Central Banking Governance in theEuropean 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 andempirically grounded analysis of central banking governance before and after theestablishment 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 encompassesthe European, transnational and international arenas; the ‘national-level’, whichconsiders the configuration of the domestic socio-economic and political environ-ment in which each central bank operates; and the ‘micro-institutional level’, whichdeals with the specific features of each central bank.

Methodologically, the research engages in a structure-focused comparison, usingqualitative methods. In order to do so, it conceptually develops and empiricallyapplies the notion of ‘mode’ of central banking governance, operationalized throughfour 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, financialregulation and supervision

• central bank legitimacy.

Empirically, this monograph focuses on the Bank of England, the Bundesbank, theBanca d’Italia and the ECB over the period 1979 to present, with particular attentionpaid to the last decade. It is grounded in extensive primary research, enriched byinterviews with policy-makers.

Central Banking Governance in the European Union will be of interest tostudents and researchers of Politics, Economics and Political Economy.

Lucia Quaglia is Senior Lecturer in Politics and Contemporary European Studiesat the Sussex European Institute, University of Sussex, UK.

UACES Contemporary European Series

Edited by Tanja Börzel, Free University of Berlin, Michelle Cini, University ofBristol and Roger Scully, University of Wales, Aberystwyth, on behalf of theUniversity Associatiion for Contemporary European Studies

Editorial Board: Grainne De Búrca, European University Institute and ColumbiaUniversity; Andreas Føllesdal, Norwegian Centre for Human Rights, University ofOslo; Peter Holmes, University of Sussex; Liesbet Hooghe, University of NorthCarolina 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 LoukasTsoukalis, ELIAMEP, University of Athens and European University Institute.

The primary objective of the new Contemporary European Studies series is toprovide a research outlet for scholars of European Studies from all disciplines. The series publishes important scholarly works and aims to forge for itself aninternational reputation.

1. The EU and Conflict Resolution Promoting Peace in the BackyardNathalie Tocci

2. Central Banking Governance in the European UnionA Comparative AnalysisLucia Quaglia

3. New Security Issues in Northern EuropeThe Nordic and Baltic States and the ESDPEdited by Clive Archer

4. The European Union and International DevelopmentThe Politics of Foreign AidMaurizio Carbone

Central BankingGovernance in theEuropean UnionA comparative analysis

Lucia Quaglia

First published 2008 by Routledge2 Park Square, Milton Park, Abingdon, Oxon 0X14 4RN

Simultaneously published in the USA and Canadaby Routledge29 West 35th Street, New York, NY 10001

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 orutilised in any form or by any electronic, mechanical, or other means, nowknown or hereafter invented, including photocopying and recording, or inany information storage or retrieval system, without permission in writingfrom the publishers.

British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication DataQuaglia, 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 2007332.1′1094—dc22 2007028585

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)

This edition published in the Taylor & Francis e-Library, 2007.

“To purchase your own copy of this or any of Taylor & Francis or Routledge’scollection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

ISBN 0-203-93280-3 Master e-book ISBN

Contents

List of tables viAcknowledgements viiList of abbreviations ix

1 Introduction: central banking governance in the European Union 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

6 Conclusions: a comparative assessment of central banking governance in the EU 145

Notes 162Bibliography 168Index 189

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 helpof many practitioners and experts in several financial institutions and countries.Although central banks are often portrayed as rather aloof institutions, in all thecentral banks highlighted in this study I found forthcoming and helpful interlocutors,who generously gave me their time, despite their very busy diaries, and were willingto share some of their insights with me. Some of these officials also read parts ofmy book, providing valuable comments. I am very grateful to all of them. It wasagreed with all the interviewees that, though I could use the information they gaveme, it would not be individually attributed. I am sure they would not agree with allthe judgements expressed in this book. All errors, omissions and interpretations inthis 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, stimulatedmy interest on economic governance in the EU and equipped me with thefundamental tools needed to conduct research in this field. I also wish to thank themfor their unfaltering support, constant commitment and constructive criticismthroughout these years, even when I was no longer one of their supervisees andbecame one of their colleagues.

Since I started my research, several academics have generously given me theiradvice, and some have commented on parts of the book. In particular, I would liketo thank Chad Damro, Kenneth Dyson, James Forder, Anthony Forster, DavidHowarth, Ivo Maes, Michael Moran, Machiko Miyakoshi, Mari Neuvanen, GeorgePagoulatos, Uwe Puetter, Claudio Radaelli, Fiona Ross, Min Shu, Francesco Stolfi,Roland Sturm, Sye Sungwook, Nelson Vaz, Paulo Vila Maior and Amy Verdun. Ialso wish to thank the series editors Tanja Börzel (who kindly read and commentedon the entire manuscript), Michelle Cini and Roger Scully, and the commissioningeditors at Routledge, Heidi Bagtazo and Amelia McLaurin, for their interest in myproject, Lolli Duvivier for reading through an earlier draft of the text and GerardM.-F. Hill for his very professional copy-editing.

I shall never forget my fellow colleagues at the Sussex European Institute andthe University of Bristol, all of whom contributed to a stimulating and supportiveenvironment in which to carry out my research. Last, but by no means least, I would

like to thank my family and friends, especially, Elke, Elspeth, Gennaro and Johnfor reminding me that, from time to time, ‘I should give the banks (and myself) arest’.

Dr Lucia QuagliaBrighton, 2007

viii Acknowledgements

Abbreviations

BaFin Bundesanstalt für FinanzdienstleistungsaufsichtBAKred Bundesaufsichtsamt für das KreditwesenBBG BundesbankgesetzBCBS Basel Committee on Banking SupervisionBCCI Bank of Credit and Commerce InternationalBEPG broad economic policy guidelinesBIS Bank for International SettlementsBSC Banking Supervision Committee of the European System of

Central BanksCBC Central Bank CouncilCCBG Committee of Central Bank GovernorsCEBS Committee of European Banking SupervisorsCESR Committee of European Securities RegulatorsCONSOB Commissione Nazionale per le Società e la BorsaCOREPER Committee of Permanent Representatives in BrusselsCPSS Committee on Payment and Settlement SystemsCRD Capital Requirements DirectiveDG Directorate-GeneralEC European CommunityECB European Central BankECJ European Court of JusticeEcofin Council of Economic and Finance MinistersECU European Currency UnitEFC Economic and Financial CommitteeEMI European Monetary InstituteEMS European monetary systemEMU economic and monetary unionEP European ParliamentEPC European Policy CommitteeERM exchange-rate mechanismESCB European System of Central BanksETUC European Trade Union ConfederationEU European Union

FSA Financial Services AuthorityFSAP Financial Services Action PlanG7, G10 Group of Seven, Group of TenHIPC harmonized index of consumer pricesIGC inter-governmental conferenceIMF International Monetary FundIOSCO International Organization of Securities CommissionsLCB Land Central BankLLR lender of last resortM monetary aggregatesMLG multi-level governanceMPC Monetary Policy CommitteeNCB national central bankOECD Organization for Economic Co-operation and DevelopmentPSBR public-sector borrowing requirementQMV qualified majority votingSEA Single European ActSIB Securities and Investments BoardSRO self-regulatory organizationTARGET Trans-European Automated Real-time Gross Settlement Express

Transfer systemTEU Treaty on European UnionUP University Press

x Abbreviations

1 IntroductionCentral banking governance inthe European Union

The establishment of Economic and Monetary Union (EMU) in the European Unionhas brought central banking governance into the spotlight. The European CentralBank (ECB) and the Eurosystem, comprising the ECB and the national centralbanks of the countries that have adopted the euro, are the main pillars of EMU, aswell as a sui generis type of central bank in a polity in the making. This results ina 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 EUbeen transformed as a result of EMU?

To answer these questions, it is necessary to understand the main features andmodes of central banking governance in the EU and, more precisely, in its memberstates, before the introduction of the single currency, because national central banks,together with the ECB, are core components of EMU. How was central bankinggovernance organized, and how did it evolve over time before EMU? What werethe main similarities and differences in central banking policies and institutionalsettings across EU countries, and what factors account for this? Have theyconverged or diverged over time, especially after EMU? How do the national centralbanks interact with the ECB and how does this shape central banking governancein the EU?

These questions are not only of academic interest, but they are also policy-relevant, because they have profound and far-reaching repercussions on theeffectiveness and legitimacy of economic governance in the EU. These are allthemes that have gained political salience and have become matters of publicconcern in the EU and its member states. Yet so far these issues have not been thefocus of systematic analysis, as indicated by the review of the relevant literaturebelow.

This monograph aims to fill the gap that exists on the politics and public policyaspects of central banking in Europe, by conducting a theoretically informed andempirically grounded analysis of central banking governance in selected countries,before and after the introduction of the single currency, extending the assessmentto 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 exploresthe multi-faceted character of central banks as specialized bureaucracies (or

technocracies), as public policy institutions involved in economic governance at thenational, international and EU levels, and as political actors in their own right.

This research project has three specific objectives. First, the project engages ina comparative analysis of central banking governance in selected countries beforeEMU, focusing on the institutional framework in which national central banks usedto operate and their core policies, and examining the overall ‘autonomy’, ‘policycapacity’ and ‘legitimacy’ of these institutions, all concepts defined below. Itidentifies 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 theinstitutional framework and policies of the ECB, addressing the main issues relatedto the autonomy, policy capacity and legitimacy of this supranational, multi-levelinstitution and comparing it with national central banks before EMU and with thoseoutside the eurozone, but within the EU. Furthermore, the external dimensions ofthe ECB – that is, its role as a global actor and its international relations – are alsoexamined, and the same is done for the other central banks.

Third, the research sheds a novel light on the role and influence of national centralbanks within the policy framework of EMU, their interaction with the ECB andtheir ‘adaptation’ to EMU, and on the role of one central bank outside EMU, but inthe EU.

The existing literature on central banking is patchy. Although several historianshave worked on specific central banks,1 they tended to provide in-depth but ratherdescriptive accounts, with ad hoc explanations owing to the absence of acomparative perspective. Moreover, given the limited availability of recent archivalmaterial, historical studies cannot cover the last thirty years.

In economics, studies of central banks have focused on measuring central bankindependence by devising appropriate indices and statistically testing the effects ofindependence 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 Haan1996). Recently, a similar statistical methodology has been applied to central bankaccountability (Bini-Smaghi and Gros 1999, 2001; Elgie 1998; de Haan 1997; deHaan and Amtenbrink 2000; de Haan et al. 2004) and, to a more limited extent,financial supervision (Masciandaro 2004, 2006).2 In general, these works haveengaged in large-scale quantitative comparisons.

Economists have largely adopted a rational choice approach, using statisticaltools, which are very useful in measuring certain institutional features and aspectsof central banking activity, but fail to capture the whole range of factors that affect central banking governance. Thus, several non-quantifiable factors aremissing from these analyses. For example, ideas – especially in the form of policyparadigms – have been overlooked, as have the intangible assets of central banks,as defined below.3 Moreover, because of the kind of data used in quantitativeanalysis, excessive emphasis has been placed on formal institutions and legalprovisions, which determine central bank de jure independence, as opposed to de

2 Introduction

facto independence. The behaviour of central banks, and their interactions withother policy-makers and policy stakeholders in often political processes and inmulti-level arenas, have been overlooked (Forder 2000).4

Finally, economists have mainly focused on one specific institutional aspect ofcentral banking governance, namely, formal central bank independence and itseffects on monetary policy. Other policies and functions of central banks – andother policies and functions that involve central banks one way or another, such asexchange-rate policy, financial regulation and supervision, advising the governmenton macroeconomic policy matters and negotiating in international forums – havebeen overlooked, not least because, unlike monetary policy, these policies aredifficult to gauge using quantitative indicators.

In political science, some scholars have used the techniques employed byeconomists to study specific central banks using quantitative methods and gametheory, especially in the case of the US Federal Reserve and the Bundesbank (seeBroz 1997; Mayer 1993; Meltzer 2002; Toma 1997). These works are prone to thesame drawbacks as economists’ studies of central banking. Some other studies ofcentral banks have been conducted using qualitative methods, for example, thepath-breaking work of Woolley (1984) on the US Federal Reserve. In Europe, onlythe Bundesbank (Heisenberg 1999; Kennedy 1991; Leaman 2001; Loedel 1999),and to a lesser extent the Bank of England (Moran 1986, 1991) and Banque deFrance (Elgie and Thompson 1998) have attracted scholarly attention.

An updating of this literature is very much needed to take into account theprofound transformation undergone by central banking in Europe in the 1990s andsince. Moreover, the adaptation (or lack of it) of these national central banks toEMU has not yet been analysed, and comparative qualitative studies of centralbanks in Europe have been rare, with the few exceptions (Apel 2003; Bernhard2002; Elgie and Thompson 1998; Goodman 1992) failing to cover the most recentand most eventful period. Furthermore, they have tended to focus on monetary andexchange-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 andpolicy templates provided by the Bundesbank (Dyson 1994), but also drawing onthe policy practices, the modus operandi and expertise of other national centralbanks, and building on well-developed working relationships between the centralbanking 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), followedby practitioners (Bini-Smaghi and Gros 1999) and academics (Dyson 2000a;Howarth and Loedel 2003, 2005; Kaltenthaler 2006). Furthermore, researchershave only marginally considered the national components of the Eurosystem. Thisis a significant gap, in so far as the Eurosystem has been criticized for being toodecentralized 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 institutionalconfiguration of national central banks, their policies and operational practicesexercise considerable influence over the policy framework of EMU.

Introduction 3

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 arenumerous and often quite different definitions of governance (for a review see Kjaer2004; Pierre and Peters 2000; Rhodes 1997; van Kersbergen and van Waarden2004), 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 betweenthe state and the market, or between the state and society, that is, between the publicauthorities and the private sector. In modern societies, functions traditionallyperformed 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 publicauthorities are seen as being no longer in a position of command; they are simplya set of actors among many in the policy-making process, even though they mightstill possess or control important resources. This approach often uses the conceptof policy network to describe the policy interaction and the exchange of resourcesbetween a variety of public and private actors (Peters and Pierre 1998) and it isoften 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) corecompetences. Several policies are no longer decided and implemented at thenational level by state authorities. Instead, these policy-making functions are shifteddownwards to the sub-national level, or upwards to the international level, that is,to international organizations (or international regimes) and the EU (Peters andPierre 1998), setting in motion a process of ‘multi-level governance’. This termdescribes the ‘dispersion of authoritative decision-making across multiple territoriallevels’ (Hooghe and Marks 2001: 1). The EU is a notable example (but not the onlyone) of this approach to governance (Bache and Flinders 2004).

The third approach links governance to the rise of the regulatory state (Majone1996; Moran 2000, 2002b), as opposed to the traditional (interventionist) state,which used to engage not only in regulatory policies, but also in distributive andre-distributive ones. The regulatory state, as the name suggests, uses mainlyregulation, 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 atleast a ‘patchwork of national regulatory styles’ (Héritier 1996: 149). Moreover, thevast 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. Thisapproach to governance brings to the fore the role of independent regulatoryagencies or non-majoritarian regulators (Coen and Thatcher 2005; Thatcher andStone Sweet 2002), which take over functions and policies previously performedby the state and interact with other public authorities as well as with the privatesector. Central banks are a very distinctive and powerful type of these independentregulatory agencies, and the notion of principal–agent is often applied to concep-

4 Introduction

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-Kochand Rittberger 2006; Jachtenfuchs 2001), there is a growing literature on ‘newmodes of governance’ in the EU (Citi and Rhodes 2007; Treib et al. 2007), wherebythis expression is mainly used to describe the Open Method of Co-ordination, ‘softlaw’, benchmarking and promotion of best practice, the policy-making activities ofnetworks of experts and regulatory agencies, and so on.

This research borrows from all three approaches to governance, but in particularfrom the third approach, which deals with the activity of regulatory agencies, eventhough it does not use a principal–agent model. That model is not well equipped tocapture the complexity of central banks’ activities and it does not apply well to themulti-level dimension explored. The focus here is on central banking governance,which concerns the institutions, policies and activities in which central banks areinvolved in a multi-level setting. The modes of central banking governance consistof four main components through which different modes are identified andoperationalized in this research: (i) central banking legal framework; (ii) centralbank ‘autonomy’; (iii) central bank ‘policy capacity’; and (iv) central banklegitimacy. Such components, which are elaborated below, are teased out from theliterature on central banks in economics and political science, part of which hasbeen reviewed above.

(i) The legal provisions concerning central banks are usually considered by economic and legal studies of central banks (the so-called statute-readingmethodology). 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 theterminology and criteria used by each classification (cf. Cukierman 1992; Grilli et al. 1991; Eijffinger and de Haan 1996). ‘Political independence’ is the ‘abilityof the central bank to select its policy objectives without influence from thegovernment’ (Alesina and Summers 1993: 153; hence it is sometimes called‘objective independence’) and it is determined by the legal provisions for theappointment of top officials (‘personnel independence’) and the decision-makingpowers assigned to the central bank (‘decisional independence’), for example,whether government representatives sit on the board of the bank, whethergovernment approval for monetary policy decisions is required and whether theobjective of price stability is explicitly part of the central bank statute. ‘Economicindependence’ refers to the ‘ability of the central bank to use macroeconomic policyinstruments without restriction’ (Alesina and Summers 1993: 153; hence it issometimes called ‘operational independence’), resisting any direct effects ofgovernment action on monetary policy (preventing the so-called monetary financingof fiscal policy). Budgetary autonomy (often referred to as ‘financial independence’)is also important, because it affects the economic resources available to the centralbank.

(ii) Central bank ‘autonomy’ (or de facto independence) from the politicalauthorities (cf. Pagoulatos 2000) is similar to what the economic literature that

Introduction 5

moved beyond legal analyses describes as ‘behavioural independence’ (Woolley1984). Autonomy is the ability of a central bank to define and (attempt to) pursuepolicy objectives that might be different from those of the government (or, moregenerally, of the main domestic forces). For example, there might be instances inwhich a central bank with a low degree of legal independence behaves largelyindependently of the government’s preferences, hence exhibiting relatively highautonomy. The opposite can also be true.

(iii) Central bank ‘policy capacity’ (cf. Pagoulatos 2000, where it is called ‘policystrength’)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 inspecific fields of activity, as well as through the interaction with other public andprivate actors at both the national and international levels. Three policy areas arecrucial for central banking governance, and hence deserve in-depth research:monetary policy; exchange-rate policy; and financial (mainly banking) regulationand supervision. To this should be added other (often ‘atypical’) functionsperformed by central banks, such as advising the government on macroeconomicmatters, or acting as a counterpower to political authority, or mediating betweenfinancial interest groups and the government – these roles performed by centralbanks often vary significantly from polity to polity.

(iv) Central bank legitimacy relates to the social acceptance of the authority ofthe central bank as a public actor, as well as its aims and powers. It can beconceptualized as adopting both an ‘input-oriented’ and an ‘output-oriented’approach to legitimacy (Scharpf 1999), adapting it to central banking. The input-oriented dimension focuses on the input into the policy-making process. Hence, anindependent central bank that is insulated from political interference in the conductof its policies and is not accountable to the political authorities is not seen aspossessing input legitimacy. The output-oriented dimension focuses on the outputof 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 outputlegitimacy. It is also important to consider the way in which the legitimacy of acentral bank is perceived by the public and how its activities are evaluated in thepolity in which it is embedded.

6 Introduction

Table 1.1 Dimensions of the dependent variable (central banking governance)

Mode Components

(i) Legal provisions(ii) Central bank autonomy (de facto independence)(iii) Central bank policy capacity

• monetary and exchange rate policies• financial (banking) regulation and supervision• atypical functions

(iv) Central bank legitimacy• input-oriented• output-oriented

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

Explanatory factors: taking stock of the literature

The academic literature in political science has identified several explanatory factorsaffecting central banking governance. Such explanations have been situated atdistinct levels of analysis, namely, international (including transnational), andnational, and they can be organized under three conceptual headings: institutions,interests and ideas.

Systemic-level explanations are generally rooted in theories of internationalpolitical economy and international politics. Some authors have highlighted theimportance of international institutions, which comprise international regimesconcerning financial supervision (e.g. the Basel I Accord; see Kapstein 1989) andinternational organizations underpinning those regimes, such as the IMF, the WorldBank and the Bank for International Settlements (BIS) (Wood, D. 2005). In theEU, EMU represents the most important institutional evolution in themacroeconomic field, and it had been preceded by European exchange-rateagreements, namely the ‘snake’ and the EMS (see Helleiner 1994; Webb 1995).6

With specific reference to central banking, the reverberation effects of internationaland EU institutions on the domestic arena unfold through two causal mechanisms,which have been highlighted by the literature on Europeanization (Börzel and Risse2003; Bulmer and Radaelli 2005; Knill and Lehmkuhl 2002). The first mechanismis adaptational pressure, whereby international regimes and internationalorganizations impose, or at least promote, specific institutional and policy templatesacross countries. The second mechanism is the provision of external resources toor constraints on domestic actors, changing the political opportunity structure, asexplained below. These two mechanisms are the basis of the two-level game,developed by Putnam (1988) with reference to chief executives, though it can beapplied to central banks, which stand at the interface between levels of governanceand operate in national and international forums. Indeed, national central banks,especially the most powerful, such as the Bundesbank, are not simply passivepolicy-takers and often engage in double-edged diplomacy in multiple and multi-level 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 macroeconomicpolicies and hence affecting the policy capacity of national macroeconomicinstitutions – first and foremost the central banks. Over time, so the causal argument goes, the power of financial markets has been strengthened by theprocess of internationalization and liberalization (Cerny 1993; Strange 1986, 1996), and these forces of unbounded capital support and actively promote the

Introduction 7

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 para-digms, which are generally informed by specific bodies of technical knowledgeand often ‘travel’ across countries (Hall 1989, 1993). Thus in monetary policy thereis the Keynesian paradigm, based on active macroeconomic policies and stateintervention, and the stability-oriented paradigm, based on price stability, centralbank independence and macroeconomic credibility (Dyson 1994, 2000a; McNamara1998). In financial supervision policy, there are less well-established paradigms,even though a shift in objectives and instruments can be detected over time. Thecausal mechanisms identified as relevant are the processes of ideational diffusion(Simmons and Elkins 2004; Marcussen 2005), facilitated by elite socialization ininternational and EU forums (Marcussen 2000), and the creation of epistemiccommunities of central bankers (Verdun 1999). Since international and EUinstitutions can facilitate ideational diffusion, there is a strong link between theideational explanation and the institutionalist one. For example, McNamara (2002a)uses sociological institutionalism to explain the spread of central bank independenceworldwide.

In contrast to systemic explanations, national-level explanations are mainlyrooted in comparative politics and comparative political economy. According tosome comparativists, domestic institutions crucially affect central banking gover-nance through a variety of causal mechanisms. Domestic political institutionsdetermine the centralization and dispersion of power and responsibilities withinthe state, affecting the constitutional position of the central bank (for example, onGermany, see Heisenberg 1999; Kaltenthaler 1998a; Loedel 1999).7 Other relevantpolitical institutions are the electoral system and the party system (Bernhard 1998,2002), which determine whether there is a coalition government or a governingparty. Intra-party or intra-coalition conflicts make the government more willing todelegate controversial monetary policy decisions to an independent central bank.Here, the main causal mechanism that affects central banking is the configurationof domestic political opportunity structure that can give (or deny) the central banksresources for policy-making.

Domestic economic (or political economy) institutions, which mainly feed intothe literature on varieties of capitalism, encompass the organization of the market(product market and labour market), relations between firms, and interactionsbetween social partners (Hall and Soskice 2001; Schmidt 2002a). They also includethe configuration of the financial and industrial sectors, the link between banks andindustry, and the organization of the financial sector, all of which affect thedistribution of economic power and political opportunity structure, which in turnaffects central banking governance. It should be noted that the literature on varietiesof capitalism has dealt only marginally with central banks, which also explains whyspecific causal mechanisms are more difficult to identify, but they can be teased outfrom the literature on interest groups and central banks.

Some scholars highlight the influence of domestic interests, namely societalforces and economic coalitions, on central banking governance, especially with

8 Introduction

reference to monetary and exchange-rate policies. The interest-groups-basedexplanation is grounded in the macroeconomic preferences of domestic forces andtheir 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 thefinancial sector (Posen 1993, 1995), which affect the conduct of monetary andexchange-rate policies. The assumption is that the financial sector is inherentlyaverse to inflation, and is therefore a natural constituency for an independent andstability-oriented central bank and sound macroeconomic policies (Goodman 1991,1992; Posen 1993; Woolley 1984). Moreover, Maxfield (1991), and to some extentPerez (1997), focus on the coalition of public and private financiers, that is, centralbankers and private bankers, blurring the boundaries between public actors andsocietal forces, and therefore providing a conceptual link to the notion of policynetworks. As far as the causal mechanisms are concerned, interest groups eitherlobby the central banks directly or they lobby the political parties, especially thosein government, which then engage in a strategic game with the central bank whende facto central bank independence is absent. Both economic and political interestsmight also try to shape the institutional framework in such a way as to further theirpolicy preferences.

Finally, there are ideas, meaning national policy discourses and polity ideas,which provide ideational policy frameworks to national policy-makers. Oneexample is the concept of ‘exceptionalism’ in managing southern Europeaneconomies (Pagoulatos 2004). The political ideologies of parties in power,according to the partisan politics approach to monetary policy elaborated byeconomists (Hibbs 1977), would also fit into this category, whereby the causalmechanisms link the political ideology of the government in office (basically, leftor right) to specific preferences in the conduct of macroeconomic policies and thechoice of the institutional setting (Alesina and Rosenthal 1995; Garrett 1998; Way2000). Left-wing governments are regarded as more prone to inflation and aretherefore, the argument goes, less keen on central bank independence and favouran expansive monetary policy. By contrast, central bank independence is postulatedto be less problematic for right-wing governments, because it locks in an anti-inflationary policy. Recently this argument has been inverted, asserting that sincecentral bank independence lends macroeconomic credibility to the government inoffice, and since left-wing governments often have a bad ‘reputation’, left-wingparties that hold office are more likely to implement reforms that increase centralbank 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 theUS Federal Reserve) have rarely been the object of analysis. Researchers have usedthis approach to study bureaucracies and/or technocracies, by focusing on thetangible and intangible assets they possess and which give them an extra leveragein policy-making. Several authors, adapting a public-choice approach, haveconceptualized central banks as self-interested bureaucracies that try to maximizetheir policy influence and their political power, often engaging in a strategic game

Introduction 9

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 andpolicy influence, for example, by implementing domestic anti-inflationary policiesand financial deregulation.

In several of the works reviewed in this section there is some overlap betweenexplanatory factors, which are not mutually exclusive and do not operate inisolation. For example, the configuration of domestic political economy institutionsand the activity of socio-economic coalitions is a case in point, as it is sometimesdifficult to make a clear distinction between them. However, what all theseexplanations 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 specificorganizational features of the central bank itself.

This study challenges this conventional wisdom, arguing that in order to explaincentral banking governance, the research needs to focus on different levels ofanalysis, not only to account for the functioning of the Eurosystem/ESCB, whichis by its very nature a multi-level system, but also to understand central bankinggovernance in the EU before EMU, or in the countries outside the eurozone. Inorder to be able to analyse different levels of governance, keeping the researchdesign 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 frameworkfor analysis. There are several reasons that justify the choice of historical institution-alism, and the use of multi-level analysis and a comparative method. First, giventhe relatively long period of time chosen for this research, historical institutionalismpermits a longitudinal approach and engagement with the complexities of history(see Pierson 2004; Pierson and Skocpol 2002; Thelen 1999). This type of institution-alism privileges qualitative methodologies (process tracing) and focuses on onecase study or a small number of studies (structured comparison). Thus, thequalitative and comparative methodology adopted in this research, which is basedon selected case studies over time, can be fruitfully embedded in a historicalinstitutionalist framework. The concept of ‘path dependency’, which is at the basisof historical institutionalism, informs most of the analysis conducted in thefollowing chapters, which also highlight ‘critical junctures’ (which often coincidewith ‘policy failures’) that led to modification of institutional and policy trajectoriesof central banks, altering path dependence.

Second, historical institutionalism considers institutions as central explanatoryvariables, even though institutionalists themselves question whether institutionscan 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 Steinmo1992; 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

10 Introduction

influence of economic ideas (or doctrines) in the conduct of economic policies andinstitutional design.

A common critique of the new institutionalism is that the macro level of analysisof institutionalists should be informed by the analysis of individual behaviour(Peters 1999), whereas individuals as ‘agents’ are often missing in institutionalistanalyses, as is politics (Dowding 2001). Several authors question the ability of this approach to explain ‘change and continuity in politics and policies, withoutincorporating agency and without devoting attention to political conflict in order toexplain change’ (Peters et al. 2005: 1,277; emphasis in the original). Other authors,however, argue that institutionalism provides a way to transcend the agent–structuredebate, allowing for the actions of purposive agents interacting within institutions(Hall and Taylor 1996, 1998; for a different view, see Hay and Wincott 1998). Thisstudy investigates the role and preferences of individuals as agents, whenever theiractions affect central banking governance significantly. However, in line withhistorical institutionalist premises, such preferences and actions are regarded asendogenous 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 theacademic milieu in which this research is located. Since historical institutionalismcan be deployed at different levels of governance, the institutionalist framework ofthis research is articulated on three interconnected levels of analysis: the ‘systemiclevel’, which encompasses the European, transnational and the 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 centralbank (Quaglia 2005b).

This research takes as a starting point the core institutionalist assumption thatinstitutions (be they international, domestic or organizational) matter, and that theyare the main explanatory variable of central banking governance; institutions frameinterests and ideas, and the actions of agents within a given policy area. The keyissues addressed in the empirical research are which institutions matter most, howand why. Two perspectives are implicit in the multi-level institutionalist approachdiscussed above and are followed throughout the book: one is a longitudinalperspective, which is used to explore the evolution of modes of central bankinggovernance within polities over time; and the other is a horizontal comparativeperspective, which is used to explain the convergence and divergence of modes ofcentral banking governance across polities.

Introduction 11

Table 1.2 The analytical framework: multi-level institutionalism

Systemic level international and EU institutionsNational level national institutionsMicro-institutional level bank-specific features

Research methods

As highlighted in the review of the literature, quantitative methods are very valuablein large-scale comparisons of central banks. The drawback is that quantitativemethods provide only partial explanations, as they fail to grasp the significance ofnon-quantifiable factors and do not allow for a detailed analysis of the multi-levelcontext in which macroeconomic institutions interact and policies are implemented.For these reasons, this research will utilize a qualitative method, which necessarilylimits the number of case studies (central banks) that can be included in thecomparison, while at the same time making it possible to take into account a vastarray of factors (including ideas or intangible factors) that affect governance in acomplex and interactive way.

The analysis is based on a ‘structured focused comparison’ (George and Bennett2005) of selected case studies over the period 1978–2005, whereby, in line with the historical institutionalist approach taken, attention will be paid both to thetrajectory of each central bank over time and to the main turning points, defined asmajor institutional reforms and/or policy shifts. Through a systematic horizontalcomparison, the project analyses and explains the differences and similaritiesconcerning the institutional arrangements and policies of the central banks selectedas case studies, evaluating the different modes of governance, and identifying themain international, domestic and micro-institutional factors that have a bearing onthis. Through in-depth longitudinal research of selected case studies, the projectconducts a similar appraisal within the same polity over time. Process tracing is usedto 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 relevantempirical material on the four case studies. Archival sources become accessibleonly after thirty years and, whereas this is not such a significant problem for theBundesbank (with the exception of the most recent period, there are severalsecondary sources available), the literature on the other central banks is rather thinand outdated. I have used a variety of primary sources to gather relevant material:textual analysis of official documents; systematic survey of press coverage; andsemi-structured elite interviews with practitioners and qualified observers in allfour cases. The material gathered through interviews has been cross-checked withinand across case studies, as well as using other sources. Of course, confidentialityhas been respected and interviews have taken place on a non-attributable basis.Finally, this book discusses economic events and policies, but it does not providean economic analysis of them. My focus, as a political scientist, is on the politicalaspects, rather than the purely economic ones. However, the following analysis isinformed 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 comparativequalitative research, three sets of criteria have been taken into account. First, the

12 Introduction

case studies cover different modes of central banking governance. Briefly, the fourcentral banks chosen exhibit significant variations in their legislation, autonomy,policy capacity and legitimacy. The ECB and the Bundesbank are among the mostindependent of central banks, whereas the Bank of England before its reform wasone of the most dependent, and the Banca d’Italia before EMU was somewhere inbetween, with its degree of independence increasing after 1981, and especially in1992 and 1993. There are also variations across the policies that these central banksperform, and how such functions are administered.

Second, the central banks selected are an interesting choice as far as EMUmembership is concerned. Three of them are part of the eurozone, since Germanyand 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, facilitatesthe 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 singlecurrency. Moreover, the post-1997 British model is often regarded as an alternativeto the Bundesbank and the ECB model (Amtenbrink 1999; Buiter 1999).

Third, these national central banks, which belong to the largest EU countries, areimportant components of the ESCB and have in the past been important players atthe 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 thecomparative research, for example, the Banque de France, as France is one of thefour largest countries in the EU. Moreover, it would be useful to introduce greatervariation, by including the central banks of small and medium-sized EU membersand/or from the new member states. On the other hand, the feasibility of the projectsuggests that the number of case studies has to be limited to keep the researchmanageable.

The timeframe of the research ranges from the establishment of the EMS in 1979to 2005, with occasional references to earlier periods. Two criteria have been usedto delimit this timeframe. The period needs to be long enough to get a handle oncentral bank roles, policies, consolidated practices and traditions, but it should not be so protracted as to render the project unmanageable. The events chosen aspoints of departure and arrival represent landmarks in central banking governancein the EU.

Some caveats are necessary. Particular care should be paid to the comparisonbetween national central banks and the ECB, for three obvious reasons. First, theECB is a supranational institution embedded in a multi-level and multinationalpolity in the making – the EU – whereas national central banks are essentiallydomestic institutions embedded in different national contexts, though grounded inthe EU and international arenas. Second, the ECB, as a result of its governancestructure, its position in the Eurosystem and its relationship with national centralbanks therein, is a multi-level, pseudo-federal institution, whereas the national

Introduction 13

central banks under consideration, with the exception of the Bundesbank before2002, were unitary institutions. Third, the timeframe is partly different, in that theanalysis of national central banks starts in the 1980s, whereas the analysis of ECBgovernance begins in 1999, when this sui generis supranational central bank wasestablished.

Given these differences, why engage in a comparative analysis? There are severalmethodological, empirical and theoretical reasons that justify this choice.Methodologically, the comparative method helps to structure the analysis, makingit more systematic and less reliant on ad hoc explanations (except when necessary,i.e. when a certain phenomenon is polity-specific). Empirically, throughout thebook 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 howthe ECB works, it is necessary to have a comparative and in-depth knowledge ofits national components, and of the Bank of England as an alternative institutionalmodel. Theoretically, the goal of this comparative analysis is to identify modes ofcentral banking governance and explanatory factors that unfold, albeit in variousways and with different timing, across polities. The analytical framework chosenfor this comparative analysis facilitates the achievement of these goals, becauseinstitutionalism is a middle-range theory, based on the core assumption of thisapproach that institutions matter, and leading up to the question of which institutionsmatter, how and why.

The overall argument in brief

Although the legal provisions concerning central banks are important – especiallyin the case of the ECB, given its treaty-guaranteed independence and the fact thatthe EU, by its very nature, is a rule-based system – modes of central bankinggovernance do not depend on formal rules so much as on the configuration ofpolitical and economic institutions that affect the distribution of power in the polityin which the central bank is embedded, be it the national arena for national centralbanks or the eurozone/EU in the case of the ECB.

Before EMU, the autonomy and policy capacities of the Bundesbank in severalfields, besides being upheld by legislation, were augmented by the power-sharingdomestic institutions of the federal state structure. By contrast, the autonomy andpolicy capacity of the Banca d’Italia were the result of weak and fragmenteddomestic institutions and an under-resourced Treasury, rather than ensuing fromlegislation. In the UK, before the 1997 reform that gave the central bank legaloperational independence, a strong executive and a powerful Treasury left limitedautonomy and policy capacity to the Bank of England, with the exception of bankingsupervision, on which the Bank possessed specific expertise and consolidatedrelations with the City, despite (or perhaps because of) relatively ambiguous legalprovisions on this matter. The ECB’s autonomy and monetary policy capacity,established by the TEU and other relevant EU legislation, are reinforced by theabsence of cohesive EU political institutions. More recently, the ECB has tried to

14 Introduction

expand the policy competences it had been assigned by the treaty, such as in the caseof TARGET 2 securities.

Modes of central banking governance – in particular central bank autonomy andpolicy capacity – are also affected by international and European institutions, whichprovide 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 infavour of certain institutional or policy choices. European exchange-rate agreementssometimes constrained the policies of the Bundesbank – on a few occasions withthe implicit support of the federal government. By contrast, the Banca d’Italiadeployed exchange-rate agreement as an external constraint in an attempt toimplement an anti-inflationary monetary policy, safeguarding its autonomy. Unlikeinternational supervisory fora and European exchange-rate agreements, all of whichare based on soft law – hence they did not affect the legal framework of theparticipating central banks – the establishment of EMU, which represented the maincritical juncture for the mode of central banking governance of two of the threenational banks – exerted adaptational pressure on the central banking legislation ofthe countries in the eurozone.

The micro-institutional features of the central bank (that is, its tangible andintangible resources) influence its autonomy and policy capacity, not only in theirown right, but also in the ability to use resources available at the national,international and European levels. Some examples of important intangible assetsare the anti-inflationary credibility of the Bundesbank; the expertise of the Bank ofEngland in financial matters; the macroeconomic expertise of the Banca d’Italia.Moreover, the perceived legitimacy of a central bank can be substantially enhancedby the microinstitutional features of the central bank itself, as evidenced by thepublic support enjoyed by the Bundesbank and the Banca d’Italia, regardless of the ‘thin’ legal provisions for their accountability. It should also be noted thatspecific micro-institutional features are likely to make adaptation to EMUmembership more difficult, as explained in the concluding chapter.

Overall, the weaker international institutions are in a given policy area, and thestronger the EU institutions are, the more likely the latter are to affect the mode ofcentral banking governance at a given point in time as well as over a period of time,promoting convergence of legal provisions, autonomy, policy capacity andlegitimacy, the last being the least amenable to modification by external influence.The opposite is also true, highlighting the fact that the process of Europeanintegration produces specific stimuli towards convergence. Indeed, the strongestpressure 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 centralbanking governance. Since domestic political and economic institutions tend tovary across countries, they are responsible for the persistent divergence of specificcentral banking features in the EU. Several of these differences have been ironedaway in the areas of monetary and exchange-rate policies by the establishment ofEMU in 1999, which imposed specific legal rules that also concerned central bank

Introduction 15

independence in the eurozone, whereas other differences remain, in particular in thedomains 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 Bancad’Italia respectively, analysing the micro-, macro- and international institutionalframework in which these central banks are embedded, the core central bankingpolicies and other roles performed by them, the relations with economic and politicalforces, and the banks’ adaptation to EMU. These chapters analyse and comparedifferent modes of central banking governance, using the concepts of central bankautonomy, policy capacity and legitimacy, evaluating continuity and discontinuityover 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 andfinancial service regulation and supervision in the EU. It sketches the interactionsbetween the ECB and national central banks, and applies the concept of mode ofcentral banking governance to the ECB.

Chapter 6 conducts a systematic comparison of the main modes of centralbanking governance, identifying and explaining similarities and differences,convergence and divergence, and their adaptation to EMU. It concludes bydiscussing the scope and limits of the comparison, the main findings, and thetheoretical and empirical contributions to the existing literature.

16 Introduction

2 The Bank of EnglandAn 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, thesecond most influential central bank in the world. Nowadays it is considered the main alternative to the ECB model, which has been adopted by national centralbanks 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 policyframework 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’tHag 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 ofEngland’s ranking in such classifications improved significantly after 1997, whenthe Bank was given operational independence in monetary policy. Its politicalindependence also increased, and new mechanisms of accountability were set inplace.

A systematic analysis of the empirical record (1978–2005) reveals that theautonomy, policy capacity and legitimacy of the Bank of England cannot be gaugedsolely by examining the central bank legal framework (Forder 2001: 203).Economists’ large-scale quantitative studies understate the Bank’s operationalindependence before the 1997 reform, because the analytical measures used aretypically formal and fail to pick up the nuances of the relationship between thecentral bank and the government. These studies also tend to overlook the centralbank’s policy capacity in financial regulation and supervision – and hence theinteraction with financial actors – because they focus mainly on monetary policy.It is worth noting that, at least according to some British central bankers, the legalprovisions concerning the central bank, up to the 1997 reform, were deliberatelyformulated in rather ambiguous terms, and this was seen as enhancing the Bank’sroom for manoeuvre rather than constraining it. Furthermore, classifications basedon 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

international institutions, such as financial supervisory regimes and exchange-rateregimes, which can provide resources (as well as additional constraints) to centralbanks interacting in the national arena.

Adopting a multi-level, historical institutionalist approach, this chapter firstoutlines the trajectory towards central bank independence in the UK, as well as theevolution of the central banking legal framework and model of legitimacy. It thenexamines the organizational, national and international institutional framework ofcentral banking governance in the UK, evaluating central bank autonomy (or de facto independence). The second part of the chapter examines the evolution ofcore policies in which the Bank of England has been involved, assessing the policycapacity 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 researchis that not only do institutions matter, but they are the main explanatory variable ofmodes of central banking governance. The crucial questions to be empiricallyaddressed then become which institutions matter most, how and why. Whenanalysing the multi-level, institutional framework of central banking governanceand its evolution over time, it is important to distinguish three levels: the micro-institutional or organizational level, mainly related to the governance structure andspecific assets that each central bank possesses, which can ‘empower’ (or not) the central bank; the macro-institutional level, that is, the national political andeconomic institutions that can provide (or deny) opportunity structures for centralbanks seeking greater autonomy and policy capacity; and the level of internationalinstitutions, especially when, either de facto or de jure, they impose or projectcertain institutional and policy templates, to which national central banks areexpected to adapt, or they provide strategic resources to national policy-makers, orthey facilitate the circulation of ideas.

The punctuated trajectory towards central bank independence inBritain

Before the Bank of England Act 1998 the main legal provisions concerning theformal institutional structure of the central bank were part of the Bank of EnglandAct passed by the Labour government in 1946, when the nationalization of the Bankwas decided by an Act of Parliament and the ownership of the Bank shifted fromshareholders to the Treasury, against government stock. The Act (Article 4.1) statedthat ‘the Treasury may from time to time give such directions to the Bank as, afterconsultation with the Governor of the Bank, they think necessary in the publicinterest’. The Bank of England had no statutory independence, even though the1946 Act was silent about the detailed execution of policies (Moran 1986; Eizenga 1991).

In 1959 the Radcliffe Committee, formed to examine the operation of themonetary system, delivered its report. It called for greater co-operation between the

18 The Bank of England

Bank of England and the Treasury, making the Bank institutionally more integratedinto the Whitehall machinery, which suggests that the Bank had previously operatedwith independence. Afterwards the Bank of England struggled to assert its authorityfor most of the 1960s and early 1970s (Kynaston 1995: 31), though in certain(perceived) technical areas, such as banking service regulation and supervision (seethe Competition and Credit Control Act, 1971; Moran 1986), the Bank had asignificant input.

After the election of the Conservative government in 1979, the Treasury assumeda responsibility for monetary policy that it had hitherto not enjoyed to the sameextent, as it was felt that ‘monetary policy was too important to be left to centralbankers’ (interview, London, January 2006). More generally, under the govern-ments of Margaret Thatcher the autonomy and policy capacity of the Bank ofEngland were reduced, even though there was no significant formal institutionalchange in this respect concerning central banking legislation. However, the de factochange of political institutions through the strengthening of the executive, and the government’s interference with tasks assigned to the Bank, impinged on theautonomy of the central bank and affected the conduct of specific policies – first andforemost, monetary policy and exchange-rate policy, as elaborated below.

Although a short reference to institutional reform in central bank independencewas inserted into the Conservative Party’s document The Right Approach to theEconomy before the 1979 general election, once the party took office the matter wasnot seriously discussed until the late 1980s. In 1988 the chancellor, Nigel Lawson,asked Treasury officials to formulate a plan for an independent but accountablecentral bank.1 Two rationales underpinned this attempt to engineer an institutionalreform. From an economic point of view, it was seen as a device to control inflationafter the disappointment with monetary aggregate targets and the decision not totake part in the exchange-rate mechanism (ERM), hence rejecting an exchange-rate target (Lawson 1992), as explained in the second part of this chapter. From apolitical point of view, an independent Bank of England was considered preferableto Thatcher’s policy vagaries, which were seen as undermining the overallcredibility of macroeconomic policies (Elgie and Thompson 1998; cf. Forder 2000).These two reform rationales were also influenced by the emergence of newmonetary policy ideas based on the ‘pseudo-theory of credibility’ and central bankindependence (Forder 2004: 4), which gained momentum internationally. Lawsonsent 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, wasinitially not interested in institutional reform of the central bank. However, by 1991this topic formed once again part of the chancellor’s political agenda, for reasonsnot very different from those discussed by his predecessor: greater central bankindependence would not only strengthen the exchange rate of the pound, which hadjoined the ERM in 1990 and was under speculative attack, but it would also providedomestic macroeconomic credibility. The reformed central bank of New Zealandwas the blueprint for Lamont’s model in the UK (Lamont 1999), presenting aninteresting case of policy learning from a country outside Europe. This model entails

The Bank of England 19

a statutory objective of price stability, whereby the government agrees with thecentral bank’s publicly stated targets in order to achieve that objective. Lamont senta memo outlining the reform proposal to the prime minister, John Major, who, likehis predecessor, was not receptive to the idea. As with Lawson’s initiatives, theBank 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 substantivecontent of it.

After the withdrawal of the pound sterling from the ERM in 1992, whichrepresented a major policy failure and a source of policy learning for the BritishGovernment, a series of incremental institutional and policy reforms took place inthe UK. Indeed, some commentators would argue that this event triggered thegradual institutional change concerning central bank independence in the early1990s (interview, London, December 2005). The government set an inflation targetin October 1992, and the Bank of England was given responsibility for preparingthe quarterly Inflation Report, initially published in the Bank of England’s Bulletin.In September 1993 the chancellor, Kenneth Clark, announced that the Treasurywould no longer examine the Inflation Report before publication, and in Novemberthat year the Bank of England was given the power to decide the timing of interestrate changes. Shortly afterwards, despite the reluctance of Major, the chancellordecided that the minutes of the monthly monetary meeting between the chancellorand 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), becauseof his opposition to the concept of central bank independence. In March 1994 thechancellor set out a new remit for funding government debt, clarifying the respectiveroles of the Bank and the Treasury (Bank of England Monthly Bulletin, May 1994).

Minutes of a meeting between the chancellor and the Governor were firstpublished in April 1994. They opened with an ad verbatim statement by theGovernor, in which he put forward a specific proposal on interest rates. The intentionwas to open up the policy-making process, so the outside world could be aware ofthe discussions taking place between policy-makers, the Bank and the Treasury(interview, London, January 2006). In this way, unlike in the past, any divergenceof policy-makers’ views would be exposed. This move increased the Bank ofEngland’s autonomy and policy capacity, by making it more difficult for thechancellor to deviate from the Bank’s advice or ‘manipulate’ it. The chancellor didsometimes fail to follow the Bank’s advice, though he generally differed by nomore than half a percentage point (interview, London, December 2005). Thepublication of minutes changed the institutional relations within the executivebetween the prime minister and the Treasury, marginalizing the former on monetaryissues.

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 centralbank. Operational decisions on monetary policy were assigned to a Monetary Policy

20 The Bank of England

Committee (MPC), discussed below. It should be noted that a similar reform – thatis, the creation of a monetary policy committee of experts – had been implementedin France in 1993.

The other important change related to banking supervision, which was assignedto the Financial Services Authority (FSA), even though the central bank remainedresponsible for monitoring the overall stability of the financial system. This waspartly attributable to the supervisory failures of the 1980s and early 1990s (TheIndependent, 22 May 1997). Another argument for separating monetary policy andbanking supervision was that the two functions together in a central bank couldgenerate conflicts of interest when setting interest rates. Losing responsibility forbanking supervision was a major blow for the Bank of England, and its timing wascompletely unexpected (The Guardian, 7 November 1998).

Institutionally, these two reforms were complementary and inextricablyentwined, because the greater operational independence of the central bank wascounterbalanced by the loss of most of its supervisory responsibilities, preventingthe Bank from becoming too powerful an institution in the UK, which was a matterof 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, butit would also establish a monetary committee, to be officially responsible forproviding advice to the chancellor (The Times, 4 April 1997; 7 May 1997). Onlyafter evaluating the functioning of this arrangement could a Labour governmentcontemplate greater independence for the Bank of England.3

The economic rationale for speeding up the reform was to increase macro-economic credibility, by giving the signal that monetary policy was not conductedaccording to political (rather than economic) considerations, as had happened manytimes 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 waselected in 1997 (Goodhart 2002: 194). The political rationale was that the creationof an operationally independent central bank would shift the blame away from thegovernment whenever high interest rates were needed to curb inflation (Elgie andThompson 1998). Indeed, the Bank came under attack in 1998, when the MPC keptinterest rates high despite the strong pound (Kynaston 2001: 774). However, in thefollowing years the overall assessment was reversed and the reformed Bank ofEngland 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 reformreveals a low level of central bank independence, both ‘political’ and ‘economic’.As for the formal political independence of the central bank, the Bank of Englandused to score poorly on the basis of legal provisions regarding personnel

The Bank of England 21

independence and decisional independence. De facto, the power of appointment wasexercised in a partisan way by the government throughout the 1960s, and especiallyunder the Conservative governments of the 1980s and early 1990s (Elgie andThompson 1998). For example, in 1983 the Governor, Gordon Richardson, wasnot reappointed following disagreements with the government – more precisely, theprime minister and the chancellor (Kynaston 2001). Robin Leigh-Pemberton, whotook over from Richardson, was a private banker and was regarded as sympatheticto the prime minister’s approach to macroeconomic policies (Reid 1988: 222). In1993 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, whohad been director-general of the Confederation of British Industry and was laterappointed as chairman of the FSA.

