Supervision should be based on a combination of offsite observations, where the supervisor analyses financial and prudential reports and other information; onsite visits where the supervisor verifies the information it has received and focuses on the governance and control processes in the bank; and personal contacts with banks’ auditors, owners, boards, management and staff in order to gain a good understanding of the bank’s business and of the competencies of the leading personalities. Recently, more stress has been given to this latter issue because the increased complexity of banking makes the importance of good corporate governance and efficient control functions even more evident. Supervisors should avoid trying to micro-manage the banks. When supervisors go too much into the details of the running of the bank, they will be seen to assume – in the eyes of the bank and also of the general public – a responsibility for the bank, which they should not have. The operational independence of supervisors has lately become even more important. The higher degree of interdependence between the institutions and markets combined with their increased complexity and thus vulnerability implies that supervisory decisions and measures must be based on purely prudential grounds without listening to non-relevant arguments. Such operational independence is inscribed in the statutes of the Swedish supervisory authority. However, independence must be tempered by accountability so the supervisors will have to explain their decisions publicly in various ways, such as reports to the Parliament, and they must be prepared to take responsibility for them afterwards.
But it’s one that has gained colour from the debate about derivatives. An oddly polarised debate. Overstating it somewhat: in one corner, a group contending that derivatives bring tangible benefits to civilisation. In the other, a group arguing that they have within them the seeds of severe disorder. Unsurprisingly, my take is that the truth lies somewhere in between. It is nicely illustrated by the quite extraordinary development of the credit derivatives market over the past five years or so.2  Dispersion of risk, and the price of risk Credit derivatives plainly have been used as an effective risk management tool by a number of banks and others. Contrary to some suggestions, the acid test is not especially whether banks, individually or in aggregate, have been net sellers of credit risk. Individual banks have been able to reduce concentrated loan exposures to single corporates, industries or countries. As the Telecom episode reminded everyone just a few years ago, that is really important, if elementary. Individual banks have also been able to increase their exposure to borrowers with which they do not have a lending relationship. (Indeed, some commentators suggest that it may sometimes be more effective for second-tier and smaller banks to take corporate credit exposure via the derivatives market than via participation in the lower tiers of loan syndicates.)