Abstract: This article concerns the role of financial supervisory bodies in the Italian banking system, and the responsibility they must share in the recent Italian banking crisis. It first gives a theoretical explanation of the purpose of financial supervision, and various structural models by which supervision can be implemented. The article then discusses the structure of financial supervision in Italy specifically, and how responsibility is divided between Banca D’Italia and CONSOB. The roles of these bodies have evolved over time due to developments in financial markets, political changes, and the involvement of the EU. Finally, the article analyses how Banca D’Italia and CONSOB failed in their supervisory roles, and the way these failures were a cause of the Italian banking crisis, making reference to specific banks including Banca Monte dei Paschi di Siena (MPS), Banca Populare di Vicenza (BPVi) and Veneto Banca.
The Purpose of Supervisory Bodies
Financial supervision refers to supervision of banks, insurance companies, and securities traded on the financial market by public bodies. It implies both the oversight of the institutions engaging in financial activities, and the transactions these institutions engage in. Legal theorists describe financial supervision as belonging to ‘public order’[i]. As such, public bodies enforce the regulations supervisory bodies enact, violations are penalized via criminal or civil sanctions, and incompatible contract clauses are declared null and void.
The overarching aim of financial supervision is to ensure the overall stability of the financial system, which might be described as a ‘public good’. Maintaining the stability of the financial system facilitates the building up of public confidence, a necessary feature of any functioning financial system. Financial stability cannot be achieved by markets alone. Financial crises are proof of this fact.
The mark of a successful regime of financial supervision, then, is a stable financial system which is unaffected by major scandals and crises. Financial crises and scandals signify not only the culpability of financial institutions, but also a failure in the effective function of supervisory bodies.
A Typology of Supervisory Functions
As part of the overarching goal of ensuring the stability of financial systems, supervisory bodies perform three main functions.
Prudential supervision is the most essential form of financial supervision. The aim of prudential supervision is to safeguard the solvency of financial institutions, and therein their ability to honor their promises to depositors or policy holders. It is necessary in order to counteract deleterious incentives on the part of financial institutions, created by the existence of government ‘safety-nets’ which protect depositors and policyholders. Government safety-nets, which prevent financial institutions from failing, are crucial in that they prevent bank runs and protect depositors. However, safety-nets also have the undesirable consequences of creating moral hazard on the part of intermediaries, leading to an adverse selection problem.
The moral hazard problem occurs because depositors know they will not suffer losses if banks fail, given the existence of a government safety-net[ii]. As such, they are dis-incentivized from imposing market-discipline on banks by withdrawing their money when they become aware that a particular bank is taking on too much risk. Consequently, banks which are protected by a government safety-net are incentivized to take on greater risk. The moral hazard problem is particularly prevalent in big banks, which are sometimes referred to as ‘too big to fail’. Governments are particularly reluctant to allow big banks to fail and cause depositors and shareholders losses because this can have wide ranging detrimental effects on the economy.
The adverse selection problem occurs because the individuals who are most likely to carry out risky transactions, which might cause bank failure are most likely to take advantage of government safety-nets[iii]. Risk-loving individuals are, as a result, more likely to enter the banking industry in order to engage in risky activities.
Prudential supervision corrects the moral hazard and adverse selection problems by monitoring and imposing limits on the amount of risk financial institutions can take on. Prudential instruments are complex and applied to each firm as a whole, including its branches and subsidiaries.
[i] Lumpkin, Stephen. “Supervision of Financial Services in the OECD Area.” Financial Market Trends 81 (2002): 81-139. Print.
[ii] Mishkin, Frederic S. “Prudential Supervision: What Works and What Deosn’t.” NBER (2001): 1-30. Web.