The Subprime Mortage Crisis and Central Banks: a Rock and a Hard Place

Urjit R. Patel
Urjit R. Patel Former Brookings Expert, Governor - Reserve Bank of India

November 11, 2007

The recent turbulence originating in the US sub-prime market led to rumours (and fear) as far away as Europe of collapse of intermediaries with concomitant concerns for the banking system. It led to comments and actions by relevant authorities, including politicians, that added to the uncertainty amongst the general public and market participants, which was most starkly observed in the context of UK’s fifth largest mortgage lender, Northern Rock (NR). An examination of the sources of confusion goes to the heart of two much-debated issues: (i) the separation of powers with respect to monetary control and financial supervision; and (ii) the practical limits to central bank independence. Briefly, proponents of separation argue that close connection with banks (a form of moral hazard) leads to bad monetary policy, while those arguing for a combined role say that the central bank should be concerned with the health of the banking system (from the perspective of preserving the efficacy of a monetary policy transmission channel).

The purpose of the article is not to apportion blame for the problems emanating from the NR matter, but rather to draw some lessons from an institutional point of view. The two aspects that pricked our interest are (a) the time lag between the financial sector supervisor (Financial Services Authority (FSA)) sharing its concerns with both the Treasury and the Bank of England (BoE) that NR “was systemically significant in the market conditions prevalent at the time”, and the media leak from the Treasury assuring liquidity support from the BoE (and a subsequent announcement that effectively guaranteed all deposits); and (b) the perception among stakeholders that there was a lack of clarity among UK’s financial decision makers, who are respected for professional sophistication and prompt action.

As India assimilates international best practices in the financial sector, the subject matter is important. Two sources of moral hazard – ownership and investment banker to the Government of India – that impact on the conduct of monetary policy have already been addressed in India. The RBI has divested its stake in financial intermediaries, and a government debt office at the Ministry of Finance will raise resources to finance the fiscal deficit; both changes are unexceptionable. However, an examination of recent events in the UK may lead to a re-evaluation of the debate for further changes in the institutional design related to the conduct of monetary policy, banking supervision, and the role of the government.

A plausible explanation of the manner is which the NR crisis was handled is that the FSA and the BoE did not see eye to eye. The Chairman of the FSA in his memorandum to the Treasury Committee admitted that he had a “slightly different” view from the BoE regarding the balance to be struck between preventing moral hazard and action to halt a crisis. Could it be that the BoE did not have faith in FSA’s analysis and assessment about the prospects of systemic risk if NR were to go belly up? Would BoE have come to a different conclusion if it had an informal feel about what was actually happening in the credit market and not just the formal information from the FSA?

Obviously the one critical dimension is coordination for effective action. There is something to be said in favour of a hierarchical structure as it can help to obviate delay on account of having to reach a consensus with counterparts at a coordination forum (in the UK, the Tripartite Coordination Committee comprises of the FSA, the BoE and the Treasury). In the present context, analogy with medicine is instructive. A radiologist (a fully qualified doctor, in his own right) takes x-rays and gives the specialist the films with a report; given the hierarchy in the medical field, the radiologist would not hold anything back and there is no question of the specialist being required to coordinate with the radiologist on the treatment for the patient. A recognised notion of primus inter pares keeps the wheels moving smoothly.

Conceptually, an important aspect of who is responsible for banking supervision is determined by who bells the cat. If rescues are primarily by the central bank (through, inter alia, lender of last resort/liquidity facility) then the central bank is a natural candidate for supervision accountability. If a rescue is financed on an explicit government fiscal basis, or, even deposit insurance then there is a good case for a separate government agency for supervision (in the UK, the latter model is in place). We occasionally forget that bailouts usually entail some form of taxation. Even the central-bank financed rescue – involving some form of liquidity injection – is taxation of the general public through seignorage (or inflation tax) and as such it is part of the government’s budget identity deployed by public finance economists to ascertain sustainability of the fiscal stance. Once the government is brought into the picture (given the fiscal dimension), then its views are paramount. Some would argue (sniff) that the system the current UK Prime Minister put in place when he was Chancellor has been undermined by the politics of wooing Middle England.

Monetary policy (and inflation targeting) is only one aspect of public policy so when other dimensions emerge, overriding the narrow mandate of a central bank can be rationalised. Some of the positions (“corner solutions”) parlayed in the Indian context about responsibility and mandates are not as clear cut as they are made out to be; nuance and subtlety is bread and butter of macroeconomic management, and can be ignored by stakeholders only at their peril. Economists feel smug about their insight regarding the merits of an independent (and narrow) central bank. Actually it is politicians who are smart; it helps to have a central bank (designated as independent) that can be blamed for taking away the punch bowl just when the party is getting started, but it can also overrule the central bank and be seen on the side of depositors, who also happen to be voters.