Basel Committee on Banking Supervision

Supervisors have a legal mandate to supervise banks and thereby protect the financial interests of the community by: (i) promoting safe and sound institutions; (ii) safeguarding continuity in the provision of financial services; (iii) protecting the interests of deposit holders; and (iv) maintaining the stability of the financial system.

Effective supervision must complement regulation. It is important that supervisors are prepared to quickly and effectively identify, assess and mitigate risks when they threaten to create vulnerabilities in the financial system.

Banks operate in a market environment and situations will arise in which risks materialise and affect the soundness of institutions. Supervisors intervene to the best of their abilities to remediate issues that could potentially lead to the failure of individual banks. Their ability to prevent failures also depends on external developments, available resources, and the risk tolerance of both the supervisor and of the bodies to which the supervisor is accountable. Regulation and supervision can never reduce the probability of bank failures to zero.

The following terms are used throughout this chapter and have the meaning given below:

1. Administrator: is a person or entity, including a government agency, appointed by the court or relevant authority, to operate a weak bank in an effort to conserve, manage and protect the bank’s assets until the bank has stabilised or has been closed. Also called “conservator” in some jurisdictions.
2. Contagion: refers to the situation that adverse events affecting one bank are quickly transmitted to other banks, eg bank runs.
3. Corrective action: refers to an action required by supervisors to deal with deficiencies and change behaviour in a weak bank. It can be implemented by the bank under the supervisor’s informal oversight or, if necessary, through formal supervisory intervention.
4. Early warning system (EWS): is an empirical model that attempts to estimate the likelihood of failure or financial distress of the bank over a fixed time horizon, based on the bank’s current risk profile.
5. Effective supervision: there is no single definition of supervisory effectiveness; however, the Committee believes the following definition provides the best foundation for the practice of supervisors. Effective supervision promotes the safety and soundness of banks and the banking system by promptly assessing prudential risks, identifying material shortcomings within banks and using the supervisory toolkit and powers appropriately to ensure that banks remediate issues in a timely manner.
   1. This definition includes both the supervisory activities and their outcome based on the supervisory life cycle, which encompasses: (i) risk-based supervisory assessment; (ii) identification of key issues, applying supervisory judgment; (iii) supervisory measures for banks to remediate in a timely manner the identified shortcomings; and (iv) a timely follow-up by supervisors to foster remediation by banks, applying enforcement and escalation strategies focused on material shortcomings.
   2. In the execution of supervisory activities, particularly in the follow-up process to ensure that banks address weaknesses in a timely manner, effective supervision necessitates that supervisors possess a “will to act”, often in the face of imperfect information.
   3. Effective supervision involves early intervention measures, as they help to identify and address potential shortcomings in a bank before they escalate into larger problems that threaten the bank or the stability of the entire banking system. It allows supervisors to be proactive (“ahead of the curve”) even in the face of imperfect information.
6. External accountability: refers to arrangements by which supervisors are responsible for their actions to external stakeholders.
7. Internal accountability: refers to internal processes and procedures that guide the supervisory process, including checks and balances and a clear division of roles and responsibilities to ensure well founded actions and decisions.
8. Resolution: refers to the plan to resolve a bank when it is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so, typically involving some change to the legal structure and ownership of the bank. The resolution regime should provide for timely and early entry into resolution before a bank is balance sheet insolvent and before all equity has been fully wiped out. There should be clear standards or suitable indicators of non- viability to help guide decisions on whether banks meet the conditions for entry into resolution. Systemically important banks are subject to a resolution planning requirement consistent with the FSB Key Attributes.
9. Revocation of licence: is the cancellation of a banking licence by the chartering authority, and hence the requirement to cease all banking business.
10. Ring-fencing: is the process of limiting exposures of a foreign branch or subsidiary to the parent bank and banking group; limiting funding from group entities (in case it is withdrawn at short notice); and imposing more stringent capital and liquidity requirements to protect local depositors and banking system. But ring-fencing at the point of failure is likely to be value destructive from a whole group perspective and lead to unequal outcomes among claimants in different jurisdictions. In the context of a conglomerate, the term is used to describe the process of protecting a bank from the adverse impact of events occurring in the wider corporate group, especially when they involve unsupervised activities.
11. Risk-based supervision: refers to supervision based on an assessment of risks. The supervisor assesses the various business areas of the bank and the associated quality of management and internal controls to identify the areas of greatest risk and concern. These areas receive the most intense supervision.
12. Sale and payment prohibition: refers to an order issued by a supervisor or another authority vested with this power, directing a bank to freeze its payments and asset sales to stop outflows from the bank. This could be done eg to gain time for finding a suitable resolution.
13. Sanctions: is the penalty for a breach of a rule, a law or a supervisory order, or for engaging in unsound practices. Sanctions can be ordered by the supervisor or, where appropriate, by a court of law. They may consist of a fine or, in some jurisdictions, criminal charges. The penalty can be imposed on the bank itself or on an individual.
14. Supervisory cycle: refers to a structured framework based on a supervisory strategy translated into a consistent, continuous and comprehensive cycle. It is useful to identify different tools and instruments of supervision and how they contribute to the ultimate objective of promoting the safety and soundness of banks and overall financial stability.
15. Supervisory rating system: is a rating system used by supervisors to reflect in a comprehensive fashion a bank’s financial condition, compliance with laws and regulations, and overall operating soundness. As such, the system helps to identify those banks whose financial, operating or compliance weaknesses require special supervisory attention and/or warrant a higher than normal degree of supervisory concern.
16. Timely corrective action: is a speedy action by the supervisor to deal with bank problems to prevent the problems from growing and becoming more difficult and costly to handle. Some jurisdictions have a formal legal framework which requires the supervisor to take a certain prescribed course of action in the event of certain defined weaknesses or violations.

In all jurisdictions, the safety and soundness of banks and the banking system is reflected in some form in the overall, strategic objective of supervision. The overall objective of supervision is determined by the supervisor’s mandate, which is often established by law and has a strategic, long-term perspective. The Basel Core Principles for Effective Banking Supervision provide a consistent framework.

Notwithstanding substantial commonality in the goals, the methods of supervision adopted by individual prudential supervisors differ markedly. Supervisors apply a variety of practices to fulfil the core objectives of supervision. This can be attributed to differences in financial conditions or market structure. However, differences often are simply due to operational history or to individual preferences in jurisdictions.

Supervisors determine their strategies from various perspectives. In addition to the ultimate goal of safety and soundness, strategic objectives can be targeted towards the financial system, institutions, consumers and/or the economy. The objectives may also include the overall stability, efficiency and competitiveness of the financial system, and preventing irregularities that may endanger the safety and soundness of the banking system. For some supervisors, the main objective of financial supervision is to ensure that financial promises to individuals are met – implying that failures are mitigated or that safety net provisions are robust – while other jurisdictions may focus on an effective functioning of the financial system, aiming at orderly resolution. Other supervisors make it more explicit that a zero-failure policy is not the ultimate objective.

Supervisors may have additional objectives, often secondary. While respecting the primary objective of promoting the safety and soundness of banks, these secondary objectives may include maintaining public confidence, fostering a reputable and competitive financial system and ensuring a sound and stable financial system that contributes to a healthy and successful economy. Some supervisors also include within their general objectives the protection of depositors and customers.

While the traditional, quantitative elements of capital buffers and liquidity requirements continue to play a central role in supervision, supervisors apply a more forward-looking approach, with attention to strategic and qualitative elements. In addition to bank-specific supervision, supervisors make more use of overarching approaches with cross-cutting analyses of the sector as a whole. This is reflected in the increased use of benchmarking exercises and thematic reviews. An approach of looking beyond individual banks enables supervisors to better detect industry trends, spot potential outliers and look at risks to financial stability.

