The regulatory landscape is about to see significant change, amidst a turbulent geopolitical environment and evolving perspectives on statutory governance. We’re poised for a wave of reduced regulation in the US and other regions. But, this may not be reflected globally, adding complications to an already fragmented regulatory environment.
Recent studies tell us that the heavy regulatory burden that financial firms worldwide are tackling is seen by some as unsustainable, so it could be argued that the easing of regulations may be advantageous. But, we need to question the longer-term consequences of these regulatory shifts. Maintaining appropriate regulatory safeguards designed to protect financial stability and the resilience of the global financial system is vital.
In this article, we look at the lessons learnt from the global financial crisis and in turn how we navigate an uncertain future to ensure financial firms robustly and proactively manage their risks and controls in this fast-changing ecosystem.
Observations from the global financial crisis
There is no doubt that in the lead up to the 2007/8 global financial crisis, there was a failure of financial regulation as well as a failure within financial firms to manage risks and controls adequately.
Operational losses reported to ORX by some of the world’s largest financial institutions reached a staggering €50bn for the period 2008 – a grim record surpassed only by the losses attributed to payment protection insurance (PPI) failures in 2011.
Figure 1: Annual gross loss per year as reported to ORX including a component arising from two mortgage related conduct event types which can be attributed to deregulation
Among the most notable was the mis-selling of mortgage-backed securities and misconduct related to mortgage foreclosures, both of which can be attributed to deregulation. They resulted in at least €40 billion in costs to firms (as shown in Figure 1) in the years immediately following, along with prison sentences and significant reputational damage. We believe from analysing data from across the financial services industry (including ratings agencies) that operational losses in fact exceeded €100 billion.
This highlighted a critical failure in institutions to challenge their business practices or comprehend the potential risks and losses associated with these schemes. Regulatory bodies, too, fell short in their oversight responsibilities.
The industry losses due to payment protection insurance (PPI) in the UK, though not explicitly related to deregulation, provide another colossal example of internal governance failing to challenge a highly profitable scheme. For both, we saw a significant delay between the period of deregulation/governance failures and the losses materialising. This lag underscores the often slow-moving nature of financial repercussions, contrasting sharply with the rapid collapse of Silicon Valley Bank in March 2023, which highlighted the unprecedented speed at which financial instability can unfold in the digital age.
Efficiency vs regulation
Financial firms have to remain profitable, but history suggests that periods of reduced regulation can lead to significant losses. Balancing effective risk management, operational efficiency, and profitability is crucial. Regulation plays a vital role in maintaining a resilient financial services system. So, how can regulators and financial firms achieve the right balance? It is a complex task, needing consideration and collaboration so that that financial systems remain robust while allowing firms to thrive.
Increased regulatory alignment would certainly be beneficial from a cost perspective – particularly for those firms that operate across jurisdictions. However, in the absence of global agreement, enterprise-wide policies that align with the most common regulatory requirements enables firms to roll out coordinated global initiatives.
What is the path forward?
Regardless of the local or global regulatory environment, financial services firms should be laser focused. given that regulatory attitudes may change again. Firms need to manage the short-term risks of weakening regulation and the potential long-term impact of this being reversed.
As set out in ORX’s strategic vision for the future of operational and non-financial risk, this is an extremely challenging environment. As they drive at pace towards their own digital vision, firms are ever more reliant on their capacity for change, as well as an ecosystem of partners and suppliers.
In developing the ORX vision, it became clear that organisations needed to focus on three areas.
They need to develop a risk framework that balances simplicity, flexibility and consistency with teams that have the right mix of skills and a positive risk culture. They also need to build digital risk capability to match their own digitalisation, enabling data-driven risk management at speed and at scale. And thirdly, they need to have effective insights to drive confident risk-based decision making - from the ecosystem, external environment and emerging risk landscape.
The extent to which regulatory shifts will unfold in the coming months and years remains unclear, but one thing is certain. It is imperative for financial institutions to stay vigilant and adaptive to maintain stability and integrity.
