Central Banking Governance in the European Union: A Comparative Analysis

Central Banking Governance in the European Union

This book fills a gap in academic literature on the politics and public policy aspects of central banking in Europe, by conducting a theoretically informed and empirically grounded analysis of central banking governance before and after the establishment of the Economic and Monetary Union (EMU). The main framework for analysis is a ‘multi-level institutionalist approach’, articulated on three interconnected levels: the ‘systematic level’, which encompasses the European, transnational and international arenas; the ‘national-level’, which considers the configuration of the domestic socio-economic and political environment in which each central bank operates; and the ‘micro-institutional level’, which deals with the specific features of each central bank. Methodologically, the research engages in a structure-focused comparison, using qualitative methods. In order to do so, it conceptually develops and empirically applies the notion of ‘mode’ of central banking governance, operationalized through four main components: • • •

•

the legal framework central bank ‘autonomy’ (or de facto independence) from the political authorities central bank ‘policy capacity’ in three policy areas that are crucial for central banking governance, namely monetary and exchange rate policies, financial regulation and supervision central bank legitimacy.

Empirically, this monograph focuses on the Bank of England, the Bundesbank, the Banca d’Italia and the ECB over the period 1979 to present, with particular attention paid to the last decade. It is grounded in extensive primary research, enriched by interviews with policy-makers. Central Banking Governance in the European Union will be of interest to students and researchers of Politics, Economics and Political Economy. Lucia Quaglia is Senior Lecturer in Politics and Contemporary European Studies at the Sussex European Institute, University of Sussex, UK.

UACES Contemporary European Series Edited by Tanja Börzel, Free University of Berlin, Michelle Cini, University of Bristol and Roger Scully, University of Wales, Aberystwyth, on behalf of the University Associatiion for Contemporary European Studies Editorial Board: Grainne De Búrca, European University Institute and Columbia University; Andreas Føllesdal, Norwegian Centre for Human Rights, University of Oslo; Peter Holmes, University of Sussex; Liesbet Hooghe, University of North Carolina at Chapel Hill, and Vrije Universiteit Amsterdam; David Phinnemore, Queen’s University Belfast; Mark Pollack, Temple University; Ben Rosamund, University of Warwick; Vivien Ann Schmidt, University of Boston; Jo Shaw, University of Edinburgh; Mike Smith, University of Loughborough and Loukas Tsoukalis, ELIAMEP, University of Athens and European University Institute. The primary objective of the new Contemporary European Studies series is to provide a research outlet for scholars of European Studies from all disciplines. The series publishes important scholarly works and aims to forge for itself an international reputation. 1. The EU and Conflict Resolution Promoting Peace in the Backyard Nathalie Tocci 2. Central Banking Governance in the European Union A Comparative Analysis Lucia Quaglia 3. New Security Issues in Northern Europe The Nordic and Baltic States and the ESDP Edited by Clive Archer 4. The European Union and International Development The Politics of Foreign Aid Maurizio Carbone

Central Banking Governance in the European Union A comparative analysis Lucia Quaglia

First published 2008 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon 0X14 4RN Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001

This edition published in the Taylor & Francis e-Library, 2007. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Routledge is an imprint of the Taylor and Francis Group © 2008 Lucia Quaglia All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Quaglia, Lucia, 1973– Central banking governance in the European Union: a comparative analysis/ Lucia Quaglia. p. cm. — (UACES contemporary European studies series; 2) Includes bibliographical references and index. 1. Banks and banking, Central—European Union countries—case studies. I. Title. HG2974.Q34 2007 332.1′1094—dc22 2007028585

ISBN 0-203-93280-3 Master e-book ISBN ISBN 10: 0-415-42751-7 (hbk) ISBN 10: 0-203-93280-3 (ebk) ISBN 13: 978-0-415-42751-7 (hbk) ISBN 13: 978-0-203-93280-3 (ebk)

Contents

List of tables Acknowledgements List of abbreviations 1

Introduction: central banking governance in the European Union

vi vii ix

1

2

The Bank of England: an old lady with new clothing

17

3

The Bundesbank: the central bank that ‘ruled Europe’

47

4

The Banca d’Italia: quis custodiet ipsos custodes?

76

5

The European Central Bank: a new experiment in central banking

106

Conclusions: a comparative assessment of central banking governance in the EU

145

Notes Bibliography Index

162 168 189

6

Tables

1.1 Dimensions of the dependent variable (central banking governance)

6

1.2 The analytical framework: multi-level institutionalism

11

6.1 Major findings on dimensions of the dependent variable

149

Acknowledgements

The primary research for this book could not have been completed without the help of many practitioners and experts in several financial institutions and countries. Although central banks are often portrayed as rather aloof institutions, in all the central banks highlighted in this study I found forthcoming and helpful interlocutors, who generously gave me their time, despite their very busy diaries, and were willing to share some of their insights with me. Some of these officials also read parts of my book, providing valuable comments. I am very grateful to all of them. It was agreed with all the interviewees that, though I could use the information they gave me, it would not be individually attributed. I am sure they would not agree with all the judgements expressed in this book. All errors, omissions and interpretations in this book are mine. In academia, I owe an intellectual debt to many people. My former supervisors, Helen Wallace and Jim Rollo, and my early supervisor, Peter Holmes, stimulated my interest on economic governance in the EU and equipped me with the fundamental tools needed to conduct research in this field. I also wish to thank them for their unfaltering support, constant commitment and constructive criticism throughout these years, even when I was no longer one of their supervisees and became one of their colleagues. Since I started my research, several academics have generously given me their advice, and some have commented on parts of the book. In particular, I would like to thank Chad Damro, Kenneth Dyson, James Forder, Anthony Forster, David Howarth, Ivo Maes, Michael Moran, Machiko Miyakoshi, Mari Neuvanen, George Pagoulatos, Uwe Puetter, Claudio Radaelli, Fiona Ross, Min Shu, Francesco Stolfi, Roland Sturm, Sye Sungwook, Nelson Vaz, Paulo Vila Maior and Amy Verdun. I also wish to thank the series editors Tanja Börzel (who kindly read and commented on the entire manuscript), Michelle Cini and Roger Scully, and the commissioning editors at Routledge, Heidi Bagtazo and Amelia McLaurin, for their interest in my project, Lolli Duvivier for reading through an earlier draft of the text and Gerard M.-F. Hill for his very professional copy-editing. I shall never forget my fellow colleagues at the Sussex European Institute and the University of Bristol, all of whom contributed to a stimulating and supportive environment in which to carry out my research. Last, but by no means least, I would

viii Acknowledgements like to thank my family and friends, especially, Elke, Elspeth, Gennaro and John for reminding me that, from time to time, ‘I should give the banks (and myself) a rest’. Dr Lucia Quaglia Brighton, 2007

Abbreviations

BaFin BAKred BBG BCBS BCCI BEPG BIS BSC CBC CCBG CEBS CESR CONSOB COREPER CPSS CRD DG EC ECB ECJ Ecofin ECU EFC EMI EMS EMU EP EPC ERM ESCB ETUC EU

Bundesanstalt für Finanzdienstleistungsaufsicht Bundesaufsichtsamt für das Kreditwesen Bundesbankgesetz Basel Committee on Banking Supervision Bank of Credit and Commerce International broad economic policy guidelines Bank for International Settlements Banking Supervision Committee of the European System of Central Banks Central Bank Council Committee of Central Bank Governors Committee of European Banking Supervisors Committee of European Securities Regulators Commissione Nazionale per le Società e la Borsa Committee of Permanent Representatives in Brussels Committee on Payment and Settlement Systems Capital Requirements Directive Directorate-General European Community European Central Bank European Court of Justice Council of Economic and Finance Ministers European Currency Unit Economic and Financial Committee European Monetary Institute European monetary system economic and monetary union European Parliament European Policy Committee exchange-rate mechanism European System of Central Banks European Trade Union Confederation European Union

x Abbreviations FSA FSAP G7, G10 HIPC IGC IMF IOSCO LCB LLR M MLG MPC NCB OECD PSBR QMV SEA SIB SRO TARGET TEU UP

Financial Services Authority Financial Services Action Plan Group of Seven, Group of Ten harmonized index of consumer prices inter-governmental conference International Monetary Fund International Organization of Securities Commissions Land Central Bank lender of last resort monetary aggregates multi-level governance Monetary Policy Committee national central bank Organization for Economic Co-operation and Development public-sector borrowing requirement qualified majority voting Single European Act Securities and Investments Board self-regulatory organization Trans-European Automated Real-time Gross Settlement Express Transfer system Treaty on European Union University Press

1

Introduction Central banking governance in the European Union

The establishment of Economic and Monetary Union (EMU) in the European Union has brought central banking governance into the spotlight. The European Central Bank (ECB) and the Eurosystem, comprising the ECB and the national central banks of the countries that have adopted the euro, are the main pillars of EMU, as well as a sui generis type of central bank in a polity in the making. This results in a distinctive mode of central banking governance in the EU, posing the questions: how does the Eurosystem work, and how has central banking governance in the EU been transformed as a result of EMU? To answer these questions, it is necessary to understand the main features and modes of central banking governance in the EU and, more precisely, in its member states, before the introduction of the single currency, because national central banks, together with the ECB, are core components of EMU. How was central banking governance organized, and how did it evolve over time before EMU? What were the main similarities and differences in central banking policies and institutional settings across EU countries, and what factors account for this? Have they converged or diverged over time, especially after EMU? How do the national central banks interact with the ECB and how does this shape central banking governance in the EU? These questions are not only of academic interest, but they are also policyrelevant, because they have profound and far-reaching repercussions on the effectiveness and legitimacy of economic governance in the EU. These are all themes that have gained political salience and have become matters of public concern in the EU and its member states. Yet so far these issues have not been the focus of systematic analysis, as indicated by the review of the relevant literature below. This monograph aims to fill the gap that exists on the politics and public policy aspects of central banking in Europe, by conducting a theoretically informed and empirically grounded analysis of central banking governance in selected countries, before and after the introduction of the single currency, extending the assessment to the EMU policy framework as a whole. Central banks are complex institutions, which straddle the ground between state and markets, politics and economics, and national, EU, transnational and international governance. This project explores the multi-faceted character of central banks as specialized bureaucracies (or

2 Introduction technocracies), as public policy institutions involved in economic governance at the national, international and EU levels, and as political actors in their own right. This research project has three specific objectives. First, the project engages in a comparative analysis of central banking governance in selected countries before EMU, focusing on the institutional framework in which national central banks used to operate and their core policies, and examining the overall ‘autonomy’, ‘policy capacity’ and ‘legitimacy’ of these institutions, all concepts defined below. It identifies and elucidates the main features of various ‘modes’ of central banking, identifying explanatory factors that can ‘travel’ beyond the selected case studies. Second, the project provides a comprehensive, in-depth analysis of the institutional framework and policies of the ECB, addressing the main issues related to the autonomy, policy capacity and legitimacy of this supranational, multi-level institution and comparing it with national central banks before EMU and with those outside the eurozone, but within the EU. Furthermore, the external dimensions of the ECB – that is, its role as a global actor and its international relations – are also examined, and the same is done for the other central banks. Third, the research sheds a novel light on the role and influence of national central banks within the policy framework of EMU, their interaction with the ECB and their ‘adaptation’ to EMU, and on the role of one central bank outside EMU, but in the EU. The existing literature on central banking is patchy. Although several historians have worked on specific central banks,1 they tended to provide in-depth but rather descriptive accounts, with ad hoc explanations owing to the absence of a comparative perspective. Moreover, given the limited availability of recent archival material, historical studies cannot cover the last thirty years. In economics, studies of central banks have focused on measuring central bank independence by devising appropriate indices and statistically testing the effects of independence on macroeconomic variables – these being, first and foremost, inflation and economic growth (see Nordhaus 1975; Kydland and Prescott 1977; Parkin and Bade 1978; Alesina 1989; Alesina and Summers 1993; Cukierman 1992; Grilli, Masciandaro and Tabellini 1991; for a review see Eijffinger and de Haan 1996). Recently, a similar statistical methodology has been applied to central bank accountability (Bini-Smaghi and Gros 1999, 2001; Elgie 1998; de Haan 1997; de Haan and Amtenbrink 2000; de Haan et al. 2004) and, to a more limited extent, financial supervision (Masciandaro 2004, 2006).2 In general, these works have engaged in large-scale quantitative comparisons. Economists have largely adopted a rational choice approach, using statistical tools, which are very useful in measuring certain institutional features and aspects of central banking activity, but fail to capture the whole range of factors that affect central banking governance. Thus, several non-quantifiable factors are missing from these analyses. For example, ideas – especially in the form of policy paradigms – have been overlooked, as have the intangible assets of central banks, as defined below.3 Moreover, because of the kind of data used in quantitative analysis, excessive emphasis has been placed on formal institutions and legal provisions, which determine central bank de jure independence, as opposed to de

Introduction 3 facto independence. The behaviour of central banks, and their interactions with other policy-makers and policy stakeholders in often political processes and in multi-level arenas, have been overlooked (Forder 2000).4 Finally, economists have mainly focused on one specific institutional aspect of central banking governance, namely, formal central bank independence and its effects on monetary policy. Other policies and functions of central banks – and other policies and functions that involve central banks one way or another, such as exchange-rate policy, financial regulation and supervision, advising the government on macroeconomic policy matters and negotiating in international forums – have been overlooked, not least because, unlike monetary policy, these policies are difficult to gauge using quantitative indicators. In political science, some scholars have used the techniques employed by economists to study specific central banks using quantitative methods and game theory, especially in the case of the US Federal Reserve and the Bundesbank (see Broz 1997; Mayer 1993; Meltzer 2002; Toma 1997). These works are prone to the same drawbacks as economists’ studies of central banking. Some other studies of central banks have been conducted using qualitative methods, for example, the path-breaking work of Woolley (1984) on the US Federal Reserve. In Europe, only the Bundesbank (Heisenberg 1999; Kennedy 1991; Leaman 2001; Loedel 1999), and to a lesser extent the Bank of England (Moran 1986, 1991) and Banque de France (Elgie and Thompson 1998) have attracted scholarly attention. An updating of this literature is very much needed to take into account the profound transformation undergone by central banking in Europe in the 1990s and since. Moreover, the adaptation (or lack of it) of these national central banks to EMU has not yet been analysed, and comparative qualitative studies of central banks in Europe have been rare, with the few exceptions (Apel 2003; Bernhard 2002; Elgie and Thompson 1998; Goodman 1992) failing to cover the most recent and most eventful period. Furthermore, they have tended to focus on monetary and exchange-rate policies, without examining other important central banking policies, and they do not include the ECB. The ECB was created anew in 1998, mainly following the institutional model and policy templates provided by the Bundesbank (Dyson 1994), but also drawing on the policy practices, the modus operandi and expertise of other national central banks, and building on well-developed working relationships between the central banking elites in the EU member states. Research on the ECB is only embryonic: the first to do so were financial journalists (Marshall 1999; Naudin 1999), followed by practitioners (Bini-Smaghi and Gros 1999) and academics (Dyson 2000a; Howarth and Loedel 2003, 2005; Kaltenthaler 2006). Furthermore, researchers have only marginally considered the national components of the Eurosystem. This is a significant gap, in so far as the Eurosystem has been criticized for being too decentralized and for leaving excessive power to the national central banks. Consequently, national central banks remain significant players in the Eurosystem/ European System of Central Banks (ESCB), and therefore the institutional configuration of national central banks, their policies and operational practices exercise considerable influence over the policy framework of EMU.

4 Introduction

The explanandum: modes of central banking governance The dependent variable of this study is central banking governance – more precisely, the transformation of modes of central banking governance in the EU. There are numerous and often quite different definitions of governance (for a review see Kjaer 2004; Pierre and Peters 2000; Rhodes 1997; van Kersbergen and van Waarden 2004), and indeed, this term has been criticized for being too vague (Rhodes 1996: 652). Briefly, three different perspectives can be taken on governance. The first considers governance as a way of conceptualizing the relation between the state and the market, or between the state and society, that is, between the public authorities and the private sector. In modern societies, functions traditionally performed by the state have been transferred to (or taken over by) the private sector, or are jointly performed by the public authorities and private agents. The public authorities are seen as being no longer in a position of command; they are simply a set of actors among many in the policy-making process, even though they might still possess or control important resources. This approach often uses the concept of policy network to describe the policy interaction and the exchange of resources between a variety of public and private actors (Peters and Pierre 1998) and it is often applied to the study of the EU (see Kohler-Koch 1999). The second approach associates governance with the fading away of the nation– state, which has shrunk in size and has lost (or is in the process of abandoning) core competences. Several policies are no longer decided and implemented at the national level by state authorities. Instead, these policy-making functions are shifted downwards to the sub-national level, or upwards to the international level, that is, to international organizations (or international regimes) and the EU (Peters and Pierre 1998), setting in motion a process of ‘multi-level governance’. This term describes the ‘dispersion of authoritative decision-making across multiple territorial levels’ (Hooghe and Marks 2001: 1). The EU is a notable example (but not the only one) of this approach to governance (Bache and Flinders 2004). The third approach links governance to the rise of the regulatory state (Majone 1996; Moran 2000, 2002b), as opposed to the traditional (interventionist) state, which used to engage not only in regulatory policies, but also in distributive and re-distributive ones. The regulatory state, as the name suggests, uses mainly regulation, as against other policy instruments, to achieve certain public objectives. This inherently limits the types of public policies still being performed by the state. The EU is an example of a ‘regulatory state’ (Caporaso 1996; Majone 1996), or at least a ‘patchwork of national regulatory styles’ (Héritier 1996: 149). Moreover, the vast majority of EU policies are regulative, rather than distributive or re-distributive, using regulation to make policy, given the limited size of the EU budget. This approach to governance brings to the fore the role of independent regulatory agencies or non-majoritarian regulators (Coen and Thatcher 2005; Thatcher and Stone Sweet 2002), which take over functions and policies previously performed by the state and interact with other public authorities as well as with the private sector. Central banks are a very distinctive and powerful type of these independent regulatory agencies, and the notion of principal–agent is often applied to concep-

Introduction 5 tualize the relation between the political authorities – the principal – and the agent, in this case the central bank (on this approach applied to the ECB, see Elgie 2002). It should also be noted that, after the ‘governance turn’ in EU studies (Kohler-Koch and Rittberger 2006; Jachtenfuchs 2001), there is a growing literature on ‘new modes of governance’ in the EU (Citi and Rhodes 2007; Treib et al. 2007), whereby this expression is mainly used to describe the Open Method of Co-ordination, ‘soft law’, benchmarking and promotion of best practice, the policy-making activities of networks of experts and regulatory agencies, and so on. This research borrows from all three approaches to governance, but in particular from the third approach, which deals with the activity of regulatory agencies, even though it does not use a principal–agent model. That model is not well equipped to capture the complexity of central banks’ activities and it does not apply well to the multi-level dimension explored. The focus here is on central banking governance, which concerns the institutions, policies and activities in which central banks are involved in a multi-level setting. The modes of central banking governance consist of four main components through which different modes are identified and operationalized in this research: (i) central banking legal framework; (ii) central bank ‘autonomy’; (iii) central bank ‘policy capacity’; and (iv) central bank legitimacy. Such components, which are elaborated below, are teased out from the literature on central banks in economics and political science, part of which has been reviewed above. (i) The legal provisions concerning central banks are usually considered by economic and legal studies of central banks (the so-called statute-reading methodology). These analyses focus on the (legal) independence of central banks, distinguishing between ‘political independence’ and ‘economic independence’ – or ‘objectives independence’ and ‘operational independence’ – depending on the terminology and criteria used by each classification (cf. Cukierman 1992; Grilli et al. 1991; Eijffinger and de Haan 1996). ‘Political independence’ is the ‘ability of the central bank to select its policy objectives without influence from the government’ (Alesina and Summers 1993: 153; hence it is sometimes called ‘objective independence’) and it is determined by the legal provisions for the appointment of top officials (‘personnel independence’) and the decision-making powers assigned to the central bank (‘decisional independence’), for example, whether government representatives sit on the board of the bank, whether government approval for monetary policy decisions is required and whether the objective of price stability is explicitly part of the central bank statute. ‘Economic independence’ refers to the ‘ability of the central bank to use macroeconomic policy instruments without restriction’ (Alesina and Summers 1993: 153; hence it is sometimes called ‘operational independence’), resisting any direct effects of government action on monetary policy (preventing the so-called monetary financing of fiscal policy). Budgetary autonomy (often referred to as ‘financial independence’) is also important, because it affects the economic resources available to the central bank. (ii) Central bank ‘autonomy’ (or de facto independence) from the political authorities (cf. Pagoulatos 2000) is similar to what the economic literature that

6 Introduction moved beyond legal analyses describes as ‘behavioural independence’ (Woolley 1984). Autonomy is the ability of a central bank to define and (attempt to) pursue policy objectives that might be different from those of the government (or, more generally, of the main domestic forces). For example, there might be instances in which a central bank with a low degree of legal independence behaves largely independently of the government’s preferences, hence exhibiting relatively high autonomy. The opposite can also be true. (iii) Central bank ‘policy capacity’ (cf. Pagoulatos 2000, where it is called ‘policy strength’)5 refers to the steering actions of public actors, in this case central banks, in defining the content and supervising the implementation of public policies in specific fields of activity, as well as through the interaction with other public and private actors at both the national and international levels. Three policy areas are crucial for central banking governance, and hence deserve in-depth research: monetary policy; exchange-rate policy; and financial (mainly banking) regulation and supervision. To this should be added other (often ‘atypical’) functions performed by central banks, such as advising the government on macroeconomic matters, or acting as a counterpower to political authority, or mediating between financial interest groups and the government – these roles performed by central banks often vary significantly from polity to polity. (iv) Central bank legitimacy relates to the social acceptance of the authority of the central bank as a public actor, as well as its aims and powers. It can be conceptualized as adopting both an ‘input-oriented’ and an ‘output-oriented’ approach to legitimacy (Scharpf 1999), adapting it to central banking. The inputoriented dimension focuses on the input into the policy-making process. Hence, an independent central bank that is insulated from political interference in the conduct of its policies and is not accountable to the political authorities is not seen as possessing input legitimacy. The output-oriented dimension focuses on the output of the policy-making process, in this instance the results delivered by central banks. Hence, a central bank that delivers effective policies is regarded as having output legitimacy. It is also important to consider the way in which the legitimacy of a central bank is perceived by the public and how its activities are evaluated in the polity in which it is embedded. Table 1.1 Dimensions of the dependent variable (central banking governance) Mode

Components

(i) (ii) (iii)

Legal provisions Central bank autonomy (de facto independence) Central bank policy capacity • monetary and exchange rate policies • financial (banking) regulation and supervision • atypical functions Central bank legitimacy • input-oriented • output-oriented

(iv)

Introduction 7 This research investigates various modes of central banking governance, identifying similarities and differences, and elucidating how and why such modes have evolved over time. To put it in another way, the various components of the modes of central banking governance are different dimensions of the dependent variable to be explained.

Explanatory factors: taking stock of the literature The academic literature in political science has identified several explanatory factors affecting central banking governance. Such explanations have been situated at distinct levels of analysis, namely, international (including transnational), and national, and they can be organized under three conceptual headings: institutions, interests and ideas. Systemic-level explanations are generally rooted in theories of international political economy and international politics. Some authors have highlighted the importance of international institutions, which comprise international regimes concerning financial supervision (e.g. the Basel I Accord; see Kapstein 1989) and international organizations underpinning those regimes, such as the IMF, the World Bank and the Bank for International Settlements (BIS) (Wood, D. 2005). In the EU, EMU represents the most important institutional evolution in the macroeconomic field, and it had been preceded by European exchange-rate agreements, namely the ‘snake’ and the EMS (see Helleiner 1994; Webb 1995).6 With specific reference to central banking, the reverberation effects of international and EU institutions on the domestic arena unfold through two causal mechanisms, which have been highlighted by the literature on Europeanization (Börzel and Risse 2003; Bulmer and Radaelli 2005; Knill and Lehmkuhl 2002). The first mechanism is adaptational pressure, whereby international regimes and international organizations impose, or at least promote, specific institutional and policy templates across countries. The second mechanism is the provision of external resources to or constraints on domestic actors, changing the political opportunity structure, as explained below. These two mechanisms are the basis of the two-level game, developed by Putnam (1988) with reference to chief executives, though it can be applied to central banks, which stand at the interface between levels of governance and operate in national and international forums. Indeed, national central banks, especially the most powerful, such as the Bundesbank, are not simply passive policy-takers and often engage in double-edged diplomacy in multiple and multilevel arenas (cf. Kapstein 1992; Loedel 1999). Other authors, still focusing on the systemic (i.e. international) level of analysis, have pointed to the influence of interests, especially the financial markets (Andrews 1994; Dyson et al. 1995) in shaping national macroeconomic policies and hence affecting the policy capacity of national macroeconomic institutions – first and foremost the central banks. Over time, so the causal argument goes, the power of financial markets has been strengthened by the process of internationalization and liberalization (Cerny 1993; Strange 1986, 1996), and these forces of unbounded capital support and actively promote the

8 Introduction institutional templates and policy choices that are most congenial for their activities, under certain conditions promoting convergence or harmonization (Simmons 2001). Other scholars have focused on ideas, mainly taking the form of policy paradigms, which are generally informed by specific bodies of technical knowledge and often ‘travel’ across countries (Hall 1989, 1993). Thus in monetary policy there is the Keynesian paradigm, based on active macroeconomic policies and state intervention, and the stability-oriented paradigm, based on price stability, central bank independence and macroeconomic credibility (Dyson 1994, 2000a; McNamara 1998). In financial supervision policy, there are less well-established paradigms, even though a shift in objectives and instruments can be detected over time. The causal mechanisms identified as relevant are the processes of ideational diffusion (Simmons and Elkins 2004; Marcussen 2005), facilitated by elite socialization in international and EU forums (Marcussen 2000), and the creation of epistemic communities of central bankers (Verdun 1999). Since international and EU institutions can facilitate ideational diffusion, there is a strong link between the ideational explanation and the institutionalist one. For example, McNamara (2002a) uses sociological institutionalism to explain the spread of central bank independence worldwide. In contrast to systemic explanations, national-level explanations are mainly rooted in comparative politics and comparative political economy. According to some comparativists, domestic institutions crucially affect central banking governance through a variety of causal mechanisms. Domestic political institutions determine the centralization and dispersion of power and responsibilities within the state, affecting the constitutional position of the central bank (for example, on Germany, see Heisenberg 1999; Kaltenthaler 1998a; Loedel 1999).7 Other relevant political institutions are the electoral system and the party system (Bernhard 1998, 2002), which determine whether there is a coalition government or a governing party. Intra-party or intra-coalition conflicts make the government more willing to delegate controversial monetary policy decisions to an independent central bank. Here, the main causal mechanism that affects central banking is the configuration of domestic political opportunity structure that can give (or deny) the central banks resources for policy-making. Domestic economic (or political economy) institutions, which mainly feed into the literature on varieties of capitalism, encompass the organization of the market (product market and labour market), relations between firms, and interactions between social partners (Hall and Soskice 2001; Schmidt 2002a). They also include the configuration of the financial and industrial sectors, the link between banks and industry, and the organization of the financial sector, all of which affect the distribution of economic power and political opportunity structure, which in turn affects central banking governance. It should be noted that the literature on varieties of capitalism has dealt only marginally with central banks, which also explains why specific causal mechanisms are more difficult to identify, but they can be teased out from the literature on interest groups and central banks. Some scholars highlight the influence of domestic interests, namely societal forces and economic coalitions, on central banking governance, especially with

Introduction 9 reference to monetary and exchange-rate policies. The interest-groups-based explanation is grounded in the macroeconomic preferences of domestic forces and their power and access to policy making (Frieden 1991; Hefeker 1997; Walsh 2000). Of particular interest in studying central banking are the power and the size of the financial sector (Posen 1993, 1995), which affect the conduct of monetary and exchange-rate policies. The assumption is that the financial sector is inherently averse to inflation, and is therefore a natural constituency for an independent and stability-oriented central bank and sound macroeconomic policies (Goodman 1991, 1992; Posen 1993; Woolley 1984). Moreover, Maxfield (1991), and to some extent Perez (1997), focus on the coalition of public and private financiers, that is, central bankers and private bankers, blurring the boundaries between public actors and societal forces, and therefore providing a conceptual link to the notion of policy networks. As far as the causal mechanisms are concerned, interest groups either lobby the central banks directly or they lobby the political parties, especially those in government, which then engage in a strategic game with the central bank when de facto central bank independence is absent. Both economic and political interests might also try to shape the institutional framework in such a way as to further their policy preferences. Finally, there are ideas, meaning national policy discourses and polity ideas, which provide ideational policy frameworks to national policy-makers. One example is the concept of ‘exceptionalism’ in managing southern European economies (Pagoulatos 2004). The political ideologies of parties in power, according to the partisan politics approach to monetary policy elaborated by economists (Hibbs 1977), would also fit into this category, whereby the causal mechanisms link the political ideology of the government in office (basically, left or right) to specific preferences in the conduct of macroeconomic policies and the choice of the institutional setting (Alesina and Rosenthal 1995; Garrett 1998; Way 2000). Left-wing governments are regarded as more prone to inflation and are therefore, the argument goes, less keen on central bank independence and favour an expansive monetary policy. By contrast, central bank independence is postulated to be less problematic for right-wing governments, because it locks in an antiinflationary policy. Recently this argument has been inverted, asserting that since central bank independence lends macroeconomic credibility to the government in office, and since left-wing governments often have a bad ‘reputation’, left-wing parties that hold office are more likely to implement reforms that increase central bank independence; it ties their hands, and therefore facilitates lower interest rates (King 2001a). It is also important to consider explanations based on the organizational level, that is, bank-specific features, which (with the exception of the Bundesbank and the US Federal Reserve) have rarely been the object of analysis. Researchers have used this approach to study bureaucracies and/or technocracies, by focusing on the tangible and intangible assets they possess and which give them an extra leverage in policy-making. Several authors, adapting a public-choice approach, have conceptualized central banks as self-interested bureaucracies that try to maximize their policy influence and their political power, often engaging in a strategic game

10 Introduction with the political authorities (Toma 1997; Toma and Toma 1986). Other authors (such as Pagoulatos 1996, 2003; Perez 1997; Quaglia 2005a, b; Woolley 1984), have traced the monetary policy elite’s quest for institutional independence and policy influence, for example, by implementing domestic anti-inflationary policies and financial deregulation. In several of the works reviewed in this section there is some overlap between explanatory factors, which are not mutually exclusive and do not operate in isolation. For example, the configuration of domestic political economy institutions and the activity of socio-economic coalitions is a case in point, as it is sometimes difficult to make a clear distinction between them. However, what all these explanations have in common is that they tend to focus on only one level of analysis, be it domestic or international, and they almost completely overlook the specific organizational features of the central bank itself. This study challenges this conventional wisdom, arguing that in order to explain central banking governance, the research needs to focus on different levels of analysis, not only to account for the functioning of the Eurosystem/ESCB, which is by its very nature a multi-level system, but also to understand central banking governance in the EU before EMU, or in the countries outside the eurozone. In order to be able to analyse different levels of governance, keeping the research design manageable, the focus will be on institutions as the main explanatory factor.

