Risk-based supervision: balancing between enforcement and the need to connect
Risk-based supervision: balancing between enforcement and the need to connect
Why don't you hand out more fines? Many of our colleagues and journalists abroad ask us this question. And it is a good question. After all, supervisory authorities tend to be associated with enforcement and a formal approach. In our case, however, things are slightly different. The AFM pursues a risk-based approach. This means that through our supervision, we aim to contribute to long-term financial well-being in the Netherlands.
Many other supervisors tend to focus on regulatory compliance among businesses. This type of supervision, driven by rules, is based on formal enforcement, including fines. In our approach, fines are part of a much broader range of instruments we can use to influence the behaviour of companies and sectors. It is this behaviour that we focus on in our supervision. The other Dutch financial market supervisor, the Dutch Central Bank (DNB), is mainly concerned with the stability of the financial system and the extent to which parties are able to fulfil their financial obligations (‘prudential supervision’).
Prohibited or harmful?
The box below presents the three types of supervision we use. Our mission-driven supervision is particularly evident in the third type. Its design is inspired by the problem-oriented approach developed by Harvard professor Malcolm K. Sparrow. His motto: 'pick important problems, fix them, then tell everybody'. The crux of the matter is to identify the important problems that you want to fix. Sparrow distinguishes between prohibited and harmful types of behaviour. In principle, a rules-based supervisor will focus exclusively on prohibited types of behaviour. After all, this is the kind of behaviour that violates laws and regulations. At the AFM, in addition to prohibited behaviour our scope also includes harmful behaviour.
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types of supervision
Supervision at the gate
In this first test we check the extent to which a company satisfies the statutory requirements – for example in a licensing procedure, or when an issuing institution submits a prospectus to the AFM for approval, before issuing securities. This also covers the vetting of new managing directors and supervisory directors of financial enterprises.
Ongoing supervision
We maintain regular contacts with companies to make sure we can identify risks at an early stage. Ongoing supervision involves various different working methods, including self-assessments by the companies under supervision. This enables us to identify companies where the risks are greater – due, for instance, to their size.
Project-based supervision
This type of supervision allows us to focus on specific problems associated with a particular company or product, or on the basis of a combination of signals and investigations. Project-based supervision also allows us to zoom in on specific groups of consumers, such as people with a mortgage.
Setting priorities
Given the thousands of companies and the huge diversity of products in the financial sector, and in view of the ever expanding tasks of the AFM, it is imperative that we set priorities and deploy our resources as effectively as possible. And we take a risk-based approach to that. This involves continuous monitoring of developments on the financial markets and at relevant companies. In this way we can identify potential problems and analyse the risks: which of those problems pose the greatest risks? Next, we set priorities based on the chance of specific problems, their size and impact. We publish the main priorities and the associated actions in the AFM Agenda. Since we believe that transparency is hugely important, we publish our trend and risk analysis for the financial market and sub-sectors in the Trend Monitor.
Comprehensive set of instruments
For each prioritised problem we formulate the supervision objectives and the effects we aim for, and these determine the action that we will take. We do however regularly adjust our priorities and actions based on the continuous risk analyses we perform. Once the priorities are clear, the next step is to select the most suitable instruments to address the (actual or potential) problems. We can choose from a wide range of formal and informal instruments to influence market players. Also see the box below. Informal influence plays an important role in addressing behaviour that is not prohibited but does cause harm. In such a case we may for example decide to sit down with the parties involved to convince them that their behaviour is harmful and that they should take measures. The AFM can also ask the legislator to grant supplementary powers and/or amend existing laws and regulations. Every year we also send a ‘legislative letter’ with concrete proposals for such amendments.
Examples of instruments
The box presents a number of examples of instruments available to us in our supervision. As regards informal supervision, we are free to develop new instruments depending on the desired effect. For example, we posted adverts on social media to reach finfluencers and used Google AdWords adverts to target a specific enterprise.
Informal influence
• Presentations and publications • Influence through the media • Interviews • Sector letters • Round table meetings • Informal discussions • Letters / emails • Guidelines • Benchmarks
Informal enforcement (without a legal obligation)
• Instructive conversations on compliance with standards • Instructive letters/emails on compliance with standards • Warning letters
Formal enforcement (sanctions imposed pursuant to the law)
• Public warnings • Instructions • Orders for incremental penalty payments • Removing policymakers from office • Appointing silent conservators (Financial Supervision Act) • Administrative fines (imposed on a company and/or an individual)
Use the most effective combination of instruments
Where possible, effectiveness is the key criterion in selecting the most appropriate instrument. Over the years, experience has taught us that a mix of preventive and repressive supervision works best. Preventive supervision means that we enter into a dialogue with market players and give information, for instance through seminars and guidance material, FAQs and interpretation guides. In repressive supervision there is an emphasis on enforcement measures, which may also take the form of an actual fine. One example of preventive supervision was our effort targeting platforms for crowdfunding. Those platforms over-exposed the benefits and under-exposed the risks. While not prohibited by law, this was potentially harmful. So we entered into a dialogue with the sector and launched a series of initiatives in cooperation with the sector association.
The influence of technological developments
Our supervisory practices evolve under the influence of technological and societal developments. For instance, financial markets increasingly operate on the basis of data and automated processes. As a supervisory authority, we need to understand the ways in which companies use artificial intelligence, for example. Moreover, as a data-driven supervisor we use data analysis to identify risks in a more targeted and efficient manner and analyse the actions of companies. In concrete terms, for the AFM this also means investing in people and systems.
A changed perspective on consumers
Another development we are experiencing in our supervision is a shift in our perspective on consumers. Twenty years ago, the view of consumers as entirely rational beings was still fairly common. However, we have since developed a more realistic picture based on consumers’ actual behaviour, and with more attention for the differences between groups of consumers. We have intensified our analyses of vulnerable consumers and now feel it is entirely self-evident to include behavioural scientists in our team. In line with this new approach, we are also witnessing a shift in our supervision from a focus on whether a particular product is right or not to a focus on whether the product is appropriate in view of the consumer and the situation they find themselves in.