Light-Touch Supervision Risks Blind Spots, Unit-Level Inspections Must Return

The history of bank failures shows supervision has often been the weakest link. Root cause analyses of the Global Financial Crisis and the banking turmoil of 2023 pointed to the same conclusion. This formed part of the thinking within the Federal Reserve System, as reflected in remarks by Michael S. Barr in his November 18, 2025, speech, The Case for Strong, Effective Banking Supervision, where he noted that “periods of weakened supervision have often preceded episodes of financial excess and instability”.

His reference to plans to reduce staffing in the Board’s Supervision and Regulation division by 30% by the end of 2026, and the risk that this could impair supervisors’ ability to act with speed and force, is notable. The shift towards lighter-touch supervision, through reduced resources, less intensive assessments, and greater reliance on banks’ internal controls, has also been flagged by Patrick Montagner of the European Central Bank.

Episodes from Northern Rock in 2008 to Silicon Valley Bank underline the risks, where inadequate supervisory intrusion came under scrutiny. The direction of travel, therefore, must be towards smarter supervision, not lighter supervision.

Risks, Not Size
Further, the European Central Bank Working Paper No. 375, A comparative review of worldwide on-site banking supervision trends through the lens of IMF/World Bank FSAP, by Alessandro Santoni, Valentina Rapalino and Roberta Nesti, flags the risk of supervisors devoting disproportionate attention to large and complex banks due to their systemic importance, while neglecting smaller institutions and the risks they may pose. In practice, systemically important banks tend to dominate supervisory calendars, while smaller banks are either excluded or examined only selectively.

Lessons from the Global Financial Crisis underline the flaw in such an approach. Systemic risk and interconnectedness do not operate in isolation, and stress can originate in smaller entities before transmitting rapidly across the system. The collapse of Lehman Brothers illustrated how distress in a single institution can propagate widely through financial linkages.

Supervisory resource allocation should therefore be institution-specific and risk-based, while remaining size-neutral. As the International Monetary Fund notes in Good Supervision: Lessons from the Field (September 2023), while a significant share of supervisory attention must focus on large and complex banks, effective supervision cannot overlook risks posed by smaller institutions to the financial system and the real economy. In practice, this implies calibrated allocation rather than disproportionate concentration. The paper also notes that while external independent reviews of risk management systems may be used, targeted or limited-scope inspections of smaller banks remain essential.

The emerging supervisory challenge lies in identifying and measuring ‘known-unknown’ risks, while building resilience against ‘unknown-unknowns’. The emphasis has shifted from tracking visible stress to detecting early vulnerabilities and addressing them before they crystallise. This marks a transition from reactive, post-event supervision to forward-looking, preventive supervision. The objective is no longer to manage crises after they emerge, but to anticipate and contain risks early enough to prevent institutional failure.

Supervisory architecture comprises both off-site and on-site elements, not only to optimise resource allocation but also to leverage available technological tools. As per the International Monetary Fund FSAP assessments, in about 65% of cases, off-site and on-site teams operate in tandem to build a clearer view of banks’ risk and control profiles, broadly aligned with Basel Core Principles. However, in nearly 28% of cases, off-site supervision has become the predominant mode, with on-site engagement diluted into sporadic or infrequent visits that are not commensurate with the size and risk profile of banks.

This shift is often attributed to “limited supervisory resources”, which in turn leads to less frequent and less comprehensive inspections, particularly of smaller banks. Off-site monitoring consequently becomes the primary supervisory tool. While SupTech has strengthened surveillance capabilities, it cannot substitute for on-ground verification. As underscored by the Basel Committee on Banking Supervision principles and the IMF’s 2020 US FSAP, on-site work remains critical to independently verify policies and controls, assess the reliability of reported data, gather additional information, and monitor follow-up on supervisory concerns.

Branch Inspections
A further gap lies in the narrowing scope of on-site inspections. The current trend, including in India, is to conduct on-site inspections largely at head or corporate offices. Inspections at sensitive branches and at circle or zonal levels have either diminished or become event-driven. This creates blind spots, where weaknesses in governance, credit underwriting, internal controls, and AML/CFT frameworks may go undetected.

In an increasingly globalised banking system, there is a case for reviving unit-level supervision, including joint inspections by home and host supervisors for cross-border operations. Effective supervision must rest on observed practice rather than reported data, with stronger on-site verification enabling more accurate supervisory judgment on the true condition of banks.

Technology-driven off-site supervision from the supervisor’s office is useful for trend analysis, peer comparison, and early warning signals. It cannot, however, be relied upon exclusively for policymaking, as it is based on data generated and reported by banks themselves, typically at the head or corporate office level. Preliminary assessments derived from off-site monitoring must therefore be validated through independent, on-site verification, particularly at the level of zones, circles, and branches.

A holistic supervisory judgement also requires an understanding of non-quantifiable factors, including risk culture, the functioning of corporate governance frameworks, credit underwriting standards, and the integrity of implementation of internal controls and procedures. These dimensions are not fully observable through data alone. Audit, compliance, and supervisory inspection serve distinct but complementary roles in this process, and cannot be treated as substitutes for one another.

In India, such unit-level on-site supervision was once standard practice. Over time, cost-driven reductions in supervisory manpower weakened this framework, particularly at the operating unit level. The consequences have become visible. Frauds originating at the branch level have increased, even as accountability is often ascribed to senior management or supervisors after the event.

There is a case to revisit this approach and restore on-site supervision at the unit level, ensuring that risks are identified and addressed at their point of origin rather than after they surface.