Regulatory and compliance risks relate to how companies respond to regulations in their sectors. But the two types of risks aren't identical. This article will define them both and explore their differences. Readers will learn how to create robust risk management programs covering both compliance violations and changes to the regulatory environment.
We will discuss emerging issues for the financial sector, where new technologies like blockchain are radically changing business compliance strategies. And we will suggest some ways to create an efficient risk management mechanism.
What is regulatory and compliance risk management?
Regulatory risk definition
Regulatory risk refers to risks caused by changes to regulations or laws. Changes to privacy laws that outlaw cookies are examples of regulatory risk. In the world of crypto-currency, tighter financial regulations pose a regulatory risk.
Compliance risks are slightly different. Compliance risk refers to risks caused by regulatory violations. Failing to encrypt credit card data to PCI-DSS standards is an example of compliance risk.
The two forms of risks are closely related. Businesses must consider both forms of risks when creating compliance strategies.
Organizations must decide which compliance risks require controls and whether to share responsibilities with third parties. And they must also have contingency plans to cope with regulatory changes.
Understanding compliance risk management
Companies must decide how to respond to both compliance and regulatory risks. They have four main responses, and each one should be part of the risk management process:
Avoidance. Can business operations be structured to avoid the risk as far as possible?
Mitigation. Can the organization put in place controls to minimize the risk? Controls could include access management tools or staff training.
Acceptance. Some risks cannot be avoided. Companies must be clear about the risks they accept, and state why this is a sound business strategy.
Transferral. Can risks be outsourced to third parties or shared? For example, credit card processing can be carried out by specialist business partners.
Risk management plays a critical role in business operations. Companies can handle adverse events and neutralize threats. With risks under control, they can innovate and expand safely.
Risk assessment: a key step in managing regulatory compliance risks
Risk assessment provides a framework to understand regulatory compliance risks. Without a solid risk assessment, organizations cannot connect regulatory requirements with business activity. This makes regulatory violations and cyber-attacks much more likely.
Risk assessments perform several important functions in the risk management mechanism:
Context. Risk assessments establish which regulations apply to the organization. They set out core regulatory requirements and provide a road map to achieve compliance. Assessments include a clear definition of what compliance means, and how to determine when risks have been successfully mitigated.
Classification. Risk assessors determine which risks have the highest priority. They assess business systems and data assets. This assessment enables security teams to focus attention on critical vulnerabilities.
Mitigation. Risk assessors connect regulatory risks to security controls. Risk management plans describe how to mitigate each risk.
Assessment and analysis. Compliance risk management audits ensure that the plan is being followed. Assessors may re-classify risks or add further risks as the plan develops. Continuous assessment also considers new laws or regulations. Assessors make recommendations based on emerging potential risks.
What are the types of business regulations?
Businesses in the United States have to consider a tangled web of regulations. Each industry has a specific regulatory burden, and regulatory compliance risks vary between companies. However, some of the most important business regulations to think about include:
HIPAA – The Health Insurance Portability and Accountability Act regulates companies that handle patient data. HIPAA includes detailed provisions about data privacy, incident reporting, security controls, and relations with third parties.
Sarbanes-Oxley (SOX) – The Sarbanes-Oxley Act regulates financial companies in the USA and deals with issues like financial reporting, internal auditing, and transparency. It makes strict demands on accounting procedures within US companies.
CCPA – The California Consumer Privacy Act protects the privacy of Californians. Companies operating in California must be able to access data held about them. Companies must not share consumer data without consent. And data must be deleted immediately.
Clean Air Act – The CAA is one of many environmental regulations affecting US businesses. It regulates the emissions of pollutants, enforcing penalties for breaches. Similar regulations cover drinking water quality and responsibility for oil spills.
Sherman Antitrust Act – Alongside other laws, the SAA regulates interstate commerce and blocks mergers that might compromise competition. Larger companies must consider regulatory risks from antitrust laws when expanding their operations, but this is less important for small businesses.
As you can probably see, laws and regulations vary in their scope and intention. Some regulations cover a specific sector. Others apply to all businesses active in the United States, while some are limited to individual states.
Some regulations influence business behavior. Others seek to protect consumers. And some regulations seek to shape the economy and environment as a whole. So there is a lot of diversity. Organizations need to be aware of relevant regulations when building a regulatory compliance program.
What is the difference between compliance and regulatory risk?
Compliance and regulatory risk are separate concepts, and it's important to understand the differences between them.
Compliance risk definition
Compliance risk is the exposure of a company to financial, legal, or criminal penalties if it fails to comply with relevant regulations.
This type of risk involves the avoidance of regulatory punishment. Organizations must be aware of how regulators assess violations. Compliance risk mitigation actions should minimize the risks that lead to penalties.
Compliance risk examples
Compliance risks vary between industries. And there are hundreds of potential examples. Regulatory compliance risk examples include:
Privacy violations. Legislation like HIPAA requires strict protection of patient privacy. In the European Union, the General Data Privacy Regulation (GDPR) covers all online businesses, demanding consent for information sharing and data retention.
Data breaches. Exposing data to hackers is one of the most common compliance violations. PCI-DSS rules require all companies that handle credit card data to implement robust controls. And financial companies that expose data risk prosecution under Sarbanes-Oxley or the Financial Modernization Act (also known as Gramm-Leach-Bliley).
Fraud. Legislation protects customers and shareholders against fraud in almost all jurisdictions. Companies must monitor employee activity, protect confidential data, and audit accounts thoroughly. If not, they face damaging prosecutions and deep reputational damage.
Anti-money-laundering laws. Money laundering is a priority area for US regulators, especially financial institutions. And the penalties are often extremely high. For example, Deutsche Bank was forced to pay $2 billion under anti-money-laundering regulations in 2022.