The analytical framework: multi-level institutionalism This research takes a multi-level institutionalist approach as the main framework for analysis. There are several reasons that justify the choice of historical institutionalism, and the use of multi-level analysis and a comparative method. First, given the relatively long period of time chosen for this research, historical institutionalism permits a longitudinal approach and engagement with the complexities of history (see Pierson 2004; Pierson and Skocpol 2002; Thelen 1999). This type of institutionalism privileges qualitative methodologies (process tracing) and focuses on one case study or a small number of studies (structured comparison). Thus, the qualitative and comparative methodology adopted in this research, which is based on selected case studies over time, can be fruitfully embedded in a historical institutionalist framework. The concept of ‘path dependency’, which is at the basis of historical institutionalism, informs most of the analysis conducted in the following chapters, which also highlight ‘critical junctures’ (which often coincide with ‘policy failures’) that led to modification of institutional and policy trajectories of central banks, altering path dependence. Second, historical institutionalism considers institutions as central explanatory variables, even though institutionalists themselves question whether institutions can be considered the sole cause of policy outcomes (Thelen and Steinmo 1992: 3). For this reason, this approach leaves open the possibility of incorporating ideas and interests to explain institutional and policy evolution (Thelen and Steinmo 1992; Hall and Taylor 1996). In particular, the possibility of incorporating ideas, mainly in the form of policy paradigms, is important for this research, given the

Introduction 11 influence of economic ideas (or doctrines) in the conduct of economic policies and institutional design. A common critique of the new institutionalism is that the macro level of analysis of institutionalists should be informed by the analysis of individual behaviour (Peters 1999), whereas individuals as ‘agents’ are often missing in institutionalist analyses, as is politics (Dowding 2001). Several authors question the ability of this approach to explain ‘change and continuity in politics and policies, without incorporating agency and without devoting attention to political conflict in order to explain change’ (Peters et al. 2005: 1,277; emphasis in the original). Other authors, however, argue that institutionalism provides a way to transcend the agent–structure debate, allowing for the actions of purposive agents interacting within institutions (Hall and Taylor 1996, 1998; for a different view, see Hay and Wincott 1998). This study investigates the role and preferences of individuals as agents, whenever their actions affect central banking governance significantly. However, in line with historical institutionalist premises, such preferences and actions are regarded as endogenous to a specific institutional context (Hall and Taylor 1996; Bell 2002). Third, the new institutionalism – specifically its historical institutionalist variant – is located at the intersection of international relations, comparative politics, comparative political economy and public policy (Bulmer 1998), which is the academic milieu in which this research is located. Since historical institutionalism can be deployed at different levels of governance, the institutionalist framework of this research is articulated on three interconnected levels of analysis: the ‘systemic level’, which encompasses the European, transnational and the international arenas; the ‘national level’, which considers the configuration of the domestic socioeconomic and political environment in which each central bank operates; and the ‘micro-institutional level’, which deals with the specific features of each central bank (Quaglia 2005b). This research takes as a starting point the core institutionalist assumption that institutions (be they international, domestic or organizational) matter, and that they are the main explanatory variable of central banking governance; institutions frame interests and ideas, and the actions of agents within a given policy area. The key issues addressed in the empirical research are which institutions matter most, how and why. Two perspectives are implicit in the multi-level institutionalist approach discussed above and are followed throughout the book: one is a longitudinal perspective, which is used to explore the evolution of modes of central banking governance within polities over time; and the other is a horizontal comparative perspective, which is used to explain the convergence and divergence of modes of central banking governance across polities.

Table 1.2 The analytical framework: multi-level institutionalism Systemic level National level Micro-institutional level

international and EU institutions national institutions bank-specific features

12 Introduction

Research methods As highlighted in the review of the literature, quantitative methods are very valuable in large-scale comparisons of central banks. The drawback is that quantitative methods provide only partial explanations, as they fail to grasp the significance of non-quantifiable factors and do not allow for a detailed analysis of the multi-level context in which macroeconomic institutions interact and policies are implemented. For these reasons, this research will utilize a qualitative method, which necessarily limits the number of case studies (central banks) that can be included in the comparison, while at the same time making it possible to take into account a vast array of factors (including ideas or intangible factors) that affect governance in a complex and interactive way. The analysis is based on a ‘structured focused comparison’ (George and Bennett 2005) of selected case studies over the period 1978–2005, whereby, in line with the historical institutionalist approach taken, attention will be paid both to the trajectory of each central bank over time and to the main turning points, defined as major institutional reforms and/or policy shifts. Through a systematic horizontal comparison, the project analyses and explains the differences and similarities concerning the institutional arrangements and policies of the central banks selected as case studies, evaluating the different modes of governance, and identifying the main international, domestic and micro-institutional factors that have a bearing on this. Through in-depth longitudinal research of selected case studies, the project conducts a similar appraisal within the same polity over time. Process tracing is used to explore both the horizontal and longitudinal dimensions, as it permits teasing out which institutional variables matter most, how and why in each case and across cases. A crucial aspect in the management of this research project was to gather relevant empirical material on the four case studies. Archival sources become accessible only after thirty years and, whereas this is not such a significant problem for the Bundesbank (with the exception of the most recent period, there are several secondary sources available), the literature on the other central banks is rather thin and outdated. I have used a variety of primary sources to gather relevant material: textual analysis of official documents; systematic survey of press coverage; and semi-structured elite interviews with practitioners and qualified observers in all four cases. The material gathered through interviews has been cross-checked within and across case studies, as well as using other sources. Of course, confidentiality has been respected and interviews have taken place on a non-attributable basis. Finally, this book discusses economic events and policies, but it does not provide an economic analysis of them. My focus, as a political scientist, is on the political aspects, rather than the purely economic ones. However, the following analysis is informed by the findings of the economic literature and economic analysis. Selection of the case studies Since a careful selection of the case studies is fundamental for comparative qualitative research, three sets of criteria have been taken into account. First, the

Introduction 13 case studies cover different modes of central banking governance. Briefly, the four central banks chosen exhibit significant variations in their legislation, autonomy, policy capacity and legitimacy. The ECB and the Bundesbank are among the most independent of central banks, whereas the Bank of England before its reform was one of the most dependent, and the Banca d’Italia before EMU was somewhere in between, with its degree of independence increasing after 1981, and especially in 1992 and 1993. There are also variations across the policies that these central banks perform, and how such functions are administered. Second, the central banks selected are an interesting choice as far as EMU membership is concerned. Three of them are part of the eurozone, since Germany and Italy both joined EMU in 1999, and the ECB is at the very centre of the system. The Bank of England is an outsider, as the UK has opted out of EMU. This selection, besides ensuring case variation of the theoretically relevant dimensions, facilitates the study of the adaptation to EMU membership at different stages of the process, including, in the case of the Bank of England, its potential membership of the single currency. Moreover, the post-1997 British model is often regarded as an alternative to the Bundesbank and the ECB model (Amtenbrink 1999; Buiter 1999). Third, these national central banks, which belong to the largest EU countries, are important components of the ESCB and have in the past been important players at the national and international level, albeit in different ways and to different extents. Each of the three national institutions has a consolidated tradition of central banking, whereas the ECB represents an intriguing ‘experiment’ in the field. In summary, each of them is a significant case study in its own right. On the one hand, it would be interesting to include more case studies in the comparative research, for example, the Banque de France, as France is one of the four largest countries in the EU. Moreover, it would be useful to introduce greater variation, by including the central banks of small and medium-sized EU members and/or from the new member states. On the other hand, the feasibility of the project suggests that the number of case studies has to be limited to keep the research manageable. The timeframe of the research ranges from the establishment of the EMS in 1979 to 2005, with occasional references to earlier periods. Two criteria have been used to delimit this timeframe. The period needs to be long enough to get a handle on central bank roles, policies, consolidated practices and traditions, but it should not be so protracted as to render the project unmanageable. The events chosen as points of departure and arrival represent landmarks in central banking governance in the EU. Some caveats are necessary. Particular care should be paid to the comparison between national central banks and the ECB, for three obvious reasons. First, the ECB is a supranational institution embedded in a multi-level and multinational polity in the making – the EU – whereas national central banks are essentially domestic institutions embedded in different national contexts, though grounded in the EU and international arenas. Second, the ECB, as a result of its governance structure, its position in the Eurosystem and its relationship with national central banks therein, is a multi-level, pseudo-federal institution, whereas the national

14 Introduction central banks under consideration, with the exception of the Bundesbank before 2002, were unitary institutions. Third, the timeframe is partly different, in that the analysis of national central banks starts in the 1980s, whereas the analysis of ECB governance begins in 1999, when this sui generis supranational central bank was established. Given these differences, why engage in a comparative analysis? There are several methodological, empirical and theoretical reasons that justify this choice. Methodologically, the comparative method helps to structure the analysis, making it more systematic and less reliant on ad hoc explanations (except when necessary, i.e. when a certain phenomenon is polity-specific). Empirically, throughout the book the comparison mainly takes place between national central banks over the same timeframe; from there, lessons of relevance to the ECB can be drawn. Moreover, in order to understand central banking governance within EMU and how the ECB works, it is necessary to have a comparative and in-depth knowledge of its national components, and of the Bank of England as an alternative institutional model. Theoretically, the goal of this comparative analysis is to identify modes of central banking governance and explanatory factors that unfold, albeit in various ways and with different timing, across polities. The analytical framework chosen for this comparative analysis facilitates the achievement of these goals, because institutionalism is a middle-range theory, based on the core assumption of this approach that institutions matter, and leading up to the question of which institutions matter, how and why.

The overall argument in brief Although the legal provisions concerning central banks are important – especially in the case of the ECB, given its treaty-guaranteed independence and the fact that the EU, by its very nature, is a rule-based system – modes of central banking governance do not depend on formal rules so much as on the configuration of political and economic institutions that affect the distribution of power in the polity in which the central bank is embedded, be it the national arena for national central banks or the eurozone/EU in the case of the ECB. Before EMU, the autonomy and policy capacities of the Bundesbank in several fields, besides being upheld by legislation, were augmented by the power-sharing domestic institutions of the federal state structure. By contrast, the autonomy and policy capacity of the Banca d’Italia were the result of weak and fragmented domestic institutions and an under-resourced Treasury, rather than ensuing from legislation. In the UK, before the 1997 reform that gave the central bank legal operational independence, a strong executive and a powerful Treasury left limited autonomy and policy capacity to the Bank of England, with the exception of banking supervision, on which the Bank possessed specific expertise and consolidated relations with the City, despite (or perhaps because of) relatively ambiguous legal provisions on this matter. The ECB’s autonomy and monetary policy capacity, established by the TEU and other relevant EU legislation, are reinforced by the absence of cohesive EU political institutions. More recently, the ECB has tried to

Introduction 15 expand the policy competences it had been assigned by the treaty, such as in the case of TARGET 2 securities. Modes of central banking governance – in particular central bank autonomy and policy capacity – are also affected by international and European institutions, which provide resources or constraints that can be strategically used by domestic actors (first and foremost, the central banks) in a two-level game, to tip the balance in favour of certain institutional or policy choices. European exchange-rate agreements sometimes constrained the policies of the Bundesbank – on a few occasions with the implicit support of the federal government. By contrast, the Banca d’Italia deployed exchange-rate agreement as an external constraint in an attempt to implement an anti-inflationary monetary policy, safeguarding its autonomy. Unlike international supervisory fora and European exchange-rate agreements, all of which are based on soft law – hence they did not affect the legal framework of the participating central banks – the establishment of EMU, which represented the main critical juncture for the mode of central banking governance of two of the three national banks – exerted adaptational pressure on the central banking legislation of the countries in the eurozone. The micro-institutional features of the central bank (that is, its tangible and intangible resources) influence its autonomy and policy capacity, not only in their own right, but also in the ability to use resources available at the national, international and European levels. Some examples of important intangible assets are the anti-inflationary credibility of the Bundesbank; the expertise of the Bank of England in financial matters; the macroeconomic expertise of the Banca d’Italia. Moreover, the perceived legitimacy of a central bank can be substantially enhanced by the microinstitutional features of the central bank itself, as evidenced by the public support enjoyed by the Bundesbank and the Banca d’Italia, regardless of the ‘thin’ legal provisions for their accountability. It should also be noted that specific micro-institutional features are likely to make adaptation to EMU membership more difficult, as explained in the concluding chapter. Overall, the weaker international institutions are in a given policy area, and the stronger the EU institutions are, the more likely the latter are to affect the mode of central banking governance at a given point in time as well as over a period of time, promoting convergence of legal provisions, autonomy, policy capacity and legitimacy, the last being the least amenable to modification by external influence. The opposite is also true, highlighting the fact that the process of European integration produces specific stimuli towards convergence. Indeed, the strongest pressure towards convergence was the establishment of EMU, preceded by the EMS. National institutions frame the domestic impact of international and EU factors, at times accelerating or more frequently slowing down the convergence of central banking governance. Since domestic political and economic institutions tend to vary across countries, they are responsible for the persistent divergence of specific central banking features in the EU. Several of these differences have been ironed away in the areas of monetary and exchange-rate policies by the establishment of EMU in 1999, which imposed specific legal rules that also concerned central bank

16 Introduction independence in the eurozone, whereas other differences remain, in particular in the domains not directly affected by EMU or EU rules, such as financial supervision.

Plan of the book Chapters 2, 3 and 4 focus on the Bank of England, the Bundesbank and the Banca d’Italia respectively, analysing the micro-, macro- and international institutional framework in which these central banks are embedded, the core central banking policies and other roles performed by them, the relations with economic and political forces, and the banks’ adaptation to EMU. These chapters analyse and compare different modes of central banking governance, using the concepts of central bank autonomy, policy capacity and legitimacy, evaluating continuity and discontinuity over time, and convergence and divergence across case studies. Chapter 5 deals with the ECB, the institutional and policy framework of EMU, and the most recent developments concerning macroeconomic governance and financial service regulation and supervision in the EU. It sketches the interactions between the ECB and national central banks, and applies the concept of mode of central banking governance to the ECB. Chapter 6 conducts a systematic comparison of the main modes of central banking governance, identifying and explaining similarities and differences, convergence and divergence, and their adaptation to EMU. It concludes by discussing the scope and limits of the comparison, the main findings, and the theoretical and empirical contributions to the existing literature.

2

The Bank of England An old lady with new clothing

The Bank of England, also referred to as the Old Lady of Threadneedle Street, is the second-oldest central bank in the world. Until the Second World War it was the most important central bank in Europe and, after the US Federal Reserve, the second most influential central bank in the world. Nowadays it is considered the main alternative to the ECB model, which has been adopted by national central banks in the eurozone. In the various classifications of (formal) central bank independence compiled by economists on the basis of the legal provisions for the institutional and policy framework of each central bank, the Bank of England scored very low before 1997 – it was traditionally regarded as a ‘dependent’ (or government-subordinated) central bank (cf. Alesina and Summers 1993; Cukierman 1992; de Haan and van’t Hag 1995; Eijffinger and de Haan 1996; Grilli et al. 1991) in terms of political and economic independence (or institutional and operational independence, depending on the terminology and criteria used by each classification). The Bank of England’s ranking in such classifications improved significantly after 1997, when the Bank was given operational independence in monetary policy. Its political independence also increased, and new mechanisms of accountability were set in place. A systematic analysis of the empirical record (1978–2005) reveals that the autonomy, policy capacity and legitimacy of the Bank of England cannot be gauged solely by examining the central bank legal framework (Forder 2001: 203). Economists’ large-scale quantitative studies understate the Bank’s operational independence before the 1997 reform, because the analytical measures used are typically formal and fail to pick up the nuances of the relationship between the central bank and the government. These studies also tend to overlook the central bank’s policy capacity in financial regulation and supervision – and hence the interaction with financial actors – because they focus mainly on monetary policy. It is worth noting that, at least according to some British central bankers, the legal provisions concerning the central bank, up to the 1997 reform, were deliberately formulated in rather ambiguous terms, and this was seen as enhancing the Bank’s room for manoeuvre rather than constraining it. Furthermore, classifications based on formal features do not take into account the central bank’s intangible assets, such as its capability to achieve its goals by ‘moral suasion’, or the effects of

18 The Bank of England international institutions, such as financial supervisory regimes and exchange-rate regimes, which can provide resources (as well as additional constraints) to central banks interacting in the national arena. Adopting a multi-level, historical institutionalist approach, this chapter first outlines the trajectory towards central bank independence in the UK, as well as the evolution of the central banking legal framework and model of legitimacy. It then examines the organizational, national and international institutional framework of central banking governance in the UK, evaluating central bank autonomy (or de facto independence). The second part of the chapter examines the evolution of core policies in which the Bank of England has been involved, assessing the policy capacity of the Bank in different areas over the last two decades or so.

The three-level framework of central banking in Britain The core assumption of the historical institutionalist approach taken in this research is that not only do institutions matter, but they are the main explanatory variable of modes of central banking governance. The crucial questions to be empirically addressed then become which institutions matter most, how and why. When analysing the multi-level, institutional framework of central banking governance and its evolution over time, it is important to distinguish three levels: the microinstitutional or organizational level, mainly related to the governance structure and specific assets that each central bank possesses, which can ‘empower’ (or not) the central bank; the macro-institutional level, that is, the national political and economic institutions that can provide (or deny) opportunity structures for central banks seeking greater autonomy and policy capacity; and the level of international institutions, especially when, either de facto or de jure, they impose or project certain institutional and policy templates, to which national central banks are expected to adapt, or they provide strategic resources to national policy-makers, or they facilitate the circulation of ideas. The punctuated trajectory towards central bank independence in Britain Before the Bank of England Act 1998 the main legal provisions concerning the formal institutional structure of the central bank were part of the Bank of England Act passed by the Labour government in 1946, when the nationalization of the Bank was decided by an Act of Parliament and the ownership of the Bank shifted from shareholders to the Treasury, against government stock. The Act (Article 4.1) stated that ‘the Treasury may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest’. The Bank of England had no statutory independence, even though the 1946 Act was silent about the detailed execution of policies (Moran 1986; Eizenga 1991). In 1959 the Radcliffe Committee, formed to examine the operation of the monetary system, delivered its report. It called for greater co-operation between the

The Bank of England 19 Bank of England and the Treasury, making the Bank institutionally more integrated into the Whitehall machinery, which suggests that the Bank had previously operated with independence. Afterwards the Bank of England struggled to assert its authority for most of the 1960s and early 1970s (Kynaston 1995: 31), though in certain (perceived) technical areas, such as banking service regulation and supervision (see the Competition and Credit Control Act, 1971; Moran 1986), the Bank had a significant input. After the election of the Conservative government in 1979, the Treasury assumed a responsibility for monetary policy that it had hitherto not enjoyed to the same extent, as it was felt that ‘monetary policy was too important to be left to central bankers’ (interview, London, January 2006). More generally, under the governments of Margaret Thatcher the autonomy and policy capacity of the Bank of England were reduced, even though there was no significant formal institutional change in this respect concerning central banking legislation. However, the de facto change of political institutions through the strengthening of the executive, and the government’s interference with tasks assigned to the Bank, impinged on the autonomy of the central bank and affected the conduct of specific policies – first and foremost, monetary policy and exchange-rate policy, as elaborated below. Although a short reference to institutional reform in central bank independence was inserted into the Conservative Party’s document The Right Approach to the Economy before the 1979 general election, once the party took office the matter was not seriously discussed until the late 1980s. In 1988 the chancellor, Nigel Lawson, asked Treasury officials to formulate a plan for an independent but accountable central bank.1 Two rationales underpinned this attempt to engineer an institutional reform. From an economic point of view, it was seen as a device to control inflation after the disappointment with monetary aggregate targets and the decision not to take part in the exchange-rate mechanism (ERM), hence rejecting an exchangerate target (Lawson 1992), as explained in the second part of this chapter. From a political point of view, an independent Bank of England was considered preferable to Thatcher’s policy vagaries, which were seen as undermining the overall credibility of macroeconomic policies (Elgie and Thompson 1998; cf. Forder 2000). These two reform rationales were also influenced by the emergence of new monetary policy ideas based on the ‘pseudo-theory of credibility’ and central bank independence (Forder 2004: 4), which gained momentum internationally. Lawson sent a memo to Thatcher outlining his proposal for reform of the Bank of England, but the prime minister did not take up the scheme (Stephens 1996: 277). Lawson’s successor, Norman Lamont, who became chancellor in 1990, was initially not interested in institutional reform of the central bank. However, by 1991 this topic formed once again part of the chancellor’s political agenda, for reasons not very different from those discussed by his predecessor: greater central bank independence would not only strengthen the exchange rate of the pound, which had joined the ERM in 1990 and was under speculative attack, but it would also provide domestic macroeconomic credibility. The reformed central bank of New Zealand was the blueprint for Lamont’s model in the UK (Lamont 1999), presenting an interesting case of policy learning from a country outside Europe. This model entails

20 The Bank of England a statutory objective of price stability, whereby the government agrees with the central bank’s publicly stated targets in order to achieve that objective. Lamont sent a memo outlining the reform proposal to the prime minister, John Major, who, like his predecessor, was not receptive to the idea. As with Lawson’s initiatives, the Bank of England was not informed of Lamont’s proposal (Stephens 1996). Thus, the Bank was largely excluded from the debate on institutional reform: it did not provide the impetus for the reform, nor did it contribute to the substantive content of it. After the withdrawal of the pound sterling from the ERM in 1992, which represented a major policy failure and a source of policy learning for the British Government, a series of incremental institutional and policy reforms took place in the UK. Indeed, some commentators would argue that this event triggered the gradual institutional change concerning central bank independence in the early 1990s (interview, London, December 2005). The government set an inflation target in October 1992, and the Bank of England was given responsibility for preparing the quarterly Inflation Report, initially published in the Bank of England’s Bulletin. In September 1993 the chancellor, Kenneth Clark, announced that the Treasury would no longer examine the Inflation Report before publication, and in November that year the Bank of England was given the power to decide the timing of interest rate changes. Shortly afterwards, despite the reluctance of Major, the chancellor decided that the minutes of the monthly monetary meeting between the chancellor and the Governor of the Bank of England would be published.2 In this instance, too, the prime minister agreed only reluctantly to the reform (Stephens 1996), because of his opposition to the concept of central bank independence. In March 1994 the chancellor set out a new remit for funding government debt, clarifying the respective roles of the Bank and the Treasury (Bank of England Monthly Bulletin, May 1994). Minutes of a meeting between the chancellor and the Governor were first published in April 1994. They opened with an ad verbatim statement by the Governor, in which he put forward a specific proposal on interest rates. The intention was to open up the policy-making process, so the outside world could be aware of the discussions taking place between policy-makers, the Bank and the Treasury (interview, London, January 2006). In this way, unlike in the past, any divergence of policy-makers’ views would be exposed. This move increased the Bank of England’s autonomy and policy capacity, by making it more difficult for the chancellor to deviate from the Bank’s advice or ‘manipulate’ it. The chancellor did sometimes fail to follow the Bank’s advice, though he generally differed by no more than half a percentage point (interview, London, December 2005). The publication of minutes changed the institutional relations within the executive between the prime minister and the Treasury, marginalizing the former on monetary issues. The main critical juncture in central banking governance in the UK was in 1997, when the newly elected Labour government – or, more precisely the new chancellor, Gordon Brown – granted operational independence to the Bank of England, reshaped its governance structure and removed banking supervision from the central bank. Operational decisions on monetary policy were assigned to a Monetary Policy

The Bank of England 21 Committee (MPC), discussed below. It should be noted that a similar reform – that is, the creation of a monetary policy committee of experts – had been implemented in France in 1993. The other important change related to banking supervision, which was assigned to the Financial Services Authority (FSA), even though the central bank remained responsible for monitoring the overall stability of the financial system. This was partly attributable to the supervisory failures of the 1980s and early 1990s (The Independent, 22 May 1997). Another argument for separating monetary policy and banking supervision was that the two functions together in a central bank could generate conflicts of interest when setting interest rates. Losing responsibility for banking supervision was a major blow for the Bank of England, and its timing was completely unexpected (The Guardian, 7 November 1998). Institutionally, these two reforms were complementary and inextricably entwined, because the greater operational independence of the central bank was counterbalanced by the loss of most of its supervisory responsibilities, preventing the Bank from becoming too powerful an institution in the UK, which was a matter of specific concern for the Treasury (interview, London, January 2006). The chancellor of the exchequer – who, with his economic adviser, Ed Balls, was the main engineer of the reform (King 2005) – took everybody by surprise, because before the 1997 election Brown had informed the Governor, Eddie George, that the Labour Party, if elected, would keep the existing framework, but it would also establish a monetary committee, to be officially responsible for providing advice to the chancellor (The Times, 4 April 1997; 7 May 1997). Only after evaluating the functioning of this arrangement could a Labour government contemplate greater independence for the Bank of England.3 The economic rationale for speeding up the reform was to increase macroeconomic credibility, by giving the signal that monetary policy was not conducted according to political (rather than economic) considerations, as had happened many times in the past (interview, London, December 2005; The Times, 4 April 1997).4 Moreover, because of the policy failures of the Labour government in the 1970s, the absence of New Labour credibility in this regard was significant when it was elected in 1997 (Goodhart 2002: 194). The political rationale was that the creation of an operationally independent central bank would shift the blame away from the government whenever high interest rates were needed to curb inflation (Elgie and Thompson 1998). Indeed, the Bank came under attack in 1998, when the MPC kept interest rates high despite the strong pound (Kynaston 2001: 774). However, in the following years the overall assessment was reversed and the reformed Bank of England gained much plaudit. The legal framework of the Bank of England A review of the statutory analysis of the Bank of England before the 1997 reform reveals a low level of central bank independence, both ‘political’ and ‘economic’. As for the formal political independence of the central bank, the Bank of England used to score poorly on the basis of legal provisions regarding personnel

