Banking supervision

Banking supervision involves the monitoring of the banking sector to assess that each of its members complies with the existing regulation. Supervisory and regulatory issues are therefore tightly connected. With the global financial crisis that erupted in 2008, their joint contribution to financial stability has been reasserted as part of the corrections and policy reforms to be carried out for the prevention of financial instability. This is consist- ent with the widely accepted view according to which “the vulnerabilities [which origi- nated the crisis] were the structural, and more fundamental, weaknesses in the financial system and in regulation and supervision that served to propagate and amplify the initial shocks” (Bernanke, 2012, p. 2). While closer supervision of all banks is deemed necessary, systemically important banks (SIBs) require “greater intensity of supervision and hence resources” (Basel Committee on Banking Supervision, 2012, p. 5).

On-site supervision of banks is combined with off-site supervision, the proportion being “determined by the particular conditions and circumstances of the country and the bank” (ibid., p. 30). In order to assess the safety of banks, as well as potential risks, and to identify “corrective actions and supervisory actions” (ibid., p. 31), the informa- tion used by the supervisors may include prudential reports, statistical returns, informa- tion on a bank’s related entities, and publicly available information (ibid.). Supervisory tools include analyses of financial statements and accounts, business model analyses, horizontal peer reviews, reviews of the outcome of stress tests undertaken by the bank, and analyses of corporate governance, including risk management and internal control systems (ibid.).

The global financial crisis resulted in an institutional rearrangement of banking supervision, with two trends emerging, and deriving from political traditions, as well as legal and constitutional constraints (Nier et al., 2011, pp. 34–6). In advanced econo- mies, several countries are “integrating prudential supervision into the central bank” (ibid., p. 9). An example of this is provided by the United Kingdom, with the creation of a Financial Policy Committee within the Bank of England and the establishment of a Prudential Regulatory Authority as a Bank of England subsidiary (Eichengreen and Dincer, 2011, p. 3). This is also the case with a number of national central banks within the euro area, such as Ireland, while at a supranational level the European Central Bank is assigned specific supervisory tasks through the establishment of a single supervisory mechanism, to be enforced in late 2014 (Council of the European Union, 2013; Micossi, 2013). The United States differs from this pattern, insofar as the federal government chairs the Financial Stability Oversight Council (FSOC), which functions separately from the Federal Reserve (Nier et al., 2011, p. 10), although the latter has been granted extended supervisory responsibility in accordance with the Dodd–Frank Act of 2010. In emerging economies, the reform has consisted in leaving the degree of integration unchanged, and establishing a new committee with macroprudential policy responsibili- ties, either chaired by the government, as in Turkey, or by the central bank governor, as in Thailand (ibid.).

Central bank involvement in supervision brings a positive effect through information gains (Dalla Pellegrina et al., 2010), especially in the macro supervision area (Blinder, 2010, p. 132), where complementarities between monetary policy and supervision are likely to be stronger (Blinder, 2010, p. 131). It may nevertheless entail several adverse effects, namely a moral hazard effect, a reputation effect, a bureaucracy effect and a conflict of interests effect (Masciandaro and Quintyn, 2009, p. 6). It may also be argued, however, that “[t]he central bank is probably best-positioned to balance the two com- peting objectives, rather than leaving them in the hands of two independent agencies” (Blinder, 2010, p. 132).

A political argument may also be put forward: increased supervisory powers, especially over systemically important financial institutions, “would push the central bank deeper into the realm of politics – which could, as a consequence, politicize monetary policy” (ibid., p. 131). Indeed, increased central bank involvement in supervision “can affect central bank independence via both the inflationary and financial distributional effects of bank bailout financing” (Masciandaro and Passarelli, 2013, p. 3). Further, with this phenomenon, “the stability of its independence will [increasingly] depend on how its choices affect the distribution of income and wealth through two channels – nominal and financial effects” (ibid.).

The role of internationally active institutions and cross-border banks during the global financial crisis revealed the insufficiency of national supervision and the neces- sity of cooperation between supervisors (Beck and Wagner, 2013), whereby, for instance, countries might agree on a minimum intervention threshold, which would allow “partial internationalization of the [cross-border] externalities” and “a tailoring of intervention policies to domestic heterogeneity” (ibid.).

See also:

Credibility and reputation; Financial crisis; Financial instability; Macro-prudential poli- cies; Macro-prudential tools; Systemically important financial institutions.