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Robert B Kahn and Ellen E Meade

This chapter discusses the evolution of central bank interactions since the early 1970s. Today, central banks have more forums in which they interact without finance ministries than they did in earlier times; interactions have shifted away from managing exchange rates and toward monitoring and regulating the international financial system, global financial institutions, and cross-border capital flows. At the same time, the rise in statutory independence has given central banks more authority to shape the response to events, and the rise of new powers and their integration in markets has resulted in the broadening out of the prominent coordinative groupings to include countries outside the historically traditional major powers. Our main conclusion is that the relationship-building that is inherent in multilateral interaction has provided a springboard for coordination in times of stress or crisis. Crises matter—they can be turning points in terms of the actions taken and the countries included in the dialogue.

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Hossein Nabilou and Alessio M. Pacces

This chapter deals with the economic rationale for regulating shadow banking. It discusses whether the regulatory initiatives proposed by academics and policymakers are consistent with this rationale. We posit that the ultimate goal of financial regulation is to promote financial stability. Therefore, we evaluate shadow banking regulation based on its ability to reduce financial instability efficiently. Regulating shadow banking is challenging because shadow banking is often defined by reference to what it is not, namely, licensed or official banking. However, such an approach does not capture the essence of the shadow banking problem. The official banking system has implicitly or explicitly supported a significant part of what is known today as shadow banking. For instance, the asset backed commercial paper (ABCP) conduits or the structured investment vehicles (SIV), which were exposed to the United States (US) housing market during the global financial crisis (GFC), all enjoyed guarantees by banks – so-called ‘put options’ – by way of contract or reputation. The remainder of shadow banking was still problematic for financial stability because of the contracts in which shadow banks were counterparty to banks. American International Group (AIG), for instance, was counterparty to a significant part of the banking system relying on credit default swaps (CDS) to insure against the default of mortgage-backed securities (MBS).

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Paul Tucker

In the aftermath of the financial crisis financial stability considerations have become more prominent in central banks’ policies and require substantial discretion in their implementation. We argue that transparency can serve as an instrument for central banks to balance the conflicting interests of different stakeholders and manage market participants’ expectations, explain their strategy and report on its implementation progress and receive comments and feedback by stakeholders. In view of the increasingly contested concept of central banks’ independence, we show that increasing and institutionalizing ex ante and ex post transparency on policy decisions and their implementation strengthen central banks’ accountability as a key ingredient and prerequisite for their independence. Finally, we hold that central banks’ new responsibilities for financial stability call for the development of a more comprehensive and inclusive approach given their strong impact on private actors and their linkages with other policy fields and governmental agencies.

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Christopher Adam, Andrew Berg, Rafael Portillo and Filiz Unsal

The monetary landscape in sub-Saharan Africa has changed profoundly during the last three decades, from money financing of fiscal deficits in the 1980s to stabilization in the context of broad reform programs and de jure money-targeting regimes in the 1990s and, more recently, efforts to modernize policy frameworks. This chapter provides an overview of the issues facing central banks as they modernize. It places these efforts in their historical context, reviews the reasons for dissatisfaction with current regimes, and discusses the challenges facing central banks in SSA. These include the nature of the monetary transmission mechanism, the prevalence of supply shocks, the volatility of fiscal policy, and the management of aid and natural resource revenues. It discusses the role of the exchange rate and discusses appropriate modeling frameworks, as well as the role of central banks in the pursuit of financial stability and in the management of natural resource wealth.

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Chiara Zilioli and Antonio Luca Riso

This chapter focuses on the scope of the principle of central bank independence in the legal framework of the European Union, which has established such principle at constitutional level for both the European Central Bank (ECB) and the national central banks (NCBs) to ensure the highest level of legitimacy. On the depth of central bank independence, the chapter offers a review of the debate between those who are concerned that monetary policy decisions have been taken out of democratic control, and those arguing that only a central bank that is independent from political power can maintain a stable currency for the benefit of the citizens and that the ECB’s accountability has been ensured through several legal requirements and practices . With regard to the scope of central bank independence, this chapter analyses the question whether this principle extends to additional tasks which have been conferred, in particular after the crisis, upon the NCBs and the ECB, including in particular micro-prudential supervision, and whether the conferral of these new tasks could jeopardize central bank independence.