With the 1997 reform, the Bank of England was granted operational indepen-dence in monetary policy, but the provisions for the appointment of the Governorremained the same, and four of the nine members of the MPC are appointed by theTreasury. However, there is no government representative with voting power inthe 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 wassucceeded by an internal appointee, the Deputy Governor, Mervyn King. Internalappointments generally imply greater autonomy for the central bank, as they suggesta less direct influence of partisan politics in the appointment process. On thatoccasion, the appointment of the Governor was also inextricably linked to thegovernment’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, theappointed members of the MPC serve for too short a time (three years), since ittakes between six months and one year for newcomers to settle in and master thetasks required (interview, London, December 2005). There is also a case to be madefor maintaining some continuity on the committee. Moreover, since the mandate isrenewable, the relatively short period of appointment, coupled with the possibilityof being reappointed, could potentially reduce the independence of these membersfrom 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 thediscount rate, which before the 1997 reform was the ultimate responsability of the Treasury, and the management and financing of the public debt, particularly, thepossibility of monetizing the public deficit. In this respect, when examining the period before 1997, it is important to distinguish between legal provisions andactual behaviour. Legal provisions did not rule out monetary financing, which did

22 The Bank of England

indeed take place in the 1970s but ceased in the late 1980s, partly because the public-sector borrowing requirement (PSBR) became positive. In the 1990s the PSBR wasat times in deficit, but apart from 1992 these deficits were never very high. Article104 of the Treaty on European Union (TEU; the Maastricht treaty) signed in 1992prohibits government borrowing from the central bank, though the UK is exemptso long as it remains a non-member of EMU. The Treasury has had access to whatis known as a Ways and Means Facility, which is held at the Bank. Since the 1997reform the facility has been frozen at just over £13 billion, as agreed between theBank of England and the Treasury. In 1997 the function of debt management onbehalf of the government was transferred to the Debt Management Office, anexecutive 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 corecomponent of its tangible assets but also affect its intangible assets, such as thecalibre of its personnel and the expertise at its disposal. Although the Bank ofEngland’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 ofEngland. Yet precisely because it is a shareholder, the Treasury has an interest inthe 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 Englandhas undergone significant changes. In the first part of the twentieth century,especially at the time of the legendary Governor Montague Norman, the centralbank’s mystique provided a specific type of expert-based legitimacy to this publicinstitution and its activities. In the 1970s, 1980s and early 1990s, the limitedaccountability and lack of transparency – the Bank had no public reportingobligations – were somewhat compensated for by the fact that the Bank had limitedformal 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 authoritiesand the transparency of the Bank’s decision-making. This model combinesindividual accountability for each member of the MPC within a collective decision-making body. The MPC’s decisions are announced after each monthly meeting,and the minutes of the meetings are published 13 days later. The quarterly InflationReport includes the MPC’s projections of inflation and output, and explains howthe Bank intends to meet the inflation target and support the government’s economicpolicy. According to the Bank of England Act passed in 1998, the Bank isaccountable to the House of Commons through the Treasury and Civil ServiceCommittee.

The Bank of England 23

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 therecommendation 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 hada rather hierarchical governance structure, because that was the institutional layoutthat would permit the Bank to maximize its autonomy and policy capacity vis-à-vis the government. In other words, to ensure that the government took due accountof 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 amainly advisory function and consisted of the Governor, the Deputy Governor andseven members of the Court of Directors chosen by secret ballot. The TreasuryCommittee stood down in 1992.

The Bank of England Act 1998 established the MPC,5 which comprises theGovernor and Deputy Governors, two of the Bank’s executive directors (the Bank’schief economist and the executive director for market operations) appointed by the Governor after consulting the Treasury, and four members appointed by thechancellor of the exchequer. The Treasury has the right to be represented in a non-voting capacity, as the aim is to facilitate the macroeconomic dialogue. TheTreasury’s representative has the opportunity to provide information about thegovernment’s plan on fiscal policy and the Bank is in a position to explain to thegovernment the Bank’s reasoning in the conduct of monetary policy (interview,London, January 2006). The members of the MPC are appointed for a renewableperiod of three years, on the basis of their professional qualifications. Whereas someof 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 theGovernor 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 bythe Governor.

In the early years of the new system some members of the MPC not drawn fromthe banking community complained about the limited amount of research supportthat was made available to them at the Bank, suggesting it was a way to try and limitthe influence of the external members in the MPC’s deliberation process (interview,London, October 2005). Other external members of the MPC would challenge thisinterpretation, however, recognizing that in the initial period there were resourceconstraints, which were addressed by the Bank by hiring new economists to provideadequate research support to the MPC (interview, London, December 2005), asdiscussed in the following section.

The Court of Directors consists of the Governor, two Deputy Governors and 16directors, appointed by the Crown for a renewable period of three years. In the pastthe directors were mainly drawn from the City elite. Some of them took part in

24 The Bank of England

standing and ad hoc committees, the most prestigious being the Committee of theTreasury (Hennessy 1992: 198). This composition of the court also facilitatedliaison 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’saffairs, with the exception of the formulation of monetary policy.

The Board of Banking Supervision is an advisory body established by theBanking Act in 1987 and before 1998 consisted of the Governor, the DeputyGovernor, the executive director responsible for banking supervision and sixindependent members appointed by the chancellor of the exchequer and theGovernor in a joint procedure. Members had the obligation to notify the chancellorif the recommendations of the independent members were not adopted, althoughthis power was never actually used (Eizenga 1991). Before 1998 the Board ofBanking Supervision was chaired by the Governor of the Bank of England, but withthe transfer of responsibility for banking supervision to the FSA, the Bank ofEngland Act 1998 provided for the non-executive, independent members to electa chairman from among their number. The chairman of the FSA and the chancellorjointly appoint the independent members, and the number of ex officio membershas now been reduced to two, namely the chairman of the FSA and the managingdirector 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’ knowledgewithin the Bank was made with the 1997 reform and the creation of the MPC, whichrepresented a peak in the Bank of England’s acquisition of expert advice from well-known academics, professional economists and practitioners. In addition, thenumber of research staff was increased, and a survey of the research staff of 34central banks indicates that the Bank of England has more than doubled its researchstaff, from 23 in 1997 to 49 in 2003 (St-Amant et al. 2005). Compared with othercentral banks, the Bank of England has the second-largest number of employeeswith doctorates. The Bank maintains a well-consolidated scheme for study grants,as well as hosting the Centre for Central Banking Studies, which conducts compara-tive studies and provides expert advice for central banks throughout the world.

In a recent study on the quality, quantity and relevance of central bank researchin Europe and other Western countries, the Bank of England ranks very high in theproduction of journal articles in the period 1990–2003 (St-Amant et al. 2005). TheBank of England, the Banca d’Italia and the ECB are the only non-Americanrepresentatives among the top ten central banks in quality-adjusted output(publications in top-level journals). As for policy relevance, the publications of theBank of England are among the most frequently cited in papers and documents ofpolicy-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

The Bank of England 25

to 2,300 after the 1997 reform, when the FSA took over the Bank’s supervisoryfunctions, 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 governancein Britain

Micro-institutional analysis of the Bank of England needs to be incorporated withinan analysis of the national institutional setting, considering the effects of nationalpolitical and economic institutions that affect central banking governance in Britain.As well as undertaking this, the following discussion analyses the institutionalrelationships between the Bank and the government, and between the Bank andinterest groups, in order to gather a more comprehensive understanding of thedegree of autonomy enjoyed by the central bank.

Political institutions in Britain

Britain is a textbook example of a parliamentary democracy, based on the so-calledWestminster model, which rests on the fusion of legislative and executive powersin the hands of the majority party in the parliament. There is a strict discipline thatparty leadership in the government enforces on the majority party. The oppositionparty is exactly that: the Westminster model rules out any direct power for theopposition. This system promotes decisive, strong government, with responsibilityfor government actions falling on the party in office (Judge 2005). Moreover, themajoritarian electoral system promotes a political system in which a limited numberof political parties exist, only two of which have governing potential. In such asystem the number of veto players is also very limited, facilitating institutional andpolicy change whenever the government so decides (Lijphart 1999). The politicalsystem is thus characterized by alternations in power and adversarial politics.

The strength of the executive is attributable to several factors: all executiveappointments are made by the prime minister; the main parties are relatively welldisciplined internally and the government dominates the legislature; the efficientcivil 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, economicpolicy-making has been led by the executive and has therefore been directed fromthe centre (Grant 2002). Moreover, as centralization within the executive issubstantial, the key actors are in effect the prime minister, the chancellor of theexchequer and the Treasury.

The level of prime ministers’ participation in macroeconomic management hastraditionally varied, depending on their interest in and understanding of economicmatters 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

26 The Bank of England

relationship between the prime minister and the chancellor can be harmonious ordiscordant, as between Margaret Thatcher and Nigel Lawson and between TonyBlair and Gordon Brown, albeit for different reasons.

The position of the Treasury in the government machinery is crucial (Middlemas1991). The British Treasury fulfils the functions of a Ministry of Economics, aswell as overseeing the preparation of the budget and controlling public expenditures– all functions that are separated in other countries (Woodward 2004: 7), such asGermany or Italy before the reforms of the Ministry of the Treasury in the 1990s.7

Besides its strong institutional position and economic resources, other intangibleassets of the Treasury are the quality of its staff – it recruits the elite of the highest-level civil service intake and has been portrayed as ‘a shaper and exporter of a civilservice elite’ (Deakin and Parry 2000: 21). Chancellors have often held the positionfor relatively long periods of time, and throughout the chancellorship of Brown theTreasury’s influence has been further strengthened, driven not only by the personalintellectual 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 thegovernment have been based on the attempt to reconcile the government’s economicprogramme and the demands of bureaucratic politics in Whitehall with the Bank’sdesire 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 doingso has varied over time. The 1997 reform changed this traditional relationship, andthe 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 isuseful to distinguish two relationships: that between the Bank – more precisely, theGovernor – and the prime minister, and that between the Bank (Governor) and the chancellor. Whereas the relationship between the Bank of England and theprime 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 awhole (including the prime minister) and the Bank of England. Interactions betweenhigh-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. Yetfor most of the period considered here, the Bank of England had practical knowledgeof the market that the Treasury lacked (Kynaston 1995: 35; interview, London,December 2005) – the Bank was often referred to as ‘the Treasury’s East Endbranch’. Until the 1998 reform, the legal authority to make public bond issues restedwith the Treasury, but in practice the Treasury and the Bank of England workedtogether (Kynaston 1995), and the Bank of England as an agent of the Treasurymanaged the public debt. However, the Treasury’s own financial expertise grew in

The Bank of England 27

the 1980s, and its links with the City, for instance, were cultivated because it wasso important to the privatization flotations.

Besides the institutional configuration, relations between the Bank and theTreasury also depended on the personalities of the chancellor and Governor, theirinteraction with the prime minister and the personality of the latter. For example,relations between the Bank of England and the government were strained underthe Conservative governments of the 1980s. Chancellor Lawson was a self-confidentand outspoken minister, who had a good knowledge of economics and was willingto 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 theexchequer presented a united front vis-à-vis the prime minister, as was the casewhen Lawson and Leigh-Pemberton confronted Thatcher on the issue of the ERMin the latter half of the 1980s. Moreover, there were examples of excellent workingrelations between Eddie George, the director responsible for markets (gilts issuanceand money market operations) at the Bank (and later Governor) and the permanentsecretaries 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 withGovernor Richardson, owing to her active involvement in economic policy and theincompatible personalities of these two public figures (interview, London, October2005). It was principally because of the disagreement between Richardson andThatcher that the former was not reappointed in 1983 and Leigh-Pemberton, whowas more in tune with the prime minister’s policies, was appointed as Governor(Kynaston 2001: 590). However, Leigh Pemberton, acting in his independentcapacity, later endorsed the report of the Delors Committee on EMU, despiteThatcher’s opposition to it (Dyson and Featherstone 1999).

Following the 1997 reform the Bank has endeavoured to avoid public disagree-ment with the government and, unlike other central banks in the eurozone, it refrainsfrom commenting on the government’s fiscal policies – which would provide apotential source of friction – except when the overall fiscal stance affects aggregatedemand (interview, London, November 2005). However, relatively little is knownabout the Treasury’s operational relationship with the Bank. On the basis of theinformation gathered, it seems that the operational independence of the Bank hasbeen 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’: sinceit 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 mindthat 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 tocontextualize central banking governance with reference to the structure of theeconomy and political economy institutions, which, taken together, can be referred

28 The Bank of England

to as the Anglo-Saxon model of capitalism, subsequently paying specific attentionto 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). Summingup, the main features are: mobility and flexibility in the labour market; limited social welfare provisions; a small mediation role for the trade unions, which tendto have a low membership density; minimal public intervention in the economy;deregulation and often de-industrialization; arm’s-length relations between thesource of finance and companies, promoting short-term financial profitability andshort-term contracts.

The British economic system is characterized by the separation between thefinancial sector and the manufacturing sector; and the economic strength andpolitical influence of the financial services sector is a distinctive feature of Britishbusiness. In contrast to other EU countries, the financial sector rests on an extensivesecurities market (Allen and Gale 2000). Indeed, in the Anglo-American system,securities traded in stock exchanges are the main source of corporate finance (Deegand Perez 2000). In the UK, as the system is market-based, there is a high degreeof non-banking intermediation, with several institutional investors (e.g. pensionfunds), because private pension schemes are widespread, reflecting the minimalwelfare state. London also hosts the largest insurance market in Europe, which,together with a well-developed securities market and a modern banking sector, haspromoted the creation of numerous financial conglomerates that took root in the UKat a relatively earlier stage than in other EU countries.

In the banking sector there are two bank circuits: retail banking, which consistsof banks operating under British law and dealing with deposits and loans; andforeign banks dealing with wholesale investment and international banking. Bothbanking circuits are characterized by the presence of several large banks. There areno public banks in the UK, and the majority of financial firms in the City are notBritish-owned. Nor is this a recent phenomenon, because already in the 1980s theCity hosted about 400 foreign banks, which helps to explain the Bank of England’sconcern about the competitiveness of London as a financial centre for most of theperiod considered.

National varieties of capitalism affect the organization of economic interests, inparticular with reference to business associations. The main business associationsin Britain, first and foremost the Confederation of British Industry, are ‘umbrellaassociations’, unlike their counterparts in Germany, whose structure is hierarchicaland centralized, which allow them to have a stronger say in policy-making,presenting coherent positions and enforcing internal discipline. In contrast, thesystem of interest representation in Britain is more pluralistic and moredecentralized.

Another important point to be made with reference to interest representation inthe 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 British-owned. 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).

The Bank of England 29

Similarly, the London Investment Banking Association, the second-largest bankingassociation 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 Englandto express their views in Whitehall, and the Bank of England relied on bankingassociations to monitor financial markets for prudential stability, credit control andthe allocation of the public debt. In turn, the Bank of England favoured them invarious ways, although it has to be said that the Bank of England has always beenmore concerned with the role of London as an international financial centre thanwith 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 theGovernor) as informal representative of financial interests in Whitehall hasgradually diminished. Representative associations became better organized andmore influential, whereas they had previously been some kind of gentlemen’s clubs(Grant 2002: 78–9). The Bank, however, remained responsive to the preferencesof 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 governmenton behalf of the financial sector unless there are public policy reasons that justifythe Bank’s involvement. The Bank has also been careful not to get involved in somesectoral issues, such as the withholding of taxes, arguing that its role as a publicpolicy 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 isarticulating the policy preferences of the City in Brussels?)

Since the configuration of the British economy and the Anglo-Saxon type ofcapitalism 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 financialcapital, and less concerned about the competitiveness of manufacturing. Since the1990s the Bank has endeavoured to change its image as an institution privilegingthe interests of the financial sector. For example, it championed the reform to facili-tate the access of small firms to credit, taking the issue up on the basis of ‘economicsub-optimality’ of the existing arrangements (interview, London, November 2005).The Bank has also been keen to point out that the conditions of the manufacturingsector, as well as other economic sectors, are continually taken into account whenformulating monetary policy. Partly as a result of this, but also reflecting the positiveeconomic climate in Britain from the late 1990s onwards, companies within themanufacturing sector have refrained from openly criticizing the central bank.

30 The Bank of England

The relations between the Bank of England and the trade unions have beenindirect and lukewarm, although they have improved since the late 1990s – forexample, Governor George addressed the Trades Union Congress in September1998 – mirroring those with the manufacturing sector as a result of the positiveeconomic environment. Nowadays one of the main concerns of the Bank of Englandappears to be what will happen to its relations with the main interest groups in thecase 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 inBritain

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 andsubstantially in the postwar period. Since then two main types of internationalinstitution 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 andsupervision of financial services, which are usually divided into three: the bankingsector, the most internationally regulated service, the securities sector and theinsurance 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 exchange-rate 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 thefact that the UK was a member of the ERM only from 1990 to 1992, the functioningof the system had both direct and indirect effects on UK monetary and exchange-rate policies, the clearest example of which was the shadowing of the D-mark in1987–98, as explained below. A more indirect effect resulted from the Germanleadership of the EMS, which meant that the Bundesbank set the monetary policystance for the rest of Europe – including the UK, which was formally outside theERM – and determined relations with other currency blocks (Loedel 1999; seeChapter 3), first and foremost the USA.

Having opted out of EMU, thereby placing the Bank of England outside theEurosystem, the UK decided not join ERM 2, the exchange-rate regime establishedbetween the eurozone and some EU countries that did not adopt the single currencybut were willing to take part in an exchange-rate agreement (see Chapter 5). Despitethe fact that the monetary and exchange-rate policies of the eurozone obviously haveindirect implications for the conduct of monetary and exchange-rate policy in Britain,convergence towards the ECB/Eurosystem model of central banking governancehas been limited and mainly indirect, owing to the lack of mandatory institutionaland policy templates. An example of indirect convergence, based on the spread ofbest (i.e. most efficient) practices, is the Bank of England’s decision to conductopen-market operations on a periodical basis in common with the Eurosystem, andnot on a daily basis as the Bank used to do (interview, London, November 2005).

The Bank of England 31

With reference to international regimes concerning banking supervision, it isimportant to mention the Basel Committee on Banking Supervision (BCBS). ThisCommittee was set up in 1974, largely in response to the international bankingcrisis that hit the UK particularly badly and was tackled through the central bankingnetwork at the BIS. Although financial interdependence affected all nationalregulators, the Bank of England was on the front line in this international jointproblem-solving exercise because of the large number of foreign banks based inLondon (Kapstein 1994). Indeed, the Governor of the Central Bank, GordonRichardson, and the Head of Banking Supervision, George Blunden, were thedriving forces behind the creation of the Basel Banking Committee, which enabledthe Bank of England to step up its supervisory policy capacity. Since the creationof the Basel Committee the Bank of England, which had been regarded as one ofthe best regulators in Europe before the policy failures of the 1990s, has been aninfluential member, a conclusion suggested by the fact that the two heads of theBank of England Banking Division served as chairmen (George Blunden and PeterCooke).

In the 1980s the core issue dealt with by the Basel Committee was theestablishment of minimal capital requirement, in order to avoid a race to the bottomin financial regulation and hence to enhance the policy capacity of the supervisoryauthorities. The US Federal Reserve and the Bank of England took the lead in thediscussion, and following a US–UK compromise,8 the Committee released aconsultative paper (the basis of the Basel 1 agreement) with the purpose of definingcapital standards (see Kapstein 1992). It proposed a two-tier system of core andsupplementary capital, weighted according to the degree of risk – in particular,credit risk.

The Basel Accord signed in 1988 was preceded by a bilateral agreement betweenthe 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 reacha bilateral agreement (Kapstein 1994: 113). Moreover, the Bank of England agreedto it as a means of counterbalancing the emerging standards in the EU, to which theBank of England objected. Subsequently, the Japanese authorities decided to jointhe US–UK agreement. Eventually, in July 1988 the central bank governors in Baselaccepted a proposal that defined the minimum capital adequacy requirements forbanks operating internationally. The Basel agreement was transposed into theCapital Adequacy Directive of 1993, which gave legal force to its provisions acrossthe EU and required domestic adaptation.

Ten years after the signing of the Basel 1 Accord, the negotiations on Basel 2gained momentum in June 1999 with the publication of the first consultative paperby the BCBS, followed by other two consultative papers and four quantitativeimpact studies concerning the implementation of the new rules. The Basel 2 Accordis based on three pillars: (i) minimum capital requirements, which cover three types of risk – credit risk, market risk and, innovatively, operational risk; (ii) thesupervisory review process, whereby supervisors are enabled to take measures thatcould go beyond the minimum capital requirements; and (iii) the discipline imposedby the market, facilitated by transparency requirements.9 The rationale of the

32 The Bank of England

revision was to gear banks’ capital requirements more closely than in the past to theactual 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 hasbeen 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, followedby Germany and Japan. Unlike Basel 1, where the Bank of England was the UK’ssole representative, in Basel 2 the Bank shared its competences with the FSA; boththese institutions had representatives on the Basel Committee. On the issue of co-operation between the Bank of England and the FSA, the former was in the driver’sseat in Basel 2 owing to its technical capacity; for example, the Bank had the staffwith previous experience in the field of ‘calibration’. All quantitative impact studiesconducted in Basel were led by senior officials from the Bank of England, whereasthe 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 paperwas to rely on external rating as standard treatment in order to establish capitalrequirements for banks. However, the Bank of England’s view was that it was toorisky to rely only on external rating, especially in markets that are not rated or haveno tradition in rating. Rating agencies do not possess better information than thebanks themselves, and thus the Bank of England suggested relying instead oninternal ratings, a proposal eventually incorporated into Basel 2 (interview, London,January 2006). Second, the Bank acted as a brake on the degree of complexity thatwas inserted in the document – the Old Lady traditionally favoured light-touchregulation – and placed emphasis on empirical testing. Third, the Bank wasconcerned about the pro-cyclical effects of Basel 2, and indeed, the first workingpaper of the Bank of England on Basel 2 raised the issue of the pro-cyclicality ofthe proposed system. Eventually, these matters were partly addressed, by changingrelevant provisions in the agreement.

Overall, the Bank of England has been an important player in international andEU regulatory and supervisory forums, often relying on its expertise in this field.Although the technical capability at the Bank remains, its influence in internationalstandard-setting bodies has been reduced by the 1997 reform, because the centralbank 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 ofEngland has been involved, with different degrees of policy capacity, over theperiod 1979–2005. These are monetary policy; exchange-rate policy, which isinextricably linked to the conduct of monetary policy; and financial supervision,several aspects of which are also linked to monetary policy. Other functions of theBank, such as its role as adviser to the government or as the (informal) representativeof the financial sector, are also reviewed.

The Bank of England 33

The main objective of this discussion is to understand the policy capacity of thecentral bank, how it evolved over time, and why. Attention is also paid to the roleof ideas in the form of policy paradigms, which are particularly important ineconomic policies. Finally, policy trajectories are evaluated in order to assessconvergence, or the lack of it.

Monetary policy capacity in Britain

Before the 1997 reform, the responsibility for monetary policy legally rested withthe Treasury. The Bank of England had no independent tasks or powers regardingmonetary policy; however, besides advisory functions, it had executive tasks in thisfield and was responsible for issuing banknotes. Thus, it was the government thatdetermined monetary policy and was responsible for its conduct before Parliament(Deane and Pringle 1994: 65).

In 1979 the newly elected Conservative government embraced the monetaristparadigm, which postulated that the main objective of monetary policy was to fightinflation by using the instrument of monetary targets and by committing thegovernment to a medium-term financial strategy that set monetary targets years inadvance (Goodhart 1991: 272–3). Although the prime minister, Thatcher, was notan economist by training, she and her economic advisers embraced the ‘rhetoric ofmonetarist theory’ (Holmes 1985: 16). The Bank of England preferred a ‘practicalmonetarism’ as opposed to the ‘ideologically loaded’ form pursued by theConservative Party (Kynaston 2001: 554). Throughout the 1980s the government’sobstinate adherence to monetary targets as the main instrument to fight inflation wasnot 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 money-based system, as outlined in the 1980 Green Paper produced by the Bank (Reid1988: 212).10

In 1990 the Conservative government formally abandoned monetary aggregates,even though political ‘discretion’ – rather than monetary rules – had prevailed inthe conduct of monetary policy in the period 1983–9 (Cobham 1997). In 1990 thepound entered the ERM, with the intention of using the exchange rate as a disin-flationary instrument and subscribing to a strategy that emphasized the importanceof ‘imported’ credibility and external commitments in the conduct of monetarypolicy (see Giavazzi and Pagano 1988). The policy objective, namely reducinginflation, did not change.11 After withdrawal from the ERM in 1992, the governmentannounced inflation-targeting and gave the Bank of England some discretion ontiming the implementation of monetary policy decisions, so as to rule out politicalbusiness cycle effects. According to several policy-makers interviewed, this change,together with the publication of minutes, increased the policy capacity of the Bankin the formulation of monetary policy significantly.

In 1997 a major institutional reform of the Bank of England introduced a statutorymonetary objective, granting the Bank operational independence. The objective of monetary policy is price stability and, subject to this, supporting government

34 The Bank of England

economic policy. If, in extreme economic circumstances, the national interestdemands it, the government has the power to give instructions to the Bank on interestrates for a limited period. Such power can only be exercised through subordinatelegislation approved by Parliament. These policy instruments are interest rates andmarket operations. Since 1997 consumer price inflation (CPI) has remained within1 percentage point of the government’s target of 2.5 per cent, revised to 2 per centof CPI in 2004. Concerns that the MPC might be biased in favour of lower inflationhave proved misplaced (Financial Times, May 2002). As a result, the Governorhas so far avoided writing the open letter to the chancellor of the exchequer thatwould be necessary if inflation deviated by more than a percentage point from thegovernment’s target.

Overall, the monetary policy paradigm moved from the postwar Keynesiandoctrine, through the monetarist theory that dominated policy in the 1980s, to amore comprehensive monetary policy paradigm in the 1990s, informed by theliterature on central bank independence and macroeconomic credibility. Lookingat the policy trajectory, the conduct of monetary policy in the UK shifted from beinga politicized activity informed by the preferences of the executive, with the Bank’spolicy capacity limited to implementation and advice, to a ‘technical’ exerciseperformed by an operationally independent central bank, with substantial policycapacity in monetary matters. In the UK, monetary policy discontinuity seems tohave 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 offinal 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 policypriority, even though the inflation-targeting used by the Bank of England is onlyone of the pillars of the ECB’s monetary policy. Moreover, the institutional settingfor 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 forconducting monetary and exchange-rate policies, which were then implementedby the Bank of England, which also acted as an adviser on these matters. The centralgold and foreign reserves of the UK were kept in the Exchanges and EqualizationAccount and were owned by the Treasury, but managed by the Bank of England asits agent. Consequently, interventions in foreign markets were executed at the riskand on behalf of the account of the Treasury, which held the ultimate power ofdecision.12

After the short-lived experience in the ‘snake’ of 1972, and after opting out ofthe ERM in 1979, exchange-rate policy became a salient topic of discussion inBritain, because throughout the 1980s the government was divided internally on

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whether to seek ERM membership (see Stephens 1996; Thompson 1996). Duringhis term as chancellor of the exchequer in 1981–2 Geoffrey Howe (later foreignsecretary) was in favour of joining the ERM, as was Nigel Lawson when he tookover 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 theunwillingness to follow the monetary policy of the Bundesbank, as well as the issueof national sovereignty.

Although the Bank of England was never particularly keen on external targetsor even any targets at all (interview, London, December 2005), by the late 1980sthe then Governor of the Bank of England, Leigh-Pemberton, supported ERMmembership, a policy strategy designed to fight inflation by using an exchange-ratetarget (see the Governor’s lecture delivered at the University of Kent, reprinted inthe Bank of England Quarterly Bulletin, December 1986). This rationale was basedon the idea of deploying an external constraint in the domestic arena in order toreduce the government’s interference with the conduct of monetary policy(Thompson 1996). Moreover, the markets were unsettled by the divergences thatexisted between the prime minister, the Treasury and the Bank of England. Thisresulted in a high interest rate premium in the UK relative to other countries. Theother reason for the Bank’s support for ERM membership was very much linked tothe pro-European attitude of Leigh-Pemberton (Stephens 1996: 32). This becameapparent during the drafting of the Delors Committee report on EMU, which wasendorsed by the Governor of the Bank of England, despite the prime minister’srequest not to sign it (Thompson 1996).

As the prime minister opposed full membership of the ERM, Lawson decidedbetween 1987 and 1988 that the pound should shadow the D-mark, using it as aninformal target for exchange-rate and monetary policies. However, Thatcherterminated this after less than one year (for a detailed account of this episode, seeStephens 1996; Thompson 1996). In 1990 inflation reached double-digit figures, andthe prime minister gave in to the pressure for the UK to join the ERM, after havingbeen urged to do so by the chancellor, the foreign secretary and the Governor of theBank 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 crisisin September 1992, which culminated in the withdrawal of the British pound andthe Italian lira from the ERM after considerable losses of reserves. This was thegreatest failure in the field of monetary and exchange-rate policy in the UK sincethe 1970s. Arguably, the Bank’s policy capacity increased after the withdrawalfrom the ERM, because in a pegged exchange-rate regime such as the ERM thedecision 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 thatguides official action to moderate the fluctuations to which the pound would beliable. Since the political authorities were also keen to be seen as dealing at arm’slength with the Bank, the autonomy of the latter from the government increasedslightly in the post-1992 period. Currency depreciation followed, interest rates werelowered and a new monetary policy framework was set in place, based on inflation-

36 The Bank of England

targeting rather than on the exchange rate as an external constraint. Indeed, theexchange-rate policy became subordinate to the conduct of monetary policy. Itremained so after the establishment of EMU, because the UK declined to join theERM 2.

Following the 1997 reform the political authorities are still responsible for thechoice of the exchange-rate regime, though the Bank has its own separate pool offoreign-exchange reserves to use at its discretion to intervene in support of itsmonetary 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 thegovernment’s reserves. However, all such intervention would be automaticallysterilized.

Everything considered, the policy capacity of the Bank was slightly greater onexchange-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 somelines 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, bethey 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, havegenerally speaking been in favour of a flexible exchange rate. The exception wasthe period in the late 1980s, when ERM membership was regarded by senior policy-makers at the Bank and at the Treasury as a way of reducing the interference of theprime minister in monetary affairs, as well as an opportunity to acquire greatermacroeconomic credibility. This strategy bears some resemblance to the Bancad’Italia’s use of the ERM as an external constraint in the national arena, hence as aresource 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 hasofficially refrained from taking a public stand. For example, when the debate onjoining the single currency heated up in the UK in the late 1990s, the Bank refusedto comment on the issue, arguing that this was a decision for the political authoritiesto take, and had the government decided to join, it would have been part of theBank’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 seniorofficials – were and still are against joining EMU for two reasons: the currentmacroeconomic policy framework in the UK is positively evaluated and joiningEMU would imply the transfer of monetary policy competences from the Bank ofEngland to the Eurosystem.

In the current conduct of exchange-rate policy the Bank of England adopts apragmatic approach, which means it is less concerned about the level of theexchange rate than the monetary authorities of the eurozone (or at least some ofthem). For the Bank of England, focusing on the exchange rate is artificial becausethe Bank has an inflation target, though exchange-rate markets are taken intoaccount in calculations underlying the formulation of monetary policy. As onepolicymaker interviewed phrased it, it would be ‘like a juggler with one arm andthree balls, trying to juggle all three at once’ (interview, London, January 2006).

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The British monetary authorities also suggest that the eurozone authorities payexcessive attention to the exchange rate of the euro, given the fact that the eurozoneis 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 Englandtowards the ECB/Eurosystem standard is minimal.

Financial supervisory capacity in Britain

Before the 1997 reform the Bank of England was responsible for the regulation ofthe banking sector. On these matters, the Bank of England had always had aconsiderable degree of policy capacity, partly because of the expertise it possessed,and partly because the government was less interested (or at least less willing) tobe directly involved in these matters. This section thus focuses on bankingsupervision, though it also briefly considers securities markets, given the influenceexerted by the Bank of England over the reform of the regulatory framework of thesecurities sector.

The Banking Act 1979, which established a comprehensive legal framework forbanking regulation, was introduced after the policy failure of the so-calledsecondary banking crisis in 1974. This document imposed, for the first time in theUK, a comprehensive system of statutory banking supervision, strengthening the Bank of England’s supervisory role. The 1979 Banking Act contained two mainprovisions, namely, that banks taking deposits had to be either recognized orlicensed (hence, establishing a two-tier licensing system), and that both recognizedand 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 systemand given broad legal power to administer the law, though under certaincircumstances banks could appeal to a tribunal established by the Treasury. Byinvestigating the origins of the Act, it seems clear that the Bank of England was thefirst to realize that new legislation was needed to regulate banking services, but itfaced the traditional dilemma of how to reconcile informality and legal control.The second catalyst that stimulated the introduction of the Banking Act was thedomestic adaptation to the draft banking directive issued by the EuropeanCommunity in 1977, which required the formal licensing of all deposit-takingcompanies operating in the member states and a growing pressure for enhancedinvestor protection (Hall, M. 1991).

The 1979 Act was amended by the Banking Act 1987, which was again drawnup 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 informingthe 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 sheeven contemplated the possibility of taking away the Bank of England’s supervisorypowers (Lawson 1992: 402). It should also be noted that, unlike in 1974, privatebankers were unwilling to share the burden of this financial rescue to the extentrequested 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

38 The Bank of England

in this field that the committee set up by the Treasury to investigate the system ofbanking supervision and the conduct of the central bank was chaired by theGovernor, Leigh-Pemberton, and included two Bank officials (Coleman 1996: 187).

Drawing on the report produced by the committee, the Treasury produced a whitepaper that formed the basis of the 1987 Banking Act, which accommodated theBank’s light-touch approach to supervision (Coleman 1996: 188). The 1987Banking Act made the central bank responsible for supervision of all the institutionswithin the monetary sector, removing the distinction between recognized banksand licensed deposit-takers. It gave greater powers to the Bank of England,including the power to issue formal directives to ensure compliance, and the Boardof 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 ashorthand term for a series of changes in ownership structure, trading practices andsupervisory arrangements implemented in the financial services sector. The Bankof England was the core promoter of regulatory change in the 1980s, with a viewto defending London’s position as a major financial centre, a situation that allowedthe Bank to play a leading role in international central banking supervision (Moran1994: 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 inthe securities sector that could potentially challenge its position, in May 1984 theBank of England created a City panel of ‘wise men’ to discuss these matters(Coleman 1996: 192). Their report was never published, but their advice wasincorporated in the 1985 white paper of the Department for Trade and Industryentitled Financial Services in the UK: A New Framework for Investor Protection(Lomax 1987; Hall, M. 1991), which was the basis for the 1986 Financial ServicesAct. The Act aimed to provide a statutory-based system of regulation. It delegatedsupervisory powers to Self-Regulatory Organizations (SROs) in different sectors,overseen by the newly created Securities and Investment Board (SIB), which wasa private body financed by levies on the industry, with a chairman appointed by thesecretary of state in agreement with the Governor of the Bank of England. The othermembers of the board were appointed by the Governor in agreement with thesecretary of state. In the case of financial conglomerates, the Bank of England wasestablished by the Act as the lead regulator (Coleman 1996: 194).

The effectiveness and policy capacity of the Bank of England in prudentialsupervision were challenged by two major policy failures in the 1990s: the Bankof Credit and Commerce International (BCCI) affair in 1991 and the Barings scandalin 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 inquiriesinto its conduct, and the Treasury and the Civil Service Committee produced areport 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 bankingsupervision to the FSA. The current model of financial service regulation and

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supervision for the entire financial sector in the UK is therefore based on a singleagency, which is responsible for micro-stability, prudential supervision, conduct ofbusiness and disclosure. Financial stability must be pursued in co-operation betweenthe FSA and the Bank of England, which is still primarily responsible for it, while the power of the competition authority in the financial field remainsunchanged. Each institution’s separate role in the tripartite framework establishedin 1997 is set out in a Memorandum of Understanding. The new regulatory structurealso ended the two-tier system that split responsibility between the SIB and theSROs. This system was regarded as inefficient, confusing for investors and lackingaccountability, because responsibilities were not clearly allocated (Treasurystatement, 20 May 1997).

There were three reasons for changing the supervisory policy framework inBritain 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 thecentral bank once it had been assigned operational independence in monetarymatters (interview, London, October 2005); and the increased complexity andinterlocking of financial activities, which changed the existing economic institutionsand made necessary the creation of more comprehensive statutory regulation anda unified approach to supervision (Treasury statement, 20 May 1997; see also The Banker, 4 July 2005), especially for financial conglomerates, bearing in mindthat the UK has the largest number of conglomerates in the EU. It should also benoted that a similar reform had been implemented in the Nordic countries in the1980s, and was subsequently carried out in Germany in 2002, as well as in otherEuropean and non-European countries.14

To sum up, the paradigm concerning banking regulation and supervision in theUK shifted from a policy style based on informality, mainly using non-statutoryinstruments such as moral suasion, voluntary compliance and non-obtrusivesupervision 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 theBank of England, which was equipped with effective instruments to exercisesupervision in an internationalized and more competitive policy setting in the 1980s(Coleman 1996: 186). In the 1990s a new policy paradigm in supervision gainedground, placing more emphasis on consumer protection and micro-efficiency, andon the institutional model that separates central banking functions, mainly monetarypolicy, 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, principallybecause, in contrast to the situation in monetary policy, supervisory policies andinstitutions have not converged significantly across the EU, though they haveconverged to some degree in European sub-groups of states. For example, aframework similar to the post-1997 British model – that is, a unified regulator forthe whole financial system but separated from the central bank – was introduced inthe Nordic countries in the 1980s and, after the Bank of England’s reform, wasadopted by the German authorities through the creation of the Federal Financial

40 The Bank of England

Supervisory Authority, the BaFin. However, by looking at the variety of models offinancial 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 performsspecific roles that relate to the domestic context in which the central bank isembedded. Some of these functions have changed over time, as part of an overallprocess of convergence in the EU. The Bank of England is banker to the governmentand 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 creditrestrictions, and the Bank of England could manage the public debt and issue newbills. After 1998 the management of the debt was transferred to the Treasury, ashappened in Italy and Germany, where a debt agency was created. In common withother EU central banks, the Bank of England manages the payments system,providing clearing and settlement systems to all clearing banks. All commercialbanks are obliged to keep a non-interest-bearing deposit at the Bank, which acts aslender of last resort (LLR) for the financial system.

Throughout the period examined in this research, the Bank of England, relyingon its intangible assets, has acted as adviser to the government, in a capacity thathas extended beyond matters of monetary policy, trying to prevent policy choicesthe Bank regarded as inappropriate. In a memorandum issued in 1980, the Bankcommented as follows: ‘Economic policy is the responsibility of the governmentand is determined by ministers. Policy decisions are, however, the end product ofthe assimilation and discussion of studies, forecasts, advice and proposals availableto ministers from a wide range of sources, in which processes the Bank of Englandhas 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 bankwould go so far as to argue that the Bank of England was one of the mostindependent central banks, not with reference to the implementation of monetarypolicy, but with reference to its role as independent adviser to the government,strengthened by the central bank’s experience with the markets (see also Eizenga1991).

However, the Bank of England’s role as adviser to the government became lessimportant as time passed, because the Treasury became more familiar with themarket, and also as a result of the difficult relations between the Bank, the Treasuryand the Prime Minister’s Office in the 1980s. Indeed, neither the chancellor,Lawson, nor Thatcher took particular account of the Bank of England’s technicaladvice. After 1998 the Bank seemed to be rather keen to delimit this advisory roleto issues framed in terms of public policies, rather than specific sectoral issuesconcerning 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

The Bank of England 41

Bank of England, which was, at least until the 1980s, often regarded as an informalrepresentative of the financial sector in policy formulation and implementation, asexplained above. Three reasons were given for this mediating role. First, the Bankof England was responsible for prudential supervision, hence there were close andfrequent interactions between the regulator (the central bank) and the regulated (thebanks). Second, the City is one of the world’s leading financial centres, which wasa comparative advantage to be cultivated by the central bank – it was a tangible assetfor the Bank. Unlike many other central banks, ‘one of the core purposes of the Bankof 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 bankdesigned to act as a counterweight, or to limit the government’s interference withthe affairs of the Bank.

It was precisely for the opposite reasons – the loss of the central bank’s compe-tences in banking supervision, operational independence from the government andthe primary focus on monetary policy – that the 1997 reform brought an end to thisspecific role performed by the central bank. The change of Governor in 2003 alsomade a difference in this respect. Whereas Eddie (later Lord) George, who hadheaded the central bank since 1993 and had spent almost his whole career at theBank, was still rather sympathetic to the traditional approach in the Bank’s relationswith the City, his successor, Mervyn King, was eager to increase the Bank’s focuson monetary policy (Financial Times, 7 January 2005). He reduced the Bank ofEngland’s three core purposes to two: monetary stability and financial stability.The third, financial efficiency and effectiveness, could either be subsumed underfinancial stability or could be dispensed with altogether, if it meant promoting theinterests of financial operators in the City, for this was no longer seen as a suitabletask for the central bank. The internal organization of the central bank wasrestructured accordingly (Financial Times, 17 January 2005).

If the Bank of England was for most of the previous period eager to rely on andfoster a central banking mystique, or was at least reluctant openly to disclose itsoperations, 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 inpolicy disputes, unless the Bank’s involvement could be justified by public policyobjectives, as opposed to particularistic interests (interview, London, November2005).

An overall assessment of the mode of central banking governance inBritain

In practice, the bank’s autonomy vis-à-vis the political authorities has fluctuatedover time, reaching its lowest ebb in the 1980s, largely as a consequence of a de factochange of political institutions in the UK, which saw the strengthening of theexecutive under a very assertive prime minister. The Bank’s autonomy increasedafter the innovations introduced in 1992–4, and even more after the 1997 reform ofthe central bank legal framework, which improved its legal economic and political

42 The Bank of England

independence and set in motion specific mechanisms to ensure accountability and transparency, overhauling the traditional bases of central bank legitimacy inBritain.

The policy capacity of the Bank has varied across policy areas, as well as overtime. As part and parcel of the Bank’s reduced autonomy, and in line with thegovernment’s interest and involvement in monetary policy and exchange-rate policyin the 1980s and early 1990s, these policies became subject to strong politicaldirection. The situation was reversed by the 1997 reform, which granted the Bankoperational independence in monetary policy, even though the government hadalready released its grip on monetary matters following the 1992 exchange-ratecrisis (or at least this was the political message it aimed to deliver).

As far as financial services regulation and supervision is concerned, the policycapacity 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 ofeconomic institutions in the UK, where the City not only had a prominent positionin the economic system, but also enjoyed consolidated relations with the centralbank. It also built on intangible assets such as expertise and moral suasion, which the Bank could command in this (perceived) technical area. Officials at theBank worried that greater independence in monetary policy would lead the govern-ment to restrict other areas of the central bank’s rather broad mandate (Coleman1996: 183), as indeed happened in 1997. The 1997 reform, which sanctioned thecreation of the FSA and conferred on it the regulation and supervision of the entirefinancial sector, left the Bank of England with a residual policy capacity in thisarea, though it is still responsible for the overall supervision of financial stabilityin 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 capacityand the autonomy of the Bank of England, although their main influence has beenon 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 limitedparticipation in EU monetary regimes and partly because of the Bank’s expertisein supervisory matters, which have been mainly discussed at the BIS, that the Bankof England’s influence has been greater in international supervisory forums (thenegotiations of Basel 1 and 2 were clear instances of this) than in EU monetaryinstitutions.

The UK’s decision to opt out of the ERM (the technical part of the EMS) and laterout of EMU has reduced the effects of EU monetary institutions on central bankinggovernance 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 bestpractice, has been noticeable (King 2005).

Although the chancellor, Brown, presented the 1997 reform as a ‘British solutionto meet British needs’ (Treasury statement, 6 May 1997), the enhanced indepen-dence of the central bank in Britain was also the result of ideational diffusion that

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began in the 1980s, in Europe and worldwide (King 2005). It was a core part of thestability-oriented paradigm, which had successfully been embodied and ‘exported’by the Bundesbank (McNamara 1998). However, it also maintained some specificBritish 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 2000sthere have been examples of institutional and policy transfer, operating in bothinward and outward directions across countries, without the direct influence of theEU. Thus the model of a single independent regulator for the whole financial sectorwas implemented in the Scandinavian countries in the 1980s and introduced in theUK in 1997. In turn, the creation of the FSA provided an institutional and policytemplate for the creation of BaFin in Germany in 2002. Yet one cannot speak ofconvergence across the EU, where very different models still co-exist even in theeurozone.

The Bank has sometimes engaged in a two-level game, a sort of joint problem-solving or ‘collusive action’ with other central banks in international or EUinstitutions in an attempt to alter domestic opportunity structure, even though thiswas the exception rather than the rule, given the configuration of domesticinstitutions. An example was the Bank’s support for ERM membership in the late1980s, as a strategy designed to increase domestic macroeconomic credibility andas an external constraint to limit the involvement of the government in monetarymatters, increasing the central bank autonomy and monetary policy capacity.However, in the UK, unlike in Italy, for example, this was less feasible, due todifferent domestic political institutions. A strong executive, the absence of majorveto-points and a normative order that does not welcome external influence, meantthat the domestic use of external constraints was less effective as a way to limit theinterference 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-levelgame. 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 theinfluence of the political authorities on central banking governance, limiting theautonomy and policy capacity of the central bank, though such interference did notextend to certain technical areas in which the Bank had specific expertise andconsolidated relations with economic interest groups, an issue that brings into the picture economic institutions and the special position of the City in the UKeconomy.

Domestic economic institutions have also affected central banking governance,especially its policy capacity in the supervisory field. Although the Bank of Englandenjoyed close and positive relations with the financial system, often acting as amediator between the City and the government, the internationalization of the

44 The Bank of England

financial community in the 1980s, and the consequent change of economicinstitutions in Britain, loosened the contacts between the central bank and thefinancial system, making the policy style and framework more formal than it hadbeen in the past. The blurring of the boundaries between various segments of thefinancial sector was also one of the driving forces of the 1997 reform of bankingsupervision.

Finally, institutional micro-assets of the central bank, such as technical knowledgeand familiarity with the market, have made a difference at the margins in centralbank autonomy and policy capacity, given the strength of the executive. Oneexample was the attempt to influence government decision-making by providingpersuasive advice, which was generally more successful when there were no strongpolitical views on a certain matter (see the Banking Acts and the Big Bang). Amongintangible factors, ‘secrecy’ and the retention of ‘mystique’ – the Bank of Englandhas never readily divulged its secrets – and the assumption that only the Bank ofEngland understood the market have augmented the Bank’s influence (Kynaston1995: 40). This changed after the 1997 reform, which made the Bank of Englandone of the most open and transparent central banks in Europe.

Conclusions

Overall, the main institutional and policy changes that have affected central bankinggovernance in Britain have been engineered and brought about by governmentaction, not by lobbying or masterminding on the part of the central bank. In a publichearing Lord Kingsdown (the former Robin Leigh-Pemberton) said that it was opento the Bank of England to stand up to the political authorities, but with considerablerestraint, to avoid provoking or inciting a constitutional clash. It was open to theBank to make any opposition public, but this could be self-defeating if it had anadverse effect on market sentiment. Moreover, not many public forums wereavailable to the central bank in the domestic arena, given the configuration of thepolitical opportunity structure.

For most of the postwar period the Bank of England and the government haddifferent policy preferences, not only where the objectives of monetary policieswere concerned, but also regarding the instruments and strategies, such as the useof 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 thoseof 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 theone that underwent the deepest and swiftest domestically originated reform, butwith the caveat concerning ideational diffusion mentioned below. The other nationalcentral banks considered here also underwent significant changes in approachingthe final stage of EMU, but this was driven by direct external pressure, namely theneed for domestic adaptation to positive institutional and policy templates imposedby the EU (to be precise, by EMU), which was not the case for the UK. Despite the

The Bank of England 45

fact that some critics regarded the reform of the Bank of England as a preparatorystep for future EMU membership, the changes implemented are still far removedfrom the transformation needed for the UK to join EMU and for the Bank of Englandto be part of the Eurosystem. Most notably, in the UK the government sets theinflation target, which is not the case in the eurozone.

46 The Bank of England

3 The BundesbankThe central bank that ‘ruledEurope’

The Bundesbank is regarded as one of the most independent central banks in theworld, with a solid reputation for price stability. It is a powerful domestic andinternational actor, which in the postwar period took over the primacy previouslyenjoyed in Europe by the Bank of England, only to be succeeded by the ECB in1999.

In the various classifications of central bank independence compiled byeconomists on the basis of the legal provisions concerning the institutional andpolicy framework of each central bank, the Bundesbank has generally scored very highly, traditionally being regarded as one of the most ‘independent’ centralbank (cf. Alesina and Summers 1993; Cukierman 1992; de Haan and Van’t Hag1995; Eijffinger and de Haan 1996; Grilli et al. 1991), in terms of both political andeconomic independence, despite the fact that the personnel independence of theBundesbank de jure has never been very high.

A systematic analysis of the empirical record (1978–2005) reveals that centralbank autonomy, policy capacity and legitimacy cannot be gauged solely by relyingon ‘statute reading’ (cf. Forder 1998). For example, the Bundesbank’s autonomyhas largely coincided with its legal independence, though there have been cases inwhich the Bank has had to make concessions to the political authorities, especiallywhen public opinion has sided with the latter, as explained below. Moreover, thepolicy capacity of the Bank has varied across policy areas, being greatest inmonetary policy but more limited in exchange-rate policy, although compared withother central banks the Bundesbank’s influence on exchange-rate policy wasremarkable. The policy capacity relating to banking regulation and supervision,though shared between the Bundesbank and other state (Länder) agencies, wasgreater than was apparent from either statutory analysis or from listening to theconventional views articulated by the Bundesbank. Similarly, the legitimacyenjoyed by the Bank cannot be gauged simply by looking at the legal provisionsfor its accountability.

