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Umbrella supervision and the role of thecentral bank 
Joseph G. Haubrich
Ã
and James B. Thomson
Ã
Federal Reserve Bank of Cleveland, PO Box 6387, Cleveland, OH 44101-1387, USA.tel:
þ
01 216 579 2802; fax:
þ
01 216 579 3050; e-mail: jhaubrich@clev.frb.org
Joseph G. Haubrich 
is a consultant and economist in Research at the Federal Reserve Bank of Cleveland, where he specialises in research relating to financial institutions and regulations. He also serves on the Bank Management Committee. Before joining the Bank in 1990, Dr Haubrich was Assistant Professor of Finance at the Wharton School of the University of Pennsylvania. Born in Oak Park, Illinois, Dr Haubrich earned his bache- lor’s degree in economics from the University of Chicago and his master’s and doctoral degrees from the University of Rochester in New York. He has also been a referee for several professional journals.
James B. Thomson 
is Vice President and Economist in the Office of Policy Analysis at the Federal Reserve Bank of Cleveland. His research interests focus on financial markets and institutions, historical banking, and gov- ernment-sponsored enterprises. Before joining the bank in 1986, Dr Thomson worked as a financial economist at the US General Ac- counting Office. He is currently a member of the American Finance Association as well as the Financial Management Association. He has published numerous papers on federal deposit insurance, bank structure, and bank capital regulation, including papers in the 
Journal of Finance
,
Journal of Money, Credit,and Banking
, and 
Journal of Small BusinessManagement
. Dr Thomson received a bache- lor’s degree in economics from Georgia Institute of Technology and a master’s and PhD in economics from The Ohio State University.
A
BSTRACT
Deregulation and financial consolidation have led tothe development of financial holding companies — allowing commercial banking, insurance, investment banking, and other financial activities to be conducted under the same corporate umbrella — and the Federal Reserve has been named supervisor of the consolidated enterprise. This paper will suggest economies of scope between the Fed’s inherent central banking responsibilities and those of an umbrellasupervisor, and that these dual roles benefit both the Fed and functional regulators.
 Journal of Banking Regulation
(2008)
10,
17–27.doi:10.1057/jbr.2008.21
INTRODUCTION
The specific roles and responsibilities of centralbanks vary widely, even among developednations. For instance, the Federal ReserveSystem is a major provider of interbanksettlement services and an interbank checkcollection system, as well as operating retail andwholesale wire-transfer systems. The Bank of Canada, on the other hand, is limited toproviding interbank settlement services, andthe Bank of England is not a bank supervisor atall. Despite differences in institutional structureand formal responsibilities, however, centralbanks all share three common objectives: toensure that the conduct of monetary policy is
&
2008 Palgrave Macmillan, 1745-6452
Vol. 10, 1 17–27
Journal of Banking Regulation 
17
www.palgrave-journals.com/jbr/ 
 
consistent with maximising social welfare(increasingly, methods such as promoting pricestability are seen as the way to achieve thisobjective), to maximise social welfare bypromoting financial system stability, and toprovide for and foster efficient and stablepayments systems.
1
Green and Todd
2
provide an economicanalysis of central banking activities with afocus on what they deem the essential centralbanking functions of the Federal ReserveSystem, specifically examining its role in thepayments system. Green and Todd argue thatthe fundamental payments role of the centralbank is to supply liquidity and settlementservices — that is, to provide a balance sheetwhere payment providers can settle their accounts with each other. The central bankprovides liquidity through intra- and inter-daylending to assure the stability and efficiency of the payments system. These authors then arguethat other Federal Reserve payments functionssuch as check processing and clearing, andoperation of retail and wholesale wire-transfer systems, are not essential central bankingfunctions. Green and Todd conclude that inthe absence of adequate economies of scopebetween the Fed’s payments system operationsand its central banking role, the Fed should berelieved from the provision of paymentsservices. (It is worth noting that the Congressvested the Fed with an operational role in thepayments system not because of perceptions of market failure in the payments system — although the same cannot be said for thediscount window — but rather as a consciousattempt to ensure the viability of the ReserveBanks.
3
)Using the framework of Green and Todd,we will examine whether an economic case canbe made for vesting the Federal Reserve withthe role of umbrella supervisor of financialholding companies. Unlike Green and Todd,who find no compelling economic rationale for the continued participation of the FederalReserve as a payments system operator, wewill show that there likely are economies of scope between the Fed’s inherent centralbanking responsibilities and those of an um-brella supervisor.In response to the panic of 1907, theNational Monetary Commission was formedto study the US financial system and to proposereforms to the monetary system as embodiedby the national banking system. The NationalMonetary Commission report was followed bythe creation of the Federal Reserve Systemwhose duties are‘To provide for the establishment of FederalReserve Banks, to furnish an elastic cur-rency, to afford means of rediscountingcommercial paper, to establish a moreeffective supervision of banking in theUnited States, and for other purposes’.