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Mingfeng Lin

The traditional banking industry’s business model is fairly simple: take the deposits from borrowers (supplier of funds) and then act as lenders to those who need the funds (demand side of funds). Banks serve many important roles in that process, and are also able to generate excellent returns for their activities. Peer-to-peer (P2P) lending represents one of the most fascinating challenges to the traditional banking industry in a very long time. With the growth of Internet and information technologies, in the middle of the 2000s many P2P lending startups emerged around the world. Some of the most notable examples include in the US and in the UK. They started to link borrowers and lenders of funds directly, rather than having them go through banks. The borrowers on these platforms can be individuals or firms. Most platforms, including and, focus on individual borrowers. Other platforms cater to the debt financing needs of businesses, particularly small and median businesses. Examples include and in the UK. Early on, most of the lenders on these platforms are individuals as well.

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Christian Johnson

The US tri-party repo market is one of the most active and liquid in global capital markets. Even more specialized than traditional repo, tri-party repo has often operated in the shadows of global finance. The US Federal Reserve, however, has helped make this market more transparent and less volatile than it has been in the past. This chapter discusses the history, size and characteristics of the US tri-party repo market. It then discusses the need for these changes and the current status of this important shadow banking product after many of these reforms have taken place. In particular, it also discusses the systemic risks both before and after the reforms to global financial markets. This reform process could also help serve as an important model for future reforms to other areas of shadow banking. Repo is often held up as one of the pillars of shadow banking, creating ‘additional sources of funding and offers investors’ alternatives to bank deposits’. Also, repo is often grouped with other shadow banking activities such as securitization and securities lending. These activities are accused of operating in the shadows of the banking system because the transactions themselves, and often the entities that enter them, typically are not subject to traditional banking regulation and disclosure requirements. Tri-party repo is often held up as particularly worrisome owing to the financial leverage that it can create and the possibility of runs on the shadow banking system during times of market stress.

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Mark Hsiao

In the wake of a series of financial crises occurring between 2007 and 2009, there has been a political consensus, at a global level, on various regulatory reforms after the G20 Pittsburgh Summit 2009. The regulatory reforms were aimed at the shadow banking system (SBS) through an enhanced market transparency and regulation of over-the-counter (OTC) derivatives. These two objectives are not mutually exclusive. From a regulatory standpoint, they are relative. This chapter analyses these two objectives in the contextual framework of the European Market Infrastructure Regulation (EMIR). The analysis focuses on the reporting obligation to the trade repository (TR) and the clearance obligation of designated OTC derivatives through the central counterparty (CCP). The chapter argues that while these two obligations can functionally transform shadow banking into a resilient market-based finance, the regulatory framework also creates an exchange platform that transforms the OTC derivative contracts into the fungible securities. The transformation is manifested in the functional role of the CCP as both the buyer and the seller to all CCP participants. By interposing the CCP in between counterparties, OTC contracts have the same counterparty. The counterparty substitute is achieved by novating their original contracts. The CCP becomes a static counterparty to all OTC derivatives contracts. Consequently, all contracts are novated with same counterparty – the CCP. The substitution and novation transform these contracts into futures contracts or fungible securities. In doing so, the legal process also shifts the bilateral counterparty risk to the CCP. When the CCP takes over the counterparty risk, the risk is reduced through a centralized process of net-off that results in a single net payment or no payment to a participant in the CCP. The role of the CCP also transforms the legal bilateral obligations and rights analogous to multilateral set-off with the resultant recipient of a single net payment. The economic advantage is that in the event of a party’s insolvency, the non-faulting party reduces the totality of its claim against the insolvent party. The CCP also deals with the potential systemic instability triggered by the breach of contractual obligation of a financial institution. These coincide with the stability objective in the Markets in Financial Instruments Directive (MiFID) and the Dodd–Frank by bringing derivatives ‘on exchange’ so as to enhance the transparency of the market. By regulating the OTC contracts from the outset as a securities product, the EMIR facilitates the market participants with a platform that makes the OTC derivatives ready and transferrable as a thing. The private-law technique becomes a tool for ‘public regulation’ and is justified by the transaction cost analysis for the ‘public good’, but there is a subtle evolution in the way that law recognizes OTC derivatives as more than just about contractual obligations and rights.

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Harold James

The chapter examines the changing experiences of German central banking with respect to political independence, and to issues such as lender of last resort actions with regard to the domestic banking system as well as to price stability. It also examines the role of foreign central bank models—of the 1844 British Bank Act on the creation of the first German central bank, or British and American central banking on the refounding of the Reichsbank after the interwar hyperinflation, and the Allied influence on the creation of the Bank Deutscher Länder (the predecessor of the Bundesbank). In addition, there is a discussion of how German central banking history and experiences influenced European thinking and helped to shape European Monetary Union.