Financial supervision

Financial supervision is a basic tenet of a resilient financial system. Supervising the various components that make up the financial system - to wit, financial institutions, markets, and infrastructures - is indeed a critical precondition for the implementation of a consistent framework for financial regulation aimed at enhancing the resilience of the financial system as a whole. Against this backdrop, financial supervision and financial regulation are intimately related. Beyond identifying and assessing emerging risk to financial stability stemming from the macroeconomic and financial environment (through macro stress tests, for instance), supervisory authorities must continuously monitor that the regulatory framework in place provides an even playing field for finan- cial institutions and that, accordingly, it does not prompt the latter to shift their activities to other less or non-regulated segments of the financial system (the so-called "boundary problem in financial regulation"; see Goodhart, 2008, pp. 48-50).

Broadly speaking, the onset of the 2008-09 global financial crisis has brought about two major changes in the scope and architecture of financial supervision. The first change relates to the shift from a micro-prudential to a system-wide, macro-prudential approach to financial supervision and regulation, focused on the stability of the financial system as a whole and its linkages with the "real side" of the economy. As a matter of fact, the pre-crisis financial supervisory framework was overly focused on supervising financial institutions (mainly banks) on a stand-alone basis to enhance their safety and soundness and, eventually, limit the risk of their failure. Yet too little emphasis was put on the supervision of financial players performing bank-like activities but falling outside the perimeter of the traditional banking system - so-called "shadow banking" financial intermediaries - whose relevance in the global financial landscape has increased dramati- cally since the 1980s, ending up being at the epicentre of the 2008-09 financial crisis. By the same token, supervisory authorities paid little or no attention to the endogenous nature of systemic risk with regard to the collective behaviour of financial institutions - a shortcoming addressed by macro-prudential supervision (Borio, 2011).

The second change, closely connected to the first, pertains to the transition currently under way in the institutional architecture of existing financial supervisory frameworks. In this regard, a tendency towards consolidation (integration) of financial supervisory powers has gained prominence following the 2008-09 financial crisis. Supervisory powers that were heretofore exercised by a constellation of functionally and institution- ally specialized authorities are now being put into the hands of a restricted number of supervisory authorities - in accordance with a kind of "integrated approach to financial supervision" (Group of Thirty, 2008, p. 36). Against this backdrop, central banks have been called upon to play a leading role in the supervision of the whole financial system. They have been entrusted with the task of carrying out macroprudential supervision (jointly with other newly created authorities) and also of supervising large and complex systemically important financial institutions. In the euro area, for instance, while micro- prudential supervision remains, to date, outside the scope of the European Central Bank's (ECB's) tasks and is carried out by the European Supervisory Authorities (ESAs) jointly with national authorities, macro-prudential supervision has been delegated to the European Systemic Risk Board (ESRB) - chaired by the president of the ECB. Moreover, the effort to create a European banking union - designed to break the nega- tive feedback loop between banks and sovereign debt - has recently led the European Commission to support the establishment of a Single Supervisory Mechanism (SSM) for banks, to become effective in 2014, which entrusts the ECB with the additional task of supervising systemically important European banks on a micro-prudential basis. The integration of micro-prudential supervision into the realm of the ECB, however, stands in glaring contrast with the recommendations of the de Larosière report - one of the most important contributions for reforming the European (and international) financial architecture - according to which adding micro-supervisory duties to the ECB "could impinge on its fundamental mandate" of maintaining price stability (see Balcerowicz et al., 2009, p. 43).

Quite the same pattern is currently underway in the United States, where the Dodd- Frank Act has been enacted in response to the shortfalls of the pre-crisis supervisory framework, mainly because of its highly fragmented structure and lack of macro- prudential supervision. The Financial Services Oversight Council (FSOC) has been charged with macro-prudential oversight of the US financial system, while the US Federal Reserve has been endowed with the responsibility of supervising bank holding companies with total consolidated assets of 50 billion US dollars or more and other systemically important (non-bank) financial institutions and financial market utilities.

Now, consolidating the conduct of monetary policy and micro-prudential and macro- prudential supervisory powers under the roof of the central bank increases the danger that "the pendulum may well have swung too far" (Friedman, 1968, p. 5). To put it bluntly, there is actually a risk of overburdening central banks with too many tasks and responsibilities (other than monetary stability) that they are not able to perform. In this respect, the potential conflicts arising from the interplay of these three broad areas of responsibility within the same institution must not be underestimated. Another concern is that financial supervision remains, to date, overly focused on supervising individual financial (especially banking) institutions, thereby overlooking other non-bank players in the financial landscape that also pose a threat to systemic financial stability. Overcoming this deficiency is especially critical in those financial systems, such as the US system, where a large fraction of financial intermediation occurs through capital markets rather than through regulated banks.

See also:

Financial crisis; Financial instability; Macro-prudential policies; Shadow banking; Systemically important financial institutions.