Risk-based approach

Regulatory risk differentiation the process used by a regulatory authority (the regulator) to systemically treat entities differently based on the regulator's assessment of the risks of the entity's non-compliance.

Regulators can include law enforcement agencies, while the word entities applies to all those under the authority of the regulator – in most cases ranging from individuals to companies to synthetic entities to multinationals operating within the regulator's jurisdiction.

The process requires the regulator to directly link a robust risk assessment to a suggested regulatory response (e.g. financial penalties, criminal imprisonment). Regulatory risk differentiation is also referred to as the Compliance Model in some regulatory agencies. See for example the Australian Prudential Regulatory Authority risk differentiation approach known as: PAIRS / SOARS. PAIRS is the Probability And Impact Rating System, while SOARS is the Supervisory Oversight And Response System.

The simplest compliance model is a regulatory framework or model known as dualistic, where the regulator reacts to an entity's behaviours depending on whether the behaviour is seen as either right or wrong. This is also known as a black and white response, and is often used for strict liability offences in law.

It is a significant improvement to shift to a compliance continuum (or spectrum), where the regulator reacts to a spectrum of compliance behaviours. The Australian Customs Office applies a compliance continuum.

When the reaction of the regulator is tied to the behaviour, it is known as a responsive compliance model. The responsive compliance model was suggested by Ian Ayres and John Braithwaite in their book Responsive Regulation: Transcending the deregulation debate which built on earlier work by John Scholz.

The Ayres and Braithwaite compliance model was elegantly represented as a compliance pyramid.

The shape of the compliance pyramid indicates:

The choice of remedy (e.g. financial penalties, criminal imprisonment) imposed by the regulator becomes increasingly severe higher up the pyramid – with the view of creating an incentive for entities to move towards more compliant behaviours. The Australian Taxation Office (ATO) uses a compliance pyramid.

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