May 27, 2019

ECB published a working paper that examines the benefits and costs associated with different supervisory architectures and suggests key elements that should be included in an optimal supervisory architecture. The paper compares the centralized and decentralized supervisory structures, also describing various benefits and drawbacks of each type of structure in the context of euro area and in relation to the design of the Single Supervisory Mechanism (SSM). The paper concludes that, overall, going forward, the challenge is to strike the right balance between higher supervisory independence, broader perspective, and more effective organizational structure that is associated with a centralized supervisor, residing within the central bank and exploiting the superior information of national supervisors.

The paper focuses on the trade-offs associated with allocating supervision to a “central” authority instead of a “local” authority and discusses the specific institutional arrangement in the euro area. It concludes that a centralized structure for supervision entails significant benefits in terms of fewer opportunities for supervisory arbitrage by banks and less informational asymmetry. The use of common and standardized rules and data to assess banks’ health drastically reduces the possibility of regulatory/supervisory shopping for banks. Furthermore, a large central supervisor can take advantage of economies of scale and scope in supervision and gain a broader perspective on the stability of the entire banking sector. For example, it can benchmark the different institutions against one another, thus reducing informational asymmetry and, in turn, improving financial stability. 

As per the working paper, the potential drawbacks of a centralized supervisory structure are the possible lack of specialization relative to local supervisors and the increased distance between the supervisor and the supervised institutions. These may translate into a more limited knowledge of the markets in which banks operate, their organizational structures and of the products they offer. There is little empirical evidence on how material these costs are. However, it seems that such concerns could be addressed by adequately designing the organizational structure of the centralized supervisor. The paper also espouses the benefits of an integrated structure of monetary policy and supervision and points out that these benefits mostly hinge on the better coordination of policies and the easier flow of information that a structure of this type allows. Coordination between the central bank and the supervisor enables each authority to account for the potential “side-effects” that its policy has on the other authority’s objective, thus reducing the scope and severity of the inefficiencies associated with a coordination failure.

The paper analyzes the implications of the analyses for the SSM and the regulatory structure in EU. The paper points out that there is some evidence supporting the idea that banks consider the SSM to be tougher than national supervisory authorities. Under this scenario, banks close to the thresholds for SSM supervision may have incentives to shrink their size so as to be subject to the more lenient assessment by national supervisors. The analysis suggests that these considerations call for a more consistent approach in setting the requirements, standards, and criteria of assessment applied to SSM and non-SSM banks. It is not only important that harmonized and proportional rules and standards exist, but also that those rules and standards are applied consistently across countries and banks. It would be important to strive for more aligned incentives between central (SSM) and national supervisors. The harmonization of the legal protection of national supervisors could represent a useful intervention to achieve more consistency in supervisory standards. Similarly, the inclusion of additional criteria, such as a reference to the bank business model, to those determining whether or not a bank falls under SSM supervision, may be beneficial in limiting the strategic behavior of regulated intermediaries.

 

Related Link: Working Paper (PDF)

 

Keywords: Europe, EU, Banking, Supervisory Architecture, SSM, Financial Stability, Research, Banking Supervision, ECB