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Monetary policy is most effective when it is credible. Transparent and accountable policy-making can help to build up a reputation and credibility. Effective direct communications with the public, including the financial markets, other policy makers and the media requires that we speak with one voice in an even-handed way with our diverse counterparties and audience. Successfully refining our area-wide communications, aimed at making our strategy, and the monetary policy based on it, transparent so that it can be well understood by the large and varied population we serve, is one of the challenges faced by the Eurosystem and, by implication, one of our priorities.

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EMU AND BANKING SUPERVISION

Lecture by Tommaso Padoa-Schioppa

Member of the Executive Board of the European Central Bank at the London School of Economics, Financial Markets Group on 24 February 1999

TABLE OF CONTENTS

I. Introduction

II. Institutional framework

III. Industry scenario

IV. Current supervision

V. Crisis management

VI. Conclusion

Tables

I. INTRODUCTION

1. I am speaking here, at the London School of Economics, only a few weeks after one of the most remarkable events in the history of monetary systems: the establishment of a single currency and a single central banking competence for a group of countries which retain their sovereignty in many of the key fields where the State exerts its power. To mint or print the currency, to manage it and to provide the ultimate foundation of the public's confidence in it has been, from the earliest times, a key prerogative of the sovereign. "Sovereign" is indeed the name that was given in the past to one currency. And a British Prime Minister not so long ago explained her opposition to the idea of the single currency with the desire to preserve the image of the Queen on the banknotes.

2. For centuries money has had two anchors: a commodity, usually gold; and the sovereign, i.e. the political power. Less than 30 years after the last bond to gold was severed (August 1971), the second anchor has also now been abandoned. Although I personally think that political union in
Europe is desirable, I am aware that the present situation, in which the area of the single currency is not a politically united one, is likely to persist for a number of years. This means that we have given rise to an entirely new type of monetary order. For the people, the success of this move will ultimately depend on the ability of governments and political forces to build a political union. For the central banker and for the users of the new currency, the success will be measured by the quality of the currency itself, and such quality will be measured in the first place in terms of price stability. This is not only a requirement explicitly set by the Treaty of Maastricht, it is also, in the opinion of most, the "new anchor" that purely fiduciary currencies need after the gold anchor is abandoned.

3. My remarks, however, will focus on another, less fundamental but still important novelty of the monetary constitution that has just come into existence. It is the novelty of the abandonment of the coincidence between the area of jurisdiction of monetary policy and the area of jurisdiction of banking supervision. The former embraces the 11 countries that have adopted the euro, while the latter remains national. Just as we have no precedent of any comparable size of money disconnected from states, we have no precedent for a lack of coincidence between the two public functions of managing the currency and controlling the banks.

In the run-up to the euro this feature of the system was explored, and some expressed doubts about its effectiveness. I will tonight examine the problems of banking supervision in the euro area. The plan of my remarks is the following. I will first review the existing institutional framework for the prudential control of banks in EMU. I will then examine the likely scenario for the European banking industry in the coming years.
Against this institutional and industry background, I shall then discuss the functioning of, and the challenges for, banking supervision and central banking in the euro area, both in normal circumstances and when a crisis occurs.

II. INSTITUTIONAL FRAMEWORK

4. The origin and developments of modern central banks are closely linked to key changes undergone by monetary systems over the past two centuries. Such changes could, very sketchily, be summarised as follows.
First, paper currency established itself as a more convenient means of payment than commodity currencies. Second, commercial bank money (bank deposits) spread as a convenient substitute for banknotes and coins. Third, the quantity of money was disconnected from the quantity of gold. Thus, a double revolution in the technology of the payment system, the advent of banknotes and that of cheques or giros, has shaped the functions that most central banks performed over this century: monetary policy and prudential supervision. Man-made money made monetary policy possible. The fact that a large, now a predominant, component of the money stock was in the form of commercial bank money made banking supervision necessary.

Ensuring confidence in the paper currency and, later, in the stability of the relationship, one could say the exchange rate, between central bank and commercial bank money, were twin public functions, and, in general, they were entrusted to the same institution. Just as money has three well-known economic functions - means of payment, unit of account and store of value - so there are three public functions related to each of them. Operating and supervising the payment system refers to money as a means of payment; ensuring price stability relates to money as a unit of account and a store of value; and pursuing the stability of banks relates to money as a means of payment and a store of value. In each of the three functions commercial banks have played, and still largely play, a crucial role.

In an increasing number of countries the original triadic task entrusted to the central bank has now been abandoned in favour of a
"separation approach", according to which banking supervision has been assigned to a separate institution. Following the recent adoption by the
United Kingdom and Luxembourg of the separation approach, only two of the
12 countries represented in the Basle Committee on Banking Supervision
(Italy and the Netherlands) have the central bank as the only authority responsible for banking supervision. In all systems, however, whether or not it has the task of supervising the banks, the central bank is deeply involved with the banking system precisely because the banks are primary creators of money, providers of payment services, managers of the stock of savings and counterparties of central bank operations. No central bank can ignore the need to have a concrete and direct knowledge of "its" banking system, i.e. the banking system that operates in the area of its monetary jurisdiction.

Personally, I have an intellectual attachment to, as well as a professional inclination for, the central bank approach to banking supervision, due partly to the fact that I spent most of my professional life in a central bank which is also to this day the banking supervisor.
Yet I can see, I think, the arguments that have led a growing number of industrialised countries to prefer the separation approach. Such arguments basically point to the potential conflict between controlling money creation for the purpose of price stability and for the purpose of bank stability. On the whole, I do not think that one model is right and the other wrong. Both can function, and do function, effectively; if inappropriately managed, both may fail to satisfy the public interest for which banks are supervised.

5. Against this background, let me now describe the institutional framework currently adopted by the Treaty. As my description will refer to the area in which both the single market and the single currency are established, it will not specially focus on the problems of the so-called
"pre-in" countries, including the United Kingdom.

The current institutional framework of EMU (i.e. the single market plus the single currency) is a construct composed of two building blocks: national competence and co-operation. Let me first briefly review the main aspects of these two building blocks and then see how the Eurosystem relates to them.

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