Risk-Based Supervision Is Key to Financial Inclusion in 2020 & Beyond

Despite its importance for financial inclusion and innovation, financial supervision attracts far less interest and resources than regulation. At a global level, there is clear messaging on the importance of enabling regulations to further digital financial inclusion and plenty of evidence-based guidance on how to design such regulations. Unfortunately, supervision in emerging markets and developing economies (EMDEs) is often ineffective and risks neutralizing regulatory reforms designed to benefit markets and consumers. With assistance from the global development community, EMDE supervisors can take several steps to identify and overcome challenges in implementing proportionate, risk-based supervision.

What is proportionate, risk-based supervision?

A man sends money to a friend at a Zoona outlet in Lusaka, Zambia. Photo: Nyani Quarmyne, International Finance Corporation
Photo: Nyani Quarmyne, International Finance Corporation

The Basel Committee defines proportionality as “tailoring the rules to fit the nature, scale and complexity of supervised entities.” Proportionality is embedded in many international standards for supervision, and it is especially important in EMDEs where innovation is transforming the financial sector. In such countries, supervisors must adapt to new institutions, business models and products entering the regulated perimeter.

Risk-based supervision can be described as an instrument for achieving proportionality. Risk-based supervisors build risk profiles, conduct risk assessments and monitor indicators to systematically identify, measure and monitor risks, determining the probability that a risk will materialize and what its potential impact may be. This enables them to better understand current and emerging risks and allocate scarce resources to the sectors, providers and products that pose the greatest risks to supervisory objectives.

Risk-based approaches require a mindset shift from compliance-based approaches. Rather than conducting periodic, one-size-fits-all checks on how providers comply with rules and avoid risks, risk-based supervisors use continual intelligence gathering and dialogue with industry to assess how providers manage risks. This requires them to have a deep knowledge of sectors and providers, critical thinking and subjective judgment. Good risk-based supervisors also monitor how risks are evolving, identify emerging risks and preemptively address them. They conduct extensive, high-quality off-site supervision for ongoing risk assessment, which enables them to allocate fewer resources to on-site inspections of providers that present low risks.



What are the major challenges for implementing risk-based supervision?

Many EMDE supervisors believe they have implemented a risk-based approach, even though they have not yet made the strategic, organizational and procedural shifts that are necessary to optimize supervisory outcomes and efficiency. For instance, some supervisors adhere to rigid annual examination schedules in which a comprehensive standard inspection is done at every institution, regardless of their risk profiles and risk levels. Others have time-consuming, resource-intensive approval processes for all financial products, regardless of type, risk and impact. Others impose banking governance standards on less complex businesses, such as nonbank e-money issuers.

CGAP interviews of a dozen experts who have technically assisted a broad range of supervisors in EMDEs show that some of the most common challenges for implementing risk-based supervision are:

  • Difficulty establishing the organizational culture and mindset for risk-based supervision
  • Lack of high-quality data and systems for accurate, efficient monitoring and risk assessment
  • Limited capacity to appreciate or differentiate risks among business models and provider types
  • Inadequate training and development programs to instill a risk-based approach

Why is it crucial to implement risk-based supervision now?

Supervision does not just complement regulation; it is integral to a balanced and effective regulatory framework. Excessively conservative or permissive supervision can undermine well-designed, proportionate regulations. There are examples of supervisory action either blocking the entry of responsible providers or letting innovative products go unchecked, only to harm large numbers of consumers. Today, risk-based supervision is needed especially in EMDEs where supervisory capacity is low and financial innovations are evolving quickly, such as in East African and East Asian countries.

The global development community can play an important role in helping such countries transition to risk-based supervision. While high-level, theoretical guidance on risk-based supervision is widely available, there is not enough practical guidance, capacity building and technical assistance to help supervisors address common implementation challenges. Given the role of data and off-site monitoring in risk-based supervision, it is also crucial to revamp data collection and analytics capabilities in EMDEs.

As the Global Partnership for Financial Inclusion pointed out in 2016, more and better efforts must be made to trigger basic conceptual, planning and operational shifts for establishing risk-based supervision in EMDEs. Since last year, CGAP has been partnering with EMDE supervisors in a few countries where innovation is burgeoning. Our goal is to better understand and report on supervisory challenges and solutions in digital financial inclusion, including the use of SupTech.

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