Regulatory guidance

What Is Regulatory Guidance?

Regulatory guidance refers to communications issued by government agencies that advise the public on how the agency interprets statutes and regulations, or how it intends to exercise its discretionary powers.²¹, ²² This type of communication is a key component of financial regulation, falling under the broader financial category of regulatory compliance. Unlike formal laws or regulations, regulatory guidance generally does not carry the full force of law, but it provides crucial insights into supervisory expectations and best practices.²⁰ Financial institutions, for instance, often rely on regulatory guidance to understand how to manage various risks, such as interest rate risk or operational risk.

History and Origin

The use of regulatory guidance has evolved significantly as governmental bodies have sought to provide clarity and flexibility in the application of complex rules. In the United States, agencies routinely issue guidance documents to explain their positions on various matters. The Administrative Conference of the United States (ACUS), an independent federal agency, has adopted numerous recommendations aimed at improving how federal agencies effectively use and make guidance documents publicly available.¹⁸, ¹⁹ For example, ACUS Recommendation 2017-5 provides best practices for agencies on the formulation and use of policy statements, which are a common form of regulatory guidance.¹⁷ The role of regulatory guidance gained particular attention in the aftermath of the 2008 global financial crisis, as regulators around the world sought to strengthen oversight and prevent future systemic failures. Measures like the Basel Capital Accord, which provides principles for managing interest rate risk, have shaped how supervisory guidance is issued and applied internationally.¹⁶

Key Takeaways

• Regulatory guidance offers insights into an agency's interpretation of laws and its supervisory expectations.
• It serves as a critical tool for financial institutions to understand and implement best practices in risk management.
• Unlike formal regulations, guidance documents typically do not have the binding force of law.
• Agencies often issue regulatory guidance to provide flexibility and clarity, particularly in complex areas like capital adequacy and liquidity management.
• Compliance with regulatory guidance is often a de facto expectation for supervised entities, influencing regulatory ratings and potential enforcement actions.

Interpreting the Regulatory Guidance

Interpreting regulatory guidance requires a thorough understanding of its intent and implications. While not legally binding, it often reflects the agency's current priorities and areas of focus for supervisory oversight. Financial institutions need to assess how the guidance applies to their specific operations, risk profile, and business model. Effective interpretation involves identifying the practices highlighted by the agency as mitigating risks or being consistent with sound principles. For instance, guidance on cybersecurity risk might suggest specific controls or governance structures that the agency views as appropriate.

Hypothetical Example

Imagine a new piece of regulatory guidance issued by a central bank concerning stress testing for financial institutions. This guidance might outline the types of economic scenarios banks should consider, the methodologies for projecting potential losses under those scenarios, and the expected frequency of such tests.

A regional bank, "Secure Savings Bank," receives this guidance. While the guidance isn't a strict regulation, Secure Savings Bank's compliance department understands that their supervisor will evaluate their stress testing framework against these new expectations. They initiate a project to update their existing stress test models, incorporating more severe macroeconomic downturns as suggested by the guidance. They also enhance their data aggregation processes to ensure the data used in the stress tests aligns with the agency's recommended level of granularity. By proactively aligning with the regulatory guidance, Secure Savings Bank aims to demonstrate robust enterprise risk management and avoid potential supervisory criticism.

Practical Applications

Regulatory guidance has numerous practical applications across the financial industry:

• Bank Supervision: The Federal Reserve, for example, publishes reports and guidance to inform the public on how it supervises and regulates financial institutions, ensuring they operate safely and soundly.¹⁵ This includes guidance on managing various risks, such as model risk management, which instructs banks on how to validate and document the models used in their operations.¹⁴
• Compliance Programs: Financial institutions integrate regulatory guidance into their internal compliance programs, developing policies and procedures that align with supervisory expectations.
• Internal Audit: Internal audit functions often use regulatory guidance as a benchmark to assess the effectiveness of a firm's controls and adherence to sound practices.
• Corporate Governance: Guidance frequently addresses aspects of corporate governance, including the responsibilities of boards of directors and senior management in overseeing risk. The Federal Reserve has issued final supervisory guidance on the effectiveness of a banking institution's board of directors, which outlines expectations for robust inquiry into risk and management accountability.¹³
• International Standards: Global bodies like the G20 emphasize the importance of central bank independence and financial stability, influencing the development of regulatory guidance worldwide.¹¹, ¹²

Limitations and Criticisms

Despite its utility, regulatory guidance is not without limitations or criticisms. A primary concern is its non-binding nature, which can sometimes lead to ambiguity regarding its enforceability. While agencies state that enforcement actions are not based solely on guidance, deviation from it can still result in supervisory mandates or ratings downgrades, effectively making it a de facto rule.⁹, ¹⁰ This can create a regulatory grey area, where institutions feel compelled to comply with documents that have not gone through the formal rulemaking process, which includes public comment periods.

Some critics argue that an over-reliance on guidance can stifle financial innovation and create an overly burdensome compliance culture. For instance, the "Model Risk Management Guidance" issued by federal banking agencies has been criticized for disrupting bank operations, creating extensive compliance bureaucracy, and impeding banks from innovating in areas like artificial intelligence.⁸ There is an ongoing debate about the appropriate balance between prescriptive regulation and flexible guidance, particularly concerning how new technologies like generative AI are addressed.

Regulatory Guidance vs. Regulation

The key distinction between regulatory guidance and a formal regulation lies in their legal force. A regulation (or legislative rule) is a binding legal obligation that has undergone a formal rulemaking process, including public notice and comment periods, and carries the full force and effect of law.⁷ Violations of regulations can directly lead to legal penalties and enforcement actions.

Regulatory guidance, conversely, outlines an agency's supervisory expectations, priorities, or general views on practices within a given subject area.⁶ It advises the public on how the agency interprets existing statutes and regulations or how it intends to exercise its discretionary authority.⁵ While guidance can provide examples of practices that are considered consistent with safety and soundness standards, it does not create binding legal obligations and agencies do not take enforcement actions based solely on supervisory guidance.⁴ However, as noted previously, non-adherence to guidance can still lead to supervisory concerns and reputational risks for financial institutions. The confusion often arises because, in practice, institutions treat strong guidance as if it were a binding rule due to supervisory expectations.

FAQs

What is the purpose of regulatory guidance?

The purpose of regulatory guidance is to provide clarity and insight into how government agencies interpret and apply laws and regulations. It helps regulated entities understand supervisory expectations and adopt practices that align with safety and soundness standards.

Is regulatory guidance legally binding?

Generally, regulatory guidance is not legally binding in the same way that a formal regulation or law is. It does not have the force and effect of law, and agencies typically do not take enforcement actions solely based on a violation of guidance.³ However, it does represent the agency's expectations and can influence supervisory assessments.

How do financial institutions use regulatory guidance?

Financial institutions use regulatory guidance to shape their internal policies, procedures, and risk controls. It helps them align their operations with supervisory expectations, enhance their governance frameworks, and prepare for regulatory examinations.

Who issues regulatory guidance?

Various government agencies issue regulatory guidance. In the financial sector, this includes central banks like the Federal Reserve, securities regulators like the SEC, and other prudential supervisors. The Administrative Conference of the United States (ACUS) also provides recommendations on how agencies should issue and manage guidance.¹, ²

Can regulatory guidance change?

Yes, regulatory guidance can change. Agencies may update, revise, or withdraw guidance as market conditions evolve, new risks emerge, or their interpretive views shift. Institutions must stay current with the latest guidance to maintain regulatory compliance.