Complex and disconnected: global standards in financial compliance

November 2021  |  FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

November 2021 Issue

The size and scope of the regulations governing the financial services (FS) industry are vast and growing – a global smorgasbord of rules, laws, legislation, statutes, directives, orders, edicts, dictums, decrees, mandates, acts and diktats that seem to replenish on a regular basis.

Hardly surprising then that there are no global standards in financial compliance. Rather, the FS industry is subject to a regulatory system that is complex and exceedingly disconnected, compliance with which involves significant financial outlay. According to CUBE, between 10 to 15 percent of a financial institution’s (FI’s) operating costs is spent on regulatory compliance.

Moreover, around 180 countries have a regulatory framework of some description in place for the industry, meaning thousands of issuing bodies creating a multitude of legislation and regulation – produced in up to 60 different languages – which may (or may not) apply to financial services. The end result is tens of thousands of rulebooks, leaving global FIs struggling to comply.

In Europe, for example, the European Systemic Risk Board’s (ESRB’s) 2019 report ‘Regulatory complexity and the quest for robust regulation’ notes: (i) an increase in the sophistication of regulatory capital computations, including those introduced by the fundamental review of the trading book (FRTB); (ii) new policy instruments, such as those relating to liquidity regulation (the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR)), macroprudential tools (e.g., countercyclical capital buffers) and bail-in debt; and (iii) new institutions, such as the single supervisory mechanism (SSM) and the Single Resolution Board (SRB), as well as numerous other European supervisory authorities.

Also noted by the ESRB is an increase in regulation as a result of the Basel Accords on banking regulation and in the granular detail of domestic financial legislation. For example, the 848 pages of the 2010 Dodd-Frank Act stand in marked contrast to the 24 and 37 pages, respectively, of the Federal Reserve Act (FRA) and the Glass-Steagall Act – two key pieces of 20th century US financial legislation.

“In 2020 alone, more than 300 million pages of regulation was produced for financial services,” says Ben Richmond, chief executive of CUBE. “However, it is created, and disseminated, in a confusing plethora of different ways. Because there is no ‘global standard’ on how regulation is produced, the volume and availability of it is impossibly immense.

“So, to expect an FI that operates in multiple jurisdictions to keep up – and comply – with all the changes, is simply unrealistic,” he continues. “There needs to be standards across the regulatory landscape on how regulations are produced, consumed and applied across the FS industry.”

Adding to the challenges facing the FS industry is that of digital transformation, a challenge that has been greatly accelerated since the emergence of the coronavirus (COVID-19) pandemic. This acceleration, in turn, has brought with it a huge range of new compliance considerations, with regulators now having to make widespread adjustments that factor in the changes that have taken place to workplace practices.

“The management of data in the context of remote or hybrid working has been something that all financial firms have had to adjust to,” explains Mr Richmond. “Many companies shifted to long-term remote working solutions, which requires compliance policies and controls to be modified to suit the new working environment.

“While the overarching principles of financial regulation are generally shared among the world’s major economies, there are, at every turn, key country-specific differences that all international financial firms need to stay on top of,” he continues. “Again, the pandemic has created additional issues in this area which need to be managed.”

Another key challenge facing FS firms is accessing new markets in the face of myriad cross-border regulations. While supranational frameworks such as the International Organization of Securities Commissions (IOSCO), Basel, the Financial Action Task Force (FATF) and the Organisation for Economic Co-operation and Development (OECD) remain common benchmarks, jurisdictional variations apply to reflect the manner in which FS firms operate in light of domestic legal, political and cultural considerations.

“While many financial centres will have common core pillars for licensing, conduct of business, marketing, financial soundness and senior management responsibility, the manner in which duties are set out differ,” adds Hari Bhambra, global head of compliance solutions at the Apex Group. “Further complexity may arise where regulators may not fully recognise other jurisdictions as equivalent, which increases costs and time.”

Global standards

To achieve a unified, international global standards in financial regulation, the implementation and adherence of regulators and the FS industry to robust regulatory harmonisation guidance and controls is key. Such guidelines include the ESRB’s seven principles in the design and reform of global financial regulation, as outlined below.

First, adaptability. Financial regulation, including the calibration of its key tools, must be able to evolve with the financial system and not become an obstacle to innovation. This includes not creating material barriers to entry or discouraging the emergence of new business models. Regulatory sandboxes and sunset clauses could be effective tools to deal with innovation in a controlled environment and ensure that obsolete rules are removed or revised.

