Ben S Bernanke: Central banking and bank supervision in the United States
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the Allied Social Science Association Annual Meeting, Chicago, 5 January 2007.
* * *
The Federal Reserve, like many central banks, is engaged in a wide range of activities beyond the
making of monetary policy. For example, the Fed plays a critical role in the U.S. payments system,
both as an overseer and as a provider of wholesale and retail payments services; it has substantial
responsibilities in the area of consumer protection, including rule-writing and enforcement; it promotes
financial stability; and, together with other agencies, it supervises both large and small banking
organizations.
In this talk I will consider the case for one of these activities - namely, the supervision of the banking
system - being conducted, at least in part, by the U.S. central bank. In some countries, such as the
United Kingdom and Japan, the responsibility for supervising banks (as well as financial institutions
and financial markets more generally) has been assigned to a single financial supervisory agency,
rather than to the central bank. In the euro area, even as the European Central Bank has assumed
responsibility for monetary policy, some national central banks or other national authorities have
retained substantial supervisory powers. Various other institutional arrangements exist around the
world, including the more traditional model in which the central bank also serves as a supervisor of the
banking system. In light of these alternative models, does it make sense for the Federal Reserve to
supervise banking organizations?
At a conceptual level, the discussion of whether the central bank should also act as a supervisor has
focused on issues of incentives and efficiency. With respect to incentives, one question that has been
raised is whether assigning both macroeconomic and supervisory goals to a single institution might not
lead to conflicts of interest. Some writers have argued, for example, that a central bank with
supervisory responsibilities might, at times, be hesitant to impose appropriate monetary restraint out of
concern for possible adverse effects on banks (Goodhart and Schoenmaker, 1995). On the other
hand, if macroeconomic and supervisory goals are interdependent, a single agency responsible for
both objectives might be better able to take those interdependencies into account than could multiple
agencies, each charged with a single goal (Wall and Eisenbeis, 1999; Bernanke, 2001). For example,
Alan Greenspan has argued along these lines that "a single regulator with a narrow view of safety and
soundness and with no responsibility for the macroeconomic implications of its decisions would
inevitably have a long-term bias against risk-taking and innovation (Greenspan, 1994, p. 130)."
The issue of the efficiency of combining central banking and supervision in one agency boils down to
whether that combination entails significant economies (or diseconomies) of scope (Goodhart, 2000;
Mishkin, 2001; Haubrich and Thomson, 2005). For instance, if supervisory activities yield information
that is useful for carrying out monetary policy or other central bank functions (or vice versa) and this
information cannot be obtained easily through interagency cooperation, then granting some
supervisory authority to the central bank may lead to better outcomes. By the same token, if
economies of scope are outweighed by the benefits of specialization - arising, for example, from
increased organizational focus, the development of more specialized expertise, or a reduction in
regulatory overlap - then the cause of efficiency may be better served by separating supervision from
central banking.1
Abstract arguments can take us only so far, however. Because financial markets, political systems,
and regulatory objectives vary across countries and because initial conditions are influenced by
historical accident, no single institutional structure seems likely to be best in all cases (Dixit, 1996).
Therefore, I will avoid generalizations today and restrict my attention to the current arrangements in
the United States.
In the U.S. context, the various issues that have been raised concerning institutional incentives seem
unlikely to be determining factors in a consideration of the preferred regulatory structure; indeed, the
side of the debate on which they would weigh is uncertain. In particular, U.S. monetary policy has
been quite successful for some time, and I am not aware of any evidence that monetary-policy
decisions have been distorted because of the Fed's supervisory role. The issue of efficiency is less
easy to dismiss, however. The U.S. bank regulatory system is complex and in some respects
duplicative, and though removing supervisory authority from the Fed would leave much of this
complexity intact, it would produce a slightly simpler allocation of supervisory responsibilities. We can
thus narrow the question I posed at the beginning, of whether the Fed should supervise banks, to the
question of whether the Fed's supervisory role generates economies of scope of sufficient social
benefit to outweigh any associated costs.
In the remainder of my remarks, I will discuss some economies of scope arising from the combination
of bank supervision and other central bank responsibilities. Although I will touch on a number of
complementarities between these activities, my focus will be the benefits of the Fed's supervisory
authority for the execution of one of its core functions: the prevention and management of financial
crises. In particular, I will argue that the Fed's ability to deal with diverse and hard-to-predict threats to
financial stability depends critically on the information, expertise, and powers that it holds by virtue of
being both a bank supervisor and a central bank.