4
This Act is generally known by its short title,the Federal Reserve Act of 1913. It is clear from the original Federal Reserve Act andsubsequent revisions thereto that the FederalReserve Banks, through their discount win-dows, were to function as liquidity facilities tothe banking system and as lender of last resortto the financial system.
5,6
Complementary tothe discount window is the use of open marketoperations to inject liquidity into the financialsystem in response to external shocks.
7
Interestingly, while one purpose of the 1913legislation was to provide for more effectivesupervision of banking in the United States, theCongress did not vest the Fed with bankingsupervision and examination authority until1917.
8
Before this, Fed member banks weresupervised by the Office of the Comptroller of the Currency (OCC) — extending the OCC’ssupervisory authority to state-chartered banksthat joined the Federal Reserve System.Apparently, OCC oversight was seen assufficient disincentive for state banks to jointhe system, resulting in Congressional revisionof the Federal Reserve Act to provide for Federal Reserve supervision of state member banks.
9–11
Moreover, while subsequent legisla-tion has added to the Federal Reserve’s super-visory and regulatory responsibilities, it is not
Journal of Banking Regulation 
Vol. 10, 1 17–27
&
2008 Palgrave Macmillan, 1745-6452
18Umbrella supervision and the role of the central bank
 
clear whether these additional duties areeconomically justified along the lines of theGreen and Todd criteria.There are three sets of arguments thatattempt to justify a bank supervisory role for the Fed. The first involves Reserve Banks’exposure to loss through their discount win-dow operations and payments system guaran-tees. The second is related to financial systemstability and the potential for systemic bankingproblems. The depository institutions sector of the financial system is particularly important tothe central bank because it is the core of thetransmission mechanism for monetary policy(in that most monetary policy actions are aimedat setting the price or quantity of reserves in thebanking system). Moreover, banks as relation-ship lenders play an important role in creditallocation. A third set of arguments centres onthe role of banks in the payments system.Clearing and settlement services provided bydepository institutions are a crucial part of thepayments system and, for this reason, centralbanks have a vested interest in banking systemstability as a means for promoting an efficientand stable payments system.
12
While a healthy depository institutionssector (and financial system) is necessary for the central bank to effectively perform itsfunctions, it does not guarantee an active rolefor the central bank as supervisor of financialinstitutions or as a payments system provider. Inorder to guarantee an active role, the timelyflow of information on depository institutionsto the central bank, some of which can only becollected and assembled as part of ongoinginspections of financial firms and routineregulatory reporting, is required. Access tosuch information does not require the centralbank to be a direct supervisor, only that amechanism exists for the central bank toacquire the information it needs from theexisting supervisory agency(ies). On the sur-face, there appears to be no reason why the Fedcould not, for instance, rely on informationprovided by the OCC or Federal DepositInsurance Corporation (FDIC) to determine abanking institution’s eligibility for certaindiscount window lending programmes; as longas the central bank can inspect and perfect lienson collateral, the risks of lending are notsufficient to warrant more than a backupexamination authority.
13
The ability of the central bank to receiveinformation from functional regulators doesnot in and of itself suggest that this arrangementis efficient. To be efficient, the functionalregulator must collect the types of informationthe central bank requires, or the informationmust be collected more efficiently by theregulator than by the central bank. Proponentsof housing the bank supervision function (or even broader financial services supervision)within the central bank point out the im-portance of attracting and retaining qualifiedstaff whose expertise and skills are needed todistinguish what types of information are usefuland should be collected, and to evaluate theinformation that is subsequently collected. It isnot clear why a central bank would have moretrouble than a stand-alone regulatory agencyattracting and retaining researchers and analystscapable of providing informed analysis of thefinancial sector.
14
The central bank would,however, need to develop and retain a largestaff of researchers and analysts whose functionsoverlap those of staff at the supervisory agency,thereby reducing the benefits of consolidatinginformation collection with the examinationfunction, possibly to the point where the netsocial benefits of consolidation are essentiallyzero.
INFORMATION, MACRO-PRUDENTIALRISKS, AND UMBRELLA SUPERVISION
The Federal Reserve’s mandate for umbrellasupervision of financial holding companiesaims at two interconnected goals. As a safetyand soundness regulator, the Fed is chargedwith understanding and examining holdingcompanies and then enforcing the appropriateregulation. From the central bank standpoint,the Federal Reserve needs to understand risk atthe holding company level to accomplish its
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2008 Palgrave Macmillan, 1745-6452
Vol. 10, 1 17–27
Journal of Banking Regulation 
19Haubrich and Thomson
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