Contributions to the Supervisors on Supervision Stocktake
“There’s a tension between two ideas. On one side, a firm can be formally compliant on governance but still have poor culture — that’s a problem. On the other, [there is] a broader interpretation of governance that incorporates culture. Supervisors examining ‘governance’ (say under SREP, in the case of the ECB) must have a clear mandate to go beyond policies and codes to understand how formal governance translates into actual practice, how it translates in culture. If we adopt this broader interpretation, good governance implies good culture by definition.”
“Selecting the right tools to address governance and business model assessments is crucial for detecting qualitative weaknesses before they manifest in financial metrics. Establishing a comprehensive set of red flags to inform supervisory action is helpful. More challenging is determining the appropriate supervisory measures for addressing these weaknesses and ensuring their timely implementation.
Linking ratings not only to a bank's risk profile but also to management's ability to meet supervisory expectations can incentivize effective corrective measures. Assigning specific responsibilities for required corrections to individual executives or board members or to specific internal committees further enhances accountability.
Supervisory frameworks must include clear procedures for communication, monitoring, and escalation. Prioritising key actions for firms is essential, as an exhaustive list of findings from various supervisory reviews can dilute focus and inflate compliance costs. Authorities could issue consolidated letters at the end of supervisory cycles, prioritising key concerns and outlining remediation steps with clear timelines. Robust IT systems are crucial for monitoring corrective actions, while structured escalation procedures ensure consistency in decision making when banks fail to address identified deficiencies.
More broadly, any effective supervisory framework must allow room for judgment. However, this judgment is optimised when informed by supervisory guidance, criteria, and indicators that support supervisory decisions without introducing rigid playbooks.”
What are the consequences for failing to consider the influence of culture in assessments of governance effectiveness?
“The 2023 banking turmoil illustrated that liquidity stress episodes often stem from structural vulnerabilities in banks, such as weaknesses in governance, business models, and internal controls. Identifying and addressing these vulnerabilities should be a primary objective of regular supervisory reviews and evaluations.”
How can supervisory culture be made more proactive and effective in connection with evaluating culture-related risk matters?
“A recent FSI paper reviews supervisory practices in major jurisdictions and offers insights for timely and effective deployment of qualitative measures within robust supervisory frameworks. The paper suggests that authorities could benefit from defining their own risk appetite frameworks, which would involve clearly articulating the level of risk they are willing to accept when making risk-based decisions. Combining top-down and bottom-up approaches in risk scoping can enhance this process.”
How should supervisory bodies approach enforcement in the context of culture risk governance and supervision?
“The effectiveness of qualitative supervisory measures crucially depends on adequate resources, legal powers, operational independence (of the supervisory authority), and a supervisory culture that encourages early intervention when needed.
Meeting, in particular, this latter requirement is challenging as it requires supervisory agencies to adopt a risk tolerance framework that accepts a non-zero level of policy mistakes and successful litigation against supervisory actions.
The effectiveness of qualitative measures also hinges on the supervisory frameworks employed by prudential authorities. For instance, an external assessment commissioned by the ECB in 2023 highlighted room for improvement in the formulation, prioritization, scalability, and monitoring of qualitative supervisory measures within the European banking union. Similar observations could likely apply to supervisory frameworks in other jurisdictions.”
What are the structural challenges to integrating culture supervision into standard oversight practices?
“The regulatory reforms following the GFC have significantly enhanced the official sector’s ability to manage financial stability risks. However, these reforms have not been matched by comparable efforts to establish more effective supervisory frameworks.
While recent evidence points to the need to enhance the safety and soundness of financial institutions, the option to do so by significantly further tightening regulation should be approached cautiously. After the far-reaching post-crisis reforms, the marginal benefits of additional regulation may have diminished, while the marginal costs of higher regulatory burdens have arguably increased.
Conversely, the case to enhance supervisory frameworks looks quite strong and should therefore become a key priority. Efforts should focus on identifying banks' vulnerabilities and addressing them through well defined, prioritised, and monitored qualitative measures. If successful, these efforts could also support ongoing initiatives to simplify the regulatory framework by streamlining minimum requirements without compromising financial stability objectives.
Targeted supervisory actions to address specific weaknesses in regulated banks — before they escalate into crises — can effectively safeguard the safety and soundness of individual financial institutions. Robust supervisory frameworks may reduce the need for frequent adjustments to regulatory requirements across the board, especially for vulnerabilities that are not uniformly relevant to all institutions. By striking the right balance between regulation and supervision, the prudential framework can achieve financial stability goals while minimising compliance costs for the sector.”
What have we learned from past approaches to culture risk governance and supervision?
“For supervision to effectively complement regulation, the deployment of well-defined qualitative measures is essential. Supervision cannot rely solely on adjusting quantitative capital or liquidity requirements to banks’ specific circumstances.
No feasible amount of capital or liquidity can compensate for risks arising from poor governance or unsustainable business models. By contrast, early supervisory dialogue and moral suasion can often resolve directly issues identified during supervisory reviews.”