Essential Elements of Independence
The need for regulatory and supervisory independence in the financial sector stems broadly from the same sources as central bank independence, and finds its origin in the literature on time inconsistency in economic policy.1 Time inconsistency occurs when the government’s optimal long-run policy differs from its optimal short-run policy, leading to situations where the government in the short run reneges on its long-term commitments. Thus, time inconsistency emphasizes the need for a credible and binding precommitment to a particular mandate that prevents violations ex post. In the case of monetary policy, Rogoff (1985) argued that one way to achieve policy credibility is to place it in the hands of a person or institution who weighs inflation deviations more heavily than in the social welfare function—the “conservative central banker” whose preferences will differ from those of the government. The need for agency independence follows from this: For the central banker to have a different reaction function, they need to be independent from government.
The analogy with supervisory independence is straightforward. Bank liquidations are typically politically unpopular, as they can result in genuine hardship for depositors and other creditors, many of who will also be voters. Vote-maximizing politicians with short time horizons may be concerned about the short-term costs of bank closures, whether fiscal, in terms of lost votes, or in terms of lost campaign contributions, and will be sensitive to the demands of these groups, particularly if these are politically well organized. Politicians may be tempted, as a result, to put pressure on supervisors to organize a bailout or exercise forbearance to avoid short-term costs. However, short-term forbearance may be the cause of higher longer-term resolution costs. Accordingly, politicians face the same incentives in relation to failing banks as they do in relation to the goal of price stability. Hence the need for independent regulators whose reaction function differs from that of their political masters.
Let us now define ways in which this independence could be made operational. For financial supervisors, there are actually four dimensions to it—institutional, regulatory, supervisory, and budgetary independence.
Institutional independence is achieved if the agency as an institution is separate from the executive and legislative branches of government. Institutional independence encompasses three critical elements:
the terms of appointment and dismissal of its senior personnel should be clearly defined to avoid political interference, and thus ensure security of tenure;
the agency’s governance structure should favor decision-making by a commission, as opposed to vesting all responsibilities in the chairperson, to reduce external influences;
decision-making should be as open and transparent as possible, to minimize the risk of political interference.
Regulatory independence refers to the ability of the agency to have an appropriate degree of autonomy in setting prudential rules and regulations for the sectors under its supervision. Autonomy in setting prudential regulations will help in ensuring that the regulatory framework is stable and predictable, complies with international best practices, and is not contaminated with political considerations.
Supervisory independence refers to the degree of independence with which the agency is able to exercise its judgment and powers in such matters as licensing, on-site inspections and off-site monitoring, sanctioning, and enforcement of sanctions (including revoking licenses), which are the supervisors’ main tools to ensure the stability of the system.
Supervisory independence is the most difficult of the four dimensions of independence to guarantee. To preserve its effectiveness, the supervisory function typically involves private ordering between the supervisor and the supervised institution. However, the privacy of the supervisory process makes it vulnerable to interference, from both politicians and supervised entities. Political interference (and interference from the industry itself) can take many forms, and can indeed be very subtle, making it difficult to shield the supervisors from all forms of interference.
As the supervisory process starts with the act of licensing a financial institution, supervisors should ideally have the final word on who can enter the system. A typical situation that may lead to problems is one where the government has the final say over the licensing of individual banks and may—either out of self-interest or lack of technical ability to assess business plans—license unviable projects. The same degree of autonomy should apply to exit procedures, based on the same argument that supervisors are in the best position to decide on the viability of individual institutions. Decisions to close or not close an institution that are taken on political, rather than technical, grounds may result in the prolongation of the life of insolvent or corrupt institutions, thus ultimately increasing resolution costs. Moreover, if the power of license revocation is not in the hands of the supervisor, the threat by the supervisor can be empty, and their other powers undermined.
To strengthen supervisory independence, it is recommended that (i) supervisors enjoy legal protection in the performance of their duties. The absence of proper legal protection in many instances has a paralyzing effect on supervision; (ii) supervisors enjoy appropriate salary levels to attract better qualified individuals who may be less prone to bribery; (iii) rules-based system of sanctions and interventions be applied (see Rules Versus Discretion Supervisory Intervention Finacial Institutions).
Budgetary independence refers to the ability of the regulatory agency to determine the size of its own budget, and the specific allocations of resources and priorities that are set within the budget. Regulatory agencies that enjoy a high degree of budgetary independence are better equipped to withstand political interference (which might be exerted through budgetary pressures), to respond more quickly to newly emerging needs in the area of supervision, and to ensure that salaries are sufficiently attractive to hire competent staff.