CENTRAL BANK GOVERNANCE – THE PREMISE OF
CENTRAL BANK INDEPENDENCE
Florin Cornel Dumiter, Horatiu Florin Soim
”Vasile Goldis” Western University of Arad, Faculty of Economic Sciences
Arad, Romania
florin_dumiter@yahoo.com, horatiu_soim@yahoo.com
Abstract
Nowadays it can be observed an important trend towards the analytical and theoretical
evolutions and interconnections of: credibility, trustworthiness, authority and central bank
governance. A high degree of education and professionalism of the central banks officials
granted through: independence from political pressures, pressures that finally exists through
monetary stimulants of short term benefits, will lead to a high level of trustworthiness. In this
paper, we present and discuss global trends in central bank governance based on some
aspect: central bank independence, central bank accountability and central bank
transparency.
Keywords
Central bank governance, monetary policy, trust and authority, central bank
credibility, transparency and accountability, corporate governance
1. THEORETICAL ASSESSMENTS REGARDING CENTRAL
BANK GOVERNANCE
In a growing literature on the topic of governance, the meaning which is most useful
for the explication of the relations of global financial governance in general, and
monetary governance in particular, is social and relational. As we can see:
”governance…does not necessarily demand tangible institutions of government. It
may not even call for the presence of explicit actors, whether state-sponsored or
private, to take responsibility for rule-making or enforcement. To suffice, all that
governance really needs is a valid social consensus on relevant rights and values”.
[1]
Governance is therefore an inherent social, relational phenomenon. While
governance relations may not develop institutional forms in practice, over time they
need not rely on institutions of government. “Governance refers to activities backed
by share goals that may not derive from legal and formally prescribed
responsibilities and that do not necessarily rely on police powers to overcome
defiance and obtain compliance. Governance…is a more encompassing
phenomenon than government. It embraces government institutions, but it also
subsumes informal, non-governmental mechanisms… Governance is thus a system
of rule that is as dependent on intersubjective meanings as on formally sanctioned
constitutions and charters”. [2]
Viv Hall in his study regarding the importance of central bank governance emphasis
that: „conceptually, governance is underpinned by the need for accountability, and
in practice, successful governance can only be achieved with the assistance of
various forms of transparency. However, just as there has been limited consideration
of accountability issues in the research literature until recently, so too there has been
little in depth analysis of central bank governance questions”. [3]
Being in compliance with Hall’s view, Siklos emphasis that: “governance questions,
until recently, largely ignored in discussions about the relationship between the
government and the central bank should be treated on an equal footing with the
accountability and the transparency considerations”. [4]
In our opinion, some important aspect as: monetary policy objectives, the decisionmaking process and the macroeconomic outcomes and performances of a central
bank are key features regarding central bank governance, aspects which must be
related to corporate governance issues in transparency and accountability.
Lessons from corporate governance for commercial enterprises, which are country
specific, can be useful for central banks. In 1999, the OECD Principles of Corporate
Governance were issued and have just been revised. The OECD notes that corporate
governance “... involves a set of relationships between a company’s management, its
board, its shareholders and other stakeholders. Corporate governance also provides
the structure through which the objectives of the company are set, and the means of
attaining those objectives and monitoring performance are determined.” [5] This
definition implies that a good governance structure ensures that the objectives and
tasks delegated to an institution are performed effectively and efficiently, thus
avoiding lack of resources.
The Basel Committee on Banking Supervision issued the same year Enhancing
Corporate Governance for Banking Organizations to supplement the OECD
principles with regard to commercial banks. The recommendations include: (i)
establishing strategic objectives; (ii) setting and enforcing clear lines of
responsibility and accountability; (iii) ensuring that board members are qualified and
conflicts of interests are monitored; (iv) ensuring there is appropriate oversight by
senior management; (v) effectively using the work conducted by internal and
external auditors; (vi) ensuring that incentive structures are consistent with the
bank’s ethical values and objectives; and (vii) conducting corporate governance in a
transparent manner.
„Commercial banks, due to their special functions and their impact on the economy,
should be held to a higher corporate governance standard that emphasizes their
fiduciary responsibilities compared to other enterprises”. [6] This approach can be
extended one step further for central banks, due to the implications of their actions.
