationary experience of the 1970s and early 1980s was taken by many as evidence
of myopia-induced inflation biases. Politicians had flunked the marshmallow test. In
response, countries began granting central banks greater degrees of monetary policy
independence, as an institutional response to a behavioral bias.52
This international trend was followed by the UK in 1997, when the Bank of England
was granted operational independence. Has this curbed the inflation bias?
49
Barro and Gordon (1983).
50
Blair (2005).
51
Haldane (2013).
52
Hammond (2012).

These measures of inflation expectations were consistently and materially above target
in the period prior to independence—the myopia or inflation bias problem looked real.
But from pretty much the point of announcement of independence, they began ratcheting
down. Within 12 months, they were aligned with the inflation target. They have stayed
there in the period since. The Bank of England has thus far passed the marshmallow test.
Another lens is provided by looking at the stability of inflation and output either side
of central bank independence. Since independence, UK inflation variability has fallen by
a factor of five and output stability by a factor of almost two. No evidence here of the
Bank behaving like an ‘inflation nutter’. And this period saw the largest macro-economic
collapse in memory, it loads the dice against independence.
For financial stability, quashing myopia-induced crisis biases is at an earlier stage. The
long history of past financial crises attests to that. Tellingly, history often ascribes political
structures and incentives a key role in determining which countries are most susceptible to
crisis.53 This tells us why financial regulation has repeatedly failed the marshmallow test.
Nonetheless, there are institutional grounds for optimism. In the UK, the FPC and
PRA have been created as independent regulatory policy bodies housed under the Bank
of England. They are a direct response to past crisis myopia. They mimic the changes
made to monetary policy 16 years ago and, at root, were done for the same reasons.
For the FPC and PRA, still in their infancy, it is far too early to tell whether they will
be able to quell future crises more effectively than regimes in the past. Surveys of market
participants’ expectations of systemic risk—the closest analogue to inflation expecta-
tions on the financial stability side—have subsided over recent years. How much of that
is attributable to the new regulatory regime, rather than external factors, is at present
unclear.
Looking internationally, unlike with monetary policy, consensus has yet to be reached
on whether regulatory policy should also be set independently from government. A recent
IMF study found only half of macro-prudential regimes internationally were operated by
central banks, though a number of others were in the hands of independent regulators.54
Perhaps with the passage of time that will change, as with monetary policy independ-
ence. Psychology suggests it should. Because the risk cycle is even longer than the business
cycle, myopia biases are even more likely when tackling financial crises than inflation
scares. The case for independence is at least as strong for regulatory policy as it is for
monetary policy.55
3. Hubris Biases
Under the UK’s new framework, decisions on monetary, macro-prudential and micro-
prudential policy are made by Committee, rather than by an individual. Committee
members are individually accountable and drawn from inside and outside the Bank. This
structure provides some safeguard against over-confidence bias—for example, by diluting
the influence of any one individual’s views on policy decision-making.
53
Calomiris (2014).
54
IMF (2013).
55
Haldane (2013).

There is evidence to support this in monetary policy decision-making. In the early days
of the MPC, the Bank used experimental evidence to assess the impact of committee
decision-making. It found they made for better decisions than individuals, by eliminating
the bad play of individuals but also by promoting learning among Committee members.56
Subsequent evidence from real-world MPC decision-making has found the same.57 For
effective information aggregation, individual MPC members need to bring a diversity
of views. While difficult to observe directly, voting patterns suggest a reasonable degree
of such diversity. There has been at least one member dissent from an MPC decision at
around half of all meetings.
External MPC members have contributed importantly to this diversity. On average,
they have been around twice as likely as internals to dissent from monetary policy deci-
sions. And although less likely to be in a minority, the Governor of the day has been
outvoted on nine occasions.58
Voting diversity does not of course prevent collective over-optimism. That might arise,
for example, if the MPC consistently over-estimated its ability to forecast the economy.
Since 1996, the Bank has published forecast paths for inflation and output growth,
together with its assessment of the uncertainty around these estimates—so-called ‘fan
charts’.59
These fan charts allow us to conduct a real-world version of Oskamp’s experiment.
During the Great Moderation, forecast errors shrunk. The MPC narrowed their fan charts
in response, becoming more precise in their estimates of future output and inflation.
Post-crisis, that picture has changed radically. Forecast errors increased. The fan charts
were widened significantly, almost doubling for both future output growth and inflation.
Like psychology students of the 1950s, there was a significant degree of pre-crisis over-
precision by the MPC in their assessment of the economy.
Despite the post-crisis widening of the fan charts, it remains unclear whether the now
higher degree of uncertainty in the fan charts is correctly calibrated.
If the fan chart distribution had been roughly right, these outcomes would be equally
distributed across the buckets. They are not. In practice, output and inflation have fallen
systemically into the tails of the distribution, with around 50 percent in the outer 20
percent buckets.
4. Groupthink Biases
A related, but distinct, decision-making defect is confirmation bias or its collective

counterpart, groupthink. As with other biases, the institutional structures of the MPC,
FPC and PRA contain a number of safeguards. Committee-based decision-making,
with individual accountability and with the chair voting last, reduces the risk of a single
collective narrative. The degree of dissent across the MPC is also a positive diagnostic.
Nonetheless, Committee-based decision-making, especially by consensus, does not
56
Lombardelli et al (2005) for the UK and Blinder and Morgan (2007) for the US.
57
Hansen, McMahon and Velasco Rivera (2014).
58
It is too soon to assess the decision-making structures of the FPC and PRA, all of whose
decisions so far have been consensual.
59
For further discussion on decision making under uncertainty, see Aikman et al (2011).

remove the risk of conformity risk. Indeed, it could even propagate groupthink if cross-
pollination becomes rather too effective. As an illustration, Michael McMahon from
Warwick University has undertaken a detailed text-based analysis of MPC minutes to
assess the importance of certain ‘topics’ in shaping the MPC’s deliberations.
For the decade prior to 2007, banking issues did not get much of a look-in. They typi-
cally accounted for only around two percent of MPC discussion time during the Great
Moderation. With hindsight, given emerging pressures in the banking sector, this was a
collective blind-spot.
The Northern Rock crisis of 2007, and the failure of Lehman Brothers in 2008, made
visible those pressures. In response, Committee-time devoted to banking issues rose to
a peak almost ten times higher than the pre-crisis period. Today, discussion of banking
issues has settled at levels below the crisis peaks, but above those in the pre-crisis period.
The proportion of MPC discussion around banks bears a striking resemblance
to market-based measures of banking risk. Since these market-based measures were
affected by risk illusion, it is reasonable to assume the MPC suffered some of that
same illusion. Just like the students in the Asch experiments, MPC yielded to the wrong
answers given by other financial actors. The MPC were looking for their keys under the
wrong lamppost.
It is too soon to tell whether any collective blind-spots remain. But compared with the
pre-crisis period, the Bank today has two extra pairs of policy eyes through the PRA
and FPC. Joint meetings between the MPC, FPC and the PRA Board now take place.
These help strengthen the committees’ peripheral vision and are a safeguard against
groupthink.
As for economic forecasting, this is the most inexact of sciences. The Bank has already
undertaken an external review of its forecasting procedures.60 And it also has taken a
sequence of measures to improve this process and the transparency around it.61 This has
included publishing more information on forecast inputs and outputs.62
So too is the Bank’s new approach to research. To caricature slightly, Bank research
in the past was typically used to nourish and support the Bank’s policy thinking and
framework. Relatively rarely was it used to challenge that prevailing policy orthodoxy, at
least in public.
That has recently changed. As part of its strategic plan, the Bank has decided to cut
the umbilical cord. In future, it will carry out, and publish externally, research covering
the whole waterfront of policy issues it faces, monetary, financial and regulatory. Through
new publications, such as its new blog Bank Underground, the Bank will put into the public
domain research and analysis which as often challenges as supports the prevailing policy
orthodoxy on certain key issues.
This research will hopefully act as spur and springboard for new policy thinking, and
perhaps in time policy change, on key central bank issues of the day, whatever they may
be. It will act as another bulwark against hubris, over-confidence and groupthink.
60
Stockton (2012).
61
See the Box ‘Changes to Section 5 of the Inflation Report’ on p. 49 of the May 2013 Bank
of England Inflation Report.
62
IEO (2015).

IV. CONCLUSION
Behavioral biases afflict us all, in every activity from setting concrete to setting interest
rates, from stress-testing steel to stress-testing banks. Central banks cannot be immune.
Because central banks’ judgements affect society at large and in large ways, it is important
there are institutional means of safeguarding against these biases.
The Bank of England’s new policy framework is part of the response to that chal-
lenge. By design, it contains institutional safeguards against many of the biases most
important for UK monetary and financial stability. But it is early days. In developing this
framework further, three principles will be important—recognition, research and revision.
Because behavior biases are often unconscious, recognizing them is crucial for building
robustness. Put differently, denying their existence is proof of their importance! Research
can help in identifying and understanding these biases and assessing institutional means
of leaning against them. The Bank hopes to make a real behavioral change of its own on
the research front in the years ahead.
Armed with that research, the Bank should be better-placed to make revisions to policy.
Historically, flexing policy frameworks has often been taken as a sign of regime failure.
Quite the opposite ought to be the case. If the Bank’s policy machine is to be robust over
time, it will need to evolve and flex. If central bank regimes are encased in glass, they are
apt to shatter when next hit by a falling Rock.
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19. Banking regulation and supervision: a UK
perspective1
Kern Alexander and Rosa María Lastra
I. INTRODUCTION
Recent international regulatory reforms emphasise macro-prudential principles and
objectives for banking regulation and supervision. The United Kingdom provides an
interesting case study of a country that has adopted institutional changes in financial
regulation to support its transition from a largely micro-prudential framework of regu-
lation to one that combines a macro-prudential framework of regulation and policy
that aims to control systemic risk with judgment-based micro-prudential supervision.
In considering macro-prudential reforms, the chapter discusses the evolving defini-
tion of banks and the necessity for law and regulation to keep pace with financial
innovation and evolving market structures. The chapter analyses the UK regulatory
reforms under the Financial Services Act 2012 and the broad remit provided to the
Bank of England’s Financial Policy Committee (FPC) to monitor financial stability
risks and to coordinate micro-prudential regulatory practices and recent legislative
reforms in the draft Financial Services Bill 2016. There will be some discussion of the
European System of Financial Supervision (EFSF) and how the European Systemic
Risk Board coordinates its macro-prudential supervisory oversight function with the
harmonised implementation of micro-prudential supervisory powers by the three
European Supervisory Authorities.2 The chapter argues that although UK regulatory
reforms have taken important steps in coordinating macro-prudential regulation and
policy with micro-prudential regulation, challenges remain in monitoring systemic
risks across the financial system and in addressing risks posed by the shadow banking
system. At outset, however, it is necessary to clarify the distinction between regulation
and supervision, as both terms are capable of being used interchangeably. Regulation
refers to the legal body of rules or standards established by banking regulatory authori-
ties or self-regulatory bodies to limit or control the risk assumed by banks or other
financial institutions, while supervision refers to the process of ensuring, or monitoring
1
This section draws on earlier writings by Lastra (1996, 2015a). Rosa Lastra would like to
thank Lucia Satragno for research assistance. Kern Alexander would like to thank Dr Francesco
Depascalis for research assistance.
2
According to the House of Lords Report on the Future of EU Financial Regulation and
Supervision, ‘macro-prudential supervision is the analysis of trends and imbalances in the financial
system and the detection of systemic risks that these trends may pose to financial institutions and
the economy. The focus of macro-prudential supervision is the safety of the financial and economic
system as a whole, the prevention of systemic risk. Micro-prudential supervision is the day-to-day
supervision of individual financial institutions’. See Report of the House of Lords’ European
Union Committee (2009).
380

Banking regulation and supervision: a UK perspective 381
compliance by banks with any specific sets of regulatory provisions imposed by the
regulatory authorities.
Generally, regulation has to do with rule-making while supervision has to do with
monitoring compliance and enforcement.3 But in recent years supervision in banking and
finance has become a richer and more multi-faceted concept. The global financial crisis
of 2007–09 spawned developments in how financial supervisors understand and confront
systemic risk. Prior to the crisis, supervisors adhered mainly to a micro-prudential focus
on the safety and soundness of individual institutions, whereas after the crisis supervisors
have expanded their focus to include a macro-prudential perspective that attempts to
mitigate risks across the financial system as a whole.4
II. WHAT IS A BANK?
The business of banking has traditionally involved at its core credit intermediation, that
is, the collection of callable savings from depositors and other lenders and the making
of longer-term loans to borrowers while providing liquidity to customers in the form of
payment facilities. The financial risks associated with credit intermediation, also known as
‘maturity transformation’, constitute a major concern for prudential regulators because
the practice of borrowing short and lending long can pose risks to society if banks fail
to manage their risks effectively. However, the scope and application of the laws that
regulate and supervise credit institutions have a much narrower definition of banking
that covers the taking of retail deposits and the provision of longer-term credit. For
instance, under EU banking law, banks are defined as undertakings ‘whose business it is
to receive deposits or other repayable funds from the public and to grant credits for its own
account’.5 This narrow legal definition excludes a large number of credit intermediaries
that are involved in the business of borrowing short and lending long and which pose
financial stability risks to society.
Although there is no universal definition of banks, the English common law historically
defined banks narrowly as businesses that accepted deposits for their customers’ accounts
while negotiating cheques on behalf of their customers that either drew on, or credited,
their accounts vis-à-vis third parties. The problem of defining banks has been made
more difficult by the emergence of multifunctional banks that operate in complex
financial groups providing a variety of financial services, including commercial banking,
merchant banking, asset management and securities broker-dealers. Although regulators
3
See Lastra (1996).
4
Above note 2.
5
See article 1 of Directive 77/780/EEC on the coordination of laws, regulations and adminis-
trative provisions relating to the taking up and pursuit of the business of credit institutions (1977)
OJEC L 322/30; and article 1 of Second Council Directive 89/646/EEC on the coordination of
laws, regulations and administrative provisions relating to the taking up and pursuit of the business
of credit institutions and amending Directive 77/780/EEC (1989) OJEC L386, and article 3(1) of
Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access
to the activity of credit institutions and the prudential supervision of credit institutions and invest-
ment firms, amending Directive 2002/87/EC and repealing Directive 2006/48/EC and 2006/49/EC
(2013) OJEU L/176/338.

in different jurisdictions have adopted quite different approaches to defining banks, the
common feature across most jurisdictions is that the legal definition of a bank is consider-
ably more narrow than the economic definition of a bank as a credit intermediary. This
constitutes a serious gap in the supervisory powers of most bank regulators.
The United Kingdom has adopted a definition under Part 4 of the Financial Services
and Markets Act 2000 (FSMA) (as amended) that the carrying on of the business of
banking is a regulated activity for which permission must be obtained from the UK
regulators, the Prudential Regulation Authority and the Financial Conduct Authority.6
The business of banking includes accepting deposits (within the meaning of section 22 of
FSMA 2000, taken with Schedule 2 and any order under section 22). Under the FSMA
2000 (Regulated Activities) Order 2001, accepting deposits is a specified kind of activity
if:
(a) money received by way of deposit is lent to others; or,

(b) any other activity of the person accepting the deposit is financed wholly, or to a
material extent, out of the capital of or interest on money received by way of deposit.
The Banking Act 2009 goes further to exclude certain institutions, such as building socie-
ties and credit unions, from being classified as banks, even though they perform similar
functions to banks such as accepting money by way of deposit and lending the money
to others.7
The UK statutory approach to defining banks provides the Treasury with discretion to
expand the definition to include other financial firms engaged in the banking business—
that is, borrowing short-term from depositors and other lenders and making longer-term
credits available to borrowers. This approach, though not without its problems, is
preferred to the common law approach, which had not appreciated the intermediary
function of banks in the economy and the role of innovation and technology in changing
the banking business. By making banking a licensable activity, the question of whether
an institution is a bank or not can be quickly resolved by inquiring whether it has been
licensed by a regulatory body or not.
III. WHY DEFINE BANKS?
Banks are highly regulated institutions, largely due to the nature of the banking business
and the risks associated with banking and the negative externalities that banking poses to
society. The blurring of the distinction between banks and non-bank financial institutions
has resulted in a clear need for regulators to be able to identify and supervise firms that
are engaged in the banking business, that is, maturity transformation involving the taking
of short-term deposits or other types of short-term liabilities and providing longer-term
6
Section 19 of Financial Services Market Act (FSMA) 2000 (as amended).
7
The Act expressly states that a bank does not include: (a) A building society (within the
meaning of section 119 of the Building Societies Act 1986), (b) A credit union (within the meaning
of section 31 of the Credit Unions Act 1979), or (c) any other class of institution excluded by an
order made by the Treasury.

credits to borrowers. For instance, some non-bank financial institutions provide services
similar to those provided by banks and could be easily confused for banks.8 The prevailing
argument is that banks require a higher level of regulation than other financial institutions,
thereby necessitating the need for regulators to identify banks by setting out a satisfactory
framework for the definition of banking and what constitutes the banking business.9
Without such a framework, much of what constitutes banking would escape regulation
and pose undue risks to the financial sector and economy. This phenomenon is sometimes
called the ‘shadow banking’ problem, a concept we discuss in more detail below.
Internationally, the importance of defining banks and the permissible activities which
they can engage in is captured in Core Principle 2 of the Basel Revised Core Principles For
Effective Banking Supervision, which provides that ‘the permissible activities of institu-
tions that are licensed and subject to the supervision as banks must be clearly defined, and
the use of the word “bank” in names should be controlled as far as possible.’10 Moreover,
Basel Core Principle 1 suggests that bank supervisors should be monitoring risks across
the financial system that may threaten the stability of individual banks.11 Before we
discuss the rationale and objectives of banking regulation and supervision, it is important
to discuss the significance of financial stability as an objective of financial regulation.
There appears to be broad consensus that the neglect of financial stability considerations
prior to the global financial crisis was one of its causes. This has led to the reinforcement
of the twin mandate of central banking: financial stability as a necessary counterpart to
monetary stability.
IV. FINANCIAL STABILITY, SYSTEMIC RISK AND BANKING
Monetary and financial stability are important governmental objectives and fundamental
economic goals.12 Defining financial stability is difficult as it encompasses several
disparate elements, but several commentators have offered their views. Crockett defines
financial stability as the ‘absence of stresses that have the potential to cause measurable
economic harm beyond a strictly limited group of customers and counterparties.’ Lastra
sees financial stability as an evolving concept, the achievement of which encompasses
a variety of elements that are typically the subject of oversight by the supervisory
authorities.13 Padoa-Schioppa defines financial stability as ‘a condition in which the
8
For instance the building societies and the credit unions in the UK provide services very
similar to banking as they accept deposits and give out loans.
9
That argument has become stronger due to the financial crises of 2007–09.
10
See Basel Committee for Banking Supervision (BCBS), ‘Core Principles for Effective
Banking Supervision’ (1997) Bank for International Settlements (BIS) <http://www.bis.org/publ/
bcbs30a.pdf>.
11
See BCBS, ‘Revised Core Principles for Effective Banking Supervision’ (2012), Core
Principle 1 states in relevant part that the primary objective of banking regulation ‘is the soundness
of banks and the banking system’.
12
Spong (2000) and Lastra, International Financial (n 1), 59.
13
Lastra, ibid, 92, these elements include good licensing policies, good supervisory techniques,
adequate capital and liquidity, competent and honest management, internal controls, transparency
and accountability.

financial system would be able to withstand shocks, without giving way to cumulative
processes, which impair the allocation of savings to investment opportunities and the
processing of payments in the economy.’14 Whatever the various definitions, financial
stability is easy to identify by the absence of financial instability and is sometimes defined
as the absence of financial instability.15
The absence of a clear-cut definition of financial stability entails that the ‘notion
of financial stability is often discussed in terms of the concept of systemic risk and
its sources’.16 Hal Scott defines systemic risk as ‘the risk that a national, or the global,
financial system will break down’.17 Systemic risk poses a threat to financial stability.
And, as the global financial crisis evidenced, these types of risks are not confined to the
banking system: they can also affect securities and derivatives markets. During the eco-
nomic meltdown, systemic risks stemmed from non-bank institutions and from financial
instruments that traditionally fell outside the regulatory perimeter. Furthermore, systemic
risks are not bounded by jurisdictional frontiers; they have a tendency to spread across
geographical borders.
The dichotomy between global markets and institutions on the one hand and national
law and national policies on the other is particularly acute in the management of systemic
risk and in the design of adequate institutional solutions to deal with its negative spillover
effects. The financial crisis signified an inflection point towards the adoption of a macro-
prudential approach to financial supervision.
Financial stability and stable banks are interrelated concepts with both impacting
equally on the stability of the other. The presence of financial stability enhances the
process of intermediation and the efficient allocation of resources, while the presence of
unsound banks in an economy threatens financial stability. It is however ironic that long
periods of financial stability often induce greater risk taking by banks. Banks all over the
world, especially in the developed countries, buoyed by long periods of financial stability
prior to the 2007–09 financial crisis, took risks in a manner that was unprecedented.18
The subprime mortgage loan crisis in the US is an example.19 Another example is how
financial innovation and technology can enhance banks’ capacity to provide credit to
the economy and to shift risk away from banks to investors who are willing to invest in
bank-originated assets. Moreover, some banks now approve loans using an automated
process whereby the customer applies for a loan online and a decision is made without the
customer having to meet with the bank officials. Despite the obvious economic benefits
of encouraging innovation in banking practices, bank risk officers and regulators should
be aware of the associated risks of new business practices.
14
See Padoa-Schioppa (2002).
15
Lastra, Central Banking (n 1).
16
Galati and Moessner (2011).
17
Scott (2010).
18
See The Economist (2007).
19
Ibid.

V. THE ECONOMIC IMPORTANCE OF BANKS
Banks play an important economic role as they, through the process of intermediation,
aid in economic growth by providing funds to those engaged in the production of goods
and services vital to economic growth.20 They are a source of funds for many businesses
and without banks commercial activities would grind to a halt.21 Although the impor-
tance of banks as a source of credit varies between countries depending on whether they
are bank-led or capital-market led financial systems, a stable banking system is considered
for most economies to be essential for economic growth and development and for the
smooth functioning of the financial system. By monitoring the repayment of loans,
banks exert sound governance over funded firms, they foster innovation and growth by
lending to entrepreneurs, they also allocate and mobilise savings efficiently by allocating
capital to those endeavours with the highest expected social return.22 The power of banks
to create money can also have negative effects on the economy if left unchecked. Banks
create money by providing liquidity in the system; excessive liquidity resulting in too much
money chasing too few goods can lead to inflation necessitating the intervention of the
Central Bank in mopping up excess liquidity through market operations.23
Studies have shown that economies with strong financial institutions or banks record
greater levels of growth than those with weak banks.24 The UK economy is an example
of how the banking sector can contribute to economic growth. In 2012, the UK financial
services sector, accounted for ten percent of UK GDP, the highest of all G7 economies.25
However, the ability of banks to aid in economic growth or mobilise and allocate savings
efficiently is largely dependent on how well capitalised they are and the liquidity of their
balance sheets. Sound banks promote the efficient allocation of resources, the efficiency
of investment and economic growth in an economy, while weak banks slow down growth
and put a strain on economic resources as public funds are utilised to bail them out of
crises to maintain financial stability or pay off depositors in order to maintain confidence
in the financial system.
VI. THE RATIONALE AND OBJECTIVE OF BANKING

REGULATION
The overriding objective of banking regulation is to safeguard financial stability and build
resilience to financial shocks, wherever they may come from, and provide a sustainable
source of credit, savings products and payment services to the broader economy (though
banking regulation is also aimed at other objectives ranging from consumer protection
20
Levine (2004); Brownbridge and Kirkpatrick (2000).
21
Goodhart (2011).
22
Levine (2005).
23
Spong (n 12).
24
Favara (2003). The author disputes the link between economic growth and financial
intermediation, he analysed the growth dynamics in the developed world and its relationship to
the financial structure and reached the conclusion that the relationship between the two is weak.
25
Monaghan (2014).

and competition concerns to anti money laundering and countering the financial of
terrorism).26 Banking regulation potentially can play an important role in mitigating the
institutional and market impediments to the banking sector’s ability to provide adequate
capital and liquidity for the economy so that it can grow sustainably. Economic theory
holds that policy and regulatory intervention in the banking sector is justified by market
failures, which can arise from negative externalities resulting from asymmetric informa-
tion, and competitive distortions.27 Evidence suggests that market discipline, on its own,
cannot adequately control the externalities in financial markets associated with excessive
banking and financial risk-taking. Accordingly, policy or regulatory intervention may
be necessary to prevent a misallocation of resources to unsustainable economic activity
that relies on excessive financial risk-taking and to support a reallocation of capital to
sustainable economic activity. Policy intervention, however, if not calibrated properly,
can also produce its own distortions in the market that can result in further externalities
and misallocations of bank capital and investment. A careful combination of market
innovation and policy frameworks that suit national circumstances may be desirable for
designing an effective and efficient banking regulation framework. In this way, banking
policy can support the efficient operation of the economy by encouraging banks to har-
ness more credit and investment for profitable and sustainable economic activity.
The justification for governmental intervention in banking regulation is strongly linked
to the economic importance of banks, systemic issues and consumer protection. Sheng,
for instance, cites the ability of banks to create money, the involvement of banks in
credit allocation, fostering competition and innovation through the prevention of cartels,
consumer protection and banks vulnerability to crisis and collapse as the main rationale
for bank regulation.28 The recent 2007–09 financial crises seem to have swung the debate
on who should regulate banking in favour of those institutions that have access to data
and information across the financial markets in order to monitor better the systemic risks
that can build up across the financial system.
The economic consequence of bank failures can be viewed as further justification for
regulation. Bank failures are costly and dissipate vital economic resources that should
have been channelled into more productive ventures. Since most governments undertake
the responsibility of preventing bank failures or rescuing ailing banks by acting as a
lender of last resort and operating a deposit insurance scheme, it’s only natural that they
regulate banks to reduce the potential for a call on the deposit insurance funds. Bank
failures impact negatively on a country’s GDP and on taxpayers’ money and slow down
economic growth. In a cross-country survey involving Indonesia, Chile, Thailand and
Uruguay, it was discovered that governments spent an average of about 13 percent of
26
Although the principal objectives of banking regulation are generally recognised to be finan-
cial stability and depositor protection, other secondary objectives have been defined by policymak-
ers to include retail customer protection (consumer protection) and financial crime. See Alexander
et al (2006) 20–33, discussing the development of regulatory objectives since the early 1970s as
financial stability (ie, systemic risk), investor protection and financial crime. More recently, the
UK Financial Services Act 2012 has extended the objectives of UK financial regulators to include:
financial stability, investor protection, consumer education, competition and financial crime.
27
See Joint Forum (2010).
28
Sheng (2009), 23–26.

GDP restoring financial systems after banking crises.29 Another study estimates that
between 1980 and 1998, banking problems cost developing and transition economies
roughly $250 billion.30 The Asian financial crisis of the late 1990s contributed in part to
the development of international bank regulatory reforms known as Basel II that were
designed to enhance the capital and risk governance of banks. Despite some incremental
reforms, the Basel II framework increased the complexity of banking regulation and
supervision that came to rely heavily on internal bank risk models to calculate regulatory
capital and which ultimately resulted in an undercapitalised banking system.31
Under Basel II, prudential supervision was structured to support market-based govern-
ance models of banks that regulators heavily relied on to ensure that the banking system
was safe and efficient.32 The financial crisis exposed bank models as being seriously flawed
in how they measured and managed financial risks. The crisis also proved that the market
is incapable of providing the sort of monetary and fiscal stimulus that was provided
by central banks and national governments to prevent a total collapse of the financial
system.33 And even though national regulatory bodies have been identified as being partly
responsible for the crises,34 greater powers have been invested in national regulators—and
in particular central banks—who now have a wider financial regulatory remit with the
move away from strictly micro-prudential regulation, to macro-prudential regulation.
VII. THE UK APPROACH TO MACRO-PRUDENTIAL

REGULATION35
In analysing UK regulatory failures before the crisis, the Turner Review found that a lack of
macro-prudential regulation and oversight of the financial system was more directly relevant
to causing the financial crisis than any specific failure relating to an individual firm.36 The
29
Klingebiel et al (2002).
30
Ibid.
31
‘Before the 2007–09 financial crisis, regulators across the international financial system
championed the economic benefits of rational, self-correcting markets and the merits of financial
innovation. A global consensus emerged that new modes of finance had reduced systemic risks’,
see HM Treasury, ‘Review of HM Treasury’s Response to the Financial Crisis’ (March 2012) 5.
32
Renner (2011).
33
To prevent a total collapse of the financial system, the UK had to part-nationalise two of the
largest banks in the world and introduce financial sector interventions costing hundreds of billions
of pounds. See HM Treasury (2010).
34
See The Economist (2013).
35
Most bank regulation has proceeded in response to a financial crisis. The UK is a case
in point. The shift from self-regulation to legal regulation in the field of financial services was
prompted by a series of crisis: the enactment of the 1979 Banking Act followed the secondary
banking crisis, and the 1987 Banking Act was enacted following the Johnson Matthey Bankers’
failure. In the US the creation of the 1913 Federal Reserve System and the Federal Deposit
Insurance Corporation in 1933 were responses to the financial crisis. At the international level,
the emergence of the Basel Committee on Banking Supervision was prompted by the collapse of
Franklin National Bank in the United States and of Bankhaus ID Herstatt in Germany during the
summer of 1974. See Lastra, Central Banking (n 1), 72.
36
Financial Services Authority (2009).

Review suggested that had there been a better understanding of the link between financial
stability and macroeconomic stability there could have been more effective measures formu-
lated to address specific risks of individual banks and firms.37 The Review cited indicators
of macro-prudential risks, such as the liquidity risks manifest in the maturity transformation
function of banks, the level of asset prices in property, equity and securitised credit as well as
the level of leverage in the financial system as areas where regulators and supervisors could
develop a better understanding of how systemic risk can arise. The Bank of England comes
under specific criticism in the Review for not formulating policy to offset the risks identified
in the Bank’s Financial Stability Reviews conducted in the years before the crisis.
Whilst the supervision of individual financial institutions was a great concern to the
FSA (a chiefly micro-prudential perspective) there was not enough investigation into
sectoral or systemic risks present in the structure of the system.38 To remedy this, the
Financial Services Act 2012 created a new institutional framework for financial regula-
tion consisting of a ‘Twin Peaks’ approach to micro-prudential supervision consisting
of a Prudential Regulation Authority, responsible for supervising individual banks and
insurance firms, and a Financial Conduct Authority, responsible for investor protection
and market abuse.39 Overseeing both supervisory authorities is the FPC, responsible
for macro-prudential oversight and making recommendations and issuing directives
regarding the use of macro-prudential measures and instruments, and assessing
macro-prudential conditions in the financial sector. The Financial Services Act 2012
authorises the FPC to implement a ‘macro-prudential’ regulatory model to control
systemic risks in the financial system. Macro-prudential regulation can be divided into
three main areas:
(1) the regulation of individual firms must take into account both firm level practices and
broader macro-economic developments in determining how regulatory requirements
will be imposed (ie, growth of asset prices and contra-cyclical bank provisioning);
(2) controls on the levels of risk-taking and leverage at the level of the financial system;
and
(3) the regulation of the infrastructure of the financial system—clearing, settlement and
payment systems—along with requirements that over-the-counter (OTC) derivative
contracts are centrally cleared and that securities and currency settlement networks
are robust and resilient.
Moreover, the FPC is expected to conduct research on macro-prudential risks and to

challenge conventional wisdom in micro-prudential regulatory practices to ensure that
generally accepted principles are continually tested. For instance, by challenging con-
ventional wisdom, the FPC is expected to challenge the judgements of other supervisors
and international organisations, such as the International Monetary Fund which issued a
37
Ibid, 85.
38
Ibid.
39
Financial Services Act 2012 <www.legislation.gov.uk/ukpga/2012/21/contents/enacted>. The
Financial Services Act 2012 was amended by the Financial Services (Banking Reform) Act 2013
enacted in December 2013, available at <http://www.legislation.gov.uk/ukpga/2013/33/contents/
enacted>.

report a year before the crisis began in 2006 claiming that ‘the dispersion of credit risk by
banks to a broader . . . group of investors . . . helped make the . . . financial system more
resilient’.40 It must be argued that greater and more vocal challenges to conventional views
as those held by the IMF and many national regulators before the crisis should go some
way to preventing them becoming generally accepted.
In addition, a more effective macro-prudential supervisory regime could result in the
UK principles-based regulatory regime becoming more rules-based at the level of the
financial system. The new focus on macro-prudential controls at the level of the financial
system will require the PRA and FPC to play a greater role in monitoring systemic risk
and imposing controls at the level of the financial system. In other words, the FPC with
support from the PRA and FCA will become the key player in the regulation of systemic
risk. The FPC would exercise primary regulatory authority to address the market failures
that arise from inter-connected financial markets and the shifting of risk off-balance sheet
to ‘shadow’ sectors of financial markets. As a result, the UK’s new regulatory regime,
based on macro and micro rule-based controls, will change the nature of financial regula-
tion dramatically and possibly lead to new regulatory risks that will arise because of the
responses of market participants who will undoubtedly seek to avoid these regulatory
controls by adopting innovative financial instruments and structures.
VIII. UK MACRO-PRUDENTIAL ‘TOOLS’ IN PRACTICE
Despite the difficult policy and institutional challenges of implementing a macro-

prudential regulatory regime, the United Kingdom and other European states are
adjusting their regulatory instruments and practices to take account of macro-prudential
objectives. In 2012, the UK Financial Policy Committee proposed a set of macro-
prudential regulatory levers or tools (ie, counter-cyclical capital requirements and limits
on distributions) that could be imposed by the FPC on the financial sector through the
micro-prudential authorities. These levers include:
Capital requirements: Capital requirements could be varied depending on the

riskiness of assets at points in economic cycle. Counter-cyclical capital buffers could
be designed to dampen the credit cycle (for example, by imposing higher capital
requirements during a boom).
Liquidity tools: Financial institutions can be required to hold liquid assets, ie assets
that can be easily turned into cash. Also, leverage ratios could be used to limit the
amount of leverage relative to the value of assets.
Forward-looking loss provisions: Financial institutions can be required to set aside
provisions against potential future losses on their lending.
Collateral requirements: Lending could be limited by imposing higher collateral
restrictions, for example if growth in lending appears to be unsustainable. An
example is a loan to value requirement, which would limit the size of a loan relative
to the value of the asset. Similarly, ‘haircuts’ on repurchase agreements would limit
40
International Monetary Fund (April 2006).

the amount of cash that can be lent as a proportion of the market value of a set of
securities.
Information disclosure: Greater transparency could help markets work better. For
example, in times of crisis, more information about different institutions’ risk
exposure could increase the flow of credit as uncertainty is reduced.
Stress tests: Stress testing by either the FPC or the other regulators could allow the
FPC to see how resilient the system would be under different, adverse scenarios.
The area of macro-prudential tools is one where there is relatively little evidence and
research. Goodhart, in particular, has highlighted that it would be good if macro-
prudential authorities such as the FPC did more analysis to understand how the various
tools will work.41 In addition, he has highlighted the need to consider what happens if
institutions fail to meet their prudential requirements, and whether a ‘ladder of sanctions’
should be considered in respect of enforcement.42 The FPC’s thinking about macro-
prudential regulation has advanced significantly in comparison with other EU and US
regulators. In 2011 and again in 2015, the FPC published papers in which it presented
some of the possible macro-prudential tools that it could wield. There is a particular
emphasis here on time-varying risks, countered through regulation which aims to deal
with cyclicality in the economic cycle and within certain sectors of the economy.
One of the first tasks of the FPC was to recommend in March 2012 several macro-
prudential levers to the UK Treasury, which would have to submit them for approval
as secondary legislation before Parliament. The Bank of England, however, recognised
in 2011 that the choice of macro-prudential tools was far from straightforward, as they
could impinge substantially on economic activity and there was little hard evidence
about how they would work in practice. For example, the Bank suggested that vary-
ing loan-to-value or loan-to-income ratios on mortgage lending would directly limit
risky lending, but would also be very difficult to calculate because of ‘the trade-off
between financial stability benefits, economic activity, and societal preferences for
homeownership.’43 Moreover, the paper notes that limiting or regulating bank remunera-
tion or distributions to shareholders may have the effect of penalising well-managed
banks alongside weak institutions. Similarly, the paper also observes that imposing
too stringent controls on trading and clearing infrastructure may have the effect of
driving this activity to less tightly regulated jurisdictions. The Australian experience
of requiring banks to hold capital against off-balance sheet exposures was cited as a
macro-prudential regulatory lever that could work effectively with limited downside
effects. Finally, the paper raised the important issue of whether UK regulatory authori-
ties would have enough discretion to apply macro-prudential levers without violating
harmonised EU regulatory standards.
41
Goodhart (n 21).
42
Ibid.
43
Bank of England (BoE), ‘Instruments of Macroprudential Policy’ (December 2011) Discussion
Paper, 36.

IX. EUROPEAN UNION MACRO-PRUDENTIAL REGULATION

AND SUPERVISION44
The European Union has embarked on a major institutional restructuring of finan-

cial regulation by creating a European System of Financial Supervision consisting
of three micro-prudential supervisory authorities—the European Banking Authority,
the European Securities and Markets Authority and the European Insurance and
Occupational and Pension Authority—and a European Systemic Risk Board (ESRB) to
conduct macro-prudential oversight of the European financial system. Moreover, the Euro
area sovereign debt crisis led to the creation of the European Banking Union consisting of
the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM).
The Banking Union aims to sever the link between banking sector crises and sovereign debt
fragility. Under the SSM framework, the European Central Bank (ECB) is empowered to
supervise either directly or indirectly all credit institutions based in participating member
states. Under the SRM, a Single Resolution Board will interact with member state resolu-
tion authorities to identify and apply recovery and resolution plans for credit institutions
and investment firms and to administer a Single Resolution Fund that is financed by
levies on financial institutions and combined with national resolution funds will provide
temporary financial support for institutions that will be restructured or wound-up.
The European System of Financial Supervision attempts to link in a coherent way the
ESRB’s macro-prudential supervision and oversight function with the three European
Supervisory Authorities (ESAs) function for coordinating the harmonised implementa-
tion of micro-prudential supervisory powers.45 Indeed, the linkage is essential for building
an efficient EU supervisory regime that allows member states to exercise more effective
supervisory oversight over individual firms and investors, whilst monitoring, measuring
and issuing recommendations and warnings about systemic risk in the broader European
financial system and across global financial markets. Moreover, the ESFS and the three
ESAs will ensure that member state regulatory and supervisory authorities can work more
effectively together at the micro-prudential level to control and manage systemic risk and
develop a harmonised regulatory code and implementation across all EU states.46
The ESRB was established, acting on the recommendations of the De Larosière Report
bearing in mind the different jurisdictional domains of the EU (the domain of the ESRB) and
the Eurozone (for which the ECB has jurisdiction).47 Responsibility for macro-prudential
44
The ESFS was adopted based on proposals by the De Larosiere Committee in February 2008
in the wake of the financial crisis that was aimed at further institutional consolidation of the previ-
ous Lamfalussy framework that had sought enhanced supervisory coordination and harmonised
implementation of EU financial legislation. The Lamfalussy institutional framework, however, had
failed to produce more harmonised standards of financial regulation across member states because
it was not able to overcome different sets of national standards, responsibilities and powers of
member state supervisors that had hampered the European financial integration process and had
resulted in disjointed supervisory practices and a failure to identify and monitor risks building up
in the financial system. See IMF (n 40).
45
See Alexander (2010).
46
Alexander (2001, 2012).
47
High-Level Group on Financial Supervision in the EU, Report on Financial Supervision in
the EU (De Larosière report) (2009).

supervision is thus currently shared between the ECB, national authorities/councils of

financial stability48 and the ESRB (though the latter’s ‘powers’ are limited).49
The ESRB has set out a set five intermediate objectives that macro-prudential policy
should aim to achieve. These intermediate objectives are:
(1) Mitigating and preventing excessive credit growth and leverage;

(2) Mitigating and preventing excessive maturity mismatch and market illiquidity;
(3) Limit direct and indirect exposure concentrations;
(4) Limit the systemic impact of misaligned incentives with a view to reducing moral
hazard; and
(5) Strengthening the resilience of financial infrastructures.50
The aforementioned intermediate objectives are seen as transitional steps towards achiev-

ing robust financial stability. The ESRB considers that: ‘identifying intermediate objec-
tives makes macro-prudential policy more operational, transparent and accountable and
provides an economic basis for the selection of instruments’.51
Banking union is a fundamental change in the institutional design for the pursuit of
financial stability in Europe.52 The first pillar of banking union is ‘single supervision’,
with the establishment of the SSM. ‘Single supervision’ in the context of banking
union means European supervision (conferred upon the ECB) for credit institutions
of eurozone Member States and of non-eurozone EU Member States that choose to
become part of the SSM.53 The SSM aims to ensure that the EU’s policy relating to
prudential supervision is applied in a ‘coherent and effective manner’ in all member
states concerned54 and provides the conditionality required in the ESM Treaty for banks
to be able to be recapitalized. The conferral of micro-prudential supervisory and some
macro-prudential powers to the ECB (Article 5 of the SSM regulation) deeply alters the
supervisory map in Europe. The second pillar of banking union is ‘single resolution’,
with a SRM55—which should be aligned with the EU Bank Recovery and Resolution
48
The CRD IV/CRR includes a number of macro-prudential instruments, such as counter-
cyclical capital buffers, systemic risk, buffers, buffers for global systemically important institutions
(G-SII) and other systemically important institutions (O-SII).
49
See Lastra and Goodhart (2015).
50
European Systemic Risk Board (2013).
51
Ibid, paragraph 4. For more details on the specific objectives and matching policy instru-
ments identified by the ESRB please see Lastra (2015b) Table 11.1.
52
See Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks
on the ECB concerning policies relating to the prudential supervision of credit institutions; and
Regulation (EU) No 1022/2013 of the European Parliament and of the Council of 22 October
2013 amending Regulation (EU) No 1093/2010 establishing a European Supervisory Authority
(European Banking Authority) as regards the conferral of specific tasks on the ECB pursuant to
Council Regulation (EU) No 1024/2013.
53
Council Regulation (EU) No 1024/2013 of 15 October 2013 conferring specific tasks on
the ECB concerning policies relating to the prudential supervision of credit institutions. [2013] OJ
L287/63, commonly referred to as SSM Regulation.
54
Council Regulation (EU) No 1024/2013 of 15 October 2013, Recital 12. See generally Lastra
(2013).
55
The Proposal for a Regulation of the European Parliament and the Council establishing uni-

Directive (BRRD)56—and a Single Resolution Fund. The third pillar is ‘common deposit
protection’.57 The jurisdictional area of banking union comprises the eurozone member
states and those other member states that establish close cooperation arrangements.58 The
third pillar, ‘common deposit protection’,59 is yet to be constructed (though a proposal
was published in November 2015).
Banking union is an incomplete edifice, since lender of last resort—‘the elephant in
the room’—should have been the fourth pillar,60 and since the arrangements for macro-
prudential supervision have become cumbersome, with the ECB, ESRB and national
authorities involved at different levels.
In addition, some macro-prudential regulatory reforms are evolving based on structural
regulation models. The UK adopted the Financial Services (Banking Reform) Act 2013
that implemented most of the proposals of the Independent Commission on Banking to
segregate the retail banking operations of a banking group into a separate subsidiary and
to prohibit it from transferring capital to its affiliate subsidiaries in the group. Also, under
form rules and a uniform procedure for the resolution of credit institutions and certain investment
firms in the framework of a Single Resolution Mechanism and a Single Bank Resolution Fund
and amending Regulation (EU) No 1093/2010 of the European Parliament and of the Council,
COM(2013) 520 final (SRM Regulation) was published in July 2013 (<http://eur-lex.europa.eu/
LexUriServ/LexUriServ.do?uri5COM:2013:0520:FIN:EN:PDF>).
The political agreement was reached by the Parliament and the Council in March 2014. The
final text of the Regulation (EU) No . . ./2014 of the European Parliament and the Council
establishing uniform rules and a uniform procedure for the resolution of credit institutions and
certain investment firms in the framework of a Single Resolution Mechanism and a Single Bank
Resolution Fund and amending Regulation (EU) No 1093/2010 of the European Parliament
and of the Council was adopted by the European Parliament on 15 April 2014. See <http://www.
europarl.europa.eu/sides/getDoc.do?pubRef5-//EP//NONSGML+AMD+A7-2013-0478+002-00
2+DOC+WORD+V0//EN>. This is commonly referred to as the SRM Regulation.
56
The BRRD was published in the OJ in June 2014. See Directive 2014/59/EU of the
European Parliament and of the Council of 15 May 2014 establishing a framework for the
recovery and resolution of credit institutions and investment firms and amending Council
Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC,
2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010
and (EU) No 648/2012, of the European Parliament and of the Council, OJ L 173, 12/06/2014,
190–348.
57
Although a single deposit guarantee scheme shall not be established for the time being (we
will continue to rely upon the existing networks of national deposit guarantee schemes) a new
Directive on Deposit Guarantee Schemes repealing Directive 94/19/EC was adopted by the Council
and the European Parliament in April 2014. Directive 2014/49/EU of the European Parliament and
of the Council of 16 April 2014 on Deposit Guarantee Schemes (recast), not yet published in the
OJ, but published by the Council: <http://register.consilium.europa.eu/doc/srv?l5EN&f5PE%20
82%202014%20INIT>.
58
For an analysis of the uneasy coexistence between banking union and single market see
Lastra, Banking Union (n 54). See also Ferran (2014).
59
The rationale for a common deposit insurance scheme is clear: with perfect capital mobility,
in order to prevent a flight of deposits from troubled countries to countries perceived to be ‘safe’,
one needs to convince ordinary citizens that a euro in a bank account in one Euro area Member
State is worth the same and is as secure as a euro in a bank account in another Euro area Member
State. This is a real challenge, as the experience with the banking crisis in Cyprus in 2012–13
evidenced.
60
See Lastra (2015c, 2015d).

the US Dodd-Frank Act,61 the Volcker rule restricts banking groups with deposit-taking
subsidiaries from engaging in proprietary trading, whilst the European Commission has
proposed for most EU states that proprietary trading be banned in EU-based banking
groups. The move towards structural regulation of banking groups is an important
element of macro-prudential regulation that will change the business models of global
financial institutions.62
Macro-prudential regulation and supervision will also necessarily involve central
banks—which are repositories of macro-economic and financial data—in monitoring
system-wide risks and working closely with micro-prudential supervisors to ensure that
innovations in financial risk-taking do not undermine financial stability. Macro-prudential
regulation will require that the practice of financial supervision is linked to factors in
the macro-economy and broader financial system.63 It will require greater intensity of
prudential regulation by host country authorities, and less deference to the supervisory
practices of a foreign banking group’s home country supervisory authority. Traditional
models of prudential supervision that rely on the principle of home country control will
become obsolete because the macro-prudential regulatory mandates of host country
authorities will necessarily involve them in supervising the local activities of cross-border
financial institutions and regulating cross-border capital flows to ensure that the host
country’s macro-prudential objectives are met. Establishing domestic and regional insti-
tutional frameworks for macro-prudential policy is an important first step in the pursuit
of financial stability. However, in order to be truly effective, these frameworks require that
domestic supervisors cooperate and coordinate their policies at an international level.64
X. CHALLENGES FOR MACRO-PRUDENTIAL REGULATION:

SHADOW BANKING
The macro-prudential policy menu needs to encompass tools for the whole financial
system—including areas that fall outside the perimeter of the regulatory radar. The
shadow banking sector, market infrastructures, market participants and financial instru-
ments can all pose a significant systemic threat to domestic and transnational financial
stability. The ‘shadow banking’ system is where financial intermediation occurs outside the
formal banking sector by non-bank financial firms which engage in maturity transforma-
tion and take on leverage by issuing debt-linked instruments to generate capital to invest in
longer-term assets.65 Of particular concern are intermediaries involved in the money and
61
See ‘The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010’ § 619
<https://www.sec.gov/about/laws/wallstreetreform-cpa.pdf>.
62
However, the European Banking Federation (EBF) contends that ‘there is no convincing
evidence that structural reform has a direct influence on systemic risk and would make restructur-
ing or resolution easier in the event of a crisis.’
63
For example, counter-cyclical capital requirements would base the determination of regula-
tory capital, in part, on the ratio of bank asset prices to the trend rate of economic growth.
64
Greene et al (2010).
65
The FSB has defined the ‘shadow banking system’ or ‘market-based’ financing system
as ‘credit intermediation involving entities and activities (fully or partially) outside the regular
banking system or non-bank credit intermediation in short’: FSB, Strengthening Oversight and

credit creation process. Regulatory instruments should aim to affect the balance sheets of
financial institutions by limiting the aggregate level of leverage and maturity mismatch in
the financial system as a whole. These controls could be tightened during periods when
there are asset price bubbles (when asset prices exceed trend economic growth) and relaxed
when the economy or financial sector slumps.
The existence of other, non-bank financial institutions therefore imposes a constraint
on the ability to place requirements on banks, as there is a danger of risky activities
moving into non-regulated sectors. However, this also suggests that it may make sense to
consider reforms across the sector as a whole, rather than focusing too much on particular
types of institutions. Indeed, Goodhart takes the view that there should be a degree of
harmonisation of ‘margin controls’ such as capital ratios, saying that:
There is a ‘level-playing-field’ argument between institutional arrangements within countries,

as well as between countries. The imposition of (asymmetric) penalties (taxes) on the most
visible, largest and probably the most efficient intermediaries (i.e. the banks) may have an
increasing effect in diverting such intermediation towards less visible, and possibly less efficient
channels.66
In addition, insurance companies can also pose a risk to taxpayer money. For example,
during the last crisis, AIG, a US insurance company, sold a substantial amount of credit
default swap coverage to banks and other investors. These derivatives turned out to be
riskier than assumed and AIG subsequently had to be ‘bailed out’ by the US Federal
Reserve and US Treasury (the largest loan the Fed has ever provided to any single
institution).67 If AIG had defaulted, banks to which AIG owed money would have
experienced substantial losses that could have toppled the US financial system and several
major European banks.
XI. CONCLUSION
International regulatory reforms now mandate that national authorities adopt macro-
prudential regulatory principles and supervisory objectives. This chapter discusses the
evolution of banking regulation and supervision from a largely micro-prudential focus
on individual firms to one that combines such approach with a macro-prudential focus
on systemic risk and financial system stability. The chapter discusses macro-prudential
regulatory reforms in the United Kingdom and some of the challenges that arise with
the transition to a macro-prudential supervisory framework and the lessons for other
jurisdictions. The United Kingdom’s regulatory reforms provide a case study for how
Regulation of Shadow Banking Policy Framework for Strengthening Oversight and Regulation of
Shadow Banking Entities (29 August 2013) available at: <http://www.financialstabilityboard.org/
publications/r_130829c.pdf>.
66
Ibid.
67
On 14 January 2011, the New York Fed’s assistance to AIG was terminated and its loans
to AIG fully repaid. See <https://www.newyorkfed.org/aboutthefed/aig>. In his comments to this
chapter, Peter Conti-Brown noted that ‘though the initial 13(3) loan was through the FRBNY, the
decision making was in Washington and Treasury also played a subsequent role’.

macro-prudential regulatory principles and tools are being adopted to identify and
control systemic risk and other financial stability objectives. Nevertheless, the financial
crisis shows how systemic risks can arise outside the formal banking sector, in particular
in the shadow banking markets. The UK legislative and regulatory regime may lack
adequate legal instruments to address these risks.
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20. Unconventional monetary policies: a re-appraisal
Claudio Borio and Anna Zabai1
I. INTRODUCTION
They were supposed to be exceptional and temporary—hence the term ‘unconventional’.

They risk becoming standard and permanent, as the boundaries of the unconventional
are stretched day after day.
Following the Great Financial Crisis, central banks in the major advanced economies
have adopted a whole range of new measures to influence monetary and finan-
cial conditions. The measures have gone far beyond the pre-crisis typical mode of
operation—controlling a short-term policy rate and moving it within a positive range. To
be sure, some of these measures had already been pioneered by the Bank of Japan roughly
a decade earlier in the wake of that country’s banking crisis and stubbornly low inflation.
But no one had anticipated that they would spread to the rest of the world so quickly and
would become so daring.
How effective have these measures been? What broader issues do they raise? These are
the two main questions we address in this chapter. We do not intend to be comprehensive
or provide a definitive analysis—the issues are far too complex and controversial. Rather,
our objective is simply to take our cue from the burgeoning literature to provide some
reflections on the subject. This should help the reader gain easier access to the rapidly
growing body of work and approach it with one more perspective in mind.
What is ‘conventional’ or not is partly in the eye of the beholder. To define our
coverage, we take as benchmark pre-crisis implementation frameworks. On that basis,
we discuss: (i) using the central bank’s balance sheet to influence financial conditions
beyond the short-term rate—‘balance sheet policies’ (Borio and Disyatat (2010)); (ii)
actively managing expectations of the future path of the policy rate to provide extra
stimulus when rates have reached their (perceived) lower bound—(interest rate) ‘forward
guidance’;2 and (iii) setting policy rates below zero in nominal terms—‘negative interest
rate policy’ (NIRP). We thus exclude from the analysis foreign exchange intervention
1
Bank for International Settlements. This chapter was prepared for R Lastra and P Conti-
Brown (eds), Research Handbook on Central Banking (Cheltenham and Northampton MA:
Edward Elgar Publishing Ltd). We thank Piti Disyatat, Dietrich Domanski and Hyun Shin for
comments and suggestions. Jeff Slee and Anamaria Illes provided excellent statistical assistance.
The views expressed in this chapter are those of the authors and do not necessarily reflect those of
the BIS.
2
Forward guidance has also been an element of standard policy frameworks for quite some
time, including pre-crisis, In that case, it was seen as enhancing both the effectiveness and trans-
parency of policy. From this perspective, it would not deserve to be classified as unconventional
(Borio and Disyatat (2010)). In this chapter, however, we are only interested in its use as a means
of providing additional stimulus when the policy rate has approached its lower bound. In this case,
forward guidance is seen as an alternative to other unconventional measures.
398

Unconventional monetary policies: a re-appraisal 399
although, analytically, it is a subset of balance sheet policies (Borio and Disyatat

(2010)).3 In addition, we limit our discussion to four central banks—the Federal
Reserve System, the European Central Bank (ECB), the Bank of Japan and the Bank
of England—except when we address NIRP, in which case we briefly touch on the
experience of the Swiss National Bank (SNB), Danish Nationalbank and the Swedish
Riksbank.
We highlight three conclusions. First, there is ample evidence that, to varying degrees,
these measures have succeeded in influencing financial conditions. There is little doubt
that they have had a lasting impact on bond yields, various asset prices and exchange rates.
Their relative effectiveness, however, is still subject to debate, as it is sometimes difficult
to disentangle their impact (eg, that of forward guidance from that of large-scale asset
purchases). The same conclusion holds for their ultimate impact on output and inflation.
Here, the empirical evidence is thinner and the researcher faces tougher challenges. These
include difficulties in developing the correct metrics and in filtering out the influence of
other factors on output and inflation (eg, so-called ‘headwinds’) as well as the need to rely
more heavily on modelling assumptions.
Second, formal econometric evidence on whether such policies are subject to
diminishing returns is limited, partly owing to methodological complications. Views,
therefore, differ. Our own assessment is that this is likely to be the case. There are
bound to be limits to how far nominal interest rates can be reduced and risk spreads
compressed. And there may be discontinuities and tipping points in the behaviour of
financial intermediaries and economic agents more generally. Examples include the
impact on the profitability and resilience of financial intermediaries and on the public’s
confidence.
Finally, there are broader questions about the long-term effectiveness and desir-
ability of these measures. Some have to do with the measures’ overall impact on the
central bank goals; others with political economy considerations, which may ultimately
undermine the central bank’s perceived legitimacy and autonomy (or ‘independence’).
Exit issues loom large. Our view is that many of these measures should be best regarded
as exceptional and for use in very specific circumstances, rather than be considered
normal tools for normal conditions. Whether this will turn out to be the case, however,
is doubtful at best and depends on more fundamental features of monetary policy
frameworks.
The rest of the essay is organised as follows. Section II presents a taxonomy of central
bank measures along the lines of Borio and Disyatat (2010) and then sketches what
central banks have done. Section III briefly summarises and evaluates the evidence on
the effectiveness of the various measures in influencing financial conditions. Section IV
examines their impact on output and inflation and addresses broader considerations,
including the issues raised by exit and political economy considerations. The conclusions
3
What is specific about foreign exchange intervention is (i) the asset purchased—denominated
in foreign rather than domestic currency—and, hence (ii) the aspect of financial conditions
targeted—the exchange rate rather than a set of domestic asset prices. But foreign exchange
intervention was already a standard policy tool pre-crisis around the world. At the same time, we
do discuss briefly the use of foreign exchange swap lines, used to address funding conditions in
foreign currency.

highlight key policy challenges in the years ahead. One box provides a critique of
prevailing analyses of ‘helicopter money’; the other discusses in more depth the role of
negative nominal interest rates in our fundamentally monetary economies, highlighting
some risks.
II. A TAXONOMY AND A FEW FACTS
1. Taxonomy
Monetary policy is implemented in two ways (Table 20.1). One is through interest rate
policy, whereby the central bank influences financial conditions by setting, or closely
controlling, a short-term rate (often overnight) and by steering expectations about where
it will be set in future (‘interest rate forward guidance’). The other is through balance sheet
policy, whereby the central bank influences financial conditions beyond the short-term
rate by adjusting its balance sheet (size and/or composition). Typical examples of balance
sheet policy include large-scale asset purchases and the supply of central bank funding
(‘liquidity’) at non-standard terms and conditions (eg at long maturities, for specific
lending purposes). Just as in the case of interest rate policy, the central bank may also
wish to steer expectations about future balance sheet adjustments (‘balance sheet forward
guidance’).
The rationale for distinguishing so sharply between interest rate and balance sheet
policy is that they can be performed independently—a point which, at least until recently,
was not fully appreciated outside the central banking community (Borio and Disyatat
(2010), Borio (1997)). The central bank can set the short-term interest rate regardless
of the size of its balance sheet and hence without engaging in balance sheet policy;
conversely, it can engage in balance sheet policy at any level of the short-term rate. This is
because the same amount of bank reserves (deposits with the central bank) can coexist with
very different levels of the policy rate; and conversely, the same policy rate can coexist with
different amounts of reserves—the ‘decoupling principle’. What is critical is how reserves
are remunerated relative to the policy rate (see below).
Balance sheet policy, in turn, can be subdivided into various categories (see also Figures
20.1 and 20.2, for a typical central bank balance sheet).
In the case of exchange rate policy (not discussed further here), the central bank alters
the net exposure of the private sector to foreign currencies through operations in the
foreign exchange market. The intention is to affect the exchange rate, its level and/or
volatility, at any given level of the policy rate.
In the case of quasi-debt management policy, central bank operations target the market
for public sector debt by altering the composition of such claims held by the private
sector. These claims include securities of different maturity as well as bank reserves held
with the central bank. The main intention is to alter the yield on government securities,
thereby influencing the cost of funding and asset prices more generally. For example, the
central bank may buy long-term government bonds and sell shorter-term bonds; or it
may finance the purchase of those bonds by issuing its own money (bank reserves). We
use the qualifier ‘quasi’ only to stress that the objectives may be quite different from those
of debt management and to indicate that any change in bank reserves in this context is

Table 20.1 A taxonomy of monetary policy implementation measures
Policy Description Examples

Interest rate Setting the policy rate and
policy influencing expectations about its
future path
Forward Communication about the future The central bank ‘expects the key . . .
guidance on policy rate path interest rates to remain at present or
interest rates lower levels for an extended period’2
Negative Setting the policy rate below zero Negative deposit interest rate at the
interest rates ECB and at the BOJ4, 5
Balance sheet Adjusting the size/composition of
policies the central bank balance sheet and
influencing expectations about its
future path to influence financial
conditions beyond the policy rate
Exchange rate Interventions in the foreign exchange
policy market
Quasi-debt Operations that target the market for Purchases of government debt
management public sector debt
policy
Credit policy Operations that target private debt Modifying the discount window facility
and securities markets (including Adjusting the maturity/collateral/
banks) counterparties for central bank
operations
Commercial paper, ABS and corporate
bond funding/purchase
Bank reserves Operations that target bank reserves The central bank conducts ‘money
policy market operations so that the monetary
base will increase at an annual pace of
about 60–70 trillion yen’1
Forward Communication about the future ‘The [BOJ] will purchase JGBs so that
guidance on balance sheet path (composition/size) their amount outstanding will increase
the balance at an annual pace of about 50 trillion
sheet yen. . . as long as it is necessary for
maintaining [the 2% price stability]
target in a stable manner’3
Notes:
1
Bank of Japan, 4 April 2013, http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf.
2
ECB, 4 July 2013, https://www.ecb.europa.eu/press/pressconf/2013/html/is130704.en.html.
3
Bank of Japan, ibid.
4
Starting on 5 June 2014, https://www.ecb.europa.eu/press/pr/date/2014/html/pr140605_3.en.html.
5
Starting on 29 January 2016, http://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf.
seen as a mere by-product of the transactions in government paper, with no independent

impact of its own.
In the case of credit policy, the central bank targets segments of the private debt market
by altering its exposure (and, by implication, the private sector’s exposure) to them. It can

Federal Reserve Eurosystem
Total assets to GDP (lhs)

50 4000
Bn of national currency
25 4000
20 3000 40 3000
Percent
Percent
15 2000 30 2000
10 1000 20 1000
5 0 0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Total Securities1 Central bank liquidity swaps Securities3 Foreign assets5

assets Lending4 Other assets
Lending 2 Other assets
Bank of England6 Bank of Japan (100 bn)
25 400 Bn of national currency 90 4000
20 300 70 3000
Percent
Percent
15 200 50 2000
10 100 30 1000
5 0 10 0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Securities7 Lending8 Other assets9 Securities10 Foreign assets5

Lending11 Other assets
Notes:
1
Securities held outright. Includes securities lent to dealers under the overnight securities lending facility.
2
Repurchase agreements, term auction credit, other loans and Commercial Paper Funding Facility.
Repurchase agreements are the cash value of agreements, which are collateralised by US Treasury and
federal agency securities.
3
Securities of euro area residents and general government debt, in euros.
4
Lending to euro area credit institutions related to monetary policy operations, in euros.
5
Including US dollar liquidity auctions. For the euro system this includes all foreign currency claims to
both residents and non-residents of the euro area.
6
The Bank of England changed the balance sheet methodology starting 24 Sept 2014, which might result
in breaks in the data and changes in the definitions.
7
Bonds and other securities acquired via market transactions up to 24 Sept 2014 and longer-term sterling
reverse repos and sterling-denominated bond holdings thereafter.
8
Fine-tuning and one-week short-term open market operations and indexed long-term repos.
9
Including US dollar liquidity auctions and loans to the Bank of England Asset Purchase Facility Fund
up to 24 Sept 2014 and foreign currency reserve assets and loans to the Bank of England Asset Purchase
Facility Fund thereafter.
10
Defined as Japanese government bonds and corporate bonds.
11
Loans excluding those to the Deposit Insurance Corporation. Includes resale agreements.
Sources: Datastream; national data.
Figure 20.1 Central bank assets
do so by modifying collateral, maturity and counterparty terms on monetary operations,

by providing loans or by acquiring private sector assets, including equities. The main
intention is to alter financing conditions for the private sector.
In the case of bank reserves policy, the central bank sets a specific target for bank

Federal Reserve Eurosystem2
Total liabilities to GDP (lhs)

24 4000 42 3200
18 3000 34 2400
Percent
Percent
12 2000 26 1600
6 1000 18 800
0 0 10 0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Total liabilities Other liabilities Currency in circulation3 Deposit facility

Currency in circulation Reserve balances1 Reserve balance4 Other liabilities
Bank of England5 Bank of Japan (100 bn)2
25 400 90 4000
20 300 70 3000
Percent
Percent
15 200 50 2000
10 100 30 1000
5 0 10 0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Currency in circulation Short-term OMOs6 Currency in circulation Resale agreement8

Reserve balances Other liabilities Reserve balances7 Other liabilities
Notes:
1
Reserve balances with Federal Reserve System Banks.
2
Total includes equity (net assets).
3
Banknotes in circulation.
4
Current accounts, covering the minimum reserve system.
5
The Bank of England changed the balance sheet methodology starting 24 Sept 2014, which might result in
breaks in the data and changes in the definitions.
6
Including to central banks.
7
Payables under repurchase agreements.
8
Current deposits; excludes government deposits, and deposits held by foreign central banks and others.
Sources: Datastream; national data.
Figure 20.2 Central bank liabilities
reserves regardless of how this is mirrored on the asset side of its balance sheet—such
as through the acquisition of foreign exchange or domestic currency-denominated
claims, be these on the public or private sector. As a result, the ultimate impact on
private sector balance sheets is not uniquely determined and depends on the asset
counterpart to the reserves’ expansion. Such a policy depends on the view that there
is something unique about bank reserves (ie that they are not perfect substitutes with
very short-term central bank or government paper). The policy has been justified on
various grounds, including inducing an expansion in money and credit, limiting strains

on the intermediaries through the assurance of ample funding and influencing the
exchange rate.4
This taxonomy is more precise than that commonly used in discussions of balance sheet
policies. The term ‘quantitative easing’ nowadays has become almost synonymous with
domestic balance sheet policies in general, ie, with those that exclude foreign exchange
intervention, not least large-scale asset purchases.5 The term ‘credit easing’ is typically
restricted to those domestic balance sheet policies that target the asset side of the balance
sheet and ignore what happens on the liability side. The term is popular among those who
consider that, by itself, the amount of excess reserves in the system is not relevant (eg,
Bernanke (2009)).6
2. What Central Banks Have Done
Post-crisis, the central banks under consideration have adopted a broad range of measures
(Table 20.2). All have actively engaged in (a variety of) credit policies, quasi-debt manage-
ment policy and forward guidance. The only central bank that has specifically targeted
bank reserves is the Bank of Japan. In all the other cases bank reserves also increased, but
only as a residual by-product of other operations, not with a numerical objective in mind.
And only two of these central banks, the ECB and Bank of Japan, have pushed policy
rates into negative territory.
There is also a certain sequence in the types of measures adopted. During the crisis
management phase, central banks relied heavily on balance sheet policies to stabilise the
financial system. As emphasis shifted to more traditional macroeconomic objectives,
central banks increasingly relied on forward guidance. The adoption of negative policy
rates is of more recent vintage, has sometimes sought to reinforce the impact of balance
sheet policies and has coincided with a typically more nuanced use of forward guidance.
As an illustration, take the evolution of balance sheet policies (eg, Fawley and Neely
(2013)) (Table 20.3). The response to the first signs of the financial crisis as far back as
August 2007, when the interbank market froze, was to adjust operations to provide much
more ample liquidity and, later, to activate inter-central bank FX swap lines, as dollars
became increasingly scarce (eg, Borio and Nelson (2008), Lenza et al (2010), Joyce et al
(2012)). Once the crisis intensified following the Lehmann Brothers’ failure in October 2008,
central banks broadened the set of measures in order to address wider market dislocations,
ranging from back-up liquidity facilities for non-bank intermediaries to purchases of
private sector assets (eg, commercial paper, mortgage-backed securities, covered bonds and
4
Borio and Disyatat (2010) consider these issues in detail. A key point, not examined further
here, is that there cannot be a strong systematic link between the amount of reserves in the system
and money and credit, ie, there is no such thing as a stable money or credit multiplier. The empiri-
cal evidence, including in that paper, fully confirms this. The point contrasts sharply with typical
textbook treatments of the subject. On this, see also eg, Goodhart (1984).
5
To be more precise, it excludes foreign exchange policy except indirectly, when it is the coun-
terpart to a targeted increase or reduction in the amount of excess reserves, ie, of bank reserves
policy.
6
For an alternative classification, more heavily focused on the private/non-private sector
distinction and highlighting the role of changes in bank reserves, see Goodfriend (2001).