22 The Bank of England independence and decisional independence. De facto, the power of appointment was exercised in a partisan way by the government throughout the 1960s, and especially under the Conservative governments of the 1980s and early 1990s (Elgie and Thompson 1998). For example, in 1983 the Governor, Gordon Richardson, was not reappointed following disagreements with the government – more precisely, the prime minister and the chancellor (Kynaston 2001). Robin Leigh-Pemberton, who took over from Richardson, was a private banker and was regarded as sympathetic to the prime minister’s approach to macroeconomic policies (Reid 1988: 222). In 1993 the Deputy Governor, Eddie George, became Governor, while an outsider, Rupert Pennant-Rea, former editor of The Economist, became Deputy Governor. When Pennant-Rea left he was replaced by another outsider, Howard Davies, who had been director-general of the Confederation of British Industry and was later appointed as chairman of the FSA. With the 1997 reform, the Bank of England was granted operational independence in monetary policy, but the provisions for the appointment of the Governor remained the same, and four of the nine members of the MPC are appointed by the Treasury. However, there is no government representative with voting power in the MPC, and there is a statutory requirement for the Bank to pursue price stability. In practice, it should also be noted that when Eddie George retired, he was succeeded by an internal appointee, the Deputy Governor, Mervyn King. Internal appointments generally imply greater autonomy for the central bank, as they suggest a less direct influence of partisan politics in the appointment process. On that occasion, the appointment of the Governor was also inextricably linked to the government’s decision on the single currency, in that King, like his predecessor, maintains a lukewarm attitude towards the single currency, as did the chancellor, Brown (Financial Times, 18 September 1998). Two criticisms can be made concerning the appointment process, and hence the personnel independence of the reformed Bank of England. To begin with, the appointed members of the MPC serve for too short a time (three years), since it takes between six months and one year for newcomers to settle in and master the tasks required (interview, London, December 2005). There is also a case to be made for maintaining some continuity on the committee. Moreover, since the mandate is renewable, the relatively short period of appointment, coupled with the possibility of being reappointed, could potentially reduce the independence of these members from the government. Second, some commentators would prefer the Treasury to provide an explicit job description, outlining in advance the criteria that will be used to judge the suitability of candidates for the post (Financial Times, 2 May 2007). The economic independence of central banks can be interpreted in two ways. The first aspect is connected with operational independence, such as setting the discount rate, which before the 1997 reform was the ultimate responsability of the Treasury, and the management and financing of the public debt, particularly, the possibility of monetizing the public deficit. In this respect, when examining the period before 1997, it is important to distinguish between legal provisions and actual behaviour. Legal provisions did not rule out monetary financing, which did

The Bank of England 23 indeed take place in the 1970s but ceased in the late 1980s, partly because the publicsector borrowing requirement (PSBR) became positive. In the 1990s the PSBR was at times in deficit, but apart from 1992 these deficits were never very high. Article 104 of the Treaty on European Union (TEU; the Maastricht treaty) signed in 1992 prohibits government borrowing from the central bank, though the UK is exempt so long as it remains a non-member of EMU. The Treasury has had access to what is known as a Ways and Means Facility, which is held at the Bank. Since the 1997 reform the facility has been frozen at just over £13 billion, as agreed between the Bank of England and the Treasury. In 1997 the function of debt management on behalf of the government was transferred to the Debt Management Office, an executive agency of the Treasury. The second aspect of economic independence refers to financial independence, that is, the economic resources available to the central bank, which form a core component of its tangible assets but also affect its intangible assets, such as the calibre of its personnel and the expertise at its disposal. Although the Bank of England’s budget does not need to be approved by the government, the latter can, in its capacity as shareholder, question the spending and financing of the Bank of England. Yet precisely because it is a shareholder, the Treasury has an interest in the profitability of the Bank (interview, London, November 2005). Model of legitimacy of the Bank of England If a long-term perspective is taken, the model of legitimacy of the Bank of England has undergone significant changes. In the first part of the twentieth century, especially at the time of the legendary Governor Montague Norman, the central bank’s mystique provided a specific type of expert-based legitimacy to this public institution and its activities. In the 1970s, 1980s and early 1990s, the limited accountability and lack of transparency – the Bank had no public reporting obligations – were somewhat compensated for by the fact that the Bank had limited formal independence. The post-1997 model of legitimacy is both input-oriented and output-oriented, as it is largely based on the principle of accountability to the political authorities and the transparency of the Bank’s decision-making. This model combines individual accountability for each member of the MPC within a collective decisionmaking body. The MPC’s decisions are announced after each monthly meeting, and the minutes of the meetings are published 13 days later. The quarterly Inflation Report includes the MPC’s projections of inflation and output, and explains how the Bank intends to meet the inflation target and support the government’s economic policy. According to the Bank of England Act passed in 1998, the Bank is accountable to the House of Commons through the Treasury and Civil Service Committee.

24 The Bank of England The micro-institutional framework: the Bank of England The governance structure of the Bank of England The Governor is appointed by the Crown for a period of five years on the recommendation of the prime minister in his capacity as First Lord of the Treasury, after consultation with the chancellor of the exchequer. Before 1997 the Bank had a rather hierarchical governance structure, because that was the institutional layout that would permit the Bank to maximize its autonomy and policy capacity vis-àvis the government. In other words, to ensure that the government took due account of the Bank’s views, only top senior officials (the Governor and Deputy Governor) were allowed to speak on behalf of the Bank (interview, London, December 2005). There was a senior standing committee, the Treasury Committee, which had a mainly advisory function and consisted of the Governor, the Deputy Governor and seven members of the Court of Directors chosen by secret ballot. The Treasury Committee stood down in 1992. The Bank of England Act 1998 established the MPC,5 which comprises the Governor and Deputy Governors, two of the Bank’s executive directors (the Bank’s chief economist and the executive director for market operations) appointed by the Governor after consulting the Treasury, and four members appointed by the chancellor of the exchequer. The Treasury has the right to be represented in a nonvoting capacity, as the aim is to facilitate the macroeconomic dialogue. The Treasury’s representative has the opportunity to provide information about the government’s plan on fiscal policy and the Bank is in a position to explain to the government the Bank’s reasoning in the conduct of monetary policy (interview, London, January 2006). The members of the MPC are appointed for a renewable period of three years, on the basis of their professional qualifications. Whereas some of them have an academic background, others are economists or practitioners from the financial sector. Decisions are made on a one-person, one-vote basis, with the Governor having the casting vote if there is no majority. The establishment of the MPC has rendered decision-making more pluralistic at the Bank; for example, on one occasion in August 2005 the MPC voted against a proposal supported by the Governor. In the early years of the new system some members of the MPC not drawn from the banking community complained about the limited amount of research support that was made available to them at the Bank, suggesting it was a way to try and limit the influence of the external members in the MPC’s deliberation process (interview, London, October 2005). Other external members of the MPC would challenge this interpretation, however, recognizing that in the initial period there were resource constraints, which were addressed by the Bank by hiring new economists to provide adequate research support to the MPC (interview, London, December 2005), as discussed in the following section. The Court of Directors consists of the Governor, two Deputy Governors and 16 directors, appointed by the Crown for a renewable period of three years. In the past the directors were mainly drawn from the City elite. Some of them took part in

The Bank of England 25 standing and ad hoc committees, the most prestigious being the Committee of the Treasury (Hennessy 1992: 198). This composition of the court also facilitated liaison between the Bank and the City (interview, London, November 2005). Nowadays, the composition of the court is more varied and includes, for example, trade union leaders. The main responsibility of the court is to manage the Bank’s affairs, with the exception of the formulation of monetary policy. The Board of Banking Supervision is an advisory body established by the Banking Act in 1987 and before 1998 consisted of the Governor, the Deputy Governor, the executive director responsible for banking supervision and six independent members appointed by the chancellor of the exchequer and the Governor in a joint procedure. Members had the obligation to notify the chancellor if the recommendations of the independent members were not adopted, although this power was never actually used (Eizenga 1991). Before 1998 the Board of Banking Supervision was chaired by the Governor of the Bank of England, but with the transfer of responsibility for banking supervision to the FSA, the Bank of England Act 1998 provided for the non-executive, independent members to elect a chairman from among their number. The chairman of the FSA and the chancellor jointly appoint the independent members, and the number of ex officio members has now been reduced to two, namely the chairman of the FSA and the managing director of financial supervision at the FSA. The intangible assets of the Bank of England Advanced economic knowledge constitutes an intangible asset for a central bank. The most significant progress in developing cutting-edge ‘technical’ knowledge within the Bank was made with the 1997 reform and the creation of the MPC, which represented a peak in the Bank of England’s acquisition of expert advice from wellknown academics, professional economists and practitioners. In addition, the number of research staff was increased, and a survey of the research staff of 34 central banks indicates that the Bank of England has more than doubled its research staff, from 23 in 1997 to 49 in 2003 (St-Amant et al. 2005). Compared with other central banks, the Bank of England has the second-largest number of employees with doctorates. The Bank maintains a well-consolidated scheme for study grants, as well as hosting the Centre for Central Banking Studies, which conducts comparative studies and provides expert advice for central banks throughout the world. In a recent study on the quality, quantity and relevance of central bank research in Europe and other Western countries, the Bank of England ranks very high in the production of journal articles in the period 1990–2003 (St-Amant et al. 2005). The Bank of England, the Banca d’Italia and the ECB are the only non-American representatives among the top ten central banks in quality-adjusted output (publications in top-level journals). As for policy relevance, the publications of the Bank of England are among the most frequently cited in papers and documents of policy-making institutions. The Bank of England has a prolific working paper series. Staff numbers at the Bank of England peaked at 7,000 in 1970, but then declined, falling to 4,000 in 1994.6 The number of employees was reduced further

26 The Bank of England to 2,300 after the 1997 reform, when the FSA took over the Bank’s supervisory functions, and about 450 officials working on banking supervision moved from the central bank to the FSA. In 2006 the Bank employed 1,900 officials, and the FSA 2,700. The national institutional framework and central banking governance in Britain Micro-institutional analysis of the Bank of England needs to be incorporated within an analysis of the national institutional setting, considering the effects of national political and economic institutions that affect central banking governance in Britain. As well as undertaking this, the following discussion analyses the institutional relationships between the Bank and the government, and between the Bank and interest groups, in order to gather a more comprehensive understanding of the degree of autonomy enjoyed by the central bank. Political institutions in Britain Britain is a textbook example of a parliamentary democracy, based on the so-called Westminster model, which rests on the fusion of legislative and executive powers in the hands of the majority party in the parliament. There is a strict discipline that party leadership in the government enforces on the majority party. The opposition party is exactly that: the Westminster model rules out any direct power for the opposition. This system promotes decisive, strong government, with responsibility for government actions falling on the party in office (Judge 2005). Moreover, the majoritarian electoral system promotes a political system in which a limited number of political parties exist, only two of which have governing potential. In such a system the number of veto players is also very limited, facilitating institutional and policy change whenever the government so decides (Lijphart 1999). The political system is thus characterized by alternations in power and adversarial politics. The strength of the executive is attributable to several factors: all executive appointments are made by the prime minister; the main parties are relatively well disciplined internally and the government dominates the legislature; the efficient civil service, though sometimes portrayed as a counterweight to the executive, actually strengthens the power of the executive; and the lack of a written constitution (Budge et al. 2004). Since the UK’s state structure tends to be centralized, economic policy-making has been led by the executive and has therefore been directed from the centre (Grant 2002). Moreover, as centralization within the executive is substantial, the key actors are in effect the prime minister, the chancellor of the exchequer and the Treasury. The level of prime ministers’ participation in macroeconomic management has traditionally varied, depending on their interest in and understanding of economic matters and their willingness to become involved in the business of their ministers (Woodward 2004: 8). It has also depended on the strength of the chancellor and the overall electoral strength of the prime minister (Grant 2002: 190). Thus, the

The Bank of England 27 relationship between the prime minister and the chancellor can be harmonious or discordant, as between Margaret Thatcher and Nigel Lawson and between Tony Blair and Gordon Brown, albeit for different reasons. The position of the Treasury in the government machinery is crucial (Middlemas 1991). The British Treasury fulfils the functions of a Ministry of Economics, as well as overseeing the preparation of the budget and controlling public expenditures – all functions that are separated in other countries (Woodward 2004: 7), such as Germany or Italy before the reforms of the Ministry of the Treasury in the 1990s.7 Besides its strong institutional position and economic resources, other intangible assets of the Treasury are the quality of its staff – it recruits the elite of the highestlevel civil service intake and has been portrayed as ‘a shaper and exporter of a civil service elite’ (Deakin and Parry 2000: 21). Chancellors have often held the position for relatively long periods of time, and throughout the chancellorship of Brown the Treasury’s influence has been further strengthened, driven not only by the personal intellectual strength of the chancellor, but also by its power base in the Labour Party (interview, London, October 2005). Relations between the Bank of England and the government On the whole, the institutional relations between the Bank of England and the government have been based on the attempt to reconcile the government’s economic programme and the demands of bureaucratic politics in Whitehall with the Bank’s desire to keep control of banking and exert some influence on monetary policy (Moran 1986). However, the extent to which the Bank has been successful in doing so has varied over time. The 1997 reform changed this traditional relationship, and the central bank now focuses its activity on monetary and financial stability. In order to analyse relations between the Bank of England and the government, which affect the Bank’s autonomy (or lack of it) from the political authorities, it is useful to distinguish two relationships: that between the Bank – more precisely, the Governor – and the prime minister, and that between the Bank (Governor) and the chancellor. Whereas the relationship between the Bank of England and the prime minister has seldom been in the spotlight (unless it was particularly bad), the Bank’s relations with the chancellor have generally been more important, with the chancellor often acting as an intermediary between the government as a whole (including the prime minister) and the Bank of England. Interactions between high-level civil servants in these three institutions have also been very important in ‘smoothing’ such relations (interview, London, December 2005). The Treasury has always been a powerful institution in the British system. Yet for most of the period considered here, the Bank of England had practical knowledge of the market that the Treasury lacked (Kynaston 1995: 35; interview, London, December 2005) – the Bank was often referred to as ‘the Treasury’s East End branch’. Until the 1998 reform, the legal authority to make public bond issues rested with the Treasury, but in practice the Treasury and the Bank of England worked together (Kynaston 1995), and the Bank of England as an agent of the Treasury managed the public debt. However, the Treasury’s own financial expertise grew in

28 The Bank of England the 1980s, and its links with the City, for instance, were cultivated because it was so important to the privatization flotations. Besides the institutional configuration, relations between the Bank and the Treasury also depended on the personalities of the chancellor and Governor, their interaction with the prime minister and the personality of the latter. For example, relations between the Bank of England and the government were strained under the Conservative governments of the 1980s. Chancellor Lawson was a self-confident and outspoken minister, who had a good knowledge of economics and was willing to interfere in the affairs of the Bank and disregard its advice (Kynaston 1995: 31). There have also been instances when the Governor and the chancellor of the exchequer presented a united front vis-à-vis the prime minister, as was the case when Lawson and Leigh-Pemberton confronted Thatcher on the issue of the ERM in the latter half of the 1980s. Moreover, there were examples of excellent working relations between Eddie George, the director responsible for markets (gilts issuance and money market operations) at the Bank (and later Governor) and the permanent secretaries at the Treasury in the late 1980s and early 1990s (Reid 1988: 223). There have also been periods of tense relations between the prime minister and the Governor. The most prominent case was Thatcher’s disagreements with Governor Richardson, owing to her active involvement in economic policy and the incompatible personalities of these two public figures (interview, London, October 2005). It was principally because of the disagreement between Richardson and Thatcher that the former was not reappointed in 1983 and Leigh-Pemberton, who was more in tune with the prime minister’s policies, was appointed as Governor (Kynaston 2001: 590). However, Leigh Pemberton, acting in his independent capacity, later endorsed the report of the Delors Committee on EMU, despite Thatcher’s opposition to it (Dyson and Featherstone 1999). Following the 1997 reform the Bank has endeavoured to avoid public disagreement with the government and, unlike other central banks in the eurozone, it refrains from commenting on the government’s fiscal policies – which would provide a potential source of friction – except when the overall fiscal stance affects aggregate demand (interview, London, November 2005). However, relatively little is known about the Treasury’s operational relationship with the Bank. On the basis of the information gathered, it seems that the operational independence of the Bank has been respected, and the Treasury has not tried to exert pressure on the MPC. According to one interviewee, ‘the chancellor was bound by his own device’: since it was ‘his reform’, ‘it was a point of principle not to contradict it in practice’ (interview, London, December 2005). That said, it is also important to bear in mind that approximately half the members of the MPC are appointed by the government (i.e. Treasury). Economic institutions in Britain Having examined the main political institutions in Britain, it is important to contextualize central banking governance with reference to the structure of the economy and political economy institutions, which, taken together, can be referred

The Bank of England 29 to as the Anglo-Saxon model of capitalism, subsequently paying specific attention to the configuration of the financial system. The Anglo-Saxon model of capitalism can be characterized in different ways (Albert 1993; Hall and Soskice 2001; Rhodes and van Apeldoorn 1998). Summing up, the main features are: mobility and flexibility in the labour market; limited social welfare provisions; a small mediation role for the trade unions, which tend to have a low membership density; minimal public intervention in the economy; deregulation and often de-industrialization; arm’s-length relations between the source of finance and companies, promoting short-term financial profitability and short-term contracts. The British economic system is characterized by the separation between the financial sector and the manufacturing sector; and the economic strength and political influence of the financial services sector is a distinctive feature of British business. In contrast to other EU countries, the financial sector rests on an extensive securities market (Allen and Gale 2000). Indeed, in the Anglo-American system, securities traded in stock exchanges are the main source of corporate finance (Deeg and Perez 2000). In the UK, as the system is market-based, there is a high degree of non-banking intermediation, with several institutional investors (e.g. pension funds), because private pension schemes are widespread, reflecting the minimal welfare state. London also hosts the largest insurance market in Europe, which, together with a well-developed securities market and a modern banking sector, has promoted the creation of numerous financial conglomerates that took root in the UK at a relatively earlier stage than in other EU countries. In the banking sector there are two bank circuits: retail banking, which consists of banks operating under British law and dealing with deposits and loans; and foreign banks dealing with wholesale investment and international banking. Both banking circuits are characterized by the presence of several large banks. There are no public banks in the UK, and the majority of financial firms in the City are not British-owned. Nor is this a recent phenomenon, because already in the 1980s the City hosted about 400 foreign banks, which helps to explain the Bank of England’s concern about the competitiveness of London as a financial centre for most of the period considered. National varieties of capitalism affect the organization of economic interests, in particular with reference to business associations. The main business associations in Britain, first and foremost the Confederation of British Industry, are ‘umbrella associations’, unlike their counterparts in Germany, whose structure is hierarchical and centralized, which allow them to have a stronger say in policy-making, presenting coherent positions and enforcing internal discipline. In contrast, the system of interest representation in Britain is more pluralistic and more decentralized. Another important point to be made with reference to interest representation in the financial sector in the UK is that trade associations are highly internationalized, in that many of their members are firms that are British-based, but not Britishowned. In the main association in the banking sector, the British Bankers’ Association, 75 per cent of the members are non-British (i.e. foreign-owned banks).

30 The Bank of England Similarly, the London Investment Banking Association, the second-largest banking association in the UK, enlists only foreign-owned companies as members. Relations between the Bank of England and economic interest groups As explained below, until the 1970s bankers relied mainly on the Bank of England to express their views in Whitehall, and the Bank of England relied on banking associations to monitor financial markets for prudential stability, credit control and the allocation of the public debt. In turn, the Bank of England favoured them in various ways, although it has to be said that the Bank of England has always been more concerned with the role of London as an international financial centre than with protecting the interests of particular firms, especially the less competitive ones (Moran 1991). Since the 1980s the role of the Bank of England (and especially that of the Governor) as informal representative of financial interests in Whitehall has gradually diminished. Representative associations became better organized and more influential, whereas they had previously been some kind of gentlemen’s clubs (Grant 2002: 78–9). The Bank, however, remained responsive to the preferences of the financial sector and its priorities – the Bank still regarded itself as the ‘paterfamilias’ of the City (interview, London, December 2005; The Guardian, 9 December 1998). Since the 1997 reform the Bank has sought to distance itself from the City. Breaking with the past, the Bank seems to be less prepared to lobby the government on behalf of the financial sector unless there are public policy reasons that justify the Bank’s involvement. The Bank has also been careful not to get involved in some sectoral issues, such as the withholding of taxes, arguing that its role as a public policy institution is ‘sectorless’ (interview, London, November 2005). As a result, financial operators in the City will from time to time ask the rhetorical question ‘Who is batting for the City now?’ (interview, London, October 2005), especially, but not exclusively, with reference to EU policy-making. (In other words, who is articulating the policy preferences of the City in Brussels?) Since the configuration of the British economy and the Anglo-Saxon type of capitalism have been based on the separation between finance and manufacturing, which many industrialists regarded as working to the detriment of the latter, traditionally the Bank of England was perceived as sympathetic to the financial capital, and less concerned about the competitiveness of manufacturing. Since the 1990s the Bank has endeavoured to change its image as an institution privileging the interests of the financial sector. For example, it championed the reform to facilitate the access of small firms to credit, taking the issue up on the basis of ‘economic sub-optimality’ of the existing arrangements (interview, London, November 2005). The Bank has also been keen to point out that the conditions of the manufacturing sector, as well as other economic sectors, are continually taken into account when formulating monetary policy. Partly as a result of this, but also reflecting the positive economic climate in Britain from the late 1990s onwards, companies within the manufacturing sector have refrained from openly criticizing the central bank.

The Bank of England 31 The relations between the Bank of England and the trade unions have been indirect and lukewarm, although they have improved since the late 1990s – for example, Governor George addressed the Trades Union Congress in September 1998 – mirroring those with the manufacturing sector as a result of the positive economic environment. Nowadays one of the main concerns of the Bank of England appears to be what will happen to its relations with the main interest groups in the case of an economic downturn in Britain (interview, London, November 2005) – the present expectation is that criticisms of its actions and policies will resurface. The international framework and central banking governance in Britain Before the Second World War the Bank of England was one of the main players in the international financial system, a position that declined gradually and substantially in the postwar period. Since then two main types of international institution have affected central banking governance in the UK and other countries, though the main effects have tended to be on policies rather than institutions. First, there are European monetary and exchange-rate regimes, such as the EMS and EMU. Second, there are regimes governing the international regulation and supervision of financial services, which are usually divided into three: the banking sector, the most internationally regulated service, the securities sector and the insurance sector. The latter are of no direct interest to central banking governance. After the unsuccessful experience of the so-called snake in 1972, a new exchangerate agreement was established in Europe with the creation of the ERM in 1979, which the UK decided not to join at its inception (see Ludlow 1982). Despite the fact that the UK was a member of the ERM only from 1990 to 1992, the functioning of the system had both direct and indirect effects on UK monetary and exchangerate policies, the clearest example of which was the shadowing of the D-mark in 1987–98, as explained below. A more indirect effect resulted from the German leadership of the EMS, which meant that the Bundesbank set the monetary policy stance for the rest of Europe – including the UK, which was formally outside the ERM – and determined relations with other currency blocks (Loedel 1999; see Chapter 3), first and foremost the USA. Having opted out of EMU, thereby placing the Bank of England outside the Eurosystem, the UK decided not join ERM 2, the exchange-rate regime established between the eurozone and some EU countries that did not adopt the single currency but were willing to take part in an exchange-rate agreement (see Chapter 5). Despite the fact that the monetary and exchange-rate policies of the eurozone obviously have indirect implications for the conduct of monetary and exchange-rate policy in Britain, convergence towards the ECB/Eurosystem model of central banking governance has been limited and mainly indirect, owing to the lack of mandatory institutional and policy templates. An example of indirect convergence, based on the spread of best (i.e. most efficient) practices, is the Bank of England’s decision to conduct open-market operations on a periodical basis in common with the Eurosystem, and not on a daily basis as the Bank used to do (interview, London, November 2005).

32 The Bank of England With reference to international regimes concerning banking supervision, it is important to mention the Basel Committee on Banking Supervision (BCBS). This Committee was set up in 1974, largely in response to the international banking crisis that hit the UK particularly badly and was tackled through the central banking network at the BIS. Although financial interdependence affected all national regulators, the Bank of England was on the front line in this international joint problem-solving exercise because of the large number of foreign banks based in London (Kapstein 1994). Indeed, the Governor of the Central Bank, Gordon Richardson, and the Head of Banking Supervision, George Blunden, were the driving forces behind the creation of the Basel Banking Committee, which enabled the Bank of England to step up its supervisory policy capacity. Since the creation of the Basel Committee the Bank of England, which had been regarded as one of the best regulators in Europe before the policy failures of the 1990s, has been an influential member, a conclusion suggested by the fact that the two heads of the Bank of England Banking Division served as chairmen (George Blunden and Peter Cooke). In the 1980s the core issue dealt with by the Basel Committee was the establishment of minimal capital requirement, in order to avoid a race to the bottom in financial regulation and hence to enhance the policy capacity of the supervisory authorities. The US Federal Reserve and the Bank of England took the lead in the discussion, and following a US–UK compromise,8 the Committee released a consultative paper (the basis of the Basel 1 agreement) with the purpose of defining capital standards (see Kapstein 1992). It proposed a two-tier system of core and supplementary capital, weighted according to the degree of risk – in particular, credit risk. The Basel Accord signed in 1988 was preceded by a bilateral agreement between the US Federal Reserve and the Bank of England in 1987. Given the fact that, overall, regulation was similar in the UK and the USA, it was relatively easy to reach a bilateral agreement (Kapstein 1994: 113). Moreover, the Bank of England agreed to it as a means of counterbalancing the emerging standards in the EU, to which the Bank of England objected. Subsequently, the Japanese authorities decided to join the US–UK agreement. Eventually, in July 1988 the central bank governors in Basel accepted a proposal that defined the minimum capital adequacy requirements for banks operating internationally. The Basel agreement was transposed into the Capital Adequacy Directive of 1993, which gave legal force to its provisions across the EU and required domestic adaptation. Ten years after the signing of the Basel 1 Accord, the negotiations on Basel 2 gained momentum in June 1999 with the publication of the first consultative paper by the BCBS, followed by other two consultative papers and four quantitative impact studies concerning the implementation of the new rules. The Basel 2 Accord is based on three pillars: (i) minimum capital requirements, which cover three types of risk – credit risk, market risk and, innovatively, operational risk; (ii) the supervisory review process, whereby supervisors are enabled to take measures that could go beyond the minimum capital requirements; and (iii) the discipline imposed by the market, facilitated by transparency requirements.9 The rationale of the

The Bank of England 33 revision was to gear banks’ capital requirements more closely than in the past to the actual economic risk with which they are faced. For calculating the capital ratio, the new accord envisages a series of simple (‘foundation’) and more sophisticated (‘advanced’) approaches to measuring credit risk and operational risk. Basel 2 has been transposed into an EU directive – the Capital Requirement Directive (2005) – which is legally binding on member states. The main driving forces in the making of Basel 2 were the USA and UK, followed by Germany and Japan. Unlike Basel 1, where the Bank of England was the UK’s sole representative, in Basel 2 the Bank shared its competences with the FSA; both these institutions had representatives on the Basel Committee. On the issue of cooperation between the Bank of England and the FSA, the former was in the driver’s seat in Basel 2 owing to its technical capacity; for example, the Bank had the staff with previous experience in the field of ‘calibration’. All quantitative impact studies conducted in Basel were led by senior officials from the Bank of England, whereas the FSA put more effort into drafting the text (interview, London, January 2006). On the whole, there were three major British inputs into the making of Basel 2. The initial route suggested by the Basel Committee in its first consultative paper was to rely on external rating as standard treatment in order to establish capital requirements for banks. However, the Bank of England’s view was that it was too risky to rely only on external rating, especially in markets that are not rated or have no tradition in rating. Rating agencies do not possess better information than the banks themselves, and thus the Bank of England suggested relying instead on internal ratings, a proposal eventually incorporated into Basel 2 (interview, London, January 2006). Second, the Bank acted as a brake on the degree of complexity that was inserted in the document – the Old Lady traditionally favoured light-touch regulation – and placed emphasis on empirical testing. Third, the Bank was concerned about the pro-cyclical effects of Basel 2, and indeed, the first working paper of the Bank of England on Basel 2 raised the issue of the pro-cyclicality of the proposed system. Eventually, these matters were partly addressed, by changing relevant provisions in the agreement. Overall, the Bank of England has been an important player in international and EU regulatory and supervisory forums, often relying on its expertise in this field. Although the technical capability at the Bank remains, its influence in international standard-setting bodies has been reduced by the 1997 reform, because the central bank now shares with the FSA the task of representing the UK’s position.

