Since the Asset Quality Review and the series of restructuring exercises undertaken thereafter at the instance of the Reserve Bank of India, the balance sheets of Indian banks are looking the cleanest they have in many years. By virtue of scrupulous adherence to stipulated regulatory norms, they have improved their solvency and liquidity cushions. Risk-governance standards are seen to be strengthened. Coupled with all these, favourable monetary policy actions and the use of timely and appropriate macroprudential tools have manifested themselves in improved profitability.
But the rigour of RBI supervision does not seem to have waned in any measure. On-site supervisors are asking more complex questions of bankers than in the past. Techniques and tools in the supervisory arsenal are seemingly getting sharper. Supervisory resources are being used more intelligently.
Doesn’t it sound strange?
In a cycle perceived to be in a healthy phase, accelerated supervisory pedals might lend the impression that the supervisor is overreacting to the detriment of the supervised’s God-sent headroom to intensify efforts to grow at a faster pace. As such, the literature reveals that supervisors are criticised as overly burdensome when things are calm and too lenient when failures occur.
“Is supervision too strict given this period of apparent calm, the good health of the banking system and the efforts made by banks and supervisors over the past 15 years?” The same kind of question was dealt with by Patrick Montagner, Member of the Supervisory Board of ECB Supervision, in his November 28, 2025 speech, “Uncertain times: vigilance, governance and the case for effective supervision”, at the 12th Annual IIF Colloquium on European Banking Regulation and Supervision.
In fact, the perception of an overdose of supervision is too simplistic, though the converse could possibly be a worry. While the view that stringent supervisory practices are said to adversely impact banks’ competitiveness lies only in theory, the real general fear is based on the surmise that, sans a stance of proactive and robust supervision, the banks’ operational standards could be diluted, generating a vicious cycle of ‘racing to the bottom’. As such, supervision of the health of individual banks is the initiating action point guiding the avowed mission of the overall stability of the macro-financial system and, in that sense, supervisory rigour is kept intense in a perennial manner.
Stability Breeds Instability
Minsky’s proposition that ‘stability breeds instability’ was found to be well-nigh true in practice in the 2008–09 global financial crisis (GFC). A sustained state of stability could be the harbinger of instability, as such a state could lead to ‘irrational exuberance’ manifested in asset bubbles, heightened leverage and ALM issues.
Intra-sectoral and inter-sectoral interconnectedness among financial entities and markets tend to aggravate the situation further. Worse still, all these elements are often interlinked and tend to appear together. Like the construct of an avalanche, in which the last grain of sand, whenever it might be added, would bring down the structure to complete ruin, the whole structure of the financial ecosystem could collapse with the mildest shock befalling it unnoticed.
Risks have multiplied from ‘known knowns’ to ‘known unknowns’ and to ‘unknown unknowns’ and are often interconnected among themselves, making their measurement complex and hence their management tough. The interconnectedness of risks is difficult to anticipate or perceive. To that extent, the fundamental exercise of institutional risk appetite, risk evaluation and risk capital allocation remains suboptimal, with the potential threats to the business hanging like the Damocles’ Sword all through.
The history of financial crises reveals that such episodes used to surface once in a century. During the last century, however, every decade-end witnessed a catastrophe. The current trend is that instability in the financial landscape can appear any time from any corner like bolts from the blue. Prospects of liquidity and asset/liability balances becoming easy victims of very quick reversals are thus getting brighter. The 2023 banking turmoil in the West seemed to be the by-product of such a trend. Sole adherence to prudential ratios would not work in a volatility-prone environment; nor would static business models function in adequate measure. Supervision has accordingly been synced across the globe, more earnestly by the RBI.
The extant Supervisory Review and Evaluation Process (SREP) of the ECB presupposes two principles: “(i) financial soundness alone is not sufficient for a positive supervisory assessment and (ii) preventive and proactive supervision must investigate the underlying causes of the headline financial ratios”.
The new supervisory approach of RBI focuses on (i) strengthening the internal defences of the banks and (ii) placing greater focus on identifying the warning signals at an earlier stage and initiating corrective action. Its revised supervisory objective accordingly is to enhance the supervised entity’s (SE’s) ability to (i) anticipate risks early, (ii) absorb losses through higher provisioning/capital buffers and (iii) adapt to the new operating environment.
No ‘Light-Touch’
Supervision should be aggressively but creatively intrusive. History shows that the moves towards lighter-touch supervision via reduced resources, less intensive assessments and a greater reliance on banks’ internal controls have backfired. Prudential supervision may have costs. These are, however, worth incurring, as they embody the inherent ability to contain the damage from potential future crises.
New-age supervision should embrace two-pronged strategic missions.
- Help in advocating an institutional architecture that is self-resilient by design
- The institutions should be led to improve their immunity from shocks with the active handholding of the supervisors.
- They should do their own vulnerability assessments with the help of a robust Early Warning System and forward-looking stress-testing techniques.
- The focus should increasingly be on such reviews to identify incipient stress and to take proactive corrective actions.
- Entities may conduct scenario assessment on an ongoing basis and ensure that sufficient provisions are maintained even in case of the indicated stress scenarios.
- Ongoing exercises on incremental capital requirements and programmes to raise capital should be ingrained in the regular schedules of senior management.
The role of risk management should shift from an ‘offensive type’ to a ‘defensive genre’.
Offensive risk management seeks to leverage risk to increase profits and shareholder value. Defensive risk management, by contrast, seeks to create a crisis-ready institution by reducing the probability of distress and protecting the sustainability of profits and shareholder confidence.
A siloed approach to risk management, focused on maximising returns within individual business lines, can generate wider negative consequences. These may take the form of regulatory fines, unforeseen liabilities or the failure of a particular business line. Any one of them can impair the entire institution rather than remain confined to the silo in which the risk originated.
The case for sustained supervisory rigour is not that banks are perpetually weak. It is that periods of apparent calm provide the best opportunity to detect vulnerabilities, strengthen governance and build buffers before stress emerges. Supervision cannot be relaxed merely because the cycle looks benign.
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