Mr. Davies looks at whether contemporary forces are eroding distinctions
between central banks and pushing them towards some common model Text of the
London School of Economic and Political Science Annual Lecture on Central Banking delivered
by the Deputy Goveror of the Bank of England, Mr. Howard Davies, on 4/3/97.
Central bankers are famous for their obsessive concern about credibility and
consistency. By that token, I should be drummed out of the club I have only recently joined.
Because when the Governor stood here a little over a year ago, he assured the audience that he
and last
was delivering the fourth in the series of LSE Bank of England lectures. But, in
keeping with the usual practice of successful television shows, I am here tonight to open a new
series. The LSE seemed to think you would prefer that to filling the schedule hereafter with
repeats.
This new series picks up where the last left off. In 1996 the Governor noted there
is nowadays a broad consensus that the raison d'être of central banks everywhere is the pursuit
of monetary and financial stability; but he observed that once you go beyond that level of
generality, each central bank is unique - in terms of its constitutional position, the range of its
activities, its size, structure and organisation. Many of these differences are the result of history.
The question I plan to address tonight is whether contemporary forces are eroding these
distinctions between central banks and pushing them towards some common model.
I shall confine myself largely to what is happening in Europe. The increasing
globalisation of financial markets is one pressure for change across the world. But in western
Europe, the Maastricht Treaty and the preparations for Economic and Monetary Union are
requiring central banks to review their statutes and to align their operating procedures. But I
also want to talk about the central banks of Eastern Europe. They are feeling similar pressures
several hope that their countries will accede to the European Union within five years or so - but
their origins are very different.
In 1989 most of the state banks of central and eastern Europe had little
understanding of the rôle of a central bank in a market economy. Since then they have had
rapidly to acquire the knowledge and skills needed to tackle acute inflationary pressures while
many of their leading banks were effectively bankrupt. At the Bank of England, we have been
actively involved in helping them by drawing on our own experience as central bankers,
adapting the lessons we have ourselves learned over the years to the unique circumstances of the
transition economies.
Much of this effort has been channelled through our Centre for Central Banking
Studies which we established in 1990 to provide technical assistance and training to other central
banks. We have given advice principally on core functions such as monetary policy and
operations, the development of money markets and payment systems, the management of
government debt, and banking supervision; but our help has also been sought in some less
obvious matters such as the physical security of central bank buildings and their contents. The
assistance is provided through our experts visiting other central banks and by their staff coming
on study visits to London, as well as through seminars and workshops here and abroad.
In the earlier years most of these events were essentially training courses. But
increasingly the participants from many countries are able to contribute more themselves to the
discussion so that they are now learning not only from our own experience as central bankers,
but also from each other. And in some instances, their experience may well hold lessons for us.
Since 1990 over 4,000 staff of other central banks - two thirds of them from the transition
economies - have participated in these various events. The work of the Centre for Central
Banking Studies, and the other inter-bank links we maintain (notably between supervisors) give
us, I believe, a privileged perspective on the development of central banking across Europe. The
analysis below - particularly the Eastern European sections - is very largely the work of Lionel
Price, the Centre's Director, and his staff.
History is important
In a study1 published by the LSE's Financial Markets Group last year, Rosa
Maria Lastra concludes that central banks are not "natural products" but products of history.
She emphasises the special relationships whereby central banks have been consciously awarded
privileges by governments, and have been expected to provide certain services and functions in
return. This may seem a dubious process, like selling monopolies. But central banking, she
kindly says, is not an "evil": that comes as a relief to some of us. Though a product of history,
and a creature favoured by the state, a central bank may serve useful economic goals in the
pursuit of stable money and sound banking. While most of their functions could be fulfilled by
a different public or private institution, central banks are today typically seen as convenient
instruments for the conduct of both monetary policy and banking supervision.
I agree with Dr Lastra's conclusions. Moreover, central banks' differing
historical origins influence not only the tasks they carry out today, but also the way in which
they think and operate. The Bank of England was established to lend money to the government;
and though the Maastricht Treaty now prohibits any buying of British government debt by the
Bank of England in the primary market, the Bank still manages government funding operations
in an essentially agency capacity (and the present Governor first came to public prominence in
this area!). By contrast, the origin of the Federal Reserve Banks in the USA lay in the provision
of a reliable nation-wide payment and depository system, and that remains a central activity.
