5 ways how to resolve the regulatory banking puzzle
Koen Vanderhoydonk from Blanco, a scaling regtech company founded in The Netherlands shares his insights on the current regulatory challenges in the financial industry and how regtech can help.
Following the 2008 financial crisis, the financial sector has experienced an increase in regulation and in the disruptive use of technology in the field. Traditional banks often still run on late nineties legacy systems not easily adapted to modern customer requirements. Technological advancements have resulted in an increased number of financial technology (fintech) companies whose purpose is to develop technology-driven products that enhance end-customer engagement with Financial institutions as well as enhancing the customer experience. It seems like a well-executed marketing plan that after the financial crisis, startups claimed that they would bring change into the industry and would be much better than the incumbent banks; better service, more transparency, and the same level of trust as the bank.
Fintech companies focused on a particular part of the banking value chain, leading to new solutions, which didn’t always fulfil the end-customers’ full spectrum of financial needs. End-customers couldn’t leave their bank completely even if they wanted to. Both fintechs and incumbents worked hard to close this gap.
Over the years, many fintech startups could not convince enough clients to become viable long-term business partners to keep their business alive. It’s been a hard time to survive for many startups. Gradually, the banks also recovered from the initial impact after the crisis. This allowed them to look forward again. They started to interact with the very entity that was once their worst nightmare; fintech. It was the birth of several incubation initiatives and in-house innovation cells within the banks, ultimately leading to financial investments into fintech.
For the first time, this new collaboration mode started to emerge. Both parties learned a lot from each other and started to collaborate more and more. Digitalization of the financial sector lifted off. At the same time, with the increased reliance on consumer data in the creation of digital products, concerns grew among regulators with regard to the distribution and usage of data privacy. It is the coupling of increased regulation with a great technology-oriented collaboration mind-set, that birthed the need for regulatory technology. Hence RegTech was born.
But what are the current challenges in the industry and how can RegTech help to solve them?
Challenges hindering the growth of the financial services industry at large
Financial firms, both old and new, have been forced to invest a significant amount of time and resources to make certain their compliance with the new laws. You would expect that the regulations would stop at some point, instead, stringent rules continue to get imposed with regulators stepping up their game every day. The 2008 crash forms the base for the fining of heavy AML related levies, with 15 million worth of fines being collected since then. This number has gone up 45% from 2015 on AML/KYC worldwide.
The modern customer prefers a fast, modern, and secure transaction, and this just so happens to be where the fintech and neobanks have created their niche. Traditional banks with Neolithic account opening or lending methods will soon have little to give when competing in the digital financial services space.
The technology “legacy” Trap-Technology is inevitable. If we don’t invent something, others will, and this is what happened in the financial industry. The business was booming for bank incumbents that they placed all of their focus on making money and none on changing or advancing technology. As a matter of fact, most banks retain their early 2000 legacy systems even today. Meanwhile, technology-driven financial service providers existing in the internet, eCommerce, and fintech have fast been going from hype to reality. If a bank would have been a telecom provider that changed technology such as a bank, they would no longer be in business.
Many fintechs are sailing the red ocean; banks no longer know what is best for them? Rob advisors and KYC providers continue to pop up like coffee bars. We’ve seen some good come out of this though, and some fintechs have actually gotten up to a strong lift-off. However, not all will survive.
Here’s a use case scenario in Germany: Despite an increase in the number of financial startups, a fair number of them have given up and gone underwater unnoticed. According to PwC’s fintech cooperation radar, 233 local fintech startups have ceased operations since 2011.
Business hires have continued to rise since 2017. The failing of a few financial startups did not prevent the hires to rise sharply to 62 at that time. In 2018, 74 fintechs disappeared, and it took till the end of May this year for the numbers to read 34- more than ever before.
Internalization: While 90-95% of our local laws and regulations are similar to outside markets, do not underestimate the impact that the remaining percentage can cause. The market may be very much global, but it is all still very local. As such, scaling a fintech company across borders remains to be the biggest hurdle for national enterprises and startups.
Hyper-scaling: The lack of US funding models in Europe has forces startups to turn the hockey stick much earlier than similar US companies. This also indirectly pushes the red-ocean story.
After the 2008 crisis, regulators made a long-term commitment to tame the financial industry. It is only natural that they feel the continuous pressure to perform and deliver on what they promised.