The Federal Reserve's supervisory authority
As a starting point, some background on the Federal Reserve's supervisory authority may be helpful.
The Federal Reserve shares the responsibility for regulating and supervising the U.S. financial system
with a number of federal and state government agencies, including the other banking agencies, the
Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission. The
Fed, along with state authorities, supervises state member banks (that is, state-chartered banks that
are members of the Federal Reserve System). In addition, it supervises the U.S. operations of foreign
banks and, in some cases, the foreign operations of U.S. banks.
The Federal Reserve also serves as the umbrella supervisor of all bank holding companies and
financial holding companies, which gives the U.S. central bank broad oversight responsibilities for
these banking organizations. However, the bank and nonbank subsidiaries of such holding companies
are often supervised by agencies other than the Fed. Supervisory responsibility is determined by the
type of charter held by the supervised company and by the principle of functional regulation, under
which the identity of the primary supervisor depends on the nature of the financial activity being carried
out. For example, the commercial banking activities of holding-company subsidiaries with national
bank charters are supervised by the Office of the Comptroller of the Currency (OCC), whereas
securities activities in nonbank subsidiaries are under the jurisdiction of the SEC. The Fed cooperates
with the OCC, the SEC, and other supervisors in determining the financial condition of the
consolidated organization.
The Fed's supervisory responsibilities require extensive engagement at both the policymaking and the
operational levels. In the policy arena, the Fed provides technical support to the Congress on
legislation related to banking and financial markets and sometimes advocates specific measures (such
as prompt corrective action for troubled depositories); along with other agencies, it represents the
United States in international forums to develop and negotiate various standards (such as bank capital
standards); it collaborates with other agencies (or, in some cases, has sole authority) to develop
regulations and supervisory guidance that implement the banking and consumer protection laws; and,
working with other agencies as appropriate, it develops norms and practices for supervisors and
examiners. At the operational level, the Federal Reserve System (including the twelve regional
Federal Reserve Banks) works closely with other agencies to examine banking organizations and to
ensure that they operate in a safe and sound manner and comply with the relevant laws and
regulations.
The Federal Reserve's supervisory activities give the institution access to a wealth of information
about the banking system. For example, the Fed's examination staff collects and analyzes information
on each supervised organization's management structure, lines of business, financial condition,
internal controls, risk-management practices, operational vulnerabilities, and much else. Moreover, the
Fed's supervisory activities provide it with a window onto financial institutions that it does not regulate
and onto developments in the broader financial markets. I have already mentioned the Fed's role as
the umbrella supervisor, which affords it access to information (as well as direct or back-up
examination authority) for all holding-company subsidiaries, nonbank organizations as well as banks.
Its supervisory activities also allow the Fed to obtain useful information about the financial companies
that do business with the banking organizations it supervises. For example, some large banks are
heavily engaged in lending and providing various services to hedge funds and other private pools of
capital. In the process of ensuring that banks prudently manage these counterparty relationships, Fed
staff members, collaborating with their colleagues from other agencies, learn a great deal about the
business practices, investment strategies, and emerging trends in this industry.2 Finally, many large
banking organizations are sophisticated participants in financial markets, including the markets for
derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed
obtains valuable information about trends and current developments in these markets. Together with
the knowledge obtained through its monetary-policy and payments activities, information gained
through its supervisory activities gives the Fed an exceptionally broad and deep understanding of
developments in financial markets and financial institutions.
The benefits of the Fed's supervisory authority for its non-supervisory activities
The extensive information and the expertise that the Fed gains in the process of supervising banks are
useful for carrying out many of the central bank's non-supervisory activities. The benefits of
supervisory information for monetary policy are perhaps the most debated. The research literature has
focused on whether information drawn from bank examinations is helpful in assessing the economic
outlook and thus in formulating monetary policy. The results have been mixed (Peek, Rosengren, and
Tootell, 1999; Feldman and others, 2003). Some evidence suggests that supervisory information is
likely to be most useful for monetary policymaking in times of financial stress. For example, the
Federal Reserve's experience suggests that such information was helpful in evaluating the availability
of credit in the early 1990s, when some banks' lending was constrained by their limited capital
(Bernanke and Lown, 1991; Greenspan, 1994). More generally, monetary policy is certainly aided by
the anecdotal information on regional economic conditions that Reserve Bank business and
community contacts, including numerous bankers, provide. Many of these contacts are fostered by the
extensive interaction between the Reserve Banks and the banks in their Districts.
