From Numbers to Nuance: The Power of Qualitative Supervision

Navigating the Complexities of Financial Supervision:

In today's rapidly evolving financial landscape, ensuring the stability of banking systems is more critical—and more challenging—than ever. The Financial Stability Institute’s (FSI) report, “Act Early or Pay Later: The Role of Qualitative Measures in Effective Supervisory Frameworks” (April 2025), sheds light on the persistent hurdles supervisors face and offers a suite of recommendations to bolster their effectiveness. This blog explores the current challenges in financial supervision, critically assesses the report’s suggestions, and concludes with key takeaways and cautions for leveraging its findings.

Context

The March 2023 banking turmoil, described as the most significant stress since the Great Financial Crisis, exposed deep-rooted vulnerabilities in bank governance and supervisory practices. Despite banks meeting capital and liquidity requirements, failures triggered by liquidity runs underscored that quantitative metrics alone cannot safeguard against crises rooted in qualitative weaknesses—poor board oversight, flawed risk management, and unsustainable business models. Governance and risk management issues often remain hidden until they manifest as financial distress. Supervisors struggle to act decisively when banks appear financially sound, as qualitative assessments require nuanced judgment that can be difficult to justify without clear evidence of immediate risk.

Supervisory Challenges

Many supervisory authorities lack operational independence, face conflicting mandates, or are under-resourced, limiting their ability to impose timely measures. Supervisors must navigate the tension between rigid rules and discretionary judgment. Over-reliance on prescriptive frameworks can stifle adaptability, while excessive discretion risks inconsistency, especially when assessing complex qualitative issues like governance or business model viability. Effective supervision demands skilled staff capable of exercising judgment on “shades of grey” issues. Yet, many authorities struggle with inadequate resources, hindering their ability to conduct thorough risk assessments or monitor corrective actions effectively. Even when weaknesses are identified, escalating to formal actions can be delayed by legal challenges or banks’ resistance. COntext

A multipronged approach

The FSI report proposes a multifaceted approach to enhance the use of qualitative measures across the supervisory process: risk scoping, risk assessment, supervisory actions, communication, and monitoring/escalation. One recommendation is to define a supervisory risk appetite to guide resource allocation and combine top-down with bottom-up approaches, with safeguards like baseline transaction testing. A clear risk appetite framework can enhance accountability and justify supervisory focus, particularly when resources are finite. However, defining a risk appetite is complex and may lead to overly cautious scoping. Bottom-up safeguards risk becoming bureaucratic, potentially diverting resources from high-risk areas if overly prescriptive. The report could better address how to calibrate these safeguards to avoid diluting focus.

Organizations are as robust as their Weakest Link

To better assess risk, the report proposes weighting governance heavily in ratings, adopting a “weakest link” approach where poor qualitative scores drive overall ratings, and establishing stand-alone business model ratings. Elevating governance and adopting a weakest link approach, as practiced in Australia and Canada, ensures qualitative weaknesses aren’t masked by strong financial metrics. However, overemphasizing governance risks skewing assessments, potentially neglecting other critical areas like liquidity. The weakest link approach may lead to overly punitive ratings for banks with isolated issues, discouraging cooperation. The report lacks guidance on balancing qualitative and quantitative factors to avoid unintended consequences.

Expanding the Toolkit

Supervisors are encouraged to expand their use of qualitative tools, assign responsibility to specific individuals, and link ratings to actions for transparency. Assigning responsibility to senior executives or board subcommittees, as in the UK and Australia, fosters accountability. Linking ratings to actions, as in the US Federal Reserve’s LFI system, clarifies expectations and escalates pressure systematically. However, gaining new powers often requires legislative changes, which the report acknowledges but doesn’t address practically. Severe measures like asset caps (e.g., Wells Fargo’s ongoing cap since 2018) may harm competitiveness if prolonged, and the report underplays the reputational risks for banks. Guidance on moral suasion versus informal actions is useful but may oversimplify complex judgment calls.

Communication Strategies in a Networked World

Communication strategies are also a focus, with proposals to issue concise, prioritized communications to senior decision-makers and disclose composite and component ratings to banks. Streamlined communication, as in the UK PRA’s PSM letters, ensures focus on critical issues. Disclosing ratings drives accountability, as banks benchmark against expectations. However, disclosing detailed ratings risks banks fixating on scores rather than underlying issues. The report doesn’t fully explore how to mitigate this or ensure disclosures don’t undermine constructive dialogue. Public enforcement disclosures may deter compliance if perceived as punitive.

