Tying Regulation to Innovation

There is no doubt that the regulatory burden on financial services firms is fatiguing and it is not surprising that most struggle to keep pace in the race for compliance. The past few months have seen the Capital Requirements Directive (CRD)3 implemented, and soon we will see components of Basel III/CRD4 come into effect alongside the Markets in Financial Instruments Directive (MiFID) II, Solvency II, and Dodd-Frank for US firms. Firms in the UK must also prepare for potential increases to Tier 1 capital ratios, as well as the widely-debated Financial Services Authority (FSA) consultation paper on banking reform and retail ‘ring-fencing’ proposed by the Vickers report.

Across this spectrum the price of compliance is staggering. Indeed, JP Morgan expects that across the 16 largest global banks between US$110bn and US$221bn of additional capital1 will need to be raised in 2011 and 2012 to meet the new requirements.

On top of this there is the considerable cost of implementing processes and procedures in order to satisfy the plethora of regulatory requirements. However, the impact of this regulatory pressure is felt not only in monetary terms.

The Limitations of Compliance

It goes without saying that the most inefficient way to comply with new regulations is to layer new technology and processes on top of existing systems. Yet this is exactly how most financial services firms choose to operate. Complexity is mainly added and rarely, if ever, is it removed.

The increasingly apparent challenge is the need to drive more fundamental and widespread change, not only to reduce this spaghetti of systems and processes, but also to drive more innovative ways of responding to regulation. Put another way, well managed regulation responses, could actually begin to promote, rather than suppress, a company’s ability to differentiate themselves and compete in the marketplace.

Can Regulation Really Drive Innovation?

Regulation is often viewed across financial institutions’ different business functions as simply something that needs to be done; rarely is it connected to the strategic business agenda. However, regulators are increasingly recognising the role specialist bodies can play in revolutionising the way financial products and services are created, delivered and managed in the market. The FSA consultation paper CP11/9, for example, cites the “desirability of facilitating innovation in connection with regulated activities.” The Treasury Select Committee is also strongly anticipating the impact regulation will have on sources of competitive advantage, including that of infrastructural interoperability.2

First Things First: The Role of Risk Managers

The role of the risk manager is to assess, monitor and control business activities in light of regulations, the firm’s risk appetite and wider market conditions. Regulations remain complex to interpret and responsibility to do so is increasingly sitting with the risk manager: counterparty risk regulations sits with credit risk managers; changes to liquidity regimes sits with treasury risk managers; and anything which impacts value-at-risk (VaR) sits with market risk managers.

However, given the significant impact that regulatory demands place across financial services firms as a whole, risk managers need to reflect on the diverse drivers of change and begin to engage with a wider set of stakeholders.

Table 1. Regulatory Demands and Stakeholders

Regulatory Demands Change Drivers Wider stakeholders
VaR Market risk Front office, credit risk, finance
Credit or counterparty risk Credit risk Front office, regulatory engagement, market risk, finance
Liquidity Treasury Front office, market risk, shareholders
Operational risk Operational risk Facilities, IT, HR
Structural risk/reform Compliance Front office, operations, treasury, market risk, credit risk, operational risk

Source: Baringa


What this highlights is the potential for a broader group within financial institutions to come together and develop a more appropriate response to new regulations and, in particular, bridge the gap between risk management, product development and operational change.

Bringing Product Innovation Full Circle

It seems perverse that while the majority of regulatory change stems from the desire to bring about improvements for consumers – be it around specific failings of certain organisations or lack of investment-led protection – the way that products are created, structured and delivered all too often fails to keep pace with retail clients’ own demands for change.

The traditional model of creating products before ‘pushing’ them through a compliance process means that many firms are missing the opportunity to critically assess the combined impacts of consumer and regulatory demands to drive more suitable product and service offerings, and hence improve their value proposition in the marketplace.

Redefining Organisation-wide Operating Structure

Arguably, the most significant opportunities presented to financial institutions today, as a result of regulatory reform, are those that necessitate enforced structural change. While much time has been devoted to critiquing or assessing the impact these reforms will have, what is more important are the clear opportunities to drive greater synergies across financial services firms if they can be encouraged to seriously consider ‘functional subsidiarisation’, essentially the separation of operational activity from specific business activity in the front office.

For more than 15 years, financial institutions have driven infrastructure initiatives aimed at improving efficiencies and lowering structural cost base: ‘rightshoring’ and outsourcing have been widely used within all but a few of the larger organisations. However, these practices are often implemented in silos. Only a select few have truly driven functional change and consolidation on a pan-business, global basis. There remains significant scope for further efficiencies across common functions such as payments, reconciliations, reference data, securities, operational lending activity etc. Ultimately the goal is to drive greater shareholder value in a way that has not been palatable to many in the past and, if regulation can act as a catalyst to do this, then regardless of wider challenges, firms would do well to embrace this change and turn it to their advantage.

Embracing the Opportunity: What’s Needed?

Today it is a rarity that regulatory reforms are assessed in terms of their impacts across firms as a whole, including wide-scale engagement with the wider stakeholders that are affected. What’s needed is a ‘regulatory change body’ spanning all operations of the firm, in a way that is appropriate and tailored to the uniqueness of each firm, that is ready to assess the impact of new regulations and steer the resulting changes front-to-back.

Such an initiative is critical in enabling not only compliance, but also opportunities to innovate across risk management, product offerings and operations. This body should be mandated to deliver holistic change. It requires real teeth, coming from active senior engagement, reporting directly to the chief executive officer (CEO) and the ability to enforce strategic transformations rather than apply series of plasters.

Only by assessing the impact of regulatory challenges across business, people, processes and technology throughout the whole organisation, can effective change strategies be delivered. No fiefdoms, no compliance strategies which just push the problem to another part of the firm; just wholly integrated change with no agenda other than the most efficient compliance which carve out a unique position in an ever-more competitive market.

1“Doomsday Regulation Scenario Laid Out”, February 17 2010.

2Treasury Select Committee, “Competition and Choice in Retail Banking”, April 2011.



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