[7]
Analyzing the economic literature regarding central bank governance we can
observe that there is “no one size fits all” best practice governance framework. The
individual central bank should therefore continue aiming for excellence in monetary
policy and corporate governance of they own rights, rather than some common
operational governance model. In this respect, a number of key desirable principles
should be adhered to:



the monetary policy objectives must be explicit stated through an effective
constitutional and legal framework. This fact includes some rights and
obligations as the following: the degree of operational independence of the
central bank, the role and duties of the governing board, the role and duties
of the chief executive;
ongoing political and public support for the monetary policy framework,
maintained through a high level of transparency and strong
accountabilities to government, to Parliament, to financial markets, and to
the public at large;
an effective governance culture for the central bank, engendering public
disclosure of the extent to which statutory and other obligations have been
met, and in a corporate governance sense, ensuring best quality financial
disclosure and risk management practices.
2. CENTRAL BANK INDEPENDENCE
2.1 The rationale of central bank independence
It is generally believed today that, throughout the world, ”independence” is a
prerequisite for achieving the goals that traditionally have been assigned to central
banks – specifically for achieving price stability. But the meaning of central bank
independence is often misunderstood, which leads to reluctance by the legislators
and political elite in developing countries to embrace it convincingly. Central bank
independence does not mean literally independence from government, because
central banks, especially in developing and emerging countries, are almost part of
the government. The relationship of central banks to the rest of government is, in
practice, much more complex than the term independence might suggest.
The rationale for granting independence to central banks is to insulate the conduct of
monetary policy from political interference, especially interference motivated by the
pressures of elections to deliver short – term gains irrespective of longer – term
costs. As The Economist noted nearly twenty years ago, “The only good central
bank is one that can say NO to politicians”. [8] The intent of this insulation,
however, is not to free the central bank to pursue whatever policy it prefers – indeed
every country specifies the goals of monetary policy to some degree – but to provide
a credible commitment of the government, through its central bank, to achieving
those goals, especially price stability.
“The logic of central bank independence can be noticed by looking at the different
views of elected politicians and of central bank decision makers. Democratic leaders
run for office promising change and improvement rather than continuity and
stability, whereas an incoming head of a central bank will almost certainly want to
continue the policies of a successful predecessor and will emphasize his or her
commitment to do so. Political independence and non-partisan monetary policy
provide the promise of monetary policy stability over time, which in turn stabilizes
expectations in asset market. Such stability and continuity are essential for a
successful monetary policy”. [9]
2.2 The gap between the jure and de facto independence
The most common way to tackle the question of credible commitment consists in
having recourse to the judicial system. ”The law, constitutional or less fundamental
is obviously one solution to the dynamic inconsistency problem”. [10]
Legal enactment of a commitment significantly increases its credibility, because of
the heavy penalties incurred if the commitment is not honoured. The legalistic
conception, which views law as the principal source of credibility is deduced from
this hypothesis. Its almost visible manifestation can be found in the importance
attribute to the central banks statues. Thus, for example, most of the indicators
supposed to measure the independence of central banks are constructed by encoding
legal data, and especially their statues.
The legalistic conception has already been the object of numerous criticisms [11],
[12], [13]. It has been pointed out that the a wide discrepancy can exists between de
jure independence as measured by these indicators, and de facto independence, as
revealed by actual behaviour. Two explanations might exist: either the
incompleteness of the law, with grey areas in term of defining rights and obligations
of each party, or the structural and significant differences between the provision of
the law and the actual practices.
To these criticisms, which are equally valid for private individuals, it can be
emphasis new ones, because they are specific to the situation of interest, where it is
government that must be constrained.
The government, as the trustee of sovereignty, possesses not only a whole arsenal of
means of exerting pressure, but also considerable prerogatives in legislative matters.
At the very least, it retains the capacity to propose laws. Thus, the aptitude of laws
to subjugate the sovereign government credibly appears to be highly questionable.
There is no short-age of examples where governments have contravened
constitutional clauses without difficulty.
2.3 Benefits of central bank independence
Independent central banks have total freedom to elaborate and conduct monetary
policies. Thus these banks can choose freely the instruments to be used.