oversight of the payments system
The Federal Reserve's is another critical central banking function. In
contrast to the situation in some other countries, the Federal Reserve lacks explicit legal authority to
oversee systemically important payments systems. Instead, the Federal Reserve's powers in this area
derive to a considerable extent from its bank supervisory authority. Notably, some key institutions
providing clearing and settlement services hold bank charters that place them under Federal Reserve
oversight.3 In its capacity as a bank supervisor, the Fed can obtain detailed information from these
institutions about their operations and risk-management practices and can take action as needed to
address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large
commercial banks that are critical to the payments system through their clearing and settlement
activities.4
As I have mentioned, the Fed also has an operational role in the payments system. In particular,
Fedwire - a system that the Fed operates for transmitting large-value payments - is a critical
component of the U.S. financial infrastructure. The operation of Fedwire and related payments
systems often involves large short-term credit exposures to system participants (reflecting so-called
daylight overdrafts). The Fed also extends overnight credit to depository institutions through the
discount window. The Fed's management of credit risk associated with these various forms of
shortterm lending relies heavily on supervisory information. In normal times, this information often is
obtained from other banking agencies. When a financial institution is under considerable stress,
however, it is helpful to have available in-house supervisors who can independently assess the
borrowing institution and evaluate its collateral.5
I have described several ways in which the Fed's supervisory authority assists it in performing its other
functions. In my view, however, the greatest external benefits of the Fed's supervisory activities are
those related to the institution's role in preventing and managing financial crises.
Bank supervision and the prevention and management of financial crises
Although the Federal Reserve is today best known to the public as the agency responsible for
monetary policy, the Fed was founded in 1913 largely in response to the periodic episodes of banking
panics and other forms of financial instability that had plagued the U.S. economy during the nineteenth
and early twentieth centuries (Friedman and Schwartz, 1963).6 Today, the Fed retains its key role in
the prevention and mitigation of financial crises, for a number of reasons. First, the Fed has unique
powers to provide liquidity to the financial system, through means that include open-market purchases,
discount-window loans, and intra-day overdrafts. Second, as I have noted, the Fed is a key player in
the payments system, functioning both as an overseer of systemically important
clearing-and-settlement systems and as a major provider of payments services. Problems in the
execution of payments - arising from institutions' uncertainties about the financial condition of their
counterparties, failures of the payments infrastructure, or both - have been central features of a
number of U.S. financial crises. Even in situations in which the payments system has continued to
function normally, the information the Fed has gleaned from its payment activities has been helpful for
understanding and managing financial stresses. Third, the Federal Reserve has developed extensive
international relationships and has worked closely with foreign central banks and, as a consequence
of its responsibility for the supervision of cross-border banking operations, with foreign supervisors.
These relationships have proved useful in past crises, and are likely to be even more critical in the
future as the globalization of finance continues. Fourth, the Fed's responsibilities for macroeconomic
stability provide it with both a strong incentive and the knowledge to prevent or mitigate financial
disruptions that threaten to spill over into the broader economy (Mishkin, 2000). Finally, the wide
scope of the Fed's activities in financial markets - including not only bank supervision and its roles in
the payments system but also the interaction with primary dealers and the monitoring of capital
markets associated with the making of monetary policy - has given the Fed a uniquely broad expertise
in evaluating and responding to emerging financial strains.
Financial stability is strengthened both by taking steps to prevent financial crises and by managing
crises effectively if they occur. To make crises less likely, over the years the Federal Reserve has
worked effectively with the Congress, other supervisors, and financial market participants to develop
statutory, regulatory, and other measures.7 The Fed has also worked with other supervisors and with
financial institutions to support the development of practices that limit systemic risk. For example, over
the past year and a half, the Federal Reserve Bank of New York has collaborated with the private
sector and with other regulators to strengthen the infrastructure that supports the credit derivatives
market. Very rapid growth in the volume of trading in that market in recent years had led to substantial
backlogs of unconfirmed trades. As a result of the cooperative efforts of market participants and
regulators, these backlogs have been cut sharply, reducing the risk that incomplete trading records
5
Indeed, the Congress, in the FDIC Improvement Act of 1991, imposed a heightened level of scrutiny on lending to troubled
institutions. In particular, if the Federal Reserve extends credit to a bank more than 5 days after the bank becomes critically
undercapitalized or to an undercapitalized bank for more than 60 days out of a 120-day period, the Federal Reserve Board
may be liable for a portion of any consequent increase in FDIC resolution costs [12 U.S.C. § 347b(b)]. In such situations, the
Fed needs the capacity to evaluate whether such loans are appropriate - a task requiring considerable information and
expertise on the operation of troubled banks and the resolution process.
