Last week, the UK government announced that it would temporarily increase the bank corporation tax from 3% to 6%. On the very same day, Chancellor John Healey sent a letter to Andrew Bailey, the Governor of the Bank of England, encouraging the Financial Policy Committee (FPC) to accelerate the reforms to capital requirements and further relax restrictions on mortgage lending.

The timing is interesting. The government raises taxes on banks and, at the same time, asks the institution responsible to safeguard financial stability to make regulation less restrictive. Is this an attempt to compensate banks for the additional tax burden? And, more importantly, what does that tell us about central bank independence?

Let’s start with what the Chancellor actually said. In his letter of the 28th of October, Healey welcomes the FPC’s ongoing review of bank capital requirements. He particularly mentions the reforms to the leverage ratio and the usability of capital buffers. He further asks the FPC to deliver these reforms “as quickly as possible” and continue working to address “overlaps identified in capital requirements”. Finally, he also welcomes the relaxation of limits to high loan-to-income mortgage lending, and suggest considering further changes to improve access to home ownership.

These are all fairly specific requests. As I read them, I thought about what all that means for central bank independence. For comparison, the letter did not ask the Monetary Policy Committee (MPC) to increase or decrease interest rates. So I dug a little bit to better understand what the legal framework is.

Central bank independence is normally discussed in the context of monetary policy. The rationale is well understood: governments have incentives to stimulate economic activity in the short run, which can lead to higher inflation but more importantly to higher inflation expectations. Delegating monetary policy to an independent institution helps overcome this problem.

But what about the macroprudential regulator? The FPC was created in 2013, and it has two objectives. The primary one is to contribute to financial stability by monitoring and acting on risks that threaten the financial sector as a whole. The secondary one is to support the economic policy of the government. This is not very different to the MPC case.

Interestingly, the Bank of England Act, under Section 9E, contains a provision under which the Treasury can make formal recommendations to the FPC about its responsibilities and matters it should consider when exercising its functions. The FPC is then required to respond, explaining whether it has acted on these recommendations, intends to act, or does not intend to do so. So the FPC does not have to follow the recommendations, but it has to explain why.

These recommendations are indeed transmitted through the remit letters between the Chancellor and the Governor which are publicly available. Like the one on the 28th of October. This is, therefore, an explicit mechanism, established by Parliament, through which the government can influence the agenda of the independent macroprudential authority. As I said, this does not mean that the FPC is not independent, since it can decide not to follow the recommendations—although this needs to be grounded on the primary objective. Yet, when looking at the institutional arrangements, one should recall that the Governor of the Bank of England is nominated by the Chancellor of Exchequer.

There are good reasons to have this arrangement, however. Macroprudential policy can be strongly distributional. Limits on mortgage lending affect those that need the most leverage, typically lower-income, younger, and first-time-buyers borrowers. Therefore, it is reasonable to provide avenues for the government to influence the conversation around the measures being implemented.

So I was curious to see whether the government has intensified the recommendations made to the FPC in recent years. I found out that, since the beginning, the government has made specific recommendations. George Osborne asked the FPC to review the leverage ratio framework in 2013, not just about the optimal level, but also about whether the FPC needed additional powers to direct this requirement. This actually led to stronger prudential regulation, rather than weaker requirements. Therefore, the recommendations are not new. The concern is therefore something else: the direction of these recommendations.

As I discussed in a previous post, macroprudential policy has a particular difficulty: its costs are often immediate and visible, while its benefits are delayed and much harder to observe. Crucially, the the benefits are also strongly distributional: households avoiding defaults during a recession tend to be lower-income as well. This creates an asymmetry in political incentives. Relaxing regulation can generate immediate benefits through increased lending and better access to mortgages. The costs, when they materialise, will become apparent only years later, most likely under another government. It is precisely this reason that provides the rationale for delegating macroprudential decisions to an independent institution.

So for now there is no evidence to suggest that the FPC’s independence is under threat. There is evidence, however, that the direction of travel, both at the Bank of England and the Government, is towards de-regulating and lowering bank capital requirements. The two institutions share this preference. In the latest report, the FPC reaffirmed the new capital (lower) requirement benchmark, while announcing more work on overlapping requirements, the same work that the Chancellor has asked to do it as quickly as possible.

To conclude, I think that the next stages of the capital review, and particularly the FPC’s response to the Chancellor’s recommendations, will therefore be worth watching. Central bank independence does not require central banks to disagree with governments. But it does require them to be able to disagree, and to explain clearly why they agree when they do.