While some banking supervision is conducted by the Fed, that is largely the remit of (myriad)
other institutions (the Office of the Comptroller of the Currency, banking regulators in each
separate state and the Federal Deposit Insurance Corporation).
The Bundesbank was set up against a background of the need to restore and
maintain a stable currency, and this, together with the concomitant political independence,
remain at the heart of its rôle. An early strong belief in the "real bills" doctrine still influences
the Bundesbank's views on appropriate collateral for central bank operations with the market,
and justifies its large branch network and staff. The Banque de France has retained more retail
banking than most other modern central banks, maintaining branches in every French
département (a network it has found difficult to slim down in face of local and trades union
opposition). It also makes use of its branches in compiling a centrale des risques, a register of
commercial bank lending, and in keeping track of the million or so individuals who have drawn
bad cheques! The Bank of Japan is more of a medley. Its rôle model when it was established in
1882 was, you may be surprised to hear, the Banque Nationale de Belgique, though some aspects
of English banking practice were also adopted. Legislation in 1942 followed the then German
model, particularly in making the Bank of Japan subservient to the Ministry of Finance; and
after the war, there was American influence.
In Figures 1 and 2, I have attempted to capture some of the distinctions between
these leading central banks. (Because I am concentrating on distinctions, I have omitted
common tasks - such as the issuance of banknotes and acting as banker for government - which
are carried out by virtually all central banks.) Figure 1 shows the UK's "scores" in five areas,
while Figure 2 adds in, by way of comparison, the other G5 countries. Mapping the distinctions
is not an easy task. For instance, though in Germany a government office is responsible for
banking supervision, it is central bank staff who undertake much of the day-to-day work of
monitoring individual banks. In France, supervision is the responsibility of the Commission
Bancaire, but its secretariat is effectively part of the Banque de France, and the Governor chairs
it. And in Japan, the central bank closely monitors the large banks, though the responsibility for
supervision formally rests with the finance ministry. Furthermore, the extent of a country's total
financial regulatory effort encompassed by the term 'banking supervision' varies - most British
banks have set up separate subsidiaries for their trading activity, regulated by securities
regulators (though the responsibility for consolidated supervision remains with the Bank of
England); by contrast, European banks tend to retain trading within the banking entity.
It is also not always apparent whether the central bank is in practice free to set
interest rates to achieve the monetary policy objectives which derive from its own statutes or
from objectives set by government. The Bundesbank clearly has that freedom; and the other EU
member states have been legislating in accordance with the Maastricht Treaty to give their
central banks independence in the field of monetary policy. In Britain, even though there have
been very welcome improvements in the transparency of monetary policy formulation since
1992, decisions on interest rates remain clearly with the Chancellor of the Exchequer though
now within a clear inflation target framework. In Japan the position is under review. The
ultimate authority on interest rates has rested legally with the Minister of Finance, though
according to Goodhart, Capie and Schnadt "it is widely understood that it would be
extraordinary if the government resorted to these provisions, and they have never been
enacted".2 The same authors conclude that the Bank of Japan "has thus enjoyed independence in
practice". What is harder to judge is the extent to which the Bank of Japan's decisions may
have been influenced at times by recognition of the latent ministerial powers.
Notwithstanding those nuances, what can be seen from Figure 2 is that the Bank
of England is quite distinctive amongst the five leading industrial countries. We have:
• the least independence in setting interest rates;
• the most comprehensive responsibility for banking supervision (though
some other banks have broader financial regulatory responsibilities);
the greatest role in managing government debt - we provide substantial
•
policy input as well as actually handling auctions as issuing agent for the
Treasury;
• the smallest branch network - we have consciously reduced the scope of
our private banking activities in recent years (focusing on areas of
comparative advantage as a public sector institution) and are now also
leaving note distribution to be handled largely by the private banks;
• a comparatively limited but increasing role in the operation of payment
and settlement systems - typically, the Bank of England participates in
payments systems which are run by the private sector, and has only
involved itself in the establishment and operation of settlement systems
when the private sector has not itself succeeded in doing so. Recently,
however, the introduction of CREST and RTGS, and the European work
on TARGET, has expanded on our work considerably.