Having so much data at their disposal can get overwhelming to the point that regulators don’t know what to do with it. Hence the rise of Supertech. Most regulators are in their exploration phase; discovering potential.
Regulators force financial institutions to be “bonus patrias familias” i.e., legally and personally responsible for running a regulated business. The board of a bank needs to be able to explain why a certain risk is accepted or not. These first lines of defence are assisted by the second and the third. If advanced analytics or AI were to discover a suspicious pattern, it would be very hard for the business to explain, let alone bring this to the regulator.
How can we resolve the regulation puzzle?
It is important to understand that there is no “loner wolf” perception in the financial sector and the decision of one financial entity could easily affect the other. What’s important is that banks and fintechs alike brave the challenges of the new playing environment and revitalize their business models. Regulators should aim at creating a consistent, clear, and fair level playing field to make that happen.
1) As mentioned in the above paragraph, financial entities should strive to move from a bilateral to a trilateral pro-active collaboration; not between fintechs an innovation hubs only, but between Business-Regulators-RegTechs. Regtech companies should unite, seek synergies, and join forces.
2) From KYC to KYD: RegTech 1.0 was the period in the 1990s and 2000s when financial institutions began introducing new technologies to monitor and analyze risks of specific regulations or processes. These developed into some of the quantitative risk management practices that we’re familiar with now.
Over the past decade, RegTech 2.0 tools have helped companies to comply with rules and improve their supervision activities. Most RegTech applications have focused on ‘Know Your Customer’ (KYC) by improving consumer protection and challenging bad behaviours.
The industry is now on the verge of RegTech 3.0– a move from KYC to ‘Know Your Data’ (KYD) as financial institutions start to view risk and regulation as data and prediction problems that can be addressed by technology.
With technologies like AI and machine learning spearheading the move from ‘big data’ to ‘smart data’, a lot can be expected when it comes to automation of complex reporting, gaining insights into regulatory practices, conducting an analysis of critical compliance risk areas, even potentially creating an end-to-end view of compliance.
Regtech has proved to be an important aspect of how companies deal with the overload of data as they become more active in developing processes to stay ahead of their innovative game. Investment in regtech is part of the wider digital transformation process that aims at completely changing the business model of the industry, including risk and compliance.
To invest in fintech and regtech is to invest in defending, progressing, and reinventing our financial institutions. Data stands at the very core of how businesses operate. More data handled the right way is a recipe for better information and provides an upside for risk and compliance.
3) From the closed data model to open data model
Perhaps the best way to handle the large amounts of data being collected daily is to arrange it in a pattern and to put it up in a distributed ledger for everyone to see. This is known as data sharing and opens up discussions for use of the distributed ledger technology in financial services.
Regulators have been collecting a lot of data since 2008 with no way of combining it.
Pattern recognition calls for the utilization of natural-language management abilities combined with biometric and facial recognition data, and information generated from social media, electronic communications, and voice data.
Such information gives regtech the capacity to pick out risks not detected by having insights on one’s data source. Now, to build such a system would take a heavy grouping of data and the deployment of real-time, robust analytics engine, as well as huge storage space. The technology can be used on a range of regulations that need proactive observation including market conduct, money laundering, and financial crime.
4) From legacy to platform thinking
Financial service providers have in the past shied away from storing their data in the cloud environment amid fears of potential security vulnerabilities. But the past 10 years have been a time of regulatory change after change, and these institutions haven’t been presented with much of a choice but to adhere to specific transactional standards and to adopt strict protections.
SaaS solutions should be built as microservices – small and autonomous. Need to change, scale, move, optimize, or transform each microservice? The flexibility offered gives you a variety of options to select from based upon your preference and could help teams keep up with the unequalled rate of regulatory change while sustaining their ability to serve and grow their customer base.
5) From execution to sensibilization
Little can be said of the efforts that have been made to bring together regulatory experts, software developers, and financial institutions. Indeed, we don’t always speak to the same language.
Since the crisis, a business gap existed whereby innovation fell on innovation managers, but now business units within the bank are slowly taking back the wheel and are starting to be in control again.
The best thing for regulators, incumbents and regtechs to do, is to actively work together and adapt and learn to speak the same language. This is what regtech is all about.
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