Regulatory Risk in a Globalised Economy: Impacts & Compliance
A comprehensive guide on regulatory risk, global compliance challenges, industry impacts, ESG expectations, and best-practice frameworks for regulated enterprises.
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Regulatory risk has also become crucial for organisations to contend with under the modern global economic order, particularly in law and compliance matters. This occurs when legislative, regulatory, or enforcement changes lead an organisation's business to fail, lose money, or damage its reputational standing. As companies become transnational and embrace newer technologies, exposure to regulatory risk is higher. Regulatory risk in industries like banking, insurance, fintech, pharma, and energy segments is more understandable, where the compliance responsibilities are not only massive but also dynamically shifting.
Defining Regulatory Risk
Regulatory risk is a risk that adverse effects will take place through non-compliance with current regulations or non-compliance with newer regulations and legal standards. They may consist of penalties, criminal penalties, business closure, and reputation damage. Threats may also be in other forms, such as non-compliance, licensing or permits, or tighter regulation by the regulator. While the regulatory environment continues to evolve mainly in response to financial crises, technological innovation, and social-political progress, firms have to be adaptive and resilient to combat such adverse conditions (Basel Committee on Banking Supervision, 2005).
Regulatory Risk in the Financial System for Globalisation
Globalisation and technological advancement have revolutionised the nature of compliance by orders of magnitude. Organisations now have to contend with multiple regulators in multiple jurisdictions with twin or opposing requirements. A bank with businesses in the United States and the European Union, for instance, would be required to comply with the EU General Data Protection Regulation (GDPR) and align under the U.S. Cloud Act. Competing data privacy laws have the potential to induce legal complexity and business complexity (European Commission, 2016; U.S. Congress, 2018). In addition, regulatory extraterritoriality is more and more happening in the guise of law, like the U.S. Foreign Account Tax Compliance Act (FATCA), which is extraterritorially applying and expecting universal compliance.
The regulatory environment is also transforming with environmental, social, and governance (ESG) expectations. Programs such as the Task Force on Climate-related Financial Disclosures (TCFD) are even turning mandatory reporting into a sought-after mandate, and regulatory risk is not just an investment risk but now a strategic risk for board-level decision-makers (TCFD, 2017).
Sectors Most Impacted by Regulatory Risk
Even though regulatory risk will touch all industries, some are more vulnerable to it based on the business they conduct and the intensity of regulation to which they have been subjected. The banking industry, insurance industry, fintech, pharma, and energy industry are a few of them.
For the financial and banking industry, companies are saddled with blanket conformity in the aspect of such Basel III capital adequacy regulations as consumer protection regulations and anti-money laundering (AML) facilities. The FATF dictates international standards on AML, and failure to comply may result in de-risking or blacklisting and compromise access to global markets (FATF, 2012).
The insurance industry is required to navigate intricate actuarial, solvency, and reporting frameworks. Risk-based capital charges and further disclosure requirements are called for under the EU Solvency II directive, and IFRS 17 dramatically alters the accounting of insurance contracts (EIOPA, 2014; IASB, 2017).
Regulatory risk is also one of the key operational risks for fintech and digital payments. Fintech players are between finance and technology, and therefore, compliance burdens cut across data protection law and financial law. Such regulations, such as the EU Markets in Crypto-Assets Regulation (MiCA), attempt to offer a harmonised regime to crypto assets, but global divergence of crypto regulation is an ongoing risk (European Commission, 2020).
The pharmaceutical and life sciences industry is confronted with regulatory challenges in drug development, approval, and regulation. Regulators like the U.S. Food and Drug Administration (FDA) and European Medicines Agency (EMA) have tight control over product safety and clinical trials. Regulatory interaction or enforcement action, like product recall or lack of post-market surveillance, can be costly in terms of monetary and reputation costs (U.S. FDA, 2020).
Regulatory risk in the energy and environmental sector is increasing due to ESG requirements, carbon disclosure, and green litigation in the industry. EU taxonomy rule-making and greenwashing question development are evidence of regulatory interest in making sustainability disclosures accessible and in line with environmental standards (ESMA, 2023).
Examples of Regulatory Risk
Some good examples illustrate the reputation and business impact of regulatory risk. HSBC's 2012 agreement with the U.S. Department of Justice, valued at $1.9 billion for failure to meet AML compliance, is a strong example of the banking non-compliance cost (U.S. DOJ, 2012). In technology, Meta was fined over €1.2 billion for the unauthorised export of data, an example of the danger of cross-border regulation of data (EDPB, 2023). Even in the pharma sector, Johnson & Johnson has faced reputation loss and legal risk due to product safety. Even in the energy sector, Shell has faced climate change litigation issues on the premise of an ESG disclosure gap and liability for carbon emissions.
Regulatory Risk Management: Frameworks and Best Practices
Organisations need to deal with regulatory risk by way of a strategy and a proactive compliance plan. Proper regulatory risk management synchronises legal, risk, audit, and compliance functions and processes and aligns them with business strategy.
Recommendations for best practice are:
- Safety Horizon Scanning: The Organisation should have a constant perspective of scanning regulatory change, supervisory guidance, and industry practice so that it can anticipate regulatory change and change its compliance position to meet it.
- Better Governance Frameworks: Keeping cross-functional compliance committees and written reporting procedures ensures regulatory risk is managed consistently and reported effectively.
- Technology and RegTech: Technology-driven models of compliance enable real-time monitoring, rule mapping, and audit trail generation with better efficiency and controls.
- Regular Training and Sensitisation: Compliance with regulation is not a one-time exercise, but a repeated cycle of training to constantly keep individuals updated on pertinent obligations, ethical behaviour, and internal regulation.
- Regulatory Engagement: Organisations take an early advantage by engaging proactively in regulatory discussions and consultations to have insight into regulatory requirements and support for effective framework development.
Emerging Regulatory Expectations
Regulators are placing greater emphasis on systemic risk, operational resilience, and sustainability.
For example, the Bank of England has required banks to achieve new operating resilience requirements to identify business-critical services and stress test what they can ride out disruption (Bank of England, 2021). Climate stress testing is also increasing, with central banks like those in the Network for Greening the Financial System (NGFS) adding scenario analysis to prudential regulation (NGFS, 2022). Institutions may anticipate greater convergence in regulation, with international institutions like IOSCO taking the lead in the convergence of ESG disclosures and cross-border mutual assistance in the enforcement of compliance.
Conclusion
Regulatory risk is an old problem of managing contemporary institutions. In the context of increasing legal sophistication, cross-border transactions, and high stakeholder expectations, organisations are forced to juggle ambitious, technology-enabled, and extensive compliance agendas. With the adoption of an understanding of industry exposures, regulators' involvement, and spending on sophisticated risk management approaches, institutions acquire the capacity to manage an ever-changing regulatory landscape and establish operational resilience and stakeholder trust.
