Centre for Economic Policy Research

1.6.3 
Supervisory oversight
If mandatory disclosure does not work because firms are still able to hide relevant
information, the free-rider problem remains severe or mandatory disclosure would
reveal proprietary information, supervisors can intervene and contain conflicts of
interest. Supervisors can observe whether a conflict of interest is being exploited
without revealing confidential information to a financial firm’s competitors so
that the firm can continue to engage profitably in information production 
activities. Supplied with this information, the supervisor can take actions to 
prevent financial firms from exploiting conflicts of interest. As part of this 
What Are the Issues? 7

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supervisory oversight, standards of practice can be developed by the supervisor
and the firms engaged in a specific information-production activity. Enforcement
of these standards would then be in the hands of the supervisor.
Supervisory oversight of this type is very common in the banking industry. In
recent years, bank supervisors have increased their focus on risk management.
They examine banks’ risk management procedures to ensure that the appropriate
internal controls on risk-taking are in place at the bank. In a similar fashion,
supervisors can examine the internal procedures and controls to restrict conflicts
of interest. When they find weak internal controls, they can require the financial
institution to modify them so that incentives to engage in conflicts of interest are
eliminated.
Although supervisory oversight has been successful in improving internal 
controls in financial firms in recent years, if the incentives to engage in conflicts
of interest are sufficiently strong, financial institutions may be able to hide 
conflicts of interest from the supervisors. Furthermore, as seen in recent banking
crises, supervisors sometimes have engaged in regulatory forbearance in which
they do not sufficiently enforce penalties on financial firms engaged in undesir-
able behaviour. There is always the issue of whether supervisors can be adequate-
ly insulated from short-term political pressures to let financial institutions off the
hook, avoid regulatory capture, and be made sufficiently accountable to prevent
conflicts of interest from getting out of control. On the other side, supervisors
could become overbearing and interfere with the efficient function of financial
firms in order to avoid having a scandal occur on their watch.