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"Stakeholders are demanding effective governance,
including enterprise risk management, transparency, accountability, and optimized
performance. At the same time, globally integrated markets are imposing increasing
volumes of regulations. Successful companies address these challenges by proactively
managing performance across the enterprise with risk-balanced strategy management, and
risk-based controls embedded in business process areas ranging from financial to human
resources, environmental to trade management."
Source: SAP
From Burden to Benefit: Making the Most of Regulatory Risk Management
Regulatory Risk Management is also known as :
Financial Business Risk Management Software,
Enterprise Risk Management,
Risk-balanced Strategy Management,
Risk-based Controls,
The Risks Associated with Regulation,
Workforce and Environmental Regulation,
Credit Risk Management,
Business Risk Management,
PPM Project Risk Management,
Category of Risk Management,
Risk Management Assessment,
Audit and Reporting Regulation,
Lack Accountability and Transparency,
Financial Services Industry,
Conflicting Compliance Obligations,
Risk Management Solution,
Growing Compliance Burden,
Risk Management Service,
Risk Management Process,
Unfamiliar Regulatory Frameworks,
Risk Management Software,
Risk Insurance Management,
Quality and Quantity of Regulation,
Multiple Regulatory Bodies,
Companies Support the Concept of Regulation,
Account Off-balance Sheet Vehicles.
Introduction
It is an irony of modern business that regulation, a concept designed to reduce risk by protecting the
interests of corporates, customers and society at large, has itself become one of the most serious
risks that companies face. From dealing with unfamiliar regulatory frameworks in overseas markets to
scanning the environment for new threats, regulatory risk management has become a time-consuming
and costly activity that demands board-level engagement and a rigorous approach.
Executives have long complained of a growing compliance burden but, in recent years, their protests
have become increasingly vocal. Both companies and industry groups have pointed out that regulation
can sometimes be disproportionate, inconsistent or lead to unintended consequences. In some cases,
they may feel that regulators can lack accountability and transparency, or that insufficient consultation
takes place before new rules come into force.
There is also the issue of complexity. As businesses around the world deepen their international
reach, they fall under the influence of new regulatory environments, which can lead to a proliferation of
overlapping, possibly conflicting compliance obligations. Extended business networks and supply chains
add an additional layer of risk. If a partner fails to comply with some aspect of regulation, it is not just the
company at fault that can suffer reputational damage, but the organisations that contract with it as well.
Increasingly, therefore, companies must take heed not just of their own compliance, but that of the key
companies with which they deal.
For companies in the financial services industry, the problem of regulatory complexity is of particular
salience. As regulators prepare their response to the worst financial crisis in a generation, it is highly
likely that the sector will face a new set of constraints, possibly involving measures such as tighter
liquidity requirements or higher capital ratios to take into account off-balance sheet vehicles.
Otherheavily regulated industries, such as pharmaceuticals and utilities, have also traditionally borne a heavier
burden than most, as have small businesses, which may lack the resources to deal with time-consuming
and costly form-filling and inspections.
Ultimately, however, no company is immune from the impact of regulation. At one level, it is clear that
business bears a significant cost in its efforts to comply with rules promulgated by governments and
regulatory bodies. For example, according to the British Chambers of Commerce, the cumulative cost
to business of new regulation in the UK since 1998 is £65.99bn. The scale of the regulatory sector was
indicated by the Hampton Review, published in 2005 to consider the scope for promoting more efficient
regulatory approaches. It found that, in the UK alone, there are 674 national and local regulatory bodies,
which together employ 61,000 people.
Whatever the direct costs of dealing with regulations, the extent of the burden can vary considerably
depending on a firm's specific approach to addressing its obligations. Some companies will have a
streamlined, highly efficient system for managing their international compliance requirements. By
adopting a unified approach to regulatory risk management, companies can
minimize costs, maximize
efficiency and reduce their risk exposure. Such firms, though, are in the minority. More often, there is
considerable duplication of cost and effort as organisations attempt to deal with the requirements of
multiple regulatory bodies across their operations.
In order to assess current concerns and approaches to regulatory risk management, the Economist
Intelligence Unit conducted a survey of senior professionals with responsibility for risk on behalf of Ace,
KPMG, SAP and Towers Perrin, and held an advisory board meeting of senior risk executives to discuss the
survey results and provide further input. From this process, a number of key findings emerge:
Companies support the concept of regulation but, as a category of risk management, it causes
grave concern.
