A classic definition of a bank is a business that receives funds from the public to invest on its own account in loan and credit transactions and that assumes the risks of liquidity, which arises when maturities are transformed, and of borrower insolvency.
However, banks’ activity has evolved in parallel to financial and technological innovations. The proliferation of new and increasingly complex instruments (such as financial futures, options, securitisations, credit derivatives) and the existence of numerous factors that influence daily management (counterparty solvency, interest rates, exchange rates, the maturity of transactions, procedures, applicable legislation, strategies and politics, and so on) have given rise to a broad spectrum of risks to which banks are exposed.
Moreover, the highly leveraged nature of the banking business means that losses on a small percentage of its assets could have a very significant impact on its capital and, consequently, its solvency.
Therefore, taking into account the important role credit institutions play in economic development, specifically, in payment systems and financial intermediation, as well as the public interest in protecting the smooth operation, efficiency and stability of the financial system, banks must be subject to prudential regulation and supervision to ensure confidence in the financial system.
An effective regulatory and supervisory model promotes fluid financial intermediation mechanisms and builds savers’ confidence in banks.
It encourages efficiency in the financial system, since it requires banks to adopt comprehensive and prudent risk management systems, promotes competition and stimulates the adoption of good practices that increase transparency for the customer and the markets in general.
Lastly, it minimises the impact and cost of banking crises and avoids outbreaks of "systemic risk" effects.
In short, banking supervision benefits:
- The banks themselves, by providing a sound and prudent regulatory channel for the pursuit of their business and an oversight system in addition to that of the directors, shareholders and internal and external auditors.
- Depositors and investors, who can take their decisions with greater confidence.
- Society at large, by having a healthy and efficient financial system.
Lastly, these reasons also justify the existence of two other functions related to public banking supervision systems: the role of “lender of last resort”, through which the monetary authorities can address temporary liquidity problems, and the creation of a legal framework of guarantees for depositors.