Table 20.2 Balance sheet policies by selected central banks since the Great Financial
Crisis
Policy Central banks

Fed BOE ECB BOJ
Balance sheet policies
Credit policy √ √ √ √
Quasi-debt management policy √ √ √ √
Bank reserves policy √
Forward guidance on interest rates
Calendar-based, qualitative √1
Calendar-based, quantitative √2 √3
State-contingent, qualitative √4 √5
√6
State-contingent, quantitative √7 √8
Negative interest rates √ √
Notes:
1
For example, in March 2009 the Fed expected low rates for ‘an extended period’.
2
For example, in August 2011 the Fed expected low rates ‘at least through mid-2013’.
3
For example, in July 2013 the ECB expected policy rates ‘to remain at present or lower levels for an
extended period of time’.
4
For example, in December 2012 the Fed expected low rates to be appropriate while unemployment was
above 6.5% and inflation was forecasted below 2.5%.
5
For example, in August 2013 the BOE expected not to raise the policy rate at least until unemployment fell
below 7%.
6
For example, in February 2012 the BOJ expected to maintain its virtually zero interest rate policy until a
yearly 2% CPI inflation goal was ‘in sight’.
7
For example, in February 2014 the BOE stated that unemployment needed to fall further before the policy
rate would be increased.
8
For example, in January 2013 the BOJ expected to keep rates at zero ‘for as long as it judge[d] appropriate
given its inflation objective’.
corporate bonds). When the euro area was later hit by a sovereign crisis, the ECB stood ready
to purchase government debt outright—an unprecedented step for the institution—so as to
address concerns in countries under strain. As financial conditions in the various countries
normalised, asset purchases and lending schemes became a tool much more clearly aimed at
boosting output and inflation. This also went hand-in-hand with a certain shift from credit
policies towards quasi-debt management policies, mainly intended to lower government
bond yields as a substitute for cutting policy rates, which were stuck at zero or thereabouts.
Across countries, the balance of the measures reflected not just evolving challenges, but
also the structure of the financial system. Thus, in the capital market-based US system,
large-scale asset purchases played a dominant role, whereas in the bank-based euro area
system liquidity provision through the banks was by far the main type of operation.
These measures have changed the size and structure of central bank balance sheets
beyond recognition (Figures 20.1 and 20.2). Post-crisis, the balance sheets have ballooned:
the Eurosystem’s by a factor of close to three and the others by a factor of four. In percent-
age of GDP, at the time of writing they are standing in a range between approximately 20
percent of GDP (Bank of England) and 70 percent of GDP (Bank of Japan). The Bank
of Japan’s and the Eurosystem’s are set to grow considerably more. On the asset side,

Table 20.3 Large-scale asset purchases and forward guidance since the Great Financial
Crisis: a timeline
Date Programme/action Description

Federal Reserve
25.11.2008 QE1 LSAPs announced: the Fed will purchase $100
billion in GSE debt and $500 billion in MBS.
18.03.2009 QE1 LSAPs expanded: the Fed will purchase $300
billion in long-term Treasuries and an
additional $750 and $100 billion in MBS and
GSE debt, respectively.
Open-ended guidance Fed expects low rates for ‘an extended period’.
11.03.2010 QE2 QE2 announced: the Fed will purchase $600
billion in Treasuries.
09.08.2011 Switch to calendar-based The Fed expects low rates ‘at least through
guidance mid-2013’.
21.09.2011 MEP The Fed will buy $400 billion of Treasuries with
remaining maturities of six to 30 years and sell
an equal amount with remaining maturities of
three years or less.
25.01.2012 Calendar-based guidance The Fed expects low rates ‘at least through late
extended to 2014 2014’.
13.09.2012 QE3 QE3 announced: the Fed will purchase $40
billion of MBS per month as long as ‘the
outlook for the labor market does not improve
substantially . . . in the context of price
stability’.
Calendar-based guidance The Fed expects low rates ‘at least through
extended to mid-2015 mid-2015’.
12.12.2012 Switch to state-contingent The Fed expects low rates to be appropriate
guidance while unemployment is above 6.5% and
inflation is forecasted below 2.5%.
European Central Bank
05.10.2010 SMP SMP announced: the ECB will conduct
interventions in the euro area public and
private debt securities markets; purchases will
be sterilised.
09.06.2012 OMT OMTs announced: countries that apply to the
European Stability Mechanism (ESM) for aid
and abide by the ESM’s terms and conditions
will be eligible to have their debt purchased in
unlimited amounts on the secondary market by
the ECB.
04.07.2013 Open-ended guidance The ECB expects the key interest rates ‘to remain
at present or lower levels for an extended
period of time’.
04.09.2014 APP/ABSPP and CBPP3 ABSPP announced: the ECB will purchase a
broad portfolio of simple and transparent ABS

Table 20.3 (continued)

with underlying assets consisting of claims
against the euro area non-financial private
sector under an ABS purchase programme.
CBPP3 announced: the ECB will also purchase
a broad portfolio of euro-denominated covered
bonds issued by MFIs domiciled in the euro
area under a new covered bond purchase
programme.
22.01.2015 APP/PSPP PSPP announced: the ECB will purchase bonds
issued by euro area central governments,
agencies and European institutions.
Bank of England
19.01.2009 APF APF established: the BOE will purchase up to
£50 billion of ‘high quality private sector
assets’ financed by Treasury issuance.
05.03.2009 APF/QE1 QE1 announced: the BOE will purchase up to £75
billion in assets, now financed by reserve
issuance; medium- and long-term gilts will
comprise the ‘majority’ of new purchases.
06.10.2011 APF/QE2 QE2 announced: the BOE will purchase up to
£275 billion in assets financed by reserve
issuance; the ceiling on private assets held
remains at £50 billion.
05.07.2012 APF/QE3 QE3 announced: the BOE will purchase up to
£375 billion in assets.
07.08.2013 State-contingent guidance The BOE ‘expects not to raise Bank Rate from
0.5% at least until unemployment falls
below7%.’
12.02.2014 State-contingent guidance The BOE states that ‘despite the sharp fall in
unemployment there remains scope to absorb
spare capacity further before raising Bank
Rate’ and that the ‘path of Bank Rate over
the next few years will, however, depend on
economic developments’.
Bank of Japan
05.10.2010 CME APP established: the BOJ will purchase ¥5 trillion
in assets (¥3.5 trillion in JGBs and Treasury
discount bills, ¥1 trillion in commercial paper
and corporate bonds, and ¥0.5 trillion in ETFs
and J-REITs).
State-contingent guidance The BOJ declares that it will ‘maintain the
virtually zero interest rate policy until it judges
. . . that price stability is in sight’.
Bank of Japan
14.02.2012 State-contingent guidance The BOJ declares that it will conduct ‘its virtually
zero interest rate policy’ and asset


purchases ‘until it judges that the 1% goal [y-o-y
CPI inflation] is in sight on the condition that
the Bank does not identify any significant risk’.
22.01.2013 State-contingent guidance The BOJ declares that it will follow ‘a virtually
zero interest rate policy’ aimed at achieving
a 2% target for ‘as long as [it] judges it
appropriate to continue’.
04.04.2013 QQE QQE announced: the BOJ will double the
monetary base and the amounts outstanding of
JGBs as well as ETFs in two years, and more
than double the average remaining maturity of
JGB purchases.
Table reports changes in forward guidance language only (ie, does not report same language used on multiple
dates).
QE 5 Quantitative Easing; LSAP 5 Large-Scale Asset Purchase; GSE 5 government-sponsored enterprise;
MBS 5 mortgage-backed securities; MEP 5 Maturity Extension Program; SMP 5 Securities Markets
Programme; OMT 5 outright monetary transactions; APP 5 Asset Purchase Programme; ABSPP 5
Asset-Backed Securities Purchase Programme; ABS 5 asset-backed securities; CBPP3 5 Covered Bond
Purchase Programme 3; PSPP 5 Public Sector Purchase Programme; APF 5 Asset Purchase Facility; CME
5 Comprehensive Monetary Easing; JGB 5 Japanese government bond; ETFs 5 exchange-traded funds;
J-REITs 5 Japanese real estate investment trusts; QQE 5 Quantitative and Qualitative Easing.
securities account for the lion’s share of the increase in the Unites States, United Kingdom
and Japan, while in the euro area loans have played a bigger role. On the liability side, in
all cases bank reserves have surged.
While not the focus of the chapter, these measures have had a profound influence on the
day-to-day operations designed to set policy rates (Keister et al (2008), Clews et al (2010),
Lenza et al (2010), Bowman et al (2010)). At the cost of some oversimplification, central
banks went from setting policy rates by fine-tuning the amount of reserves in the system
as dictated by reserve requirements to doing so through the rate paid on excess reserves.
They also greatly broadened the range of eligible collateral and maturity of operations
and, in some cases, widened that of counterparties. In the process, the distinction between
normal lending operations and those that would have taken place only when markets and
institutions are under market stress has become blurred. That is, the distinction between
normal and ‘lender of last resort’ or ‘emergency liquidity assistance’ operations has
become fuzzier (Domanski et al (2014)).
III. INFLUENCE ON FINANCIAL CONDITIONS: WHAT DO

WE KNOW?
What has been the effect of these policies on financial conditions? We next consider, in
turn, the impact of balance sheet policies, forward guidance and negative interest rates.
We summarise primarily formal econometric evidence, but, where such studies are not

available, briefly comment on less formal evidence. Here we focus on domestic financial
conditions and postpone the discussion of the impact on foreign markets to the next
section.
1. Balance Sheet Policies
The formal econometric evidence about balance sheet policies does not quite follow
the classification laid out above. Rather than being based on the markets affected it is
organised along types of instrument. Thus, most of it concerns the impact of large-scale
asset purchases, regardless of whether they involve private sector or government assets.
The number of studies assessing the effects of credit policies pursued through central
bank lending facilities is much smaller.
Analytically, through what channels should large-scale asset purchases influence
asset prices and financial conditions? Economists think in terms of two broad sets of
mechanisms, which are hard to disentangle in practice. The first operates through the
specific characteristics of the asset bought, ie, those that make it an ‘imperfect substitute’
in private sector portfolios. By altering the amount of the asset held in those portfolios,
the central bank can then affect its price and yield. This may be because the asset has
specific risk/return characteristics, in isolation or as part of a broader portfolio, making
it attractive to a particular group of investors, or because it provides services not fully
captured by its cash flows, such as liquidity or collateral services.7 The second mechanism
works by influencing market participants’ views about future monetary policy decisions
and/or the state of the economy (‘signalling’). The future monetary policy decisions
could, in principle, concern purchases themselves, but they may relate to other measures,
not least the timing and extent of future changes in the policy rate—typically the preferred
interpretation. For instance, investors may consider a large-scale government bond
purchase as a signal that the central bank will keep the policy rate low for longer, which
would naturally lower the yield on the bond.8 In turn, regardless of the mechanism at
7
Modern macroeconomic theory has highlighted a set of sufficient conditions under which
balance sheet policies are neutral (Wallace (1981), Eggertsson and Woodford (2003), Woodford
(2012)). First, assets must be valued only for their pecuniary returns, which rules out things like
liquidity and collateral services (see Araújo et al (2015) for an example of a model in which assets
are valued for their collateral services). Second, agents can buy arbitrary quantities at the same
(market) prices. There are no binding constraints on positions other than budget constraints,
and therefore no limits to arbitrage (see Gertler and Karadi (2011) for an example of a model in
which there are limits to arbitrage arising from frictions affecting financial intermediaries). Finally,
central bank asset purchases do not provide any information about future policy rates. In other
words, the ‘irrelevance’’ theory holds the future policy interest rate reaction function constant
(Bhattarai et al (2015)).
8
The most common way of thinking of the yield of a bond of a given residual maturity is as
the compound yield on a series of one-period investments over the corresponding maturity plus a
risk premium. So, if the sequence of expected one-period interest rates (eg, ‘policy rates’) is lower,
the yield will be as well. As a first approximation, the first set of mechanisms operates on the risk
premium and the second on the sequence of expected short-term rates. This distinction, however, is
not water tight: for instance, if the central bank painted a bleak picture of the economy, this could
depress participants’ willingness to take on risk. For a discussion of this and related issues, see also
Bauer and Rudebusch (2014).

work, changes in the yield of the asset in question will ripple through the system, as they
encourage further portfolio adjustments. For instance, if the yield on government bonds
falls, yield-hungry investors may be induced to shift into riskier assets—an aspect of the
so-called ‘risk-taking channel’.9,10
The empirical evidence follows a variety of approaches. The most common one consists
of examining the behaviour of the relevant asset prices (or yields) around the policy
announcement—‘event analysis’. Ideally, one seeks to identify the ‘surprise’ element, since
the presumption is that markets only react to what they have not expected, ie, to what is
not already priced in. The second is to link directly through econometric methods the size
and composition of the central banks’ balance sheets or other indicators of the operations
to the behaviour of asset prices and returns. Event analysis is probably the more reliable
approach, as it better identifies the source of the market reaction. The disadvantage is that
the window over which the change is examined has to be rather small—typically ranging
from minutes to at most a few days—to avoid including the impact of other factors.11 In
addition, some studies seek to decompose the change into the risk (or term) premium and
a measure of the expected path of future interest rates.
A look at the studies points to a number of findings (Table 20.4). First, there is
general agreement that large-scale asset purchases did have sizeable effects on financial
conditions. This is true regardless of the assets purchased—eg, government bonds or
mortgage-backed securities—and of the financial prices considered—those of the assets
purchased or others, such as equities and the exchange rate. Because of the different types
of programmes and the methodologies used, it is very hard to provide a simple guide to
the size of the effects. But, say, the cumulative impact of the Fed programmes on ten-year
government bond yields may have been of the order of over -100 basis points.12
Second, most of the impact appears to take place on announcement, rather than once
the purchases are actually executed. This is consistent with the view that markets are
forward-looking, pricing actions once they are expected.
Third, the studies have a hard time distinguishing between the impact on the risk
premium and on the expected path of future policy rates. Authors differ in their
interpretation. This is hardly surprising, given the nature of the problem. Most probably,
both mechanisms are at work.
The literature on the impact of credit policies implemented through lending facilities
is smaller. That said, certain preliminary conclusions seem reasonable (Table 20.5). In
particular, the measures appear to have helped alleviate liquidity shortages in financial
markets. Summarising the Federal Reserve experience, for example, Fleming (2012) argues
9
For an introduction to the risk-taking channel, see Borio and Zhu (2012); for further elabo-
ration or examples, see, in particular, Rajan (2005); for its operation in the context of exchange
rates, see Shin (2012)).
10
Central banks have indeed used variations on these arguments to rationalise their actions.
For instance, the Bank of England has argued that by pushing up the price of sovereign bonds,
asset purchases drive investors into riskier securities, further compressing yields.
11
Combinations of the two methods are also possible, by including the (surprise element of) an
announcement in dynamic econometric relationships.
12
Consider the estimates in Table 20.4. Averaging the effects of QE1 across studies, we obtain
about -76 basis points. Doing the same for QE2 and (the more limited evidence) for QE3 we get -28
and -7 basis points, respectively. This amounts to -112 in total.

Table 20.4 Impact of balance sheet policies on domestic yields and the exchange rate
Study Method Estimates

∆ 10-year ∆ 30-year ∆ FX (%)
Treasury MBS yield
yield (bp) (bp)
United States
QE1 – $1.75 trillion MBS; $300 billion Treasuries; $172 billion agency securities
Krishnamurthy and Event study –1071a –1071b
Vissing-Jorgensen
(2011)
Gagnon et al (2011) Event study –912a –1132b
Hancock and Time series regressions –443c
Passmore (2011)
Christensen and Event study, affine –894a
Rudebusch (2012) no-arbitrage model of the (–60,–33,–7)
term structure
D’Amico and King Cross-section regression –305a
(2013)
D’Amico et al (2012) Time series regression –356a
(66,34)
Bauer and Rudebusch Affine no-arbitrage model of –897a
(2014) the term structure (38,62)
Neely (2015) Event study –948a –5.988c
Chadha et al (2013) Time-series regression –90 to –1159a
QE2 – $600 billion Treasuries
MEP – $667 billion long-term Treasuries purchased; $667 billion short-term Treasuries sold
Krishnamurthy and Event study –3010a –810b
Vissing-Jorgensen
(2011)
Swanson (2011) Event study –1611a
Hamilton et al (2012) Time series regression –2212a
D’Amico et al (2012) Time series regression –4513a
(78,22)
All programmes (includes QE3, $823 billion MBS; $790 billion Treasuries)
Swanson (2015) Time series regression –7.4614a –0.2614c
United Kingdom
QE – £375 billion gilts
∆ gilts yield ∆ FX (%)
(bp)
Joyce et al (2011) Event study –100bp15a –415c
(10,90)
Joyce and Tong Event study, time series –97.616a
(2012) regression (2.5)
Christensen and Event study, affine no– –4317a
Rudebusch (2012) arbitrage model of the (47,–135,–12
term structure

Study Method Estimates

∆ 10-year ∆ 30-year ∆ FX (%)
Treasury MBS yield
yield (bp) (bp)
McLaren et al (2014) Event study –9318a
(52)
Euro area
APP – planned purchases of €1.14 trillion until September 2016
∆ 10-year Treasury ∆ FX (%)
yield (bp)
Altavilla et al (2015) Event study –4719a –1219c
Japan
Monetary easing since 2008
∆ 10–year Treasury ∆ FX (%)
yield (bp)
Lam (2011) Event study –2420a –0.320c
Ueda (2012) Announcement effects –9.921a –0.5221b
Hausman and Wieland Announcement effects –11.422a 3.5522b
(2014)
Imakubo et al (2015) Models of the term –8023a
structure
Notes: (All tables and figures referred to are within the papers mentioned in column 1 of this table.)
1a,b
Cumulative change (Table 1).
2a,b
Cumulative effect based on baseline event set (Table 1).
3c
This is not a yield change but the change in abnormal MBS pricing (ie, the difference between actual
and predicted), in basis points, during the announcement period (Table 3, entry (1,9)).
4a
Actual yield change (first line) and split of actual yield change between signalling channel and portfolio
balance channel (plus residual), in percent, based on preferred term structure models (Table 4 and Table 8,
last row).
5a
The first line reports the stock effect, based on comparison of actual and counterfactual yield curves
(Figure 5), while the second line is the flow effect on eligible securities on purchase day (see Section 4.3.2).
6a
Yield change and split between local supply effects (66%) and duration effects (34%); see discussion at
the end of Section 6.
7a
Actual yield change (first line) and split of model-implied yield change (-94 bp) between signalling
channel and portfolio balance channel, in per cent, based on restricted risk pricing specification of the
term structure model (Table 5).
8a
Cumulative effect of buy and sell events (Table 2).
8c
Average change in the exchange rate (measured as the foreign currency price of 1 dollar), cumulative
effect of buy and sell events (Table 3).
9a
Impact on 5-year forward 10-year rate (Figure 3).
10a,b
Cumulative change based on two-day window (Table 5).
10b
Not significant.
11a
Cumulative change based on first four announcements (Table 3).
12a
A $400 maturity swap at the zero lower bound is estimated to reduce yields by 13 bp (Table 5); the
actual swap was $667 billion and since the model is linear, one obtains 667/400*13 bp 5 22 bp.
13a
Yield change and split between local supply effects (78%) and duration effects (22%); see discussion at
the end of Section 6.
14a
Impact of a change in purchases about $300 billion larger than anticipated by markets (Section 3 and
Tables 2 and 3).

14c
Average change in the exchange rate (measured as the foreign currency price of 1 dollar) after a change in
purchases about $300 billion larger than anticipated by markets (Section 3 and Table 4, authors’ calculations).
15a
Cumulative change in gilt yields and split across signalling channel (10%) and portfolio balance channel
(90%) (Chart 9).
15c
Cumulative change in sterling exchange rate, measured as the foreign currency price of one pound (Chart
17).
16a
First row reports the average change in yield following QE announcement in medium- to long-term gilts
(Table 3, average of last row excluding the first entry), while the second row reports the further yield
reduction in eligible gilt yields that happened ahead of each auction (flow effects, see Section 6).
17a
Actual yield change (first line) and split of actual yield change between signalling channel and portfolio
balance channel (plus residual), in per cent, based on preferred term structure models (Tables 12 and 15,
last row).
18a
Total decline in five- to 25-maturity gilt yields, and share of local supply effect (Section 2.2 and Table 4).
19a
Cumulative change based on controlled event study with two-day window (Table 1).
19c
Percentage change based on controlled event study with two-day window, exchange rate measured as the
dollar price of one euro (Table 6).
20a
Cumulative effect (Table 3a).
20c
Expressed as number of dollars per yen, not significant (Table 3a).
21a
Comprehensive Monetary Easing programme announcement (5 October 2010) effect (Table 5,
penultimate row). This is not an event study, so a significance level is not provided.
21b
Comprehensive Monetary Easing programme announcement effect on the exchange rate, expressed as
the yen price of 1 dollar (so a negative entry is a yen appreciation).
22a
QQE announcement (4 April 2013) effect (Table 2). This is not an event study, so a significance level is
not provided.
22b
QQE announcement effect on the exchange rate, measured as the yen price of one dollar (Table 2). This
is not an event study, so a significance level is not provided.
23a
Maximum impact of QQE programme computed as gap between actual and natural yield curve (Figure
8, bottom right panel).
that these measures improved market functioning while adhering to the general principle
of lending against collateral at a penalty rate. The evidence about unconventional policy
actions implemented by the ECB also suggests that they helped relieve stress in money
markets and ease credit conditions more generally.
2. Forward Guidance
Interest rate forward guidance is not a post-crisis development. To varying degrees, central
banks have traditionally sought to influence private sector expectations about the path
of future policy rates. In most cases, pre-crisis this was done indirectly, by explaining the
central bank’s strategy, ie, how it would respond if inflation rose or a recession occurred,
etc—information about its ‘reaction function’. In a few cases, the central bank was much
more specific, announcing the policy rate’s expected path, possibly embellished with
estimates of the surrounding uncertainty (eg, the Reserve Bank of New Zealand or the
Swedish Riksbank).13 In these cases, the central bank took pains to indicate that these
forecasts depended on the information available at the time: new information could lead
to revisions. With rare exceptions, there was no sense in which the paths could be regarded
as unconditional commitments or promises.
13
For Sweden, see Rosenberg (2007). For a more recent take on the Reserve Bank of New
Zealand’s experience, see McDermott (2016).

Table 20.5 Impact of liquidity support measures by the Fed and the ECB on financial
markets
Study Program Methodology Dependent variable Results

Federal Reserve
McAndrews TAF Event study Daily change in 2 bp reduction in the daily
et al (2008) the Libor-OIS spreadchange1a
spread Announcement and
implementation both
effective1b
Williams TAF Event study Libor-OIS spread No significant TAF impact2
and Taylor (and others)
(2009)
Christensen TAF Use multifactor Libor rates 70 bp reduction in Libor
et al (2014) arbitrage-free level3
model of term
structure and
bank credit risk to
decompose Libor
movements (bank
risk premium
changes vs
liquidity premium
changes);
counterfactual
analysis
Wu (2008) TAF Event study Libor-OIS spread 40 bp reduction in spread4
Thornton TAF Event study Libor-Treasury No significant TAF impact5
(2010) spread
Baba and RCA Principal FX swap USD auctions and
Packer (2009) component deviations from commitment to unlimited
analysis; short-term CIP swap lines significantly
time series decreased deviations
regression from CIP post-Lehman
Brothers6
Auctions
-6 (EUR/USD),
-6.9 (CHF/USD),
-6.5 (GBP/USD)
Commitment
-30.2 (EUR/USD), -34.6
(CHF/USD), -32.6 (GBP/
USD)
Aizenman RCA Dummy variable CDS spreads CDS spreads of EMEs
and Pasricha regressions for that received swap lines
(2010) differences in declined more after swap,
means; but recipient/non-recipient
event study difference not significant7a


Swap countries experienced
greater appreciations7b
Rose and RCA Panel regressions CDS spreads Swap arrangements
Spiegel benefited countries with
(2012) greater trade and asset
exposure to the US more8
Fleming et al TSLF Time series Changes in repo TSLF mitigates shortages of
(2010) regressions rates and liquid Treasury collateral9
spreads between
Treasury and
other repos
Hrung and TSLF Time series Changes in the TSLF mitigates shortages of
Seligman regressions FF-repo spreads liquid Treasury collateral10
(2011)
Duygan- AMLF Panel regressions Change in AMLF helped stabilise net
Bump et al MMMFs total asset flows to MMMFs11a
(2013) assets under AMLF reduced ABCP
management; yields by about 100 bp11b
spread between
AMLF- eligible
ABCP issued
by FIs and non-
AMLF eligible
unsecured
commercial
paper issued by
the same FI
Duca (2013) CPFF Vector US firms funding CPFF implementation
autocorrection mix: bank loans coincided with break in
model, linear vs commercial linkage between corporate-
regressions paper Treasury bond yield
spread and funding mix
(the higher the spread, the
larger the share of bank
loans in the funding mix)
Campbell TALF Event study Change in the Spring 2009 TALF
et al (2011) spreads on announcements influenced
different the market-level pricing of
asset-backed highly rated auto ABS and
securities relative CMBS12
to changes in
broader market
indexes.
Ashcraft TALF Panel regressions Changes in yield Significant impact on CMBS
et al (2011) spreads of legacy spreads in first three
TALF-eligible months of programme
CMBS bonds From July 2009 through


September 2009, rejection
from TALF programme
associated with initial
80 bp increase in yield
spreads that later declined
to 40 bp13
European Central Bank
Abbassi FRFA Time series Euribor rates Increase in the aggregate
and Linzert operations regression amount of outstanding
(2011) and open market operations
LTROs between August 2007 and
June 2009 associated with a
reduction in Euribor rates
(3m, 6m, 12m) of more
than 100 bp14
Angelini et al LRTOs Panel regressions Spread between 1-month LTROs reduced the
(2011) rates on spread by 15 bp
unsecured and 3-month LTROs reduced the
secured interbank spread by 10 bp15
loans
Beirne et al CBPP Primary market: Relative issuance Programme increased relative
(2011) cointegration of covered issuance of covered bank
analysis bank bonds and bonds but did not increase
Secondary market: outstanding outstanding amount of
regression amount of bank bank bonds16a
analysis bonds Spread declined by about
Covered bonds 12 bp for the euro area as a
yield spread whole16b
relative to riskless
benchmark
TAF 5 Term Auction Facility; Libor 5 London interbank offered rate; OIS 5 overnight indexed swap.
The spread between the two rates is a measure of money market strain; CDS 5 credit default swap; RCA
5 reciprocal currency agreements; CIP 5 covered interest parity; EMEs 5 emerging market economies;
TSLF 5 Term Securities Lending Facility; AMLF 5 ABCP MMMF liquidity facility; ABCP 5 asset-
backed commercial paper; MMMF 5 money market mutual fund; FF 5 federal fund; FIs 5 financial
institutions; CPFF 5 Commercial Paper Funding Facility; TALF 5 Term Asset-Backed Securities Loan
Facility; ABS 5 asset-backed securities; CMBS 5 commercial mortgage-backed securities; FRFA 5
fixed rate full allotment; LTROs 5 long-term refinancing operations; CBPP 5 Covered Bond Purchase
Program.
Notes: (All tables and figures referred to are within the papers mentioned in column 1 of this table).
1a
See Table 5.
1b
See Table 7.

2
See Tables 2 and 3.
3
See Figure 1.
4
See Table 2, column (3).
5
See Table 1.
6
See Tables 9–12.
7a
See Table 5.
7b
The exchange rate appreciated by about 4% upon announcement in swap countries, while it depreciated
by about 0.15% in non-swap countries. See Table 6.
8
See Tables 7a and 7b for estimates.
9
Each additional billion US dollars in Treasuries lent out increases the repo rate by 1 bp (see Table 2).
10
Each additional billion US dollars in Treasuries lent out decreases the FF-repo spread by 1.2 bp (see
Table 3, column 2).
11a
See Table II. AMLF reduced asset outflows by about 1.5 percentage points for the average participating
fund. Note that MMMFs experienced a 3% average decrease in daily assets in the week prior to the
AMLF.
11b
See Table IV, columns (1) and (3). Average yield in the relevant period was about 4.8%.
12
The 3 March 2009 TALF announcement reduced the auto-loan ABS spread by 63 bp and the
government-guaranteed student loan ABS spread by 38 bp (see Table 2). The 23 March 2009 and 19
May 2009 TALF announcements are associated with 60-250 bp drops in CMBS spreads, depending on
the CMBS measure (see Table 3).
13
In the period from October 2009 through March 2010, a rejection was associated with an immediate
increase in yield spreads of only 15 bp. Prior to the TALF legacy announcement, the spread was around
300 bp. See Figure 13 and related discussion.
14
See Table 1 and the discussion in Section 4.
15
See Table 3.
16a
See Chart 4.
16b
See Table 2 and Appendix 2. Prior to the introduction of the programme, the German covered bond
spread over the riskless sovereign climbed as high as 350 bp (see Chart AI in Appendix 2). Other country
spreads achieved much higher peaks.
Things changed when policy rates hit the perceived lower bound. At that point, if
central banks wished to ease financial conditions further they either had to engage
in balance sheet policies or they had to steer expectations more actively. Thus,
forward guidance became more common. Not surprisingly, the Bank of Japan had
already experimented with various forms of forward guidance around the time it had
pushed its policy rate to zero in 1999, well before the Great Financial Crisis (eg, Ugai
(2007)).14
Forward guidance can be distinguished along two dimensions. The guidance may relate
to a certain period of time (‘calendar-based’) or be conditional on economic conditions
(‘state-contingent’); and it may contain specific numerical values (‘quantitative’) or be
expressed in vaguer terms (‘qualitative’). For instance, the central bank may state that
it will keep the policy rate unchanged for the foreseeable future (calendar-based and
qualitative), or until a two percent inflation target is reached (state-contingent and
quantitative) or for one year (calendar based and quantitative), or until labour market
14
In fact, the Bank of Japan resorted to forward guidance even before pushing the policy rate
to zero. And a similar episode began in the United States in August 2003, when the Federal Reserve
stated that it would maintain accommodation ‘for a considerable period’, as an alternative to
further cuts in the policy rate (eg, Woodford (2012)).

conditions improve sufficiently (state contingent and qualitative). Of course, depending

on the complexity of the statement, combinations are also possible.
The central banks considered here span the whole range of possibilities and have
sometimes switched from one form to another (Table 20.2). All of them have relied on
the qualitative calendar-based variety and only the Federal Reserve on its quantitative
counterpart, such as when in August 2011 it announced that it expected to keep rates
low ‘at least through mid-2013’. All, except the ECB, have used the state-contingent type,
typically with reference to inflation and/or labour market conditions. This has included
both qualitative and quantitative guidance.
Forward guidance works through one of the two mechanisms already discussed for large-
scale asset purchases, ie, signalling. The central bank seeks to influence market expectations
about the future policy rate path. Beyond this, however, there are some subtle elements.
One view, advocated by some economists, is that for forward guidance to be effective, it
must involve a form of pre-commitment (eg, Eggertsson and Woodford (2003), Woodford
(2012)). In this case, the central bank promises to implement a policy that, once the times
comes, it would not have an incentive to carry through—technically, a ‘time inconsistent’
strategy. For instance, it might promise to keep interest low to raise inflation even beyond
the point when, from an ex post perspective, it would be optimal to do so. The idea is
that, provided this commitment is credible, it could be optimal ex ante. For example, by
lowering expected inflation sufficiently, it could reduce ex ante real interest rates and boost
output further. The notion is similar to that of Ulysses tying himself to the mast to resist
the sirens’ call, or to a government that commits to destroy new houses built next to a
dangerous river bed even if, once they are built, it would be prohibitively unpopular and
costly to tear them down.
Central banks, however, have generally been reluctant to portray their policies this way.
They do not regard announcements as sufficiently strong pre-commitment mechanisms.
At most, some reputational capital may be at stake.15 And even then markets and the
public may not be forgiving if they see that the central bank pursues an ex post costly
policy (eg, allowing inflation to rise) once the benefits have already been reaped. Rather,
central banks have stressed forward guidance as a means of clarifying their intentions
and, when state contingent, to underline their determination to pursue specific objectives
(eg, Bernanke (2012), Dudley (2013) and Tucker (2013)). That said, in practice some
ambiguity has been inevitable.
The formal evidence suggests that forward guidance can generally succeed in influencing
bond yields in the right direction, but with some qualifications (Table 20.6). The evidence
has typically been positive for the United States, a bit more mixed for Japan and, given the
very limited studies available, less clear for the euro area and, even more so, for the United
Kingdom. In addition, it does appear that guidance can help make markets less respon-
sive to economic news, keeping their focus on the authorities’ charted course.
At least two factors may explain why forward guidance need not be as effective as
originally hoped.
15
That said, purchases of long-term assets, for example, could be interpreted as a commitment
to keep interest rates low for a while, since the central bank would incur losses by raising rates. For
this suggestion, see, for instance, Clouse et al (2003) and for a formal treatment, Bhattarai et al (2015).

Table 20.6 Impact of recent forward guidance on market beliefs and the yield curve
Study Method Type of Key takeaway

guidance
United States
Campbell Time series Open- Guidance had a large influence on the 2-
et al (2012) regressions on ended and and 5-year Treasury yields, and mattered
asset prices calendar- even more for the 10-year yield1
based
Woodford Evidence from Calendar- Flattening of the OIS yield curve
(2012) OIS rates around based after the ‘mid-2013’ and ‘mid-2014’
announcements announcements2
Femia et al Evidence from the Calendar- Expectations of monetary policy
(2013) futures-implied based and tightening as implied by interest rate
path of the threshold- futures moved further out into the future
FFR, one- based with each announcement3a
year swaptions Uncertainty around interest path fell3b
and survey of Survey of primary dealers suggests
primary dealers calendar-based guidance conveyed more
accommodative policy stance (perceived
Taylor rule shifted down)3c
Threshold guidance did not convey a
further shift in the reaction function,
but solidified expectations through
transparency3d
Raskin (2013) Time series Calendar- Percentiles out to three years became
regression on the based unresponsive to macroeconomic news
85th percentile after ‘mid-2013’ announcement4
of the h-quarters
ahead option-
implied interest
rate distributions
Swanson Evidence from Open- Guidance affected beliefs about ZLB
and Williams survey of ended and length5a
(2014) forecasters, calendar- This was transmitted to yield curve
daily options based (post ‘mid-2013’ announcement, 2-year
data, time series Treasury yields become less sensitive to
regressions on news; post ‘mid-2014’ announcement,
Treasury and they become insensitive to news)5b
Eurodollar
futures yields
Filardo and Event study Open-ended, Futures rates and long-term bond yields
Hofmann Evidence from calendar- declined on most announcement dates6a
(2014) futures-implied based, Volatility of expected interest rates
volatility of threshold- (implied by futures on interbank rates)
expected interest based fell at short horizons6b
rates
Del Negro Panel regression on Calendar- Announcements lower the short-term
et al (2015) changes in based rate four quarters ahead by 15 bp, and

Study Method Type of Key takeaway

guidance
h-quarter ahead the long-term rate by 20 bp, raising one-
private forecasts year ahead expectations of GDP growth
and inflation by 0.3 percentage points7
Swanson Time series Open-ended, Finds that guidance is associated with a
(2015) regression calendar- decrease in Treasury yields as far out as
based, the 10-year8a
threshold- A boom in the stock market and a
based depreciation of the dollar8b
Japan
Filardo and Event study Threshold- Very small announcement effects on
Hofmann based under futures rates10
(2014) CME
United Kingdom
Filardo and Event study Threshold- Interest rates did not drop upon announce-
Hofmann based ment, though they did drop (but only at
(2014) short maturities) when MPC expressed
concern about appropriateness of policy
rate expectations in inflation report11
1
See Table 6.
2
See Figures 3 and 4.
3a
See Figure 13b. See Figure 2.
3c
3d
See Figure 6 and related discussion.
4
See Table 4, Figures 6 and the discussion in Section 6.
5a
5b
See Figure 3.
6a
See Graph 1.
6b
See Graph 2.
7
See Figure 3.
8a
See Table 3.
8b
See Table 4.
9a
See Table 10 (column 2) and the discussion preceding it.
9b
See Figure 11.
10
See Graph 1.
11
See Graph 1.
The guidance may not be fully understood. This may be the case, in particular, if it is
too complex or state-contingent, as the conditions envisaged may not be expressed very
clearly. After all, the central bank may wish to retain sufficient flexibility to respond
to unforeseen circumstances and, in the case of committee decision-making, it might
be difficult to reach agreements and compromises.16 Qualifiers like ‘substantial’ or
16
See Feroli et al (2016) for a discussion of how forward guidance, especially if calendar-based,
may hurt a central bank’s reputation and credibility if it is perceived as a commitment to a certain

‘sufficient’ are intentionally fuzzy. Fuzziness and ambiguity also weaken the force of
announcements.
Even if understood, the guidance may not be fully believed. For one, the central bank
may not be able to guarantee the consistency of future decisions beyond short horizons,
eg up to one or two years, especially in committee structures with high turnover. In addi-
tion, the market may not share the central bank’s view about the outlook or the workings
of the economy. For instance, in both the case of the Bank of England and the Federal
Reserve, employment objectives were reached considerably faster than policymakers had
expected despite subdued inflation. This may undermine the central bank’s credibility and
result in unwanted changes in market conditions. The issue is compounded by markets’
natural preference for calendar-based guidance and hence their tendency to translate
state-contingent statements into specific time frames—after all, timing is of the essence
in trading (Tucker (2013)).
These complications, and others that will be discussed later, may explain why, over time,
central banks appear to have downplayed forward guidance somewhat. There has been
a certain shift from the quantitative and state-contingent type to the qualitative variety.
And when quantitative elements have been retained, they have tended to refer directly to
the ultimate goals, such as inflation, rather than to intermediate variables. This has gone
hand-in-hand with statements about the importance of retaining flexibility in light of new
incoming information—‘data dependence’.
3. Negative Policy Rates
Negative policy rates are the latest addition to the arsenal of unconventional monetary
policy measures. Because only two of the central banks considered here have adopted
them—the ECB and the Bank of Japan—and, moreover, the Bank of Japan has done so
only very recently, here we discuss also the experience of Danish Nationalbank, the SNB
and the Swedish Riksbank.17
To non-cognoscenti, the very idea that nominal interest rates can become negative must
sound extremely odd. How is it possible that anyone would pay for the privilege of parting
with his or her money? In fact, to simplify, the possibility arises because the central bank
can determine the quantity of bank reserves in the system and there is nothing banks can
do to avoid holding them—the banking system as a whole is simply stuck with them.18 The
central bank can then charge negative interest on them—in effect, a form of tax. As banks
seek, unsuccessfully, to avoid the tax, the negative interest rate spreads to other rates in
the economy through arbitrage relationships.
This, however, does not mean that interest rates can be set at any negative level. Far
course of action. The authors argue that if macroeconomic events change in an unexpected
manner, the central bank will either have to stick to its promise—which may be suboptimal given
the new circumstances—or else have to renege on it, thereby damaging its credibility.
17
This section draws on Bech and Malkhozov (2016), who provide a detailed analysis of the
implementation of negative policy rates and of their transmission to other rates.
18
This, of course, is just another way of saying that the central bank has full control over
the amount of bank reserves, which is the key to set the policy rate (eg, Borio (1997), Borio and
Disyatat (2010), among many others).

Percent
0.00
–0.25
–0.50
–0.75
–1.00
–1.25
–1.50
Q1 14 Q2 14 Q3 14 Q4 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16
ECB1 Bank of Japan3 Danmarks Nationalbank5

2 4
Swiss National Bank Sveriges Riksbank
Notes:
1
Rate on the ECB deposit facility.
2
Interest rate charged by the Swiss National Bank on sight deposits.
3
Interest rate on the third tier of excess reserves held at the Bank of Japan.
4
Rate of interest banks receive when they deposit funds at the Riksbank.
5
Rate on one-week certificates of deposit.
Sources: Bloomberg; Datastream.
Figure 20.3 Central bank deposit rates sink into negative territory
from it. Quite apart from undesirable economic and broader consequences (see below),
there are technical constraints. If, in order to preserve their profitability or to avoid
making losses, banks pass on the negative rates to their depositors, at some point these
will shift into cash, squeezing the banks’ sources of funding. Where that point is, exactly,
is unclear. It will depend on the attractiveness of cash as a settlement medium, on storage
and insurance costs and on other psychological and institutional factors (eg, McAndrews
(2015), Rognlie (2015)). But the lower the rates sink into negative territory and the longer
they are expected to remain there, the higher the likelihood that the shift will occur, as this
makes it more advantageous to incur the fixed (sunk) costs needed to facilitate holding
and storing cash.
At the time of writing, among the central banks that have adopted them, negative
policy rates range from –0.1 (Bank of Japan) to –1.25 (Riksbank) (Figure 20.3). None of
the central banks in question has said that it has reached the effective zero lower bound,
suggesting that further reductions are technically possible.
The experience so far suggests that modestly negative policy rates transmit to the rest of
money market and capital market rates for the most part much like positive rates do. This
is the case as long as contracts are sufficiently flexible to accommodate them and market
practices can adjust, which need not always be the case.
Their transmission to bank rates, by contrast, has proved more problematic. In par-
ticular, such rates have only been partially transmitted to wholesale deposit rates and so
far not at all to retail deposits. Ostensibly, banks are reluctant to do so, presumably out
of concerns with the reaction of depositors. Moreover, at least in one case (Switzerland),

banks have actually responded by raising their mortgage rates, in all probability in order
to preserve their profitability and facilitated by high concentration among lenders.
Indeed, concerns with the impact of persistently negative rates on banks’ profitability
and resilience contributed to a major sell-off of bank shares in February 2016 (BIS
(2016b)).
This points to the limits of the strategy as a means of boosting financial conditions
through the banking system. If policy rates do not transmit to lending rates, they cannot
boost the demand for loans. If they do transmit to lower lending rates but not to deposit
rates, they squeeze banks’ profits, over time possibly undermining their willingness and
ability to lend. And if they transmit to both lending and deposit rates, they risk unsettling
the deposit base, making it harder for banks to attract funds.
This leaves exchange rate depreciation and, possibly, direct borrowing from capital
markets as the main channels through which negative rates can ease financial condi-
tions. Indeed, especially the central banks that have used negative rates explicitly to
target the exchange rate—the SNB and Danmarks Nationalbank—have taken a lot
of care to protect banks’ profits. They have done so by exempting a fraction of bank
reserves from the negative rate, thereby driving a wedge between the marginal rate, more
directly related to other market rates, and the average rate paid on reserves. The ECB’s
concession of loans at subsidised rates has had a similar effect. That said, the impact
on bank profitability arises not so much from the direct tax on bank reserves but from
the compression of the yield curve (Borio et al (2015)). We return to these issues below.
IV. INFLUENCE ON THE MACRO-ECONOMY AND BROADER

CONSIDERATIONS
The previous analysis suggests that, on balance, unconventional monetary policies have
succeeded in influencing financial conditions, probably beyond original expectations.
Their effectiveness may vary across instruments and circumstances, but their impact is
beyond doubt.
The behaviour of government bond yields is the most telling example. Such yields
reflect the combined influence of central banks and market participants.19 Central banks
influence bond yields by setting the policy rate, by engaging in large-scale purchases
and by providing signals about future policy actions and their interpretation of macro-
economic developments. Market participants, in turn, influence yields by adjusting
portfolios based on their expectations of central bank policy, their views about the other
factors driving yields, including the macro-economy, their attitude towards risk and vari-
ous balance sheet constraints. Clearly, central banks may not control such yields closely,
but have a heavy thumb on the scale. Otherwise it would hardly be possible to explain
how, in early July 2016, over USD 10 trillion of sovereign paper was trading at negative
rates, in some cases far out the maturity spectrum, even up to 30 years, in Switzerland
(Figure 20.4).
19
Of course, they also reflect the amount of securities outstanding and hence the actions of the
government (see also below).

The overall amount soars…1 … and the longest maturities lengthen2
USD trn Percent
CONTI-BROWN 9781784719210 PRINT.indd 424

10 0.00
8 –0.04
–0.08
6
–0.12
4
–0.16
2
424
–0.20
0
Q1 14 Q3 14 Q1 15 Q3 15 Q1 16
Italy
Japan
France
Sweden
(3-year)
(8-year)
(8-year)
(9-year)
(15-year)
(15-year)
(30-year)
Germany
Denmark
Switzerland
Notes:
1
Analysis based on the constituents of the Bank of America Merrill Lynch World Sovereign Index as of February 2016.
2
Yield per maturity, Bloomberg generic yields, prevailing on 6 July 2016.
Sources: Bank of America Merrill Lynch; Bloomberg; BIS calculations.
Figure 20.4 Government bonds trade at negative yields
Claudio Borio and Anna Zabai - 9781784719227

Downloaded from Elgar Online at 02/14/2020 08:27:28AM
19/04/2018 13:04
The more fundamental questions, though, are whether such policies have been effective
in attaining central banks’ ultimate objectives, couched in terms of output and inflation,
and what their limitations might be. These are much harder to answer—judgement plays a
much bigger role. We next turn to them, by first examining the (limited) formal empirical
evidence and then by widening the focus to explore broader considerations, including of
a political economy nature.
1. Formal Empirical Evidence on Output and Inflation
While the literature on the impact of unconventional monetary policies on financial

conditions is vast, that on their effect on output and inflation is much more limited. This
largely reflects the difficulties involved.
At the cost of some oversimplification, three types of approaches are possible (Table
20.7). At one end of the spectrum, one can seek to measure directly the effects of the
variables of interest on output and inflation. For instance, for balance sheet policies
one can examine the effect of changes in the size and structure of the central bank’s
balance sheet on output and inflation, typically in a small system of equations that
trace the main regularities in the data. A handful of studies have followed this route,
and found evidence of effects in the desired direction (Table 20.7). A specific problem
with such studies is that the relationship between the variables of interest is bound to
be highly unstable and to exhibit breaks. As the decoupling principle indicates, there
need be no stable link, and definitely no causal link, between the policy rate and the
size and structure of the central bank’s balance sheet. So, any patterns observed in the
period preceding the adoption of balance sheet policies are highly suspect and bound
to change following their implementation. Thus, it is not clear what these studies really
capture.
At the other end, one can follow a theory-based approach. In this case, one embeds a
specific view of how balance sheet policies are expected to work in a general equilibrium
model of the economy and then traces their effect through the system. Recently, some
studies have begun to follow this approach. The corresponding models, however, are
not taken to the data directly, and rely on other information to set the size of the key
parameters (‘calibration’), as in eg, Gertler and Karadi (2013). The results, therefore, are
primarily intended to shed light on the transmission mechanisms involved and are less
useful as a guide to the actual size of the effects. They are best regarded as setting the basis
for more refined empirical work.
An approach that lies somewhere in between is to follow a two-step procedure. One first
maps the specific measures into more traditional variables or ‘shocks’ normally included
in models and econometric work; then, based on this mapping, one traces the effect
on output and inflation. For example, a number of studies have mapped balance sheet
policies into a synthetic (or ‘shadow’) policy rate. The reliability of the method depends
critically on the quality of the mapping. This may be highly problematic. In particular,
the decoupling principle undermines attempts to derive the shadow rate from the size
and structure of the central bank’s balance sheet. The approach is more reliable when the
mapping is simpler (eg when the model already contains a bond rate).
The bottom line is that these results generally have to be taken with more than a
pinch of salt. The more data-dependent methods rely heavily on unreliable extrapolation

Table 20.7 Impact of large-scale asset purchases on output and inflation
Study Country/sample Method Peak impact on output

and inflation
First approach
Kapetanios et al UK (different time Different VARs GDP increases by 1.4%
(2012) periods for each Counterfactual: no 100 bp to 3.6%
VAR, simulations reduction in gilt yields CPI inflation increases
for Sep 2008, by 1.2 percentage
May 2010) points (pp) and 2.6 pp1
Baumeister and US (1965–2011, TVP-SVAR US
Benati (2013) simulations for Counterfactual: no 60 bp GDP growth increases
2009) reduction in 10-year bond by 0.9 pp
yield spread Inflation increases by
0.5 pp2a
UK (1975–2011, TVP-SVAR UK
simulations for Counterfactual: no 50 bp GDP growth increases
2009) reduction in 10-year bond by about 2 pp
yield spread Inflation increases by
about 2 pp2b
Gambacorta et al CA, EA, JP, NO, Panel VAR GDP increases by 1.3%
(2014) SE, CH, UK, Shock: increase in balance to 3.2%
US (Jan 2008– sheet CPI increases by 0.2% to
June 2011) 1.5%3
Weale and US (Mar 2009– Bayesian VAR GDP increases by 0.58%
Wieladek (2015) May 2014) Shock: asset purchase CPI increases by
0.62%4a
UK (Mar 2009– GDP increases by 0.25%
May 2014) CPI increases by
0.32%4b
Hausman and JP VAR and forecast-based QQE contributed 1 pp to
Wieland (2014) counterfactuals GDP growth in 20135
Pesaran and UK (1980 Q3– General autoregressive GDP growth increases
Smith (2012) 2008 Q4, distributed lag (ARDL) by 0.75–1 pp6
1980 Q3–2011 Q2) model
Counterfactual: no 100 bp
reduction in gilt yields
Second approach
Gertler and US (calibrated) DSGE-based counterfactual GDP increases by 3.5%
Karadi (2013) exercise for QE1 Inflation increases by
4 pp7a
DSGE-based simulation of GDP increases by about
QE2 1%
Inflation increases by
1.5 pp7b
Third approach
Chung et al (2012) US FRB/US model simulation GDP increases by about
based on estimates of the 3%

Study Country/sample Method Peak impact on output

and inflation
effect of asset purchases Inflation increases by
(worth $2.6 trillion) on 1 pp8
term premia
Chen, Cúrdia and US (estimated) DSGE-based counterfactual GDP increases by
Ferrero (2012) exercise based on QE2 size 0.13 pp
Inflation increases by
0.03 pp9
Engen et al (2015) US FRB/US model simulation Unemployment
based on estimates of decreases by 1.2 pp
changes in expectations Inflation increases by
for the FOMC policy rule 0.5 pp10
and of the effect of asset
purchases on term premia
1
Average across models (see Table 6).
2a
Difference between troughs of the median of the distribution of the counterfactual paths (see Figure
3).
2b
Difference between troughs of the median of the distribution of the counterfactual paths (see Figure 5).
3
Peak effect on output after a 3% balance sheet expansion is between 0.04% and 0.1%, while peak effect
on prices is between 0.005% and 0.045% (see Figure 3). Since balance sheets over the sample period
increased by about 100%, these numbers are multiplied by 100/3 to obtain estimates in the table (see
Figure 3 and related discussion).
4a,b
Peak impact of an asset purchase worth 1% of nominal GDP (see Figure 2).
5
See the discussion in Section II 6. See Figures 4 and 5.
7a
See Figure 6.
7b
See Figure 1.
8
See Figure 10.
9
Peak impact of a QE2-sized asset purchase as captured by posterior median impulse response (see
Figure 3).
10
See Figure 10.
from previous relationships. And the more theory-based ones are better regarded as
illuminating the mechanisms at work. There is clearly an effect, but its size and stability
are quite uncertain.
2. The Importance of Context and Measure-specific Characteristics
The limitations of the evidence discussed so far are one reason for the widely differing
views concerning the measures’ effectiveness. There is general agreement that central bank
actions, which naturally relied heavily on unconventional policies, were essential during
the crisis management phase. At the time, the measures prevented the financial system
from imploding and dragging down the economy. The steps were simply an extension
of the traditional lender of last resort role, adapted to the specific circumstances. By
contrast, views differ widely concerning the measures’ effectiveness in steering output
and inflation beyond the crisis management phase. In particular, a common impression

is that despite central banks having deployed the tools vigorously and beyond what was
imaginable pre-crisis, output growth has remained disappointing and inflation stubbornly
below objectives.
To help understand this disappointment, we need to delve deeper into the broader
economic context and the specific characteristics of the measures.
Context here largely means the laborious recovery from a balance sheet recession (Borio
(2014a)). The recession ushered in by the financial crisis is less amenable to traditional
monetary policy measures because of the legacy of the previous financial boom. Easier
monetary conditions struggle with an impaired banking system, which obstructs the
transmission of policy and misallocates credit—the basic constraint is capital rather than
liquidity.20 Easier conditions also have a hard time stimulating an overly indebted private
sector, focused on repairing balance sheets rather than spending. And they cannot do much
to correct the misallocation of resources fostered by the boom (Borio, Kharroubi, Upper
and Zampolli (2016)); think, for instance, of idle cranes in a bloated construction sector.
Policymakers can push hard on the accelerator, but they may fail to get the hoped-for
traction.21
The measure-specific characteristics suggest that the tools may be subject to diminish-
ing returns (eg, BIS (2016a)). In some cases, this may reflect the evolution of economic
conditions. For instance, some argue that balance sheet measures are likely to be most
effective when financial markets are segmented and dislocated, so that the authorities’
intervention can help alleviate the corresponding distortions.22 But more generally, there is
clearly a limit to how far risk premia can be compressed, expectations guided and interest
rates pushed into negative territory. As those physiological limits are approached, policy
loses effectiveness and trade-offs worsen.
An obvious such example is the measures’ impact on the financial system’s
profitability, resilience and hence ability to support the economy. We have already
discussed the effect of persistently negative policy rates on banks (eg, Borio et al
(2015)). And such rates, and ultra-low yields more generally, also have a bigger
debilitating effect on insurance companies and pension funds, whose liabilities have
a longer maturity than their assets (eg, EIOPA (2014)). The plight of pension funds
is especially telling. It makes much more transparent the need for households to save
more for retirement, which could weigh down on consumption (Rajan (2013)),23 and
20
This is not to say that the measures cannot help banks in the short term, not least by
generating capital gains. Rather, the point is that over time the real solution is to recognise losses,
recapitalise the institutions and restore underlying profitability—tasks that easy monetary policy
cannot accomplish and may even contribute to delaying.
21
As discussed in detail elsewhere, the heavy reliance on monetary policy post-crisis has
reflected the failure of other policies to take their fair share of the burden. See, for instance, Borio
(2014a) and BIS (2016a).
22
For instance, in Vayanos and Vila (2009), clientele effects (ie limits to arbitrage) are driven by
arbitrageurs’ risk aversion. The higher the risk aversion, the less likely are arbitrageurs to substitute
bonds across different maturities; so that the more segmented the yield curve, the more powerful
quantitative easing is.
23
For instance, a recent survey indicates that only a small percentage of households would
spend more if faced with negative rates and a similar percentage would actually spend less. No
doubt, here confidence effects are at work too. See Cliffe (2016).

for sponsoring companies to replenish any underfunding, which could weigh down on
investment.24
The pension fund example highlights the broader possibility of counterproductive
effects on confidence—hardly captured by the formal macroeconomic models used to
estimate the effects by extrapolating from more normal times. Take, for instance, forward
guidance. Even when it is fully understood and credible, it may have unintended conse-
quences. For, in order to convince markets that interest rates will remain unusually low for
unusually long, the central bank may need to paint a rather bleak picture of the outlook.
Paradoxically, the more credible the central bank is, the larger this effect is likely to be.
Or take negative policy rates. The adoption of such extraordinary measures is unlikely to
convey a reassuring message about the state of the economy, especially to those economic
agents unfamiliar with the typical economist’s way of thinking—thinking in which real
(inflation-adjusted) variables are the only thing that matters for behaviour (Box 20.1).
This analysis points to a couple of conclusions. First, it suggests that, over time, as
the power of the measures through domestic channels diminishes, policy may end up de
facto relying more on exchange rate depreciation—not necessarily by design, but simply
by default. This appears to have happened. It is no coincidence, perhaps, that exchange
rates have been increasingly prominent in central bank statements (BIS (2016a)). Globally,
however, this has presented problems of its own. Depreciation may result in unwelcome
appreciation elsewhere, especially in countries struggling with the similar problems or
worried about strong capital inflows as they seek to constrain the build-up of financial
booms (eg, Borio (2014b), Rey (2013), Bruno and Shin (2012)). Indeed, there is evidence
that large-scale asset purchases have affected not just exchange rates, but also capital
flows and asset prices in other countries (Table 20.8). In turn, unwelcome exchange rate
appreciation can induce other countries to ease policy in order to fend it off. Hence the
frequent references to ‘currency wars’ and ‘competitive depreciations’ (eg Rajan (2014)).
This helps explain why monetary policy has looked unusually easy globally, regardless of
benchmarks (eg, Hofmann and Bogdanova (2012), Taylor (2013), Borio (2016)).
Second, it also suggests that, over time, the balance between the benefits and costs of
the measures deteriorates. The effectiveness tends to diminish, especially as the policy
room for manoeuvre narrows. And any side-effects tend to grow—on the profitability and
resilience of the financial system, on risk-taking in financial markets and on the global
balance of policies (eg, Borio (2014a), Borio and Disyatat (2014)). Ultimately, this may
undermine the credibility of central banks.25
24
The macroeconomic models used nowadays simply assume that lower (real) interest
rates always raise consumption by making consumption today more attractive relative to
consumption tomorrow (the ‘intertemporal substitution effect’). They rule out the possibility
of depressing consumption as agents need to save more in order to get a given income in the
future (the ‘income effect’). See Woodford (2003, Chapter 4) for a discussion of how consump-
tion depends on the expected future path of real interest rates in textbook New Keynesian
models.
25
There is, indeed, some evidence consistent with this view (see BIS (2016a), Chapter IV).
The impact of the measures on output and inflation appears to have declined in some countries
(eg Hesse et al (2017)) while that on the exchange rate has not. Similarly, there is evidence that the
impact of interest rates on lending weakens as they fall to very low levels and squeeze net interest
margins (Borio and Gambacorta (2017)).