Supervisors seek to strike an adequate balance between the application of a uniform, rules-based approach as opposed to a more targeted approach, tailored to the specific circumstances of the individual bank.

In a market environment, banks can fail. An effective crisis management framework allows supervisors to intervene at an early stage and to facilitate an orderly resolution of a troubled bank, thereby preserving financial stability.

The expansion of supervisory activities and the challenges to assess their effects increase the relevance of developing a structured framework to measure the impact of supervision. It is useful to identify different tools and instruments of supervision and how they contribute to the ultimate objective of promoting the safety and soundness of banks and overall financial stability.

Impact assessment and accountability are part of a continuous evaluation process to monitor and enhance supervisory effectiveness. Supervisors regularly evaluate their methodologies and operating frameworks to establish what works best in their jurisdictions. As financial market and supervisory practices evolve, supervisors adapt their approaches to consider relevant developments.

Supervision is embedded in a consistent, continuous and comprehensive cycle. The key elements of a supervisory cycle are based on a supervisory strategy that includes:

1. Clarity regarding the objectives of supervision, (“what do we want to achieve?”), translated into activities through a structured planning process.
2. Evaluating impact (“how do we know if our activities contribute to meeting our objectives?”).
3. Accountability (“how do we demonstrate to key stakeholders that our supervision has been effective?”).

It is the responsibility of the supervisor to further clarify its strategy and translate the general objectives into supervisory actions. Supervisors may have discretion to refine their strategic objectives and determine their supervisory strategies.

A comprehensive framework that clearly translates the (multi-year) strategic objective(s) into supervisory actions offers useful guidance to the supervisory process and supports a constructive dialogue with supervised banks on what is expected from them. A framework which defines and clarifies the objectives and supervisory actions ex ante also provides a strong basis for evaluating the impact of supervision ex post.

Consistently and coherently linking a supervisor’s overall mandate with its activities promotes the development of actionable strategic objectives, prioritises its actions and focuses on the intended outcomes. This can be organised through a top-down or a bottom-up process with close involvement at the board or senior executive level. This planning process can provide a clear link between the different levels of supervisory planning. This is essential to ensure consistency with the ultimate, strategic objectives and supervisory activities. These top-down and bottom-up processes need not be mutually exclusive and may be applied in combination.

A clear link between the different levels of supervisory planning is essential to ensure consistency with the ultimate, strategic objectives and supervisory activities. The inclusion of the following four key elements in the planning process can help ensure that the general objectives of banking supervision discussed above are met in practice:

1. Identification of bank-specific and system-wide vulnerabilities through verification work and forward-looking analysis;
2. Escalation of findings to the supervisory decision-making bodies;
3. Enforcement of the legal and regulatory framework; and
4. Timely preventive and corrective actions. This includes contributing to resolution processes where other public sector bodies are also involved, such as the deposit insurance fund or the ministry of finance.

Notwithstanding the differences in implementation, it is particularly important that supervisors provide clarity on their objectives as stated in the Basel Core Principles, defining upfront the effects that supervisors want to achieve. Supervisors not only provide direction to the supervisory process and a clear focus towards the relevant ultimate outcomes, they also give supervised banks clarity on what is expected from them and contribute to an effective dialogue and better prioritisation of actions. Finally, defining desired effects is a necessary precondition for any analysis of impact and accountability.

Typical ways to communicate expectations include annual reports, financial stability reports, business consultations and circular letters sent to the banking industry. Supervisors use regular public announcements and explanations of regulatory and supervisory policies and approaches to make sure that expectations about supervisory objectives are known. Communication on individual banks’ supervisory expectations is primarily done as part of the bank-specific supervisory dialogue, eg through the supervisory review and evaluation process (SREP).

Confidentiality legislation may impose limits on disclosure. Transparency and communication must consider the rules governing the legislation regarding confidentiality of information. These are likely to set limits on how far supervisors in many jurisdictions may disclose bank-specific supervisory information as well as information that affects the privacy of individuals and their activities. This does not preclude disclosure of overarching policy goals that the supervisor pursues for certain groups of banks or for particular risk issues.

An effective supervisory review process1 requires supervisors to implement a risk-based supervisory approach with forward-looking aspects. Supervisory activities (eg supervisory planning and resource allocation) should be prioritised in accordance with the risk profile and systemic importance of individual banks and banking groups. In this forward-looking approach, the supervisor identifies the areas of greatest concern by assessing the bank's various business lines and risks; its associated strategies; and the quality of its governance, management and internal controls. The supervisory focus is directed to these areas to allow the supervisor to identify and address weaknesses at an early stage.

In practice, this means identifying the significant business units and areas of inherently high risk, such as a division of the bank that is consciously targeting riskier borrowers. The supervisor’s efforts may be concentrated on examining risk exposures and the robustness of the controls in these areas, if necessary through regular on-site examination. This approach may also identify and focus on relatively weak controls, such as an internal audit function that is understaffed relative to the bank’s peers. The supervisor’s resources will be targeted on discovering more about the areas of weakness with a view to implementing a remedial action plan, where needed.

The adoption of a risk-based supervisory framework is premised on the ability and willingness of supervisors to exercise sound judgment, for example, in determining which areas of a bank pose the greatest supervisory concern. To ensure that well-supported judgments are being made within and across supervisory teams, supervisors should have in place robust internal governance processes.

The supervisory review comprises the gathering of quantitative and qualitative information on the risks facing the bank and the assessment of the bank’s ability to control or mitigate these risks through internal governance and control structures and capital and liquidity resources. Supervisors should use a range of approaches for gathering the information, and they should establish systems for substantiating judgments on the bank’s capability to mitigate the identified risks.

Effective banking supervision should consist of some form of both on-site and off-site supervision with forward-looking aspects. If deterioration or potential deterioration in the bank’s condition is detected in the off-site reviews, which typically involve analysis of information submitted by the bank, on-site examination can be used to assess more precisely the nature, breadth and depth of the problem. On-site and off-site supervision should consider a number of sources of information and assessment processes to identify risks and weaknesses.

In addition, supervisors use a number of forward-looking tools to facilitate the early identification of a weak bank. These include the supervisory review of a bank’s business models, the quality of its governance, risk management and control functions and, when appropriate, stress testing practices. Collectively, these assessments provide valuable insights into a bank’s future risk profile. They may also be used as the basis for pre-emptive corrective measures against weak banks, even if their reported capital and liquidity positions or earnings performance may otherwise appear strong.

The breadth, depth and frequency of on-site examinations will be driven by the bank’s overall risk profile. This can be determined by assessing the level and trend of risks in the bank, the adequacy of its risk management systems (including the reporting structure) and its financial strength in terms of earnings and capital and liquidity resources. There can be general, full-scope examinations, or specific ones focusing on segments of operations or types of risk. On-site examinations can cover most of the subsequent key elements of the supervisory review process, and they also provide a more qualitative analysis. The purpose of such qualitative assessments is for the supervisor to determine whether management has the ability to identify, measure, monitor and control the risks faced by the bank.

On-site examinations are performed in regular intervals, depending on the risk profile of the bank. For small banks with low risk and a stable financial position, the examination cycle may be extended. Conversely, banks with weak or deteriorating financial ratios should be examined more frequently. In some cases, for larger banks, a risk-based approach (ie concentrating on areas of known or suspected deficiencies in a bank) is complemented by a rolling programme of reviews centred on areas of impact rather than a single, full-scope review. A rolling programme within large banks is useful for ensuring that, from time to time, an assessment equivalent to a full-scope examination is undertaken without the excessive commitment of resources that would be required for a comprehensive review. This will help to identify areas of potential weakness and prevent overreliance upon reactive tools.

Examination reports should be prepared in a timely fashion. When there are significant weaknesses calling for immediate attention, supervisory action should be initiated without waiting for the report to be finalised. All or parts of an examination (eg where special skills are needed) may be commissioned by supervisors but undertaken by external auditors or other “skilled persons” other than the supervisor.

