As the global expansion slows and western economies slump toward recession, supervisory authorities face a perfect storm of challenges.
Repeated stress tests indicate that banks’ and insurers’ capital stacks are sufficient to withstand a strong credit shock. But observers worry about the lesser-understood risks. Sector-wide resilience is one of the bigger question marks.
Any issues will be laid at the feet of the supervisory authorities, so it is crucial for them to begin to tackle the difficult questions now. We’ve prepared a quick health check to help financial services supervisors get ahead of the challenges and prepare for tomorrow.
Don’t get too comfortable
The financial world has evolved considerably in the past few years. Despite the “crypto winter” of 2022, digital assets are becoming an increasingly important part of the investment universe. Central bank digital currencies are already on the horizon for some major economies. In the payments space, new entrants and products have redefined the value chain over the past few years.
At the same time, the focus for supervisors has been on balance sheet incumbents — that is, large, established banks, insurance companies, and asset managers — whose value share of traditional financial services has gone down from 90% to 65% over the last decade, according to Oliver Wyman’s State of Financial Services Industry 2022 report.
The potential consequences of a weakness or even a failure in the financial services industry could further destabilize an already weak economic situation.
Supervisors need to keep up with the current, changing situation while preparing for tomorrow. The danger is that the economic tailwinds (rising interest rates, volatility in the fintech market, return of customer trust) provide a pause in the shift in the financial services ecosystem’s move away from the traditional balance sheet incumbents. In turn, this pause could give the supervisory authorities a false sense of comfort that they are ready for the evolving financial services world.
Get ready for tomorrow
In the decade following the global financial crisis (GFC), regulations and supervisory authority tools were strengthened substantially, with Basel III at the center of the prudential regulatory approach. In addition, the supervisory approach for many advanced economies now includes an explicit conduct element to the existing prudential focus.
This new focus has dealt with some egregious instances of the mis-selling of financial products, such as insurance as a non-optional add-on to credit card bills in the United Kingdom. However, the main focus has been on traditional risks generated by the activities of balance sheet players.
Data and technology have driven a marked shift to capital-light services with a different set of winners: almost a third of the top 50 financial institutions are data and technology firms, not the traditional financial services balance-sheet focused entities. The sector is entering uncharted waters of rising interest rates and inflation after an unprecedented decade of ultra-cheap money. It is not just commercial entities that are facing the unknown, but also the supervisors of the financial services sector.
Supervisors face some of the same internal pain points, problems, and issues that we see in incumbent, balance-sheet focused, regulated entities. However, unlike regulated entities, there is no supervisor for the supervisor. Thus, we pose six questions for financial services supervisors that can serve as a guide heading into 2023.
1. Are the risks covered?
Immediately after the GFC, the regulated entities were roughly 65% of the financial services ecosystem. Thus it could be argued that most of the possible risks were covered. However, Oliver Wyman calculations show that currently only 35% of financial services entities are regulated. A first question in the supervisor’s self-assessment would be to ask which risks are covered currently by the regulated and supervised entities, and which risks are missing.
2. Whose risk is it?
The organization of supervisors is generally a matrix, with the firm types (large banks, life insurance, market infrastructure) representing one major axis and the other organizing elements being a mixed bag including the risk supervision area (such as bank stress testing, fundamental review of the trading book) and supervisory activity (authorizations, sandbox, resolution). This results in organizational silos and pockets. In today’s world of a connected ecosystem with holistic risks, supervisors need to ask who pulls risks across the full ecosystem together and understands what a real threat to the system would be.
3. Are you getting it all done?
Many supervisors are operating with a technological infrastructure that is significantly out of date, suffering from similar issues as regulated incumbents. This includes monolithic and inflexible systems and systems that do not interact with each other, populated in places with inaccurate, incomplete, and out-of-date data. With data and technology firms now driving the value creation —and potentially the risks — in financial services, making full use of all available data and information in a timely manner is essential to understand the risks of the sector and respond to them.
In today’s data-driven world, being able to effectively make sense of all available information and spot patterns early is being increasingly driven by artificial intelligence. Buy now, pay later algorithms and the use of unstructured data to inform and improve expert-driven credit models are two examples. This is achieved by creating integrated teams of subject and data experts to produce such models. Automating the use of the models brings significant efficiencies.
Supervisory authorities need to prioritize getting fit-for-purpose infrastructure in place and becoming comfortable having much more flexible, cross-functional teams.
4. Are you fast enough?
During the initial COVID-19 crisis, supervisory authorities moved quickly; the UK Prudential Regulation Authority, for example, allowed banks to draw down on their countercyclical capital buffer on March 9, 2020. However, supervised firms often receive feedback on a supervisory visit or the results of a supervisory review or waiver application many months after the initial event for feedback. The eventual conclusion could take more than a year after the initial communication. With the financial services world moving ever faster, supervisory authorities must ensure they can keep up with the developments.
5. Low risk tolerance — a camel for the jet age?
The current supervisory processes and approach have come about by adding new parts to the process when new risks appear and lead to new regulatory tools. It is questionable that such a layering-on approach has produced the most effective and efficient supervisory processes — and whether continuing in such a vein will provide the best approach for supervising the evolving financial services industry.
6. Is your mindset up to date?
Our transformation work with supervisors has shown that changes need to be made carefully and by taking staff along on the journey. Doing things quicker, with less governance and relying more on data and technology, has many benefits but requires a higher risk tolerance at organizational and individual levels. Supervisory authorities must ask themselves how they can manage the shift in mindset that allows their supervisors to be more empowered.
No rest for the weary
In today’s fast moving, data-driven world, supervisors cannot afford to stand still while the industry evolves around them. With today’s budget problems, throwing money to add resources is not an option. Asking the tough questions today is a necessary first step to better supervising the industry tomorrow.
Discussions with Miriam Martin, Dom Weh, Maria Fernandes and several supervisors also contributed to this article.