Central banking policies in Britain This second part of the chapter discusses three main areas where the Bank of England has been involved, with different degrees of policy capacity, over the period 1979–2005. These are monetary policy; exchange-rate policy, which is inextricably linked to the conduct of monetary policy; and financial supervision, several aspects of which are also linked to monetary policy. Other functions of the Bank, such as its role as adviser to the government or as the (informal) representative of the financial sector, are also reviewed.

34 The Bank of England The main objective of this discussion is to understand the policy capacity of the central bank, how it evolved over time, and why. Attention is also paid to the role of ideas in the form of policy paradigms, which are particularly important in economic policies. Finally, policy trajectories are evaluated in order to assess convergence, or the lack of it. Monetary policy capacity in Britain Before the 1997 reform, the responsibility for monetary policy legally rested with the Treasury. The Bank of England had no independent tasks or powers regarding monetary policy; however, besides advisory functions, it had executive tasks in this field and was responsible for issuing banknotes. Thus, it was the government that determined monetary policy and was responsible for its conduct before Parliament (Deane and Pringle 1994: 65). In 1979 the newly elected Conservative government embraced the monetarist paradigm, which postulated that the main objective of monetary policy was to fight inflation by using the instrument of monetary targets and by committing the government to a medium-term financial strategy that set monetary targets years in advance (Goodhart 1991: 272–3). Although the prime minister, Thatcher, was not an economist by training, she and her economic advisers embraced the ‘rhetoric of monetarist theory’ (Holmes 1985: 16). The Bank of England preferred a ‘practical monetarism’ as opposed to the ‘ideologically loaded’ form pursued by the Conservative Party (Kynaston 2001: 554). Throughout the 1980s the government’s obstinate adherence to monetary targets as the main instrument to fight inflation was not shared by the Bank of England, which adopted a more pragmatic approach, reflecting largely its daily contacts with the markets. Already in 1980 the Bank had tried to persuade the government not to switch to a mechanistic moneybased system, as outlined in the 1980 Green Paper produced by the Bank (Reid 1988: 212).10 In 1990 the Conservative government formally abandoned monetary aggregates, even though political ‘discretion’ – rather than monetary rules – had prevailed in the conduct of monetary policy in the period 1983–9 (Cobham 1997). In 1990 the pound entered the ERM, with the intention of using the exchange rate as a disinflationary instrument and subscribing to a strategy that emphasized the importance of ‘imported’ credibility and external commitments in the conduct of monetary policy (see Giavazzi and Pagano 1988). The policy objective, namely reducing inflation, did not change.11 After withdrawal from the ERM in 1992, the government announced inflation-targeting and gave the Bank of England some discretion on timing the implementation of monetary policy decisions, so as to rule out political business cycle effects. According to several policy-makers interviewed, this change, together with the publication of minutes, increased the policy capacity of the Bank in the formulation of monetary policy significantly. In 1997 a major institutional reform of the Bank of England introduced a statutory monetary objective, granting the Bank operational independence. The objective of monetary policy is price stability and, subject to this, supporting government

The Bank of England 35 economic policy. If, in extreme economic circumstances, the national interest demands it, the government has the power to give instructions to the Bank on interest rates for a limited period. Such power can only be exercised through subordinate legislation approved by Parliament. These policy instruments are interest rates and market operations. Since 1997 consumer price inflation (CPI) has remained within 1 percentage point of the government’s target of 2.5 per cent, revised to 2 per cent of CPI in 2004. Concerns that the MPC might be biased in favour of lower inflation have proved misplaced (Financial Times, May 2002). As a result, the Governor has so far avoided writing the open letter to the chancellor of the exchequer that would be necessary if inflation deviated by more than a percentage point from the government’s target. Overall, the monetary policy paradigm moved from the postwar Keynesian doctrine, through the monetarist theory that dominated policy in the 1980s, to a more comprehensive monetary policy paradigm in the 1990s, informed by the literature on central bank independence and macroeconomic credibility. Looking at the policy trajectory, the conduct of monetary policy in the UK shifted from being a politicized activity informed by the preferences of the executive, with the Bank’s policy capacity limited to implementation and advice, to a ‘technical’ exercise performed by an operationally independent central bank, with substantial policy capacity in monetary matters. In the UK, monetary policy discontinuity seems to have been the norm rather than the exception, with a major turning point in 1997, preceded by significant changes in 1992–4. It is also possible to detect a gradual policy convergence towards EU standards, largely set by the Bundesbank before 1999 and by the ECB afterwards, in terms of final objective (price stability), though less in terms of instruments. In other words, there has been a convergence on the view that controlling inflation is a policy priority, even though the inflation-targeting used by the Bank of England is only one of the pillars of the ECB’s monetary policy. Moreover, the institutional setting for monetary policy has exhibited less convergence vis-à-vis EMU countries, despite the fact that the UK has opted for an operationally independent central bank, which is, however, less independent than the Bundesbank or the ECB. Exchange-rate policy capacity in the UK Before the 1997 reform the UK government was ultimately responsible for conducting monetary and exchange-rate policies, which were then implemented by the Bank of England, which also acted as an adviser on these matters. The central gold and foreign reserves of the UK were kept in the Exchanges and Equalization Account and were owned by the Treasury, but managed by the Bank of England as its agent. Consequently, interventions in foreign markets were executed at the risk and on behalf of the account of the Treasury, which held the ultimate power of decision.12 After the short-lived experience in the ‘snake’ of 1972, and after opting out of the ERM in 1979, exchange-rate policy became a salient topic of discussion in Britain, because throughout the 1980s the government was divided internally on

36 The Bank of England whether to seek ERM membership (see Stephens 1996; Thompson 1996). During his term as chancellor of the exchequer in 1981–2 Geoffrey Howe (later foreign secretary) was in favour of joining the ERM, as was Nigel Lawson when he took over the post in 1985, as it was perceived as a way to control inflation in Britain, whereas Thatcher opposed the choice on the basis of arguments relating to the unwillingness to follow the monetary policy of the Bundesbank, as well as the issue of national sovereignty. Although the Bank of England was never particularly keen on external targets or even any targets at all (interview, London, December 2005), by the late 1980s the then Governor of the Bank of England, Leigh-Pemberton, supported ERM membership, a policy strategy designed to fight inflation by using an exchange-rate target (see the Governor’s lecture delivered at the University of Kent, reprinted in the Bank of England Quarterly Bulletin, December 1986). This rationale was based on the idea of deploying an external constraint in the domestic arena in order to reduce the government’s interference with the conduct of monetary policy (Thompson 1996). Moreover, the markets were unsettled by the divergences that existed between the prime minister, the Treasury and the Bank of England. This resulted in a high interest rate premium in the UK relative to other countries. The other reason for the Bank’s support for ERM membership was very much linked to the pro-European attitude of Leigh-Pemberton (Stephens 1996: 32). This became apparent during the drafting of the Delors Committee report on EMU, which was endorsed by the Governor of the Bank of England, despite the prime minister’s request not to sign it (Thompson 1996). As the prime minister opposed full membership of the ERM, Lawson decided between 1987 and 1988 that the pound should shadow the D-mark, using it as an informal target for exchange-rate and monetary policies. However, Thatcher terminated this after less than one year (for a detailed account of this episode, see Stephens 1996; Thompson 1996). In 1990 inflation reached double-digit figures, and the prime minister gave in to the pressure for the UK to join the ERM, after having been urged to do so by the chancellor, the foreign secretary and the Governor of the Bank of England. The decision was taken with minimal consultation with the Bank, which had limited policy capacity in this area. A variety of international, European and domestic factors led to the ERM crisis in September 1992, which culminated in the withdrawal of the British pound and the Italian lira from the ERM after considerable losses of reserves. This was the greatest failure in the field of monetary and exchange-rate policy in the UK since the 1970s. Arguably, the Bank’s policy capacity increased after the withdrawal from the ERM, because in a pegged exchange-rate regime such as the ERM the decision of the fixing of the official parity is taken by the government. In contrast, in a floating regime it is the central bank’s interpretation of market information that guides official action to moderate the fluctuations to which the pound would be liable. Since the political authorities were also keen to be seen as dealing at arm’s length with the Bank, the autonomy of the latter from the government increased slightly in the post-1992 period. Currency depreciation followed, interest rates were lowered and a new monetary policy framework was set in place, based on inflation-

The Bank of England 37 targeting rather than on the exchange rate as an external constraint. Indeed, the exchange-rate policy became subordinate to the conduct of monetary policy. It remained so after the establishment of EMU, because the UK declined to join the ERM 2. Following the 1997 reform the political authorities are still responsible for the choice of the exchange-rate regime, though the Bank has its own separate pool of foreign-exchange reserves to use at its discretion to intervene in support of its monetary policy objective. If the government were to give instructions to this effect, the Bank, acting as its agent, could intervene in the foreign markets, using the government’s reserves. However, all such intervention would be automatically sterilized. Everything considered, the policy capacity of the Bank was slightly greater on exchange-rate policy than on monetary issues and, as in the case of monetary policy, this capacity was substantially increased after the 1997 reform. There are some lines of continuity in the UK’s exchange-rate policy from the late 1970s onwards, the main constant being its refusal to join European exchange-rate agreements, be they ERM 1, ERM 2 or EMU. In terms of instruments, British policy-makers, whether at the central bank, the Treasury or in the prime minister’s office, have generally speaking been in favour of a flexible exchange rate. The exception was the period in the late 1980s, when ERM membership was regarded by senior policymakers at the Bank and at the Treasury as a way of reducing the interference of the prime minister in monetary affairs, as well as an opportunity to acquire greater macroeconomic credibility. This strategy bears some resemblance to the Banca d’Italia’s use of the ERM as an external constraint in the national arena, hence as a resource to be deployed by the central bank domestically in a two-level game (Quaglia 2004a). On the question of whether the UK should join EMU or not, the Bank has officially refrained from taking a public stand. For example, when the debate on joining the single currency heated up in the UK in the late 1990s, the Bank refused to comment on the issue, arguing that this was a decision for the political authorities to take, and had the government decided to join, it would have been part of the Bank’s duty to do everything it had to (interview, London, October 2005). However, informally those at the helm of the central bank – though by no means all senior officials – were and still are against joining EMU for two reasons: the current macroeconomic policy framework in the UK is positively evaluated and joining EMU would imply the transfer of monetary policy competences from the Bank of England to the Eurosystem. In the current conduct of exchange-rate policy the Bank of England adopts a pragmatic approach, which means it is less concerned about the level of the exchange rate than the monetary authorities of the eurozone (or at least some of them). For the Bank of England, focusing on the exchange rate is artificial because the Bank has an inflation target, though exchange-rate markets are taken into account in calculations underlying the formulation of monetary policy. As one policymaker interviewed phrased it, it would be ‘like a juggler with one arm and three balls, trying to juggle all three at once’ (interview, London, January 2006).

38 The Bank of England The British monetary authorities also suggest that the eurozone authorities pay excessive attention to the exchange rate of the euro, given the fact that the eurozone is a large trading and currency bloc that almost equals the size of the US market. Overall, the convergence of the exchange-rate policy of the Bank of England towards the ECB/Eurosystem standard is minimal. Financial supervisory capacity in Britain Before the 1997 reform the Bank of England was responsible for the regulation of the banking sector. On these matters, the Bank of England had always had a considerable degree of policy capacity, partly because of the expertise it possessed, and partly because the government was less interested (or at least less willing) to be directly involved in these matters. This section thus focuses on banking supervision, though it also briefly considers securities markets, given the influence exerted by the Bank of England over the reform of the regulatory framework of the securities sector. The Banking Act 1979, which established a comprehensive legal framework for banking regulation, was introduced after the policy failure of the so-called secondary banking crisis in 1974. This document imposed, for the first time in the UK, a comprehensive system of statutory banking supervision, strengthening the Bank of England’s supervisory role. The 1979 Banking Act contained two main provisions, namely, that banks taking deposits had to be either recognized or licensed (hence, establishing a two-tier licensing system), and that both recognized and licensed banks had to contribute to a deposit protection fund (Coleman 1996: 187). The Bank of England was appointed as the sole superior of the banking system and given broad legal power to administer the law, though under certain circumstances banks could appeal to a tribunal established by the Treasury. By investigating the origins of the Act, it seems clear that the Bank of England was the first to realize that new legislation was needed to regulate banking services, but it faced the traditional dilemma of how to reconcile informality and legal control. The second catalyst that stimulated the introduction of the Banking Act was the domestic adaptation to the draft banking directive issued by the European Community in 1977, which required the formal licensing of all deposit-taking companies operating in the member states and a growing pressure for enhanced investor protection (Hall, M. 1991). The 1979 Act was amended by the Banking Act 1987, which was again drawn up after a major policy failure, namely the Johnson Matthey Bankers affair of 1984. On that occasion the Bank of England agreed to rescue the firm without informing the government, until it was too late for the government to reverse the decision (Reid 1988: 228–30). The prime minister, Thatcher, was so disappointed that she even contemplated the possibility of taking away the Bank of England’s supervisory powers (Lawson 1992: 402). It should also be noted that, unlike in 1974, private bankers were unwilling to share the burden of this financial rescue to the extent requested by the central bank, which ultimately had to bear much of the cost (Kynaston 2001: 656). It is, however, indicative of the policy capacity of the Bank

The Bank of England 39 in this field that the committee set up by the Treasury to investigate the system of banking supervision and the conduct of the central bank was chaired by the Governor, Leigh-Pemberton, and included two Bank officials (Coleman 1996: 187). Drawing on the report produced by the committee, the Treasury produced a white paper that formed the basis of the 1987 Banking Act, which accommodated the Bank’s light-touch approach to supervision (Coleman 1996: 188). The 1987 Banking Act made the central bank responsible for supervision of all the institutions within the monetary sector, removing the distinction between recognized banks and licensed deposit-takers. It gave greater powers to the Bank of England, including the power to issue formal directives to ensure compliance, and the Board of Banking Supervision was created to advise the central bank on supervisory issues, as explained above. In the securities sector, the Bank of England provided an important input into the so-called Big Bang in the London financial markets. The ‘City revolution’ is a shorthand term for a series of changes in ownership structure, trading practices and supervisory arrangements implemented in the financial services sector. The Bank of England was the core promoter of regulatory change in the 1980s, with a view to defending London’s position as a major financial centre, a situation that allowed the Bank to play a leading role in international central banking supervision (Moran 1994: 162). Although the Bank was not responsible for the supervision of securities, there was some inevitable involvement, in that many banks operated in securities. In a pre-emptive move to prevent the creation of a strong regulatory authority in the securities sector that could potentially challenge its position, in May 1984 the Bank of England created a City panel of ‘wise men’ to discuss these matters (Coleman 1996: 192). Their report was never published, but their advice was incorporated in the 1985 white paper of the Department for Trade and Industry entitled Financial Services in the UK: A New Framework for Investor Protection (Lomax 1987; Hall, M. 1991), which was the basis for the 1986 Financial Services Act. The Act aimed to provide a statutory-based system of regulation. It delegated supervisory powers to Self-Regulatory Organizations (SROs) in different sectors, overseen by the newly created Securities and Investment Board (SIB), which was a private body financed by levies on the industry, with a chairman appointed by the secretary of state in agreement with the Governor of the Bank of England. The other members of the board were appointed by the Governor in agreement with the secretary of state. In the case of financial conglomerates, the Bank of England was established by the Act as the lead regulator (Coleman 1996: 194). The effectiveness and policy capacity of the Bank of England in prudential supervision were challenged by two major policy failures in the 1990s: the Bank of Credit and Commerce International (BCCI) affair in 1991 and the Barings scandal in 1995.13 In neither case did the Bank of England intervene by providing funding. Moreover, unlike in 1984, the Bank was unable to monitor the official inquiries into its conduct, and the Treasury and the Civil Service Committee produced a report that criticized the Bank for failing to apply the law (Coleman 1996: 189). It was partly in response to these events that the 1997 reform assigned banking supervision to the FSA. The current model of financial service regulation and

40 The Bank of England supervision for the entire financial sector in the UK is therefore based on a single agency, which is responsible for micro-stability, prudential supervision, conduct of business and disclosure. Financial stability must be pursued in co-operation between the FSA and the Bank of England, which is still primarily responsible for it, while the power of the competition authority in the financial field remains unchanged. Each institution’s separate role in the tripartite framework established in 1997 is set out in a Memorandum of Understanding. The new regulatory structure also ended the two-tier system that split responsibility between the SIB and the SROs. This system was regarded as inefficient, confusing for investors and lacking accountability, because responsibilities were not clearly allocated (Treasury statement, 20 May 1997). There were three reasons for changing the supervisory policy framework in Britain in 1997: the policy failures of the early 1990s, not only in the banking sector, but also in the two-tier system of the SIB (for example, the mis-selling of pensions); concerns about too much institutional power being concentrated in the hands of the central bank once it had been assigned operational independence in monetary matters (interview, London, October 2005); and the increased complexity and interlocking of financial activities, which changed the existing economic institutions and made necessary the creation of more comprehensive statutory regulation and a unified approach to supervision (Treasury statement, 20 May 1997; see also The Banker, 4 July 2005), especially for financial conglomerates, bearing in mind that the UK has the largest number of conglomerates in the EU. It should also be noted that a similar reform had been implemented in the Nordic countries in the 1980s, and was subsequently carried out in Germany in 2002, as well as in other European and non-European countries.14 To sum up, the paradigm concerning banking regulation and supervision in the UK shifted from a policy style based on informality, mainly using non-statutory instruments such as moral suasion, voluntary compliance and non-obtrusive supervision by the central bank in the 1970s (Reid 1988: 206), to a more formally (i.e. statutorily) regulated system, with expansive formal powers assigned to the Bank of England, which was equipped with effective instruments to exercise supervision in an internationalized and more competitive policy setting in the 1980s (Coleman 1996: 186). In the 1990s a new policy paradigm in supervision gained ground, placing more emphasis on consumer protection and micro-efficiency, and on the institutional model that separates central banking functions, mainly monetary policy, from prudential supervision. Over time, policy discontinuity seems to prevail in the UK in this area. This, however, does not result in overall convergence with the rest of the EU, principally because, in contrast to the situation in monetary policy, supervisory policies and institutions have not converged significantly across the EU, though they have converged to some degree in European sub-groups of states. For example, a framework similar to the post-1997 British model – that is, a unified regulator for the whole financial system but separated from the central bank – was introduced in the Nordic countries in the 1980s and, after the Bank of England’s reform, was adopted by the German authorities through the creation of the Federal Financial

The Bank of England 41 Supervisory Authority, the BaFin. However, by looking at the variety of models of financial services regulation and supervision even across the eurozone (for example, Italy, Spain and France), it is difficult to detect significant convergence at this stage. Other functions and roles of the Bank of England The Bank of England provides a variety of services to the government and performs specific roles that relate to the domestic context in which the central bank is embedded. Some of these functions have changed over time, as part of an overall process of convergence in the EU. The Bank of England is banker to the government and the bankers’ banks. It is responsible for the main account of the government, though it is currently trying to pull out from retail banking for government deposits. In the past, central bank lending to the public authority was permitted without credit restrictions, and the Bank of England could manage the public debt and issue new bills. After 1998 the management of the debt was transferred to the Treasury, as happened in Italy and Germany, where a debt agency was created. In common with other EU central banks, the Bank of England manages the payments system, providing clearing and settlement systems to all clearing banks. All commercial banks are obliged to keep a non-interest-bearing deposit at the Bank, which acts as lender of last resort (LLR) for the financial system. Throughout the period examined in this research, the Bank of England, relying on its intangible assets, has acted as adviser to the government, in a capacity that has extended beyond matters of monetary policy, trying to prevent policy choices the Bank regarded as inappropriate. In a memorandum issued in 1980, the Bank commented as follows: ‘Economic policy is the responsibility of the government and is determined by ministers. Policy decisions are, however, the end product of the assimilation and discussion of studies, forecasts, advice and proposals available to ministers from a wide range of sources, in which processes the Bank of England has a role to play which can be distinguished from that of government departments’ (Bank of England 1980: 177–80). Some former senior officials at the central bank would go so far as to argue that the Bank of England was one of the most independent central banks, not with reference to the implementation of monetary policy, but with reference to its role as independent adviser to the government, strengthened by the central bank’s experience with the markets (see also Eizenga 1991). However, the Bank of England’s role as adviser to the government became less important as time passed, because the Treasury became more familiar with the market, and also as a result of the difficult relations between the Bank, the Treasury and the Prime Minister’s Office in the 1980s. Indeed, neither the chancellor, Lawson, nor Thatcher took particular account of the Bank of England’s technical advice. After 1998 the Bank seemed to be rather keen to delimit this advisory role to issues framed in terms of public policies, rather than specific sectoral issues concerning the City, as had happened for most of the period considered in this study. All the central banks have relatively close contact with the banking community, and more generally with the financial system, but this was particularly true of the

42 The Bank of England Bank of England, which was, at least until the 1980s, often regarded as an informal representative of the financial sector in policy formulation and implementation, as explained above. Three reasons were given for this mediating role. First, the Bank of England was responsible for prudential supervision, hence there were close and frequent interactions between the regulator (the central bank) and the regulated (the banks). Second, the City is one of the world’s leading financial centres, which was a comparative advantage to be cultivated by the central bank – it was a tangible asset for the Bank. Unlike many other central banks, ‘one of the core purposes of the Bank of England has always been to ensure the effectiveness of the financial system’ (interview, London, January 2006). Third, this was also a strategy of the central bank designed to act as a counterweight, or to limit the government’s interference with the affairs of the Bank. It was precisely for the opposite reasons – the loss of the central bank’s competences in banking supervision, operational independence from the government and the primary focus on monetary policy – that the 1997 reform brought an end to this specific role performed by the central bank. The change of Governor in 2003 also made a difference in this respect. Whereas Eddie (later Lord) George, who had headed the central bank since 1993 and had spent almost his whole career at the Bank, was still rather sympathetic to the traditional approach in the Bank’s relations with the City, his successor, Mervyn King, was eager to increase the Bank’s focus on monetary policy (Financial Times, 7 January 2005). He reduced the Bank of England’s three core purposes to two: monetary stability and financial stability. The third, financial efficiency and effectiveness, could either be subsumed under financial stability or could be dispensed with altogether, if it meant promoting the interests of financial operators in the City, for this was no longer seen as a suitable task for the central bank. The internal organization of the central bank was restructured accordingly (Financial Times, 17 January 2005). If the Bank of England was for most of the previous period eager to rely on and foster a central banking mystique, or was at least reluctant openly to disclose its operations, the image that has been promoted since the 1997 reform is that of an ‘intellectual arbiter’ and a ‘technical body’ that has refrained from intervening in policy disputes, unless the Bank’s involvement could be justified by public policy objectives, as opposed to particularistic interests (interview, London, November 2005). An overall assessment of the mode of central banking governance in Britain In practice, the bank’s autonomy vis-à-vis the political authorities has fluctuated over time, reaching its lowest ebb in the 1980s, largely as a consequence of a de facto change of political institutions in the UK, which saw the strengthening of the executive under a very assertive prime minister. The Bank’s autonomy increased after the innovations introduced in 1992–4, and even more after the 1997 reform of the central bank legal framework, which improved its legal economic and political

The Bank of England 43 independence and set in motion specific mechanisms to ensure accountability and transparency, overhauling the traditional bases of central bank legitimacy in Britain. The policy capacity of the Bank has varied across policy areas, as well as over time. As part and parcel of the Bank’s reduced autonomy, and in line with the government’s interest and involvement in monetary policy and exchange-rate policy in the 1980s and early 1990s, these policies became subject to strong political direction. The situation was reversed by the 1997 reform, which granted the Bank operational independence in monetary policy, even though the government had already released its grip on monetary matters following the 1992 exchange-rate crisis (or at least this was the political message it aimed to deliver). As far as financial services regulation and supervision is concerned, the policy capacity of the central bank was noteworthy before the creation of the FSA in 1997. Such advanced policy capacity was the result of the particular configuration of economic institutions in the UK, where the City not only had a prominent position in the economic system, but also enjoyed consolidated relations with the central bank. It also built on intangible assets such as expertise and moral suasion, which the Bank could command in this (perceived) technical area. Officials at the Bank worried that greater independence in monetary policy would lead the government to restrict other areas of the central bank’s rather broad mandate (Coleman 1996: 183), as indeed happened in 1997. The 1997 reform, which sanctioned the creation of the FSA and conferred on it the regulation and supervision of the entire financial sector, left the Bank of England with a residual policy capacity in this area, though it is still responsible for the overall supervision of financial stability in co-operation with the Treasury and the FSA. With reference to the multi-level institutional framework outlined in Chapter 1, international and EU institutions have had an impact on both the policy capacity and the autonomy of the Bank of England, although their main influence has been on policy-making (hence, fostering policy convergence), rather than on institutions, which tend to be more resilient to change.15 It is partly because of the UK’s limited participation in EU monetary regimes and partly because of the Bank’s expertise in supervisory matters, which have been mainly discussed at the BIS, that the Bank of England’s influence has been greater in international supervisory forums (the negotiations of Basel 1 and 2 were clear instances of this) than in EU monetary institutions. The UK’s decision to opt out of the ERM (the technical part of the EMS) and later out of EMU has reduced the effects of EU monetary institutions on central banking governance in Britain, at least as far as direct adaptational influence is concerned, meaning the imposition of specific policy and institutional templates. However, indirect influence, promoting the circulation of specific economic ideas and best practice, has been noticeable (King 2005). Although the chancellor, Brown, presented the 1997 reform as a ‘British solution to meet British needs’ (Treasury statement, 6 May 1997), the enhanced independence of the central bank in Britain was also the result of ideational diffusion that

44 The Bank of England began in the 1980s, in Europe and worldwide (King 2005). It was a core part of the stability-oriented paradigm, which had successfully been embodied and ‘exported’ by the Bundesbank (McNamara 1998). However, it also maintained some specific British features, ingrained in the domestic institutional context and normative order, such as the mechanisms for central bank accountability and transparency. Finally, in financial services regulation and supervision in the 1990s and 2000s there have been examples of institutional and policy transfer, operating in both inward and outward directions across countries, without the direct influence of the EU. Thus the model of a single independent regulator for the whole financial sector was implemented in the Scandinavian countries in the 1980s and introduced in the UK in 1997. In turn, the creation of the FSA provided an institutional and policy template for the creation of BaFin in Germany in 2002. Yet one cannot speak of convergence across the EU, where very different models still co-exist even in the eurozone. The Bank has sometimes engaged in a two-level game, a sort of joint problemsolving or ‘collusive action’ with other central banks in international or EU institutions in an attempt to alter domestic opportunity structure, even though this was the exception rather than the rule, given the configuration of domestic institutions. An example was the Bank’s support for ERM membership in the late 1980s, as a strategy designed to increase domestic macroeconomic credibility and as an external constraint to limit the involvement of the government in monetary matters, increasing the central bank autonomy and monetary policy capacity. However, in the UK, unlike in Italy, for example, this was less feasible, due to different domestic political institutions. A strong executive, the absence of major veto-points and a normative order that does not welcome external influence, meant that the domestic use of external constraints was less effective as a way to limit the interference of the political authorities and to tip the balance in favour of the Bank’s policy preferences. At times the Bank of England has played a three-level game. For example, it was eager to reach an agreement on Basel 1 – a legally non-binding international agreement that was later transposed into an EU directive – as a way to counteract the EU banking legislation that was being discussed in the 1980s. Domestic political institutions, principally the strong position of the executive, which increased de facto throughout the 1980s, are crucial in explaining the influence of the political authorities on central banking governance, limiting the autonomy and policy capacity of the central bank, though such interference did not extend to certain technical areas in which the Bank had specific expertise and consolidated relations with economic interest groups, an issue that brings into the picture economic institutions and the special position of the City in the UK economy. Domestic economic institutions have also affected central banking governance, especially its policy capacity in the supervisory field. Although the Bank of England enjoyed close and positive relations with the financial system, often acting as a mediator between the City and the government, the internationalization of the

The Bank of England 45 financial community in the 1980s, and the consequent change of economic institutions in Britain, loosened the contacts between the central bank and the financial system, making the policy style and framework more formal than it had been in the past. The blurring of the boundaries between various segments of the financial sector was also one of the driving forces of the 1997 reform of banking supervision. Finally, institutional micro-assets of the central bank, such as technical knowledge and familiarity with the market, have made a difference at the margins in central bank autonomy and policy capacity, given the strength of the executive. One example was the attempt to influence government decision-making by providing persuasive advice, which was generally more successful when there were no strong political views on a certain matter (see the Banking Acts and the Big Bang). Among intangible factors, ‘secrecy’ and the retention of ‘mystique’ – the Bank of England has never readily divulged its secrets – and the assumption that only the Bank of England understood the market have augmented the Bank’s influence (Kynaston 1995: 40). This changed after the 1997 reform, which made the Bank of England one of the most open and transparent central banks in Europe.

