Judgment Day

• Author: S. Raihan Zamil
• Position: the IMF's Banking Policy and Supervision Advisor to Bank Indonesia and a former official at the U.S. Federal Deposit Insurance Corporation.

IN the wake of the global financial crisis, there have been numerous proposals to reform the oversight of the global financial system—from the Group of 20 advanced and emerging economies (G-20) and international standards setters. Nearly all of the proposed reforms focus on strengthening bank-centered regulations, such as capital, liquidity, loan loss provisioning, or compensation arrangements. These enhancements, particularly higher capital and liquidity buffers, should make the global financial system better able to absorb and provide more tangible backstops to curb excessive risk-taking at banks.

Still, changing rules alone is insufficient to foster financial stability if the quality of their application—that is, supervision—is not effective. The business of banking supervision—and the risk management practices of banks—remains inherently subjective, regardless of the imposition of new, or tightening of existing, rules. For this reason, the proposed regulatory reforms are akin to “trying to prevent another outbreak of H1N1 through high level epidemiological planning, without involving the doctors and health workers on the ground” (Palmer, 2009).

Strengthening micro-prudential supervision should be at the forefront of the global reform agenda and is the linchpin in fostering financial system stability. Enhancements to macro-prudential supervision (which focuses on an assessment of common shocks affecting the broader financial system), although necessary, are beyond the scope of this article.

Two sides of a coin

Regulation and supervision are often used interchangeably when describing the official sector’s role in the oversight of the banking system. In practice, regulation and supervision serve two distinct but related functions:

•Laws and regulations are the collective set of rules that provide the banking authority with powers to license banks, set minimum operating and risk management standards for banks, and take necessary corrective measures—including revocation of banking licenses—in problem bank situations. The main intent is to require bank management to behave prudently because banks are the guardians of depositor funds.

•Supervision is the authorities’ means of implementing these rules through ongoing off-site surveillance and periodic on-site examinations of individual banks. Supervisors carry out these tasks by evaluating banks’ corporate governance, internal controls, and risk management practices; their financial capacity; and their compliance with various laws and regulations. Based on their risk assessments, supervisors are also responsible for taking timely actions against problem banks or problems in banks.

Supervision traditionally has taken a back seat to regulation within the international reform agenda for two main reasons. First, its application is local and context driven. Second, it is a far more complex “fix” than strengthening regulations. Regardless, the lack of international focus on the practice of supervision has unintended consequences.

An example is the formulation and implementation of the Basel II capital accord, whose stated objective is to strengthen financial stability through enhanced capital requirements, better supervision, and robust market discipline. In practice, the overwhelming focus of Basel II was on the technical construct of regulatory capital, with limited emphasis placed on strong supervision until very late in the process.

Because the architect of Basel II (the Basel Committee on Banking Supervision) is also the international standards-setting body for bank regulatory and supervisory standards, the relative importance it places on supervision often influences—or in many cases reinforces—the preexisting biases within some national regulatory bodies that regulatory policy development is a more important function than the activities of front-line supervisors. This perspective, if widely held, has significant implications for both resource allocation and the prioritization of internal reforms within each jurisdiction. Thus, the starting point in the reform agenda begins with changing our collective mindsets on the importance of strong supervision in fostering financial system stability.

Judgment is essential

Strong supervision is premised on the ability and willingness of supervisors to take timely actions (Viñals and Fiechter, 2010), according to an IMF staff position note. To have the ability to act, supervisors must possess sufficient legal authority and resources, a clear strategy, and strong working relationships with other regulators. To have the willingness to act...