How Risk-Based Supervision System Works?

In the previous article, we have already studied what risk-based supervision is. We now know why regulatory bodies all across the world are adopting the risk-based supervision system and what its benefits are. However, it is also important to understand the manner in which a risk-based supervision system can be implemented.

The details of the steps which need to be taken in order to implement the risk-based supervision system have been explained in the below article.

Step #1: Introspection

The first step in the creation of a risk-based supervision system is, to begin with, introspection. It is important for the regulator to be aware of the number of resources that they have on hand.

It is also important for the regulator to closely understand the legal framework which governs the regulatory process. The industry skills and readiness possessed by the regulator should also be taken into account. This is the most important step in the entire process since it gives the regulator a fair understanding of the types of risks that they will be able to monitor.

Step #2: Setting the Ground Rules

The regulatory authorities can only manage the risks being taken by the pension funds if there is a consensus about the way in which risk has to be measured as well as managed. This requires the regulatory agency to be explicit about the ways in which they are going to monitor risk.

The types of risks which will be monitored as well as the measures which will be used to manage the risk need to be explained clearly. The type of risk management scoring system, whether quantitative or qualitative also needs to be clearly mentioned to the pension funds.

Step #3: Creating the Dashboard

The next step in the risk-based supervision process is to ensure that the risks are properly codified and a dashboard is maintained. It is common for pension fund supervisors to have a dashboard that depicts different types of risks such as liquidity risks, reputational risks, credit risks as well as operational risks.

Pension fund regulators then try to understand the correlation between different types of risks. It is the job of the pension fund supervisor to understand these risks at a local level as well as at a systemic level. It is the job of the pension fund regulator to understand and avoid systemic risks from being created in the system.

The pension fund supervisor should have a clear understanding of the various types of risks on a gross as well as a net level. They must have a dashboard in place in order to frequently monitor the changing levels of these risks.

Step #4: Creating the Scoring Mechanism

In the first two steps, the parameters which will be considered for risk scoring have been identified and mapped.

The next step is to create a mechanism that allows for the allocation of scores to various pension funds. This is done by providing a weight to every parameter. This helps create a weighted average formula that can be used to create a final credit score. The regulatory authority then decides on the threshold limits. This includes the limits of the overall score as well as the limits of the individual parameters.

Step #5: Quality Review

Once the risks have been mapped and a scoring system has been generated, the model will help allocate regulatory resources based on the risk score generated. However, this report should not be directly considered for action by the supervisors. This is because often times there are data issues that lead to false flag alarms and the resources of the regulator end up being squandered.

Most pension regulators around the world have a quality review system in place wherein the data and the calculations are verified before the regulators are involved. This verification can be done either manually or automatically.

Step #6: Allocation of Regulatory Resources

The last step in the process is the assignment of regulatory resources to the pension funds. As mentioned above, the thresholds and benchmarks created can be used to categorize the issues as high, low, or medium priority.

Based on the severity of the risk being mitigated, resources can be allocated. Once the regulatory resources are allocated, they will become a temporary stakeholder in the pension fund.

The pension fund managers will have to make periodic presentations to these regulators till the risk measurement parameters have been brought under control. It is also important for the pension fund regulator to have a policy in place in order to escalate their actions if the pension fund management is unable to control the risk factors and bring them to an acceptable level.

Based on the approach mentioned above, a lot of people have the misconception that a risk-based supervision system is only about creating a risk scoring system. However, this is not true. The system adopts a much broader approach.

However, the scoring system is indeed a pivotal part that helps it identify the top five or ten funds which need regulatory support from the hundreds of funds that they are supposed to supervise.