Despite all too common protests from corporates and industry groups about regulatory creep and
compliance costs, the overall sentiment among respondents to our survey is that regulation has a positive
impact on business. Just one-quarter agree that regulation does more harm than good, reflecting a
strong consensus that an effective regulatory regime is a necessary feature of the economic landscape.
Nevertheless, it is clear that the risks associated with regulation are severe. The Economist Intelligence
Unit's Risk Barometer, (an index that tracks major business threats on a quarterly basis) shows that
regulatory risk is seen by executives as the most significant threat to their business, ahead of country
risk, market and credit risk, IT and people risks, or terrorism and natural disasters.
How did a concept that has broad support from industry, and which is designed to protect them against
unfair competition and nefarious business practice, end up topping the list of risks that companies
face? Part of the answer must lie in the quality and quantity of regulation being promulgated around the
world. For example, many businesses in the US are still reeling from the impact of the Sarbanes-Oxley Act
of 2002, a hastily devised set of rules enacted in the wake of the Enron scandal that compels company
directors to provide evidence of probity on a range of issues. Today, even one of the architects of the Act,
Michael Oxley, admits that the legislation that bears his name may have been fl awed.
A second issue is the sheer volume of regulation that companies must deal with, particularly if they
operate internationally. Among our survey respondents, audit and reporting regulation tops the list
of the most resource-hungry category by some margin, no doubt reflecting the significant investment
that has been made to deal with regulation such as the Sarbanes-Oxley Act, the International Financial
Reporting Standards, Basel II, Solvency II and other such major initiatives. Workforce and environmental
regulation are also prominent on the list, however. In the European Union, working time directives
have led to significant costs being borne by business, while environmental legislation such as the Waste
Electrical and Electronic Equipment Regulations (WEEE) has also had a costly impact.
In some jurisdictions, there is a clear distinction between regulations that are controls - binary rules
that are either complied with or not - and regulations that are principles-based, which may be subject
to judgment calls. For example, the UK has a stronger culture of "comply or explain" than the US, where
regulation tends to be rules-based. For companies that operate in multiple jurisdictions, there is often a
requirement to get to grips with this cultural variation, in addition to the scale and scope of regulation
itself.
The key problem with managing regulatory risk is complexity.
If one word could sum up the problems that respondents face with managing regulatory risk, it is
"complexity". Individual regulations may overlap or conflict with others, or be difficult and
time-consuming
to implement. As a company grows or expands into new geographical markets, it must contend
with additional regulatory environments. And as its business encompasses more and more partner and
supplier relationships, it must be aware of the compliance capabilities of those organisations as well as its
own.
It has become a fact of life that businesses must juggle multiple compliance priorities, and it seems
that this is a major obstacle to managing regulatory risk effectively. Two-thirds of respondents point to
the complexity of the business environment as being the main factor that hinders their ability to manage
regulatory risk, while just under half point to the lack of regulatory
harmonization between jurisdictions
as being a key hurdle.
Regulatory risk management is consuming a growing amount of time and resources.
New regulations, increased business complexity and the need to deal with rules in multiple environments
are forcing companies to spend more time and resources on managing regulatory risk. More than eight in
ten respondents say that they have increased their focus on regulatory risk issues in the past three years,
and a similar proportion expect this trend to continue over the next three years. Although this theme is
common across all industries, respondents in financial services appear to be most affected, with 56%
having allocated a significantly greater amount of time and resources to regulatory risk in the past three
years, compared with 32% from other industries.
It is clear that regulatory risk is an activity that attracts the support of senior managers, and to which
companies are prepared to devote substantial financial resources. Asked about the factors that might
hinder their regulatory risk efforts, insufficient budget and inadequate support from senior management
score towards the bottom of the list. These findings suggest that business leaders recognise the
importance of the issue, but also that there is little appetite for scaling back expenditure on managing
the risks.
That regulatory risk management has the ear of top executives is also apparent from the seniority of
the individuals that have overall responsibility for the activity. Among companies questioned for our
survey, it is almost universal for a C-level executive to have oversight of regulatory risk management, and
more often than not, this is the chief executive, the chief risk officer or the chief financial officer. It is
extremely unusual for responsibility to be delegated to business unit heads or regional directors.