Banks are typically required to submit timely financial statements to the supervisor in the form of regulatory returns and other ad hoc financial reports. The frequency of reporting depends on the nature of the data. Market-based and other data that become obsolete fairly quickly require a shorter reporting interval. A quarterly frequency would be the shortest appropriate interval for many types of prudential data, such as loan classification and provisioning, risk concentration, insider lending and capital adequacy. Supervisors should have the legal power to require banks to report all data that are relevant for supervision, with sanctions available to punish banks submitting deficient, incorrect or late returns.

Supervisors utilise statistically driven early warning systems based in large part on the regulatory reports submitted by banks. These models typically estimate the likelihood of failure or financial distress over a fixed time horizon. Alternatively, some EWS aim at predicting future insolvency by estimating potential future losses.

Enforcing compliance with regulatory requirements does not necessarily guarantee that risks are contained. This is particularly evident, in cases where banks have an unsustainable business model, inappropriate risk management, or when the underlying culture or behaviour remain unaddressed. Assessing business models can serve as an effective approach for early detection of the risks and vulnerabilities that could turn strong banks into weak ones.

The common characteristics of non-viable business models include:

1. Excessive reliance on an inappropriate funding structure, given the business model.
2. Excessive concentrations across the business model – funding customer base, sources of income and/or risk. Even with sound risk management tools, such concentrations can be destabilising and leave the bank vulnerable to sudden changes in the business environment.
3. Earnings asymmetry/volatility, identified by significant changes in the earnings mix over a short time frame, particularly when driven by non-core business lines. Such changes also suggest vulnerability to sudden changes in the business environment.
4. Unrealistic strategic assumptions, particularly excessive optimism about capabilities, growth opportunities, economic indicators and market trends, which leads to poor strategic decisions that imperil business model viability.
5. Production of and investment in complex products, leading to significant increases in risk exposure, often without appropriate controls, oversight or understanding of the nature of the risk.

The assessment of business models requires the supervisor to both develop an understanding of the viability of the bank’s current business model and form a view of its sustainability, given the strategic choices that the bank is making and/or the impact of changes to the business environment in which it operates.

The outcome of the assessment can provide supervisors with a valuable supervisory tool by allowing for the early detection of potentially risky exposures incurred or actions taken by the bank to generate current or future profits that may ultimately lead to its failure.

Whenever the outcome of the assessment suggests that the business model is non-viable or unsustainable, supervisors should consider timely corrective action, even if the bank has not yet breached any operational limits.

A feature of business model analysis is the review of a bank’s financial information and forecasts and proposed business strategy and plans. Such a review can produce a wide array of financial ratios with which to assess the performance and financial condition of the bank and to gauge the sensitivity of its condition to projected changes in the wider economic and business environment. The results can be used to support the analysis of whether potential weaknesses in the business model are likely to materialise as a result of the projected changes.

The quality of governance and management is probably the single most important element in the successful operation of a bank.2 Therefore, a critical element of the supervisory review process is to regularly evaluate a bank’s corporate governance practices, including the quality of board and senior management oversight, board independence and the effectiveness of the bank’s risk management and control functions (including internal audit and compliance).

Under a risk-based supervisory regime, these reviews serve two important purposes. First, they help supervisors determine the reliability of a bank’s own risk management and control processes, which in turn helps to inform the scope, resource needs and areas of focus during the off-site reviews and on- site examination process. Second, they are used to take early corrective action against banks that have inadequate governance and risk management practices, even if their financial condition and performance indicators still appear robust.

As part of their evaluation of the overall corporate governance of a bank, supervisors should assess the appropriateness of criteria used by banks in the selection of board members and senior management, including whether their skill sets are commensurate with the nature and complexity of the bank. In particular, an assessment of the overall risk culture of a bank provides valuable insights into the effectiveness of its board and senior management. Such a review entails an evaluation of the extent to which the board and senior management set the right tone and how that has been put into practice in the business lines, as well as in the risk management and control functions.

Supervisors should also assess the depth and breadth of interaction between the board and the risk management and control functions; how information flows to and from the board and senior management; and how potential problems are escalated and addressed throughout the organisation. Ultimately, supervisors should use existing powers under applicable law to hold the board and senior management accountable for material shortcomings in a bank’s business model, stress testing practices, or other weaknesses in policy, practice or condition.

Management Information Systems (MIS), data aggregation and reporting3

Supervisors should require banks to maintain MIS that produce information on a timely basis, both in normal times, for recognising weakness, and during resolution.4 MIS provide key information such as risk exposures, liquidity positions, interbank deposit and short-term exposures to, and of, major counterparties. The adequacy of MIS should be assessed by timely analysis of information on both a qualitative and a quantitative basis.

Supervisors should request information on a banking organisation’s stress testing framework and results to assess liquidity and solvency vulnerabilities, enhance capital planning and liquidity contingency planning, identify appropriate actions and assist with recovery and resolution planning.

Stress testing5

Stress tests can be a key instrument for the early detection of a weak bank. Stress testing is not only a useful process, but also a means to engage in a dialogue directly with the bank to identify potential weaknesses of banks in a forward-looking manner, and to alert bank managers to take the necessary corrective actions. Stress test results are one of the instruments used by supervisors to inform the overall decision about corrective action, given that the formality of stress testing processes will differ depending on the size and complexity of the banks.

Macroeconomic or system-wide stress tests are used by supervisors and macroprudential authorities to assess the robustness of the financial system more broadly, rather than focusing on specific banks, and may assist in identifying systemic vulnerabilities. System-wide stress testing also helps supervisors identify individual banks’ weaknesses.

Supervisors in some jurisdictions complement banks’ forward-looking stress testing with supervisory stress tests based on common scenarios. Prominent among these supervisory tests are those designed to assess the adequacy of capital and liquidity. That prominence is appropriate, given the importance of capital and liquidity to a bank’s viability. Supervisory stress testing in these two areas should include an evaluation of the interaction between capital and liquidity and the potential for both to become impaired at the same time. Depletions and shortages of capital or liquidity can prevent the bank from performing effectively as a financial intermediary, destroy the trust and confidence of counterparties, diminish its capacity to meet legal and financial obligations, or lead to the bank’s insolvency.

Supervisory capital and liquidity stress testing should consider how losses, earnings, cash flows, capital and liquidity would be affected in an environment in which multiple risks manifest at the same time – for example, an increase in credit losses in an adverse interest rate environment. Additionally, supervisors (and banks) should recognise that at the end of the time horizon considered by a given stress test, there may still be substantial residual risks or problem exposures that may continue to put pressure on capital and liquidity resources.

Stress test outcomes must be carefully reviewed, especially in terms of consistency with the bank’s situation and risk profile. This assessment should precede any decision about possible supervisory corrective measures. Such action might require a bank to raise its level of capital above the minimum to ensure that it continues to meet its minimum capital requirements over the capital planning horizon during a stress period. Supervisors may also identify liquidity deficiencies and may require that management takes appropriate action, such as increasing the liquidity buffer of the bank, decreasing its liquidity risk, and strengthening its contingency funding plans. Stress testing results may also be used to inform the appropriate supervisory response should a bank face financial or other difficulties.

Authorities should evaluate a bank’s recovery plan as part of the overall supervisory process, assessing its credibility and likelihood of its effectiveness in both market-wide and idiosyncratic stress situations. Feasibility assessments of recovery options should help identify whether remediation actions must be undertaken by banks to remove barriers for effective recovery options.

Resolution authorities and/or supervisors can use the information gained from resolvability assessments to require banks to make changes to their business practices, structures or organisation before they become weak.