These maps cannot easily convey a sense of the dynamics of change in central
banking. Central banks are evolving creatures, which respond to political and economic forces
around them. One unusually powerful force, which will change their environment
fundamentally, is EMU. But before considering its impact, I would like to consider the state of
play in the rest of (non-EU) Europe, where exciting transformations of a different kind have
occurred in the last decade.
Turning socialist state banks into central banks
The central banks of the formerly planned economies of central and eastern
Europe have generally developed important responsibilities in each of my five areas (Figure 3).
The old state banks have been transformed to fill the vacuum left by the dissolution of the
mechanisms and institutions of a planned economy. Most had extensive branch networks and
already operated rudimentary payment systems - though transfers often relied on correspondent
banking relationships and slow and unreliable postal systems. But under the old regime there
was little if any requirement for the other functions - setting interest rates, managing government
debt, and supervising banks. Instead the main roles of the state banks had been the provision of
banknotes; and making the financial transfers between state enterprises inherent in the central
economic plans. The perceived importance of cash, and the bookkeeping culture, still influence
to varying degrees their successor institutions. But these banks have been hit by a series of
powerful shocks.
(i) Monetary policy
The first is the shift from centralised control of the economy to a market-based
system. Instead of directing money to meet enterprises' deficits - a job which required a large
branch network and hordes of bureaucrats - the aim is to influence the behaviour of the economy
by using indirect instruments of monetary policy to guide interest rates and the exchange rate,
and to conduct the prudential supervision of the new commercial banks. But many of the
bureaucrats find it difficult to work out which bits of information they need and how often, and
prefer instead to demand a substantial volume of data without prioritisation. Some of the staff
of eastern European central banks, used to passing on raw data which can be checked against
enterprises' targets, find it difficult to analyse information with the aim of learning something
about the behaviour of markets, consumers or firms. The simple questions, "Why are we doing
this?", "What does this mean?" can be too hard to ask. New goals, however well-enshrined in
the constitution and law, do not change culture overnight.
The second culture shock has been the move from a monobank to a two-tier
banking system. The old system had two separate monetary circuits - one for cash (used mainly
by individuals) and the other in transfers between bank accounts (used by enterprises). One of
the early tasks of western advisers was to try to convince the would-be central bankers in the
east that monetary policy was not just a matter of regulating the supply of banknotes. And many
of the same people found it difficult to accept that the provision of credit by a central bank
whether to government or to enterprises - is likely to have inflationary consequences. When the
basic problem is a shortage of national savings (often because the state is pre-empting private
savings through its budget deficit and off-budgetary spending), the central bank cannot
magically create extra real resources by relaxing monetary policy. Were it so, we central
bankers would be even more popular people than we are now.
The response of the eastern European and CIS central banks to their new goals
has been tempered by a number of factors:
-how long the old culture had prevailed;
-how democratic the new regime is (independent central banks do not get
on well with autocracies);
-the size of the country;
-the availability of foreign currency to the government, whether from
export revenues (oil or gas) or loans from international financial
institutions; and
-in the case of the ten (yes, ten!) applicants from the region to join the EU,
how quickly they believe they need to move into line.
The differences between these central banks are perhaps most marked in relation
to monetary policy and financial relations with the government. The westernmost of the
transition countries have typically liberalised the most, adopting policies and structures which
are already very close to those of their EU neighbours;
while, further East, reform and market-based operations are still viewed with
some scepticism (everyone of course pays lip service to the benefits of and need for market
reform and structural adjustment, but many do not in their hearts believe it will work for them),
and the markets that have been introduced are subjected to discretionary administrative
controls - particularly in crises.