This chapter begins by providing an overview of the stable trajectory of centralbank independence in Germany, followed by a discussion of the central bank legalframework and model of legitimacy. It then analyses the micro-institutional featuresof the Bundesbank, before considering the broader institutional framework in whichit is embedded, as well as specifically discussing the Bank’s relationship with the

political authorities and economic forces, to gain an understanding of the Bank’slevel of autonomy. Throughout the discussion, particular attention will be paid tothe analysis of the international setting, given that the Bundesbank, at least until theestablishment of the ECB, used to be one of the major players in international andEU institutions. The second part of the chapter discusses the evolution of the mainpolicies conducted by the Bundesbank, such as monetary policy and exchange-ratepolicy, or policies in which the Bank was involved, such as financial supervision,and various services to the German Government, including advisory functions. Inaddition, the policy capacity of the Bank in different policy areas is assessed overtime. The chapter then concludes by extrapolating the specific features of the modeof 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 independentof the German Government. In response to the hyper-inflation suffered by Germanyafter the First World War and in the interwar period, and to counter the inflationaryprocess that followed the Second World War, the law establishing the Bundesbank– the Bundesbankgesetz (BBG) – explicitly referred to the protection of the currencyas the primary objective of the Bank (Hayo 1998). Such an objective had twodimensions that informed the policy debate in Germany, as described in the secondpart of this chapter. The first dimension concerned the juxtaposition of the externalvalue and the internal value of the currency, that is, exchange-rate stability versusinternal price stability. The second dimension concerned the relationship betweenmonetary policy and other macroeconomic policies or, to put it another way, thetrade-off between monetary policy objectives (first and foremost, price stability) andbroader economic objectives (primarily, economic growth).

After its establishment there were never any serious efforts to overturn the centralbank’s independence through the modification of the Bundesbank Law (Goodman1992; 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 themain critical juncture for central banking governance in Germany, the Bundes-bank’s institutional reforms proved minimal – path dependency prevailed, with theexception of the amendments introduced after German reunification in 1991.Moreover, unlike the reforms undergone by other central banks in Europe in thesame period, the institutional changes experienced by the Bundesbank did not affect the degree of independence of the central bank, or the priority of pricestability. Instead, they affected the degree of centralization of the Bank’s governancestructure and its policy scope, and were primarily in response to changes in thedomestic and EU institutional context. It should also be noted that, unlike the Bankof England and to a more limited extent the Banca d’Italia, they did not tend toensue from policy failures.

48 The Bundesbank

The first significant reform of the governance structure of the Bundesbank, whichwas triggered by German reunification and agreed after a debate that lasted about twoyears, ending with a political compromise, saw a reconfiguration and a reductionin the number of state central banks, the Landeszentralbanken (LCBs), whosefunctions are explained in the following section. The main purpose was to limit thenumber of (state-based) decision-makers in the Central Bank Council. The secondmajor reform of the Bundesbank was an indirect adaptation to membership of theEurosystem, and indeed the Bundesbank took the lead in 1999 by appointing acommittee headed by the Deputy President of the Bank, Jürgen Stark, to formulatea plan for the reform of the internal organization of the Central Bank. However, thetwo alternative proposals put forward by the committee failed to gather broadsupport within the federal structure of the Bundesbank (interview, Frankfurt,January 2006). Subsequently, a commission of experts chaired by the Bundesbank’sformer President, Karl Otto Pöhl, suggested a mixed model, combining severalfeatures of the two proposals previously put forward (Financial Times, 5 July 2000).

In January 2001 the SPD finance minister, Hans Eichel, presented two comple-mentary reform proposals, which went further than the reform proposed by the Pöhlreport. The first of the finance minister’s proposals concerned the governancestructure of the Bundesbank and envisaged a single-tier governing body, themembers of which would be appointed by the federal government. The LCBs wereto be replaced by regional offices (interview, Frankfurt, January 2006). AlthoughEichel’s proposal was opposed by the states, especially by Bavaria, it was supportedby 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 Finanz-dienstleistungsaufsicht (BaFin, the Federal Financial Supervisory Authority). Thus,Eichel proposed the establishment of a single regulator, replacing and taking overthe supervisory functions of the three existing federal authorities that dealt with themain segments of the financial sector. Banking supervision, which had previouslybeen performed by the Federal Banking Supervisory Board, the Bundesaufsichtsamtfür das Kreditwesen (BAKred) in conjunction with the Bundesbank, wouldconsequently be transferred to the single regulator.

This reform had the full support of big private banks (Financial Times, 12 June2001), which favoured a one-stop regulatory body for the whole financial sector asa result of the changes concerning political economy institutions in Germany –briefly, the blurred boundaries between various segments of the financial sector. Bycontrast, the Bundesbank was keen to carve out a greater role in banking supervision(Dyson 2002: 222).2 Likewise, many states were unhappy with the governmentproposal on banking supervision, because it would inevitably endanger the compe-tences of the LCBs in this field (Financial Times, 12 June 2001), given that theywere de facto heavily involved in supervisory activities, as explained below.3

As the Bundesrat (the upper house of the German Parliament) opposed both theseproposals and the Bundesbank opposed the second one (some LCB presidents

The Bundesbank 49

also opposed the streamlining of the governance structure of the Bank), the federal government made two amendments to its original plan. Instead of the six-member executive board initially proposed, an eight-person, single-tier board of theBundesbank was to be created, with half the nominations made by the federalgovernment and half by the Bundesrat, an amendment that represented a clearconcession to the states (Dyson 2003: 223). Moreover, in a concession to theBundesbank, the amended plan entitled the Bundesbank to exercise joint bankingsupervision 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 Bundesratafter the members of the Christian Democratic Union (CDU), many of whomopposed Eichel’s reform proposal, had walked out in protest over the government’simmigration bill. Subsequently, the federal government issued a protocol to clarifythe relations between the Bundesbank and the BaFin, as well as the central bank’scompetences in banking supervision. The ECB was consulted by the federalgovernment on these reforms, which were by and large endorsed by the ECB inAugust and November 2001. However, the ECB provided external support to theBundesbank in its domestic institutional battle, first to extend its supervisorycompetences,4 and failing this, in keeping the national central bank involved insupervisory matters, given their implication for the stability of the financial system.5

The rationale of the first institutional reform was to make the decision-makingprocess within the Bundesbank more efficient, to enable it to articulate its interestsin the ESCB/Eurosystem more effectively (Dyson 2003: 218). It was an indirectadaptation to EMU membership because the decentralized governance structure of the Bundesbank made decision-making at the Bank rather slow. Moreover, onseveral occasions the members of the Council of the Bundesbank undermined theauthority of the President within the Eurosystem, by making public statements onmonetary policy or exchange-rate policy in the euro area, at times contradicting theECB’s stated position (Financial Times, 15 June 2000).

The rationale of the second reform was to increase the competitiveness andattractiveness of Germany as a financial centre, providing an improved regulatoryframework (interviews, Frankfurt, January 2006) by adopting the model of the FSAin Britain in 1997. Unlike in the UK, the reform in Germany was not a response tomajor policy failures, but was instead triggered by an incremental change ofeconomic institutions within the country, in particular the increasingly blurredboundaries between segments of the financial sector and the formation of financial(insurance and banking) conglomerates, such as Allianz-Dresdner and MünchnerRück-HypoVereinsbank (Financial Times, 12 June 2001), and the international-ization of this sector. It should also be noted that many of the changes in the financialsector were the indirect result of the introduction of the euro, which gave a newimpulse to financial integration in the EU. Moreover, the reform of the supervisoryframework was also an indirect adaptation to EMU, which had triggered competitionbetween the main financial centres in Europe to attract capital, bringing to the forethe objective of making Frankfurt the most important financial centre in theeurozone (interview, London, December 2005).

50 The Bundesbank

Overall, except for the crucial issue of transferring key responsibilities in monetaryand exchange-rate policies to the ECB, the Bundesbank’s legal adaptation to theinstitutional and policy templates of EMU has been minimal, because the design ofthe 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 actorin the negotiations for the TEU (Dyson and Featherstone 1999), but it was alsoregarded as a highly successful model in the 1980s (McNamara 1998) and wastherefore considered a suitable template for the ECB and the national central banksin the Eurosystem. Thus the Bundesbank has been a core actor in promotingideational diffusion, primarily, though not exclusively, through the EMU frame-work (Radaelli 2000). Such diffusion has also extended outside the EMU framework(see the reforms towards greater central bank independence in several central andeast European countries in the 1990s), and has been part of a broader trend towardscentral bank independence internationally (McNamara 2002a). Moreover, centralbank independence was also part of the acquis communautaire (the consolidatedbody of EU law) for the new member states. Hence, there was specific legaladaptational 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 Bundesbankhas scored highly as far as political independence is concerned, and very highlywhere economic independence is concerned. Political independence is oftensubdivided into personnel independence (who has the power of appointing the topmanagement of the central bank), which is not very high for the German centralbank, and decisional independence in terms of setting objectives, which isremarkable. The procedures for the appointment of top personnel, which have beendescribed 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 wereappointed as presidents of LCBs, despite not having the necessary professionalqualifications (Sturm 1989: 4).

Nonetheless, the Bundesbank has not become a partisan political institution, forseveral 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 fullyembrace the central banking operating culture and the stability-oriented paradigm,because the Bundesbank has a strong assimilative power – the so-called Becketeffect (Neumann 1999: 279).7 The directors have generally been independent, andso have the presidents (interview, Frankfurt, January 2006).

Second, the entry age and the period in office have been combined in such a waythat individuals have entered office at the end of their working lives (Neumann1999: 279). For example, the average age of six presidents (out of eight so far) was60, although Pöhl was 47. The Executive Board was appointed for at least eightyears, twice the tenure of politicians, both within the federal and the state govern-ments. Overall, there was a high degree of personnel continuity in the governingbodies of the Bank, especially in the Executive Board (Sturm 1990).

The Bundesbank 51

Third, political appointments were not the rule, and, most importantly, did notfollow the electoral cycle. For example, Pöhl, a Social Democrat and formerjournalist, was one of the longest-serving civil servants in Europe; he was appointedby the leader of the Social Democratic Party (SPD), Helmut Schmidt in 1980, andreappointed by the leader of the CDU, Helmut Kohl (Kennedy 1991). Overall, inchoosing the members of the Executive Board, the federal government mainlyselected individuals acceptable to the banking community and broadly in agreementwith the main economic policy objectives of the government.

The appointment of the single-tier Governing Board established by the 2002reform seems to have been informed mainly by criteria based on professionalqualifications and reputation. For example, Axel Weber, appointed as President in2004, is a highly respected academic economist. However, one of the personsinterviewed pointed out that the likelihood of civil servants rising through theBundesbank’s ranks to the top decision-making positions at the Bank is now muchlower than before the reform (interview, Frankfurt, January 2006).

Indeed, a recurrent criticism of the personnel policy of the Bundesbank is thatoutsiders have often been ‘parachuted’ into the top positions at the Bank, ratherthan rising through the internal ranks. When compared with other central banks, theBundesbank 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 thesingle-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 theBundesbank and joined international organizations, such as the BIS.

As far as decisional independence is concerned, government representatives areentitled to attend CBC meetings without voting power (Article 13 of the BBG),although this rarely happens. Moreover, before EMU the federal government couldsuspend the Bundesbank policy acts for two weeks. Although this power was neverused (Marsh 1992: 73–4), this provision was abolished in preparation for EMUmembership. The Bank’s President is entitled to attend government meetingsdealing 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 economicresources available to the organization, which form a core component of the tangibleassets of each central bank. They also affect its intangible assets, such as the calibreof the personnel it employs and the expertise it has access to, by influencing salarylevels. The Bundesbank is owned by the federal government, and all the Bank’sprofits, after the funding of reserves, go to the federal government.

The second aspect of economic independence is connected with the managementand financing of the public debt, and in particular the possibility of monetizing thepublic deficit. Direct credits of the Bundesbank to the federal state and state budgetswere restricted by the Bundesbank Act to emergency measures in order to solveshort-term liquidity problems, and they had maximum ceilings. These credit facilitieswere then abolished in 1994 to adapt the central bank legislation to the provisionsof the TEU. The Bundesbank had a high degree of operational independence, whichmeans that it had at its disposal the instruments for the conduct of monetary policy.

52 The Bundesbank

Model of legitimacy of the Bundesbank

The Bundesbank is a legal person sui generis, which is not subordinated to thefederal government and for which the exemption from parliamentary control isconstitutional (Stern 1999: 156). Further, the Bundesbank is not subject to reviewby the Bundestag (the lower house of the German Parliament), even though theBank’s annual accounts and audit report are transferred to the Bundestag, a practiceintroduced a few years ago. The high degree of central bank independence meantthat there was not input-oriented legitimacy.

The model of output-oriented legitimacy on which the Bank has rested since itsinception did not undergo any significant changes, at least until the establishmentof EMU. This was because the Bank was domestically a highly respected institutionand was able to justify its policies on the basis of an output-based model oflegitimacy (cf. Scharpf 1997). Since the Bundesbank delivered policy outputs thatwere regarded in Germany as effective and efficient by the vast majority of policy-takers (those affected by the decisions taken), who were stability-oriented, theBank’s legitimacy was never seriously questioned domestically, though such amodel of legitimacy was criticized in other countries, such as the UK, or when itwas 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 policy-making body of the Bundesbank and comprised the presidents of the LCBs and theExecutive Board. The presidents of LCBs were appointed by the federal presidentat the suggestion of the Bundesrat, which based its selection on a proposal made bythe state governments, following consultation with the Central Bank Council. Thepresidents of the LCBs were frequently card-carrying members of the party in officein the states and, except where the state governments changed, LCB presidentswere generally re-elected for a second eight-year term until retirement, usually atthe age of 65 or 67 (Marsh 1992: 68–9). On occasion nominees for LCB presidencywere turned down by the Central Bank Council, only to be appointed on therecommendation of the minister president of the state (Neumann 1999: 278).

The organization and size of LCBs varied across the individual states, but before2002 each LCB had both a managing board and a supervisory advisory board,appointed by the LCB presidents. Although members of the supervisory board werenot appointed to represent the economic sector to which they belonged, they weredrawn from local businesses, banking, agriculture and trade unions. Within thefederal structure of the Bundesbank the LCBs acted as listening posts and playedan important role in relation to public opinion, by explaining Bundesbank policies(Kennedy 1991: 18). Some LCB presidents were also able to articulate regional orlocal interests in Frankfurt, thus affecting the decision-making of the Central BankCouncil.

The Bundesbank 53

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. TheCouncil took not only the most important decisions on monetary policy, but alsoon administrative matters. According to a former member of the Executive Board,policy-making in the Council was a matter of persuasion and argument (Kennedy1991: 15), while other commentators argued that the Council was largely controlledby the LCB presidents (Conradt 2001: 233). These were often perceived as inward-looking, and they sometimes had a strong sense of attachment to their states, whichinformed their policy decisions. By contrast, the LCBs often complained that theBundesbank’s Executive Board was too internationally oriented and therefore paidexcessive attention to external factors (Smyser 1993: 50).

The Executive Board (Direktorium), which until its demise in 2002 was basedin Frankfurt, was composed of between six and ten (legal maximum) members,who were appointed for eight years by the federal president on the recommendationof the federal government, after consultation with the Central Bank Council (CBC)(Neumann 1999: 278). The Bundesbank Law stated that suitable appointees shouldhave special professional qualifications, and while some members of the ExecutiveBoard had political affiliations and others were technocrats, very few came fromwithin the Bundesbank (Marsh 1992: 72). Before 2002 the Executive Board was in charge of the day-to-day management of the bank, implementing the policydecisions taken by the Council and becoming involved when immediate action wasrequired (Stern 1999: 121).8 After the 2002 reform the Bundesbank adopted a morecentralized decision-making structure, discussed above. 9 The single-tier GoverningBoard is now the main policy-making body of the Bank, taking over many of thefunctions previously performed by the Central Bank Council. The eight-memberboard of the Bundesbank is nominated jointly by the federal government and theBundesrat.

The President of the Bundesbank had only one vote in the CBC, and since 2002he has one vote in the single-tier Governing Board. The President represents theBundesbank internationally, although before EMU his ability to commit the Bundes-bank to a particular international policy depended largely on his leadership skillsin the Council. Obviously, consensus in the Council reinforced the Bundesbank’sexternal stance, but, if consensus was lacking, the Bundesbank’s President had totry 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, January2006).

It is also necessary to understand how the decision-making process of the single-tier Executive Board of the Bundesbank interacts with the decision-making processof the ECB’s Governing Council. Members of the ECB Governing Council are notsupposed to act as representatives of national central banks, and therefore thePresident of the Bundesbank does not act on a mandate from the Bundesbank whentaking part in decisions concerning the monetary and exchange-rate policies of theeurozone. Consequently, the President’s vote in the ECB’s Governing Council doesnot need to be confirmed or approved by the Bundesbank’s Executive Board. The

54 The Bundesbank

only exception is when voting in the Governing Council of the ECB is not carriedout on the basis of one person, one vote, but instead on the basis of the capitalsubscriptions of national central banks, albeit still according to the majority votingprinciple. In this situation, the Bundesbank President has a clear mandate from theGoverning Board of the Bundesbank, as, for instance, in the case of decisionsconcerning the distribution of the ECB’s profits. Another case of a formal mandatefrom the Bundesbank to its President is when the ECB has no competence in acertain area and a vote is taken in the ECB Governing Council to expand the ECB’stasks, 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 carriedout in response to the ECB decision-making process was the extraction of theEuropean Relations Unit from the International Relations Department, making itreport directly to the President and the Governing Board of the Bundesbank. Themain task of this department is to co-ordinate the preparations of the BundesbankPresident for the ECB Governing Council, to ensure that the positions of the Presidentare consistent over time and across policy issues, which had not necessarily beenthe case in the early years of EMU.

Overall, until 2002 the governance structure of the Bundesbank and the ‘pluralismof appointing institutions’ (Stern 1999: 123–4) reflected the configuration ofpolitical institutions in Germany. The collegial nature of the decision-makingstructure and the internal organization of the Bundesbank before 2002, while similarto the current decentralized structure of the ECB, strongly differentiate it from boththe 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 the2002 reform.

A core issue, which has at times been explicit and at times implicit and whichconcerns the Bundesbank’s internal organization, has been the division of powerbetween 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 wasprevented 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 reformdid 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 head-quarters in Frankfurt, as well as the definition of the core functions to be performedby 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 fosterits independence and policy capacity: its personnel and their expertise, its credibilityin the conduct of anti-inflationary policies, as emphasized in economists’ studies(see Giavazzi and Giovannini 1987; Giavazzi and Pagano 1988; cf. Cukierman1992) and its status as a self-confident bureaucracy, at the very heart of the Germanstate, highly respected domestically and admired internationally (Kennedy 1991;

The Bundesbank 55

Marsh 1992). Indeed, the Bank projected and perceived itself as a special civilservice entrusted with the goal of defending price stability in Germany. For over40 years the stability culture widespread in Germany at all levels of society was acondition sine qua non for the Bundesbank’s independence.

As part of its intangible assets, the Bundesbank has been careful to foster publicsupport for its activities, meaning the support of public opinion, interest groups andfinancial press, especially whenever disagreements with the federal governmentemerge (Goodman 1992: 339). For example, with regard to the controversy betweenthe Bundesbank and the government on German monetary union, the Bundesbanklost out on the issue of a one-to-one exchange rate, partly because public opinionsided with the government, as elaborated further below. By contrast, in 1996–7public opinion lent valuable support to the Bundesbank on the issue of therevaluation of the gold reserve (Duckenfield 1999), as detailed below.

As far as technical knowledge and scientific production are concerned, theBundesbank does not appear to be in the top rank among central banks, even thoughits performance has improved in the period post-EMU. The number of researchersat the Bank has increased threefold in the last decade or so, moving from five in 1997to 16 in 2003 (St-Amant et al. 2005). However, these numbers are quite low whencompared with the numbers of researchers at the Bank of England, the Banca d’Italiaand the ECB. The number of Bundesbank employees with doctorates is alsorelatively low.11 Scientific production (in journal articles published by staff) remainsrather limited, even though it has increased since 1999, and in 2000 the Bundesbankestablished its working paper series. These improvements were the result of adeliberate strategy to step up the Bank’s research capabilities, as a way to increaseits leverage in policy-making discussion within the ECB. The appointment of AxelWeber, a highly respected academic, as President contributed to fostering theemphasis placed on research.

After German reunification the Bundesbank employed approximately 18,000staff, but this was gradually reduced to 15,000 in 1998, and 12,000 in 2006, with afurther planned reduction to 11,000 by 2007. As of 2006 there were about 9,000employees at state level and 3,000 employees in the central offices in Frankfurt, aslight increase over the previous year despite the significant cut in staff membersat the state level.

The national institutional framework of central banking governancein Germany

The micro-institutional analysis of the Bundesbank needs to be embedded withinthe analysis of the national institutional setting, considering the effects of nationalpolitical and economic institutions on central banking governance in Germany.This section also analyses the institutional relationship between the Bank and thepolitical authorities and economic interest groups, in order to gain a better under-standing of the degree of autonomy enjoyed by the central bank.

56 The Bundesbank

Political institutions in Germany

Germany is a federal state, characterized by decentralization, institutional pluralismand a social market economy (Sturm 2003: 102). The chancellor (prime minister)controls several resources and maintains influence over the main policies and thedirection of the government, but, unlike the British prime minister, the Germanchancellor is highly constrained by the constitution, co-governing forces and vetopoints (Schmidt, M. 2003: 26), such as those related to German federalism and tothe predominance of political parties, the so-called party state.

Unlike the UK, Italy and other unitary states, German has a federal governmentseated 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 theallocation of competences. Two core principles inform German co-operativefederalism: separation of power and institutionalization of joint responsibilitiesbetween different levels (Scharpf 1997).

Moreover, because of constitutional provisions the passage of legislation inGermany often requires broad coalitions, comprising not only the governing parties,but also the main opposition party and the majority in both chambers. It is thereforea non-majoritarian state structure – a grand coalition state – which is quite differentfrom the British majoritarian system (Schmidt, M. 2003: 27). The proportionalelectoral system has tended to result in coalition governments, rather than the single-party governments produced by the majoritarian electoral system in the UK.However, unlike Italy, the governing coalition at the federal level has so far onlycomprised two parties, though with various factions therein.

In the federal government three political figures are responsible for economicpolicy (with the exception of monetary policy, which was first the monopoly of theBundesbank, and then of the ECB and Eurosystem) – the chancellor, the ministerof economics and the minister of finance. These posts are usually divided betweenthe coalition parties, whose interests tend to be reflected in any economic policy;thus coalition negotiations can be very complex, because the parties in office havedifferent 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 economicstaff, its real input into economic policy depends on the approach taken by thechancellor. For example, under Helmut Schmidt the chancellery office of economicsshaped and directed the economic policy of the government and kept contacts withthe business community and the Bundesbank (Smyser 1993: 43–4).

Roles within the cabinet are less flexible, though ministers’ influence on economicpolicies also depends on their personality and party base. In the first postwar periodthe Ministry of Economics was very powerful, but from the 1970s onwards it cededprestige to the Ministry of Finance, which is involved in credit matters, isresponsible for the federal budget, sets economic priorities and takes part in G7meetings, 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

The Bundesbank 57

Division and the European Division of the economics ministry were transferred tothe finance ministry.

The rationale for this change was twofold: it aimed to present a unified Germanapproach to EMU policies (Dyson 2003: 221) and, perhaps more importantly, it waspart of a domestic power-struggle within the cabinet, whereby the finance ministertried to expand the competence of his ministry at the expense of the economicsministry (interview, Brussels, December 2005). The transfer was reversed under thegrand coalition in 2005. It should be noted that, especially before the restructuringthat took place in the 1990s, the finance ministry in Germany was not as powerfulas the UK Treasury, and it was further weakened by the federal state structure inGermany. This also meant that the Bundesbank, like the Banca d’Italia, faced arelatively weak counter-power institution in the domestic arena.

Overall, the power-sharing domestic political institutions of German federalismhave been reflected in the decentralized governance structure of the Bundesbankand the pluralism of appointing institutions. They have also strengthened theautonomy of the central bank, by weakening the power of the federal government(cf. Lohman 1998). Moreover, the high number of veto points in the politicalsystem have also made it difficult to reform the German central bank, as explainedabove.

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 beenbased on consensus, historically there have been two main (potential) sources oftension 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); andthe contrast between domestic economic priorities (price stability) and externalforeign 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 alocomotive by stimulating economic growth. Chancellor Schmidt and the Bundes-bank disagreed on this issue and the government ultimately prevailed, triggering amacroeconomic expansion (Putnam 1988). By contrast, during the financial crisisof 1987 the US administration wanted Germany to adopt an expansionary economicpolicy, which was opposed by the Bundesbank, especially as far as monetary policywas concerned, resulting in disagreement between the USA and the Bundesbank(Loedel 1999; Heisenberg 1999). After pressure from the federal government, theinternational financial community and German business interests, the Bundesbanklowered interest rates six weeks after the New York stock exchange crisis.

European monetary co-operation proved a constant source of tension between theBundesbank and the federal government, though it should be said that there werealso disagreements within the government on this issue. This was the case with the

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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 wereadamant supporters of a wide EMU according to the deadline set in the TEU.

One of the most recent controversies between the Bank and the federalgovernment concerned the revaluation of the gold reserves in 1996–7, an issue thathad both an internal and a European dimension, and was one of the few occasionswhen the central bank and the finance ministry took opposing positions. Inapproaching EMU, the Bundesbank had a large amount of undervalued goldreserves, 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 thepublic deficit in 1997 – in so doing finding a shortcut to fulfilling the fiscalconvergence criteria in order to join EMU – the President of the Bundesbank, HansTietmayer, opposed it, arguing that this would represent government interferencewith monetary policy, and would challenge central bank independence.

In a couple of instances the government maintained the upper hand over the Bankalso 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 andthe East German currency in 1989, which led the federal government to limit theone-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 thatwere within the competence of the government, it was generally done in a way thatwas not detrimental to market confidence (Smyser 1993: 47) or the central bank’sreputation. Moreover, party politics as such seldom came into play. For example,despite the fact that Karl Otto Pöhl was appointed as President of the Bundesbankby an SPD-led coalition government, his relations with CDU governments, on thewhole, were less complicated than relations with the previous Social Democraticgovernments.13 At the same time, despite its consolidated position in the domesticinstitutional setting, the Bundesbank has been careful about the battles it has choseto fight with the political authorities (Goodman 1992). There were occasions whereit decided to submit to political pressure, especially when public opinion sided withthe government (Duckenfield 1999).

Economic institutions in Germany

The configuration of the financial system in Germany should be viewed within thecontext of the Rhenish model of capitalism (Rhodes and Alperdoorn 1998; Albert1993) or the co-ordinated market economy (Hall and Soskice 2001). This modelexperienced significant changes in the 1990s and 2000s, partly as a result ofdomestic reforms (of tax and pensions) undertaken by the public authorities (thefederal government); partly because of market forces triggered by international

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competition and globalization; and partly as a result of European integration interms of market integration and EU legislation (cf. Schmidt, V. 2002a). Since the1990s the German model of capitalism has slowly moved towards a more liberaldimension.

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 mainlyregulatory, though the welfare state is well developed; the competition regimeprevails, though some policy areas, such as banking, were granted special exemptionsuntil the 2000s; strong interest groups and centralized trade unions, with high(though declining) union density, engage in collective bargaining, regulating wagesthrough legally binding industry-wide agreements. In the Rhenish model ofcapitalism, the market co-exists with more or less institutionalized networks of co-operation, 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 asencouraging the representation of banks on the supervisory boards of firms andvice versa, resulting in interlocking directorships – a situation referred to asDeutschland AG (Albert 1993). The model of corporate governance was based onthe 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 samepolicy preferences, although this configuration of economic institutions has begunto change in the 2000s. The so-called silent revolution in Germany (The Banker, 4April 2005) that was triggered in 2002 by making the selling of cross-holding sharesand capital participation tax-free has meant that the cross-holdings of banks andindustry have now begun to be disentangled (Deeg and Perez 2000).

Banks, in particular public banks, used to lend to the Mittelstand (small andmedium-sized enterprises, SMEs) both extensively and at low margins (FinancialTimes Deutschland, 22 August 2002), though this practice has been challenged bythe changes experienced by the banking sector in Germany under the pressure ofEU and domestic reforms, which can be summarized as an attempt to increasecompetition (The Banker, 4 April 2005; 4 November 2004). The EuropeanCommission successfully challenged the state guarantees to the public banks asanti-competitive, with the result that they had to be phased out by 2005 to create alevel playing field, thereby ending the competitive disadvantage to which the privatebanks 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 the1990s 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 useof debt securities was among the lowest, even though it was expanding rapidly (TheBanker, 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 bankingas well as investment banking services. The universal banks in Germany can be

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divided into three main sectors: private banks (comprising approximately one-quarter of German banks); savings banks (Sparkassen), with approximately 36 percent of total banking assets, dealing mainly with residents and Landesbanken;16

and co-operatives, making up about 20 per cent of total banking assets (FinancialTimes Deutschland, 12 June 2002). There are also specialized banks dealing withcredit for the agricultural sector, for example. In the private banking sector thereare four main banks, though there are also smaller private banks. The Sparkassenand Landesbanken, which are public banks (hence non-profit maximizers), makeup about half the banking system. Group competition (Gruppenwettbewerb) hasbeen widespread in Germany, which means that banks do not compete individually,but tend to collaborate within the three categories, which have powerful interestgroups (Deeg 1999).

As elaborated further below, the configuration of political economy institutionsin Germany, especially the link between bank and industry, helps to explain thewidespread support for the objective of price stability and the Bundesbank’smonetary policy. Similarly, the changes that have occurred in the financial system,including the formation of financial conglomerates, have been a driving force behindthe reform of the supervisory framework for financial services in Germany. In turn,several features of the financial system have been changing because EMU has givena new impulse to financial integration and competition in Europe. At the same time,the Modell Deutschland began to lose economic competitiveness, and consequentlyattractiveness, in the 1990s.

Interest groups have traditionally been highly integrated into the policy-makingprocess in Germany. Sectoral policies are negotiated by the relevant federalminister, state governments and interest groups. In this model, formal co-ordinationis weak, but underlying social and political consensus limits conflicts (Keating1999: 349). The result is consensual, incremental policy, where a change ingovernment does not result in major policy shifts.

There are three main umbrella organizations in Germany: the Bundesverband derDeutschen Industrie (BDI), the association of German industry, which is the mostpowerful; the Bundesvereiningung Deutscher Arbeitgeberverbände (BDA), theemployers’ association and a key player in wage negotiations; and the DeutscheIndustrie und Handelstag (DIHT), the industrial and trade confederation of smallbusinesses, which produce about three-quarters of German output. In the financialsector the main associations are the Deutsche Bankenverband, the association ofGerman 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, thestrong ties between industrial (exporting) firms and banks in Germany have meantthat industrialists tended to share the bankers’ preferences (cf. Maxfield 1991: 435),

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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. Suchcommonality of interest was strengthened by the fact that the public banks, inparticular, used to lend extensively to the Mittelstand. That said, in the run-up toEMU there were times when the Bundesbank’s policy preferences, for example fora ‘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 awide EMU.

Despite its traditional image of maintaining an arm’s-length relationship with thefinancial sector, the Bundesbank has had close interaction with the banking systemon supervisory issues, carrying out on-site inspections and data collection at state level, an activity that continued after the 2002 reform. For example, in 1997the Bundesbank and the BAKred created the BAKIS, a database that allows thecomparison of data from co-operative and savings banks. The central bank has alsobeen responsive to the interests and policy preferences of the German bankingsector, especially the small public banks, with which the Bundesbank, through theLCBs and, after 2002, through its branches, has developed close contacts (interview,Frankfurt, January 2006), as evidenced throughout the negotiations of the Basel 2Accord (see below).

The Deutsche Gewerkschaftsbund is the confederation of German trade unions,a highly centralized and well-organized body, though its membership shrank in the1980s and 1990s. Before EMU, relations between the Bundesbank and the tradeunions 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 ofcapitalism, allowed trade unions to respond in an anti-inflationary way to theanticipated actions of an inflation-fighting central bank (Hall and Franzese 1998).Such relations have been reshaped by the establishment of EMU, because theBundesbank 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, acentral position that the Bank assumed in the late 1960s and that became moreprominent over time, until the establishment of EMU. On the one hand, theBundesbank’s influence has been paramount, especially in the European context,though it should be recognized that, most of the time, the Bundesbank onlyreluctantly agreed to act as a leader either in the international system or in theEuropean 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 exchange-rate policies. Moreover, in certain instances the federal government tried to useinternational and/or European monetary co-operation in a power game with thecentral bank to alter the domestic opportunity structure, with a view to rebalancing

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domestic economic priorities, prioritizing economic growth over price stability, asoccurred in 1978. This two-level game (Putnam 1988) in which the Bank founditself often resulted in a contradiction between the domestic economic objectivespursued by the central bank (first and foremost, price stability) and the foreignpolicy objectives pursued by the federal government.

Following the end of the Bretton Woods system in 1971, the Bundesbank provedto be wary of exchange-rate commitments and any sort of international monetaryco-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 theBremen Council (July 1978) conclusions, the EMS was intended to be a ‘schemefor the creation of closer monetary co-operation leading to a zone of monetarystability in Europe’. The Bundesbank and the German finance ministry were insteadcritical about exchange-rate co-operation, fearing that this would lead to an ‘inflationcommunity’. In response they managed to change important features of the systembefore it was agreed at European Community level (Ludlow 1982). Moreover, thePresident of the Bundesbank, Otmar Emminger, sent Chancellor Schmidt a letterstating that if domestic monetary stability was in danger, the Bank would suspendmarket 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 theforeign minister vehemently supported the project, the Bundesbank espoused the ‘coronation theory’, calling for prior economic convergence among Europeancountries and the liberalization of capital movements in the EU before movingtowards 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 ofestablishing EMU, provided this was done in such a way as to safeguard monetarystability 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 anindependent central bank. This came out very clearly during the discussions in theso-called Delors Committee composed of EU central bank governors and someindependent macroeconomic experts, chaired by the then President of the EuropeanCommission Jacques Delors, which produced a report containing a blueprint forEMU (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 supervisoryforums than the US Federal Reserve and the Bank of England. The most importantinternational agreements in the field of banking supervision are the Basel 1 and 2Accords, which established quantitative standards (capital ratios), even though thenational frameworks for regulation and supervision remained substantiallyunchanged. 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

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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 Bundes-bank and the BAKred – argued that universal banks, which were prevalent inGermany, were different from the commercial banks that were widespread in theUSA, and hence that different capital requirements were needed. They also arguedthat the strong links between banks and industry made German banks different fromthose in other countries (Stern 1999). Thus, both Bundesbank and BAKred engaged,albeit largely unsuccessfully, in international disputes over the definition of liablecapital (Kapstein 1994). At the same time, the negotiations of Basel 1 strengthenedthe supervisory authorities vis-à-vis the domestic banking associations, turningthem into ‘gatekeepers’ with informational advantages (Luetz 2003), altering thedomestic 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 BAKreduntil 2002 and afterwards the BaFin, the single financial supervisor) in negotiatingBasel 2 was the implication of the new capital rules concerning the access to andterms of bank credit for SMEs.17 There was also the concern that the new ruleswould penalize small and medium-sized banks (mainly public banks). Given theimportant role played by the SME sector in Germany and the high number of smallpublic banks, political pressure was exerted on the Bundesbank, the BAKred andthe BaFin at the state and federal levels. This was coupled with the lobbyingactivities of, and public consultation with, various sectors of society (interview,Frankfurt, January 2006) and represented a crucial difference from Basel 1. TheBundesbank took part in several hearings before the federal Parliament and receivedmore than 200 letters and policy documents from the public, including churches.

When negotiating the Basel 2 Accord, it did not prove problematic to define acommon position between the Bundesbank and the BAKred/BaFin, for they werefocused on different elements at the working level: the BaFin dealt with regulatoryissues, whereas the Bundesbank focused on economic studies. The Bundesbankseemed to be more responsive than the BAKred/BaFin to the policy preferences ofthe small banks, owing to the close and frequent contacts they had with the branchesof the Bundesbank at local level (interview, Frankfurt, January 2006). It is alsoworth recalling that on certain issues, such as the creation of a consolidatingsupervisor and the treatment of intra-group exposure, there were very differentpolicy preferences within the German banking community, whereby the interest ofthe (larger) private banks were pitted against the (small) public banks (for moredetails, see Quaglia 2008).

Overall, the Bundesbank has been an important actor in both international andEuropean monetary diplomacy, but on issues relating to banking supervision it was less so, even though it was on several occasions willing and able to articulatethe preferences of the German banking system in the making of internationalagreements. The Bundesbank’s international role has been significantly underminedby the establishment of the ECB and the BaFin, though the Bundesbank stillparticipates in many international forums, such as the IMF, the World Bank and G7

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meetings. Moreover, the Bundesbank and the BaFin exerted considerable influencein the negotiations leading up to Basel 2, in which the ECB participated as anobserver.

Central banking policies in Germany

The main objective of the second part of this chapter is to evaluate the policycapacity of the Bundesbank in several areas. In monetary policy at least, Germanyrepresents 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 monetarypolicy in Germany, and the federal government was responsible for determininggeneral economic policy. On the one hand, the Bundesbank was bound to supportthe government’s economic policies (Article 12 of the BBG). On the other hand, theBundesbank was independent of government action in relation to monetary andcredit policy, and its priority was to ‘safeguard the value of the currency’ (Article 3of the BBG). The Bundesbank perceived its role as the guardian of monetarystability, supporting the government’s economic policies in so far as they did notconflict with price stability (Kennedy 1991: 9).

In the 1970s the prevailing economic paradigm at the Bundesbank shifteddrastically towards price stability by embracing a European version of monetarism(cf. von Hagen 1999). In 1974 the Bundesbank decided for the first time to setpublic monetary growth targets (Giersch et al. 1992: 189), even though it neverintroduced multi-year monetary targets. Since 1988, M3 has played a key role asan indicator and an intermediate target, whereas the Bundesbank had previouslyused central bank money. The overall objective of the Bundesbank’s monetarypolicy 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 bankliquidity through open-market operations, refinancing policy and minimum reserves(Stern 1999). Open-market operations became more important over time, and thusthe Bundesbank gradually became more involved in market management (Smyser1993: 49).

In practice, the use of monetary aggregates was almost abandoned at least onthree 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 EMScurrencies.18 Depending on the critics, monetary targets and, more generally, themonetary policy of the Bundesbank were regarded as either too dogmatic or toodiscretionary (Baltensperger 1999: 514). Those who favoured the use of monetarytargets argued that abandoning them would be detrimental to the anti-inflationaryreputation of the Bundesbank. The sceptics argued that since the targets were often(and sometimes widely) exceeded, this damaged the Bundesbank’s credibility.

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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 notedthat 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 aprolonged recession, a situation that was exacerbated by the attempt to fulfil theEMU convergence criteria.

Throughout most of the period considered here, Germany’s inflation track recordproved the best in Europe, especially in a decade of very high inflation, such as the1970s. Some economists would argue that the low inflation in Germany should beascribed 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 alsoenjoyed the status of a reserve currency. Other authors argue that the low level ofinflation was part and parcel of Rhenish capitalism or the co-ordinated marketeconomy model, in which trade unions, employers’ associations, the governmentand the central bank are involved in a co-operative game of macroeconomic policyto secure price stability and stable growth (Hall and Franzese 1998; McNamaraand Jones 1996). Other commentators argue that the low level of inflation inGermany 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 prevailedin the conduct of monetary policy. In an analysis of monetary policy in Italy, Franceand Germany during the period 1973–82, Goodman (1992) concluded that, whereasmonetary policy was manipulated for electoral purposes in Italy and France, thishad 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 monetaryauthorities 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 adeflationary squeeze, to counteract the fiscal expansion pursued by the federalgovernment, mainly to finance expenditure in eastern Germany without raisingtaxes 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 resem-blance to the ‘game’ played the central bank and the political authorities in Italy inthe 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 theBundesbank’s scepticism concerning EMU as envisaged in the TEU, signed in1992. Several commentators (Connolly 1995; Hefeker 1997) have even argued thatthe 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 toexchange-rate policy.

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Over the period considered here, monetary policy in Germany was characterizedby continuity, and indeed the Bundesbank was one of the main forces drivingmonetary policy convergence in the EU, intended as convergence towards thestability-oriented economic paradigm, through the mechanism of ideationaldiffusion. This monetary policy template, adopted by the ECB, had as its primaryobjective price stability. Domestically, in the realm of monetary policy, the onlysignificant change that ensued from EMU membership – which, however, was alsoa good opportunity for modernization imposed from outside – was the closing downof a refinancing facility at the Bundesbank: purchase of the bill of exchange(Wechselpapier) was abolished. This instrument was outdated, disliked by thebanking 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 andthe economic ministry, often with an input from the foreign ministry – wasresponsible for external monetary relations, albeit with significant input from theBundesbank (Loedel 1999: 11). Whereas the choice of exchange-rate regime wasmade by the federal government after advice from the central bank, the conduct ofexchange-rate policy fell in a grey area: the central bank was responsible for day-to-day management and currency interventions, while the federal governmentretained authority on devaluation or revaluation (or parity realignments) withinfixed or semi-fixed exchange-rate regimes. However, since exchange-rate policy hasa direct effect on monetary policy and price stability, the central bank also exerteda 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 policyin periods of exchange-rate tensions, the political authorities could influence thepolicy implemented by the Bank, at least up to a point, as in the case of the ERMcrisis 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 currencymarket. Eventually, the Bundesbank was able to cease currency interventions in theexchange-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 anongoing balancing act (which sometimes resulted in a conflict) between internal andexternal currency stability (Eijffinger and Schalig 1993: 77), and between domesticeconomic and foreign policy objectives (Loedel 1999). For most of the time, theBundesbank’s strategy in the conduct of monetary and exchange-rate policies wasto minimize the collateral damage of external factors on domestic price stability.The policy-making process was complicated not only by the fact that the federalgovernment shared responsibility for exchange-rate policy with the Bundesbank,but also by the need for German policy-makers to negotiate with foreign policy-makers in complex two-level games, in which the Bundesbank was involved as an

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autonomous actor. At times these issues were also controversial within the Bankitself, between the Executive Board, which was generally more outward-orientedand sensitive to issues concerning international and European politics, and theLCBs, which were mostly more inward-oriented, as mentioned above. On a fewoccasions, disagreement on these issues even emerged within the ExecutiveBoard.20

As far as policy evolution is concerned, when the Bretton Woods system becameunstable, its demise was welcomed by the Bundesbank, which in 1973 officiallyrequested to be released from the exchange-rate interventions needed to stabilizethe US dollar in the Smithsonian agreement. From the 1970s onwards the Bankexpressed a clear aversion to any exchange-rate regime that could affect itsmonetary policy, and hence its domestic policy capacity (interview, Frankfurt,January 2002). The core elements of the exchange-rate paradigm of the Bundesbankwere, first, a concern that European or international exchange-rate agreementsshould not affect the conduct of domestic monetary policy, thus limiting theBundesbank’s policy capacity and interfering with the bank’s autonomy, second,a preference for flexible (or semi-flexible) exchange-rate regimes and, third, anunwillingness to use market interventions to defend exchange-rate parities iffundamentals were out of line. The strategy consisted of combining the foreignpolicy objectives of the government, European integration and constructiverelations 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 anassertive stance in international institutions, at times adopting a different positionto that of the national government and retaining a decisive influence on the formatand implementation of European exchange-rate agreements, such as the EMS andEMU (Heisenberg 1999; Loedel 1999). To achieve its objective in internationalforums, the Bank was also willing and able to use domestic political opportunitystructure mobilizing domestic resources, such as public opinion, sympatheticpoliticians, the financial press, academic economists and interest groups. Severalelements of the exchange-rate policy paradigm of the Bundesbank were reflectedin 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, theconfiguration of ERM2 was strongly influenced by the Bundesbank, which, in the light of the policy learning that took place in ERM1, wanted to limit thecompulsory interventions of the ECB to support currencies with divergent funda-mentals as much as possible in ERM2. It also wanted the ECB to be free to suspendintervention 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 onexchange-rate policy. The main reason is there is no predominant or benchmarkmodel, and it remains a controversial policy hotly debated by policy-makers alsoat the national level in various EU countries. Moreover, as discussed in Chapter 5,within the ECB and the Eurosystem the Bundesbank has sometimes expressedcontradictory preferences on the exchange-rate policy of the euro.

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Financial supervision capacity in Germany

Unlike the Banca d’Italia and the Bank of England before the 1997 reform, theBundesbank 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 2002with the BaFin). The Bundeskartellamt is the federal anti-trust authority responsiblefor federal competition policy, a responsibility shared with the anti-trust authoritiesof the states and the economy ministry. The finance ministry is responsible forelaborating banking policy, but the central bank must be consulted on all mainchanges, and the Bundesbank’s agreement is required on matters concerning capitaladequacy and liquidity (Coleman 1996: 75). In the securities sector, the Bank hadregulatory responsibility for issuing D-mark securities in foreign markets.

The Banking Act (Kreditwesengesetz or KWG) was adopted in 1934 and wassubsequently amended several times, either as a result of policy failures and thediscovery of ‘loopholes’ in the existing regulation, or because of the need to adaptto the international and EU regime of banking regulation, especially the directivesissued in the 1980s and 1990s. Before 2002 banking institutions, according to theKWG, were subject to BAKred supervision, with the co-operation of the Bundes-bank. The BAKred was created in 1962 and was legally an independent federalauthority, reporting to the finance ministry. Since the BAKred did not have its ownadministrative 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 Bundes-bank, and not to the BAKred. The Bundesbank and the BAKred were to inform eachother of observations and findings that could be significant for their functions. ThePresident of the BAKred retained the ability to attend the Bundesbank’s meetingson occasions when banking supervision was discussed, and in turn the Bundesbankwas entitled to express an opinion on the appointment of the President of theBAKred (Coleman 1994: 286).

As far as the policy paradigm for banking supervision is concerned, until the late1980s and early 1990s the main objectives were the stability and soundness of thebanking system in Germany (and more generally, the financial system), even when this was ensured at the expense of competition and efficiency, with businessmigrating to other financial centres such as London or Luxemburg (interviews,Frankfurt, January 2006; London, January 2006). The policy instruments weremainly based on an extensive body of regulation, which limited the introduction ofnew financial tools, while the strategy was based on the concept that banking wasa specific type of activity, for which restraints imposed on competition and financialinnovation were to be tolerated. At the same time, there was the attempt to strengtheninternational co-operation to avoid international crises or bank failures spreadingacross the country and to prevent regulatory arbitrage (Kapstein 1992).

Until the establishment of EMU, the Bundesbank posited that banking supervisionand monetary policy should be kept separated and should not be performed by the

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same body (the central bank) because of the potential for conflict of interests (Marsh1992: 59). In other words, the argument proposed that the objectives of safeguardingthe currency and ensuring the soundness of the banking system were not alwayscompatible. Moreover, it was feared that any supervisory failures could tarnish thereputation of the central bank as a monetary authority. In its contributions to bankingregulation and supervision in Germany, the Bundesbank prioritized its monetarypolicy functions and the objective of currency stability (Coleman 1996: 132). Onthe whole, before 2002 this approach to banking supervisions had been successful– there were few banking crises in Germany in the postwar period, although thiswas helped by the ‘conservative’ features of the German banking system (Marsh1992: 59).

In the 1990s the banking system, and more generally the financial system, under-went major changes, resulting in increased banking competition, the de-segmentationof financial activities, a shift towards a more market-based approach, securitizationand 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 andcontinental Europe (Luetz 1998). Some of these changes were part of the domesticadaptation to EU legislation in the securities sector, such as the Investment ServicesDirective. It is also worth noting that, together with the federal finance ministry, thelarge commercial banks and the Frankfurt stock exchange, the Bundesbank was amember of the coalition that promoted the modernization of the securities marketin the 1990s, overcoming its traditionally cautious approach (Coleman 1996: 141).

The system of financial services regulation and supervision in Germany wasoverhauled in 2002, when a single supervisor was established for the entire financialsector, taking over functions previously performed by the three different authoritiesresponsible for banking, securities and insurance. When the law governing theintegrated supervision of financial services entered into force in May 2002, the Federal Banking Supervisory Office, the Federal Supervisory Office forInsurance Enterprises and the Federal Supervisory Office for Securities Tradingwere amalgamated to form the German Financial Supervisory Authority (BaFin).The Bundesbank and the BaFin have spelled out the details of their respective rolesin their day-to-day supervisory activities in a Memorandum of Understanding, inorder to avoid duplication of work. Under the agreement the Bundesbank is assignedmost 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 Bundesbankmainly 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 reformundertaken in the UK, even though it maintained a system of ‘dual supervision’(interview, Frankfurt, January 2006). Yet the BaFin, unlike the FSA, is not anindependent authority. It is instead a body of the finance ministry and is stillorganized according to the traditional market segmentation (banking, securities andinsurance), whereas the FSA is organized according to functions. Moreover, the

70 The Bundesbank

BaFin has two bases, one in Frankfurt (for securities) and one in Bonn (for bankingand insurance), though it is in the process of enhancing its offices in Frankfurt todeal with banking supervisory matters. Whereas the FSA reports to Parliament andconsults with the Bank of England and the Treasury, the BaFin reports directly tothe finance ministry. In addition, the FSA’s funding is entirely provided by thoseit regulates, and not partly by the state.

The origins, modalities and rationales of the reform are explained in the first partof this chapter. Here, it should be noted that the Bundesbank’s unsuccessful attemptto extend its competences in supervision in 2001–2 contradicted the conventionalargument that had been articulated by the Bank before EMU, namely that monetarypolicy 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 thepolicy-making environment, because national central banks, including the Bundes-bank, 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 nationalcentral banks are members, the Bundesbank has only one vote. The argument assertsthat the change makes it possible for central banks to undertake supervisoryfunctions, and since central banks have the technical expertise and practicalknowledge of the market, they are better positioned than other state authorities toperform this task, even for the whole of the financial sector (interview, Frankfurt,January 2006).

