Viewpoint: Regulatory Philosophy

• Author: S. Raihan Zamil
• Position: IMF’s Banking Policy and Supervision Advisor to Bank Indonesia
• Pages: 50-51

Page 50

Risk-based supervision sought to spur innovation and reward good behavior but helped bring about the global financial crisis

THE causes of the financial crisis are widely acknowledged, but what is less well understood in the public debate is how the philosophical approach to the regulation and supervision of the global financial system played an enabling role in the runup to the current financial crisis. This philosophical approach is often described as the “risk-based supervision” (RBS) framework. It has been adopted by the leading developed economies, as well as many other countries throughout the world. Although the RBS framework can be used to describe a general philosophical approach to regulation and supervision of the entire financial system, I will use the term more narrowly—as it applies to official oversight of the banking system.

At the core of the RBS philosophy lies the view that a banking organization can engage in virtually all forms of financial activity, as long as it has robust risk management systems and sufficient earnings and capital to support those underlying risks. In short, RBS seeks to liberalize the powers of well-managed banks, to spur innovation, and to reward good behavior.

The RBS framework also aims to promote proactive financial sector supervision by early identification and resolution of weak risk management practices, before their effects threaten the stability of both individual banks and the banking system as a whole. Virtually all countries that have adopted this approach have aligned their legal, regulatory, and supervisory approach to support this overarching philosophy.

Where risk-based supervision falters

Although the ideals of RBS are admirable and the framework has yielded tangible benefits, its shortcomings are rarely discussed, given the presumption that the RBS approach is the best way to oversee a nation’s banking system. The unfolding of the current financial crisis has exposed fundamental cracks in this approach to banking system oversight.

First, the RBS philosophy outsources critical public policy matters—such as whether certain financial activities are permissible and the implications for broader financial system stability—to individual bank supervisors. To take a recent notorious example, should banks be allowed to originate and/or purchase via securitization home mortgage loans that...