Partly because of the influence of the IMF and other western advisers as well as,
in the case of EU applicants, the need to harmonise with EU law and practice, the legislation
governing the new central banks usually follows a common model, giving them autonomy to
pursue an objective of monetary stability. What is interesting is that the aspects of monetary
control whose merits we debate in the west - the degree of independence of the central bank,
inflation targets versus monetary targets, fixed or floating exchange rates - have in terms of
results been of secondary importance to the understanding and acceptance of the case for reform
on the part of the public, parliament and government. There is little benefit to a central bank
being independent of government if the parliament is able to force it to grant subsidised credits
to favoured sectors. And independence counts for little if the government persists in running a
deficit while non-monetary means to finance it have yet to be developed.
If we look at five of the central European countries where reform is most
advanced - the Czech and Slovak Republics, Slovenia, Hungary and Poland - the first two have
succeeded in bringing annual inflation down to single figures, while inflation in Hungary and
Poland is just below 20%. All except Hungary monitor an intermediate monetary target, but
these targets have proved unreliable friends in the transitional economies generally. It has been
far from easy to predict the velocity of money when the economic and financial structure is in
turmoil. The more important success factor appears to be exchange rate policy. The Czechs and
Slovaks have been able to hold their exchange rates fixed against a Deutsche Mark/US dollar
basket. This has not been sufficient to deliver the inflation rates of 1-3 % seen in Germany and
the United States, as the transition economies are experiencing faster rates of growth in
productivity in tradables; they need to permit their currencies to appreciate if they are to lower
their inflation rates further. But their fixed exchange rates have cemented and enhanced the
credibility of the sound monetary and budgetary policies being followed.
Yet fixing the exchange rate is not the only route to lowering inflation. Slovenia
has succeeded with a managed float, though a key factor has been its willingness to keep their
real exchange rate relatively high. In contrast, Hungary and Poland have tried to prevent the
inevitable real appreciation of their currencies by continually depreciating their nominal
exchange rates in reflection of their higher rates of inflation. Polish policy became less
accommodating last year, and Hungary may be set to follow.
Of course, an exchange rate peg is far more credible if a country has sizeable
foreign exchange reserves. The Baltic states were fortunate in this respect as they regained
access to the gold held by their central banks in London and Paris before the War; and Estonia
and Lithuania have gone as far as to fix their exchange rates rigidly in a currency board system
which removes discretion from monetary policy. (Note that these countries too are experiencing
real appreciation: annual inflation is nearly 15% despite their fixed exchange rates.) The IMF is
now encouraging Bulgaria to follow suit and adopt a currency board as the central bank there
has not been able to impose a sufficiently tight monetary policy in the face of lack of progress
on other aspects of reform. But the currency board can only succeed as part of a comprehensive
package of fiscal and structural measures. The strict monetary policy rules of a currency board
can work well if fiscal policy is highly responsible - or will become so as a result of the currency
board; if not, it may put severe strains on the banking system, as has been the case in the Baltic
states.
(ii) Banking supervision
This potential conflict between monetary policy and maintaining the stability of
the banking system is not one which has greatly troubled most western industrial countries in
recent years. But in some transition economies, such conflicts have been real. In most, the
problem has not been so much to maintain the stability of the banking system as to create a
robust banking system from a number of often insolvent state-owned banks spun off from the
old monobank, together with newly created commercial banks whose behaviour has frequently
been far from prudent.
In contrast to the diverse arrangements in the west, banking supervision in
transition economies is nearly always the responsibility of the central bank (although in some
cases the Ministry of Finance is also involved in the licensing of banks). An exception is
Hungary, where supervisory responsibilities have in large measure been transferred to the State
Banking Supervision Office: the central bank is nominally responsible only for monitoring
banks' liquidity and foreign exchange positions, although in practice its role extends rather more
widely.
In most of the countries - especially in those with hopes of acceding soon to the EU - banking
legislation approximating to western standards is (or is about to be) in place. But in practice,
banking supervision has proved a difficult topic to master. Whereas monetary policy requires a
highly trained but small cadre of economists in the head office of the central bank, large
numbers of supervisors are needed, often spread across the country, to deal with a multitude of
new banks with poor quality accounts. And the skills of assessing risk and the quality of
management have not always come easily to staff from a bookkeeping background whose
instincts are to tick boxes rather than make judgements. Staff who have acquired the skills
needed are frequently enticed away to work for commercial banks at higher salaries.
