When Innovation Runs Ahead, Supervision Must Catch Up Fast

The gap between how fast financial innovation moves and how fast regulators can respond is widening. If supervisory technology — SupTech — does not keep pace with the digital transformation of finance, the tail will continue to wag the dog.

The risks of allowing that gap to grow were dramatically illustrated by the collapse of “Synapse”^[1], arguably the most disruptive event in the short history of FinTech. 

Synapse's failure exposed every vulnerability that critics of bank-FinTech arrangements had prophesied: reconciliation failures, consumer harm, regulatory confusion, and no clean lesson to take away. The episode sharpened four urgent questions: how do customers trust banks that rely on technology to improve outcomes? How should regulators support innovation without enabling systemic fragility? How do supervisors build confidence to let innovation proceed? And how do we price in the costs and risks that inevitably accompany it?

Financial stability is a public good and when innovation outpaces regulation, the interim costs are real: elevated regulatory arbitrage, weakened consumer protection, and eroded public trust — all of which compound into a more fragile financial system.

The problem is structural.

As the Bank of England's David Bailey has noted, supervisory action and enforcement are "largely retrospective, relying on ex-post reporting and quarterly or annual figures." Meanwhile, the innovation delta — the gap between regulators' capacity to supervise financial innovation and the pace of that innovation itself — is widening. The divergence, Bailey argues, reflects a fundamental misalignment between innovators and regulators along institutional, technological, and organisational lines.

Closing the Gap
The answer lies in deploying technology to fight technology. SupTech, defined by the Bank for International Settlements as "innovative technology used by supervisory authorities to support their work", is already in use. A BIS survey of 39 financial authorities found that at least half use SupTech applications in bank supervision (Di Castri et al. 2019). These tools automatically digitise and analyse regulatory reports to identify early risk exposures, enabling more forward-looking, hypothesis-driven supervision targeted at institutions where weaknesses are most likely to emerge (Broeders and Prenio 2018).

The evidence that this works is growing. Research by Hans Degryse, Cédric Huylebroek, and Bernardus Van Doornik found that deliberate attempts to hide credit risk fell, and borrower creditworthiness assessments improved, in institutions subject to SupTech-enabled scrutiny. Better supervision also reduces the need for punitive sanctions, which carry real economic costs: regulatory penalties reduce personal income growth by 0.70 percentage points and push up unemployment by 0.16 percentage points.

Beyond credit risk, the potential applications are substantial: climate risk assessment, economic sentiment analysis, natural disaster risk modelling, market risk prediction, and AI-assisted evaluation of conduct and culture. Machine learning models can predict financial distress in SMEs, flag liquidity risks and sudden capital outflows in mutual fund portfolios, and help supervisors monitor market-wide risks such as overvaluation in specific asset classes (Alan Bortolotti & Claudia Curi 2025).^[2] 

India's Edge
The Reserve Bank of India’s Centralised Information Management System and DAKSH — its advanced supervisory monitoring system — sit alongside dedicated tools for monitoring digital payments and FinTech activity, and regular resilience testing of digital infrastructure.

The RBI has also built an intra-sectoral interconnectedness database covering banks and NBFCs, early warning indicators for the macro-financial system, and tools for identifying potentially vulnerable entities and borrowers: all aimed at spotting distress before it metastasises.

What remains a work in progress is measuring inter-sectoral interconnectedness across banking, insurance, and mutual funds. As the pace of financial cycles accelerates, so does the complexity of identifying a tipping point in a bust or an inflection point in a boom. This is now among the more technically demanding challenges in supervision.

SupTech helps supervisors manage systemic risk. But supervised entities must also take on the responsibility to address institution-specific risks. Not merely because they are required to, but because it is in their own interest. Under contemporary supervisory philosophy, the emphasis is on strengthening internal defences: the ability to identify, measure, and mitigate risks, with technology as the common denominator. And as banks increasingly rely on third-party technology service providers, they must ensure that the risks embedded in those providers do not migrate into their own balance sheets.

The financial ecosystem is moving fast. Supervisors must move faster.

1 Synapse Financial Technologies – a San Francisco-based "Banking-as-a-Service" (BaaS), financial entity (2014-2024) - acting as a middle layer between fintech apps and FDIC-insured partner banks - collapsed, leaving more than 100,000 users unable to access their money.

2 Appears as part of the Advanced Neural Artificial Intelligence: Theories and Applications volume in the Smart Innovation, Systems and Technologies series.