Banking Supervision

Reasons for its existence

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, in addition to this function, assumes the risks of liquidity, which arises when maturities are transformed, and of borrower insolvency.

However, the activity carried out by credit institutions has developed in line with financial and technological innovation. As a result, the proliferation of new, increasingly complex instruments such as financial futures, options, securitisations, credit derivatives, etc. and the existence of numerous factors that influence daily management (counterpart solvency, interest rates, exchange rates, transaction maturity, procedures, applicable legislation, strategies and politics, etc.) give rise to a broad spectrum of risks that must be subjected to a prudential regulation and supervision process to guarantee confidence in the system.

There are more reasons that justify the existence of a special administrative supervisory system for financial institutions, namely:

• The important role they play in economic development and, in particular, payment systems and financial intermediation.
• The highly leveraged nature of the banking business, so that impairment of a small percentage of its assets could have a very significant impact on its capital and, consequently, its solvency.
• The proper functioning of the financial system, its efficiency and stability is in the public's interest.

Additionally, an effective regulation and supervision model promotes the fluidity of financial intermediation mechanisms and generates confidence, on the part of savers, in the institutions.

It encourages efficiency in the financial system, since it forces credit institutions to adopt comprehensive and prudent risk management systems, as well as promoting competition and stimulating the adoption of good practices that increase transparency for the customer and the markets in general.

Finally, it minimises the impact and cost of banking crises and avoids outbreaks of the "system risk" effect.

In short, banking supervision benefits:

• The credit institutions themselves, by providing a sound and prudent regulated channel for the pursuit of their business and a system of supervision to supplement that of the directors, shareholders and internal and external auditors.
• Depositors and investors, who can take their decisions in an environment marked by greater confidence.
• Society in general, which will have a healthy and efficient financial system.

Finally, the aforementioned reasons also justify the existence of two additional functions in relation to public models of supervision: the "lender of last resort" function, a competency of the monetary authorities in which they address temporary liquidity problems, and the creation of a legal framework for credit institution depositor guarantees.