Regulatory autonomy and banking stability: new global evidence
In this Bank of England blog Rhiannon Sowerbutts presents the findings on the relationship between regulatory independence and financial stability from his paper with Nicolò Fraccaroli and Andrew Withworth “Does regulatory and supervisory independence affect financial stability?” The authors constructed a novel Regulatory and Supervisory Independence (RSI) index covering 98 countries from 1999-2019. This index measures three dimensions of independence: institutional (appointment rules and tenure), regulatory (autonomy in setting technical rules), and budgetary (role of elected officials in budget approval).
Findings
- Regulatory independence improves financial stability: The research demonstrates that a one-unit increase in supervisory independence is associated with a 0.4 percentage point reduction in non-performing loans (NPLs). This relationship holds even when controlling for factors like GDP and credit growth, providing strong evidence that independence directly benefits financial stability.
- Independence matters more than central bank status: Crucially, when the researchers replaced their regulatory independence measure with traditional central bank independence metrics, they found no similar relationship. This highlights that regulatory independence is distinct from and more important than central bank independence for financial stability outcomes.
- Universal benefits with important nuances: The benefits of regulatory independence are broadly universal, applying to both advanced and emerging economies, and to banks regardless of size, ownership structure, or political connections. However, the research reveals that these benefits are stronger when the central bank serves as the supervisor (as in the UK system) compared to separate regulatory agencies.
- Global regulatory challenges: 80% of countries have inadequate regulatory and supervisory independence according to IMF assessments. This widespread deficiency has been linked to banking crises in countries like Korea and Japan during the 1990s, and research shows that macroprudential policies tend to become looser before elections due to political pressures.
Regulatory independence and financial stability
By: Rhiannon Sowerbutts – Bank of England
Additional evidence supporting regulatory independence from the BIS
This BIS research provides a more nuanced framework for understanding what constitutes effective supervisory independence. Beyond the three dimensions identified in the Bank Underground article above (institutional, regulatory, and budgetary), the literature reveals that legal protections are crucial enablers that allow supervisors to fulfill their tasks more effectively. This legal framework dimension helps explain why some supervisors with formal independence still struggle with effectiveness.
- Supervisory forbearance and crisis management: This BIS paper provides compelling evidence about how independence addresses supervisory forbearance – a critical mechanism not fully explored in the original article. Independent supervisors with credible resolution frameworks can provide “the credible option of market exit through orderly resolution,” which alleviates concerns about political pressure to delay necessary interventions. This finding explains why the 0.4 percentage point reduction in NPLs observed in the Bank Underground study may actually underestimate the full benefits of independence during crisis periods.
- Operational mechanisms of independence: The authors of the BIS paper highlight the specific operational channels through which independence improves outcomes. Early intervention regimes are more efficient when they are discretionary, flexible, and forward-looking – all characteristics that require supervisory independence from political interference. The research emphasizes that “timing is essential” and that “actions taken well before actual breaches of thresholds are considered particularly effective”. This provides the operational explanation for why independent supervisors achieve better NPL outcomes.
- Institutional design insights: The research reveals important nuances about institutional arrangements that complement the Bank Underground findings. While that study found stronger benefits when the central bank serves as supervisor, the BIS research explains this through information advantages and reduced moral hazard considerations regarding lender-of-last-resort facilities. Additionally, the literature emphasizes that supervisors need “an independent view to complement and challenge the perspectives of banks’ management and third parties”.
Lessons on supervisory effectiveness – a literature review
Authors: Anton Badev, Laura Baztán Gutiérrez, Samuel Da Rocha Lopes, Klaus Duellmann, Yushi Endo, Daniel Foos, Laura Hierro Rosello, Spyros Palligkinis, Rita Redondo Oliveira, Naoto Tanaka, Farin Vaghefi, Thomas Vieten
From: Board of Governors of the Federal Reserve System, European Central Bank, European Banking Authority, European Central Bank, Bank of Japan, Deutsche Bundesbank, Bank of Spain
A constitutional perspective for the U.S.
In this paper Christina Parajon Skinner argues that the Fed’s supervision function has become the most powerful agency in Washington, wielding sweeping authority over major banks and, by extension, the economy’s direction on issues like climate change, cryptocurrency, and ESG matters. Unlike monetary policy, which justifies independence through its quasi-legislative role in regulating money’s value, bank supervision constitutes executive power that should remain accountable to the President.
Policy Overreach Examples: Between 2020-2024, Fed supervisors used their discretionary authority to pursue policy entrepreneurship in areas where Congress had not granted explicit authority, including climate risk supervision, cryptocurrency restrictions, and banking culture oversight. These initiatives effectively preempted legislative action and steered economic resources toward politically favored outcomes without democratic input.
Proposed Solutions
- Structural Reform: Create separate supervisory committees within the Fed, similar to the UK’s Bank of England model, with Treasury participation and external expertise. This would preserve informational benefits while ensuring political accountability.
- Enhanced congressional oversight: Require Fed supervisors to justify novel interpretations of their mandate through detailed testimony covering legal authority, implementation methods, and interaction with other Fed functions.
- Transparency requirements: Mandate disclosure of international supervisory negotiations and clarify that congressional information requests override FOIA exemptions claimed by Reserve Banks.
The Independence of Central Bank Supervision
Author: Christina Parajon Skinner
From: University of Pennsylvania – The Wharton School