(iii) Managing government debt
Another field in which central and eastern European central banks are generally
more heavily involved than their western counterparts is in the management of government debt.
(Hungary, where there is a separate debt office under the Ministry of Finance, broadly on the
Irish model, is again an exception.) Under the old regimes governments relied on their state
banks for finance, but the new statutes of the central banks - usually following an IMF model
limit the provision of finance to government. Ceilings are mostly around 5% of government
revenues, though in Estonia and Lithuania they are zero. With monetary financing restricted,
new methods of financing governments have had to be developed and nearly all the central
banks have taken a leading part in this process.
Even where the government's own financing needs have been small, as in the
Czech Republic, central banks have been keen to establish markets in short-term paper in which
they can conduct monetary operations. Several of them have issued their own bills for this
purpose, particularly where in the early years the finance ministry was reluctant to issue
government paper. Whether the market being developed is in government, central bank or
private paper, the central banks have had to strike a difficult balance in deciding how frequently
to intervene in the markets. In the absence of intervention, a market can remain illiquid and
unused. But if the central bank intervenes too much and holds prices too steady, then private
market-makers will not develop. This dilemma is not unique to transition countries. Similar
dilemmas arise elsewhere, and some western central banks still sometimes play a role, if only a
marginal one, in balancing supply and demand in the domestic securities and foreign exchange
markets.
(iv) Payment and settlement systems
One area of activity in which the new central banks do mirror the diversity of
their western counterparts is in responsibility for payment and settlement systems. Of the nine
central banks in central and eastern Europe, five operate the main clearing system themselves.
In the other four countries the position is roughly as it is here, with the central bank participating
in, and providing final settlement for, a privately owned clearing system. In Russia the central
bank has been slow to develop its own payment system, and commercial banks have been
putting parallel mechanisms in place. In the west, technological developments and a desire to
reduce systemic risks have been drawing central banks like ourselves into greater involvement in
payment and settlement services, especially in the provision of real-time gross settlement. No
doubt the central banks in the transition economies will feel the same pressures before long.
(v) Branch networks
On the last of my five metrics of central bank functions - the size of the branch
network (which I use as a convenient proxy for the extent of their involvement in straight
banking activities and in note distribution) - the transition central banks occupy an intermediate
position. The extensive branch networks of the monobanks went largely to the savings banks,
and in some case they have been turned into commercial banks. The result has been surprisingly
consistent across central and eastern Europe, with one branch remaining for every 1⁄2 - 1 million
people (except for the Bank of Estonia which has no branches, a scrupulous qualification).
Some of the new central banks are even now questioning, as we have done, whether they need
branches - as distinct from regional agencies - at all. Following the setting up of a State
Treasury, the Hungarian central bank has closed more than half its branches.
Obviously the political structure and geography of the country is material. In the USA and
Germany, the maintenance of a branch network reflects the federal structure of the state. In
Russia, a federal state with a very large geographical area, the Central Bank has sixty territorial
branches and nineteen regional banks - apparently rather modest numbers for a country with
some 150 million people spread across ten time zones. But in addition the CBR in 1994 ran
1,356 cash and settlement centres, 13 banking schools, and 30 "other organisations". To run this
empire the bank employed over 52,000 staff, having created over 7,000 additional posts in the
previous two years to conduct its various new functions.
Central bank staffing and costs
All this shows that, even though all European central banks face similar pressures,
the solutions remain quite diverse. That is reflected in relative costs. Comparable data are hard
to come by, but the Bank of Russia appears to have more staff per head of population than any
other. The People's Bank of China is larger, employing some 150,000 people (but only 1,000 in
head office where policy is centralised), but considering the PBoC's continuing role as banker to
the state-owned enterprises that looks small in relation to a population of 1.2 billion. Other very
large central banks are the Reserve Bank of India with 32,000 staff and the US Federal Reserve
System with 25,000.