Conclusions Overall, the main institutional and policy changes that have affected central banking governance in Britain have been engineered and brought about by government action, not by lobbying or masterminding on the part of the central bank. In a public hearing Lord Kingsdown (the former Robin Leigh-Pemberton) said that it was open to the Bank of England to stand up to the political authorities, but with considerable restraint, to avoid provoking or inciting a constitutional clash. It was open to the Bank to make any opposition public, but this could be self-defeating if it had an adverse effect on market sentiment. Moreover, not many public forums were available to the central bank in the domestic arena, given the configuration of the political opportunity structure. For most of the postwar period the Bank of England and the government had different policy preferences, not only where the objectives of monetary policies were concerned, but also regarding the instruments and strategies, such as the use of monetary aggregates in the 1980s or pegging the exchange rate in the late 1980s. The Bank’s approach generally tried to reconcile its policy preferences with those of the government although, where disagreement was inevitable or irreconcilable, the government generally kept the upper hand. Among the central banks selected as case studies, the Bank of England was the one that underwent the deepest and swiftest domestically originated reform, but with the caveat concerning ideational diffusion mentioned below. The other national central banks considered here also underwent significant changes in approaching the final stage of EMU, but this was driven by direct external pressure, namely the need for domestic adaptation to positive institutional and policy templates imposed by the EU (to be precise, by EMU), which was not the case for the UK. Despite the

46 The Bank of England fact that some critics regarded the reform of the Bank of England as a preparatory step for future EMU membership, the changes implemented are still far removed from the transformation needed for the UK to join EMU and for the Bank of England to be part of the Eurosystem. Most notably, in the UK the government sets the inflation target, which is not the case in the eurozone.

3

The Bundesbank The central bank that ‘ruled Europe’

The Bundesbank is regarded as one of the most independent central banks in the world, with a solid reputation for price stability. It is a powerful domestic and international actor, which in the postwar period took over the primacy previously enjoyed in Europe by the Bank of England, only to be succeeded by the ECB in 1999. In the various classifications of central bank independence compiled by economists on the basis of the legal provisions concerning the institutional and policy framework of each central bank, the Bundesbank has generally scored very highly, traditionally being regarded as one of the most ‘independent’ central bank (cf. Alesina and Summers 1993; Cukierman 1992; de Haan and Van’t Hag 1995; Eijffinger and de Haan 1996; Grilli et al. 1991), in terms of both political and economic independence, despite the fact that the personnel independence of the Bundesbank de jure has never been very high. A systematic analysis of the empirical record (1978–2005) reveals that central bank autonomy, policy capacity and legitimacy cannot be gauged solely by relying on ‘statute reading’ (cf. Forder 1998). For example, the Bundesbank’s autonomy has largely coincided with its legal independence, though there have been cases in which the Bank has had to make concessions to the political authorities, especially when public opinion has sided with the latter, as explained below. Moreover, the policy capacity of the Bank has varied across policy areas, being greatest in monetary policy but more limited in exchange-rate policy, although compared with other central banks the Bundesbank’s influence on exchange-rate policy was remarkable. The policy capacity relating to banking regulation and supervision, though shared between the Bundesbank and other state (Länder) agencies, was greater than was apparent from either statutory analysis or from listening to the conventional views articulated by the Bundesbank. Similarly, the legitimacy enjoyed by the Bank cannot be gauged simply by looking at the legal provisions for its accountability. This chapter begins by providing an overview of the stable trajectory of central bank independence in Germany, followed by a discussion of the central bank legal framework and model of legitimacy. It then analyses the micro-institutional features of the Bundesbank, before considering the broader institutional framework in which it is embedded, as well as specifically discussing the Bank’s relationship with the

48 The Bundesbank political authorities and economic forces, to gain an understanding of the Bank’s level of autonomy. Throughout the discussion, particular attention will be paid to the analysis of the international setting, given that the Bundesbank, at least until the establishment of the ECB, used to be one of the major players in international and EU institutions. The second part of the chapter discusses the evolution of the main policies conducted by the Bundesbank, such as monetary policy and exchange-rate policy, or policies in which the Bank was involved, such as financial supervision, and various services to the German Government, including advisory functions. In addition, the policy capacity of the Bank in different policy areas is assessed over time. The chapter then concludes by extrapolating the specific features of the mode of central banking governance in Germany, placing it in a comparative perspective, thus establishing a benchmark for other case studies.

The three-level framework of central banking in Germany The stable trajectory of central bank independence in Germany Since its establishment in 1957 the Bundesbank has been statutorily independent of the German Government. In response to the hyper-inflation suffered by Germany after the First World War and in the interwar period, and to counter the inflationary process that followed the Second World War, the law establishing the Bundesbank – the Bundesbankgesetz (BBG) – explicitly referred to the protection of the currency as the primary objective of the Bank (Hayo 1998). Such an objective had two dimensions that informed the policy debate in Germany, as described in the second part of this chapter. The first dimension concerned the juxtaposition of the external value and the internal value of the currency, that is, exchange-rate stability versus internal price stability. The second dimension concerned the relationship between monetary policy and other macroeconomic policies or, to put it another way, the trade-off between monetary policy objectives (first and foremost, price stability) and broader economic objectives (primarily, economic growth). After its establishment there were never any serious efforts to overturn the central bank’s independence through the modification of the Bundesbank Law (Goodman 1992; Sturm 1989), which was supported by both mainstream political parties and the vast majority of public opinion.1 On the whole, before EMU, which was the main critical juncture for central banking governance in Germany, the Bundesbank’s institutional reforms proved minimal – path dependency prevailed, with the exception of the amendments introduced after German reunification in 1991. Moreover, unlike the reforms undergone by other central banks in Europe in the same period, the institutional changes experienced by the Bundesbank did not affect the degree of independence of the central bank, or the priority of price stability. Instead, they affected the degree of centralization of the Bank’s governance structure and its policy scope, and were primarily in response to changes in the domestic and EU institutional context. It should also be noted that, unlike the Bank of England and to a more limited extent the Banca d’Italia, they did not tend to ensue from policy failures.

The Bundesbank 49 The first significant reform of the governance structure of the Bundesbank, which was triggered by German reunification and agreed after a debate that lasted about two years, ending with a political compromise, saw a reconfiguration and a reduction in the number of state central banks, the Landeszentralbanken (LCBs), whose functions are explained in the following section. The main purpose was to limit the number of (state-based) decision-makers in the Central Bank Council. The second major reform of the Bundesbank was an indirect adaptation to membership of the Eurosystem, and indeed the Bundesbank took the lead in 1999 by appointing a committee headed by the Deputy President of the Bank, Jürgen Stark, to formulate a plan for the reform of the internal organization of the Central Bank. However, the two alternative proposals put forward by the committee failed to gather broad support within the federal structure of the Bundesbank (interview, Frankfurt, January 2006). Subsequently, a commission of experts chaired by the Bundesbank’s former President, Karl Otto Pöhl, suggested a mixed model, combining several features of the two proposals previously put forward (Financial Times, 5 July 2000). In January 2001 the SPD finance minister, Hans Eichel, presented two complementary reform proposals, which went further than the reform proposed by the Pöhl report. The first of the finance minister’s proposals concerned the governance structure of the Bundesbank and envisaged a single-tier governing body, the members of which would be appointed by the federal government. The LCBs were to be replaced by regional offices (interview, Frankfurt, January 2006). Although Eichel’s proposal was opposed by the states, especially by Bavaria, it was supported by the Executive Board, first and foremost by the President of the Bundesbank, Ernst Welteke. The second proposal concerned financial services supervision in Germany, whereby banking supervision, together with securities and insurance supervision, would be centralized within one body, the newly created Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin, the Federal Financial Supervisory Authority). Thus, Eichel proposed the establishment of a single regulator, replacing and taking over the supervisory functions of the three existing federal authorities that dealt with the main segments of the financial sector. Banking supervision, which had previously been performed by the Federal Banking Supervisory Board, the Bundesaufsichtsamt für das Kreditwesen (BAKred) in conjunction with the Bundesbank, would consequently be transferred to the single regulator. This reform had the full support of big private banks (Financial Times, 12 June 2001), which favoured a one-stop regulatory body for the whole financial sector as a result of the changes concerning political economy institutions in Germany – briefly, the blurred boundaries between various segments of the financial sector. By contrast, the Bundesbank was keen to carve out a greater role in banking supervision (Dyson 2002: 222).2 Likewise, many states were unhappy with the government proposal on banking supervision, because it would inevitably endanger the competences of the LCBs in this field (Financial Times, 12 June 2001), given that they were de facto heavily involved in supervisory activities, as explained below.3 As the Bundesrat (the upper house of the German Parliament) opposed both these proposals and the Bundesbank opposed the second one (some LCB presidents

50 The Bundesbank also opposed the streamlining of the governance structure of the Bank), the federal government made two amendments to its original plan. Instead of the sixmember executive board initially proposed, an eight-person, single-tier board of the Bundesbank was to be created, with half the nominations made by the federal government and half by the Bundesrat, an amendment that represented a clear concession to the states (Dyson 2003: 223). Moreover, in a concession to the Bundesbank, the amended plan entitled the Bundesbank to exercise joint banking supervision with the BaFin (interview, Frankfurt, January 2006). The modified proposal was eventually approved by the federal Parliament with the use of a legislative manoeuvre, in that the bill was passed by the Bundesrat after the members of the Christian Democratic Union (CDU), many of whom opposed Eichel’s reform proposal, had walked out in protest over the government’s immigration bill. Subsequently, the federal government issued a protocol to clarify the relations between the Bundesbank and the BaFin, as well as the central bank’s competences in banking supervision. The ECB was consulted by the federal government on these reforms, which were by and large endorsed by the ECB in August and November 2001. However, the ECB provided external support to the Bundesbank in its domestic institutional battle, first to extend its supervisory competences,4 and failing this, in keeping the national central bank involved in supervisory matters, given their implication for the stability of the financial system.5 The rationale of the first institutional reform was to make the decision-making process within the Bundesbank more efficient, to enable it to articulate its interests in the ESCB/Eurosystem more effectively (Dyson 2003: 218). It was an indirect adaptation to EMU membership because the decentralized governance structure of the Bundesbank made decision-making at the Bank rather slow. Moreover, on several occasions the members of the Council of the Bundesbank undermined the authority of the President within the Eurosystem, by making public statements on monetary policy or exchange-rate policy in the euro area, at times contradicting the ECB’s stated position (Financial Times, 15 June 2000). The rationale of the second reform was to increase the competitiveness and attractiveness of Germany as a financial centre, providing an improved regulatory framework (interviews, Frankfurt, January 2006) by adopting the model of the FSA in Britain in 1997. Unlike in the UK, the reform in Germany was not a response to major policy failures, but was instead triggered by an incremental change of economic institutions within the country, in particular the increasingly blurred boundaries between segments of the financial sector and the formation of financial (insurance and banking) conglomerates, such as Allianz-Dresdner and Münchner Rück-HypoVereinsbank (Financial Times, 12 June 2001), and the internationalization of this sector. It should also be noted that many of the changes in the financial sector were the indirect result of the introduction of the euro, which gave a new impulse to financial integration in the EU. Moreover, the reform of the supervisory framework was also an indirect adaptation to EMU, which had triggered competition between the main financial centres in Europe to attract capital, bringing to the fore the objective of making Frankfurt the most important financial centre in the eurozone (interview, London, December 2005).

The Bundesbank 51 Overall, except for the crucial issue of transferring key responsibilities in monetary and exchange-rate policies to the ECB, the Bundesbank’s legal adaptation to the institutional and policy templates of EMU has been minimal, because the design of the ECB has been greatly influenced by the model of the Bundesbank (Maes 2004) – it was a matter of institutional fit.6 Not only was the Bundesbank a powerful actor in the negotiations for the TEU (Dyson and Featherstone 1999), but it was also regarded as a highly successful model in the 1980s (McNamara 1998) and was therefore considered a suitable template for the ECB and the national central banks in the Eurosystem. Thus the Bundesbank has been a core actor in promoting ideational diffusion, primarily, though not exclusively, through the EMU framework (Radaelli 2000). Such diffusion has also extended outside the EMU framework (see the reforms towards greater central bank independence in several central and east European countries in the 1990s), and has been part of a broader trend towards central bank independence internationally (McNamara 2002a). Moreover, central bank independence was also part of the acquis communautaire (the consolidated body of EU law) for the new member states. Hence, there was specific legal adaptational pressure for the new member states to adopt this institutional template. The legal framework of the Bundesbank In the economists’ classification of central bank independence, the Bundesbank has scored highly as far as political independence is concerned, and very highly where economic independence is concerned. Political independence is often subdivided into personnel independence (who has the power of appointing the top management of the central bank), which is not very high for the German central bank, and decisional independence in terms of setting objectives, which is remarkable. The procedures for the appointment of top personnel, which have been described above, can be subject to political influence, especially at the state level; there were a number of cases where elder politicians of state parties in power were appointed as presidents of LCBs, despite not having the necessary professional qualifications (Sturm 1989: 4). Nonetheless, the Bundesbank has not become a partisan political institution, for several reasons. First, as the Bank has always been keen to point out, once appointed, the members of decision-making bodies do not act in a partisan way and fully embrace the central banking operating culture and the stability-oriented paradigm, because the Bundesbank has a strong assimilative power – the so-called Becket effect (Neumann 1999: 279).7 The directors have generally been independent, and so have the presidents (interview, Frankfurt, January 2006). Second, the entry age and the period in office have been combined in such a way that individuals have entered office at the end of their working lives (Neumann 1999: 279). For example, the average age of six presidents (out of eight so far) was 60, although Pöhl was 47. The Executive Board was appointed for at least eight years, twice the tenure of politicians, both within the federal and the state governments. Overall, there was a high degree of personnel continuity in the governing bodies of the Bank, especially in the Executive Board (Sturm 1990).

52 The Bundesbank Third, political appointments were not the rule, and, most importantly, did not follow the electoral cycle. For example, Pöhl, a Social Democrat and former journalist, was one of the longest-serving civil servants in Europe; he was appointed by the leader of the Social Democratic Party (SPD), Helmut Schmidt in 1980, and reappointed by the leader of the CDU, Helmut Kohl (Kennedy 1991). Overall, in choosing the members of the Executive Board, the federal government mainly selected individuals acceptable to the banking community and broadly in agreement with the main economic policy objectives of the government. The appointment of the single-tier Governing Board established by the 2002 reform seems to have been informed mainly by criteria based on professional qualifications and reputation. For example, Axel Weber, appointed as President in 2004, is a highly respected academic economist. However, one of the persons interviewed pointed out that the likelihood of civil servants rising through the Bundesbank’s ranks to the top decision-making positions at the Bank is now much lower than before the reform (interview, Frankfurt, January 2006). Indeed, a recurrent criticism of the personnel policy of the Bundesbank is that outsiders have often been ‘parachuted’ into the top positions at the Bank, rather than rising through the internal ranks. When compared with other central banks, the Bundesbank had a large number of ‘outsiders’ in its Executive Board, as well as in the top positions in LCBs. External appointments have also been common in the single-tier Governing Board introduced in 2002. This can be demotivating for the staff of the Bank and is one of the reasons why some senior officials have left the Bundesbank and joined international organizations, such as the BIS. As far as decisional independence is concerned, government representatives are entitled to attend CBC meetings without voting power (Article 13 of the BBG), although this rarely happens. Moreover, before EMU the federal government could suspend the Bundesbank policy acts for two weeks. Although this power was never used (Marsh 1992: 73–4), this provision was abolished in preparation for EMU membership. The Bank’s President is entitled to attend government meetings dealing with issues that are of interest to the Bank. The economic independence of central banks can be interpreted in two ways. The first, which can be called financial independence, refers to the economic resources available to the organization, which form a core component of the tangible assets of each central bank. They also affect its intangible assets, such as the calibre of the personnel it employs and the expertise it has access to, by influencing salary levels. The Bundesbank is owned by the federal government, and all the Bank’s profits, after the funding of reserves, go to the federal government. The second aspect of economic independence is connected with the management and financing of the public debt, and in particular the possibility of monetizing the public deficit. Direct credits of the Bundesbank to the federal state and state budgets were restricted by the Bundesbank Act to emergency measures in order to solve short-term liquidity problems, and they had maximum ceilings. These credit facilities were then abolished in 1994 to adapt the central bank legislation to the provisions of the TEU. The Bundesbank had a high degree of operational independence, which means that it had at its disposal the instruments for the conduct of monetary policy.

The Bundesbank 53 Model of legitimacy of the Bundesbank The Bundesbank is a legal person sui generis, which is not subordinated to the federal government and for which the exemption from parliamentary control is constitutional (Stern 1999: 156). Further, the Bundesbank is not subject to review by the Bundestag (the lower house of the German Parliament), even though the Bank’s annual accounts and audit report are transferred to the Bundestag, a practice introduced a few years ago. The high degree of central bank independence meant that there was not input-oriented legitimacy. The model of output-oriented legitimacy on which the Bank has rested since its inception did not undergo any significant changes, at least until the establishment of EMU. This was because the Bank was domestically a highly respected institution and was able to justify its policies on the basis of an output-based model of legitimacy (cf. Scharpf 1997). Since the Bundesbank delivered policy outputs that were regarded in Germany as effective and efficient by the vast majority of policytakers (those affected by the decisions taken), who were stability-oriented, the Bank’s legitimacy was never seriously questioned domestically, though such a model of legitimacy was criticized in other countries, such as the UK, or when it was adopted as a template for the ECB. The micro-institutional framework: the Bundesbank The governance structure of the Bundesbank Before 2002 the Central Bank Council (Zentralbankrat) was the main policymaking body of the Bundesbank and comprised the presidents of the LCBs and the Executive Board. The presidents of LCBs were appointed by the federal president at the suggestion of the Bundesrat, which based its selection on a proposal made by the state governments, following consultation with the Central Bank Council. The presidents of the LCBs were frequently card-carrying members of the party in office in the states and, except where the state governments changed, LCB presidents were generally re-elected for a second eight-year term until retirement, usually at the age of 65 or 67 (Marsh 1992: 68–9). On occasion nominees for LCB presidency were turned down by the Central Bank Council, only to be appointed on the recommendation of the minister president of the state (Neumann 1999: 278). The organization and size of LCBs varied across the individual states, but before 2002 each LCB had both a managing board and a supervisory advisory board, appointed by the LCB presidents. Although members of the supervisory board were not appointed to represent the economic sector to which they belonged, they were drawn from local businesses, banking, agriculture and trade unions. Within the federal structure of the Bundesbank the LCBs acted as listening posts and played an important role in relation to public opinion, by explaining Bundesbank policies (Kennedy 1991: 18). Some LCB presidents were also able to articulate regional or local interests in Frankfurt, thus affecting the decision-making of the Central Bank Council.

54 The Bundesbank Before EMU, the Central Bank Council set monetary policy in Germany and (indirectly) in the rest of Europe, as discussed in the second part of this chapter. The Council took not only the most important decisions on monetary policy, but also on administrative matters. According to a former member of the Executive Board, policy-making in the Council was a matter of persuasion and argument (Kennedy 1991: 15), while other commentators argued that the Council was largely controlled by the LCB presidents (Conradt 2001: 233). These were often perceived as inwardlooking, and they sometimes had a strong sense of attachment to their states, which informed their policy decisions. By contrast, the LCBs often complained that the Bundesbank’s Executive Board was too internationally oriented and therefore paid excessive attention to external factors (Smyser 1993: 50). The Executive Board (Direktorium), which until its demise in 2002 was based in Frankfurt, was composed of between six and ten (legal maximum) members, who were appointed for eight years by the federal president on the recommendation of the federal government, after consultation with the Central Bank Council (CBC) (Neumann 1999: 278). The Bundesbank Law stated that suitable appointees should have special professional qualifications, and while some members of the Executive Board had political affiliations and others were technocrats, very few came from within the Bundesbank (Marsh 1992: 72). Before 2002 the Executive Board was in charge of the day-to-day management of the bank, implementing the policy decisions taken by the Council and becoming involved when immediate action was required (Stern 1999: 121).8 After the 2002 reform the Bundesbank adopted a more centralized decision-making structure, discussed above. 9 The single-tier Governing Board is now the main policy-making body of the Bank, taking over many of the functions previously performed by the Central Bank Council. The eight-member board of the Bundesbank is nominated jointly by the federal government and the Bundesrat. The President of the Bundesbank had only one vote in the CBC, and since 2002 he has one vote in the single-tier Governing Board. The President represents the Bundesbank internationally, although before EMU his ability to commit the Bundesbank to a particular international policy depended largely on his leadership skills in the Council. Obviously, consensus in the Council reinforced the Bundesbank’s external stance, but, if consensus was lacking, the Bundesbank’s President had to try to win it in the CBC through lengthy negotiations (Loedel 1999). However, since 2002 the President has become relatively more powerful within the Bank, largely owing to the changes in governance structure (interview, Frankfurt, January 2006). It is also necessary to understand how the decision-making process of the singletier Executive Board of the Bundesbank interacts with the decision-making process of the ECB’s Governing Council. Members of the ECB Governing Council are not supposed to act as representatives of national central banks, and therefore the President of the Bundesbank does not act on a mandate from the Bundesbank when taking part in decisions concerning the monetary and exchange-rate policies of the eurozone. Consequently, the President’s vote in the ECB’s Governing Council does not need to be confirmed or approved by the Bundesbank’s Executive Board. The

The Bundesbank 55 only exception is when voting in the Governing Council of the ECB is not carried out on the basis of one person, one vote, but instead on the basis of the capital subscriptions of national central banks, albeit still according to the majority voting principle. In this situation, the Bundesbank President has a clear mandate from the Governing Board of the Bundesbank, as, for instance, in the case of decisions concerning the distribution of the ECB’s profits. Another case of a formal mandate from the Bundesbank to its President is when the ECB has no competence in a certain area and a vote is taken in the ECB Governing Council to expand the ECB’s tasks, in which case unanimity in the Council is also required (interview, Frankfurt, January 2006). One example of the reform of the internal organization of the Bundesbank carried out in response to the ECB decision-making process was the extraction of the European Relations Unit from the International Relations Department, making it report directly to the President and the Governing Board of the Bundesbank. The main task of this department is to co-ordinate the preparations of the Bundesbank President for the ECB Governing Council, to ensure that the positions of the President are consistent over time and across policy issues, which had not necessarily been the case in the early years of EMU. Overall, until 2002 the governance structure of the Bundesbank and the ‘pluralism of appointing institutions’ (Stern 1999: 123–4) reflected the configuration of political institutions in Germany. The collegial nature of the decision-making structure and the internal organization of the Bundesbank before 2002, while similar to the current decentralized structure of the ECB, strongly differentiate it from both the centralized governance structure of the Bank of England before its 1997 reform, and from the very hierarchical internal organization of the Banca d’Italia before the 2002 reform. A core issue, which has at times been explicit and at times implicit and which concerns the Bundesbank’s internal organization, has been the division of power between the centre in Frankfurt and the periphery, namely, the LCBs. Until 2002, with the exception of the 1992 reform, any shift of power towards the centre was prevented by the presence of institutional veto points, such as the state authorities, in the federal German polity.10 According to some observers, even the 2002 reform did not go far enough, because the eight-member Executive Board is still too large, and its composition has hampered the restructuring of the Bundesbank’s headquarters in Frankfurt, as well as the definition of the core functions to be performed by the central bank (interview, Frankfurt, January 2006). Intangible assets of the Bundesbank The Bundesbank had three main intangible assets on which it could rely to foster its independence and policy capacity: its personnel and their expertise, its credibility in the conduct of anti-inflationary policies, as emphasized in economists’ studies (see Giavazzi and Giovannini 1987; Giavazzi and Pagano 1988; cf. Cukierman 1992) and its status as a self-confident bureaucracy, at the very heart of the German state, highly respected domestically and admired internationally (Kennedy 1991;

56 The Bundesbank Marsh 1992). Indeed, the Bank projected and perceived itself as a special civil service entrusted with the goal of defending price stability in Germany. For over 40 years the stability culture widespread in Germany at all levels of society was a condition sine qua non for the Bundesbank’s independence. As part of its intangible assets, the Bundesbank has been careful to foster public support for its activities, meaning the support of public opinion, interest groups and financial press, especially whenever disagreements with the federal government emerge (Goodman 1992: 339). For example, with regard to the controversy between the Bundesbank and the government on German monetary union, the Bundesbank lost out on the issue of a one-to-one exchange rate, partly because public opinion sided with the government, as elaborated further below. By contrast, in 1996–7 public opinion lent valuable support to the Bundesbank on the issue of the revaluation of the gold reserve (Duckenfield 1999), as detailed below. As far as technical knowledge and scientific production are concerned, the Bundesbank does not appear to be in the top rank among central banks, even though its performance has improved in the period post-EMU. The number of researchers at the Bank has increased threefold in the last decade or so, moving from five in 1997 to 16 in 2003 (St-Amant et al. 2005). However, these numbers are quite low when compared with the numbers of researchers at the Bank of England, the Banca d’Italia and the ECB. The number of Bundesbank employees with doctorates is also relatively low.11 Scientific production (in journal articles published by staff) remains rather limited, even though it has increased since 1999, and in 2000 the Bundesbank established its working paper series. These improvements were the result of a deliberate strategy to step up the Bank’s research capabilities, as a way to increase its leverage in policy-making discussion within the ECB. The appointment of Axel Weber, a highly respected academic, as President contributed to fostering the emphasis placed on research. After German reunification the Bundesbank employed approximately 18,000 staff, but this was gradually reduced to 15,000 in 1998, and 12,000 in 2006, with a further planned reduction to 11,000 by 2007. As of 2006 there were about 9,000 employees at state level and 3,000 employees in the central offices in Frankfurt, a slight increase over the previous year despite the significant cut in staff members at the state level. The national institutional framework of central banking governance in Germany The micro-institutional analysis of the Bundesbank needs to be embedded within the analysis of the national institutional setting, considering the effects of national political and economic institutions on central banking governance in Germany. This section also analyses the institutional relationship between the Bank and the political authorities and economic interest groups, in order to gain a better understanding of the degree of autonomy enjoyed by the central bank.

