Financial stability within the broader mandate of central banks: a political economy perspective



Financial stability within the broader mandate of central banks: a political economy perspective

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Viral Acharya, CV Starr professor of economics at NYU’s Stern School of Business, believes central banks should be able to handle financial crises without being subject to the short-term vagaries of politics. But they should also be democratically accountable. In this article prepared for March 2, 2015 A conference at the Brookings Hutchins Center on Fiscal and Monetary Policy, Acharya offers four solutions to help find this balance:

  1. Rules: Acharya suggests that Congress create rules that limit how the Fed can react in a crisis. For example, Congress could require the Fed to provide emergency liquidity only to institutions meeting a minimum solvency standard. As well as letting people know what to expect in a crisis, it could help protect the central bank from political criticism afterwards.
  2. Wider scope of the regulations: Acharya argues that Congress should let the Fed regulate growth and leverage in shadow banks, institutions normally outside the jurisdiction of the Fed. Otherwise, financial institutions could escape regulation by simply calling themselves other than banks. To avoid this “regulatory arbitrage”, Acharya suggests regulating “by function rather than by form”.
  3. Financial stability mandate: Acharya thinks Congress should give the Fed an explicit financial stability mandate. In a booming economy, Fed regulations limiting financial excesses could be politically unpopular. (How many politicians would support higher capital requirements for banks, which would result in some voters being denied a mortgage?). An explicit financial stability mandate could help the central bank justify steps taken to reduce excessive risk-taking on Wall Street in good times. Additionally, since there are limits to what regulation can achieve, Acharya believes the Fed should consider using interest rates as a tool to promote financial stability.
  4. Responsibility sharing: Acharya argues that regulators other than the Fed should also play a role in crisis management and prevention. Such a sharing of power would make it difficult for politicians and regulated institutions “to influence the entire regulatory apparatus” by influencing “one regulator”.

Acharya believes Congress has made significant progress in each of these four areas, particularly in the Dodd-Frank financial reform law. But he maintains that there is still a lot of room for improvement.

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