6
The first sentence of the Federal Reserve Act assigned the new central bank the responsibilities of furnishing an elastic
currency, affording a means of rediscounting commercial paper, and establishing more effective supervision of banking.
Each of these responsibilities was closely tied to the goal of preventing or ameliorating financial panics; in particular, the
furnishing of an elastic currency and the rediscounting of commercial paper both involved the provision of liquidity to the
financial system as needed to avoid seasonal or other financial stresses.
7
For example, the Federal Reserve has supported, and sometimes helped to craft, clarifications of the legal framework that
underpins financial contracts, which are critical when contracts must be unwound in a crisis. In the regulatory and
supervisory areas, the Fed has helped to develop risk-sensitive bank capital standards and encouraged banks to continue
upgrading their methods for measuring and managing risk.
BIS Review 1/2007
could complicate the evaluation of firms' positions and financial conditions in a crisis. A number of
other cross-cutting initiatives are under way, including, for example, a coordinated review of how major
firms use stress-testing techniques to measure their credit and market risks. As the financial system
becomes more complex, more global, and more interconnected, public-private collaborations that
transcend national borders and cut across types of institutions, markets, and financial instruments will
become increasingly valuable. The Fed will continue to initiate and support such efforts.
Because of the Fed's unique perspective on issues of financial stability - a perspective based on
statutory authority, historical experience, and an appreciation of the links between financial and
macroeconomic stability - the participation of the U.S. central bank in collective efforts to prevent
financial crises seems highly desirable. The Federal Reserve's supervisory authority is useful in
helping the institution to more effectively identify issues and potential problems, by giving it a "seat at
the table" that allows it to be heard on these issues, and by increasing its contact and influence with
financial-market participants and other supervisors. In short, the Fed's supervisory powers help both to
give it a voice in policy discussions concerning financial stability and to increase the quality of its
contributions to those discussions.
With strong private-sector institutions and good public policies in place, episodes of severe financial
stress should be relatively infrequent. When financial problems do develop, however, the Fed and
other policymakers face the important threshold question of whether public action is warranted; in
particular, they must weigh the expected benefits of taking action against the possibility that such
action will encourage excessive private risk-taking in the future (the moral hazard problem). To
minimize the moral hazard problem, policymakers should act only in those cases in which it seems
likely that inaction would risk systemic problems with the potential to damage the broader economy;
and if they act, they should do so in ways that disturb market outcomes as little as possible.
In those cases when policymakers choose to respond to an actual or potential crisis, however, the
actions taken should be informed, timely, and effective. From the Fed's perspective, the ability to act
effectively in a financial crisis is greatly enhanced by its ongoing supervisory role. Such events can
involve significant and unpredictable interdependencies across institutions, markets, and the real
economy and, in some cases, breakdowns in communications or in the financial infrastructure. In a
situation of financial stress, the Federal Reserve's supervisory function helps it to obtain timely and
reliable information on conditions in the banking sector, the payments system, and the capital markets,
while helping the Fed maintain the in-house expertise necessary to gather and evaluate such
information quickly and to make sound judgments about possible policy responses. Moreover, the
Fed's ongoing relationships with the financial firms it supervises, as well as with other supervisors, can
ease communications and improve cooperation in a crisis, leading to more effective crisis
management.
It is true that, in some episodes of financial stress, important information was provided voluntarily by
securities firms and other organizations over which the Federal Reserve has limited or no regulatory
authority, or by other supervisors; moreover, some of the expertise that proved most valuable was
derived from the Fed's non-supervisory activities. Nevertheless, examination authority and a
knowledgeable and experienced examination staff have often proved essential. After the September
11 terrorist attacks, for example, Federal Reserve examiners were sent to the backup sites of the large
banking firms that had been affected. These staff members proved crucial in discerning what was
happening in a highly confused and uncertain situation. The information they obtained helped the Fed
assess the damage that had been done, think through the potential implications for financial markets,
and evaluate possible remedial actions.
Perhaps the most important remedial action taken by the Fed in the wake of the September 11 attacks
was its provision of massive amounts of liquidity, which helped avoid logjams in the payments system
and ensure that credit for the financial system and the economy would be available as needed.
Methods of providing liquidity included open-market purchases, intra-day overdrafts that were well
above normal levels, discount-window lending, the crediting of banks on regular schedules for checks
in process of collection, securities lending, and currency swaps that allowed foreign central banks to
provide dollar liquidity to financial institutions in their own countries (Ferguson, 2003). In undertaking
these steps, the Federal Reserve benefited from its knowledge of the liquidity management practices
of key institutions, their funding positions, and their financial conditions, as well as from its ability to
evaluate the collateral provided by institutions requesting funds. This information and expertise,
gained in part through its supervisory role, allowed the Fed to supply the needed liquidity efficiently
and without undue risk.