BOX 20.1 DELVING INTO NEGATIVE INTEREST RATES AND ‘MONEY

ILLUSION’
It is common in economics to assume that agents’ behaviour is, or at least should be, only a function
of real (ie, inflation-adjusted) variables. This is modelled, in particular, by assuming that they derive
utility exclusively from real variables, such as real incomes, real money balances and the like. It is
also common to treat departures from this assumption as ‘irrational’. For instance, an agent should
be indifferent between receiving the same real income regardless of whether in one case prices have
risen and in the other fallen. If the agent prefers the outcome with a higher nominal income but the
same real income, then he/she is said to suffer from ‘money illusion’ (Fisher (1928)).
Do agents disregard real quantities? Is this necessarily irrational? And what are the implications
for negative interest rates? In what follows we will argue that nominal quantities do appear to matter
over and above real quantities, that this need not be ‘irrational’ but may reflect at least in part the
fundamental role money plays in our economies, and that this has significant implications for the
impact that negative nominal rates may have on behavior.
There is, in fact, a voluminous literature indicating that agents behave as if they had money illu-
sion. The evidence takes a variety of forms. One is surveys designed to tease out money illusion (eg,
Shafir et al (1997), Shiller (1997)). Another is controlled experiments in the form of ‘games’ played
out within groups (eg, Fehr and Tyran (2001), Noussair et al (2008) and references therein) or of a
neurological character, monitoring the brain’s reactions to specific stimuli (Weber et al (2009)). Yet
another is econometric studies, for instance those that examine the behaviour of asset prices, such
as equity (Modigliani and Cohn (1979)), house prices (Brunnermeier and Julliard (2007)) or bonds
(Shiller (2015)). In all of these cases, nominal variables, such as nominal interest rates, appear to
play a role over and above real ones.
The factors that lie behind this type of behaviour are not fully understood. As often argued, psy-
chological biases or cognitive limitations may well be at work. For instance, the price level is in fact
an index computed based on the prices of a basket of goods and services, which are weighted dif-
ferently depending on the intended use. Coming to grips with that concept is more complicated than
dealing with dollars or pounds. But more fundamental factors may also be relevant.
One has to do with the choice of price level. A question to ask is ‘whose price level?’. In a world
in which economic agents differ widely, the general price level need not correspond to anyone’s
needs in particular. It is well known that consumer spending patterns differ greatly, depending on
age, income and the like, that individual producers care about different prices, and so on. The mental
experiments that lie at the heart of money illusion and are embedded in benchmark models ask
‘what would happen if all prices changed by a certain amount?’. Zero inflation in this sense is not
the same as a much more realistic situation in which prices change by varying amounts, including
in opposite directions, and they just happen to cancel out in aggregate for a particular index. In this
second case, some economic agents gain, others lose. In such circumstances, even if agents do
not experience money illusion, they will behave as if they do. Moreover, whenever agents do not
have accurate knowledge of the behaviour of all the relevant prices, it is natural for them to rely more
heavily on nominal rather than real variables.1
Such considerations are likely to be especially relevant in the proximity of price stability, ie when
the aggregate price level, as conventionally measured, rises or falls gradually. In fact, in this case it
is almost a certainty that some prices will rise and others will fall so that, strictly speaking, there is
no general increase (inflation) or decrease (deflation) as envisaged in the standard counterfactual
questions asked in the models and in mental experiments.
A second factor has to do with the critical role money plays as a ‘unit of account’, ie as the unit in
which all prices are measured, contracts are struck, and assets and liabilities denominated. Money
acts as a standard unit of measurement for all the (relative) prices in the economy, greatly reducing
information costs (Brunner and Meltzer (1971)). By quoting all prices relative to the same unit—the
‘numeraire’—the number of price quotes is dramatically cut, with clear efficiency gains. This greatly
simplifies what needs to be known and communicated, much like a standard unit of measurement
helps in other scientific fields and walks of life. Moreover, once the same unit is also naturally used to

denominate deferred cash flow receipts (assets) in contracts, it makes sense to denominate liabilities
in the same unit in order to reduce ‘exchange rate’ risk (Doepker and Schneider (2013)).
Much like, say, it makes sense for oil producers whose revenues are denominated in US dollars
to incur liabilities in the same currency: by so doing, they hedge their risk. In turn, it is natural for the
unit of account and medium of exchange (or settlement) to coincide.
Once contracts as well as assets and liabilities are denominated in nominal terms, then they
take on a life of their own in influencing behaviour. The corresponding nominal ‘inertia’ and ‘rigidities’
are, in fact, a reflection of the deep and pervasive role money plays in our fundamentally monetary
economies.2 The strength of the underlying forces helps explain what would otherwise be a puzzling
phenomenon, ie the limited reach and fragility of indexation mechanisms (Shiller (1997)).
The analysis also sheds light on why nominal interest rates may be relevant for behaviour quite
apart from real interest rates. And it indicates that the instinctive aversion to negative interest rates
has deep roots in how our economies work, rather than being just a sign of irrational behaviour.
Likewise, zero may not just be a point along a seamless continuum, but have a significance of its
own: it marks the difference between receiving something in exchange for the sacrifice of parting
with one’s money and paying for the corresponding ‘privilege’, between encouraging the use of the
unit of account and discouraging it.
One possible implication is that negative rates may adversely affect behaviour in ways that would
not be understood if one reasoned purely in real terms. Regardless of whether inflation is positive
or negative, negative nominal rates are likely to be perceived as a ‘tax’—a more visible one than
associated with inflation, as conventionally measured. This also raises huge communication chal-
lenges for policymakers who resort to them in order to boost inflation. One rationale for adopting
low inflation objectives is precisely to reduce the hidden tax inflation levies on the population, as it
erodes the purchasing power of income and wealth. With negative interest rates put in place in order
to boost inflation, it is as if economic agents were taxed twice. The justification relies on models in
which negative real rates would generate better economic outcomes and whose rationale, therefore,
needs to be convincingly explained.
A second implication is that the prospect of setting interest rates at any negative level as a means
of boosting output would risk backfiring and undermining the functioning of the economy. This option
has been proposed, in particular, to address the debt overhang problem (Rogoff (2014)). More gener-
ally, it is the logical implication of models in which it is only real variables that influence behaviour.
Our analysis points to potentially far-reaching consequences of the prospect of charging a tax of, in
principle, an unconstrained size on the holdings of the settlement medium which, in turn, coincides
with the unit of account.3 This is the medium on which the whole economic edifice is built.
1
Lucas (1972) famously developed a model along these lines, in which agents could only observe
a sub-set of prices (from their ‘information islands’) and hence sought to distinguish general from
relative price changes based on the imperfect information available to them.
2
The depressing effect of persistently negative interest rates on bank profitability in the text is just
one example of the far-reaching effect of these forces.
3
This argument is distinct from the other implications resulting from the mechanisms needed to
implement the measure. One that has attracted much attention is the potential loss of privacy linked
to the elimination of cash (eg Cochrane (2014)).
The combination of context and measure-specific characteristics raises serious exit issues.
On the one hand, it is compelling for central banks to press further on the accelerator in
order to achieve their objectives. Naturally, if inflation remains stubbornly below target,
they may hardly see any alternative. Failing to press further could be viewed as signalling
the measures’ ineffectiveness and that central banks have given up on their mandates.
Markets could then lose confidence in central banks’ ability to deliver and governments
could accuse them of undermining their own policies. The increasingly insistent discussion
of helicopter money, regardless of its inherent merits, is just the latest example of the
incentives at work (Box 20.2). On the other hand, unless the measures do prove sufficient

Table 20.8 Some evidence about the external impact of US monetary policy
Impact of US unconventional monetary policy on foreign asset markets

Study Methodology Dependent variable
∆ Exchange rate ∆ Bond yields ∆ Equities
(pp) (bp or pp) (pp)
Chen et al Announcement –0.821a –79.701b 10.751c
(2012) effects
Fratzscher et al Event study –1.452a –0.062b –0.422c
(2013)
Neely (2015) Event study –21.63a
Rogers et al Event study –74b
(2014)
Gilchrist et al (–2,–13)5b
(2014)
Bowman et al VAR –197b
(2015)
Glick and Event study –3.88a
Leduc (2015)
Impact of US unconventional monetary policy on capital flows
Study Methodology Dependent variable Results
Ahmed and Panel Net private capital LSAPs not significant for total
Zlate (2014) regressions inflows net inflows but positive and significant
for portfolio net inflows9a
A 10 bp fall in the US ten-year
yield associated with LSAPs increases
net portfolio capital flows to EMEs by
about 0.2% of recipients’ GDP9b
Fratzscher et al Event study Inflows into equity Both LSAP announcements and
(2013) and bond operations affect inflows in the US,
funds EMEs and AEs10a
Chen et al Event study Equity and debt Loosening unconventional US monetary
(2014) portfolio policy surprises are associated with
inflows equity portfolio inflows into EMEs11
LSAPs 5 large-scale asset purchases; EMEs 5 emerging market economies; AEs 5 advanced economies.
1a
Announcement effect of QE1 on Asian EME exchange rates, measured as local currency price of 1 US
dollar, so a negative value implies a USD depreciation (see Table IV.1).
1b
Announcement effect of QE1 on Asian EME 10-year bond yields, in basis points (bp) (see Table IV.1).
1c
Announcement effect of QE1 on Asian EME equity prices (see Table IV.1).
2a
Impact of QE1 announcement on the exchange rate return viz other AEs. A negative value means a
depreciation of the USD (see Table 6, column 3, first row).
2b
Impact of QE1 announcement on 10-year bond yields in AEs, in percentage points (pp) (see Table 5,
column 9, first row).
2c
Impact of QE1 announcement on the equity return in AEs (see Table 5, column 3, first row).
3a
Cumulative response of foreign long-term yield changes to US policy announcements over event windows
4b
Average ten-year foreign yield intradaily change following a 25 bp decline in the US 10-year yield,

in bp (see Table 6, column 1, average over UK Gilt, Italian ten-year, German ten-year and Japanese
ten-year).
5b
Minimum and maximum response of ten-year foreign yields (two-day change) to an unanticipated easing
of unconventional monetary policy, in bp (see Table 3 and the discussion in Section 3.1).
6b
Maximum impact of a shock that lowers US ten-year yields by 25 bp on an index of 10-year EME yields,
in bp (see Figure 2, first row, first column).
7b
Impact of a 100 bp US unconventional monetary policy long-term path surprise on the trade-weighted
value of the dollar, in pp, within a 60-minute announcement window (see Table 3 and the discussion in
footnote 13). A negative value corresponds to a depreciation.
8a
Impact of a one percentage point long-term path surprise during the unconventional period, in percent. A
negative value corresponds to a depreciation. See Table 3 and the discussion in Section 3.2.
9a
Suggests LSAPs affected composition rather than volume of flows. See Table 7 and the discussion in
Section 4.2.3.
9b
See Table 8 and the discussion in Section 4.2.3.
10a
QE1 announcements, for example, are associated with inflows into US equity (and bond) funds and
outflows from EME- and other AE-based equity (and bond) funds (Table 4, first row). The same is true
of liquidity-supplying operations (Table 4, third row). MBS purchases, on the other hand, resulted in net
inflows into bond funds of all three regions, and net outflows from US equity funds (Table 4, last row).
QE2 announcements and the related purchases of Treasuries, on the other hand, led to outflows from US
bonds and equities and inflows into EME equities (Table 4, second and fourth rows).
11
See Table 2 (third row).
or other factors come to the rescue, sooner or later their limitations would become fully
apparent. The consequences would be similar. The market turbulence in February 2016,
seemingly exacerbated in part by a loss of confidence in central banks’ powers, highlights
the dilemmas involved (BIS (2016b)). Markets’ dependence on central bank support is hard
to shake off (eg, El-Erian (2016)). And even short of such loss of confidence and cred-
ibility, the narrowing room for policy manoeuvre would make it harder to address the next
recession, whenever it arises, unless central banks manage to ‘reload the gun’ ahead of time.
3. The Political Economy
Unconventional monetary policy measures also raise delicate political economy issues.26
Here, we focus on two—the policies’ perceived impact on inequality and the complications
linked to balance sheet measures.
It has long been recognised that monetary policy has an impact on income and, in
particular, wealth distribution. The policy’s incidence differs across segments of the
population, depending on their sources of income, the amount and structure of their
wealth, and their exposure to unemployment. To cite probably the best-known case, the
differential impact between debtors and creditors has been analysed extensively by those
exploring the political economy of monetary policy.
At the same time, as long as economic performance is satisfactory and monetary policy
measures evolve within a narrow range, these issues can easily fade into the background.
This is very much what happened pre-crisis, during the period of the so-called Great
Moderation, as growth was generally strong and inflation low and stable.
26
In order to keep the chapter manageable, we do not discuss those that arise in the context of
credit policies during the management of crises, involving the role of central banks in emergency
liquidity provision. Rather, we focus on the deployment of tools in the performance of traditional
monetary policy functions.

BOX 20.2 UNDERSTANDING ‘HELICOPTER MONEY’
As central banks have been testing the limits of unconventional monetary policies, many observers
have started to consider other possible options. One that has been gaining ground is ‘helicopter
money’ (Friedman (1969)) or, more soberly described, ‘overt money finance’ of government deficits
(Turner (2013)). How is it supposed to work and differ from what central banks have done so far, by
purchasing government debt and ‘financing’ it by increasing bank reserves?
There is broad agreement that helicopter money is best regarded as an increase in the nominal
purchasing power of economic agents in the form of a permanent addition to their money balances
(Bernanke (2003)). Functionally, and communication aside, this is equivalent to an increase in the
government deficit that coincides with (is financed by) an equivalent and permanent increase in
non-interest bearing central bank liabilities. Thus, on the financing side, the main difference with
central bank government asset purchases financed by issuing non-interest bearing bank reserves
discussed in the text is that it is intended and perceived to be a permanent, rather than reversible,
operation (eg Woodford (2012), Reichlin et al (2013)). The central bank credibly commits never to
withdraw the increase in the reserves.
There is also general agreement that how the nominal expansion will be split between increases
in the price level and in output depends on the broader features of the economy, notably how much
prices are allowed to adjust (‘nominal rigidities’). But, regardless of the split, in the models typically
used to analyse the operation, permanent monetary financing boosts nominal demand more than
temporary monetary financing because it relaxes the (consolidated) government sector intertem-
poral budget constraint. This is the budget constraint that cancels out the claims and liabilities
between the government and the central bank. Less debt finance means lower interest payments,
forever. Even if the government issued its debt, if this was purchased by the central bank which, in
turn, issued non-interest bearing bank reserves, the consolidated government sector would incur a
lower interest debt service burden. All else equal, this saving would boost nominal demand, as no
additional taxes would need to be raised.
But is this argument correct? In what follows we will argue that the analytical models used to
address this question fail to appreciate that either helicopter money results in interest rates perma-
nently at zero—an outcome no one regards as desirable—or else it is equivalent to either debt- or
tax-financed government deficits—in which case in the models it would not produce the desired
additional expansionary effects (Borio, Disyatat and Zabai (2016)). This arises because the models
fail to distinguish between cash and bank reserves and abstract from the intrinsic features of the
demand for bank reserves and the ‘decoupling principle’ discussed in the text.
The tricky part here is the ‘permanent’ element of the financing. We will next show that unless
the central bank sets the interest rate permanently at zero, it has only two options to implement the
desired expansion in reserves. Either it pays interest on reserves at the policy rate—but then this is
equivalent to debt financing from the perspective of the consolidated public sector balance sheet, as
there are no interest savings—or else the central bank imposes a non-interest bearing compulsory
reserve requirement—but then this is equivalent to tax-financing, as someone in the private sector
must bear the cost.1 Either way, the additional boost to demand will not materialise.
The reasoning is simple. Graph A illustrates in a stylised way how the policy rate is set in the
market for bank reserves (Borio and Disyatat (2010)). Banks hold reserves for two main reasons: (i)
to meet any reserve requirement; and (ii) to provide a cushion against uncertainty related to payment
flows. At the same time, holding reserves implies an opportunity cost. Banks forego the possibility
of lending funds in the overnight interbank market—where they can earn i—but they obtain the rate
at which reserves are remunerated, i^d (ie the rate on the deposit facility). Since payment system
arrangements effectively do away with end-of-day settlement uncertainty, when the opportunity cost
i-i^d is positive, the amount of reserves demanded for settlement purposes in excess of the reserve
requirement (excess reserves) is very interest-inelastic, ie, in effect vertical—vertical portion of the
demand schedule.2 As a result, in order to voluntarily hold any amount in excess of the requirement,
the opportunity cost of doing so must be zero, ie, banks need to be indifferent between holding these
balances and lending them overnight. This means that the rate they can get in that market must be
equal to what they earn on the excess balances—horizontal portion of the demand curve.

Thus, what is critical for achieving the interest rate target is how excess reserves are remunerated
and where the central bank sets the supply of bank reserves, ie on which portion of the demand
curve for bank reserves it decides to operate.
There are two possible schemes. In the first (Scheme 1), the central bank decides to set the
policy rate above the remuneration on its deposit facility, if present, or zero, if absent. Let R_min^.
be the compulsory reserve requirement. In this case, the central bank must first supply the amount
of reserves R_0^s and can then set the policy rate, i^*, anywhere it wishes on the vertical segment
of the demand curve (by eg, signalling or carrying out an operation at that rate). The Reserve Bank of
Australia used to operate this way (Figure 20.5, centre panel).
What happens if the fiscal deficit is money financed in this case? Assume that the deficit is
increased by an amount R_1^s-R_0^s so that the supply of bank reserves shifts to R_1^s. Then,
the interest rate falls to zero and, if the increase is supposed to be permanent, it stays there, forever.
If the central bank wishes to avoid that outcome and, at some point, wants to raise the policy rate
again, it has only two choices. The first is to remunerate excess reserves at the policy rate, so that
the rate on the deposit facility, i^d, becomes key. If so, it then operates on the horizontal segment
of the demand curve (Scheme 2). This is, for instance, how the Reserve Bank of New Zealand
implements policy. But this means higher interest expenses for the government, with no budgetary
savings. Alternatively, the central bank may raise non-remunerated required reserves to R_1^s, so
continuing to operate under Scheme 1. But this is equivalent to imposing a tax on the banking system,
and hence the private sector generally, for the same amount. The tax could result, for instance, in a
higher intermediation margin.
The reason why the models do not bring this out is because they omit a realistic determination
of the nominal interest rate. A typical approach is to abstract from bank reserves altogether and to
assume that a demand for money (think of it as cash) that increases smoothly as the interest rate
declines. This means that the interest rate will be positive unless the amount of money reaches a
maximum amount (‘satiation point’), at which point the rate declines to zero. Thus, for instance, as
the monetary financing of the government deficit increases, the interest rate falls but it does not
reach zero over the relevant range.3 In other models, the demand is simply a function of nominal
income (eg, a cash-in-advance constraint), and the interest rate is set separately (eg, Krugman
(1998)). Again, this is more easily rationalised if we think of money as cash (or non-interest bearing
bank deposits) rather than bank excess reserves, which do not depend on either the price level
or income. In fact, in real life central banks meet entirely passively the public’s demand for cash,
which therefore does not influence the setting of the interest rate. If they did not, either the amount
in excess of desired balances would end up with the banks, and effectively be switched into excess
reserves, or if would fall short of the demand, frustrating the public, which would presumably turn to
alternative means of payment.
This analysis suggests a number of further observations. First, the prevailing models used to
justify helicopter money imply that the price of a more expansionary monetary policy is actually
giving up on monetary policy forever. Once the models are complemented with a realistic interest
rate-setting mechanism, a permanent money-financed fiscal programme with the desired budgetary
savings can only be implemented by giving up on monetary policy forever.
Second, for much the same reasons, short of permanent financing, these models would suggest
a rather limited additional expansionary impact of monetary financing.
Third, all this excludes the ‘choreography’ of helicopter money and transmission mechanisms not
included in the models. In particular, what would the impact of more overt, if still temporary, financ-
ing be? This is harder to tell. The impact on confidence is quite unpredictable. Some argue that it
would be positive (eg Turner (2013)). But it might equally be negative, except perhaps in the short
run. The measures could convey the sense that the economic situation is quite gloomy and requires
exceptional steps. Moreover, any impact would be temporary unless the operation was repeated
over and over again in size.
And therein lies the danger: this could raise questions about the broader institutional implications,
including the de facto subordination of monetary to fiscal policy, with unpredictable consequences.
Indeed, as widely recognised, the policy obviously undermines central bank independence. This
is why proponents typically explore ways in which co-ordination could be constrained by rules and
by the central bank’s decisional autonomy. In fact, central banks are generally not allowed to credit

Reserves are remunerated at a rate below the policy rate (Scheme 1) or at the policy rate (Scheme 2) Graph A
The market for bank reserves1 Scheme 1: Australia Scheme 2: New Zealand
CONTI-BROWN 9781784719210 PRINT.indd 436

7 2.0 10 10
rate, i
Interbank
Reserve 1.7 8 8
demand 6
* S1
i 5 1.4 6 6
Percent
Percent
AUD bn
AUD bn
id 4 1.1 4 4
S2
Reserve
supply 3 0.8 2 2
436
2 0.5 0 0
s reserves, 03 04 05 06 07 03 04 05 06 07 08 09
Rs = Rmin R
R
Lhs: Lhs: Overnight cash rate
The central bank chooses the target rate i *,
Cash rate Lending facility Rhs: Bank reserves
the deposit rate i d, the reserve requirement
Rmin ≥ 0 and the reserve supply Rs. Cash rate target Deposit facility
Rhs: Balances
Note:
1 Each dot indicates an equilibrium. Under Scheme 1 (S1), excess reserves are remunerated at a rate below the policy rate. The equilibrium rate
equals the policy rate, i = i *, and the quantity of reserves equals the reserve requirement, R = Rmin. Under Scheme 2 (S2), the deposit rate equals
the policy rate, i d = i *. The equilibrium rate equals the policy rate, i = i *, and the quantity of reserves is pinned down by the reserve supply, R = Rs.
Sources: Reserve Bank of Australia; Reserve Bank of New Zealand.
Figure 20.5 An illustration of equilibrium in the market for bank reserves
Claudio Borio and Anna Zabai - 9781784719227

Downloaded from Elgar Online at 02/14/2020 08:27:28AM
19/04/2018 13:04
citizens’ accounts directly (eg Grenville (2013)), in the process reducing their own equity capital and
putting their financial strength at risk. The reason is that the transfer, as opposed to its financing, is a
quintessential fiscal task. Sooner or later, the perception of fiscal dominance could indeed erode the
value of money, but at the cost of losing the public’s confidence in monetary institutions, so painfully
gained over the years. If so, it would be Pyrrhic victory.
1
Turner (2013) explicitly sees permanent overt money finance as a way of avoiding the unwelcome
consequences of low interest rates, such as excessive risk taking, encouraging more debt, etc. He
makes only a passing reference in a footnote to higher reserve requirements as needed to avoid
preventing an offsetting liability in the consolidated public sector balance sheet; but he does not
assimilate it to a tax. In his latest book, he stresses that higher requirements are desirable in order
to slow down credit expansion (Turner (2016)). This, however, is another issue and does not affect
the previous discussion.
2
For simplicity, here we avoid the complications that arise when reserve requirements have aver-
aging provisions, which do not really affect our argument. For the details, see Borio (1997).
3
Buiter (2014) argues that even when the rate is zero to start with, permanent increases in money
financing will increase nominal aggregate demand. This is because he assumes that money—not
just the additional income transfer—is valuable by itself and this will induce agents to spend more
(money is included in the agent’s utility function with these properties). This, however, at most applies
to cash and not to excess reserves. Moreover, the central bank simply meets the demand for cash
passively. If it tried to issue more, in all probability this would simply lead the public to shift into bank
deposits and banks, in turn, to ask for the central bank to replace the excess cash with more conveni-
ent electronic entries on their books.
Things have changed post-crisis. On the one hand, the financial crisis has put the spotlight
on the growing inequality that had been developing for decades (eg, Piketty (2014)). On
the other hand, the extreme monetary policy settings have focused attention on central
banks’ role, not least given their greater and explicit reliance on boosting asset prices and
given the impact of persistent exceptionally low interest rates on savers. Not surprisingly,
central banks have been drawn into the debate (eg Yellen (2015), Draghi (2015), Mersch
(2014) and Haldane (2014)). Once again, the genie is out of the bottle.
Formal evidence on the impact of monetary policy on inequality is limited. To illustrate
the issues involved, we draw on a recent study by Domanski et al (2016), which considers
the link between monetary policy and wealth distribution. Through a set of simulations
based on household surveys, the study concludes that wealth inequality—as measured
by the difference between the wealth of the eightieth and twentieth percentiles in the
distribution—has increased post-crisis. The impact of monetary policy is harder to pin
down. But given typical portfolio configurations, it tends to raise inequality by boosting
equity prices but may lower it by boosting house prices. France and, especially, Germany
are exceptions in this respect, since the twentieth percentile holds a smaller proportion
of its wealth in both equities and real estate than the eightieth percentile. In these cases,
inequality increases on both counts.
This illustration highlights the communication challenges central banks face. The direct
impact of policy on asset prices, especially equities, is quite visible. And if one focuses on
the richest (eg, the top one percent) and poorest segments of the population, it is hard to
argue that policy does not raise wealth inequality. The defence has to rely on the argument
that policy is sufficiently effective in boosting output and employment—a key source of
income and, over time, wealth (eg, Bernanke (2015), Mersch (2014)). But, regardless of its
merits, it is politically difficult to counter an argument based on immediate observation
with one based on a counterfactual.

The challenges balance sheet policies raise are at least as tough. They ultimately derive
from a simple fact: central banks have a monopoly over interest rate policy (the policy
interest rate) but not over balance sheet policy (Borio and Disyatat (2010)). Almost any
balance sheet policy can, or could be, replicated by the government; conversely, any bal-
ance sheet policy has an impact on the consolidated government sector balance sheet.
Balance sheet policy needs to be viewed as part of this larger balance sheet. For example,
the central bank may purchase long-term bonds, but its efforts could be frustrated if
government debt managers lengthened maturity in order to lock in unusually low yields
(eg, McCauley and Ueda (2009), Borio and Disyatat (2010) and Turner (2011)). Likewise,
the government could directly intermediate funds, by borrowing in the market in order to
carry out credit policies without involving the central bank.
This helps explain why balance sheet policies have a quasi-fiscal character and blur the
line between the government and the central bank. If the central bank engages actively
in credit policies, it may be criticised for favouring one set of borrowers over another—a
concern especially acute in the United States. And if it purchases government paper on a
large scale it may be criticised for financing the government—a common concern in some
European countries. In the euro area, these problems are exacerbated by the co-existence
of sovereigns with differing credit quality, so that purchases inevitably have distributional
implications across countries.
All this puts a premium on co-ordination and raises deeper questions about central
bank independence. For one, it is not entirely clear what instrument independence means
in the case of balance sheet policies, given the close interrelationships between central
bank and government measures and the lack of exclusive control over the instruments.
More generally, extensive reliance on balance sheet policy may also threaten the central
bank’s operational independence in interest rate policy.
A key channel relates to the financial risks the central bank faces. As discussed earlier,
balance sheet policy typically involves large increases in the central bank’s balance sheet.
Purchases of long-term debt raise duration, and hence market, risk; credit policies, in
addition, generate credit risk.27 To be sure, various mechanisms have been used to reduce
credit risks (eg, collateral, government guarantees against credit losses or indemnifica-
tion). And the relevance of these reputational and budgetary risks is country-specific,
varying with institutional and cultural factors. Even so, this does not make them less
relevant.
Should one care about operational independence per se? No doubt, operational inde-
pendence is only a means to an end. But experience suggests that it has a habit of coming
under threat precisely when it is most valuable. And loss of independence may also go
hand-in-hand with a loss of legitimacy and credibility of the institution.
27
These risks are even larger in the case of exchange rate policies, given the typical range of
fluctuations in exchange rates.

V. CONCLUSION
Originally, the monetary policy measures central banks adopted in the wake of the
financial crisis were regarded as unconventional; almost a decade on, they have become
commonplace.
We have argued that this development is a risky one. Unconventional monetary policy
measures, in our view, are likely to be subject to diminishing returns. The balance between
benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political
economy problems loom large. Short-term gain may well give way to longer-term pain.
As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with
the next recession, which will inevitably come. The overall pressure to rely on increasingly
experimental, at best highly unpredictable, at worst dangerous, measures may at some point
become too strong. Ultimately, central banks’ credibility and legitimacy could come into
question.
In many respects, of course, extensive reliance on unconventional monetary policies is
not so much the cause but the effect of deeper fault lines. One, discussed here, is the nature
of the recession and subsequent recovery ushered in by the financial crisis. Another is the
unbalanced post-crisis policy mix, which left monetary policy to carry the bulk of the
burden (BIS (2016a)). Yet another one has to do with the forces that have kept inflation
stubbornly low and below targets—forces that are not fully understood and have drasti-
cally narrowed central banks’ options (eg, BIS (2014)). But a final one is arguably the
less than fully adequate character of current monetary policy frameworks—frameworks
focused on short-term inflation control and that struggle to take financial stability
systematically into account, despite its potentially huge macroeconomic costs (eg, Borio
(2016)). But this, important as it is, is another story.
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21. Central banks and payment system risks:
comparative study
Benjamin Geva*
I. INTRODUCTION
This chapter examines the role of central banks in addressing risks in payment systems.
Part II is an overview of payment systems and traditional central banking. Part III
outlines the policy discussion that led to fastening the role of payment system risk
regulator on central banks. It further endeavours to draw the line on central banks’ role
in addressing payment system risks and financial stability in general. Part IV proceeds to
discuss legislation in the United Kingdom, Canada, South Africa and Australia governing
central banks’ powers in relation to payment system risks.
The chapter is a sequel to my earlier article on central banks and financial stability.1
Besides adding a few updates it narrows the focus to the national payment and settle-
ment system and in this context expands on the comparative discussion, and revises the
analysis. In the process, I highlight the role of the central bank in addressing payment
system risks as a distinct component of its broader role in guarding financial stability.
Against this conclusion, Part V assesses the efficacy of legislation in the four countries
under discussion.
II. PAYMENT SYSTEMS AND CENTRAL BANK’S FUNCTIONS
Broadly speaking, a national payment system refers to an entire scheme consisting of

institutions, arrangements and rules facilitating monetary payments in a country, as well
as into and out of it, usually in the currency that the country has adopted.2 To that end,
the modern payment system has been described to consist of ‘a complex set of arrange-
* For research assistance at the final stages of the preparation of this chapter, I am grateful to
Leonidas Mylonopoulos and Janet Tong, respectively of the 2016 and 2017 graduating classes of
Osgoode Hall Law School. Views expressed in this article—as well as all errors—are solely mine.
1
B Geva, ‘Systemic risk and financial stability: the evolving role of the central bank’ 2013(10)
JIBLR 403.
2
Said currency is referred to as the ‘national currency’ or ‘official currency’ of the country.
It is the unit of account in which prices are set and domestic payments are to be made. Coins and
banknotes (‘currency’) denominated in that unit of account are usually ‘legal tender’, in which (in
the absence of agreement to the contrary) a debtor may pay and which a creditor must accept in
discharge of private and public debts. Typically, the central bank is the guardian of the value of that
unit of account, the issuer of coins and banknotes denominated in it, and the depositary of domes-
tic banks’ reserve or settlement accounts in that unit of account. ‘Currency’, ‘national currency’
and ‘legal tender’ are defined (albeit incompletely), eg, in BA Garner (ed in chief), Black’s Law
Dictionary, 9th edn (St Paul, MN: West, 2009) at 440 and 979. For more satisfactory definitions
445

ments involving such diverse institutions as currency, the banking system, clearing houses,
the central bank, and [possibly] government deposit insurance.’3
The present discussion refers to the payment system insofar as it relates to non-cash
payments taking place through the intermediation of banks.4 The operation of such a
payment system consists of messaging, clearing and settlement. Messaging of payment
orders is an activity that takes place in both the customer and interbank domains. Both
clearing and settlement are interbank activities. Clearing is the interbank processing of
payment orders and the establishment of amounts owed by and to banks. Settlement is
the interbank payment of such amounts. The clearing and settlement activity may be said
to take place over an interbank payment system. Typically, in a national payment system,
settlement, if not for all banks, then at least for all large banks acting for themselves and
for correspondent small banks, mostly happens on the books of the central bank acting in
its capacity as ‘banker’s bank’. A national payment system over which non-cash payments
take place can be described as a pyramid.5 Its base consists of customers having accounts
with either small or large banks. A few large banks (‘direct clearers’) have accounts on
the books of the national central bank (the apex of the pyramid) where they settle. Each
of the numerous small banks (‘indirect clearer’) has an account with a large bank acting
as its correspondent.6
The central bank’s liability is the safest settlement asset. Hence, in holding settlement
accounts for large banks, the central bank already goes a long way in contributing to risk
reduction.7 Besides safety and risk reduction, other reasons for a central bank to act as set-
of ‘legal tender’, visit <http://www.merriam-webster.com/dictionary/legal%20tender> or <http://

en.wikipedia.org/wiki/Legal_tender#cite_note-0>.
3
MS Goodfriend, ‘Money, Credit, Banking, and Payment System Policy’ in DB Humphrey,
The US Payment System: Efficiency, Risk and the Role of the Federal Reserve (Boston: Kluwer
Academic Publishers, 1990), at 247. The qualification of the ‘government deposit insurance’ in the
text is mine, since this element is not universally present.
4
Throughout this chapter, ‘bank’ is loosely used to broadly mean any deposit-taking institu-
tion or even any regulated financial institution receiving and carrying out payment instructions
from and for the public.
5
For this imagery, see EG Corrigan, ‘Luncheon Address: Perspectives on Payment System
Risk Reduction’ in DB Humphrey (ed), The US Payment System: Efficiency, Risk and the Role
of the Federal Reserve (Boston: Kluwer Academic Publishers, 1990) at 129, 130; HI Blommestein
and BJ Summers, ‘Banking and the Payment System’ in BJ Summers (ed), The Payment System –
Design, Management and Supervision (Washington: International Monetary Fund, 1994) 15, at
27; and BJ Summers, ‘The Payment System in a Market Economy’ in BJ Summers, ibid, at 1, 5.
The direct-indirect clearer terminology for large and small banks, respectively, is from Canadian
Payments Association By-law No. 3 — Payment Items and Automated Clearing Settlement System,
SOR/2003-346, at s 1.
6
While this is the most common architecture, there is an alternative model under which the
small banks also maintain their accounts with the central bank, even as their payment activity is
cleared on their behalves by large banks.
7
Committee on Payment and Settlement System (CPSS), Core Principles for Systemically
Important Payment Systems (Basel: BIS, January 2001) [hereafter: SIPS Report]. Available online:
<http://www.bis.org/cpmi/publ/d43.pdf>. See Principle VI, under which ‘[a]ssets used for settle-
ment should preferably be a claim on the central bank; where other assets are used, they should
carry little or no credit risk and little or no liquidity risk.’ It is fully discussed in the SIPS Report,
ibid, at 34–36.

Central banks and payment system risks: comparative study 447
tlement agent for a payment system are service assurance (even in circumstances of severe
financial stress), competitive neutrality, efficiency, and emergency liquidity provision as a
last resort. Counterarguments, however, include competitive distortion, some inevitable
exposure to direct risk, and moral hazard. Therefore:
[i]n deciding when to act as settlement agent . . . the [central bank] needs to balance these vari-
ous considerations in the context of [its] three Core Purposes which are to maintain monetary
stability, to maintain the stability of the financial system, and to maintain the effectiveness of
financial services in the [country].
Hence, it is only for the ‘significantly important payment systems’ that it is essential for a
central bank to act as a settlement agent.8 As a rule, it is the large banks which settle for
such a payment system.
Over the accounts on its books, a central bank carries out its main mandate as a
conductor of the national monetary policy, fulfills its task as a lender of last resort, and
serves as a banker to commercial banks as well as to the government.9 To effectively carry
out these tasks, a robust and well-functioning interbank payment system is needed and
has evolved. It is from this perspective that payment systems are said to form ‘the founda-
tion on which central banks’ core functions are built’ and are further described as ‘the
bridge between [such functions], for a breakdown of the payment system would inevitably
disrupt both monetary and financial stability.’10 Maintaining both stabilities constitutes
‘[t]he modern objectives of central banks’ that ‘developed from their early roles in the field
of payment systems.’11
To distinguish it from the customer domain, the interbank domain, consisting of
clearing and settlement, is referred to as a ‘clearing and settlement system’ and pos-
sibly, as an abbreviation, a ‘settlement system.’ In its broad sense, ‘payment system’
encompasses both the ‘clearing and settlement system’ and the customer domain. At
the same time, to stress the distinction between the customer and interbank domains,
the entire ‘payment system’ is often referred to as ‘the payment and settlement system.’
The central bank’s interest lies in the entire payment activity in the economy, and hence
8
Bank of England, Bank of England Settlement Accounts (November 2002), at 5. ‘Significantly
important payment systems’ must be taken to mean ‘systemically important payment systems’
discussed further below.
9
The ‘classic’ fourfold functions of a modern central bank are said to be: (i) acting as a man-
ager of the National Debt and banker to the government; (ii) regulating the currency; (iii) serving
as a banker’s bank; and (iv) acting as a lender of last resort. See EV Morgan, The Theory and
Practice of Central Banking 1797–1913 (New York: AM Kelly, 1965, reprint of 1943 edition) at 1.
10
AG Haldane and E Latter, ‘The role of central banks in payment systems oversight’ (2005)
45 Bank of England Quarterly Bulletin 66, at 67.
11
Sir John Gieve, Deputy Governor, Financial Stability, Bank of England, in his Foreword to
Mark Manning, Erlend Nier and Jochen Schanz (eds), The Economics of Large-value Payments and
Settlement: Theory and Policy Issues for Central Banks (Oxford: Oxford University Press, 2009).
He further observed that, at present, ‘central banks . . . continue to provide the ultimate settlement
asset’ and ‘exert influence through ownership, operation, and oversight of key components of the
financial infrastructure.’ He went on to identify the introduction of same-day finality in payment
and securities settlement systems as ‘[t]he most fundamental change in recent times’ against which
policymakers ‘have to ensure that settlement risk remains contained.’

in the ‘payment system’ as a whole, and yet primarily, in ‘the clearing and settlement
system.’
A payment system can be characterized as either retail or large-value. A retail payment
system typically handles a large volume of relatively low-value payments. It may be
operated either by the private sector or the public sector, using a multilateral deferred net
settlement (DNS) or, less frequently, a real-time gross settlement (RTGS) mechanism. A
large-value payment system typically handles high-value and high-priority payments. It is
usually operated by central banks, using an RTGS or equivalent mechanism.12
The central bank ‘generally plays a variety of essential roles in the payment system. It is
an operator, an overseer in core payment arrangements, a user of payment services and a
catalyst for system reform’.13 For its part, ‘[o]versight of payment and settlement system’
is said to promote ‘the objectives of safety and efficiency . . . by monitoring existing and
planned systems, assessing them against these objectives and, where necessary, inducing
change.’14
III. PAYMENT SYSTEM RISKS AND THE CENTRAL BANK
The Committee of Payment and Settlement Systems (CPSS)15 of the Bank for International
Settlement (BIS) observed that ‘[s]afe and efficient payment systems are critical to the
effective functioning of the financial system.’16 Accordingly, it concluded that ‘[r]obust
payment systems are . . . a key requirement in maintaining and promoting financial
stability.’17 To that end, Manning, Nier and Schanz opined that, as guardians of financial
stability, ‘central banks take an interest in the smooth functioning of the financial infra-
structure as a whole’ and thus ‘typically take a particularly strong interest in the identifica-
tion and mitigation of [all such] risks that might disrupt settlement in the Large Value
Payment System, in which ultimate settlement occurs across the central banks’ books.’18
For their part, measures to achieve financial stability are not limited to payment and
settlement systems. Rather, financial stability is ‘a broad and discretionary concept that
generally [refers] to the safety and soundness of the [entire] financial system and to the
12
CPSS and Technical Committee of the International Organization of Securities Commissions
(IOSCO), Principles for financial market infrastructures (Basel: Bank for International Settlement,
Steering Group co-chairs: WC Dudley, M Kono and K Casey, April 2012), at 8 [hereafter: FMI
Report]. Available online: <http://www.bis.org/publ/cpss101a.pdf>.
13
Committee on Payment and Settlement Systems (CPSS), General guidance for national pay-
ment system development (Basel: Bank for International Settlements, Working Group Chairman:
S O’Connor, January 2006), at 1. Available online: <http://www.bis.org/cpmi/publ/d69.pdf>.
14
Committee on Payment and Settlement Systems (CPSS), Central bank oversight of payment
and settlement systems (Basel: Bank for International Settlements, Working Group Chairman: M
Andersson, May 2005), at 1 [hereafter: Central Bank Oversight Report]. Available online: <http://
www.bis.org/publ/cpss68.pdf> (emphasis added).
15
Recently renamed (under a revised charter) Committee on Payments and Market Infrastru
ctures (CPMI). See Press Release dated 1 September 2014. Available online: <http://www.bis.org/
press/p140901.htm>.
16
SIPS Report, supra n 7, at 1.
17
Ibid.
18
Manning, Nier and Schanz, supra n 11, at 41–42.

stability of the payment and settlement systems.’19 To address risks to financial stability,
‘macro-prudential’ regulation focused on preventing or safeguarding against systemic
risks20 is required. In this broad concept, systemic risk21 is ‘a risk of disruption to financial
services that is caused by an impairment of all or parts of the financial system and [which]
has the potential to have serious negative consequences for the real economy.’22
The central bank’s role in maintaining financial stability is universally recognized even
if the exact scope of its role, and its relationship with the role of other regulators and
supervisors, are contested.23 This subject is discussed elsewhere in this volume. At the
same time, as was pointed out, it is specifically recognized that financial stability ‘also
[refers to] the smooth operation of the payment systems.’24 The central bank’s role in
relation to this component of financial stability is the subject of this chapter.
At a minimum, a central bank is able, ‘in the event of financial stress, to supply emer-
gency liquidity to certain participants in a payment and settlement system in an attempt
to encourage the orderly settlement of transactions in the overall financial system.’25
However, more broadly, in addressing the supervisory, operational and policy setting
responsibilities of central banks in relation to the national payment system, Spindler and
Summers spoke of a ‘direct linkage [that] exists between the payment system and the
execution of monetary policy.’ They further pointed at the ‘important two-way interac-
tion [which] exists between the payment process and the stability of the banking and
19
Rosa M Lastra, International Financial and Monetary Law, 2nd edn (Oxford: Oxford University
Press, 2015) at 126. Emphasis added. See in general: DW Arner, Financial Stability, Economic Growth,
and the Role of Law (Cambridge: Cambridge University Press, 2007) at 72; G Shinasi, ‘Responsibility
of Central Banks for Stability in Financial Markets’, IMF Working Paper WP/03/121 (June 2003),
at 4 (a point with which Arner, ibid, agrees at 72); G Shinasi, Preserving Financial Stability (IMF,
September 2005), at 2, available online: <http://www.imf.org/external/pubs/ft/issues/issues36/ei36.
pdf>; M Foot, ‘What is financial stability and how do we get it?’ The Roy Bridge Memorial Lecture
(UK, Financial Services Authority, 3 April 2003), at para 16, available online: <http://www.fsa.gov.
uk/library/communication/speeches/2003/sp122.shtml>; WF Duisenberg, ‘The Contribution of the
Euro to Financial Stability’ in Christa Randzio-Plath (ed), Globalization of financial Markets and
Financial Stability – Challenges for Europe (Baden-Baden: Nomos Verlagsgesellschaft, 2001) 37, at
38. For a collection of essays on the broader economic and financial aspects of financial stability,
see A Dombret and O Lucius (eds), Stability of the Financial System: Illusion or Feasible Concept?
(Cheltenham, UK and Northampton, MA, USA: Edward Elgar, 2013).
20
Marc Labonte, ‘The Dodd-Frank Wall Street Reform and Consumer Protection Act:
Systemic Risk and the Federal Reserve’, CRS Report to Congress (27August 2010), at 2. Available
online: <http://www.llsdc.org/assets/DoddFrankdocs/crs-r41384.pdf>.
21
See, eg, JW Crow, A Bank for All Seasons: The Bank of Canada and the Regulatory Challenge
(e-brief). (Toronto: CD Howe Institute, June 2009), at 1. Available online: <http://www.cdhowe.
org/pdf/ebrief_82.pdf> [Hereafter: Crow, Bank for All Seasons].
22
See Jaime Caruana, ‘Systemic risk: how to deal with it?’ (BIS, February 2010), quoting from
‘Guidance to assess the systemic importance of financial institutions, markets and instruments:
initial considerations’ (October 2009). Available online: <http://www.bis.org/publ/othp08.htm>.
23
For example, contrast Crow, Bank for All Seasons, supra n 21, together with J Crow, Seeking
Financial Stability: The Best Role for the Bank of Canada, Commentary No. 369 (Toronto: CD Howe
Institute, December 2012) and P Jenkins and G Thiessen, Reducing the Potential for Future Financial
Crises: A Framework for Macro-Prudential Policy in Canada, Commentary No. 351 (Toronto: CD
Howe Institute, May 2012), at 2. Available online: <http://cdhowe.org/pdf/Commentary_351.pdf>.
24
Lastra supra n 19, at 126.
25
Ibid, at 9.

the financial system’, with stability being ‘the broader concern of the central bank.’26
Similarly, the CPSS spoke of central banks’ interest in the ‘stability of interbank pay-
ment and settlement systems’, as well as of their ‘broader objective of limiting systemic
risk in payment systems and financial markets.’27 In this narrower scope of settlement
system operation and design, to be discussed heretofore in this chapter, systemic risk
is defined as ‘the risk that the illiquidity or failure of one institution, and its resulting
inability to meet its obligations when due, will lead to the illiquidity or failure of
other institutions.’28 The interest in stability and systemic risk is considered relevant to
central banks’ exercise of their traditional roles as ‘the ultimate providers of interbank
settlements, . . . lenders of last resort [to the banking system], and . . . [conductors] of
monetary policy.’29
Having observed that central bank oversight on payment and settlement systems ‘has
become more distinct and formal in recent years’,30 the CPSS rationalized this as being
‘part of a growing public policy concern with financial stability in general.’31 The CPSS
also made the following connection between ‘financial stability’ and, in effect, systemic
risk caused by settlement failure, stating that:
Well designed and managed systems help to maintain financial stability by preventing or con-
taining financial crises and help to reduce the cost and uncertainty of settlement, which could
otherwise act as an impediment to economic activity.32
So far as settlement failure is concerned, the CPSS did not limit its interest to the elimina-
tion of ‘systemic risk’. Rather, by focusing on systemic risk, the CPSS was concerned
with payment systems in which a systemic risk may arise, namely, systemically important
payment systems. Specifically,33
A payment system is systemically important where, if the system were insufficiently protected
against risk, disruption within it could trigger or transmit further disruptions amongst partici-
pants or systemic disruptions in the financial area more widely.
26
JA Spindler and Bruce J Summers, ‘The Central Bank and the Payment System’ in BJ
Summers (ed), The Payment System – Design, Management and Supervision, supra n 5, 164, at 176.
Operational responsibilities are the provision of interbank settlement facilities and in relation to
the large value system. However, not all central banks operate a large-value transfer system.
27
CPSS, Report of the Committee on Interbank Netting Schemes of the central banks of the
Group of Ten countries (Lamfalussy Report) (Basel: Bank for International Settlements, Committee
Chairman: MA Lamfalussy, November 1990), at 6 [hereafter: Lamfalussy Report]. Available
online: <http://www.bis.org/publ/cpss04.pdf>.
28
Ibid, at 6–7. This definition is sufficient for our purposes. For some recent variations and
elaborations, see, eg, HS Scott, ‘The reduction of systemic risk in the United States financial
system’ (2010) 33 Harv JL and Pub Pol’y 671, at 673; and AI Anand, ‘Is systemic risk relevant to
securities regulation?’ (2010) 60 Univ of Toronto LJ 941, at 942.
29
Lamfalussy Report, supra n 27, at 4.
30
Ibid, at 1.
31
Ibid, at 1. On this point, see also Committee on Payment and Settlement Systems (CPSS),
Clearing and Settlement Arrangements for Retail Payments in Selected Countries (Basel: Bank for
International Settlements, September 2000) at 11 [hereafter: Retail Clearing Report]. Available
online: <https://www.bis.org/cpmi/publ/d40.pdf>.
32
Central Bank Oversight Report, supra n 14, at 1.
33
SIPS Report, supra n 7, at 5, ¶ 3.02.

Altogether, the CPSS identified five types of payment system risks. These are credit risk,
liquidity risk, operational risk, legal risk and systemic risk.34 Credit risk is the risk that a
participant will be unable to fully meet its financial obligations within the system either
when due or at any time in the future. This is same as insolvency risk. Liquidity risk is
the risk that a participant will have insufficient funds to meet financial obligations within
the system as and when expected, although it may be able to do so at some time in the
future. Unlike the credit (ie insolvency) risk, liquidity risk is temporary; yet, settlement
obligations are time-sensitive, and hence the impact of the risk may be quite serious. Legal
risk is the risk that a poor legal framework or legal uncertainties will cause or exacerbate
credit or liquidity risk. Operational risk is the risk that operational factors such as
technical malfunctions or operational mistakes will cause or exacerbate credit or liquidity
risks. Finally, systemic risk is the risk that the inability of one of the participants to meet
its obligations, or a disruption in the system itself, could result in the inability of other
system participants, or even of financial institutions in other parts of the financial system,
to meet their obligations as they become due. Effectively, this is the risk of a ‘domino
effect’ of defaults started by one participant, namely, the risk that one failure may cause
widespread liquidity or credit problems and as a result, could threaten the stability of the
system or of financial markets. It typically emerges as a follow-up to the manifestation
of any of the other risks.
Fundamentally, these are all settlement default risks that may be caused in various
circumstances and hence lead to diverse consequences. To prevent or at least contain
such risks, the central bank ought to be concerned with the integrity of the payment
and settlement system. It ought to ensure the continuous, smooth and uninterrupted
operation, as well as the completion of the settlement process. Measures taken are to
address matters such as the choice of settlement model (eg DNS, RTGS), access regime
and operation rules. Specifically, the central bank may insist on measures to be taken by
system participants, such as bilateral credit limits, bilateral debit caps, collateralization of
debit positions, and loss sharing formulas.
The CPSS drafted the following ten Core Principles, all ‘intended for use as universal
guidelines to encourage the design and operation of safer and more efficient systemically
important payment systems worldwide:’35
I. The system should have a well-founded legal basis under all relevant jurisdictions.
II. The system’s rules and procedures should enable participants to have a clear
understanding of the system’s impact on each of the financial risks they incur
through participation in it.
III. The system should have clearly defined procedures for the management of credit
risks and liquidity risks, which specify the respective responsibilities of the system
operator and the participants and which provide appropriate incentives to manage
and contain those risks.
IV. The system should provide prompt final settlement on the day of value, preferably
during the day and at a minimum at the end of the day.
34
Ibid, at 5, ¶ 3.01.
35
Ibid, at 1, ¶1.2. The Core Principles are listed at 3.

V. A system in which multilateral netting takes place should, at a minimum, be

capable of ensuring the timely completion of daily settlements in the event of an
inability to settle by the participant with the largest single settlement obligation.
VI. Assets used for settlement should preferably be a claim on the central bank; where
other assets are used, they should carry little or no credit risk and little or no
liquidity risk.
VII. The system should ensure a high degree of security and operational reliability and
should have contingency arrangements for timely completion of daily processing.
VIII. The system should provide a means of making payments which is practical for its
users and efficient for the economy.
IX. The system should have objective and publicly disclosed criteria for participation,
which permit fair and open access.
X. The system’s governance arrangements should be effective, accountable and
transparent.
Systems should seek to exceed the minima stated in Core Principles IV and V.
Certainly, the central bank’s power regarding the first Core Principle is limited. All
other Core Principles could be applied by the central bank through setting standards
with which a systemically payment system and/or its participants must comply in
order to obtain central bank services. This, however, assumes that it is within the
central bank’s power to impose and enforce appropriate restrictions and conditions.
Presumably, it is against this background that the CPSS went on to set four central
bank responsibilities by applying the Core Principles to systemically important pay-
ment systems:
A. The central bank should define clearly its payment system objectives and should
disclose publicly its role and major policies with respect to systemically important
payment systems.
B. The central bank should ensure that the systems it operates comply with the Core
Principles.
C. The central bank should oversee compliance with the Core Principles by systems it
does not operate and it should have the ability to carry out this oversight.
D. The central bank, in promoting payment system safety and efficiency through the
Core Principles, should cooperate with other central banks and with any other
relevant domestic or foreign authorities.
All four responsibilities are said to stem from the central bank’s leading role in pursuing
the public policy objectives of safety and efficiency in payment systems.36
Subsequently, the FMI Report37 provided for principles covering all financial market
infrastructures (FMIs)38 and not only systematically important payment systems. These
36
See in detail, ibid, at 57–58, section 8.
37
FMI Report, supra n 12.
38
An FMI is defined, ibid, at 7, ¶1.8, to be: ‘a multilateral system among participating institu-
tions, including the operator of the system, used for the purposes of clearing, settling, or recording
payments, securities, derivatives, or other financial transactions.’ In addition to systemically impor-

principles were rationalized by the need ‘to enhance safety and efficiency in payment,
clearing, settlement, and recording arrangements, and more broadly, to limit systemic
risk and foster transparency and financial stability.’39 The report specifically stated that
disruption caused by financial shocks resulting from inadequately managed systemic
crises ‘could extend well beyond the FMIs and their participants, threatening the stability
of domestic and international financial markets and the broader economy.’40 It went
on to address ‘[r]esponsibilities of central banks, market regulators, and other relevant
authorities for financial market infrastructures’.41 The report did not delineate both
core principles specifically applicable to payment systems as well as to central bank’s
responsibilities, and in substance has not superseded them.
In turn, the objectives of safety and efficiency exist not only for systemically important
payment systems but also retail payment systems.42 A payment system is said to be
systemically important ‘where, if the system were insufficiently protected against risk,
disruption within it could trigger or transmit further disruptions amongst participants
or systemic disruptions in the financial area more widely.’43 For such a system, exclusive
reliance on market forces to achieve these two objectives is specifically rejected since
‘operators and participants do not necessarily bear all the risks and costs’ designed
to achieve safety and efficiency.44 Certainly, this point also applies to a retail system.
Even though they are typically not systemically important, ‘[r]etail payment systems
and instruments are significant contributors to the broader effectiveness and stability
of the financial system, in particular to consumer confidence and to the functioning of
commerce.’45 Risks and efficiency in retail payment systems that are of concern to central
banks primarily refer to operations and settlement. Both are typically addressed by the
involvement of central banks in the development of technical standards, the exercise
of oversight responsibilities, as well as by the provision of services (albeit not only in
connection with settlement but also in relation to the entire infrastructure), as well as in
the operation of government payments.46
tant payment systems, FMIs falling into this definition are central securities depositories (CSDs),
securities settlement systems (SSSs), central counterparties (CCPs) and trade repositories (TRs).
39
Ibid, at 10–11, ¶1.15. Note also the enhanced use of central bank money in systems
not operated by the central bank but rather by FMIs: Committee on Payment and Settlement
Systems (CPSS), The role of central bank money in payment systems (Basel: Bank for International
Settlements, Chairman: T Padoa-Schioppa, August 2003).
40
Ibid, at 11, ¶1.15.
41
Ibid, at 4.
42
Committee on Payment and Settlement Systems (CPSS), Policy issues for central banks in
retail payments (Basel: Bank for International Settlements, working group Chairman: C Tresoldi,
March 2003) at 1 [hereafter: Retail Payment Report]. Available online:<http://www.bis.org/publ/
cpss52.pdf>. Regarding risks and retail system innovations, see, eg, Committee on Payment
and Settlement Systems (CPSS), Innovations in retail payments: report of the working group on
innovations in retail systems (Basel: Bank for International Settlements, May 2012) at 2, 12, 20–21.
Available online: <http://www.bis.org/cpmi/publ/d102.pdf>.
43
SIPS Report, supra n 7, at 5, ¶ 3.02.
44
Ibid, at 4, ¶ 2.2.
45
Retail Payment Report, supra n 42, at 41, ¶ 6.1.
46
Retail Clearing Report, supra n 31, at 10–17 and 36–40. Regarding risks and retail system
innovations, see, eg, Committee on Payment and Settlement Systems (CPSS), Innovations in retail

IV. CENTRAL BANKS AND PAYMENT SYSTEM RISKS:

COMPARISON
1. Preface
As indicated, central banks may address payment system risks by means of oversight
as well as by setting standards, with which payment systems and/or participants must
comply in order to get central bank services. A safer and better way, however, is to anchor
central bank powers with respect to payment systems through legislation. In addition to
adding clarity and structure, legislation may extend powers to apply also to systems that
do not get central bank services. This may be the case for some retail systems.
In the United States, the Federal Reserve is heavily involved as an operator47 and
regulator of non-cash payment systems,48 and provides leadership in the efforts for its
modernization.49 Curiously, the broad authority to regulate ‘any aspect of the payment
system’, as opposed to in specific areas or aspects,50 is explicitly conferred on the Federal
Reserve Board (the ‘Board’) only with respect to cheques and only in order to carry out
the provisions of the Expedited Funds Availability Act.51 Having dealt with payment
system risk for many years,52 it was only with the recent passage of the Dodd-Frank Act53
that, with the view of mitigating ‘systemic risk in the financial system’ and the promotion
of ‘financial stability’, the Board was given the authority to promote ‘uniform standards
for’ as well as play ‘an enhanced role in’54 both the ‘management of risks by systemically
important financial market utilities’ and the ‘conduct of systemically important payment,
clearing, and settlement activities by financial institutions.’55 Designation of systemically
payments: report of the working group on innovations in retail systems (Basel: Bank for International
Settlements, May 2012) at 2, 12, 20–21. Available online: <http://www.bis.org/cpmi/publ/d102.pdf>.
47
See, eg, B Geva, The Law of Electronic Funds Transfers (New York: LexisNexis, loose-leaf)
at §1.06[2].
48
In general, for the role of the Federal Reserve in US payment system, see, eg, Paul M
Connolly and Robert W Eisenmenger, The Role Of The Federal Reserve In The Payments System.
Available online: <https://www.bostonfed.org/economic/conf/conf45/conf45f.pdf>.
49
See, eg, The Federal Reserve Banks, Payment System Improvement – Public Consultation
Paper (Federal Reserve Financial Services, 10 September 2013), available online: <https://fedpay
mentsimprovement.org/wp-content/uploads/2013/09/Payment_System_Improvement-Public_Con
sultation_Paper.pdf>; Federal Reserve System, Strategies for Improving the U.S. Payment System
(26 January 2015), available online: <https://fedpaymentsimprovement.org/wp-content/uploads/str
ategies-improving-us-payment-system.pdf>.
50
For example, the Electronic Fund Transfer Act of 1978 (15 USC 1693 et seq); the Depository
Institutions & Monetary Control Act of 1980 (H.R. 4986, Pub. L. 96-221), also called Monetary
Control Act.
51
Expedited Funds Availability Act, 12 USC § 4008(c)(1)(A) (2010).
52
For the Federal Reserve Board’s long-standing objectives in the payment system, see ‘The
Federal Reserve in the Payments System’, September 2001, FRRS 9-1550. For the current relevant
document, see: Federal Reserve Policy on Payment System Risk, as amended effective 23 September
2016. Available online:<http://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf>.
53
Dodd-Frank Wall Street Reform and Consumer Protection Act, (Pub L 111-203 111th
Congress).
54
See, ibid, s 802(b).
55
‘Systemically important’ and ‘Systemic importance’ are defined in, ibid, s 803(9) to mean:

important ‘financial market utilities’, such as clearing houses,56 as well as of ‘payment,

clearing or settlement activities’57 is, however, made by the Financial Stability Oversight
Council (FSOC).58 At the same time, under section 805, risk management standards to be
adhered to by such utilities are to be set by the Board, albeit in consultation with the FSOC
and supervisory agencies.59 Under the same Act, the Board also plays a role in FSOC,60 of
which the objective is the achievement and maintenance of financial stability.61
The ensuing discussion covers countries which have comprehensive statutes addressing
the role of the central bank in specifically regulating payment system risks, in addition to
its role in guarding financial stability. This arrangement is contrary to that of the United
States, where the central bank’s power in relation to payment system risk derives from
its broader power, albeit shared with other regulators, in relation to financial stability.
The countries to be discussed are the United Kingdom, Canada, South Africa and
Australia.
As set out below, all four countries have legislation under which the central bank plays
a major role in the designation of interbank settlement systems for specific oversight
and regulation. A common element in such legislation is the finality of settlement, so
as to preclude insolvency from affecting prior settlement and netting. In Canada62 and
South Africa,63 settlement finality is accorded to all designated systems. In the UK64 and
‘a situation where the failure of or a disruption to the functioning of a financial market utility
or the conduct of a payment, clearing, or settlement activity could create, or increase, the risk
of significant liquidity or credit problems spreading among financial institutions or markets and
thereby threaten the stability of the financial system of the United States.’ There is no definition in
Title VIII for ‘systemic risk’.
56
Under, ibid, s 803(6) ‘financial market utility’ is defined to mean ‘any person that manages
or operates a multilateral system for the purpose of transferring, clearing, or settling payments,
securities, or other financial transactions among financial institutions or between financial institu-
tions and the person’.
57
Defined in, ibid, s 803(7): ‘an activity carried out by 1 or more financial institutions to facili-
tate the completion of financial transactions, but shall not include any offer or sale of a security
under the Securities Act of 1933 (15 USC 77a et seq), or any quotation, order entry, negotiation or
other pre-trade activity or execution activity.’
58
See, ibid, s 804.
59
Under, ibid, s 806 (a) and (b), the Board may authorize a Federal Reserve Bank to establish
and maintain an account for a designated financial market utility as well as to provide it discount
and borrowing privileges, though only in unusual or exigent circumstances.
60
Members of the FSOC (chaired by the Secretary of Treasury), one of whose 10 voting
members is ‘the Chairman of the Board of Governors’ of the Fed, are listed in the Dodd-Frank
Act, in, ibid, s 111(b).
61
More specifically, per, ibid, its Preamble, the Act was designed ‘[t]o promote the financial
stability of the United States by improving accountability and transparency in the financial system,
to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consum-
ers from abusive financial services practices, and for other purposes’. See also, ibid, s 112, which
provides for the authority of the FSOC.
62
Payment Clearing and Settlement Act, SC 1996, c 6, Sch (hereafter PCSA), at s 8.
63
National Payment System Act 78 of 1998 (NPSA), at ss 4A(8) and 8(2)(a) [hereafter: NPSA],
as amended by National Payment System Amendment Act 22 of 2004, National Credit Act 34 of
2005, Co-operative Banks Act 40 of 2007, and Financial Services Laws General Amendment Act
22 of 2008.
64
The Financial Markets and Insolvency (Settlement Finality) Regulations 1999, S. I. 1999,

Australia,65 specific designation or approval to that end is required. Finality of settlement,

being an automatic result of the designation, will not be addressed in this chapter, which
focuses on the central bank’s powers to designate and regulate payment and settlement
systems.
2. Legislation in the UK
The Bank of England (BOE) does not operate non-cash payment systems,66 yet it has been
assigned a primary role in payment system risk control. Under the Bank of England Act
199867 (as amended by the Financial Services Act 201268), the BOE is assigned the primary
responsibility for financial stability.69 A new financial stability objective was specifically
added to its objective of the maintenance of price stability in the conduct of monetary
policy, as set out in section 11 of the Bank of England Act 1998.70 Its section 9B(1) now
provides for the establishment of the Financial Policy Committee, whose membership is
dominated by the Bank but also includes an appointee Chancellor of the Exchequer and
financial regulators.
The Financial Services (Banking Reform) Act 201371 mandates the establishment of the
No. 2979, implementing EU Directive 98/26 on settlement finality in payment and securities
settlement systems, [1998] OJ L 166/45. Under s 2(1), and other than for a system
(i) which is, or the operator of which is, a recognised investment exchange or a recognised
clearing house for the purposes of the [Financial Services Act 1986, 1986 c 60]
(ii) which is, or the operator of which is, a listed person within the meaning of the Financial
Markets and Insolvency (Money Market) Regulations 1995[S.I. 1995/2049] or
(iii) through which securities transfer orders are effected (whether or not payment transfer
orders are also effected through that system) . . .,
the ‘designating authority’ is the Bank of England.
65
The Payment Systems and Netting Act 1998, C2013C00382 [hereafter: PSNA]. See particu-
larly ss 9(3) and 12(1). See also ss 14 and 15(1). The approving authority is the Reserve Bank of
Australia.
66
This is about to change: Bank of England, A blueprint for a new RTGS service for the United
Kingdom, May 2017, available online: <http://www.bankofengland.co.uk/markets/Documents/
paymentsystem/rtgsblueprint.pdf>.
67
Bank of England Act 1998 (UK), 1998, c 11. Available online: <http://www.legislation.gov.
uk/ukpga/1998/11/contents>.
68
Financial Services Act 2012, c 21. Available online: <http://www.legislation.gov.uk/ukpga/2
012/21/contents/enacted>.
69
An addition made by s 238 of the Banking Act 2009 (UK) 2009, c 1, Part 7. Available online:
<http://www.legislation.gov.uk/ukpga/2009/1/part/7>. As further amended by the Financial Services
Act 2012, ibid, at s 2(1).
70
The Bank of England Act 1998 section 2A now states that:
‘(1) An objective of the Bank shall be to protect and enhance the stability of the financial system
of the United Kingdom (the ‘Financial Stability Objective’).
(2) In pursuing the Financial Stability Objective the Bank shall aim to work with other relevant
bodies (including the Treasury, the Financial Conduct Authority and the Prudential Regulation
Authority).’
71
Financial Services (Banking Reform) Act 2013 c 33, Part 5. Available online: <http://www.
legislation.gov.uk/ukpga/2013/33/part/5/enacted>.

Payment Systems Regulator (PSR).72 Its regulatory powers are restricted to payment sys-
tems designated by HM Treasury. In addition to the PSR, the BOE is to be consulted by the
Treasury before making a designation order to ‘a recognised inter-bank payment system.’73
Particularly,74 ‘[i]n considering whether to make a designation order in respect of a payment
system, the Treasury may rely on information provided by—(a) the Bank of England . . .’75
Most importantly, Part 5 of the Banking Act 200976 ‘formalises the [BOE]’s role in the
oversight of payment systems,77 whilst providing that the [BOE] may continue to oversee
inter-bank payment systems on an informal basis where it considers it appropriate.’78 Part
V enables the BOE to oversee certain systems for payment between financial institutions
(section 181).
Under section 184(1), the Treasury may by order (‘recognition order’)79 specify an inter-
bank payment system,80 other than an inter-bank system operated solely by the BOE, as
a recognized system.81 Under section 185(1),
The Treasury may make a recognition order in respect of an inter-bank payment system only
if satisfied that any deficiencies in the design of the system, or any disruption of its operation,
would be likely—
72
Ibid, at s 40(1).
73
Ibid, at s 45(1).
74
Ibid, at s 45(2).
75
The PSR started working in April 2014 and became fully operational on 1 April 2015. Its
goals are the promotion of competition and innovation as well as to ensure payments systems are
operated and developed in the interests of their users. See, eg, <https://www.psr.org.uk/about-psr/
background-psr and https://www.psr.org.uk/payment-systems/who-we-regulate>.
76
Banking Act 2009 (UK) 2009, c 1, Part 5, at ss 181–206. Available online: <http://www.legis
lation.gov.uk/ukpga/2009/1/part/5>.
77
Acknowledged to exist in Bank of England, Oversight of Payment Systems (November 2000).
Available online: <http://www.bankofengland.co.uk/publications/Documents/psor/ops.pdf>.
78
Banking Act 2009 (UK) 2009, c 1, ‘Explanatory Notes’, Part 5, at s16 [hereafter: Explanatory
Notes]. Available online: <http://www.legislation.gov.uk/ukpga/2009/1/pdfs/ukpgaen_20090001_en.
pdf>.
79
For de-recognition see, supra n 76, s 186A (introduced by s 104 of the Financial Services Act
2012 (UK) 2012, c 21) and 187.
80
Under, ibid, s 182(1), ‘inter-bank payment system’ is defined to mean ‘arrangements designed
to facilitate or control the transfer of money between financial institutions who participate in the
arrangements.’ S 182 goes on to define ‘financial institutions’ as banks and building societies, and
‘money’ as including credit. It further provides that ‘[t]he fact that persons other than financial
institutions can participate does not prevent arrangements from being an inter-bank payment
system’ and that ‘[a] system is an inter-bank payment system for the purposes of this Part whether
or not it operates wholly or partly in relation to persons or places outside the United Kingdom.’
Other terms are defined in s 183.
81
Under, ibid, s 185(2), in considering whether to specify a system the Treasury must have
regard to—
(a) the number and value of the transactions that the system presently processes or is likely to
process in the future,
(b) the nature of the transactions that the system processes,
(c) whether those transactions or their equivalent could be handled by other systems,
(d) the relationship between the system and other systems, and
(e) whether the system is used by the Bank of England in the course of its role as a monetary
authority..