Supervisors are expected to supplement their microprudential supervision with efforts to identify risks in the financial system as a whole. This macroprudential approach allows supervisors to take actions to head off systemic financial instability or improve the resilience of systemically important banks and the financial system.6 Surveillance of the banking system entails identifying potential external shocks to the domestic and international environment and assessing how the banking system will be affected by these shocks. Pertinent issues involve the ability of the banking sector to absorb such shocks. Also important are considerations about whether losses can be spread through credit intermediation and the liquidity of financial markets. The answers to these questions will help determine the choice of particular macroprudential instruments.

Many central banks and supervisors publish surveillance analyses of the banking system in their annual reports and, on a more frequent basis, in standalone financial stability reports. Some jurisdictions have established authorities dedicated to macroeconomic surveillance and to monitoring market developments. These authorities are also likely to play an important role in deciding which macroprudential instruments should be activated and when. Where there are separate authorities, all relevant authorities should be closely involved in determining the macroprudential factors to be considered by microprudential supervisors.

Surveillance of the banking system and the financial system as a whole can provide early warning indicators of problems that may affect individual banks. Analysis of the state of the economy and credit conditions can help inform the supervisory approach to individual banks. For example, if economic surveillance suggests that there is a significant risk of a sharp decline in real estate values, the supervisor would be wise to monitor more closely those banks with particular exposure to the sector.

Evidence from past episodes of bank weakness or failures may also be indicative of the macroeconomic factors that could provide an early indication of bank risk. Various empirical studies have been conducted on leading indicators of banking crises. Macroeconomic factors frequently cited in these studies include a marked slowdown in real output, asset price bubbles (eg in financial assets or real estate), increases in real interest rates and currency depreciation, particularly when these negative shocks follow a period of rapid credit growth and/or financial deregulation.7 When a country is overbanked, such macroeconomic factors may affect a number of small banks, which poses the risk of their simultaneous failure.

Recovery planning and contingency planning may give supervisors and resolution authorities a deeper insight into banks’ potential behaviour in crisis situations. In many jurisdictions, only a limited number of banks in the financial system are obliged to produce formal recovery plans. However, many more banks may have developed contingency plans. A horizontal analysis of all available plans may provide a valuable contribution to the supervisor’s assessment of the banking system as a whole. Such analysis may give an insight into risks identified by the banks themselves, the chosen indicators for such risks and the proposed mitigation tools. This benchmark approach may also provide the supervisor with the opportunity to identify and spread best practices for relevant banks regarding objectives, content and the level of operational detail available in recovery plans.

Supervisors and macroprudential authorities frequently share analyses of macroprudential developments with bank management to encourage prudent responses. For example, if a build-up in a particular type of investment or reliance on a common funding source appears to be creating a concentration risk, supervisors will want banks to be aware of the risk and to evaluate its potential effect on their business. History shows that when many banks and investors in an economy fund a high level of commercial real estate assets and valuations rise rapidly, the risks of a large drop in values can be pronounced. The effect of such a loss in values may be particularly severe for banks with business models that focus on funding real estate markets, and supervisors may focus particular attention on banks with such models when a build-up in commercial real estate loans is observed.

One supervisory approach to measuring credit risk is to trace the effects of an exogenous adverse event, such as an increase in interest rates or a marked slowdown in aggregate demand, and thus output growth,8 using a quantitative macroeconomic model or more qualitative analysis. The impact on banks’ household and corporate customers would depend on their own vulnerability at the time. This, in turn, is likely to depend on factors such as the level of, and recent trend in, household and corporate income and on capital gearing of the corporate sector on average and across the distribution.

The position of firms and households at the top end of the distribution of fragility indicators would be particularly important since these would be the ones most likely to default on their loan repayments. In turn, the impact on banks of deterioration in the corporate and household (and overseas) position would depend on the composition of banks’ exposures and the capital cushion available to withstand losses.

Various macroprudential instruments are available to counter risks identified during system surveillance. These can include countercyclical capital buffers, and capital buffers for systemically important banks. These instruments are designed to constrain excessive risk-taking during economic upswings while enhancing the financial system’s resilience to shocks during cyclical downturns.

Similarly, if supervisors are observing a rapid build-up in exposures to real estate when market conditions suggest the possibility of unsustainable valuations, one macroprudential approach to address related risks could be to raise risk-based capital requirements for real estate loans held by banks or to impose maximum loan-to-value ratios. Similarly, if macroeconomic monitoring suggests that banks are relying heavily on potentially volatile funding sources, supervisors may require individual banks to further diversify their funding sources or hold more liquid assets.

Frequent contact and dialogue with bank managers and the board of directors are important components of effective supervision. To the extent practicable, supervisors should have regular contact with the management of all banks, and not only those in poor financial condition. Discussing strategies, plans, and deviations from existing business plans or changes in management with banks’ top executives will allow supervisors to update and review the existing supervisory framework as necessary. Supervisors should also review with management their efforts to correct identified weaknesses in the previous on- site examination.

An official meeting with the bank’s senior management and/or board of directors should be held at the conclusion of each on-site examination. Depending on the type of supervisory system, as well as the circumstances and condition of the bank, it can be useful to hold another meeting at least once before the next on-site examination. Frequent meetings can be useful for riskier or problem banks.

There may or may not be a statutory duty for the board of directors to report material weakness in the bank to the supervisor. In some jurisdictions, an audit committee of the board of directors is required to report to the supervisor, without delay, any irregularity in the management of the bank or any violation of banking regulations. Regardless of whether there is a statutory obligation, supervisors should cultivate an understanding with the management of banks that it is better to inform the supervisor of a problem earlier rather than later.

In addition to formal contact between the supervisor and bank management, there should be regular dialogue at different staff levels. A good practice is to meet with banks on issues not related to the situation of an individual bank, for instance, on future regulations or macroeconomic developments. If such a dialogue is created, bank managers and directors can be more willing to inform the supervisor of emerging questions or problems.

The supervisor and the external auditor should have an effective relationship that includes appropriate communication channels for the exchange of information relevant to carrying out their respective statutory responsibilities.9 External auditors may identify weaknesses in a bank sooner than the supervisor, such as during the statutory financial audit or while executing an on-site examination on behalf of the supervisors. A bank’s external auditor should identify and assess the risks of material misstatement in the bank’s financial statements, considering the complexities of banking activities and the need for banks to have a strong control environment. Where significant risks of that nature are identified, the auditor should respond appropriately. Beyond this, external auditors may also uncover other material issues during their audit work, such as material breach(es) of prudential requirements that are relevant for communication to the supervisor. Hence, by periodically meeting with external auditors and regularly following the auditor’s reports and letters, the supervisor can gain an early indication of control weaknesses or areas of high risk in the bank.

For small banks in which equity capital is narrowly or privately held, external audits can be especially helpful to supervisors in the early identification of needed improvements in financial management. External auditors’ reports and letters may contain information on deficiencies – eg weaknesses in internal controls related to financial reporting – that may have a significant impact on the safety and soundness of the institution. For larger banks, such findings may also contribute to a safe and sound banking system.

The auditor’s reports and letters to the bank and its board of directors should be available for the supervisor at the bank. The supervisor may wish to arrange to directly receive a copy of all such reports and letters. Moreover, where this is allowed, supervisors should review auditors’ work papers to better focus their resources and avoid unnecessary duplication. Supervisors should also carefully consider that independence issues, such as providing consulting services to the bank that they audit, may impair the effectiveness of a bank’s external auditor in identifying weaknesses.

There should be regular and effective dialogue between the banking supervisor and the relevant audit oversight body. In many jurisdictions, audit oversight bodies are responsible for independently monitoring the quality of statutory audits as well as audit firms’ policies and procedures supporting such quality. Therefore, banking supervisors and audit oversight bodies have a strong mutual interest in ensuring high-quality audits by audit firms. Effective dialogue can be established through both formal (eg regularly scheduled meetings) and informal channels (eg ad hoc discussions, telephone conversations).

