New Advantages of Tying One’s Hands: Financial Supervision, Monetary Policy and Central Bank Independence

Abstract

We investigate the reasons that induce policymakers to assign banking supervision to central banks rather than involving authorities outside the banking sector. On the one hand, empirical results provide evidence that policymakers prefer that, conditional on several known features affecting supervisory task assignment, the latter are better to be given to central banks. On the other hand, higher central bank operational freedom (economic independence) is associated with a reduced degree of supervisory powers. This outcome is explained by a trade-off between central bank’s higher capability of achieving better information on the status of the banking sector and the possibility of making an instrumental use of monetary policy as a means to hide supervisory misconduct. We find that a feature mitigating this trade-off is the presence of some specific goals in the central bank’ statute aimed at increasing its political independence. We explore which statutory goals are better suited to solve such conflict.