(a) to threaten the stability of, or confidence in, the UK financial system,82 or
(b) to have serious consequences for business or other interests throughout the United
Kingdom.
Before making a recognition order, the Treasury must consult with the BOE and notify
the system operator.83 Where the inter-bank payment system also operates as a provider
of financial services to the public, the Treasury must further consult with its regulator.
Similarly, under section 192, in exercising powers under Part 5 of the Banking Act 2009,
the BOE is mandated to ‘have regard to any action that [such regulator] has taken or could
take’, as well as to consult with it.
The Explanatory Notes rationalize section 185(1) as covering ‘consequences of a “sys-
temic nature”’.84 Thereby, they suggest that it is a systemic risk that is bound to ‘threaten
the stability of, or confidence in the UK financial system’.85 However, under section
185(1), a recognition order is available not only in case of a systemic risk; rather, under
paragraph (b), to trigger a recognition order, it suffices to have a likelihood of ‘serious
consequences for business or other interests throughout the United Kingdom.’ Either
way, risks leading to the issue of a recognition order, as covered by paragraphs (a) and (b)
of section 185(1), must be reflected in an inter-bank payment system and must have been
caused by ‘any deficiencies in the design of the system, or any disruption of its operation.’
Under section 188, the BOE ‘may publish principles [that are approved in advance by
the Treasury] to which operators of recognized inter-bank payment systems are to have
regard in operating the systems’. In that regard, so far as its oversight is concerned, the
BOE has formally adopted ‘the internationally agreed’86 principles pronounced by the
CPSS and IOSCO in their joint Report on Principles for financial market infrastructures
(April 2012).87
Section 189 authorizes the BOE to publish codes of practice about the operation of
recognized inter-bank payment systems. As well, section 190(1) permits the BOE to
require the operator88 of a recognized inter-bank payment system:
(a) to establish rules for the operation of the system;

(b) to change the rules in a specified way or so as to achieve a specified purpose;
82
Under, ibid, s 183(c), ‘“the UK financial system” has the meaning given to “the financial
system” by s 3(2) of the Financial Services and Markets Act 2000 (market confidence).’ This
subsection on market confidence provides that:
the financial system operating in the United Kingdom and includes—
(a) financial markets and exchanges;
(b) regulated activities; and
(c) other activities connected with financial markets and exchanges.
83
Ibid at s 186.
84
Explanatory Notes, supra n 78, at s 185, §414.
85
Ibid.
86
UK, Bank of England, Standards for Financial Market Infrastructure. Available online:
<http://www.bankofengland.co.uk/financialstability/Pages/fmis/standards/requirements.aspx>.
87
FMI Report, supra note 12, and see discussion in paragraph containing notes 38–41 above.
88
Under, supra n 76, s 183(a), ‘a reference to the “operator” of an inter-bank payment system
is a reference to any person with responsibility under the system for managing or operating it’.

(c) to notify the Bank of any proposed change to the rules;

(d) not to change the rules without the approval of the Bank.
Under section 191, the BOE may give directions to the operator of a recognized inter-
bank payment system which
(a) require or prohibit the taking of specified action in the operation of the system;89
(b) set standards to be met in the operation of the system.
A new section 191(3) recognizes the possibility of the issuance by the BOE of ‘a direction
. . . given for the purpose of resolving or reducing a threat to the stability of the UK
financial system’.90 Finally, section 193 gives the BOE the power to ‘appoint one or more
persons to inspect the operation of a recognised inter-bank payment system . . .’
It is noteworthy that the authority to issue a ‘recognition order’ is in the hands of the
Treasury and not the BOE. The latter has an advisory role, but not the final word. For
its part with respect to a recognized inter-bank payment system, the BOE may (i) publish
principles to which operators of recognized interbank payment systems are to have regard
in operating the systems (section 188); (ii) publish a code of practice (section 189); (iii)
require the operator to establish and change (as well as not to change) rules that must
be advised to the BOE (section 190); (iv) direct operators as to required and prohibited
actions and set standards (section 191); and (v) appoint inspectors (section 193).
In relation to such powers, principles published under section 188 require advance
approval by the Treasury. At the same time, in exercising powers with respect to the
publication of a code of practice (section 189), setting requirements as to system rules
(section 190), issuing directions (section 191), and appointing inspectors (section 193),
the BOE is entirely independent of any Treasury involvement. Regardless, as indicated, in
exercising powers under Part 5, under section 192 the BOE shall have regard to any action
that the financial institutions regulator has taken or could take.
An enforcement mechanism by means of a court restraint order, issued on application
of the BOE in the event of ‘a reasonable likelihood’ of either a compliance failure or of
its continuance, is provided for under section 202A.91
In the final analysis, so far as financial stability is concerned, under section 185(1) of
the Banking Act 2009, a recognition order will be made by the Treasury upon satisfaction
that deficiencies in the design of inter-bank payment system, or any disruption of its
operation, would be likely ‘to threaten the stability of, or confidence in, the UK financial
system’. At the same time, under section 2A(1) of the Bank of England Act 1998, the
protection and enhancement of ‘the stability of the financial system of the United
89
Under, ibid, s 183(b) ‘a reference to the operation of a system includes a reference to its
management’.
90
The provision, introduced by s 104 of the Financial Services Act 2012 (UK) 2012, c 21, in
Part 5, exempts from liability for damages an operator complying with it. See s 191 (3). Exemption
for any complying person from liability in connection with any direction may be ordered by the
Treasury. See s 191(5). Available online: <http://www.legislation.gov.uk/ukpga/2012/21/contents/
enacted>.
91
Financial Services Act 2012, ibid, at s 104(7) (this provision came into force on 1 April 2013
by the Financial Services Act 2012 (Commencement No 2) Order 2013).

Kingdom’ is an objective of the BOE. While this objective covers more than inter-bank
payment systems, it does not give specific enforcement measures such as the issuance of
a recognition order (by the Treasury, albeit in consultation with the BOE) and the steps
entailed (to be taken by the BOE). Neither the Treasury nor the BOE is expressly charged
with the determination of ‘payment system policy’, though arguably, the area is covered
by their overlapping powers in relation to financial stability and payment system risk.
3. Legislation in Canada
Introduction
Bank of Canada (BOC) is not an operator of a non-cash payment system. Two federal
statutes are relevant to the delineation of its powers in respect to national payment
systems:92
● The first statute is the Payment Clearing and Settlement Act93 (‘PCSA’), which
addresses risk in clearing and settlement systems.
● The second is the Canadian Payments Act94 (‘CP Act’), which covers two distinct
subjects: (i) the Canadian Payments Association and its powers, particularly in
relation to national systems for clearing and settlement, and (ii) the Minister of
Finance’s powers to designate and regulate payment systems of national scope.
The Payment Clearing Settlement Act95 (‘PCSA’)

The PCSA deals with the supervision and regulation, by the BOC, of clearing and set-
tlement systems96 for payment obligations among financial institutions. This is the only
statute dealing with the BOC’s role in the payment system.
92
A third statute addressing payment systems issues is the Payment Card Networks Act
(PCNA) SC 2010, c 12, s 1834 designed to regulate national payment card networks. The PCNA
addresses the bilateral relationship of a card network operator with the card issuer as well with the
acquirer. It gives the Financial Consumer Agency of Canada, established under s 3 of the Financial
Consumer Agency of Canada Act SC 2010, c 12, s 1834, the mandate to supervise the payment card
network operators to determine whether they are in compliance with the provisions of the PCNA
and the regulations: PCNA ibid s 5. It neither confers powers on, nor interacts with the powers of
the Bank of Canada in any way and hence will not be discussed further here.
93
PCSA, supra n 62.
94
Canadian Payments Act, RSC 1985, c C-21 [hereafter: CP Act].
95
PCSA, supra n 62.
96
Under, ibid, s 2,
‘clearing and settlement system’ means a system or arrangement for the clearing or settlement of
payment obligations or payment messages in which
● (a) there are at least three participants, at least one of which is a Canadian participant and
at least one of which has its head office in a jurisdiction other than the jurisdiction where the
head office of the clearing house is located;
● (b) clearing or settlement is all or partly in Canadian dollars; and
● (c) except in the case of a system or arrangement for the clearing or settlement of derivatives
contracts, the payment obligations that arise from clearing within the system or arrangement
are ultimately settled through adjustments to the account or accounts of one or more of
the participants at the Bank. For greater certainty, it includes a system or arrangement for

The passage of the PCSA was rationalized by the importance of clearing and settlement
systems and their risk-free operation for ‘the stability of the financial system and the
maintenance of efficient financial markets’, and hence, for ‘the health and strength of the
national economy’ and ‘the national interest’. In assigning the supervision and regulation
tasks to the BOC, the Preamble of the PCSA goes on to explain that:
the Bank of Canada, in promoting the economic and financial welfare of Canada, takes actions
to promote the efficiency and stability of the Canadian financial system, including providing
the means of settlement of Canadian dollar payments, acting as lender of last resort and, in
consultation with other central banks, developing and implementing standards and practices
to recognize and manage risk associated with systems for clearing and settling payment
obligations.
The object of the supervision and regulation tasks assigned to the BOC under the
PCSA is the risk control in clearing and settlement systems. Originally, the scope of the
statute was limited to ‘systemic risk’, defined in section 2 as:
the risk that the inability of a participant to meet its obligations in a clearing and settlement
system as they become due, or a disruption to or a failure of a clearing and settlement system,
could, by transmitting financial problems through the system, cause
● (a) other participants in the clearing and settlement system to be unable to meet their obliga-
tions as they become due;
● (b) financial institutions in other parts of the Canadian financial system to be unable to meet
their obligations as they become due; or
● (c) the clearing and settlement system’s clearing house or the clearing house of another
clearing and settlement system within the Canadian financial system to be unable to meet
its obligations as they become due.
In December 2014, the definition was expanded by the addition of a new sub-paragraph:
● (d) an adverse effect on the stability or integrity of the Canadian financial system.
Furthermore, in December 2014, the list of risks covered by the PCSA was enlarged by
the addition of ‘payments system risk’, defined in section 2 to mean:
the risk that a disruption to or a failure of a clearing and settlement system could cause a
significant adverse effect on economic activity in Canada by
● (a) impairing the ability of individuals, businesses or government entities to make payments;
or
● (b) producing a general loss of confidence in the overall Canadian payments system, which
includes payment instruments, infrastructure, organizations, market arrangements and legal
frameworks that allow for the transfer of monetary value.
Under section 4(1) of the PCSA,
the clearing or settlement of securities transactions, derivatives contracts, foreign exchange

transactions or other transactions if the system or arrangement also clears or settles payment
obligations arising from those transactions.

[i]f the Governor of the Bank is of the opinion that a clearing and settlement system could be
operated in a manner that poses a systemic risk or payments system risk and the Minister is of
the opinion that it is in the public interest to do so, the Governor may designate the clearing and
settlement system as a clearing and settlement system that is subject to this Part.
Section 6 of the PCSA authorizes the BOC Governor to issue directives to a clearing
house of a designated clearing and settlement system and its participants to take or refrain
from an action in relation to systemic and payment system risks. As well, the PCSA pro-
vides the BOC with certain powers enabling it to monitor and control risk in designated
systems. Thus, systems must provide the BOC with advance notice of any significant
changes to the system, including changes in relation to operation and applicable norms,
and with such information as the Bank requests.97 For its part, the BOC may conduct
audits and inspection,98 and may enter into an agreement with a system governing such
matters as netting, risk control, certainty of settlement and finality of payment, nature of
financial arrangements among participants and operation of the system.99
The Canadian Payments Act100 (‘CP Act’)

The CP Act does not deal with the BOC’s powers. It is, however, addressed here insofar as
powers thereunder may intersect, if not overlap, with those of the BOC under the PCSA.
The CP Act consists of two unrelated parts. Part 1 governs the Canadian Payments
Association (CPA) in particular, as the infrastructure management organization for
the Canadian national payment system. Part 2 provides for the Minister’s101 power to
designate payment systems.
The CPA was established in 1980.102 At present, under Part 1 of the CP Act, the CPA
objects are stated in section 5(1) to:
(a) establish and operate national systems for the clearing and settlement of payments and
other arrangements for the making or exchange of payments;
(b) facilitate the interaction of its clearing and settlement systems and related arrangements
with other systems or arrangements involved in the exchange, clearing or settlement of
payments; and
(c) facilitate the development of new payment methods and technologies.
In pursuing its objects, the CPA is mandated under section 5(2) to ‘promote the effi-
ciency, safety and soundness of its clearing and settlement systems and take into account
97
Ibid, at ss 9 and 5.
98
Ibid, at s 10.
99
This was provided in s 5 of the original statute and is now addressed in PCSA, ibid, at s
13.2. The December 2014 amendment enhances the scope of the BOC Governor’s power to review,
prohibit and place conditions on a foreign institution’s participation in a clearing and settlement
system (s 22.1). The amendment further provides clarifications with respect to the BOC’s authority
to impose annual fees for the administration of the Act (s 12.1), its authority to act as a custodian
and settlement agent for a clearing house (s 12) and its authority to enter into oversight and infor-
mation sharing agreements with governmental authorities and regulatory bodies.
100
CP Act, supra n 94.
101
Ibid, under s 2(1), ‘Minister’ is defined to mean the Minister of Finance.
102
For a comprehensive discussion on the CPA see, eg, Bradley Crawford, The Law of Banking
and Payment in Canada, vol 1, loose-leaf (Aurora, ON: Canada Law Book, 2008–2014), at Chapter 6.

the interests of users’.103 The CPA carries out its objects by making by-laws, rules, and
statements of principle and standards.104 Under section 18(2), ‘a by-law is not effective
until approved by the Minister . . .’ who may disallow any rule.105
Previously, section 5 of the original Act stated that ‘[t]he objects of the Association
are to establish and operate a national clearings and settlements system and to plan the
evolution of the national payments system.’106
Part 2 of the CP Act, consisting of sections 36–42, does not apply to the CPA (CP
Act section 36.1). Under section 37(1) of the CP Act, the Minister has the power to
‘designate’ a payment system,107 thereby bringing it under the Minister’s authority.
To date, the Minister has not exercised this power. In order to designate a payment
system, the Minister must decide that it is in the public interest to do so, and the pay-
ment system must be national or substantially national in scope, or play a major role
in supporting transactions in Canadian financial markets or the Canadian economy.
Under section 37(2) of the CP Act, the Minister is required to consider the following
factors in determining whether it is in the public interest to designate a payment
system:
(a) the level of financial safety provided by the payment system to the participants and users;
(b) the efficiency and competitiveness of payment systems in Canada; and
(c) the best interests of the financial system in Canada.
Once a system is designated, the Minister is authorized to require information and to issue
directives and guidelines, including to make, amend or repeal a rule.108
103
Under, supra n 94, s 2(1), ‘user’ is defined to mean in Part 1, ‘a person who is a user of
payment services but is not a member.’
104
Respectively these powers are set out, ibid, in ss 18(1), 19(1), and 19.1.
105
Ibid, at s 19.2(3). As well, under s 19.3, and subject to consultation, if the Minister is of the
opinion that it is in the public interest to do so, the Minister may, in writing, direct the Association
to make, amend, or repeal a by-law, rule or standard.
106
Banks and Banking Law Revision Act, SC 1980-81-82-83, c 40, at s 58.
107
Under, supra n 94, s 36, ‘payment system’ is defined to mean, ‘a system or arrangement for
the exchange of messages effecting, ordering, enabling or facilitating the making of payments or
transfers of value’.
108
Under, ibid, s 40(1), and following consultations, ‘The Minister may issue a written directive
to the manager or a participant of a designated payment system in respect of
(a) the conditions a person must meet to become a participant in the designated payment
system;
(b) the operation of the designated payment system;
(c) the interaction of the designated payment system with other payment systems; or
(d) the relationship of the designated payment system with users.
As well, under s 40(3),
The Minister may specify in a directive that a manager of a designated payment system or a
participant shall, within such time as the Minister considers necessary,
(a) cease or refrain from engaging in an act or course of conduct;
(b) perform such acts as in the opinion of the Minister are necessary in the public interest; or
(c) make, amend or repeal a rule.’

Towards harmonization?
The present legislative scheme contains overlaps and leaves gaps. To begin with, neither
‘financial stability’ nor ‘payments system policy’ is identified by statute as an objective of
the central bank, or in fact, any other body. As for the latter, as indicated, historically, the
CPA was mandated ‘to plan the evolution of the national payments system.’ However,
other than in the operation of payment systems, its mandate has shrunken to the facilita-
tion of ‘the development of new payment methods and technologies.’109 Even so, the CPA
is the only body with a pro-active statutory mandate, albeit limited, in the evolution of
the payment system.
Second, there is an overlap between the BOC’s powers to address payment system risks
and those of the Minister to designate a payment system, eg, on the basis of ‘financial
safety.’110 Third, the Minister’s power to take into account competitiveness111 appears to
overlap with powers of competition authorities.112 Fourth, while section 36.1 of the CP
Act ‘does not apply to the [CPA]’, it is not clear whether the Minister’s powers under
CP Act Part 2 may affect payment systems operated by the CPA, and if so, what the
relationship is between the Minister’s powers under CP Act Part 1 and those under CP Act
Part 2. Fifth, there is nobody specifically assigned with payment services market conduct
responsibility. In light of existing general customer and consumer protection powers
allocated under both federal and provincial laws, the danger here is more of an overlap
rather than a gap.113 Finally, no authority is accorded the task of licensing payment service
providers who are not otherwise regulated financial institutions.
In its recent consultation document, ie, The Balancing Oversight Discussion Paper,114 the
Government of Canada pointed out that, under CP Act Part 2, the Federal Government
‘has responsibilities with respect to the oversight and regulation of payment systems
that are national or substantially national in scope, or systems that play a major role in
supporting transactions in Canadian financial markets or the Canadian economy.’ To
that end, it ‘has developed an oversight framework in which each system is assigned a
place along a continuum according to the overall level of risk it poses to the economy.’115
Systems were divided into three categories:116
109
Ibid, at s 5(1)(d), reproduced in the text that follows supra n 102.
110
Ibid, at s 37(2)(a), reproduced in the text that follows supra n 107.
111
Ibid.
112
Competition Act, RSC 1985, c C-34.
113
Overlap of jurisdictions is recognized in Canadian law under the ‘double aspect doctrine’
pronounced in Hodge v The Queen (1883), 9 App Cas 117, at 130. However, under what came to be
known as ‘federal paramountcy’, ‘where there are inconsistent (or conflicting) [competent] federal
and provincial laws, it is the federal law which prevails.’ See Peter W Hogg, Constitutional Law of
Canada, 5th ed supp (Toronto: Carswell, 2011), at 16-2 to 16-3.
114
Department of Finance Canada, Balancing Oversight and Innovation in the Ways We Pay:
A Consultation Paper (13 April 2015). Available online: <http://www.fin.gc.ca/activty/consult/
onps-ssnp-eng.asp>.
115
Ibid, at 5.
116
In a way this is a reminiscent of the three-partite division by the BOE to systemically
important payment systems, payment systems of system-wide importance, and others, albeit for
another purpose, that of the role of the central bank as a settlement agent. See Bank of England
Settlement Accounts, supra n 8, at 5–6.

● National retail payment systems processing low-value payments, such as card

networks and online payment systems;
● Prominent payment systems, such as the Automated Clearing and Settlement
System (ACSS), being the ‘retail’ system operated by the CPA through which the
majority of payments in Canada are cleared; and
● Systemically important systems, such as the Large-Value Transfer System (LVTS)
operated by the CPA, being the ‘wholesale’ system through which financial institu-
tions transfer the largest value of payments in Canada.
According to that paradigm, oversight relating to safety and soundness is the strictest
on the third (systemically important systems) and lightest on the first (national retail
systems). Conversely, in relation to user protection, the increasing weight on user protec-
tion is from the systemically important systems (the strictest oversight) to the national
retail payment systems (the lightest oversight). For its part, the public policy of efficiency
would apply across the spectrum.
The Balancing Oversight Discussion Paper enumerated, in its Annex 3, three objectives
to be met by the regulation and oversight of the Canadian payment system. These are:
safety and soundness; efficiency; and meeting the needs of Canadians, defined to include
consumers, business and governments, as well as participants and entities operating a pay-
ments system. However, division of responsibilities is neither by statute nor by authority.
Rather, each authority is expected to adhere to these objectives in carrying out its own
tasks.
It is therefore possible that, notwithstanding the fact that this aspect is not addressed
by the consultation paper, the following division of powers may exist:
● BOC’s powers under the PCSA apply to both the systemically important and
prominent systems. They also exist for national retail systems. It is the absence of
a risk, and not the system’s a priori classification, which precludes a system from
becoming subject to the BOC’s powers.
● The Minister’s powers under CP Act Part 2 then focus on national retail payment
systems, but also exist for both prominent and systemically important systems—
to the extent that such powers do not collide with those of the BOC under the
PCSA.
● The CPA’s powers under CP Act Part 1 are available for both prominent and
systemically important systems—albeit subject to the powers of both the BOC and
the Minister under the PCSA and the CP Act Part 2. In fact, the Minister’s powers
for systems established and operated by the CPA are not only under the CP Act Part
2 but also, in relation to CPA’s norms, under CP Act Part 1.
In the final analysis, this is not a rational division of powers, so gaps and overlaps among
payment systems, as mentioned above, continue to exist. Reform of the legislative and
regulatory framework for the operation and development of payment systems in Canada
remains a work in progress.

4. Legislation in South Africa
South African Reserve Bank (SARB) provides the only inter-bank settlement system
in the country117 and is entrusted with the leadership of payment system developments.
Particularly, under section 10(1) of South African Reserve Bank Act 90 of 1989,118 SARB
is given the power ‘necessary to establish, conduct, monitor, regulate and supervise
payment, clearing or settlement systems’, and also to ‘participate in any such payment,
clearing or settlement systems.’
Section 2 of the National Payment System Act 78 of 1998 (NPSA)119 confirms this
power. Section 3(1) of the NPSA goes on to provide that ‘the Reserve Bank may recognise
a payment system management body established with the object of organising, managing
and regulating the participation of its members in the payment system.’120
Pursuant to this, SARB recognized the Payment Association of South Africa (PASA)
to be the payment system management body, established with the object of organizing,
managing and regulating the participation of its members in the payment system. PASA
thus manages the conduct of its members in all matters relating to payment system
instructions and supports the SARB in its role as an overseer of the payment system.
PASA ensures members’ compliance and, to that end and where necessary, imposes on
them penalties and sanctions.121
117
CPSS, ‘Payment, clearing and settlement in South Africa’ Red Book (Basel: BIS, 2012), at §3.1
[hereafter: Red Book, South Africa]. Available online: <https://www.bis.org/cpmi/publ/d105_za.pdf>.
To that end, SARB introduced a sophisticated settlement system called South Africa Multiple Option
Settlement (SAMOS). The SAMOS system is a subset of the general ledger of the SARB. Inter-bank
retail payment transactions are cleared and submitted to SAMOS for settlement by BankservAfrica,
which is owned by South Africa clearing and settlement banks. BankservAfrica, Strate Limited for
securities settlement, and Visa and MasterCard for international card schemes are the operators of the
Payment Clearing House (PCH) system. Unlike in Canada, real time clearing (RTC) is available for
customers using Internet banking. See Introduction, ibid, at 1.3.3, 2.2.1.1 and 3.1 to 3.7.
118
As amended by Transfer of Powers and Duties of the State President Act 51 of 1991, Safe
Deposit of Securities Act 85 of 1992, South African Reserve Bank Amendment Act 10 of 1993,
General Law Third Amendment Act 129 of 1993, South African Reserve Bank Amendment Act
2 of 1996, South African Reserve Bank Act 39 of 1997, South African Reserve Bank Amendment
Act 57 of 2000, and Exchange Control Amnesty and Amendment of Taxation Laws Act 12 of 2003.
119
NPSA, supra n 63.
120
Ibid, s 3(2) goes on to provide that: ‘The Reserve Bank may recognise a payment system
management body as contemplated in subsection (1) if the Reserve Bank is satisfied that:
(a) the payment system management body, as constituted, fairly represents the interests of its
members;
(b) the deed of establishment or constitution, as the case may be, and the rules of the payment
system management body, including the rules relating to admission as members of that
body, are fair, equitable and transparent; and
(c) the payment system management body will enable the Reserve Bank to adequately oversee
the affairs of the payment system management body and its members and will assist the
Reserve Bank in the discharge of the Reserve Bank’s responsibilities, specified in section
10(1)(c)(i) of the South African Reserve Bank Act, regarding the monitoring, regulation
and supervision of payment, clearing and settlement systems.’
121
Red Book, South Africa, supra n 117, at 1.3.2.

Further, section 4A(1) of the NPSA goes on to confer on the RBSA the power to
‘designate a settlement system’,122 provided ‘such designation is in the interest of the
integrity, effectiveness, efficiency or security of the payment system.’123
The Reserve Bank is given a broad directive issuance power that is not limited to the
designated clearing and settlement system. Rather, under section 12(1) of the NPSA,
‘after consultation with the payment system management body’, the Reserve Bank may
‘issue directives to any person regarding a payment system124 or the application of the
provisions of this Act’. Under section 12(2), grounds for such directive may include
controlling systemic risk;125 protection of the ‘public interest relative to the integrity, effec-
tiveness, efficiency or security of the payment system’; addressing the public interest in
general; the integrity, effectiveness, efficiency or security of the payment system; national
financial stability; and any other matters that the Reserve Bank considers appropriate.
Over and above such a directive, under section 12(3), the Reserve Bank may target ‘a
person’126 and issue directives against individuals, requiring them to perform or refrain
from performing certain acts.
Money transmission is strictly regulated. In principle, this is an activity available
only to regulated financial institutions. Thus, under section 7 of the NPSA, only ‘the
Reserve Bank, a bank, mutual bank, a co-operative bank, a designated clearing system
participant, branch of a foreign institution, . . . a designated settlement system operator’,
postal companies or the PostBank,127 ‘may as a regular feature of . . . business accept
money or payment instructions from any other person for purposes of making payment
122
‘Settlement system’ is defined, supra n 86, in s 1 to mean ‘a system for the discharge of
payment or settlement obligations or the discharge of payment and settlement obligations between
participants in that system.’
123
Under NPSA, supra n 63, s 4A(3),
‘In considering the designation of a settlement system, the Reserve Bank may have regard to any
or all of the following matters:
(a) the purpose and scope of the settlement system;
(b) the rules of the settlement system;
(c) any laws or regulatory requirements relating to the operation of the settlement system,
and the extent to which the settlement system complies with those laws or regulatory
requirements;
(d) the importance of the settlement system to the national financial and payment system;
(e) any other matters that the Reserve Bank considers appropriate.’
124
Broadly defined to mean in, ibid, s 1, as ‘a system that enables payments to be effected or
facilitates the circulation of money and includes any instruments and procedures that relate to the
system’.
125
Defined in, ibid, s 1 to mean: ‘the risk that failure of one or more settlement system partici-
pants, for whatever reason, to meet their payment obligations, including the payment obligations of
clearing system participants, or their settlement obligations may result in any or all of the other set-
tlement system participants being unable to meet their respective payment or settlement obligations’.
126
Defined in, ibid, s 1 to include a trust.
127
However, under, ibid, s 7(4), ‘The Minister of Finance may, after consultation with the
Reserve Bank and the payment system management body, . . . and subject to such conditions as
the Minister may determine, exempt any person or category of persons from the [prohibition] of
subsection (2) if the Minister is satisfied that such exemption will be in the public interest and will
not cause undue risk to the payment system’.

on behalf of that other person to a third person . . .’. Alternatively, ‘the money is accepted
or payment made in accordance with directives issued by the Reserve Bank . . .’.
Under section 15, the SARB is mandated ‘with the co-operation of the payment system
management body’ to establish a standing committee in order ‘to review this Act from
time to time . . . and . . . make recommendations to the Minister of Finance with regard
to amendments to this Act.’
5. Legislation in Australia
Overview
By way of summary:128
In Australia, payment system providers are overseen by three regulators: the Australian
Securities and Investments Commission (ASIC) is responsible for ensuring consumer protec-
tion and market integrity in payment systems; the Australian Prudential Regulation Authority
(APRA) is responsible for supervising the safety and soundness of financial institutions whose
activities give rise to liabilities in the payments system; and the Payments System Board (PSB)
of the Reserve Bank of Australia (RBA) is responsible for ensuring systemic stability as well as
efficiency and competition in the payment system. The Australian Competition and Consumer
Commission (ACCC) applies the general competition law.129
The Reserve Bank of Australia (RBA) operates an RTGS large-value payment system.130
What follows is a discussion on the regulatory role of the RBA in the context of the overall
scheme of payment system regulation and supervision in Australia.
The Reserve Bank Act 1959

The Payments System Board of the Reserve Bank (‘PSB’) is established under section
10A of the Reserve Bank Act 1959.131 Under section 25A, the PSB consists of the RBA
Governor (Chair), an RBA representative (Deputy Chair),132 an APRA representative,133
and up to five other members.
128
Australian Government Productivity Commission, Business Set-up, Transfer and Closure:
Productivity Commission Draft Report (May 2015) at 196 (§9.1) [hereafter: ACPC Report].
Available online: <http://www.pc.gov.au/inquiries/current/business/draft>.
129
Elsewhere, at 201 (§9.2), dealing with the division of powers as to competition, the ACPC
Report, ibid, explains that: ‘regulating entry into and competition in the Australian payments system
falls under the responsibility of both the ACCC and the PSB of the RBA. Specifically, competition
and access to the payment systems is the responsibility of the ACCC under the Competition and
Consumer Act 2010 (Cth) unless a system is “designated” by the PSB under the Payment Systems
(Regulation) Act 1998 (Cth). After “designating” a payment system, the PSB is able to set an access
regime for new entrants and standards for that system . . . The RBA works closely with the ACCC
in setting payment system rules and access regimes.’
130
CPSS, ‘Payment, clearing and settlement systems in Australia’, Red Book (Basel: BIS,
2011), at 3.2.1 [hereafter: Red Book, Australia]. Available online: <https://www.bis.org/cpmi/publ/
d97_au.pdf>.
131
Reserve Bank Act, 1959, C2015C00201 [hereafter: RBA]; Act No 4 of 1959 as amended,
taking into account amendments up to Public Governance and Resources Legislation Amendment
Act (No 1) 2015.
132
RBA, ibid, at ss 25C and 25D respectively.
133
APRA is the Australian Prudential Regulation Authority, which is the prudential regulator

Under section 10B, the PSB is given the power ‘to determine the Bank’s payments
system policy’134 and ‘take whatever action is necessary to ensure that the Bank gives effect
to the policy it determines.’ Within the limits of these powers, it is required to ensure that:
(a) the Bank’s payments system policy is directed to the greatest advantage of the people
of Australia; and
(b) the powers of the Bank under the Payment Systems (Regulation) Act 1998135 and the
Payment Systems and Netting Act 1998136 are exercised in a way that, in the Board’s
opinion, will best contribute to:
(i) controlling risk in the financial system; and
(ii) promoting the efficiency of the payments system; and
(iii) promoting competition in the market for payment services, consistent with the
overall stability of the financial system; and
(c) the powers and functions of the Bank under Part 7.3 of the Corporations Act 2001137
are exercised in a way that, in the Board’s opinion, will best contribute to the overall
stability of the financial system.
In the hierarchy of the Reserve Bank governance, the PSB and the Reserve Bank Board
are of equal ranking.138 However, under section 10C(1), the Reserve Bank Board is first
between equals so that, in the event of policy inconsistency,
(a) the Reserve Bank Board’s policy prevails; and

(b) the Payments System Board’s policy has effect as if it were modified to remove the
inconsistency.139
of the Australian financial services industry. Its authority and scope is determined pursuant to the
Australian Prudential Regulation Authority Act 1998, C2015C00391.
134
Defined in, ibid, s 5 to mean: ‘policy for the purposes of the Bank’s functions or powers
under:
(a) the Payment Systems (Regulation) Act 1998; and
(b) the Payment Systems and Netting Act 1998; and
(c) Part 7.3 of the Corporations Act 2001.
And is specifically excluded from the definition of “monetary and banking policy”.’
135
Payment Systems (Regulation) Act 1998, C2011C00182, Act No 58 of 1998 as amended
[hereafter: PSRA]. Compilation was prepared on 15 April 2011 taking into account amendments
up to Act No 24 of 2011, discussed infra (iii).
136
PSNA, supra n 65.
137
Corporations Act 2001, C2015C00336 Act No 50 of 2001 as amended, taking into account
amendments up to Tax and Superannuation Laws Amendment (2015 Measures No 1) Act 2015.
Such powers and functions are discussed below in (iv).
138
RBA, supra n 131, at s 8A.
139
The section goes on to leave for the Governor to determine the existence of any inconsist-
ency as well as to resolve any dispute as to the demarcation of the line between ‘monetary and
banking policy’ and ‘payment system policy’ (respectively falling under the jurisdiction of the
Reserve Bank Board and the PSB) in the first place. Difference of opinion with the Government is
governed by s 11.

Payment Systems (Regulation) Act 1998

Section 6(1) of the Payment Systems (Regulation) Act 1998140 states that the statute ‘pro-
vides for the regulation of payment systems141 and purchased payment facilities.’142 Part
3 gives the Reserve Bank the power to designate payment systems.143 Under section 11(1),
‘[t]he Reserve Bank may designate a payment system if it considers that designating the
system is in the public interest.’ As well, under section 18(1), ‘[t]he Reserve Bank may . . .
determine standards to be complied with by participants144 in a designated payment
system if it considers that determining the standards is in the public interest.’ To both
ends, section 8 provides that:
In determining . . . if particular action is or would be in, or contrary to, the public interest, the
Reserve Bank is to have regard to the desirability of payment systems:
(a) being (in its opinion):
(i) financially safe for use by participants; and
(ii) efficient; and
(iii) competitive; and
(b) not (in its opinion) materially causing or contributing to increased risk to the financial
system.
It may also have regard to other matters that it considers to be relevant, ‘but [it] is not
required to do so.’145
Section 21(1) mandates the Reserve Bank to give a direction to a participant in a
designated payment system upon the participant’s failure to comply with either a standard
or an access regime. It goes on to provide that ‘[t]he direction is to require the participant
to take specified action, or to refrain from specified action, as the Reserve Bank consid-
140
PSRA, supra n 65.
141
Ibid, at s 7: ‘payment system means a funds transfer system that facilitates the circulation of
money, and includes any instruments and procedures that relate to the system.’
142
In principle under, ibid, s 9(1), ‘A purchased payment facility is a facility (other than cash) in
relation to which the following conditions are satisfied:
(a) the facility is purchased by a person from another person; and
(b) the facility is able to be used as a means of making payments up to the amount that, from
time to time, is available for use under the conditions applying to the facility; and
(c) those payments are to be made by the provider of the facility or by a person acting under
an arrangement with the provider (rather than by the user of the facility).’
Under, ibid, s 9(2), ‘The holder of the stored value, is the person who is to make payments as
mentioned in paragraph (1)(c).’ Generally speaking, such a holder may either be a bank or acting
under authority given by the Reserve Bank under Part 4.
143
Ibid, at s 10.
144
For the definition of ‘participant’, see, ibid, s 7.
145
In determining standards for compliance under, ibid, s 10(2), the Reserve Bank is assigned
the following powers:
(a) it may impose an access regime on the participants in the payment system . . .; . . .
(b) it may make standards to be complied with by participants in the payment system . . .; . . .
(c) it may arbitrate disputes relating to the payment system . . .; and
(d) it may give directions to participants in the payment system . . .

ers appropriate having regard to the failure.’ It ‘must be consistent with any applicable
standards and with any applicable access regime.’146 Under section 12, the Reserve Bank
may impose an access regime147 on participants in a designated payment system.148
The Corporations Act 2001

Part 7.3 of the Corporations Act 2001,149 containing subsections 820A–827D, governs
licensing of clearing and settlement (CS) facilities. The license is to be issued by the
Minister upon the advice of ASIC.150 Under section 768A(1), and subject to exceptions
enumerated in section 768A(2),151 a CS facility is
a facility that provides a regular mechanism for the parties to transactions relating to financial
products152 to meet obligations to each other that:
146
As well, in ibid, s 21(4),’The direction may deal with the time by which, or the period during
which, it is to be complied with . . . [and] is to be given by notice in writing given to the participant.’
147
PSRA, supra n 65, under s 7:
‘access, in relation to a payment system, means the entitlement or eligibility of a person to
become a participant in the system, as a user of the system, on a commercial basis on terms that
are fair and reasonable.
access regime, in relation to a designated payment system, means an access regime:
(a) that has been imposed by the Reserve Bank under section 12; and
(b) that is in force.’
148
Per, ibid, s 12, the access regime imposed must be one that the Reserve Bank considers
appropriate, having regard to:
(a) whether imposing the access regime would be in the public interest; and
(b) the interests of the current participants in the system; and
(c) the interests of people who, in the future, may want access to the system; and
(d) any other matters the Reserve Bank considers relevant.
149
Corporations Act 2001, supra n 137.
150
Ibid, at ss 824A and 824B.
151
Under, ibid, s 768A(2), these are:
(a) an ADI (within the meaning of the Banking Act 1959) acting in the ordinary course of its
banking business;
(b) a person acting on their own behalf, or on behalf of one party to a transaction only;
(c) a person who provides financial services to another person dealing with the other person’s
accounts in the ordinary course of the first person’s business activities;
(d) the actions of a participant in a clearing and settlement facility who has taken on the
delivery or payment obligations, in relation to a particular financial product, of another
person who is a party to a transaction relating to a financial product;
(e) conducting treasury operations between related bodies corporate;
(h) operating a facility for the exchange and settlement of non-cash payments . . . between
providers of non-cash payment facilities;
(i) any other conduct of a kind prescribed by regulations made for the purposes of this
paragraph.
152
Under, ibid, s 763A in principle, a financial product is
(1) . . . a facility through which, or through the acquisition of which, a person does one or more
of the following:

(a) arise from entering into the transactions; and

(b) are of a kind prescribed by regulations made for the purposes of this paragraph.
Not being the licensing authority under Part 7.3 of Corporations Act 2001, the RBA
nevertheless plays a role in the regulation of CS facility licensees. Primarily, under section
827D, the RBA ‘may, in writing, determine standards for the purposes of ensuring that
CS facility licensees conduct their affairs in a way that causes or promotes overall stability
in the Australian financial system.’153 As well, section 827C permits the RBA to ‘give advice
to the Minister in relation to any matter concerning clearing and settlement facilities.’154
V. FINAL OBSERVATIONS
In a nutshell, systemic risk in payment systems adversely affects financial stability and is
not yet addressed under general macro-prudential regulation. Nor is systemic risk the only
risk affecting payment systems. For their part, central banks are best positioned to deal
with all payment system settlement risks.
To some degree, this is recognized in all countries surveyed. In each one, the central
bank bears primary responsibility in setting payment systems policies and implementing
them to combat payment systems risks. Such responsibilities cover, but are not limited
to, systemic risk. In both South Africa and Australia, the central bank plays a role in
guarding financial stability, albeit as an incident to its primary position in relation to
payment system risks.
In Canada, the quest for financial stability was cited as a primary factor for giving the
(a) makes a financial investment (see section 763B);

(b) manages financial risk (see section 763C);
(c) makes non-cash payments (see section 763D).
In principle, under, ibid, s763D(1),
(1) . . . a person makes non-cash payments if they make payments, or cause payments to be made,
otherwise than by the physical delivery of Australian or foreign currency in the form of notes
and/or coins.
153
Under, ibid, s 827D, the provision goes on to state that:
(2) The standards are to be complied with by:
(a) all CS facility licensees; or
(b) a specified class of CS facility licensees, in the case of a standard that is expressed to apply
only in relation to that class.
(2A) If there is an inconsistency between the standards and the derivative transaction rules
or the derivative trade repository rules, the standards prevail to the extent of the
inconsistency.
(3) Before the Reserve Bank determines a standard, it must consult with:
(a) the CS facility licensees that will be required to comply with the standard; and
(b) ASIC.
(4) A standard may impose different requirements to be complied with in different situations
or in respect of different activities.
154
For the Minister’s duty to ‘have regard’ to the advice see, ibid, s 827A(2)(h).

central bank regulatory powers in relation to payment systems.155 However, among the
central banks surveyed, only the BOC has no explicit statutory role in guarding financial
stability. The other extreme is the United Kingdom, where financial stability is both a
factor in exercising powers relating to payment systems and a central bank’s objective on
its own.
Overall, the approach in the four countries surveyed is contrary to that in the United
States, where the statutory responsibility of the central bank focuses on systemic risk
which in relation to the payment system is either a derivative or constituent of the broader
plan of the preservation and enhancement of financial stability. It is thus quite ironic that
the central bank, which may have the greatest involvement in its national payment system,
has the least statutory powers to act in relation to it.
With respect to payment systems, the central bank ought to focus on smooth operation,
and not address unrelated policies such as those concerning competition and possibly
licensing (other than perhaps in setting standards for them). Particularly, there is no firm
basis for fastening on the central bank the exclusive or even the primary responsibility for
factors affecting financial stability that are not generated in the design and operation of
payment and settlement systems.
Accordingly, I argue that legislation in the United Kingdom and Australia went too far.
In the UK, I am concerned with the imposition on the central bank of the primary respon-
sibility with respect to financial stability in general, even as it is watered down by the broad
composition of the FPC. I am also troubled by the entangled and uneven relationship
of the central bank with the Treasury regarding payment systems and financial stability
powers.156 In Australia, I find that the central bank may have assumed an unnecessarily
broad regulatory role in payment systems, particularly in relation to competition.157 At the
other extreme, I argue that the United States legislation should have bolstered the statu-
tory responsibilities of the central bank in relation to payment systems. Possibly in South
Africa, where the statutory focus is on payment systems risk, albeit, unlike in Australia,
without setting a standard for payment system policy, the position is optimal. It remains
to be seen if legislative reform in Canada will attain optimality as well.
In the final analysis, by assigning to the European Systems of Central Banks (ECSB)
the power ‘to promote the smooth operation of payment systems’, the drafters of the
European System of Central Banks and the European Central Bank158 captured the
essence of the regulatory role of central banks in payment systems. Had the efficacy
of a statute been measured solely by its brevity, this language would have been mostly
commended.
155
See text that follows supra n 96.
156
See discussion supra Part IV.2, on the BOE’s powers in relation to payment system risks and
financial stability.
157
See supra Part IV.5, subsections ‘The Reserve Bank Act 1959’ and ‘Payment Systems
(Regulation) Act 1998’.
158
Commission of the European Communities, Treaty Establishing the European Union,
Protocol on the statute of the European System of Central Banks and of the European Central
Bank, 1992 OJ C 191, 68 (7 February 1992). An unofficial consolidated version is available online:
<https://www.ecb.europa.eu/ecb/legal/pdf/en_statute_2.pdf>. See Article 3.1.

22. Digital currencies, decentralized ledgers and the
future of central banking
Max Raskin and David Yermack
I. INTRODUCTION
Digital currencies were created to compete with central banks.
Nakamoto’s (2008) design of bitcoin, as a ‘Peer to Peer Electronic Cash System’, was
intended to allow network members to transfer value directly between each other without
any role for a trusted third party, such as a central bank. Few people noticed the launch
of bitcoin in early 2009, but its creator, still unknown today, had a clear political agenda.
The first block of bitcoins was accompanied by the encoded text, ‘The Times 03/Jan/2009
Chancellor on brink of second bailout for banks’ (Elliott and Duncan, 2009). Appearing
near the lowest depths of the global financial crisis, this headline from The Times provided
an implicit commentary on the fragility of the world banking system and the inability of
central banks to do anything about it. Bitcoin’s anonymous creators symbolically hard-
coded this message into the ‘genesis block’ of their main innovation, the blockchain. They
could hardly have expected that within five years, their blockchain and its shared ledger
would be viewed as major breakthroughs in financial record-keeping, with central banks,
stock exchanges and numerous other financial markets beginning to co-opt the disruptive
technology in order to modernize their own operations.
This chapter evaluates the challenges and opportunities for central banks in a world that
appears to have been irreversibly changed by the arrival of algorithmic digital currencies.
The world economy had been moving away from hard currency in favor of electronic
payment systems for many years before the arrival of bitcoin. Such an innovation was
not unexpected, with prominent economists of past generations such as John Nash (2002)
and Milton Friedman speaking openly of the opportunities for an algorithmic currency,
issued according to a mathematically fixed policy rule, to usurp the role of central banks
and discretionary monetary policy.1 Yet bitcoin represented a radical departure from
past schemes, with a novel focus on decentralized governance and record-keeping that
placed control of money in the hands of its users, rather than a committee of elected
politicians or a circle of enlightened experts. The equations underlying bitcoin stipulated
a predetermined and transparent rate of monetary growth, pre-empting the use of
1
See Babbage (2011), which provides a concise introduction to the structure of bitcoin and
begins by recounting Friedman’s oft-repeated calls for replacing the US Federal Reserve System
with an automated rule for money creation. In a videotaped 1999 interview that has been widely
shared on the Internet, Friedman seemed to anticipate the arrival of bitcoin ten years later when
he stated, ‘I think that the Internet is going to be one of the major forces for reducing the role of
government . . . The one thing that’s missing, but that will soon be developed, is a reliable e-cash,
a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B
knowing A.’
474

Digital currencies, decentralized ledgers and the future 475
discretionary monetary policy that might debase the currency in response to an economic
slump.
At the time of this writing, bitcoin faces a significant governance issue, as its com-
munity of users has been unable to reach consensus about how to scale its network
to accommodate rapid growth in transaction volume. Ironically, the lack of political
leadership that seemed so important in the design of bitcoin is an obstacle in settling on
a strategy for the currency to grow. Even as the bitcoin network struggles with delays and
bottlenecks, blockchains and distributed ledger innovations have been incorporated by
hundreds of knock-off imitator digital currencies. These innovations have also inspired
financiers, regulators and academics to reconsider the first principles of central banking,
including whether central banks should reinvent their national currencies in algorithmic
form, residing on national blockchains and shared ledgers overseen by the very institu-
tions that bitcoin’s creators wished to do away with.
Central banking in an age of digital currencies is a fast-developing topic in monetary
economics. Algorithmic digital currencies such as bitcoin appear to be viable competitors
to central bank fiat currency, and their presence in the marketplace may pressure central
banks to pursue tighter monetary policy. However, the technology behind digital curren-
cies may be co-opted by central banks themselves, giving them more power and greater
control over monetary policy than ever before. This chapter provides a brief introduction
to these topics, with the caveat that the field is changing so quickly that new issues and
opportunities seem likely to re-shape the research agenda frequently. Section II provides
a brief overview of the structure of bitcoin and alternative digital currencies. Section III
considers how central banks have reacted to competition from alternative currencies,
outside the official national monetary base. Section IV discusses implications of the
possibility that central banks may issue their own digital currencies with blockchain and
distributed ledger architecture. Section V provides an overview of operational benefits
that may accrue to central banks from incorporating the new technology into their
processing systems, even if they choose not to issue digital currency. Section VI concludes
the chapter.
II. EMERGENCE OF DIGITAL CURRENCIES
Digital currencies that circulate today confound some members of the public who
question the value of an asset that exists only in computer memory. However, the idea
of virtual money is not new, as electronic payment systems have steadily grown with
advances in computer memory and communications technology, inexorably supplanting
hard currency and paper checks in advanced economies. The distinguishing features of
digital currencies really come from their independence from any political authority or
commercial sponsor as well as their decentralized governance and record-keeping.
Various forms of electronic money have circulated for decades. Twenty years ago, both
the Office of the US Comptroller of the Currency (1996) and the Bank for International
Settlements (1996) published reports noting the proliferation of ‘electronic cash’ stored
on ‘smart’ debit cards that consumers could use at a point of sale. These devices differed
in two important ways from the digital currencies circulating today: they were always
denominated in units of a sovereign currency, such as the US dollar, and their stored value

was created via a transfer of value from a third party, typically a credit card issuer such
as MasterCard or Visa. Early concerns about the growth of electronic cash focused on
computer security issues and the solvency of the third party guarantors.
Online fantasy games provided a platform for issuing virtual currencies beginning in the
late 1980s, and today many regard these as predecessors of bitcoin and other autonomous
digital currencies. These massively multiplayer online role-playing games, or MMORPGs,
have internal economies in which players earn rewards in the fantasy currency and spend
them to acquire in-game powers or objects from other players. Some of these currency
markets have become deep enough that they have migrated to external platforms, where
they trade on a speculative basis against real-world currencies (Kim, 2015). Promoters of
these games need to consider issues such as seignorage and inflation of the monetary base
much like a central bank would.
To some observers, the first private digital currency to establish itself as a medium of
exchange in the real economy was M-Pesa, a currency denominated in mobile phone
minutes that was launched in Kenya by Safaricom in 2007. M-Pesa could be acquired by
anyone with a mobile phone and could be transferred over great distances at extremely
low cost. Within two years, it had been used by more than half the population of Kenya
(Jack and Suri, 2011). Kaminska (2015) observes that M-Pesa appears to have succeeded
because Safaricom, which is 40 percent owned by the multinational giant Vodaphone, is
trusted by the public more than the Kenyan banking system, but she argues that M-Pesa
really resembles a money transmission service more than a standalone currency, since
its sponsor collateralizes units of M-Pesa with Kenyan hard currency deposits in escrow
accounts. The reach of M-Pesa does not appear to have extended beyond the Kenyan
economy, although parallel mobile phone-based currency systems have been introduced
in other developing nations.
Bitcoin, proposed in an Internet posting2 by Nakamoto (2008) and introduced into
circulation in 2009, probably has a more clear-cut claim to being the first successful
private digital currency, as it is used in countries all around the world and is not tied to
any established banking system as is the case with M-Pesa. Bitcoins are circulated over an
open computer network that can be joined by anyone with an Internet connection. Users
of the network store bitcoins in computer memory banks colloquially known as digital
wallets, and transfers occur via an encryption system described in Babbage (2011) and
numerous other sources. Bitcoins can be acquired in the stream of commerce (by exchang-
ing goods and services for bitcoins) or as a reward for participating in ‘mining’, the
activity by which users update the network’s ‘blockchain’, or archive of previous bitcoin
transactions. Bitcoins paid out as mining fees represent the seigniorage of new currency,
which occurs at a fixed rate that periodically ratchets downward until it is scheduled to
asymptotically approach no new money creation in 2140.
Bitcoin features a number of innovations in security, seigniorage, and transparency that
appear to have contributed to its success. Its archival blockchain links together all previ-
2
The Nakamoto (2008) white paper was posted via a link provided to www.bitcoin.org/bitcoin.
pdf distributed to The Cryptography Mailing List at www.metzdown.com. The original post, includ-
ing introductory comments by the author, can be viewed at www.mail-archive.com/cryptography@
metzdowd.com/msg09959.html.

ous transfers of a given unit of currency as a method of authentication. The blockchain

is known as a ‘shared ledger’ or ‘distributed ledger’, because it is available to all members
of the network, any one of whom can see all previous transactions into or out of other
digital wallets. Perhaps most importantly, the process of reaching ‘consensus’ to validate
transactions on a bitcoin network requires no trusted third party, such as a central bank,
credit card issuer, or mobile phone company, to play the role of authenticator. Instead,
authentication relies upon an algorithmic proof-of-work process that enables users to
trust one another with very high levels of confidence, removing the need for sponsor to
play the role of enforcer or gatekeeper on the network. This feature reduces the central
bank to a set of equations in the bitcoin economy.
Bitcoin’s success has spawned hundreds of imitator digital currencies, which are gener-
ally distinguished from one another by differences in their protocols for mining and proof
of work. Although bitcoin continues to have by far the largest market capitalization,
successful competitor digital currencies have included litecoin, ripple, and most recently,
the ether currency that circulates on the Ethereum platform.3
III. CENTRAL BANKS AND COMPETITION FROM DIGITAL

CURRENCIES
When an autonomous digital currency circulates in an economy, it competes with the

official currency issued by the country’s central bank. Competition between official cur-
rency and private money is nothing new, and in various societies alternative money has
included commodities like gold and silver as well as other goods that have served as stores
of value and media of exchange. However, in most countries the local currency faces its
greatest competition from foreign governments’ currencies, especially the US dollar. For
a central bank, the challenges posed by a digital currency are basically the same as those
posed by the presence of a competing foreign currency.
For an economy, competition among currencies causes suppliers to drive price and
quality to an appropriate equilibrium that reflects utility (Hayek, 1976). Historically,
most of these suppliers have been central banks, although there are numerous and well-
documented examples of non-central bank currency used both idiosyncratically and
generally (Radford, 1945). One benefit from competition between different monies is the
stability produced by the flexibility of contracting parties to choose settlement terms.
Private creditors and debtors, if given a free choice, will tend to use the currency that is
neutral as between them. Debtors would not want to contract in currencies that would
appreciate after contracting, and creditors would not want to contract in currencies that
would depreciate. Thus, from the point of view of consumers of money, having competi-
tors in the provision of money is a check on the unilateral behavior of the supplier. Put
into concrete terms, digital currencies could offer a country struggling with a mismanaged
money supply a way of creating stability.
Argentina provides an instructive recent example of how digital currencies, like
3
More than 700 digital currencies have been launched since the inception of bitcoin, and a
list with current market values is maintained at http://coinmarketcap.com/all/views/all/.

foreign currencies, have the ability to provide a check against a central bank’s policy
rules that are detrimental to a country. According to the World Bank, Argentina has
experienced double-digit inflation every year except one since 2002.4 Such a situation
wreaks havoc on a country’s economy by adding unwanted risk to capital allocation
decisions. Before the 2015 election of President Mauricio Macri, The New York Times
reported on the use of bitcoin in evading the country’s currency controls amid an
atmosphere of financial instability (Popper, 2015). When the Argentine peso and
the country’s central bank were unable to provide individuals with the qualities they
demanded of their money, they were relatively free to switch to other options, which
included not only digital currencies but also the US dollar and other foreign currencies.
A country which risks its participation in global financial markets if its currency is
too unstable will be more likely to tolerate the use of black and grey market options.5
Prior to becoming president, Macri served as mayor of Buenos Aires, where he helped
organize a bitcoin forum. After being inaugurated, one of his first actions was to lift
the country’s currency controls.
A slightly different approach was adopted by Ecuador, which officially banned
bitcoin in 2014, but introduced its own digital currency project called Sistema de Dinero
Electrónico (electronic money system) (Rosenfeld, 2015). Modeled on private providers of
mobile money, the system gives individuals access to mobile credit accounts denominated
in currency approved by the central bank. Ecuador’s official currency is the US dollar,
which it adopted after years of monetary instability. As articulated by the Ecuadorian
government, the new digital system is not designed to replace the dollar, but to save money
on replacing deteriorating physical bills. Some, however, have seen the project as a move
towards de-dollarization and an attempt by the government to assert more control over
the economy (White, 2014).6 Certainly the banning of bitcoin and other digital currencies
demonstrates that the advantages of competition are not what the Banco Central del
Ecuador envisioned in establishing the new system.
With the above benefits in mind, we now turn to the costs of competing digital curren-
cies, which primarily consist in undermining a central bank’s ability to conduct monetary
policy as a monopolist. In a world where central banks are forced to compete with other
central banks and private actors, supply and demand alone will drive which money is used
as the generally accepted medium of exchange. However, central banks operate under
regimes that have enacted legal tender laws whose function is to compel acceptance of
their notes.7 Such laws do not require parties to contract in the currency of the central
bank, but they deny legal recourse to a party who refuses to accept the legal tender of the
country as payment for debts contracted in some other medium of exchange. This gives
4
http://data.worldbank.org/indicator/NY.GDP.DEFL.KD.ZG/countries/AR?display5default.
5
Iran provides another recent example. See Raskin (2012).
6
As White writes, ‘In sum, there is no plausibly efficient or honorable reason for the
Ecuadoran government to go into the business of providing an exclusive medium for mobile pay-
ments. Consequently it is hard to make any sense of the project other than as fiscal maneuver that
paves the way toward official de-dollarization. I gather that President Correa does not like the way
that dollarization limits his government’s power to manage the economy.’
7
See, eg, 31 U.S.C §5103 (United States); Coinage Act 1971 §2 (United Kingdom); Reserve
Bank Act 1959 §36(1) (Australia); Bank of Israel Law 1954 §30 (Israel).

rise to Gresham’s Law, namely that bad money drives out the good.8 At the same exchange
rate, a debtor is less likely, ceterus paribus, to pay in appreciated currency if he has the
option to pay in depreciated currency.
Legal tender laws therefore confer a monopoly privilege on the government, allowing
it to operate its printing press. Without such laws, central banks would not be nearly as
powerful. If consumers were allowed to refuse acceptance of central bank currency for
public and private debts, a regime of free banking would exist and the central bank would
be forced to operate monetary policy in accord with the demands of its consumers and
not according to political or policy goals untethered from the market. Whether the central
bank’s monopoly power is desirable is beyond the scope of this chapter and is part of an
enduring ‘rules versus discretion’ debate in macroeconomics.
The history of American monetary policy provides an important example. Until the
1861–65 US Civil War, currency in the United States was issued by private banks, includ-
ing the First Bank of the United States, which, though chartered by Congress, was still a
private institution. In order to fund the Civil War without raising taxes, Congress passed
the Legal Tender Act in 1862, which authorized the issuance of $150 million in United
States notes, which were declared to be ‘lawful money and legal tender in payment of all
debts, public and private, within the United States, except duties on imports and interest
on the public debt.’ This legislation was politically controversial and was at first declared
unconstitutional by the US Supreme Court. Writing for the Court on behalf of a 4:3
majority in Hepburn v Griswold, Chief Justice Salmon P Chase held that forcing parties to
accept depreciated currency violated the Constitution’s prohibition against governmental
taking of property without due process of law. The Chief Justice found no distinction
between the Legal Tender Act ‘and an act compelling all citizens to accept, in satisfaction
of all contracts for money, half or three-quarters or any other proportion less than the
whole of the value actually due, according to their terms. It is difficult to conceive what
act would take private property without process of law if such an act would not.’9
The Hepburn decision was reversed the next year in a pair of 5:4 decisions that were
supported by two new Justices who, coincidentally, were appointed by President Grant on
the same day that Hepburn was decided.10 Together these two decisions are known as the
Legal Tender Cases, and few in the American legal scene today advocate their reversal.11
8
Mundell (1998) states that ‘The correct expression of Gresham’s Law law is: “cheap money
drives out dear, if they exchange for the same price.” That proposition is neither trivial nor obvious.’
9
Hepburn v Griswold, 75 U.S. 603 (1870). Ironically, Chase had served as President Lincoln’s
Secretary of the Treasury and had played a role in enacting the Legal Tender Act in 1862.
10
Knox v Lee and Parker v Davis, 79 U.S. 457 (1871).
11
See Bork (1987) who at his Supreme Court confirmation hearings testified, ‘I cite to you the
legal tender cases. Scholarship suggests – these are extreme examples, admittedly – scholarship sug-
gests that the framers intended to prohibit paper money. Any judge who today thought he would go
back to the original intent really ought to be accompanied by a guardian rather than be sitting on a
bench.’ But see Epstein (2014), who writes, ‘As a matter of constitutional principle, therefore, Legal
Tender laws should fall by the wayside, thereby preserving both the rule of law and the stability of
private expectations . . . One way to counteract this risk [of arbitrary power to inflate or deflate]
is to let the government print whatever (cheap) currency it will, but to discipline its behavior by
allowing other banks to issue their own currency (whether or not backed by gold) in competition
with the federal government.’

The US has reached a political consensus that the federal government should not operate
without a legal safety net that privileges its currency.
These events in nineteenth century United States history provide an interesting
context for understanding the 2014 political debate in Iceland. That country confronted
an alternative to its króna in the form of a private, autonomous digital currency called
auroracoin that was targeted squarely at the Icelandic market. Introduced by the pseu-
donymous Baldur Friggjar Óðinsson, auroracoin entered circulation in March 2014 by
way of an ‘airdrop’ in which 50 percent of auroracoins were distributed evenly to holders
of Iceland’s Kennitala national identification. These events occurred when Iceland was
operating under strict capital controls in the aftermath of the global financial crisis, which
had decimated the country’s banking system. The introduction of auroracoin prompted
the government to hold a parliamentary meeting of the Economic Affairs and Trade
Committee. Frosti Sigurjónsson, chairman of the committee, wrote, ‘There is evidence
however that this is a case of [a money] scam and illegal’, but the government ultimately
took no action against it (Cawrey, 2014). By all accounts, auroracoin has been a failure
and has not supplanted the Icelandic króna in any meaningful way.
Along with legal tender laws, governments can use licensing requirements for money
transmission to regulate indirectly the threat from competing currencies. These laws make
it easier for governments to combat tax evasion and money laundering, which have been
widely reported uses of digital currencies such as bitcoin.
Countries have taken different attitudes towards digital currencies, ranging from
equivocating or hostile to laissez-faire and encouraging. Often an overlap exists between
these attitudes and how the country treats foreign currencies generally. For instance, in
China the government imposes capital controls, combined with active market interven-
tion by the central bank, to affect the value of the renminbi, demonstrating a policy
choice that disfavors private actors setting the values of foreign exchange rates. Similarly,
the country’s attitude towards bitcoin and other digital currencies also ties the hands of
private actors. Although it is legal for individuals to own bitcoin in China, banks and
financial institutions are prohibited from doing so. In April of 2014, the People’s Bank
of China ordered commercial banks and trading companies to shut down accounts that
dealt in bitcoin. In addition to concern about the financial well-being of their citizenry, the
Chinese government may see bitcoin and other digital currencies as a threat to the coun-
try’s capital controls, given the ease of transmitting bitcoin across international borders.
The United Kingdom, on the other hand, allows the private use of bitcoin as well as the
opening of businesses that transact in the currency. Many officials in the United States
government have expressed a similar attitude of benign neglect toward digital currencies
(Raskin, 2013).12 Although anti-money laundering laws apply in both countries, neither
has attempted to ban bitcoin or prevent its proliferation. Indeed, Andrew Haldane, the
Bank of England’s Chief Economist and a contributor to this volume, has suggested
12
While the US has tolerated the circulation of private digital currencies and other instruments
such as the Ithaca Hour (which takes its value from the price of an hour of labor), the government’s
forbearance does not extend to private coinage incorporating precious metals. The United States
in 2009 prosecuted the issuer of Liberty Dollars, a private currency pegged to the market prices of
gold and silver. Liberty Dollars had shapes and denominations similar to the official US coinage
but featured portraits of Congressman Ron Paul, a political libertarian.

that digital currencies might be a solution to the supposed zero lower bound problem of
monetary policy, as we discuss in Section IV below. The US Library of Congress provides
a comprehensive analysis of bitcoin’s treatment in various jurisdictions.13
IV. SHOULD CENTRAL BANKS ISSUE THEIR OWN DIGITAL

CURRENCIES?
Although bitcoin and other digital currencies were created to bypass the control of central
banks, the possibility of a central bank withdrawing its bills and notes from circulation
and replacing them with its own digital currency has become an appealing topic of debate
among monetary economists. This would result in omnipotent uber-banks such as the US
Federal Reserve co-opting the very technology that was created to compete against them.
Koning (2014), in a blog post titled ‘Fedcoin’, has advanced the most trenchant and
widely discussed proposal for a central bank digital currency, although his work draws on
a number of earlier, similar proposals by others. The Fedcoin ideas have been taken up
and discussed by two top officials of the Bank of England, Haldane (2015) and Broadbent
(2016), in recent public speeches, leading to some speculation that the UK might be
the first country to launch a national digital currency. If a digital pound did enter the
marketplace, it would almost certainly have to circulate alongside traditional coins and
banknotes, at least for a time, to accommodate citizens who were uncomfortable with
modern technology as well as those who were unable to afford ordinary consumer devices
such as mobile phones.
Under the Fedcoin proposal, citizens and businesses would be permitted to open
accounts at the central bank itself, rather than depositing their funds in commercial
banks as is done today. Central banks historically have not taken deposits from the public,
because the sheer volume of required record-keeping and customer contact would be
overwhelming (Winkler, 2015). Digital technology overcomes these concerns, since cloud-
based servers and storage could easily accommodate very large volumes of financial
transactions, and bank branches and ATMs would not have to be maintained if currency
could be accessed via mobile phones and other hand-held electronics. Central bank digital
accounts could initially be funded by permitting depositors to convert existing currency,
presumably at a one-to-one rate, and the new digital currency would reside on a blockchain
operated by the central bank. When depositors wished to spend their digital currency, they
would transfer it over the blockchain to the account of a counterparty, with the central
bank coding each transaction into its blockchain. Rather than being updated by miners
in competition with one another, the blockchain would instead be overseen by a trusted
third party—the central bank—which would have the exclusive right to add or modify
entries. In addition, a central bank’s blockchain would almost certainly be kept hidden, at
least to an extent, in order to preserve the privacy of citizens and the competitive secrets of
businesses. Because of these two differences, a central bank’s blockchain would be mark-
edly different than the open, shared ledger that is characteristic of digital currencies that
operate by consensus of the network members and do not rely on a powerful gatekeeper.
13
See http://www.loc.gov/law/help/bitcoin-survey/.