The Bundesbank’s attempt to increase the regulatory and supervisory functionsof the national central banks in the eurozone was supported by the ECB (FinancialTimes, 12 June 2001), which, like the Bundesbank, was keen to point out thecomplementarity between monetary policy and banking supervision policy, andhow such a relationship prompted repercussions on the stability of the system. Thiswas an interesting case of a two-level game, in which the Bundesbank tried to usethe resources that were available at EU level – in this instance the support of theECB – to alter the domestic political opportunity structure, tipping the balance inpolicy controversies. At the EU level, the Bundesbank faced problems in securinga role in banking supervision level in the new Committee of European BankingSupervisors (Dyson 2003: 223).

Overall, the policy paradigm in banking regulation and supervision in Germanyhas moved towards a greater emphasis on competition and efficiency within thefinancial system, taking into account the changes that occurred in the most recentperiod, first and foremost the blurring of market segmentation. However, theparadigm 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 centralbank. For its part, after EMU there has been a clear (and unsuccessful) attempt bythe Bundesbank to carve out a new policy-making role by acquiring supervisorycompetences for the entire financial sector.

Although it is ultimately difficult accurately to assess policy convergence in thisarea, because different policy paradigms and institutional frameworks co-exist

The Bundesbank 71

within the EU, Germany has moved towards the British–Scandinavian models offinancial service supervision. Unlike the Bank of England, the German central bankresisted this change with considerable force, but with only very limited success. Bycontrast, the Banca d’Italia, which faced a different domestic political opportunitystructure, managed to fend off any attempt to reduce its power in this field, eventhough 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, inthat it oversees the payments system, acts as an issuing institution, and manages thegovernment account and the public debt, a function that was transferred to a separateagency following the 2002 reform. The Bundesbank acts as the banker to thegovernment, as well as the bankers’ bank, though it does not act as ‘lender of lastresort’, a role that the Bundesbank has traditionally rejected.

The Bundesbank has been an influential adviser to the government on inter-national 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 onehand, unlike many other central banks the Bundesbank not only possesses the powerto advise, but has on occasion also taken decisions that contradicted governmentpolicy. On the other hand, there have been cases when the Bundesbank’s advice hasbeen almost completely ignored by the government, as in the case of Germanmonetary union. Finally, the Bundesbank’s role in international and Europeandiplomacy – a crucial, atypical role performed by the German central bank – hasbeen discussed above.

The much reduced domestic and international role as a result of EMU – what theFinancial Times called ‘the descent from Olympus’ – was, according to OtmarIssing, former chief economist of the Bundesbank and later member of the ECBExecutive Board, a ‘culture shock’ for the Bundesbank (Financial Times, 15 June2000). Overall, the Bundesbank is still in the process of identifying its core functionsbefore 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 concerningcentral 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 personnelindependence of the Bank, while formally rather low, has in practice been strongerthan might be assumed by simply reading its statute – the so-called Becket effect.Such autonomy, besides being underpinned by national legislation, has beenstrengthened by the configuration of domestic political and economic institutionsand the intangible assets of the Bank, as elaborated below. Given the limited legalprovision for accountability, the Bundesbank depended largely on output-oriented

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legitimacy and was therefore keen to keep public opinion and leading financialcommentators on its side and to remind domestic public opinion of the importanceof price stability (Goodman 1992).

The policy capacity of the Bank has varied across policy areas. It was greatest inmonetary policy, because, besides being underpinned by legal provisions, theprevailing stability-oriented economic paradigm and the configuration of economicinstitutions played out in favour of the Bundesbank’s primacy. In contrast, theBank’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 sharedbetween the Bundesbank and another state agency, the BAKred. De facto, theBundesbank was involved in banking regulation and supervision, at both state level,through the collection of data, and international level, since the central bank wasthe leading representative for Germany during the negotiations of internationalsupervisory agreements, such as the Basel Concordat and the Basel 1 Accord. The 2002 reform, despite the Bundesbank’s lobbying activity and the supportiveposition expressed by the ECB on this matter, left the Bank with the same policycompetences in the supervisory field as before. However, the central bank’s policy capacity has since diminished, because the BaFin is a more powerfulinstitution than the BAKred and is thus a potentially more threatening institutionalrival for the central bank.

With reference to the multi-level institutionalist framework articulated in theintroductory chapter, international institutions have played a role in affecting the autonomy and policy capacity of the Bundesbank, sometimes enhancing it andat times reducing it, even though the Bank has occupied a leading position in policy-making in international forums, especially in European monetary regimes. Theexternal projection of the Bundesbank was facilitated by the configuration ofnational institutions, which gave the Bank independence and full responsibility formonetary matters, including those negotiated in international fora and the intangibleassets of the Bank.

Overall, the Bundesbank has been one of the main actors promoting monetarypolicy convergence in Europe by spreading the stability-oriented paradigm andproviding a successful model that has encouraged the setting up of independentcentral banks across the EU. This also explains why the adaptational pressure exertedby EMU onto the central banking legislation in Germany was minimal, with theexception of the transfer of monetary policy and related competences to the ECB.This qualification highlights an important scope condition for domestic change totake place as a result of external adaptational pressure: the rules and templatespromoted 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 theBundesbank have been shared with the BAKred and later with the BaFin, and partlybecause 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

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expertise can be an important intangible asset for a central bank to be able to affectinternational policy-making. If anything, in the supervisory field, Germany was onthe receiving end of ideational diffusion, establishing a single financial supervisorfor the entire financial system, following the reform introduced in the UK.

Power-sharing domestic political institutions, especially the federal statestructure, the relatively weak executive and the consensual style of policy-making,all increased the autonomy and policy capacity of the Bundesbank by affecting thedomestic political opportunity structure. Before the 2002 reform they also affectedthe bank’s governance structure, both by encouraging decentralization and bymaking institutional reforms difficult, as a result of the presence of several vetoplayers. The presence of certain economic institutions, and first and foremost thestrong links that existed between bank and industry, meant that these economicsectors shared similar preferences that were largely consistent with the anti-inflationary monetary policy of the central bank.

At the micro-level, apart from tangible assets such as statutory independenceand exclusive competence on monetary matters, the Bank’s intangible assets in theform of macroeconomic credibility, as well as the public support the Bank hasenjoyed and has been eager to foster, have strengthened the autonomy and theoverall policy capacity of the Bundesbank. Moreover, the D-mark and the Bundes-bank were the symbol of German economic success within the internationaleconomy – all elements that explain the reluctance of public opinion to abandon theD-mark in favour of the euro, and why it was difficult the Bundesbank to adapt toEMU, as elaborated in the concluding chapter.

Conclusions

The Bundesbank has been defined as an ‘economic policy counterweight to thegovernment’ (Marsh 1992: 169). For most of the postwar period the Bundesbankand the government had similar preferences in economic policy, or at least thegovernment would usually support the objective of price stability, acknowledgedas the primary task of the central bank and its monetary policy. Whenever thegovernment wanted to the deviate from this, conflict with the Bundesbank wasbound 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 theBundesbank.21

The institutional and policy templates of the Bundesbank were used as steppingstones in the creation of the ECB, which also meant that the Bundesbank’s legaladaptation to conform to the EMU framework was limited, because such a frame-work was largely informed by the model provided by the German central bank. Inapproaching EMU, which represented the main critical juncture for central bankinggovernance in Germany, the major problem for the Bundesbank was the transfer ofpolicy capacity and competences (of ‘decision-making power’, so to speak) in themonetary and related fields.

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In practice, the Bundesbank’s adaptation to EMU – to be precise, its trans-formation into being only one (albeit important) component of the Eurosystem,resulting in a reduced decision-making role in European monetary politics – hasbeen difficult for a central bank that, to paraphrase David Marsh (1992), used to ‘ruleEurope’. 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 manystatements been made by its officials. It may be argued that the Bundesbank wasvery concerned about the exchange rate of the euro, but a more probable explanationis that the Bank had not yet learnt to cope with its new role within the ESCB.

Moreover, the Bundesbank has undergone several significant indirect adaptationsmediated by national political and economic institutions. The 2002 reform of the Bundesbank is largely an indirect adaptation to EMU, in that membership of theEurosystem made it necessary to streamline the decision-making process within the Bundesbank by changing its governance structure. The increased competitionin 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 inGermany, by adopting a revised version of the ‘British model’ of supervision. Itshould be noted that since the creation of EMU, the competitiveness of Frankfurtas a financial centre has become an important goal for the Bundesbank, whereas thishad not been the case previously (Financial Times, 20 June 2000).

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4 The Banca d’ItaliaQuis custodiet ipsos custodes?1

The Banca d’Italia has often been described as the least independent among thegroup of independent central banks, or, to put it another way, as the mostindependent of the dependent central banks (Financial Times, 22 November 1989).Before the legislative changes introduced in the 1990s in preparation for EMUmembership, the Banca d’Italia used to score very low as far as economicindependence was concerned, whereas the procedures for the appointment of theGovernor and the other members of the Executive Board gave the bank a highranking for political independence (to be precise, personnel independence).

A systematic analysis of the empirical record reveals that, from the early 1980sonwards, the autonomy of the Italian central bank was much higher than a statutoryanalysis would suggest. This is because, as with the Bank of England, the analyticalmeasures used by economists are typically formal and fail to pick up the nuancesof the relationship between the central bank and the government. These studies alsotend to overlook the central banks’ policy capacity in financial regulation andsupervision, which in the case of the Banca d’Italia extended to competition policyin the banking sector, giving it one of the most extensive and discretionary remitsin 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 theBanca d’Italia was strengthened by the weakness of domestic political institutions,based on power fragmentation, rather than (as in Germany) power sharing (Maesand Quaglia 2006). The weaknessof the Italian state and the assets of the centralbank also help to account for some of the atypical functions performed by the centralbank in Italy over time. The relative strengthening of domestic political institutionsand the measures required to adapt to the single currency account for the (at timesdifficult) ‘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 theBanking Law of 1936. Before the legal changes introduced in preparation for EMUmembership in the 1990s, the Banca d’Italia was not statutorily independent of the

government, nor was it assigned the specific objective of safeguarding pricestability. However, a fine-grained analysis reveals an incremental trajectory towardsgreater central bank independence from the late 1970s onwards. Hence, pathdependency was accompanied by some incremental changes, only some of whichwere the result of critical junctures triggered by policy failures.

The first important reform took place in 1981, when the central bank’s economicindependence was increased by the so-called divorce between the Banca d’Italia andthe Treasury, whereby the central bank was freed from its obligation to buy allTreasury bills that remained unsold at auction. The reform, initiated by the Treasuryminister, 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 lettersbetween 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; mytranslation):

The imperative was to change the regime of economic policy . . . Italianmembership 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 Treasuryminister and the Banca d’Italia Governor. Before a coalition of those whoseinterests were affected could take counter-action, it was a fait accompli. Itwould have been too costly, especially on the exchange-rate market, to go backto the old status quo . . . The intention was to dramatise the separation betweenthe two institutions, increase the Banca d’Italia’s credibility and contribute toa disinflation process less painful in real terms . . . promote the formation ofpositive expectations in the market . . . The divorce was an unavoidableconsequence of EMS membership.

It should be noted that although it was presented as a ‘technical reform’, it hadsignificant direct effects on the conduct of monetary policy and indirect consequencesfor the conduct of fiscal policy, as explained below. It also represented an interestingexample of a two-level game engineered by the Bank and the Treasury, in that theyskilfully 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 indepen-dence. On the other hand, the Bank continued to provide some form of support forits ‘divorced partner’ by buying a large share of the public debt (Repubblica, 26 July1991). After all, the options were either to monetize there and then, or let a crisisbreak out with unpredictable effects (Epstein and Schor 1989). For example, in1982 the Bank followed this course of action and refused to buy a large share of thebonds that the Treasury had not managed to place in the market. The Treasurywithdrew the maximum amount of 14 per cent on the account it had at the Bancad’Italia and, needing more funding, asked Parliament to sanction extension of itsoverdraft facility. The overdraft was granted immediately, because the threat of afiscal crisis was too destructive to contemplate.

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In the 1980s and early 1990s two parallel market reforms – the processes ofinternal and external liberalization – had a significant impact on the de factoeconomic independence of the Banca d’Italia. The financial system becamerelatively 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 establishmentfor 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 freemovement of capital. Such external pressure was exploited in the national arena bythe central bank, with some support from the Treasury, in that the goal of the marketreforms implemented in the 1980s and early 1990s was to make monetary policymore independent of fiscal policy, by enabling the Treasury to place its bonds onthe market, which therefore needed to be enhanced and made more efficient (Carli1993; Sarcinelli 1995). Indeed, net subscription by the Banca d’Italia for Treasurybills decreased over the 1980s and became negative in the 1990s (Passacantando1996). These reforms enhanced the central bank’s autonomy from the politicalauthorities and its policy capacity in the monetary field, but they also meant that itwas 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 theinstruments at its disposal) took place shortly after the TEU was signed. In 1992the Banca d’Italia was granted exclusive power to set interest rates without approvalfrom the Treasury. In 1993 the Treasury’s overdraft facility at the Banca d’Italiawas transformed into an interest-bearing deposit that must always be in credit. Thesechanges almost completed the formal independence of the Bank, though it shouldbe 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, whichneeded formal approval by the Treasury minister, had never been refused by thelatter. Nor had the Treasury minister had ever changed the discount rate without aproposal from the Bank (interview, Rome, March 2002). The Treasury’s overdraftaccount at the Bank had not been used since the late 1980s.

Legally, such changes were needed to comply with the EMU provisionscontained in the TEU, hence they were triggered by the legal adaptational pressureexerted by EMU. However, the institutional changes introduced in 1992–3 were also attempts to increase the credibility of the domestic macroeconomic policyframework, especially after the failure of the ERM policy in 1992, just as the Britishauthorities’ policy had failed.

In approaching the final stage of EMU, the Banca d’Italia had to undergo furtherformal institutional changes in order to comply with the EMU institutional andpolicy templates. These stipulated that the members of the Board of Directors (theConsiglio Superiore, discussed below) were to be appointed for five years, ratherthan three, as had previously been the case; that in the case of a breach of the lawthe Treasury minister’s power to suspend or abrogate the deliberations of the Boardof Directors falling within the competence of the ESCB was abolished; and that the

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Treasury minister’s approval of deliberations on the investment of reserves wasabrogated.2

A third reform took place in 2005, in the wake of a scandal that involved theGovernor of the Banca d’Italia, Antonio Fazio. The Law on Savings, which had beenin the making since 2002 and was eventually adopted in December 2005, introducedthree important amendments to the legislation governing the central bank. Althoughthese changes constituted an overdue institutional adaptation to EMU membershipand to deeper European financial integration, fostered by the introduction of thesingle currency (1999) and by the Commission’s FSAP (1999), they were triggeredby the policy failure of the ‘Fazio affair’, which is discussed below.

The first change introduced by the Law on Savings concerned the ownershipstructure of the central bank, whereby only the state and public bodies were nowallowed to hold shares in the bank’s capital. Before 2005, as a consequence of theprocess 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 changeconcerned its governance structure, to be precise, the decision-making process,which was rendered more pluralistic in that all central bank decisions with externalimplications – 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 Governoralone, as had been the case in the past. Moreover, the Bank now had to providewritten justifications for the decisions taken, especially in the supervisory field, andminutes 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 theExecutive Board, which give the government a greater say in the process.

The reform basically leaves untouched the extensive supervisory powers of thecentral bank, although the tasks concerning banking competition policy are trans-ferred to the Competition Authority, established by law in 1990 and separate fromthe central bank, as explained in the second part of this chapter. Whereas the Bancad’Italia would conduct its evaluation of mergers and acquisitions by taking intoaccount ‘sound and prudent management issues’, the Competition Authority wouldbase its assessment on the impact on competition of mergers and acquisitions (Law262, December 2005; my translation).

It should also be noted that during drafting of the Law on Savings, whichamended central banking legislation, the Italian Government requested the ECB’slegal 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 ECBsuggested the introduction of the principle of collegiality for the Executive Board’sdecision-making on measures related to non-ESCB tasks and the introduction of afixed-term mandate, renewable once, for all members of the Executive Board. Thissuggestion was eventually incorporated into the relevant legislation in December2005. The ECB also repeatedly highlighted the need to ensure that the plannedtransfer of the Banca d’Italia’s share capital to the state was compatible with theprovisions of the TEU on the avoidance of monetary financing and the need forsound fiscal policy.

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Interestingly, in September 2005 the Italian Government was keen to enlist thesupport 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 dismissthe Governor, who was at the centre of a major controversy after being accused ofpreventing foreign takeovers, an unsuccessful attempt was made by the governmentto enlist the direct intervention of the ECB on this matter, with a view to alteringthe domestic political opportunity structure. The ECB, however, refrained fromintervening, on the ground that it was not part of its remit.

The rather paradoxical situation in which the Italian Government found itself in2005 is an interesting example of an institutional lock-in caused by a combinationof national and EU legislation. According to EU legislation, national governmentscan dismiss national central bank governors only if they are found guilty of seriousmisconduct. Moreover, governors are entitled to appeal to the European Court ofJustice. According to Italian law before the 2005 reform, a governor’s appointmentdid not have a time or age limit, and the incumbent could only be dismissed via acumbersome joint decision-making procedure on the basis of a proposal from theBoard of Directors, a body embedded in the Bank, as explained below. The strongguarantees provided by EU legislation against the unfair dismissal of nationalcentral bank governors assume a fixed-term mandate for the governors, as is the casein all other EU countries (apart from Denmark, which does, however, have an agelimit), at the end of which the government has the power to renew the mandate ornot, as the case may be. A fixed-term mandate did not apply to Italy before the 2005reform, hence the institutional deadlock.

It is telling that when the Treasury minister, Domenico Siniscalco, resigned inSeptember 2005 following a serious disagreement with the Governor of the Bancad’Italia, he wrote a letter to the President of the ECB, Jean-Claude Trichet, raisingthe issue of ‘independence of government from central banks’ (Financial Times,22 September 2005). The previous Treasury minister, Giulio Tremonti, had resignedin 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 externalpressure, mainly exerted through financial markets, and faltering support fromwithin the Bank.

The legal framework of the Banca d’Italia

Until the changes introduced in the early 1990s, in economists’ rankings the Bancad’Italia used to be awarded fairly high scores for political independence (especiallyfor personnel independence, more than decisional independence), but scored ratherlow on economic independence. The main legal provisions that underpin centralbank personnel independence are the procedures for the appointment of the board,the length of tenure in office, and the incompatibility between political roles andpositions within the bank. The procedures for the appointment of the Governor and the other members of the Directorate are discussed below, arguing that, before

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2005, the legislation very much limited the direct influence of the politicalauthorities in the appointment process. Furthermore, the practice of internalappointments to senior and top positions in the Bank has generally prevailed, and therefore the governor is generally chosen from among deputy governors, anddeputy governors are normally chosen from among senior officials at the Bank. Onthe one hand, this tended to strengthen the autonomy of the central bank. On theother 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 fromthe process of appointment. For example, in 1980 an outsider, Lamberto Dini, wasappointed as Director-General, reportedly receiving the support of sectors of theChristian Democratic Party. In 1993 the junior Deputy Director, Antonio Fazio,reportedly supported by Catholic forces, was promoted to Governor, instead of theincumbent Director-General, Dini, who was not supported by the outgoingGovernor or the senior Deputy Director-General, Tommaso Padoa Schioppa, wholacked 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 thisoffice 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 Treasuryfrom 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, whenthe overdraft account of the Treasury at the central bank was closed down, asdiscussed above. Moreover, until 1992, it was the Treasury Minister who announcedany change in interest rates, after discussion with the central bank. However,evidence gathered through interviews suggests that in practice it was always thegovernor proposing the change, which was never refused by the minister. Thefinancial independence in terms of economic resources available to the central bankis remarkable.4

Model of legitimacy of the Banca d’Italia

Until the 2000s the legitimacy of the Banca d’Italia had hardly ever been questionedin 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, theBanca d’Italia was not legally independent of the government, and this arrangementprovided 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 accepteddomestically because the Banca d’Italia, like the Bundesbank, could rely on output-oriented legitimacy, namely, widespread public acceptance of its activities and thepolicy output it delivered.

Public opinion surveys indicated that the Banca d’Italia was among the mostrespected and trusted institutions in Italy (as revealed by Eurobarometer data). In

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turn, the Bank deliberately tried to foster its image as a high-calibre and efficientcivil service and an apolitical institution involved in public policy, especially in the1980s and early 1990s, when the Bank’s legal independence was still fragile, asdiscussed below. When the legal independence of the Banca d’Italia was increasedin 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 inparliamentary hearings when invited to do so. The Banca d’Italia (to be precise, theGovernor) also presents an annual report on the activities of the Bank and the overallmacroeconomic situation in which the central bank has operated. However, such areport is not presented to either the government or Parliament. Instead, it is presentedto the assembly of quota-holders, which has basically no formal power over theBank and, unlike Parliament and the government, cannot change legislation relatingto the central bank. This reporting procedure is quite similar to the arrangements inplace for the ECB: it presents its report to the European Parliament, which does nothave the power to change the legislation governing the ECB. The Banca d’Italiaused to produce annual reports of its supervisory activity, but since 2005 they arepublished 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 andhierarchical central banks in Europe – Guarino (1988) refers to it as a monocraticinstitution.5 The Governor legally represents the Bank and is its signatory; he/shechairs the General Assembly and the meetings of the Board of Directors, reads theFinal 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 parliamentaryhearings, 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 thatall responsibilities in the field of monetary, exchange-rate and supervisory policieswere concentrated in his hands – there were no formal mechanisms for collegialdecision-making procedures. In practice, the main decisions were often taken after consultation with the other members of the Executive Board (though this wasnot so much the case during the Fazio governorship), and senior officials from the research department and other operational departments frequently attendedmeetings, depending on the subject under discussion (interviews, Rome, September2001). The decision-making process was made more pluralistic in 2005, so thatdecisions with external implications for the Bank are no longer to be taken by theGovernor alone, but are instead taken by the five members of the Executive Board,

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through a formal voting procedure. This procedure does not apply to decisionsconcerning the activities of the ESCB (Eurosystem), where the Governor votes inhis/her personal capacity, as is the case at the Bundesbank.

The Executive Board (Direttorio) consists of the Governor, the Director-Generaland three Deputy Directors-General.6 This body was established during thegovernorship of Guido Carli in the 1960s, even though power continued to beconcentrated in the hands of the Governor (Guarino 1988) until the 2005 reform.Before 2005 the nominations of all four members of the Executive Board, hencealso the Governor, were proposed by the Board of Directors and had to be approvedby a decree of the President of the Republic, acting on a proposal of the primeminister together with the Treasury minister, after discussion in the Council ofMinisters (Article 19 of the Bank Statute). The 2005 reform increased the govern-ment’s influence in appointment procedures, in that the members of the ExecutiveBoard are appointed by presidential decree, acting on a proposal of the primeminister, followed by a deliberation of the Council of Ministers, having consultedthe Board of Directors. In other words, after the 2005 reform the Board is onlyconsulted – 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 wasexceptional among central banks. In practice, since the Second World War thelongest period for governors to have remained in office was for a decade or so, andlikewise for the members of the Executive Board. The same body that proposedappointment of members of the Executive Board, the Consiglio Superiore, couldrepeal their appointment through a joint decision-making procedure involving thegovernment and the President of the Republic (Finocchiaro and Contessa 2002).Since 2005 each member of the Executive Board has a six-year mandate, which canbe renewed only once and can be repealed by the government after consultation withthe Consiglio.

The Consiglio Superiore (Board of Directors) is composed of 13 members andis 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 themeetings. One delegate from the Treasury can take part in these meetings, withoutvoting rights. The members of the Consiglio are elected by the holders of the Bank’scapital quotas and are appointed for five-year terms, which are renewable. They areelected by a secret vote in a process apparently immune from interference by thegovernment of the day, generally following proposals put forward by the Bankitself (interviews, Rome March 2002). Guarino (1988) describes the Consiglio asa body deeply integrated into the Bank’s tradition, jealous of the autonomy enjoyedby the institution and supporting the general guidelines of the Governor. Thisbecame quite apparent in 2005, when the Consiglio was very reluctant to withdrawits support from the Governor, who was at the centre of a scandal, as explainedfurther below. The Consiglio and the Committee of the Consiglio (a smaller sub-set) are in charge of the general administration of the Bank.

The General Assembly of the shareholders (Assemblea Generale) meets everyyear on the last working day of May. The shareholders of the capital of the central

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bank, namely banks and other financial institutions, take part. The Director-Generalof the Treasury attends the meeting, but no members of the government – this is tosignal the independence of the Bank from the political powers. The main task ofthe Assembly is to approve the annual budget of the Banca d’Italia, given that it hasbudgetary and organizational autonomy. De facto, such approval is a formality.

The adaptation of the governance structure and the internal organization of thecentral bank to membership of the Eurosystem has so far been very limited. Withinthe Economic Research Department, four of the five existing sectors have beengiven competences also for the analysis of eurozone data, and additional structures,such as the Monetary Policy Co-ordination Committee and the Euro Policy LiaisonOffice have been created, with co-ordination tasks on issues relating to the euroarea 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 anaccompanying person, generally from the Economic Research Department, for themeeting 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’sadvanced macroeconomic knowledge and its reputation as a ‘sound’ and trustedinstitution also play an important role in fostering central bank autonomy, as wellas strengthening its policy capacity.

The Banca d’Italia has extensive economic expertise, and before the upgradingof the Treasury’s capabilities in the 1990s it had a near monopoly of macroeconomicknowledge in Italy (Quaglia 2005b). The number of research staff is the highestamong 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 thelargest research department in Europe throughout the period considered in the study(1990–2003), even though the Bank considerably expanded its research staff in theperiod 1996–2003. This was a deliberate strategy to strengthen the Bank’s influencewithin the Eurosystem and in ECB decision-making. A study of the quantity, qualityand relevance of research in 36 central banks in developed countries since 1990indicates that the number of journal articles published by members of the Bancad’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 non-American 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 verywilling to use it to its best advantage – it was able to do so because of the specificconfiguration of domestic institutions, as elaborated below. For example, the Banca d’Italia devoted much of its energies and its best minds to the introductionof market reforms mentioned at the beginning of this chapter and, though ‘thepolitical significance of these technical improvements was not understood’ (Carli1993: 391), they secured more independence from the fiscal authorities. Another

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example is the exchange-rate policy conducted by the central bank in the 1980s, asdetailed below.

The Research Department of the Banca d’Italia has been the research centre parexcellence in the economic field in Italy, as well as a school of high finance and abreeding ground for talented civil servants.7 The vast majority of top positionswithin the Bank are held by officials who have come from the Servizio Studi, andindeed, 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 intasks related to banking supervision or, before the 2005 reform, banking competitionpolicy. There have been no substantial cuts in staff numbers in preparation for orafter EMU membership, and indeed a recurrent criticism is that having lost the taskof conducting monetary and exchange-rate policies at the national level, the Bancad’Italia is overstaffed and is refusing to adapt its structure to its diminished policycompetences. However, this status quo is bound to change with the appointment ofthe new governor, Mario Draghi, and there are plans in place for a reduction inpersonnel 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 traditionallyportrayed as a ‘weak’ state (Ranci 1987), with a porous structure and a dispersedand poorly co-ordinated set of institutions, punctuated by personalism, fragmen-tation and a Byzantine bureaucracy (Ferrera and Gualimini 1999). The executivehad limited powers vis-à-vis the legislature, and the prime minister’s position withinthe executive was also relatively weak compared with the UK and France, forexample. 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 shakyelectoral basis of prime ministers and their short stay in office, and the provisionsof the Italian constitution, which, after the dramatic experience of Fascism, set inplace a system of ‘checks and balances’ (Regonini 1993) that tended to favour thelegislature at the expense of the executive.

Until 1994 the electoral system of almost perfect proportionality resulted in alarge number of small political parties being represented in parliament and formingpart of the government majority (Regonini 1993), increasing the instability of eachadministration, which had to mediate the policy preferences of up to five politicalparties. Most of the time a consociational policy style prevailed in public policy,whereby the main opposition party directly participated in policy-making andsupported the choices made by the government majority.

The formal and substantial powers of the prime minister and the executive inmacroeconomic policy-making were quite limited and rested mainly on the primeminister’s function as the arbiter between domestic forces (Hine 1993). The complexinstitutional structure also meant that a multitude of economic ministries were

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involved in macroeconomic policy-making in various ways – a typical example of Italian ‘fragmentation’ (Quaglia and Maes 2004). For example, three mainministries dealt with macroeconomic policies, namely the Treasury, the Ministryof the Budget and Economic Planning, and the Ministry of Finance. Of these, theTreasury 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 ofinstitutional changes, which, paraphrasing Vincent Della Sala (1997), strengthenedand hollowed out the Italian state, accompanied by a complete transformation ofthe party system, whereby old parties disappeared and a large number of the oldparty elite was dismissed, while new political parties with new political elitesemerged, such as the Northern League and Forza Italy. After the 1993 referendumthe electoral system became (quasi-)majoritarian, still with 25 per cent of propor-tional representation, and the party system was reshaped into a bipolar format withtwo main coalitions, namely centre-left and centre-right.8 As a result of thesedomestic factors, coupled by significant external events (first and foremost EMU),the role of the executive in macroeconomic policies, especially fiscal policy, wasstrengthened, and budgetary powers were in effect shifted from the parliament tothe ‘core’ executive. After 1996 government stability gradually increased, and thebalance of power alternated between centre-left and centre-right coalition.

As part of a wider set of institutional reforms, some significant changes aimed atimproving the macroeconomic policy framework were introduced in the 1990s,with a view to securing EMU membership by fulfilling the convergence criteria. Thethree economic ministries were merged and reorganized, and the Treasuryunderwent a major restructuring, whereby internationally recognized academiceconomists and professionals with advanced training were appointed at senior level,salary scales were increased, and interaction with academia was promoted (Quaglia2005b). It is noteworthy that at the level of senior officials and ministers there hasbeen a small but significant flow from the Banca d’Italia to the Treasury. Theupgrading of the Treasury, and the pressure exerted by the EMU process, augmentedthe prominence of the Treasury in macroeconomic policy-making, and also itsposition vis-à-vis the Banca d’Italia.

It would, however, be incorrect to portray Italy as a ‘strong state’ after the reformsof the 1990s. Indeed, once the pressure to secure EMU membership came to anend, the fragmentation of the state structure and the weakness of political institutionsresurfaced, as evidenced by the length of time it took for the domestic debate onreform of the Banca d’Italia to come to a conclusion – from the late 1990s untilDecember 2005. The fact that it took so long to introduce overdue changes, despitethe fact that Italy’s macroeconomic credibility was being jeopardized by politicalinaction, is clear evidence of this.

Overall, weak and fragmented political institutions in Italy strengthened theautonomy of the central bank and its policy capacity, even in the period prior to1992–3, when new legal provisions gave the Bank greater legal independence.Moreover, the Bank was frequently forced to perform ‘atypical’ functions, whichshould have been carried out by other parts of the state apparatus, but which the

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weak state, stalled by partitocracy, was unable to perform. The reform of politicalinstitutions that took place in the 1990s ‘normalized’ several functions performedby 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 Bancad’Italia were characterized by the need to reconcile their different objectives inmacroeconomic policy, and by the Bank’s attempts to preserve its autonomy, toenhance its policy capacity and often to act as a ‘technical’ counter-power. Whereasthe Bank advocated sound (stability-oriented) macroeconomic policies, the govern-ment favoured expansionary policies, especially in the fiscal field. In economists’jargon, relations between the government and the Banca d’Italia in this periodresembled what is called the ‘Stackelberg game’ – the core issue at the basis of thegame being whether it is the monetary authorities or the fiscal (political) authoritieswho act as ‘leaders’ in setting macroeconomic policy – which is discussed in thesection on monetary policy. However, throughout this period there were somecommon goals shared by the central bank and the government, first and foremostsupport for European monetary integration. The situation changed in 1992, whenItaly undertook a major fiscal adjustment to meet the convergence criteria to joinEMU. Under the centre-left government (1996–2001) this became a politicalpriority, 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 thefirst wave.

As in the case of the Bank of England, relations between the Governor, the primeminister and the Treasury minister (post-1998 the title changed to minister for theeconomy) depended on the personalities involved and their approaches to economicpolicies, the main difference being that in Italy the prime minister and the Treasuryminister were much less powerful than in the UK, especially before the politicalreforms of the 1990s. On the whole, working relations between the Banca d’Italiaand the Treasury have been good, with top civil servants and ministers often drawnfrom the Bank or having been advisers there. For example, in the late 1980 andearly 1990s the central bank and the Treasury worked together to promote theprocess of internal and external liberalization of the financial market in Italy, and in the late 1990s and 2000s they collaborated in updating financial servicesregulation (interviews, Rome March 2002; September 2001). Before the 1990srelations between the central bank and the Treasury were often dominated by theBank, 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’Italiaand the Treasury. The most salient and recent examples occurred in 2002–5 inconnection with the bankruptcies of Cirio and Parmalat, and the controversialtakeovers of BNL and Antonveneta, all of which triggered a series of reformproposals regarding the framework for financial supervision in Italy. The personalityclash between the Treasury minister, Giulio Tremonti, and Governor Antonio Fazio

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also played a role, though tensions remained after Domenico Siniscalco, formerlyDirector-General of the Treasury, took over from Tremonti in 2004. It should benoted that following the disagreements between the Governor and the Treasuryministers 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, togetherwith the weakness of successive coalition governments, plus the fact that politicalinterests have fragmented voices in the Italian system, has increased the Bancad’Italia’s autonomy and influence in the policies in which it was involved (Quaglia2005a).

Second, there was an inclination on the part of government, and politicians more generally, to let the Bank make difficult decisions, supposedly on technicalrather than political grounds. This was part of a larger picture, where the tacitacknowledgement of the absence of strong political institutions fostered policy-making by technocrats, several of whom moved to important political positions inthe 1990s. The events that took place in 2005 suggest that the process of technocraticprimacy (and the central bank’s autonomy) might have gone too far.

Third, since the Bank had a near monopoly of expertise in Italy, the widerimplications 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 accessto technical knowledge. Unlike the British Treasury, which is an intellectuallyrobust institution, the Italian Treasury until the late 1980s had a limited pool ofexpertise to draw on. Moreover, many of the experts consulted by the Treasurywere either seconded from the central bank or had worked there, or happened toshare the Bank’s views on several macroeconomic matters. This power relationchanged when the Treasury updated its capabilities in the 1990s, and it is quiterevealing that in 2005 Mario Draghi, a former Director-General of the Treasury, wasappointed to succeed Governor Fazio.

Economic institutions in Italy

Unlike in Germany or the UK, it is difficult to pigeonhole the Italian model ofcapitalism, for it is neither a liberal model nor a corporatist one. Some authors arguethat, to some extent, the Italian variety of capitalism resembled the ‘statist’ Frenchmodel, the main difference being that the public authorities are less efficient in Italythan 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 theItalian 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 andinefficient, as was the welfare state. Protective labour market legislation benefitedthose who were already employed, reducing flexibility in the labour market. Thestate took part in labour negotiations, although tripartite agreements in incomes

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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 therewas an attempt to make the labour market less rigid by introducing a more flexiblewage structure and contracts.

In terms of corporate governance, before the 1990s many companies, even largeones, tended to be family-owned and family-managed, often through interlockingownership managed by the powerful merchant bank, Mediobanca (Della Sala2004).9 This was a family type of capitalism created by an underdeveloped capitalmarket and outdated legislation that discouraged shareholder involvement. Incontrast to Germany, before the revision of Italy’s banking legislation in 1993 therewas a complete separation between banks and industry in terms of ownership andshareholding (Deeg 2005).

Until the 1990s the Italian financial system was mainly ‘bank-oriented’, in thatit was characterized by an extensive activity of financial intermediation performedby banks (Ciocca 2005: 4). Thus it resembled Germany, rather than the British‘market-oriented’ system, where securities markets were already well developed inthe 1980s. Before the reform of the 1990s the Italian banking sector was largelystate-owned and characterized by two anomalies. The first anomaly was the divisionbetween public long-term credit institutions (istituti di credito speciale) and short-term credit institutions (istituti di credito ordinario), with few private banks andmany public savings banks and co-operative banks. Each of these categories wasin turn divided into several segments, on top of which there were geographicalboundaries that restricted their activity. The second anomaly in the Italian bankingsystem was the low degree of competition as a result of internal and externalprotectionism (Monti 1998).

The extensive public sector was partly dismantled in the 1990s in both theindustrial and the banking sector. With the revision of banking, finance andcorporate legislation in Italy in the 1990s, the financial system became more market-oriented, even though it remained bank-centred in a different way, in that the declinein the use of traditional bank instruments did not coincide with a reduction in therole of the banks, which engaged extensively in securities trading and wereimportant market shareholders (Ciocca 2005: 9). Segmentation in the banking sectorcame to an end – the formal change took place with the transposition in 1992 of theSecond Banking Directive issued in 1988, which introduced the all-purposeuniversal bank in Italy – and the banking system was privatized, modernized andconsolidated. Between 1995 and 2005 the number of banks in Italy dropped from970 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, runapproximately 40 per cent of the banking network and have a market share of about45 per cent in loans (Financial Times, 4 December 2004). As of 2005, there are nobig public banks in Italy.

However, Italy’s generous state pension system means that pension funds as wellas financial conglomerates are underdeveloped compared with Germany and theUK, for example. As discussed in the previous chapters, these were importantfactors that triggered the reform of the framework for financial supervision in these

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countries, leading to the creation of single regulatory authorities. Yet, externalpressure for change mounted in Italy in the 2000s, when an increasing number offoreign financial companies, with the backing of the European Commission (whichwas keen to promote further financial market integration in Europe), tried topenetrate the national banking sector, straining the existing institutional and policyframework in the field of banking supervision and competition policy, as discussedbelow.

Interactions between the Banca d’Italia and economic interest groups

In Italy the system of representation by economic interest groups, which has oftenbeen characterized as ‘bargained pluralism’ (Hine 1993), is much more fragmentedthan 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 oftendifferent ‘views’ inside the various associations and that they do not always ‘speakwith one voice’, partly because they have a low degree of centralization and areloosely organized. Firms have a greater chance of getting a sympathetic hearingfrom 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 (inter-view, Rome, September 2001). The Italian banking association, the AssociazioneBancaria Italiana (ABI), represents all financial and banking operators andintermediaries, 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 ofprivatizations in the 1990s significant segments of the Italian banking sector werepublic, and the Banca d’Italia had a say in the appointment of the boards of thesefirms. It was common practice for the central bank to propose a list of names ofpotential managers, with the government deciding on the appointment of the seniormanagement of public banks (interview, Rome, March 2002). Moreover, the Bankhas extensive power of prudential supervision and had the task of monitoringcompetition in the banking sector. On the other hand, before the 2005 reform themembers of the Executive Board were proposed to the government by a Consigliomainly representing banks and credit agencies that held Banca d’Italia stock.However, each member of the Consiglio is chosen by the Bank itself from threecandidates proposed according to the regional representation of the Bank, thesistema delle terne – approximately one in each region (interview, Rome, March2002).

Until the 1990s the banking system was relatively responsive to the Banca d’Italia– the so-called ‘moral suasion’ of the Bank (cf. the Bank of England). Somecommentators argue that once the banking system had been privatized and severalprivate banks had become owners of capital shares of the Banca d’Italia, the centralbank became more responsive to the priorities of Italian banks, at least onsupervisory and competition matters (interview, Rome, September 2005), anargument often echoed by the Anglo-Saxon press (e.g. the Financial Times, TheEconomist). Thus, the argument goes, when the internationalization of banking

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gained momentum in the EU in the 1990s, the Banca d’Italia tried to protect theItalian banking system from foreign competition by preventing foreign takeoversof Italian banks, as discussed in the following section.

Interaction with the manufacturing sector, mainly through Confindustria, whichrepresents employers from the manufacturing and services sectors, related to theconduct of monetary and exchange-rate policy, namely, the level of interest ratesand the level of the exchange rate. In the 1980s the tight monetary policy stance andthe ‘hard’ exchange-rate policy implemented by the central bank were the maintopic of debate between the Bank and industrial enterprises, though they refrainedfrom openly criticizing the Bank and its policies.

Similarly, the three main trade unions, which tend to be close to political parties,have seldom been openly critical of the central bank. In the 1980s the Bankfrequently called for an anti-inflationary incomes policy, also engaging in asignalling game ‘Italian style’ with entrepreneurs and workers (Quaglia 2004a).The clearest example was the Banca d’Italia’s refusal in 1980 to grant devaluationthrough a parity realignment within the ERM, as called for by the car manufacturerFiat (at the time one of the main Italian enterprises) to compensate for high domesticinflation and salary increases demanded by the trade unions.

The largely positive attitude of economic interest groups, especially the tradeunions, towards the Banca d’Italia is rather striking when compared to the rathermore hostile attitude of the trade unions and the manufacturing sector in the UK,for example. This can be attributed to the fact that for most of the postwar periodthe Bank was regarded as the real steering authority of the Italian economy,especially in the period leading up to the 1990s, when domestic political institutionswere particularly weak.

International institutions and domestic repercussions in Italy

International institutions can reinforce or weaken the autonomy of central banks vis-à-vis the government (Goodman 1992), as well as central bank policy capacityin various fields. Of course, this depends on how national institutions frame externalpressure as well as the intangible assets of the central bank. Some authors regardcentral bank independence and exchange-rate regimes as alternative forms ofdelegating the conduct of monetary policy (Bernhard 2002), in that peggedexchange-rate regimes constrain the room for manoeuvre of the central bank of thecountry pegging its exchange rate, especially when the safeguard of capital controlsis eliminated.

There is a considerable literature in economics on the role of the EMS in tying thehands of national authorities, which in return would be able to borrow ‘credibility’from the country leader of the system, namely Germany, with the positive effect ofreducing interest rates in the followers’ countries in the medium term (Giavazziand Pagano 1988). At the same time the EMS strengthened the positions of domesticinstitutions engaged in the fight against inflation – first and foremost the centralbanks – which skilfully deployed it as an ‘external constraint’ in the national arenawith a view to changing the domestic political opportunity structure.

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An important point is that the Banca d’Italia used an ‘exchange-rate rule’ ratherthan a ‘monetary rule’ (i.e. establishing monetary aggregates), because during aphase when the institutional framework concerning the central bank was still beingdefined and central bank autonomy was incomplete, a monetary rule could havegenerated undue political pressure on the Bank, slowing down institutionalevolution towards autonomy (Sarcinelli 1995). In contrast, the goal of a stablecurrency acquired a sort of symbolic value and was shared by a wide range of political and social forces, which viewed it as a necessary prerequisite toparticipation in the process of European integration, which enjoyed widespreadpublic endorsement in Italy (Quaglia 2004a).

It should be noted that to a limited extent the EMS, and to a greater extent EMU,set specific institutional and policy templates to be adopted by the participatingcountries, hence exerting adaptational pressure at the domestic level. Indeed, severalreforms of the central banking framework in Italy were the result of the working ofthe EMS or the establishment of EMU. European exchange-rate agreement alsopromoted the ideational diffusion of the stability-oriented paradigm ‘exported’ fromGermany to other European countries (Dyson 1994, McNamara 1998).

International regimes of banking supervision, in particular the activity of theBasel Committee, have affected banking supervision policy in Italy. As argued inprevious chapters, the Basel Committee produces gentlemen’s agreements, whichbecome legally binding when they are transposed into EU legislation, as was thecase for the Basel 1 and Basel 2 Accords. Hence, the adaptational pressure exertedby international supervisory forums on the national supervisory framework islimited. Furthermore, the agreements produced deliberately refrain from puttingforward specific institutional frameworks to be implemented domestically becausenational diversity is still too great. Unlike the Bundesbank and the Bank of England,the Banca d’Italia, given its extensive supervisory powers, is the sole representativefor Italy in the Basel Committee. In the negotiations of both Basel 1 and Basel 2,the Bank endeavoured to make sure that issues that were important for thecompetitiveness of the Italian banking system were taken into account in draftingthe agreement.

In the making of Basel 2, the Banca d’Italia had three strong policy preferences,two of which largely reflected the preferences of the financial sector and economicconditions in Italy. The first preoccupation of the Banca d’Italia – and of the Bundes-bank and the German Financial Supervisory Authority (BaFin) – was the effect that the new regulations would have on small and medium-sized enterprises, which constitute a significant part of the Italian and the German economy(interviews, Rome, July 2006; Frankfurt, January 2006). During the negotiationsGerman and Italian policy-makers co-operated on this matter – for example, byconducting joint studies – and achieved positive results because the final draft ofBasel 2 is regarded as providing favourable treatment for small and medium-sizedenterprises.

The second goal of the Italian, British and German authorities was to make thenew accord less pro-cyclical, in which they were successful, as becomes obviouswhen the first draft of the accord is compared with the draft eventually agreed on

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in 2004. The third policy preference concerned Italian policy-makers only andcentred on the definition of ‘credit default’. Since in Italy, unlike all other EUcountries, debits to banks are usually paid well after 90 days, the initial definitionof default in paragraph 452 of the Basel 2 Accord, which gave a limit of 90 daysbefore declaring default, was seen as strongly penalizing the Italian banking system(interview, Rome, July 2006). The representatives of the Banca d’Italia successfullynegotiated the insertion of a ‘special condition’, set to expire within five years, for‘one country’ (namely, Italy) in footnote 89 of the final agreement.

Central banking policies in Italy

Monetary policy capacity in Italy

Before the legal changes approved in the early 1990s, responsibility for monetarypolicy in Italy was formally shared between the Treasury and central bank (Articles20 and 25 of the Bank’s Statute). However, in practice, especially after the divorcein 1981 (see above), the Bank had a high degree of policy capacity on this matter.That said, such monetary policy capacity was de facto limited by the conduct offiscal policy. It should also be noted that before the changes introduced in order to comply with the TEU, the Bank was not assigned the statutory objective ofmaintaining price stability.

In the 1970s the prevailing policy paradigm at the Bank was in line with theKeynesian school, whereby the final objective of monetary policy in that period wasto develop the national income (Peluffo and Rey 1995), as well as to safeguard the profitability of business and hence the level of private investment, while thecountry was engaged in an export-oriented growth. As for policy instruments, somecumbersome administrative controls were put in place, and the unauthorized exportof capital became a penal offence (Rossi 1998).

From the mid-1970s onwards the objective of monetary stability became moreimportant, and the Banca d’Italia slowly gave up the policy of ‘monetarycompliance’ pursued in the previous decade. However, the change in the Bank’smodus operandi brought to the surface the conflict between monetary control andfinancing the public-sector borrowing requirement, which was only partly addressedby the divorce in 1981. Moreover, in order for the Bank to regain monetary control,a new attitude towards the financial system was also required – supervisory policy was tightened up, with a negative impact on the central bank, as explainedbelow.

In the 1980s the monetary policy paradigm at the Bank changed substantially,largely as a result of ideational diffusion, that is, imported stability-orientedeconomic ideas (see Quaglia 2005a). The main objective of monetary policy becamethe fight against inflation. Exchange-rate policy became a key component of theoverall strategy followed by the Banca d’Italia, whereby the quantity of money(M2) was the intermediate target and the exchange rate ‘a quasi final objective’(Sarcinelli 1995). Thus, monetary policy had an intermediate target-and-a-half,namely, the exchange rate and, in so far as was consistent with this, the money

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supply. The instruments were market-based, that is to say, open-market inter-ventions (Passacantando 1996), whereas administrative controls on banking creditwere lifted in 1983.

Throughout the 1980s the Banca d’Italia, following a worldwide trend started by Paul Volcker, Governor of the US Federal Reserve, tightened its monetary policyto fight inflation. However, in contrast to what happened in other countries, theBank did not have the co-operation of the fiscal authorities and the social partners;indeed, it had to run a tight monetary policy in an unco-ordinated, if not unco-operative game with fiscal and income polices (the so-called Stackelberg game).Arguably, the goal of the Bank was to influence both fiscal policy, by setting it ona ‘sustainable’ track (Bruni and Monti 1992), and incomes policy, by encouragingwage moderation and the abolition of the wage-indexation mechanism (Ciampi1990).

Over the 1980s nominal interest rates soared in Italy, and real interest rates turnedincreasingly positive, because national and international interest rates increasedsubstantially while domestic inflation decreased, despite the fact that an inflationrate differential remained vis-à-vis the less inflationary countries in Europe. Thetight monetary policy implemented by the Banca d’Italia was instrumental not only in squeezing inflation, but also in resisting pressure for lira realignments withinthe ERM. The other side of the coin was that the (relatively) ‘strong’ exchange-rate policy of the Italian monetary authorities resulted in an overvaluation of the lira, which had a negative effect on the international competitiveness of Italianproducers, and hence the current account of the balance of payments. Moreover, thehigh interest rates swelled the public debt and made private investment moreexpensive.

The policy failure of the lira’s exit from the ERM brought about a reorientationof the policy paradigm of the monetary policy of the Banca d’Italia, although thefinal objective, namely price stability, did not change. In his final remarks of 31 May1995 Governor Fazio made explicit reference to an inflation target, which was,however, not regarded as the intermediate objective (Rossi 1998). The floatingexchange rate – the lira did not re-enter the ERM until the end of 1996 – was nolonger considered either a formal or an informal target. Policy instruments mainlyrelied on market-based control, adopting a ‘European model’ (Sarcinelli 1995).

Approaching the final stage of EMU, inflation and interest rates in Italy convergedtowards the lowest level in the EU, fulfilling one of the convergence criteria forEMU membership. Since 1999 monetary policy in the eurozone has been conductedby the ECB. Overall, monetary policy is an area in which a high degree ofconvergence had been achieved even before EMU, in terms of both policyparadigms, as a consequence of ideational diffusion promoted by international andEU institutions, and domestic adaptation ensuing from Italy’s membership of theEMS. As for instruments, it should be noted that although monetary targets wereintroduced in Italy in the 1970s, they were hardly ever followed.