As with external audits, supervisors should have unfettered access to reports and all other documents issued by the internal control and audit functions of a bank. Supervisors should examine these on a regular basis, at a minimum during each on-site examination but preferably more frequently.

Internal auditors generally report to the board of directors or a committee of the board. The supervisor should make it clear that directors and management of the bank are expected to immediately relay to the supervisor any information from the internal auditors regarding material weaknesses. Nevertheless, supervisors should also meet periodically with the bank’s internal auditors to discuss, among other items, the key risk areas identified by the internal audit function and to understand the risk mitigation measures taken by the bank to address the noted deficiencies. In some jurisdictions, supervisors use the internal audit function of smaller banks to review a specific, identified risk.

Banking supervisors should maintain close communication with other domestic agencies that have an interest in the bank’s financial condition. Interested parties normally include the central bank, the resolution authority, the deposit insurer, the government/ministry of finance, conduct authorities, supervisors of the securities and insurance industries and the overseer of the payment systems. Even if the central bank has no banking supervisory role, the supervisor should communicate with its relevant officers, such as those responsible for monetary and exchange rate policy, payment systems and financial stability. Supervisors should communicate with foreign supervisors regarding banks with cross- border operations through colleges of supervisors or bilateral contacts.10

In some jurisdictions, it is normal practice for supervisors and other agencies to sign memoranda of understanding (MoUs) covering the types of information to be exchanged and the protection of information that is shared. This agreement is especially important when sharing involves agencies outside the usual supervisory circle, such as a private deposit insurance agency, where confidentiality of information may be an issue. The execution of an MoU should not be regarded as the only solution, however, if there are practicable ways of exchanging information expediently.

For cross-border exchanges of information between banking supervisors, there are differing views within the supervisory community as to whether an MoU is the best channel if it is not statutorily required. MoUs take time to negotiate and may end up being overly legalistic, impeding rather than facilitating the exchange of information. Many jurisdictions have still found it useful to execute MoUs to set the framework for mutual cooperation. Whatever the form of arrangement chosen, it must ensure that the exchange of information can take place under the most difficult of circumstances, eg during a time of severe bank problems.

All G-SIBs have crisis management groups (CMGs), which are designed to develop preferred group resolution strategies and plans, resolvability assessments and cooperation agreements to coordinate international information-sharing necessary to implement the preferred resolution strategy.

Some jurisdictions have implemented CMGs for D-SIBs as well. In addition to CMGs, some jurisdictions have established or are required to establish so-called “resolution colleges” to address resolution planning issues at banking groups with cross-border activities. While CMGs and resolution colleges typically are responsible for coordinating and agreeing to resolution plans, assessment of recovery plans varies across jurisdictions. In some cases, either CMGs, supervisory colleges or a third body (eg resolution colleges) can be responsible for assessing recovery plans, while in other cases these groups may share the responsibility.

Market signals

Signals from the market, through information in the press, external credit ratings or otherwise, are a valuable source of information about the condition of a bank and its possible direction. The supervisor should treat information from these sources carefully since it may be unreliable. Nevertheless, it may often be an indicator that warrants further investigation.

Many supervisors use a supervisory rating system (SRS) to draw together a numerical expression of risks to which the bank is exposed and their possible prudential impact. A major benefit of the SRS is that it provides a structured and comprehensive framework. Quantitative and qualitative information is collected and analysed on a consistent basis and supervision is focused on deviations from the norm. In many jurisdictions, banks below a certain rating would automatically receive special supervisory attention. The SRS identifies the banks that are more susceptible to future problems, which helps focus further supervisory resources. Supervisory ratings should be the basis for subsequent supervisory actions, which may be targeted on specific issues (eg poor asset quality, weak credit risk management, inadequate profitability) or the general condition of the bank.

Although rating systems may vary in name and in the particular components they encompass, they typically include many common factors. Importantly, an SRS will incorporate a judgmental assessment of the bank’s board and senior management, including the appropriateness of their strategy and the quality of risk management and internal control systems. These qualitative judgments help to provide forward-looking assessments of a bank’s credit, liquidity, market, interest rate, operational and other material risks and their implications for earnings and capital adequacy.

In providing a comprehensive picture of the current and future profile of banks, the SRS should highlight the main strengths, weaknesses and risks of the bank. The rating given to each component (eg credit risk, capital adequacy, profitability) should consider all information available, considering the appropriateness of a bank’s risk mitigation measures and the quality of its risk management and internal control systems. Indicators based on quantitative information, which are often evaluated through peer group analysis, can be contextualised with qualitative information. This allows supervisors to focus on outlier banks. An SRS does not preclude ad hoc decisions to collect and analyse specific data outside the SRS framework.

The SRS process should combine in a consistent way the information and analysis of both off- site and on-site supervision. On-site examiners should be promptly informed of indications of weaknesses in specific banks, and they should alert off-site examiners to look for specific areas, banks and/or activities where they suspect that weaknesses may exist. The use of a common methodological framework should lead to closer cooperation between off-site and on-site supervisors.

The methodological framework underlying the SRS should support a forward-looking approach to supervision through early intervention. The adoption of early intervention measures should aim to correct or at least reduce identified weaknesses to prevent a further deterioration of the situation that may ultimately threaten the bank’s viability. Supervisors should pay particular attention to deficiencies in bank governance and risk management, since problems in these areas are often leading indicators of a bank’s future risk profile. Material shortcomings in these areas should therefore be subject to prompt supervisory intervention to address the noted weaknesses.

Corrective action should be considered in accordance with the magnitude and/or stage of a bank’s weakness.

1. Early remediation indicators should be based on regulatory capital and liquidity levels, stress test results, risk management weakness and market indicators. However, the defined early remediation indicators should not oblige authorities to automatically apply early remediation measures because it is expected that the authority will examine the situation of the institution thoroughly.
2. Remediation requirements range from a heightened supervisory review at the outset to restrictions on expansion and dividends, with action being taken at the early stages of financial weakness.
3. More severe requirements – including a prohibition on expansion and capital distributions, raising capital and divesting certain assets – generally would apply to banks at more advanced stages of financial weakness.

General principles for corrective action

The following principles should guide supervisors in implementing corrective action:

1. The fulfilment of supervisory objectives, including financial stability and depositor protection.
2. Immediate corrective action. The bank and the supervisor should take prompt action to prevent the problems from growing and exacerbating the financial weakness of the bank.
3. Senior management commitment. The senior management of the bank must be committed to the action plan for corrective action. Otherwise, the replacement of management should be considered.
4. Proportionality. Corrective action should be appropriate to the circumstances and scale of the problem.
5. Comprehensiveness. Both causes and symptoms of weakness must be addressed by the corrective programme.

Implementation of corrective action

Determining the nature and seriousness of the weakness

Formulating a corrective action plan requires an in-depth assessment of the nature and seriousness of the weakness. After a weakness is first detected, the supervisor must decide on who is to do the assessment and how it should be done. The assessment must identify causes, the size and character of the problem and whether liquidity and solvency are going to be an immediate concern.

The bank’s board of directors, its management and the supervisor may have different views as to the nature and seriousness of the bank’s weaknesses. An on-site assessment is usually the most efficient way to identify the full extent and nature of the problems faced by a bank. Problem banks may mask their most significant troubles in a way that can be detected only by on-site work. An on-site examination also helps to uncover the underlying causes of a weakness rather than merely the symptoms. Depending on the circumstances, the supervisor may require the assistance of external auditors and other independent expert advisers.

An essential part of the assessment is to determine the bank’s present and expected liquidity and capital position, and evaluate the bank’s contingency plans and recovery plans.