The Bundesbank 57 Political institutions in Germany Germany is a federal state, characterized by decentralization, institutional pluralism and a social market economy (Sturm 2003: 102). The chancellor (prime minister) controls several resources and maintains influence over the main policies and the direction of the government, but, unlike the British prime minister, the German chancellor is highly constrained by the constitution, co-governing forces and veto points (Schmidt, M. 2003: 26), such as those related to German federalism and to the predominance of political parties, the so-called party state. Unlike the UK, Italy and other unitary states, German has a federal government seated in Berlin and 16 state governments. They are represented in the Bundesrat, which has an input into legislation, with the power of veto depending on the allocation of competences. Two core principles inform German co-operative federalism: separation of power and institutionalization of joint responsibilities between different levels (Scharpf 1997). Moreover, because of constitutional provisions the passage of legislation in Germany often requires broad coalitions, comprising not only the governing parties, but also the main opposition party and the majority in both chambers. It is therefore a non-majoritarian state structure – a grand coalition state – which is quite different from the British majoritarian system (Schmidt, M. 2003: 27). The proportional electoral system has tended to result in coalition governments, rather than the singleparty governments produced by the majoritarian electoral system in the UK. However, unlike Italy, the governing coalition at the federal level has so far only comprised two parties, though with various factions therein. In the federal government three political figures are responsible for economic policy (with the exception of monetary policy, which was first the monopoly of the Bundesbank, and then of the ECB and Eurosystem) – the chancellor, the minister of economics and the minister of finance. These posts are usually divided between the coalition parties, whose interests tend to be reflected in any economic policy; thus coalition negotiations can be very complex, because the parties in office have different economic philosophies (Smyser 1993: 43). The office of the chancellor reflects the need for compromise and conciliation, but also the chancellor’s ‘style’. Since such an office has only a small economic staff, its real input into economic policy depends on the approach taken by the chancellor. For example, under Helmut Schmidt the chancellery office of economics shaped and directed the economic policy of the government and kept contacts with the business community and the Bundesbank (Smyser 1993: 43–4). Roles within the cabinet are less flexible, though ministers’ influence on economic policies also depends on their personality and party base. In the first postwar period the Ministry of Economics was very powerful, but from the 1970s onwards it ceded prestige to the Ministry of Finance, which is involved in credit matters, is responsible for the federal budget, sets economic priorities and takes part in G7 meetings, though many international financial issues are left to the Bundesbank (Smyser 1993: 45). The finance ministry has been strengthened following EMU (under Oskar Lafontaine, but also under Hans Eichel), when the Economic Policy

58 The Bundesbank Division and the European Division of the economics ministry were transferred to the finance ministry. The rationale for this change was twofold: it aimed to present a unified German approach to EMU policies (Dyson 2003: 221) and, perhaps more importantly, it was part of a domestic power-struggle within the cabinet, whereby the finance minister tried to expand the competence of his ministry at the expense of the economics ministry (interview, Brussels, December 2005). The transfer was reversed under the grand coalition in 2005. It should be noted that, especially before the restructuring that took place in the 1990s, the finance ministry in Germany was not as powerful as the UK Treasury, and it was further weakened by the federal state structure in Germany. This also meant that the Bundesbank, like the Banca d’Italia, faced a relatively weak counter-power institution in the domestic arena. Overall, the power-sharing domestic political institutions of German federalism have been reflected in the decentralized governance structure of the Bundesbank and the pluralism of appointing institutions. They have also strengthened the autonomy of the central bank, by weakening the power of the federal government (cf. Lohman 1998). Moreover, the high number of veto points in the political system have also made it difficult to reform the German central bank, as explained above. Relations between the Bundesbank and the government The relationship between the political authorities, first and foremost the government, and the Bundesbank has been complex. Although in the majority of cases it has been based on consensus, historically there have been two main (potential) sources of tension between Bundesbank and government: the conflict between price stability, prioritized by the central bank, and low interest rates to stimulate economic growth, preferred by the government, especially in the period up to 1982 (Sturm 1990); and the contrast between domestic economic priorities (price stability) and external foreign policy objectives (international co-operation and European integration) (Loedel 1999). German reunification – or to be precise German monetary union – was another source of tension, as discussed above. In 1978 at the Bonn summit the USA put pressure on Germany to act as a locomotive by stimulating economic growth. Chancellor Schmidt and the Bundesbank disagreed on this issue and the government ultimately prevailed, triggering a macroeconomic expansion (Putnam 1988). By contrast, during the financial crisis of 1987 the US administration wanted Germany to adopt an expansionary economic policy, which was opposed by the Bundesbank, especially as far as monetary policy was concerned, resulting in disagreement between the USA and the Bundesbank (Loedel 1999; Heisenberg 1999). After pressure from the federal government, the international financial community and German business interests, the Bundesbank lowered interest rates six weeks after the New York stock exchange crisis. European monetary co-operation proved a constant source of tension between the Bundesbank and the federal government, though it should be said that there were also disagreements within the government on this issue. This was the case with the

The Bundesbank 59 establishment of the EMS in 1978 (Ludlow 1982), the ERM crises in 1992–3 (Connolly 1995; Hefeker 1997) and EMU (Dyson and Featherstone 1999; Heisenberg 1999; Loedel 1999), as elaborated below. Throughout the 1990s there were recurrent tensions between the Bundesbank12 and the finance ministry, which were in favour of either a restricted EMU or a postponement of the project, and the Chancellor’s Office and the Ministry of Foreign Affairs, which were adamant supporters of a wide EMU according to the deadline set in the TEU. One of the most recent controversies between the Bank and the federal government concerned the revaluation of the gold reserves in 1996–7, an issue that had both an internal and a European dimension, and was one of the few occasions when the central bank and the finance ministry took opposing positions. In approaching EMU, the Bundesbank had a large amount of undervalued gold reserves, whereas the TEU required the gold reserves to be valued at market price (Loedel 1999). When the government proposed to use the profits to reduce the public deficit in 1997 – in so doing finding a shortcut to fulfilling the fiscal convergence criteria in order to join EMU – the President of the Bundesbank, Hans Tietmayer, opposed it, arguing that this would represent government interference with monetary policy, and would challenge central bank independence. In a couple of instances the government maintained the upper hand over the Bank also on domestic issues. One of the most notable case was German monetary union, when the Bundesbank opposed the one-to-one exchange rate for the D-mark and the East German currency in 1989, which led the federal government to limit the one-to-one exchange rate to personal savings below a certain amount; above that, the exchange would be two-to-one. However, even when the chancellor over-ruled the Bundesbank on matters that were within the competence of the government, it was generally done in a way that was not detrimental to market confidence (Smyser 1993: 47) or the central bank’s reputation. Moreover, party politics as such seldom came into play. For example, despite the fact that Karl Otto Pöhl was appointed as President of the Bundesbank by an SPD-led coalition government, his relations with CDU governments, on the whole, were less complicated than relations with the previous Social Democratic governments.13 At the same time, despite its consolidated position in the domestic institutional setting, the Bundesbank has been careful about the battles it has chose to fight with the political authorities (Goodman 1992). There were occasions where it decided to submit to political pressure, especially when public opinion sided with the government (Duckenfield 1999). Economic institutions in Germany The configuration of the financial system in Germany should be viewed within the context of the Rhenish model of capitalism (Rhodes and Alperdoorn 1998; Albert 1993) or the co-ordinated market economy (Hall and Soskice 2001). This model experienced significant changes in the 1990s and 2000s, partly as a result of domestic reforms (of tax and pensions) undertaken by the public authorities (the federal government); partly because of market forces triggered by international

60 The Bundesbank competition and globalization; and partly as a result of European integration in terms of market integration and EU legislation (cf. Schmidt, V. 2002a). Since the 1990s the German model of capitalism has slowly moved towards a more liberal dimension. In the postwar period Germany’s economic system could be characterized as a ‘social market economy’ (Padgett 2003), in which the role of the state is mainly regulatory, though the welfare state is well developed; the competition regime prevails, though some policy areas, such as banking, were granted special exemptions until the 2000s; strong interest groups and centralized trade unions, with high (though declining) union density, engage in collective bargaining, regulating wages through legally binding industry-wide agreements. In the Rhenish model of capitalism, the market co-exists with more or less institutionalized networks of cooperation, which is why it is often referred to as a co-ordinated market economy (Hall and Soskice 2001). Until recently there was no separation in Germany between bank and industry. Corporate governance favoured insiders and cross-shareholding, as well as encouraging the representation of banks on the supervisory boards of firms and vice versa, resulting in interlocking directorships – a situation referred to as Deutschland AG (Albert 1993). The model of corporate governance was based on the Hausbank system,14 as opposed to the practice of hostile takeovers in the UK. This has also meant that the banking sector and industry basically shared the same policy preferences, although this configuration of economic institutions has begun to change in the 2000s. The so-called silent revolution in Germany (The Banker, 4 April 2005) that was triggered in 2002 by making the selling of cross-holding shares and capital participation tax-free has meant that the cross-holdings of banks and industry have now begun to be disentangled (Deeg and Perez 2000). Banks, in particular public banks, used to lend to the Mittelstand (small and medium-sized enterprises, SMEs) both extensively and at low margins (Financial Times Deutschland, 22 August 2002), though this practice has been challenged by the changes experienced by the banking sector in Germany under the pressure of EU and domestic reforms, which can be summarized as an attempt to increase competition (The Banker, 4 April 2005; 4 November 2004). The European Commission successfully challenged the state guarantees to the public banks as anti-competitive, with the result that they had to be phased out by 2005 to create a level playing field, thereby ending the competitive disadvantage to which the private banks had been subject (Grossman 2006). The banking and insurance markets in Germany are among the largest in Europe, and some of the main European market-players are located in Germany. Until the 1990s the financial system tended to be mainly bank-based (Allen and Gale 2000),15 in that the use of credit facilities was among the highest in Europe, whereas the use of debt securities was among the lowest, even though it was expanding rapidly (The Banker, 4 July 2005). Moreover, the banks, also because of their universal remit, are among the main traders of securities. The universal bank model means that the banks can provide commercial banking as well as investment banking services. The universal banks in Germany can be

The Bundesbank 61 divided into three main sectors: private banks (comprising approximately onequarter of German banks); savings banks (Sparkassen), with approximately 36 per cent of total banking assets, dealing mainly with residents and Landesbanken;16 and co-operatives, making up about 20 per cent of total banking assets (Financial Times Deutschland, 12 June 2002). There are also specialized banks dealing with credit for the agricultural sector, for example. In the private banking sector there are four main banks, though there are also smaller private banks. The Sparkassen and Landesbanken, which are public banks (hence non-profit maximizers), make up about half the banking system. Group competition (Gruppenwettbewerb) has been widespread in Germany, which means that banks do not compete individually, but tend to collaborate within the three categories, which have powerful interest groups (Deeg 1999). As elaborated further below, the configuration of political economy institutions in Germany, especially the link between bank and industry, helps to explain the widespread support for the objective of price stability and the Bundesbank’s monetary policy. Similarly, the changes that have occurred in the financial system, including the formation of financial conglomerates, have been a driving force behind the reform of the supervisory framework for financial services in Germany. In turn, several features of the financial system have been changing because EMU has given a new impulse to financial integration and competition in Europe. At the same time, the Modell Deutschland began to lose economic competitiveness, and consequently attractiveness, in the 1990s. Interest groups have traditionally been highly integrated into the policy-making process in Germany. Sectoral policies are negotiated by the relevant federal minister, state governments and interest groups. In this model, formal co-ordination is weak, but underlying social and political consensus limits conflicts (Keating 1999: 349). The result is consensual, incremental policy, where a change in government does not result in major policy shifts. There are three main umbrella organizations in Germany: the Bundesverband der Deutschen Industrie (BDI), the association of German industry, which is the most powerful; the Bundesvereiningung Deutscher Arbeitgeberverbände (BDA), the employers’ association and a key player in wage negotiations; and the Deutsche Industrie und Handelstag (DIHT), the industrial and trade confederation of small businesses, which produce about three-quarters of German output. In the financial sector the main associations are the Deutsche Bankenverband, the association of German private banks; the Deutsche Sparkassen und Giroverband-Finanzgruppe (DSGV), which represents savings banks (Sparkassen) and the banks of the states (Landesbanken), which are all public banks; and the Landesbausparkassen (building and loan associations). Relations between the Bundesbank and economic interest groups As far as relations between the Bundesbank and economic forces are concerned, the strong ties between industrial (exporting) firms and banks in Germany have meant that industrialists tended to share the bankers’ preferences (cf. Maxfield 1991: 435),

62 The Bundesbank and, since banks are traditionally inflation-averse (Posen 1995: 47–50; Posen 1993: 257–60), this created a commonality of interest in low inflation in Germany. Such commonality of interest was strengthened by the fact that the public banks, in particular, used to lend extensively to the Mittelstand. That said, in the run-up to EMU there were times when the Bundesbank’s policy preferences, for example for a ‘core’ EMU (with a limited number of members) were different from those of economic forces such as the BDI and private banks, which were in favour of a wide EMU. Despite its traditional image of maintaining an arm’s-length relationship with the financial sector, the Bundesbank has had close interaction with the banking system on supervisory issues, carrying out on-site inspections and data collection at state level, an activity that continued after the 2002 reform. For example, in 1997 the Bundesbank and the BAKred created the BAKIS, a database that allows the comparison of data from co-operative and savings banks. The central bank has also been responsive to the interests and policy preferences of the German banking sector, especially the small public banks, with which the Bundesbank, through the LCBs and, after 2002, through its branches, has developed close contacts (interview, Frankfurt, January 2006), as evidenced throughout the negotiations of the Basel 2 Accord (see below). The Deutsche Gewerkschaftsbund is the confederation of German trade unions, a highly centralized and well-organized body, though its membership shrank in the 1980s and 1990s. Before EMU, relations between the Bundesbank and the trade unions were mainly informed by implicit co-ordination, in that the system of co-ordinated wage bargaining, which was a core feature of the German variety of capitalism, allowed trade unions to respond in an anti-inflationary way to the anticipated actions of an inflation-fighting central bank (Hall and Franzese 1998). Such relations have been reshaped by the establishment of EMU, because the Bundesbank no longer control monetary policy in Germany, hence the implicit co-ordination between the central bank and the trade unions cannot take place. The international framework and central banking governance in Germany The Bundesbank has been one of the main players in the international system, a central position that the Bank assumed in the late 1960s and that became more prominent over time, until the establishment of EMU. On the one hand, the Bundesbank’s influence has been paramount, especially in the European context, though it should be recognized that, most of the time, the Bundesbank only reluctantly agreed to act as a leader either in the international system or in the European context. On the other hand, the Bundesbank has also been subject to international pressure, exerted in an attempt to influence the Bank’s conduct of monetary and exchangerate policies. Moreover, in certain instances the federal government tried to use international and/or European monetary co-operation in a power game with the central bank to alter the domestic opportunity structure, with a view to rebalancing

The Bundesbank 63 domestic economic priorities, prioritizing economic growth over price stability, as occurred in 1978. This two-level game (Putnam 1988) in which the Bank found itself often resulted in a contradiction between the domestic economic objectives pursued by the central bank (first and foremost, price stability) and the foreign policy objectives pursued by the federal government. Following the end of the Bretton Woods system in 1971, the Bundesbank proved to be wary of exchange-rate commitments and any sort of international monetary co-operation that might reduce its room for domestic manoeuvre (cf. Loedel 1999; Heisenberg 1999). At the end of the 1970s European monetary integration was once again brought on to the agenda with the creation of the EMS. As stated in the Bremen Council (July 1978) conclusions, the EMS was intended to be a ‘scheme for the creation of closer monetary co-operation leading to a zone of monetary stability in Europe’. The Bundesbank and the German finance ministry were instead critical about exchange-rate co-operation, fearing that this would lead to an ‘inflation community’. In response they managed to change important features of the system before it was agreed at European Community level (Ludlow 1982). Moreover, the President of the Bundesbank, Otmar Emminger, sent Chancellor Schmidt a letter stating that if domestic monetary stability was in danger, the Bank would suspend market interventions, in contravention of the operating procedures of the ERM (Emminger 1980). EMU returned to the agenda in the late 1980s. Whereas the chancellor and the foreign minister vehemently supported the project, the Bundesbank espoused the ‘coronation theory’, calling for prior economic convergence among European countries and the liberalization of capital movements in the EU before moving towards EMU (Dyson and Featherstone 1999). The official view of the Bundesbank, as repeatedly put forward in its Monthly Bulletin (October 1990; February 1992; January 1994; January 1996), was that the Bank was in favour of the final goal of establishing EMU, provided this was done in such a way as to safeguard monetary stability in the future. During the negotiations surrounding the creation of EMU, Pöhl in his position as President of the Bundesbank reiterated that price stability was the prime objective of monetary policy, which had to be conducted by an independent central bank. This came out very clearly during the discussions in the so-called Delors Committee composed of EU central bank governors and some independent macroeconomic experts, chaired by the then President of the European Commission Jacques Delors, which produced a report containing a blueprint for EMU (Verdun 1999). If the Bundesbank was the core player in EU monetary and exchange-rate forums, it was a somewhat less important player in international regulatory and supervisory forums than the US Federal Reserve and the Bank of England. The most important international agreements in the field of banking supervision are the Basel 1 and 2 Accords, which established quantitative standards (capital ratios), even though the national frameworks for regulation and supervision remained substantially unchanged. In the making of both agreements the German supervisory authorities, like many other central banks and supervisory authorities involved, acted not only as country representatives defending their national interests, but also as

64 The Bundesbank international public regulators pursuing the public good of financial stability, through joint problem-solving. In the negotiations of Basel 1, the German supervisory authorities – the Bundesbank and the BAKred – argued that universal banks, which were prevalent in Germany, were different from the commercial banks that were widespread in the USA, and hence that different capital requirements were needed. They also argued that the strong links between banks and industry made German banks different from those in other countries (Stern 1999). Thus, both Bundesbank and BAKred engaged, albeit largely unsuccessfully, in international disputes over the definition of liable capital (Kapstein 1994). At the same time, the negotiations of Basel 1 strengthened the supervisory authorities vis-à-vis the domestic banking associations, turning them into ‘gatekeepers’ with informational advantages (Luetz 2003), altering the domestic political opportunity structure. The Basel 2 Accord of 2004 is based on differentiated, as opposed to uniform, standards. A key issue for the German authorities (the Bundesbank, the BAKred until 2002 and afterwards the BaFin, the single financial supervisor) in negotiating Basel 2 was the implication of the new capital rules concerning the access to and terms of bank credit for SMEs.17 There was also the concern that the new rules would penalize small and medium-sized banks (mainly public banks). Given the important role played by the SME sector in Germany and the high number of small public banks, political pressure was exerted on the Bundesbank, the BAKred and the BaFin at the state and federal levels. This was coupled with the lobbying activities of, and public consultation with, various sectors of society (interview, Frankfurt, January 2006) and represented a crucial difference from Basel 1. The Bundesbank took part in several hearings before the federal Parliament and received more than 200 letters and policy documents from the public, including churches. When negotiating the Basel 2 Accord, it did not prove problematic to define a common position between the Bundesbank and the BAKred/BaFin, for they were focused on different elements at the working level: the BaFin dealt with regulatory issues, whereas the Bundesbank focused on economic studies. The Bundesbank seemed to be more responsive than the BAKred/BaFin to the policy preferences of the small banks, owing to the close and frequent contacts they had with the branches of the Bundesbank at local level (interview, Frankfurt, January 2006). It is also worth recalling that on certain issues, such as the creation of a consolidating supervisor and the treatment of intra-group exposure, there were very different policy preferences within the German banking community, whereby the interest of the (larger) private banks were pitted against the (small) public banks (for more details, see Quaglia 2008). Overall, the Bundesbank has been an important actor in both international and European monetary diplomacy, but on issues relating to banking supervision it was less so, even though it was on several occasions willing and able to articulate the preferences of the German banking system in the making of international agreements. The Bundesbank’s international role has been significantly undermined by the establishment of the ECB and the BaFin, though the Bundesbank still participates in many international forums, such as the IMF, the World Bank and G7

The Bundesbank 65 meetings. Moreover, the Bundesbank and the BaFin exerted considerable influence in the negotiations leading up to Basel 2, in which the ECB participated as an observer.

Central banking policies in Germany The main objective of the second part of this chapter is to evaluate the policy capacity of the Bundesbank in several areas. In monetary policy at least, Germany represents the benchmark for assessing policy convergence in several areas in the EU. Monetary policy capacity in Germany Before the establishment of EMU the Bundesbank was responsible for monetary policy in Germany, and the federal government was responsible for determining general economic policy. On the one hand, the Bundesbank was bound to support the government’s economic policies (Article 12 of the BBG). On the other hand, the Bundesbank was independent of government action in relation to monetary and credit policy, and its priority was to ‘safeguard the value of the currency’ (Article 3 of the BBG). The Bundesbank perceived its role as the guardian of monetary stability, supporting the government’s economic policies in so far as they did not conflict with price stability (Kennedy 1991: 9). In the 1970s the prevailing economic paradigm at the Bundesbank shifted drastically towards price stability by embracing a European version of monetarism (cf. von Hagen 1999). In 1974 the Bundesbank decided for the first time to set public monetary growth targets (Giersch et al. 1992: 189), even though it never introduced multi-year monetary targets. Since 1988, M3 has played a key role as an indicator and an intermediate target, whereas the Bundesbank had previously used central bank money. The overall objective of the Bundesbank’s monetary policy was to maintain price stability, meaning an inflation rate of about 2 per cent; M3 was the medium-term target, and the instruments were interest rates and bank liquidity through open-market operations, refinancing policy and minimum reserves (Stern 1999). Open-market operations became more important over time, and thus the Bundesbank gradually became more involved in market management (Smyser 1993: 49). In practice, the use of monetary aggregates was almost abandoned at least on three occasions, in 1978, 1987 and 1992 (Neumann 1999: 301; Baltensperger 1999: 487), when the target had been missed by a wide margin. In all these cases this was caused by foreign-exchange operations to support the US dollar or EMS currencies.18 Depending on the critics, monetary targets and, more generally, the monetary policy of the Bundesbank were regarded as either too dogmatic or too discretionary (Baltensperger 1999: 514). Those who favoured the use of monetary targets argued that abandoning them would be detrimental to the anti-inflationary reputation of the Bundesbank. The sceptics argued that since the targets were often (and sometimes widely) exceeded, this damaged the Bundesbank’s credibility.

66 The Bundesbank There were four periods of high interest rates in Germany: 1965–6, 1973–5, 1979–82 and 1989–94. In all these instances deflation was followed by recession. Indeed, the monetary policy of the Bundesbank has been criticized for the ‘stabilization crises’ it induced in the economy (Leaman 2001). It should be noted that the dynamic export sectors in Germany assisted recovery from these recessions, though this was more difficult in the 1990s, when the whole of Europe was in a prolonged recession, a situation that was exacerbated by the attempt to fulfil the EMU convergence criteria. Throughout most of the period considered here, Germany’s inflation track record proved the best in Europe, especially in a decade of very high inflation, such as the 1970s. Some economists would argue that the low inflation in Germany should be ascribed not so much to Bundesbank policy as to the country’s trading structure, based on high value-added exports, small quantities of imported raw materials, which resulted in trade surplus, and a strengthening of the D-mark, which also enjoyed the status of a reserve currency. Other authors argue that the low level of inflation was part and parcel of Rhenish capitalism or the co-ordinated market economy model, in which trade unions, employers’ associations, the government and the central bank are involved in a co-operative game of macroeconomic policy to secure price stability and stable growth (Hall and Franzese 1998; McNamara and Jones 1996). Other commentators argue that the low level of inflation in Germany is explained by the broad support of public opinion for price stability (Hayo 1998). The objective of price stability has been broadly shared by the federal government, but whenever this was not the case, the Bundesbank’s objective generally prevailed in the conduct of monetary policy. In an analysis of monetary policy in Italy, France and Germany during the period 1973–82, Goodman (1992) concluded that, whereas monetary policy was manipulated for electoral purposes in Italy and France, this had not been the case in Germany, not because the German Government did not try, but because the Bundesbank was truly independent (see also Neumann 1999: 281). Most of the time, unlike in Italy, the degree of co-operation between the monetary authorities and the fiscal ones (namely, the political authorities) was satisfactory, although it fell short of its objectives during the process of German reunification. Between 1989 and 1994 the Bundesbank tightened monetary policy, enacting a deflationary squeeze, to counteract the fiscal expansion pursued by the federal government, mainly to finance expenditure in eastern Germany without raising taxes in the western states. However, the side effects of high interest rates were to worsen the situation of the public finances, a situation that bears some resemblance to the ‘game’ played the central bank and the political authorities in Italy in the 1980s and early 1990s (see Chapter 4). The monetary policy choices made by the Bundesbank on this occasion should also be viewed in the light of the Bundesbank’s scepticism concerning EMU as envisaged in the TEU, signed in 1992. Several commentators (Connolly 1995; Hefeker 1997) have even argued that the Bundesbank’s monetary policy in 1992–3 was designed to unravel the ERM/ EMS, and hence to prevent EMU – this is discussed below with reference to exchange-rate policy.

