Acting under uncertainty - the case for supervisory risk appetite frameworks
Periodic episodes of banking sector distress invariably expose weaknesses in banks' governance and risk management and shortcomings in supervision. A recurring challenge for supervisory authorities (SAs) is the lack of an explicit framework to define, manage, and communicate their tolerance for supervisory risk: the risk that supervisory actions or inaction fail to achieve prudential objectives. This gap can lead to unclear, inconsistent or ineffective supervisory practices, undermining authorities' ability to address problems in banks in a timely manner.
This paper develops a supervisory risk appetite framework (RAF) to strengthen SAs governance, culture and effectiveness. It sets out an approach to define supervisory risk appetite, translate it into operational guidance to support supervisory decisions, and foster consistent application through robust governance arrangements. While the RAF outlined in this paper is designed for a safety and soundness mandate, its underlying principles can be adapted by SAs with other mandates.
By making supervisory trade-offs explicit and institutionally anchored, supervisory RAFs strengthen accountability, reduce unwarranted variability in supervisory actions, and support more timely, consistent and credible supervisory interventions.
JEL classification: G20, G21, G28
Keywords: supervision, banking supervision, supervisory risk, legal risk, supervisory judgment, risk-based supervision, risk appetite, risk tolerance, supervisory culture, governance, supervisory governance, early intervention, supervisory prioritisation, Pillar 2, supervisory effectiveness, supervisory review
