Lesson 2: The Supervisor's Toolkit - From Friendly Chats to Forcing Change
Today, we'll discover what powers supervisors actually have to make banks behave responsibly.
Welcome Back!
In Lesson 1, we learned that supervisors are professional "bank watchers" who protect depositors' money and keep the financial system stable. Today, we'll discover what powers supervisors actually have to make banks behave responsibly.
Think of this lesson as learning about a doctor's medical bag - what tools are available, when to use each one, and why sometimes the gentle approach works while other times you need stronger medicine.
Part A: The Escalation Ladder - From Soft to Hard Power
Starting with a Conversation
Imagine you're a supervisor and you discover a bank is taking on too much risk. What can you do? Let's start with the gentlest approach:
Level 1: "Moral Suasion" (The Friendly Chat)
A supervisor said:
"Very often, when we find something, banks concur with our assessment, promptly fix the issue and that's the happy end of the story."
How it works:
- Supervisor: "We've noticed you're lending a lot to risky borrowers. We're concerned."
- Bank: "You're right. We'll tighten our lending standards."
- Problem solved! No formal action needed.
Real Example: When European supervisors started talking to banks about climate risks in 2019, many banks voluntarily began improving their risk assessment.
But here's the catch: This only works when banks WANT to cooperate. What if they don't?
Part B: When Nice Doesn't Work - The Formal Powers
Level 2: Written Warnings and Requirements
When friendly chats fail, supervisors move to formal written communications:
"Matters Requiring Attention" (MRAs)
- Official findings that must be addressed
- Given in writing with specific deadlines
- Bank must provide a plan to fix the issue
From the SVB case: SVB had 31 open supervisory findings when it failed - triple the normal amount! The bank kept promising to fix things but never quite got around to it.
Level 3: Binding Legal Requirements
Now we're getting serious. Supervisors can:
1. Force Higher Capital Requirements
- "Your normal capital buffer is 8%, but you're risky, so now it's 12%"
- This is expensive for banks - it's money they can't lend out for profit
2. Restrict Business Activities
"We have the power to restrict or limit the business, operations or network of institutions"
Real example: "You cannot open any new branches until you fix your risk management"
3. Stop Dividend Payments
- Banks hate this - shareholders get angry
- But it keeps money in the bank for safety
4. Require Specific Actions
- "You must hire a Chief Risk Officer within 60 days"
- "You must stop making cryptocurrency investments"
- "You must improve your IT systems by December"
Part C: The Nuclear Options
Level 4: Enforcement and Penalties
When banks still don't comply, supervisors can impose:
Periodic Penalty Payments:
"We have told a number of banks to remedy the shortcoming by a certain date and, if they don't comply, they will have to pay a penalty for every day the shortcoming remains unresolved."
- Can be up to 5% of daily turnover
- Continues until the problem is fixed
- Example: €100,000 per day until proper risk controls are implemented
Major Fines
- Up to 10% of annual turnover
- Or twice the profits gained from the violation
- These can reach hundreds of millions of euros
Level 5: The Ultimate Powers
Removing Bank Management
"We have the power to remove at any time members from the management body"
Think about that - supervisors can fire the CEO or board members of a bank!
Revoking the Banking License
- The "death penalty" for banks
- The bank must stop operating
- Usually only for the most serious violations
Part D: Why Don't Supervisors Use These Powers More Often?
The Hesitation Problem
One report has identified why supervisors sometimes hesitate:
1. Fear of Being Wrong
- What if the supervisor forces changes and makes things worse?
- What if the bank sues and wins?
2. Political Pressure
- Politicians might say: "Don't be too hard on our local bank!"
- "You're hurting economic growth!"
3. Regulatory Capture:
"Capture can occur when supervisors develop too close a relationship with banks"
After years of working with the same banks, supervisors might become too friendly.
4. The "Crying Wolf" Problem
- If supervisors are always alarming about risks that don't materialize
- People stop listening when real dangers emerge
The SVB Failure - A Cautionary Tale
The Supervisor identified the problem clearly:
"Supervisors did identify vulnerabilities, but did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough"
Timeline of Missed Opportunities:
- 2021: Six supervisory findings on liquidity risk - SVB says "we'll fix it"
- July 2022: SVB fails its own internal stress tests - keeps operating
- November 2022: More warnings issued - still no forced action
- March 2023: Bank collapses in 48 hours
The supervisors had ALL these tools available but hesitated to use them forcefully.
Part E: The Art of Choosing the Right Tool
The Proportionality Principle
Supervisors must always choose the least intrusive effective measure. It's like medicine - you don't use chemotherapy for a common cold!
Consider this scenario: A bank has weak IT systems that could be hacked.
Option 1: Friendly suggestion to improve → Bank might ignore
Option 2: Formal requirement with 6-month deadline → Reasonable
Option 3: Immediate ban on all online banking → Too extreme
The supervisor must justify why Option 2 is proportionate to the risk.
The Escalation Strategy
Modern supervision uses an "escalation ladder":
- Identify the problem (through examination)
- Informal discussion (moral suasion)
- Formal finding (MRA with deadline)
- Binding requirement (if MRA not addressed)
- Enforcement action (penalties if still not fixed)
- Removal of management or license (last resort)
Each step gives the bank a chance to fix things, but the consequences get progressively worse.
Today's Key Takeaways
- Supervisors have powerful tools - from friendly persuasion to removing bank executives
- The escalation ladder moves from soft (moral suasion) to hard power (enforcement)
- Most problems are solved informally - but the threat of formal action must be credible
- Hesitation can be fatal - SVB showed what happens when supervisors don't act decisively
- Proportionality matters - use the minimum force necessary to fix the problem
- The mere existence of powers often makes them unnecessary - banks comply because they know what could happen
A Critical Insight
From the IMF's "Good Supervision" paper:
"Supervisors must be willing and empowered to take timely and effective action, to intrude on decision-making, to question common wisdom, and to take unpopular decisions."
The tools mean nothing without the will to use them.
Check Your Understanding
- What's the difference between "moral suasion" and a binding requirement?
- Why might a supervisor choose to restrict a bank's business instead of fining it?
- What are three reasons supervisors might hesitate to use their powers?
- How did hesitation contribute to SVB's failure?
- What does "proportionality" mean in choosing supervisory tools?
Preview of Lesson 3
Next time: "Reading the Warning Signs - How Supervisors Detect Problems"
We'll learn how supervisors actually examine banks, what they look for, and how they spot troubles before they become crises. We'll decode the CAMELS rating system and understand what "risk-based supervision" really means.
Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.
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