Mugur Isărescu: Recent developments in central bank governance
Panel presentation by Mr Mugur Isărescu, Governor of the National Bank of Romania, at the
"Central Bank and Supervisory Governance" conference, organized by the National Bank of
the Netherlands, Amsterdam, 12 February 2016.
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Ladies and gentlemen,
It is a great honour to address the audience during this high-level conference on a subject of
special interest to all of us, the recent developments in central bank governance leading to
heated debates every time they are brought to the fore.
Mr. He has done a wonderful job in structuring the challenges of nowadays' central banking
and in outlining the importance of effective governance arrangements in order to meet these
challenges - his presentation is a testimony to IMF's unique ability to draw upon a vast set of
worldwide institutional experiences. I, in turn, will draw mainly upon a narrower, but hopefully
no less relevant, set of institutional experiences, gathered during my tenure as Governor of the
National Bank of Romania.
In my address today I intend to deal with the issue of recent developments in central bank
governance by looking at:
1. The central bank objectives as the starting point in designing its governance
framework;
2. How the NBR dealt with the financial stability as an objective, from an institutional
point of view; integrating or separating monetary policy and supervision;
3. A short history of institutional developments within the NBR for ensuring financial
stability;
4. The internal control layers in the NBR;
5. Pros and cons of different institutional alternatives: banking supervision and
macroprudential authority - inside or outside the central bank;
6. A historical perspective on the experience of becoming a modern central bank, a
process undergone not only by the NBR.
1. Defining the objectives - the starting point in designing central bank governance
It goes without saying that ground zero in building the central bank governance framework is
clarifying the objectives it has to pursue. For quite a long time, at least in Europe, "price
stability" enjoyed the position of overriding objective, but since the outbreak of the crisis it
became obvious that the "inflation first" approach may turn counterproductive in an
environment of financial instability. Therefore, financial stability concerns made their way up
on central bankers' agenda.
Is that really a novelty? As the representative of an emerging economy central bank that never
had the luxury of being concerned exclusively with price stability, I dare say it is not. Actually,
central banking has always been about the preservation of, to quote Charles Goodhart, "the
three aspects of stability", namely price stability, (external) currency stability and financial
stability. Moreover, the fact that these aspects of stability do condition each other was not
discovered in the aftermath of the crisis - central bankers, maybe even more so
emergingmarket central bankers, have long been keenly aware that failure to ensure one kind of stability
is bound to jeopardise the achievement of the others.
What the crisis has indeed challenged is the widespread conviction that meeting one particular
stability criterion, while necessary in order to achieve the others, is also a sufficient condition
to do so - after all, maintaining price stability, while valuable in itself, has proved insufficient to
ward off major financial or macroeconomic instability. As a matter of fact, Andrew Crocket
claimed ever since 2003 that the "peace dividend" yielded by the successful war against
inflation had not lived up to expectations and therefore the battlefront against financial
instability should not be overlooked.
Regardless of how this battlefront is approached, it is of the essence to make sure that the
tasks entrusted to the central bank are feasible. Otherwise, if the monetary authorities are
overburdened with possibly conflicting goals, the major risk is to render them inefficient and
unable to deliver a single one of their objectives. This is the very reason why the issue of
central bank governance is so intricate and delicate: one needs to reconcile objectives that,
under certain circumstances, might even prove incompatible.
2. Integrating or separating price and financial guardianship
Given that the conference focuses on central bank and supervisory governance, allow me to
touch on the issue of integrating price guardianship and financial guardianship within the
central bank. As you probably remember, the idea that the two tasks should be completely
separated has gained ground in the 1990s. The rationale behind this view was to free the
monetary policy conduct from conflicting objectives and thus render policymakers' mission and
life easier. It was advocated that banking sector supervision should no longer be assigned to
the central bank, but rather to an independent agency (which might also ensure the
consolidated supervision of all financial markets).
I, myself, found the idea rather interesting at the end of the 1990s, when the collapse of several
Romanian banks influenced the decision-making process at the National Bank of Romania. I
realised at the moment how costly it was in terms of reputation for a central bank to be in
charge of supervision and prudential regulation - not to mention that the separation appeared
quite fashionable after the newly-established Financial Services Authority had become
operational in the United Kingdom.
