One of the most critical moments in financial-sector supervision is when supervisors need to decide if they should “intervene” in a “problem bank” (a bank that is gliding towards insolvency or is already insolvent). This decision is critical because, if supervisors wait too long to intervene, the worth of the bank will continue to erode, losses to depositors may increase, and systemic risks may increase, ultimately leading to high costs to the government and, thus, the taxpayers.
In the wake of every banking crisis, the debate about “rules versus discretion” in supervisory intervention flares up. This discussion regarding supervisory intervention in problem banks focuses on the incentives for supervisors to act swiftly and decisively in order to minimize losses to depositors, and society more widely.
In this debate, rules are often proposed as the preferred solution (with some discretion left), because the closure of a financial institution remains a tricky event where many interests collide (private, political, business), and even independent supervisors can be seduced by self-interest if the stakes get high. The rules-based intervention system in the United States (prompt corrective actions) has proven many of its merits over the years, and made the product ready for export to other jurisdictions around the world. Until recently, most European supervisory frameworks relied more on discretion than rules, but the 2007–08 financial crisis seems to change the mood, and more voices are being heard in favor of a rules-based system.
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