Pim Poppe

Managing Partner

The risks of regulations and supervision

Risk management and regulations are closely intertwined. Sometimes risk management improves with regulations. Sometimes regulations are just a burden. And sometimes regulations even hurt proper risk management. Right now, we need more common sense and less detailed rules.

As a risk manager, one must think about regulations. Regulations can help one do what is necessary. But at the same time, regulations greatly burdens internal financial and managerial resources. Not complying with regulations even becomes a risk in itself. Furthermore, complying with regulations and capital requirements may also give a false sense of security. We stop thinking.

Therefore, as a regulator and supervisory authority, one must think about the effect of one’s actions on sound risk management.

More regulations

Since the global financial crisis of 2008, new regulations have emerged in all kinds of field. The idea behind this was that accidents should and can be prevented with regulations. This applies in particular to banks, certainly to insurers, but also to a large extent to pension funds and asset managers. Detailed and stringent rules have been introduced for capitalization, liquidity, and stress testing, to name a few.

Obtaining a banking, insurance, payment services, or brokerage license is increasingly difficult. In addition, potential management and supervisory board members are being assessed by supervisory bodies more than ever. The licensing system rule book has expanded, and reporting requirements have exploded.

The density and complexity of the additional financial regulations have had predictable consequences for the scale and scope of the regulatory resources. However, in financial institutions, this growth is even more pronounced. A considerable proportion of employees in the financial sector now work directly or indirectly for regulations concerning risk management.

Good for consultants

As a consultant, I naturally like regulations and the detailed supervision they provide. Many jobs and additional activities have been created, which are beneficial to us, businesswise. We help clients get licenses, build regulatory-compliant risk models, align governance with regulations, and help to report correctly about risks. In that sense, therefore, we, as a risk consultancy firm, should not complain.

Bad for society

As a citizen, however, I wonder whether all of this is socially desirable. Resources have been added to comply with regulations. Resources that society could also use differently. And finally, the client of the financial institution still pays the costs of improperly calibrated regulations. The end customer is the citizen who saves in the bank, the investor in an investment fund, or the pension fund beneficiary.

How can regulations harm?

The first issue which can arise from regulations is the fact that too many regulatory rules are stacked on top of each other: for example, capital requirements, rule books for getting a license, assessment of prospective management and supervisory board members by supervisory bodies, and data-driven reporting requirements.

The second problem is that the calibration of the risk weights and available capital calculations sometimes isn’t realistic. As a result, too much or too little capital must be held. Why, for example, is diversification considered to be in pillar I for insurers and pension funds, but not for banks? How can they both be right?

The third problem is that the level of detail in regulations is disproportionate to the intended effect on risk management.

Finally, risk managers are also changing their behavior. They focus primarily on compliance with the nitty gritty of the detailed rule books. That changes their attitude towards overall risk management and towards the institutes they are working for.

No fit for all regulatory tool kit

A final thought concerns the differences between banks and insurers on the one hand and pension funds on the other. The main difference is that due to capital requirements and improved burden sharing at banks and insurers, the shareholder will be primarily affected by poor risk management. The shareholders, therefore, have the incentive to enforce good risk management. Consumers are more or less safe given the enlarged capital cushion.

In pension funds, there is no shareholder who supplies a capital buffer. If the directors don’t properly manage the fund, the participants will be hurt. They are still on the hook. Therefore, the mix of the regulatory toolkit should be different, and more regulatory scrutiny is needed, because the risk mitigating role of equity and equity holders is missing.

More common sense needed

Overall, it is not easy to design good regulations and supervision. Nevertheless, there is scope to improve regulations by simplifying the proportionality and differences between institutions and sectors. We could also move away from detailed regulations and give more weight to the judgement and discretion of the competent supervisor who understands risks and risk management.

In other words, we need more common sense and less detailed rules. Hopefully, the regulators and supervisors will supply that in the future.