It has led some to question whether a central bank blockchain would be a blockchain at
all. Such centralization would also represent a single point of failure that could make the
entire financial system vulnerable to hacking or sabotage.
By concentrating deposits in the central bank, Fedcoin schemes would implicitly end
the practice of fractional reserve banking, thereby ‘narrowing’ the banking system so
that depositors dealt directly with the central bank rather than with intermediary private
banks. In many ways, Fedcoin represents a revival of the 1933 ‘Chicago Plan’, a widely
discussed academic proposal to end fractional reserve banking in order to restore public
confidence during the Great Depression (Fisher, 1936).
Monetary policy would become much easier for the central bank to implement under a
digital currency system. The bank could commit to an algorithmic rate of money creation
and control it precisely via interest on customer deposits. In principle, this interest rate
could be negative. Such a policy could be modified by contingent smart contracts that
could change the rate of money creation if the economy followed certain future paths.
Alternatively, the central bank could retain discretion to adjust the money supply on a
tactical basis as part of a stabilization policy. In either case, the concept of open market
operations would be superseded by direct manipulation of customer balances, which
could be targeted finely toward certain geographical regions or distinct demographic
or economic clienteles of depositors. Broadly speaking, this narrowing of the banking
system to a direct relationship between citizens and the central bank would represent
financial socialism. The implications of this innovation would be vast, and below we
sketch some of its potential benefits and costs.
Allowing private accounts at the central bank would solve many problems inherent in
the current fractional reserve banking system. The central bank would not be vulnerable
to bank runs, and governments could exit the business of providing deposit insurance
and occasional bailouts as the lender of last resort to inadequately funded commercial
banks. Commercial banks would no longer have to engage in ‘maturity transformation’,
under which they raise funds from short-term demand deposits and lend them out in
long-term mortgages and other loans. Risk-shifting and other moral hazard problems on
the part of banks, which now receive free deposit insurance from the government, might
be eliminated.
In macroeconomics, the main advantages to a central bank of having its own digital
currency would come from giving the government more control and understanding of
the financial system. Such control would permit better intervention in response to the
business cycle while also ensuring better individual compliance with tax collection and
anti-money laundering statutes.
As articulated by Haldane (2015), a central bank digital currency could solve the ‘zero
lower bound’ problem by permitting the central bank to reduce interest rates below zero
as a strategy to encourage spending and investment. When money circulates in the form
of bills and notes, negative interest rates can be difficult to implement because citizens can
hoard hard currency, obtaining an interest rate of zero, and refuse to deposit it into banks
which would confiscate some fraction of it under a negative interest rate regime. Haldane
notes that for much of the twentieth century, relatively high real interest rates around the
world made the zero lower bound problem all but irrelevant. However, a sustained drop
in real interest rates in recent years has made the problem potentially important again.
This has occurred for a variety of reasons, including the economic slump during the

global financial crisis and changing demographic patterns that affect savings patterns in
advanced economies.
If the main innovation of digital currency is to permit the central bank to force inter-
est rates below zero, the public might come to resent the technology or even prevent its
introduction. In 2013, the ‘bail-in’ recapitalization of banks in Cyprus proved politically
controversial and difficult to implement, after the government proposed that banks
increase their equity by reducing the balances in certain customer accounts. A negative
interest payment by a bank to its depositors would mean much the same thing, and
citizens might have difficulty seeing the broad public benefits of an interest rate policy
that led the government to erase some of their cash from computer memory. The Cypriot
Financial Crisis fueled a massive increase in the price of bitcoin, seeing the currency rise
to its current all-time high of $1216.73 per bitcoin.
If a central bank digital currency did narrow the banking system by transferring the
deposit-taking function away from commercial banks and into the hands of the central
bank, the dangers to the commercial banking sector could be severe. Commercial banks
would lose access to their main source of funds and would either have to cut back on
lending or raise new capital by issuing securities to investors. The new financing would
probably be far more costly and less stable than demand deposits. As a result, commercial
banks might greatly reduce their lending activity to both businesses and private citizens,
such as for mortgage loans or commercial lines of credit. It is not clear how the economy
might compensate to offset the effects of this likely credit contraction. Perhaps, however,
the abolition of mandatory fractional reserve banking would smooth out the business
cycle if done through private reforms (see von Mises (1912)).
A related problem would likely arise in the regulatory sphere. A central bank that took
deposits from the public would end up competing head to head with commercial banks,
even as it served as the regulatory overseer of the same institutions.
Such an expansion of state-established banking would not occur without criticism. A
central bank controlling and tracking a national digital currency would have immense
power to observe and potentially to control an individual’s finances. The government
could determine how much currency each individual owned and on what and where
he spent his money, without the need for any independent judiciary to subpoena the
information. Many people prefer to hold hard currency for precisely this reason. If
governments issued digital currency, a political clientele would very likely emerge
out of concern that digital currency would create a dangerous temptation for abuse.
Additionally, although the cost of creating physical currency is not a total check on the
government’s ability to devalue a currency, without having to print dollars or mint coins,
a central bank would be able to hyperinflate in a costless manner simply by adding more
zeros to accounts.
Though free banking, like a free economy, is more difficult to control and understand
than a centrally planned economy, modern economics has come to the conclusion that
through the channeling of incentives, well-defined property rights, and profit calculation,
such disorganization produces a more robust and productive system.

V. CENTRAL BANK OPERATIONS USING BLOCKCHAINS
Central banks may never elect to narrow the banking system and issue digital currency
along the lines of the Fedcoin model. However, like other financial institutions central
banks may see great appeal in the blockchain technology that lies at the foundation of bit-
coin and other algorithmic currencies, and central banks may choose to adapt blockchains
for use in their payments processing and transaction clearing functions. Even though the
original goal of digital currency blockchains was to facilitate peer-to-peer value transfers
that could bypass the interbank clearing process, the technology may ironically find its
widest use in allowing central banks to move money more reliably and more cheaply
between their depositors. The central bank currency would be a settlement currency, akin
to the function served by gold in the past.
Banks perform these bookkeeping and settlement tasks not only for themselves, but
also on behalf of commercial banks. Although blockchain technology remains in its
infancy, estimates of its potential savings in processing and bookkeeping costs often fall
in the range of 50 percent to 80 percent. For a central bank processing enormous volumes
of transactions,14 the possible size of these savings is substantial.
When central banks oversee payment and settlement functions on behalf of the entire
financial system, they seek to provide a system that is both safe and efficient in order to
create a high level of public confidence in the health of the banking system (see Bank
for International Settlements (2005)). Central banks process transactions on behalf of
businesses, consumers, banks and international counterparts, and even small gains in
efficiency can save vast amounts of money. Despite the potential to achieve efficiencies
through economies of scale, certain segments of the money transfer market such as
international remittances remain extraordinarily costly for users. According to the World
Bank, at the end of 2015 the average cost of an international money transfer was 7.37
percent worldwide, and it was only modestly lower, at 6.89 percent, for sending funds
overseas from one of the G8 countries.15 Such transfers typically take several days to
complete due to many layers of checking and verification in the clearing process.16 In
addition, fraud and theft remain problems, even when the parties involved are govern-
ment central banks.17 While the international money transfer market involves numerous
intermediaries in addition to central banks, blockchain technology could make many of
them unnecessary. It would have the beneficial side effect of allowing central banks to
14
As an example, The US Federal Reserve’s FedWire electronic transfer service has handled an
average daily volume of $3 trillion since November 2013, and the Fed operates several other payment
and clearing services such as the Automated Clearinghouse (ACH) system. Fedwire statistics are
available at https://www.frbservices.org/operations/fedwire/fedwire_funds_services_statistics.html.
15
See https://remittanceprices.worldbank.org/sites/default/files/rpw_report_december_2015.
pdf.
16
Perhaps, however, both the monetary and time cost of international remittance is a designed
feature of the system to ensure compliance with national policies designed to combat ills like ter-
rorism and sex trafficking.
17
In a widely reported recent case, the government of Bangladesh lost $81 million in March
2016 when thieves operating through Philippine banks obtained access codes that enabled them to
purloin the funds from Bangladesh’s account at the Federal Reserve Bank of New York (Whaley
and Gough, 2016).

monitor the behavior of their depositors more directly, helping to defeat problems such
as money laundering and tax evasion.
VI. CONCLUSIONS
Digital currencies present central banks with challenges and opportunities. In some
economies, bitcoin has emerged as viable competition for fiat currencies during periods
when the central bank is perceived as weak or untrustworthy, although to date these
cases remain limited to troubled economies with capital controls. More interestingly,
the blockchain technology behind digital currencies has the potential to improve central
banks’ payment and clearing operations, and possibly to serve as a platform from which
central banks might launch their own digital currencies. A sovereign digital currency
could have profound implications for the banking system, narrowing the relationship
between citizens and central banks and removing the need for the public to keep deposits
in fractional reserve commercial banks. This could lead to a serious de-funding of the
commercial banking sector and have spillover effects into credit creation and monetary
policy. Debates over the wisdom of these policies have led to a revival of interest in clas-
sical monetary economics. Competition among fiat currency and private digital currency
evokes the nineteenth century ‘free banking’ era, while the possibility for central banks to
issue digital currency recalls the 1930s Chicago Plan for narrowing the financial system
by eliminating fractional reserve banking.
As a disruptive new technology, digital currency forces governments and central banks
to choose between banning, tolerating or co-opting its innovations. In most mature
economies, central banks have taken the middle course, with a few openly examining
the possibility of incorporating sovereign digital currencies into their operations. With
so much still to be learned about the possibilities of digital currencies and blockchains,
a central bank digital currency still appears to be a radical proposition that carries
significant risks for the rest of the financial system. Moreover, a mandatory central bank
digital currency with the protection of legal tender laws would stand athwart the vision of
competition, decentralization and openness that the creators of modern digital currencies
envisioned.
REFERENCES
Babbage (2011) ‘Virtual Currency: Bits and Bob’ The Economist, June 13.
Bank for International Settlements (1996) ‘Implications for Central Banks of the Development of Electronic
Money’ available at http://www.bis.org/publ/bisp01.pdf.
Bank for International Settlements (2005) ‘Central Bank Oversight of Payment and Settlement Systems’ avail-
able at http://www.bis.org/cpmi/publ/d68.htm.
Bork, Robert H (1987) ‘Excerpts From Questioning of Judge Bork by Senate Committee Chairman’ The New
York Times, September 16.
Broadbent, Ben (2016) ‘Central Banks and Digital Currencies’ available at http://www.bankofengland.co.uk/
publications/Documents/speeches/2016/speech886.pdf.
Cawrey, Daniel (2014) ‘Icelandic Parliament Committee Holds Closed Session to Discuss Auroracoin’ Coindesk,
March 14, available at http://www.coindesk.com/icelandic-parliament-committee-holds-closed-session-dis
cuss-auroracoin/.

Elliott, Francis and Gary Duncan (2009) ‘Chancellor on Brink of Second Bailout for Banks’ The Times
(London), January 3.
Epstein, Richard A (2014) The Classical Liberal Constitution: The Uncertain Quest for Limited Government
(Cambridge MA: Harvard University Press).
Fisher, Irving (1936) ‘100% money and the public debt’ Economic Forum, April–June 1936, 406–20.
Haldane, Andrew G (2015) ‘How Low Can You Go?’ available at http://www.bankofengland.co.uk/publications/
Documents/speeches/2015/speech840.pdf.
Hayek, Friedrich A (1976) Denationalisation of Money: The Argument Refined, Institute of Economic Affairs.
Jack, William and Tavneet Suri (2011) ‘Mobile Money: The Economics of M-Pesa’ National Bureau of Economic
Research Working Paper 16721.
Kaminska, Izabella (2015) ‘Mpesa: The Costs of Evolving an Independent Central Bank’ Financial Times, July
15.
Kim, Thomas (2015) ‘The predecessors of bitcoin and their implications for the prospect of virtual currencies’
PLoS ONE 10(4): e0123071, doi:10.1371/journal.pone.0123071.
Koning, JP (2014) ‘Fedcoin’ available at http://jpkoning.blogspot.com/2014/10/fedcoin.html.
Mundell, Robert (1998) ‘Uses and abuses of Gresham’s law in the history of money’ 2(2) Zagreb Journal of
Economics 3–38.
Nakamoto, Satoshi (2008) ‘Bitcoin: A Peer to Peer Electronic Cash System’ available at https://bitcoin.org/
bitcoin.pdf.
Nash, John F Jr (2002) ‘Ideal money’ 69 Southern Economic Journal 4–11.
Office of the Comptroller of the Currency (1996) ‘An Introduction to Electronic Money Issues’ unpublished
manuscript, available at http://www.occ.gov/topics/bank-operations/bit/intro-to-electronic-money-issues.pdf.
Popper, Nathaniel (2015) ‘Can Bitcoin Conquer Argentina?’ The New York Times, April 29.
Radford, Robert A (1945) ‘The economic organisation of a P.O.W. camp’ New Series 12(48) Economica 189–201.
Raskin, Max (2012) ‘Dollar-Less Iranians Discover Virtual Currency’ Bloomberg News, November 29.
Raskin, Max (2013) ‘U.S. Agencies to Say Bitcoins Offer Legitimate Benefits’ Bloomberg News, November 18.
Rosenfeld, Everett (2015) ‘Ecuador becomes the first country to roll out its own digital cash’ CNBC, February 9.
von Mises, Ludwig (1912) The Theory of Money and Credit (Vienna: Theorie des Geldes und der Umlasufmittel).
Whaley, Floyd, and Neil Gough (2016) ‘Brazen Heist of Millions Puts Focus on Philippines’ The New York
Times, March 16.
White, Lawrence H (2014) ‘Dollarization and Free Choice in Currency’ George Mason University Department
of Economics Working Paper No 14-44.
Winkler, Robin (2015) ‘Fedcoin: how banks can survive blockchains’ 6 Konzept 6–7.

23. Central banks, systemic risk and financial sector
structural reform
Saule T Omarova
I. INTRODUCTION
In the aftermath of the 2008 financial crisis, safeguarding financial stability is
increasingly recognized as an integral part of central banks’ mandate, alongside their
traditional task of ensuring monetary stability. Effective prevention of systemic risk—a
capacious category that encompasses a wide range of potentially significant threats to
financial stability—is one of the most important and challenging issues confronting
central banks in the post-crisis era (Caruana, 2010). This renewed attention to systemic
risk and financial stability has prompted an important shift from the predominantly
microprudential pre-crisis paradigm of financial regulation and supervision, which
focused on the safety and soundness of individual firms, to an explicitly macropru-
dential approach that targets system-wide effects of risk-taking by individual market
actors (BIS, 2012; IMF, 2012; BoE, 2011). Central banks are at the very core of this
process, actively developing new macroprudential policies and supervisory tools, while
at the same time repurposing some of the old and familiar ones (Hockett, 2015). This
evolving macroprudential regime operates through enhanced capital standards, liquid-
ity requirements, regular ‘stress test’ exercises, and other methods designed to reduce
systemic risk (Yellen, 2015).
Reforming the institutional structure of the financial industry, or structural reform, is a
distinct method of addressing systemic risk by limiting the range of permissible transac-
tions or organizational affiliations among different types of financial firms. Structural
reforms seek to alter the fundamental pattern of interconnectedness in the financial
system, in order to block certain channels through which risk is transmitted and shocks
are amplified (Caruana, 2010). In that sense, reforms to financial industry structure do
not merely supplement macroprudential measures (Fischer, 2016) but operate as a more
blunt, deeper—indeed, foundational—form of macroprudential regulation.
This chapter focuses on financial sector structural reform as an important dimension
of central banks’ post-crisis systemic risk prevention agenda. Unlike macroprudential
regulation in the more familiar sense, outright structural reform of the financial industry
has not been explicitly included in the agenda for international regulatory reform under
the aegis of the G20. Nevertheless, a number of countries—including the US, UK,
Germany, France and Belgium—have initiated their own reforms aimed at restructuring
their financial sectors. A major industry restructuring effort is also being pursued at the
European Union (‘EU’) level. These reforms seek to establish separate regulatory regimes
for different categories of financial activities and institutions, but often differ in how
they draw those all-important categorical lines. Meanwhile, various alternative reform
proposals call for more radical structural reforms, ranging from modern variations on the
487

Glass-Steagall era separation between commercial and investment banks to even more
restrictive forms of ‘narrow’ banking.
It is still too early to tell whether, and to what extent, any of the current US and
European structural reforms will succeed in practice. It is also difficult to judge which
specific structural reform plan offers the most effective conceptual blueprint for minimiz-
ing and controlling systemic risk. This is both a reflection of the inherent complexity of
the task at hand and a product of the familiar political-economy dynamic surrounding
high-stake regulatory reforms. The latter explains, for example, why financial industry
groups, fearing potential loss of profits as a result of proposed structural divisions,
argue vociferously against reform. To make things even more complicated, issues of
industry structure are often lumped together with other, closely related but conceptually
distinct, regulatory concerns, such as breaking up ‘too big to fail’ (‘TBTF’) banks or
finding an efficient method of resolving them (Kashkari, 2016; Federal Reserve Bank of
Minneapolis, 2016). Finally, with reform efforts still in a state of flux, it is not yet clear
what role, if any, the relevant jurisdictions’ central banks should play in determining the
direction, speed, and potential outcomes of structural reforms currently under way.
This chapter does not claim to answer these questions. Far more modestly, it begins
defining and exploring the broader analytical and policy terrain on which such answers
may be found. Part II identifies and describes three principal models that form a con-
tinuum of potentially available financial sector structural reform choices. Parts III and IV
apply this conceptual framework to analysis of post-crisis structural reforms in the UK,
EU, and US. Part V argues that issues of financial industry structure are deeply embedded
in central banks’ regulatory and policy agenda and, in light of this connection, discusses
potential implications of current structural reforms for central banks’ post-crisis financial
stability mandate.
II. DEFINING THE CONTINUUM OF CHOICES: THREE

STRUCTURAL MODELS
In principle, there are three models that represent conceptually distinct choices along the
industry structure continuum: (1) the ‘universal bank’ model; (2) the ‘holding company’
model; and (3) the ‘strict separation’ model. In practice, it is difficult to find any of these
three models in its pure form, as most countries’ approaches to their financial industry
structure tend to combine elements of different models. Nevertheless, identifying some of
the key features of these models provides a helpful context for assessing current structural
reform efforts.
1. The ‘Universal Bank’ Model
Under the ‘universal bank’ model, the predominant form of organization for continental
European banks, depository institutions are allowed to engage in a wide variety of busi-
ness activities beyond traditional banking. Universal banks freely operate across sectoral
boundaries as they take deposits, make loans, trade and deal in securities, and underwrite
insurance policies (Benston, 1994). In some countries—most notably, Germany—
universal banks are also allowed to make controlling equity investments in non-financial

Central banks, systemic risk and financial sector structural reform 489
companies, often their lending clients (Alexander, 2015). These various activities can be
conducted either by a single entity or by affiliated entities within a conglomerate structure
(Dierick, 2004; Benston, 1994). In contrast to the US bank holding company model, how-
ever, universal banks are generally free to choose their precise organizational structure.
The arguments in favor of universal banking stress the fact that it maximizes individual
banks’ ability to diversify their balance sheets and to achieve greater economies of scope
and scale, which potentially enhances their safety and soundness. The key risks associated
with the model include the heightened danger of risk contagion that could disrupt provi-
sion of core banking services, increased possibilities for regulatory arbitrage and obfusca-
tion of risk allocation within the group structure, and greater potential for conflicts of
interests and abuse of concentrated economic power by financial conglomerates that are
‘too big to fail’ (Dierick, 2004: 14–16).
From the mid-1980s until the onset of the crisis in 2008, many European countries
pursued aggressive deregulatory policies in their financial services sectors that encouraged
further diversification of European financial institutions’ activities. By the early 2000s,
the European financial services industry became highly concentrated, and a handful of
its largest financial conglomerates significantly increased the size of their balance sheets
(ECB, 2005; Dierick, 2004). The pre-crisis list of the largest bancassurance groups in
Europe included Deutsche Bank, BNP Paribas, HSBC, Lloyds, Royal Bank of Scotland,
ABN Amro, Fortis, Dexia, and many other household names (Dierick, 2004: 9).
This list alone should explain why the trajectory of universal banking groups’ growth,
and the changes in their individual or cumulative systemic risk footprint, are matters of
utmost concern to European central banks and financial regulators, both at the national
level and at the EU level. The fundamental regulatory challenge in this respect is the inher-
ent difficulty of isolating and targeting specific sources of excess leverage and risk accu-
mulation that affect micro- and macro-stability of core banking products and services,
so seamlessly incorporated in universal banks’ complex business strategies. As the 2008
financial crisis demonstrated, failure to fulfill this difficult task makes ex post bailouts of
financial conglomerates an unavoidable political reality (Domanski et al, 2014).
2. The ‘Holding Company’ Model
Under the ‘holding company’ model, followed in the US, banking institutions may oper-
ate across sectoral lines only subject to statutory limitations and conditions. Thus, US
depository institutions are generally precluded from conducting non-banking activities,
either directly or through a subsidiary.1 Since the 1980s, federal regulators have gradually
expanded bank-permissible activities to include, among other things, trading and dealing
in a wide range of derivatives (Omarova, 2009). Yet, despite this regulatory loosening of
the statutory prohibitions, US banks are not permitted to engage in full-service invest-
ment banking or insurance underwriting. Any financial activities outside traditional
banking may be conducted only by banks’ corporate parents, or ‘bank holding companies’
(‘BHCs’), which are subject to group-wide regulation and supervision by the Board of
Governors of the Federal Reserve System (the ‘Federal Reserve’) under the Bank Holding
1
National Bank Act of 1863,12 U.S.C. 24 (Seventh).

Company Act of 1956 (the ‘BHC Act’).2 The BHC Act limits the scope of financial activi-
ties permissible for BHCs mainly to activities ‘closely related’ to banking, which include
activities like leasing and lending but exclude securities or insurance underwriting.3
These and other activities ‘financial in nature’ or ‘complementary’ to finance may be
conducted only by BHCs that qualify for a special status of ‘financial holding companies’
(‘FHCs’) by satisfying, among other things, certain supervisory criteria for managerial
strength and capital adequacy. FHCs can engage in investment banking, merchant
banking, insurance business, and other authorized activities directly or through their
non-depository subsidiaries.4 Non-financial activities and investments, such as trading
in physical commodities, are generally impermissible even for FHCs, unless specifically
authorized under the statute (Omarova, 2013).
As a practical matter, large US FHCs’ business activities span across sectoral borders
much in the same manner as those of European universal banks. Nevertheless, explicit
legal and regulatory limitations on banking institutions’ ability to operate across sectoral
lines fundamentally distinguishes the US ‘holding company’ structure from universal
banking. This internal tension between the strict tenets of the holding company model,
on the one hand, and the reality of nearly universal cross-sectoral conglomeration, on
the other, is one of the fundamental factors that complicate the Federal Reserve’s task
as a systemic risk regulator and the formal ‘umbrella’ regulator of US BHCs. Much like
its European counterparts, the Federal Reserve faces the challenge of untangling the
complex patterns of economic risk transfer within and among de facto fully diversified
and integrated financial conglomerates, while also managing the legal and regulatory
organizational and transactional ‘walls’ between banking and non-banking FHC
affiliates.5
3. The ‘Strict Separation’ Model
The ‘strict separation’ model represents the most restrictive point on the continuum of
structural choices. It prohibits depository institutions from offering certain types of
financial products and services or, more broadly, entering into certain types of financial
transactions. Perhaps the best-known historical example of strict separation in action was
the prohibition on affiliation between commercial and investment banks under the Glass-
Steagall Act of 1933.6 Enacted in response to the trauma of the Great Depression, that
law mandated complete economic, legal, and organizational separation of deposit-taking
from securities trading and underwriting.
2
Bank Holding Company Act of 1956, 12 U.S.C. § 1841 et seq .
3
12 U.S.C. § 1843(c)(8).
4
12 U.S.C. § 1843(k).
5
Regulation of credit extension and certain other transactions between banks and their affili-
ates within a holding company structure is an important part of the Federal Reserve’s mandate
under Sections 23A and 23B of the Federal Reserve Act. 12 U.S.C. §§ 371c; 371c-1. However,
guarding this statutory wall is a difficult task that may become outright impossible in times of crisis
(Omarova, 2011).
6
Banking Act of 1933 (Glass-Steagall Act), Pub. L. No. 73-66, 48 Stat. 162 (codified as
amended in scattered sections of 12 U.S.C.).

Beginning in the 1980s, a variety of factors—technological and financial innovation,

cross-sectoral competitive pressures, regulatory arbitrage and regulatory competition—
led to the gradual erosion of the Glass-Steagall regime (Wilmarth, 2015). In 1999,
Congress enacted the Gramm-Leach-Bliley Act (the ‘GLB Act’) that formally repealed
the specific Glass-Steagall provisions prohibiting organizational affiliation between banks
and investment banks.7 After nearly 70 years, the US system of strict structural separation
between banking and non-banking financial services gave way to the more permissive
FHC structure.
The sobering experience of the late 2000s, however, reignited debates about the
desirability of hard-wired intra-industry structural boundaries, in order to protect the
solvency and stable operations of financial entities and activities clearly imbued with
public interest. Thus, current proposals for so-called ‘narrow’ or ‘safe’ banking are direct
attempts to re-envision the old ‘strict separation’ model for the post-crisis era (Kotlikoff,
2011; Wilmarth, 2012; Levitin, 2016). The principal common characteristic of these
proposals is their categorical prohibition on organizational combination, either within
a single entity or a holding company, of deposit-taking and provision of basic payment
services with other financial services and activities (including lending). In that sense, the
narrow banking proposals seek to impose even more stringent activity restrictions on
deposit-taking institutions than restrictions that were in place under the Glass-Steagall
Act.
To the extent strict separation and universal banking constitute opposite ends of the
structural continuum, the relative benefits and shortcomings of the former are largely
the inverse of those associated with the latter. A successfully implemented model of
strict separation can enhance systemic stability by protecting banks from contagion
risks, by simplifying their internal organization and making them more transparent and
manageable, by reducing potential for conflicts of interest and abuse of concentrated
economic power, and by eliminating the need for bailing out TBTF institutions. On
the other hand, the model’s critics argue—often by interpreting the experience of the
Glass-Steagall era—that strict structural separation is bound to stifle financial innova-
tion, prevent economically efficient transactions, and hurt the safety and soundness of
the banking system by forcing risky activities into unregulated or less regulated sectors
(Guynn and Kenadjian, 2015; Huertas, 2015; Benston, 1994).
Experience shows, however, that the less restrictive structural models discussed above
do not necessarily perform better, especially in terms of safeguarding systemic stability.
Not surprisingly, in the wake of the latest financial crisis, both US and European authori-
ties have embarked on the path of bank structural reform. Examining how and why these
jurisdictions are moving along the continuum of structural choices helps to get a better
sense of the role that central banks are, and should be, playing in that process.
7
Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act), Pub. L. No. 106-
102, 113 Stat. 1338 (codified in scattered sections of 12 and 15 U.S.C.).

III. FROM ‘UNIVERSAL BANK’ TO ‘HOLDING COMPANY’:

BANK STRUCTURAL REFORMS IN EUROPE
In the pre-crisis boom years, the European banking sector experienced unprecedented
consolidation and growth, both in absolute and relative terms.8 After a painful wave of
near-failures and public bailouts of some of Europe’s largest universal banks in 2008–09,
several European countries—including the UK, Germany, France and Belgium—sought
to address this newly salient TBTF problem through structural reform. The European
Commission (‘EC’) initiated a parallel EU-level effort to address systemic issues posed
by the risky trading activities and opaque structure of the large universal banks that
dominate the region’s financial sector. A brief overview of the reform efforts in the UK
and EU shows that European policy-makers are in the process of orchestrating a major
conceptual shift along the continuum of structural choices, discussed above, from the pure
‘universal bank’ model to a more restrictive ‘holding company’ model.
1. United Kingdom: Retail Ring-Fencing
The traumatic events of September 2008 nearly brought down some of the largest, globally
active British banks (FSA, 2009; Alexander, 2015). Partly in response to the controversial
bailouts of the Royal Bank of Scotland and Lloyds, Chancellor Osborne appointed the
Independent Commission on Banking (‘ICB’), or the Vickers Commission, tasked with
developing recommendations on reforming the structure of the British banking industry.
In September 2011, the ICB published its final report that called for ‘ring-fencing’ of retail
bank operations from the riskier wholesale or investment activities pursued by banking
conglomerates (ICB, 2011). With some modifications, this report formed the basis for
the Financial Services (Banking Reform) Act 2013.9 The Bank of England’s Prudential
Regulation Authority (‘PRA’) is required to implement the new ring-fencing regime,
which is set to come in full force in 2019.
Under the Banking Reform Act, as supplemented by secondary legislation adopted
by HM Treasury in 2014, all UK banks with retail and small-business deposits exceeding
£25 billion are required to conduct all of their retail deposit-taking, overdrafts and associ-
ated payments activities—ie, ‘core activities’—in separately organized and capitalized
subsidiaries, known as ‘ring-fenced bodies’.10 Only ring-fenced bodies—and banks with
retail deposits below the £25-billion threshold, which are exempt from the ring-fencing
requirement—are permitted to conduct such core activities.
Ring-fenced banks are prohibited from conducting ‘excluded’ activities, such as ‘deal-
ing in investments as principal’, within or outside the UK.11 This broadly stated ban on
proprietary trading by ring-fenced entities, in effect, erects a structural barrier between
retail deposit-taking and investment banking activities. Secondary legislation has clarified
8
As of 2011, the EU banking sector assets constituted nearly 350 percent of the region’s GDP,
compared to 78 percent in the US. See Quintana et al (2014).
9
Financial Services (Banking Reform) Act 2013.
10
Financial Services and Markets Act 2000 (Ring-Fenced Bodies and Core Activities) Order
2014, SI 2014/1960.
11
Banking Reform Act, Sec. 142D.

the scope of ‘excluded activities’ to include, for example, dealing in physical commodities
and derivatives, while also carving out specific exemptions from the exclusion.12 Pursuant
to these exemptions, ring-fenced banks can conduct proprietary trading for the purposes
of managing their own liquidity or hedging their own risks, such as interest rate or
exchange rate risks, arising out of their lending and other permissible activities. The
legislation also permits these entities to enter into simple derivatives transactions with
their clients, such as exchange rate or currency swaps, subject to certain limits on the size
and risk level of such derivatives activities.13
In addition to delineating the perimeter of ‘excluded’ activities, the legislation imposes
‘prohibitions’ on ring-fenced banks establishing branches or subsidiaries outside of the
European Economic Area (‘EEA’), as well as on their transactions with certain types
of counterparties.14 Perhaps most notably, the legislation prohibits these entities from
incurring economic exposure to financial institutions located outside of the ring-fence:
investment banks, hedge funds and other entities that tend to be highly leveraged and rely
on short-term wholesale funding. Specific exemptions, however, allow ring-fenced banks
to transact with other financial institutions in the course of hedging their own risks,
issuing covered bonds or securitizing loans, or financing trade.
These prohibitions aim to limit the exposure of public utility-like ring-fenced banks to
externally generated risks and thus minimize the danger of cross-sectoral and cross-border
contagion (Alexander, 2015). This reflects the broader objectives behind the UK’s new
ring-fencing scheme: (1) to ensure stable, uninterrupted provision of vital retail banking
services by shielding them from external financial shocks; and (2) to make large banking
institutions easier to resolve in the event of a failure (ICB, 2011). In other words, the focus
of the reform is on enhancing both the resilience and the resolvability of the systemically
important retail banking sector (PRA, 2014:7).
To achieve these lofty goals, the ring-fence around the relevant entities must be suf-
ficiently robust to withstand the banking groups’ attempts to get around it. Pursuant to
the Banking Reform Act, UK regulators have been developing rules to ensure that each
ring-fenced bank is legally, economically and organizationally independent—and easily
separable—from the rest of the group. Each such bank must be established as a legally
separate and independently governed entity within the larger corporate group (PRA,
2015). It also has to comply with applicable capital and liquidity requirements on a stand-
alone basis and manage its exposure to affiliates on an arm’s length basis.
It is too early to judge the practical impact of these measures. An important unknown
in this respect is the ability of the PRA, as the prudential regulator in charge of imple-
menting the new regime, to resist the industry’s efforts to have the rules relaxed, perhaps
one little bit at a time.15 Assessing potential efficacy of this evolving regime is especially
difficult in light of the parallel process of structural reform at the EU level.
12
Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014,
SI 2014/2080.
13
Ibid.
14
Ibid.
15
See, eg, Omarova, 2009 and Omarova, 2011.

2. European Union: (Potential) Subsidiarization
In October 2012, the High-Level Expert Group on structural reform in the European
financial sector, established by EU Commissioner Michel Barnier, issued a report—widely
known as the Liikanen Report—containing recommendations on reforming the structure
of European banks. In parallel to the Vickers Commission’s recommendations, the report
generally advocated the ‘ring-fencing’ solution to the problem of restructuring and simpli-
fying large, diversified EU banking conglomerates. In contrast to the Vickers approach,
however, the Liikanen Report recommended mandatory ring-fencing of all high-risk
trading activities for banks with trading assets exceeding a certain threshold. Under this
proposal, all of such banks’ proprietary and market-making activities would have to be
conducted in a separately organized and capitalized ‘trading entity’, while deposit-taking
and other traditional banking activities could be carried out anywhere in the corporate
group. The ring-fenced trading entity would not be allowed to fund itself with deposits or
provide retail banking services (Liikanen Report, 2012).
The Liikanen Report formed the basis for the proposed regulation, unveiled by the
European Commission’s (‘EC’) in January 2014.16 In some important respects, however,
the proposed regulation departs from the original Liikanen Report’s recommendation.
Thus, the EC opted against mandatory ring-fencing of banks’ trading activities in favor
of a general prohibition on proprietary trading in financial instruments and commodities,
combined with potential supervisor-imposed separation of high-risk trading activities
within individual groups.17
The proposed regulation imposes a ban on proprietary trading by the largest EU ‘credit
institutions’ (including deposit-taking banks and their subsidiaries and affiliates) that
are either (1) designated as ‘global systemically important banks’ (‘G-SIBs’), or (2) have
assets and trading activities in excess of a certain size threshold.18 To prevent banks from
circumventing the ban, the draft regulation prohibits them from investing in and sponsor-
ing hedge funds.19 Despite its seemingly harsh tone, however, the proposed ban is very
narrowly drawn, as the definition of ‘proprietary trading’ is limited to position-taking
entirely unconnected to any client activity or hedging the bank’s own risk and carried on
by the bank’s formally designated proprietary trading units.20 This narrow reach of the
ban was seen as ‘allay[ing] many concerns’ in the industry (Freshfields, 2014:1).
The draft regulation allows deposit-taking entities, or ‘core credit institutions’, within
large EU banking groups to continue conducting a wide range of non-proprietary trading
but makes it expressly subject to the discretion of the competent supervisory authority.21
The proposal requires supervisors to conduct regular reviews of trading activities of
individual groups that include a core bank, with a view to determining whether such
16
Commission Proposal of 29 January 2014 for a Regulation of the European Parliament and
of the Council Regulation of the European Parliament and of the Council on structural measures
improving the resilience of EU credit institutions. CO/2014/043 final – 2014/0020 (COD).
17
Commission Proposal, Explanatory Memorandum Sec. 3.3.1.
18
Ibid, Arts 3(1)(a); 6(1)(a).
19
Ibid, Art 6(1)(b).
20
Ibid, Art 5(4).
21
Ibid, Arts 8–10.

activities—especially market-making, investing in and sponsoring risky securitizations,

and derivative trading—should be ring-fenced in a separately organized and capitalized
trading subsidiary.22 The proposed regulation outlines certain general metrics for supervi-
sory assessments, which are expected to be further developed into technical standards by
the European Banking Authority (‘EBA’) and then adopted by the Commission.23 If, on
the basis of these standards, the supervisor finds that an individual group’s trading activi-
ties exceed certain limits and pose risk to the EU’s financial stability, such activities will
have to be separated.24 The supervisor may require ring-fencing—or ‘subsidiarization’—
even if the relevant limits are not exceeded but potential risk to financial stability renders
such a measure prudent.25
The EC’s proposed regulation was widely seen as a significantly weakened version of
the original Liikanen Report, insofar as it moved away from the idea of mandatory sub-
sidiarization (Alexander, 2015; Freshfields, 2014). Given the highly political and complex
nature of EU decision-making, it is difficult to discern the ultimate shape the European
structural regulation of financial conglomerates will take (Gordon and Ringe, 2015). For
present purposes, however, the important takeaway concerns the general trajectory of
post-crisis structural reforms in Europe, from its traditionally permissive ‘universal bank’
model to the intermediate ‘holding company’ model traditionally associated with the US.
In principle, this movement along the structural continuum reflects European policy-
makers’ desire to reduce the riskiness and complexity of the largest European banks’
activities, to make them easier to resolve, and to minimize the likelihood of taxpayer-
funded bailouts in the future. Ring-fencing and subsidiarization are seen as the means
to achieve these goals, while also avoiding potential economic and political costs of a
strict structural separation. Yet, as the US experience shows, the holding company model
poses its own challenges and may, in many respects, significantly complicate the task
of regulators and supervisors in charge of policing intra-group transfers of risk and
subsidy (Omarova, 2013; Omarova, 2011). The pre-crisis failure of US bank regulators
to fulfill that task effectively has prompted post-crisis efforts at structural reform of the
US financial industry.
IV. FROM HOLDING COMPANY (BACK) TO STRICT

SEPARATION? STRUCTURAL REFORMS IN THE US
The principal piece of post-crisis structural reform in the US is the so-called ‘Volcker
Rule,’ named after the former Chairman of the Federal Reserve System Paul Volcker.
Enacted as part of the Dodd-Frank Act in 2010, this controversial regime introduced
certain limited-scope strict prohibitions on FHCs’ permissible activities, while preserving
the overall holding company structure that has existed in the US since 1956.26 However,
22
Ibid, Art 9(1).
23
Ibid, Arts 9(2)–9(4).
24
Ibid, Art 10(1).
25
Ibid, Art 10(2).
26
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124
Stat. 1376 (2010) (codified in scattered sections of 12 U.S.C.).

the Rule’s complex architecture of categorical prohibitions, exclusions, exemptions and

exemption-limiting ‘backstops’ raises serious questions about its implementation and
efficacy.27 As alternative proposals for a more radical move toward a strict separation
model continue to circulate in political and academic circles, the future trajectory of
structural reform in the US remains uncertain.
1. The Volcker Rule
In the Dodd-Frank Act, Congress amended the BHC Act by adding a new Section 13
that imposes a general prohibition on all ‘banking entities’—a broad term referring to
federally-insured banks and all of their affiliates within the BHC/FHC structure—from
(1) conducting short-term ‘proprietary trading’ in financial instruments (including securi-
ties and derivatives), and (2) having ‘ownership interests’ or sponsoring certain ‘covered
funds’ (including, principally, hedge funds and private equity funds).28 The original
impetus behind this provision was to erect a strict structural barrier between publicly
subsidized banks that offer systemically critical public utility-type products and services,
on the one hand, and non-depository financial institutions that trade and deal in risky
financial assets, on the other (Merkley and Levin, 2011). In that sense, the Volcker Rule
was initially conceived as a shift toward the ‘strict separation’ model. As enacted, however,
the Rule’s transformative aspirations are significantly diluted by many exclusions and
exemptions from its prohibitions.29
In December 2013, the Federal Reserve and other federal bank regulators issued a joint
final rule defining the scope of the statutory prohibitions and exemptions.30 The explana-
tory preamble to the rule ran for nearly 900 pages in the original release, which reflects
the dazzling complexity of the statutory scheme. As implemented by the regulators, the
Volcker Rule attempts to draw a myriad of fine lines between transactions and activities
that, despite being economically similar, are either (1) prohibited, (2) categorically excluded
from the prohibitions, or (3) specifically exempt from them. This elaborate line-drawing,
in effect, translates the statute’s harshly prohibitive main operative provision into a far
more porous and fluid regime, whose applicability and degree of intrusiveness depend on
facts and circumstances surrounding transactions at hand.
The Rule defines proprietary trading broadly, as ‘engaging as principal for the
trading account of the banking entity in any purchase or sale of one or more financial
instruments.’31 The scope of prohibited proprietary trading is tied to three different
tests, depending on (1) the intended purpose of the transaction (ie, whether a transac-
tion is entered into for the purpose of a short-term resale, gain from short-term price
movements, or hedging such short-term transactions), (2) its classification under the
27
For a sample of recent contributions to the debate on the viability and potential conse-
quences of the Volcker Rule, see, eg, Massari and Rosenberg, 2015; Guynn and Kenadjian, 2015;
Dombalagian, 2013; Chow and Surti, 2011.
28
12 U.S.C. § 1851 (2012).
29
See, 12 U.S.C. § 1851(d).
30
See, 12 C.F.R. Parts 44 (OCC), 248 (Federal Reserve), 351 (FDIC) and 17 C.F.R. Part 255
(SEC).
31
12 C.F.R. § 248.3(a).

market risk capital rules, and (3) the status of the entity (ie, whether the banking entity
is a registered swaps dealer).32 It then creates a series of definitional exclusions from the
prohibition. For example, ‘spot’ trades in foreign exchange and physical commodities
are excluded from the definition of ‘financial instrument’.33 Similarly, securities lend-
ing and repurchase transactions are excluded from the definition of ‘proprietary
trading’.34
Furthermore, the Rule sets forth conditions under which non-excluded proprietary
trades may be nevertheless exempt from the general prohibition. Among the most signifi-
cant statutory categories of such ‘permitted activities’ are market-making and hedging.
The Rule allows banking entities to conduct proprietary trading as part of their bona fide
market-making if, among other things, the volume, types and risks of financial instru-
ments being bought and sold are designed not to exceed ‘reasonably expected customer
demand’, based on the analysis of historical customer demand, current inventory, and
relevant market trends.35 Similarly, a banking entity is allowed to conduct proprietary
trading for bona fide hedging purposes if, among other things, such activity significantly
mitigates ‘specific, identifiable risks’ related to the entity’s assets and, at its inception,
does not create any significant new risk that is not hedged simultaneously.36 With respect
to both market-making and hedging activities, the Rule also requires that (1) the banking
entity establish a dedicated internal compliance program that meets specified regulatory
requirements; and (2) the relevant staff compensation arrangements not be designed to
encourage prohibited proprietary trading.37
The Volcker Rule regime governing bank entities’ ownership and sponsoring of ‘cov-
ered funds’ contains a similarly complex system of exclusions and exemptions.38 Certain
loan securitizations, joint ventures and non-US funds are explicitly excluded from the
definition of a ‘covered fund’.39 Acquiring an ownership interest in a covered fund solely
as an agent and on behalf of a customer is also excluded from the general prohibition.40
The Rule specifically exempts from the prohibition activities in connection with ‘organ-
izing and offering’ a covered fund, subject to a long list of conditions and quantitative
limitations on permissible investments.41 One of the most significant provisions in this
respect, dubbed ‘Super 23A’ in reference to Section 23A of the Federal Reserve Act,
prohibits banking entities from extending credit to covered funds they organize, sponsor
or advise.42
All permitted activities under the Volcker Rule are subject to ‘prudential backstop’
provisions that override the exemptions for activities involving material conflicts of
interest, exposing the banking entity to high-risk assets or strategies, or posing a threat
32
12 C.F.R. § 248.3(b).
33
12 C.F.R. § 248.3(c).
34
12 C.F.R. § 248.3(d).
35
12 C.F.R. § 248.4.
36
12 C.F.R. § 248.5.
37
12 C.F.R. §§ 248.4; 248.5.
38
12 C.F.R. § 248.10 (d)(9).
39
12 C.F.R. § 248.10 (c).
40
12 C.F.R. § 248.10 (a).
41
12 C.F.R. § 248.11.
42
12 C.F.R. § 248.14(a)(1).

either to the banking entity’s safety and soundness or to the US financial stability.43 Each
regulator responsible for administering the Volcker Rule, including the Federal Reserve,
has an express authority to terminate any activity that violates or enables evasion of the
Rule.44 It is not clear, however, how assertively or consistently these multiple agencies
would be willing to exercise this authority, especially in situations calling for the applica-
tion of prudential backstops or anti-evasion provisions. The inherent difficulty of making
numerous requisite qualitative determinations, many of which turn on the notoriously
elusive proof of intent, renders the administration and enforcement of—as well as com-
pliance with—the new regime particularly challenging (Massari and Rosenberg, 2015;
Dombalagian, 2013; Chow and Surti, 2011).
Concerns about the regime’s complexity and potential impracticability are commonly
voiced both by those who demand more stringent regulation of big banks and by those
who oppose it. Some critics see the Volcker Rule as a hollow shell of the original idea,
impotent and full of loopholes (Eisinger, 2012; Sheppard, 2014). Others attack it as a
heavy-handed attempt to over-regulate and restore the outdated divisions of the Glass-
Steagall era (Davidoff, 2012). As usual, the reality fits somewhere between these criticisms.
It would be inaccurate to interpret the Volcker Rule as a reinstated Glass-Steagall regime
of strict functional separation (Dombalagian, 2013). On the one hand, the general scope
of activity prohibitions under the Volcker Rule is broader than the scope of the Glass-
Steagall Act’s prohibition on affiliation between commercial and investment banks. On
the other hand, the intricate web of capacious exclusions and exemptions—the ‘doors’ in
the wall between traditional banking and proprietary trading—significantly weaken the
Volcker Rule as a structural separation device. At best, the Rule represents an attempt to
find the middle ground between the currently permissive US FHC regime and the strict
sectoral division of the Glass-Steagall era.
Yet, it may not be possible to find a workable ‘middle ground’ of this kind. It may very
well be that an effective shift along the continuum of structural choices from the ‘holding
company’ model to ‘strict separation’ requires an explicit and unreserved ‘push-out’ of
certain activities beyond banking groups’ organizational boundaries. This possibility
is the focus of the post-crisis—and post-Dodd-Frank—debate on the desirability and
practicability of more radical structural reforms in the US.
2. Potential Alternatives: Proposals for Strict Structural Separation
In an interesting historical parallel to the Great Depression era, in the wake of the
latest crisis there have been several attempts to legislate structural separations between
depository institutions and other financial market intermediaries. Thus, in July 2013, a
by-partisan group of US Senators, led by Elizabeth Warren and John McCain, introduced
a bill aptly entitled the ‘21st Century Glass-Steagall Act of 2013’.45 The bill’s stated goal
was to reinstitute the key operative provisions of the Glass-Steagall Act of 1933 that were
43
12 C.F.R. §§ 248.7; 248.15.
44
12 U.S.C. § 1851(e)(2).
45
The original text of the proposed legislation is available at http://www.warren.senate.gov/
files/documents/21stCenturyGlassSteagall.pdf.

repealed by the GLB Act. The proposed bill would: (1) expressly prohibit federally insured
deposit-taking institutions from affiliating or having interlocking management with
securities firms, insurance companies and derivatives dealers; and (2) tighten the scope of
banks’ permissible activities, among other things, by prohibiting investments in structured
or synthetic products.46 The existing statutory category of an FHC would be eliminated,
and all FHCs would have to terminate their non-conforming activities and divest all of
their securities, insurance and derivatives subsidiaries within a five-year period.47
Another intriguing parallel between the country’s two great financial crises in modern
history is the recent re-emergence of proposals for even more radical restructuring of
the financial sector along the lines of so-called ‘narrow’ or ‘utility’ banking. Today’s
proponents of ‘narrow banking’ advocate separating banks’ deposit-taking function from
their lending function, thus restricting or even taking away banks’ power to create credit
and money and effectively turning them into ‘safe’ money-market mutual funds (Levitin,
2016; Wilmarth, 2012; Pennacchi, 2012; Kotlikoff, 2011). In principle, these proposals
build on the idea of ‘100 percent reserve banking’, advanced in the wake of the Great
Depression by economists Irving Fisher and Henry Simons and later developed by the
Austrian and Chicago school economists (Levitin, 2016: 414). While some of the current
variations allow ‘narrow banks’ to engage in low-risk lending (White, 2016), others restrict
banks’ activities to providing basic payments and safekeeping services and investing in
government debt and other short-term money instruments. It is difficult to envision how
‘narrow banking’ proposals would be implemented in practice, given the fact that any
attempt to do so would entail sweeping changes in the way credit is created, monetary
policy is conducted, and financial services are performed and regulated (Levitin, 2016).
A conceptually different proposal seeks to preserve financial stability by strictly limit-
ing and regulating the universe of financial institutions authorized to issue deposit-like
short-term labilities, such as repos (Ricks, 2013). Under this ‘licensed money’ regime,
entities authorized to issue federally-guaranteed short-term ‘money-claims’ would be
subject to what closely resembles the existing US bank regulation, including capital
requirements and activity limitations. Much like the existing US regulation, the proposed
regime would generally allow affiliations between licensed money-claim issuers and other
financial institutions within a single corporate structure. Unlicensed entities, however,
would be prohibited from funding themselves by issuing money-claims (Ricks, 2013).
The primary purpose of this approach is to reduce the likelihood of destabilizing panics
of the kind that took place in the fall of 2008. From a structural perspective, this regime
would operate as a readjustment, rather than a complete overhaul, of the existing model.
Nevertheless, by limiting access to short-term funding markets, the proposed scheme can
potentially shrink the shadow banking sector, a major source of financial instability and
systemic risk.
As this brief overview demonstrates, the future trajectory of structural reforms in the
US remains a deeply contested subject. Of course, the center-stage in today’s policy debate
is occupied primarily by the familiar issues related to the implementation of Dodd-Frank
and Basel III rules (Fischer, 2016; Yellen, 2015). Yet, just beneath the surface or in the
46
Ibid, Sec.3.
47
Ibid, Sec.4.

background of these regulatory issues de jour, there is a persistently open question of

whether the ultimate remedy for systemic risk must operate on the more fundamental level
of the institutional structure of finance.
V. WHY IT MATTERS: STRUCTURAL REFORM ON CENTRAL

BANKS’ AGENDA
Even a brief description of structural reforms currently pursued or contemplated in

the US, UK and EU underscores their potentially transformative and far-reaching
impact on the global financial system. Although not much has happened yet to bring
such transformative effects to life, structural reform already occupies an increasingly
important place on central banks’ policy agenda. An obvious reason for it is the fact that
central banks are often given formal responsibilities to implement and administer laws
governing financial industry structure, such as the Volcker Rule or the UK’s ring-fencing
regime. More generally, however, this heightened post-crisis salience of industry structure
on central banks’ agenda is both (1) a logical extension of their newly affirmed focus on
safeguarding financial stability, and (2) an institutional response to the growing pressures
on central banks to act as default regulators of ‘all things systemic’—and, as part of
this de facto mandate, to fill the gaps that a successful structural reform of the financial
industry ought to fill. The discussion below elaborates on these more subtle links.
1. Systemic Risk Implications: The Pros and Cons of Structural Reform
To the extent that the structure of the financial services industry significantly affects
long-term financial and monetary stability, it should be an issue of high importance
to central banks. Given the high stakes involved, however, it is not surprising that the
ability of any particular structural measure to reduce systemic risk in practice is always
a subject of heated debates. So, what are the main potential benefits and harms of using
structural reform—a blunt regulatory tool—to solve the complex puzzle of systemic risk
prevention? While the preceding discussion of European and US reforms mentioned
some of the arguments for and against them, a brief recap of these arguments’ key points
helps to highlight why central banks should—and, to a great extent, already do—have a
strong voice in this debate.
As a general matter, structural reforms are typically justified on several grounds
(Mitchell, 2011; PRA, 2014; Merkley and Levin, 2011). First, all of the current structural
reforms, described above, are rationalized as hard-wired measures necessary to protect the
safety and soundness of publicly-guaranteed core depository institutions by insulating
them from the additional, often different in their dynamics, risks generated elsewhere in
the financial markets.
Second, it is claimed that legal, economic and organizational barriers between core
depositories and other financial intermediaries would help to prevent the emergence of
TBTF conglomerates that enjoy unjustified ‘special’ privileges and are largely shielded
from operation of market discipline. This line of argument ties together concerns about
potential leakage of public subsidy to support financial speculation and concerns about
costly public bailouts of large financial conglomerates.

Third, structural reforms are often explicitly aimed at eliminating or minimizing

potential conflicts of interest that arise when banking institutions are allowed to have a
direct economic stake in a wide variety of financial transactions. In addition to preventing
banks from abusing their informational and funding advantages to the detriment of their
clients, these measures seek to increase the allocative efficiency in markets for capital.
Fourth, all of the current reform efforts are advocated as an effective method of
simplifying the organizational structure of large financial conglomerates and, as a result,
making it easier for the regulators to regulate and supervise them. Drawing categorical
lines between permissible and impermissible activities is meant to define a more manage-
able and transparent universe, both for the purposes of financial institutions’ internal
governance and for the purposes of government oversight. As the discussion above
illustrates, an important thread in this line of argument is the expectation that structural
separation would increase the resolvability of individual financial institutions.
At the same time, however, many industry insiders and observers remain skeptical
about the ability of the ongoing structural reforms, discussed above, to deliver on their
promised benefits. In general, these reforms are criticized as unnecessarily harsh and
excessively blunt measures that, contrary to their proclaimed goals, would significantly
diminish both the safety and soundness of individual banks and overall systemic stability.
Critics argue that breaking up financial conglomerates will destroy crucial efficiencies and
economies of scale and scope, which arise from combining different specialized financial
intermediaries. They argue that limiting banks’ permissible activities and affiliations will
render them incapable of diversifying their assets and thus increase their risks. They also
claim that such measures will increase systemic risk by driving risky activities from the
regulated banking sector into the unregulated—and, therefore, more dangerous—shadow
banking sector (Guynn and Kenadjian, 2015; Huertas, 2015).
Another set of objections to structural reforms focus primarily on thorny issues of
practical implementation. Critics argue that these reforms impose unjustifiably high
compliance costs on the financial industry. They claim that mandated structural changes
are extremely complicated, while the legislative and regulatory rules are insufficiently
detailed to provide meaningful guidance for the industry. As a result, the reforms are
seen as not only harmful but impracticable (Guynn and Kenadjian, 2015; Huertas, 2015).
It is not the purpose of this chapter to adjudicate the relative merits of these arguments.
What is more interesting for present purposes is that, in essence, these criticisms point at
the fundamental problem that all structural reforms seek to resolve but inevitably recreate
at a new level—the regulatory ‘boundary’ problem (Goodhart, 2011, Brunnermeier at al,
2009). This perennial ‘boundary’ problem arises from the fact that (almost) any effective
finance-regulatory measure restricts regulated entities’ ability to generate the highest
private profits they otherwise could generate (Brunnermeier at al, 2009: 67). As the returns
achievable in the regulated sector fall, regulated entities seek to shift their business activities
to the unregulated sector that promises higher profits. The crux of the boundary problem
is not simply the inevitable dilutive, or even outright subversive, effects of these activity
flows on the relevant regulatory regime, but also the inherent procyclicality of such flows:
During good times funds will flow from the regulated to the unregulated, and the regulated will
seek to find ways of transferring business to unregulated associates. During crises the flow will
reverse, likely with serious adverse consequences ((Brunnermeier at al 2009: 69).