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Exchange-rate policy capacity in Italy

Before EMU, responsibility for exchange-rate policy was shared between the Bancad’Italia and the Treasury. The Bank was responsible for day-to-day managementof the exchange rate, whereas the government decided on the exchange-rate regime,and the Treasury, together with the Bank, was involved in parity realignment. Defacto, as regards monetary policy, the influence of the Bank on exchange-rate policywent well beyond what was prescribed by legal provisions for three reasons: theBank had the technical expertise in the field, which the government and the Treasurylacked; it had the credibility to interact effectively in international monetary forums;and it was used to dealing with the financial market.

The role of the exchange rate as an instrument of economic policy has been a topicof intense discussion among policy-makers in Italy, particularly within the centralbank. In the 1970s the Italian authorities responded to the oil shock by lettinginflation go up and allowing the exchange rate to depreciate (Giavazzi and Spaventa1989). In 1978, when the EMS was negotiated, senior policy-makers at the Bancad’Italia (as well as many Italian economists) were reluctant to join it, fearing thatItaly’s membership of the exchange-rate system would not be supported bysufficiently convergent national economic policies (Maes and Quaglia 2003). If so,the lira would have to leave the ERM, and this could constitute a threat to thecredibility of the Banca d’Italia. In the end the lira entered with a wider fluctuationband – 6 per cent instead of 2.25 per cent – which had been adamantly advocatedby the Bank and negotiated in central bank forums (Ludlow 1982).

Participation in the EMS, which was an exchange-rate regime based on anadjustable peg, produced a major shift in Italian exchange-rate policy and monetarystrategy, as a result of ideational diffusion of the stability-oriented paradigm anddomestic adaptation to the European exchange-rate agreement. This was furthersupported by changes in the domestic monetary policy framework, the so-calleddivorce, which strengthened the position of the Banca d’Italia. From the first halfof the 1980s onwards, realignments of the lira never fully compensated for inflationdifferentials between Italy and the low-inflation countries within the ERM (Bini-Smaghi and Vona 1988). Furthermore, from 1987 to 1992 no realignments tookplace, leading to an appreciation of the lira in real terms and reversing the exchange-rate policy of the 1970s (Rossi and Gaiotti 2004). The so-called ‘strong’ exchange-rate policy (or ‘hard currency’ option) implemented by the Bank consisted indeploying the exchange rate as an ‘external constraint’ in the domestic arena, whereit was used to fight inflation by disciplining the trade unions and promotingindustrial restructuring. It was also intended to force the political authorities toimplement a restrictive fiscal policy.

The policy failure of the withdrawal of the lira from the ERM in September 1992reversed the exchange-rate policy followed by the Italian authorities during the1980s. The floating lira became an important element of the Italian strategy after1992, fostering an export-led boom, which in turn sustained Italian economicgrowth in a phase of fiscal retrenchment and slow growth in the EU. Yet this choiceof letting the lira float was made for a variety of reasons, one being the lukewarm

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attitude of some countries, especially Germany, towards the lira’s re-entry into theERM. The lira re-entered the ERM in November 1996, this being essential to fulfilthe convergence criteria.

As far as the policy paradigm guiding exchange-rate policy is concerned – or tobe more precise, the use of the exchange rate as a policy instrument to achievedeterminate outcomes – two opposing views could be detected within the Bank. Oneline of thought was in favour of a ‘flexible’ exchange rate for the lira and was,therefore, wary of EMS and EMU membership. The ‘flexiblist’ view prevailed inthe 1970s and was advocated, for example, by Paolo Baffi, who was Governor of the Banca d’Italia when the EMS was set up (Baffi 1989, 1978). It was sharedby Governor Fazio with reference to EMU membership, which he did not support.The second line of thought advocated a rigid, at times even strong (i.e. overvalued)exchange rate and regarded EMU membership as a major achievement after thesetback of the ERM currency crisis in 1992.

These different lines of thought on the use of the exchange rate, and thus on implementing exchange-rate policy, tended to coincide with different views onEuropean monetary integration and, more generally, the usefulness of the ‘externalconstraints’. This was the prevailing approach during the governorship of Fazio. The ‘Europeanist’ view, which carried weight during the govenorship of Ciampi,saw ‘Europe’, or rather, European (monetary) integration, as the main solution todomestic problems (Quaglia 2004a).

Unlike in monetary policy, convergence concerning exchange-rate policy is moredifficult to assess, both in terms of policy paradigm and policy output. Withreference to the latter, those critical of EMU membership would argue that the lossof competitiveness that affected Italian goods and services and the deficit in thebalance of payments since the late 1990s suggest that, as far as real variables areconcerned, Italy was not ready for EMU. One official at the Banca d’Italia likenedItaly to a medium-weight boxer trying to fight a match with a heavyweight boxerwithout having undergone the proper training (interview, Rome, September 2003).

Financial supervision and banking competition policy capacity in Italy

The Banca d’Italia is responsible for the systemic stability of the financial sector,including all financial intermediaries; the prudential supervision of banks andsecurities market intermediaries; the oversight of relevant markets for monetarypolicy; and the oversight of the payments system. Until 2005 the Bank wasresponsible for safeguarding competition in the banking sector. The CommissioneNazionale per le Società e la Borsa (CONSOB) regulates the Italian securitiesmarket, ensuring transparency and correct behaviour by participants in the securities market and disclosure of information to the public by listed companies,including banks.

The central bank has inspective powers, which entitle it to conduct on-site andoff-site inspections, and regulatory powers, which entitle it to issue secondarylegislation under principles fixed by law (primary legislation). Traditionally, ampleroom is left for secondary legislation in this sector (Ciocca 2005: 43). The Banca

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d’Italia is also consulted in the drafting of primary legislation, and because of the expertise at its disposal, as well as its generally constructive relations with the Treasury at the level of senior officials, it has a remarkable input in shaping legislation. Two noticeable examples were the Consolidated Banking Law of 1993 and the Consolidated Finance Law of 1998 (interviews, Rome, June 2004).

Until 1993 banking supervision had been regulated by the 1936 Banking Law,which defined the powers of the banking supervisory authority, rather than theobjectives of supervision. It also established the principle of the separation betweenbanks and industry, and the separation between ordinary banks dealing with short-term credit and investment banks offering long-term loans. It should be noted thatthe central bank has played an important function in the evolution of the bankingsector, and more generally the financial sector in Italy, not only by shaping therelevant regulations, but also by implementing supervisory and competitionpolicies, as became evident in the 2000s. Before 2005, any acquisition of acontrolling stake in an Italian bank or control of more than 5 per cent of the sharesof any Italian bank was subject to authorization by the Banca d’Italia.

In the 1990s there was an overhaul of banking legislation in Italy. In 1990 theso-called Amato-Carli Law, named after the two Treasury ministers who workedon it (Law 218), established that banks were profit-making enterprises, which hadnot been the case before, as a vast part of the banking system had been state-owned.This reform opened the door to the injection of competition into the system and tothe privatization of the numerous public banks – small savings banks and largepublic banks – pursued throughout the 1990s, partly in response to the need to curbthe public debt.

In 1990 the Law on Competition Policy created the Competition Authority (theAutorità Garante della Concorrenza e del Mercato) – also referred to as the Anti-trust Authority – largely in response to the development of EU competition policy.The Banca d’Italia was given the responsibility for competition policy in thebanking sector, on the grounds that this was a ‘special’ sector, the stability of whichwas paramount for the economy. The law conferred on the Banca d’Italia specificinstruments to deal with banking concentration, abuse of dominant positions andcollusion. However, the Bank’s decisions were to be taken after it had consulted theCompetition Authority, and a memorandum of understanding was signed betweenthese two institutions in 1996.

In 1991 the Law on Financial Intermediaries was issued to regulate securitiestrading. In the supervisory field, it established the principle of supervision by objectives: the central bank was assigned responsibility for the stability of banks and investment firms, whereas the CONSOB, created in 1974, was assignedresponsibility for the transparency and disclosure of banks and financialintermediaries, with the aim of safeguarding investors.

The Consolidated Banking Law of 1993 brought Italian legislation into line withEU legislation (to be precise, the Second Banking Directive of 1989), by introducingtwo major innovations that aimed to establish universal banking in Italy. It allowedbanks to hold shares in industrial concerns and eliminated the distinction between

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banks and special credit institutions, thus allowing all banks to perform operationspreviously limited to specific types of intermediaries. The 1998 Consolidated Lawon Finance (also known as the Draghi Law) established the rules on corporategovernance and company takeovers; and, by facilitating the issuing and trading ofsecurities, it increased the protection of minority shareholders and the transparencyof corporate governance. The Banking Law of 1993 and the Financial Act of 1998aimed at improving the competitiveness of the Italian system – they were theequivalent of the ‘Big Bang’ in the UK in the 1980s (cf. Moran 1991), even thoughevents in Italy unfolded later and at a slower pace. These two laws outlined thegeneral objectives of supervision: stability; healthy and prudent management;efficiency; and competitiveness of the financial system.

It should be said that, at least until the 2000s, the Banca d’Italia had traditionallybeen regarded as an effective supervisor,11 as suggested by the absence of significantbanking crises in Italy in the postwar period. However, because of its high degreeof policy capacity in supervision and competition policies, this has also been an areain which the Bank has been subject to attempts by political and economic interestgroups to influence it. Unlike in monetary policy, which has the characteristics ofa common good, where costs and benefits are diffused, in financial supervisionthere are specific winners and losers. There have been several instances in whichthe Banca d’Italia has come under pressure in various ways.

The most dramatic episode took place in March 1979, when Mario Sarcinelli, theDeputy Director-General, was arrested following allegations of wrongdoing incarrying out his supervisory duties; Governor Baffi was also indicted, but was sparedprison because of his age (Financial Times, 6 February 1990). According to somenewspaper accounts (Financial Times, 26 and 27 March 1979), the supervisiondepartment of the Banca d’Italia had started to investigate and uncover the illegalactivities of some of the banks linked to Italian financiers with questionablereputation and with influential political connections. The case against Sarcinelliand Baffi was brought in an attempt to halt the investigation, and as a ‘backlash’against the officials in charge of it (Onado 1979). Although the senior officials atthe Bank were cleared of any charges and the allegations against them were provedto be groundless, the political attack weakened the position of the Bank in itssupervisory role (interviews, Rome, June 2002).

Except for the bankruptcy of Banco Ambrosiano in 1981, there were no majorfinancial scandals in Italy in the 1980s and 1990s. By contrast, the early 2000sproved to be a more turbulent period, with the insolvency of the Argentinean bonds,the financial collapse of Cirio in 2002 and Parmalat’s insolvency in 2003. Theseevents caused tension between the Banca d’Italia and the political authorities, andbetween the central bank and the CONSOB, which were both responsible fordifferent aspects of supervision. These policy failures triggered a heated debateabout the configuration and allocation of supervisory responsibilities and weakenedpublic confidence in the existing supervisory framework.

Several legislative proposals were discussed by the executive and by the legis-lature between 2002 and 2005. The proposal most fervently supported by theTreasury minister, Giulio Tremonti, envisaged the creation of an independent

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supervisory authority outside the central bank, similar to the British FSA, assigningcompetition policy in the banking system to the Competition Authority. If approved,this proposal would have deprived the central bank of its most important remainingfunctions, and for this reason the Bank fought hard against it. By deploying itsexpertise and institutional prestige, but also through intense lobbying activity andthe support of sympathetic politicians from a cross-section of political parties, theBank managed to safeguard its prerogatives in the supervisory field (interview,Rome, June 2004), even though it lost the responsibility for competition policy inthe banking sector.

In 2005 two episodes threatened the credibility and reputation of the central bank,weakening its ability to resist changes that were incorporated at the 11th hour in theLaw on Savings. At the centre of both episodes was the Bank’s ‘grand design’ forreshaping the banking system in Italy. The configuration of the financial system isof primary interest for central banks, and in turn such a system can be heavilyinfluenced by central banking policies, as discussed in the chapter on the Bank ofEngland. This is particularly true in Italy, because here the central bank hasextensive powers in this field, and because such powers in the end rest with theGovernor (Sole 24 Ore, 16 February 2002).

Governor Fazio consistently opposed foreign shareholdings and never authorizeda foreign takeover, in an attempt to prevent, or at least to slow down, foreignpenetration of the Italian market (Financial Times, 11 February 2005; 17 February2005; 31 March 2005). The Bank’s official explanation was that this strategy wasdesigned to give the domestic banking system time to adjust and to becomecompetitive internationally. There have also been allegations that, in authorizing (ordenying) domestic takeovers and mergers, Governor Fazio acted in a discretionarymanner, for example, by vetoing the takeover offer by San Paolo IMI for Banco diRoma (later Capitalia), and the merger between Unicredito and Banca Commercialein 1999, while supporting several bank acquisitions made by Banco di Roma, whichwas transformed in Capitalia (Financial Times, 20 February 2005; Repubblica,19 December 2005).

The cases that made headlines across Europe, because they involved foreignbanks, related to two proposed takeovers of Italian banks in 2004–5: one by aSpanish group, Banca Bilbao Vizcaya Argentaria, of Banca Nazionale del Lavoro,and the other by ABN Amro of Banca Antoniana Popolare Veneta (Antonveneta).In both cases Governor Fazio intervened to block the foreign takeover bid whileendorsing counterbids by two Italian banks, Banca Popolare di Lodi and Unipol,respectively. The foreign banks involved in the attempted takeovers complained tothe European Commission, which had given its authorization on the ground that thebids did not jeopardize competition in the banking sector. An anti-trust inquirylaunched by the competition commissioner, Neelie Kroes, was dropped for lack of conclusive evidence. The internal market commissioner, Charlie McCreevy, also expressed his concern in a letter to Governor Fazio in 2005 (Financial Times,18 February 2005).

The Antonveneta case was subsequently investigated by Italian magistrates, whobegan to gather evidence of wrongdoing (insider trading and abuse of office) by the

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Governor. It also emerged that the Governor and some close collaborators hadoverturned the negative opinion given by the supervisory department of the Bancad’Italia, which had refused to authorize Lodi’s acquisition of the Antonveneta share.This caused an institutional crisis within the central bank, which eventuallytriggered a reform of its governance structure.

The Banca Nazionale del Lavoro and Antonveneta episodes brought to the surfacetwo potential shortcomings of the existing policy framework in Italy. The first wasthe concentration of powers concerning banking supervision and competition policyin the hands of one person, the Governor, given the fact that the Bank, prior to the2005 reform, was a monocratic institution. Second, the concentration of supervisorypowers and banking competition policy in one institution – the central bank – raisedthe issue of trade-offs between different (and at times incompatible) objectives, aswell as the danger of capture of the regulator by the regulated (for some authoritativeopinions see Sole 24 Ore, 19 April 2001; 30 March 2002).

To understand the behaviour of the Banca d’Italia in these episodes, it is necessaryto explore the evolution of its policy paradigm on banking supervision andcompetition. Until the end of the 1980s the banking sector in Italy was under-developed, inefficient, inward-oriented and mostly publicly owned – it wasuncompetitive and protected from internal and external competition. The policyparadigm on banking supervision privileged the stability rather than the efficiencyor competitiveness of the sector.

In the late 1980s and 1990s the banking sector was gradually opened up as a resultof EU legislation as well as domestic reforms implemented by the Banca d’Italiain conjunction with the Treasury (see the Amato-Carli Law, the ConsolidatedBanking Law 1993 and the Consolidated Finance Law 1998). The system becamerelatively more ‘market-oriented’, opening up (de jure) the market to foreign banks,through the implementation of various banking directives. There was a shift of thepolicy paradigm from structural supervision, aimed at shaping the configuration ofthe banking system, to prudential supervision (Onado 2003: 180).

However, with the pace of financial interpenetration quickening in the 1990s, theapproach adopted by the Bank, or more precisely, the Governor, became moredirigiste, trying to modernize and reshape the banking system in Italy by orches-trating the domestic concentration of banking activities and by protecting it fromforeign penetration (Financial Times, 4 December 2004; interview, London,December 2005; interview, Frankfurt, January 2006). This ‘economic patriotism’was supported by the less competitive elements of the Italian financial sector andsome of the political class. Mario Draghi, who before his appointment as Governorin 2005 had occupied a very senior position in a private international bank inLondon, had already given clear signals in favour of a more outward-oriented,competition-friendly approach.

Despite the 2005 reform, the framework for financial services regulation andsupervision and competition policy in the banking sector in Italy remains ratherdistinctive. Convergence has been minimal owing to the absence of positive EUguidelines and the lack of a consensus on a specific policy paradigm, or best modelacross Europe. It should also be noted that the Banca d’Italia opposed any expansion

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of the ECB’s competence in the supervisory field (Sole 24 Ore, 16 February 2002),and by closing ranks with some other national central banks, it was successful indoing so.

Other functions and roles of the Banca d’Italia

The Banca d’Italia has performed a variety of services for the government, eventhough they have been reduced over time. The Bank used to act as banker to thegovernment, a function that came to an end in 1993 and was ruled out by the EMUprovisions in the TEU. Nowadays the government has a non-interest-bearing depositat the Bank, and the overdraft facility has been closed. The Bank used to managethe public debt, in conjunction with the Treasury, a function that was graduallyphased out after the divorce in 1981. In the 1990s this task became the competenceof the Treasury alone. The Bank manages the payments system, a task that is sharedwith other central banks in the Eurosystem. All banks based in Italy are obliged tokeep a non-interest-bearing deposit at the Bank, which acts as lender of last resort.

The Banca d’Italia has often acted as an adviser to the government on a varietyof matters. During the 1980s the Bank provided technical advice on economic policyand was very active on issues related to European monetary integration. However,while the Bank’s advice on certain matters, for example, EMU issues or financialregulation, was influential, in that it affected the conduct of policy, on other matters,such as fiscal policy or structural reform, the Bank’s advice had little effect, if any.

Over time the Bank has performed other functions that can be regarded as country-specific, that is to say, resulting from the configuration of the Italian socio-economicand political system. This meant that the Banca d’Italia acted outside the traditionalboundaries of a central bank, performing certain functions that should arguablyhave been carried out by other parts of the Italian state apparatus or civil society.

The Bank has been at the forefront of the development of Italy’s ‘economicculture’. Its Research Department has been the research centre par excellence in theeconomic field in Italy; the Bank has awarded scholarships for postgraduateeducation abroad (the Stringher, Mortara and Menichella awards); and the Bank’sAnnual Report and the interest it generates has no equal in other countries, whichmeans that it attracts attention no only for what it does, but also for what it ‘thinks’.

The Banca d’Italia has also been a breeding ground for talented civil servants andthe financial elite. It has exported credibility, expertise and personnel for the conductof Italian economic policy to other parts of the Italian state apparatus, the privatesector and international organizations. For example, two Italian prime ministers inthe 1990s had spent most of their career at the helm of the central bank as Governorand Deputy Governor. They also held the position of Treasury minister, foreignminister (Dini) and President of the Republic (Ciampi). In the same decade,continuing a well established pattern that started in the 1980s, several senior officialsfrom the central bank moved to senior positions at the Treasury, the Confindustriaand private banks. Interestingly, in Italy the Bank has been the exporting institution,whereas central banks in other countries more usually import senior officials(Quaglia 2005b).

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The Banca d’Italia has represented a credible interface with the outside world.Since the postwar period it has interacted with foreign institutions (i.e. othermonetary authorities and international organizations) and, more generally, has keptcontacts with the outside world. It has been one of the most outward-orientedinstitutions in Italy, a country where the state apparatus has traditionally been rather‘parochial’. Until the 1990s, whenever foreign delegations were sent to Rome togain an understanding of Italian macroeconomic policies, they would always paya visit to the central bank, even to discuss issues related to fiscal policy and structuralreforms (interviews, Brussels, March 2002).

Several of these atypical functions of the Banca d’Italia came to an end in the2000s, partly as a result of EMU, partly because of the relative strengthening of the state apparatus – indeed, one central banker described it as the ‘normalization’of central banking in Italy. Likewise, the central bank’s self-assigned role as‘protector’ of the Italian banking system ended with the resignation of GovernorFazio in 2005. Overall, there has been a convergence in the role performed bycentral banks, particularly their atypical functions, which have tended to disappear.In other words, greater legal independence and policy capacity in the monetaryfield have generally coincided with a normalization of the functions executed bycentral banks in other fields.

An overall assessment of central banking governance in Italy

The case study of the Banca d’Italia clearly suggests that considering merely legalindependence not only misses an important part of the story, but also ultimatelyprovides a misleading picture of central banking governance in Italy. In a letter tothe Financial Times (13 March 1992), Governor Ciampi argued that ‘a meaningfulappraisal of central bank independence requires a thorough evaluation of theinstitutional setting and of the bank’s modus operandi as developed over time andconsolidated in practice’.

The Banca d’Italia was remarkably more autonomous than many studies usingindices constructed on the basis of legal provisions reveal. What is even moresurprising it that it acquired and preserved a certain autonomy over time in a systemtypically colonized at all levels by the political parties (La Palombara 1987). Theinstitutional trajectory towards greater central bank independence was mainly aquest for greater economic independence.

A crucial specificity of the Italian mode of central banking governance seems tohave been the establishment of a particular kind of credibility – mainly relying onthe Bank’s tangible and intangible assets – that enabled it to extricate monetaryissues from the influence, or for that matter, the interference of the political class,even before full independence was granted in approaching EMU. Even in the very‘politicized’ Italian domestic arena, there was ‘the need to have a competent andsuper partes institution running the show’ (interview, Rome, September 2001).The Banca d’Italia, in turn, seemed to be committed to fostering this view, in so faras its power rested on its perceived legitimacy based on performing technical tasksin an apolitical manner, which would have been lost if it had gained a reputation

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for acting in a partisan manner (cf. Beck 1984). Before 2005 the issue of thelegitimacy and accountability of the Banca d’Italia had seldom, if ever, been raised.

In the period up to the early 1990s, the monetary and exchange-rate policycapacity of the Bank was constrained more by the conduct of fiscal policy than bylegal provisions concerning instrument independence, as explained above. Moregenerally, the Bank performed a crucial role in macroeconomic policy-making,given that Italy was often forced to steer its economy by means of monetary policyalone, because fiscal policy was paralysed by partitocracy. After joining EMU, theBanca d’Italia retained extensive policy capacity in banking supervision andcompetition policy, until 2005. The events of 2005 suggest that the Bank’s policycapacity in this field and its personnel independence might have gone too far, raisingthe question of quis custodiet ipsos custodes?

The factors that affected the autonomy and policy capacity of the central bankoperated at three levels – organizational, international and national – all of whichmust be taken into account to provide a meaningful explanation. External factors,which have been excluded by many indices of independence, and the way in whichthey have been used domestically are very important in the Italian case, where thestrategy of the so-called external constraint has often been used to alter the domesticpolitical opportunity structure. The Banca d’Italia has often been willing and ableto use external factors in the domestic environment to enhance central bankautonomy and policy capacity, by deploying its intangible assets. International andEU institutions have also affected the mode of central banking governance bypromoting the ideational diffusion of the stability-oriented paradigm.

The weakness and fragmentation of domestic political institutions de factoaugmented the autonomy and policy capacity of the central bank in the 1980s. It was a relatively ‘strong’ central bank in a ‘weak’ state. Despite the relativestrengthening of domestic institutions in the 1990s, the events of 2005 suggest thatthe fragmentation of the policy-making process and the presence of competingcentres of power remain a hindrance to effective policy-making in Italy. Thisconfiguration of the domestic political opportunity structure, coupled with the slowevolution of economic institutions in Italy, explain why institutional and policychange in areas concerning banking supervision and competition was delayed andlimited. It is also important to remember that, in the supervisory field, there are fewbinding institutional and policy templates exerting adaptational pressure on nationalsupervisory frameworks.

The establishment of EMU represented the main critical juncture for centralbanking governance in Italy. This was due not only to the adaptational pressure toadopt specific templates in the national central banking framework, but also to agenuine difficulty in defining a new role for the Banca d’Italia, partly becauseseveral special functions performed by it had been transferred to other parts of thestate apparatus, and partly because it had lost many of its traditional functions,which had been transferred to the ECB. Some high-calibre officials (often the mostoutward-oriented ones) left the Bank to take up senior positions in internationalorganizations, at the ECB, at the Treasury or in private banks. Among the nationalcentral bank governors, Fazio was one of those most determined to safeguard the

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competences of national central banks within the Eurosystem – or, to put it anotherway, to limit the competences and power of the ECB and its Executive Board inFrankfurt.

Conclusions

The Banca d’Italia often acted as a technical counter-power to the Italian Govern-ment’s economic policy, especially in the period leading up to the 1990s, when thegovernment and the central bank had different preferences and objectives ineconomic policy, even though they shared the same pro-European approach in foreign policy. Throughout the 1990s the preferences and policy objectives alsodiverged, albeit in a different way. Whereas the coalition governments in thatdecade, except for the short-lived Berlusconi government in 1994, were in favourof joining EMU from the beginning, the Governor and other senior officials weresceptical of Italian membership of the single currency, even though no formalstatement was ever made in this respect.

In approaching the final stage of EMU, the Banca d’Italia’s legal measures toconform to the institutional and policy conditions of EMU were limited, becauseimportant changes concerning central banking legislation had already been intro-duced in the early 1990s. In 1999 the major issue for the Banca d’Italia was thetransfer of policy competences (of ‘decision-making power’) to the ECB. It is truethat since the creation of the EMS in 1979 the Italian central bank had largelyfollowed the monetary policy conducted by the Bundesbank. However, some roomfor manoeuvre remained domestically, and at least nominally the Bank, togetherwith the Treasury, was in charge of monetary and exchange-rate policies in Italy.

In terms of contributions to the ESCB/ECB, it is worth mentioning that the Bancad’Italia played an important role in the establishment of the Trans-EuropeanAutomated Real-time Gross Settlement Express Transfer system, or TARGET,which was completed in 1999. TARGET was created by interconnecting 12 nationaleuro real-time gross settlement systems and the ECB payment mechanism, and isused for the settlement of central bank operations, large-value euro interbanktransfers, and other euro payments in real time. In October 2002 the GoverningCouncil of the ECB decided to establish TARGET 2 in preparation for enlargementof the Eurosystem, based on a single shared platform for those central banks thatdecided to join it and were willing to give up their own national real-time grosssettlements platform. The central banks of Italy, France and Germany, building ontheir expertise in payment systems, offered to provide the technical platform in2002, and the ECB Council accepted in 2004. Moreover, these central banks are alsoinvolved in devising TARGET 2 for securities.

Adaptation to membership of the ESCB has been relatively difficult for the Bancad’Italia, especially among the top-level management – this was the case withGovernor Fazio and some of his closer advisers. More generally, at the level of seniorofficials there seems to be the clear intention of safeguarding the role of the Bancad’Italia within the Eurosystem. In terms of employees and internal organizationalstructures, no major restructuring has taken place since joining EMU, although this

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could change after the appointment of Mario Draghi. Indeed, the Banca d’Italia hasundergone some overdue indirect adaptations to EMU in the most recent period –most noticeably the 2005 reform, followed by a discussion concerning internalrestructuring.

This delayed response can in part be ascribed to institutional features, such as the persistent weakness and fragmentation of the country’s domestic politicalinstitutions, the enduring strength of the central bank (which is still one of the mosttrusted institutions in Italy), and the constitutional central bank independenceembedded in the ‘ECB model’, with a distinctive Italian variation (governorappointed for life and largely through an internal process). Finally, the delayedadaptation of the central bank in Italy also depended on the attitudes of the Governor(oversimplifying it, his ‘Euroscepticism’), because the Governor, before the 2005reform, had unchecked power within the Bank and considerable influence in Italy.

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5 The European Central BankA new experiment in centralbanking

The European Central Bank (ECB) is an extraordinary experiment in centralbanking – it is a supranational central bank set up in 1998, building on theestablished co-operation among central banks in the EU. Such co-operation hadbeen institutionalized over time through the activities of the Committee of CentralBank Governors (CCBG) (Andrews 2003), which was set up in 1974 and becamethe European Monetary Institute (EMI) in 1994. The EMI was the forerunner of theECB.

In economists’ classifications (de Haan and van’t Hag 1995; Eijffinger and deHaan 1996) the ECB is ranked as the most independent central bank in the world,in terms of both economic and political independence. In contrast, the few studiesthat also engage in a formal (statute-based) evaluation of central bank accountability(de Haan 1997; de Haan et al. 1999; Bini-Smaghi 1998; Bini-Smaghi and Gros1999; 2001) rank the ECB very low, though not all of them. An in-depth analysisof the empirical record reveals that the ECB’s autonomy (or de facto independence)is amplified by the decentralized political system in which it operates. There havebeen no clear instances in which the ECB has bowed to political pressure inconducting its policies. As for accountability, in practice the Bank has often gonebeyond what is prescribed by the relevant EU legislation, in order to foster politicalsupport for its policies and to legitimize its institutional setting (Amtenbrink 2002),as explained in the following sections.

The policy capacity of the ECB varies across policy areas; it is greater inmonetary policy, whereas exchange-rate policy could potentially be subject topolitical influence. Since the euro has not taken part in international exchange-rateagreements, this has not been the case, though the issue remains sensitive. TheECB’s policy capacity is minimal in prudential supervision, despite the Bank’sattempt to expand its supervisory tasks. Financial services regulation and super-vision in the EU was modified by the introduction of the Lamfalussy framework in2004, which was negotiated with the ECB mainly fighting a rearguard battle. Thispolicy area has also been affected by the Basel 2 Accord signed in 2004, transposedinto the Capital Requirement Directive in 2005.

The multi-level institutional framework outlined in Chapter 1 and applied to thecase studies of three national central banks can be extended, with some provisos,to the ECB. This chapter first analyses the micro-institutional aspects of the ECB,

notably its relatively short institutional trajectory, the two-tier governance structure,the treaty-guaranteed economic and political independence, and the model oflegitimacy on which the ECB rests. The complex, multi-level relationships between the ECB and national central banks are also examined. This chapter thenconsiders the institutional framework of the eurozone and the EU, that is, thepolitical and economic context in which the ECB operates, evaluating the de factoindependence (or autonomy) of this supranational bank. Finally, the ECB’sinteraction with other international financial institutions is briefly examined.

The second part of the chapter focuses on the policies within the remit of theECB, starting with monetary and exchange-rate policies, and then moving to otherfunctions performed by the Bank. Issues related to prudential supervision are alsodiscussed. The aim is to assess the policy capacity of the ECB in different areas,and the interaction with the national components of the Eurosystem and various EUbodies that are involved in these policies.

The framework of central banking in the EU and Eurozone

The relatively short institutional trajectory of the ECB–ESCB

The ECB’s independence, functions and governance structure are defined by aninternational treaty,1 the Treaty on European Union (TEU; also referred to as theMaastricht Treaty) and the Protocol on the European System of Central Banks(ESCB) of 1992, subsequently amended by the Treaty of Amsterdam in 1997 andthe Treaty of Nice in 2001. The ESCB includes the ECB and all the national centralbanks of the EU member states, whereas the Eurosystem comprises the ECB, basedin Frankfurt, and the national central banks of those countries that have adopted the euro. The treaty text refers to the ‘ESCB’ rather than to the ‘Eurosystem’, on the assumption that eventually all EU member states will adopt the euro. Theterm ‘Eurosystem’ was officially adopted by the Governing Council of the ECB inNovember 1998, and the Constitutional Treaty explicitly uses it in the relevanttreaty articles (I-29). In practice, the Eurosystem and the ESCB will co-exist for aslong as there are EU member states outside the eurozone. Hence the term ‘ESCB’must be read as ‘Eurosystem’ in several treaty articles mentioned below (Scheller2004: 45).

The ESCB (to be read as ‘Eurosystem’) defines and implements the monetarypolicy of the eurozone (Article 105.2 of the TEU), whereas competences inexchange-rate policy are shared between the monetary authorities and politicalauthorities (Article 111), as explained in the second part of this chapter. The ESCBconducts foreign-exchange operations, holds and manages the official foreignreserves of the eurozone countries, and promotes the smooth operation of thepayment systems (Article 105.2). It has no direct responsibility for bankingsupervision, but the ESCB contributes to ‘the smooth conduct of policies pursuedby the competent authorities relating to the prudential supervision of creditinstitutions and the stability of the financial system’ (Article 105.5). The ECB hasthe exclusive right to authorize the issuance of bank notes within the eurozone,

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which are issued by the ECB and national central banks (NCBs) (Article 106). Thespecific division of competences and attribution of tasks within the Eurosystem isdiscussed below.

The primary objective of the ESCB is ‘to maintain price stability’ and ‘withoutprejudice to the objective of price stability, the ESCB shall support the generaleconomic policies in the EU with a view to contributing to the achievement of theobjectives of the Union as laid down in Article 2’ (Article 105.1). In turn, Article2 of the TEU states that ‘the objectives of the Union are a high level of employmentand sustainable and non-inflationary growth’. This means that the priority of theESCB is to maintain price stability, and once this is achieved, it can devote itsattention to the pursuit of other economic objectives, such as economic growth andemployment, although in practice it has refrained from doing so, as explained below.This clear list of priorities for central banks resembles that of the German centralbank, the Bundesbank, the main difference being that the ESCB’s priorities areenshrined in an international treaty (Herdegen 1998).

Given its relatively recent establishment, the discussion of the institutionaltrajectory of the ECB–ESCB mainly focuses on the activity of the EuropeanConvention and the Inter-Governmental Conference (IGC), with a view to explainingwhy no significant reform of the existing institutional and policy framework ofEMU has been introduced in the Constitutional Treaty. This is important, becauseseveral of the arguments articulated throughout the negotiations (in the Conventionand the IGC) echoed the broader public debate on EMU, as explained in thefollowing sections.

The EMU framework was discussed by the 2002–3 European Convention on theFuture of Europe, which preceded the 2003–4 IGC that negotiated and eventuallyagreed the Constitutional Treaty in June 2004.2 In the Convention, the WorkingGroup on Economic Governance was the one most involved in discussions on EMU. The mandate of this group had three main headings: monetary policy, whichincluded discussion of the asymmetry between monetary and fiscal policycompetences in the EU, and the Stability and Growth Pact (SGP); economic policy,including various methods of co-ordination; and institutional issues, that is, theaccountability of the ECB, the external representation of the eurozone and the roleof the Eurogroup.3

The ECB was not a member of the Convention because reportedly the Belgianpresidency, under which the preparatory work for the Convention was conductedin 2001, forgot to include it, since the ECB is not one of the EU institutions listed in Article 7 of the TEU – the European Parliament (EP), the Council ofMinisters, the Commission, the European Court of Justice (ECJ) and the Court of Auditors (interview, Frankfurt, January 2006). Instead, the legal foundation ofthe ECB is provided for in Article 8 of the TEU, under the heading ‘otherinstitutions’ of the EU, and it figures under the same heading in Article 30 of theConstitutional Treaty, which has not yet been ratified. Nonetheless, the ECBfollowed the work of the Convention very closely (see ECB, Monthly Bulletin,August 2004), and the President of the ECB was once invited to present the Bank’sviews at the Convention in September 2002.

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By looking at the summaries of the various meetings of the Working Group thattook place in 2002–3, the following points were the subject of in-depth discussion.4

As far as monetary policy was concerned, some members of the Working Groupsuggested that the mandate of the ECB should be broadened, so as to include notonly price stability, but also economic growth and employment. Other members didnot agree. The accountability of the ECB was questioned by some members, whocalled for a greater role for the EP in appointing the Executive Board of the ECBand in monitoring the activity of the ECB. Some members also suggested that theBank should publish the minutes of the meetings of the Governing Council. Incontrast, other members thought that the ECB was sufficiently accountable and thatsticking to established rules would provide confidence.

There was consensus that the external representation of the eurozone had to beimproved, but whereas some members envisaged a greater role for the president ofthe Eurogroup, others preferred a greater involvement of the Commission. Therewas no agreement on how to reform the SGP, or on the need to reform it. The Pact was left outside the Constitutional Treaty. As for economic policies, somemembers suggested increasing the role of the Commission and the EP. The WorkingGroup endorsed the change in the voting system of the Governing Council of theECB, and the Bank produced an official document on this (discussed below).

In the end, in the absence of an agreement, the Working Group put forward very limited reform proposals. Reportedly, there was a divide between ‘left’ and ‘right’, which signals a move towards a more ‘normal’ functioning of politicsin the eurozone. Moreover, the ECB felt that EMU issues should largely be left offthe agenda of the Convention, as the time was not ripe, and the chair of the groupwas instrumental in doing so (interview, Brussels, November 2003).

The various drafts of the Constitutional Treaty that were discussed in the plenarysession moved around the articles related to the single currency, especially thearticle on exchange-rate policy, but overall it was ‘much ado about nothing’. The only important change introduced in the final draft presented by the Conventionto the Council in June 2003, and which was the starting point for the IGCnegotiations, was the Protocol on the Eurogroup, which represented a step towardsits institutionalization.

The President of the ECB wrote two letters to the Convention. The first letter, sentin May 2003, reaffirmed that ‘no changes [of the EMU framework] in substanceshould occur . . . in line with the final report of the Convention Working Group onEconomic Governance’. The second letter, sent in June 2003, proposed includinga reference to price stability in Article I-3 on the objectives of the Union, proposedpreserving the ECB’s prerogatives in its fields of competence in the externalrepresentation of the eurozone in Article III-81 and expressed concern about anychange in the ECB’s status of ‘other institution’ in the treaty.5 It should be notedthat the main points raised by the ECB were also shared by the Bundesbank(Bundesbank 2003: 2).

The IGC basically confirmed the Convention draft on EMU provisions, thoughit ultimately agreed to include price stability among the Union’s objectives and decided that the members of the Executive Board should no longer be appointed

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‘by common accord’, which gave each member state veto power, but instead byqualified majority voting (QMV) in the European Council. The IGC confirmed thatthe ECB should be listed under ‘other institutions’ and should have ‘legalpersonality’ (ECB 2004a).

It is worth noting that during the IGC the ECB strongly and successfully opposedthe introduction of a new article, proposed by the Commission, allowing for amend-ment of the ESCB rules by a simplified procedure (see the letter sent by the ECBto the Italian presidency in November 2003, IGC document 58/03).6 An opinion ofthe ECB on the draft treaty was published in September 2003 in the Official Journalof the EU (OJEC 229/7; CON/2003/20), reiterating some of the points alreadymentioned by the ECB in its correspondence with the Convention and the IGC. TheECB’s legal opinion also suggested a rewording of the exchange-rate convergencecriterion, emphasizing the importance of a two-year ‘participation’ in the successorregime to the exchange-rate mechanism, ERM2, as a condition for EMU member-ship, as discussed in the second part of this chapter.

Looking at the relatively short institutional trajectory of the ECB, it is clear thatin the absence of agreement on how to reform the ECB and/or EMU framework thestatus quo has prevailed. This has been the result of path-dependency, but also of locking-in, owing to the presence of several veto points in the multi-level EUinstitutional setting. Moreover, there seems to be no consensus on an alternativeeconomic paradigm other than the stability-oriented one, which informed the ECB’s original institutional and policy templates and which had also been the resultof a political compromise at the time the TEU was negotiated (cf. Dyson andFeatherstone 1999).

Micro-institutional framework of the ECB–ESCB

The two-tier governance structure of the ECB

The ECB is based on a two-tier governance structure, with a decentralizedconfiguration reminiscent of the federal configuration of the Bundesbank before the2002 reform. The decision-making bodies of the ECB have two main functions: theygovern the ECB itself as well as the Eurosystem and the ESCB (Scheller 2004: 51).

The Governing Council is the main decision-making body of the ECB andconsists of the six members of the Executive Board, plus the governors of all thenational central banks from the eurozone countries. Membership of the Council ispersonal and cannot be delegated (except in specific circumstances, as in discussionsof financial matters or in the case of prolonged illness).7 Following an informalagreement between the Council of Economic and Finance Ministers (Ecofin) andthe ECB, a member of the Commission (generally the commissioner for economicand monetary affairs) and the president of the Eurogroup (a body described below)may attend without voting rights. All governors may be accompanied by one personfrom their NCBs, usually a senior official. The Governing Council formulatesmonetary policy, taking decisions on objectives and instruments and, like theExecutive Board, it operates as a collegiate body, which means that ‘decisions are

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subject to collective deliberation’ and ‘all members bear collective responsibilityfor them’ (Scheller 2004: 61; Issing 1999: 510).

The 1992 TEU established the principle of one man/woman, one vote, regardlessof the size of the country or the contribution of each central bank to the ECB’scapital. Thus, as of 2007 the 13 national central bank governors and the six membersof the Executive Board account for the total of 19 votes. The President has a castingvote in case of a tie. Legally, the vast majority of decisions in the Governing Councilcan be adopted by simple majority, though an explicit vote is rarely taken and theCouncil aims to reach consensus (Dyson 2000: 33; Howarth and Loedel 2003).8

Unanimity is required to recommend amendments of the Statute of the ESCBthrough the ‘simplified amendment procedure’ (Article 41 of the ESCB Statute) orthe ‘enabling clause’ introduced by the Nice Treaty (Article 10.6 of the ESCBStatute).

For decisions on financial matters, such as the capital of the ECB, the transfer offoreign assets, the allocation of incomes to national central banks and the like, votesin the Governing Council are weighted according to the national central banks’shares in the subscribed capital of the ECB. The weight of the votes of members ofthe Executive Board is zero. As a rule, the Governing Council decides by a simplemajority of weighted votes, so that a decision is adopted if the votes cast in its favourrepresent more than 50 per cent of the subscribed capital of the ECB. For somedecisions, such as increases in the capital of the ECB, a qualified majority of two-thirds and at least half of the shareholders is required. In practice, since minutes andvoting records are not made available to the public and participants refuse tocomment on this, it is difficult to identify voting coalitions and divisions in theCouncil.

The enlargement of the EU in 2004 and 2007 brought to the fore the need tostreamline the decision-making structure of the ECB following an enlargement ofEMU (Heisenberg 2003). The (partial) reform eventually agreed represents aninstitutional adaptation to enlargement, limited by path-dependency and locking-in. The European Council of Nice in 2001 agreed on a simplified procedure toamend the membership of the ECB governing bodies and asked the ECB to makea concrete proposal (Scheller 2004: 71). In late 2002, using the newly inserted‘enabling clause’, the ECB presented a proposal that had been elaborated in secrecyand had eventually been approved by the Governing Council (Gros 2005). TheECB proposal was endorsed by a decision of the European Council in March 2003,though it was opposed by the EP. It will be implemented when the number ofmembers of the Governing Council exceeds 21.

According to the revised version of Article 10.2 of the ESCB Statute, allgovernors of the national central banks in the eurozone will be entitled to attend the meetings of the Governing Council, but not all of them will have the right tovote. For this purpose, eurozone member states will be divided into three groupsaccording to economic size, which will in turn be determined by a compositeindicator: five-sixths GDP and one-sixth aggregate balance of the monetary andfinancial institutions. Each group will have only a limited number of votes, whichmeans that countries will have to take turns in exercising the right to vote, albeit

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with different frequency within each group. The number of countries (or to beprecise, governors of national central banks) having the right to vote at any giventime will be limited to 15, plus the votes of the six members of the Executive Board.The votes will be distributed as follows (Gros 2005; Belke and Styczynska 2006):group 1 comprises the five largest members and has four votes (so it has the highestvoting frequency); group 2 comprises the middle-sized countries and is allocatedeight votes (the number of members varies, so voting frequency falls as the eurozoneexpands, and it is at any rate lower than group 1); group 3 comprises the smallcountries and has three votes (voting frequency falls as the eurozone expands, andthis has the lowest frequency).

The Executive Board consists of the President, the Vice-President and four othermembers, and it acts as a collegiate body. The members of the Executive Board areappointed by common accord of the heads of state and government of the eurozonecountries, on a recommendation from the Ecofin Council, after consulting the EPand the Governing Council of the ECB. This appointment procedure, which requiresunanimity, was amended to qualified majority by the Constitutional Treaty signedin 2004, but this has not yet entered into force and is unlikely to do so, given theratification problems encountered. The rationale for this change in appointmentprocedures, which also represents an institutional adaptation to the enlargement ofthe EU (and, in the future, of EMU), is to avoid the deadlock that occurred duringthe appointment procedure of the first ECB President in 1998, which was resolvedwith the widely criticized compromise outlined below.

In the first round of appointments in 1998 the members of the Executive Boardwere appointed for different periods, ranging from five to eight years, to ensure astaggered renewal of the Board. Thereafter, their mandate is for eight years and notrenewable. According to the Treaty, they should be appointed from among personsof recognized standing and professional experience in monetary or banking matters.The responsibilities of the Executive Board are to prepare Governing Councilmeetings and to implement monetary policy for the eurozone in accordance with the guidelines specified and decisions taken by the Governing Council. In sodoing, the Board gives the necessary instructions to the eurozone national centralbanks; it manages the day-to-day business of the ECB; and it exercises certainpowers delegated to it by the Governing Council, including some regulatory tasks.It normally acts by a simple majority of votes cast by the members who are presentin person. In the event of a tie, the President has the casting vote and is primus interpares.

Research on the internal functioning of the ECB suggests that the role of theExecutive Board is far from being limited to the mere execution of decisions takenby the Governing Council. Because of the large size and heterogeneity of theCouncil, which meets only twice a month, the agenda-setting powers of the Boardhave an obvious impact on ECB policies (McNamara 2005). The Board is based inFrankfurt, it meets at least once a week, and its members are more likely to embracean EU-wide perspective than are NCB governors. A comparison with the role ofthe Frankfurt-based directorate at the Bundesbank before the 2002 reform isinstructive.

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The General Council comprises the President and Vice-President of the ECB,plus the governors of the national central banks of the 27 EU member states. Theother members of the ECB’s Executive Board, the President of the EU and amember of the European Commission may attend the meetings, though they do nothave the right to vote. The General Council carries out the tasks taken over fromthe EMI and which the ECB is required to perform in stage three of EMU, becausenot all EU member states have adopted the euro. Hence, the functioning of theERM2 (see below) is discussed in the General Council, and so is the collection ofstatistics. The General Council is responsible for the adoption of the convergencereports required by the treaty for new members to join EMU, and it will be dissolvedonce all EU member states have introduced the single currency.

There are two main, inter-related institutional issues concerning the governancestructure of the ECB and the ESCB (i.e. the Eurosystem). A third issue, which ismostly related to its organizational structure and scope of governance, is discussedbelow. The first issue is the sharing of decision-making capacity between theExecutive Board and NCB governors, which is part of a broader discussion of the relationship between ‘centre’ and ‘periphery’ in the Eurosystem, and the balanceof power between the national and European elements of the ESCB/Eurosystem(Begg et al. 1998a; Bini-Smaghi and Gros 1999; Howarth and Loedel 2003). In the Governing Council, the centre (the Frankfurt-based Executive Board) has sixvotes, whereas the NCBs have 13 votes, which are bound to rise to 15 when EMUenlarges and the 2003 reform comes into effect. This skewed distribution of poweris important because, arguably, the Executive Board is better placed and more likelyto make decisions in the interest of the eurozone as a whole, as opposed to nationalinterests – this topic is discussed further below. The Bundesbank, before the 2002reform, faced a similar dilemma. Yet it could also be argued that members of theExecutive Board need the votes of only four national central bank governors tohave a majority in the Council.

The second and related open issue is the reform of the decision-making bodiesin preparation for the enlargement of the eurozone. The new system – which wasendorsed in 2003, but will enter into force only when EMU enlarges to 15 members– has been criticized for being exceedingly complex because of the way in whichthe groups are defined, and for not being very efficient, because it does not reduce the number of members taking part in the policy-making discussion(potentially up to 33 in an EU comprising 27 member states). It does not substan-tially alter the number of voting members or the distribution of decision-makingpower between the ‘centre’ (Executive Board) and the ‘periphery’ (national centralbanks) (Gros 2005). The new system is also unfair towards the new member states,because of the way in which the three groups have been devised by using acomposite indicator, which includes financial assets. Such an indicator over-estimates the size of Luxembourg, which ends up in the second group, whereas thethird group (with the lowest voting power) would consist exclusively of the newmembers (Gros 2005; Belke and Styczynska 2006). It should be noted that thedecision on this reform was taken by the ‘insiders’, that is, the member states andcentral banks that were already in EMU.

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The legal framework of the ECB

In the economists’ indices of central bank independence the ECB’s score is veryhigh, higher even than that of the Bundesbank, traditionally regarded as one of the most independent central banks in the world. However, as in the case of theBundesbank, the weakest point seems to be the personnel independence of the ECB,that is, the ‘power of appointment’. On the one hand, the governors of nationalcentral banks and the members of the Executive Board have security of tenure: aminimum term of office for NCB governors of five years and a non-renewable termof office for members of the Executive Board of the ECB of eight years, withremoval of either from office possible only in the event of incapacity or seriousmisconduct and the European Court of Justice being competent to settle anydisputes.

On the other hand, NCB governors are appointed according to national proceduresthat are characterized by different degrees of political influence in the appointmentprocess, as examined in the previous chapters. This also raises the concern thatNCB governors might vote in the Governing Council according to national interests.Moreover, the appointment of the Executive Board, and especially of the President,can be subject to politicization, or at least it can be at the centre of politicaldiscussions, as happened with the appointment of the first President in 1998.Whereas the candidacy of Wim Duisenberg was supported by Germany, theNetherlands and less intensely by other EU countries, France supported its owncandidate, the governor of the Banque de France, Jean-Claude Trichet. After lengthyand acrimonious negotiations a contested political compromise was found, wherebyDuisenberg voluntarily declared that he would serve for at least four years but wouldnot serve the full term, after which ‘a French national’ would take over. This wasindeed the case, and Trichet became the second President of the ECB in 2005. AsBuiter (1999) notes, the problem was not that the appointment was a political issue,but rather that the discussion centred on the nationality of the President.

If initially the main controversies in appointing the members of the Board centredon the position of President, as time passed and new members of the ExecutiveBoard had to be appointed, other political sensitivities emerged. In several instancesthis resulted in the juxtaposition of the large member states (France, Germany, Italyand Spain), which were regarded as having ‘some sort of entitlement to a seat’(Mayes 2005: 88), and the small and medium-sized countries, some of which, suchas Ireland, Portugal and Belgium, have never had a national from their country onthe board, despite the fact that some of them put forward highly qualified contenders.

