The RegTech sector is overbought, resulting in massively inflated valuations of juvenile companies proposing glorified box-ticking dashboard solutions marketed as AI/ML-driven cutting-edge technologies.

The financial sector is RegTech’s main ambassador, being not only the key beneficiary of these solutions, but also the leading investor through private equity firms. Bolstering RegTech valuations are aligned with a rapidly increasing global cost of financial crime compliance, which is in the end, transferred to banks’ customers. 

Since the introduction of the Patriot Act in the early 2000s, the banking sector is committed to a relentless effort for tackling global terrorism and  transnational financial crime. The global spend on financial crime compliance at financial institutions had reached $274.1 billion in 2022, representing a 29% increase from $213.9bn in 2020. Banks increased the resources allocated to fight financial crime including both higher staff numbers and more spending on compliance technology solutions.

The demand for technology solutions in compliance sparked investors’ interest towards RegTech firms. Global investments in RegTech had a strong growth in 2022, rising to $18.6bn from $11.8bn in 2021. Investors rushed into RegTech firms,  while the FinTech sector went through a significant contraction. With over $50bn injected by the private equity investors, the valuation of the RegTech sector reached the $300bn mark. 

Historically, high interest rates juxtaposed over an hyperinflationary unstable macroeconomic environment breed heightened crime and corruption.  While the total size of financial crime affecting a $100 trillion global economy is rampantly increasing, only a fraction can be reasonably tackled by financial institutions using technology. With a total amount of laundered funds representing 2.7% of the global GDP, the size of addressable financial crime is in the $300-500bn range.

Schwarzthal Tech

It is obvious that the solution to the economic crime epidemic costs more than the problem itself. Moreover, despite the increasing spending, each year, regulators are inflicting to banks multi-billion of dollars in fines  and penalties for insufficiencies in fighting financial crime.

While investors have bought the narrative of AI’s game-changing role in compliance software solutions, little is known about the real capabilities of RegTech players to soundly develop such technologies. For a bank to use such AI-driven solutions, an extensive and deep-dive internal validation process aligned to the highest prudential standards in terms of model risk management would be required. Needless to say, for most traditional banks and financial supervisory bodies, the validation of AI-algorithms is at an embryonic stage. 

Therefore, at best, most compliance technologies are nothing more than glorified box-ticking solutions and data management capabilities. Regardless of the many penalties and the underperformance of their compliance process, banks are paying utterly high prices for solutions that are far from solving the problem and are only bolstering the valuation of RegTech firms.    

Like any other bubble, the RegTech bubble will burst one day; the spillover effects will go beyond the financial sector and impact the real economy.  

RegTech 50 – UK’s most innovative compliance technology creators for 2022

There is nothing new under the sun. More than two decades ago, in the midst of the Basel 2 prudential framework implementation, the financial sector consumed massively risk management technologies. Software companies proposing solutions for managing financial risks were thriving with valuations going through the roof. But the underlying technologies were rudimentary, untested and implied a lot of customised services.

The resultant 2008 credit crunch unleashed havoc and led to an unprecedented economic crisis. The economic crisis triggered by Lehman’s default was in a big part the result of banks using unchallenged, overpriced and rigid technologies. In the aftermath, most software vendors that were popular with banks more than a decade ago, faded away or were acquired by other companies. 

Most likely, the next black swan in the financial sector will stem from the poor management of non-financial risks and RegTechs will have a part in the play.