Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference
Add the QFINANCE search widget to your website

Home > Capital Markets Best Practice > Rules versus Discretion in Supervisory Interventions in Financial Institutions

Capital Markets Best Practice

Rules versus Discretion in Supervisory Interventions in Financial Institutions

by Marc Quintyn1

Executive Summary

  • One of the most critical moments in financial-sector supervision is when supervisors need to decide if they should “intervene” in a “problem bank” (a bank that is gliding towards insolvency or is already insolvent). This decision is critical because, if supervisors wait too long to intervene, the worth of the bank will continue to erode, losses to depositors may increase, and systemic risks may increase, ultimately leading to high costs to the government and, thus, the taxpayers.

  • In the wake of every banking crisis, the debate about “rules versus discretion” in supervisory intervention flares up. This discussion regarding supervisory intervention in problem banks focuses on the incentives for supervisors to act swiftly and decisively in order to minimize losses to depositors, and society more widely.

  • In this debate, rules are often proposed as the preferred solution (with some discretion left), because the closure of a financial institution remains a tricky event where many interests collide (private, political, business), and even independent supervisors can be seduced by self-interest if the stakes get high. The rules-based intervention system in the United States (prompt corrective actions) has proven many of its merits over the years, and made the product ready for export to other jurisdictions around the world. Until recently, most European supervisory frameworks relied more on discretion than rules, but the 2007–08 financial crisis seems to change the mood, and more voices are being heard in favor of a rules-based system.

Introduction

Financial supervisors’ main task is to monitor the behavior and actions of the institutions under their area of responsibility. They check compliance with the regulatory framework, and, when necessary, impose sanctions and enforce them. So, in every jurisdiction, a key component of the regulatory and supervisory framework is the nature, timing, and form of intervention by the supervisors in case the health of an individual institution fails. The supervisors step in to address the problems in the financial institution in an effort to protect the depositors of this institution and of other institutions, as well as the taxpayers’ money by avoiding or limiting contagion (the systemic risk).

Supervisors typically have a toolbox of instruments and sanctions at their disposal, ranging from orders to comply with specific rules, over monetary fines, to the ultimate sanction, closure of a financial institution. Typically, these sanctions are graded. They start from small corrections when the problems are still minor, in the hope the bigger interventions can be avoided.

Practice around the globe has amply shown that the decision as to when and how to intervene in a problem bank is the Achilles heel of the supervisory process. Reasons abound for this! Firstly, a weak regulatory framework inherently leads to weak supervision and lack of enforcement rules. For instance, the regulatory framework may lack pointers for supervisors regarding the timing of an intervention, may not be specific enough regarding the intervention instruments, or may leave the supervisors without the power to collect the critical data to properly analyze a financial institution’s health. Secondly, politicians may dissuade supervisors from intervening in a problem institution for fear that this (connected) institution gets a bad press, or worse.

Judgment is another factor that could influence the supervisory decisions. Supervisors faced with bank problems may believe that these problems are temporary, and will go away without supervisory action. Finally, some form of self-interest may also be at play. Supervisors faced with a problem bank may take a “not on my watch” approach, and hide the problems as long as possible. This behavior can be explained by the fact that society may see the problems in a bank as a reflection of weak supervision, which is damaging for the supervisor’s reputation.

Whatever their cause, these situations typically lead to forbearance, i.e., refraining from addressing an institution’s problems head-on. Such forbearance is bound to lead to a deepening of the problems in that specific institution, and ultimately to an increase in the costs of addressing them, among others, because these problems could be contagious. These costs will eventually fall on the shoulders of the depositors, the government, and ultimately the taxpayers.

Starting from this reality, the “rules versus discretion” debate in supervisory intervention is about the question: in order to limit political interference, reduce the risk of judgmental errors, and self-interested behavior, and thus forbearance, should the supervisor, when intervening in an individual bank, be bound by strict rules, or have the discretion to take action when deemed necessary?

Back to Table of contents

Further reading

Book:

  • Nieto, Maria, and L. Wall. “Prompt corrective action: Is there a case for an international banking standard?” In D. Evanoff, G. Kaufman, and J. La Brosse (eds). International Financial Instability: Global Banking and National Regulation. World Scientific Studies in International Economics Series, Vol. 2. Singapore: World Scientific, 2007, ch. 23.

Articles:

  • Benston, George J., and George G. Kaufman. “Risk and solvency regulation of depository institutions: Past policies and current options.” Federal Reserve Bank of Chicago Staff Memorandum no. 88-1 (1988): 1–67.
  • Benston, George J., and George G. Kaufman. “FDICIA after five years.” Journal of Economic Perspectives 11:3 (Summer 1997): 139–158. Online at: econpapers.repec.org/RePEc:aea:jecper:v:11:y:1997:i:3:p:139-58
  • Kydland, Finn E., and Edward C. Prescott. “Rules rather than discretion: The inconsistency of optimal plans.” Journal of Political Economy 85:3 (June 1977): 473–491. Online at: www.jstor.org/pss/1830193

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share