Financial market supervision: some conceptual issues

BIS Economic Papers No 19
May 1987


This paper attempts to discuss some of the conceptual issues involved in understanding the goals, constraints and methodology of financial market (prudential) supervision. The focus is on banking supervision, since much of the experience to date has been in that field.

There are several reasons for undertaking such an investigation. Firstly, as indicated in the recent report released by a Study Group of the central banks of the Group of Ten countries (BIS, 1986), financial deregulation and innovation have increased concerns about financial market stability. As a consequence, greater attention has been paid to the role of prudential supervision in securing stability. It is, however, worthwhile to investigate how prudential supervision can actually contribute to stability. This paper provides a conceptual framework for analysing this subject in the belief that changing financial conditions and demands on supervision require such exercises as a means of orienting policy. Secondly, it seems to be widely believed that, among other factors, an economy's financial structure influences the character of its supervisory system. A theoretical basis for this hypothesis grounded in the costs of supervision and incentives to circumvent supervisory norms is suggested in the paper. It is also suggested that a changing financial structure is likely to require changes in supervision.

Thirdly, a growing theoretical literature has been produced on the strategic behaviour of central banks as providers of fiat money. This literature has been surveyed recently by Cukierman (1986). Shubik (1984, Chapter 16) provides a more general discussion of the application of game-theoretic reasoning to problems in monetary and financial theory involving the behaviour of large institutional actors. In addition, Goodhart (1985) has stimulated discussion of the logical and historical foundations of central banks as institutions. The analysis in this paper is in the spirit of this literature. It also suggests that the financial supervision function in an economy - a public function - is not independent of private decisions.

The largest question of the logical origin of multiple central bank goals and their relationship is not treated. In a sense, this avoids important issues. Prudential supervision in some countries, for example Japan, the Netherlands and the United Kingdom, is a central bank function. Presumably there is a link between the provision of central bank credit and other services and supervisory activities. In other countries, such as Canada, Germany and Switzerland supervision is performed by agencies which are not part of the central bank. An interesting analytical task, for example, is to state conditions under which it is in some sense optimal for supervision to be performed independently of credit and general monetary operations, and to explain the consequences of such independence. This topic is not dealt with here. The focus is kept on the supervisory function.

The methodologies used in the disciplines of history, law, political science, sociology and economics can all be usefully applied in investigating issues surrounding prudential supervision. The methodology adopted here is derived from the public choice branches of economics and political science. The methodology employs economic principles of choice to explain the existence and functioning of important institutions (supervision) that support market activity, but are not themselves part of ordinary markets. At least in the longer run, the structure and performance of these institutions is seen as the product of voluntary choices by the ultimate private decision-makers in an economy. In this paper, several "models" of this type are discussed in order to illustrate that increasingly complex assumptions about the behaviour of private decision-makers can lead to increasingly rich and complex supervisory goals and systems. This methodology, however, can lead to an over-emphasis on the influence of private interests in determining public decisions, especially in the shorter run. Hence one must bear in mind that abstractions from one discipline need to be tempered with the insights from others.

Section I introduces a basic model in which the goal or function of supervision is to enforce prudential self-regulatory standards set by market participants. Four different types of financial structure are discussed, which have varying effects on the possibility and nature of self-regulation. Section II discusses a rationale for supervision that rests on maintenance of economy-wide liquidity. At the conceptual level, this topic is still in the formative stage, and the discussion indicates some of the issues involved in linking supervision to the maintenance of liquidity. Section III discusses one rationale for discretionary prudential supervision by a public body, which suggests that supervision may help to resolve an ongoing conflict of interest between bank depositors and shareholders.