Regulatory change – a managerial balancing act
I have spent the past four years investigating how banks have dealt with the unprecedented volume of regulatory change since the financial crisis. This is the first of a trilogy of posts which outline some of my key findings. Whilst acknowledging that the current regulatory challenges facing the financial sector are different – Brexit, FinTech, MiFid 2, General Data Protection Regulation – they are all still characterized by a high degree of uncertainty. This was the single most important issue arising from my research, which can therefore give some insights as to how such challenges may be navigated by the financial industry today. If you would like to read the full research report, please email your contact details to firstname.lastname@example.org
Post-mortems of the financial crisis pointed to regulatory failure as one of the key causes of the crisis. Very quickly, the global policy community moved to reform existing regulations and seek new regulatory solutions in a bid to prevent another crisis in the future. The pace and scale of these regulatory changes was unprecedented and even today, the work is not yet complete. In the chaotic aftermath of the financial crisis, banks were faced with significant amounts of uncertainty – the amended rules were unclear, the implementation deadlines were shifting, the impacts of the new rules were unknown and the tougher, more judgement-led supervision was more unpredictable. At the same time, banks that had suffered in the crisis were downsizing, deleveraging and trying to return their organizations back to profit.
It is an oversimplification to claim that the organizational priorities of profit-making and regulatory compliance are always in conflict. However, when resources (both human and financial) are scarce, tensions are more likely to exist between these different organizational priorities. In the post-crisis context, this conflict was further exacerbated by high levels of environmental uncertainty. The ambiguity of the rules lent themselves to multiple interpretations, there was no prescribed template for what constituted compliant solutions and the financial impacts could not be accurately estimated.
Effective management of regulatory change required banks to do two things – they had to find ways to navigate and manage the uncertainty of regulatory change and do so in such a way that balanced conflicting organizational goals. Typically, a distinction is made between risk and uncertainty on the basis that risk is calculable using probability mathematics and uncertainty is not (Knight, 1921). An alternative perspective found in more recent work on organizations, risk and uncertainty is that the very act of using the tools and techniques of risk management is an attempt to effect an uncertainty to risk transformation (Power, 2007). Responses to post-crisis regulatory reform can be viewed from this perspective. Banks used the practices of risk management to manage the uncertainty of regulatory change.
Two key risks are associated with the risk of regulatory change. The first is the risk that changing prudential regulations could have a significant adverse financial effect on the firm, not only because of the costs involved in making the requisite operational changes but also the potential impact on profits and shareholder returns from higher capital requirements. The second is the risk of regulatory non-compliance, which, given both public and political sentiment in the aftermath of the crisis, was potentially higher than it had ever been. Balancing the management of both these risks was a real challenge for the organizations that took part in my research.
To understand better the nature of this challenge and what measures could be taken to address it, I identified the ways in which both of these risks were being managed in similar ways across the UK banking industry. I found that the processes that my research participants described fell into ten categories of regulatory risk management practices. These are shown in the figure below.
Several of these practices offer opportunities for different constituencies within banks to come together and reconcile conflicting priorities. For example, in determining the changes that needed to be made to systems, processes and controls, decisions could be made as to whether the organization wished to invest in strategic solutions to derive benefits over and above compliance or whether work would be done to ensure all the regulatory requirements were met but not exceeded. Ultimately, such negotiations allow a bank to articulate its appetite or tolerance for the dual risks of regulatory change in such a way as to balance organizational priorities.
Knight, F. H. (1921). Risk, uncertainty and proﬁt. New York: Hart, Schaffner and Marx.t
Power, M. (2007). Organized uncertainty: Designing a world of risk management. Oxford University Press