Neither the ECB nor the national central banks – nor any member of their decision-making bodies – can seek or take instructions from an EU institution or body, orfrom any government of an EU member state. The governments of member statesmust respect this principle and must not seek to influence members of the decision-making bodies of the ECB (Article 108 of the TEU).

So far, the empirical record suggests that the ECB has not bowed to politicalpressure, not least because its mandate is clear and safeguarded by the Treaty. Itwould therefore have been difficult for other bodies or authorities to influence the

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conduct of monetary policy. If anything, the ECB has been very determined todemonstrate its autonomy. For example, in 1999 it delayed the lowering of interestrates during a tug-of-war with the German finance minister, Oskar Lafontaine, whohad openly questioned the independence of the ECB (Dyson 2000: 14) and hadcalled for the setting up of exchange-rate target zones, to the annoyance of the ECB.The ECB eventually did cut interest rates, but only after Lafontaine’s departurefrom office.9

Operational independence is guaranteed by the treaty provisions on the conductof monetary policy, and to a lesser extent exchange-rate policy – the ECB has at itsdisposal all the instruments and competences necessary for the conduct of monetarypolicy and is authorized to decide autonomously how and when to use them – aswell as by the provisions safeguarding its economic independence. However, Buiter(1999: 190) notes that the provisions concerning exchange-rate policy (Article 109)could potentially limit the ECB’s operational independence.

Both the ECB and the NCBs are prohibited from granting loans to EU bodies ornational public-sector entities, ruling out any possibility of monetary financing.These provisions apply to all EU central banks, with the exception of the UKGovernment’s Ways and Means overdraft facility with the Bank of England, as established in the protocol of certain provisions relating to the UK (Scheller2004: 73; see also Chapter 2). The ECB is entrusted with the task of monitoringcompliance with these rules.

In terms of financial independence, the ECB’s financial resources are separatefrom those of the EU: the bank has its own budget, its own funds, its foreign-reserveassets, its general reserve fund and its claim on the NCBs resulting from the ECB’sshare in the issue of euro banknotes. ECB capital is underwritten and paid up bythe eurozone national central banks. The purpose of the bank’s own fund is togenerate revenue to cover the ECB’s administrative costs. The EU’s non-eurozonenational central banks are required to contribute to the operational costs incurredby the ECB in relation to their participation in the ESCB, by paying a minimalpercentage of their subscribed capital.10 The NCBs in the eurozone share themonetary income (the so-called seignorage), and the ECB’s net profits – reducedby the distribution of seignorage income and transfers to the general reserve funds– are distributed to the national central banks according to their capital share in theECB (Scheller 2004: 113–18).

The model of legitimacy of the ECB

The legitimacy of the ECB is based on ‘accountable independence’ (Magnette 2000:327), which emphasizes, however, ex-post accountability and output-orientedlegitimacy, rather than transparency and openness of the decision-making process.According to the ECB (2002: 46; see also Padoa Schioppa 2004: 33) ‘accountabilityand independence are two sides of the same coin’. Accountability is understood bythe ECB as ‘the legal and political obligation to justify and explain its decisions tothe citizens and their elected representatives’ (ECB 2002a: 45). The ECB regardsaccountability as necessarily ex-post; otherwise it would result in unwarranted

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interference (ECB 2002a: 46). Moreover, unlike the Bank of England, which issubject to a system of individual accountability, the decision-making bodies of theECB are collectively accountable, except for the non-Eurosystem functionsperformed by NCBs, which in these cases are held accountable by the nationalauthorities (Scheller 2004: 127).

In order to be accountable, the ECB has reporting obligations, which are laiddown in Article 15 of the ESCB Statute. The ECB is required to publish quarterlyreports on the activities of the ESCB/Eurosystem, as well as a consolidated weeklyfinancial statement. In addition, it has to produce an Annual Report addressed tothe EP, the Council of Ministers, the Commission and the European Council on itsactivities and on the monetary policy of the previous and the current year (ECB2002a: 48). The ECB publishes a Monthly Bulletin, in addition to a quarterly one,and it produces a range of other task-related publications.

The ECB President reports to the Committee on Economic and Monetary Affairsof the EP on a quarterly basis. Moreover, other Executive Board members haveappeared before the EP to testify on various issues relating to the ECB’s compe-tences. It should, however, be noted that the EP, unlike national parliaments,11 doesnot have the power to change the legal provisions concerning the ECB (Forder2005) – for example, by threatening to reduce the Bank’s independence. Whereasa former member of the Executive Board argues that ‘accountability is thus limitedtoday by the incompleteness of political union in Europe’ (Padoa Schioppa 2004:34), other authors argue that the ECB’s emphasis on the EP as the body to whichthe Bank should be accountable is basically a strategic choice, explained by thelimited power of the EP with reference to the ECB (Forder 2005).

Other criticisms of the ECB’s accountability concern the transparency of thedecision-making process; they call for the publication of minutes and voting patternsalong the lines of the reformed Bank of England12 and stress that the politicalauthorities, not the ECB, should define price stability (mostly, fix the inflationtarget), as happens in the UK and New Zealand (Amtenbrink 1999; Bini-Smaghiand Gros 1999; Howarth and Loedel 2003).

One of the members of the Executive Board, Otmar Issing (1999: 506; see alsoECB 2002a: 46) has argued that the ECB’s legitimacy should be judged on theresults it delivers (its ‘deeds’), namely the public good of a stable and trustedcurrency – an output-oriented model of legitimacy (Hodson and Maher 2002: 400;see also Scharpf 1999; Vila Maior 2006), rather than ‘its words’, or the transparencyof the decision-making process – input-oriented legitimacy. However, the Bank iskeen to point out that it has also input legitimacy because it has been established byan international treaty, ratified by the member states. ‘The political process wherebynational governments appoint the members of the ECB’s decision-making bodies,that is, the members of the Executive Board and the members of the GoverningCouncil, confers further “input legitimacy” on the ECB’ (ECB 2002a: 46).

On the issue of the accountability and legitimacy of the ECB and the Eurosystem,the main differences have emerged between the monetary authorities (central banks)and the political authorities (Jabko 2003), as well as between the political authoritiesin certain countries, such as Germany, where the central bank’s output-oriented

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legitimacy is widely accepted, and the political authorities of other countries, suchas the UK and France, which emphasize the need for input-oriented legitimacy. It should also be noted that, before the creation of EMU and the establishment of the ECB, domestic debate on the accountability of continental national centralbanks had been quite limited, as highlighted in the case of the Banca d’Italia and the Bundesbank. In contrast, the issue of central bank accountability featuredprominently in the discussion surrounding reform of the Bank of England inthe 1990s.

The intangible assets of the ECB

The ECB has a relatively flat organizational structure, so as to avoid a deephierarchy. It is organized into 17 business areas, each headed by a senior managerwho reports to a member of the Executive Board. Several area heads also chairESCB committees, which are discussed below. The ECB is still in the process ofconsolidating its organizational structure (the process is referred to as ‘the ECB inmotion’; cf. ECB Annual Report, 2003), starting from the most tangible aspects,such as building on its own site in Frankfurt, instead of the rented Eurotower andsurrounding commercial structures, to the most intangible ones, such as buildingits reputation as an inflation-fighter and establishing itself as an important researchcentre.

The ECB has engaged in the formation of a multinational environment at theBank,13 building on the common professional culture of the central bankingcommunity (for a discussion of European central bankers as an ‘epistemiccommunity’ see Verdun 1999) and its distinctive operational code, based on the self-perception as well as the active projection of central banks as technical, apolitical,independent bodies (interview, Frankfurt, January 2006). ‘Competence, integrity,efficiency and effectiveness, team work and European integration’ – in an internalpublication of the ECB these are the ‘values’ explicitly recognized by this institutionas its constitutive elements and included in its mission statement.

The ECB is also aware of the importance of developing cutting-edge economicexpertise. For example, it commissioned an external review of the research activityof its staff members, and the results were overall positive (Goodfriend et al. 2004).A study concerning the quality, quantity and relevance of research produced bynational central banks reveals that the ECB’s research staff more than doubled from12 in 1998 to 25 in 2003, all with advanced academic qualification (i.e. doctorates)(St-Amant et al. 2005). Compared with other central banks, the ECB working paperseries is among the most prolific, and the number of working papers published everyyear increased from eight in 1999 to 98 in 2003. So did the production of publishedjournal articles. In terms of quality, the ECB, the Bank of England and the Bancad’Italia are the sole non-American representatives among the top ten central banksin quality-adjusted output (St-Amant et al. 2005).

In terms of recruitment and career patterns, when the ECB was established in1998 it had about 400 employees, the vast majority of whom came from nationalcentral banks. Over time such imports from national central banks have decreased;

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in 2005 only about 20 per cent of the new intake came from national central banks.Fewer than 50 per cent of all ECB employees came from a national central bank,but at the senior level they are still the vast majority. As mentioned above, comparedwith the other central banks studied, the ECB appears to be less hierarchical andmore flexible in its organizational structure, with several internal review processesand multiple sources of assessment also for senior management (interview, Frankfurt,January 2006). Unlike in the Commission, in the ECB there is no quota system,either formal or informal, for recruitment and career patterns, and each departmentdecides on appointments in its sector of activity. There is no recruitment through ageneral competition process, as is the case in the Commission, though the ECB hasintroduced a graduate programme with entry based on a general competition.

The impression is that the ECB is eager to promote a system based on merit andintense competition, attracting ambitious professionals whose expectations might,at times, be difficult to manage. Indeed, the ECB faces difficulties in retaining itsstaff, and turnover is relatively high compared to similar institutions, though this ispartly attributable to the multi-nationality of its staff. Staff members, especiallythose seconded from national central banks, often decide to go back to their homecountry after a period of secondment to the ECB in Frankfurt (interviews, Frankfurt,January 2006). Salaries at the ECB are comparable to average salaries for similarpositions in national central banks or international organizations (Scheller 2004:158), though ECB officials enjoy a favourable fiscal regime.

The ECB and national central banks in the Eurosystem/ESCB

The interaction between the ECB and national central banks has been partlydiscussed in previous chapters, but they mainly focused on how national centralbanks have adapted to membership of the Eurosystem. Here, the perspective isreversed, focusing on how the ECB interacts with national central banks. Since theinterplay of the ‘centre’ and ‘periphery’ in the decision-making process of theEurosystem has been discussed above, this section mainly deals with the conductof Eurosystem tasks.

The national central banks perform tasks related to the Eurosystem and othercentral bank functions related to national and international functions, provided thatthese functions do not interfere with the objectives and tasks of the Eurosystem. TheECB may bring non-compliant NCBs before the ECJ, if it considers that an NCBhas failed to fulfil an obligation under the ESCB Statute (Article 35.6).

The first task of NCBs in the Eurosystem is to contribute to the decision-makingof the ECB Governing Council. Besides their decision-making functions, thenational central banks perform almost all operational tasks of the Eurosystem,because they conduct monetary policy operations under the direction of the ECB;they carry out most external operations as agents of the ECB; they provide paymentand securities settlement facilities; they ensure production and handling of bank-notes under the direction of the ECB; they collect statistics for the ECB; and theycollaborate in translating documents and carrying out economic analysis, also takingpart in joint research projects within the Eurosystem network (Scheller 2004: 50).14

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The non-Eurosystem national and international tasks of national central banksvary from country to country, but they generally include collecting statistics; actingas fiscal agent; advising the government; performing supervisory functions; takingcare of international representation (G8, G10, G20, OECD, BIS, IMF); andconducting economic research and training. Several of these activities have beenexamined in previous chapters.

The ECB manages its own funds, conferred by the NCBs, oversees cross-borderlarge-value payment and clearing systems, and may undertake external operationsand other market operations. It is up to the ECB to decide whether to implement its decisions itself or indirectly, by delegating to national central banks, which thusbecome operating arms of the ECB (Zilioli and Selmayr 2001). However, theprinciple of decentralization, as enshrined in Article 12.1 of the ESCB, states that‘to the extent deemed possible and appropriate, the ECB shall have recourse to thenational central banks to carry out operations that form part of the task of the ESCB[Eurosystem]’.

The ECB has about 1,300 employees, whereas the NCBs in the Eurosystem have a combined total of more than 50,000, though approximately half of them areemployed in non-Eurosystem activities, such as prudential supervision (Scheller2004: 50–1). In 2006 the Bundesbank employed some 12,000 staff, the Bancad’Italia about 8,000, and the Bank of England, which is not a member of theEurosystem, about 1,900.

It has been pointed out above that the main ECB decision-making body, whichalso governs the Eurosystem, has a two-tier governance structure, where the balanceof power in decision-making tends to be tilted in favour of the national components.Moreover, the Eurosystem is relatively decentralized, leaving a considerable amountof Eurosystem operational tasks to be performed by the national central banks,which, depending on the case, can also retain significant non-Eurosystem tasks(Bini-Smaghi and Gros 1999).

Given this status quo, it is not surprising that differences have emerged betweenthe centre in Frankfurt and national central banks concerning the reform of thegovernance structure of the ECB and the distribution of power in the Eurosystem.According to Tommaso Padoa Schioppa (2004: 31–3), it is crucial to distinguishbetween decision-making and institutional arrangements concerning monetarypolicy, in which the Eurosystem has acquired a supranational outlook and chartspolicy that is in the interest of the eurozone as a whole, and non-monetary issuesrelated to the management of the Eurosystem, the distribution of power and theallocation of competences therein, in which the national central banks have (rathersuccessfully) tried to preserve their prerogatives vis-à-vis the ‘centre’.

Concretely, these non-monetary issues concern the printing of banknotes, themanagement of assets held in the balance sheet, money transfer mechanisms,supervisory arrangements and external representation. In these areas the integrationand effectiveness of the Eurosystem needs to be developed, because these variousactivities are ‘hardly harmonized, shared or pooled’, which incurs the risk of givingcontradictory messages to the outside world, creating hidden competition betweencentral banks, and causing efficiency losses in the system (Padoa Schioppa 2004:

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xv). It should also be noted that the ECB’s budget – including, for example, thepossibility of increasing the number of staff in Frankfurt – has to be approved bythe ECB Governing Council, where national central banks are in the majority.

To improve the functioning of the Eurosystem and the ESCB, the ESCBcommittees were established by the Governing Council to provide expertise in theirfields of competence and facilitate the decision-making process and the implemen-tation of decisions. The ESCB committees are usually chaired by senior ECBmembers of staff and they report to the Governing Council via the Executive Board(Scheller 2004: 62). Participation in the ESCB committees is generally restrictedto staff members of the Eurosystem central banks. However, representatives of thenon-participating NCBs take part in meetings when an ESCB committee is dealingwith matters that fall within the remit of the General Council. At present there are12 regular ESCB committees, ranging from the Banknote Committee to the ExternalCommunications Committee, the Accounting and Monetary Income Committee, theInternational Relations Committee and so on. To this one should add the BankingSupervision Committee of the ESCB and the Human Resources Conference. ESCB committees are very important in preparing the decisions of the GoverningCouncil, which is the main reason why the Bundesbank has attempted to improveits internal co-ordination in participating in these committees (interview, Frankfurt,January 2006).

On the whole, the relationship between the ECB and the national central bankshas worked relatively well. One of the persons interviewed pointed out that theECB in its initial phase went through a period of ‘puberty’, trying to flex its musclesvis-à-vis the national central banks, though this phase is now over (interview,Frankfurt, January 2006). Yet national central banks, especially those that used tobe important players in their own right before EMU, have been reluctant to endorseany centralization of the Eurosystem – in particular, centralizing its governancestructure and rationalizing the conduct of operational tasks, as well as (going a stepfurther) transferring tasks such as prudential supervision from national to EU/Eurosystem level.

It was argued in Chapter 3 that the German central bank provided the institutionalmodel for the establishment of the ECB in three key respects: its independencefrom political authorities (and societal forces); a ‘technocratic’, output-orientedlegitimacy (Dyson 2000: 24); and the decentralized governance and organizationalstructure. However, the two-tier governance structures and the decentralizedorganizational structure were also an obvious choice, at least for the early stages ofthe ECB, given the specific features of the multi-level and multi-national politicalsystem in which the ECB is embedded, and which is analysed below. The EUpolitical system has often been likened to the interlocking federalism in Germany(cf. Scharpf 1988, 1994).

Macro-institutional framework of the EU

Micro-institutional analysis of the ECB and the Eurosystem needs to be embeddedin an analysis of the institutional settings of the EU and the eurozone to gain a full

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understanding of the autonomy of the Bank. This section analyses the political andeconomic institutions of the EU that are relevant for central banking governance,also focusing on the institutional relationships between the Bank and politicalauthorities, first and foremost the Ecofin Council and the Eurogroup, and lessfrequently the European Council and the Council in the composition of heads ofstate and government. The limited contacts between the ECB and economic interestgroups are also explored.

The EMU framework has three main characteristics: centralized monetary policyconducted by the ECB, which is also largely responsible for the day-to-day conductof exchange-rate policy; decentralized fiscal policy, which mostly remains at thenational level within the limits set by rules at EU level (the Excessive DeficitProcedure and the SGP); and a decentralized, multi-level political system (Dyson2000). In addition, there are mixed EU and national competences in economicpolicies, on the basis of voluntary co-ordination, soft rules and non-legislative policyinstruments (cf. Hodson and Maher 2002; Wessels and Linsenmann 2002).

The political institutions of the EU

The EU can be defined as a ‘polity in the making’ – it is more than an internationalorganization, but less than a traditional Westphalian state (Caporaso 1996; Wallace1983). It is also a ‘multi-level system of governance’, in which sovereignty is sharedand pooled in certain fields (Scharpf 1999, 1994; Hooghe and Marks 2001, 2003).Thus, the political institutions of the EU are different from those of the memberstates, even though approaches using comparative politics to assess the EU (seeHix 1994, 2005) argue that they are comparable and can be analysed using the sameconceptual tools. In this respect the EU mostly resembles the German type offederalism, based on power-sharing political institutions and interlocking politics,at times degenerating into a joint decision trap owing to the large number of vetopoints and to the principle of subsidiarity (Scharpf 1988, 1994).

The EU lacks a unified or monolithic executive. The European Council is thehighest political body of the EU and is usually involved in the most importantpolitical decisions concerning the Union, its policies and institutions (on the Councilof Ministers, including the European Council, see Hayes-Renshaw and Wallace2006; Westlake and Galloway 2006). For example, with reference to economicgovernance in the EU, the Cologne process described below was agreed at theEuropean Council meeting in Cologne under the German presidency. All the treatynegotiations conducted in IGCs, including the negotiations of the ConstitutionalTreaty, are eventually concluded by a European Council meeting.

With specific reference to EMU, the Council in the composition of the heads of state or government – meaning only those from the member states without aderogation (in effect, those in the eurozone) – appoints the members of the ECB’sExecutive Board, on the basis of a proposal by the Ecofin Council. The EuropeanCouncil also decides on the most significant (or contentious) changes to theinstitutional or policy framework of EMU. For example, the change of voting weightin the governance structure of the ECB was eventually decided by the European

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Council. The approval of the Lamfalussy framework for financial services regulationand supervision in the EU was discussed by the European Council, which was alsoinvolved in the final stage of the negotiations concerning the revision of the SGP,discussed below.

The Ecofin Council is composed of the economic and finance ministers of themember states. It meets formally on average once a month in Brussels, and informallyonce every six months in the country holding the EU presidency. The so-calledinformal Ecofin also includes national central bank governors. The Council dealswith EU economic and financial policies in a number of areas, including economicpolicy co-ordination, economic surveillance, monitoring of member states’budgetary policy and public finances, the euro, financial markets integration,economic relations with third countries and the EU budget.

Within EMU, the Ecofin Council has potentially an important role to play in theexchange-rate policy of the eurozone, as examined below. Moreover, the EcofinCouncil was one of the main decision-makers in the 2005 revision of the SGP andin reform of financial services regulation and supervision, through the so-calledLamfalussy process. Similarly, the negotiations of Basel 2, and in particular thetransposition of this non-legally binding international agreement into legallybinding EU legislation, discussed below, was overseen by the Ecofin Council. Inpractice, discussions within the Eurogroup have rendered discussion within theEcofin Council somewhat less important (Puetter 2004: 865).

The ECB has the right to be invited to participate in meetings of the Ecofin Councilwhenever matters related to the objectives and tasks of the ESCB are discussed,including the Broad Economic Policy Guidelines (BEPG) and reform of thefinancial sector. The ECB participates in Ecofin Council meetings – and also inpreparatory meetings in competent sub-structures of Ecofin, when the ECBexercises its right to initiate ‘complementary legislation’ – and as a rule it is invitedto participate with observer status in the preparation of other EU legislation ofrelevance for the ECB (ECB 2000a: 55). The ECB also attends the six-monthlyinformal meetings of the Ecofin Council.

The Eurogroup, which was established by a resolution of the Luxemburg EuropeanCouncil in December 1997, is composed of the economic and finance ministers ofthe eurozone countries. In its activities it is supported by the Eurogroup workinggroup of the EFC. Since the Eurogroup was established, its influence has beensignificant but not paramount, because the existing members of the eurozonedownplayed it, so as not to upset the ‘pre-in’ member states. However, given the factthat some of them are unlikely to join EMU in the near future, the eurozone membershave decided to increase co-operation amongst themselves, by strengthening theEurogroup. In 2004 the first President of the Eurogroup, Jean-Claude Juncker, wasappointed. Moreover, the Constitutional Treaty contains a specific protocol on theEurogroup, which under the draft treaty provisions may ‘strengthen budgetarydiscipline and surveillance’, as well as ‘set out economic policy guidelines’.

The Eurogroup can be considered as an attempt to establish within the eurozone‘a communication channel comparable with the informal contacts between govern-ments and central banks which traditionally exist within nation states’ (ECB 2000a:

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57). The atmosphere of openness in the Eurogroup is reinforced by the fact that themeetings are restricted to ministers, the European commissioner and the Presidentof the ECB (each with one accompanying person), in contrast to the large numberof participants at Ecofin meetings (Puetter 2006). It should, however, be noted thatespecially in the light of EMU enlargement the Eurogroup is likely to become toolarge a forum for this kind of discussions. At the very least, eurozone meetings arenot comparable to the confidential consultations that can take place at the nationallevel between monetary and fiscal authorities.

The Ecofin Council and (even more so) the Eurogroup are the political counter-weight to the ECB. However, these are hardly homogeneous bodies, for theirmembers – the national governments of the member states – have often differentpreferences, and it is sometimes difficult to reach agreement in these EU forums,even though decisions are mostly taken by QMV. Some Ecofin decisions haveproved very divisive – for example, the decision to suspend the SGP for France andGermany (see below).

The Economic and Financial Committee (EFC) is the successor of the MonetaryCommittee established by the Treaty of Rome in 1957 (see Kees 1994; Verdun2000). The member states, the Commission (DG Economic and Financial Affairs)and the ECB each appoint two members to the Economic and Financial Committee.The member states used to appoint one senior official from the national central bankand one from the finance ministry to attend the Council, but after the 2004enlargement this was restricted to one official (usually from the finance ministry orthe Treasury) per member state (Scheller 2004: 135). Members of the Committeeand alternates are selected from among experts possessing competence in theeconomic and financial field (Article 2 of the Protocol on the Economic and FinanceCommittee). It has several working groups, such as the ERM2 Committee and theEurogroup Working Group, and others for euro coins, bonds and bills. A FinancialStability Table is attached to the Committee. The Committee’s tasks are basicallythe same of those of the former Monetary Committee: to prepare the groundworkfor Ecofin Council and Eurogroup meetings; to provide a forum for dialogue atsenior level between central banks and finance ministries; and to oversee themanagement of ERM2. The ECB may not participate in voting, and the Committeerefrains from discussing the conduct of monetary policy (ECB 2000a: 59)

The Economic Policy Committee (EPC), which was established in 1974, albeitwith minor functions, contributes to the preparation of the work of the EcofinCouncil and the Eurogroup in co-ordinating the economic policies of the memberstates and the EU, focusing on structural reform. The Committee is composed oftwo members from each member state, generally senior officials from nationalfinance or economic ministries and from national central banks. The Commission’sDG for Economic and Financial Affairs and the ECB also send two members.According to its revised statute, which expanded its tasks, the Committee focuseson structural policies for improving growth potential and employment in the EU.The Committee provides support for the Council in formulating the Broad EconomicPolicy Guidelines and contributing to multilateral surveillance, the MacroeconomicDialogue under the Cologne process, the Cardiff process and the Luxembourg

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process (see below), including preparation of Employment Guidelines, Recommen-dations for Member States’ Employment Policies and the Joint Employment Report.It has working groups on issues such as wage developments, country reviews andlabour markets.

The Commission is an important actor in EMU, where the main competences ofthe Commission, like those of the Council, concern the ‘economic’ part of EMU.It formulates the Broad Economic Policy Guidelines to be adopted by the Council;it monitors economic developments and the budgetary situation in member statesfor the purpose of multilateral surveillance; and it prepares reports on the ExcessiveDeficit Procedure and submits opinions to the Council on this. The Commission istherefore the official ‘guardian’ of the SGP, as explained below; it prepares theperiodical convergence reports for those member states that have not yet adoptedthe euro. The commissioner responsible for economic and monetary affairs attendsEcofin Council meetings and participates in meetings of the ECB GoverningCouncil (ECB 2000a: 58).

With reference to financial market integration and financial services regulation andsupervision, including in the banking sector, DG Internal Market has been the mainpolicy actor within the Commission. In 2001 the Commission issued a FinancialServices Action Plan (FSAP), which contained 92 measures to be implemented inorder to promote financial integration in Europe. The plan was followed by a greenpaper on financial services policy 2005–10 in May 2005, which was discussed in apublic consultation process and was followed by a white paper in December 2005.DG Internal Market has also been involved in negotiations on transposing the Basel2 Accord into the Capital Requirement Directive in 2005. Finally, DG Competitionhas an input on issues related to banking and financial services competition,including bank mergers and acquisitions. In recent years DG Competition and DGInternal Market have come out quite strongly against national competition regimesthat de facto pose hindrances to financial market integration.15

The ECB maintains close relations with the Commission, for it is involved in anumber of working groups established under the aegis of the Commission, in areassuch as financial market integration (e.g. the so-called Giovannini Group) andprudential supervision (e.g. the Banking Advisory Committee, renamed theEuropean Banking Committee after the Lamfalussy reform) (ECB 2000a: 58).However, at times there is creeping competition between these two supranationalbodies, as highlighted above with reference to the Commission’s proposalconcerning provisions for the amendment of the ESCB Statute during negotiationson the Constitutional Treaty.

The ECB is part of the institutional framework of the EU and therefore maintainsclose relations with the Union’s other institutions. As mentioned above, thePresident of the Council and a member of the Commission may participate, withouthaving the right to vote, in meetings of the Governing Council of the ECB. ThePresident of the Council may submit a motion for deliberation to the GoverningCouncil of the ECB. The President of the ECB is invited to participate in Councilmeetings whenever the Council is discussing matters relating to the objectives andtasks of the ESCB. The Economic and Financial Committee also serves as an arena

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to promote dialogue at the level of senior officials between the central banks andthe finance ministries. Other formal contacts, which are also part of the proceduresfor the accountability of the ECB, include the President’s presentation of the ECB’sAnnual Report to the EP, and more frequent appearances of the ECB Presidentbefore the EP monetary committee.

The distinctive institutional configuration of the multi-level and multi-nationalpolitical system of the EU, briefly discussed in this section, is important because itreinforces the autonomy of the ECB. Indeed, the ECB does not face a unified, strongpolitical counterweight in EMU, unlike national central banks before or outsideEMU, whose main political interlocutors are their national governments. This wasthe case with the very independent Bundesbank, and is still the case for the Bankof England.

This multi-level institutional setting of the EU also has clear implications for theconduct of macroeconomic policies in the eurozone, especially for the so-calledpolicy mix (see below). Whereas the ECB maintains that ex ante macroeconomicpolicy co-ordination is unnecessary in EMU (Issing 2002: 345, 350) and that‘dialogue’ with the relevant macroeconomic authorities will suffice, fostered bythe informality and policy deliberation that prevail in the Eurogroup (Puetter 2006:49, 96–100),16 others (e.g. Buiter 1999: 205) argue that the current kind of inter-action between the ECB and the other EU institutions is insufficient to ensuremacroeconomic policy co-ordination, as explained below.

Relations between the ECB and the political authorities

In relations between the ECB and the political authorities there have been threemain sources of tension: the SGP, exchange rates and supervision. The Stability andGrowth Pact agreed in 1997 has been a contentious issue between the ECB and thepolitical authorities, especially those in non-compliant member states, notablyFrance and Germany, followed by Italy. The ECB regards the SGP as an instrumentneeded to prevent excessive deficits, and hence excessive financial marketborrowing by the member states, which would create negative externalities in theeurozone and would force the ECB to react with a restrictive monetary policy.17 Itis interesting to note that the Bundesbank, like the ECB, expressed its concernsabout any dilution of the pact and regretted ‘the ECOFIN Council’s decision not toproceed as envisaged with the excessive deficit procedure against Germany andFrance’ (Bundesbank 2003: 4).

More generally, the Pact feeds into the broader debate on the overall co-ordination of macroeconomic policies and the most appropriate mix of monetaryand fiscal policy in the eurozone (cf. Dornbusch et al. 1998; Issing 2002). This wasa constant problem in the USA and Italy throughout the 1980s, as well as inGermany immediately after reunification. The problem is compounded in theeurozone, where an independent supranational central bank is not matched by asingle centralized political authority responsible for fiscal policy.

The French Government had already raised this issue in 1991, when the TEU wasbeing negotiated, and it was relaunched in 2000 by the French presidency calling

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for a gouvernement économique, implying a form of political counterweight atEuropean level to the ECB’s control over monetary policy (Dyson 2000: 13; Elgie2002: 193).18 The creation of the Eurogroup was a step in this direction, whichexplains why German policy-makers, as well as non-eurozone policy-makers,insisted on the use of the word ‘Group’ instead of ‘Council’ (Puetter 2006).Moreover, the EU has very slowly increased its competences in economic policies,and the Treaty of Amsterdam, signed in 1997, explicitly recognized employmentpolicies as a matter of common concern and set out procedures for their surveillance.Fiscal and labour market policies, while continuing to be decided mostly at thenational level, are subject to closer EU surveillance, as explained below.

Disagreements between the ECB and the political authorities – particularly theEcofin Council, the Eurogroup and some ministers therein – have emerged onexchange-rate policy. For a short while in 1999 there was a tug-of-war between theECB and the German finance minister, Oskar Lafontaine, over the prospect of settingexchange-rate targets. This was also part of a broader discussion that involved theFrench finance minister, Dominique Strauss-Kahn, on whether the politicalauthorities or the monetary authorities should set the exchange rate of the eurozone.Lafontaine openly called for an interest-rate cut in order to lower the value of theeuro so as to boost exports. The ECB regarded this call as an attempt to challengethe Bank’s institutional independence and reacted by stiffening its monetary policystance (Campanella 2000). More generally, the level of the euro has been a recurrentsource of controversy in the conduct of exchange-rate policy of the euro. It shouldbe noted that on this issue the preferences of the member states have differed widely,as have the preferences within the Eurosystem. In addition, the legal provisions on this issue are rather ambiguous and open to different interpretations, as explainedbelow.

The third source of tension has been the ECB’s role in prudential supervision,which has also been a delicate matter in relations between the centre and theperiphery of the Eurosystem. Whereas the ECB (or at least a portion of its ExecutiveBoard) has been keen to expand its involvement in this policy, and several nationalcentral banks have been eager to safeguard their supervisory competences, theEcofin Council has thwarted the ECB’s ambitions, and several finance ministrieshave tried to reduce the competence of national central banks in this policy area,albeit with different degrees of success (cf. Germany and the UK, compared withItaly). The issue, which came to the fore in negotiation of the so-called Lamfalussyframework, is discussed below. Finally, it is worth noting that relations between theECB and the Council also depend on the Council’s presidency (interview, Frankfurt,January 2006).

The economic institutions of the EU

Since the establishment of EMU a whole range of complementary processes,methods and strategies have been introduced in the EU, starting with the Stabilityand Growth Pact in 1997, the European Employment Strategy (Luxemburg process)in 1997, the Cardiff process (product and capital market reform) in 1998, and the

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Macroeconomic Dialogue (Cologne process) in 1999. Some of these procedures,notably the SGP and the Macroeconomic Dialogue, focus on stabilization policies,the policy mix and demand management (Collignon 2004), and are more relevantwith reference to the ECB. Other processes, such as the Luxemburg and Cardiffprocesses, emphasize ‘structural reforms’ and the supply side (Hodson and Maher2001), and are not discussed here.

It should be noted that these post-EMU developments in the EU were largelyinstitutional responses to the introduction of the single currency, in an attempt todevelop the economic arm of EMU. Indeed, the EMU framework is asymmetric andimbalanced, in that the ‘monetary’ part, which is ECB-centric and hence trulysupranational, is much more developed than the ‘economic’ part, which mainlyremains at the national level (Dyson 2000; Verdun 1996). Nevertheless, criticswould argue that these changes have fallen short of the institutional adaptationneeded to cope with the new policy environment brought about by EMU.

The Stability and Growth Pact was agreed at the Amsterdam European Councilin 1997.19 Originally called the ‘Stability Pact’, it had been proposed in late 1995by the German finance minister, Theo Waigel, under the auspices of the Bundes-bank. It comprised two regulations, one strengthening the procedure for mutualsurveillance (peer review) of budget and economic policy, one strengthening theprocedure that dissuaded member states from running excessive deficits (Brunilaet al. 2001). At the insistence of the French Government the word ‘growth’ wasinserted in the title of the document, though its content was mainly about fiscaldiscipline, hence ‘stability’. The Pact put into effect multilateral surveillance(Article 103 of the TEU) and the Excessive Deficit Procedure (Article 104c of theTEU and related protocol).

The Pact had a political rationale and an economic rationale (for a review, seeBuiter 1999, 2003; Brunila et al. 2001). Politically, it was designed to appeasedomestic public opinion in Germany and overcome the widespread reluctance toabandon the D-mark. At that time Germany feared loose fiscal policies in EMU,especially in southern European countries (Heipertz and Verdun 2005). Theeconomic rationale of the Pact was to facilitate policy co-ordination in EMU,because if countries were to run excessive deficits, this might have negative spill-over effects in the eurozone, pushing up interest rates. More generally, the goal wasto ensure fiscal discipline in EMU, as inspired by the stability-oriented paradigmof ‘sound money’ and ‘sound public finance’ (Dyson 1994).

During the Italian presidency in the second half of 2003 the Stability and GrowthPact was the hot issue. Whereas France and Germany, which (along with Italy)were experiencing severe problems complying with the Pact, pressed for flexibilityin the interpretation of its rules, the smaller countries (such as Finland, Austria and the Netherlands, none of which had budgetary problems) tried to resist thesemoves and backed the Commission’s attempt to implement the rules. The Italianpresidency, after calling a vote on the issue, worked out a political compromise thatgave France and Germany more time to comply with the Pact, while at the timesuspending the threat of fines if they failed. Some of the smaller member statesregarded the episode as a clear instance of large countries bending EU rules and

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flexing their muscles (Financial Times, 28 November 2003). The Commission tookthe Council to the European Court of Justice on procedural grounds, after the latterfailed to take further action against France and Germany for persistent breaches ofthe Pact’s rules. At the political level, discussions on reform of the Pact continued.

In March 2005 the heads of state and government agreed to reform the Stabilityand Growth Pact on the basis of a proposal put forward by the Ecofin Council.Under the revised Pact, member states must still keep their public deficits below 3 per cent of GDP and their debts below 60 per cent of GDP. However, the Pact’srules have been made more ‘flexible’: member states can avoid an Excessive DeficitProcedure if they experience negative growth, whereas previously this was only thecase if they experienced negative growth of 2 per cent or more (an extreme case);and they can refer to ‘relevant factors’ to avoid an Excessive Deficit Procedure, forexample, taking into account their financial contributions to the EU budget. Finally,they will have longer deadlines before fines are imposed.

The Macroeconomic Dialogue (the Cologne process), which originated in aGerman initiative during its EU presidency in 1999, brought together the Council,Commission, ECB and European social partners, at political and expert levels, inorder to improve the policy mix in the eurozone, by bringing wages and incomespolicy into the discussion (Hodson and Maher 2001: 724). The MacroeconomicDialogue was intended to prevent conflicts between monetary, fiscal and incomespolicies, by including social partners in the dialogue. It was an attempt at institution-building at EU level, on the basis of the German model pre-EMU (see Chapter 3),but the social partners at EU level lack the strength they had at national level inGermany before 1999, and ECB monetary policy has remained unresponsive towage bargaining processes (Dyson 2003).

The Broad Economic Policy Guidelines are at the centre of the economic policyco-ordination process and have acquired increased significance since the LisbonEuropean Council (see below). Such guidelines outline the EU’s medium-termeconomic policy strategy, focusing on growth- and stability-oriented macroeconomicpolices, economic reforms to raise Europe’s growth and employment potential, andstrengthening of sustainability. The guidelines, which are multi-annual, are bothgeneral and country-specific; they are drawn up annually by the Commission andthe Council with the involvement of the Economic and Financial Committee. TheIntegrated Guidelines, which the European Commission adopted in April 2005,outline a strategy on macroeconomic, microeconomic and employment policies,bringing together the Broad Economic Policy Guidelines and the EmploymentGuidelines. Unlike the Excessive Deficit Procedure, the guidelines are not supportedby sanctions (Hodson and Maher 2001: 735).

This distinctive configuration of macroeconomic institutions affects centralbanking governance in the EU in several ways. It raises the issue of whether a fullmonetary union should be complemented by fiscal union, feeding into the debateon fiscal federalism, as originally argued in the McDougall Report in 1977. TheECB’s official position is that it need not, even if privately some officials reckonthat in the long term this will be the case (McNamara 2005). Another relatedmacroeconomic issue is the lack of co-ordination between monetary and fiscal

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policies, and to some extent incomes policy. The ECB’s official position is thatsuch ex ante co-ordination is unnecessary (Issing 2002; see also Alesina et al. 2001),but some economists disagree.

There is an ongoing debate about the varieties of capitalism in the EU and thequestion of whether they are converging towards a common model or whethernational diversities persist. Recent studies have concluded that whereas convergencehas taken place, it has occurred in some economic sectors (and sub-sectors) morethan in others (Schmidt, V. 2002a). Furthermore, significant differences betweencountries have persisted, and national institutions have resisted international and EUpressure towards convergence. Overall, national varieties of capitalism in Europehave become more liberal and less statist or corporatist, largely as a result ofEuropeanization and globalization, which are seen as unleashed by, and at the sametime reinforcing, neoliberal forces that are at the core of the EU project: free trade,market competition, minimal state intervention in the economy, a reduced welfarestate, and stability-oriented macroeconomic policies (Schmidt, V. 2002a).

Of particular interest for central banking governance is the configuration of thefinancial system in Europe or, to be precise, the combination of different financialsystems in the EU (for a review, see Gaspar et al. 2003; see also Moran 2002a). Inthe past the presence of national currencies served as a protective barrier to theentry of foreign companies (and hence external competition) in domestic financialmarkets. This was clear in the banking sector, which was still organized along thelines of national borders. The introduction of the single currency has reduced marketsegmentation, increasing cross-border activity and leading towards a two-levelmarket structure, some companies operating at European level and others only atnational level. Moreover, a series of directives in connection with the single-marketprogramme engineered a reorganization of the banking sector throughout Europe.This ‘internationalized’ national banking systems, as did a wave of intra-state andcross-national mergers and acquisitions, and the creation and consolidation of largebanking groups active at EU level.

Yet some countries have been affected more than others by this process, becausemarkets for financial services in the eurozone remain somewhat segmented alongnational lines, partly because of latent protectionism (or ‘economic patriotism’, aterm that has recently gained momentum in the financial press) among memberstates. For example, the banking sectors in Italy and Germany remain relativelysheltered from international competition.20

As for securities, which are also relevant to central bank activities, there has beenan internationalization of bond issues and trading across Europe, with bankingintermediation of diminishing importance and stock markets having increasingimportance,21 partly owing to the presence of institutional investors, first andforemost pension funds, whose growth has been stimulated by the curtailment ofthe welfare state. However, some national financial systems, such as those inGermany and Italy, have remained bank-oriented, with underdeveloped securitiesmarkets in which banks are still important players. Stock exchanges in the EU as awhole are still considerably less developed than in the USA, though the UK mirrorsAmerican trends.

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The diversity within the convergence of capitalism in the EU, in particular withreference to the configuration of the financial system, has important implicationsfor the ECB and the Eurosystem, which have to take into account and accommodatethese national differences in charting policies.

Relations between the ECB and economic interest groups

If it is difficult to evaluate the relationship between national central banks andinterest groups, it is even more difficult to do so with the ECB, because the ECBhas been eager to keep economic forces at arm’s length, in order to stress itsindependence. As mentioned, the attempt to involve the ECB in a MacroeconomicDialogue with social partners has had very limited results, not least because themain associations at EU level, such as the European Trade Union Confederation(ETUC), are relatively weak, and the Bank has been keen to stress that it is‘dialogue’, not ‘co-ordination’.

On a number of occasions the ECB has held open consultations on financialregulation with actors in the financial sector, though the Bank has been adamant inkeeping its relations with market players at arm’s length. Moreover, even in thefinancial sector, leading associations at EU level remain less effective than nationalassociations, owing to the diverse preferences of their members, many of which stilloperate in structurally different national financial systems. As explained in previouschapters as well as in the next section, this became quite evident in negotiations ofthe Basel 2 Accord, during which the preferences of national banking sectorsdiverged and were paramount in shaping the positions of the national authoritiesnegotiating in international forums.

International institutions and the ECB

The ECB participates in international institutions, and external representation of theeurozone is a complex and controversial issue, which was largely left unaddressedin the drafting of the TEU in 1992, but became very topical after establishment ofEMU in 1999 (see Henning and Padoan 2000: 36–8). The issue resurfaced duringthe negotiations and drafting of the Constitutional Treaty. Several interests are atplay, and the search for suitable institutional arrangements has been complicatedby the multi-level game in which the ECB finds itself. The game involves thenational central banks of the Eurosystem, national governments (separately and in the Ecofin Council and Eurogroup), the Commission and third countries,especially the USA.

The starting point is the need to represent the views of the eurozone in multilateralinstitutions. However, international inter-governmental institutions, such as theIMF or OECD, are organized on the basis of a strict correlation between onecurrency and one country, which is not the case for the eurozone (Padoa Schioppa’sparliamentary hearing 1999). Moreover, non-EU countries are eager to avoid over-representation of the EU in certain forums, such as the G8, as a consequenceof EMU.22

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Second, there is the need to safeguard the ECB competences as well as thecompetences of the EU member states, both within the eurozone and outside (seeZilioli and Selmayr 2001; Herrmann 2002). On issues related to monetary policy,the ECB has repeatedly pointed out that the eurozone should be representedexternally by the Eurosystem/ESCB, by making reference to Article 6.1 and Article6.2 of the ESCB Statute. Article 6.1 states that ‘in the field of international co-operation involving the tasks entrusted to the ESCB, the ECB shall decide how theESCB shall be represented’. However, Dutzler (2003: 60, emphasis in original)argues that ‘the Statute determines how and not if the ESCB is to be represented’.In order to answer the ‘if’ question, one should refer to Article 111.4 of the TEU,which states that ‘the Council shall, on a proposal from the Commission and afterconsulting the ECB, acting by a qualified majority decide on the position of the EUat international level as regards issues of particular relevance to economic andmonetary union and, acting unanimously, decide its representation in compliancewith the allocation of powers laid down in Articles 103 and 105’.

Third, there is the issue of how the ECB/Eurosystem itself should be represented,bearing in mind what has been said before with reference to its decentralizedconfiguration and governance structure. Article 6.2 of the Statute of the ESCB statesthat ‘the ECB and, subject to its approval, the national central banks, may participatein international monetary institutions’. This, together with Article 6.1, is interpretedby the ECB as meaning that it is the ECB’s prerogative to decide how it should be represented in international monetary institutions, whether by the ECB and/orby eurozone national central banks. Hence, the participation of national centralbanks in international monetary institutions is subject to the approval of the ECB(Padoa Schioppa’s parliamentary hearing, 1999). Nevertheless, if the ECB were todisapprove of the participation of national central banks in certain internationalmonetary institutions, it would be difficult for the Bank to prevent this, given thedistribution of votes in the Governing Council (Dutzler 2003).

In practice, whenever international co-operation concerns monetary policy, theECB represents the eurozone. With reference to exchange-rate policy, which is ashared competence between the ECB and the Council and the Eurogroup, thePresident of the ECB and the President of the Eurogroup participate in G8 meetings.In the area of payment systems, the ECB and the national central banks participateand formulate their views. In prudential supervision, the ECB participates togetherwith the national supervisory authorities (Scheller 2004: 142).

Even though the ECB cannot be a member of the IMF, which is an inter-governmental organization, the IMF Executive Board in 1999 decided to grantobserver status to the ECB. Common positions of the Eurosystem on monetarypolicy matters are delivered by the ECB’s observer at the Fund, whereas onexchange-rate matters the presidency of the Eurogroup is also involved. The ECBobserver might be invited to attend other IMF meetings. The President of the ECB is invited to attend with observer status the International Monetary andFinancial Committee.

The Organization for Economic Co-operation and Development (OECD) isanother inter-governmental body, yet the EU is represented there. Following the

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decision of the OECD Secretary-General in 1999, the ECB participates in allrelevant OECD meetings alongside the Commission, as part of the EU delegation,each expressing their views within their sphere of competence. The ECB alsoparticipates in the work of the relevant committees and working groups of theOECD.

Unlike inter-governmental institutions, such as the IMF and the OECD, the BISis a central banking institution. Thus, since 2000 the ECB has been a shareholderof the BIS, with voting and representation rights at the annual meeting (Scheller2004: 149). The President of the ECB participates in meetings of the G10 Governorsorganized in the context of the BIS, and ECB representatives take part in thecommittees set up under the aegis of the G10 governors. The ECB has observerstatus in the Basel Committee on Banking Supervision (BCBS) and participates inits sub-group. Between 2000 and 2005 a member of the Executive Board of theECB chaired the Committee on Payments and Settlement Systems. The ECB is amember of the Committee on the Global Financial System and the FinancialStability Forum set up by the G7 and based at the BIS (Scheller 2004: 149–50).

It is not possible to review here all the international policy-making processes inwhich the ECB has been involved so far. As for the national central banks discussedin the previous chapters, the focus here is on exchange-rate policy and prudentialsupervision. Since its establishment the ECB has not taken part in internationalexchange-rate agreements, even though it has occasionally engaged in co-ordinatedinterventions with other central banks in the exchange-rate market. By contrast, animportant reform of the framework for banking regulation and supervision hastaken place under the aegis of the BIS, culminating in the Basel 2 Accord, in whichthe ECB and the Commission participated as observers in the Basel Committee onBanking Supervision. It is therefore worth examining the participation of the ECBin this international policy process.

Since the EU decided that the Basel 2 Accord, which is a gentlemen’s agreement,would be transposed into binding EU legislation – the Capital Requirement Directive– the Commission, the ECB and the EU member states sitting in the BCBS wereaware of the need to ensure the suitability of Basel 2 rules for application to the EUsingle market. Indeed, the Commission’s service review of capital requirement thattook place in parallel with the activities of the BCBS, and the Basel and EUprocesses, ran for five years (see Quaglia 2006a). The ECB took part as an observerin the work of the BCBS, participating in all the sub-groups that worked on Basel2 (e.g. implementation groups, the risk management group, the capital requirementtask force, etc.) and providing ‘technical’ contributions (interview, Frankfurt,January 2006). The ECB was involved in the consultation process concerning thethree consultative papers issued by the BCBS and provided written comments onConsultation Papers 2 and 3. Reportedly, the ECB’s input was significant inavoiding excessive pro-cyclicality (Article 106 of Basel 2).

Unlike national central banks (e.g. the Bundesbank or the Bank of England), theECB did not consult with major European financial associations, as this was seenas potentially overlapping with the intense consultations taking place at nationallevel, and furthermore the ECB was keen to keep an arm’s-length relationship with

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financial interest groups. Deliberately, the ECB refrained from putting forwardproposals that could be seen as favouring certain parts of the financial sector, or thebanking system in specific countries. As a general rule, the Bank has welcomed the Basel 2 Accord, supporting its core principles.

Overall, the ECB has been a relatively important actor in the external relationsof the eurozone as far as exchange rate policy is concerned, as exemplified by theG7 concerted interventions in 2001. It has participated, sometimes with observerstatus, in international regulatory forums, such as Basel 2, providing some input tothe discussion, whereas at other times it has been a full member of the relevantcommittees, such as in the CCPS, where the member of the ECB Executive Boardin charge of external relations was the chair who oversaw the publication of the‘Core Principles for Systemically Important Payment Systems’ and the ‘Recom-mendations for Securities Settlement Systems’ in 2001. The degree of participationand influence of the ECB in international institutions has largely mirrored its internalcompetences or tasks.

The policies of the ECB

This second part of the chapter discusses three main policies in which the ECB hasbeen involved to different degrees over the period 1999–2005. The Eurosystem hasexclusive competence for the monetary policy of the eurozone, it has sharedcompetences with the political authorities in the conduct of exchange-rate policy,and it has minimal competences in prudential supervision, which remains mainlythe responsibility of national supervisory authorities, either central banks oragencies separated from the central banks.

The monetary policy of the ESCB

Although the monetary policy framework of the ESCB had to be set up anew whenthe ECB was established in 1998, it drew heavily on the policy template used by the Bundesbank, which adopted a monetarist approach (Howarth and Loedel2003). In October 1998 the ECB’s Governing Council agreed on a monetary policyframework consisting of three elements (see Issing et al. 2001; Padoa Schioppa2004: 68–75). First, the ECB provided a quantitative definition of price stability as‘a year-on-year increase in the harmonized indices of consumer prices (HICP) forthe eurozone of below 2 per cent . . . over the medium term’. This initial definitionwas criticized for being ‘asymmetric’ (Svensson 2001, 2002), and hence potentiallydeflationary, ‘ambiguous’, because the length of the medium term was not defined(Galí et al. 2004), and overly ‘ambitious’ because, for example, the inflation targetin the UK is 2.5 per cent, while Germany had an average inflation rate of 2.9 percent over the period 1949–98 (Padoa Schioppa 2004). Finally, some economists feltthat it would be more appropriate to focus on gross inflation, not on consumer priceinflation.

