Technology and Regulation: A chicken and egg situation?

Last month, the International Federation of Accountants (IFAC) and the OECD’s Business and Industry Advisory Committee (BIAC) published a damning report on the cost of regulatory divergence in the financial sector. The survey of over 250 experts and business leaders revealed that financial institutions on average lose 5% to 10% of their annual turnover because of having to reconcile different legislations in their transactions. This amounts to no less than US$780bn a year.

Over the past five years, over half (51%) of financial institutions surveyed have had to use resources they could have directed towards risk management, growth or innovation to deal with inconsistencies in international regulations, particularly in the area of competition law, market-based regulation, and consumer protection. Inconsistencies arise from different regulatory frameworks or definitions and different approaches to the same issue, but even in countries that had adopted the same rules, there were costs associated with duplicative reporting requirements or varying interpretations of the regulations.
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To manage this, financial institutions have had to hire more compliance staff, invest in training and efficient IT systems, and use external consultants. Banks were the second-most affected segment after capital market respondents, with almost 80% reporting material or very material costs derived from regulatory divergence, while over 50% of asset managers also felt that pressure.
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Worryingly, 65% of organisations surveyed expected these costs to increase further in the next five years, due to the resurgence of protectionist policies around the world.

According to the report, this could all be avoided with better co-operation among regulators, enhanced alignment of rules and definitions, and increased transparency in how new regulations are developed. There’s one thing that the study doesn’t mention, however, and that is the potential that technology presents to solve this problem.

Machine learning solutions can register detailed regulatory information, keep systems up to date automatically, and include compliance checks into transaction processes, removing the need for time-consuming manual verifications. The growth of this sector in recent years has resulted in the emergence of “regtech” or regulatory technology, as a buzzword.

In trade finance in particular, regulatory costs and oversight have been blamed for a significant reduction in correspondent banking relationships, making it more difficult for emerging market corporates to access the funding they need to sell across borders. But technological progress and advances in artificial intelligence (AI) have shaped the beginning of a solution to these issues, by harmonising language, infrastructure and transparency for financial institutions big and small.

In a recent report, the Centre for Global Development hailed the potential of new regtech tools such as machine learning, biometrics, big data, know-your-customer (KYC) utilities, blockchain and legal entity identifiers (LEIs) to limit the de-risking of banks. It added, however, that to maximise the advantages of this technology, policymakers would need to invest time in understanding how it works, and come up with the right regulatory framework to enhance it.

Technology, therefore, can solve issues of regulatory divergence, but for it to work, it will require some level of regulation itself. How will the financial sector solve this Catch 22?