In assessing the prospects of insolvency, there must be an assessment of the fair value of the bank’s net assets. In this regard, it is essential to determine correctly the quality of the loans, how many are impaired and whether collateral can be enforced and the proper recognition of, and provisioning for, non-performing loans. It is also essential to assess the extent of insider and connected lending, and to measure prudently the fair value of “hard to value” assets and complex financial products held in the trading book or otherwise carried at fair value.11 On the liabilities side, the assessment must verify whether recorded values are adequate (eg with reference to liabilities measured at fair value through profit and loss), that all contingencies are recorded, and that all off-balance sheet items are known and under control. In the assessment, the bank should consider the effects of (closeout) netting and possible setoffs.

An accurate assessment of the fair value of the bank’s net assets should indicate the actions required. However, even if the value of the net assets is positive, solvency problems may arise in the near term.

In assessing the bank’s liquidity position, the bank’s long-term cash flow should be analysed to identify the real inflow and outflow of funds. For both normal and stressed conditions, any potential mismatches must be considered to ensure that a sufficient stock of unencumbered liquid assets is available to meet any cash flow gaps. Moreover, supervisors should be aware of the bank’s survival time under different scenarios, while also considering impediments, such as liquidity transfer restrictions within cross-border groups (eg ring-fencing measures).

If the supervisor forms the view that there is an immediate and significant threat of illiquidity or insolvency, immediate corrective action and close cooperation with resolution authorities are essential. On the other hand, where the bank is exposed to financial strain or another form of weakness that does not pose an immediate threat, the supervisor’s possible range of actions is broadened and may include “close monitoring” to better assess conditions and prompt the bank to adopt adequate corrective measures.

Range of corrective actions

Supervisors generally have a variety of tools for dealing with weak banks. These range from the ability to require specific action by the bank to mitigate the weakness, to prohibiting activities that will aggravate the weakness. Supervisors should possess effective means of addressing management problems, including the power to have controlling owners, directors and managers replaced or their powers restricted. Examples of the main corrective measures which supervisors need to have at their disposal include:

1. Governance measures:
   1. require the bank to enhance governance, internal controls and risk management;
   2. require the bank to submit an action plan of corrective actions;
   3. require the activation of recovery plans;
   4. require changes in the legal structure of the banking group, in close cooperation with the resolution authorities;
   5. remove directors and managers;
   6. limit compensation (including management fees and bonuses) to directors and senior executive officers, including consideration of the possible need for clawbacks; and
   7. require prior supervisory approval of any major capital expenditure, material commitment or contingent liability.
2. Cash availability measures:
   1. call for cash injection by shareholders and new investors; and
   2. call for new borrowing/bond issuing and/or rollover of liabilities/secure line of credit.
3. Shareholders’ rights measures:
   1. suspend some or all shareholders’ rights, including voting rights;
   2. prohibit the distribution of dividends or other withdrawals by shareholders;
   3. appoint an administrator or conservator; and
   4. mergers and acquisitions.
4. Bank operations and expansion measures:
   1. require the bank to enhance or change capital and/or liquidity and strategic planning;
   2. restrict concentrations or expansion of bank operations;
   3. downsize operations and sales of assets, including the closing of branches at home or abroad;
   4. prohibit or limit particular lines of business, products or customers (including concentration limits); and
   5. require immediate or enhanced provisioning for assets of doubtful quality and for those not carried at fair value.

Incentives for timely corrective action and preventing forbearance

Timely corrective action is essential, as delays in addressing bank problems can lead to rapid deterioration of the situation. In many cases, the bank’s board of directors, management and shareholders, as well as supervisors, have tended to postpone taking timely and adequate corrective action.

The most basic cause for inaction is that all parties may be reluctant – in good faith – to take the measures needed to remedy the situation in the hope that the problems will rectify themselves. The supervisor may be under explicit or implicit pressures from politicians or lobby groups to postpone measures. Therefore, international standards (such as the Basel Core Principles) include recommendations that jurisdictions enact laws and regulations to support supervisors acting promptly and adequately in relation to the bank problems encountered.

It is important to establish incentives for supervisors that encourage early and decisive action in response to indications of material deterioration in the condition of banks. Unless such incentives are firmly established, supervisors may not act soon enough to prevent further financial deterioration or failure. Moreover, supervisors should supplement their focus on individual banks with a macroprudential perspective, through liaison with macroprudential authorities where the authorities are separate, and be encouraged to require appropriate actions by all supervised institutions at the earliest sign of a threat to financial stability from the weak bank.

Supervisors should have the discretion to act pre-emptively when weakness in a bank is detected, without waiting for a threshold to be breached. Supervisory measures should be tailored to the specific situation. Even if there is no pre-specified time limit within which the supervisor must act after identifying a problem, best practice is normally to act as quickly as possible to prevent an escalation of the problem. Decisions not to act in a particular case (and the reasons for that conclusion) should be documented in the same way as decisions to act. In those instances in which a bank reaches the point of non-viability (ie it is no longer viable, or likely to be no longer viable, and with no reasonable prospect that any recovery actions will be successful), the supervisor and, where appropriate, the resolution authority should act decisively to ensure the failing bank is restored to viability or resolved in an orderly manner since timely intervention is essential when recovery actions have been exhausted.

In some jurisdictions, legislation prescribes that the supervisor must act with due promptness in all situations, and that failure to do so will make the supervisor liable to formal criticism or even financial responsibilities to the injured parties, such as depositors. Such requirements serve to emphasise the need for effective early supervisory intervention, a clear mechanism for dealing with banks approaching the point of non-viability, and decisive action when a bank reaches the point of non-viability.

In some circumstances there may still be a limited role for discretion in the decision to trigger early intervention. This discretion must be used only after a conscious decision about the probabilities of recovery, endorsed at senior levels, and reached after an explicit analysis of the risks (particularly to critical economic functions) if the bank does not recover. One effective combination would include rules for pre-agreed acceptable supervisory actions – which protect the supervisor from undue interference in the decision process – plus room for flexibility in particular circumstances. In any case, supervisors must, at a minimum, set up a structured internal governance process aimed at ensuring that discretionary decisions are taken at a level appropriate to the significance of the issue, and with a clear indication of the underlying reasons. In case of a breach of early warning threshold levels, the process should also track the reasons behind any decision to defer or mitigate the severity of supervisory measures that are ordinarily taken in these situations. Regardless of any flexibility that may have been applied by the supervisor’s early intervention, supervisors must avoid forbearance in determining if a bank is failing or likely to fail and advise related authorities promptly in determining if it is not reasonably likely that any further remedial action will be taken to restore viability to the bank. In these circumstances, the bank should be placed into resolution promptly.

Escalation of corrective action and supervisory resources

Corrective measures differ in the level of intrusiveness into a bank’s management of its affairs. The specific measures used by a supervisor will depend on the nature and seriousness of the difficulties encountered by a bank and the level of cooperation provided by its management.

Typically, supervisors are willing to use informal methods and less intrusive corrective action when the bank’s problems are less serious. It helps also if bank management is cooperative and moves promptly and vigorously to deal with its problems. Supervisors should monitor the bank’s progress in implementing changes, including those from recovery plans, where relevant.

If the bank faces more serious problems or is not cooperating, the supervisor may have to take formal action to ensure compliance with its recommendations. Formal action is binding on the bank, with penalties for non-compliance. Depending on domestic regulations, formal action will involve the issue of some form of supervisory or enforcement notice outlining the measures that the bank and its management must take and the time frame for acting. It could also involve “cease and desist” orders requiring the bank and/or its management to stop engaging in a specified practice or violation. In some jurisdictions, such orders may also be issued to parties affiliated with the bank, such as the bank’s accountants or auditors, to prevent or halt violations or unsafe or unsound practices.

