Financial supervision: The future of regulation and technology

@LawAhead

Regulations in the financial sector are in a constant state of growth in the effort to improve the degree of security in banking. How can we keep up with regulations in the financial sector? Here’s how tech is helping us close the gap.

AuthorLuis MaldonadoProfessor IE University and Senior Advisor at everis

Regulations in the financial sector are in a constant state of growth in the effort to improve the degree of security in banking and maintaining financial stability. Regulations are pillars of the sector, meaning that compliance is of utmost importance for future success. Keeping current on regulations proves challenging because they often require an increasing amount of information. Luckily, as regulations advance and multiply, so does technology. Tools such as cloud services and artificial intelligence help organize and supervise hard-to-handle quantities of information and make the sector more efficient.

While regulatory change is abundant across the globe, the EU presents an interesting and noteworthy case. The Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM), and the European Banking Authority (EBA) outline and set the parameters for supervisory guidelines in the EU, combining technological tools with these changes to make complex supervision possible, as explained in the IE Law School and everis joint 2018 report “Technology in banking: the opportunity to comply and complete.”

 

Post-crisis business model

In the wake of the financial crisis, recovery measures were implemented, which have led to improved solvency and liquidity levels; however, as is evident upon examination of EU banks’ return on equity (ROE) (currently 6.6% compared to 10% in 2007), EU banks are still struggling to recover.

The business model has been one of the four aspects of the Supervisory Review and Evaluation Process (SREP), which serves to keep tabs on financial institutions by assessing and grading capital and liquidity. For these tests to be successful, banks rely on technology to provide the examiner with complete and accurate data every year that indicates the institutions’ future expectations.

Decreasing credit risk through risk management

The most important aspect of risk management is the post-crisis buildup of credit risk on non-performing or unpaid loans (NPLs), which make up 4% of all loans in the EU. This means that banks must make increased efforts to lower this number.

There is an inherent technological effect that comes with decreasing these numbers—in this case, it is not only the need for a system to properly classify NPLs but also one that complies with updated reporting obligations. The effect of this demand is worse for institutions that had not previously classified their NPLs correctly. It is now recommended to maintain data on new indicators such as redefault rates, meaning that additional data must be stored.

When it comes to credit risk, default or non-payment becomes relevant. In the absence of regulations in this domain, the EBA constructed guidelines require operational systems to contain more detailed information. Instead of calculating default based on the period of outstanding payment as it was previously calculated, by the year 2020 the significance of the credit obligation must be considered on a daily basis.

A key aspect for supervisors when it comes to risk management is eliminating the possibility of false data, which, in the past, was abundant. The solution came in December 2017 when the Basel Committee on Banking Supervision tweaked the Basel III Accord to limit the use of internal ratings-based (IRB) approaches. At the same time, the European Central Bank (ECB) implemented the targeted review of internal models (TRIM), requiring institutions to have tools that guarantee data quality and system maps to allow the thorough tracing of information.

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An improved yet complicated stress test

In 2018, the EBA performed stress tests on 48 banks in the EU with the goal of providing a common analytical framework to supervisors and the general market to obtain information about resistance to economic shock. The grades received are applied to the SREP performed yearly by the SSM. The current test requests more data than ever, requiring institutions to invest great effort in terms of manpower to organize information and the quantity and quality of their data. This reality sparks the need for advanced tools and control processes. This benefits not only the regulators, but the institution as well because it provides bank managers with the ability to access information that will help them plan appropriately and make informed decisions in the future.

 

The minefield of reporting and its solutions

Reporting is complicated in large part because of the amount of information required. Work has been done to simplify and standardize the process. For example, the AnaCredit system was created to keep a record of bank loans and the Banks’ Integrated Reporting Dictionary (BIRD) to streamline the organization of data and solidify a common language for data transfer, thus simplifying communication between financial institutions and supervisors.

The goal is to improve efficiency of the European Reporting Framework (ERF) by minimizing the overlap of information through coordinating the collection of data that the ECB and EBA require. Big data and new technology make this possible.

Standardized, consolidated regulation that takes advantage of new technology is on its way to creating efficient, streamlined, and accountable financial institutions. While it’s a complicated journey saturated with information and regulatory changes, standardized regulation is a catalyst for positive change.

 

Access the article in Spanish here

Luis Maldonado has developed his career finance, both in the public and private sector. He was advisor to the Minister of Economy in Spain, Director of Strategic Consulting at PwC and CSO for a retail bank. He has also worked for five years at the International Monetary Fund, where he held different positions, as advisor to the Managing Director and in the Monetary and Financial Markets Department. More recently, he was Managing Director of the PwC-IE Business School Financial Sector Center. Currently, he is professor at IE Business School, Senior Advisor at Everis and Senior Digital Financial Sector Specialist at the IFC (World Bank Group). Luis Maldonado holds a Ph.D. in Economics from Alcalá University, he is State Economist for the Government of Spain, and he holds Degrees in Law and in Business Administration from ICADE University.