Most financial crises do not involve loss of human life and damage to physical infrastructure of the sort
that occurred on September 11, 2001. But even in the case of purely financial events, the Fed's
supervisory powers give it the knowledge (and, in some cases, the influence) needed to work with
other supervisors and the private sector to help resolve the situation. In the aftermath of the 1987
stock market crash, for example, the Fed drew on its supervisory experience to evaluate the funding
and credit risks facing major banking organizations. On-site examiners obtained timely information on
potentially significant lending losses and liquidity pressures. Besides issuing a public statement that
the discount window was available to provide liquidity, Federal Reserve officials contacted senior
managers of major banks - many of whom had ongoing relationships with the Fed as the result of
supervisory interactions - to discuss the situation. These discussions encouraged the banks, when it
was consistent with appropriate risk management, to make credit available to securities firms, allowing
them to make necessary payments and avoiding possible payment gridlock (SEC, 1988; Greenspan,
1994).
The Fed undertook similar discussions with other supervisors and with financial firms in response to
the failure of Drexel Burnham Lambert in 1990 and the collapse of Long Term Capital Management
(LTCM) in 1998. As the condition of Drexel deteriorated, other firms became less willing to trade with
it, making it difficult to wind down its positions in an orderly manner (Breeden, 1990). Because of the
Federal Reserve's ongoing supervisory relationships with the main clearing banks and its detailed
knowledge of the payments system, the Fed was able to address the banks' concerns and facilitate
the liquidation of Drexel's positions (Greenspan, 1994). In the case of LTCM, the Federal Reserve had
the credibility with large financial firms to facilitate a discussion, from which emerged a private-sector
solution that helped to avoid potential market disruptions (Greenspan, 1998).8
A general point that emerges from many of these examples is that financial crises and panics often
involve problems of coordination and collective action (Diamond and Dybvig, 1983). The job of the
crisis manager in such cases is to assist in solving these coordination problems and to help all parties
arrive at a cooperative solution. The market information, the wide-ranging expertise, and the
relationships that the Fed has developed in part through its supervisory activities have been invaluable
in allowing the central bank to act as an "honest broker" in such situations.
I have focused today on the benefits of the Fed's supervisory role for its other central bank
responsibilities, but the reverse is also true: The Fed's non-supervisory activities help it to be a better
supervisor, which in turn promotes financial stability. For example, in its conduct of monetary policy,
the Federal Reserve monitors financial market developments closely and interacts regularly with the
primary dealers in government securities. The knowledge thus gained has improved the Fed's ability
to understand and evaluate banks' financial-market activities. The Fed's capital-market expertise is
also useful in the regulatory process. For example, the Federal Reserve made substantial
contributions to the revisions to the Market Risk Amendment to the Basel I Capital Accord, under
which the capital charge for banks' trading assets is more closely tied to the market risk of their overall
portfolios.
Conclusion
How best to preserve financial stability is a complex subject with a long history, and my remarks today
have touched lightly or not at all on some central questions - among them, how to determine when
financial events justify public action and how the responsibilities for maintaining financial stability
should be allocated among private and public actors. Also, I should be clear that my purpose today is
not to make a comprehensive case that our current regulatory structure is ideal. To the contrary, we
should always be looking for ways to make supervision more effective and less burdensome. My point
today is a narrower one: that the supervisory authority of the Fed has significant collateral benefits in
helping it carry out its responsibilities for financial stability. In particular, the information, expertise, and
powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to
prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed
is able to respond more quickly, more effectively, and in a more informed way than would otherwise be
possible.
Yogi Berra reminded us that prediction is very hard, especially about the future. In that spirit, the
Federal Reserve continues to work actively to prepare for the possibility of financial stress. For
example, we have created cross-disciplinary teams of experts - including staff drawn from bank
supervision - to monitor financial developments and to consider possible crisis scenarios and the
appropriate policy responses. We have worked with other agencies both here and abroad to improve
our abilities to communicate and coordinate in a crisis situation. We also continue to take measures to
ensure that our communications, information systems, and policy processes will remain viable should
critical infrastructure be disrupted. The Federal Reserve has established a strong record of promoting
financial stability, and we will continue to work to ensure the vibrancy and resilience of the U.S.
financial system.
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