Independence includes the power to define its own internal structure, as well as the
way in which supervision and control of the financial system will take place. Here it
is important to mention that the main criticism against the central bank
independence is based on political arguments. The argument is that turning over
decisions about interest rates, exchange rates, the efficiency of the financial system,
and other monetary matters to a staff of unelected officials, is simply
"undemocratic". In a democratic society, it is argued, all decisions should be subject
to scrutiny by the elected members of the legislative and the concept of an
independent central bank is, therefore, not acceptable.
Although there are plenty of other areas where decision making is delegated to
autonomous central bank has to report in some form or another to the Legislative
branch, which has the ultimate power to change the laws governing the central bank.
The independent unelected officials - the judiciary is a prime example - there is a
fundamental confusion here between being independent and lacking accountability.
No central bank can be totally independent in the sense that it does not have to
answer to anyone. Even the most autonomous central bank has to report in some
form or another to the Legislative branch, which has the ultimate power to change
the laws governing the central bank. ”Independence signifies ignoring pressures,
whatever its source. The independence of central banks goes... beyond independence
from political, executive and legislative power. For me it also equates with
independence from private or collective economic interest, autonomy versus the
short term, frequently imposed by capital markets and, finally, freedom of action
vis-à-vis the monetary policy of other central banks”. [14]
An extensive literature examines the relationship between the independence of the
central bank and macroeconomic performance. The empirical studies generally find
an inverse relationship between measures of central bank independence and both
average inflation and variability of inflation, for both developed and developing
countries. These are only correlations, however, and thus do not prove causation.
The inverse relationship could also reflect the fact that countries with less aversion
to inflation might be less likely to have independent central banks.
In addition, there is no consistent evidence of a relationship between central bank
independence and real economic activity or consistent evidence that central bank
independence lowers the cost of reducing inflation or increases the effectiveness of
stabilization policy. On balance, the evidence for the benefits of central bank
independence is strong enough to satisfy those who find theoretical arguments
persuasive, although it is not strong enough to convince sceptics.
3. THE THREE
GOVERNANCE
PILLARS
OF
CENTRAL
BANK
Another very important aspect represents the correlation between central bank
independence and the governance of the central bank, aspect that has generated
considerable debates over the recent years. As central banks are created by
Government legislation, we can survey that there is always some kind of
relationship between the central bank and the Government. Indeed, the central bank
and the government cannot be completely separated; the actual debate regarding this
problem consists in the appropriate degree of separation between them [15].
The independence of the central bank and the governance of the central bank are
related problems of the central bank. On the one hand, central bank independence
refers to the ability of the central bank to establish the objectives and the use of
monetary policy instruments without instruction, guidance or interference from the
Government, and, on the other hand, central bank governance refers to the three
pillars: central bank independence, central bank transparency and central bank
accountability; for this reason a good governance in a central bank is a function of
its independence.
The word governance is synonymous with the exercise of authority, direction and
control. A central bank can be easily seen as a corporate body, and all the
corporate governance issues for a corporation are mostly applicable for a central
bank. Similarly, the issues of authority (authority to execute its policies), direction
(direct the economy towards its objectives) and control (control of its tools and
techniques for achieving its goals) are also applicable for a central bank.
Previously, the central bank literature was mostly concentrated on the independence
issue, but the current literature is very much directed towards governance of central
bank, which includes, analytical framework of degree of autonomy, directors and
their functions and the management of the central bank board.
3.1 The interconnection and the implications of the three pillars of central
bank governance
Central bank governance is arguably defined by a number of key-concepts of pillars,
which together should form the basis of the legal framework governing a central
bank and on which central bank governance should rest, that is independence,
democratic accountability and transparency. While these concepts are in the first
instance introduced separately, this is not to say that they should be considered in
isolation. In fact, we can argue that these three pillars are intertwined and in some
instances positively or negatively correlated.
The relationships between the three pillars of central bank governance and
stakeholders, as well as the multiple ways in which these pillars relate to each other
are presented in Figure 1.
In modern democratic societies, independent central banks take their legitimacy
from their accountability vis – á – vis of those (for example the public at large or the
Parliament) who have delegate to them the tasks of gaining and maintaining price
stability, objective that is seen as a public good. For this purpose, it must be
establish a high degree of central bank independence, because of the monetary
temptations of the political leaders, temptations which are in conflict with the price
stability objective; moreover, it is important the hypothesis in which monetary
policy needs to be delegated to an specialised institution.
