The Case for Supervisory Risk Appetite Frameworks

In a recent paper published by the Financial Stability Institute (FSI), Monica Balan (European Central Bank) and Raihan Zamil (FSI) argue that supervisory authorities (SAs) lack an effective means to manage supervisory risk and propose a supervisory risk appetite framework to fill this gap.

The authors contend that both the 2007 Global Financial Crisis and the March 2023 banking turmoil revealed not only weaknesses in banks’ governance and risk management, but also significant shortcomings in supervision. Yet while international standard-setters have pushed banks to strengthen their governance, culture, and risk appetite frameworks, this focus has not extended to SAs themselves. This gap leaves regulators without a structured means to define, manage, or communicate their tolerance for supervisory risk, defined as the risk that supervisory actions fail to achieve prudential objectives.

Balan and Zamil propose a framework built around three components: clearly defined risk appetite statements, measurable operational indicators, and robust governance arrangements. Only a small number of SAs, to include Canada’s Office of the Superintendent of Financial Institutions and the European Central Bank, have adopted such frameworks to date, and the authors point to these as potential models for other supervisors.

Balan and Zamil emphasize that supervisory risk appetite frameworks and supervisory culture are mutually reinforcing. Cultural norms in a SA determine whether the risk appetite is “embedded in day-to-day supervision or remains a formal statement with limited influence,” they explain. At the same time, such frameworks provide structure to “guide supervisory activities and decision-making, which in turn enhances culture.”

“Supervisory risk cannot be fully eliminated,” they write. “SAs operate with finite resources, expanding responsibilities and imperfect information, and within complex financial systems. Efforts to fully eliminate supervisory risk are unrealistic and may be undesirable, as excessive interventions that seek to minimise firms’ risk-taking may undermine their ability to support the real economy. Effective supervision therefore requires SAs to recognise and manage inherent trade-offs in pursuing prudential objectives.”