At the same time, I vividly remember the conflict between price stability and financial stability,
when I had to mediate the divergent positions taken during Board meetings by the deputy
governors coordinating the two functions, not by virtue of personal affiliations, but due to the
very nature of the specific tasks they had been entrusted with. I was wondering, in light of
these Board disputes, whether separating the monetary policy and the supervision functions
was preferable.
At hindsight, I believe that Romania has made the right choice preserving banking supervision
as a prerogative of the central bank, sorting out such disputes under the same roof.
Coming to the current NBR governance framework, I would like to start by pointing out that it
ensures a complete separation as regards the coordination of the relevant departments: while
the Governor is in charge of the monetary policy area, the First Deputy Governor coordinates
the Supervision Department; one Deputy Governor takes care of financial stability and the
other, of bank resolution.
The nine-strong Board of Directors runs the central bank, but the process of preparing its
decisions in the areas of monetary policy and prudential supervision takes place in two distinct
structures: the Monetary Policy Committee and the Supervisory Committee, respectively,
which comprise members of the executive management and experts in the relevant areas. As
separation is not the same thing as complete isolation, I have to add that both committees are
chaired by the Governor...
Pursuant to the NBR Statute, the Board is tasked to act as a first appellate forum for sanctions
on credit institutions. In order to avoid conflicts of interest that may appear, the following
institutional arrangements are in place: separate Board meetings, a certain degree of
autonomy of the Supervision Department and recusal from the proceedings of the First Deputy
Governor, in his capacity as coordinator of the Supervision Department.
I would like to add a special remark regarding the new role of the NBR as the resolution
authority, arising from the provisions of the Bank Recovery and Resolution Directive. We have
configured the activities and reporting lines in order to ensure full operational independence
and to avoid conflicts of interest between the supervision and resolution functions. Of course,
this takes place without prejudice to the exchange of information and cooperation obligations.
To be more specific, supervisory decisions do not pose constrains to resolution-related ones.
Moreover, the staff involved in performing the resolution function is structurally separated from
the other NBR functions.
3. Romania: a short history of institutional changes for ensuring financial stability
The global crisis has made obvious for all of us that price stability and financial stability are
much more intertwined than we used to think. I believe this development has farther-reaching
consequences when it comes to the future of central banking. As I pointed out in November
last year at the World Policy Conference organised in Montreux, I cannot imagine a future
where the explicit concern for financial stability and the macroprudential policy are not central
banking fixtures.
In Romania, the concern for ensuring and strengthening financial stability was visible in several
significant changes of the institutional framework, operated already before the outbreak of the
global economic and financial crisis. Specifically, the NBR's Financial Stability Department was
created as early as 2004, with the first edition of the annual Financial Stability Report - a report
that will be published on a half-yearly basis starting this year - being released in 2006.
Of course, no matter how much or how responsibly the central bank would get involved in
safeguarding financial stability, this public good can only be delivered through cooperation and
coordination with the other institutions tasked with financial market supervision and regulation.
Relevant in this respect is that in Romania a National Committee for Financial Stability was
established as early as 2007. The Governor of the National Bank of Romania, the Minister of
Public Finance, the President of the Financial Supervisory Authority and the Chairman of the
Bank Deposit Guarantee Fund are members of this committee, whose key objective is to
ensure the exchange of relevant information, as well as to prevent, appraise and manage any
issues with a potentially systemic impact.
Efforts are currently underway to turn this entity set up based on an agreement among member
institutions into a National Committee for Macroprudential Oversight, whose composition, tasks
and areas of competence shall be set forth by law. This inter-institutional structure will act as
a macroprudential authority, within the meaning of ESRB Recommendation 2011/3.
4. NBR: the internal control layers
I imagine we all agree that improving the governance structure is essential for a central bank
and I strongly believe the sharing of views and experience made possible by reunions such as
the one we are attending is extremely beneficial for the process.
As far as the NBR is concerned, enhancing the governance has been a steady concern over
the course of time, the ultimate goal being the alignment with the best practices, often with IMF
support.