Regulatory intervention in the financial
services sector
Since August 2007, the financial services industry
has been in the grip of the worst crisis for more than
a generation. Major write-downs on asset-backed
securities have led to the collapse of US investment bank
Lehman Brothers, the near-collapse of several other
major institutions and a sustained slump in liquidity,
bank lending and share prices.
Although the causes of the credit crisis are by no
means straightforward, poor regulatory architecture
and ineffective regulatory oversight are undoubtedly
perceived as playing a role. On the former, US Treasury
Secretary Hank Paulson has proposed a move away
from the current, fragmented US regulatory system
to one where there are fewer regulators with broader
powers. On the latter, the debate continues and, to
date, regulators have been careful not to jump to policy
conclusions. As the Bank of International Settlements
noted in its recent report: "Implementation will...
face many difficulties, not least the need to avoid
exacerbating near-term market tensions in the pursuit
of laudable medium-term objectives."
Ultimately, however, a substantive regulatory
response to the crisis seems inevitable. The
respondents in our survey who represent the financial
services industry expect intervention in several key
areas. In their view, the most likely initiative will be to
impose new liquidity standards. In June this year, the
Basel Committee issued new principles for governing
liquidity that include the requirement that banks
should hold "a robust cushion of unencumbered,
high-quality liquid assets to be in a position to
survive protracted periods of liquidity stress". The
regulators hope to turn these principles into binding
legislation by the end of 2008, so it seems certain that
a requirement for more generous liquidity buffers will
soon be in place.
Three-quarters of respondents expect higher
capital ratios to take into account off-balance sheet
vehicles. Since August 2007, it has become clear
that regulators have been wrong-footed by the rapid
development of the so-called "shadow banking"
system, a sprawling network of opaque entities, such
as structured investment vehicles and collateralised
loan obligations, that are not recognised on banks'
balance sheets. By early 2007, the shadow banking
system had accumulated almost US$10 trillion in
assets, which was roughly equivalent to those held by
the traditional banking system at the time. Yet despite
their colossal size, these vehicles fell largely outside of
regulators' radar. With assets in the shadow banking
system in free-fall since last August, it seems highly
likely that regulators will expect banks to carry higher
capital ratios that take into account the existence of
these off-balance sheet vehicles.
There are also high expectations among
respondents that the loan origination process will
face stricter regulatory controls. Many commentators
have described how the process of securitisation,
whereby loans were packaged and sold to third-party
investors, went hand in hand with a decline in lending
standards, because loan originators no longer had
an incentive to ensure the creditworthiness of their
borrowers. Recent scrutiny of the sub-prime market
has revealed widespread malpractice in a sector that
has been, to date, lightly regulated. It seems highly
likely, therefore, that loan originators will be subject to
tighter controls in the future.
One potential regulatory initiative that has
attracted considerable attention in recent months
is notable by its lack of support among survey
respondents. Just 15% expect intervention in the
remuneration of banking professionals, despite
widespread sentiment that the bonus culture,
particularly in investment banks, has exacerbated
the current situation. Although most would agree
that short-termism and the encouragement of
excessive risk-taking in anticipation of rewards are
problematic, regulatory intervention in remuneration
will not be straightforward. Indeed, regulators such
as the Financial Services Industry in the UK have
already stated that it is not their role to intervene in
the quantum or design of remuneration systems. A
more indirect route, however, whereby remuneration
practices are considered as part of a bank's overall risk
profile, may well be considered.
There is overall satisfaction with the way in which regulatory risk is managed, but certain
weaknesses and inefficiencies persist.
The extent of resources allocated and strength of board-level support suggest that regulatory risk
management is a relatively mature activity in most organisations. In general, companies rate their overall
capabilities highly, with 70% claiming that they are successful at ensuring compliance with regulations.
There also seem to be established channels for communicating regulatory risk information to the board,
with 60% rating themselves as successful in this area. Communication with regulators also appears to be
good.
But this overall picture of strong performance must be set against a number of specific weaknesses.
The challenge of dealing with multiple regulatory environments, both domestically and internationally,
presents difficulties to companies as they attempt to run projects and initiatives as efficiently as possible.
It is interesting to note that, while companies are comfortable with their overall compliance capabilities,
they perceive juggling multiple projects to be their second biggest weakness, with just 28% seeing
themselves as successful in this area.