Digitalization in Supervision is a Must

Monitoring and escalation improvements include using IT systems for tracking corrective actions and establishing escalation guidance with verification processes. IT enhancements, like the ECB’s common platform, streamline monitoring. Structured escalation ensures consistency and proportionality. However, over-reliance on IT risks reducing supervision to checklists, potentially undermining judgment. The report could better address how to integrate technology with human expertise. Escalation guidance may not account for cultural differences across jurisdictions, where cooperative versus confrontational approaches vary.

Supervisory judgment is identified as the glue that binds the entire process. The report proposes enhancing judgment through training on biases and case studies, balancing prescriptive rules with discretion to find a “sweet spot.” Training on fast and slow thinking, inspired by Kahneman, is practical for navigating complex decisions. The rules-judgment triangle offers a useful framework. However, the “sweet spot” is vague and context-dependent, risking oversimplification. Training alone may not address cultural or resource barriers to judgment, and the report underestimates the challenge of fostering risk-tolerant cultures in politically sensitive environments.

Overall, the report’s strength lies in its holistic approach, addressing each supervisory phase with actionable ideas drawn from global practices.

In terms of key takeaways, the report reinforces that qualitative measures—targeting governance and strategy—are essential to prevent crises, as quantitative metrics alone are insufficient. Enhancing supervision requires coordinated improvements across scoping, assessment, actions, communication, and monitoring, with judgment as the “glue.” Practices like the UK’s targeted letters, Canada’s weakest link approach, and the US’s IT-driven monitoring offer adaptable models for jurisdictions worldwide. This should not be interpreted as moving away from quantitative approach, but balancing it with a qualitative focus on strategy and governance, elements that are not captured by ratios or quantitative models.

However, recommendations must be tailored to jurisdictional realities—resource constraints, legal frameworks, and cultural norms may limit applicability. Overly rigid adoption of suggestions risks stifling judgment or overwhelming supervisors, particularly in under-resourced agencies. Proportionality is key. Legislative and political hurdles to gaining new powers or fostering risk-tolerant cultures are significant and require broader stakeholder engagement beyond supervisory agencies.

The FSI report provides a valuable roadmap for strengthening financial supervision, but its success hinges on pragmatic adaptation. Supervisors must weigh its insights against local constraints, ensuring that the pursuit of early action doesn’t compromise fairness or flexibility. As the report warns us - " As Ernest Hemingway bluntly putit: “How do you go bankrupt? Gradually and then suddenly.” (Hemingway (1926)). Bank failures or problem banks do not appear in isolation; they are often the result of cumulative behaviours, decisions, actions and inactions by a bank’s leadership. The universal challenge for all supervisors is to detect and take action on those qualitative weaknesses during the “gradual” phase. The stability of the banking system hinges on their ability to do so."

FSI Report Recommendations by Supervisory Phases

1. Risk Scoping

• Define a risk appetite framework to align supervisory actions with institutional tolerance.

• Combine top-down (sectoral priorities) and bottom-up (bank-specific risks) assessments.

• Use baseline transaction testing to ensure that qualitative areas are not overlooked.

• Adjust supervisory focus dynamically based on emerging risks.

2. Risk Assessment

• Adopt a “weakest link” approach to ensure that any serious qualitative weakness affects the overall rating.

• Introduce stand-alone business model viability ratings.

• Elevate governance ratings to influence composite ratings directly.

• Develop red flags and early warning indicators for governance and strategic risk.

3. Supervisory Actions

• Expand the use of qualitative tools such as business restrictions and senior leadership changes.

• Create a menu of options for supervisors based on severity and urgency.

• Establish responsibility for corrective action at board subcommittees or named executives.

• Clarify guidance for informal tools like moral suasion.

4. Central Bank/ Supervisory Communication

• Streamline supervisory messages via consolidated reports at the end of each cycle.

• Disclose composite and component ratings to banks to increase clarity.

• Prioritize issues and expected timelines for remediation.

• Avoid overemphasis on rating scores in communications.

5. Monitoring and Escalation

• Use advanced IT platforms to track progress on supervisory actions.

• Define escalation pathways and verification procedures for closure of issues.

• Adopt structured panels or committees for escalation decisions to enhance consistency.

• Ensure escalation accounts for varying cultural attitudes toward confrontation and cooperation.

6. Supervisory Judgment

• Train supervisors on cognitive biases and decision frameworks (e.g., fast vs. slow thinking).

• Promote case-based learning using past supervisory outcomes.

• Encourage a risk-tolerant culture within supervisory bodies.

• Balance discretion with structured guidance to avoid regulatory inconsistency.

Reference

Balan, Monica, Fernando Restoy, and Raihan Zamil. Act Early or Pay Later: The Role of Qualitative Measures in Effective Supervisory Frameworks. FSI Insights on Policy Implementation No. 66. Basel: Bank for International Settlements, April 2025. https://www.bis.org/publ/fsiins66.htm.