Should Europe reconsider its supervisory governance? Two is better than one

Donato Masciandaro, Marc Quintyn , 14 October 2012

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In the aftermath of the first wave of the 2008 financial crisis, few analyses zoomed in on supervisory failures (as opposed to regulatory failures) as one of the contributing factors to the crisis.

Supervisory failures are part of the crisis picture ...

A few studies though dissected the supervisory problems in great detail and concluded that supervisory failure (unfortunately) also deserves a central place among the chief contributors. Without being exhaustive, the best expert analyses are offered by Financial Services Authority (2009), Palmer and Cerutti (2009), Tabellini (2008), Viñals et al. (2010) and Weder di Mauro (2009).

These authors identify "weak supervisory independence and accountability, industry and/or political capture, wrong incentive structures provided by the political establishment, lack of audacity on the part of supervisors to probe or to take matters to their conclusion and to be intrusive, and lack of coordination and exchange of information among major stakeholders in the supervisory process.”

... despite major improvements in governance before the crisis

These are no doubt extremely disappointing conclusions. Indeed, since the late-1990s worldwide efforts have been undertaken to improve supervisory practice and governance, with the specific objective of overcoming these very weaknesses. The Basel Core Principles for Effective Bank Supervision had a significant component geared toward supervisory practice. In addition, several countries strengthened supervisory governance. 

Based on the criteria for supervisory governance, developed in Quintyn et al. (2007), we see in Figure 1 that by 2007 supervisors worldwide enjoyed much higher governance levels than before the reforms. These legal reforms were often accompanied by revisions of the institutional structure for supervision in the wake of the establishment of the FSA in the UK (1997).

Figure 1. Evolution of supervisory governance index, before reform, in 2007, and 2009

Source: Authors’ calculations

Note: For the methodology, see Quintyn et al. (2007). The governance index is the average of the independence and accountability index.

While the great hope was that improvements in supervisory governance would help avoid or at least mitigate potential future crises by reducing the risks for political, industry or self-capture, the awakening after 2008 was rather rude. As Figure 2 demonstrates, among the ‘victims’ of the crisis we count several countries with high governance ratings. Eleven (among them the first five ranked) of the 15 first ranked in this figure were affected severely. In all, only a few countries escaped.

These findings are corroborated by Masciandaro et al. (2011), who found a significant negative relationship between supervisory governance and economic resilience in 2008-9, after controlling for other potential sources of impact. In sum, political and industry capture were not stopped by better governance arrangements. In fact, capture was stronger than ever before and political and industry capture were interwoven (Buiter 2008).

Figure 2. Supervisory governance and failed and assisted banks

Note: Failed and government assisted banks as% of total bank assets in the country.

Source: Authors' calculations for governance indicators and Laeven and Valencia (2010) for bank data.

What has been proposed … ?

Their analyses lead the abovementioned authors to recommend that supervision “be more intrusive, proactive, risk-based, and result-oriented”. To achieve this, they suggest “clarifying the mandate for supervisors, having more independence and accountability, and bringing in more and higher skilled professionals that enjoy higher monetary compensation.” Thus, better supervision hinges to a great extent on further improving supervisory governance.

… and what has been done so far?

Policymakers’ responses to supervisory failures so far have been threefold:

  • The strongest response has been to make macroprudential supervision a standalone supervisory branch (with a specific mandate and instruments). In most countries this new activity is assigned to the central bank, but we also notice a significant direct government involvement in this new policy area.
  • Many countries have improved the governance arrangements for microprudential supervisors (Figure 1).
  • Advanced countries have tended to concentrate microprudential supervision more in the hands of the central banks (Figure 3).

Figure 3. Degree of central bank involvement in microprudential supervision (Herfindahl-Hirsch index for 2007 and 2009)

Source: Authors’ calculations.

So, supervisory governance, quo vadis?

While it is beyond doubt that financial supervision needs to rest on solid governance pillars to withstand capture (Masciandaro et al. 2010 and Dijkstra 2010), we would like to point out some limitations and potential pitfalls which bring us to our proposal.

The limitations that governance arrangements are facing stem from the fact that, by the nature of the supervisory work, the contract between the supervisor and society (in the principal-agent sense) will always be incomplete given the great range of contingencies associated with supervision. Hence, it is misleading to believe that supervisory governance can be defined in such a way that each and every possibility of capture will be eliminated. Defining the right governance arrangements to address the supervisors’ incentive problems has its own limitations.

Moreover, the crisis has demonstrated that some of the more successful approaches to supervision are the result of long-fostered corporate cultures that helped to brace the institution against capture. In other words, supervisory governance needs to be nurtured by the right corporate culture. Or, de facto independence is at least as important as de jure independence. The crisis showed indeed that several countries with strong (de iure) governance arrangements were severely hit, while others with relatively weaker arrangements emerged relatively unscathed. Palmer and Cerutti (2009) point at Canada: the supervisory agency’s de jure independence is not among the highest, but its de facto independence is high, which, combined with a strong supervisory culture, has contributed to escaping from the crisis. Combining these two arguments forces us to think creatively in new directions to address supervisory failures.

