Michał Kruszka – Director of Research and Regulatory Supervision Department

In a public debate, financial supervision is occasionally presented as a ‘brake’ or a barrier to the development of the financial market. Such a statement is based on a somehow intuitively justified view that regulations often increase the cost of functioning of supervised entities, while its implementation requires time and limits willingness to take risk. However, the experience of the last two decades shows that the key question should not be ‘Should we regulate/supervise?’ but ‘How to do that?’. Actions of well-designed supervision of the financial market can be compared to safety belts in a car. They are not supposed to accelerate drive but to reduce the tragic effects of an accident. In the case of the financial market, effective supervision supported by appropriate regulations reduces the risk of insolvency of specific institutions, contributing to the reinforcement of stability of the entire market. It is particularly important when juxtaposing the costs of adjustments to regulatory requirements that are usually modest and transitional, with the costs of financial crises, which are often high, with the effects of market stability loss experienced in the long term.

A statement to the effect that supervision is a brake of development is usually based on a simple but misleading mental shortcut: because the supervisor limits risk, it must also limit development. In practice, we can see, however, that risk in financial markets is of pro-cyclic nature, meaning that in the period of good economic conditions the willingness to leverage, ease credit standards and make optimistic valuations grows faster than the real capabilities to absorb losses. In such conditions, lack of adequate prudential framework does not accelerate development but is conducive to growth based on an excessive, and therefore underrated, risk. Only when the economic situation is worsening, it proves that some part of earlier benefits attributed to fast growth was in fact an illusion leading to weaknesses which are revealed in a crisis. Then, the cost of such economic downturn is usually much higher than earlier savings arising from milder regulations. This is confirmed by the experience of bank crises, which usually lead to a permanent decline of a product and to a long period of economic recovery¹. 

It is worth mentioning several myths which are to highlight the contradiction between responsible financial supervision and market development. The first states that regulations always increase costs and decrease the supply of financing. This claim is only partially true as it skips the aspect of time horizon and substitution mechanisms. In the short term, the tightening of capital or liquidity requirements can increase the cost of bank financing and translate into higher credit spreads, which slows down the pace of growth. Fair estimations for Basel III, however, indicate that the macroeconomic cost in the transition period is rather low (decimals of percentage point of the annual GDP growth) and is to be the ‘price’ for reducing probability and deepness of crises².

Therefore, supervision works like a low premium for financial institutions on taking excessive risk, paid for an insurance policy covering rare but high-loss catastrophic events, whose effects are felt by entrepreneurs and households.

The second myth is of more institutional character. The assumption is that supervision stifles competition, which is why the market becomes less innovative, and the offer is less available. In reality, well-designed rules often strengthen qualitative competition as they eliminate some advantages based on regulatory arbitrage and transferring risk to clients or tax payers. Where supervisory framework is consistent and enforced, the market often develops more through products better adjusted to the needs of real economy and not by maximising short-term viability based on hidden risk³. 

The third myth has a strictly market-related dimension and states that ‘profitability of the sector is the measure of its health, so the supervision authority that lowers profitability causes detriment to development’. Such an approach is based on an erroneous assumption that puts an equal sign between the entity’s profitability and stability (if that was the case, bankruptcies such as that of Lehman Brothers or Credit Suisse would be impossible). In a period of good economic condition, high profitability is often a reward for taking risk, which does not seem dangerous at a given moment. Some part of this risk becomes visible only after the economic situation worsens. If the supervision authority requires that institutions create capital buffers or limit excessive leverage, this may lower short-term profitability. At the same time, this increases the resilience of the sector and its capability to keep financing the economy in the most difficult times. From the perspective of real economy, it is not key for the financial sector to be maximally profitable in favourable economic conditions but to be able to finance enterprises and households in a stable manner also at the slowdown phase. If capital buffers are built in the period of good economic situation, they may be used during the period of slowdown to sustain lending activity. Then, regulation is not pro-cyclical, but it plays a stabilising role⁴. This is the continuity of lending activity and confidence in financial institutions that build a cornerstone for solid development of the market.

It needs to be admitted that criticism of supervision is not always unfounded. The issue is not the objective itself, being stability, but the manner in which it is achieved. Supervision may indeed limit the development of the market if it is not adjusted to the scale and nature of a specific risk, namely if it does not apply the principles of proportionality and the concept of risk-based supervision is not followed. If regulatory requirements are equal for large, systemically important institutions and for small entities of limited scale of business, the costs of compliance may be relatively much higher for the latter. In such a situation, the role of regulations as a barrier to entry and a factor conducive to concentration is stronger, which in the long term has a negative impact on the quality and availability of services, and as a result, on the pace of financial market development, its innovation and competitiveness.

To sum up, apart from the question ‘Does supervision hamper the development of the financial market?’, it is worth asking another one: ‘What kind of development of the financial market do we consider right?’. If by development we understand a fast growth of assets, high margins and valuations rising in a short period of time, then supervision can really be seen as a restraining factor. The market may, for some time, dynamically generate growths in assets and profits, but at the same time it becomes more vulnerable to crises, which in the long run leads to losses, reputational damage, and limitation of willingness to invest. If, however, development means stable and permanent increase in access to financing, increased confidence in institutions, higher transparency and higher resilience to shocks, then supervision is an element which is necessary and it becomes a solid cornerstone of sustainability. Such an approach creates framework in which the market can function without excessive tensions and risks of violent turbulences. In this sense, supervision resembles the infrastructure of preventive healthcare, where it is natural that preventing diseases is far better than treating its symptoms.  

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¹Laeven, L., Valencia, F. (2020). Systemic Banking Crises Database II. IMF Economic Review
²Slovik P., Cournède, B. (2011). Macroeconomic Impact of Basel III. OECD; Angelini, P. i in. (2011). Basel III: Long-term impact on economic performance and fluctuations. BIS Working Paper
³Barth, J. R., Caprio, G., Levine, R. (2007). Reassessing the Rationale and Practice of Bank Regulation and Supervision around the Globe. IMF
⁴Aiyar, S., Calomiris, C. W., Wieladek, T. (2014). Identifying channels of credit substitution when bank capital requirements are varied, Bank of England Working Paper