Basel Committee highlights best practice for early intervention

There have been “important developments” in supervision since the 2008 crisis, with supervisors becoming more forward looking and adopting new qualitative and quantitative methods in overseeing financial firms, the Basel Committee on Banking Supervision says.

Early intervention – taking action before regulations are “materially breached” – has required supervisors to adapt their organisations, methods and culture, the Basel Committee says in a document surveying best practice in the field.

Supervisors must be both willing and able to intervene early, having the appropriate expertise and the necessary “culture for intervention”, the report says.

“Early supervisory intervention is challenging because effective supervision is based not on ensuring compliance with the letter of the rules but also with their spirit,” the committee notes.

Expert judgement needs to be complemented by the right “organisational infrastructure”, the report finds. This includes “supervisory reinforcement” through risk assessments to maximise early detection, a “clear framework” for when actions should be taken and internal governance processes to develop supervisors’ capabilities.

The document includes a table setting out a taxonomy of risks and the growing supervisory intensity that should accompany them – low risks (stage one) entail normal supervisory processes, rising to “imminent risk” (stage four), which implies supervisors should be wielding formal powers and demanding institutions produce a “remediation plan” in a “short timeframe”. The fifth and final stage is non-viability, at which point supervisors hand over to the resolution authority.

Many supervisors have implemented early warning systems, which raise red flags when firms’ prudential indicators breach certain limits or prove to be significant outliers. The Basel Committee notes how the Federal Reserve makes use of various algorithms to classify regulated firms according to their risk and the China Banking Regulatory Commission takes a similar approach.

Such systems can be complemented with stress testing and a range of thematic reviews, which focus on particular areas of supervisory concern. “Horizontal reviews” can highlight how a firm compares with those operating in similar business lines and whether any of its prudential indicators look anomalous.

The Basel Committee goes on to examine the process for escalating supervisory action, starting with increased communication with the firm in question, rising to joint efforts with the firm to identify problem areas and develop solutions, and ultimately the possibility of imposing sanctions.

In terms of capacity building, the Basel Committee says training can help to develop the skills necessary for team members to take early action. This should be complemented by the right tone coming from senior managers.

“Supervisors benefit when senior management gives them a clear and strong message that they support supervisors taking early intervention and continually remind supervisors that they expect early intervention as part of the normal supervisory process,” the report says.