In 2002–3 the ECB undertook a ‘serious evaluation’ of its monetary policystrategy, and the first criticism reported above was addressed by replacing the word

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‘below’ with ‘close to’.23 The review also inverted the order of the two pillars ofthe monetary policy strategy of the ECB, though it refrained from any more drasticchange. This was a deliberate choice so as to promote continuity in policy-makingand build on the ECB’s ‘track record’ and ‘jurisprudence’ established in the earlyyears (Padoa Schioppa 2004: 82).

Since 2003 the first pillar of the ECB strategy has been the ‘economic analysis’,that is, a broad-based assessment of the outlook for future price developments,conducted by the Bank using a range of economic and financial indicators, such asprice indices, the balance of payments, the exchange rate, the fiscal stance, wagenegotiations and so on. Since December 2000 staff projections of GDP and HICPhave been published twice a year, though the Governing Council does not assumeresponsibility for the projections (Scheller 2004: 84). This is to make clear that theECB, unlike the Bank of England, for example, does not follow explicit inflationtargeting.

The second pillar of the ECB strategy is the ‘monetary analysis’ (before 2003 thiswas the first pillar), that is, a quantitative ‘reference value’ for the growth of a broadmonetary aggregate (M3), derived in a manner consistent with price stability. Inprinciple, the faster M3 growth accelerates, the higher the risk of rising inflation,though the Bank maintains that it does not react automatically to deviations fromthe reference value. The ECB’s attachment to M3 growth was inherited from theBundesbank, which had a powerful voice in setting the ECB’s monetary policystrategy (Howarth and Loedel 2003), though different views co-existed within theGoverning Council and the Executive Board (interview, January 2002 Frankfurt).

Several economists would favour abandoning monetary ‘reference values’,because they can confuse the markets, and in practice the ECB has substantially andrepeatedly missed the M3 reference values set in advance. The preferred alternativefor several economists would be to opt for explicit inflation-targeting, as practisedby the Bank of England. Yet the ECB argues that it prefers to rely on various sets of indicators, and that switching to an inflation target could endanger thecredibility of the ECB, at least until has built a consolidated record (‘reputation’)as an inflation-fighter (interviews, Frankfurt, January 2002).

A second concern is that the Eurosystem has been too slow to react to changes inthe international and European context, in that important monetary policy decisionshave sometimes been postponed while awaiting a consensus in the GoverningCouncil, implying that the large governance structure of the ECB has had negativerepercussions in policy-making. For example, there is some evidence that the ECBwas slow to cut interest rates between 2000 and 2001 (Begg et al. 2002).

A third criticism is that the ECB has exceeded the 2 per cent upper limit forinflation in several consecutive years, without openly acknowledging and revisingthe ceiling (Galí et al. 2004), whereas the ECB argues that price stability is to bemaintained over the medium term, justifying temporary trespasses of the 2 per centlimit.

The execution of monetary policy is mainly performed by the national centralbanks under the direction of the ECB, and the main instruments to regulate liquidityare open-market operations.24 On the one hand, decentralized execution of monetary

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policy, mainly through market operations by NCBs, complicates the performanceof this task and can impose some extra costs. On the other hand, there are severalfinancial centres in the eurozone, and national banking communities often preferto interact with NCBs (Buiter 1999: 204; Padoa Schioppa 2004: 83–5). Furthermore,decentralized execution has not caused serious problems, not even in emergencysituations, such as the aftermath of the terrorist attacks on the USA in September2001, when urgent intervention in the markets was needed (Padoa Schioppa 2004:85). It should be noted that in its early years the Bundesbank also had fullydecentralized execution of monetary policy, which was subsequently rationalized.

Overall, the monetary policy paradigm of the ECB, which was provided by theBundesbank and prioritizes the objective of price stability, has remained unchangedsince its inception, with only minimal alterations to its monetary policy strategy.

The exchange-rate policy of the eurozone

According to Article l09 of the TEU, ‘the Council may, acting unanimously on arecommendation from the ECB or from the Commission, and after consulting theECB in an endeavour to reach a consensus consistent with the objective of pricestability, after consulting the EP . . . conclude formal agreements on an exchangerate system for the ECU [euro] in relation to non-EU currencies . . . In the absenceof an exchange-rate system in relation to one or more non-EU currencies . . . theCouncil, acting by a qualified majority either on a recommendation from theCommission and after consulting the ECB or on a recommendation from the ECB,may formulate general orientations for exchange-rate policy in relation to thesecurrencies. These general orientations shall be without prejudice to the primaryobjective of the ESCB to maintain price stability.’

Although in practice neither of these instances has occurred so far, the provisionsfor the exchange-rate policy of the eurozone were controversial when the TEU wasnegotiated and remained so afterwards (see Kenen 1995; Henning and Padoan 2000:36). Whereas Germany was in favour of limiting as much as possible the influenceof the political authorities, France favoured a much greater role for them (Howarth2001; Loedel 1999). The text agreed in the TEU represented a compromise solution,and therefore the relevant treaty articles are open to different interpretations. Suchprovisions combine rather than share ‘the power and the responsibilities of allplayers, so that neither body is able to act without the consent of the other’ (Dutzler2003: 51; see also Herrmann 2002; Cohen 2003; McNamara and Meunier 2002).This ambiguity came to the fore in 1999, when Oskar Lafontaine and DominiqueStrauss-Kahn, respectively the finance minister of Germany and France, openlyraised the issue of which body should set the exchange rate of the eurozone, arguingthat it was the responsibility of the political authorities (Dyson 2000: 14).

The political controversies over the exchange-rate policy of the eurozone werenot limited to the disagreement between Lafontaine and the ECB, as explainedabove. Instead, they have been a recurrent feature of the first years of the eurozone.Shortly after the inception of EMU the exchange rate of the euro depreciated,especially vis-à-vis the US dollar, but also against the pound sterling. In December

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1999 the single currency fell below US$1:1 for the first time, causing severe stress in the conduct of exchange-rate policy. On the one hand, from an economicpoint of view the weakening of the euro is a non-issue for many economists and central bankers (Alesina et al. 2001). EMU has transformed a group of smallopen economies into a large closed economy, so the external value of the euro isnot economically significant, except in severe economic circumstances or a case ofextreme exchange-rate volatility. This seems to be the view taken by the Bank ofEngland, for example.

On the other hand, the exchange rate of the euro was a politically sensitive matter(Padoa Schioppa 2004: 145), particularly in France and Germany shortly after theestablishment of EMU. In Germany this was because of the international rolepreviously performed by the D-mark, as well as the reluctance, if not hostility, of thepublic to giving up this ‘strong’ currency in favour of the euro, perceived as a ‘weak’currency. In France the exchange rate has often been regarded as an indicator of ahealthy economy (and a symbol of national prestige), and throughout the history ofEuropean monetary integration French policy-makers have been adamant that thesingle European currency should rival the US dollar as an international currency.

The uncertainty over exchange-rate policy in the early years was compoundedby the inconsistent attitude of the ECB. In 1999 it had initially said that it did notmind what level the euro reached, but then appeared to change its approach.Moreover, central bankers in the eurozone – the Bundesbank was particularly vocalon this – released contradictory statements (Jansen and de Haan 2004). It was aclear case of the ECB speaking with more than one voice (Henning and Padoan2000: 39).

In September 2000 there were a number of G7 interventions, involving the co-ordinated purchases of euros. A second round of interventions was conducted bythe ECB in November 2000 (Cottrell 2001: 76). The exchange rate regained valueafter 2002, and in 2004 there was a concern that the strong euro could have anegative effect on exports from the eurozone.

Another important open issue with regard to the exchange-rate policy of theeurozone concerns the enlargement of the EU in May 2004 and the prospect of newmembers joining EMU. Under EU rules, the new member states must spend aminimum of two years in ERM2, or at least within the normal ERM fluctuationband (the treaty is quite ambiguous on this issue). They must also meet the other convergence criteria concerning inflation, such as interest rates, public debtand deficits – which measure ‘economic convergence’ – before they can enter theeurozone.25 ‘Legal convergence’ means that national legislation has to be madecompatible with relevant EU legislation, especially the provision for safeguardingcentral bank independence (Scheller 2004: 37). The ECB has taken the view thatthese countries should not rush to adopt the euro because they may need differentmacroeconomic policies and exchange-rate flexibility in the next few years.

The provisions agreed for ERM2 in 1996, which largely reflected the policypreferences of the Bundesbank, established that, in order to defend the parity of the currencies in ERM2,26 central bank interventions are automatic and unlimitedin principle, without prejudice to price stability. Should this primary objective

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be endangered, the ECB and the other participating national central banks couldsuspend intervention and initiate the procedures for a realignment (Scheller 2004: 93).

As far as the execution of exchange-rate policy is concerned, both the ECB andthe NCBs hold and manage foreign reserves; the ECB reserves have been trans-ferred by the NCBs as a means of intervention should the need for foreign-exchangeintervention arise, in which case the ECB could also ask for further contributionsfrom NCB reserves (Scheller 2004: 94). Foreign-exchange operations carried outby NCBs for their own purposes need prior authorization from the ECB, as they canaffect liquidity in the eurozone.27

Overall, the ECB has devoted less attention to the exchange rate than had beenthe case with European central banks in the past (Begg et al. 2002). There is no‘active’ exchange-rate policy in the eurozone (ECB 2001a: 57), and central bankofficials remain sceptical about currency stabilization vis-à-vis the US dollar(Henning and Padoan 2000: 39). However, the Bank is also aware that the exchangerate of the euro is politically sensitive, and that there is a great deal of symbolismattached to it. With regard to exchange rates, the conventional ECB view is to stressthe priority of domestic (i.e. eurozone) stability and to remain concerned aboutexcessive exchange-rate moves (statement by Jean-Claude Trichet, 5 February2004). Unlike in monetary policy, the uncertainty about the exchange-rate policyof the single currency is compounded by the complex and rather ambiguousinstitutional arrangement for the conduct of this policy, as well as by divergentpolicy preferences (Henning and Padoan 2000).

Financial services regulation and supervision in the EU

The ESCB and the ECB have no direct responsibility for banking supervision.However, Article 105.5 of the TEU states that ‘the ESCB shall contribute to thesmooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financialsystem’. Moreover, according to Article 105.6, ‘the Council may, acting unanim-ously on a proposal from the Commission and after consulting the ECB and afterreceiving the assent of the EP, confer upon the ECB specific tasks concerning policiesrelating to the prudential supervision of credit institutions and other financialinstitutions with the exception of insurance undertakings’. In practice, this provisionhas not been used so far. The Constitutional Treaty contains provisions that slightlyincrease the competence of the ECB is this area, though not substantially.

Since its creation the ECB has tried to expand its supervisory tasks, but has metwith the resistance of the national central banks, the national supervisory authoritiesand member states’ governments. Moreover, the ECB itself, even the ExecutiveBoard, seems to have been in two minds on this issue: whereas some members ofthe Board, such as Tommaso Padoa Schioppa, who was also responsible for bankingsupervision at the ECB, and to some extent Wim Duisenberg, were keen to expandthe ECB’s supervisory responsibilities, other members were not (interview, London,December 2005). It is a disagreement rooted not only in bureaucratic politics

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(power distribution between the ‘centre’ – that is, the ECB – and the national centralbanks, and between the central banks and the supervisory agencies and Treasuries),but it is also a matter of dissimilar policy paradigms, rooted in different nationalinstitutional arrangements.

This had already come to the fore when the TEU was negotiated in 1992 (seeDyson and Featherstone 1999), because whereas German policy-makers, and inparticular the Bundesbank, were keen to limit the supervisory competences of theECB, in accordance with the Bundesbank’s model of (formally) separatingmonetary policy from supervisory policy, other policy-makers, such as the Bankof England and the Banca d’Italia, were less sanguine on this, partly because, at thenational level, the central banks already had (at times extensive) supervisoryresponsibilities.

Since the establishment of the ECB in 1998 this issue has become a bone ofcontention both within the Eurosystem – that is, between the ECB and the nationalcentral banks – and between the ECB and member states and other policy actors,such as national supervisory authorities, notably the FSA in the UK. It has alsobecome a controversial issue domestically, for example, in the UK, Germany andItaly, as highlighted in previous chapters.

Between 1999 and 2004 EU regulation and supervision of financial services –banking, securities and insurance – developed from a rather minimal set of rules and‘thin’ institutional arrangements into a more articulated and institutionalizedframework, the so-called Lamfalussy framework, first developed to apply tosecurities and later extended to the other two segments of the financial sector(Quaglia 2007a).

The ECB initially opposed the extension of the Lamfalussy framework fromsecurities to other financial sectors, especially banking,28 and it unsuccessfullyattempted to reshape the agenda for reform, making the case for enhancing the roleof central banks in prudential supervision on two grounds (ECB 2001b). The ECBargued that, since it was responsible for systemic stability in case of a systemiccrisis, either in the banking system, insurance sector or pension funds, it would bethe first institution the market would look to in such a situation. The ECB alsopointed out that any potential conflict of interest between the conduct of monetarypolicy and banking supervision – an argument often used to prevent central banksfrom being active in prudential supervision – was ruled out in the EMU policyframework because monetary policy decisions were outside the exclusive controlof national central banks (ECB 2003b; Financial Times, 23 March 2001; 30 January2002; 14 April 2002; 11 July 2002).29

However, once it became clear that the Lamfalussy model had gathered enoughsupport in the EU, the ECB engaged in a rearguard action to ensure that it and thenational central banks would be represented on the relevant committees.30 Oneexplanation for the stance of the ECB has to do with its two-tier governance structure,in that the national central banks – which constitute the bulk of its decision-makingbody – are eager to increase their role in banking supervision, now they have losttheir role in setting monetary policy (Financial Times, 30 January 2002). Theframework was negotiated throughout 2002, and in December 2002 the Ecofin

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Council approved a proposal by the Economic and Financial Committee for theextension of the Lamfalussy framework to other sectors, namely banking andinsurance. It also took on board the ECB’s request for involvement (Economic and Financial Committee 2002). During 2003 and 2004 the new framework was setin place.

The EU policy framework established in 2004 is based on a complex multi-levelsystem of EU rule-making and enhanced co-operation between national supervisoryauthorities, underpinned by new EU committees (such as the Securities Committeeset up in 2001) and reformed committees (such as the Banking Advisory Committeeand the Insurance Committee, which date back to 1977 and 1992 respectively). Thefunctional division between banking, securities and insurance is maintained.

Among this plethora of committees established as part of the Lamfalussyframework, the most relevant for the ECB is the Committee of European BankingSupervisors (CEBS) set up in 2004 in London. This committee, which compriseshigh-level representatives from the banking supervisory authorities and centralbanks of the member states and the ECB, was seen as potentially overlapping withthe tasks of the Frankfurt-based Banking Supervision Committee (BSC). The CEBSadvises the Commission, either at the Commission’s request or on the Committee’sown initiative, in particular as regards the preparation of draft-implementingmeasures in the field of banking activities. It contributes to the consistent implemen-tation of EU directives and to the convergence of member states’ supervisorypractices throughout the EU. This function is very important in the implementationof the Basel 2 Accord and the Capital Requirement Directive.

After the creation of the ECB, the Banking Supervision Committee (BSC) of theESCB with a secretariat at the ECB was established in Frankfurt, comprisingbanking supervisors from all EU member states. Edgar Meister, from the Bundes-bank, was appointed as the chair. The BSC assists the ECB in drafting bankinglegislation and supports the Eurosystem in the conduct of its tasks in the field ofprudential supervision of credit institutions and financial stability (ex Article 105.5of the TEU). In 2003 it published a Memorandum of Understanding, that is, anagreement between supervisors that has no legal force but sets out the respectivetasks and duties of all the parties. When the Lamfalussy framework was established,the need arose to clarify the relationship between the Banking SupervisionCommittee and the Committee of European Banking Supervisors.

Another important reform in the regulation and supervision in the financial sector(especially banking and securities) is the Capital Requirement Directive, approvedin 2005. Capital requirements were already regulated by existing EU legislationissued in the 1990s, implementing and extending to all EU banks the Basel 1 Accord.When the Basel 2 Accord began to be negotiated, the member states agreed that thenew capital requirements framework agreed in Basel 2 would be incorporated intoEU legislation (see Quaglia 2006a). The ECB was invited in an observer capacityto monitor the work of the Commission and the Ecofin Council on the transpositionof Basel 2 into the Capital Requirement Directive, and the ECB’s legal opinion onthe directive was required by the Treaty (see European Central Bank, ‘Opinion of the European Central Bank of 17 February 2005’, CON/2005/4; 2005/C 52/10).

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At the implementation level – the transposition into an EU directive – the ECB haspressed for more financial regulation to be transferred to the committee level (in thebanking sector, the CEBS), as envisaged by the Lamfalussy report.

Until the late 1980s banking supervision was largely in the hands of central banks,or executed in close co-operation with them, in many European countries. In the late1980s the Nordic counties created the first integrated authorities in Europe,31

followed by the establishment of the FSA in the UK in 1998 and the FinancialSupervisory Authority (BaFin) in Germany in 2002. Some countries, for examplethe Netherlands, have moved in the opposite direction by strengthening thesupervisory powers of their central bank. Other countries, such as Italy, have hardlychanged their policy framework, and the central bank remains a powerful policy-maker on supervisory issues, including beyond the banking sector.

Different policy paradigms have underpinned these models, and although the integrated model is gaining ground in many of the new member states, theMediterranean countries (Spain, Portugal, Greece, Italy) and some new memberstates (Poland) retain strong supervisory responsibilities for their central banks. Forall these reasons, significant policy convergence is hard to detect in the EU, and ithas been difficult for the ECB to support a specific paradigm, given the variety ofviews within the ECB/ESCB, and given that the Bank has minimal competences inthis policy area.

Other functions of the ECB

The ECB is not a banker to the eurozone governments and does not carry out taskson their behalf. However, the national central banks in the Eurosystem still performsome services, such as holding their government’s account. The ESCB promotesthe smooth operation of the payment systems and contributes to the stability of thefinancial system, a task that is related to prudential supervision (discussed above).The ECB advises EU institutions: it has to be consulted in several instances, and insome cases its assent is needed for a decision to be taken. It is also consulted bynational governments whenever changes of central banking legislation arediscussed, as reported in previous chapters.

The oversight of the payments systems is shared between the ECB and thenational central banks. The former oversees cross-border, large-value paymentsystems, first and foremost TARGET 1 and 2 (see Chapters 3 and 4), whereas the latter oversee domestic systems. In 2001 the ECB applied the ‘core principlesfor systemically important payment systems’ agreed by the G10 Committee onPayment and Settlement Systems (CPSS). In contrast, the tasks of the Eurosystemused to be very limited with reference to oversight of securities clearing andsettlement systems. However, in 2007 the ECB decided to set up its own platformfor the clearing and settlement of TARGET 2 securities. Reportedly, this initiativewas relatively controversial both in the Governing Council of the ECB and in theEcofin, where it was also discussed. The main argument used by the ECB to justifythe creation of TARGET 2 S was to improve the efficiency of the system for clearingand settlement and that some national central banks performed (or used to perform)

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this function. Critics argued that it was an attempt by the ECB to expand itscompetence, it could have a negative effect on the primary task of the ECB and itwould lead to the creation of a public monopoly in this field.

As hinted above with reference to the no-bail-out rule, financial stability andcrisis management were a much debated issue in the early years of the eurozone,one critical argument being that the responsibilities for managing a banking orfinancial crisis were not clearly assigned (or openly disclosed) and the large numberof authorities potentially involved was detrimental to the provision of emergencyliquidity (Begg et al. 1998a; Buiter 1999: 201; Dyson 2000: 17) – this is the functionof the so-called lender of last resort (LLR) (see also Goodhart 1999, 2000). TheECB’s view is that, should the function of LLR need to be performed, providingliquidity to solvent but illiquid operators, national arrangements would apply;national central banks without supervisory power would get access to supervisoryinformation and they would be responsible for intervention. In cases needing a largeamount of liquidity, the ECB Council would be involved (Padoa Schioppa 2004:177–8).

Besides the provision of liquidity to banks to prevent a systemic crisis, a generalshortage of liquidity might be caused by a gridlock in the payments system or anexternal shock. The concerted actions of the ECB and the US Federal Reserve inresponse to the events of 11 September 2001 are examples of a successful operationto prevent a liquidity shortfall. This proved that the Eurosystem is prepared to handlethis kind of market turbulence (Padoa Schioppa 2004: 118).

The ECB has regulatory powers and can issue regulations and decisions, which‘enables it to fulfil its mandate autonomously without relying on legal acts by theEU institutions or the member states’ (Scheller 2004: 68). These powers are limitedto the extent necessary to perform the tasks of the Eurosystem. As part of its advisoryactivities, the ECB can issue recommendations and initiate EU legislation in itsfield of competence.

The ECB is also consulted by the national authorities when relevant nationallegislation is discussed. For example, when the reform of the Bundesbank was putforward in 2002, the ECB issued a legal position, stressing the importance of co-operation between the newly created single financial authority, BaFin, and theBundesbank in matters related to financial supervision. The ECB also took a legalposition on the reform of the Banca d’Italia and the Savings Law introduced by theItalian Government in 2004–5, and it expressed its opinion on the reform of the Bankof England.32 In some of these episodes the Bank has taken part in a two-level game,generally played by the national central banks or, in the most recent Italian case, bythe national government (see Chapter 4).

Overall, the ECB has been less keen than national central banks to take up specificor ‘extraordinary’ roles, and has also had fewer chances to do so. The ECB is still a ‘disembedded’ institution (Verdun and Christiansen 2000), whose high degreeof independence and relatively low degree of accountability have been subject to criticisms that have challenged the legitimacy of this institution. The Bank would have been even more criticized had it tried to expand its sphere of action orinfluence. The ECB might not agree with all decisions taken by other EU

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institutions, but if the matter is not within its sphere of competence, the ECB doesnot get involved nor make known its views; at least, it does not openly criticize thedecision, for example, with reference to some aspects of enlargement (interview,Frankfurt, January 2006).

Moreover, the ECB has been adamant in stressing the priority of price stabilityand its primary institutional responsibility in the conduct of monetary policy. Article2 of the TEU, which requires the ECB to support, subject to the attainment of pricestability, the economic policies and policy objectives of the EU, such as economicgrowth and employment, has been understated by the Bank (Padoa Schioppa 2004;Scheller 2004).

An overall assessment of the mode of central banking governance inthe eurozone

The ECB itself and other parts of the EMU framework have undergone processesof institutional adaptation, such as the reform of the ECB voting system or the revision of the Stability and Growth Pact. These institutional changes have,however, been made more problematic – or at least slowed down and reduced inmagnitude – by the configuration of the political institutions of the EU, characterizedby a high number of veto points in the system, often located at different levels of governance. This form of power-sharing (at times a ‘joint-decision trap’, Scharpf 1988) has increased the autonomy of the ECB, as it did in the case of theBundesbank and, with a different twist, in the case of the Banca d’Italia. It shouldhowever be noted that the governance structure of the ECB itself is characterizedby several potential veto players – the national central banks.

Besides the effect of political institutions, the configuration of economicinstitutions in the EU and the eurozone has also tended to augment the ECB’sautonomy, making ex ante macroeconomic policy co-ordination in the eurozoneunlikely (Dyson 2000: 15). Moreover, the weak representation of the interests ofmajor EU associations, including trade unions, reduces the possibility of the ECB’sinteraction with them, even if the Bank wished to follow this route (which it doesnot). This has prompted one of the members of the Executive Board to speak of the‘solitude’, not just independence, of the institution.

The ECB’s policy capacity in the monetary field is unquestioned, becausecompetences in the conduct of monetary policy are clearly defined by the Treaty,and the policy is underpinned by a shared, stability-oriented macroeconomicparadigm. By contrast, the policy capacity of the ECB in the conduct of exchange-rate policy is weaker (Hadjiemmanuil 2001; Buiter 1999: 190), owing to theambiguous distribution of institutional responsibilities at EU level betweenmonetary and political authorities, a situation that is potentially similar to that inwhich the Bundesbank found itself before EMU. The crucial difference is that the eurozone is not party to exchange-rate agreements, which could impinge on theECB’s autonomy and policy capacity.

Its policy capacity is minimal in banking supervision, and the ECB has mainlybeen consulted on issues of reform of financial services regulation and supervision.

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Overall, these arrangements seem to be weaker than those in place in Germanybefore EMU. Also, the Bundesbank was the main negotiator for Germany innegotiations for Basel 1 and Basel 2, which the ECB was not for Basel 2. Super-visory policy in the EU is still characterized by the coexistence of different nationalinstitutional models, though a more robust framework is being set in place with implementation of the Lamfalussy reform, which represents an institutionaladaptation to the changing configuration of financial markets in the EU andworldwide.

The ECB is often criticized for not being sufficiently accountable, transparent orultimately democratically legitimate (Buiter 1999; Amtenbrink 1999; Forder 2005;Hadjiemmanuil 2001: 157). Yet a comparative analysis of the experience of nationalcentral banks before and after EMU suggests that, in the cases of two of the centralbanks selected for this study, the Bundesbank and the Banca d’Italia, the provisionsfor ensuring transparency and accountability are no better – if anything, theirprovisions are much weaker. That said, it is also true that the ECB is a disembeddedcentral bank, whereas national central banks have been embedded in nationalpolities. Hodson and Maher (2001) point out that ‘legitimation is presumed forpolicy formed at the national level’. Similarly, by extension, one could argue that‘legitimacy is presumed for national institutions, in this instance national centralbanks’, whereas it has to be established in the case of the ECB.

The ECB is involved in a multi-level game in which the players are the nationalcomponents of the Eurosystem (that is, national central banks), national govern-ments and various EU institutions, such as the Commission. The game becomeseven more complex when the external dimension is added to it, and indeed theexternal representation of the eurozone remains a contested issue, partly becauseof its link to exchange-rate policy, another grey area of the EMU framework.

Conclusions

The ECB is the centrepiece of EMU. Consequently, any understanding of centralbanking governance in the eurozone should start from there, but should alsoconsider the complex, multi-level institutional architecture of the EU. The gover-nance structure of the ECB, and more generally the Eurosystem, remains verydecentralized, leaving a great amount of power to national central banks – forexample, in terms of their voting weight in the main decision-making body of theECB, the Governing Council (Gros 2005; Buiter 1999: 202). Moreover, severalimportant functions are still performed by national central banks in the Eurosystem(Bini-Smaghi and Gros 1999). This means that national central banks remainsignificant players in the Eurosystem, within which they interact in different waysand to which they have adapted according to their different traditions. Therefore,it is important to gather a good understanding of central banking governance at thenational level before and after EMU, as shown in previous chapters.

Since its creation the ECB has undergone no significant changes in its formaldegree of independence or its governance structure, even though an agreement ona partial streamlining of the latter was achieved after complex negotiations in 2003.

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However, such a reform has not yet been implemented, and according to manyobservers it fell short of what was required in the light of EMU enlargement,providing interesting similarities with the Bundesbank’s minimal reform afterGerman reunification. Moreover, as with the state central banks in the federalstructure of the Bundesbank before 2002, national central banks have retainedconsiderable power, competences and resources within the Eurosystem. It istherefore likely that in the future the ECB will have to undergo more substantialinstitutional centralization to increase its effectiveness, as did the Bundesbank in2002.

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6 ConclusionsA comparative assessment ofcentral banking governance in the EU

This book has analysed central banking governance in the EU before and after EMU was established. It has explored the multi-faceted character of central banksas public policy institutions involved in economic governance, as specializedbureaucracies (or technocracies) and sui generis as political actors active in national,international and transnational arenas, hence engaged in a variety of multi-levelgames.

The research question that informed this study was how central banking gover-nance in the EU has been transformed by EMU. In order to answer this question,other sub-questions have been identified. How did central banking governance workin different countries before EMU, and why? How did national central banks adaptto EMU membership, and why? How does the Eurosystem work?

Adopting a truly comparative perspective, the ECB has been compared cumgrano salis to selected national central banks before and after EMU, and to anotherEU central bank outside the eurozone. The concept of the mode of central bankinggovernance, as operationalized in this research, has provided a useful benchmarkfor the comparison. Briefly, as explained in Chapter 1, modes of central bankinggovernance consist of four basic components: the legal provisions, central bankautonomy, policy capacity and legitimacy.

Theoretically, a multi-level institutionalist framework has been adopted, pointingto institutions, at different levels, as the main explanatory variables of the variousmodes of central banking governance. Methodologically, the research has engagedin a structured, focused comparison of modes of central banking governance in theEU over time and across polities, complemented by process-tracing within each casestudy. Unlike the vast majority of works on central banks, a qualitative methodologyhas been used.

Empirically, the analysis has covered the multi-level institutional framework inwhich the central banks are embedded, that is: the organizational, national, EU andinternational levels; their core policies, namely monetary and exchange-ratepolicies, and financial supervision (mainly banking supervision); and other (at times atypical) functions performed by the central banks in various polities. Thetimeframe chosen for this research is sufficiently long to permit a thoughtfulevaluation of continuity and change, convergence and divergence, in modes ofcentral banking governance.

This concluding chapter first presents the main findings, discussing the modesof central banking governance in the four cases, subsequently evaluating theexplanatory power of the multi-level institutionalist framework outlined in Chapter 1. It then assesses convergence and divergence of modes of central bankinggovernance over time and across polities. Finally, this chapter elaborates on therole of central banks as conscious or unconscious players in multi-level games. Thefinal section attempts some generalizations: what lessons can be learnt from thesecase studies about future central bank adaptation to EMU, especially for newmembers of the Eurosystem?

Modes of central banking governance in the EU: lessons from thecase studies

The four case studies represent different modes of central banking governance,even though there are some similarities across cases. Overall, before the watershedreforms introduced by EMU, these modes remained stable over time, even thoughpath dependency was interrupted by critical junctures that largely coincided withmain policy failures, such as the withdrawal of the pound from the ERM in 1992and several supervisory failures in the 1980s and 1990s in the UK; the withdrawalof the lira from the ERM in 1992 and the Fazio affair in the 2000s in Italy; and thelist could continue. In addition, EMU represents the main critical juncture for twoof the three national central banks (it was not a critical juncture for the UK, whichopted out of the single currency), as explained below.

From its inception, the Bundesbank’s legislation gave the central bank a highlevel of independence. Looking at the empirical record, the Bundesbank’s autonomy(or behavioural independence) was an important feature of central bankinggovernance in Germany, even though there were a few instances where the Bankpreferred to avoid a potential confrontation with the political authorities, or else thelatter prevailed over the policy preferences of the central bank, as with the issue ofGerman monetary unification. Monetary policy was the responsibility of theBundesbank, which also played an important role in banking supervision, despitethe fact that the powers legally assigned to the central bank in the supervisory fieldwere quite limited, or at least rather vague. Among other functions performed bythe central bank, the Bundesbank was an important player in its own right at theinternational and EU levels. Finally, the Bundesbank primarily enjoyed output-oriented legitimacy, upheld by the widespread public support for its activities,despite the fact that the legal provisions for central bank accountability wererelatively ‘thin’.

The Bank of England, before the 1997 reform, had a low degree of legal indepen-dence. Statutory provisions coupled by a strong executive and a powerful Treasurysubstantially constrained the central bank’s autonomy, even though some room formanouvre was available to the Bank. However, the Bank of England played a keyand largely autonomous role in banking supervision and more generally bankingpolicy for part of the period considered. The 1997 reform reversed the status quo:the Bank of England was given legal operational independence and became

146 A comparative assessment

responsible for the conduct of monetary policy, whereas banking supervision wastransferred to a single supervisory authority. Among other functions performed by the Bank of England, it is important to mention the strong ties with the City (arelationship that loosened after 1997 and came to an end in the 2000s) and itsactivities in international supervisory fora, first and foremost the BCBS. Before the1997 reform, central bank independence was minimal, hence the provisions foraccountability were understated. Since 1997, the legitimacy of the central bank isboth input-oriented, in that the final objective of monetary policy is decided by the political authorities (the Treasury) and there are robust mechanisms for thecentral bank’s accountability, and also output-oriented, in that the Bank’s policyperformance has been appraised positively.

The Banca d’Italia, before the reforms introduced in the approach to EMU, hadlimited legal independence, especially economic independence. Despite this, centralbank autonomy was an important feature of central banking governance in Italy, dueto the weakness of domestic institutions, even though there were instances wherethis autonomy was challenged – the most extreme case being the politically-chargedjudicial investigations launched against the governor and one of his deputies in1979. De jure, the conduct of monetary policy was shared between the Bancad’Italia and the Treasury, even though in practice the Bank formulated andconducted it. The Banca d’Italia had extensive and discretionary powers in bankingsupervision. Moreover, for most of the period considered, the Banca d’Italia actedas a technical counter-power to the government and it had de facto a monopoly of macroeconomic expertise in Italy. Overall, the provisions for accountability were quite limited, not least because legally the Bank had limited independence,which also meant that the Banca d’Italia mainly rested on output-oriented legitimacy,indicated by the widespread public support it enjoyed. The mechanisms foraccountability were not stepped up when Italy joined EMU, despite the fact that thelegal independence of the central bank was increased.

The ECB is by law the most independent central bank in the world. Its autonomyis enhanced by the absence of cohesive EU institutions, especially a robust politicalcounter-power. The ECB conducts monetary policy in the eurozone and has aminimal role in banking supervision. The ECB (and the Eurosystem) have thestatutory task of promoting the smooth operation of payment and settlementsystems, and the Bank represents the eurozone in certain international fora. Atypicalroles performed by the Bank are difficult to identify, because it is rule-bound andprioritizes the conduct of monetary policy, even though the Bank has (unsuccess-fully) tried to expand its competence in banking supervision and more recently (andsuccessfully) in securities clearing and settlement. The legitimacy of the ECB isdiscussed below.

EMU represented the main critical juncture for the modes of central bankinggovernance of two of the three national central banks discussed in Chapters 2 to 4.If we look at adaptation to EMU/Eurosystem membership, few changes wererequired to the central banking legal framework in Germany, as the ECB was createdfollowing the Bundesbank’s model. However, in the run-up to the final stage ofEMU, when decision-making power was transferred to the ECB, the Bundesbank

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had to adapt to a diminished international and national status. This proved to berather problematic for the bank – as suggested, for example, by the numerous pressstatements on exchange-rate policy released by its senior management during theearly years of the eurozone – because the Bundesbank had been such an importantnational and international actor before EMU. The cultural and institutional shockof the ‘descent from the Olympus’ was mitigated by the fact that the ECB was builtand operated according to the template provided by the Bundesbank and several ofits senior officials moved to the ECB, which is located in Frankfurt.

From the TEU (1992) onwards, in preparation for EMU several amendments ofthe central banking legal framework were introduced in Italy – mainly concernedwith central bank independence and the conduct of monetary policy. In the finalstage of EMU, the decision-making power in monetary policy was officiallytransferred from the national level to the ECB, even though in practice in the pastthe Italian central bank had by and large followed the monetary policy decisionstaken by the Bundesbank. However, in its own way the Banca d’Italia had been avery influential actor in the domestic arena – it was a ‘strong’ institution in a ‘weak’state, operating at the interface of national, European and international levels ofgovernance. This ‘exceptional’ status might explain why it was relatively difficultfor the Banca d’Italia to adapt to membership of the Eurosystem, though this wasalso partly attributable to the rather ‘Eurosceptic’ attitudes of its top managementin a crucial period for EMU (1993–2005).

The degree of adaptation of the Bank of England to the EMU framework hasbeen limited in scope compared with the other case studies, because it is not part ofthe Eurosystem. If anything, the Bank of England is often presented as an alternativemodel to the ECB (cf. Buiter 1999). Should the UK join EMU in the future, it islikely that the Bank of England’s adaptation to membership of the Eurosystemwould be uneasy, not only as far as the institutional framework and monetary policy are concerned, but also in view of the Eurosceptic attitudes of the seniormanagement at the Bank. This bears some similarities with the experience of theBanca d’Italia in the early years of EMU.

As far as the ECB is concerned, since its establishment in 1998 it has undergonea process of incremental institutional adaptation of its monetary policy framework,its governance structure, its relations with national central banks, and its relationsin various international arenas.

Evaluating the explanatory power of the multi-level institutionalistframework

The introductory chapter outlined a multi-level institutionalist framework thatpostulated the effects of institutions situated at various levels of governance onmodes of central banking, leaving open for empirical investigation the questions ofwhich institutions matter most, how and why. In the light of the material presentedin the previous chapters by taking a longitudinal perspective and a horizontalperspective, this section discusses the main causal mechanisms and scope conditionsconcerning institutional influence.

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Table 6.1 Major findings on dimensions of the dependent variable

Bundesbank Bank of England Bank of Italy ECB

Legalprovisions

Before EMUHigh economicand politicalindependence

After EMUUnchanged, buttreaty-guaranteedindependence

Before 1997Low politicaland economicindependence

After 1997Highoperationalindependence

Before EMUHigh politicalindependence,low economicindependence

After EMUTreaty-guaranteedindependence

After 1998Treaty-guaranteedeconomic andpoliticalindependence

Central bankautonomy

Before EMUHigh (but somecaveats)

After EMUHigh (butmember ofeurosystem)

Before 1997Low

After 1997High

Before EMURelatively high

After EMUHigh (butmember ofeurosystem)

After 1998High (butmember ofeurosystem)

Central bankpolicy capacity

Before EMUMonetarypolicy:highExchange-ratepolicy:medium-highde factoBankingsupervision:lowAtypical role:economicforeign policyactor

After EMUMonetary andexchange-ratepolicies:member ofeurosystemBankingsupervision:involvedAtypical role:none

Before 1997Monetarypolicy:lowExchange-ratepolicy:lowBankingsupervision:highAtypical role:mediator City–government

After 1997Monetarypolicy:highExchange-ratepolicy:relatively highBankingsupervision:noneAtypical role:none

Before EMUMonetarypolicy: mediumExchange-ratepolicy:mediumBankingsupervision:highAtypical role:technicalcounter-power

After EMUMonetary andexchange-ratepolicies:member ofeurosystemBankingsupervision:in chargeAtypical role:none

After 1998Monetarypolicy:highExchange-ratepolicy:medium-highBankingsupervision:noneAtypical role:none

Legitimacy mainly output-oriented

Before 1997mainly input-oriented

After 1997input- andoutput-oriented

mainly output-oriented

After 1998mainly output-oriented

International and European institutions affect the various components of modesof central banking governance and tend to promote their convergence (cf theliterature on Europeanization).1 The first causal mechanism through which inter-national and EU institutions affect modes of central banking governance is‘adaptational pressure’ on national central banking legislation, which takes placewhenever there are specific EU and (less frequently) international rules to beincorporated into national legislation and they are different from what is already inplace at national level. The changes required by EMU membership in the countriesof the eurozone are the most notable example of this, and fit (or misfit) variessignificantly across the three case studies. For example, change concerning the legalprovisions on central bank independence was minimal in Germany, given the factthat E(M)U rules were similar to German legislation (for the reasons explained inChapter 3). By contrast, in Italy national legislation concerning central bankindependence had to be changed after the signing of the TEU.

The second causal mechanism by which systemic international institutions mayaffect the autonomy and policy capacity of central banks is by providing them withextra resources (or, at times, constraints) to be deployed at the domestic level. Thefirst scope condition for this to happen concerns the configuration of nationalpolitical institutions, because a weak executive and a fragmented state structureprovide multiple points of access for external influence, whereas a strong andpowerful executive can more easily resist external pressure and can limit the abilityof the central bank to play a two-level game (cf. Putnam 1988), which is discussedfurther below. The second scope condition is the micro-institutional features, suchas expertise and international contacts, that can enable a central bank to exploit toits advantage external factors (or resist external constraints). The Banca d’Italiadeliberately used the external constraints posed by the EMS in an attempt to imposemacroeconomic discipline on the fragmented policy-making structure in Italy. TheBundesbank was able (most of the time) to resist potential external constraintsimposed by European exchange rate agreements on the conduct of monetary policyin Germany.

The third mechanism through which international and EU institutions affectmodes of central banking governance is ‘ideational diffusion’, promoting the spreadof specific policy paradigms (Marcussen 2000). The most notable example was thespread of the stability-oriented paradigm, based on an independent central bankand the priority of maintaining price stability (Dyson 1994; McNamara 1998). Amodified version of this paradigm underpinned the 1997 reform of the monetarypolicy framework in the UK (King 2005), which opted out of EMU and was in theERM for less than two years. This highlights the fact that diffusion of ideas canoccur even when there is no legal adaptational pressure, such as EMU rules to beincluded in national central bank legislation in the eurozone. Unlike in monetarypolicy, in the supervisory field there is no prevailing policy paradigm or institutionalmodel (Busch 2004). Ideational diffusion has taken place ad hoc, with the singlefinancial supervisory authority adopted in the UK and Germany, but rejected inItaly. This suggests that one scope condition for the diffusion to take place is theexistence of a consensual policy paradigm and an institutional model perceived as

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successful. Moreover, domestic policy failures might favour learning processes.The second scope condition is the presence of receptive domestic actors – first andforemost, the central bank with the resources to act – promoting the spread of aspecific policy paradigm.

Overall, the weaker the international institutions and the stronger the EUinstitutions are in a given policy area, the more likely the latter are to promoteconvergence in policy and, to a lesser extent, in institutional arrangements. In areas such as monetary and exchange-rate policies, where international institutionshave largely been absent and EU institutions have been robust, the latter have been comparatively more influential than the former, fostering a process of policyconvergence among the participating member states. Thus, the processes of Europeanintegration generate specific stimuli towards convergence, in addition to generaltrends resulting from international pressure. Indeed, the convergence of modes ofcentral banking governance is much more advanced in Europe than anywhere else.

Borrowing from the ‘Bundesbank model’, EMU has imposed specific institutionaland policy templates, based on central bank independence, stability-orientedmonetary policy (and more generally macroeconomic policies) and a model ofoutput-based legitimacy (Hodson and Maher 2002), not only for the ECB, but alsofor national central banks in the Eurosystem. Nonetheless, as previous chapterssuggest, it is relatively easier to transplant legal provisions, and to some extentinstitutional and policy frameworks, than to replicate sources of legitimacy ensuringthe democratic accountability of these technocracies, as elaborated below withreference to the Bundesbank and the ECB. This also suggests that the ideationaldiffusion that can be promoted by international and European institutions – anothercausal mechanism through which systemic institutions affect mode of centralbanking governance – has to come to terms with domestic norms and institutions.

In areas such as banking supervision, where EU institutions have been relatively‘thin’ – at least until the creation of the Lamfalussy framework (2004) and theestablishment of the London-based Committee of European Banking Supervisors(2004) and the Frankfurt-based Banking Supervisory Committee (2000) –international institutions, such as the Basel Committee on Banking Supervision,have been more influential than EU institutions, promoting a gradual process ofpolicy convergence. Such a process, which involved, for example, the definition of capital requirements as well as practical co-operation between national super-visory authorities, extended well beyond Europe, since the USA, Canada and Japanare members of the Basel Committee. Moreover, the Basel 1 Accord was eventuallyadopted by 50 countries worldwide, and the same is likely to happen with Basel 2.

Overall, the convergence stimulated by international regulatory institutions hasbeen much less intense than in the case of European monetary and exchange-rateagreements, such as the EMS and EMU, because international regulation andstandard-setting processes are less developed than the process of European monetaryintegration and they are based on soft laws, rather than binding rules. Hence,adaptational pressure is lower, or at least can be more easily avoided. Moreover, ithas involved specific features of policies, rather than institutions, because nationalsupervisory framework differs considerably, as explained below.

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Changes in international and EU institutions – such as the establishment of theEMS in 1979, the ERM crises in 1992–3, the Basel 1 Accord in 1988, the Basel 2Accord in 2002 and the Lamfalussy framework in 2004 – trigger policy shifts that alter policy trajectories. However, institutions tend to be ‘sticky’, and majorinstitutional changes, such as those mentioned above, are the exception rather thanthe rule. Incremental and informal changes are also important, albeit more difficultto detect – or at least their exact timing and specific effects are hard to establish.Some examples are the evolution of the ERM into a semi-fixed exchange-rateregime in the second half of the 1980s, the change in the remit of the Basel BankingCommittee, and so on.

National institutions affect modes of central banking governance and explaintheir divergence (or partial convergence). National political institutions determinethe ‘strength’ of the political authorities, especially the government, vis-à-vis thecentral bank in a way that goes beyond the concept of ‘core executive’ (cf. Elgieand Thompson 1998). The more fragmented and dispersed – and generally speakingthe ‘weaker’ – domestic political institutions are, the stronger the central bank’sautonomy and policy capacity are likely to be, even though bank-specific factorsalso come into play. In other words, the scope condition is that the central bank must be willing and able to use the opportunity structure, hence the importance ofmicro-institutional assets. The most important political institutions in determiningthe domestic political opportunity structure are first and foremost the presence (or absence) of majoritarian institutions and a centralized (or fragmented) statestructure.

The Bundesbank’s autonomy and monetary policy capacity, besides beingsafeguarded by legislation, were enhanced by the federal state structure, charac-terized by power-sharing institutions and the absence of powerful institutionalrivals: the Ministry of Finance and the banking supervisory authority lacked theassets of the Bundesbank. The Banca d’Italia’s autonomy and policy capacity,which were not safeguarded by legislation, were facilitated by the fact that the Bankoperated in a fragmented institutional context, characterized by weak institutions,an under-resourced treasury and no banking supervisory authority outside thecentral bank. By contrast, the Bank of England’s autonomy and policy capacitywere limited not only by statutory provisions, but also by a strong executive,cohesive state structure and a well-resourced treasury. In the case of the ECB, itscast-iron legal independence is augmented by the weakness of EU politicalinstitutions, the fragmentation of authority across national lines, and the lack of aunitary and powerful executive in the EU. This is why any meaningful assessmentof central bank autonomy and policy capacity cannot solely rely on statutoryanalysis (Forder 2000) and needs to be contextualized within the nationalinstitutional setting in which the central bank operates.

Domestic political institutions determine the number of potential veto players inthe polity (cf. Luetz 2004), and hence the possibility (or the difficulty) of bringingabout institutional reforms of central banks. The larger the number of veto players,the more difficult, or time-consuming, the reform is likely to be. This was broughtto the fore when a major reform of the Bank of England was implemented in 1997,

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only a few months after the Labour Party came to power, whereas the reforms ofthe Bundesbank in both 1991 and 2002 took years to be agreed. A major reform of the Banca d’Italia was under discussion from 2001 to 2005 and was eventuallyagreed in a much watered-down format after a scandal in 2005, coupled withinternational and EU pressure. The large number of veto points in the EU systemand the high degree of ECB independence, which is constitutionally protected andwould require a cumbersome process of amendment involving too many players,feed into the criticism of excessive ECB independence.

Finally, domestic institutions, broadly conceived so as to include the normativesocial order (or polity ideas), affect central banks’ legitimacy, explaining why theBundesbank model has hardly ever been questioned in Germany, whereas even a‘softened’ version of it is unacceptable in the UK (Busch 1994). This also accountsfor the ECB’s difficulty in grappling with the legitimacy issue, for the ECB is stilla disembedded institution in the EU (Verdun and Christiansen 2000) and thenormative social order of this multi-national polity is heterogeneous.

Central banks’ policy capacity and autonomy are also affected by domesticeconomic institutions, even if these effects are rather ambiguous and vary acrosspolicies, being less pronounced in monetary and exchange-rate policy owing to abasic public goods problem (Gowa 1988). By contrast, interest groups can moreeasily identify their preferences concerning financial supervision; hence they arewilling to engage in lobbying activities. Central banks’ responsibility for bankingsupervision and broader supervisory competences provides these technocracieswith extra resources vis-à-vis the political authorities, altering the domestic oppor-tunity structure, but it can also impose constraints in relations with the sectorregulated, as shown by the experience of the Bank of England in the 1980s and1990s, and the Banca d’Italia in the 2000s.

As in the case of international institutions, domestic institutional changes arerare, but they introduce dynamism into the evolution of central banking governance.Textbook examples are the reform of the Bank of England and the creation of theFSA in 1997; the reform of the Bundesbank and the creation of the BaFin in 2002;and the formal attribution of competition policy in the banking sector to the Italiancentral bank in 1990. Sometimes institutional changes are incremental and/or notformalized. An informal change of political institutions that diminished the autonomyand policy capacity of the Bank of England took place under the Conservativegovernment in the 1980s. Similarly, changes affecting economic institutions, suchas the blurring of boundaries between different sub-sectors of the financial system,both in the UK and Germany, have promoted the creation of a single regulatoroutside the central bank for the entire financial system.

Micro-institutional factors can affect modes of central banking governance,making convergence more likely or more difficult, depending on the specificcircumstances. The causal mechanism by which the micro-institutional features ofthe central bank – that is, its governance structure, and tangible and intangibleresources – affect its autonomy, policy capacity and legitimacy is by empoweringthe central bank vis-à-vis other domestic forces, which however depends on scopeconditions.

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Intangible resources, including expertise (or economic knowledge), credibilityand public support are especially important for central banks that have limitedformal independence or do not have clearly defined policy competences – this is thefirst set of scope conditions. For example, a strategic use of technical knowledgewas deployed by the Banca d’Italia in the conduct of monetary and exchange-ratepolicies in the 1980s. This was a way of excluding the political authorities’involvement in these policies, so the bank could attempt to pursue anti-inflationarypolicy objectives. Another example was the reorganization of financial servicesregulation and supervision in the UK in the 1980s, which was masterminded by theBank of England relying on its expertise in the field and its consolidated contactswith the market. After all, central banks are political actors, which operate usingthe resources at their disposal to protect their bureaucratic autonomy and policycapacity, and to legitimize their conduct.