One would expect the number of staff employed by a central bank to depend not
just on the population of the country (and in this there should be some economies of scale) but
also on the range of tasks it has and how efficiently it conducts them. At the Bank of England
we take a lot of interest in comparative efficiency: we are determined to be a value for money
central bank, and benchmark ourselves against others wherever possible. Some of the data we
use are confidential: central banks are more candid with each other in private than they are in
public. But there are a few published measures. A study in 1995 by Fry, Goodhart and
Almeida3 of a sample of 30 central banks, largely from developing countries, tested twelve
variables as possible explanations of non-supervisory staff numbers. Most significant was a
country's population, with an elasticity of one half, confirming substantial economies of scale
across the sample countries. There were positive relationships with real per capita income
(central banking appears to be a luxury good!), the number of branches, and the use of exchange
controls (both of which would increase staff needs). Perhaps surprisingly the more independent
central banks seemed to employ fewer staff (perhaps that could be the basis of an
accommodation with Gordon Brown!). Amongst the variables which showed no relationship
was the inflation rate (though there could be a simultaneity problem here).
Figure 4 shows the numbers of staff employed two or three years ago by the
central banks of various industrial countries and some of the transition economies. There is
clearly the expected positive relationship with population, but the ratio varies hugely: a central
bank on the highest of the three parallel lines has ten times the staff per million population as
one on the lowest line. The extent of this dispersion is more apparent in Figure 5 which shows
the number of staff per million population for the large countries. With only around 3,500
people - down by more than 50% over the last twenty years and still falling fast - the Bank of
England itself is one of the most modestly staffed in relation to its population. In contrast to the
significant results found by Fry et al. from their sample of developing countries, regression
analysis on the industrial country data shows only weak evidence of small economies of scale.
Nor did other variables tested on industrial countries yield any significant results. As for the
transition economies, their staff numbers generally conform to those in industrial countries with
similar populations. The exception is the Bank of Russia, whose staff looks abnormally large.
Some of these central banks are still growing as they seek to carry out their new functions; but
one or two, like the National Bank of Hungary, are already reviewing what they are doing and
how they do it, and are slimming down. By the end of this year, they expect to have 40% fewer
staff than two years ago.
These variations in staff numbers naturally have an impact on the running costs of
central banks, but relative salary levels and non-staff costs are obviously also important. Figure
6 is based on data for 1992, taken from central banks' Annual Reports. The vertical axis shows
the gross operating costs of each central bank as a percentage of GDP. The horizontal axis
shows population. For a swathe of countries across the bottom of the chart - from New Zealand
at 0.06% through Sweden, Denmark, Switzerland, the Netherlands and Australia (0.04 - 0.05%)
to Britain (0.037%) and Canada and the United States at 0.03% - there may be some scale effect,
but several European countries do not fit this model at all. The central banks of Italy and France
- countries with the same population as the UK - then cost 5 and 3.5 times more than us, and the
picture has changed little since. Some of the differences may be down to national culture, but
another factor may be that the funds at the disposal of the different central banks vary widely.
In particular, I suspect that some of our relative cheapness may be attributable to the Bank
Charter Act of 1844, since which time the seignorage on our banknote issue has been passed
directly and immediately to the government. This is not generally the case abroad, at least in
European countries - west or east - where profits, a fraction of seignorage, are passed only
periodically to government. (The UK is also unusual in that foreign exchange reserves, and any
profits earned on them, belong to the government rather than to the central bank, although the
Bank of England does of course have responsibility for managing the reserves).
Looking at the European continent as a whole, it is interesting that, whereas the
common history of central and eastern European countries over the last half century has
produced broadly similar central banks in the different countries - at least in those which are
contemplating accession to the European Union - the central banks of the existing member states
are a disparate bunch. What remains to be seen is how far the advent of Economic and
Monetary Union may induce more homogeneity and, indeed, reduce costs. It ought to be the
case, after all, that one monetary policy is cheaper to administer than 15, or 25.
The European Central Bank will appear a much more concentrated creature than
the central banks we have been looking at. It will be responsible for the issuance of euro
banknotes (known to the cognoscenti as bridging finance) but beyond this, in terms of the
diagram I