Financial supervision has changed substantially during last two decades. From overconservative supervision scheme the world has moved to much liter and liberal supervisory scheme.
With a view to limiting the risk of financial instability, significant restrictions on the lines of business, geographical location and operation of financial enterprises existed in many countries, sometimes supplemented by ceilings on deposit rates, new entry restrictions and official tolerance of cartel-type agreements. The result, in many cases, was the establishment of cartelized oligopolistic clubs of semi-specialized intermediaries, that led to the appearance of largely self-regulating clubs with agreed rules of conduct.
The cartelized oligopolistic structure limited competition, guaranteed franchise value and reduced likelihood of failure. This was partly due to international stability achieved by the Bretton Woods arrangements. This reduced the need for financial supervision. So over the years banking supervision did not play the central role in the central banking activities, due to the structure that reduced the need for regulation and allowed self-regulation. In the United States the Federal Reserve became the major player in regulation and supervision only after enactment of Bank Holding Company act in 1956 that assigned central bank supervisory function over BHCs.
Oligopolistic structure reduced competition, efficiency and innovation. The protected and regulated financial system was abolished under the conditions of increased international competition, technological innovation, drive for efficient, improved services for customers and return of liberal, market based ideology. Instability and failures became frequent and led to greater involvement of central banks in supervisory activities. Moreover, this also led to the blurring of the previously clear boundaries between different types of financial intermediation. Universal banking became more popular and commonplace. Banking mixed with insurance, bank assurance, and undertook fund management. Eventually, this meant that the attempt to supervise separately by function would end up with multiple supervisors involved with the same institution.
So, one obvious conclusion that was reached was placing responsibility for the supervision of all financial intermediaries in one institution. But this naturally caused a problem for central banks, wishing to maintain internal control of banking supervision.
On the other hand, such unification results in economies of scale arising from single set of central support services (information services, premises, human resources, financial control etc), a unified management structure, a unified approach to standard-setting, authorization, supervision, enforcement, consumer education and tackling of financial crime. It also results in economies of scope implying that single services regulator will be able to tackle cross-sector issues more effectively and efficiently than multiple separate specialist regulators.
Alternatively, placing all supervision under the roof of the central bank would require taking responsibility for supervision over activities which lay outside its historical sphere of expertise and responsibility. One obvious example of this would be market price risk versus credit risk. Banking institutions mostly deal with credit risk, while securities firms face market price risk that derives from fluctuations in market price of securities held by the financial institution.
An even more serious problem would arise out of how to set the boundaries between those sub-sets of depositors/institutions which would be covered by the deposit insurance, the lender of last resort (LOLR) facilities, etc., and those not so covered. The central bank would be unwilling to extend its operational remit to dealing with financial markets and institutions where issues related to systemic stability are limited and customer protection of much greater importance.
One more proposal was delegating supervisory responsibilities to multiple agencies outside the central bank. This option requires full and free exchange of information among multiple agencies at national and international level. Within the European Community, legislation has imposed a duty on these authorities to cooperate, however implementation of this may be more difficult. This model also requires the harmonization of capital standards. This would imply that the risks incurred would be subject to the same standards irrespective of the unit of the corporate organization they are incurred.
An obvious problem with the model is allocation of responsibilities between different supervisors. Traditionally, countries have organized their prudential framework along institutional lines. This has generally been on a tripartite basis (banks, securities firms, insurance companies), except in countries such as Germany and Switzerland which have universal banking systems, where securities business is generally regarded as the banking business. So it is difficult to allocate it under the specific supervisor.
One alternative proposal was to divide the structure of supervision into two purposes: systemic stability (prudential supervision) and customer protection (conduct of business supervision). This was the Twin Peaks proposal, advocated in the UK primarily in the work of Michael Taylor (1995 and 1996). The supervisory body charged with customer protection would naturally take the lead in some areas, markets and institutions. Contrary to this, the body charged with responsibility for systemic stability would take the lead in dealing with the payments system, and with certain aspects of banking and, perhaps, other financial markets. In practice, however, to a large extent a �systemic stability� regulator and a �customer protection� regulator most probably would implement the regulation of a bank in exactly the same way, so there would be considerable duplication and overlap. Dealing with two supervisors would also raise the cost of supervised entities. The Twin Peaks concept has, so far, not found favor in practice, though, the US system has evolved in a way that approximates it, with the Federal Reserve coming close to a systemic stability (prudential) supervisor, and the Securities and Exchange Commission (SEC) undertaking the conduct of business role.
One important point is dividing tasks according to micro and macro approaches. Customer protection issues are generally associated with micro level decision-making, while systemic stability deals mostly with macro, however to some extent with micro-level as well. It has been argued that keeping macro part of systemic stability issues with the central bank and micro part with an independent agency would restore clarity and responsibility.
It is worth discussing how this problem applies to developing countries. The financial structure in developing and transitional countries is quite distinct from developed economies. They tend to be simpler, more dependent on standard commercial banking and degree of blurring boundaries in these countries is low. In developed countries the complexity of financial sector and blurring boundaries force central bankers to extend their activities further away from traditional limits. It also creates multiplicity of supervisors or unified supervisory body outside the central bank. This is not the case in developing countries. The banking system, insurance companies and stock exchange can co-exist without much friction or overlap.
Thus, the strength of argument concerning the changing structure of financial system and whether the central bank should regulate non-bank financial institutions as well largely depends on the degree of blurring boundaries between various types of financial intermediaries and readiness of the central bank to tackle with the responsibilities that lie outside its historical sphere of expertise. Practically observed trend towards separation of regulatory function from the central bank can be explained by the development of the financial markets in different countries that tends to make this argument decisive.
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