The need for transparency is an essential condition of accountability as is founded in
the democratic deficit hypothesis. The modern central bank architecture must
encompass the three pillars of central bank governance (Figure 1) for the purpose of
increasing and maintaining a high level of central bank credibility. Moreover, the
international consensus agreed by practitioners and academics referring to the
central bank governance pillars: central bank independence, central bank
accountability and central bank transparency, can generate divergent view from the
society perception, Parliament, Government, all those elements creating a long run
perspective reforms towards a credible central bank.
Being in compliance with the independence granted by public authorities and of the
expected mandate, the central bank has the duty to communicate the monetary
policy results. For this purpose it needs to be established a dialog between society
and central bank, including an exercise of accountability from the political institutes.
The potential conflicts between the three pillars of central bank governance are
focused on central bank independence and on central bank accountability. If there
exists a negative correlation between these two pillars, than it can be establish de
veto mechanism – a component of the accountability pillar – who can subjugate
central bank independence through the behavioural influence of the central bank
behaviour by the Government or Parliament. In the presence of this mechanism, it
must be explicit and public stipulated the appliance conditions for it, in order to
override a possible political influence over the central bank. Contrary, a veto clause
will subjugate both central bank independence and accountability.
Consensus
Consensus
Public at
large
Consensus
Public good:
Price stability
Accountable to
Parliament
Accountable to
Govern
ment
Delegation to
Enhace
Enhance
Independent
from
Central
bank
E
n
h
a
n
c
e
Transparent vis – á - vis
Financial
markets
Figure 1 Pillars of central bank governance
Source: Laurens, Arnoane & Selgado (2009).
A similar arrangement can be realised through the dismissal power of the central
bank officials through the lack of performances – arrangement who can be seen as
an ex post mechanism of central bank accountability.
These potential conflicts between central bank independence and central bank
accountability implies the presence of an de veto mechanism and an dismissal
power, which mean taking into account the several country circumstances, and
especially the specifications and the elements of their political systems.
3.2 The network of central bank governance relationships
Central bank governance it can be identified, especially, in the independence of the
central banks. In our opinion, central bank governance is a concept that emphasis a
high number of entities that participates in implementing monetary policy:
 Central banks;
 Parliament;
 Society;
 Governments;
 Private entities;
 International financial institutions;
Moreover, it is very important to present and analyze the global financial
governance system and the important role played by the independent central banks.
Figure 2 presents the relational channels of the central bank governance, as well as
the different entities capacity of gaining central banks credibility. These
relationships, as well as the appropriate channels will be described by the
alphabetical letters of the figure arrows, starting with A and finishing with K.
Channel A results from the grant of a charter’s independence to the central bank by
the government. This is a public pronouncement, a speech act with performative
effect on the part of the government. This grant of independence may come in many
forms and statutory/constitutional forms are preferred by market actors. It may
include operational independence and/or goal independence – choice of acceptable
rates of inflation.
Channel B represents the central bank capacity in influencing the government’s
fiscal policy, through advice, debate between central banks officials and Finance
Ministers specialists. In the case of central bank independence, this influence is
realised by the public pressures of the central bank governor regarding adopting
prudent fiscal policies by the government. The degree of authority of this form
available to a given central bank is proportional to both its degree of real
independence from the government and to the credibility with which market actors
view the central bank’s independence, pronouncements and monetary policy
decision-making record.
The government delegates deontic powers, through cannel C, to the finance ministry
to determine exchange rate policy, and often to formulate fiscal policy, or at a
minimum to manage the government’s debt structure – assessing the forms and mix
of maturities of debt instruments to be offered on the markets, or otherwise to be
contrived. In the case of central bank independence, private entities consider that it
will be able to monetize the public debt, especially through decreasing the
purchasing parity power of the title holders.
In countries that retain monetary sovereignty, the finance ministry exercise deontic
powers, through channel D, to determine the direction of national exchange rate
policy, and to instruct the central bank to execute its exchange rate policy by buying
and selling the national currency, and instruments denominated in the national
currency on the foreign exchange market. The central bank, if it is independent, may
asses independently whether to “sterilize” the effects on the money supply of
transactions oriented towards exchange rate management.