The Bundesbank 67 Over the period considered here, monetary policy in Germany was characterized by continuity, and indeed the Bundesbank was one of the main forces driving monetary policy convergence in the EU, intended as convergence towards the stability-oriented economic paradigm, through the mechanism of ideational diffusion. This monetary policy template, adopted by the ECB, had as its primary objective price stability. Domestically, in the realm of monetary policy, the only significant change that ensued from EMU membership – which, however, was also a good opportunity for modernization imposed from outside – was the closing down of a refinancing facility at the Bundesbank: purchase of the bill of exchange (Wechselpapier) was abolished. This instrument was outdated, disliked by the banking industry and cumbersome to use, though it was useful for SMEs (interview, Frankfurt, January 2006). Exchange-rate policy capacity in Germany Before EMU the federal government – or more precisely the finance ministry and the economic ministry, often with an input from the foreign ministry – was responsible for external monetary relations, albeit with significant input from the Bundesbank (Loedel 1999: 11). Whereas the choice of exchange-rate regime was made by the federal government after advice from the central bank, the conduct of exchange-rate policy fell in a grey area: the central bank was responsible for dayto-day management and currency interventions, while the federal government retained authority on devaluation or revaluation (or parity realignments) within fixed or semi-fixed exchange-rate regimes. However, since exchange-rate policy has a direct effect on monetary policy and price stability, the central bank also exerted a strong influence over the decisions of parity realignment (Neumann 1999: 295).19 It should be noted that, even in the conduct of day-to-day exchange-rate policy in periods of exchange-rate tensions, the political authorities could influence the policy implemented by the Bank, at least up to a point, as in the case of the ERM crisis in 1992–3. Connolly (1995) describes the so-called sweetheart deal in 1992, whereby the Bundesbank, under political pressure from the German Government, provided massive support to the French franc, thus intervening in the currency market. Eventually, the Bundesbank was able to cease currency interventions in the exchange-rate market by referring to Otmar Emminger’s letter mentioned above (interview, Frankfurt, January 2002). As in monetary policy, there was in the conduct of exchange-rate policy an ongoing balancing act (which sometimes resulted in a conflict) between internal and external currency stability (Eijffinger and Schalig 1993: 77), and between domestic economic and foreign policy objectives (Loedel 1999). For most of the time, the Bundesbank’s strategy in the conduct of monetary and exchange-rate policies was to minimize the collateral damage of external factors on domestic price stability. The policy-making process was complicated not only by the fact that the federal government shared responsibility for exchange-rate policy with the Bundesbank, but also by the need for German policy-makers to negotiate with foreign policymakers in complex two-level games, in which the Bundesbank was involved as an

68 The Bundesbank autonomous actor. At times these issues were also controversial within the Bank itself, between the Executive Board, which was generally more outward-oriented and sensitive to issues concerning international and European politics, and the LCBs, which were mostly more inward-oriented, as mentioned above. On a few occasions, disagreement on these issues even emerged within the Executive Board.20 As far as policy evolution is concerned, when the Bretton Woods system became unstable, its demise was welcomed by the Bundesbank, which in 1973 officially requested to be released from the exchange-rate interventions needed to stabilize the US dollar in the Smithsonian agreement. From the 1970s onwards the Bank expressed a clear aversion to any exchange-rate regime that could affect its monetary policy, and hence its domestic policy capacity (interview, Frankfurt, January 2002). The core elements of the exchange-rate paradigm of the Bundesbank were, first, a concern that European or international exchange-rate agreements should not affect the conduct of domestic monetary policy, thus limiting the Bundesbank’s policy capacity and interfering with the bank’s autonomy, second, a preference for flexible (or semi-flexible) exchange-rate regimes and, third, an unwillingness to use market interventions to defend exchange-rate parities if fundamentals were out of line. The strategy consisted of combining the foreign policy objectives of the government, European integration and constructive relations with the USA with the economic objective of the Bank – price stability. Informed by this policy paradigm, the Bank was willing to negotiate and take an assertive stance in international institutions, at times adopting a different position to that of the national government and retaining a decisive influence on the format and implementation of European exchange-rate agreements, such as the EMS and EMU (Heisenberg 1999; Loedel 1999). To achieve its objective in international forums, the Bank was also willing and able to use domestic political opportunity structure mobilizing domestic resources, such as public opinion, sympathetic politicians, the financial press, academic economists and interest groups. Several elements of the exchange-rate policy paradigm of the Bundesbank were reflected in its approach to EMU, including the negotiations on the treaty provisions for the exchange-rate policy of the eurozone, as explained in Chapter 5. Also, the configuration of ERM2 was strongly influenced by the Bundesbank, which, in the light of the policy learning that took place in ERM1, wanted to limit the compulsory interventions of the ECB to support currencies with divergent fundamentals as much as possible in ERM2. It also wanted the ECB to be free to suspend intervention if this posed a threat to price stability in the eurozone (interview, Frankfurt, January 2002). Unlike monetary policy, it is difficult to assess policy convergence in the EU on exchange-rate policy. The main reason is there is no predominant or benchmark model, and it remains a controversial policy hotly debated by policy-makers also at the national level in various EU countries. Moreover, as discussed in Chapter 5, within the ECB and the Eurosystem the Bundesbank has sometimes expressed contradictory preferences on the exchange-rate policy of the euro.

The Bundesbank 69 Financial supervision capacity in Germany Unlike the Banca d’Italia and the Bank of England before the 1997 reform, the Bundesbank has no formal responsibility for the regulation and supervision of the banking system. However, it is by law involved in the implementation of banking supervision (before 2002 together with the BAKred, and since 2002 with the BaFin). The Bundeskartellamt is the federal anti-trust authority responsible for federal competition policy, a responsibility shared with the anti-trust authorities of the states and the economy ministry. The finance ministry is responsible for elaborating banking policy, but the central bank must be consulted on all main changes, and the Bundesbank’s agreement is required on matters concerning capital adequacy and liquidity (Coleman 1996: 75). In the securities sector, the Bank had regulatory responsibility for issuing D-mark securities in foreign markets. The Banking Act (Kreditwesengesetz or KWG) was adopted in 1934 and was subsequently amended several times, either as a result of policy failures and the discovery of ‘loopholes’ in the existing regulation, or because of the need to adapt to the international and EU regime of banking regulation, especially the directives issued in the 1980s and 1990s. Before 2002 banking institutions, according to the KWG, were subject to BAKred supervision, with the co-operation of the Bundesbank. The BAKred was created in 1962 and was legally an independent federal authority, reporting to the finance ministry. Since the BAKred did not have its own administrative apparatus at state level, it worked closely with the Bundesbank, which had branches in each state. Information and data were collected by the LCBs, which then forwarded them to the BAKred and the Bundesbank. Moreover, most reports and other documents provided by banks were submitted to the Bundesbank, and not to the BAKred. The Bundesbank and the BAKred were to inform each other of observations and findings that could be significant for their functions. The President of the BAKred retained the ability to attend the Bundesbank’s meetings on occasions when banking supervision was discussed, and in turn the Bundesbank was entitled to express an opinion on the appointment of the President of the BAKred (Coleman 1994: 286). As far as the policy paradigm for banking supervision is concerned, until the late 1980s and early 1990s the main objectives were the stability and soundness of the banking system in Germany (and more generally, the financial system), even when this was ensured at the expense of competition and efficiency, with business migrating to other financial centres such as London or Luxemburg (interviews, Frankfurt, January 2006; London, January 2006). The policy instruments were mainly based on an extensive body of regulation, which limited the introduction of new financial tools, while the strategy was based on the concept that banking was a specific type of activity, for which restraints imposed on competition and financial innovation were to be tolerated. At the same time, there was the attempt to strengthen international co-operation to avoid international crises or bank failures spreading across the country and to prevent regulatory arbitrage (Kapstein 1992). Until the establishment of EMU, the Bundesbank posited that banking supervision and monetary policy should be kept separated and should not be performed by the

70 The Bundesbank same body (the central bank) because of the potential for conflict of interests (Marsh 1992: 59). In other words, the argument proposed that the objectives of safeguarding the currency and ensuring the soundness of the banking system were not always compatible. Moreover, it was feared that any supervisory failures could tarnish the reputation of the central bank as a monetary authority. In its contributions to banking regulation and supervision in Germany, the Bundesbank prioritized its monetary policy functions and the objective of currency stability (Coleman 1996: 132). On the whole, before 2002 this approach to banking supervisions had been successful – there were few banking crises in Germany in the postwar period, although this was helped by the ‘conservative’ features of the German banking system (Marsh 1992: 59). In the 1990s the banking system, and more generally the financial system, underwent major changes, resulting in increased banking competition, the de-segmentation of financial activities, a shift towards a more market-based approach, securitization and reform of the stock exchange, and the modification of corporate governance law and practices (Deeg and Perez 2000). In the securities sector, there was a series of reforms to promote Frankfurt as the leading financial centre in Germany and continental Europe (Luetz 1998). Some of these changes were part of the domestic adaptation to EU legislation in the securities sector, such as the Investment Services Directive. It is also worth noting that, together with the federal finance ministry, the large commercial banks and the Frankfurt stock exchange, the Bundesbank was a member of the coalition that promoted the modernization of the securities market in the 1990s, overcoming its traditionally cautious approach (Coleman 1996: 141). The system of financial services regulation and supervision in Germany was overhauled in 2002, when a single supervisor was established for the entire financial sector, taking over functions previously performed by the three different authorities responsible for banking, securities and insurance. When the law governing the integrated supervision of financial services entered into force in May 2002, the Federal Banking Supervisory Office, the Federal Supervisory Office for Insurance Enterprises and the Federal Supervisory Office for Securities Trading were amalgamated to form the German Financial Supervisory Authority (BaFin). The Bundesbank and the BaFin have spelled out the details of their respective roles in their day-to-day supervisory activities in a Memorandum of Understanding, in order to avoid duplication of work. Under the agreement the Bundesbank is assigned most of the operational tasks in banking supervision, as has been the case in the past. According to this gentlemen’s agreement, the BaFin mainly supervises large banks (both private and public, such as the Landesbanken), whereas the Bundesbank mainly supervises the savings banks, co-operative banks and small private banks (interview, Frankfurt, January 2006). The reform introduced in Germany bears some resemblance to the 1998 reform undertaken in the UK, even though it maintained a system of ‘dual supervision’ (interview, Frankfurt, January 2006). Yet the BaFin, unlike the FSA, is not an independent authority. It is instead a body of the finance ministry and is still organized according to the traditional market segmentation (banking, securities and insurance), whereas the FSA is organized according to functions. Moreover, the

The Bundesbank 71 BaFin has two bases, one in Frankfurt (for securities) and one in Bonn (for banking and insurance), though it is in the process of enhancing its offices in Frankfurt to deal with banking supervisory matters. Whereas the FSA reports to Parliament and consults with the Bank of England and the Treasury, the BaFin reports directly to the finance ministry. In addition, the FSA’s funding is entirely provided by those it regulates, and not partly by the state. The origins, modalities and rationales of the reform are explained in the first part of this chapter. Here, it should be noted that the Bundesbank’s unsuccessful attempt to extend its competences in supervision in 2001–2 contradicted the conventional argument that had been articulated by the Bank before EMU, namely that monetary policy and banking supervision policy should not be performed by the same body, with the consequence that central banks should not handle prudential supervision. The Bundesbank argued that the final stage of EMU substantially changed the policy-making environment, because national central banks, including the Bundesbank, are no longer responsible for monetary policy in their own countries. Instead, monetary policy in the eurozone is conducted by the ECB, and although the national central banks are members, the Bundesbank has only one vote. The argument asserts that the change makes it possible for central banks to undertake supervisory functions, and since central banks have the technical expertise and practical knowledge of the market, they are better positioned than other state authorities to perform this task, even for the whole of the financial sector (interview, Frankfurt, January 2006). The Bundesbank’s attempt to increase the regulatory and supervisory functions of the national central banks in the eurozone was supported by the ECB (Financial Times, 12 June 2001), which, like the Bundesbank, was keen to point out the complementarity between monetary policy and banking supervision policy, and how such a relationship prompted repercussions on the stability of the system. This was an interesting case of a two-level game, in which the Bundesbank tried to use the resources that were available at EU level – in this instance the support of the ECB – to alter the domestic political opportunity structure, tipping the balance in policy controversies. At the EU level, the Bundesbank faced problems in securing a role in banking supervision level in the new Committee of European Banking Supervisors (Dyson 2003: 223). Overall, the policy paradigm in banking regulation and supervision in Germany has moved towards a greater emphasis on competition and efficiency within the financial system, taking into account the changes that occurred in the most recent period, first and foremost the blurring of market segmentation. However, the paradigm change has primarily affected policy-makers in the finance ministry, rather than in the Bundesbank. To the extent that the paradigm has changed there, it seems to have been instrumental in the changed structural position of the central bank. For its part, after EMU there has been a clear (and unsuccessful) attempt by the Bundesbank to carve out a new policy-making role by acquiring supervisory competences for the entire financial sector. Although it is ultimately difficult accurately to assess policy convergence in this area, because different policy paradigms and institutional frameworks co-exist

72 The Bundesbank within the EU, Germany has moved towards the British–Scandinavian models of financial service supervision. Unlike the Bank of England, the German central bank resisted this change with considerable force, but with only very limited success. By contrast, the Banca d’Italia, which faced a different domestic political opportunity structure, managed to fend off any attempt to reduce its power in this field, even though it lost the responsibility for competition policy in the banking sector in 2005. Other functions and roles of the Bundesbank Like other central banks, the Bundesbank provides services to the government, in that it oversees the payments system, acts as an issuing institution, and manages the government account and the public debt, a function that was transferred to a separate agency following the 2002 reform. The Bundesbank acts as the banker to the government, as well as the bankers’ bank, though it does not act as ‘lender of last resort’, a role that the Bundesbank has traditionally rejected. The Bundesbank has been an influential adviser to the government on international financial and economic matters as well as on domestic economic matters, and it has not been reticent in giving its advice (Sturm 1989, 1990). On the one hand, unlike many other central banks the Bundesbank not only possesses the power to advise, but has on occasion also taken decisions that contradicted government policy. On the other hand, there have been cases when the Bundesbank’s advice has been almost completely ignored by the government, as in the case of German monetary union. Finally, the Bundesbank’s role in international and European diplomacy – a crucial, atypical role performed by the German central bank – has been discussed above. The much reduced domestic and international role as a result of EMU – what the Financial Times called ‘the descent from Olympus’ – was, according to Otmar Issing, former chief economist of the Bundesbank and later member of the ECB Executive Board, a ‘culture shock’ for the Bundesbank (Financial Times, 15 June 2000). Overall, the Bundesbank is still in the process of identifying its core functions before undertaking an appropriate reorganization of its central structure (interview, Frankfurt, January 2006). An overall assessment of central banking governance in Germany The autonomy of the Bundesbank, as enshrined in the legal framework concerning central bank independence, is largely confirmed by the empirical record. However, there have been cases in which the Bank had to defer to the political authorities, especially when public opinion sided with the latter. At the same time, the personnel independence of the Bank, while formally rather low, has in practice been stronger than might be assumed by simply reading its statute – the so-called Becket effect. Such autonomy, besides being underpinned by national legislation, has been strengthened by the configuration of domestic political and economic institutions and the intangible assets of the Bank, as elaborated below. Given the limited legal provision for accountability, the Bundesbank depended largely on output-oriented

The Bundesbank 73 legitimacy and was therefore keen to keep public opinion and leading financial commentators on its side and to remind domestic public opinion of the importance of price stability (Goodman 1992). The policy capacity of the Bank has varied across policy areas. It was greatest in monetary policy, because, besides being underpinned by legal provisions, the prevailing stability-oriented economic paradigm and the configuration of economic institutions played out in favour of the Bundesbank’s primacy. In contrast, the Bank’s policy capacity on exchange-rate issues was ultimately subordinated to the government’s decisions concerning the exchange-rate regime. Until 2002 the policy capacity on banking regulation and supervision was shared between the Bundesbank and another state agency, the BAKred. De facto, the Bundesbank was involved in banking regulation and supervision, at both state level, through the collection of data, and international level, since the central bank was the leading representative for Germany during the negotiations of international supervisory agreements, such as the Basel Concordat and the Basel 1 Accord. The 2002 reform, despite the Bundesbank’s lobbying activity and the supportive position expressed by the ECB on this matter, left the Bank with the same policy competences in the supervisory field as before. However, the central bank’s policy capacity has since diminished, because the BaFin is a more powerful institution than the BAKred and is thus a potentially more threatening institutional rival for the central bank. With reference to the multi-level institutionalist framework articulated in the introductory chapter, international institutions have played a role in affecting the autonomy and policy capacity of the Bundesbank, sometimes enhancing it and at times reducing it, even though the Bank has occupied a leading position in policymaking in international forums, especially in European monetary regimes. The external projection of the Bundesbank was facilitated by the configuration of national institutions, which gave the Bank independence and full responsibility for monetary matters, including those negotiated in international fora and the intangible assets of the Bank. Overall, the Bundesbank has been one of the main actors promoting monetary policy convergence in Europe by spreading the stability-oriented paradigm and providing a successful model that has encouraged the setting up of independent central banks across the EU. This also explains why the adaptational pressure exerted by EMU onto the central banking legislation in Germany was minimal, with the exception of the transfer of monetary policy and related competences to the ECB. This qualification highlights an important scope condition for domestic change to take place as a result of external adaptational pressure: the rules and templates promoted by international institutions should be different from the national ones, otherwise no real change will ensue (cf. the literature on Europeanization, e.g. Börzel and Risse 2003). On supervisory policies, partly because the domestic competences of the Bundesbank have been shared with the BAKred and later with the BaFin, and partly because the Bank has not been at the cutting edge of the technical debate in this field, the Bundesbank has been much less influential internationally. Indeed, technical

74 The Bundesbank expertise can be an important intangible asset for a central bank to be able to affect international policy-making. If anything, in the supervisory field, Germany was on the receiving end of ideational diffusion, establishing a single financial supervisor for the entire financial system, following the reform introduced in the UK. Power-sharing domestic political institutions, especially the federal state structure, the relatively weak executive and the consensual style of policy-making, all increased the autonomy and policy capacity of the Bundesbank by affecting the domestic political opportunity structure. Before the 2002 reform they also affected the bank’s governance structure, both by encouraging decentralization and by making institutional reforms difficult, as a result of the presence of several veto players. The presence of certain economic institutions, and first and foremost the strong links that existed between bank and industry, meant that these economic sectors shared similar preferences that were largely consistent with the antiinflationary monetary policy of the central bank. At the micro-level, apart from tangible assets such as statutory independence and exclusive competence on monetary matters, the Bank’s intangible assets in the form of macroeconomic credibility, as well as the public support the Bank has enjoyed and has been eager to foster, have strengthened the autonomy and the overall policy capacity of the Bundesbank. Moreover, the D-mark and the Bundesbank were the symbol of German economic success within the international economy – all elements that explain the reluctance of public opinion to abandon the D-mark in favour of the euro, and why it was difficult the Bundesbank to adapt to EMU, as elaborated in the concluding chapter.

Conclusions The Bundesbank has been defined as an ‘economic policy counterweight to the government’ (Marsh 1992: 169). For most of the postwar period the Bundesbank and the government had similar preferences in economic policy, or at least the government would usually support the objective of price stability, acknowledged as the primary task of the central bank and its monetary policy. Whenever the government wanted to the deviate from this, conflict with the Bundesbank was bound to arise, with the Bank maintaining the upper hand in most instances, especially on issues where it could rely on the support of domestic public opinion, which has largely supported the stability-oriented policy paradigm espoused by the Bundesbank.21 The institutional and policy templates of the Bundesbank were used as stepping stones in the creation of the ECB, which also meant that the Bundesbank’s legal adaptation to conform to the EMU framework was limited, because such a framework was largely informed by the model provided by the German central bank. In approaching EMU, which represented the main critical juncture for central banking governance in Germany, the major problem for the Bundesbank was the transfer of policy capacity and competences (of ‘decision-making power’, so to speak) in the monetary and related fields.

The Bundesbank 75 In practice, the Bundesbank’s adaptation to EMU – to be precise, its transformation into being only one (albeit important) component of the Eurosystem, resulting in a reduced decision-making role in European monetary politics – has been difficult for a central bank that, to paraphrase David Marsh (1992), used to ‘rule Europe’. For example, on matters relating to exchange-rate policy in the eurozone, Jansen and de Haan (2004) found 82 statements made by Bundesbank officials (excluding the President); in no other European central bank have so many statements been made by its officials. It may be argued that the Bundesbank was very concerned about the exchange rate of the euro, but a more probable explanation is that the Bank had not yet learnt to cope with its new role within the ESCB. Moreover, the Bundesbank has undergone several significant indirect adaptations mediated by national political and economic institutions. The 2002 reform of the Bundesbank is largely an indirect adaptation to EMU, in that membership of the Eurosystem made it necessary to streamline the decision-making process within the Bundesbank by changing its governance structure. The increased competition in the financial markets of the EU, largely as a result of the introduction of the euro, has been a catalyst in reshaping the regulatory framework for financial services in Germany, by adopting a revised version of the ‘British model’ of supervision. It should be noted that since the creation of EMU, the competitiveness of Frankfurt as a financial centre has become an important goal for the Bundesbank, whereas this had not been the case previously (Financial Times, 20 June 2000).

4

The Banca d’Italia Quis custodiet ipsos custodes?1

The Banca d’Italia has often been described as the least independent among the group of independent central banks, or, to put it another way, as the most independent of the dependent central banks (Financial Times, 22 November 1989). Before the legislative changes introduced in the 1990s in preparation for EMU membership, the Banca d’Italia used to score very low as far as economic independence was concerned, whereas the procedures for the appointment of the Governor and the other members of the Executive Board gave the bank a high ranking for political independence (to be precise, personnel independence). A systematic analysis of the empirical record reveals that, from the early 1980s onwards, the autonomy of the Italian central bank was much higher than a statutory analysis would suggest. This is because, as with the Bank of England, the analytical measures used by economists are typically formal and fail to pick up the nuances of the relationship between the central bank and the government. These studies also tend to overlook the central banks’ policy capacity in financial regulation and supervision, which in the case of the Banca d’Italia extended to competition policy in the banking sector, giving it one of the most extensive and discretionary remits in Europe, as suggested by the policy controversies that emerged in the 2000s. In contrast to the Bank of England, the autonomy and policy capacity of the Banca d’Italia was strengthened by the weakness of domestic political institutions, based on power fragmentation, rather than (as in Germany) power sharing (Maes and Quaglia 2006). The weaknessof the Italian state and the assets of the central bank also help to account for some of the atypical functions performed by the central bank in Italy over time. The relative strengthening of domestic political institutions and the measures required to adapt to the single currency account for the (at times difficult) ‘normalization’ of the functions performed by the central bank.

The three-level framework of central banking in Italy The incremental path towards central bank independence in Italy The legal framework of the Banca d’Italia and its activities was outlined in the Banking Law of 1936. Before the legal changes introduced in preparation for EMU membership in the 1990s, the Banca d’Italia was not statutorily independent of the

The Banca d’Italia 77 government, nor was it assigned the specific objective of safeguarding price stability. However, a fine-grained analysis reveals an incremental trajectory towards greater central bank independence from the late 1970s onwards. Hence, path dependency was accompanied by some incremental changes, only some of which were the result of critical junctures triggered by policy failures. The first important reform took place in 1981, when the central bank’s economic independence was increased by the so-called divorce between the Banca d’Italia and the Treasury, whereby the central bank was freed from its obligation to buy all Treasury bills that remained unsold at auction. The reform, initiated by the Treasury minister, Nino Andreatta, under the auspices of the Governor of the Banca d’Italia, Carlo Azeglio Ciampi, was implemented by means of a formal exchange of letters between them, without any involvement of Parliament or the rest of the government. This institutional change was triggered by a variety of internal or external factors, as indicated by Andreatta’s account of the ‘divorce’ (Sole 24 Ore, 26 July 1991; my translation): The imperative was to change the regime of economic policy . . . Italian membership of the EMS was in danger . . . The divorce did not have at that time, or later on, political support. It was born as an ‘open plot’ between the Treasury minister and the Banca d’Italia Governor. Before a coalition of those whose interests were affected could take counter-action, it was a fait accompli. It would have been too costly, especially on the exchange-rate market, to go back to the old status quo . . . The intention was to dramatise the separation between the two institutions, increase the Banca d’Italia’s credibility and contribute to a disinflation process less painful in real terms . . . promote the formation of positive expectations in the market . . . The divorce was an unavoidable consequence of EMS membership. It should be noted that although it was presented as a ‘technical reform’, it had significant direct effects on the conduct of monetary policy and indirect consequences for the conduct of fiscal policy, as explained below. It also represented an interesting example of a two-level game engineered by the Bank and the Treasury, in that they skilfully deployed the ‘external constraint’ posed by the EMS in the domestic arena, as elaborated below. On the one hand, the divorce gave the Banca d’Italia greater economic independence. On the other hand, the Bank continued to provide some form of support for its ‘divorced partner’ by buying a large share of the public debt (Repubblica, 26 July 1991). After all, the options were either to monetize there and then, or let a crisis break out with unpredictable effects (Epstein and Schor 1989). For example, in 1982 the Bank followed this course of action and refused to buy a large share of the bonds that the Treasury had not managed to place in the market. The Treasury withdrew the maximum amount of 14 per cent on the account it had at the Banca d’Italia and, needing more funding, asked Parliament to sanction extension of its overdraft facility. The overdraft was granted immediately, because the threat of a fiscal crisis was too destructive to contemplate.

78 The Banca d’Italia In the 1980s and early 1990s two parallel market reforms – the processes of internal and external liberalization – had a significant impact on the de facto economic independence of the Banca d’Italia. The financial system became relatively more ‘market-oriented’, sanctioning the end of ‘internal protection’ through measures promoting more efficient management of the public debt, competition in the banking system and a reduction of ‘external protectionism’, mainly by introducing freedom of capital movement and freedom of establishment for banks. These reforms represented in part an institutional adaptation to the EU ‘output’, because Italy had to comply with the EU directives on banking and the free movement of capital. Such external pressure was exploited in the national arena by the central bank, with some support from the Treasury, in that the goal of the market reforms implemented in the 1980s and early 1990s was to make monetary policy more independent of fiscal policy, by enabling the Treasury to place its bonds on the market, which therefore needed to be enhanced and made more efficient (Carli 1993; Sarcinelli 1995). Indeed, net subscription by the Banca d’Italia for Treasury bills decreased over the 1980s and became negative in the 1990s (Passacantando 1996). These reforms enhanced the central bank’s autonomy from the political authorities and its policy capacity in the monetary field, but they also meant that it was scrutinized more closely by the financial markets. The second set of institutional reforms that formally increased the central bank’s ‘instrument independence’ (meaning its ability to use without restriction the instruments at its disposal) took place shortly after the TEU was signed. In 1992 the Banca d’Italia was granted exclusive power to set interest rates without approval from the Treasury. In 1993 the Treasury’s overdraft facility at the Banca d’Italia was transformed into an interest-bearing deposit that must always be in credit. These changes almost completed the formal independence of the Bank, though it should be noted that the Bank had de facto instrument independence even before the reform, because in practice changes in the discount rate proposed by the Governor, which needed formal approval by the Treasury minister, had never been refused by the latter. Nor had the Treasury minister had ever changed the discount rate without a proposal from the Bank (interview, Rome, March 2002). The Treasury’s overdraft account at the Bank had not been used since the late 1980s. Legally, such changes were needed to comply with the EMU provisions contained in the TEU, hence they were triggered by the legal adaptational pressure exerted by EMU. However, the institutional changes introduced in 1992–3 were also attempts to increase the credibility of the domestic macroeconomic policy framework, especially after the failure of the ERM policy in 1992, just as the British authorities’ policy had failed. In approaching the final stage of EMU, the Banca d’Italia had to undergo further formal institutional changes in order to comply with the EMU institutional and policy templates. These stipulated that the members of the Board of Directors (the Consiglio Superiore, discussed below) were to be appointed for five years, rather than three, as had previously been the case; that in the case of a breach of the law the Treasury minister’s power to suspend or abrogate the deliberations of the Board of Directors falling within the competence of the ESCB was abolished; and that the

The Banca d’Italia 79 Treasury minister’s approval of deliberations on the investment of reserves was abrogated.2 A third reform took place in 2005, in the wake of a scandal that involved the Governor of the Banca d’Italia, Antonio Fazio. The Law on Savings, which had been in the making since 2002 and was eventually adopted in December 2005, introduced three important amendments to the legislation governing the central bank. Although these changes constituted an overdue institutional adaptation to EMU membership and to deeper European financial integration, fostered by the introduction of the single currency (1999) and by the Commission’s FSAP (1999), they were triggered by the policy failure of the ‘Fazio affair’, which is discussed below. The first change introduced by the Law on Savings concerned the ownership structure of the central bank, whereby only the state and public bodies were now allowed to hold shares in the bank’s capital. Before 2005, as a consequence of the process of privatization of the banking sector that unfolded in Italy in the 1990s, private banks held a large part of the central bank’s shares. The second change concerned its governance structure, to be precise, the decision-making process, which was rendered more pluralistic in that all central bank decisions with external implications – with the exception of those concerning the activities of the ESCB – were now to be taken by the four-member Executive Board, not by the Governor alone, as had been the case in the past. Moreover, the Bank now had to provide written justifications for the decisions taken, especially in the supervisory field, and minutes of Executive Board meetings now had to be kept. The third change was the introduction of a fixed-term mandate for the Governor and the Executive Board, along with procedures for appointing and dismissing the Governor and the Executive Board, which give the government a greater say in the process. The reform basically leaves untouched the extensive supervisory powers of the central bank, although the tasks concerning banking competition policy are transferred to the Competition Authority, established by law in 1990 and separate from the central bank, as explained in the second part of this chapter. Whereas the Banca d’Italia would conduct its evaluation of mergers and acquisitions by taking into account ‘sound and prudent management issues’, the Competition Authority would base its assessment on the impact on competition of mergers and acquisitions (Law 262, December 2005; my translation). It should also be noted that during drafting of the Law on Savings, which amended central banking legislation, the Italian Government requested the ECB’s legal opinion three times (May 2004, October 2005 and December 2005).3 In its opinion issued in October 2005, in the wake of the Fazio affair, the ECB suggested the introduction of the principle of collegiality for the Executive Board’s decision-making on measures related to non-ESCB tasks and the introduction of a fixed-term mandate, renewable once, for all members of the Executive Board. This suggestion was eventually incorporated into the relevant legislation in December 2005. The ECB also repeatedly highlighted the need to ensure that the planned transfer of the Banca d’Italia’s share capital to the state was compatible with the provisions of the TEU on the avoidance of monetary financing and the need for sound fiscal policy.