More severe corrective action should be considered if there is an increased danger of failure. In such cases, close cooperation with resolution authorities is required. In such cases, the supervisor may impose a sale and payment prohibition on the bank to prevent or limit the dissipation of assets. To prevent new customers from being disadvantaged, the bank might be prohibited from accepting payments that are not intended for the redemption of debts to the bank unless there is a deposit insurance scheme in place which undertakes to satisfy the entitled parties in full.

An escalation of the corrective action would mean an increase in the intensity of supervision. Escalation therefore has resource and cost implications for the supervisor, which should be acknowledged and addressed. However, a lack of resources cannot be used as a justification for inaction. A supervisor should ensure, consistent with the Basel Core Principles, that its operational budget allows for the additional costs associated with corrective action, eg legal and consulting fees. It should also include in its supervisory plans a statement of how additional financial and staff resources would be obtained if necessary.

Formulating a plan of corrective action

In formulating a corrective action plan, it makes sense to give priority to the more serious weaknesses. A coordinated plan that attempts to deal concurrently with various weak areas may, however, be necessary because quite often the various issues are interrelated.

Any action plan, therefore, should comprise a package of corrective measures which, taken together, will resolve not only symptoms but also causes. Given that poor management is usually a contributing factor, an assessment of management’s ability should be included in the action plan.

As part of its action plan, the bank should be required to develop a detailed capital and operating plan showing how the bank’s financial health will be restored. The plan must show the bank’s projections for its income, dividends, assets, liabilities, capital, liquidity, non-performing assets and loan charge-offs, assessed in a conservative manner.

A key factor in determining whether the action plan will be successful is the commitment of the board of directors, and ultimately of the major shareholders, of the bank. It is important for the supervisor to establish an open and frank dialogue with the board, particularly the major shareholders, to secure their commitment to the bank, including the possibility of promptly injecting new capital or finding new shareholders.

If management is to focus on turning around the bank, it should have as few distractions as possible, and should defer any plans for new branches, acquisitions or major new business initiatives in the interim. A voluntary undertaking of this nature can be incorporated into the action plan.

The action plan should be approved by the board of directors and should give the supervisor reasonable assurance that the weaknesses will be satisfactorily addressed within an acceptable period of time. In some cases, for example, where statutory requirements have been violated, or where formal supervisory action has been taken against the bank, the law may require the supervisor to formally approve the action plan.

Monitoring and enforcing compliance with corrective actions

The board of directors and management, as well as the supervisor, should carefully monitor the implementation of the action plan. Banks should be asked to provide the supervisor with regular updates on the progress of the remedial programme against the action plan. In turn, the supervisor must be able to assess whether there is satisfactory progress, or whether additional corrective actions are necessary. Usually, this approach can resolve a large number of weak banks.

In some jurisdictions, the commitment by the board of directors to the action plan and its time frame is formalised in a written agreement signed by the supervisor and the bank, and the bank will be put under more intensive supervision.

The supervisor may have to consider the use of all available penalties and sanctions to enforce compliance with supervisory regulations and recommendations. These can range from warnings and fixed fines for minor violations to substantial fines of corporate officers for major violations. Corrective actions such as the dismissal of managers or directors can also be used to enforce prior supervisory orders that have not been complied with. It is important that the penalties and sanctions be applicable to the bank itself or to the relevant individual persons. The ultimate action is the threat of bank closure or revocation of the bank licence.12

The decision to revoke a bank’s authorisation and/or place it into resolution should be taken only when it is clear that the bank is failing or likely to fail, and it is not reasonably likely that further remedial or supervisory action can restore the bank to viability. The sanction of revoking the licence is absolute and should be exercised with utmost care to avoid exacerbating the problems for the bank’s stakeholders and the financial system. This does not mean that the revocation tool should not be used, but rather that the consequences of the action must be carefully considered and anticipated. In general, revocation of a banking licence should be accompanied by resolution strategies.

Supervisors should stipulate a time frame within which banks should comply with the remedial actions. This time frame should be related to the urgency and seriousness of the weakness, including the risk of contagion. If provided in the banking legislation, supervisors could bring an action in court to enforce the remedial actions.13

Banks faced with orders from the supervisor may, depending on domestic law, appeal against them. Given the importance of prompt compliance with corrective action, it is important that this not be delayed in the courts. Some jurisdictions have established arrangements whereby some decisions of the supervisor are immediately effective, even if the bank challenges them in the courts.

Cooperation and collaboration with other agencies

Just as information-sharing and close cooperation with other agencies are important in the identification of bank weaknesses, collaboration is even more important when it comes to dealing with a weak bank. In enforcing corrective action, the bank supervisor needs to consider whether to consult with or inform the government, the central bank, the resolution authority and other regulatory agencies about the assessment and proposed course of action. Early interaction with the resolution authorities is necessary to ensure a credible and feasible resolution of the weak bank in the event of a failure and to ensure that corrective actions do not adversely impact the bank’s resolvability. The supervisor usually has an interest in reciprocal consultation with the central bank, as its action may have an impact on the central bank’s dealings with the weak bank, and vice versa. For instance, the central bank might want to exclude a weak bank from its list of eligible counterparties to monetary policy operations or from major payment and settlement systems. Conversely, such a decision by the central bank will limit the options available to the supervisor. The supervisor should also understand the circumstances in which it can involve the government and other agencies in the supervisory action plan. This applies particularly to those agencies which have a direct interest in the soundness (including liquidity issues) of the bank. In some jurisdictions, supervisors may need to consult with the ministry of finance or apply to the court for orders to revoke licences.

As a financial stability issue, a systemic crisis situation may trigger special procedures involving the finance ministry and the central bank. It is essential for each agency to know the relevant procedures and be able to activate them promptly.

Supervisors monitor their activities to assess whether and how far their actions are contributing to achieving their objectives. Through constant monitoring and evaluation, supervisors can assess what works best and understand how their actions contribute to achieving their objectives.

When evaluating effectiveness, the following elements should be considered:14

1. Causality: assessing supervisory performance includes proving a clear relationship between supervisory activities (“cause”) and observed outcomes (“effect”).
2. Time horizon: Supervisory programmes aim to build long-term resilience by fostering a culture of sound prudential management that enables banks to withstand economic shocks, as well as changing market conditions. While supervisory measures may negatively impact a bank’s immediate financial position, they may serve to reduce the probability or impact of the bank’s failure in the long-term.
3. Unintended consequences: A performance measurement framework based on quantitative elements can be susceptible to behaviour that is driven by a focus on those specific indicators (ie “what gets measured, gets done”).
4. Confidentiality: Legislative confidentiality requirements can make it difficult for supervisors to demonstrate the effectiveness of supervision.

Using a broad range (portfolio) of indicators that operate at different levels of the supervisory process can provide a comprehensive and cohesive overview of supervisory effectiveness. There is no single indicator that uniquely captures supervisory effectiveness. Supervisors can mitigate methodological problems in measuring effectiveness if they apply a wide variety of performance metrics to assess the impact of supervision. This multifaceted approach allows for the inclusion of various perspectives in the assessment process, making it more robust and less susceptible to the influence of outliers compared to relying on a single indicator.

Through constant monitoring and evaluation, supervisors can assess what works best and understand how their actions contribute to achieving their objectives (see figure 1 as an example). When the indicators in a portfolio are aligned and cascade into a cohesive picture of how supervisory action may lead to the desired prudential outcomes, they allow establishing the links between supervisory resources, action planning, specific goals, and prudential impact.

Figure1: Example of an overall framework with a broad portfolio of performance indicators

Translating the overall objectives into both measurable and qualitative indicators can reduce the level of abstraction and focus the monitoring process. Quantifiable indicators with clearly defined targets of ambition provide informative input for further discussion. Where possible, performance indicators are developed in a SMART way (ie specific, measurable, attainable, relevant and time-bound). The overall evaluation of effectiveness is best considered within the relevant context, which for example could consist of supportive, plausible (qualitative) evidence.

