Regulating financial services in the new reality
Here we are at the beginning of 2021, longing to plan ahead, and yet most of us are still dealing with the here and now and the deep impacts of the pandemic. After the challenging 2020 and a rather rocky start to 2021, it is vital that the financial services sector embraces the evolving new reality. Amid the disruption caused by COVID-19, regulators are seeking to encourage growth and innovation while maintaining their focus on resilience and good conduct. Below are key issues which have been thrown into sharp focus and should remain front of mind.
Remote governance and controls
In response to the immediate impact of COVID-19 lockdown measures, many financial services firms had fared reasonably well. However, the pandemic has revealed that for some, governance arrangements and controls need to be reinforced and enhanced further, and that things might need to be done differently in the future. There are opportunities now to prevent the risk of additional, potentially more damaging impacts from future challenges.
As home working is extended and hybrid working arrangements become the norm, firms need to think carefully about how the firm’s overall culture and purpose can be maintained in order to ensure positive employee conduct.
Strong corporate governance is the glue that holds a firm together and it comes under strain in times of crisis. In response to the pandemic, many firms have recognised the benefits of adopting a more technology-based focus to their governance arrangements. Regulators will be keen to understand how firms maintain robust and objective decision-making in the new environment.
Recalibrating risk and rethinking the associated controls by risk management, compliance and internal audit functions have been challenged by the lack of ability to perform physical oversight in the office. Increasingly new tools and approaches will need to be considered to ensure appropriate support, oversight and challenge.
ESG and climate change
If the pandemic has taught us anything, it is that sustainability will be an imperative in the new reality. No matter how challenging it may be to implement, firms must embrace the challenge.
Various global initiatives are underway to address concerns that not enough companies are disclosing information about their climate-related risks and opportunities. Recognising the challenges that companies are facing in reporting ESG risks, standard-setting bodies are seeking to enhance and align their approaches to corporate reporting, both financial and non-financial.
European financial regulators are calling on firms to include ESG factors in their risk frameworks and in stress testing exercises, and in their investment processes, product governance and disclosures. Firms and regulators are aware of the significant challenges involved. Quantification of ESG factors is complex. There is a significant data challenge and methodologies and tools to estimate scale and impact are still evolving. Despite this, firms are expected to engage, and to act now.
Ensuring stability and resilience
With ongoing concerns about the potential impacts of the rate of economic recovery and heightened credit risk, regulators are undertaking further analyses and are contemplating additional requirements.
Some issues such as the transition from LIBOR to risk free rates (RFRs) and liquidity management in open-ended investment funds were already on regulatory agendas, and the pandemic has renewed determination to pursue these further.
Although financial markets have recovered to almost pre-crisis levels, there are continuing concerns about the decoupling of financial market performance and underlying real economic activity. Regulators are reviewing, collectively and separately, the “pinch points” or vulnerabilities in market-based finance or non-bank financial intermediation.
Whilst capital and liquidity ratios remain robust, there are early signs of deterioration in asset quality for some banks. Increases in non-performing loans are expected as the pandemic persists, and many of the impacts are yet to be realised. Bank consolidation, particularly in the Eurozone, is likely to increase. Profitability challenges, including the need to reduce costs while embracing new technologies, are growing. And regulatory expectations around ESG, operational resilience and implementation of remaining Basel reforms add to the burden.
As governments and businesses start to refocus on the future rather than immediate crisis response measures, financial services regulators are also moving into a new phase of adjustment and support.
The prime roles of technology and operational resilience
COVID-19 has been a catalyst for rapid adoption of technology bringing change on a greater scale and at a faster pace than any firm’s own strategy or any regulatory initiative. Accelerated deployment in the first lockdown effectively implemented years of change in just a few months, as firms moved to, and continue to operate, large-scale remote working. Regulators recognise the benefits of new technologies and the need for innovation but are concerned about new and heightened risks.
The fundamental building block behind all technologies and digitalisation is data. Firms need to ensure the integrity of exponentially-expanding databases and that they have the expertise to store and manage them. This includes balancing the need both to protect customers’ and market sensitive information whilst potentially delivering services across borders to maximise efficiencies. Increasingly firms will need to demonstrate they use data ethically and to have robust governance and controls in place regarding their use of data.
Firms have always been expected to manage their operational risk, plan for contingencies, and have in place back-up systems and disaster recovery plans, but in the new reality, true enterprise resilience is much more than this. Governance and accountability is key. Firms are expected to plan for when, not if, disruption occurs and to articulate in detail how they would be able to recover or maintain continuity of critical services. Operational resilience requires clear understanding of end to end processes for firms’ most important services and the impact that disruption to these would have on customers and the wider financial sector. Regulators are increasingly focusing on digital resilience and third party dependencies.