It is commonly agreed that the banking system is a uniquely important sector of the overall financial system. This is true since the banking institutions within the system are the creators of money, custodians of public funds and operators of the payment mechanism. For these reasons, the banking institutions have to be supervised in the public interest. The world over, central banks have evolved to supervise the banking system with three primary objectives namely, protection of depositors; maintenance of monetary stability and preservation of public confidence.
While the objectives have been generally accepted, however, vigorous debate often arises as how much supervision and what form or approach of supervision can best attain these objectives. In some countries the supervision is very rigid and comprehensive like Malaysia, involving both off-site and on-site examinations on the banking institutions by the Central Bank of Malaysia. In Australia, however, the supervision is less comprehensive, largely involving off-site examination. In other words, no examinations are conducted on the banks, rather the Reserve Bank of Australia conducts desk review of the periodical statistical returns submitted by the banks. Apart from this, the Reserve Bank of Australia relies on the banks' auditors to report matters as specified by them.
This paper does not attempt to conclude which is the better approach, but suggested that some form of supervision must exist in the banking system depending on the needs of the country. It should be noted that whatever level or approach of bank supervision, it alone cannot guarantee bank soundness. Further, there is always a cost to bank supervision and hence there should be a limit to supervision. On one hand, we need a prudent, low-risk banking system, while at the same time the banking system must be competitive, innovative, and supportive of its customers. Bank supervision should not overdo the one which seriously effect the other.