The boundary problem is a generic phenomenon associated with any effective finance-
regulatory action (Goodhart, 2011: 342), and indeed is familiar in broader legal and
regulatory debates generally. However, it is especially salient in the context of structural
reform, simply because a direct government-mandated reordering of intra-industry and
intra-firm divisions is the quintessential boundary-building exercise.48 Moving from the
less restrictive to the more restrictive choices on the continuum of structural reform,
moreover, tends to exacerbate the regulatory boundary problem.
By leaving organizational decisions largely to the firms’ managers, the universal bank
model allows a relatively free flow of financial activities within and among individual
entities.49 While the universal bank model is less likely to create acutely visible boundary
problems, it is also less likely to protect large conglomerates’ core banking operations
from contagion and other externally generated risks. This trade-off was laid bare during
the recent financial crisis and provided the impetus for European efforts to move toward
a more restrictive holding company model.
By insulating the groups’ core banking operations from the rest of their activities,
the holding company model makes the boundary problem both more visible and more
challenging. This reflects a fundamental tension at the heart of the model: while each
banking group (an FHC, in the US regulatory vocabulary) is a single economic enterprise,
it is prohibited from taking full advantage of its bank subsidiaries’ low funding costs and
large balance sheet capacities. The US experience, especially after the passage of the GLB
Act in 1999, vividly illustrates both the inevitable procyclical flows of activities and risks
across that intra-entity regulatory border and the difficulty of policing such flows from
the outside (Omarova, 2011; Omarova, 2009).
The boundary problem is most salient—and controversial—in the strict separation
model that imposes the most overtly restrictive activity prohibitions on the entire banking
group. What makes this approach intuitively appealing is the clarity of the bluntly drawn
lines between what is in, and what is out, of the entire banking group’s business perimeter.
If successful, this approach is more likely to bring the greatest expected benefits of
structural separation, as outlined above. The degree of its success, however, is much more
directly tied to the regulators’ practical ability to manage the stark boundary problem it
creates—a tall order, especially in boom times. Not surprisingly, one of the key arguments
in favor of the current European choice to keep trading activities within banking groups is
that this more moderate approach would minimize the outflow of risky activities into the
unregulated sector, thus minimizing the severity of the boundary problem (Gambacorta
and Van Rixtel, 2013).
In sum, placing specific structural reform efforts in this conceptual context highlights
the importance of an inherent trade-off between their potential to yield systemic stability-
enhancing benefits, on the one hand, and the severity of the boundary problem they raise,
48
Goodhart identifies geographic cross-border flow of financial activities as a separate
‘boundary’ problem (Goodhart, 2011). While cross-border arbitrage is a critical issue in financial
regulation, it is not addressed in this chapter.
49
In practice, universal banks are often set up as conglomerates (eg, European bancassurance
groups), but these decisions are driven by factors other than a special industry-wide legislative
or regulatory scheme seeking to control systemic risk through mandatory large-scale structural
segmentation.

on the other. It also shows why the Federal Reserve, Bank of England (‘BoE’), European
Central Bank (‘ECB’), and other European countries’ central banks—these designated
guardians of systemic financial stability in the post-crisis era—must play the key role in
deciding where and how to draw the newly pertinent structural boundaries. What is less
intuitively obvious, however, is that central banks also have a significant institutional stake
in the successful outcome of the current—and, potentially, future—efforts to restructure
financial services industry.
2. Institutional Implications for Central Banks
In order to appreciate fully why structural reform is an issue of critical importance to cen-
tral banks, it is helpful to consider the effects of structural choices on their jurisdictional
reach, liquidity support function, substantive regulatory and supervisory mandates, and
institutional capacity.
Regulatory perimeter
Structural divisions in the financial sector fundamentally shape, and are shaped by, the
jurisdictional lines defining the responsibilities and powers of the central bank, both as
a monetary policy-maker and as a financial sector regulator. The most readily available
examples of this dynamic arise in connection with central banks’ exercise of their explicit
regulatory and supervisory authorities.
Thus, in the US, the statutory criteria for subjecting banking groups to regulation and
supervision by the Federal Reserve under the BHC Act establish a crucial structural divi-
sion in the US financial sector. Before the recent crisis, much of the regulatory arbitrage
in the US financial sector involved effective replication of banking activities outside, or
on the edges, of the Federal Reserve’s regulatory perimeter (Gerding, 2014). By expanding
the outer limits of BHC-permissible activities, the GLB Act significantly expanded the
Federal Reserve’s jurisdictional reach to include ‘umbrella’ oversight of securities, insur-
ance and other FHC-permissible activities. The post-1999 changes in financial markets,
in turn, led to further expansion of the Federal Reserve’s regulatory perimeter under the
Dodd-Frank Act, which brought within it two new categories of ‘systemically important
financial institutions’ (‘SIFIs’) and ‘financial market utilities’. While well-justified on
systemic risk grounds, these measures potentially complicate both the existing industry
structure and the Federal Reserve’s regulatory and supervisory duties. They may also
encourage new forms of regulatory arbitrage, as financial firms seek to position them-
selves inside or outside the newly expanded Federal Reserve jurisdiction.50
Liquidity support perimeter

Structural reforms can also have a potentially significant impact on central banks’ tra-
ditional lender-of-last-resort (‘LOLR’) role. On the most basic level, drawing structural
50
By early 2016, two designated SIFIs, General Electric and MetLife, have already decided
to divest some of their business lines. See, Ryan Tracy, ‘MetLife’s Planned Divestiture is Latest
Fallout From Stricter Regulation’ Wall St. J. (12 January 2016). In June 2016, FSOC formally
rescinded General Electric’s SIFI designation. See, Ted Mann and Ryan Tracy, ‘GE Capital Sheds
“Systemically Important” Label’ Wall St. J. (29 June 2016).

boundaries in a way that limits direct access to central bank liquidity backup facilities
only to closely regulated ‘core’ banks creates powerful incentives for financial institutions
to acquire such subsidy-eligible banks. At the same time, the growing volume and signifi-
cance of money- and credit-creation outside of the regulated banking system put pressure
on central banks to start providing liquidity support to a broad range of ‘shadow’ banks
(Domanski et al, 2014; Tucker, 2014; Mehrling, 2011). This is exactly what happened
during the 2008–09 crisis, when the Federal Reserve, BoE, ECB, and other central banks
effectively acted as ‘dealers of last resort’ propping up markets in asset-backed securities
and commercial paper (Domanski et al, 2014; Mehrling, 2011). Thus, to the extent that
structural reforms succeed in severing the key channels of systemic interconnectedness
and shrinking the size of the shadow banking sector, they will also help to resolve cur-
rent ambiguity with respect to the post-crisis scope of central banks’ liquidity support
functions.
Substantive regulatory mandate

Structural reforms also directly implicate issues related to central banks’ substantive
regulatory mandates and supervisory tools. For instance, in a holding company model,
one of the critically important substantive regulatory goals is effective maintenance of
the internal structural boundary between publicly subsidized banks and their non-bank
affiliates. As discussed above, the Federal Reserve administers both the general regime
governing US banks’ transactions with affiliates under Section 23A of the Federal
Reserve Act and the new ‘Super 23A’ regime under the Volcker Rule. The UK and EU
reforms contemplate similar limitations on intra-group transactions, in recognition of the
importance of the ‘height’ of the internal ‘fence’ (ICB, 2011).
‘Living wills’ and, more broadly, emerging group resolution regimes provide another
example of how industry structure shapes central banks’ supervisory toolkits. It is the
continuing existence of large bank-centered conglomerates in the US and EU that neces-
sitates periodic production and supervisory review of their complex internal resolution
plans, or ‘living wills’. As experience shows, however, it is a highly complicated and
controversial exercise, whose practical usefulness remains subject to doubt (Heltman,
2016). By contrast, restructuring the financial industry along the lines of a more strict
separation would likely render the institution of ‘living wills’—as well as complex special
regimes for bank affiliate transactions—either superfluous or far less critical for systemic
risk purposes.
Institutional capacity and autonomy

Financial sector structural reforms are also potentially relevant from the point of view of
central banks’ institutional capacity to perform their numerous functions. As examples
above show, it appears that, in general, less clearly defined structural boundaries put
greater pressures on the central bank’s capacities as a financial regulator and supervisor,
monetary authority and last-resort liquidity provider. The Volcker Rule, with its highly
complex and context-dependent hierarchy of activity prohibitions and allowances,
provides a vivid illustration of this capacity-pushing effect.
Central banks’ capacity is also closely tied to their institutional autonomy and inde-
pendence, not only from politicians but also from private interest groups (Conti-Brown,
2016). Allowing extensive structural affiliations between banks and other financial firms

accordingly expands the central bank’s regulated-industry constituency. Facing a greater

number of larger—and more closely economically and politically aligned—industry
actors potentially increases the likelihood of certain perniciously subtle forms of regula-
tory capture and erosion of the central bank’s mission-oriented culture (Kwak, 2014;
Baxter, 2012).
To summarize, issues of financial industry structure are deeply embedded in—indeed,
they permeate—central banks’ evolving regulatory and policy agenda. Highlighting the
determinative effects of underlying structural choices on central banks’ daily functions
helps to appreciate why central banks need to develop a better understanding of the
potential implications of specific structural reforms both for long-term financial stability
and for their own institutional design and development.
VI. CONCLUSION
The purpose of this chapter is to start exploring some of the complex issues that post-
crisis reforms of financial industry structure present in the context of central banks’
evolving efforts to safeguard systemic financial stability. The structure of the financial
system is one of the key determinants of the system’s ability to contain and moderate—
or, conversely, transmit and amplify—risks generated in particular market segments
(Caruana, 2010). And the more complex and fast-moving the financial system is, the
higher is the importance of specific structural choices and boundaries that channel and
organize its inner flows.
Explicitly confronting these choices will help central banks to establish a more robust
framework for pursuing their broad systemic stability goals. By contrast, failure to
understand the full implications of structural reforms—and to assert a more cohesively
articulated and public role in shaping their objectives and outcomes—threatens to make
central banks’ post-crisis job more difficult to perform and less likely to bear fruit.
Unresolved structural problems will not simply dissipate but will likely resurface on the
central banks’ ‘to-do’ lists, albeit in a different guise and in an ad hoc manner. In order to
avoid having to play endless rounds of ‘whack-a-mole’, it might be necessary for central
banks to put financial sector structural reform on top of their present policy priorities.
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24. The role of macro-prudential policy*
Charles Goodhart
I. WHY?
The term ‘macro-prudential’ began to be used in regulatory circles as far back as 1979
(Clement 2010), but became popularised when used by Andrew Crockett, then General
Manager of the Bank for International Settlements (BIS), in a speech (2000), ‘Marrying
the micro- and macro-prudential dimensions of financial stability’. Macro-prudential
regulations focus more on the banking system as a whole, whereas micro-prudential
regulations relate to the individual bank. Since the onset of the Great Financial Crisis
(GFC) in 2008, macro-pru has become a commonly used buzz-word in banking circles.
In this chapter we shall briefly note:
Why this has happened;

What macro-pru entails;
Who should manage it;
And how it has been done to date.
The onset of the Great Financial Crisis in 2008 shattered the belief that a Central
Bank’s functions could be limited to using a single instrument, the interest rate, for
achieving a single objective, price stability, as generally represented by an inflation
target.1 Inflation targets had, in most developed countries, been successfully met in
the years leading up to the GFC; indeed, during these years of the Great Moderation
(1992–2007), macro-economic developments more generally had been rather favorable
with steady growth and low unemployment. Nevertheless financial instability occurred,
with a boom in housing, property and bank credit giving way to a financial bust of
epic, global proportions.
The need to combine adherence to price stability, initially via maintenance of the Gold
* Portions of this chapter overlap with my chapter on ‘The Use of Macroprudential

Instruments’ in the CEPR e-book, edited by Dirk Schoenmaker for CEPR Press in 2014, pp.
11–20.
1
Some Central Banks, eg, the Federal Reserve System, also were mandated to have regard to
employment as a further objective. Most of the time, however, the main shocks hitting the economy
are to demand, rather than to supply. In such cases above target inflation would accompany an
unsustainable output gap, with employment above its ‘natural’ level, so there would be a ‘divine
coincidence’ as Blanchard and Gali (2005) termed it between measures to stabilise inflation around
target and to return employment to its ‘natural’ sustainable level.
When there was a supply shock, say to oil production and prices, that could be handled by
making the inflation target ‘flexible’, Svensson (1997), with the policy measures only seeking to
drive inflation back to target after the direct effects of the supply shock had dropped out of the
reckoning.
508

The role of macro-prudential policy 509
Standard, with the achievement of financial stability had long been seen as the central
problem of Central Banking (H Thornton, (1807), W Bagehot (1873), as also described
in Goodhart (1988)). Nevertheless in the years prior to 2008, the financial stability role
of Central Banks was systematically downgraded. This was partly because of a view
that, whereas it was difficult to perceive (unsustainable) booms, it was relatively easy to
‘clean up’ after a bust, the ‘Greenspan put’, which added to the markets’ view that risk
had receded.
But it was also due to a combination of myths:
That the maintenance of macro-economic (price) stability would ensure financial

stability, in contrast to the Minsky hypothesis that greater macro-stability would
engender more risk-taking, see for example Wray 2016, and Minsky 1982 and
1986.
That a combination of macro-economic stability with adherence to the Basel II
capital adequacy requirements would ensure that banks would be, and be seen to be,
solvent. That banks’ internal risk models, so central to Basel II, would necessarily
reflect reality, including via the use of ever more sophisticated financial innovations
to direct risk to its most efficient home.
That bank solvency, thus assured, would enable banks always to borrow from
wholesale markets to obtain and manage their liquidity.
That financial instability can be a problem for developing countries, but not for
advanced economies.
It also occurred at a time of the apogee of belief in the efficient markets hypothesis, not
only that markets would never become dysfunctional, but also that agents could assess,
and protect against risk, so as to avoid potential catastrophe. See for example Greenspan
(1999).
Even so, some had argued, even prior to the GFC, that Central Banks could, and should,
have leant against the wind in their use of their single interest rate instrument. (See Borio
and White (2004), Borio, Furfine and Lowe (2001), Borio and Lowe (2002), Cecchetti,
Genbert, Lipsky and Wadhwani (2000), and Cecchetti, Genberg, and Wadhwani (2003).)
But using one instrument to achieve two objectives would often lead to a failure to succeed
sufficiently with either objective. Central Bankers believed in the Tinbergen principle,
that the authorities would need as many instruments as they had objectives to function
effectively. In view of the earlier history of worsening inflation in the 1960s and 1970s,
the struggle to rein back inflation in the 1980s, and the success of the Great Moderation
in the 1990s and 2000s, few Central Bankers agreed to abandon giving primacy to price
stability. Indeed they firmly rejected proposals to recast and to raise the inflation target
itself, as in Blanchard, Dell’Ariccia and Mauro (2010), in order to make it easier to avoid
the zero lower bound (ZLB).
So Central Banks became obligated to achieve two objectives, financial stability as
well as price stability. While this had historically been a central function for those Central
Banks operating in the nineteenth century, when adherence to the Gold Standard ensured
the maintenance of price stability, it had not been foremost in the minds of those prepar-
ing a legal mandate for more recently established Central Banks. Clauses relating to such
matters as maintaining a well-running payment systems were stretched in concept to cover

financial stability overall as well, as in the case of the European Central Bank (ECB),2 and
potentially, the Riksbank.3
Anyhow, after the GFC struck, Central Banks now found themselves saddled with two
responsibilities and objectives, financial stability as well as price stability. If you have two
objectives, the Tinbergen principle indicates that you need two (sets of) instruments to
achieve both ends satisfactorily. This need was seen almost as soon as the GFC struck,
(Brunnermeier et al, 2009), and the set of instruments designated for this role was given
the title of macro-prudential instruments.
II. WHAT?
The main threat to financial stability has mostly come from the banking system, though
the experience of the Tulip mania, the South Sea Bubble and other manias show that
this is not necessarily so (Kindleberger and Aliber, 2011). The banking system combines
high leverage with massive maturity mismatch (liabilities of much shorter duration than
assets), which makes them liable to runs. In recent decades this mismatch has been aggra-
vated by the increasing weight of property-related loans, especially housing mortgages, in
banks’ portfolios (Jorda, Schularick and Taylor, 2014a). But in the interwar period, it was
the banks’ involvement with Stock Exchange financing that in the USA often provided
the trigger for panics.
After the experience of bank runs and failures in the USA during the Great Depression,
1929–33, the authorities there introduced deposit insurance, in order to prevent future
runs, Banking Act (1933). Even in countries without explicit deposit insurance, there
was a general belief that the authorities would never allow ordinary retail depositors in
a properly licenced bank to lose money, ie, that that there was implicit deposit insurance
and that bank deposits were safe.
While this perception has been threatened on occasions, eg, Northern Rock in the UK
(2007), Money Market Mutual Funds ‘breaking the buck’ in the USA (2008), Cypriot
bank crisis (2012/13), it has remained largely unscathed. As bank lending, mainly to
finance household mortgages and Commercial Real Estate, grew much faster than (retail)
2
‘One of the Eurosystem’s basic tasks is “to promote the smooth operation of payment
systems” (Article 3.1 of the Statute of the European System of Central Banks and of the European
Central Bank). The legal basis for the Eurosystem’s competence in the area of payment and set-
tlement systems is contained in Article 127(2) of the Treaty on the Functioning of the European
Union.
According to Article 22 of the Statute of the European System of Central Banks and of the
European Central Bank, “the ECB and the national central banks may provide facilities, and the
ECB may make regulations, to ensure efficient and sound clearing and payment systems within
the Union and with other countries”.
The safe and efficient functioning of market infrastructures for payments, securities and
derivatives is an important element of a sound currency and is essential to the conduct of monetary
policy and for the maintenance of financial stability. The Eurosystem has a keen interest in the
prudent design and management of market infrastructures operating in its currency.’
3
Under the Swedish Riksbank Act, 1988, Article 2, ‘The Riksbank should also promote a safe
and efficient payment system’.

deposits from the 1980s onwards, banks turned increasingly to wholesale markets to
finance their needs (see Jorda, Schularick and Taylor (2014b, 2015)). Such wholesale,
market funding was not insured. Moreover, such market loans were made by, often risk
averse, informed lenders, such as Money Market Mutual Funds (MMFs), other banks,
and various wealth-managing funds. These lenders are highly sensitive to information,
and rumours, about changing conditions in financial markets and institutions.
Thus, by 2000, banks had got themselves into a dangerous condition, with an increas-
ing proportion of their loan book consisting of illiquid mortgages, or mortgage backed
securities (mbs), largely financed by uninsured, flighty wholesale deposits. Mortgage secu-
ritisation, for on-sale to longer-term savings intermediaries, was an appropriate means
to mitigate this mismatch. The problem was that too many bankers thought that these
securitised products had an attractive risk-return profile and bought them up themselves
(Lehman, UBS), rather than on-selling them to non-banks.
Anyhow, under current circumstances, it is the interactions between banks and shadow-
banks, ie, financial intermediaries that borrow short and make longer term loans, but
are not regulated as banks, on the one hand, and housing and property markets on the
other, that are the main focus for macro-prudential concerns. Derivative markets more
generally are a further, but usually secondary worry, since the gross volume outstanding is
so large, and the interconnections between the main players so extensive. As has been well
documented, eg Jorda, Schularick and Taylor (2014a,b), most post WWII financial crises
in developed economies have occurred after a boom, linking sharply increasing housing
(property) prices with fast growing bank credit expansion, has turned into a bust.
In the context of such a bust, any bank that is over-levered, with insufficient equity,
and holds relatively few liquid assets, ie, with an excessive mismatch, is a danger to itself
and to the financial system more broadly. So reforms have been set in place, eg, Basel III,
the Liquidity Coverage Ratio, etc, to strengthen both individual banks and the banking
system more broadly at all times. When these relate primarily to each bank individually,
and are meant to remain in place at all times, they go under the general heading of micro-
prudential measures.
In contrast, macro-prudential instruments are intended to be adjusted according to
the danger of a financial crisis, and to the current stage of the financial cycle, to tighten
during the boom over asset (housing) prices and credit expansion, and to be relaxed, or
even removed entirely, during the subsequent slump. Also they are to be applied, usually
to all banks, irrespective of that bank’s individual position, because of macro-prudential
concern with the system as a whole. Although the basic concern is systemic, it may, and
does, frequently relate to components of the financial system, such as the housing market
(or even to sub-parts of that market), and to parts of the banking (and shadow banking)
systems, such as over-the-counter (OTC) derivatives or investment banking, and, as
such, is often granular, in particular much more granular than the use of interest rates in
monetary policy more broadly.
So its defining characteristics involve being more counter-cyclical (nb, with the relevant
cycle being financial, rather than macro-economic) than micro-prudential policy and
more granular than the interest rate policy of the Monetary Policy Committees around
the world. Into this category come time and state-varying capital and liquidity require-
ments for banks and state-varying margin controls for various asset markets, eg, Loan to
Value (Income) ratios (LTVs/LTIs) for mortgages.

One obvious feature of macro-prudential measures (instruments) is how much they

overlap with other sets of policies. This is particularly so with micro-prudential measures.
The two (macro- and micro-prudential) cover mostly the same instruments, for example
capital and liquidity requirements for banks and margins, such as LTVs and LTIs, in asset
markets (especially housing). The main difference is that micro-prudential measures are
institution-specific, while macro-pru measures are state (phase of the cycle) specific.4
A continuing problem is that micro-prudential measures, although intended to remain
constant over time and over states, are in practice highly pro-cyclical. After a crisis, a bust,
everyone gets risk-averse, and the micro-prudential (and common) response is that ‘that
must never happen again’. So after a crisis, in the downturn, micro-prudential measures
tend to get tightened severely. But in a boom, everyone is optimistic. The constraining
effect of the prior round of micro-prudential measures then appears to be both unneces-
sary and undesirable. And so they get relaxed.
The intended function of macro-prudential measures is to be contra-cyclical, but this
runs directly counter to the tendencies of micro-prudence, indeed of human nature.
How, for example, does one justify reducing bank capital requirements in a bust on
contra-cyclical grounds, just after the bust has shown bank capital to have been generally
insufficient? There are some answers to such concerns. If banks held sufficient equity
that they virtually never went bankrupt, contra-cyclical adjustments would be easier to
make. But human nature is pro-cyclical. This suggests that the use of macro-prudential
instruments will prove less effective than currently hoped, and that this is a field where
pre-set rules of operation would be desirable to prevent time-inconsistent pro-cyclical
behaviour from dominating.
Not only does macro-prudence overlap with micro-prudence, but it also overlaps with
straightforward macro-monetary policy. This latter is mainly undertaken via changes in
the official short-term rate. But macro-prudential measures take effect in many instances
by changing the effective cost of borrowing/lending in particular (though often sizeable)
financial markets. Thus the higher (tighter) the general level of interest rates, the less is the
need for macro-prudential measures in order to restrain and calm some particular market.
Similarly the tighter are macro-prudential measures in some key markets, the less is the
need for official short rates to rise in order to achieve some overall aggregate effect on
the macro-economy. Similarly, the adoption of requirements for holding excess reserves,
as applied by the Peoples Bank of China, and/or paying interest on banks’ reserves at
the Central Bank, as at the Fed since 2008 (Bernanke 2015, 325), has aspects both of
monetary and of macro-prudential policy.
The overlap is even more apparent in the case of unconventional monetary measures
to support and to restart dysfunctional markets. In such cases macro-monetary and
macro-prudential measures effectively merge. Was the credit-easing (CE) policy by the
Fed, to support US housing finance, macro-monetary or macro-prudential, or both
simultaneously? Exactly the same question could be asked about the ECB’s Securities
Market Programme (SMP) and Outright Monetary Transactions (OMT) programs.
4
Emergency lending, Lender of Last Resort (LOLR) actions and Quantitative Easing come
at the intersection of monetary policy and macro-prudential policies, with (in the case of LOLR)
micro-prudential implications as well.

Virtually all monetary policy actions have fiscal implications and consequences,
perhaps few more so than standard changes in the official short-term interest rate. Nor
is there any historical justification for the claim that Central Banks should confine their
open-market-operations to government debt; prior to 1914 they operated primarily
in the private-sector commercial bill market. Nevertheless once Central Banks move
beyond the regulation of banks and operations in public sector debt to take actions that
directly influence prices, and rates of return, in other asset markets, it does raise a ques-
tion about the appropriate sphere of influence, and limits to the powers of, (unelected)
Central Bankers as contrasted with the democratically elected legislatures. Indeed, the
effects of the kinds of quantitative restrictions, over margins, capital requirements, etc,
that Central Banks can, on occasion, impose on asset markets can be largely mimicked,
and have similar effects, by changing tax rates on those same market actions. There is
a sizeable literature, see Perotti and Suarez (2011) on the comparative advantages of
quantity or price restrictions.
Prior to the GFC, the relevant operational independence and activity of Central Banks
was in most cases relatively narrowly and clearly defined. Post GFC, with the added
responsibility for Financial Stability as an objective, and greater control over, and opera-
tional commission for, both macro- and micro-prudential regulation and supervision, the
previous clear limits have both widened and become blurred.
But this is to take for granted that macro-prudential measures will be allocated to
Central Banks, rather than to some other specialised institution. Such an assumption is
not generally valid. We turn next to this issue.
III. WHO?
We have claimed that Central Banks have now, willy-nilly, been allocated responsibility for
financial stability. If so, it would seem odd not also to give them command over the main
levers, the macro-prudential instruments, for achieving such stability. Moreover, several of
such instruments involve either imposing requirements on banks, eg, state-varying capital
requirements, or changes to the Central Bank’s own portfolio, eg, acting as market-maker
of last resort via Credit Expansion (CE) that would seem necessarily to be within the
natural province of Central Bank decision-making.
A problem with this is that, if the Central Bank is tasked with the achievement of
financial stability and allocated responsibility for using macro-prudential instruments to
that end, then it needs the micro-level information base in order to do so efficiently. This
line of reasoning would suggest that micro-prudential regulation and supervision should
also now come increasingly under the aegis of the Central Bank, as has been happening
in the ECB and Bank of England (BoE), and partially in the Fed.
So, although the main Central Banks did not cover themselves with glory in the run-up
to the GFC, an outcome of the GFC has been a massive expansion of Central Bank
powers and responsibilities. It is not, as of now, clear exactly where the limits to such
powers and responsibilities may be established.
Nevertheless some countries, eg, Sweden, have given part, or all, of control over macro-
prudential policy-making to a separate body, usually that institution(s) with responsibility
for micro-prudential measures. Reasons for this include:

Democratic concern about the award of excessive powers to an unelected techno-

cratic institution;
Fear that concern with financial stability may distort the pursuit of the more impor-
tant price stability objective;
Concern that the objective of achieving financial stability may lead the Central Bank
into areas of policy, notably in setting LTVs or LTIs in housing markets, that involve
other political or quasi-fiscal considerations that should be ultra vires for a Central
Bank.5
In those, still perhaps relatively few, instances where the exercise of macro-prudential
powers has been awarded to some other regulatory body, ie, not to the Central Bank, the
obvious and natural interest of the Central Bank in how such powers are being exercised
has generally meant that there is an oversight committee, with both bodies participating,
with the Treasury in the Chair, capable of resolving disagreements between the two main
parties. The Financial Stability Oversight Committee (FSOC) in the USA is an important
example. It is, as yet, too early to tell how such oversight committees will work, though
many are sceptics; the experience of the Tripartite Committee in the UK in 2007–10 was
not particularly encouraging.
Whereas the normal problem is whether to allocate decisions on macro-prudential instru-
ments to the Central Bank or to a separate regulatory authority, the issue in the Eurozone is
rather different, which is whether to make the ECB responsible for such decisions, or to leave
them with the National Central Banks (NCBs). At the moment the tide has been flowing
strongly towards giving such powers to the ECB, for the same kind of reasons as led to it
becoming the single supervisory authority (SSM). This raises the (constitutional/structural)
issue of which bodies should be responsible for macro-prudential measures within the euro-
zone. Up until the end of 2014, the structural arrangements within the EU were, according
to the European Banking Authority (EBA) Report (July 2015), ‘On the Range of Practices
Regarding Macroprudential Measures Communicated to the EBA’, as follows:
The European Systematic Risk Board (ESRB) provided general analytical advice;
The competent (or designated) authority within each Member State took the actual
decisions whether, and what, macro-prudential measures to apply;
The EBA attempted to coordinate.
But now the situation has changed.6 Given its new role in the SSM, the ECB has direct
5
Willem Buiter (2014, 2015) has been particularly keen to limit the role of Central Banks
to their prior core functions for the above reasons. When faced with the complication that many,
perhaps most, macro-prudential measures involve actions affecting the Central Bank’s own balance
sheet, he has suggested that the separate macro-prudential agency be given special powers to adjust
that balance sheet at their own volition, independently of the wishes of its own Central Bank. It is,
however, difficult to envisage any Central Bank Governor agreeing to such an intrusion on its right
to control its own balance sheet.
6
This is indicated from the following quotation from the same EBA Report (pp 25/26):
‘Given that the ECB took over its supervisory role for SSM countries at the end of 2014, it is not
surprising that over the period in scope of this report notifications were received from national

responsibility for monetary policy and ultimate responsibility for micro-prudence. So

it must, surely, take a leading role in setting macro-prudential instruments which lie in
between, but exactly what role? There are a range of unanswered questions:
What does the ECB see as its future responsibilities for setting macro-prudential
instruments? What will be the division of responsibility between the ECB and member
state authorities for varying macro-prudential instruments? What will happen if they
should disagree? Will each have a veto, or does the final decision then go somewhere else,
eg Ecofin?
The ECB can, and will, do its own analysis and seek to manage coordination among
member states. What role, if any, is then left for the ESRB and EBA in this respect?
Responsibility for macro-prudential supervision is thus currently shared between the
ECB, national authorities/councils of financial stability7 and the ESRB (though the
latter’s ‘powers’ are limited).8
Be that as it may, the marked institutional differences between some asset markets,
eg, the housing market, in the different Eurozone countries and the need for macro-
prudential measures to be much more granular in operation, than either macro-pru or
monetary policy, could eventually tell in the opposite direction.
competent or designated authorities only. Based on Art. 5 of the SSM Regulation [Council
Regulation (EU) No. 1024/2013] the ECB has binding macroprudential competences for articles
in scope of the CRR/CRD. It can apply higher requirements for capital buffers than those
applied by national competent or designated authorities and apply more stringent measures
aimed at addressing systemic or macroprudential risks. Some questions arising from the ECB’s
role and the observations made regarding first notifications are the following:
● Process requirements, e.g. regarding notifications and consultations, should hold in the same
way for the ECB as for national authorities. Art. 5 of the SSM Regulation also requires that,
in a separate notification, the ECB should be informed in advance of national macropruden-
tial measures that fall under the CRR/CRD.
● The need for coordination across microprudential and macroprudential authorities will
include the ECB, in particular as competent authority for all SSM banks. The output of the
ECB’s macroprudential activities related to Art. 5 of the SSM Regulation are communicated
and shared with the NCAs through several committees and finally up to the SSM Supervisory
Board. In this way these measures are communicated within the SSM at an early stage.
● Regarding the use of Pillar 2 for macroprudential purposes, the same coordination issues
arise as described above but with a more complex governance structure and with potentially
less widespread effects, in that an SSM-wide decision using Art. 103 CRD could at least
ensure consistency between SSM participating countries. Hence, coordination issues would
be relevant mainly between SSM and non-SSM countries but would also take advantage of
the more integrated governance structure offered by the SSM.’
7
The CRD IV/CRR includes a number of macro-prudential instruments, such as counter-
cyclical capital buffers, systemic risk buffers, buffers for global systemically important institutions
(G-SII) and other systemically important institutions (O-SII).
8
Angeloni (2015),
‘Country specific risks are better addressed at an early stage by national macro prudential
measures . . . This justifies the fact that in the euro area financial architecture macro prudential
policy is a shared competence between national and European authorities. . . . Several member
states have introduced measures to address excessive credit growth mainly related to mortgage
lending . . . such as caps on loan-to-value ratios.’

IV. HOW?
The use of macro-prudential instruments is still pretty much in its infancy. Its previous
main use has been in small states, such as Hong Kong and Estonia, with currency pegs.
This meant that macro-prudential measures were about the only counter-cyclical mon-
etary policy instruments that they could deploy. The results have generally been felt to
have been beneficial, in the right direction, but not really sufficient to maintain the desired
level of stability (see Akinci and Olmstead-Rumsey (2015)).
There is hardly any experience of larger countries with a floating rate in using such an
instrument. While the Financial Services Authority (FSA) in Sweden has adopted macro-
pru measures to try to calm the housing market there, the Riksbank has tended to claim
that not enough had been done. See various speeches by the Governor of the Riksbank,
Stefan Ingves, in 2015.
The Financial Policy Committee in the UK (FPC) has sought to side-step potential
political concerns about intrusion into the politically sensitive housing market by focus-
sing their measures on guidance on how banks should operate in that market. Proposals
about the conduct of bank mortgage business, the Mortgage Market Review (MMR) and
limits on bank issuance of high LTI mortgage loans, are examples. Currently in 2014/15
the UK housing market appears to be cooling and stabilising, which is encouraging,
though causation is always hard to demonstrate.
Prior to the onset of the GFC, most analysts placed most weight on the rate of growth
of the monetary base as the determinant of broad money growth and bank credit expan-
sion, in a bank multiplier analytical context. In the aftermath of quantitative easing
(QE), and with a combination of a massive increase in bank reserves in conjunction with
sluggish monetary expansion, that analytical framework has collapsed. Particularly at a
time of sharply rising required bank equity ratios, much more analytical weight is now
being placed on bank (equity) capital as the crucial constraint on credit expansion. For
some supporting recent empirical work, see Aiyar, Calomiris and Wieladek, (2014).
In so far as a main potential macro-prudential instrument is the ability to vary the
required capital ratio applicable either to all loans, or to loans of a particular type (eg
mortgages of certain kinds), this suggests that macro-prudential instruments could be
more efficacious (than some of us had feared), and have a quite separate effect, (on
monetary growth and the macro-economy), from the standard variation in policy rates
decided by Monetary Policy Committees (MPCs). But only time will tell.
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Akinci, O and J Olmstead-Rumsey (2015) ‘How Effective are Macroprudential Policies? An Empirical
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Wray, LR (2016) Why Minsky Matters (Princeton NY, Princeton University Press).

25. Transparency of central banks’ policies
Christine Kaufmann and Rolf H Weber
I. INTRODUCTION
1. Central Banks’ New Central Role
Central banks have long been criticized for following a tradition of secrecy and
‘mystique’.1 In fact, until the 1950s it was widely accepted that leading an independent
monetary policy may put limits on transparency. One of the first criticisms was articu-
lated in a hearing of the Committee on Finance and Industry—the so-called Macmillan
Committee—established by the British government in the aftermath of the 1929 stock
market crash for investigating its causes. Following up on a statement by the then Deputy
Governor of the Bank of England, Sir Ernest Harvey, that the Bank did not intend to
publish an annual report similar to the Federal Reserve Board, the subsequent exchange
between Committee member Milton Keynes and the Deputy Governor took place on 12
December 1929:2
Keynes: ‘. . . Is it a practice of the Bank of England never to explain what its policy is?’
Harvey: ‘Well, I think it has been our practice to leave our actions to explain our policy.’
Keynes: ‘Or the reasons for its policy?’
Harvey: ‘It is a dangerous thing to start to give reasons.’
Keynes: ‘Or to defend itself against criticism?’
Harvey: ‘Because the reasons often are based on information which has been obtained in the
strictest confidence, sometimes from foreign countries, and which we should not feel ourselves
at liberty to publish. As regards criticism, I am afraid, though the Committee may not all agree,
we do not admit there is need for defence; to defend ourselves is somewhat akin to a lady starting
to defend her virtue.’
While such a testimony would hardly be repeated by any central banker these days, the
debate on balancing transparency and independence has gained momentum mainly due
to the relevance of monetary policy decisions for market participants and society at large.
For many central banks, the recent financial and economic crises have led to an
expansion of their mandate and a redefinition of their role from shaping the monetary
policy and act as a lender of last resort to become ‘national and global firemen’ with
growing responsibility for the resilience of economies, the stability of financial systems
and individual financial institutions, macro and micro-prudential supervision and
1
Karl Brunner, ‘The Art of Central Banking’ in Hermann Göppl/Rudolf Henn (eds), Geld,
Banken und Versicherungen (Königstein 1981) X.
2
Committee on Finance and Industry, Minutes of Evidence (London, 1931) Vol 1, paras
435–37. See also Otmar Issing, ‘Kommunikation, Transparenz, Rechenschaft – Geldpolitik im
21. Jahrhundert’ (2005) 6 Perspektiven der Wirtschaftspolitik 521, 523.
518

Transparency of central banks’ policies 519
macro-economic and quasi-fiscal policy. Hand in hand with this expanded mandate,
central banks’ balance sheets and the related risks have grown.3 Not surprisingly, this new
‘central role’ of central banks and central bankers for the economy at large has triggered
debates on the magic triangle of power, risks and responsibility in which—as this chapter
aims to show—transparency plays a key role.
2. Notion and Scope of Transparency
In the aftermath of the financial crisis, transparency has become a priority in the agenda
of regulators.4 The focus of transparency is twofold: By emphasizing its role in restor-
ing market confidence and in establishing adequate organizational rules for financial
institutions it aims at the micro-level, while its contribution to improving legal and ethical
behavior concerns the macro-level.5
Transparency is usually defined by reference to terms such as ‘easily seen through, . . .
evident, obvious, clear’.6 Historically, with reference to the Supreme Court Justice Louis
Brandeis, the early promoter of data privacy (in the form of a ‘right to be let alone’,
1890) as well as of transparency (‘sunlight is said to be the best of disinfectants’, 1914),
transparency prohibits arbitrary and unforeseeable actions by the absolute sovereign in
justice matters requiring the publication of the law in force.7
Transparency has also been recognized as a pillar of good governance8 since it is
essential for providing legal certainty as well as for maintaining trust in financial markets.
With the aim of properly shaping transparency policies, clear objectives and principles
that are understandable by all stakeholders need to be implemented.9 The published rules
bind those who are addressed by them and, as a consequence, the concerned persons can
be held accountable and—inter alia—face (legal) consequences. Therefore, accountability
must be closely liaised with the transparency concept.10
3. Transparency as an Anchor for Financial Regulation
In the Atlantic Charter, signed in 1941, Franklin D Roosevelt and Winston Churchill
agreed that stable monetary and financial systems are an important building block
3
Philip Middleton/David Marsh, ‘Challenges for central banks: wider powers, greater
restraints – the financial crisis and its aftermath’ (2013) 1(2) The Journal of Financial Perspectives
47, 48.
4
To the importance of the transparency issue at the first G-20 summit in Washington DC
in November 2008 see Rolf H Weber, ‘The legitimacy of the G20 as a global financial regulator’
(2013) 28(3) Banking and Finance Law Review 389, 394.
5
See Christine Kaufmann and Rolf H Weber, ‘The role of transparency in financial regula-
tion’ (2010) 13(3) Journal of International Economic Law 779, 780–81.
6
Oxford English Dictionary Online, 2nd edn 1989.
7
For further details see Kaufmann and Weber (supra note 5), 782.
8
Rosa M Lastra and Heba Shams, ‘Public Accountability in the Financial Sector’ in E Ferran
and CAE Goodhart (eds), Regulating Financial Services and Markets in the 21st Century (Oxford,
Oxford University Press, 2001) 165, 170–71.
9
Kaufmann/Weber (supra note 5), 780.
10
See below part II.

for a peaceful post-war order. Transparency was considered essential for ensuring
efficient markets, for limiting information asymmetries and for establishing adequate
information flows between the different actors. In this context, the development of
corporate governance principles in public institutions and private enterprises played a
crucial role by requiring publicly accessible accounts as a pre-condition for a sustainable
society.11
Transparency calls for robust regulation, not for more regulation. The objective
of transparency is therefore not a quantitative increase of information, but ‘more’ in
terms of information quality.12 Too much information may overburden the addressees
thus making it very difficult for them to adequately process and consume information
(so-called ‘Cassandra effect’);13 furthermore, such a situation could cause them to ignore
‘the prospects of future changes about the actual character of which we know nothing’14
completely.
Transparency requires States (i) to introduce legal obligations in respect of the disclo-
sure of relevant information on certain activities and (ii) at the same time to ensure access
to that information for all stakeholders with legitimate interests.15 From a substantive
perspective, enhancing transparency depends on the purpose for which the information
is collected, on the incentives for stakeholders to provide that information, and on the
strategies adopted to encourage transparency.16
II. TRANSPARENCY AND ACCOUNTABILITY IN CENTRAL

BANKS
1. Impact of Transparency on Accountability
As mentioned above,17 confidence and trust play an important role in establishing

sound financial markets. With a view to the two key features of transparency, a state
is first required to anchor financial regulation in its overall constitutional framework
and secondly to define the key values and procedures for being applicable to market
participants.18 Accordingly, manifold relationships at different levels are relevant, for
example the relations between the state and the financial institutions and the relations
11
See also Christopher Hood, ‘Transparency in Historical Perspective’ in Ch Hood and D
Heald (eds), Transparency: The Key to Better Government? (Oxford, Oxford University Press, 2006)
3, 17 and 20.
12
Kaufmann and Weber (supra note 5), 788.
13
Rolf H Weber, ‘Kassandra oder Wissensbroker – Dilemma im Global Village’ in: J Becker,
RM Hilty, JF Stöckli and T Würtenberger (eds), Festschrift für Manfred Rehbinder (Bern/
München, Beck, 2002) 405, 407.
14
John Maynard Keynes, ‘The General Theory of Employment’ (1937) 51 Quarterly Journal
of Economics 209, 214.
15
16
Ronald B Mitchell, ‘Sources of transparency: information systems in international regimes’
(1998) 42 International Studies Quarterly 109–10.
17
See above section I.2.
18

between the financial institutions and investors or customers. Since non-compliance or

negative consequences may occur, the transparency principle must be complemented
with accountability mechanisms which may take different forms.19 Beyond its role in
securing its implementation, accountability, together with the constitutional principle of
checks and balances, is a prerequisite for legitimacy and a key ingredient of democratic
governance.20
Accountability can be understood as a relationship between an actor and a forum
in which the actor (the accountable) has an obligation to explain and justify his or her
actions or decisions based on defined criteria to another person (the accountee), and
to assume responsibility for the decisions, ie face consequences if for instance damages
occurs.21 From a procedural perspective, accountability measures may take place in the
decision-making process itself (ex ante) for example with stakeholder consultations
before a policy is adopted or after the decision (ex post) by providing stakeholders
with instruments to change the policy, to hold policymakers responsible or to bring a
complaint.22
The legal literature distinguishes various types of accountability, namely moral,
administrative, political, managerial, market, legal, constituency related and professional
accountability.23 Depending on the context, different forms of accountability may be
relevant.24
2. Impact of Accountability on Governance
As an aspect of governance, accountability needs to be looked at from different

perspectives: First, with regard to actors, both internal actors that are part of a rule or
policymaking process as well as external stakeholders and their constituencies respec-
tively, who are outside of the process but affected by it, need to be included. The second
dimension refers to the framework in which measures and rules are shaped that can be
based on individual participation by states, central banks or regulators or on informal
networks. The latter is particularly important outside the traditional formal law-making
process. Third, the domestic and the international level are equally relevant for shaping and
19
Lastra and Shams (supra note 8), 166–69.
20
21
Rolf H Weber, Shaping Internet Governance: Regulatory Challenges (Zürich, Springer, 2009)
133; Joost Pauwelyn, ‘Informal International Lawmaking: Framing the Concept and Research
Questions’ in Joost Pauwelyn, Ramses A Wessel and Jan Wouters (eds), Informal International
Lawmaking (Oxford, Oxford University Press, 2012) 13, 28.
22
Pauwelyn, ibid, 28; Rosa M Lastra and Fabian Amtenbrink, ‘Securing Democratic
Accountability of Financial Regulatory Agencies – A Theoretical Framework’ in RV Mulder
(ed), Mitigating Risk in the Context of Safety and Security. How Relevant is a rationale approach?
(Rotterdam, Erasmus University, 2008) 107–32.
23
Rolf H Weber, ‘Realizing a New Global Cyberspace Framework’ (Zürich, 2014) 78. For a
discussion that includes economic literature see Luis Garicano and Rosa M Lastra, ‘Towards a new
architecture for financial stability: seven principles’ (201) 13(3) Journal of International Economic
Law 597–621, 616–20.
24
Fabian Amtenbrink, ‘Towards an Index of Accountability for Informal International
Lawmakers’ in Joost Pauwelyn, Ramses A Wessel and Jan Wouters (eds), Informal International
Lawmaking (Oxford, Oxford University Press, 2012) 337, 347–51.

Table 25.1 Central bank accountability: stakeholders and audiences
Accountability – International level Accountability – Domestic level

Informal Individual Individual Informal
law-making participants participants law-making
network network
External ex ante and ex ante: ex ante: ex ante and
stakeholders ongoing: appointement, appointement, ongoing:
consultation, comments, comments, multistakeholder
comments consultation multistakeholder consultation,
ex post: ex post: consultation comments
complaints complaints ongoing: ex post: mediation,
mechanism mechanism, parliamentary court proceedings
ombudssystem supervision
ex post: judicial
review
Internal ex ante: ex ante: ex ante: ex ante:
stakeholders nomination of nomination parliamentary nomination of
members ongoing: mandate, vote members
ongoing: participation, ex post: ongoing:
participation, veto (parliamentary) participation,
veto ex post: control, veto
ex post: ombudssystem, comment, judicial ex post: mediation,
complaints complaints review court proceeding
mechanism, mechanism
mediation
assessing accountability. Finally, accountability and related transparency mechanisms

may take place ex ante, ongoing or ex post.
In summarising these elements, external and internal accountability from an interna-
tional and a domestic perspective could have the following design:25
As indicated in the table above accountability is based on and linked to transparency in
various respects: Information is the key ingredient of effective participation; open access
to information is a prerequisite for democratic control, comments and voting rights. Yet,
effective accountability requires not only transparency but also mechanisms for assigning
consequences such as taking corrective measures or launching complaints.26 Furthermore,
experience, particularly after the outbreak of the financial crisis in 2007, shows that the
need for accountability mechanisms at the international level rises in line with the degree
of autonomy of the involved stakeholders and the power exercised by them (de jure or de
facto).27 This is even more relevant for informal rule-making processes which may lack
25
See also Joost Pauwelyn, ‘The Rise and Challenges of “Informal” International Law-
Making’ in S Mueller, S Zouridis, M Frishman and H Kistemaker (eds), The Law of the Future and
the Future of Law (Oslo, Hiil, 2011) 125, 133.
26
Amtenbrink (supra note 24), 349–50.
27
Pauwelyn (supra note 25), 136.

democratic legitimacy or for institutions which are not embedded in a democratic system
and its respective accountability mechanisms but influence the international financial
system.28
Regulatory strategies need to take into consideration the respective accountability
requirements of external and internal stakeholders at the international and the domestic
level. For example, experience shows that more is done at the ex post than at the ex ante
level. In addition, central banks will hardly face consequences for their own actions which
results in a key element of accountability not being implemented.
III. ECONOMIC ASSESSMENT OF TRANSPARENCY POLICIES

IN CENTRAL BANKS
1. Economic Impacts of Transparency
In the economic literature it is widely discussed whether the move of central banks from
rather secretive to more transparent policies has actually had positive economic impacts
and effectively assisted central banks in managing market participants’ expectations.
Detailed research on the economic effects of central bank transparency published in the
early years of this century resulted in mixed conclusions, depending on the specific area
of central banks’ activities.29
In addition, new theoretical research models have emerged, concentrating on
coordination games and decision-making processes within committees. On the one
hand, agents have both public and private information, and are therefore faced with
a coordination motive in addition to a desire to match the economic fundamentals.
On the other hand, the decision-making must reflect the accountability principle.30
In fact, with regard to central banks’ new mandate for macro-prudential supervision
empirical research clearly indicates that the communication of macro-prudential policy
objectives and their implementation plays an essential role in coordinating expectations
of economic agents.31
Typically, five different categories of transparency are distinguished, namely political,
economic, procedural, policy and operational. Not surprisingly, empirical evaluations of
these categories lead to rather complex if not inconclusive results. Still, in more general
terms, recent research on economic effects seems to justify a general increase in transpar-
ency, with the exception of procedural transparency since it may have detrimental side
28
An example in this regard is the People’s Bank of China whose decisions are of increasing
relevance for the international financial system not least due to the Chinese renmimbi becoming
part of the basket of Special Drawing Rights (SDR) currencies as of 1 October 2016.
29
Carin van der Cruijsen and Sylvester Eijffinger, ‘The Economic Impact of Central Bank
Transparency: A Survey’ in PL Siklos, MT Bohl and ME Wohar (eds), Challenges in Central
Banking (Cambridge, Cambridge University Press, 2010) 261, 262, 283–84.
30
van der Cruijsen and Eijffinger (supra note 29), 279–81.
31
Benjamin Born, Michael Ehrmann and Marcel Fratzscher, ‘Communicating about macro-
prudential supervision – a new challenge for central banks’ (2012) 15 International Finance 179,
181–82.

effects on the quality of the discussion and debate32 or exacerbate misalignments between
the exchange rate and fundamentals.33
2. Transparency and Monetary Policies
Early discussions on central banks’ transparency focused on monetary policy. The

economic literature advocated increased transparency with regard to monetary policies,
concluding that this transparency in the conduct of monetary policy must go hand in
hand with the independence of central banks since they respond to the same or, at least,
related imperatives.34 Furthermore, transparency appears to rise in countries with more
developed financial markets, even in the absence of a corresponding strengthening of
central bank independence.35
In the context of the design of monetary policies, transparency (as well as account-
ability and independence, respectively) is usually measured in form of special indexes.
Different approaches are possible; a relatively broad description of variables in the
context of central bank accountability could include the following:36
(1) Mandate: Stipulation of the central bank’s mandate

– Objectives of monetary policy in the central bank law
● Prioritization of objectives?
● Degree of clarity of objectives
● Quantification of objectives
● Key assumptions in generating outlook.
– Role in securing financial stability
– Operational instruments of monetary policy and financial stability measures
● Are monetary policy and operational objectives the same?
● Economic modeling procedures.
(2) Transparency: Regular information published about the monetary policy decision-
making and their justification.
– Obligation to publish specific inflation or monetary policy reports
– Publication of minutes of the governing board within reasonable time.
– Publication of committee voting record.
32
van der Cruijsen and Eijffinger (supra note 29), 287.
33
Ricardo T Fernholz, ‘Exchange rate manipulation and constructive ambiguity’ (2015) 50
International Economic Review 1323–46.
34
N Nergiz Dincer and Barry Eichengreen, ‘Central bank transparency and independence,
updates and new measures’ (2014) 10 International Journal of Central Banking 189, 236.
35
Dincer and Eichengreen, ibid, 236. A special, hereinafter not deepened discussion point
concerns the decision-making related to monetary policies; to this theme see Philippe Maier, ‘How
Central banks Take Decisions: An Analysis of Monetary Policy Meetings’ in PL Siklos, MT Bohl
and ME Wohar (eds), Challenges in Central Banking (Cambridge, Cambridge University Press,
2010) 320–56.
36
The list draws on Amtenbrink (supra note 24), 351–53 and Florin Cornel Dumiter, ‘Central
bank independence, transparency and accountability indexes: a survey’ (2014) 7 Timisoara Journal
of Economics and Business 35, 44.

–Obligation for central bank to publicly explain to which extent objectives have
been reached?
– Does the central bank have a communication policy?
(3) Governance: Degree of independence and responsibility mechanisms for the central
bank
– Is the central bank subject to monitoring by Parliament (including duty to report
or explain specific measures)?
– Has the Government the right to give instructions?
– Has the central bank a possibility for an appeal in case of an instruction?
– Can the central bank law be changed by simple majority in Parliament?
– Can a central bank governor be dismissed based on performance?
Other approaches distinguish between different kinds of transparency with the possibility
to subdivide each group (for example political, economic, procedural, policy and opera-
tional transparency) or between the objectives and the strategies.37 In order to achieve
highly reliable results the literature suggests developing an aggregate index for measuring
the manifold relevant elements, in order to overcome the different sizes and complexities
of samples.
3. Transparency and Financial Stability
A special and more recent economic research question concerns the impact of central
bank transparency on financial stability.38 The analyses usually evaluate the Financial
Stability Reports published by many central banks. These Reports present the overall
assessment of risks and threats to the financial system and an evaluation of the capacity
for coping with them.39 Partly, a newly constructed Financial Stability Transparency
(FST) index is proposed, composed of a relatively large number of items; the applied
elements address the legal foundations of the Reports, the frequency of publications, the
forward looking elements in the analyses, the coverage of the Reports, the mentioning
of stress tests, and the existence of specific financial stability policy committees.40 The
relevance of the latter as key elements of the post-financial crisis regulatory reform has
been reflected in the growing literature on macro prudential supervision as an instrument
aimed at financial stability.41
37
Dumiter (supra note 36), 44–45; see also Pierre L Siklos, ‘Transparency is not Enough:
Central Bank Governance as the Next Frontier’ in S Eijffinger and D Masciandaro (eds), Handbook
of Central Banking, Financial Regulation and Supervision. After the Financial Crisis (Cheltenham/
Northampton, Edward Elgar, 2011) 132, 152–57 (hereinafter Siklos, Transparency).
38
Roman Horváth and Dan Vaško, ‘Central bank transparency and financial stability’ (2016)
22 Journal of Financial Stability 45–56; Dincer and Eichengreen (supra note 34), 189–253.
39
Horváth and Vaško, ibid, 46.
40
Ibid, 47.
41
For instance by Rosa M Lastra, ‘Systemic risk and Macro-prudential Supervision’ in
N Moloney, E Ferran and J Payne (eds), Oxford Handbook on Financial Regulation (Oxford,
Oxford University Press, 2015) 311, 325–29, with references to the Financial Stability Oversight
Council (FSOC) in the US, the European Systemic Risk Board in the EU or committees within the
central bank such as the Financial Policy Committee (FPC) in the Bank of England.

As a result, recent studies conclude that financial stability-related transparency has

continuously increased during the last few years, not least in the interest of the central
banks themselves, and that it is more substantial in the developed countries, even if
variations are still quite remarkable across central banks. Furthermore, the assumption
prevails that central banks are more transparent if they are thoroughly regulated and
supervised and that central banks being used to communicate transparently in some
areas of their activities are often prepared to transmit transparency to new areas of their
businesses (ie financial stability transparency).42
4. From Transparency to Governance
In economic research it is increasingly acknowledged that the core principles of sound

monetary policies are linked to other factors such as information about how much guid-
ance should be offered to financial markets and to the public generally. Consequently, a
specification of a common set of institutional rules constituting a code of good conduct
and permitting central banks to deliver their monetary policy responsibilities effectively
should be developed.43 In view of this assessment, the dual responsibility of central banks
encompasses both the accountability to the government and the responsibility to explain
their actions and views to the public. As for the latter, obtaining public or political support
would be a side-effect but not a goal in itself. In the long run, the effectiveness of these
principles should translate into trust in the central bank institution.44
New research in this field addresses the relationship between good governance and
good monetary policy, founded on a specific ‘mission statement’ of the central bank.
Analyses based on large sets of data have reached the conclusion that apart from
‘traditional’ indicators such as central bank independence, other indicators that measure
the type of decision-making structures, the availability and quality of data, the clear and
quantifiable objectives and the accountability of central banks are of major importance.45
IV. REGULATORY FRAMEWORK FOR TRANSPARENCY

POLICIES IN CENTRAL BANKS
1. Transparency Measures
Transparency measures are communications and publications in all possible forms,

electronically or in paper form, actively done or passively served.46
Common measures to communicate and explain monetary policy include the publica-
42
Horváth and Vaško (supra note 38), 54.
43
Pierre L Siklos, ‘Institutional Rules and the Conduct of Monetary Policy. Does a Central
bank Need Governing Principles?’ in PL Siklos, MT Bohl and ME Wohar (eds), Challenges in
Central Banking (Cambridge, Cambridge University Press, 2010) 357, 359 (hereinafter Siklos,
Institutional Rules).
44
Siklos, Institutional Rules (supra note 43), 361.
45
Siklos, Transparency (supra note 37), 365 and 378.
46
For a detailed overview Issing (supra note 2), 534–35.

tion of monetary policy targets, such as for example inflation targets or interest rates,
combined with a report on how the objectives were achieved and an explanation of the
reasons why this may not have been the case. This information will often be provided in
regular monetary policy reports and public announcements or conferences of a central
bank’s governing board. Similarly, for macro-prudential supervision and financial stabil-
ity issues, specific reports will be published. On all central bank mandates, speeches
and interviews by members of the central bank’s decision-making bodies may be given.
Increasingly, central bank governors will appear before parliamentary committees to
explain monetary policies and their implementation.
In addition, as recently confirmed at a high level Central Bank Communications
Conference, ‘forward guidance’ on the likely future course of monetary policy plays an
important role. It means communicating not only the central bank’s assessment of current
economic conditions and risks for achieving its monetary policy goals, but also what this
assessment implies for its future monetary policy orientation.47
The prime example is the United States48 where the Federal Reserve Act requires the
Federal Reserve Board to semi-annually submit written Monetary Policy Reports. These
reports are complemented with testimonies of the Federal Reserve Board Chair before
the Committee on Financial Services of the House of Representatives and the Committee
on Banking, Housing, and Urban Affairs, of the Senate. Most importantly, the hearings
allow for questions by Committee members.
Until 2005, there was little discussion on financial regulation in this forum, mostly
because market liberalization and the corresponding trust in the self-regulation of mar-
kets were in full swing. With the financial crisis unfolding, reporting to Congress took a
different turn: The praise for the enigmatic, Delphi-style remarks of the then Governor
Alan Greenspan on interest rates—the key instrument used by the Fed at the time—was
quickly replaced with sharp criticism on its regulatory inactivity and negligence. While
the Fed took up this criticism and—similar to other central banks—changed its policy
from relying not only on adjusting fund rates but supplementing its interest policy with
rounds of quantitative easing. These measures resulted in what has been perceived as
unprecedented financial market activism of the Federal Reserve. Since the Fed did neither
have an obligation to seek Congress’ approval for this change in policy nor did it ask for
Congress’ opinion on a voluntary basis, discussions on reviewing the allocation of regula-
tory powers for bank supervision were launched. Under the impression of increasing
political pressure, the Fed decided in favor of a more open communication strategy by
holding press conferences immediately following important meetings of the Federal Open
Market Committee (FOMC).49 This new policy allows market participants to learn about
important decisions without having to wait for the publication of the minutes (three weeks
47
Central Bank Communications Conference. Communications challenges for policy effective-
ness, accountability and reputation, organised by the European Central Bank, Frankfurt 14–15
November 2017, Mark Carney, Mario Draghi, Haruhiko Kuroda, Janet Yellen and David Wessel
(chair), Policy panel ‘At the heart of policy: challenges and opportunities of central bank commu-
nication’, available at: https://www.youtube.com/watch?v5DI7p-g51O8g (accessed 30 November
2017).
48
Middleton and Marsh (supra note 3), 50–51.
49
The phenomenon of managing expectations goes hand in hand with the increasing public

after the meeting) or the full transcript of the FOMC’s deliberations (with a five-year
delay). In addition, in order to overcome the statutory limitations on the publication
of FOMC members’ position, the Fed started to publish selected papers on individual
opinions in an anonymous form. As a result, attempts to shift direct supervision of banks
from the Fed to a new supervisory authority failed. Instead, Congress decided to mandate
the Treasury with chairing the Financial Stability Oversight Council, a body responsible
for designing and implementing macro-prudential supervision in the United States.50
Right from the beginning, the European Central Bank (ECB) has been called upon
to inform transparently about its intentions and strategies. Today, the ECB’s policy on
transparency is based on three pillars: Credibility, self-discipline and predictability.
(1) Credibility refers to the stipulation of the central bank’s mandate as outlined above in
section III.2(1). Accordingly, the ECB strives at clearly communicating its mandate
and its implementation.
(2) The criterion of self-discipline must be seen in the political context in which the
ECB operates. It relates to criterion (2) in section III.2 above, transparency measures
that allow for explanation and justification of policy measure. In addition, the ECB
sees transparency and the related public scrutiny as an incentive for coherence and
consistency. The ECB’s call on self-discipline also applies to its officials who are not
supposed to prejudice the determination of the ECB monetary policy with public
statements prior to the internal decision-making process and thereby—at least
psychologically—limit the ECB’s room for manoeuvre.
(3) Predictability is essential from a democratic as well as from an economic point of
view. The ECB reiterates the need for a clear monetary policy strategy and empha-
sizes the need for a rule-based approach with its reference to a ‘systematic response
pattern of monetary policy to economic developments and shocks’. Needless to say,
predictability is essential in managing market expectations and thereby enhancing
the effectiveness of monetary policy.
Unlike the US Federal Reserve, the ECB does not publish the minutes of its Governing
Council’s monetary policy meetings but a summary with the relevant decisions shortly
after a meeting took place and before the date of the next one. In addition, monetary
policy decisions are explained in detail at a press conference held every six weeks. The
President, assisted by the Vice-President, chairs the press conference.
Similarly to the US system, the ECB President reports to the European Parliament on
monetary issues in a quarterly Monetary Dialogue. However, this reporting system does
not have the same teeth as the congressional hearings of the Governor of the Federal
Reserve. In addition, the ECB’s annual report on monetary policy is presented and
discussed in the Parliament. With the creation of a Single Supervisory Mechanism (SSM)
led by the ECB, additional and partially different accountability requirements have been
scrutiny of central banks. However, since the expectation issue is not a legal topic it falls outside the
scope of this contribution.
50
Peter Conti-Brown, The Power and Independence of the Federal Reserve (Princeton/Oxford,
Princeton University Press, 2016) 161–62.

introduced.51 The practical modalities are governed by an Interinstitutional Agreement

(IIA) between the Parliament and the ECB.52 The accountability arrangements follow the
US example and apart from the submission of an annual report include the appearance of
the chair of the Supervisory Board before the competent committee and answering ques-
tions. In addition, upon request by the competent committee confidential oral discussions
with the chair and vice-chair of the competent committee may take place upon request:
Interinstitutional Agreement between the European Parliament and the European Central Bank on
the practical modalities of the exercise of democratic accountability and oversight over the exercise
of the tasks conferred on the ECB within the framework of the Single Supervisory Mechanism
2. Hearings and confidential oral discussions

– The Chair of the Supervisory Board shall participate in ordinary public hearings on
the execution of the supervisory tasks on request of Parliament’s competent committee.
Parliament’s competent committee and the ECB shall agree on a calendar for two such hearings
to be held in the course of the following year. Requests for changes to the agreed calendar shall
be made in writing.
– In addition, the Chair of the Supervisory Board may be invited to additional ad hoc
exchanges of views on supervisory issues with Parliament’s competent committee.
– Where necessary for the exercise of Parliament’s powers under the TFEU and Union law,
the Chair of its competent committee may request special confidential meetings with the Chair
of the Supervisory Board in writing, giving reasons.
A specific problem during the last few years concerned the purchase of financial assets
by national central banks in the Euro area. Such purchases usually have the purpose
to lower the interest rate; by doing so, national central banks risk to interfere with the
ECB monetary policy. In an attempt to increase the transparency, the ECB decided on
5 February 2016, to publish the previously confidential ‘Agreement on Net Financial
Assets’ (‘Anfa’); this Agreement contains rules and upper limits for net financial assets
of national central banks. The upper limits for such kind of transactions and for each
member country of the Euro area is yearly determined by the ECB. This transparency
should avoid further speculation related to interest rates.
51
Arts 20–21 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 supervi-
sion of credit institutions, OJ L 287/63, 29.10.2013; Art 3 of the Regulation (EU) No 1022/2013
of the European Parliament and of the Council of 22 October 2013 amending Regulation (EU)
No 1093/2010 establishing a European Supervisory Authority (European Banking Authority)
as regards the conferral of specific tasks on the European Central bank pursuant to Council
Regulation (EU) No 1024/2013, OJ L 287/5, 29.10.2013. For a discussion of the differences
between accountability and transparency in banking supervision and monetary policy see Rosa
M Lastra, International Financial and Monetary Law (2nd edn, Oxford, Oxford University Press,
2015) paras 2.159–2.194.
52
Interinstitutional Agreement between the European Parliament and the European Central
bank on the practical modalities of the exercise of democratic accountability and oversight over
the exercise of the tasks conferred on the ECB within the framework of the Single Supervisory
Mechanism, OJ L 320/2, 30.11.2013.

2. Regulatory Strategies
The examples of the US and the ECB are particularly relevant for the purpose of this
article because they not only illustrate some of the key challenges with regard to transpar-
ency and accountability in the light of expanded central banks’ mandates but also shed
light on possible regulatory strategies.
First of all, it is interesting to note that while most central banks assumed new respon-
sibilities regarding financial stability in the aftermath of the financial crisis, the related
shift in powers and the impact on individual and market participants’ freedom has not
always been reflected in the regulatory framework.53
Secondly, this raises questions about the role of transparency for the accountability
and legitimacy of central bank policy measures. Despite the absence of binding rules, a
trend towards increasing transparency with an emphasis on ex post measures as outlined
in section II.2 above can be observed. Thus the focus is on explanation of adopted
measures and policies rather than on discussing them beforehand. An exception in
this regard may be seen in the European Parliament’s right to invite the Chair of the
Supervisory Board54 for ad hoc exchanges of view or to request confidential ad hoc
meetings provided that they are necessary for the Parliament to perform its functions.55
As a rule, external stakeholders are rarely involved in the shaping of rules and policies.
However, they may influence future policies by reacting in ex-post consultations and
events.
The lack of ex ante transparency is often justified with the economic rationale that
monetary policies need to be rule-based in order to be predictable and to warrant
central banks’ independence in choosing implementation measures.56 From a norma-
tive perspective, this leads to the question about the form of such rules for monetary
policy as mentioned in section III.2(1). With a clear definition of the objectives
of monetary policy in the central bank law or a document of equal legal standing,
the transparency deficit can be compensated by the law-makers’ deliberate decision
to vest the central bank with a specific mandate and to delegate the respective powers
to it.
While this is the case in many countries for the objectives of traditional monetary
53
Council of Europe, Safeguarding human rights in times of economic crisis, Issue Paper
(2013), 17–20; OHCHR, Report on austerity measures and economic and social rights, UN Doc
E/2013/82, 7 May 2013, paras 12–14; Olivier De Schutter and Margaret Salomon, ‘Economic
Policy Conditionality, Socio-Economic Rights and International Legal Responsibility: The Case
of Greece 2010–2015’, Legal brief prepared for the Special Committee of the Hellenic Parliament
on the Audit of the Greek Debt (Debt Truth Committee), 15 June 2015.
54
Although the Supervisory Board—unlike the ECB Governing Body—does not have its legal
basis in European Treaty law, but has been created by article 26 of Regulation 1024/2013 (supra
note 50), its independence has been secured by a set of rules, including mediation procedures
should the ECB Governing Body object draft decisions by the Supervisory Board (Art 25 para 5
Regulation 1024/2013).
55
Interinstitutional Agreement (supra note 51), para 2.
56
John B Taylor, ‘The effectiveness of central bank independence vs. policy rules’ (2013) 48
Business Economics 155, 161; Othmar Issing, ‘The Mayekawa Lecture: Central banks – Paradise
Lost’ Monetary and Economic Studies, Bank of Japan, November 2012, 55, 58–59.

policy, the development of similar rules for central banks’ new mandate in safeguarding
financial stability is still in its infancy. Efforts in improving the regulatory quality of
rule-making should therefore be strengthened in this context. The respective rules might
thereby not be identical to those related to monetary policies.
These findings feed into the discussions on central banks’ role as lender of last resort
(LOLR). The terms under which a central bank would lend and the necessary collaterals
should be pre-defined and made transparent.57 Some central banks, such as the Bank
of England, reacted to the financial crisis by linking regulatory discussions on the role
as lender of last resort and the new supervisory mandate. As a result, a set of criteria
for acting as a LOLR and receiving the respective support has been published. The
Emergency Liquidity Assistance (ELA) reflects the need for flexibility and thus for
deviation from these published facilities for supporting financial stability. According
to a published Memorandum of Understanding between the Bank of England and the
Treasury this discretionary power is however subject to the Treasury’s approval:58
Responsibilities
4. The key principle of financial crisis management is to make clear who is in charge of what,
and when. The Bank and the Treasury have clear and separate responsibilities. The Bank has
primary operational responsibility for financial crisis management. The Chancellor and the
Treasury have sole responsibility for any decision involving public funds. When the Bank has
formally notified the Treasury of a material risk to public funds, and either there is a serious
threat to financial stability, or public funds are already committed by the Treasury to resolve or
reduce such a serious threat and it would be in the public interest to do so, the Chancellor may
use powers to direct the Bank.
5. The Bank has primary responsibility for financial stability and operational responsibility for
managing financial crises. Its responsibilities in a financial crisis stem from:
...
the provision, when authorised by the Treasury, of Emergency Liquidity Assistance (ELA –
defined as support operations outside the Bank’s published frameworks) to firms that are at risk
but are judged to be solvent; . . .
The Chancellor’s power of direction over the Bank
25. The Bank has primary responsibility for financial stability and operational responsibility for
managing financial crises. But consistent with the Treasury’s overall responsibilities, the Chancellor
may, in some circumstances during a financial crisis, use additional powers to direct the Bank. This
is provided for in Section 61 of the Act, which allows the Chancellor to direct the Bank to:
● conduct special support operations for the financial system as whole, in operations going
beyond the Bank’s published frameworks;
● provide ELA in a support operation going beyond the Bank’s published frameworks to one
or more firms that are not judged by the Bank to be solvent and viable;
57
Rosa Maria Lastra, Legal Foundations of International Monetary Stability (Oxford, Oxford
University Press, 2006) 125.
58
Memorandum of Understanding on financial crisis management, available at http://www.ba
nkofengland.co.uk/about/Documents/mous/statutory/moufincrisis.pdf. For a comprehensive dis-
cussion of the fundamental changes in the United Kingdom’s LOLR framework Rosa M Lastra,
‘Emergency Liquidity Assistance and Systemic Risk’ in A Anand (ed), Systemic Risk, Institutional
Design, and the Regulation of Financial Markets (Oxford, Oxford University Press, 2016) 175–206.

