Challenges of Risk-Based Supervisory System

In the previous articles, we have studied what a risk-based supervisory system for pension funds is. We have also studied the various steps which need to be taken in order to set up such a system.

It is true that this system is being adopted on a large scale worldwide because of the various benefits that it offers. However, it is also true that there are some significant challenges with this system.

It would be a huge mistake for pension fund regulators to only focus on the positives and implement the system without truly understanding the challenges involved in the process.

Some of the important challenges related to the implementation and management of a risk-based supervisory system have been mentioned in detail below:

1. Managing the Complexity: Managing the risk of a single pension fund can be quite complex in itself. There are a wide variety of mathematical calculations and economic indicators which need to be taken into account while managing even a single fund. However, when the risk management scope is extended to the entire industry, then the quantum of complications gets amplified.

   Pension fund regulators have to sift through thousands of data points and indicators to zero down on a few which can explain the risk levels of the entire system. Once the pension fund supervision model has been created, it might appear to be very simple to implement. However, the reality is that there is a considerable amount of complexity that needs to be managed while creating the system.

   Fortunately, many such systems have already been created across the world. Hence, newer systems can be created with less effort by adapting these systems to the local standards.

2. Aggregating the Risks: It is important to realize that while it is common for risk management professionals to break down the risk being faced by a pension fund, it is not completely possible to do so.

   Almost all the risks which are faced by the system are correlated to each other. Sometimes these correlations are positive whereas other times these correlations are negative. This means that as per the risk-based supervisory system when an attempt is made to aggregate the risks, a huge operational challenge is created.

   Some risks get amplified when aggregated at a systemic level whereas other risks get reduced while doing so. The bottom line is that aggregation of risks can be quite challenging.

3. Timely Flow of Data: The entire concept of risk-based supervision of pension funds is based on the idea that the regulator can monitor the risks just like pension fund management. Now, the pension fund management has access to the data of the fund.

   The regulator may not have real-time access to the data. Even if they do have access to the data, the data may not be structured in the proper format. As a result, aggregating the data in a format that can be used for analysis can be quite challenging for the regulator.

   Also, in many parts of the world, there might be data privacy concerns that make the transfer of such data difficult. Hence, it must be understood that having a fully functional data management system is a prerequisite to the implementation of a risk-based supervisory system.

4. Ensuring that the System is Forward-Looking: Another important aspect of the risk-based supervision system is that it needs to be forward-looking. The forward-looking characteristic is what distinguishes a risk-based supervision system from other systems. Hence, the data being transferred to the regulator and used for analysis needs to be current.

   There is no point in transferring historical data since the regulators cannot really use the same to undertake any preventive steps. The pension fund regulators have to constantly ensure that every data point and every decision being made is done with a focus on the future.

5. Structure and Governance of the Risk Management Process: Designing the reporting structure of the risk-based supervision system can also be quite a challenge. This is because of various factors.

   Firstly, it requires the participation and co-operation of people across various organizations. Hence, organizational boundaries have to be blurred and data sharing mechanisms have to be set up.

   Another challenge is the fact that the resultant organization structure must allow for regulatory action to take place at a quick pace. However, at the same time, the need to provide accurate data is very high.

6. Managing the Gaps: The last and most crucial challenge is to ensure that the gaps which arise while managing a risk-based system are monitored and periodic action is taken.

   For instance, if there are gaps in the information flow between the participant company and the supervisor, it needs to be identified and corrected as soon as possible. Similarly, if there is a gap in the way credit scoring is done, some risks could be completely missed out.

   In such cases, the pension fund regulator has to be intelligent enough to recognize these gaps and fix them in a timely manner. The inability to do so could prove expensive to the regulator and to the pension system as a whole.

Hence, even if implementing a risk-based supervisory system is beneficial, it is not an easy task. There are several challenges that need to be overcome before such a system starts providing the expected benefits.