The difficulty of juggling multiple compliance projects may encourage companies to take a belt
and braces approach to resourcing the activity on the grounds that it is better to spend more than
is absolutely necessary than run the risk of non-compliance. Equally, however, a proliferation of
new regulations often leads to inefficiency as companies bolt on new teams to deal with emerging
requirements. Either way, the upshot is duplication of effort. Indeed, more than half of respondents
say that this is one of the main costs associated with regulatory risk, and just one-quarter consider
themselves to be successful at minimising duplication in multiple environments.
Today's complex business networks add new layers of regulatory risk. It is one thing for a company
to manage the multitude of compliance projects within its own walls, but what about the regulatory
obligations of its partners and suppliers? Consider, for example, a manufacturer that relies on a partner
to create components for its products. If the components are non-compliant, then the manufacturer's
product is also in breach, and this creates serious reputational and financial implications.
Certainly, respondents see this aspect of regulatory risk management as a key area of weakness: just
three in ten respondents rate themselves as being successful at gaining visibility into compliance within
the partner network or supply chain. Moreover, few conduct frequent checks into the compliance of
companies with which they work. Just three in ten request formal details of compliance from key partners
on a regular basis, while the remainder seek this information only during the due diligence process, on an
ad hoc basis or not at all.
Companies plan to invest in people, processes and technology to improve regulatory risk
management.
We have seen already that companies expect to increase the resources that they allocate to regulatory
risk management, and that they recognise weaknesses in their current capabilities. Given these two
findings, to which areas are organisations most likely to direct their attention as they seek to improve the
management of their regulatory risk exposure?
Respondents to our survey point to three main areas of focus. In order of priority, these are people,
processes and technology. Investments in people could take two forms: recruitment to bolster numbers,
or training to improve capabilities. Among our respondents, it is the latter that is seen as a higher
priority, with 62% expecting to invest in training of compliance professionals over the next three years,
and 29% planning to increase headcount. This suggests that most companies are seeking quality rather
than quantity in their compliance teams, and that they hope to maximise the capabilities of the human
resources they have rather than invest in new personnel.
For many organisations, issues around duplication of effort and the inefficiency of business processes
are an unfortunate side-effect of the complexity of the regulatory environment. In this sense, external
complexity leads to a kind of self-imposed complexity as companies seek to juggle multiple priorities
without thinking through ways of rationalising and streamlining the process. It is interesting to note
that, at present, less than one-third of respondents say that they have a single, unified approach to
managing multiple regulatory initiatives. Although there are clearly differences between individual
regulations, there are also many shared attributes, and those companies that adopt a more unified
approach are likely to reap benefits in terms of greater efficiency, reduced expenditure and, ultimately,
diminished risk exposure. The formalisation and documentation of compliance processes, which just
under half of respondents say that they plan to adopt, is an important step on the way to greater
unification of compliance activities.
The role of information technology in ensuring compliance is widely recognised, with two-thirds of
respondents agreeing that IT is an essential tool for managing regulatory risk. In the next three years,
41% plan to invest in new technology to facilitate compliance, rising to 50% among respondents from the
financial services industry.
Asked about the capabilities that their organisation looks for in technology to address regulatory risk,
respondents point to controls monitoring as being the most desirable. By checking business processes
against predetermined parameters across the entire enterprise, controls monitoring has the potential to
streamline compliance by automating checks and cutting down on manual interventions. Dashboards and
reports, the second most desirable capability according to respondents, can then provide notification to
management of potential transgressions by providing a summary of key performance indicators related to
compliance activities.
Investments in people and technology often go hand in hand. For example, some companies seek to
distil risk information throughout the entire organisation by installing risk dashboards not just in the
boardroom, but at the desks of operational employees. In doing so, they hope to strengthen risk culture
and ensure an effective way of communicating risk information throughout the organisation.
An end in itself or a benefit to the business?
It is tempting to view regulatory compliance as an end in itself - a hoop that business must jump through
in order to secure its licence to operate. Clearly, some regulatory initiatives may be more advantageous
and proportionate than others and, in some cases, executives could be forgiven for doubting the benefits
of a particular obligation. But whatever the pros and cons of individual regulations, this does not detract
from the sentiment among respondents that, overall, effective regulatory risk management brings
intrinsic benefits to the business.
Aside from the obvious advantage of keeping the business out of trouble, effective regulatory risk
management provides the business with important information about transactions and day-to-day
activities. This improves decision-making and provides visibility into the company's business processes. It
comes as no surprise, therefore, that 55% of respondents see greater business processes efficiency as the
key benefit of more effective regulatory risk management.