● provide ELA in a support operation going beyond the Bank’s published frameworks to one
or more firms on terms other than those proposed by the Bank; . . .
A third observation relates to the element of accountability that goes beyond transparency:
There are hardly any consequences which a central bank or the ECB is faced with for
its decisions.59 In the light of central banks’ independence which from an economic
perspective is seen as a prerequisite for conducting an effective monetary policy,60 this
is not surprising. Yet, it is less obvious with regard to the second pillar of central banks’
responsibilities, financial stability, which has a more immediate effect on private actors,
including not only financial institutions, but also entrepreneurs and consumers. In addi-
tion, new tools such as Quantitative Easing touch upon fiscal policy and therefore raise
questions on political responsibility. At least from a scientific perspective it appears to
be worthwhile to develop ideas on how to integrate consequences for such actions in
accountability principles.
3. Independence and Democratic Legitimacy
With the expansion of central banks’ mandates in the aftermath of the financial crisis,
their independence has increasingly been questioned given the asymmetry between the
increased scope of the mandate, its impacts and the perceived lack of transparency and
accountability mechanisms. Regardless of the legal nature of such measures, once they
affect individual freedom or public policy-making they must be justified and therefore
require accountability mechanisms.61 Over the last decades a broad consensus has emerged
that price stability or low and stable inflation should be a monetary policy’s primary
focus. Moreover, there is a general agreement that an implementation strategy should
include a quantitative definition of price stability, a forward-looking monetary policy
and transparency of the decision-making process and the respective communication with
stakeholders. With regard to the conceptualization of price stability, some fundamental
differences remain however, particularly on two issues: firstly on the question whether
monetary policy decisions should be based on an inflation forecast and thereby on a real-
economy model or on a strategy which attributes a more prominent role to money and
credit and secondly, whether a central bank’s mandate should include other objectives,
such as for example the prevention of unemployment.62 Clearly, the latter would increase
59
Matt Peterson and Christian Barry, ‘Who Must Pay for the Damage of the Global Financial
Crisis?’ in Ned Dobos, Christian Barry and Thomas Pogge (eds), Global Financial Crisis: The
Ethical Issues (London, Palgrave Macmillan, 2011) 158–84.
60
See the seminal article Alberto Alesina and Lawrence H Summers, ‘Central bank independ-
ence and macroeconomic performance: some comparative evidence’ (1993) 25 Journal of Money,
Credit and Banking 151–62 and the more recent work by Alex Cukierman, ‘Central bank inde-
pendence and monetary policymaking institutions – past, present and future’ (2008) 24 European
Journal of Political Economy 722–36; Christopher Corwe and Ellen E Meade, ‘The evolution of
central bank governance around the world’ (2007) 21(4) Journal of Economic Perspectives 69–90.
61
Joost Pauwelyn, Ramses A Wessel and Jan Wouters, ‘When structures become shackles:
stagnation and dynamics in international lawmaking’ (2014) 25 European Journal of International
Law 733, 746–47.
62
Issing (supra note 56), 60–61.

a central bank’s exposure to challenges of its actions because conflicts between different
objectives are likely to occur. This is also the case if financial stability is included in a
central bank’s mandate.63
While there is ample literature on the definition of price stability, financial stability is still
an open and somewhat vague concept. It relates very closely to the supervision of financial
institutions which may not be covered by a central bank’s mandate. Conflicts between the
objective of price stability and financial stability may occur when—in order to stabilize
the financial system—collateral criteria are adjusted or liquidity to the banking system is
extended with large-scale implications for a central bank’s balance sheet and at the risk
of sparking inflation.64 Moreover, acting or refusing to act as LOLR in the context of
financial stability measures inevitably leads to the central bank interfering directly with
private financial institutions and their customers.65 This raises important questions about
the political legitimacy and responsibility for such actions. In the event that public funds
are used for interventions such as saving a systemically important financial institution,
parliaments would regularly want to be involved. A traditional concept of central banks’
independence as the counterpart to a rule-based monetary policy does not accommodate
these challenges. Since with the exception of the ECB the objective of financial stability is
rarely translated into a clear mandate for the central bank an accountability gap occurs.66
Not surprisingly, this gap has increasingly resulted in calls for limiting central banks’
independence.67 From a legal perspective, expanding central banks’ mandate with respon-
sibility for financial stability requires additional accountability measures. The objective
of financial stability needs to be translated into criteria which can are subject to a clearly
defined communication policy in the interest of transparency. A good example in this
regard, apart from the ECB, is the Swedish Central Bank’s communication policy pub-
lished in January 2016.68 While most central banks have developed a solid communication
strategy for monetary policy issues, there is still considerable room for improvement with
regard to financial stability measures.
Once the criteria and their implementation are made transparent, the central bank
needs to be held accountable by involving the relevant actors. In a democratic system this
63
Lastra (supra note 51), paras 2.85–2.103.
64
65
See for example Andrew Hauser, ‘Between feast and famine: transparency, accountability
and the Lender of Last Resort’, Speech given at the Committee on Capital Markets Regulation
conference, ‘The Lender of Last Resort: an international perspective’, Washington DC, 10 February
2016, 5.
66
Issing (supra note 56), 64. Whether the monetary stability goal in article 127.1 of the Treaty
on the Functioning of the European Union (TFEU) is de iure on equal footing with the goal of
financial stability as it can be derived from articles 127.5 and 127.6 of the TFEU is discussed con-
troversially. In contrast, the Dodd-Frank Act and recent changes in the law that governs the Bank
of England explicitly name financial stability as objectives that are at least at the same level as price
stability. Markus K Brunnermeier, Harold James and Jean-Pierre Landau, The Euro and the Battle
of Ideas (Princeton/Oxford, Princeton University Press, 2016) 316–21 and 368–74.
67
Christopher J Waller, ‘Independence + Accountability: why the Fed is a well-designed central
bank’ (2011) Federal Reserve Bank of St. Louis Review 293, 299–300; Conti-Brown (supra note 50),
239–54.
68
Sveriges Riksbank, The Riksbank’s communication policy, adopted by the Executive Board
on 27 January 2016.

will regularly imply actions by the Parliament either by establishing the necessary legal
basis or by taking note of a central bank’s actions at least ex post. Given the likeliness
of conflicting interests between financial stability and monetary policy goals, and the
linkages with supervision of financial institutions defining clear responsibilities and
establishing a sound institutional framework which engages all relevant actors is essential.
From a governance perspective it needs to be examined whether a clear separation of
monetary policy-making and the identification of macro-prudential risks either in two
different institutions or different departments within a central bank would facilitate a
central bank’s interaction with other relevant governmental institutions such as fiscal
authorities.69
In sum, expanding a central bank’s mandate does not necessarily require to cut on
its independence. Rather, central bankers’, law-makers’ and politicians’ awareness that
central bank independence is not a goal in itself but a means to an end needs to be raised
and acted upon accordingly.
V. OUTLOOK
For many central banks one of the key lessons from the financial crisis has been that
financial stability considerations need to play a more prominent role while at the same
time allowing for the necessary discretion in implementing monetary policy goals.
Transparency can be crucial for balancing conflicting interests by enabling the central
bank to manage market participants’ expectations, explain its strategy to the affected
stakeholders, report on its progress in implementation and last but not least benefit from
comments received.
Central banks are at a crossway, their independence is under siege. We have argued that
increasing and institutionalizing ex ante and ex post transparency on policy decisions and
their implementation with a view to internal and external stakeholders can substantially
contribute to central banks’ accountability. What still needs to be developed is a more
comprehensive and inclusive approach with regard to central banks’ new responsibilities
for financial stability given their strong impact on private actors and their linkages with
other policy fields and governmental agencies.
69

26. The lender of last resort: regimes for stability and
legitimacy* 70
Paul Tucker
After years—no, decades—of barely being discussed, the 2007–09 phase of the Great
Financial Crisis prompted renewed interest in the role of central banks as lenders of last
resort or, as I prefer to put it, liquidity insurers of last resort.
This debate is often portrayed as a threat to public welfare or the independence of
central banks or both. Far from that, however, it actually provides an opportunity for
this elemental part of central banking to be put on a footing that matches up to the deep
norms and beliefs of today’s democratic societies.
Those fundamental values require a careful articulation of the roles and powers of
unelected officials and of the people’s elected representatives who oversee them. This
chapter addresses how that might be done for the lender of last resort (LOLR). It has
five sections. The first two are devoted to ground clearing, summarizing the substance of
the LOLR function, the hazards it entails and the conditions it must meet to be effective;
and articulating some general principles for legitimate delegation to independent agencies.
The third section, the core of the chapter, applies those Principles for Delegation to the
LOLR function. The fourth section returns to substance, addressing the implications for
two concrete issues—collateral policy and whether central banks should ever lend to non-
banks—and the fifth and final section highlights some of the institutional implications
for central banks. As the LOLR they are unavoidably involved in and have an inalienable
interest in prudential regulation and supervision. A generation’s neglect of that truth
needs to become a historical curiosity.
Three broad themes run through the chapter. First, no less than a central bank’s
monetary policy responsibilities, the LOLR function needs to be framed as a public
policy regime. It is not safe for the boundaries of central bank action to be a process of
discovery. Second, such regimes should make clear the objectives of the LOLR function.
Public debate and legislative deliberation are almost inevitably confused, fraught or both
when, as too often at present, they revolve solely around hazards and constraints rather
than seeking clarity on objectives. Third, the breakthrough in the technology for resolving
distressed financial intermediaries without taxpayer solvency bailouts is transformational
for the LOLR, as it relieves central bankers of the dilemma of using—or, as some see it,
abusing—their powers to sustain fundamentally unsustainable firms. Central bankers
ought to be shouting this from the roof tops, opening every speech about their LOLR
role and responsibilities with a disquisition on the revolution in resolution policy and
technology.
* What follows draws on, and is expanded upon in, Unelected Power: The Quest for Legitimacy
in Central Banking and the Regulatory State by Paul Tucker. Copyright © 2018 by Paul Tucker.
Published by Princeton University Press. Reprinted by permission.
535

I. THE FUNCTIONS OF THE LOLR
This section of the chapter addresses what the LOLR is: what it seeks to achieve, the
hazards entailed and, thus, the trade-offs between various social goods and costs.
1. Essentials
Central banks are the economy’s liquidity re-insurers.1 As a general matter (words I am
choosing carefully and to which I shall return), they do not provide liquidity insurance
directly to everyone in the economy but only to those private sector financial firms that
themselves provide liquidity insurance to households, businesses and other types of
financial intermediaries. Those primary liquidity insurers are, of course, predominantly
the banks, and in particular the commercial banks.
As such, the LOLR is an integral part of a monetary economy with fractional-reserve
banking. Because banks do not hold enough highly liquid, safe assets to cover their on-
demand liabilities, they are simply unable to meet their promise to pay if everyone calls
upon them to do so at the same time. Because, in the face of withdrawals, they will tend
to sell their liquid assets first, because other assets will generally be sold at a discount and
because payment is made on a ‘first come, first served’ basis, it can make sense to run from
a bank simply because others are running. That is the neuralgia of panic.
The costs are borne by society as a whole, not only by an ailing bank’s customers,
because the consequent withdrawal of financial services, collapse in asset values and
rise in risk aversion damages the performance of the economy. Perhaps the most
famous episode is the United States having to resort to barter during the 1930s. That
prompted the introduction of deposit insurance, but the problem of runs is only
mitigated, not solved, by deposit insurance so long as banks have uninsured short-term
liabilities.2
The LOLR is meant to keep the show on the road. In my preferred paraphrase of Walter
Bagehot’s famous dictum:
Central banks should make clear that they stand ready to lend early and freely (ie without limit),
to sound firms, against good collateral, and at rates higher than those prevailing in normal
market conditions.
1
What follows is expanded upon in Paul Tucker, ‘The Lender of Last Resort and
Modern Central Banking: Principles and Reconstruction’, Rethinking the Lender of Last
Resort, BIS Paper No 79, Bank for International Settlements, September 2014; and ‘How can
Central Banks deliver Credible Commitment and be “Emergency Institutions”?’, Chapter
1 of Central Bank Governance & Oversight Reform, edited by John H Cochrane and John B
Taylor, Hoover Institution Press Publications, 2016. These papers developed the thinking
behind the policy analysis set out in P Tucker (2009): ‘The repertoire of official sector interven-
tions in the financial system: last resort lending, market-making and capital’, presentation
at the Bank of Japan 2009 International Conference: Financial System and Monetary Policy:
Implementation.
2
It is a peculiarity of the US debate that deposit insurance is sometimes seen as a substitute
for the LOLR. That effectively assumes that society should bear the social costs of the liquidation
of fundamentally solvent firms.
536

Regimes for stability and legitimacy 537
Bagehot’s contribution, which is often misunderstood, was the call for clarity: for
what during the late-twentieth century came to be termed pre-commitment. The practice
of acting as the LOLR long preceded his interventions, with a former Governor of the
Bank of England commenting on a 1820s crisis that ‘we lent in modes that we had never
adopted before, . . . by every possible means consistent with the safety of the Bank’.3
It had long been understood that by providing liquidity, the central bank could calm
markets and avoid economic collapse; or as, with more words, we would put it today,
the LOLR can reduce the need for a forced sale of assets which otherwise would depress
values, causing avoidable insolvencies and knocking the economy as a whole onto an
inferior equilibrium growth path. That much had been clear to Francis Baring when, in
1797, he coined the term lender of dernier resort.4
Bagehot’s contention was that by committing to do so, the central bank could reduce
the probability of panics, since everyone would know that liquidity would not dry up and,
thus, that sound but illiquid banks would not fail. In terms of my rendering of doctrine,
the burden of his contribution comes, therefore, in the words ‘should make clear that they
stand ready to lend early’. That’s to say, no hanging around, and no uncertainty.
In other words, the LOLR can reduce both the probability and impact of runs. It
helps to preserve stability in the face of unwarranted runs but also contains the spread of
panic to sound firms in the face of warranted runs on other, fundamentally bust firms. Its
purpose or objective is to contain contagion.
The commitment part of this was contentious in Bagehot’s day, and has been ever since.
At the time, former Governor Hankey responded that going along with Bagehot would
just make banks take more risk, with some of them becoming fundamentally unsound:
in his own words, the promise of support was a threat to ‘any sound theory of banking’.5
By the late 1980s/early 1990s, seasoned policy makers and practitioners such as then
New York Fed President Jerry Corrigan had articulated this alternative doctrine as
‘constructive ambiguity’.6 In doing so, they injected a degree of confusion into public
debate, perhaps especially in the US. In Bagehot’s terms, as indeed in Francis Baring’s, the
Discount Window available to banks is a LOLR facility, as are the scheduled open-market
operations.7 Corrigan’s question was really about what happens when a bank cannot
satisfy the terms of the Window, or when it is a non-bank that seeks liquidity support and
whose distress could have social costs.
3
D Kynaston, City of London: The History (London: Chatto & Windus, 2011) Chapter 4.
4
Baring referred to the central bank as ‘the centre or pivot, for enabling [the monetary and
credit] machine to perform its functions’. See F Baring (later Lord Northbrook) ‘Observations on
the establishment of the Bank of England. And on the paper circulation of the country’, 1797.
5
Kynaston, above note 3, Chapter 7.
6
See e.g. Corrigan, ‘Statement before the United States Committee on Banking, Housing and
Urban Affairs’, Washington DC, 3 May 1990.
7
One school of thought in the US, associated with the Richmond Fed, long held that the
LOLR could and should operate solely via OMOs to address aggregate shortages of central bank
money. This implicitly assumes that the money markets work and, therefore, that there are never
circumstances where one bank holds more money than it wishes but either will not or cannot
lend to a bank that is sound but short. There can be distributional problems, creating the need for
bilateral facilities. See Tucker, above note 1.

2. Hazards, and Concepts
Where does this leave us? On the one hand, liquidity insurance based on liquidity and
risk transformation reduces the need for households, businesses and other financial
intermediaries to self-insure by holding stocks of liquid securities, releasing resources
for use in the risky enterprises that generate growth and prosperity.8 But, on the other
hand, like all insurance regimes, it incorporates problems of moral hazard and adverse
selection. Separately, since the LOLR liquidity re-insurance is provided by the state, it
faces problems of credible commitment and, more widely, of government failure.
The time-consistency problems cut both ways. If central banks cannot credibly commit
to provide liquidity reinsurance, panic is more likely. If they can so commit, risk-taking in
the economy as a whole is more likely to be excessive unless some other effective remedy
can be found.
Those questions—the ones that preoccupied Bagehot and Hankey in the middle of the
nineteenth century—revolved around the costs and benefits of time-consistent liquidity-
reinsurance policy. But there is another, distinct problem, which our nineteenth century
peers barely discussed. It is whether central banks will lend when they shouldn’t, when
the underlying problem is one of solvency. In other words, will they oversupply liquidity
re-insurance by lending to institutions that are fundamentally unsound, helping to re-
equify them by setting soft terms? That, in a nutshell, is the accusation levelled by some
at the Federal Reserve: that it used LOLR technology to effect a fiscal bailout rather than
staying within the confines of liquidity assistance to sound businesses.
The responses to this catalogue of benefits and costs could hardly be more varied. At
one end of the spectrum of opinion, the inherent problems of LOLR liquidity reinsurance
are seen as smaller than the benefits of fractional-reserve banking (FRB) to the economy
as a whole. At the other end of the spectrum, the problems are regarded as insuperable.
Either fractional-reserve banking should be banned or the central bank LOLR should be
abolished in order to incentivize banks to internalize the costs of their liquidity risks, or
both. In between those two extremes lies the challenge of designing an effective LOLR
regime for the banking system we have; a regime designed to provide liquidity re-insurance
not solvency support. That is the focus of this chapter.
Four concepts shape the analysis of the LOLR: time consistency, moral hazard, adverse
selection, and what I call the ‘fiscal carve-out’ delineating the space in which an independ-
ent central bank can operate. How those concepts are handled shapes a jurisdiction’s
response to the liquidity-fragility of banking and banking-like financial intermediation.
A brief recap of each is warranted.
Credible commitment
Acting as the lender of last resort involves making commitments: to lend in order to stave
off or contain systemic distress. Those commitments need to be credible, which requires
8
If the likelihood of deposit withdrawals and credit facility draw-downs are not highly cor-
related, the aggregate benefits are greater. See A Kashyap, R Rajan and J Stein, ‘Banks as liquidity
providers: an explanation for the coexistence of lending and deposit-taking’ (2002) 57(1) The
Journal of Finance 33–73.

amongst other things that they be time consistent. The regime won’t work well if people
believe a central bank will change its mind, or has no clear principles.
Moral hazard
As with any kind of insurance, liquidity insurance creates incentives to take more of
the insured risk, in this case liquidity risk. Moral hazard is a major issue that must be
addressed if a regime is to serve society well over time. Unless care is taken, that can
conflict with time consistency. If a central bank pledges not to provide assistance in some
form or other (eg, to insolvent firms) but then buckles in the face of systemic distress,
future promises to the same end will probably not be believed, exacerbating moral hazard
and putting the financial system on an unstable course. So ways have to be found to
underpin the credibility of commitments designed to contain moral hazard.
Adverse selection
Many types of insurance are plagued by a problem of adverse selection, with only the
riskiest being prepared to take up the offer of insurance. That leaves the insurer exposed
to bad risks. In the case of LOLR, which serves a public policy purpose, the consequential
challenge is how to design a regime that firms are prepared to use before it is too late to
contain the liquidity crisis and its wider costs to society.
Fiscal risks and costs

Finally, there is no getting away from the fact that LOLR assistance is risky, even when
all lending is to businesses that were fundamentally sound when the loans were extended.
However well protected, the central bank can end up suffering losses. This isn’t a theoreti-
cal point: losses have crystallised in practice. A central bank will cover its losses by writing
down its capital or by paying less seigniorage over to the government. Either way, that
simply transfers the costs to government. Ultimately, losses are a fiscal issue. They must
be covered by higher taxation (or lower public spending) or by higher seigniorage, ie,
resorting to inflation as a tax.
Fiscal issues can, therefore, arise in two ways: by the central bank lending to an ex
ante insolvent firm; and when, although a borrower was sound when liquidity assistance
was extended, it subsequently deteriorates and defaults, and the central bank’s collateral
proves insufficient to cover its exposure.
3. The Resolution Revolution
The post-crisis reform programme changes my account of the LOLR in one very impor-
tant way. With the necessary legislation now in place in the United States and the EU and
with new regulatory policies on firms’ capital structure, it is now credible that the biggest
and most complex global financial intermediaries could be resolved without taxpayer
solvency support.9
9
For an account of the analysis underpinning the new resolution policies, see P Tucker, ‘The
Resolution of Financial Institutions without Taxpayer Solvency Support: Seven Retrospective
Clarifications and Elaborations’, European Summer Symposium in Economic Theory, Gerzensee,

For the authorities as a whole, this means that they need no longer be faced with a
desperate choice between bankruptcy and systemic disorder or going to the fiscal author-
ity to seek a taxpayer bailout when a ‘systemic’ firm is fundamentally bust.
In consequence, there should be much less pressure on central banks to treat solvency
problems as liquidity problems. If the condition of an initially solvent firm deteriorates
after LOLR support has been extended, they can withdraw support and put the firm into
resolution.
In short, a statutory resolution regime for handling irretrievably bankrupt firms makes
‘no’ from the LOLR credible. That offers the most important response to those critics
concerned that some central banks overstepped the mark in the past, and needs to be
energetically explained by the central banks.
In future, a fatally wounded firm will go into resolution rather than going to the
Window. Instead, the action will move to post-resolution provision of liquidity to funda-
mentally sound firms and to innocent bystanders. Central banks need to make this change
clear in public statements of their LOLR principles. Indeed, they ought to be shouting
from the rooftops about the transformation for them brought about by the revolution in
resolution policy and technology.
Whether or not they do so, I am going to describe how these changes can be inscribed
into a LOLR regime.
But why a regime? Fundamentally, because we live in democracies and central bankers
are not elected.
II. PRINCIPLES FOR LEGITIMATE DELEGATION TO

INDEPENDENT AGENCIES
What should be clear from the discussion thus far is that the LOLR is powerful; that, in
one direction, the power can be used to bailout fundamentally insolvent businesses, an act
of fiscal policy; and, in the other direction, that the LOLR capability can be underused,
allowing contagion to spread. This poses questions about who should hold the LOLR
power and on what terms.
In my strong view, it is nigh on impossible to make progress with those questions
without addressing deeper issues about the role of unelected power in our democratic
societies. Even where such issues are not explicitly addressed, they are implicit in any
LOLR course of action or inaction. Better, in my view, to bring them into the open.
The questions are not unique to central banks. They run through the architec-
ture and operation of the administrative state, with its plethora of independent
agencies, semi-independent agencies and agencies under the day-to-day control of
elected politicians. Independent central banks lie towards one end of that spectrum,
being insulated from the day-to-day politics of both executive government and elected
legislatures.
My broad answer to the general question of conditions for the legitimacy of independ-
Switzerland, 3 July 2014. Misinformation circulates about resolution regimes and policies, which
must be confusing for the people’s elected representatives.

ent agencies in a democratic, liberal republic comes in two broad parts: criteria for whether
to delegate, and precepts for how to delegate.10 Summarizing (selectively):
Criteria for whether to delegate: a policy function should not be delegated to an inde-
pendent agency unless: society has settled preferences; the objective is capable of being
framed in a reasonably clear way; delegation would materially mitigate a problem of cred-
ible commitment; and the policymaker would not have to make first-order distributional
choices. Whether those conditions are satisfied in any particular field is properly a matter
for public debate and for determination by elected legislators.
Precepts for how to delegate: (1) the agency’s purposes, objectives and powers should
be clear and set by legislators; (2) its decision-making procedures should be set largely by
legislators; (3) the agency itself should publish the operating principles that will guide its
exercise of discretion within the delegated domain; (4) there should be transparency suf-
ficient to permit accountability for the agency’s stewardship of the regime and, separately,
for politicians’ framing of the regime; and, (5) it should be clear ex ante what (if anything)
happens, procedurally and/or substantively, when the edges of the regime are reached but
the agency could do more to avert or contain a crisis.
At root, the Principles require delegated responsibilities and powers to be framed as
regimes.11 While that is familiar in the field of monetary policy, it is not so obvious that
LOLR (or other central bank) functions have been laid down with as much care and
clarity over the past century or more. Filling that gap lies at the heart of what applying
the Principles to LOLR liquidity reinsurance amounts to.
III. APPLYING THE PRINCIPLES FOR DELEGATION TO

LOLR LIQUIDITY REINSURANCE
Central banks perform two apparently quite different functions. On the one hand, they are
expected to operate monetary policy in a systematic manner in order to smooth fluctua-
tions in economic activity without jeopardizing the economy’s nominal anchor. On the
other hand, in their role as the lender of last resort, they are expected to operate with the
flexibility of the economy’s equivalent of the US cavalry. Big picture, the monetary-policy
authority is an institution designed for normal circumstances, whereas the LOLR is an
institution for economic and financial emergencies.
How can such different functions and associated mind-sets be housed within the
same organization? If a central bank succeeds in building a reputation for operating a
10
There is in fact a third component comprising conditions for delegating multiple missions:
only if they are inextricably linked, and in particular rely on seamless flows of information, and
decisions are taken by separate policy committees, with overlapping membership but each with a
majority of dedicated members.
11
A preliminary version of the Principles for Delegation was given in Tucker, ‘Independent
Agencies in Democracies: Legitimacy and Boundaries for the New Central Banks’, the 2014
Gordon Lecture, Harvard Kennedy School, 1 May 2014. A fuller explication is forthcoming.
Various of the principles draw on the work of Alesina and Tabellini on whether to delegate to
technocrats, of Milgrom and Holmstrom on the incentive problems of multiple-mission agents,
and of Pettit on forging the people’s purposes and on contestability.

systematic monetary policy, is that reputation jeopardized when it reveals its normally
hidden innovative side during a crisis? Conversely, might a reputation for rule-like
behavior in normal times sap confidence in its ability to ride to the rescue in a crisis? In
other words, how can central banks sustain a rich, multi-purpose reputation that faces,
Janus-like, in two directions?
Three of our Design Precepts will help to dissolve those potential tensions. They are
the first, third and fifth precepts requiring, respectively, the central bank’s powers and
objectives to be set by legislators; the central bank to state the Operating Principles that
guide its exercise of discretion; and the need for ex ante clarity around what happens
when a central bank reaches the boundaries of a domain it has been delegated. But
the prior question is whether the LOLR power should be delegated to independent
central banks at all or whether, alternatively, it should be under the control of executive
government.
To answer these questions, we are going to plod through the application of the
Principles to society’s LOLR.
1. Whether to Delegate the LOLR Function
Some—in truth, only a few—argue that all LOLR decisions should be taken by the elected
government, on the advice of a prudential supervisor located outside the central bank,
which would simply implement the decisions. This is profoundly wrongheaded.
The finance ministry is even more exposed to credibility problems than the central
bank in promising not to lend to fundamentally bust firms; it has incentives to dress up
a true solvency bailout as liquidity assistance if a firm’s bankruptcy would disrupt the
economy and make the elected government unpopular. Separating the two functions helps
to overcome that problem. If the central bank declines to lend on grounds of insolvency,
the government still has the bailout option, if it doesn’t trust its resolution regime. That
it’s a bailout, and the initiative of elected politicians to pursue bailout, should be clear to
legislators and the public.
Further, as an advisor on whether to lend, prudential supervisors are conflicted,
because the time bought by lending might avoid their own failings coming to light; that
is sometimes what forbearance is about. Their advice is needed, but it can’t be definitive
as they have incentives to shade.
Finally, LOLR assistance affects monetary conditions; the central bank has to decide
whether to accommodate an aggregate shock to the demand for money or whether to
address a problem in the distribution of reserves, which requires a monetary judgement. It
was the cognitive denial of the links between monetary policy, LOLR policy and banking
system stability that helped lead the world to the crisis from which it has still not fully
recovered.
Each currency area needs a LOLR regime

Even after a quarter century, debates about monetary regimes continue. But much more
is needed in many jurisdictions to articulate and explain a regime for the LOLR liquidity-
reinsurance function. In terms of legitimacy, prerequisites include a clear role for elected
representatives in defining and overseeing the regime. In terms of substance, prerequisites
are that its terms should mitigate the inherent problems of adverse selection and moral

hazard, be time-consistent, and provide clarity about the amount and nature of ‘fiscal
risk’ that the central bank is permitted to take on the state’s behalf.
2. Design Precept 1: Purposes, Powers and Constraints
The most important of the five Design Precepts for how to delegate is the first,
requiring that legislators specify a clear purpose, monitorable objective and powers for
the independent agency. How much of that is done via primary legislation and how
much via secondary legislation can reasonably depend upon local constitutional conven-
tions and norms, but legislators must put the key stakes in the ground after rich public
debate.
Purposes
In the case of the LOLR, one of the striking things about the post-crisis debates is that
they revolve almost entirely around constraints, with almost no attention paid to purposes
or objectives. One possible approach would be to cast the LOLR as follows: liquidity assis-
tance extended to a fundamentally solvent entity (or entities) which would otherwise default
or collapse with material social costs in terms of systemic instability or the withdrawal of
services to the rest of the economy or the public finances.
This incorporates:
a definition of LOLR operations, in a way that incorporates liquidity assistance to

firms or markets delivered via regular monetary operations and discount window
assistance;
a purpose, in terms of avoiding or containing the social costs of unnecessary failure
or disorderly wind down; and
a constraint, in terms of borrowers not being fundamentally insolvent.
Powers, and the fiscal carve out

That leaves open a standard set of questions—about the population of eligible borrowers,
eligible collateral, haircuts, maturities, penalty rates, and so on—but it helps to frame the
terms in which those issues should be debated, determined and explained. The answers
chosen by any jurisdiction would amount to specifying the Powers of its LOLR.
Together with the Constraint, those powers would draw the boundary between actions
reserved by elected policymakers to themselves and those delegated to the LOLR in
pursuit of its mandated Objective. I see that as being part of a broader fiscal carve-out
defined for each jurisdiction’s central bank. In most countries, this fiscal carve-out
(FCO) is implicit or scattered across many statutes and agreements. It is my contention,
articulated more fully elsewhere, that the FCO should be explicit, as complete as possible,
and transparent.12
12
The FCO is elaborated upon in P Tucker, ‘The only game in town? A new constitution for
money (and credit) policy’, Myron Scholes Lecture, Chicago University Booth School of Business,
2014; and in Unelected Power (see note (*) p. 535).

Some flesh will be put on this in Section IV but, for the moment, I want to focus more
closely on the Constraint.
Constraints
Quite apart from the wider moral hazard arguments against the state bailing out funda-
mentally bust firms, there are specific arguments against central banks doing so.
First, it is quite simply wrong for a politically insulated authority knowingly to lend,
even on a secured basis, to a firm with negative net assets, as the lender is making others
worse off; short-term unsecured creditors escape as bankruptcy is deferred, but longer-
term unsecured creditors end up as claimants in bankruptcy with a call on a smaller pool
of assets. Contrary to the doctrine of economists as diverse as Hawtrey, Schwartz and
others, a central bank cannot guard against this solely by taking excess collateral.13
Second, using or being suspected of using LOLR as a mechanism for bailing out fun-
damentally bust banks creates a massive stigma problem. If it is believed that the central
bank will not turn away insolvent firms, then it becomes toxic for a solvent but illiquid
firm to borrow from the central bank if there is any chance of that becoming known.
Third, if the state wishes to provide solvency support (which I am absolutely not
advocating!), that is a decision for the elected government under the control of the
legislature. Central bank independence is valuable to society, but it relies on boundaries.
Central banks should not violate those boundaries, and governments should not press
them to do so. But the boundaries need to be known and understood. In other words, the
constraint on not lending to fundamentally insolvent firms is part of the fiscal carve out
that is necessary to underpin the legitimacy of independent central banks.
Purposes revisited: a potential conflict with securities regulation

There is one further point that I want to make about the first Design Precept’s call for clear
objectives and powers. There exists a troubling, indeed potentially explosive but bizarrely
neglected conflict between the public policy goals of, on the one hand, financial system
stability and, on the other hand, transparent markets. Charged with the former, central
bankers typically resist early disclosure of exceptional liquidity assistance. Charged
with the latter, securities regulators have a reflex response in favor of early disclosure;
firms with publicly traded securities should disclose materially relevant information in
the interests of fairness and efficiency. There is a profound tension here that, sooner or
later, will lead to disaster; a central bank will extend assistance only to find that the crisis
spreads when the recipient feels bound to disclose.
This is an elephant in the room. It must be tackled. Not by central bankers or regulators,
but by elected politicians, legislators. Only they can make the trade-off, and defend it to
the people. The choice will be better for being made during peacetime, so that the financial
system and the various official sector agencies can adjust accordingly.
13
Imagine a bank with equity of one, short-term liabilities of nine and long-term liabilities of
90. It has ten riskless Treasury Bills, but all its other assets are of doubtful value. The central bank
lends ten against the Treasury Bills, which allows all short-term creditors to be repaid. But the firm
is fundamentally bust and goes into bankruptcy. The longer-term creditors are worse off than if the
firm had gone into bankruptcy before the central bank’s liquidity support, because they have lost
their entitlement to a share of the value of the Treasury Bills.

3. Design Precept 2: Processes, and Governance
The second Design Precept is about processes and governance. There is much to say here,
but I will confine myself to one point.
Within the constraints of the statutory regime, decisions on the design and utilization
of LOLR facilities should be taken by a formally constituted committee of the central
bank, on a one-person-one-vote basis, and with each member publicly accountable. As
with monetary policy, that kind of structure will help to give bite to internal deliberations,
aid accountability, and underpin independence from politics and the industry.
The prudential supervisors are essential advisors on whether to lend but, even where
prudential supervision is part of the central bank, they should not have a vote. I have
never seen a case of firm failure without accusations of supervisory incompetence, fairly
or unfairly. Anticipating that, supervisors can be tempted by forbearance, financed where
necessary by central bank assistance. In difficult cases, the decision to lend needs to be
based on hard-headed assessments of solvency, the prospect of getting the money back,
and the public policy objective.
4. Design Precept 3: Operating Principles
Under the third Design Precept, how a central bank plans to comply with the constraint
of not supporting fundamentally bust firms should be covered in its LOLR Operating
Principles.
None of this is to say that judgments on solvency are easy. The future is uncertain.
Economic and financial conditions can turn out better or worse than expected. For that
reason alone, a firm might reasonably be judged solvent at the point at which a loan is
granted but later become insolvent. Alternatively, the supervisors and central bank might
have misjudged its initial position. All that being so, a solvency judgment is inherently
probabilistic. It would be sensible for central banks to frame their decisions on solvency
in terms of forward-looking probabilities. What does that mean operationally?
Plainly, LOLR assistance should not be extended if a firm is fundamentally insolvent
today or the central expectation is that it will be so tomorrow. Beyond that, society needs
to decide what level of probability warrants support. Elected representatives of the people
should probably determine that probability threshold, which should be incorporated into
the remit under first Design Precept.
If the people’s representatives determine the threshold, the LOLR needs to make a
judgment of probabilities in any particular case. That forward-looking view of solvency
would need to factor in the likely effects of the LOLR intervention itself. Particularly
if liquidity problems led to a systemic crisis, the economy might move onto an inferior
path of output, with a higher default rate and so greater losses to banks and other
intermediaries. In consequence, this is not simply about estimating the solvency
position of a potential borrower at the moment before any liquidity is provided. If
the market is in the grip of a liquidity panic, the provision of liquidity might dispel
the panic and restore the firm’s solvency position. Faced with a problem of multiple
equilibria, LOLR interventions might be able to get the economy and the distressed
firm(s) back onto a healthy path. So the LOLR would need to make a judgment about
the likely effects of various possible course of action. Where an action was likely to

have potent effects, a potential borrower might remain solvent if in receipt of liquidity
assistance but not otherwise. Alternatively, if all feasible actions would most likely not
lift an economy back onto its previous path, an ailing firm might not warrant liquidity
support. And if the firm is fundamentally bust (has a net assets deficiency) whatever
the (realistic) economic outlook, then no amount of central bank lending can provide
a cure, however effective.
Such judgments are obviously difficult. But they are not completely foreign territory.
When producing the economic forecasts that guide their monetary policy decisions, cen-
tral banks have to make judgments that are similar in kind, including feedbacks from the
credit system. The extra ingredient in forming probabilistic views on solvency is to cascade
down the macro forecast, via asset classes, to individual firms. But that is what supervisors
and macro-prudential authorities are committed to doing in their asset-quality reviews
and stress tests.
Despite appearances and contrary to some responses, there is nothing novel in this.
Lenders of last resort have been making such judgments since the dernier resort first
emerged to stabilize the monetary system. In one of the more striking episodes, indeed
the one that inspired Bagehot, the Governors of the Bank of England let a fatally flawed
Overend Gurney fail after taking a careful look at it, but lent copiously to the rest of the
system to contain the anticipated panic during the crisis of 1866.14 But the pre-conditions
for trust in public bodies have evolved. What’s needed today is the injection of the kind
of formality, analytical rigour and transparency that transformed the processes, and
legitimacy, of monetary policy during the 1990s.
Hence, under the third Design Precept, central banks should articulate how they will
decide whether a firm is fundamentally unsound. Since this is, unavoidably, what is going
on, it would be better to be clear about it, and for central banks to explain how they
make the forecasts that underpin such forward-looking judgments. By doing so, they
will constrain themselves to building for their LOLR function the kind of staff-based
machinery that for at least a quarter century has supported their interest-rate decisions.
Moreover, by publishing such LOLR Operating Principles the nature and potential
effects of LOLR liquidity reinsurance would be better understood in general, and particu-
lar decisions to lend (and decisions not to lend) could be evaluated ex post.
5. Design Precept 4: Transparency and Accountability
Public debate and evaluation is at the heart of the fourth Design Precept, on transparency
and accountability.
If how a central bank lender assesses solvency and how it values collateral are publicly
understood in broad terms ex ante then, with appropriate lags, its decisions and actions
are capable of being assessed ex post.
The central bank needs to be able to demonstrate ex post that its view on solvency
etc. was properly grounded and defensible. Drawing on the new regime of stress-testing
or other methods, the framework employed should be held up to the light: whether it
was robust, employed with integrity etc. In the same vein, if losses were incurred they
14
Kynaston, above note 3.

should be published or at least disclosed to key members of the legislative committee that
oversees the central bank.
The key issues here are timing and confidentiality: when would public evaluation be safe
rather than liable to tip the system into crisis, with the costs that imposes on the public?
There appears to be a nasty dilemma here. On the one hand, even with the kind of regime
outlined above, how can we have proper accountability without transparency? But, on the
other hand, how can LOLR operations succeed if the fact of liquidity assistance is always
broadcast to the world?
The United States is seeking to square this circle by requiring, under Dodd-Frank,
public disclosure after two years. Many wise heads think this may well backfire horribly,
hurting the American people, and perhaps the world given the country’s responsibilities
as the provider of the dominant reserve currency.
Another possible solution would be to provide, via statute, for the relevant commit-
tees of the legislature to hear evidence in camera and subject to a duty of secrecy where
national welfare would be materially jeopardised by public disclosure. That warrants
debate. Accountability mechanisms should no more be built on the hoof than emergency
central banking operations.
6. Design Precept 5: Emergencies
Emergencies are the difficult terrain of the fifth Design Precept for legitimate delegation
to independent agencies.
Since financial crises are bound to recur, it would be foolhardy to pretend that every
eventuality could be catered for in any ex ante regime. The big question is whether that
means that independent central banks must, for the public good, be left to write their own
script as liquidity reinsurers of last resort.
Away from the day-to-day debates of economic researchers and policymakers, there
is an active and contested debate amongst political theorists and constitutional scholars
about the nature, acceptability and even inevitability of ‘emergency powers’ exercised
by the executive branch of government when a nation is faced with an existential crisis.
While such debates usually revolve around national security, war and terrorism, in the
years following the most intense phase of global financial crisis, some scholars argued
that many of the measures taken by the US Treasury and the Fed entailed the exercise of
exceptional executive power.15
The response to this of the Principles for Delegation is to insist upon a distinction
between elected and unelected power. Only elected policymakers face ex post account-
ability via the ballot box.
The corollary, represented by the fifth Design Precept, is that, as a body led by unelected
policymakers, the central bank should not itself determine where it could reasonably
venture beyond previous understandings of its boundaries. Any such steps should be
15
For an eloquent statement of that view, see E Posner and A Vermeule, The Executive
Unbound: After the Madison Republic (Oxford, Oxford University Press, 2010). For a different
perspective, closer to my own, see Nomi Lazar, States of Emergency in Liberal Democracies
(Cambridge, Cambridge University Press, 2009).

sanctioned (or not) by elected representatives of the people, because they will be directly
accountable.
Thus, unlike some commentators, I do not especially object to the provision of
the Dodd-Frank reforms that requires the Fed to get the permission of the Treasury
Secretary (after, one hopes, consulting the President) to conduct certain liquidity-support
operations.
In broad equivalence, where the Bank of England wishes to go beyond its published
framework for providing liquidity support (its discount window and open-market opera-
tions), it must obtain the permission of the Chancellor of the Exchequer. That provides
a healthy incentive for the published framework to be as complete as possible, while
recognizing that at best it will only ever cater for the kinds of crisis the authorities have
either experienced, witnessed or imagined.
This account gives edge to questions such as to whom and against what collateral a
central bank might lend, since if they are not answered up front then, under our Principles
for Delegation, in a crisis they must be answered on the run by our elected representatives.
IV. BACK TO THE SUBSTANTIVE REGIME
In this section of the chapter, I shall therefore offer answers to those two substantive
issues, revealing the role played by the concepts with which I began. In particular, my
conclusions are driven by the imperative of credible commitment, without which a LOLR
regime would be a regime in name only.
1. Collateral Policy
A pledge to lend against only a narrow class of very high-quality collateral, whatever
the circumstances, is not credible. It is the essence of liquidity stress that a firm has
exhausted its options for raising funds in the market or will make things worse if it
appears to beg for funds in the market. Given the negative externalities of bank distress,
it does not serve society for a central bank to refuse to lend to a solvent firm against a
wide range of assets. Ex post, it will lend unless comprehensively barred from doing so
by the law and, in the face of chaos, legislators do not lift or waive the law. That being
so, any constraints need to be completely credible in order to influence private market
risk-taking behavior.
But, and it is a pretty big ‘but’, a central bank has no business lending against assets that
it cannot understand, value and manage. It owes that duty to the people, since they will
bear the cost of any losses. In consequence, the central bank has to lend on the basis that
it could manage the assets as an outright owner if, notwithstanding its initial assessment
of solvency, the firm deteriorates and goes into either bankruptcy or a formal resolution
proceeding. Anticipating that means that central banks’ collateral teams need to be expert
(and to have high prestige within the organization).
Valuations and haircuts (the excess of collateral over the loan) matter hugely. For
reasons given earlier, there should be no room for closet solvency support via soft terms.
Rightly or wrongly, there are suspicions of central banks indulging in that in the past.
For this reason alone, central banks should make public not only a schedule of their

core haircuts, but also as much as they can about how they go about valuing collateral
and setting haircuts.16 They should, however, retain discretion to set higher haircuts in
the circumstances of any particular case, including judgments about the counterparty’s
current and prospective solvency margin.
What is clear, then, is that collateral management is a core central bank function.
Having banks pre-position collateral with the central bank helps operationally, as it gives
the central bank time and space to evaluate it, as well as providing insights into the banks’
portfolios and risk management.
2. Whether to Lend to Non-banks
Another perennial question that, following the crisis, can no longer be dodged, is whether
central banks should ever lend to non-banks. Obviously, some central banks, especially
the Federal Reserve, did so. Were they wrong? Again, the challenge is how to construct a
regime that is time-consistent and disciplined.
It is not credible to hold that a central bank will never lend to an entity that is not a de
jure bank. At times, as well as being significant lenders to the real economy, non-banks
combine some or all of maturity transformation, leverage, the provision of monetary-like
services, and complex interconnections with the rest of the system. As such, they can
form part of the de facto monetary system, occasionally posing bank-like systemic threats
to stability. An obvious case is the major US securities dealers. In 2008, they suffered a
massive liquidity run when hedge funds and others withdrew idle balances. Quite simply,
prime brokerage services include basic banking; the dealers were very obviously in the
liquidity insurance business. Either that should be stopped, or those dealers should be
regulated as banks, with access to the window.
More generally, jurisdictions must face up to the facts when intermediaries regulated
as non-banks are, in fact, conducting banking. As with so much in this field, the point
is not new, having been made by Henry Simons as long ago as the 1930s.17 But with the
post-crisis re-regulation of de jure banks, it is liable to be a much bigger issue in the years
ahead. Some of the economic substance of banking will inevitably re-emerge elsewhere:
this is what is known as shadow banking. For example, anybody holding low-risk securi-
ties can build themselves a shadow bank by lending out (‘repo-ing’) their securities for
cash and investing the proceeds in a riskier credit portfolio. And they can do so very
quickly. Sometimes, their liquidity fragility and the systemic significance of their collapse
will be identified only ex post.
If solvent non-banks are confident of being able to borrow from the LOLR while
escaping unscathed in regulatory terms, the incentives to enter shadow banking will be
even greater. I am doubtful that piece-by-piece measures, tackling one manifestation
of stability-threatening shadow banking at a time, can be sufficient to address the
LOLR’s dilemma or the broader risks to stability. At root, the challenge is that finance
16
For a step in this direction, see S Breeden and R Whisker, ‘Collateral risk management at the
Bank of England’ (2010) Bank of England Quarterly Bulletin, Second Quarter.
17
HC Simons, ‘Rules versus authorities in monetary policy’ (1936) 44 Journal of Political
Economy 1.

is a ‘shape-shifter’, and so will always be wriggling through cracks in the rules. If that is
broadly correct, a general policy is needed.
A coherent regime might look something like this:
● where a firm is obviously conducting banking-type functions, make it become a de

jure bank, giving it access to the window;
● state publicly that where a non-bank’s liquidity distress would be expected to create
a systemic crisis, then the central bank will in principle be prepared to lend; but
● the decision will be case by case in the light of the circumstances;
● as the central bank would be exercising discretion to extend the domain of its
LOLR function, it would consult the executive branch of government, and would
(with suitable delay) provide an account to the legislature;
● the management and senior non-executive directors (or trustees) of any such firm
would be removed; and would be punished if it turned out that they had deliberately
or knowingly been running a de facto bank in non-bank clothing;
● the business model of the firm (and, crucially, any firms substantively like it,
whether or not they had turned to the central bank for liquidity assistance) would
have to change in order to exclude de facto banking.
The statutory framework for the regulatory regime would need to be set up in a way
that made those responses credible. The reality of shadow banking cannot be denied, but
we don’t have to embrace the threats to stability. By working backwards from the LOLR’s
dilemma, the need for a general policy becomes apparent.
V. IMPLICATIONS FOR THE ROLE OF CENTRAL BANKS IN

REGULATION AND SUPERVISION
What are the implications of this analysis for the broader role and responsibilities of
central banks? Prophetically, Paul Volcker warned the world in a valedictory lecture in
1989: ‘I insist that neither monetary policy nor the financial system will be well served if
a central bank loses interest in, or influence over, the financial system.’18
In institutional terms, the thesis of this chapter is that Volcker was correct if for no
other reason than that, as the LOLR, as the economy’s liquidity reinsurer to its private
sector liquidity insurers, the central bank is intimately involved in the fate and stability of
the financial system and its connections with the real economy. I will confine myself to
just three points that expand upon this.
First, a central bank’s decision to lend will not be a positive signal that a recipient is
fundamentally sound unless the central bank has, and is known to have, access to private
information. This is a critical element of the case for central banks being involved in bank-
ing supervision; the private information comes largely from being the supervisor. It is not
absolutely essential that the central bank is the regulator. But in a regime with a separate
18
Paul Volcker, ‘The Triumph of Central Banking?’ Per Jacobsson Lecture, 1989. The question
mark in the title was underlined during the Q and A.

regulator, it is absolutely essential that society does not rely on co-operation and informa-
tion sharing being the product of goodwill or enlightened self-interest; the capacity for
turf problems knows no bounds in the public sector. So if not the de jure regulator, the
central bank must have direct access to individual firms and a right to require information
from firms materially relevant to its function as LOLR (and, more broadly, as monetary
authority). Japan operates a regime along those lines.
Second, whether or not it is formally the regulator, the central bank must have a formal
say in framing and calibrating the regulatory regime. A separate supervisor cannot be
expected to internalize the risks faced by the LOLR, especially if it is given or takes upon
itself a goal of sponsoring growth in the industry. So a credible LOLR regime entails that
the central bank must be involved in regulation and supervision.
Third, in protecting themselves as actual or contingent lenders, central banks gather
information that can and, I believe, should be used for wider macro-prudential purposes.
Just as historically some central banks got into the prudential supervision of banks
through managing their counterparty risks, so the control of their collateral risks makes
them a de facto monitor of the state of the underlying asset markets. In particular, as and
when a repo market becomes large, as ABS repo surely did in the run up to the 2007 liquid-
ity crisis, central banks can’t really avoid taking a view on whether the supposedly ‘safe
assets’ being used as collateral are indeed safe. If they’re not safe enough for the central
bank, then the authorities should be worried about whether the money market’s liquidity
is sustainable. On this view, the central bank’s LOLR function makes it a de facto moni-
tor of ‘safe’ assets and of some systemically significant markets. That’s exactly the role
played by the Bank of England in the old bill market over the century or more in which it
implemented monetary policy primarily by buying and lending against bankers’ accept-
ances. It is an issue that, perhaps, remains neglected in the post-crisis reform programme.
VI. CONCLUSION
The relative neglect of LOLR in the core literature on central banking over the past 20
years is a tragedy—one that contributed to central banks losing their way and finding
themselves struggling for breath when faced with a liquidity crisis in 2007. It is hard to
credit that mainstream macroeconomics devoted so much effort to conceptualising the
case for central bank independence and to articulating ever more sophisticated models of
how monetary policy works while leaving out of those models the fragile banking system
that called central banking into existence as a liquidity insurer in the first place.
While we wait for future historians and institutional sociologists to help us make sense
of this, the current generation must put the past behind them and design LOLR opera-
tions and facilities that can be both effective, which requires credibility, and legitimate,
which requires due subordination to the people’s elected representatives. The answer lies
in carefully designed regimes or mandates. This chapter has set out one way of thinking
about the construction of such regimes, offering thoughts on purposes, powers and
constraints.
Of the constraints, surely the most important is that the central bank, a body of
unelected officials, should not knowingly lend to a firm that is irretrievably and funda-
mentally insolvent. If ‘no monetary financing’ is the golden rule for a credible nominal

anchor, so ‘no lending to irretrievably insolvent borrowers’ should become the golden rule
for the liquidity reinsurer.
That ‘liquidity support’ has for many people, perhaps especially in the US, become
synonymous with ‘solvency bailout’ is a tragedy of the first order that saps away the
legitimacy of central banks. Let me put it brutally. Developing a reputation, whether
valid or invalid, for being prepared to lend to insolvent firms undermines the purpose
and effectiveness of the LOLR. It stigmatizes use of the liquidity reinsurer, and it invites
proposals to limit the scope or autonomy of the LOLR. Given the inter-dependencies in
global finance, this should be of concern even in those jurisdictions that have emerged
from crisis without deep suspicions of the LOLR.
If the most important part of the solution is the golden rule of not lending to funda-
mentally, irretrievably insolvent institutions, the other absolutely necessary component is
clarity around the social purpose of the LOLR. It is somewhat remarkable that debates
about how to restrain the LOLR can proceed without prior consensus on objectives. It is
not at all remarkable that absent such a consensus, ex post oversight and accountability
can be muddled.
Unsurprisingly, much of the heavy lifting falls to legislators. In nearly all key jurisdic-
tions, however, they have already delivered a statutory resolution regime for handling
irretrievably bankrupt businesses, making it credible for the LOLR to say ‘no’ when they
should. Central bankers should be celebrating that far and wide.
Under this new dispensation, the central bankers are now free to articulate the frame-
work and processes through which they assess solvency when making LOLR decisions.
And they can free themselves to talk publicly about the purposes of their role as liquidity
reinsurers without being misunderstood as advocating bailouts or the encroachment into
the preserve of fiscal policymakers.
So long as we have anything like the current financial system, we can’t do away with the
LOLR. In terms of understanding and broad support, it ought to stand full square with
central banks’ monetary policy role. That won’t come quickly, but it can be done.

27. Concluding observations
Rosa María Lastra
This Research Handbook on Central Banking is unique, not only because it covers
geographically and functionally the key themes in central banking, and includes as con-
tributors some of the most distinguished names in the central banking fraternity, but also
because it relies on an interdisciplinary approach where law, history, economics, finance,
accounting, anthropology and political science help us explore in depth and breadth the
institutional aspects of central banking.
This project was born out of a phone call. When Edward Elgar asked me to put together
a handbook on central banking, I wanted to engage someone with whom I could share
my passion for the subject, and to pass on the torch of my enthusiasm for an effective
inter-disiciplinary approach. That phone call was to Peter Conti-Brown, a historian and a
lawyer with a firm grounding in economics, and the outstanding central banking scholar
of his generation.
The gestation of this project gathered momentum in 2016 with a conference hosted by
the Bank of England where the Centre for Commercial Law Studies (CCLS)/ Queen Mary
University of London (QMUL) and Wharton joined forces and where we were fortunate
enough to have as speakers in the conference the authors of the chapters included in this
volume. We dedicated the conference to Charles Goodhart, a mentor and intellectual
father. And like a seed planted in good terrain, that initial phone conversation fructified
and has now become a most worthwhile edited collection, one that will appeal both to
the specialist (central banker, economist, lawyer, consultant, journalist, student) and
to the general public. This book is destined to stand the passage of time, notwithstanding
the evolving character that characterizes the theory and practice of central banking.
Writing the conclusions for a volume covering such a wide array of topics from an inter-
disciplinary perspective, could prove a lengthy exercise if one attempted to summarize the
contents of each chapter. Instead, the focus in these final remarks is to briefly reflect upon
central banking going forward.
The key issues in the debate which permeate through the chapters—the need to
reconcile the workings of a technocratic agency with the demands of democracy in order
to ensure legitimacy, balancing independence and accountability; how much to decide by
rule and how much to leave to central bank discretion; the consistency between its core
role in monetary policy and the broader mandate of financial stability; the role of central
banks during the crisis and the expansion of their mandate in response to the crisis; the
centrality of the institution as government’s bank and bankers’ bank; the idiosyncratic
nature of an entity which is both an agency and a bank—are likely to remain the subject
of controversy for the foreseeable future.
In a recent paper with Charles Goodhart, the doyen of central banking, we discuss how
anti-globalization movements, emboldened by the ‘will of the people’, have challenged the
traditional political landscape and how this is affecting central bank independence. The
root of this argument is not new. Rousseau’s Discourse on Inequality and many others
553

since (Thomas Piketty’s Capital in the Twenty-first Century being a significant contempo-
rary contribution) emphasize how wealth and income inequality feed popular discontent
and how those that feel disenchanted, with little to lose, will vote, rebel or protest against
the ‘establishment’.1 Populist movements tend to appeal to this ‘will of the people’, pit-
ting it against the establishment. Central banks have become part of that ‘establishment’.
My co-editor Peter elegantly characterised in the introduction the last century as the
‘central banking century’. Following the global financial crisis, the supporting conditions
for independence (an overarching theme in our volume) have weakened, and with that
central bank independence may become increasingly at risk over the next few decades for
underlying economic and political reasons. With expanded mandates, the effectiveness of
central banks as monetary agents, lenders of last resort, supervisors and crisis managers
may diminish. And as a sceptical public questions their actions and calls for further
mechanisms of accountability, the danger is that central bank credibility—that intangible
element that provides much of the justification for key central bank functions such as
monetary policy and lender of last resort—can get undermined.
Editing this book with Peter has been one of the most satisfying research experiences
in my life. I have learnt so much from working with him: at each stage in the way from
the early identification of themes and authors to the final stages of reading carefully each
chapter. In the words of St Teresa of Avila: ‘Es más bonito el camino que la posada’,
which freely translated means it is always nicer to walk than to reach the destination. What
is heartening is there is still a way ahead to be walked!
London, 26 June 2017
1
See David Goodhart, The Road to Somewhere: The Populist Revolt and the Future of Politics
(London: Hurst Publishers, 2017); James Vance, Hillbilly Elegy: A Memoir of a Family and Culture
in Crisis (New York: Harper Collins Publishers, 2016).

Index
Abalkin, L 95 International Accounting Standards Board

Abbassi, P 416 and IFRS accounting 316–17, 319, 320,
Abbott, K 335 322, 328
Abdelal, R 105 negative equity 321, 324, 330
Abuka, C 221 operating costs 325, 326–7
accountability profit recognition and distribution 328–9
central banks’ policies 520–23, 530, 531–2, quantitative easing (QE) 330
533 realised gains and losses on foreign exchange
European System of Central Banks (ESCB) 320–21
158, 159–60, 164, 171–4 revaluation deficits 321
lender of last resort (LOLR) 546–7 securities holdings 321–2, 323, 326, 327
supervisory, and institutional path of central seigniorage 326
bank independence 299–300, 311–13 shareholder distribution and foreign
see also transparency exchange 321
accounting 314–32 shareholder value issues and equity 323–4
assets 319–23, 326, 327 shareholders, financial ‘buffers’ and
balance sheet 317–24, 331 potential losses 329
bank notes as liabilities 318–19 unrealised valuation gains 320
bank reserves 330 valuation using current values 322
brand/reputation as asset 323 see also balance sheet policies
central bank currency swaps (CBCS) 330–31 Acemoglu, D 366
cost-based accounting 322 Adam, C 3, 208–28
credit risks and equity financing 324 Adler, G 324
digital currency development 330 Africa, sub-Saharan see sub-Saharan Africa,
equity 323–4, 330 monetary policy
European System of Central Banks (ESCB) Ahamed, L 16
160, 317, 322 Ahmed, S 432
exchange rate movements and foreign Aikman, D 375
currency reserves 320, 328 Ainslie, G 368
expected loss approach to impairments 328 Aiyar, S 516
expenses 326–7 Aizenman, J 414
fair value accounting 322 Akinci, O 516
financial instruments and their valuation Alesina, A 118, 155, 156, 300, 532
321–2 Alexander, K 4, 380–97, 489, 492, 493
financial statements, reasons for 316–17 Aliber, R 510
foreign currency reserves 320–21 Alichi, A 223–4
future research 330–31 Altavilla, C 412
gold reserves 319–20 Amtenbrink, F 156, 157, 158, 164, 171, 311,
‘helicopter money drop’ policy 331 312, 521, 522
impairment issues 327–8 Anand, A 450
income generation 325–6 Andenas, M 176, 312
income recognition policy and profit Andrew, A 12
distribution 328 Andrle, M 222, 223
income statement 324–9 Angelini, P 416
incurred loss approach to impairments Angeloni, I 359, 515
327–8 Araújo, A 409
inflation and currency values 320 Archer, D 319, 324, 328
intangibles 322–3 Arda, A 164
555

Argentina 276–85 passim, 287, 290, 293, 294, market equilibrium for bank reserves 436
477–8 national comparisons, Australia, payment
Armas, A 287 system risks 468–72
Arner, D 449 National Security Act 253, 254
Asch, S 369 non-bank financial intermediaries (NBFI)
Ashcraft, A 415 255–6
Ashwin, B 258, 259 NSW Current Account Depositors’ Act
Asian financial crisis 104–6, 109, 142 (1893) 249
and road to G-20 see international NSW Monetary Confidence Bill 248
diplomacy and coordination, Asian payment system regulation 468–72, 473
financial crisis and road to G-20 Payment Systems (Regulation) Act 470–71
see also financial crises effects private banks and colonial governments 247
Aslund, A 103 Reconstruction and Development Board 268
Asmussen, J 198 Reserve Bank Acts 255, 266–8, 468–9
asset purchase programmes Reserve Bank, market valuation approach to
accounting 319–23, 326, 327 accounting 322
EU currency union 187, 194–203 Statutory Reserve Deposit (SRD)
European System of Central Banks (ESCB) mechanism 256
402, 406–7, 426 trading banks 247, 248–9, 253–4, 255, 261,
international diplomacy and global financial 262
crisis 358–9 ultra vires doctrine 266
Japan 402, 407–8, 426 autonomy
and lending schemes 405–8, 409–13, 425–7 currency and monetary control, Japan 54–5
New Zealand 261 institutional path of central bank
US, Federal Reserve System 402, 406, 426–7 independence 304, 307
Association of South East Asian Nations systemic risk and financial sector structural
(ASEAN) 349 reform 504–5
Athanassiou, P 163, 176
Australasia see Australia; New Zealand Baba, N 63, 414
Australia Babis, V 175
bank notes as legal tender 247, 249–52 Bade, R 300
Banking Acts 254, 255, 267–8 Bagehot, W 37, 38, 40, 43, 178, 509, 536–7
Campbell Inquiry 256, 257 Bailey, A 370
capital against off-balance sheet exposures as Baker, A 337
macro-prudential regulatory lever 390 balance sheet policies
central banking 250–58 accounting 317–24, 331
command economy system 253–5 unconventional monetary policies 400,
Commissioner of Taxation v Unit Trend 404–5, 409–13, 417, 425, 428–9, 437–8
Services 266 see also accounting
Commonwealth Bank Acts 250, 252, 253, Baldini, A 216, 224
254, 255 Ball, L 372
Corporations Act 471–2 Balls, E 334, 360
deregulation 255–8 Baltensperger, E 257
devaluation (1931) 252–3 Bangia, R 68, 69, 86
exchange rate management 256, 257, 259, Bank for International Settlement (BIS) 131,
267–8 147, 241, 336, 337
Financial Corporations Act 256 Committee of Payment and Settlement
financial crises (1840s and 1890s) 248–9 Systems (CPSS), payment system risks
fiscal and monetary policy separation 257 448, 450–52, 458
foreign exchange 247–8, 252–3 international diplomacy and coordination
free banking system, early 246–50 339–41
gold standard 247, 251, 252, 253 bank notes
government securities 253–4, 256 China 130, 145–6
inflation control 255, 256–8 Japan 57
interest rate controls 256, 353, 354 as liabilities 318–19

Index 557
‘Mahatma Gandhi Series’, India 76–7 Bolivia 275, 284, 285

New Zealand 246–7, 249–50, 251, 258, 259 Bordo, M 25, 342, 343, 345, 347, 357
bank reserves policy 400–401, 402–4, 408, 421, Borio, C 4, 29, 331, 334, 337, 341, 398–444, 509
423, 434–6 Bork, R 479
Barker, J 330 Born, B 523
Barkovskii, N 97 Borodin, A 112
Barro, R 156, 373 Boughton, J 350, 351, 352
Barry, C 532 Bowker, T 112
Basel Committee on Banking Supervision 45, Bowman, D 408, 432
71, 108, 144, 341 brand/reputation as asset 323
Basel II prudential supervision 110, 111, 114, Brandi, T 169
387 Braun, R 63
Basel III 225 Brazil 277, 279, 281–91passim, 293
Basel Revised Core Principles For Effective Breeden, S 549
Banking Supervision 383 Bretton Woods system 43, 47, 131, 237, 240,
Batini, N 219 280, 282, 340
Bauer, M 409, 411 Broadbent, B 481
Baumeister, C 426 Brownbridge, M 385
Baxter, L 505 Brunner, K 430, 518
Bayoumi, T 274 Brunnermeier, M 430, 501
Bech, M 421 Bruno, V 429
behavioural biases 366–9, 371–6 Bryson, B 311
see also psychology of central banking Buchheim, C 239
Beirne, J 416 Buffie, E 223
Belgium 202–3 Buiter, W 324, 514
Bell, S 254, 256, 257 Bulir, A 221
Benati, L 426 Butlin, S 246, 248, 249, 251, 253
Benes, J 219, 220
Benhabib, J 61 Calomiris, C 374
Benston, G 488, 489, 491 Camdessus, M 350
Berg, A 3, 14, 208–28 Campbell, S 415, 419
Bergman, M 366 Canada 426, 460–65
Bergsten, C 333, 334, 337, 347 Balancing Oversight Discussion Paper 464–5
Bernanke, B 16, 28, 29, 30, 59, 243, 310, 311, Hodge v The Queen 464
334, 336, 355, 357, 365, 371, 418, 434, 437 Canales, J 285
Beukers, T 168 Capie, F 2, 34–52, 370
Bezanson, A 7 capital adequacy 70–72, 122, 143, 149–50, 225,
Bhala, R 2, 68–93 330, 490, 509
Bhattarai, S 409, 418 capital flow management measures (CFMs),
Bholat, D 3, 314–32 Latin America 289
Bilbiie, F 26 capital market development, China 137–8
Billings, M 44 capital ratios 35–6, 44–5, 46, 49, 50
Bindseil, U 316, 324 Carbo, L 277
Bini Smaghi, L 163, 198–9 Carrasco, C 277, 278
bitcoins see under digital currencies Carse, S 43
Blackstone, B 358 Carstens, A 285
Blair, T 373 Caruana, J 357, 449, 487
Blanchard, O 274, 291, 508, 509 Castello-Branco, M 155
Blinder, A 25, 26, 28, 64, 365, 375 Cawrey, D 480
blockchains, digital currencies 476–7, 481–2, Cecchetti, S 67, 509
484–5 central bank currency swaps (CBCS),
Blommestein, H 446 accounting 330–31
Blustein, P 351, 352 Chadha, J 411
Bodenhorn, H 9 Chailloux, A 355
Bogdanova, B 429 Chandler, A 16, 20