Indicators can be classified into different categories of the supervisory process.

1. Supervisory resources: Indicators in this category are based on supervisory input to determine operational priorities and allocate resources. The riskiness of an entity and the potential impact of a failure on the financial system determine the amount and intensity of supervisory activity. The analysis is an input into a planning document (for example a supervisory action plan) mapping out the risks and associated activities. Further feedback is gathered from all levels in the organisation, from the supervision teams to the highest management level. The plan is reviewed at least once a year (sometimes quarterly), with the results fed back into the plan. Some indicators used in this category include: thematic issues/industry risks, riskiness of entity, size of entity, complexity, budget and number of staff.

2. Supervisory activities: These indicators relate to the throughput of the supervisory process. They focus on supervisory activities and include the range of tools and instruments that supervisors use to identify and mitigate risks. The activities typically follow the identified risks and reflect the operational planning and resource allocation choices, targeting areas considered most effective. Indicators in this category include: number of risk profiles prepared, percentage of activities completed compared with plan, timeliness of closing supervisory issues and actions, progress of corrective actions undertaken by banks, throughput time for activities, number of onsite reports and visits, number of meetings with banks regarding supervision and timeliness of examination reports.
3. Output: These indicators are based on the quality of output from supervisory activities, tracking how banks have responded to the findings that come out of various prudential reviews. These indicators help in planning and scheduling future supervisory activities and often include a feedback loop designed to assess the impact of supervisory actions on the risk score. Some indicators used in this category include: number of entities in a heightened risk status (for example higher probability of failure percentage of supervisory rating downgrades and migration of risk scores), matrix of overall risk scores, consolidated index of risk and controls, impact of adjustments and recommendations from supervision, index of repeated infringements after a legal proceeding, stakeholder surveys, internal audit and national audit office and external party reviews (eg those undertaken by the World Bank, IMF, or Basel Committee).
4. Outcomes: These indicators are based on the ultimate objectives of supervision. This category is the most relevant, but also the most difficult to analyse and manage as a measure of effectiveness due to the difficulty in proving causality. Supervisors use various measures to monitor the financial condition of supervised banks, including market indicators and supervisory parameters for risk assessment and monitoring purposes. They are typically analysed alongside broader economic trends and developments in financial markets to give context to the changes in values. Some indicators used in this category include: bank credit ratings, bank failure numbers, capital and liquidity ratios, movement in proximity to failure scores, movement in quarterly risk scores, loan loss reserves, credit risk (bad loans, defaulted loans), confidence index on financial system and estimated recoveries on failed banks (percentage recovered).

Supervisors have developed qualitative tools to complement quantitative indicators in the assessment of supervisory effectiveness. While quantitative indicators provide a constructive basis, performance measurement based solely on quantitative indicators does not necessarily provide a complete picture and findings must be verified and supported by qualitative evidence. Supervisors assess the impact of supervisory recommendations through routine supervision, onsite and offsite monitoring, and deep dives into specific issues.

Regular management reports create an important feedback loop into the supervisory process. Evaluating supervisory impact benefits from frequent reporting to senior management or the board, monitoring and discussing progress and possibly adjusting supervisory action. To support this process, good management information systems are important to record the follow-up and results of supervisory measures.

Impact assessment can be supported by an internal quality assurance process as a means of challenging the findings and intended outcomes of supervisory plans. Checks and balances within the supervisory process provide a critical review of activities and thereby enhance effectiveness.

In accordance with what is expected from banks in their risk management, many supervisors apply a three-lines-of-defence model to assess their own processes to monitor performance and effectiveness. First, supervisors are responsible for critically evaluating their own activities within their day-to-day operations, both as an organisation and at a business unit level. Second, the supervisory process can be supported by a control mechanism to monitor, coordinate and challenge planned operational activities, relying on line management and existing reporting lines and control functions, as well as incorporating supervisory self-assessments to assess the impact of their supervisory activities. Finally, validation is a key component in the assessment of supervisory effectiveness. Internal reviews concentrate on the qualitative aspects of the supervision activities – reviewing the timeliness of actions and relevance and quality of recommendations made, as well as checking for compliance against the documented policies and procedures. The findings from these reviews feed back into the planning process.

Accountability gives insight into the role of supervision and the results that it can achieve, thereby contributing to the effective management of expectations. It also strengthens supervisors´ willingness to act and to deliver sound supervisory outcomes.

An independent institutional setting is important for effective supervision. Supervisors are given independence and are delegated a wide range of powers to regulate and supervise banks. This independence enables supervisors to act based on their mandate and technical expertise and to withstand industry and political interference.

Financial stability is a public objective and political leaders are ultimately held responsible by the general public for a sound and stable financial sector, even when this task has been delegated to an independent authority. Accountability reinforces checks and balances and is a key element in maintaining public confidence in the banking system. Accountability of financial supervision is particularly important when decisions are made that may involve public money.

Supervisors need to demonstrate that they operate under good governance and according to their mandate and objectives. Clear communication to stakeholders and supervised banks can contribute to a more constructive dialogue. In pursuit of transparency, supervisors employ various ways to inform their stakeholders about their objectives. By showing the choices they make in their supervisory strategies and the intended effects of their actions, supervisors can make their actions more effective.

Increased understanding about the impact of supervision can also contribute to strengthening the accountability of supervisors. Supervisors enhance transparency about their strategies, supervisory frameworks and policies, including through the publication of this information in their annual report and other regular publications.

These different aspects of operational independence, accountability and transparency are not mutually exclusive; on the contrary, they interact. Transparency puts supervisors’ actions and decisions under public scrutiny. At the same time, supervisors strive to remain independent and respect legal confidentiality requirements. A balanced system of accountability, incorporating these elements is consistent with the Basel Core Principles (CP2, EC1).

A structured control and quality assurance process supports the supervisory cycle. The design of supervisory actions and intended impact can be improved if supervisors are challenged by other experts within the organisation, following a structured approach. This responsibility can be assigned to a separate, dedicated department or through internal checks and balances within the existing governance structure.

Effective decision-making benefits from a strong internal organisation and a clear division of responsibilities. This naturally follows from the hierarchical structures within the bank. All staff members within a supervisory agency are, to varying degrees, accountable for their actions and play a role in internal accountability. Greater responsibility is placed on senior officials within each agency to ensure the organisation remains accountable for its actions.

Decision-making and supervisory processes benefit from clear internal processes and procedures. This includes rules about delegation, guidelines for internal decision-making and regular internal reporting. This provides for checks and balances within the organisation.

Supervisors are also subject to reviews of their regulatory framework and internal processes by external organisations. Various mechanisms for promoting external accountability have been implemented. These include the establishment of channels for supervisors to disseminate relevant information to allow different stakeholder groups to make informed judgments. These include a mixture of peer reviews, stakeholder analyses and external evaluations that offer a broad picture from various perspectives. A well designed system of accountability supports operational independence, strengthens supervisors and enhances transparency of supervisory actions and decisions, without disclosing confidential bank-specific information.

Organisations also maintain audit and/or quality assurance functions to assess whether internal processes are being appropriately followed. These functions’ primary outputs include audit or quality assurance reports. In general, audit and quality assurance function activities and reports are risk-based. These reports include a wide range of performance indicators to judge progress against supervisory review plans for banks, such as follow-up activities on recommendations to banks during the examination process.

External accountability arrangements reflect different types of stakeholders. These arrangements also reflect the institutional design of supervision, where an independent supervisor acts as an agent to which a public task has been delegated and which is responsible for demonstrating to the principal (the community) that it has acted according to its mandate.15

External accountability can be supported by effective channels through which supervisors can disseminate relevant information to allow stakeholders to make informed judgments. There are differences in practices as to how these information channels are used by supervisors and how information is disseminated through these channels.