The second biggest benefit, according to 48% of respondents, is the competitive advantage that can
be derived from implementing best practice. This could manifest itself in a number of different ways:
for example, quicker time to market through enhanced decision-making; more effective appraisal of
investment opportunities; or the boosting of the bottom line through greater operational efficiency.
Perhaps the biggest prize, though, is the ability to turn effective regulatory risk management into a
market differentiator by instilling confidence in existing and prospective customers or investors. For
some firms, regulatory compliance serves "a gold stamp" that tells the market that a company takes its
obligations seriously.
Dealing with existing compliance obligations is just one aspect of regulatory risk management;
according to 46% of respondents, the ability to anticipate future regulatory change is another important
benefit to be derived from managing the process effectively. Our research suggests that 83% of
respondents currently scan the environment in order to anticipate regulatory change, but companies are
split between those that take a proactive approach to pre-empting new legislation and those that adopt
a reactive approach. Those that adopt a proactive approach, who tend to represent the larger companies
from industries such as financial services, may be in the minority, but it seems likely that this approach
would do much to secure the competitive advantage that respondents see as such a key benefit of
effective regulatory risk management.
Regulatory risks: a global perspective
How do companies around the world rate the scale of the regulatory burden in key countries and regions?
According to our respondents, the US presents the heaviest burden, just as it did three years ago when
we asked this question in an earlier Global Risk Briefing report on regulatory risk. On the face of it, this
may seem surprising because, compared with many other countries, the regulatory regime in the US is
relatively light. What has changed perceptions, however, is the Sarbanes-Oxley Act. Although it came into
force six years ago, the fall-out from the legislation can still be felt, and many companies continue to have
difficulties with the more onerous aspects of the rules. The prospect of an imminent shift from US GAAP to
International Financial Reporting Standards may also be influencing the high burden rating for the US.
France is seen as presenting the second-highest regulatory burden on the list. The country's restrictive
labour legislation and reputation for red tape, particularly for smaller businesses, has long been seen as a
brake on investment. President Sarkozy has pledged to institute reforms to the more burdensome aspects
of France's legislation, but progress so far has been relatively slow.
One important change when we compare the results of this survey with those from three years
ago is the rise of China on the list. In 2005, China was eighth, while today, it is seen as the third most
burdensome country in regulatory terms. Partly, no doubt, this reflects the much deeper investments that
have been made in China over the past three years by multinational businesses, but it is clear nevertheless
that respondents are concerned by the regulatory issues that they encounter.
Looking to the future, respondents continue to expect problems on the regulatory front from China.
Asked about the impact they expected from changes to regulation over the next three years, China leads
the pack, suggesting that respondents think that things may get worse on the regulatory front before
they get better.
About the survey
The Economist Intelligence Unit surveyed 320 executives around the world in September 2008 about their
attitudes to environmental risk management. The survey was sponsored by ACE, KPMG, SAP and Towers Perrin.
Respondents represent a wide range of industries and regions, with roughly one-third each from Asia and
Australasia, North America and Western Europe.
Approximately 50% of respondents represent businesses with annual revenue of more than US$500m. All
respondents have influence over, or responsibility for, strategic decisions on risk management at their companies.
The Economist Intelligence Unit's editorial team conducted the survey and wrote the paper. The findings
expressed in this summary do not necessarily reflect the views of the sponsors. Our thanks are due to the survey
respondents for their time and insight.
Conclusion
The paradoxical view that regulation is both a blessing and a curse continues to be widely held among
senior executives. While they recognise the need for protection in key areas, they are often frustrated
by what they see as overly complex, unnecessary bureaucracy to achieve this goal. As companies expand
internationally and develop highly integrated business networks, the challenge of compliance becomes
an increasingly difficult one to meet.
Although regulatory regimes are undoubtedly complex and would, in most cases, benefit from rationalisation and simplification, companies themselves must also bear some of the responsibility for the
problems that they face. In the constant race to keep up with new obligations, many organisations create
a kind of self-imposed complexity by duplicating the compliance effort and bolting on new teams and
processes as and when new requirements emerge.
TTo date, few companies have put in place a unified approach to managing regulatory risk, but in order
to ensure robust compliance, anticipate future regulatory change and enhance competitive advantage,
this must surely be a an important long-term objective. With regulation certain to remain a key
component of doing business in the future, anything that can provide reassurance that obligations are
being met in a way that also secures broader business benefits would be highly desirable.