Within EMU, cutting-edge economic knowledge and information are importantassets for the national central banks in the Eurosystem, for they are means to wieldinfluence in the decision-making process of the Governing Council (interview,Frankfurt, January 2006). The Bundesbank, for example, enlarged its researchdepartment in the 2000s. The Banca d’Italia devotes part of the activities of its well-established research department to economic analyses of the eurozone. The ECBhas expanded its research staff substantially since 1999 and has undertaken anexternal audit of its internal research. Outside the eurozone, the Bank of Englandhas also sought to acquire top-level economic expertise, mainly through appoint-ments to the MPC, but also by expanding its research staff. Finally, economicstudies of central banks have begun to recognize the importance of these intangibleassets, trying to measure and compare the research activities and output of centralbanks (cf. Eijffinger et al. 2002; St-Amant et al. 2005).

Empowerment of the central bank depends not just on intangible assets, but onanother scope condition: political opportunity structure. Different opportunitystructures determined by the configuration of domestic political institutions explain why the Banca d’Italia was able to deploy its intangible assets to gain aconsiderable degree of autonomy and policy capacity vis-à-vis the national govern-ment, whereas this option was not available to the Bank of England, which, despiteits expertise, had to deal with strong domestic institutions and an intellectuallyrobust Treasury.

As far as reform of the governance structure is concerned, the four central banksexamined have moved in different directions, largely because of their differentstarting points. Overall, they seem to have moved towards a mid-way position.Whereas the Bundesbank, which previously had a federal structure, increased thecentralization of its decision-making structure in 2002, the Bank of England, whichhad previously had a hierarchical structure, adopted a more pluralistic decision-making structure with the establishment of the Monetary Policy Committee in 1997.The Banca d’Italia also moved towards a less hierarchical decision-making structurein 2005. A reform of the voting system of the ECB was agreed in 2003, in an attemptto streamline decision-making, though it has not yet been implemented and is likelyto require further adjustment as a consequence of EMU enlargement.

154 A comparative assessment

To sum up, whereas international and EU institutions tend to promote conver-gence, national institutions are better suited to explaining divergence or slow (orpartial) convergence. Micro-institutional factors can play out both ways, promotingor slowing down convergence. Overall, distinctive micro-institutional features aremore likely to make convergence harder to achieve, a point that is elaborated below.It is, however, difficult to separate neatly international and European factors (theactivities of the BCBS are a case in point), and it can also be problematic todistinguish between national and international (or EU) factors, owing to thepervasive effects of the process of European economic integration and financialglobalization on the domestic arena. The reform of the Bank of England and thecreation of the FSA, the reform of the Bundesbank and the creation of the BaFin,and the reform of the Banca d’Italia, which lost its competence for bankingcompetition policy, are interesting cases of interconnecting and mutually reinforcingexternal and internal factors. Similarly, micro-level reforms of central banks(especially their governance structure) are often part of broader domesticinstitutional changes, as in the case of the Bank of England in 1997, the Bundesbankin 2002, and the Banca d’Italia in 2005.

Convergence and divergence in central banking governance in the EU

Overall, modes of central banking governance have tended to converge in the EUduring the last two decades or so, with an intensification taking place in the run-upto EMU. However, this assessment needs to be qualified, because convergence hasinvolved some aspects (primarily, central bank institutional independence and theconduct of monetary policy), but not others, such as financial supervision andinstitutional bases for democratic legitimacy. Worldwide, there has been a general institutional convergence towards the model of independent central banks(McNamara 2002a), though the most significant trend was that in the EU after theEMU project was launched, and as a consequence of it. Nonetheless, importantnational differences remain within the EU. Notably, the Bank of England enjoysonly operational independence, whereas the ECB and the national central banks ofthe eurozone have goal independence, within the remit of protecting price stability.

This trend towards central bank independence has been reflected in the substantialamendment of central banking legislation in various countries. The exception isGermany, which already had legislation in place to safeguard the independence ofthe Bundesbank and its monetary policy capacity.2 It should, however, be noted thateven before the relevant legislative changes some central banks had alreadymanaged to acquire greater autonomy from their national governments and greaterpolicy capacity, as in the case of the Banca d’Italia in the 1980s and the Bank ofEngland after the 1992 exchange-rate crisis.

The policy capacity of central banks has converged in some areas, such asmonetary policy, but less so in others, such as financial regulation and supervision.The limited convergence that has taken place in the supervisory field has mostlyinvolved agreement on common principles, rather than on policy objectives,instruments and institutional arrangements, which continue to vary across the EU.

A comparative assessment 155

It is also important to bear in mind that supervisory policy has been a core activityfor some central banks (the Banca d’Italia and the Bank of England before 1997),but not for others (the Bundesbank and the ECB).

Examples of distinctive national supervisory institutional arrangements abound.For instance, a distinctive version of the ‘twin-peak’ model of supervision is usedin Italy. The UK adopted a single supervisory agency for the entire financial sectorin 1997, and a similar reform was implemented in Germany in 2002. Several of therecent reforms in this field across the EU have moved towards a single supervisorfor the entire financial sector, generally outside the central bank,3 exhibiting a certaindegree of convergence. However, different macro regional models of supervisoryauthorities persist within the EU, in that the most noticeable alternative to the Anglo-German model outlined above is the ‘Mediterranean model’, which assigns animportant supervisory role to the central bank.

This lack of convergence appears even more pronounced if the assessment isextended to banking policy. For example, the policy paradigm that prevailed amongthe top management of the Banca d’Italia until 2005 contained a strong preferencefor ‘economic patriotism’. By contrast, the Bank of England since the 1980s and tosome extent the Bundesbank since the 1990s have been keen to put in place thedomestic regulatory and market conditions necessary to attract internationalinvestors.4

Beyond these three policy areas, there has also been convergence in the otherfunctions performed by central banks, while their atypical functions have tendedto disappear. In other words, greater legal independence and policy capacity in the monetary field have often coincided with a normalization of the functions ofcentral banks. The ‘mediating’ role performed by the Bank of England between the financial sector and the government was abandoned in the 1990s, and since the1997 reform the Bank has been eager to promote its image as a ‘technicalinstitution’. The function of the Banca d’Italia as a ‘technical counter-power’ to the government came to an end in the 1990s. After 1999 the international role of the Bundesbank – which had been a foreign (economic) policy actor in its ownright and, paraphrasing Marsh (1992), the bank that ruled Europe – was reduced toa more domestic dimension.

All these processes of (at least partial) convergence that took place over time,even before EMU was established, help to explain the national central banks’satisfactory adaptation to EMU, the successful establishment of the ECB and theoverall smooth functioning of the Eurosystem/ESCB. They also explain whytensions in the Eurosystem/ESCB have emerged in areas where convergence before EMU had been minimal, such as financial supervision, as well as in issuesconcerning the legitimacy of these non-majoritarian institutions, given the fact thatdifferent models of accountability and transparency persist across Europe.

This issue came to the fore in the debate about the so-called democratic deficitof the ECB. Briefly summarizing the main points of this discussion, which weredealt with in greater depth in previous chapters, especially Chapter 4, the ECB isoften criticized for being too independent and not sufficiently accountable ortransparent (McNamara and Meunier 2002), excessively focused on price stability

156 A comparative assessment

and hence ultimately making political distributive choices (Verdun 1998), insteadof taking purely regulatory decisions (cf. Majone 1996; Wincott 1992). Moreover,the ECB is often portrayed as a disembedded institution (Verdun and Christiansen2000), not flanked by strong EU-level political institutions, and lacking a Europeandemos (Jabko 2003).

On the one hand, the analysis of the institutional templates, policies and legis-lations of national central banks before EMU reveals that the legitimacy of thesenon-majoritarian institutions had hardly ever been questioned, even thoughprovisions for transparency and accountability were not particularly robust inGermany, Italy or the UK (before the 1997 reform). On the other hand, it could beargued that in the case of Italy and the UK such provisions were less necessary, sincetheir central banks had only limited formal independence, though they had aconsiderable degree of autonomy and capacity, at least in certain areas, as suggestedin the preceding chapters. It is also true that the Bundesbank was less independentthan the ECB is now, given the fact that it was embedded in a national system ofchecks and balances (McNamara and Jones 1996) and faced a unified politicalcounter-power, the federal government, and a homogeneous demos that shared theBundesbank’s priority of price stability (Verdun 1998).

The reformed Bank of England provides an alternative model of accountability,which according to some proponents (Buiter 1999) could be adopted by the ECB. Whereas more salience is given to input-oriented legitimacy in the UK, the Bundesbank’s model, which left its imprint on the ECB, relies mainly on output-oriented legitimacy, that is, the policy results achieved – ‘deeds, not words’, asargued by the ECB’s chief economist, Otmar Issing (Issing 1999: 506). Yet theargument could be turned on its head, asking to what extent the British model,which is embedded in a specific consolidated national polity, could successfully betransplanted into the eurozone, a multinational polity in the making.

Multi-level games in central banking governance in the EU

Central banks have often engaged in double-edged diplomacy, or two-level games,across national and international forums, crossing the line that separates domesticand international bureaucracies from distinctive political actors. Sometimes centralbanks have taken part in three-level games: national, EU and international. TheBundesbank has been the most notable example of a powerful three-level player;for instance, during the functioning of the EMS it played a pivotal role in Europeanmonetary co-operation and transatlantic monetary relations (Loedel 1999). TheBank of England has also on occasion played a three-level game; for example, itwas eager to reach an agreement on Basel 1 – a non-legally-binding internationalagreement later transposed into an EU directive – as a way to counteract the EUbanking legislation that was being discussed in the 1980s (Coleman 1996). TheECB inherently faces a variety of interconnected games: it has to co-operate withactors at EU level (Ecofin, Eurogroup, European Parliament, Commission), with its own components in the member states (the national central banks of theEurosystem) as well as other national actors, such as governments, and (beyond

A comparative assessment 157

the EU) with third countries, especially the USA, and international bodies such as the IMF and World Bank (Howarth and Loedel 2003).

On occasion central bankers have been willing to engage in ‘collusive actions’in international or transnational arenas, trying to tip domestic policies in a certaindirection, gain more autonomy from national governments, or jointly regulatefinancial markets and other economic forces (Kapstein 1989). For example, theEMS provided an external policy location embedded in the EU level of the gamewhere central bankers could pursue their monetary policy preferences vis-à-visnational political authorities and economic interest groups, generally through astrategic use of exchange-rate policy. This was particularly true in the case of theBanca d’Italia (Quaglia 2004a), though the Bank of England also attempted thisstrategy in the late 1980s (Elgie and Thompson 1998).

In the negotiations of Basel 1 some central bankers, among them the domesticallyindependent Bundesbank, welcomed the external constraints placed on them(Kapstein 1992: 282). As central banks, they were in favour of stricter capitaladequacy standards, but they preferred to be seen as being coerced into the inter-national agreement because of the opposition of powerful domestic interest groups.Moreover, the implementation of Basel 1 strengthened the domestic position of thesupervisory authorities (the Bundesbank and BAKred) in relation to powerfulindustrial associations – Germany was a clear instance of this (Kapstein 1994).

A more recent example of a two-level game played by an EU central bankoccurred during the negotiations leading up to the reform of the Bundesbank in2002. In this instance the Bundesbank largely succeeded in mobilizing resourcesat EU level – to be precise, the ECB – which intervened, with limited success, inthe domestic debate on the reform of banking supervision, supporting the positionadvocated by the Bundesbank. Another attempt to mobilize the ECB, in this caseagainst a national central bank, was made by the Italian Government with referenceto the Banca d’Italia’s highly criticized conduct in banking competition policy inthe summer of 2005, which led to calls for the resignation of the governor.

At other times central banks have acted mainly as representatives of their countryin international or transnational forums, defending national interests or the interestsof domestic groups, as happened during the international negotiations of Basel 1,and especially of Basel 2. In both cases non-central-banking national supervisoryauthorities, such as the BAKred and BaFin for Germany and the FSA for the UK,were also involved in the negotiations, rendering the game more complicated, inthat the national authorities had to co-ordinate among themselves. In the case ofBasel 2 it was clear to all participants that it was not simply an internationalagreement on banking regulation, but that it was a matter of financial diplomacy anda very political game, in which the national authorities tried to obtain competitiveadvantages by means of banking regulation (interview, Frankfurt, January 2006).

Basel 2 also required close co-operation between the public authorities (centralbanks and supervisory agencies) and the banking sector, which was involved in anintensive and extensive consultation, providing data, information and expertise,with the flow of information going both ways (Quaglia 2008). For example, aftereach important meeting in Basel the Bundesbank and the BaFin organized a

158 A comparative assessment

debriefing session for the German banks, either in Frankfurt or in Bonn (interview,Frankfurt, January 2006). The British Treasury and FSA also organized debriefingsessions. It should be noted that the Bank of England has always been keen topromote London as a leading financial centre in Europe, and after EMU the Bundes-bank has become sympathetic to the goal of promoting Finanzplatz Deutschland.

The examples mentioned above are some clear instances of a multi-level game being played involving central banks. However, three important caveatsshould be added with reference to the terminology of multi-level governance. First, many authors (Baker 2005; Hudson 2005; Langley 2005) working oninternational political economy would disagree with the word ‘level’, which implies a vertical hierarchy, whereas in many cases the policy environment ischaracterized by horizontal arenas and connected but dispersed policy locations.Hence, they would prefer the terminology of multi-dimensional policy space andmultiple arenas.

Second, the approach taken in this research has privileged official institutions andbodies, rather than private actors, whereas the traditional governance approachencompasses both private and public spheres. However, a perspective that focuseson public institutions permits a more parsimonious operationalization of theresearch, which is necessary for a study covering four central banks.

Third, only some international or transnational institutions have been discussedin the empirical chapters, usually those that are more relevant for the policydiscussed (cf. Hirst and Thompson 1999; Baker 2005). For example, multilateralfinancial institutions (such as the IMF, World Bank and OECD), informal or lessinstitutionalized multilateral arrangements (such as the various G7 forums) andtrans-governmental networks other than the BCBS (such as the IOSCO – theInternational Organization of Securities Commissions – and CCP) are only brieflymentioned. Whereas multilateral financial organizations have states as members,the transnational regulatory networks are composed of national regulators andsupervisory bodies in a given area of finance, hence they are not entirely capturedby focusing on traditional international organizations (Baker et al. 2005).

General lessons, caveats and proposals for further research

This research has demonstrated the importance of contextualizing the analysis ofcentral banks and their activities in the domestic, international and EU institutionalsettings in which these technocracies operate. As argued in the introduction,focusing only on one level – be it national, international or EU – would overlookan important part of the explanation. Similarly, the traditional statutory analysisperformed by economists leaves unexplored many important aspects of centralbanking governance, which cannot be gauged by conducting a legal analysis.Finally, in order to understand the functioning of the Eurosystem and the ECB, as well as the advantages and disadvantages of different models, one needs toappreciate the institutional configuration and core policies of national central banksbefore EMU, their adaptation to this new policy regime, and the main features ofpotential alternative models.

A comparative assessment 159

What generalizations can be made from these case studies about the adaptationof national central banks to membership of the Eurosystem? What lessons can beextrapolated for the national central banks that will be going through that processin the future as a consequence of EMU enlargement?

Central banks that have been very important players domestically and inter-nationally are likely to find it more difficult to adapt to membership of theEurosystem, which implies a diminished role, internationally and domestically, anda loss of policy competences. Such central banks are more likely than others toresist attempts at any further centralization in Frankfurt or any increase in ECBresources or competences, though this will also depend on the attitude of the topmanagement. In a sense, size seems to matter, but it should be borne in mind thatthis research has focused on the central banks of large countries. A somewhatspeculative caveat is that central banks in small states might actually come tosupport further ECB/Eurosystem centralization as a counterbalance to the influenceof the large central banks in the Eurosystem.

For all the prospective members of the Eurosystem, there is likely to be a sort ofhalfway stage, when they adapt the governance structure of their central bank, byreforming decision-making structures that are too decentralized, such as that of theBundesbank before 2002, or excessively hierarchical, such as the monocraticstructure of the Banca d’Italia before 2005. Specific co-ordination units for Euro-system activities will be created, though some of these structures have already beenset in place by a few central banks of the new member states in the run-up to EMU membership. A strengthening of the research departments of the nationalcentral banks of the new members will be an important intangible asset, becausetechnical knowledge, expertise, data and convincing arguments are ways to exertinfluence in the Governing Council of the ECB and the ESCB committees, andmore generally in the Eurosystem.

It is also likely that, once they are in the Eurosystem, national central banks willtry to claim a greater domestic role in banking or even financial supervision, thoughmuch will depend on the national institutional arrangements in place. Central banks’claims will succeed if they have political support, the backing of the financial sector,and prior policy competences and resources (such as expertise, knowledge of themarket or personnel), and if other supervisory authorities jostling for power areabsent.

Three important qualifications are needed concerning some of the findings ofthis research. First, this study examined a small sample of important central banksin the EU. The case selection did not include central banks of small member statesor the new member states, and this might have biased the results. Second, theresearch focused on core, but by no means all, activities of central banks. Forexample, the functioning of the payment systems was not investigated. Finally, theanalysis conducted at each of the three levels was necessarily concise owing tospace constraints.

In the light of these qualifications, three main proposals can be put forward forfurther research. The first is to introduce variation by increasing the number of casestudies and looking at other central banks in the EU. For example, one could focus

160 A comparative assessment

on central banks from small member states, or the new member states, or evencentral banks outside the EU. Or one could increase the number of policy areas/issues studied, or other activities of central banks could be included, such aspayments systems or participation in international bodies, such as the IMF, the G7and the World Bank. Finally, each of the three levels of analysis, but in particularthe international one, could be explored further.

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Notes

1 Introduction

1 Fforde 1992; Hennessy 1992; Kynaston and Roberts 1995; Wood, J. 2005 on the Bankof England; Collana Storica of the Banca d’Italia; de Haan 2000 on the Bundesbank;Buyst et al. 2005 on the National Bank of Belgium.

2 A few works have also looked at the role of central banks in wage-bargaining processes,in and across countries, generally using game theory (Franzese 2001; Hall and Franzese1998).

3 Economists have recently attempted to measure such features. For example, Eijffinger,de Haan and Koedijk 2002 set out to measure the research performance of central banksin the EU. St-Amant et al. (2005) extend the analysis to other Western countries.

4 Woolley (1984: 13) uses a behavioural definition of central bank independence: ‘Acentral bank is independent if it can set policy instruments without prior approval fromother actors and if, for some minimal time period . . ., the instrument settings clearly differfrom those preferred by other actors’.

5 Pagoulatos (2000: 343–4) uses the concept of ‘policy strength’, defined as ‘the abilityof a central bank to operate with the desired efficacy within a certain frameworkprescribed by the degree of government-granted independence or the lack thereof’. Ahigh degree of policy strength means that a central bank can exert substantial control incertain policy areas.

6 Recently, the exchange-rate regimes have been modelled as an alternative device tocentral bank independence in order to fight inflation (see special issue of InternationalOrganization, 2002, 56, 4).

7 A handful of authors have argued that state structure – or, to be precise, categorizationas either a federal state or a unitary one – affects the degree of central bank independenceand consequently the conduct of monetary policy, in that federal states are more likelyto have independent central banks (Lohmann 1998; Posen 1993).

2 The Bank of England

1 Treasury papers released under the Freedom of Information Act confirm that, by the late1980s, the thinking in the Treasury had shifted in favour of greater central bankindependence (see Financial Times, 8 March 2005).

2 In December 1993 the Treasury and Civil Service Committee called for a moreautonomous central bank, on the lines of the New Zealand model. The Bank of England'saccountability would be ensured by an annual report to Parliament and appearancesbefore the Treasury and Civil Service Committee.

3 The election manifesto of the Labour Party contained the commitment to 'ensure thatdecision-making on monetary policy is more effective, open, accountable and free fromshort-term political manipulation' (The Times, 4 April 1997).

4 After Gordon Brown's announcement of the reform, government bonds recorded a hugeone-day gain in price, reaching one of the best quotations in decades. Long-term interestrates fell by over 30 basis points (Treasury statement, 20 May 1997). This indicated thatthe macroeconomic policy framework of the UK had gained increased credibility.

5 It should be noted that, strictly speaking, the MPC and the Board of Banking Supervision(see below) have no governance function at the Bank.

6 Such a decline is also explained by the fact that exchange controls were lifted in the UKin 1979 (Hennessy 1992: 203); hence no official was required to enforce the controlmechanisms.

7 Only France has a similar arrangement, combining responsibility for the public finances,national macroeconomic management and functions related to budget revenue(Woodward 2004: 7).

8 There have always been 'special' relations between the US Federal Reserve and the Bankof England (Pringle 1995: 148).

9 Another international document to be mentioned is the trading book review, which wasagreed by the Basel Committee and the International Organization of SecuritiesCommissions (IOSCO) in July 2005: it introduced advanced rules for trading activities,also to be incorporated into EU legislation.

10 In his 1986 lecture at Loughborough University's Banking Centre, the Governor of theBank of England, Leigh-Pemberton, acknowledged that financial innovation hadtriggered changes in the financial system that made policy decisions based on monetarytargets complex to the point ‘at which we would do better to dispense with monetarytargets altogether’ (Bank of England 1986: 507).

11 The ERM was about reducing inflation again, because inflation had been controlled in1983–8.

12 The legislative underpinning for the Exchanges and Equalization Account was theExchange Equalization Act, 1979.

13 See Report on Banking Supervision and BCCI (Treasury and Civil Service Committee1992b, c).

14 There are important differences between the Scandinavian, British and Germansupervisory models. The British model goes further than the other two in overhaulingthe conventional system of supervision, by focusing on functions performed by financialcompanies and not on traditional segments of the market such as banking, securities andinsurance (interview, London, December 2005).

15 This is largely in line with the findings in the literature on Europeanization (cf. Börzeland Risse 2003; Bulmer and Radaelli 2005; Haverland 2000; Knill 2001; Knill andLehmkuhl 2002).

3 The Bundesbank

1 There were some exceptions; according to Marsh (1992), for example, in 1978 thechancellor, Helmut Schmidt, mentioned the possibility of amending the Bank’slegislation to reduce its independence if the Bank refused to agree to the EMS. It shouldbe noted, however, that accounts of this episode differ; for example, Neumann (1999:299) denies this claim.

2 In June 2000 the President of the Bundesbank indicated that he might be willing to accepta trade-off, under which the central bank lost its debt responsibilities but gained fullresponsibility for the regulation of the whole financial sector (Financial Times, 20 June2000).

3 Unlike the Bundesbank, the federal body, the Bundesaufsichtsamt für das Kreditwesen(BAKred), based first in Berlin and then in Bonn, lacked branches at state level and localoffices. The Bundesbank branches therefore performed several supervisory-relatedactivities, such as data collection.

Notes 163

4 ECB legal opinion on the reform of the Bundesbank, CONV 2001/17: ‘the ECB suggeststhat assignation to the Deutsche Bundesbank in the draft Act of the statutory respon-sibility of contributing to the prudential regulation and supervision of financialintermediaries might be considered’ [emphasis in original].

5 ECB legal opinion on the law establishing an integrated financial services supervisionin Germany, CONV 2001/35: ‘This is in line with the ECB’s view that maintaining theclose involvement of national central banks in prudential supervision is a mandatorycondition to allow the Eurosystem to contribute adequately to monitoring the risks tofinancial stability in the euro area.’

6 Paradoxically, Section 3 of the Bundesbank Act had to be reworded by inserting anexplicit reference to ‘price stability’, replacing the reference to (the potentially moreambiguous) ‘safeguarding of the value of the currency’ (Article 3 of the BBG), which,as explained below, could be subject to different interpretations (interview, Frankfurt,January 2006).

7 Thomas Becket, as chancellor of King Henry II, upheld the interests of the King vis-à-vis the Church, but once appointed as Archbishop of Canterbury he represented theinterest of the Church against the Crown.

8 The Executive Board used to hold weekly meetings before CBC sessions.9 The Seventh Act amending the Bundesbank Act of 23 March 2002, published in the

Bundesgesetzblatt on 28 March 2002.10 It should, however, be noted that some members of the Executive Board also favoured

a decentralized federal decision-making structure for the Bundesbank.11 The Bundesbank has its own university (Hochschule), where a large proportion of its

officials are educated.12 However, the Bundesbank adopted a more accommodating stance on EMU once Ernst

Welteke became president in 1999, and also because EMU had already begun.13 However, relations with Chancellor Kohl became more problematic towards the end,

owing to a major disagreement concerning German reunification, as explained above.14 The ‘house bank’ rests on intense and exclusive relations of one industrial firm with one

bank.15 The broad definition of banking activities should be noted, including buying and selling

securities for third persons and investment funds.16 These are central institutions of the savings banks and bankers to the respective state. 17 See http://www.bundesbank.de/bankenaufsicht/bankenaufsicht_basel.en.php (accessed

October 2005).18 In 1978, when the EMS was set up, the abolition of monetary targets was ruled out, as

this could give the wrong signal to the market operators (von Hagen 1999: 432).19 In the EMS this was close to a veto power as a result of the so-called Emminger letter,

which was reportedly invoked by the Bank in 1992–3 in order to suspend marketinterventions to support the currencies under speculative attack in the ERM (Connolly1995).

20 For example, President Klausen and Vice-President Emminger had a very differentapproach to exchange-rate policy in the 1970s (Heisenberg 1999).

21 Helmut Schlesinger used the term Stabilitätskultur (Neumann 1999: 303). This supportsthe political culture argument.

4 The Banca d’Italia

1 ‘Who will stand guard over the guardians?’ – Decimus Junius Juvenalis (AD 55–128),Roman satirical poet.

2 Law decree N 43 of March 1998, issued to permit the integration of the Banca d’Italiainto the ESCB.

3 See CON/2004/16; CON/2005/34; CON/2005/58.

164 Notes

4 Reportedly, the Bank’s officials are amongst the best-paid civil servants in Italy. TheGovernor is one of the best-paid governors in the world.

5 Two of the people interviewed likened this system to the Papacy; a third intervieweeemphasized the importance of the internal hierarchy by likening it to a military structure.

6 The number of Deputy Directors-General was raised from two to three in 2006.7 The Bank has awarded scholarships for postgraduate study in top-level foreign

universities (the Stringher, Mortara and Menichella awards), and several award-holdershave subsequently joined the Research Department.

8 The electoral system was reformed again in 2006, and proportional representation wasreintroduced.

9 Despite the changes experienced by the Italian financial system in the 1990s and thedeath of the founding father of Mediobanca, Enrico Cuccia, the role of the bank remainsimportant in the 2000s (Financial Times, 4 March 2005).

10 San Paolo and Banca Intesa merged in 2006, creating the biggest Italian bank.11 In the 1990s the Deputy Vice-Governor, Tommaso Padoa Schioppa, was Chairman of

the Basel Committee, taking over this prestigious position from senior officials at theBank of England.

5 The European Central Bank

1 It should, however, be noted that some legal scholars consider the treaty as theconstitution of the EU (Weiler 1999).

2 The Convention included representatives from the ‘old’ and ‘new’ member states, as well as from the candidate countries. It was composed of members from the EuropeanParliament, the national parliaments, the national governments and the EuropeanCommission.

3 The mandate of the Working Group on Economic Governance is in CONV 76/02. 4 The final report of the Working Group on Economic Governance can be found in CONV

357/02. 5 This is quite a technical legal point. In substance, the ECB’s concern is that if the Bank

is listed among the EU institutions, this could pose a threat to its independence.6 See http://www.ecb.int/press/pr/date/2003/html/pr031127.en.html (accessed in

November 2005).7 This was the case with the Finnish Governor, Matti Vanhala, in 2004.8 A two-thirds majority is needed if the Governing Council finds that non-eurosystem

functions of national central banks are interfering with the activities of the eurosystem.9 For a different interpretation of ‘The battle between Ecofin 11 and the ECB’, see

Campanella (2000). 10 See http://www.ecb.int/ecb/orga/capital/html/index.en.html (accessed in August 2005).11 For example, this was the case in Germany before EMU and is the current arrangement

in the USA.12 It should, however, be noted that in the countries where the publication of minutes and

voting records takes place, it does so with a time lag that varies from central bank tocentral bank.

13 The ECB’s management is also keen to portray diversity, in terms of nationality, genderor religion, as an asset.

14 Each NCB maintains its own banknote printing centre, dealing room and foreignreserves; NCBs can also maintain their own representative offices abroad.

15 See Chapter 4 with reference to the ‘protectionist’ attitudes of the Banca d’Italia.16 The ECB line of argument is that a clear assignment of objectives and allocation of

responsibilities will lead to implicitly co-ordinated outcomes ex post (Issing 2002: 348).17 See http://www.ecb.int/press/pr/date/2005/html/pr050321.en.html (press release).

Notes 165

18 For example, French policy-makers argued in favour of giving the Ecofin Councilresponsibility for exchange-rate policy (Dyson and Featherstone 1999), whereas Germanpolicy-makers were concerned not to challenge the independence of the ECB (Dyson2000: 13).

19 The Pact established 3 per cent of GDP as the upper limit of fiscal deficit, aiming for fiscalbalance in the medium term, with fines of up to 0.5 per cent of GDP to be imposed oncountries with excessive deficits. Votes on the existence of excessive deficit and theimposition of fines are taken by the Ecofin Council by qualified majority. EU countriesoutside the eurozone are not subject to fines.

20 That said, in order to assess the degree of market interpenetration it is important to focuson financial products and services, rather than ownership structure (Padoa Schioppa2004: 103).

21 However, several banks trade in securities, for example in Germany, where banks stilldominate.

22 See http://www.ecb.int/press/key/date/1999/html/sp990317.en.html – Tommaso PadoaSchioppa, member of the Executive Board of the European Central Bank, introductorystatement at the Sub-Committee on Monetary Affairs, European Parliament, Brussels,17 March 1999.

23 Gross inflation was also to be considered, although HICP remains the main indicator.24 For a review of the monetary policy operations of the ECB, see Scheller 2004: 86–9. For

a review of its external operation, see Scheller 2004: 90–99.25 In June 2004 Estonia, Lithuania and Slovenia were the first of the EU’s new members

to join ERM2, followed in May 2005 by Cyprus, Latvia and Malta. In 2007 Sloveniajoined EMU. Malta and Cyprus are set to join in 2008.

26 A resolution of the European Council of 16 June 1997 established ERM2 to link thecurrencies of EU member states outside the eurozone to the euro. ERM2 replaced theEuropean Monetary System, created in 1979. Within the framework of ERM2, exchange-rate stability is explicitly subordinated to the primary objective of price stability for allparticipating currencies. ERM2 is a multilateral arrangement of fixed but adjustableexchange rates, with a central rate and a standard fluctuation band of ±15 per cent. Theeconomic policies of participating states should be consistent with preservating thecentral rate, thus avoiding misalignments. Interventions at the margin are in principleautomatic and unlimited, unless they conflict with the primary objective of price stabilityin the member state or the eurozone. Very short-term financing can be made availableto support such interventions.

27 By contrast, investment operations of national central banks in foreign financial marketsare not subject to prior authorization.

28 Duisenberg, Hearing of the Economic and Monetary Committee of the EP, 8 October2003; Padoa Schioppa, Hearing of the Economic and Monetary Affairs Committee ofthe EP, 10 July 2002.

29 See also Padoa Schioppa, Hearing of Economic and Monetary Committee of the EP, 10 July 2002.

30 Duisenberg, Hearing of Economic and Monetary Committee of the EP, 8 October 2002;see also ECB 2004a.

31 Norway integrated bank and insurance supervision in 1986, followed by Denmark in1988 and Sweden in 1992.

32 The EMI also gave its opinion on the amendment of the Banca d’Italia’s Statute inFebruary 1998 (CON/98/07) and March 1998 (CON/98/13); to the Italian Governmentin February 1998 (CON/97/32); and to the UK Government in connection with the Bankof England Act in May 1998 (9CON/98/24) and January 1998 (CON/97/27).

166 Notes

6 Conclusions

1 Börzel 1999; Börzel and Risse 2003; Knill and Lehmkul 2002; Radaelli 2003.2 Specific legislation had to be passed in Germany to enable the transfer of monetary and

exchange-rate policy competences to the ECB and allow for the Bundesbank’sparticipation in the Eurosystem.

3 However, in Ireland and the Netherlands the central banks have become the singlesupervisory authorities for the entire financial sector.

4 A possible explanation of this asymmetry between convergence in monetary policy andin financial governance is that national financial systems still differ widely across EUcountries, hence financial services regulation and supervision are influenced byidiosyncratic aspects that are less important in the conduct of macroeconomic policy. Iwish to thank Paulo Vila Maior for pointing this out to me.

Notes 167

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ABN Amro 87, 99–100acquis communautaire 51, 160Allianz-Dresdner 50Amato-Carli Law 97, 100Andreatta, Nino 77Anglo-Saxon model of capitalism 29, 30Antonveneta (Banca Antoniana Popolare

Veneta) 87, 99–100Argentinean bonds, insolvency of 98Assemblea Generale 83Associazione Bancaria Italiana (ABI) 90

Baffi, Governor Paolo 96, 98BaFin 41, 44, 49, 50, 64, 65, 69, 70–1, 73,

92, 140, 141, 153, 158BAKIS 62BAKred 62, 64, 69, 73, 158Balls, Ed 21Banca Bilbao Vizcaya Argentaria 99Banca Commerciale 99Banca d’Italia 13, 25, 37, 48, 72, 76–105;

accountability 147; adaptation to EMUframework 103, 148; autonomy 147,152; divorce between Treasury and 77,78, 81, 95, 101; economic interestgroups and 90–1; economic patriotism156; Euro Policy Liaison Office 84;Euroscepticism 148; exchange ratepolicy 15, 95; Executive Board 82, 83;functions and roles 101–2; governancestructure 82–4; government and 87–8;intangible assets 15, 84–5, 154; legalframework 80–1; micro-institutionallevel 82–5, 155; model of legitimacy81–2; monetary policy 93–4; MonetaryPolicy Co-ordination Committee 84;personnel policy 81; prior to EMU 14;publications 84; reform 76–80; researchdepartment 84, 154; staff 85;

supervisory policy 156; as technicalcounter-power 156; use of technicalknowledge 154; twin-peak model ofsupervision 156; two-level game 91, 95,157, 158; veto in 153; withdrawal fromERM 95–6

Banca Intesa 89Banca Nazionale del Lavoro (BNL) 99,

100Banca Popolare di Lodi 99Banco Ambrosiano 98Banco di Roma (Capitalia) 99Bank for International Settlements (BIS)

7, 32, 43, 132Bank of Credit and Commerce

International (BCCI) 39Bank of England 3, 13, 17–46;

Accountability 157; adaptation to EMU framework 148; autonomy 152;Committee of the Treasury 25; Court of Directors 24–5; economic interestgroups and 30–1; exchange rate policy35–8; functions and roles 41–2;governance structure 24–5; governmentand 27–8; intangible assets 15, 17, 25–6; legal framework 21–3, 146;micro-institutional framework 24–6,155; model of legitimacy 23; monetarypolicy 34, 35; operational independence20–1, 155; personnel policy 22; prior toEMU 14; publications 25; punctuatedtrajectory towards central bankindependence 18–21; reform 18–21,155; research department 25; staff 25–6; supervisory policy 21, 156; astechnical institution 156; two-levelgame 36, 44, 157, 158; veto in 152–3;Ways and Means overdraft facility 115

Index

Bank of England Act: 1946 18; 1998 18,23, 24, 25

bank-oriented system 89Banking Act (England and Wales): 1979

38; 1987 25, 38, 39Banking Act (Kreditwesengesetz; KWG)

(Germany) 69Banking Advisory Committee 124, 139Banking Law (1936) (Italy) 76, 97Banking Supervisory Committee (BSC)

139, 151Banque de France 3, 13bargained pluralism 90Barings scandal 39Basel 1 Accord 7, 32, 151, 152, 158;

Germany and 63, 64, 73; Italy and 92;UK and 44

Basel 2 Accord 32–3, 151, 152, 158; ECBand 130, 132–3; Germany and 63, 64,65; Italy and 92–3; UK and 33

Basel Committee on Banking Supervision(BCBS) 32, 33, 92, 132, 147, 151, 152,155, 159

Basel Concordat 73Becket effect 51, 72behavioural independence 6benchmarking 5Berlusconi, Silvio 104Big Bang (UK) 39, 45, 98Blair, Tony 27Blunden, George 32Banca Nazionale del Lavoro (BNL) 87Board of Banking Supervision 25Bretton Woods system 63, 68Britain: central banking policies

33–46; economic institutions 28–30;exchange-rate policy 35–8; financialsupervision policy 38–41; internationalframework and central bankinggovernance in 31–3; nationalinstitutional framework of centralbanking governance in 26–31; mode of central banking governance 42–5,146–8; monetary policy 34–5; politicalinstitutions 26–7; Treasury ministry 27, 28

British Bankers’ Association 29Broad Economic Policy Guidelines

(BEPG) 122, 123, 124, 128Brown, Gordon 20, 21, 22, 27, 43budgetary autonomy 5Bundesaufischtsamt für das Kreditwesen

(BAKred) 49

Bundesbank 3, 7, 9, 13, 31, 35, 36, 44,47–75, 155; accountability 53;adaptation to EMU framework 75, 148;autonomy 146, 152; Central BankCouncil 52, 53, 54; economic interestgroups and 61–2; exchange-rate policy67, 68; Executive Board 54–5; functionsand roles 72; governance structure 53–5;government and 58–9; independence155; intangible assets 15, 55–6, 74; legalframework 51–2; micro-institutionallevel 53–6, 155; model of legitimacy 53; monetary policy 146, 152; personnelpolicy 52; prior to EMU 14; reform48–51; research department 154; staff56; supervisory policy 73–4, 156;technical knowledge and scientificproduction 56; two-level game 157; veto in 153

Bundesbank Law 48, 54Bundesbankgesetz (BBG) 48Bundeskartellamt 69Bundesrat 49, 50Bundesverband der Deutschen Industrie

(BDI) 61Bundesvereiningung Deutscher

Arbeitgeberverbände (BDA) 61

Capital Adequacy Directive (1993) (EU)32

Capital Requirement Directive (2005)(EU) 33, 106, 132, 139

Capitalia 89Cardiff process 123, 126Carli, Guido 83central bank autonomy (de facto

independence) 5–6central bank independence 9central bank legitimacy 6central bank policy capacity 6central bank legal framework 5Centre for Central Banking Studies 25Christian Democratic Union (CDU) 50Ciampi, Carlo Azeglio 77, 96, 101, 102Cirio 87, 98City revolution 39Civil Service Committee 39Clark, Kenneth 20Cologne process 123, 127, 128, 130Commissione Nazionale per le Società e la

Borsa (CONSOB) 96, 97, 98Committee of Central Bank Governors

(CCBG) 106

190 Index

Committee of European BankingSupervisors (CEBS) 71, 139, 151

Committee on Payment and SettlementSystems (CPSS) 140

Competition and Credit Control Act (1971)19

Competition Authority (Italy) 79, 97, 99

Competition Authority (Germany) 69Competition Policy, Law on (1990) (Italy)

97concertazione 89Confederation of British Industry 29Confindustria 91, 101Consiglio Superiore 83Consolidate Finance Law (1998) (Italy)

(Draghi Law) 97, 98, 100Consolidated Banking Law (1993) (Italy)

97–8, 100Constitutional Treaty 130consumer price inflation (CPI) 35Cooke, Peter 32co-ordinated market economy model 60,

66coronation theory 63Council of Economic and Finance

Ministers (Ecofin) 108, 110, 121–2, 123,157

Court of Auditors 108credit risk 33critical junctures 10

Davies, Howard 22de facto independence 5–6, 106, 107Debt Management Office 23decisional independence 5Delors, Jacques 63Delors Committee 28, 36, 63Department of Trade and Industry (DTI)

39dependent variable 6, 149Deutsche Sparkassen und

Giroverband-Finanzgruppe (DSGV) 61

Deutsche Bankerverband 61Deutsche Gewerkschaftsbund 62Deutsche Industrie und Handelstag

(DIHT) 61Deutschland AG 60DG Internal Market 124Dini, Lamberto 81, 101Draghi, Mario 81, 85, 88, 100, 105Duisenberg, Willem 114, 137

Economic and Financial Committee (EFC)123, 124–5, 128

Economic and Monetary Union (EMU) 1,2, 7, 13–15, 154; Banca d’Italia and 103,104; Bank of England and 31; Britishwithdrawal from 13, 34, 35–6;Bundesbank and 53, 59, 75, 147–8;establishment 15, 69; framework 108,121, 151; UK and 37, 43, 45, 46

economic convergence 136economic independence 5economic patriotism 129Economic Policy Committee (EPC) 123Eichel, Hans 49, 50, 57electoral system: Germany 57; Italy 85;

UK 26Emminger, Otmar 63, 67Eurogroup 110, 121, 122–3, 125, 157European Banking Committee 124European Central Bank (ECB) 1, 2, 13,

14, 50, 53, 71, 106–46; accountability115, 116; autonomy 125, 142; Bancad’Italia contribution to 104; Bundesbankcontribution to 73, 74; Constitutionaltreaty 109; creation 3; democratic deficitof 156–7; economic analysis 134;economic interest groups and 130; in theEurosystem/ESCB 118–20; exchangerate policy 135–7; Executive Board 112,113, 121, 137; financial independence115; functions of 140–2; goalindependence 155; Governing Council109, 112–13, 120, 154; institutionaltrajectory of 107–10; intangible assets117–18; international institutions and130–3; legal-framework 114–15; micro-institutional level 110–20; modelof legitimacy 115–17, 147; monetarypolicy 133–5; non-monetary issues119–20; operational independence 115; personnel policy 114; politicalauthorities and 125–5; researchdepartment 117; supervisory policy 126, 156; two-tier governance structure110–13; two-level game 158; veto in153; voting system 154

European Commission 90, 108, 118, 124,157; Integrated Guidelines 128

European Convention on the Future ofEurope 108

European Council 121European Court of Justice (ECJ) 80, 108,

114, 118, 128

Index 191

European Employment Strategy(Luxemburg process) 123–4, 126, 127

European Monetary Institute (EMI) 106European monetary system (EMS) 7, 31,

43, 59, 158; creation of 63, 152European Parliament (EP) 108, 157European Securities Committee 139European System of Central Banks

(ESCB) 1, 3, 13, 46, 78, 79; Bancad’Italia contribution to 104; Bundesbankcontribution to 73, 74; ECB in 118–20;Protocol (1992) 107; see also ECB

European Trade Union Confederation(ETUC) 130

European Union (EU): Capital AdequacyDirective (1993) 32; CapitalRequirement Directive (2005) 33, 106,132, 139; economic institutions 126–30;enlargement 111; financial servicesregulation and supervision in 137–40;framework of central banking 107–33;Investment Services Directive 70;macro-institutional framework of120–30; political institutions 121–5;Second Banking Directive (1989) 97

Eurosystem see ESCBEurozone: exchange-rate policy of 135–7;

framework of central banking 107–33;monetary policy of 133–5; mode ofcentral banking governance 142, 143,146–8

exceptionalism 9Excessive Deficit Procedure 121, 124, 127,

128exchange-rate mechanism (ERM) 19, 28,

31, 36, 43, 44; ERM1 37, 68; ERM2 31,37, 68; crises 59, 152; Banca d’Italiaand 94–6; Bank of England and 35–8;Bundesbank and 67, 68; withdrawal of pound sterling from 20, 34, 146;withdrawal of lira from 146

Fazio, Antonio 79, 80, 81, 82, 87, 88, 94,96, 99, 102, 103, 104, 146

Fiat 91Finance Ministry, Germany 57, 58Financial Act 1998 (Italy) 98financial independence 5Financial Services Act (1986) (England

and Wales) 39Financial Services Action Plan (FSAP) 124Financial Services Authority (FSA) 21, 25,

39, 40, 43, 138, 153, 158, 159

Finanzplatz Deutschland 159Forza Italia 86

game theory 3George, Lord Eddie 21, 22, 28, 31, 42German Financial Supervisory Authority

see BaFinGerman model of capitalism 59–61Germany: central banking policies

65–74; economic institutions 59–61;exchange-rate policy 67–8; FederalBanking Supervisory Office 70; FederalSupervisory Office for InsuranceEnterprises 70; Federal SupervisoryOffice for Securities Trading 70;Finance ministry 57, 58; financialsupervision policy 69–72; inflation in 66; interest rates 66; internationalframework and central bankinggovernance in 62–5; mode of centralbanking governance 72–4, 146–8;monetary policy 65–7; nationalinstitutional framework of centralbanking governance in 56–61; politicalinstitutions 57–8; stable trajectory ofcentral bank independence 48–51; three-level framework 48–65

Giovannini Group 124Gruppenwettbewerb 61

harmonized indices of consumer prices(HICP) 133, 134

Hausbank system 60historical institutionalism 10–11hostile takeovers 60Howe, Geoffrey 36

ideational diffusion 150, 151input-oriented approach 6, 147interest-groups-based explanation 9Inter-Governmental Conference (IGC) 108International Monetary Fund (IMF) 7, 64,

130, 132, 158, 159, 161International Organization of Securities

Commissions (IOSCO) 159Investment Services Directive (EU) 70Issing, Otmar 72, 116, 157istituti di credito ordinario 89istituti di credito speciale 89Italy: central banking policies

93–104; economic institutions 88–91;exchange-rate policy 95–102; financialsupervision and banking competition

192 Index

policy 96–101; incremental pathtowards central bank independence in76–80; international framework andcentral banking governance in 91–3;mode of central banking governance102–4, 146–8; monetary policy 93, 94;national institutional framework ofcentral banking governance 85–8;political institutions 85–7; three-levelframework 76–93; Treasury ministry 87,88

Japan, Basel Accord and 32, 33Johnson Matthey Bankers affair 38Juncker, Jean-Claude 122

Keynesianism 8, 35, 93King, Mervyn 22, 42Kingsdown, Lord see Leigh-Pemberton,

Robin 45Kohl, Helmut 52Kroes, Neelie 99

Lafontaine, Oskar 57, 115, 126, 135Lamfalussy framework 106, 122, 138–9,

140, 151, 152Lamont, Norman 19, 20Landesbanken 61, 70Landesbausparkassen 61Landeszentralbanken (LCBs) 49, 53–4, 55,

62, 68Lawson, Nigel 19, 20, 27, 28, 36, 41legal convergence 136Leigh-Pemberton, Robin 22, 28, 36, 39lender of last resort (LLR) 41, 141Lodi 100London Investment Banking Association

30Luxembourg process 123–4, 126, 127

Macroeconomic Dialogue (Cologneprocess) 123, 127, 128, 130

Major, John 20market-oriented system 89Maastricht Treaty 14, 23, 53, 107, 111,

135, 148McCreevy, Charlie 99McDougall Report 128Mediobanca 89Meister, Edgar 139Memorandum of Understanding 40micro-institutional level 11, 150, 153, 155Mittelstand 62

Modell Deutschland 61monetary financing of fiscal policy 5Monetary Policy Committee (MPC) 20–1,

35, 123, 154; establishment 24, 25monetary policy paradigm 35moral suasion 40, 90multi-level governance 4multi-level institutionalism 10–11, 148–55,

159

national-level explanations 8, 11New Zealand, central bank of 19–20Norman, Montague 19, 23Northern League 86

objectives independence 5Open Method of Co-ordination 5operational independence 5operational risk 33Organization for Economic Co-operation

and Development (OECD) 130, 131–2,159

output-oriented approach 6, 147

Padoa Schiopppa, Tommaso 81, 130, 131,133, 137

Parmalat 87, 98path dependency 10Pennant-Rea, Rupert 22pension schemes 29personnel independence 5Pöhl, Karl Otto 49, 51, 52, 59, 63policy failures 10policy network 4policy strength 6political independence 5principal–agent model 4–5private banks: Germany 61; Italy 101process tracing 12pseudo-theory of credibility 19public-choice approach 9–10public-sector borrowing requirement

(PSBR) 23

qualified majority voting (QMV) 110, 123

Radcliffe Committee 18–19regulatory state 3retail banking 29, 41Rhenish model of capitalism 59, 60, 66Richardson, Governor Gordon 22, 28,

32

Index 193

San Paolo IMI 89, 99Sarcinelli, Mario 98savings banks (Sparkassen) (Germany) 61Savings, Law on (2005) (Italy) 79, 141,

99Schmidt, Helmut 52, 57, 58, 63Second Banking Directive (1989) (EU) 97secondary banking crisis (1974) 38Securities and Investment Board (SIB) 39,

40seignorage 115Self-regulatory Organizations (SROs) 39,

40September 11th 2001 141silent revolution 60Siniscalco, Domenico 80, 88sisterma delle terne 90small and medium-sized enterprises

(SMEs) 60, 64Smithsonian agreement 68‘snake’ 7, 31, 35social market economy 60soft law 5Sparkassen 61Stability and Growth Pact (SGP) 108, 125,

126, 127, 128, 142stability-oriented paradigm 8Stackelberg game 87, 94Stark, Jürgen 49statute-reading methodology 5Strauss-Kahn, Dominique 126, 135structured focused comparison 12sweetheart deal (1992) 67systemic-level analysis 7–8, 11

Thatcher, Margaret 19, 27, 28, 34, 36, 38,41

Tietmayer, Hans 59trade associations 29trade unions: Germany 62; Italian 91; UK

29, 31Trans-European Automated Real-time

Gross Settlement Express TransferSystem 104; TARGET1 140;TARGET2 155, 104, 140; TARGET 2Securities 140

Treasury, British 27–8; Exchanges andEqualization Account 35

Treasury, Italian 87, 88Treaty of Amsterdam (1997) 107, 126Treaty of Nice (2001) 107Treaty of Rome (1957) 123Treaty on European Union (TEU)

(Maastricht Treaty) 14, 23, 53, 107, 111,135, 148

Tremonti, Giulio 80, 87, 88, 98Trichet, Jean-Claude 80, 114

umbrella associations 29Unicredito 99Unipol 99universal bank model 60–1US Federal Reserve 3, 9, 32, 63

Volcker, Paul 94voluntary compliance 40

Waigel, Theo 127Way and Means Facility 23Weber, Axel 52, 66Wechselpapier 67Westminster model 26Welteke, Ernst 49, 164World Bank 7, 64, 158, 159, 161

194 Index