Improving Banking Supervisory Mechanisms
In the OIC Member Countries
5
1. Introduction
It is well-established in the economics and finance literature that financial development is
closely related to the growth prospects of countries. An efficient financial system is key to
achieving sustainable economic growth. On the other hand, the recent financial crisis in 2008
showed that problems in the financial system might be contagious and they can be detrimental
to economic growth. In this regard, a sound and stable financial system should be one of the
major concerns of policy makers.
The banking sector is an important part of the financial system, and turmoil in the banking
sector affects overall financial stability. The lessons learned from the 2008 crisis pave the way
for the construction of new approaches for the supervision of the banking system to enhance
the resilience of banks during times of volatile macroeconomic conditions. The suitability and
effectiveness of financial regulation and supervision have been a focal point of discussion
among policy makers and experts, which sheds light on the lack of coherence in the regulatory
framework of countries despite the significant efforts at the global scale, especially by the
Basel Committee of Banking Supervision. It is now well-understood that financial globalization
and the highly interconnected financial system requires enhanced coordination of countries in
their efforts to achieve an efficient regulatory framework.
In this report, the implications of these new regulatory approaches in the global banking
system in the aftermath of the crisis are investigated, and their implications in the context of
OIC countries are discussed. We aim to provide policy recommendations to enhance the
strength of the supervisory mechanisms and coordination for the member countries by laying
out similarities and differences in banking sectors.
1.1 Banking Sector: The Rationale for Regulation and Supervision
The recent financial crisis with widespread effects in the world has underlined once again the
importance of regulation in financial markets and initiated an intense discussion of regulatory
reforms to avoid repetition of financial market meltdowns coupled with deep recessions and
huge burdens imposed on taxpayers. In this section, the rationale and challenges of banking
regulation are discussed from both micro- and macro-prudential perspectives.
Designing optimal regulations for the banking industry has been an important challenge for
academics and policy makers for decades. Banks are vital for the economy with their function
of financial intermediation, i.e. channeling idle resources toward productive investments and
providing means of risk-sharing. However they might induce important risks on the
functioning of the economy in the case of their failures, as has been seen several times in
history.0F
1
The banking sector serves a unique function in the economy through its role in the payment
and deposit system and generation of credit to households and firms. The starting point of
banking regulation is the deposit insurance aimed at the protection of customers, preventing
bank runs which trigger fire sale of assets and lead to further withdrawals. This issue is
modeled in the seminal paper by Diamond and Dybvig (1983), and mainly stems from the
maturity transformation of the banking system, i.e. banks borrow from depositors for the short
term and extend credit with longer maturity. A loss of confidence of depositors in the banks
induces a self-fulfilling panic and collapse of the banking system. Therefore, monitoring the
liquidity and maturity structure of assets and liabilities of banks remains one of the important
1See Freixas and Rochet (2008).