Financial Regulators Need Independence

• Author: Udaibir S. Das, Marc Quintyn, and Michael W. Taylor
• Position: Deputy Division Chiefs in the IMF's Monetary and Exchange Affairs Department/IMF's Financial Sector Issues Representative in Indonesia

Granting more operational autonomy to the agencies that keep an eye on the financial sector can bolster financial stability.

Political interference in financial sector regulation and supervision contributed to the depth and magnitude of nearly all of the financial crises of the past decade.

As a result, the global community-increasingly aware of the need for good regulatory governance as part of a broader effort to prevent (or better manage) financial crises and improve financial sector supervision-has started to look for ways to insulate regulators and supervisors from improper influence. In recent years, the international community, including the IMF and the World Bank, has launched a number of initiatives to promote and monitor good governance-meaning the way institutions are run, supervised, and held accountable. We are at a point now where we can begin to draw some lessons and rethink our approaches to policymaking. We can also say with greater certainty that the independence of regulatory and supervisory agencies is a cornerstone of good regulatory governance, a topic that has received little attention.

A financial system is only as strong as its governing practices, the financial soundness of its institutions, and the efficiency of its market infrastructure. Instilling and applying sound governance practices is a responsibility shared by market participants and supervisors. Market participants must establish good governance practices to gain the confidence of their clients and the markets. Regulatory agencies play a key role in instilling, and overseeing the implementation of, good governance practices. And regulatory agencies need to follow sound governance practices in their own operations or they will lose the credibility and moral authority they need to be effective in their oversight role-opening the door to moral hazard, unsound market practices, and, ultimately, financial crises.

The case for independence

Establishing adequate independence arrangements is crucial to reducing the likelihood of political interference in the supervisory process. While many central banks have become legally more independent in the past 20 years-with demonstrably positive results in terms of increased monetary stability-the debate on regulatory independence is at the same stage the debate on central bank independence was two decades ago.

Nonetheless, independence for financial regulatory agencies matters for financial stability for many of the same reasons that central bank independence matters. An independent regulator can ensure that the rules of the regulatory game are applied consistently and objectively over time. If bankers know in advance that insolvent banks will be closed-and that lobbying to keep them open will fail-they will behave more prudently, thereby reducing the likelihood of a full-blown banking crisis. In contrast, when politicians become directly involved in enforcing regulations, they may...