Regulatory change requires companies to implement systems to analyze regulation.
Bart Chilton, a former commissioner of the U.S. Commodity Futures Trading Commission (CFTC), once said that loopholes in the implementation of financial regulation would always exist because the economic power of Wall Street is disproportionally stronger than that of the regulatory agencies.
Whether Chilton’s statement is valid, its underlying logic is easily identifiable: as long as government agencies perceive that firms are exploiting financial regulatory loopholes, regulators will respond with new regulations. In addressing the challenge of continual regulatory transformation, financial services firms will need a means of systematically assessing the risks of new financial regulations and engaging constructively with regulators to influence the policy-making process.
The post-2007 financial regulatory landscape has drastically shifted in its scope, reach, and enforcement as a response to the systemic failures during the global financial crisis. Financial regulation has been a key driver for identifying the deficiencies of the pre-2007 financial system and for building a new structure aimed at safeguarding systemic stability by defining specific objectives and imposing stringent requirements. But, in the process, the economic value of financial services firms has been downwardly affected. It is estimated that financial regulation will cost a financial services firm up to 3.5% in pre-tax return on equity on average.
However, the current financial regulatory landscape makes financial services firms face much more than compliance costs and divestments from business lines due to shrinking profit margins. Indeed, the post-2007 financial regulatory landscape is characterized by an unprecedented period of transformation and uncertainty. One indication of this uncertainty is the amount of unpublished regulatory information, such as government manuals or internal policies.
Financial services firms are always aiming for increased profitability. But how easy is it to define business strategies and to reach profitability when navigating a landscape of “known unknowns?” The solution: financial services firms need to embed financial regulation within their business strategies, increasing regulatory predictability through early warning systems and using their senior executives to influence regulatory policy-making.
Financial services firms can maximize their long-term value by embedding regulatory uncertainty within their business strategies. These firms are already implementing new risk management frameworks characterized by strengthening:
- information technology infrastructure across business lines to reduce cost redundancies. This enables financial services firms to enhance data integrity and reporting and obtain a more granular level of information so as to achieve informational advantage within the marketplace; and
- regulatory risk management that aggregates exposures across all business lines to enhance decision-making and scenario planning. This enables financial services firms to optimize capital management and access diversified and contingency funding sources.
However, financial services firms need to go two steps further to address the uncertainty in the financial regulatory landscape. These two steps are: (i) implementing a financial regulatory early warning system; and (ii) implementing a financial regulatory government-affairs function. Financial services firms need to have a clear understanding of the determinants of the financial regulatory environment in which they operate in order to examine the value at stake, as well as the level of uncertainty for each regulation and the positions of the main stakeholders.
One key step to help financial services firms in gaining a competitive advantage in the marketplace is to implement technology products that can help assess the likelihood and risks of changing financial regulations. Financial services firms can implement early warning systems through advanced analytics that quantify the macroeconomic effects of unanticipated movements in the financial regulatory landscape so as to help devise sound scenarios to inform their business strategies.
In addition, through data mining, financial services firms can implement pattern recognition-based algorithms for clustering and selecting relevant data about financial regulation. This can serve to avoid missing regulatory deadlines, predict the nature of the financial regulation to emerge from the political process, or determine boundaries of systemic risk (which can also inform future financial regulatory requirements).
Financial regulation is a dynamic tug-of-war that contains recognizable elements that can be leveraged for predicting its future. Once early warning systems are in place, the organizational capabilities of the financial services firms will translate the modeling outputs into tangible business actions to drive profitability.
Another key step is for the financial services firms to implement or improve the governmental affairs function within the firm so that the firm can better influence the policy-making process. The main aim of the governmental affairs function should be to engage constructively with the regulator by agreeing upon trade-offs between divergent stakeholders’ interests. The key is to build a human-capital heavy function that is composed of people who can seize and exploit the socio-political determinants behind financial regulation and gather a deep understanding of the main stakeholders’ interests.
Once this governmental affairs function is set into place, it then becomes imperative to embed it within the firm’s business model so as to ensure both a constant communication flow with senior executives and to ensure that its vision and actions are shared across the organization. Senior executives should also engage regularly with regulators.
Financial regulation is one of the main catalysts in reshaping the balance of powers among market players. Therefore, managing the uncertainty it creates is a key objective for market players, helping them defend or even strengthen their sector positioning. Indeed, as the financial regulatory landscape continues to evolve, firms need to redefine their business models by making them more internally coherent and flexible in relation to external forces. Concretely, this means that financial services firms will have to embed financial regulation within their business strategies, implementing early warning systems and enhancing the governmental affairs team so that it serves as the strategic arm of senior executives for influencing regulatory policy-making.