Let me just point out that the NBR shifted from an internal auditors' Commission to the auditing
of financial statements by external auditors as early as 2001, while the following year saw the
establishment of the Audit Committee as a substructure of the NBR Board (at a time when not
even the ECB had such a committee in place!).
In addition to the Audit Committee, the NBR's internal control system includes several control
layers. In fact, there are three lines of defence against any factors that might jeopardise the
fulfilment of the NBR objectives.
First of all, the National Bank of Romania takes a functional approach to risk management,
meaning that each organisational unit has primary responsibility for identifying, assessing and
managing the risks associated with its own activities and operations. The risk management
process is an integral part of the NBR's internal control system and represents the bank's first
line of defence. Each organisational unit implements operational control procedures within its
area of responsibility, in accordance with the levels of risk tolerance set in advance by the
executive management. Furthermore, the NBR applies the approach known as the "Chinese
wall", which separates the departments in charge of monetary policy formulation and
implementation, on one hand, from the departments entrusted with other statutory tasks, on
the other.
The second line of defence is functional on certain business segments with high-risk financial
exposure, e.g. international reserve management. This line of defence monitors compliance
with the risk limits approved by the bank's executive management and reports any breach.
A major role in this line of defence is played by the decision-making/advisory committees within
the central bank. Apart from the two committees dedicated to monetary policy and supervision
that I have already mentioned, particularly significant is the Foreign Reserve Management
Committee.
In addition to the risk monitoring by the operational structures, the NBR's Internal Audit
Department - which functions as the third line of defence - examines the overall controls in
place and determines whether they are properly designed and functional, so as to ensure the
reliability and integrity of financial and operational information, the effectiveness of the activities
carried out, asset protection, as well as compliance with applicable legal and contractual
provisions.
5. Different institutional arrangements for banking supervision and financial stability
As we all know, the responsibility for banking supervision rests in some countries with the
central bank, whereas in others it lies with a distinct authority. Both options are valid and a
one-size-fits-all solution will probably not be reached, given the country-specific financial
conditions and institutional arrangements. However, this does not necessarily exclude looking
into the arguments for or against either alternative.
As I already said, I believe that it is better to have supervision integrated in the central bank.
First of all, the ongoing complex challenges to financial and economic stability call for
identifying, using and corroborating tons of information in order to articulate the adequate
policies. The central bank relies on its database and expertise, which are prerequisites for
managing such a challenging environment. Beyond this major advantage, there are also other
benefits of such an institutional arrangement. Independence from political influence is essential
for effective supervision. And central banks are institutions enjoying a high level of
independence that a newly-established government agency would not be able to gain, at least
in the short run.
Besides, clearly acknowledging the links between price stability and financial stability means
that they need to be taken into account when formulating the monetary policy. Moreover, as
Benoît Coeuré pointed out, data collected and analyses conducted as part of banking
supervision provide valuable information about the financial sector and may feed into the
assessment of the state of the economy, being useful for the monetary policy decision-making
process.
Of course, literature identifies some disadvantages of integrating supervision in the central
bank. The risk of this arrangement resulting in a too loose monetary policy, due to the
conflicting objectives, which I have already referred to, is an important drawback. However, as
Beck and Gros stressed in an article from 2012, with the rise of macro-prudential regulation as
an additional tool, it is not clear whether price and financial stability still conflict with each other.
Another disadvantage is that the reputation and/or the independence of the central bank might
be undermined: if its decisions and actions in the area of supervision and resolution are
perceived as wrong or suboptimal, this may negatively affect the credibility of the monetary
policy, as it is conducted by the same institution. Moreover, the temptation of politicians to
capture the central bank may rise, as it has much more power than in the case when its only
mission is to deliver price stability.
The various arrangements on assigning banking supervision also have a bearing on the design
of the national macroprudential authority. Depending mainly on who conducts the supervision
of banks, different institutional solutions are adequate for this authority: it may be represented
by a committee or board comprising representatives of the relevant institutions, by the central
bank or by another authority tasked with financial market supervision. Boards are in place or
envisaged in 13 EU countries, the central bank is - or is projected to be - the national
macroprudential authority in 13 other EU countries, whereas two opted for - or are considering
- entrusting this role to the national supervisory authority.