Second, diversity. The diversity of FIs and business practices should be preserved, as this represents a powerful safeguard against systemic instability. By introducing some redundancy, diversity also ensures substitutability, i.e., the ability to find ongoing elements of the system that can replace failed elements and ensure the continuity of core functions. Excessive homogenisation of regulated entities and activities is to be avoided.

Third, proportionality. The burden of regulation – in terms of compliance and enforcement costs, as well as wider costs such as the induced distortions to competition and innovation, and the diversion of activity to less regulated sectors – should be commensurate with the importance of the market imperfection at stake.

Fourth, resolvability. A regulation should allow unviable entities to exit the system, without endangering systemic stability. Efforts should be intensified in the areas of recovery and resolution of all FIs, and policies tackling internal structure and complexity must be adopted so as to ease the resolution process.

Fifth, systemic perspective. Financial regulation should aim to ensure the continuous provision of critical financial services to society. A regulatory system that favours the concentration of activities in a limited number of FIs can become more vulnerable owing to its dependence on the survival of these few institutions. A systemic perspective requires a comprehensive understanding of correlations and interlinkages, as well as an understanding of macroeconomic feedback mechanisms.

Sixth, information availability. Regulatory information should allow for prompt identification of contagion channels and pockets of vulnerability. Timely information enables policies to be implemented that react effectively to new developments, either by recalibrating or activating existing regulatory tools or by activating crisis management tools.

Finally, non-regulatory discipline. The presence of regulatory discipline should not entail the removal of non-regulatory discipline. On the contrary, the discipline that derives from market players, effective governance structures and the prevalence of high ethical and personal responsibility standards in the management of FIs is complementary to financial regulation and may reduce its need to rely on complex rules.

Clearly, however, for such guidance to be effective requires a high degree of cooperation between jurisdictions – a standards-based system that is open, interoperable and available to the entire FS industry.

“While regulators continue to work together to recognise equivalence which increases the scope to facilitate trade cooperation agreements, such as the UK and Singapore, the ability to streamline and create a unified global standard will remain a challenge,” accepts Ms Bhambra. “Each jurisdiction will have its own domestic considerations – political, legal and otherwise – which may determine what the remit and scope of each regulator is, and what ambitions there are for each particular financial centre.”

Automation

Over the past 18 months, the COVID-19 pandemic has highlighted the role that automation has to play in easing the regulatory compliance burden. And while not necessarily a means of standardising regulation itself, automation can be used to align FI’s business operations across different sets of regulations and remove barriers, as well as manage associated cyber risks.

“Automation plays a significant role in identifying applicable regulatory requirements and linking to FIs’ specific business operations,” suggests Ms Bhambra. “Collating information on investor and client profiles and marketing actually enables FIs to use their own regulatory and compliance data as invaluable business development data.

“Automation of reporting output for regulatory submissions, while also using the same data for management information, increases operational efficiency and enhances the quality of compliance,” she continues. “It can also further enable FIs to recognise the commercial value, not just the cost, of their own compliance infrastructure.”
In the view of Mr Richmond, while there will always be the need for some human oversight when it comes to making decisions that relate to an FI’s compliance policies, automation is an invaluable asset to improving efficiency in this area. “Artificial intelligence capabilities are perfectly suited to quickly distilling vast amounts of documentation to help compliance and legal professionals make decisions more quickly and accurately,” he notes.

Long way to go

In summary, due to the complexity of regulatory compliance, FIs often struggle to clearly identify the regulations that apply to them, especially if they operate in multiple jurisdictions and offer a broad range of products and services.

Furthermore, FIs with a global presence need to understand a multitude of changing regulations that impact different business areas – currently a laborious and time-consuming process. Unfortunately, the lack of regulatory traceability has led FIs to implement overly complex and costly operating environments that often may not demonstrate compliance.

“In an ideal world, there would be one integrated regulatory framework that can be applied across all jurisdictions,” says Mr Richmond. “Clearly, this is an unlikely panacea and far from today’s reality – regulation is subject to ongoing change because of politics, reaction to market events and attempts to prevent issues that may arise in the future.

“As a result of these, and other, factors, there will always be differences in opinions between jurisdictions and regulators over how regulation should be applied to FIs,” he adds. “So, in short, we are starting to see industry voices looking to standardise regulations, but clearly there is a long way to go.”

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Fraser Tennant