How to balance innovation and risk is an ageless dilemma for regulators. Over the last decade, two distinct and diverging trends have exacerbated this dilemma even further in the financial industry. On the one hand, information technologies have been developing rapidly. An increase in computing power, information storage, interconnectedness, new advances in computer science, and artificial intelligence has created new and unprecedented possibilities for information processing. The financial industry is one of the most affected by these developments.
Financial intermediaries at their core exist because of informational frictions of the financial market. They create value by solving informational problems, for example, what is the risk of the borrower, what portfolio allocation is suitable for a given customer, has money been delivered, has contingency aligned to trigger option execution or payments on an insurance contract and so on. Therefore, it is not surprising that the development of information technologies has created an unparalleled opportunity for existing financial sector participants to develop innovative products, and has also brought new fintech startups to the market.
On the other hand, we see the emergence of new risks in the financial sector and increased correlation across different risk classes and markets. As a result, the scope and depth of regulation have increased in response to these new risks. This trend has accelerated since 2008 and represents a challenge for financial innovators. Usually, regulation is tailored towards existing institutions and existing business models. This creates entry barriers for fintech startups and also discourages the introduction of new products by existing financial firms. As a result, the financial sector has encountered difficulties in fully embracing new possibilities and lags behind in information technology adoption compared to other industries.
To reconcile the tension between these fundamental trends by favoring innovation at the expense of regulation is not a viable option. This could not only endanger financial stability, but also hinder the development of new business models. The wait-and-see strategy works only in limited cases in financial regulation and could result in the development of models with high systemic risk. In addition, it should be noted that well-designed regulation increases public trust, which is fundamental for success in the financial industry.
There is a need for a new supervisory policy framework, which does not simply move along the risk-innovation tradeoff curve but considers specific features of information technologies and advances the innovation-risk frontier for a better social outcome. This could be achieved by advancing the risk-based regulatory approach to the next 2.0 level and developing new regulatory tools.
Faced with these challenges, the National Bank of Georgia (NBG) has embarked on a journey to develop a new fintech-friendly regulatory toolkit under the umbrella of the Open Regulation Framework (ORF). The risk-based supervisory approach, which is embedded in the DNA of NBG, was used as a basis for the ORF.
NBG had to analyze emerging best practices and setbacks from peer regulators, going back to the very first principles of regulation, and reconstructed a flexible regulatory framework to be used in a dynamic and changing technological environment, while at the same time being highly risk-sensitive.
The ORF is based on several underlying principles ...
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