80 The Banca d’Italia Interestingly, in September 2005 the Italian Government was keen to enlist the support of the ECB not only in the drafting of national legislation, as prescribed by the TEU, but also in its efforts to topple the Governor of the Banca d’Italia. Since the Italian Government lacked the legal power and political will to dismiss the Governor, who was at the centre of a major controversy after being accused of preventing foreign takeovers, an unsuccessful attempt was made by the government to enlist the direct intervention of the ECB on this matter, with a view to altering the domestic political opportunity structure. The ECB, however, refrained from intervening, on the ground that it was not part of its remit. The rather paradoxical situation in which the Italian Government found itself in 2005 is an interesting example of an institutional lock-in caused by a combination of national and EU legislation. According to EU legislation, national governments can dismiss national central bank governors only if they are found guilty of serious misconduct. Moreover, governors are entitled to appeal to the European Court of Justice. According to Italian law before the 2005 reform, a governor’s appointment did not have a time or age limit, and the incumbent could only be dismissed via a cumbersome joint decision-making procedure on the basis of a proposal from the Board of Directors, a body embedded in the Bank, as explained below. The strong guarantees provided by EU legislation against the unfair dismissal of national central bank governors assume a fixed-term mandate for the governors, as is the case in all other EU countries (apart from Denmark, which does, however, have an age limit), at the end of which the government has the power to renew the mandate or not, as the case may be. A fixed-term mandate did not apply to Italy before the 2005 reform, hence the institutional deadlock. It is telling that when the Treasury minister, Domenico Siniscalco, resigned in September 2005 following a serious disagreement with the Governor of the Banca d’Italia, he wrote a letter to the President of the ECB, Jean-Claude Trichet, raising the issue of ‘independence of government from central banks’ (Financial Times, 22 September 2005). The previous Treasury minister, Giulio Tremonti, had resigned in 2004 after falling out with the Governor of the Banca d’Italia in an attempt to reduce his powers. Governor Fazio eventually resigned in December 2005, driven by heavy domestic political pressure from the government, indirect external pressure, mainly exerted through financial markets, and faltering support from within the Bank. The legal framework of the Banca d’Italia Until the changes introduced in the early 1990s, in economists’ rankings the Banca d’Italia used to be awarded fairly high scores for political independence (especially for personnel independence, more than decisional independence), but scored rather low on economic independence. The main legal provisions that underpin central bank personnel independence are the procedures for the appointment of the board, the length of tenure in office, and the incompatibility between political roles and positions within the bank. The procedures for the appointment of the Governor and the other members of the Directorate are discussed below, arguing that, before

The Banca d’Italia 81 2005, the legislation very much limited the direct influence of the political authorities in the appointment process. Furthermore, the practice of internal appointments to senior and top positions in the Bank has generally prevailed, and therefore the governor is generally chosen from among deputy governors, and deputy governors are normally chosen from among senior officials at the Bank. On the one hand, this tended to strengthen the autonomy of the central bank. On the other hand, critics argue that this made the Bank ‘self-referential’. The personnel independence of the Banca d’Italia has at times been challenged, and the influence of the political authorities could not be completely excluded from the process of appointment. For example, in 1980 an outsider, Lamberto Dini, was appointed as Director-General, reportedly receiving the support of sectors of the Christian Democratic Party. In 1993 the junior Deputy Director, Antonio Fazio, reportedly supported by Catholic forces, was promoted to Governor, instead of the incumbent Director-General, Dini, who was not supported by the outgoing Governor or the senior Deputy Director-General, Tommaso Padoa Schioppa, who lacked the support of the centre-right coalition. The situation was similar in 1994, with the appointment of a new Director-General, rather than the promotion to this office of the senior Deputy Director-General, Padoa Schioppa. In 2005 an outsider, Mario Draghi, adviser to the Bank in the 1980s and Director-General of the Treasury from 1991 to 2001, was appointed Governor. In contrast to the relatively high political (especially personnel) independence, the Bank’s economic independence (also referred to as operational independence) was very low before the ‘divorce’ in 1981, and it was completed only in 1993, when the overdraft account of the Treasury at the central bank was closed down, as discussed above. Moreover, until 1992, it was the Treasury Minister who announced any change in interest rates, after discussion with the central bank. However, evidence gathered through interviews suggests that in practice it was always the governor proposing the change, which was never refused by the minister. The financial independence in terms of economic resources available to the central bank is remarkable.4 Model of legitimacy of the Banca d’Italia Until the 2000s the legitimacy of the Banca d’Italia had hardly ever been questioned in Italy. Before the statutory changes introduced in order to comply with the TEU, unlike the Bundesbank, but like the Bank of England before the 1997 reform, the Banca d’Italia was not legally independent of the government, and this arrangement provided input-oriented legitimacy. Yet in practice, as discussed in this chapter, the Bank had a high degree of autonomy from the government and extensive policy capacity in several areas. This status quo was, however, broadly accepted domestically because the Banca d’Italia, like the Bundesbank, could rely on outputoriented legitimacy, namely, widespread public acceptance of its activities and the policy output it delivered. Public opinion surveys indicated that the Banca d’Italia was among the most respected and trusted institutions in Italy (as revealed by Eurobarometer data). In

82 The Banca d’Italia turn, the Bank deliberately tried to foster its image as a high-calibre and efficient civil service and an apolitical institution involved in public policy, especially in the 1980s and early 1990s, when the Bank’s legal independence was still fragile, as discussed below. When the legal independence of the Banca d’Italia was increased in the run-up to the final stage of EMU, there was hardly any domestic debate, despite the fact that the procedures for accountability had not been stepped up. These issues came to the fore during the Fazio affair in 2005. In terms of accountability, the Governor and other senior officials take part in parliamentary hearings when invited to do so. The Banca d’Italia (to be precise, the Governor) also presents an annual report on the activities of the Bank and the overall macroeconomic situation in which the central bank has operated. However, such a report is not presented to either the government or Parliament. Instead, it is presented to the assembly of quota-holders, which has basically no formal power over the Bank and, unlike Parliament and the government, cannot change legislation relating to the central bank. This reporting procedure is quite similar to the arrangements in place for the ECB: it presents its report to the European Parliament, which does not have the power to change the legislation governing the ECB. The Banca d’Italia used to produce annual reports of its supervisory activity, but since 2005 they are published at six-monthly intervals. The micro-institutional level: the Banca d’Italia The governance structure of the Banca d’Italia Before the 2005 reform the Banca d’Italia was one of the most centralized and hierarchical central banks in Europe – Guarino (1988) refers to it as a monocratic institution.5 The Governor legally represents the Bank and is its signatory; he/she chairs the General Assembly and the meetings of the Board of Directors, reads the Final Remarks of the Annual Report at the end of May (the Considerazioni Finali) and decides on the career of the Bank’s officials. The Governor deals with the press, releases interviews, gives speeches, appears in front of the Parliament (usually in the committees that deal with economic issues) and takes part in parliamentary hearings, though other members of the Executive Board are also invited (Finocchiaro and Contessa 2002). Until 2005 the Governor had wide powers and discretion within the Bank, in that all responsibilities in the field of monetary, exchange-rate and supervisory policies were concentrated in his hands – there were no formal mechanisms for collegial decision-making procedures. In practice, the main decisions were often taken after consultation with the other members of the Executive Board (though this was not so much the case during the Fazio governorship), and senior officials from the research department and other operational departments frequently attended meetings, depending on the subject under discussion (interviews, Rome, September 2001). The decision-making process was made more pluralistic in 2005, so that decisions with external implications for the Bank are no longer to be taken by the Governor alone, but are instead taken by the five members of the Executive Board,

The Banca d’Italia 83 through a formal voting procedure. This procedure does not apply to decisions concerning the activities of the ESCB (Eurosystem), where the Governor votes in his/her personal capacity, as is the case at the Bundesbank. The Executive Board (Direttorio) consists of the Governor, the Director-General and three Deputy Directors-General.6 This body was established during the governorship of Guido Carli in the 1960s, even though power continued to be concentrated in the hands of the Governor (Guarino 1988) until the 2005 reform. Before 2005 the nominations of all four members of the Executive Board, hence also the Governor, were proposed by the Board of Directors and had to be approved by a decree of the President of the Republic, acting on a proposal of the prime minister together with the Treasury minister, after discussion in the Council of Ministers (Article 19 of the Bank Statute). The 2005 reform increased the government’s influence in appointment procedures, in that the members of the Executive Board are appointed by presidential decree, acting on a proposal of the prime minister, followed by a deliberation of the Council of Ministers, having consulted the Board of Directors. In other words, after the 2005 reform the Board is only consulted – its opinion is not legally binding. Before 2005 all four members of the Executive Board were appointed sine die, that is, their mandates were open-ended and without any age limit, which was exceptional among central banks. In practice, since the Second World War the longest period for governors to have remained in office was for a decade or so, and likewise for the members of the Executive Board. The same body that proposed appointment of members of the Executive Board, the Consiglio Superiore, could repeal their appointment through a joint decision-making procedure involving the government and the President of the Republic (Finocchiaro and Contessa 2002). Since 2005 each member of the Executive Board has a six-year mandate, which can be renewed only once and can be repealed by the government after consultation with the Consiglio. The Consiglio Superiore (Board of Directors) is composed of 13 members and is chaired by the Governor, who votes only when his/her casting vote is required. It meets monthly, and the other members of the Executive Board also attend the meetings. One delegate from the Treasury can take part in these meetings, without voting rights. The members of the Consiglio are elected by the holders of the Bank’s capital quotas and are appointed for five-year terms, which are renewable. They are elected by a secret vote in a process apparently immune from interference by the government of the day, generally following proposals put forward by the Bank itself (interviews, Rome March 2002). Guarino (1988) describes the Consiglio as a body deeply integrated into the Bank’s tradition, jealous of the autonomy enjoyed by the institution and supporting the general guidelines of the Governor. This became quite apparent in 2005, when the Consiglio was very reluctant to withdraw its support from the Governor, who was at the centre of a scandal, as explained further below. The Consiglio and the Committee of the Consiglio (a smaller subset) are in charge of the general administration of the Bank. The General Assembly of the shareholders (Assemblea Generale) meets every year on the last working day of May. The shareholders of the capital of the central

84 The Banca d’Italia bank, namely banks and other financial institutions, take part. The Director-General of the Treasury attends the meeting, but no members of the government – this is to signal the independence of the Bank from the political powers. The main task of the Assembly is to approve the annual budget of the Banca d’Italia, given that it has budgetary and organizational autonomy. De facto, such approval is a formality. The adaptation of the governance structure and the internal organization of the central bank to membership of the Eurosystem has so far been very limited. Within the Economic Research Department, four of the five existing sectors have been given competences also for the analysis of eurozone data, and additional structures, such as the Monetary Policy Co-ordination Committee and the Euro Policy Liaison Office have been created, with co-ordination tasks on issues relating to the euro area and the Eurosystem monetary policy. Another internal structure that has been set up is a division to co-ordinate the whole set of activities related to the ECB Governing Council, which puts together the dossier for the Governor and an accompanying person, generally from the Economic Research Department, for the meeting of the Governing Council in Frankfurt. The intangible assets of the Banca d’Italia Beyond ‘tangible’ institutional assets, other ‘intangible’ assets such as the Bank’s advanced macroeconomic knowledge and its reputation as a ‘sound’ and trusted institution also play an important role in fostering central bank autonomy, as well as strengthening its policy capacity. The Banca d’Italia has extensive economic expertise, and before the upgrading of the Treasury’s capabilities in the 1990s it had a near monopoly of macroeconomic knowledge in Italy (Quaglia 2005b). The number of research staff is the highest among European central banks, ex equo with the Bank of England (St-Amant et al. 2005). Moreover, this is not a relatively recent trend, as the Banca d’Italia had the largest research department in Europe throughout the period considered in the study (1990–2003), even though the Bank considerably expanded its research staff in the period 1996–2003. This was a deliberate strategy to strengthen the Bank’s influence within the Eurosystem and in ECB decision-making. A study of the quantity, quality and relevance of research in 36 central banks in developed countries since 1990 indicates that the number of journal articles published by members of the Banca d’Italia is one of the highest, with an upward trend post-1999 (St-Amant et al. 2005). Moreover, the Banca d’Italia, the Bank of England and the ECB are the sole nonAmerican representatives among the top ten central banks in quality-adjusted output (i.e. publications in top-quality academic journals). Not only did the Banca d’Italia have technical knowledge, but it was also very willing to use it to its best advantage – it was able to do so because of the specific configuration of domestic institutions, as elaborated below. For example, the Banca d’Italia devoted much of its energies and its best minds to the introduction of market reforms mentioned at the beginning of this chapter and, though ‘the political significance of these technical improvements was not understood’ (Carli 1993: 391), they secured more independence from the fiscal authorities. Another

The Banca d’Italia 85 example is the exchange-rate policy conducted by the central bank in the 1980s, as detailed below. The Research Department of the Banca d’Italia has been the research centre par excellence in the economic field in Italy, as well as a school of high finance and a breeding ground for talented civil servants.7 The vast majority of top positions within the Bank are held by officials who have come from the Servizio Studi, and indeed, an ‘internal co-optation in a positive sense’ takes place (interview, Rome, March 2002). The Bank has about 8,000 employees, the majority of whom are employed in tasks related to banking supervision or, before the 2005 reform, banking competition policy. There have been no substantial cuts in staff numbers in preparation for or after EMU membership, and indeed a recurrent criticism is that having lost the task of conducting monetary and exchange-rate policies at the national level, the Banca d’Italia is overstaffed and is refusing to adapt its structure to its diminished policy competences. However, this status quo is bound to change with the appointment of the new governor, Mario Draghi, and there are plans in place for a reduction in personnel as well as internal reorganization of the Bank. The national framework of central banking governance in Italy Political institutions in Italy Before the wide-ranging changes that took place in the 1990s, Italy was traditionally portrayed as a ‘weak’ state (Ranci 1987), with a porous structure and a dispersed and poorly co-ordinated set of institutions, punctuated by personalism, fragmentation and a Byzantine bureaucracy (Ferrera and Gualimini 1999). The executive had limited powers vis-à-vis the legislature, and the prime minister’s position within the executive was also relatively weak compared with the UK and France, for example. The weakness of the Italian executive was a side effect of several factors: the strength of the political parties (partitocracy) in a multi-party system, the shaky electoral basis of prime ministers and their short stay in office, and the provisions of the Italian constitution, which, after the dramatic experience of Fascism, set in place a system of ‘checks and balances’ (Regonini 1993) that tended to favour the legislature at the expense of the executive. Until 1994 the electoral system of almost perfect proportionality resulted in a large number of small political parties being represented in parliament and forming part of the government majority (Regonini 1993), increasing the instability of each administration, which had to mediate the policy preferences of up to five political parties. Most of the time a consociational policy style prevailed in public policy, whereby the main opposition party directly participated in policy-making and supported the choices made by the government majority. The formal and substantial powers of the prime minister and the executive in macroeconomic policy-making were quite limited and rested mainly on the prime minister’s function as the arbiter between domestic forces (Hine 1993). The complex institutional structure also meant that a multitude of economic ministries were

86 The Banca d’Italia involved in macroeconomic policy-making in various ways – a typical example of Italian ‘fragmentation’ (Quaglia and Maes 2004). For example, three main ministries dealt with macroeconomic policies, namely the Treasury, the Ministry of the Budget and Economic Planning, and the Ministry of Finance. Of these, the Treasury was de facto the most influential. Italy underwent significant changes during the 1990s, when it moved from the First to the Second Republic. This transition was characterized by a series of institutional changes, which, paraphrasing Vincent Della Sala (1997), strengthened and hollowed out the Italian state, accompanied by a complete transformation of the party system, whereby old parties disappeared and a large number of the old party elite was dismissed, while new political parties with new political elites emerged, such as the Northern League and Forza Italy. After the 1993 referendum the electoral system became (quasi-)majoritarian, still with 25 per cent of proportional representation, and the party system was reshaped into a bipolar format with two main coalitions, namely centre-left and centre-right.8 As a result of these domestic factors, coupled by significant external events (first and foremost EMU), the role of the executive in macroeconomic policies, especially fiscal policy, was strengthened, and budgetary powers were in effect shifted from the parliament to the ‘core’ executive. After 1996 government stability gradually increased, and the balance of power alternated between centre-left and centre-right coalition. As part of a wider set of institutional reforms, some significant changes aimed at improving the macroeconomic policy framework were introduced in the 1990s, with a view to securing EMU membership by fulfilling the convergence criteria. The three economic ministries were merged and reorganized, and the Treasury underwent a major restructuring, whereby internationally recognized academic economists and professionals with advanced training were appointed at senior level, salary scales were increased, and interaction with academia was promoted (Quaglia 2005b). It is noteworthy that at the level of senior officials and ministers there has been a small but significant flow from the Banca d’Italia to the Treasury. The upgrading of the Treasury, and the pressure exerted by the EMU process, augmented the prominence of the Treasury in macroeconomic policy-making, and also its position vis-à-vis the Banca d’Italia. It would, however, be incorrect to portray Italy as a ‘strong state’ after the reforms of the 1990s. Indeed, once the pressure to secure EMU membership came to an end, the fragmentation of the state structure and the weakness of political institutions resurfaced, as evidenced by the length of time it took for the domestic debate on reform of the Banca d’Italia to come to a conclusion – from the late 1990s until December 2005. The fact that it took so long to introduce overdue changes, despite the fact that Italy’s macroeconomic credibility was being jeopardized by political inaction, is clear evidence of this. Overall, weak and fragmented political institutions in Italy strengthened the autonomy of the central bank and its policy capacity, even in the period prior to 1992–3, when new legal provisions gave the Bank greater legal independence. Moreover, the Bank was frequently forced to perform ‘atypical’ functions, which should have been carried out by other parts of the state apparatus, but which the

The Banca d’Italia 87 weak state, stalled by partitocracy, was unable to perform. The reform of political institutions that took place in the 1990s ‘normalized’ several functions performed by the central bank, and several tasks were transferred to the reformed Treasury. Relations between the Banca d’Italia and the government Overall, until the early 1990s relations between the government and the Banca d’Italia were characterized by the need to reconcile their different objectives in macroeconomic policy, and by the Bank’s attempts to preserve its autonomy, to enhance its policy capacity and often to act as a ‘technical’ counter-power. Whereas the Bank advocated sound (stability-oriented) macroeconomic policies, the government favoured expansionary policies, especially in the fiscal field. In economists’ jargon, relations between the government and the Banca d’Italia in this period resembled what is called the ‘Stackelberg game’ – the core issue at the basis of the game being whether it is the monetary authorities or the fiscal (political) authorities who act as ‘leaders’ in setting macroeconomic policy – which is discussed in the section on monetary policy. However, throughout this period there were some common goals shared by the central bank and the government, first and foremost support for European monetary integration. The situation changed in 1992, when Italy undertook a major fiscal adjustment to meet the convergence criteria to join EMU. Under the centre-left government (1996–2001) this became a political priority, whereas the Banca d’Italia – or to be precise, Governor Fazio and some of his advisers – did not share the government’s objective of joining EMU in the first wave. As in the case of the Bank of England, relations between the Governor, the prime minister and the Treasury minister (post-1998 the title changed to minister for the economy) depended on the personalities involved and their approaches to economic policies, the main difference being that in Italy the prime minister and the Treasury minister were much less powerful than in the UK, especially before the political reforms of the 1990s. On the whole, working relations between the Banca d’Italia and the Treasury have been good, with top civil servants and ministers often drawn from the Bank or having been advisers there. For example, in the late 1980 and early 1990s the central bank and the Treasury worked together to promote the process of internal and external liberalization of the financial market in Italy, and in the late 1990s and 2000s they collaborated in updating financial services regulation (interviews, Rome March 2002; September 2001). Before the 1990s relations between the central bank and the Treasury were often dominated by the Bank, but this partly changed after the institutional upgrading of the Treasury in the early 1990s. Of course, there were periods of acrimonious relations between the Banca d’Italia and the Treasury. The most salient and recent examples occurred in 2002–5 in connection with the bankruptcies of Cirio and Parmalat, and the controversial takeovers of BNL and Antonveneta, all of which triggered a series of reform proposals regarding the framework for financial supervision in Italy. The personality clash between the Treasury minister, Giulio Tremonti, and Governor Antonio Fazio

88 The Banca d’Italia also played a role, though tensions remained after Domenico Siniscalco, formerly Director-General of the Treasury, took over from Tremonti in 2004. It should be noted that following the disagreements between the Governor and the Treasury ministers in 2004 and 2005 it was the latter two who had to resign, not the Governor (though he too eventually resigned in December 2005). When analysing the interactions between the government and the Banca d’Italia, three considerations are in order. First, Italy has generally been portrayed as a ‘weak’ state, in which the executive has limited political capacity. This, together with the weakness of successive coalition governments, plus the fact that political interests have fragmented voices in the Italian system, has increased the Banca d’Italia’s autonomy and influence in the policies in which it was involved (Quaglia 2005a). Second, there was an inclination on the part of government, and politicians more generally, to let the Bank make difficult decisions, supposedly on technical rather than political grounds. This was part of a larger picture, where the tacit acknowledgement of the absence of strong political institutions fostered policymaking by technocrats, several of whom moved to important political positions in the 1990s. The events that took place in 2005 suggest that the process of technocratic primacy (and the central bank’s autonomy) might have gone too far. Third, since the Bank had a near monopoly of expertise in Italy, the wider implications of certain technical decisions taken by it were not always understood, a priori, by the government and the political class, which did not have direct access to technical knowledge. Unlike the British Treasury, which is an intellectually robust institution, the Italian Treasury until the late 1980s had a limited pool of expertise to draw on. Moreover, many of the experts consulted by the Treasury were either seconded from the central bank or had worked there, or happened to share the Bank’s views on several macroeconomic matters. This power relation changed when the Treasury updated its capabilities in the 1990s, and it is quite revealing that in 2005 Mario Draghi, a former Director-General of the Treasury, was appointed to succeed Governor Fazio. Economic institutions in Italy Unlike in Germany or the UK, it is difficult to pigeonhole the Italian model of capitalism, for it is neither a liberal model nor a corporatist one. Some authors argue that, to some extent, the Italian variety of capitalism resembled the ‘statist’ French model, the main difference being that the public authorities are less efficient in Italy than in France (Schmidt, V. 2002a). Indeed, Della Sala (2004: 1045) labels it as ‘dysfunctional state capitalism’. It should be noted that both the French and the Italian varieties of capitalism have become less statist in the 1990s and 2000s, though the process has been quicker and more marked in France than in Italy. Until the 1990s state intervention in the Italian economy was extensive and inefficient, as was the welfare state. Protective labour market legislation benefited those who were already employed, reducing flexibility in the labour market. The state took part in labour negotiations, although tripartite agreements in incomes

The Banca d’Italia 89 policy were successfully managed only in the run-up to the final stage of EMU – the so-called concertazione (Molina and Rhodes forthcoming). In the 2000s there was an attempt to make the labour market less rigid by introducing a more flexible wage structure and contracts. In terms of corporate governance, before the 1990s many companies, even large ones, tended to be family-owned and family-managed, often through interlocking ownership managed by the powerful merchant bank, Mediobanca (Della Sala 2004).9 This was a family type of capitalism created by an underdeveloped capital market and outdated legislation that discouraged shareholder involvement. In contrast to Germany, before the revision of Italy’s banking legislation in 1993 there was a complete separation between banks and industry in terms of ownership and shareholding (Deeg 2005). Until the 1990s the Italian financial system was mainly ‘bank-oriented’, in that it was characterized by an extensive activity of financial intermediation performed by banks (Ciocca 2005: 4). Thus it resembled Germany, rather than the British ‘market-oriented’ system, where securities markets were already well developed in the 1980s. Before the reform of the 1990s the Italian banking sector was largely state-owned and characterized by two anomalies. The first anomaly was the division between public long-term credit institutions (istituti di credito speciale) and shortterm credit institutions (istituti di credito ordinario), with few private banks and many public savings banks and co-operative banks. Each of these categories was in turn divided into several segments, on top of which there were geographical boundaries that restricted their activity. The second anomaly in the Italian banking system was the low degree of competition as a result of internal and external protectionism (Monti 1998). The extensive public sector was partly dismantled in the 1990s in both the industrial and the banking sector. With the revision of banking, finance and corporate legislation in Italy in the 1990s, the financial system became more marketoriented, even though it remained bank-centred in a different way, in that the decline in the use of traditional bank instruments did not coincide with a reduction in the role of the banks, which engaged extensively in securities trading and were important market shareholders (Ciocca 2005: 9). Segmentation in the banking sector came to an end – the formal change took place with the transposition in 1992 of the Second Banking Directive issued in 1988, which introduced the all-purpose universal bank in Italy – and the banking system was privatized, modernized and consolidated. Between 1995 and 2005 the number of banks in Italy dropped from 970 to 785 (Financial Times, 17 February 2005). The five biggest banks, Unicredito, Banca Intesa, San Paolo IMI,10 Capitalia and Monte dei Paschi di Siena, run approximately 40 per cent of the banking network and have a market share of about 45 per cent in loans (Financial Times, 4 December 2004). As of 2005, there are no big public banks in Italy. However, Italy’s generous state pension system means that pension funds as well as financial conglomerates are underdeveloped compared with Germany and the UK, for example. As discussed in the previous chapters, these were important factors that triggered the reform of the framework for financial supervision in these

90 The Banca d’Italia countries, leading to the creation of single regulatory authorities. Yet, external pressure for change mounted in Italy in the 2000s, when an increasing number of foreign financial companies, with the backing of the European Commission (which was keen to promote further financial market integration in Europe), tried to penetrate the national banking sector, straining the existing institutional and policy framework in the field of banking supervision and competition policy, as discussed below. Interactions between the Banca d’Italia and economic interest groups In Italy the system of representation by economic interest groups, which has often been characterized as ‘bargained pluralism’ (Hine 1993), is much more fragmented than in Germany. The main interest groups are umbrella organizations and, as a rule, their influence on public policies is weakened by the fact that there are often different ‘views’ inside the various associations and that they do not always ‘speak with one voice’, partly because they have a low degree of centralization and are loosely organized. Firms have a greater chance of getting a sympathetic hearing from the public authorities if they approach them individually, and not as part of an umbrella organization – this was especially the case in the banking sector (interview, Rome, September 2001). The Italian banking association, the Associazione Bancaria Italiana (ABI), represents all financial and banking operators and intermediaries, whether public or private, Italian or foreign. As is the case with all central banks, interaction with the financial system has been very important for the Banca d’Italia. On the one hand, until the wave of privatizations in the 1990s significant segments of the Italian banking sector were public, and the Banca d’Italia had a say in the appointment of the boards of these firms. It was common practice for the central bank to propose a list of names of potential managers, with the government deciding on the appointment of the senior management of public banks (interview, Rome, March 2002). Moreover, the Bank has extensive power of prudential supervision and had the task of monitoring competition in the banking sector. On the other hand, before the 2005 reform the members of the Executive Board were proposed to the government by a Consiglio mainly representing banks and credit agencies that held Banca d’Italia stock. However, e