Incentives in banking and the role of supervision

As part of its Central Bank Speaker Series, the Frankfurt School Centre for Central Banking (CfCB) hosted a guest lecture by Professor Claudia Buch, Chair of the Supervisory Board of the European Central Bank (ECB) and former Vice President of the Deutsche Bundesbank on October 22.

Emanuel Mönch, Professor of Financial and Monetary Economics and Co-Director of the CfCB, opened the event by highlighting Claudia Buch’s outstanding extensive academic and policy experience, which spans senior leadership roles in research, advisory, central banking and financial supervision.

In her lecture, titled “Incentives in Banking and the Role of Supervision”, Claudia Buch explored the importance of incentive structures in the banking sector and the critical role that effective supervision plays in maintaining financial stability. Well-aligned incentives, she argued, ensure that banks act prudently and in the public interest, while misaligned incentives can foster excessive risk-taking, short-termism, and ultimately financial crises – with significant economic costs.

Professor Buch provided an overview of the progress made since the establishment of the European Banking Union. The past decade has seen banks in Europe become better capitalised and more liquid, reflecting advances in regulation, supervision, and internal risk management. This progress, she noted, has strengthened confidence in the European banking sector. Buch emphasised, however, that maintaining this trust requires continuous attention to governance, risk management, and long-term strategic alignment. Failures such as those of Credit Suisse and Silicon Valley Bank in March 2023 highlighted the costs of poor governance and misaligned incentives. She explained that robust capital buffers, sound risk culture, and effective supervision are central to preventing such crises.

Within banks, the design of compensation and hiring practices plays a critical role. Incentive structures that reward short-term profits can encourage excessive risk-taking, whereas deferring variable pay and linking it to long-term performance helps to align employee interests with the stability of the institution. Diversity within management boards, she noted, also strengthens decision-making and risk culture.

Buch stressed that self-regulation within the financial industry is not sufficient to safeguard stability. Effective supervision and regulation remain essential to ensure that decision-making in banks aligns with the broader public interest. She described the instruments used by supervisors, including capital and liquidity requirements, fit-and-proper assessments for bank managers, and ongoing evaluations of governance structures.

She also outlined how the ECB ensures high supervisory standards through internal governance and accountability – including regular staff rotation, benchmarking, and transparency towards the European Parliament – to maintain independence and consistency across all supervised institutions.

In the discussion that followed, Ms. Buch addressed questions on topics ranging from technological innovation and regulatory divergence between Europe and the United States to the resilience of the financial system in the face of geopolitical tensions and private credit market risks. She noted that Europe needs to further deepen its capital markets and investment union to improve access to equity financing and support long-term, innovative growth. Ms. Buch concluded by emphasising that the resilience of the financial system depends on ongoing efforts to strengthen governance, manage emerging risks, and adapt supervisory practices to a rapidly changing environment.

Once again, the event underscored the Centre for Central Banking’s importance as a key forum for dialogue between academia, policymakers, and the financial sector.