Rightly Perceiving Compliance for Sound Bank Governance and
Acknowledging Potential Costs and Risks of Digital Banks
[Published in the Business Standard on September 14, 2023]
Dr. Shah Md. Ahsan Habib
Failing to perceive ‘compliance’ rightly and sufficiently remains a critical challenge in the banking industries in several global economies including Bangladesh. Are compliances only about following the rules and regulations of the central banks? Not really. How to perceive the issue of ‘compromising with the compliance requirements’! Does it mean only compromising with the interests of a central bank? Not truly. ‘Compliance’ is a much bigger term in the context of any banking industry and is directly associated with governance and ownership structure. It is an ethical issue on the part of the agents or bank management to take care of the interests of their principles.
Compliance needs to be viewed as a natural extension of the governance duties. ‘Compliance Risk’ is the most critical banking risk today, and the growing compliance risk has notable implications. While having a compliance program is sufficient for complying with laws and regulations in banks, today very commonly banks are at risk of falling short of meeting compliance goals without a strong code of ethics. Therefore, no compliance program should be considered complete without a developed code of ethics. By having all employees aware of what is considered ethically correct, the bank has less chance of violating laws or causing harm. In the evolving banking industry, compliance has significant cost implications that are growing exponentially, and the cost of compliance might be even higher for digital banks.
The principle-agent framework is relevant to banking. Shareholders and depositors are the risk takers and suppliers of funds to undertake financing activities by the banking institutions. Shareholders have scopes to play roles in decision-making as part of the board and to take care of their interests. Bank management is supposed to reflect the efficiencies of their operations to serve the shareholders’ interests. Then who is supposed to take care of the interests of the depositors? It is mainly the central bank that is responsible to take care of the interests of the depositors. Especially ‘prudential regulations’ of the central banks are associated with the risk-taking activities of banks and the interests of the depositors. On the part of the management, it is ‘regulatory compliance’ that is crucial to protect the interests of the depositors. Thus compromising with the compliance requirements means compromising with the interests of the key principle of banks-depositors. It is clearly unethical on the part of any agents. A banking institution may be operated in the public or private sector, however, practically all banks are in a sense public entities i.e. depositors or common people are part of the owners. Rightly acknowledging this fact and perceiving the importance of compliance is crucial for repairing the governance flaws in the existing banks, and founding the digital banks.
The benefits of digital banking and the cost advantages of digital banks are well recognized. Mobile Financial Services (MFS) offered unthinkable benefits by reaching vulnerable sections in the developing world in many instances. Though both MFS and digital banks contribute to the ongoing transformation of the financial industry, catering to diverse consumer needs in an increasingly digital world, indeed these are distinct concepts. The scope of a digital bank is expected to be much wider than MFS. In Bangladesh, MFS and digital payment services have played remarkable roles in promoting financial inclusion which is logically shadow banking in nature i.e. less regulated. Such shadow banking activities are desirable as well considering their socio-economic benefits. Like brick-and-mortar banks, the functional scope of digital banks includes deposits, loans, and risk-shouldering functions alongside payment facilitation that must be comprehensively regulated and supervised.
It is well-recognized that increasing trends of compliance requirements are burdensome and have notable cost implications. It has been affecting the profitability of the banking industries throughout the globe, however, cannot be bypassed or ignored. Digital banks and digital banking activities need a robust compliance framework. Digital banks are more susceptible to money laundering and fraud risks than brick-and-mortar or traditional banks. Compliance with regulations is made more challenging with the innovations happening in digital banking. It makes it more difficult when regulations have not yet caught up with the technological advancements in several associated areas. Open banking is a tremendous innovation, and also associated with significant risk, new challenges, and in some countries increased compliance issues. Data protection regulation became another major legislative and regulatory provision that is now part of the compliance requirements for doing business in several economies.
Compliance challenges for digital banks can be particularly complex due to the evolving nature of the financial industry and the unique characteristics of digital banking. Maintaining robust cybersecurity measures to protect against data breaches, hacking, and unauthorized access is crucial for compliance and maintaining customer trust. With the passage of time, digital banks may confront additional financial regulations, including anti-money laundering, KYC requirements, consumer protection laws, data privacy regulations, and more that may challenge the cost advantage of digital banks. Moreover, digital banks often partner with third-party service providers for various functions, such as payment processing, customer support, and technology solutions. Managing compliance among these partnerships is critical, as some of these activities of digital banks can fall under the category of shadow banking. As the financial landscape continues to evolve and technology enables new financial services, regulators may need to adapt to ensure that potential risks associated with shadow banking are appropriately addressed. To address these challenges, digital banks need to invest in robust compliance programs, implement advanced technology solutions, and train human resources on compliance procedures.
The approach toward compliance framework changed remarkably in the developed world where banks are forced to allocate adequate resources to install an effective compliance framework, however, generally, this is not the case in a number of developing countries. Regulatory compliance should be treated as a major strategic issue for the bank leadership of the upcoming digital banks in the country in an environment where most traditional banks are yet to invest sufficiently in their compliance frameworks with sufficient human resources and skillsets. The country’s regulatory reporting also broadly remained paper-based. Compliance framework must be well-placed as a major strategic issue of all existing banks in the country; and must find due impetus in the strategic planning of the upcoming digital banks.
Operational and credit risks are critical challenges for banks that need special attention to sustain in the industry. Reliance on advanced technology and online platforms leads to new risks, and digital banks need to have contingency arrangements. Credit risk management by digital banks without human involvement can be particularly challenging with the presence of limited access to reliable credit data; large informal economies; tradition and culture of willful default; weakness in legal enforceability; absence of social pressure on willful defaulters; and limited financial and digital literacy.
The country’s willful default situation in some brick-and-mortar banks might be a critical challenge for new entrants in the industry. For the micro and small borrower segments, successful lenders like Microfinance Institutions (MFIs) often engage in in-person strategies to reach and serve their clients, who are typically individuals with limited access to traditional financial services. These strategies are workable for building trust, understanding clients’ needs, and ensuring the effective delivery of financial services. This environment might be challenging to manage credit risk by the digital banks of the country. Enforcement of the newly amended Bank Companies Act is expected to bring positive changes in the willful default scenario if efficiently enforced. The situation demands additional efforts and resources on the part of the upcoming digital bank to efficiently handle the situation.
Probably digital banks represent the future of the banking industry. Digital banks are expected to complement traditional brick-and-mortar banks in the future by offering convenient, tech-savvy, and cost-effective financial services. The choice between digital and traditional banking might depend on individual preferences, needs, and the specific services offered by each type of institution. While digital banks offer numerous advantages, it is essential to consider potential downsides and fundamental barriers in the country’s banking industry in the process of installing digital banks.