Exploiting architecture to strengthen governance

This is where another recent trend comes into play: the separation of macro- and micro-supervision offers a great opportunity to conceive a solution that offsets some of the inherent weaknesses that we just discussed: let us combine this new architecture with governance arrangements to better align supervisory incentives.

Here is the reasoning: in response to the crisis, the new trend has been to establish a separate function for macroprudential supervision. Some countries are assigning the two functions to separate agencies, while others prefer to have them under one roof.

We argue that the presence of two agencies involved in the same field of operation (but with a different mandate) would allow for checks and balances which could reduce the likelihood of capture. This proposal is based on a model developed by Laffont and Martimort (1999), recently extended by Boyer and Ponce (2012).

Laffont and Martimort’s model shows that, in cases where supervisors are vulnerable to capture, separation of mandates has advantages. Separation breaks the monopoly of information acquisition and thus limits supervisors’ discretion in engaging in socially wasteful activities (such as succumbing to capture). Separation introduces a Bayesian-Nash behaviour between partially informed supervisors which reduces the total collusive offers they make. The transaction costs of collusive activities increase and preventing collusion becomes easier. Separation improves social welfare.
Thus, institutional separation of micro- and macro-supervision now offers a unique opportunity to create a system of checks and balances with a positive impact on the incentive structure of supervisors that would enhance the effectiveness and responsiveness of supervision.

An effective architecture from a governance point of view would therefore be to house macroprudential supervision in the central bank and microprudential supervision in a separate agency. The advantages would be that (i) it provides checks and balances that would better align supervisors’ incentives; (ii) not all power is concentrated in one mega-agency; (iii) synergies are created because the analytical scope of macroprudential supervision is closer to the core focus of the central bank; and (iv) the link between macroprudential supervision and the lender of last resort is preserved.

The proposal would entail some costs (reporting to two agencies and the need for coordination and communication between these agencies). However, the theoretical models on which this proposal is founded indicate that these costs would be lower than the potential benefits. Finally, these arrangements could potentially introduce some competition among the two supervisors but since their mandates would be different it would not be the type of competition that financial institutions could exploit.

At this crucial juncture, with some important constituencies, such as the EU, reconsidering their supervisory architectures, these considerations should perhaps be part of the discussions.

The views expressed in this column are those of the authors and do not necessarily represent those of the IMF or IMF policy.

References

Boyer, P and J Ponce (2012), “Regulatory Capture and Banking Supervision Reform”, Journal of Financial Stability, 8(3):206-217.

Buiter, W (2008), “Lessons from the North Atlantic Financial Crisis”, paper presented at the conference “The Role of Money Markets”, Columbia Business School and Federal Reserve of New York, 29-30 May.

Dijkstra, R (2010), “Accountability of financial supervisory agencies: An Incentive Approach”, Journal of Banking Regulation, 11:115-128.

Financial Services Authority (2009), “The Turner Review. A Regulatory Response to the Global Banking Crisis”, FSA, London, March.

Laeven, Luc and Fabian Valencia (2010), “Resolution of Banking Crises: the Good, the Bad and the Ugly”, IMF Working Paper WP/10/146.

Laffont, JJ and D Martimort (1999), “Separation of Regulators against Collusive Behavior”, RAND Journal of Economics, 30(2):232-262.

Masciandaro, Donato, Pansini, Rosaria, and Marc Quintyn (2011), “The Economic Crisis: Did Financial Supervision Matter?”, IMF Working Paper WP/11/261.

Nier, E, J Osiński, L Jácome, and P Madrid (2011), “Towards Effective Macroprudential Policy Frameworks: An Assessment of Stylized Institutional Models”, IMF Working Paper WP/11/250

Palmer, J and C Cerruti (2009), “Is there a need to rethink the supervisory process?” paper presented at the International Conference “Reforming Financial Regulation and Supervision: Going back to Basics”, Madrid, 15 June.

Quintyn, M, S Ramirez, and MW Taylor (2007), “The Fear of Freedom. Politicians and the Independence and Accountability of Financial Supervisors”, in D Masciandaro and M Quintyn (ed.), Designing Financial Supervision Institutions: Independence, Accountability and Governance, Edward Elgar.

Tabellini, G (2008), “Why did bank supervision fail?”, in Andrew Felton and Carmen Reinhart (eds.), The First Global Financial Crisis in the 21st Century, A VoxEU.org Publication.

Viñals, J, J Fiechter, et al. (2010), “The Making of Good Supervision: Learning to Say “No”,” IMF Staff Position Note SPN/10/08,

Weder di Mauro, B (2009), “The Dog that didn’t Bark”, The Economist, 1 October.

Topics: EU policies, International finance
Tags: financial regulation

Donato Masciandaro
Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University
Division Chief, Africa, at the IMF Institute