Core Principles for Effective Banking Supervision

Effective supervision of banking organizations is an essential component of a strong economic environment in that the banking system plays a central role in making payments and mobilizing and distributing savings.

Strong and effective banking supervision provides a public good that may not be fully provided in the marketplace and, along with effective macroeconomic policy, is critical to financial stability in any country. While the cost of banking supervision is indeed high, the cost of poor supervision has proved to be even higher. In drawing up these core principles for effective banking supervision the following precepts are fundamental:

• The key objective of supervision is to maintain stability and confidence in the financial system, thereby reducing the risk of loss to depositors and other creditors;
• Supervisors should encourage and pursue market discipline by encouraging good corporate governance and enhancing market transparency and surveillance;
• In order to carry out its tasks effectively, a supervisor must have operational independence and the authority to enforce its decisions;
• Supervisors must understand the nature of the business undertaken by banks and ensure to the extent possible that the risks incurred by banks are being adequately managed;
• Effective banking supervision requires that the risk profile of individual banks be assessed and supervisory resources allocated accordingly;
• Supervisors must ensure that banks have resources appropriate to undertake risks, including adequate capital, sound management, and effective control systems and accounting records;
• Close cooperation with other supervisors is essential, particularly where the operations of banking organizations cross national boundaries.

Banking supervision should foster an efficient and competitive banking system that is responsive to the public's need for good quality financial services at a reasonable cost. Generally, it should be recognized that there is a trade-off between the level of protection that supervision provides and the cost of financial intermediation. The lower the tolerance of risk to banks and the financial system, the more intrusive and costly supervision is likely to be, eventually having an adverse effect on innovation and resource allocation.