Health and Safety. Health and Safety laws and regulations are administered by the Occupational Safety and Health Administration (OSHA). They seek to protect employees and customers from harm and mandate severe penalties for avoidable violations.
Process violations. Process risks involve poorly configured or insecure business processes. In the digital realm, this type of risk includes inadequate network security. Companies may fail to carry out network scanning or penetration testing as demanded under PCI-DSS rules. If this leads to malware attacks that compromise customer data, the company affected could be liable.
Environmental damage. Many US laws regulate the way companies interact with the external environment. Breaches of these laws and regulations can have serious financial consequences. For example, oil company BP was fined $5.5 billion under the Clean Water Act following the Deepwater Horizon oil spill.
Regulatory risk definition
Regulatory risk is the exposure of a company to losses or penalties due to changes in the regulatory or legal environment.
Changes in the law can render previously normal business activities illegal. Prohibition is probably the most famous example from US history, but regulations change constantly.
Companies need to research and assess potential regulatory changes. They need a proactive regulatory risk management strategy. That way, they can make changes to their operations before they experience regulatory penalties or legal challenges.
Regulatory risk examples
As with compliance risk, regulatory risks are context-specific. Every business sector has its own body of relevant regulations. Examples include:
Privacy regulations. The rise of social media marketing and online tracking has led to a legislative and social response. Companies that gather customer data need to stay informed about the regulatory framework. For example, when GDPR came into force in 2018, online merchants suddenly needed to inform website visitors about tracking cookies. And companies that failed to do so faced huge fines.
Emissions laws. Environmental regulations change as scientists learn more about how we affect the natural world. Emissions legislation is a good example. Companies need to know about allowable greenhouse gas emissions or ways to mitigate emissions via credits or offsets.
Antitrust laws. Large corporations must anticipate efforts by regulators to maintain a competitive marketplace. The European Union fined Microsoft over $500 billion for bundling Internet Explorer with all Windows installations. And in 2017 it fined Google $2 billion for excluding competitors from the market.
Regulatory risk vs. compliance risk
Compliance risk and regulatory risk are two different concepts. But in practice, they work together to secure businesses against regulatory penalties.
The way this works is simple. Regulatory risks can become compliance risks or make existing compliance risks more important.
Risk managers must understand how emerging laws or regulatory frameworks will affect business operations. They need a strategic perspective. And their analysis should feed into compliance risk management strategies as the regulatory environment changes.
An effective compliance risk management strategy has two components. Risk assessors design controls and processes to deal with existing regulations. And they also anticipate upcoming changes to regulations. They put plans in place to deal with these changes and avoid confusion or compliance gaps.
Both forms of risk are complemented by measures to handle governance risk. This refers to the way the business is managed. This includes a properly constituted board, with officers responsible for ethics and compliance.
Financial regulatory compliance
The financial sector faces a complex set of regulations. Bank failures in the 20th century led to a strict set of rules about the role of different financial institutions. These rules were relaxed in the 1990s and 2000s. But since the 2008 financial crisis, the federal government has strengthened financial regulations in every area.
Modern financial companies must handle regulatory compliance risk areas like disclosure and reporting, corporate structure, liquidity requirements, business investment methods, and data security.
The most important regulatory body in finance is the Securities and Exchange Commission (SEC), although the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) also play key roles.
In the European Union, the responsibility to administer regulations lies with the European Banking Authority (EBA), while the European Data Protection Supervisor (EDPS) handles violations of GDPR.
Blockchain's influence on financial regulatory compliance
Blockchain technology has become an emerging frontier in the financial sector. And the growth of blockchain technologies such as crypto-currencies is leading to new regulatory compliance risk areas.
In the United States, there has been confusion over whether crypto-currencies represent securities or commodities. This has created a regulatory vacuum, with no agency claiming responsibility to regulate blockchain-based currencies.
At the same time, the need for regulations has increased due to high-profile instances of fraud or business failure. So businesses engaged in the blockchain sector face a series of regulatory risks. Examples include:
Tighter rules on coin issuers to prevent fraud
Capital requirements for exchanges
Privacy rules to secure customer currency wallets
Rules on cross-border crypto transactions
Accounting laws to properly value crypto assets
Blockchain already presents compliance risks. For example, companies must ensure that currencies are encrypted. Blockchain processes must integrate with IT systems safely. And third party agreements with blockchain-related service providers should comply with existing data security or privacy rules.
In the future, companies will seek to harness decentralized blockchain processes in many ways. But as they do so, they will need to put in place robust compliance programs.
Conclusion: ensure compliance with solid risk management programs
Whether companies are developing blockchain solutions or selling SaaS products, compliance risk management should be a priority. And putting in place a risk management plan is essential. Effective risk management processes are based around:
Internal expertise. Competent and well-informed compliance officers skilfully link regulations and internal systems. Risk and compliance teams assess all relevant risks. They generate risk management plans that explain how to mitigate regulatory compliance risk. And they understand how compliance risks emerge from changing regulations.
Compliance software. Compliance software makes the risk management process more efficient and limits the potential for human error. Compliance systems centralize information within easy-to-understand risk management plans. They allow seamless cross-departmental collaboration. And they make compliance audits simple.
Every company should have a comprehensive compliance risk management program. Solid risk management analyzes the regulatory context and anticipates future developments. It understands existing regulations, making it possible to put in place appropriate controls. And it places compliance risk management where it belongs – at the heart of business operations.
The result is a reduced risk of data breaches and regulatory penalties. And companies will be less exposed to reputational damage. Instead, they can focus on serving customers and improving their products.