Managing divergence: how to stay ahead

The regulatory response to the global financial crisis included the development of internationally coordinated standards and a commitment to avoid fragmentation, protectionism and regulatory arbitrage. Fast forward to today, however, and the pace and scale of regulatory reforms that can be seen in many jurisdictions, including the UK, US and EU, underlines the growing risk that financial services firms will be subject to divergent, and possibly conflicting, requirements.

In this article we outline four principles that firms can apply to navigate this increasingly complex landscape and manage the resulting risks. 

So what is driving this trend?

One factor is that many jurisdictions are reviewing core aspects of their regulatory rulebooks, in part to reflect market developments that have taken place since major reforms were enacted following the financial crisis. In the UK, the regulatory agenda is also being driven by the government’s post-Brexit autonomy and ambition of supporting the UK’s role as an open, dynamic and competitive global financial centre.

Macro-economic pressures are also contributing. Many financial centres are focusing on ways to enhance their competitiveness and remove unnecessary barriers to growth. Reforms underway in the US, EU and elsewhere are seeking to improve resilience, unlock liquidity, promote retail investor participation, and tackle existing inefficiencies caused by inappropriate regulatory requirements.

Another factor increasing the potential for divergence is the expanding scope of regulatory rules. Many financial centres have implemented, or are in the process of developing, rules covering issues beyond traditional regulatory requirements. Proposals covering environmental, social and governance (ESG) requirements, artificial intelligence (AI), digital assets, and the resilience of critical third parties, are being implemented in many jurisdictions.

Despite moves towards international consistency in certain areas (such as banking prudential requirements and resolution frameworks) these drivers, combined with heightened geopolitical tensions and national policy agendas, are making divergence more rather than less likely going forward.

Why should firms care?

Divergence can increase compliance, reporting and operational risks and costs; in some cases, following the laws of one country conflicts with the requirements of another. For instance, global investment research rules are not currently aligned.  Fragmented markets may also result in lower levels of liquidity and market efficiency, impacting the cost of doing business.

Boards and senior executives, as well as front office, compliance, risk and internal audit functions should be alive to these potential impacts, and take steps to manage any risks.

Navigating divergence rules

Applying the following four principles will help firms to monitor and mitigate the risks to their businesses. 

1.  Assess the policy-making lifecycle to understand drivers of change. Taking a strategic view of the drivers behind a regulatory development – including societal and technological trends, policymakers’ objectives, and political influences - will help firms to better plan their responses to regulatory changes, and understand the likely impact on their business. This approach will also help firms to anticipate where future changes may emerge. The level of risks arising from divergence will vary depending on the extent to which firms operate cross-border, and the market segments they operate within. For multi-functional, globally-active firms, boards and senior executives should actively consider the extent to which they are exposed to risks arising from divergence in regulatory requirements, and reflect this risk in the development and maintenance of their control environments as well as their medium-to-long term strategic planning.
2. Use technology-enabled solutions to track regulatory divergence. The scale and pace of regulatory change in many jurisdictions means it is increasingly important to utilise technology to track and manage regulatory developments. Technology can considerably reduce the time and cost required to track regulatory developments and support reporting and accountability for key regulatory processes.  Firms should consider the extent to which board/senior management, key committees, and other governance arrangements should be informed about emerging issues, and provide challenge and assurance to this internal tracking.
3. Consider the optimal organisational design for compliance functions. Firms should also consider how to manage their compliance function in a more fragmented world, taking into account issues such as their level of local expertise, local regulators’ expectations, and the extent to which they may be able to rely on group-level common frameworks and systems if relevant. Firms should consider how to manage their compliance in a cost-efficient way, including the potential for utilising outsourcing or executed managed services.
4. Review control functions to ensure they are responsive to regulatory change. Firms’ control frameworks, including internal policies and procedures, training pathways, and self-reviews or attestations, should be regularly reviewed and updated to reflect regulatory developments and take account of diverging requirements where relevant. Technology-based or automated systems are likely to be effective in ensuring reporting and disclosure requirements are met, particularly where the same data set is used to meet regulatory requirements in multiple jurisdictions.

Divergence is not new, but its increasing prevalence means firms face additional compliance, reporting and operational risks and cost. Taking steps to proactively monitor and mitigate any impacts means firms can manage the risks in a strategic, cost effective and responsive way.