Supervising the bank supervisor: risks and strategies of coverage

Abstract: 

The growth of an economy is strongly reliant on the stability and health of its financial system. These, in turn, intensely depend on an efficient and effective micro-prudential supervision of the banking sector.

The naïve assumption of an ever perfect and efficient supervisor is just as dangerous as placing full and blind faith in the continuous and perfect functioning of market mechanisms. It is a myth that must be critically assessed following the disastrous events that have led to the current financial crisis. There are in fact several reasons why banking supervision may fail: its “capture” by specific interest groups (politicians, supervised entities, or the supervisor itself) can dissociate its objectives from the public interest; and insufficient or inadequate resources, conflicting or ambiguous mandates and inadequate institutional design can all seriously hinder its functioning and effectiveness.

Once these risk factors are identified, it is then possible to determine the set of “hedging instruments” that are available to society with the aim of increasing the probability that the supervisory function efficiently fulfils the social utility objectives that it has been assigned: adequate resources, appropriate choice of institutional structure, systematic use of “impact analysis” and, most crucially, the successful implementation of the four core principles of good supervisory governance (independence, transparency, accountability, and integrity).

The objective of this dissertation goes well beyond the simple identification of these hedging strategies. It advocates the need to adopt a professionalised and proactive social risk management framework that integrates these individual strategies in a “portfolio approach” to achieve the most efficient protection of the public interest.

The idea of a “portfolio” of hedging strategies arises from the fact that, considered individually, each of these strategies is seldom fully effective in accomplishing social objectives and may, in some cases, even be counterproductive due to the multidimensional nature of the risks associated with the supervisory activity. On the contrary, when the various strategies are combined into a portfolio, therein results a superior outcome due to the strong interrelations between the different strategies, which often reinforce each other in the accomplishment of the public interest.  Furthermore, the strong influence of the socio-economic environment in the effectiveness of these strategies suggests a dynamic nature to the problem of social risk management, and therefore this portfolio of hedging strategies needs to be periodically reassessed and rebalanced to maintain its efficiency.
Finally, this approach must be at all times rational and therefore it should not be mistaken for a simple increase of the supervisory activity (or control thereof). Like any control system, its implementation invariably entails costs and therefore higher levels of protection should only be undertaken to the extent that its merits and effects on financial stability more than compensate for the costs involved.

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