Opting for the central bank as a national macroprudential authority can be warranted by the
experience accumulated in the field, especially in the case of a dominant position of the
banking sector, and by the possibility of a quick implementation of adopted measures (since
the institution is responsible for identifying systemic risks and, at the same time, has available
the macroprudential tools to put into practice the measures considered adequate).
Some disadvantages of having supervision integrated in the central bank are manifest in this
case as well, such as the backfiring of potential errors in the area (be they real or merely
perceived as such by the public) on monetary policy credibility or a keener interest in politically
capturing the institution as a result of the substantial rise in central bank powers.
As Klaas Knot has showed more than once, the key argument in favour of creating a board is
that it enables the pooling of the expertise of all financial market supervisors and of the
government; the drawbacks would be more diffused accountability and the risk of delayed
implementation of recommendations, given the involvement of several institutions. A prominent
role of the central bank in the board (either by chairing it or through the number of members
assigned) might mitigate the risk of inaction.
In the case of Romania, where the supervision of banks and non-bank financial institutions is
the task of the NBR, while the Financial Supervisory Authority (FSA) oversees the other
financial markets, the solution that emerges as adequate is the one identified in the draft law
promoted by the Government: a National Committee for Macroprudential Oversight. The
decision-making body of this committee is to be made up of nine members: the Governor, the
First-Deputy Governor, the two Deputy Governors and the Chief Economist of the National
Bank of Romania; the President and the First-Vice President of the Financial Supervisory
Authority, as well as two Government representatives appointed by the Prime Minister.
Addressees of National Committee recommendations - the NBR and the FSA, as sectoral
financial supervisory authorities, and the Government - should act on them unless inaction
can be adequately justified ("act or explain" mechanism).
6. Reforming central bank governance after the fall of communism
I have always been of the opinion that one cannot truly understand the present or have a
glimpse into the future without knowing the past and learning its lessons. These lessons begin
with the transition from a monetary authority in a command economy to a modern central bank
operating in a market economy, an experience that is, for sure, familiar to many of us present
here - I believe half of the central banks in this constituency, including Romania's, are "new
kids on the block".
Of course, there are different stages of development in terms of institutional framework. Some
central banks are presently undergoing the process of shaping and consolidating their
governance, an endeavor intended to transform them into modern monetary authorities. And,
believe me, I know from experience how complicated such a process can be!
In the early nineties, when I took over as Governor of the National Bank of Romania, a
tremendous effort was needed to put into practice the transition from a monobank-type system
to a two-tier system. It was by no means a simple task to reform an institution that had operated
in the context of centralised planning of the entire economic activity and to separate
commercial banking operations from central bank operations, which remained the
responsibility of the NBR.
The new NBR only counted less than 5 percent of the former central bank employees, most of
them in the cash management and accounting units! Therefore, we had to build from scratch
several departments that are key to the functioning of a modern central bank, such as monetary
policy, economic research, banking supervision and regulation...
Fortunately, the NBR was given a helping hand in improving its governance structure when it
needed it the most. Just to give two examples, banking supervision was set up at the NBR with
the extremely useful support of De Nederlandsche Bank and the forex market was put in place
with the assistance from the central bank of Belgium. We are extremely grateful to both
institutions for their generous support.
Like they say, what goes around, comes around - it is now our turn to share our experience. I
am glad to say that the NBR - in a consortium with De Nederlandsche Bank - has been
involved since June 2015 in a Twinning project dedicated to the National Bank of Moldova, the
NBR providing expertise in the areas of regulation and authorisation, supervision, financial
stability and human resources.
While speaking about my own experience in reforming the NBR in the early 1990s, after the
fall of communism, the words of Walter Bagehot have come to my mind. Referring to the
needed changes in the governance framework of the Bank of England, he wrote in his book
"Lombard Street: A Description of the Money Market", published as early as 1873, that "putting
new wine into old bottles is safe only when you watch the condition of the bottle, and adapt its
structure most carefully".
I find this metaphor particularly adequate for guiding us in the demanding task of tailoring the
structure of central banks to the challenges of today and tomorrow. Let me add only that - as
I once put it - good wine is as difficult to make as good monetary policy. And proper dosage is
of the essence in both cases.