The paper investigates whether monetary policy and banking supervision should be separated, or not. It starts with a historical evolution of the Central Bank's micro-function (banking supervision). The role of the lender of last resort and the introduction of deposit insurance is discussed. There is currently a diversity of institutional arrangements, but the differences are found to be greater in appearance than in reality.
The main argument for divorcing the monetary from the bank regulatory authority is that the combination of functions might lead to a conflict of interest. This conflict can arise in different ways. The most important instance is that interest rates are held down because of concern with the 'health' of the banking system, when purely monetary considerations suggest higher rates. It is argued that this conflict between 'regulatory' and 'monetary' objectives depends to some extent on the structure of the banking and financial systems (i.e. whether banks are dependent on wholesale or retail markets for short term funding).
A first argument against separation is the role of the Central Bank in the payment system, in particular with respect to preventing systemic risk. The different payment arrangements are analysed. In so far as the Central Bank as lender of last resort is likely to support a failing participant, it is assuming the risks and effectively becoming the implicit guarantor of the system.
