The number of pension funds, as well as the amount of money being managed by these funds, is increasing exponentially every day. This is creating advantages for the investors. However, this is also creating a lot of problems for the regulators. This is because regulators have scarce resources and they have to manage the regulation of the entire industry with them.

The risk-based supervision model is born out of the need for pension funds to focus their scarce resources while monitoring the activities of pension funds.

In this article, we will have a closer look at what risk-based supervision is as well as the various advantages of using this approach over the traditional approach.

What is Risk-Based Supervision?

Risk-based supervision is a structured approach followed by pension fund regulators. As per this approach, the pension fund regulators do not pay equal attention to all pension funds. Instead, they ask all pension funds to submit periodic reports. After these reports have been submitted, the regulators use them to ascertain which funds are facing the highest risk.

The funds with low or medium risk are not given much attention. The funds which are perceived to have a higher risk witness a greater amount of regulatory control action. The risk-based model is essentially a model which links the application of supervision with the quantum of perceived risks. The perception of risks can either be quantitative or qualitative.

The risk-based supervision model is quite flexible and it depends upon the regulator applying it. There are instances where the model has been deployed in a very quantitative model. This means that a specific risk score is generated for every pension fund based on various parameters. On the other hand, it is also possible that the model is deployed in a qualitative manner where the risk perception is based on questionnaires instead of being based on verifiable mathematical calculations.

Benefits of Risk-Based Supervision

The concept of risk-based supervision has been adopted by many countries. This is because of the fact that there are several advantages to having this system. Some of them have been mentioned below:

1. Firstly, it is important to note that no pension fund regulator in the world has the time and resources to closely monitor each and every pension fund. Hence, prioritization does take place in one form or another. However, when it comes to risk-based supervision, the prioritization is done in a formal manner instead of an ad-hoc manner. There are clear and explicit rules which govern the prioritization.

2. Another advantage of risk-based supervision is that it helps in identifying the possible issues with the help of current information. Other regulatory models try to mine past data in order to find out probable issues that may occur in the future. This approach has not been very effective. On the contrary, risk-based supervision has proved to be more effective within a short period of time.

3. Risk-based supervision goes a step beyond compliance. As per this approach, compliance is necessary but it is not the end goal. Instead, compliance procedures are considered to be a means to an end. The final goal is to understand the risk in a timely manner and then use the information to de-risk the pension fund before any adverse event takes place.

4. Risk-based supervision replaces the strict application of rules with a more flexible system. The same regulator is able to behave in a lenient manner or a strict manner depending upon the performance of the pension fund in question.

   Risk-based supervision does not mean that the traditional system is abandoned. Instead, it just means that rules are just being applied in a more rational manner.

5. A very important point is that under this system pension funds are incentivized to keep their risks low and run their operations in an effective manner. This is because pension funds are known to avoid regulatory scrutiny. As per this model, if they do not have their ducks in a row, the regulator is likely to intervene.

   The pension funds which are not well run are likely to receive more regulatory intervention. It is quite likely that pension funds will make efforts to ensure that they do not receive this attention since it will impede their day-to-day working and increase their cost of operations.

6. It is also important to note that empirical studies have shown that risk-based supervision drastically increases the probability that major financial problems will be spotted in a timely manner. It also makes it possible for the regulators to devote their time and attention to remedying such issues in a timely manner.

The fact of the matter is that the application of risk-based supervision is growing rapidly in the market. It is true that the model is facing some risks and challenges. However, based on the current trajectory, it is likely that risk-based models will become dominant in the world in the next few decades.

The regulatory bodies need to be careful in the sense that they should roll out the system gradually. The supervisory authority, as well as the industry, need to be given some time in order to adjust to this new approach.