Managing investment compliance during a recession

Published on December 7, 2022 by Sanjukta Chatterjee

The US economy has been struggling lately to fight fears of an impending recession. Major financial entities such as big banks, prominent economists and former policymakers are opining that a downturn is a near certainty as the Federal Reserve (Fed) tries to control inflation. Rising gas prices, a hawkish Fed and a generally slowing economy are the three main risks facing the world's largest economy right now. A recession is likely to impact banking and financial services, as well as compliance. Investment compliance management (ICM) involves adhering to investment-related restrictions, monitoring and administration, and is a particularly vulnerable function during economic slowdowns. This blog discusses how a potential US recession can affect banks’ investment compliance in general and what financial institutions can do to mitigate the effect.

Investment risk management

• Regulatory updates and reporting

• Internal risk appetite

• Penalty for non-compliance

• Compliance oversight

Regulatory updates and reporting

In the event of a recession, regulatory bodies such as the SEC, PRA, SFC and HKMA will likely look to implement policies to ensure market liquidity is not adversely impacted. Firms need to ensure there is no relaxation of oversight on regulations pertaining to trade compliance and investment restrictions, as these are opportunities for investment compliance fraud. It is well known that, during a recession, some asset classes – such as derivatives and structured products – are more volatile than others, and regulations should be passed to identify and prevent non-compliance in trading these products. Additional provisions could be introduced in current regulations financial institutions adhere to when monitoring trade and investment compliance, so as not to tighten market liquidity further.

Reporting is likely to be highlighted in the event of a US recession. Regulators may demand reports of current and forward-looking information at a greater frequency or covering a wider spectrum, and a firm’s regulatory reporting process should be robust enough to meet this challenge. Compliance should extend from fund accounting reports to the development of the final exceptions file, and regulators should analyse relevant regulations at each stage for gaps. During a recession, banks and other financial institutions are at most risk of collapse; thus, the reporting process is important for detecting signs of wrongdoing in capital markets.

Internal risk appetite

Financial institutions differ in terms of the risk they can take on their trade balance sheets and P/L statements. Some firms are more likely than others to take up risky assets in their regular operations. However, during a recession, there is increased volatility overall and for risky assets in particular. Firms need to clearly define and articulate their risk appetite, especially when regulations do not define a particular number or percentage. Firms that provide fiduciary services to asset management clients also need to adhere to asset managers’ requirements in this regard. An example is monitoring investment restrictions and cashflow for asset-manager trades where certain thresholds have been implemented in line with general regulatory requirements.

Penalty for non-compliance

Regulators impose high penalties for violation of investment compliance regulations. In the wake of the 2008 financial crisis, failure to keep investors adequately informed of developing impairments to performance and assets resulted in a number of enforcement actions. Investment fraud events such as the Lehman Brothers crash and the Satyam scam occurred in 2008 during the height of the global financial crisis, leading to the collapse of both institutions. During a recession, firms need to be more vigilant in terms of investment compliance-related activities since rising inflation and slowing economic growth imply that liquidity is at a premium. Hence, a firm would find it difficult to pay fines and penalties imposed during a recession without this affecting its balance sheet and likely leading to its collapse. Related impacts such as loss of reputation, suspension of trading licence and over-leveraging to pay off liabilities are likely to damage the financial institution’s prospects in the long run.

Compliance oversight

The remote-working framework will likely continue until early 2023, when the US recession is expected. With financial institutions and asset managers transitioning to a hybrid work model, surveillance of traders would become increasingly difficult. Advances in technology enable remote supervision of employees, but it remains challenging to replicate the full suite of compliance measures normally available to businesses. Without full oversight, the probability of non-compliance with investment regulations rises, and market or trade manipulation becomes a strong possibility. Firms could consider enhanced testing or sampling of transactions to show enforcement agencies their commitment to compliance. Providing additional training to both in-house and external regulators and compliance managers would be necessary to adapt to a recessionary environment that increase the pressure to comply with regulation.

Conclusion

The impending US recession is likely to lead to a more volatile financial market while economic growth slows further. Investment compliance is likely to become a hot topic as banks and financial institutions try to maintain compliance and monitor market manipulation and misconduct in a post-pandemic world. New developments such as the introduction of the T+1 settlement cycle in the US capital markets need to be incorporated within the compliance framework while ensuring that daily operations are not adversely impacted. Hence, we expect investment risk mitigation to continue amid a US recession and oversight of asset managers and trading firms to grow and remain relevant.

How Acuity Knowledge Partners can help

Acuity can help balance your compliance workload or manage retention while maintaining best practices. Our dedicated team of 150+ compliance experts are supporting compliance teams globally and addressing the challenges of increasing the effectiveness of their compliance programs, managing with fewer internal resources, ensuring high-quality results, while reducing turnaround times and lowering costs.

References:

https://www.morganstanley.com/ideas/recession-2022-potential-how-bad

https://www.nytimes.com/2022/06/28/business/recession-probability-us.html

https://www2.deloitte.com/us/en/insights/economy/us-economic-forecast/united-states-outlook-analysis.html

https://www.weforum.org/agenda/2022/04/recession-investor-bank-pandemic-united-states/

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