Chappell, N 250, 258, 259, 261 State Administration of Foreign Exchange

Chazan, G 110 (SAFE) 135
Chen, H 427, 432 ‘state bank’ model 133
Chen, J 432 stock exchange, first 138
Chile 275–91passim, 324 World Trade Organization (WTO) accession
China 145
accountability mechanisms 523 China, and evolutionary theory of central
digital currencies 480 banking, socialist market economy 139–50
economic cycle and Latin America 293 Asian Financial Crisis 142
economic development effects on Latin central banking reforms 140–44
America 293 Commercial Banking Law 143
mobile banking 73 deposit insurance scheme 149
China, and evolutionary theory of central exchange connect programs 150
banking 128–54 exchange rate liberalization 146–7
Agricultural Bank of China 135 exchange rate stabilization 142
capital adequacy 122, 143, 149–50 failed financial institutions, resolving 144
capital market development 137–8 financial stability and macro-prudential
China Securities Regulatory Commission policy framework, strengthening 147–9
(CSRC) 143, 144, 145 illegal financial activities 141–2
‘command and control’ model 136–7 insurance industry and systemic risks 148–9
Commercial Paper Law 144 interest rate liberalization 146
consumer price index (CPI) 141 international banks as stakeholders 148
debt securities market 138 international cooperation 149
financial crises effects and macro-prudential joint stock banks 137–8, 143, 147, 148
policies 131–2 macro-economic management 141–2
financial sector reform foundation 137–8 market-based financial sector 149–50
financial system birth 134–5 monetary and exchange rate policy
futures trading 138 modernization 145–50
Great Qing Bank 132–3 monetary policy tools 140–41
Guangdong International Trust Investment open capital account 150
Company bankruptcy 144 rural credit cooperatives sector 148
Industrial and Commercial Bank of China securities industry and systemic risks 148
(ICBC) 135 supervisory framework reform 144, 152–3
inflation targeting 138–9, 142 treasury securities 145–6
insurance industry 135, 137 China, People’s Bank of China 117–27
interest rate liberalization 141 China Banking Regulatory Commission
lender of last resort 130, 132 (CBRC) 121, 124
modernization 145–50 China Insurance Regulatory Commission
non-bank financial institutions 137 (CIRC) 124
note issue monopoly 130, 145–6 China Securities Regulatory Commission
open market operations in treasuries market (CSRC) 123–4
141 collateral requirements 122, 123, 144
People’s Bank of China (the PBOC) founded Coordination Meeting System 124
133, 136 deposit insurance scheme 125–7
People’s Insurance Corporation of China financial regulatory structure 123–5
(PICC) 135 financial stability instruments 120–23
pre-reform era 132–4 financial stability oversight committee 124–5
Provisional Banking Regulation (1986) 137 global financial crisis effects 124
quantitative control of aggregate credit and independence and accountability 118–20
money supply 136 Law of Administrative Procedure 119–20
reform era 134–50 lender of last resort 121–2
Required Reserve Ratio (RRR) system 141, macro-prudential regulation 122–5
146, 149, 512 monetary policy 118, 119–20
shadow banking system 152–3 principal-agent relationship with State
socialist commercial economy 135–9 Council 118–19

Index 559
Renminbi (RMB) internationalization 117 Conti-Brown, P 1–33, 296, 395, 398, 504, 528
Shanghai Free Trade Zone (FTZ) 117 Cooper, J 13
transparency and accountability 120 Cooper, R 334, 339
Chinoy, S 80 Corbo, V 282
Chow, J 496, 498 Cornish, S 255, 256, 257
Christensen, J 411, 414 Corrigan, E 446, 537
Christiano, L 63 Corwe, C 532
Chugaev, S 97 cost-based accounting 322
Chung, H 426 Costa Rica 278, 279, 283, 284, 286, 287
Churm, R 193 covered bonds purchase programmes, EU
Chwieroth, J 105 194–6, 201
Clarida, R 62 Crawford, B 462
Clemens, R 263 crawling pegs, Latin America 282, 286
Clement, P 508 credit policy
Clews, R 408 intermediation concerns, UK 381–2
Cliffe, M 428 unconventional monetary policies 401–2
Clifford, A 16, 20, 22 US credit-easing (CE) policy 512
Clouse, J 418 Credit Rating Agencies (CRAs) 115, 188,
Cochrane, J 431 189–90, 191, 195
Coenen, G 63 credit risks 87, 324, 389, 438, 451
Coeuré, B 169 Crockett, A 508
Coghlan, T 246, 247, 249 Cross, K 368
Cohn, R 430 Crow, J 449
Coleman, W 251, 252 Crowe, C 55
collateral policy Cuba 279
China 122, 123, 144 Cukierman, A 155, 285, 300, 306, 308, 532
EU currency union 188–92 Cúrdia, V 58
lender of last resort (LOLR) 548–9 currency boards (1970s), sub-Saharan Africa
transparency of central banks’ policies 531, 210–11
533 currency swaps
UK 389–90 central bank currency swaps (CBCS) 330–31
unconventional monetary policies 402, 408, international diplomacy and coordination
409, 413 357–8
Collier, P 211, 225–6 currency unions
Colombia 275–9passim, 283–91passim EU see EU currency union, ECB’s
‘command and control’ model, China 136–7 developing role
command economy system, Australasia 253–5, sub-Saharan Africa 217–18, 222
261 Cyprus 190, 191, 201, 483
commercial, socialist commercial economy, Czech Republic 324
China, and evolutionary theory of central
banking 135–9 D’Amico, S 411
commercial banks Darbyshire, R 3, 314–32
China 143 Davidoff, S 498
and digital currencies 483 Dawe, S 269
Russia 108–9, 110, 111 De Carvalho Filho, E 209
UK 39–40, 42, 49, 50 De Haan, J 119, 157
commercial discount policy (1920s), Germany De Larosière Report, EU 391–2
231–2 De Schutter, O 530
competition and digital currencies 477–81 Deane, R 261
Congdon, T 50 Debelle, G 370
constitutional framework, European System of Decker, F 3, 245–73
Central Banks (ESCB) 158–64, 174 democratic legitimacy 308, 532–4
consumer price index (CPI) demonitization crisis, India 76–7
China 141 Denmark 422, 423, 424
Japan 60 deposit insurance

China 125–7, 149 Eccles, M 17–19, 20–21

and digital currencies 482 Ecuador 275, 277, 278, 283, 284, 286, 287, 478
macro-prudential policy role 510–11 efficient markets hypothesis 151, 509, 520
Russia 109, 110 Eggertsson, G 61, 409, 418
US 536 Eichengreen, B 16, 216, 334, 524, 525
deregulation Eijffinger, S 523, 524
Australia 255–8 Eisinger, J 498
India 82–5 El Salvador 276, 284
New Zealand 262–4 El-Erian, M 296, 433
Russia 97, 103–4 Elderson, F 158
UK 42–3 Elkin, W 255
Desan, C 7 Elliott, F 474
Destler, I 342, 343–4, 346, 348 Endler, J 163
Dhar, B 84 Engen, E 427
Diamond, P 366 Epstein, R 479
Dierick, F 489 EU
digital currencies 474–86 Bank Recovery and Resolution Directive
abuse concerns 483 (BRRD) 392–3
and accounting 330 De Larosière Report 391–2
bitcoins 474–5, 476–7, 483 Exchange Rate Mechanism (ERM) 47–8
blockchains 476–7, 481–2, 484–5 Liikanen Report 494, 495
commercial banking sector effects 483 Outright Monetary Transaction program
competition and central banks 477–81 244
competition and central banks, benefits Single Resolution Mechanism (SRM) 166,
477–8 391, 392–3
competition and central banks, legal tender sovereign debt crisis 185, 197, 391, 405
laws 478–9 systemic risk, subsidiarization and ring-
and deposit insurance 482 fencing 494–5
‘electronic cash’ on debit cards 475–6 TACIS (Technical Aid to the
emergence 475–7 Commonwealth of Independent States)
and interest rates 482–3 program 99, 108, 109–10
issuance by central banks, consideration of universal banks 488–9
481–3 see also individual countries
M-Pesa 476 EU Court of Justice
money transfer market, saving potential Gauweiler v Deutscher Bundestag 167–9, 177,
484–5 199–201, 298
online fantasy games 476 OLAF 158, 159, 174, 176, 298, 304
Dincer, N 216, 524, 525 Peter Paul v Bundesrepublik Deutschland 312
diplomacy and coordination see international Pringle v Government of Ireland 167, 199,
diplomacy and coordination 201
Disyatat, P 398, 400, 404, 421, 429, 434, 438 UK v Parliament and Council 166
Domanski, D 408, 437, 489, 504 EU currency union, ECB’s developing role
Dombalagian, O 496, 498 184–207
Dombret, A 449 asset purchase programmes 187, 194–203
Dominguez, K 345 asset purchase programmes, covered bonds
Dominican Republic 279, 284, 287 purchase programmes 194–6, 201
‘domino effect’, payment system risks 451 Asset-backed Securities Purchasing
Draghi, M 187, 194, 197, 206, 229, 437 Programme (ABSPP) 201
Drake, P 275 collateral assessment and conditionality
Duca, J 415 compliance 190–91
Duisenberg, W 449 collateral eligibility requirements 192
Duke, E 355, 357, 358 collateral haircut schedule 189
Dumiter, F 524, 525 collateral widening 188–92
Duncan, G 474 Corporate Sector Purchase Programme
Duygan-Bump, B 415 (CSPP) 202–3

Index 561
Credit Rating Agencies (CRAs) 188, 189–90, constitutional framework, transparency

191, 195 obligations 159
economic policy involvement 205–6 Delarosière Report 165–6
‘expropriation’ of savers and undermining of Economic and Monetary Union 165
pension funds 187 Emergency Liquidity Assistance 178
financial crisis and monetary policy mandate Eurogroup as interlocutor 172
185–94 European Financial Stability Facility
forward guidance approach 187–8 (EFSF) 166
future challenges 206–7 European Parliament as interlocutor 172
Harmonised Index of Consumer Prices European Stability Mechanism (ESM) 167,
(HICP) 186 199, 200, 201
interest rate setting 186–8, 207 European Supervisory Agencies (ESAs) 166
lender of last resort 203–4 European Systemic Risk Board (ESRB)
Long-Term Refinancing Operations 165–6
(LTROs) 188, 192–4, 195, 196 financial crisis and new institutional
negative interest rates 186–7 developments 165–7, 170
Outright Monetary Transactions (OMT) independence principle 156–82
185, 197–201, 512 information and dialogue exchange with
price stability objectives 185–6 other institutions 160
Private Sector Involvement (PSI) 191 institutional interlocutors 172
prudential supervision 206–7 interest rate forward guidance 416
Public Sector Purchasing Programme Interinstitutional Agreement (IIA) 529
(PSPP) 202 intra-institutional independence 175, 176
Securities Markets Programme (SMP) and legal personality 297–8, 305, 306
196–7, 512 macroprudential policy-making
Single Resolution Fund (SRF) Agreement responsibilities 514–15
207 monetary policy and prudential supervision
Single Supervisory Mechanism (SSM) 207, separation 170–71
391, 392, 528–9 national competent authorities (NCAs) 171,
Eurogroup as interlocutor, European System 173, 174
of Central Banks (ESCB) 172 national level and new supervisory tasks
European Financial Stability Facility (EFSF) 176–82
166 national parliaments, accountability to
European Parliament as interlocutor, 172–3
European System of Central Banks negative policy rates 422
(ESCB) 172 Outright Monetary Transactions (OMT)
European Stability Mechanism (ESM) 167, programme 167–8
199, 200, 201 payment system regulation 473
European Supervisory Agencies (ESAs) 166 price stability objective 170
European System of Central Banks (ESCB) prudential supervision 169–76
155–83 Single Supervisory Mechanism (SSM) 166,
accountability 158, 159–60, 164 170, 171–3, 175, 176–7
accounting framework 317, 322 supervisors’ accountability 171–4
‘Agreement on Net Financial Assets’ (Anfa) Supervisory Board 171, 172, 173, 174–5
529 supervisory tasks and preservation of the
asset purchases 402, 406–7, 426 principle of independence 174–6
auditing checks 160 transparency policy 528–9, 530
balance sheet policies 405, 412 troika (Member States, Commission and
constitutional framework 158–64, 174 IMF) 166, 169
constitutional framework, reasons for European System of Financial Supervision 391
ECB independence in Treaty 158–9, European Systemic Risk Board (ESRB) 165–6,
160–61 391–2
constitutional framework, scope and evolutionary theory see China, and
limits of ECB independence in Treaty evolutionary theory of central banking
159 exchange connect programs, China 150

exchange rate policy global see global financial crisis

Australia 247–8, 252–3, 256, 257, 259, 267–8 Latin America 286–7
China 142, 145–50 UK 49–51
exchange rate movements and foreign US 28–30
currency reserves 320, 328 financial stability
Germany 235 China 120–23, 124–5, 147–9
India 77–85 Financial Stability Forum (FSF) creation
inter-central bank FX swap lines 404 338
Jurgensen report and international goal 299–300, 301, 306, 307
diplomacy and coordination 345, 347 Japan 56–7
Latin America 277, 278, 280, 281, 282, 286, macro-prudential policy role 509–13
293 and payment system risks 448–50
New Zealand 247–8, 258–60, 261, 263 and psychology of central banking 372–3,
Plaza Accord and international diplomacy 374
and coordination 342–8 sub-Saharan Africa 224–6
realised gains and losses on foreign exchange and systemic risk 383–4
320–21 and transparency of central banks’ policies
Russia 104–5 525–6, 530, 532–3
and shareholder distribution 321 UK 35–9, 38–44, 45, 47, 48–9, 383–4, 388
sub-Saharan Africa 214, 215, 217, 219–20, US 29–30
221–2, 224 see also monetary policy; price stability
expected loss approach to impairments 328 Finland 203
see also accounting fiscal implications, macro-prudential policy
expenses, accounting 326–7 role 513
external shocks, response to, sub-Saharan fiscal and monetary policy separation,
Africa 216, 221–2, 224 Australia 257
fiscal policy, sub-Saharan Africa 211–12, 222,
fair value accounting 322 223
Fairgrieve, D 312 fiscal risks and costs, and lender of last resort
Fak, A 106 (LOLR) 539
fan charts, psychology of central banking 375 Fischer, S 55, 370, 487, 499
Favara, G 385 Fisher, I 430, 499
Fedcoin, US 481–2 Fitz-Gibbon, B 249
Fedorov, B 95–6, 97 Flandreau, M 334
Fehr, E 430 Fleming, M 357, 415
Feldman, G 231 FMI Report (financial market infrastructures)
Feldstein, M 335, 343, 347 452–3
Femia, K 419 Foot, M 47, 449
Ferejohn, J 367 foreign currency reserves, accounting 320–21
Fernandez, R 282 foreign exchange see exchange rate policy
Fernández-Albertos, J 296, 300 forward guidance approach, EU 187–8
Fernholz, R 524 forward guidance, interest rate 413–21
Feroli, M 420–21 fractional reserve banking 36, 39, 482, 483,
Ferran, E 175, 393 536, 538
Ferrell, R 23 Fraga, A 309
Figner, B 367 France 203, 423, 424
Filardo, A 419, 420 Frankel, J 342, 343, 345, 346, 347
financial autonomy see autonomy Frattianni, M 299
financial crises effects Fratzscher, M 432
Asian see Asian financial crisis free banking 9–10, 36, 246–50, 302, 479
Australia 248–9 Friedman, M 26, 39, 157, 310–11, 365, 434
China 131–2 Fry, M 324
EU currency union 185–94 Fujiki, H 62
European System of Central Banks (ESCB) Fujiwara, I 61–2, 63–4
165–7, 170 Funabashi, Y 346, 347, 348

Index 563
future research 64–5, 66–7, 330–31 Reichsbank Law (1924) 232

futures trading 138, 419, 420 Reichsbank as lender of last resort 230–31
reunification effects 309–10
G-5 and G-7 groupings 337, 338, 346, 347, 348 ‘Schachtianism’ and external trade 235
G-10, and OECD Working Party Three (WP3) Germany, central banking tradition legacy,
336–7, 340 Great Depression and Nazification of
G-20 formation 338–9, 354, 359 Reichsbank 233–8
G-22 (Willard Group) 338 exchange controls 235
G-33, international diplomacy and Four Year Plan 235
coordination 338 inflation and price controls 235–6
Gagnon, J 411 Nazi ‘leadership principle’ application 236
Gaidar, Y 95, 96, 97, 99, 102 New Europe blueprint 236–7
Gailmard, S 366 political intrusion effects 233–6
Galati, G 384 state-led economy expansion effects 234–5
Gali, J 508 Gertler, M 62, 409, 425, 426
Gambacorta, L 426, 429, 502 Geva, B 4, 445–73
Garicano, L 122, 171, 312, 313, 521 Giblin, L 252, 253, 254
Geithner, T 28 Gieseler, K 169
Gerashchenko, V 94, 96, 98, 102–4, 105, 106, Gieve, J 447
109 Gilchrist, S 432
Gerding, E 503 Gilman, M 105
Germany Gizycki, M 249
Corporate Sector Purchase Programme Glass, C 14, 15
(CSPP) 202–3 Glick, R 432
government bond yields 423, 424 global financial crisis
universal banks 488–9 China 124
Germany, central banking tradition legacy institutional path of central bank
229–44 independence 310–11
Bank Inquiry (1933) 234 and international diplomacy see
and Bretton Woods regime 237, 240 international diplomacy and
Bundesbank and Bretton Woods fixed coordination, global financial crisis
exchange rate regime 240 Latin America 289–90, 292
Bundesbank and European Monetary macro-prudential policy role 508–9
System 241–2 Russia 111–14
Bundesbank independence implications 240 sub-Saharan Africa 209, 210, 216, 224
Bundesbank Law (1957) 239–40 see also Asian financial crisis; financial crises
Bundesbank and price stability 240–41, 243, effects
309–10 Goel, A 368
commercial discount policy (1920s) 231–2 gold reserves, accounting 319–20
currency reform and Deutsche Mark gold standard
introduction 239 Australia 247, 251, 252, 253
Delors Committee and European monetary Germany 229, 232, 233, 237–8
union 242–3 Latin America 275–6, 277–8
EU Outright Monetary Transaction New Zealand 247, 252
program 244 UK 35, 37, 43, 46–7
Euro crisis effects 244 US 14, 131
and European Central Bank 243–4 Gollan, R 248, 251, 252
gold standard 229, 232, 233 Gómez, J 287
gold as vital wartime raw material 237–8 Goodfriend, M 404, 446
Great Inflation 231–2 Goodhart, C 4, 11, 67, 123, 126, 169, 313, 341,
Imperial Germany and Reichsbank 230–31 385, 390, 392, 395, 404, 501, 502, 508–17
Mefo-Wechsel bills 234, 235 Gordon, D 156, 373
post-war economic reforms, and Bank Gordon, J 495
deutscher Länder (BdL) 238–9, 240 Gortsos, C 170
Reichsbank and Bundesbank as models 229 Gough, N 484

governance policy, transparency of central Higson, C 323

banks 521–3, 526, 534 Hilsenrath, J 358
government bond purchases 409–10, 423–4 Ho, C 357
government securities 17, 21, 37, 54, 57, 71–2, Hockett, R 487
145, 327, 328, 358, 400 Hodgetts, B 263
Australasia 253–4, 256, 261, 263 Hofmann, B 419, 420, 429
see also securities Hogg, P 464
Graham, J 260 Holder, R 248, 249, 251, 254, 259
Granville, B 103 ‘holding company’ model 489–90, 492–500,
Greece 190, 191, 201, 206 502
Green, R 344, 348 see also systemic risk and financial sector
Greene, E 394 structural reform
Greenspan, A 26–8, 509 Holmes, D 27
Gregory, T 38 Holmes, F 262
Grenville, S 437 Holtham, G 302
Griffiths, B 47 Honduras 279, 284
Grilli, V 155, 300 Hong Kong 73
Grimes, A 262 Honohan, P 211
Grippa, F 287 Hood, C 520
groupthink (confirmation) biases 369, 375–6 Hopkin, B 302
see also psychology of central banking Horáková, M 316
Guatemala 275, 283, 284, 287 Horváth, R 525, 526
Gunning, J 211 Howe, D 8, 9
Guttentag, J 126 Hrung, W 415
Guynn, R 491, 496, 501 hubric (over-confidence) biases 368–9, 374–5
Gyohten, T 343, 345, 346, 354 see also psychology of central banking
Huertas, T 491, 501
Habermeier, K 358 Hughes, P 369
Häde, U 160 Hyman, S 17
Haldane, A 3–4, 365–79, 437, 447, 480–81, 482
Hamilton, A 7–8 Iaryczower, M 369
Hamilton, J 64, 411 Iceland 480
Hammond, B 10, 11 Ickes, B 102
Hammond, G 107, 373 Imakubo, K 412
Hampson, F 335 IMF
Hancock, D 411 consultations, Russia 99
Hansen, S 375 emergency loan, India 79
hard pegs and currency unions, sub-Saharan Financial System Stability Assessment
Africa 217–18, 222 (FSSA), Russia 109
Hausman, J 412, 426 packages, Asian financial crisis 348, 350,
Hawke, G 248, 259, 260, 261 351–2, 353, 354
Hawtrey, R 41, 248, 250 stabilization loan, Russia 105
Hayashi, F 58, 63 Stand-by Arrangements, Latin America 281
Hayek, F 477 import-substitution industrialization, Latin
He, D 122 America see Latin America, import-
Heinbecker, P 335 substitution industrialization
Heinsohn, G 262 income generation, accounting 325–6
helicopter money 331, 431–3, 434–7 income recognition policy, accounting 328
Heltman, J 504 incurred loss approach to impairments,
Henderson, D 345 accounting 327–8
Henning, C 333, 334, 337, 342, 343–4, 346, independence principles
347, 348, 349, 353, 354 and democratic legitimacy 532–4
Herring, R 126 European System of Central Banks (ESCB)
Hertig, G 56 156–82
Hetzel, R 22 Germany 240

Index 565
institutional path see institutional path of statutory liquidity and capital adequacy
central bank independence ratios 70–72
Japan 54–5, 64–5 Uruguay Round, multilateral trade
Latin America 284–5, 288 negotiations (MTNs), India’s
India participation in 83–4
Canara Bank v PRN Upadhyaya 70 inflation
Sajjan Bank (Private) Ltd v Reserve Bank of Australia 255, 256–8
India 69 and currency values 320
India, Reserve Bank 68–93 Germany 231–2, 235–6
ATMs 72 Latin America 278, 279, 281–2, 283, 285,
bank-driven computerization 72 286, 287
Banking Regulation Act (1949) 69–70, 87 New Zealand 256–7, 262–4
branching 87–8 and output 425–7
Business Correspondents (BCs) 75–6 public attitudes and perception of 372
colonial-era legislation 69 US 24–6, 343–6, 348, 354
demonitization crisis 76–7 inflation targeting
financial sector liberalization 82–5 China 138–9, 142
First Generation Economic Reforms 80–81, Latin America 287–9, 291, 292, 294
82, 87, 89, 91 Russia 102, 103, 106–7, 112–13, 114
foreign acquisitions 89–90 sub-Saharan Africa 209, 212, 214, 216, 218,
foreign bank entry and regulation 88–90 219, 220, 221–2, 223–4
Foreign Exchange Dealers’ Association of UK 46–9, 50
India (FEDAI) 83 Inoue, T 63
foreign exchange (FX) regulation 77–85 institutional arrangements, Latin America
Foreign Exchange Management Act (1999) 275–7
82–5 institutional change, US see US, institutional
Foreign Exchange Regulation Acts 77–9, 83 change
GATS commitments 88–9 institutional implications, systemic risk 503–5
Government Owned Banks (GOBs) 75, 86 institutional interlocutors, European System of
immovable property regulations 85 Central Banks (ESCB) 172
International Monetary Fund (IMF) institutional path of central bank
emergency loan 79 independence 296–313
Islamic banking proscription 70 absolute independence, case against 305–8
License Raj system 81 democratic legitimacy 308
Magnetic Ink Character Recognition economic test of independence 304
(MICR) technology 72 financial autonomy 304, 307
‘Mahatma Gandhi Series’ banknotes and financial stability goal 299–300, 301, 306,
money laundering 76–7 307
market-determined exchange rate 79–82 functional or operational guarantees 303–4
mobile banking and payments 73–4 global financial crisis effects 310–11
National Electronic Funds Transfer System incentive structure 303
(NEFT) 72–3 independence from what 299–300
National Payments Corporation of India independence from whom 298–9
(NPCI) 73 judicial review 312
Non-banking Financial Companies legal articulation 302–5
(NBFCs) 89–91 legal structure 296–8
Payments Act (2007) 73–4 limits of independence 305–11
payments banks 74–6 monetary control instruments 303, 306–7
payments system regulation 72–7 monetary independence 299, 300–302, 305–6
private sector banks 86–7, 88, 89 operations officers, appointment of 307
Real Time Gross Settlement System (RTGS) organic guarantees and professional
72–3 independence 303
Reserve Bank of India Act (1934) 68–9, 87 political argument in favour of independence
securities investment 84–5 301–2
small banks 74–6 political compromise effects 306–7

public or private ownership issues 296–7 Korean crisis and rollover of loans 351–2,
public sector lending restrictions 304 354
regulatory powers 304–5 Manila Framework 353
seigniorage taxation use 308–9 international diplomacy and coordination,
and sovereign rights 301 global financial crisis 354–9
supervisory independence and accountability asset purchase programs 358–9
299–300, 311–13 bilateral currency swap arrangements 357–8
transparency in monetary policy 312–13 coordinated policy rates reduction 356
insurance company risks, UK 395 liquidity shortages, dealing with 356–7
insurance industry, China 124, 135, 137, International Financial Reporting Standards
148–9 (IFRS) 109, 110, 316–17, 319, 320, 322,
intangibles, accounting 322–3 328
interbank payment system, need for well- International Monetary Fund see IMF
functioning 447, 450 Ireland 190, 328
interest rates Israel 324
Australia 256 Issing, O 157, 518, 526, 530, 532
China 141, 146 Italy 203, 423, 424
and digital currencies 482–3 Iwata, S 63
EU currency union 186–8, 207 Ize, A 324, 328
forward guidance 413–21
Latin America 281, 286, 287, 292 Jácome H, L 3, 274–95
negative 186–7, 430–31 James, H 3, 229–44
New Zealand 261, 262 Janis, I 369
zero interest rate policy (ZIRP), Japan Japan, Bank of Japan 53–67, 328
58–60, 61–2 asset purchases 402, 407–8, 426
international diplomacy and coordination autonomy on currency and monetary
333–64 control 54–5
Bank for International Settlements 339–41 balance sheet policies 405, 412
Brexit effects 360 Bank of Japan Act 53, 54–7
coordination episodes 342–59 bank notes, issuing 57
diplomacy 335–41 consumer price index (CPI) guidelines 60
exchange rates and Jurgensen report 345, Financial Services Agency (FSA) 65
347 financial system stability 56–7
exchange rates and Plaza Accord 342–8 future research 64–5, 66–7
Financial Stability Forum (FSF) creation government bond yields 424
338 independence 54–5, 64–5
future direction 359–61 interest rate forward guidance 417, 420
G-5 and G-7 groupings 337, 338, 346, 347, international finance 57
348 lender of last resort 56–7
G-20 formation 338–9, 354, 359 liabilities 403
G-22 (Willard Group) 338 monetary policy 55–6, 58–65, 551
G-33 338 negative policy rates 422
history 333–4 New Keynesian model 62
joint actions 334 on-site examinations 57, 65–7
minilateralism 335 payment and settlement system 57
OECD Working Party Three (WP3) and Policy Board and monetary control 55–6
Group of Ten (G-10) 336–7, 340 prudential policy 65–7
international diplomacy and coordination, Public Finance Act and government
Asian financial crisis and road to G-20 securities 54
348–54 quantitative easing policy (QEP) 60, 61
ASEAN+3 and Chiang Mai Initiative (CMI) Vector Autoregression (VAR) methodology
353–4 63–4
Asian Monetary Fund (AMF) suggestion zero interest rate policy (ZIRP) 58–60, 61–2
353 Jenkins, P 449
IMF packages 348, 350, 351–2, 353, 354 Jensen, M 367

Index 567
Jochmann, W 235 Krueger, A 80

Johnson, J 2, 94–116 Krugman, P 61
Johnson, S 30 Kumar, R 77
joint stock banks 41, 43, 137–8, 143, 147, 148 Kurozumi, T 62
Joplin, T 40, 49 Kwak, J 505
Jorda, O 510, 511 Kydland, F 26, 156
Joyce, M 404, 411 Kynaston, D 537, 546
Julliard, C 430
Jung, J 353 Labonte, M 449
Jung, T 62 Laibson, D 368
Lam, W 412
Kahn, R 3, 29, 333–64 Lambert, R 370
Kahneman, D 365, 368, 369 Lane, J 366
Kanda, H 2, 53–67 Langdon, K 338, 359
Kane, E 24 Lastra, R 3, 4, 34, 55, 118, 122, 123, 155, 156,
Kapetanios, G 426 157, 158, 159, 162, 163, 165, 170, 171, 174,
Kaplan, A 369 296–313, 380–97, 398, 449, 519, 521, 525,
Karadi, P 62, 409, 425, 426 529, 531, 532, 553–4
Kashkari, N 488 Latin America 274–95
Kashyap, A 538 banking crises and bailouts 286–7
Kato, T 351 capital flow management measures (CFMs)
Kaufmann, C 4, 518–34 289
Keister, T 408 central bank independence 284–5, 288
Kemmerer, E 275, 277 central banks’ board of directors 277,
Kenadjian, P 491, 496, 501 279–80
Kennan, G 230 Chinese economic development effects 293
Kennedy, D 18, 19 crawling pegs 282, 286
Kenya 476 exchange rates 277, 278, 280, 281, 282, 286,
Kessy, P 212 293
Kettl, D 20, 22 future direction 290–94
Keynes, J 46, 520 global financial crisis effects 289–90, 292
Kharas, H 338, 347 gold standard 275–6, 277–8
Khosla, R 75 Great Depression 277–8
Kim, T 476 IMF Stand-by Arrangements 281
Kimura, T 62 inflation 278, 279, 281–2, 283, 285, 286, 287
Kindleberger, C 510 inflation targeting 287–9, 291, 292, 294
King, M 370 institutional arrangements 275–7
King, T 411 interest rates 281, 286, 287, 292
King, W 42 Kemmerer’s recommendations 275, 277
Kirkpatrick, C 385 macroprudential policy function 290–92
Kirshner, J 21 monetary policy, forward-looking 285–7
Kirton, J 338–9 monetary stability 275–6
Kisch, C 255 price stability 286, 291–2
Klagge, N 357 unsynchronized global cycles, effects of
Klingebiel, D 387 293
Klüh, U 324 see also individual countries
Koeda, J 63 Latin America, import-substitution
Köstem, S 112 industrialization 278–84
Kotlikoff, L 491, 499 and Bretton Woods system 280, 282
Kozlov, A 94–5, 100, 109, 110–11 capital controls 280, 282
Kraft, J 354 central bank mandates 279–80
Krasner, S 333 debt crisis 282–3
Krishnamurthy, A 60, 62, 64, 411 monetary policy during 280–84
Krivobok, R 115 ‘tablita’ arrangements 282
Krolzig, H-M 64 Latter, E 447

Lawson, N 47 oversupply concerns, lender of last resort

Laxton, D 219, 224 (LOLR) 538
Lazar, N 547 and payment system risks 451
Leach, R 22 requirements, macro-prudential policy role
Leduc, S 432 511–12
legal articulation, institutional path of central shortages, dealing with, global financial
bank independence 302–5 crisis 356–7
legal personality statutory liquidity and capital adequacy
European System of Central Banks (ESCB) ratios, India 70–72
297–8, 305, 306 support measures, interest rate forward
US, Federal Reserve System 297, 301, 304–5, guidance 414–17
306 support perimeter, systemic risk and
lender of last resort (LOLR) 535–52 financial sector structural reform
China 121–2, 130, 132 503–4
collateral policy 548–9 Liu, X 2, 128–54
credible commitment and time consistency ‘living wills’ and group resolution regimes 504
538–9, 548–50 Loewenstein, G 365, 367
emergencies 547–8 Lombardelli, C 375
EU currency union 203–4 Lombardi, D 338, 347
fiscal carve-out decisions 543–4 Long-Term Refinancing Operations (LTROs),
fiscal risks and costs 539 EU currency union 188, 192–4, 195, 196
functions 536–40 Louis, J-V 161, 165
governance considerations 545 Lowenstein, R 11, 12, 14
history and essential functions 536–7 Lucas, R 431
independent agencies, principles for Lucius, O 449
legitimate delegation 540–48
independent agencies, principles for M-Pesa, digital currencies 476
legitimate delegation, application to McAndrews, J 414, 422
LOLR liquidity reinsurance 541–8 McCallum, B 63
Japan 56–7 McCauley, R 438
lending to non-banks 549–50 McClure, S 367
liquidity oversupply concerns 538 McCracken, S 3, 245–73
and macro-prudential supervision 551 McCraw, T 8
moral hazard and adverse selection 538, 539, McDermott, J 413
542–3 McGee, R 110
New Zealand 269 McLaren, N 412
operating principles 545–6 McMahon, M 376
regulation and supervision implications Macfarlane, I 256, 257, 263
550–51 macro-economic management, China 141–2
resolution possibilities 539–40 macro-economy influence, unconventional
securities regulation, potential conflict with monetary policies 423–38
544 macro-prudential policy
transparency and accountability 531, 533, China 122–5, 131–2, 147–9
539, 544, 546–7 European System of Central Banks (ESCB)
UK 36–7, 38, 39, 40–42, 46, 531 169–76, 514–15
Lenza, M 404, 408 Japan 65–7
Levin, J 496, 500 Latin America 290–92
Levine, R 385 and lender of last resort (LOLR) 551
Levitin, A 491, 499 sub-Saharan Africa 224–5
Liao, M 123 UK 51, 389–94, 516
liberalization see deregulation macro-prudential policy role 508–17
‘licensed money’ regime proposal 499 capital and liquidity requirements for banks
Liikanen Report, EU 494, 495 and margins 511–12
Linzert, T 416 contra-cyclical function 512
liquidity deposit insurance 510–11

Index 569
and efficient markets hypothesis 151, 509, Mitchell, R 520

520 Miyao, R 63
financial stability and price stability mobile banking and payments, India 73–4
objectives 509–10 Modigliani, F 430
financial stability threat 510–13 Moessner, R 384
fiscal implications 513 Mohanty, M 84
global financial crisis effects 508–9 Momani, B 99
micro-prudence overlap 511–13 Monaghan, A 385
mortgage securitisation 511 monetary policy
powers given to other regulatory body 514 Australia 257
quantitative easing (QE) effects 516 China 118, 119–20, 140–41, 145–50
shadow banking 511 EU currency union 185–94
Tinbergen principle 509, 510 EU, Outright Monetary Transactions
wholesale market loans 511 (OMT) 185, 197–201, 512
Magnetic Ink Character Recognition (MICR) and institutional path of central bank
technology, India 72 independence 299, 300–302, 303, 305–6,
Maier, P 524 306–7, 312–13
Majone, G 156 Japan 54–6, 58–65, 551
Malkhozov, A 421 Latin America 280–84, 285–7
Mancini Griffoli, T 358 and payment system risks 449–50
Mandle, W 259, 260, 261 and prudential supervision separation,
Mann, T 503 European System of Central Banks
Manning, M 447, 448 (ESCB) 170–71
Manukova, L 99 Russia 102–7, 112–14
Marcus, G 226 sub-Saharan Africa see sub-Saharan Africa,
Marsh, D 309, 519, 527, 534 monetary policy
Masciandaro, D 182 transparency of central banks’ policies
Massari, J 496, 498 524–5, 526–9, 530–31, 532, 533–4
Masson, P 216 unconventional see unconventional
Matiukhin, G 96 monetary policies
Meade, E 3, 29, 55, 56, 333–64, 532 see also financial stability; price stability
Meckling, W 367 money transfer market, and digital currencies
Mehrling, P 15, 504 484–5
Meltzer, A 16, 20, 22, 24, 25, 311, 430 money-laundering 110–11, 386, 480–81, 482
Merkley, J 496, 500 Montiel, P 220–21
Merler, S 193 moral hazard and adverse selection, lender of
Merrett, D 249 last resort (LOLR) 538, 539, 542–3
Mersch, Y 357, 437 Morgan, E 447
Mexico 275, 277, 278, 284–91passim, 324 Morgan, J 375
Michaud, F-L 357 Moser-Boehm, P 319, 324, 328
micro-prudence overlap, macro-prudential Moyo, D 212
policy role 511–13 Mundell, R 479
Middleton, P 519, 527, 534 Murphy, E 370
Miller, G 53, 300, 301, 305, 306, 307 myopia (impatient) biases 367–8, 373–4
Miller, M 27 see also psychology of central banking
Milne, A 50
Milton, S 324 Nakamoto, S 474, 476
minilateralism, international diplomacy and Nakazono, Y 64
coordination 335 Napoletano, G 165
Minsky, H 509 Nash, J 474
Mirani, L 74 national competent authorities (NCAs),
Mischel, W 365, 367 European System of Central Banks
Mishkin, F 334, 371 (ESCB) 171, 173, 174
Mishra, P 220–21 National Electronic Funds Transfer System
Mitchell, J 500 (NEFT), India 72–3

national level and new supervisory tasks, and lender of last resort (LOLR) 549–50
European System of Central Banks UK 382–3
(ESCB) 176–82 Nordhaus, W 156, 368
national parliaments, accountability to, North, D 2
European System of Central Banks Norway 426
(ESCB) 172–3 Noussair, C 430
Neely, C 411, 432 Nurske, R 275
negative equity, accounting 321, 324, 330
negative interest rates 186–7, 430–31 Obstfeld, M 293, 360
see also interest rates O’Connell, S 211, 221
Nelson, W 404 Oda, N 63
Neumann, M 240 Odling-Smee, J 99, 103
New Zealand OECD Working Party Three (WP3) and
bank note issue and state banking 258, 259 Group of Ten (G-10) 336–7, 340
bank notes as legal tender 246–7, 249–50, Ogden, T 42
251 Okimoto, T 63
bank run (1893) 249–50 Okina, K 62
Bank-note Issue Act (1893) 250 Olmstead-Rumsey, J 516
Banks Indemnity (Exchange) Act (1932–33) Olsen, M 109
259 Omarova, S 487–507
central banking 258–64 online fantasy games, digital currencies 476
command economy 261 operating costs, accounting 325, 326–7
deregulation 262–4 Orlowski, J 367
Employment Contracts Act (1991) 264 Orphanides, A 25
exchange rate control 247–8, 258–60, 261, Oskamp, S 368
263 Ostry, J 219
free banking system, early 246–50 Outright Monetary Transactions (OMT)
gold standard 247, 252 programme, EU 167–8, 185, 197–201, 512
government securities 253–4, 261, 263
inflation control 256–7, 262–4 Packer, F 414
interest rate controls 261, 262 Padoa-Schioppa, T 169, 242, 383–4, 453
interest rate forward guidance 413 Paraguay 277, 279, 284, 287, 290
legislative frameworks 264–9 Parkin, M 300
lender of last resort 269 Pasricha, G 414
market equilibrium for bank reserves 436 Passmore, W 411
private banks and colonial governments Pastor, G 103
247 Patterson, J 19
Public Finance Act (1989) 269 Pattillo, C 218
reserve asset ratio system 261 Paulson, H 28
Reserve Bank of New Zealand 258, 268–9 Pauwelyn, J 521, 522, 532
Reserve Bank of New Zealand Acts 259–60, payment system regulation
264 Australia 468–72, 473
Reserve Bank of New Zealand Amendment Canada 460–65
Acts 260, 261, 262 European System of Central Banks (ESCB)
Strategic Finance v Bridgman 266 473
trading banks 247, 248–9, 253–4, 255, 261, India 72–7
262 South Africa 466–8
ultra vires doctrine 266 UK 456–60
see also Australia payment system risks 445–73
Nicaragua 278, 279, 284 Bank for International Settlement (BIS),
Niemeyer, O 255, 259 Committee of Payment and Settlement
non-banks Systems (CPSS) 448, 450–52, 458
Australia 255–6 central bank’s functions 445–53
China 137 credit risk 451
India 89–91 ‘domino effect’ risk 451

Index 571
financial stability measures 448–50 macro-prudential policy role 509–10

FMI Report (financial market sub-Saharan Africa 209, 210, 214
infrastructures) 452–3 and transparency of central banks’ policies
interbank payment system, need for well- 532
functioning 447, 450 see also financial stability; monetary policy
legal risk 451 Pritchard, M 261
liquidity risk 451 Private Sector Involvement (PSI), EU currency
messaging, clearing and settlement 446, union 191
447–8 profit recognition and distribution, accounting
and monetary policy execution 449–50 328–9
national comparisons 454–72 Promisel, L 338, 359
operational risk 451 prudential policy see macro-prudential policy
safest settlement asset 446–7 psychology of central banking 365–79
safety and efficiency objectives 453 ‘3M’ regime and constrained discretion
systemic risk limitations 450–51 370–71
systemically important payment systems Bank of England’s policy framework 369–71
452–3 behavioural biases 366–9, 371–6
universal guidelines 451–2 economic forecasting procedures review 376
pegs fan charts 375
crawling pegs, Latin America 282, 286 financial stability perceptions 372–3, 374
hard pegs and currency unions, sub-Saharan Great Moderation replaced by Great
Africa 217–18, 222 Recession 365, 376
Pennacchi, G 499 groupthink (confirmation) biases 369, 375–6
pension funds 187, 428–9 hubric (over-confidence) biases 368–9, 374–5
Perera, A 324 myopia (impatient) biases 367–8, 373–4
Perotti, E 513 preference biases and principal/agent
Peru 275, 277, 281, 283–91passim, 293 relationship 366–7, 371–3
Pesaran, M 426 public attitudes and perception of inflation
Peterson, M 532 372
Piketty, T 437 public or private ownership issues, institutional
Pisani-Ferry, J 359 path of central bank independence 296–7
Plumptre, A 248, 253, 260 public sector lending restrictions 304
Polden, K 251 Public Sector Purchasing Programme (PSPP),
political argument in favour of independence EU currency union 202
301–2
political compromise effects 306–7 quantitative easing (QE)
political economy issues, unconventional accounting 330
monetary policies 433–8 Japan 60, 61
Popper, N 478 macro-prudential policy role 516
Portillo, R 3, 208–28 sub-Saharan Africa 209–10
Portugal 190 quasi-debt management policy, unconventional
Posen, A 241 monetary policies 400–401
Posner, E 547 Quigley, N 261, 262
preference biases and principal/agent Quinn, S 39
relationship 366–7, 371–3 Quintyn, M 156, 170, 311
see also psychology of central banking
Preobragenskaya, G 110 Radford, R 477
Prescott, E 26, 58, 156 Rae, G 39–40
Pressnell, L 38 Rajan, R 67, 359, 428
price stability Rakove, J 16
EU currency union 185–6 Ramo, J 28
European System of Central Banks (ESCB) Raskin, M 4, 419, 474–86
170 Real Time Gross Settlement System (RTGS),
Germany 240–41, 243, 309–10 India 72–3
Latin America 286, 291–2 Reddell, M 263

regulation and supervision implications, lender Gosbank USSR 96–7, 100

of last resort (LOLR) 550–51 IMF consultations 99
regulatory ‘boundary’ problem, and systemic IMF Financial System Stability Assessment
risk 501–2 (FSSA) 109
regulatory framework, transparency of central IMF stabilization loan 105
banks’ policies 526–34 inflation targeting 102, 103, 106–7, 112–13,
Reichlin, L 434 114
Reis, R 25, 26, 365 International Financial Reporting Standards
Renner, M 387 (IFRS) 109, 110
reputation as asset 323 monetary policy 102–7, 112–14
Required Reserve Ratio (RRR) system, China National Card Payment System 115
141, 146, 149, 512 origins 95–9
reserve asset ratio system, New Zealand 261 perestroika (restructuring) program 95–6
revaluation deficits, accounting 321 price liberalization and macroeconomic
Rey, H 429 stabilization program 97, 103–4
Ricks, M 499 ruble zone 97, 102, 103
‘ring-fencing’ of retail bank operations, UK ruble-dollar exchange rate 104–5
492–3, 494–5 Sberbank control 108–9
Ringe, W-G 495 sovereignty issues 95, 96, 97, 103, 112, 115
Riso, A 3, 155–83 Soviet Union collapse 97, 99, 107
Robinson, J 366 structural problems 100–101
Rogers, J 432 transformation 99–101
Rognlie, M 422 transparency improvements 106
Rogoff, K 360 Ukrainian challenge and sanctions 114–15
Rose, A 415 Ryterman, R 102
Rosenberg, G 496, 498
Rosenberg, I 413 safest settlement asset, payment system risks
Rosenfeld, E 478 446–7
Ross, S 367 Salomon, M 530
Roubini, N 350 Samm, C 155
Rubin, R 28, 352 Sampson, S 345
Rudd, J 25 Samuelson, R 24
Rudebusch, G 409, 411 Saraogi, R 68, 69, 71, 72, 86, 87, 88, 89, 90
Russia, Bank of Russia 94–116 Sarmiento, D 168
anti-money laundering law 110–11 Satterlee, H 11
Asian financial crisis effects 104–6, 109 savings, ‘expropriation’ of savers, EU currency
banker training courses 99–100, 101, 107–8 union 187
banking supervision 107–11 Schedvin, C 254, 255, 256
‘Black Tuesday’ 103–4 Schmidt-Hebbel, K 287
commercial banks 108–9, 110, 111 Schoenmaker, D 123, 169
Credit Rating Agency of the Russian Schwarcz, D 30
Federation 115 Schwartz, A 26, 310–11, 365
debt cancellation 103 Scott, H 384, 450
deposit insurance system 109, 110 securities
EU TACIS (Technical Aid to the China 123–4, 138, 143, 144, 145–6, 148
Commonwealth of Independent States) EU Securities Markets Programme (SMP)
program 99, 108, 109–10 196–7, 512
Federal Financial Markets Service 113–14 government see government securities
FIMACO bank and hard-currency reserves holdings, accounting 321–2, 323, 326, 327
99 India 84–5
five-year strategy for banking sector and lender of last resort (LOLR) 544
development 109, 111 mortgage securitisation, macro-prudential
GKOs (short-term treasury instruments) policy role 511
104–5 Seidel, R 275
global financial crisis effects 111–14 seigniorage 212, 308–9, 326, 476–7, 539

Index 573
Selgin, G 9 South Korea 73

Seligman, J 415 sovereign debt crisis 283, 287, 323, 328
Selmayr, M 156, 157, 159, 163 EU 185, 197, 391, 405
Senior, S 370 sovereign debt management 130, 146, 212
Setser, B 350 sovereign rights, and institutional path of
shadow banking 45–6, 152–3, 394–5, 504, 511 central bank independence 301
Shafir, E 430 sovereign wealth funds 225–6
Shams, H 156, 158, 162, 519, 521 sovereignty issues, Russia 95, 96, 97, 103, 112,
shareholder distribution and foreign exchange, 115
accounting 321 Spain 203
shareholders, financial ‘buffers’ and potential Spiegel, M 415
losses, accounting 329 Spindler, J 449–50
Shefrin, H 367 Spong, K 383, 385
Sheng, A 386 Stadermann, H-J 248
Shepard, W 76, 77 Stasavage, D 212
Sheppard, L 498 ‘state bank’ model, China 133
Shiller, R 372, 430 Statutory Reserve Deposit (SRD) mechanism,
Shin, H 429 Australia 256
Shinasi, G 449 Steiger, O 262
Shioji, E 63 Steil, B 43
Shiratsuka, S 62, 63 Stella, P 324
Shlaes, A 16 Stevens, G 257
Sibert, A 365 Stewart, C 107
Siegman, C 340–41 Stock, J 63
Siekmann, H 160 stock exchange, first, China 138
Siklos, P 525, 526 Stockton, D 376
Silber, W 24 Stone Sweet, A 157
Simmons, B 339 Straub, R 26
Simons, H 549 ‘strict separation’ model, and systemic risk
Sims, C 63 490–91, 495–500, 502
Sinclair, K 259, 260, 261 Strong, B 16–17
Sinclair, P 324 Suarez, J 513
Singapore 73 sub-Saharan Africa, monetary policy 208–28
Singh, M 79–81 analytical and forecasting capacity 216, 219,
Singh, S 76–7 225
Single Resolution Fund (SRF) Agreement, EU capital adequacy requirements 225
207 capital flows as source of external shocks
Single Resolution Mechanism (SRM), EU 166, 222
391, 392–3 CFA Franc Zone 210, 211, 217–18
Single Supervisory Mechanism (SSM), EU challenges 220–24
166, 170, 171–3, 175, 176–7, 207, 391, 392, currency boards (1970s) 210–11
528–9 current 213–16
Singleton, J 263, 264 exchange rate management 214, 215, 217,
Sisoyev, G 115 219–20, 221–2, 224
Smith, C 260 external shocks, response to 216, 221–2, 224
Smith, R 426 financial stability goal 224–6
Smith, V 41 fiscal policy 211–12, 222, 223
Smits, R 3, 162, 168, 169, 170, 184–207, 298 forecasting and policy analysis systems
Snidal, D 335 (FPAS) 224
socialist market economy, China see China, forward-looking strategy and
and evolutionary theory of central communications 216, 219
banking, socialist market economy global financial crisis effects 209, 210, 216,
socialization of risk, UK 45–6 224
Sorkin, A 28 hard pegs and currency unions 217–18, 222
South Africa 466–8 history 210–13

inflation targeting 209, 212, 214, 216, 218, ‘holding company’ model 489–90, 492–5,
219, 220, 221–2, 223–4 502
legal frameworks and operational ‘holding company’ model to ‘strict
independence 213–14 separation’ model, US 495–500
macroprudential policy 224–5 importance of 500–505
modernization 218–20 institutional capacity and autonomy 504–5
monetary operation expenses 213–14 institutional implications 503–5
monetary transmission mechanism 220–21 ‘licensed money’ regime proposal 499
natural resource wealth, central banks as liquidity support perimeter 503–4
custodians of 225–6 ‘living wills’ and group resolution regimes
operational policies of central banks 215 504
policy analysis models 223–4 ‘narrow’/‘utility’ banking proposal 499
post-colonial era 211, 218–19 non-excluded proprietary trades 497–8
price stability 209, 210, 214 regulatory ‘boundary’ problem 501–2
principles-based benchmark 209–10 regulatory perimeter 503
quantitative easing experimentation 209–10 ‘ring-fencing’ of retail bank operations, UK
Rand Common Monetary Area (CMA) 211, 492–3, 494–5
217, 218 shadow banking sector 504
Reserve Money Targeting (RMT) 215 ‘strict separation’ model 490–91, 495–500,
reserve policy coordination 223 502
subsidiarization and ring-fencing, EU 494–5 subsidiarization and ring-fencing, EU 494–5
Sullivan, K 316 substantive regulatory mandate 504
Summers, B 446, 449–50 too-big-to-fail (TBTF) problem 488, 491,
Summers, L 118, 155, 291, 300, 532 492, 500
Sumner, S 16 ‘universal bank’ model 488–9, 490, 491,
Sunstein, C 366 492–5, 502
supervision Volcker Rule 495–8, 504
China 144, 152–3
European System of Central Banks (ESCB) Tabellini, G 156
166, 169–82 Taleb, N 368
and institutional path of central bank Tannan, M 68, 69, 70, 72, 87
independence 299–300, 311–13 Taylor, J 26, 61, 347, 360, 414, 429, 530
Japan 57, 65–7 Taylor, M 156, 170, 311
and lender of last resort (LOLR) 550–51 Ter Kuile, G 172
Russia 107–11 Thakor, A 368
UK see UK banking regulation and Thaler, R 366, 367, 368
supervision Thatcher, M 157
Surti, J 496, 498 Thiessen, G 449
Svenson, O 368 Thornton, D 414
Svensson, L 61, 508 Thornton, H 40, 49, 178, 509
Swanson, E 411, 419, 420 Timberlake, R 9
Sweden 326, 413, 422, 423, 424, 426, 513–14, Tinbergen, J 157, 509, 510
516, 533 Tocker, A 248, 258
Swinburne, M 155 Tompson, W 95, 97
Switzerland 422–3, 423, 424, 426 Tong, M 411
systemic risk Toniolo, G 334, 337, 340, 341
China 148–9 too-big-to-fail (TBTF) problem 488, 491, 492,
limitations, and payment system risks 500
450–51 Tracy, R 503
systemically important payment systems trading banks, Australasia 247, 248–9, 253–4,
452–3 255, 261, 262
UK banking regulation and supervision transparency of central banks’ policies 518–34
383–4 accountability, impact on 520–23, 530,
systemic risk and financial sector structural 531–2, 533
reform 487–507 as anchor for financial regulation 519–20

Index 575
collateral criteria 531, 533 Financial Services (Banking Reform) Act

economic impacts 523–4 393–4, 456–7
European System of Central Banks (ESCB) Mortgage Market Review (MMR) 516
528–9, 530 national comparisons, UK, payment system
financial stability impact 525–6, 530, 532–3 risks 456–60
future direction 534 payment system regulation 456–60, 473
governance policy 521–3, 526, 534 Payment Systems Regulator (PSR) 457
independence and democratic legitimacy systemic risk and retail ring-fencing 492–3
532–4 Three Rivers District Council v Bank of
institutional path of central bank England 312
independence 312–13 UK, Bank of England’s objectives and
lender of last resort (LOLR) role 531, 533, development 34–52
539, 544, 546–7 anonymity protective device 42
monetary policies 524–5, 526–9, 530–31, Bank Charter Act 38, 46
532, 533–4 Banking Acts 45, 49, 51, 457, 458, 459
new central role 518–19 Baring Crisis (1890) 38, 41, 46
price stability concept 532 Bretton Woods System 43, 47
regulatory framework 526–34 capital ratios 35–6, 44–5, 46, 49, 50
Russia 106 City of Glasgow Bank failure 38
transparency measures 526–9 commercial banks 39–40, 42, 49, 50
see also accountability deregulation 42–3
Trichet, J-C 196–7, 207 Discount Market 50
troika (Member States, Commission and European Exchange Rate Mechanism
IMF), EU 166, 169 (ERM) 47–8
Truman, E 342, 343, 345, 347, 348, 351 financial crisis effects 49–51
Tucker, P 4, 370, 418, 504, 535–52 Financial Services Authority (FSA) 49
Tuckett, D 369 financial stability 35–9, 38–44, 45, 47, 48–9
Turner, A 434, 437, 438 floating of sterling (1972) 47
Turner, H 233 fractional reserve banking 36, 39
Tversky, A 368 gold standard 35, 37, 43, 46–7
Tyran, J-R 430 inflation targeting 46–9, 50
lender of last resort 36–7, 38, 39, 40–42, 46,
Ueda, K 60, 63, 64, 412, 438 531
Ugai, H 417 Northern Rock crisis 49–50
UK origins 34–9
Attorney-General v Great Eastern Railway Overend and Gurney Crisis 37–8, 42
Company 266 post World War II developments 43–9
Bank of England Act 456, 459–60 Prudential Regulatory Authority (PRA) 51
Bank of England asset purchases 402, 407, regulatory environment 42–3
426 shadow-banking sector growth 45–6
Bank of England balance sheet policies 405, ‘shadowing the deutschmark’ policy 47
411–12 socialization of risk 45–6
Bank of England Funding for Lending ‘too-big-to-fail doctrine’ 42, 45
Scheme 193 and US dollar exchange rate 47
Bank of England interest rate forward UK banking regulation and supervision
guidance 420, 421 380–97
Bank of England liabilities 403 bank definition 381–3
Bank of England and psychology of central Banking Act 382
banking 369–71 Basel II prudential supervision 387
Bank of England seigniorage 326 Basel Revised Core Principles For Effective
Banking Reform Act 492, 493 Banking Supervision 383
bitcoin use 480–81 collateral requirements 389–90
Brexit 360 credit intermediation concerns 381–2
Emergency Liquidity Assistance (ELA) 531 distinction between banks and non-bank
Financial Services Acts 50–51, 370, 388, 456 financial institutions 382–3

economic consequence of bank failures negative policy rates 421–3

386–7 output and inflation, empirical evidence
economic importance of banks 385 425–7
EU, Bank Recovery and Resolution pension funds and recession recovery 428–9
Directive (BRRD) 392–3 political economy issues 433–8
EU, De Larosière Report 391–2 quasi-debt management policy 400–401
EU, Single Resolution Mechanism (SRM) taxonomy 400–404
391, 392–3 ‘universal bank’ model, and systemic risk
EU, Single Supervisory Mechanism (SSM) 488–9, 490, 491, 492–5, 502
391, 392 unrealised valuation gains, accounting 320
EU, sovereign debt crisis and creation of Unsal, F 3, 208–28
European Banking Union 391 Urminsky, O 365, 367
European System of Financial Supervision Uruguay 277, 279, 281, 283, 284, 286, 287, 290
391 US
European Systemic Risk Board (ESRB) Bank Holding Company Act 489–90, 496,
391–2 503
Financial Policy Committee (FPC) 388–400 Chicago Plan 482
Financial Services and Markets Act (FSMA) credit-easing (CE) policy 512
382 deposit insurance 536
Financial Stability Reviews 388 digital currencies 480, 481
financial stability and systemic risk 383–4 Dodd-Frank Act 29, 394, 454, 495, 496, 503,
governmental intervention justification 547, 548
386–7 Exchange Stabilization Fund 344, 348
insurance company risks 395 Expedited Funds Availability Act 454
macro-prudential levers 389–90 external impact of monetary policy 432
macro-prudential regulation 387–9, 391–4, Fedcoin 481–2
516 Financial Stability Oversight Council
market innovation and policy frameworks (FSOC) 29–30, 455, 514, 528
combination 386–7 global financial crisis effects 354–9
shadow banking challenges 394–5 Gramm-Leach-Bliley Act 491, 502, 503
Turner Review 387–8 Hepburn v Griswold 479–80
Ukraine 114–15 ‘holding company’ banking model 489–90,
ultra vires doctrine 198, 266, 514 502
unconventional monetary policies 398–444 ‘holding company’ banking model to ‘strict
asset purchases and lending schemes 405–8, separation’ model 495–500
409–13, 425–7 insurance company risks 395
balance sheet policies 400, 404–5, 409–13, Legal Tender Act 479–80
417, 425, 428–9, 437–8 mobile banking 73
bank reserves policy 400–401, 402–4, 408, Plaza Accord 342–8
421, 423, 434–6 Smoot-Hawley Tariff Act 340
collateral requirements 402, 408, 409, 413 trade-weighted US Dollar Index 342–4
context and measure-specific characteristics, twin deficits 342, 344
importance of 427–33 Volcker Rule 495–8, 504
credit policy 401–2 US, institutional change 6–33
government bond purchases 409–10, 423–4 Aldrich-Vreeland Act 12
helicopter money 431–3, 434–7 Banking Act (1935) 18–19
influence on financial conditions 408–23 Board of Governors of the Federal Reserve
inter-central bank FX swap lines 404 System 18–19, 20–21
interest rate forward guidance 413–21 Consumer Financial Protection Bureau
interest rate forward guidance, liquidity (CFPB) 29–30
support measures 414–17 Election of 1912 13–14
macro-economy influence 423–38 Federal Open Market Committee (FOMC)
measures adopted by central banks 404–8 17, 21, 25–6, 527–8
negative interest rates and money illusion Federal Reserve Act 10, 11, 14, 16, 29, 497,
430–31 504

Index 577
Federal Reserve Banks 14, 15, 16, 17, 18, valuation and accounting
19 unrealised valuation gains 320
Federal Reserve Board 15, 17 using current values 322
Federal Reserve Board, Governor position Van Buren, M 8
17–18, 19, 22–8 Van den Berg, C 159, 242
Federal Reserve Board, Monetary Policy Van der Cruijsen, C 523, 524
Reports 527–8 Van Rixtel, A 502
Federal Reserve Board, payment system Vanderlip, F 11, 13
regulation 454–5 Vartiainen, H 366
Fed–Treasury Accord (1951) 19–22 Vaško, D 525, 526
financial crisis effects and lessons 28–30 Vayanos, D 428
free banking rise 9–10 Vázquez, F 284, 285
Glass-Steagall Act 17, 490–91, 498–9 Vector Autoregression (VAR) methodology,
gold standard 14, 131 Japan 63–4
and Great Depression 16–17, 131, 310–11, Venezuela 276, 278, 283, 284, 294
510 Vermeule, A 547
Greenspan’s monetary policy 26–8, 509 Vila, J-L 428
inflation, combatting, and Volcker 24–6, Villasenor, J 87
343–6, 348, 354 Vissing-Jorgensen, A 60, 62, 64, 411
inflation concerns 20–22, 23 Vlcek, J 221
Jacksonian Bank Wars 11 Volcker
Jekyll Island meeting 12–14 inflation, combatting, and Volcker, US,
legislative debate and functions of institutional change 24–6, 343–6, 348,
institutionalized money 14 354
Money Trust hearings 13 P 495–8, 504, 550
National Bank Acts 10 Von Hagen, J 120
National Bank (Bank of the United States) Von Mises, L 483
origins 7–9
National Monetary Commission (NMC) Wallace, N 409
12–13 Walsh, C 156
National Reserve Association (NRA) 13 Wang, M 367
New Deal 17–19 Warburg, P 10, 12–13, 14–15, 16
nineteenth century 7–10 Wass, D 302
Panic of 1907 and JP Morgan 11–12 Wateska, L 367
‘real bills doctrine’ 14 Watson, M 63
structural basis 14–15 Weale, M 426
Warburg’s banking reforms 10 Weber, B 430
Wilsonian Compromise 14–16, 19 Weber, J 429
US, institutional change, Federal Reserve Weber, R 4, 518–34
System Wedel, J 104
asset purchases 402, 406, 426–7 Weenink, H 158
balance sheet policies 405, 411, 438 Weisberg, J 352
control by domination (Nixon and Burns) Werner, A 287
22–4 Wessel, D 28
cost-based accounting 322 Westrup, J 171
founding 11–16, 130, 131 Whaley, F 484
government bond yields 424 Whisker, R 549
interest rate forward guidance 414–16, White, A 499
419–20, 421 White, E 369
and legal personality 297, 301, 304–5, 306 White, L 9, 478
liabilities 403 White, W 509
power consolidation between presidents and Wicker, E 11
Fed chairs 22–8 Wieladek, T 426
regulatory perimeter 503 Wieland, J 412, 426
second founding 16–19 Wieland, V 63

Williams, J 25, 414, 419 Yasin, Y 95, 96

Williamson, J 342 Yellen, J 437, 487, 499
Wilmarth, A 491, 499 Yermack, D 4, 474–86
Winkler, R 481 Yudaeva, K 112–13
Wolf, M 310
Wood, G 2, 34–52, 264, 268 Zabai, A 4, 29, 398–444
Woodford, M 58, 61, 409, 417, 418, 419, 429, Zagouras, G 166, 169, 170, 175
434 Zaks, D 104
Woodruff, D 104 Zaring, D 30
Woolley, J 24 Zauberman, G 365, 367
World Trade Organization (WTO) accession, zero interest rate policy (ZIRP), Japan 58–60,
China 145 61–2
Wray, L 509 see also interest rates
Wu, S 63 Zhou, X 145
Wu, T 414 Zhou, Z 2, 117–27
Zilioli, C 3, 155–83
Yamanaka, T 2, 53–67 Zlate, A 432

(Research Handbooks in Financial Law) Peter Conti-Brown, Rosa Maria Lastra - Research Handbook On Central Banking (2018, Edward Elgar Publishing)

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CONTI-BROWN 9781784719210 PRINT.

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Rosa Maria Lastra

RESEARCH HANDBOOKS IN FINANCIAL LAW

Cheltenham, UK• Northampton, MA, USA

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2017960003

This book is available electronically in the

ISBN 978 1 78471 921 0 (cased)

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

CONTI-BROWN 9781784719210 PRINT.indd 4 19/04/2018 13:04

List of figures vii

1 The central banking century: an introduction to institutional central banking 1

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13 Central banking in Australia and New Zealand: historical foundations and

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4.1 Call Rate, Current Deposits and the ‘Monetary Base’ 59

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Christopher Adam, Oxford University

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René Smits, University of Amsterdam; Queen Mary University of London

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decision-making processes—including their limitations—helps us unpack exactly how

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I. CENTRAL BANKING WHIPLASH IN THE LONG

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2. Interregnum: Free Banking and Bimetalism

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3. Paul Warburg’s Confusion, Paul Warburg’s Solutions

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II. FOUNDING THE FEDERAL RESERVE

1. The Panic of 1907

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‘independent treasury system’ to deploy funds in precisely a fashion envisioned by

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3. The Election of 1912

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4. The Legislative Debate: The Functions of Institutionalized Money

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a private banker in the old-school European banking tradition, viewed as an inherently

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III. THE SECOND FOUNDING OF THE FEDERAL RESERVE

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1. The Federal Reserve and the New Deal

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IV. THE FED-TREASURY ACCORD OF 1951

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V. THE INCESSANT POLITICAL DANCE BETWEEN

1. Control by Domination: Richard Nixon and Arthur Burns

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2. Volcker: The Giant that Slew Inflation