The first instalment of the Fourth Industrial Revolution (4IR) has been characterised by acceleration; explosions of data, surges of computing power, amplification of robotics. Regulators have been hard pressed to keep pace, and governments have been grasping at technologists’ vapour trails. As an example, the European Commission agreed on a revision to the MifID regime in 2011 to improve upon financial market transparency and consumer protection. It took seven long years of drafting and false starts before MifID II was finally implemented in 2018. During that same time period, global investment in fintech increased by more than tenfold.
To level out this skewed playing field and promote collaboration, two things need to happen: regulators have to get ahead, and innovators have to step in line. For without some serious culture change, we risk breaches - not only of legislation, but of public trust too.
Regulation is a reputational issue
Around 50% of US adults favour more regulation on tech firms - not surprisingly given that it’s the consumers who so often pay when there is a lag between innovation and regulation.
A string of high-profile cases has dented public trust in businesses and governing institutions, with each failure becoming part of the folklore. It was a regulatory black hole in the energy sector that allowed Enron to use accounting loopholes, special purpose entities, and poor financial reporting to guzzle billions from shareholders. The implementation of GDPR came just after the Cambridge Analytica controversy of 2018 undermined the democratic rights of voting citizens.
A lack of clarity is still pervasive today - particularly amid turbulent regulatory change in Europe and the US. The Financial Conduct Authority (FCA) has published concerns surrounding Brexit, non-financial misconduct, and data usage in its annual assessment of the general insurance sector. It also suggested that remuneration and other incentive practices may be driving poor conduct at insurance firms, and that well-publicised cases of misconduct “raise questions about the culture at firms in the wholesale insurance sector”.
A lack of imperatives for businesses?
A lack of regulatory consequence has caused inertia amongst businesses in their willingness to prioritise customer ethics. For their part, governments seem to be realizing this discrepancy between action and consequence. For example, after a rise in operational failures in the UK financial industry, the Commons Select Committee advised that regulators should “ensure failures do not go unpunished” in order to prevent further harm. The FCA has followed suit by increasing fines, such as last year when they fined Standard Chartered Bank £102.2 million for poor AML controls.
Inertia can also be explained in commercial and operational terms. Financial services firms have been lacking the technology to handle the increase in regulation since the 2008 crash. Instead, they’ve had to increase spending on ever-larger compliance teams. In the years since the financial crisis, compliance and fincrime personnel at major banks have doubled in six years and now equate to 3% of a bank’s headcount, according to Boston Consulting Group.
The distance between businesses and regulators is partly down to these compliance difficulties. “If the RegTech industry were a mountain we’d only be at base camp”, according to a notable KPMG report.
But looking ahead, the possibilities are enormous. Compliance across financial services no longer has to be a pain point. Artificial intelligence and machine learning can enable companies to move from big data to ‘smart data’ to gain insights into regulatory practices, automate complex reporting, conduct meaningful analysis of critical compliance risk areas and even create an end-to-end view of compliance.
Yesterday’s regulations hold back tomorrow’s technologies
One of the key questions we have to ask is whether better regulation means a tapering of innovation. No one wants to put the genie back in the bottle if the genie is promising better healthcare, more personalised banking, and more cost-efficient legal services.
The initial regulatory response to fintech developments was supportive. The emphasis was on encouraging innovation; using regulatory sandboxes, accelerators and innovation hubs; and taking a ‘technology neutral’ approach. Now however, is the tricky phase - regulators are turning their attention towards the risks (not just the benefits) posed to regulated firms, to financial stability, and to consumers.
“Will regulation push on, or be pushed back?”, asks KPMG’s Regulation 2030 report. Their conclusion? Regulation and supervision are more likely to push on than be pushed back over the next ten years.
This may be true, but the approach of regulators needs updating. “If the volume and pace of digital transformation continue to remain the way it is, the existing regulatory approach won’t work,” says Bakul Patel, associate director of Digital Health for the US Food and Drug Administration.
A recalibration is now underway to find the balance between regulation and innovation. The UK Government’s Industrial Strategy expressly aims to support innovation rather than curb it. The Financial Stability Board (FSB), an international body working alongside the the IMF, the World Bank and the international sectoral standard setters, is undertaking an evaluation of the effects of the G20 financial regulatory reforms. Meanwhile, the EU is conducting various reviews of financial sector legislation, in banking (capital requirements and proportionality), insurance (post-implementation review of Solvency II) and securities (via MiFIII and EMIR).
The fallout from these moves towards tighter regulation may mean that businesses have to focus their innovative energy more toward compliance than on ever-refined services.
Do we risk a crisis of confidence in modern businesses?
"Trust is like the air we breathe - when it's present, nobody really notices. When it's absent, everyone notices." - Warren Buffett
Trust took a hit with the last financial crisis, and it hasn't recovered since. This was emphasised in a speech by Andrew Bailey, Chief Executive of the FCA, who argued that the “Greed is Good” era of Wall Street has given way to a pressing need for social responsibility.
Worldwide, two-thirds of adults say corruption is widespread in business. Correspondingly, a recent Pew Research Center report shows a decline in trust in the US government, one of the many bodies in place to hold businesses to account. In Western Europe, trust in the military exceeds that in banks and financial institutions, parliaments and the news media.
In this climate, continuing to rely on ‘self regulation’ is an unreasonable prospect. The rise of non-profit, open-sourcing organisations like OpenAI are an effective way to morally hold businesses to account, but recent years have arguably shown that stronger financial imperatives, enforced by the FCA and other governing bodies, are the surest way to inspire good conduct and more trust in our providers.
Encourage innovation and inspire trust
As we hover on the cusp of 4IR, the next ten years of regulatory action is likely to see tighter restrictions on data usage and financial conduct, as governing bodies strive for a business environment that supports innovation while holding it to account. Instead of responding to the latest technologies of the day, it’s time that legislation is designed with potential future advancements in mind, setting a solid foundation for businesses to proceed with innovation.
Most importantly, public trust in businesses and regulators - which is arguably the basis for a thriving marketplace - needs urgent resuscitation. To make this happen, the existing approach to regulating new technologies must change into a more collaborative, ethically-based, and unbiased initiative.