Commercial
banks
G
I
F
H
Central
bank
J
E
B
Bond
markets
A
K
FOREX
markets
D
Rating
agencies
H
K
I
Finance
ministry
Government
J
C
Figure 2 Central bank governance networks
The central bank in turn may exercise deontic powers, through channel E, to
influence the exchange rate policy of the finance ministry, again either through
advice sought by the finance ministry, or through pressure of public pronouncements
on finance ministry exchange rate policy, for independent and credible central
banks.
The central bank has quite strong deontic power, channel F, over commercial bank
lending and practices through its reserves requirements, its regulatory functions in
many countries and particularly through its control over the issue of currency and
intermediated credit.
The major deontic power of the commercial banks, channel G, is the power to
induce the central bank, when it chooses the accommodate the commercial bank, to
generate money to back the credit that commercial banks extend to private or public
sector borrowers.
Through channel H, the central bank assigns to actors in the bond markets and the
foreign markets the deontic power to adjudicate the credibility of its commitment
mechanism and of the money that it generates. This is assigned when open market
operations are chosen as the instrument of monetary policy and of exchange rate
policy which the central bank executes on behalf of a finance ministry – or in
countries with currency boards, on its own behalf.
The actors in the bond market exercise delegated deontic power, channel I, to
adjudicate the credibility of the central bank monetary policy and also signal to the
government their judgment of the prudence of government fiscal policy. This
authority is exercised in the decision to extend credit to governments through
purchases of disintermediated sovereign debt instruments.
The foreign exchange markets similarly exercise delegated deontic powers, channel
J, to adjudicate the credibility of the central bank monetary policy and the prudence
of government fiscal policy. An adverse judgement is rendered by a drop in the
exchange rate of the currency in question. This adverse judgement can be welcomed
or rued by the government, dependent upon the exchange rate policy formulated by
the finance ministry.
Private ratings agencies exercise delegated deontic powers and authority, channel K,
to “grade” the credibility of central bank monetary policy and government fiscal
policy and assign this credibility a ranking relative to that of other issues of debt.
The rating agencies engage in ongoing surveillance and issue ongoing signals to the
markets through ratings changes. Ratings downgrades can result not only in higher
yield spreads (demands for higher risk premiums by bond investors as a quid pro
quo to purchase fresh debt) but also may result in a complete suspension of access to
the disintermediation global capital markets.
4. CONCLUSIONS
The traditional argument in favor of a strong and independent central bank is that the
power to spend money should in some way be separated from the power to create
money. Numerous episodes in the world’s economic history testify to a
government’s potential tendency to abuse of its power to create money. During
elections periods, many governments have given in to the temptation to improve its
expenses or to reduce interest rates. This may boost spending and employment in the
short term, but ultimately it usually also causes higher inflation over the long term,
unless the capacity of the economy can meet this higher level of demand.
Politicians, the elected representatives who make laws and determine public policy,
are themselves subject to pressures inherent in the structure of government. They are
expected to respond to the desires and needs of their constituents. And constituent
expectations tend not to be tempered by such realities as cost and resource limits. In
short, politicians are under pressure to accomplish more than available resources
permit. This can mean attempting more than we can afford or are willing to pay for.
Such pressures probably give our national policies and goals an inflationary tilt.
It is clear, from the conceptual and empirical material presented above, that there is
no ideal model for best practice central bank governance, and no one-to-one
correspondence between excellence in monetary policy performance and excellence
in governance.
It can be sustained, however, that there are key governance principles (or basic
common elements), which should underpin excellence in central bank governance;
also that the individual economy frameworks should then allow for their different
political systems, constitutional and legal frameworks, commercial and financial
institutional structures, and attitudes of the public at large (i.e. for different models).
The common elements and different models should also be seen in the context of
each of our four central banks having maintained strongly credible monetary policy
performance over the past decade. An effective central bank governance should be
underpinned by:
• an effective constitutional and legal framework, stating explicitly the
objectives for monetary policy;
• ongoing political and public support for the monetary policy framework,
maintained through a high level of transparency and strong accountabilities
to government, to Parliament, to financial markets, and to the public at
large;
• an effective governance culture for the central bank, engendering public
disclosure of the extent to which statutory and other obligations have been
met, and in a corporate governance sense, ensuring best quality financial
disclosure and risk management practices.
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