In May 2015 the Financial Stability Board (FSB) agreed a work plan on measures to reduce misconduct risk, covering:
- reforms to incentives to reduce misconduct;
- improved global standards of conduct in the fixed income, commodities and currency (FICC) markets; and
- coordination of reforms to major financial benchmarks
The FSB objective is to strengthen the resilience of the financial system by raising expectations for, as well as awareness of, good practice standards of behaviour and conduct across markets and market participants.
Their message is clear: “Ethical conduct, and compliance with both the letter and spirit of applicable laws and regulations, is critical to public trust and confidence in the financial system”.
The FSB also believes misconduct is relevant to prudential oversight given its potential to affect the safety and soundness of a particular financial institution; an obvious step considering the scale of fines already levied on financial institutions and indeed future pay-outs provided for under stress tests.
Earlier this week, the FSB provided an update in its second report: Measures to reduce misconduct risk.
The role of incentives in reducing misconduct.
- The FSB will develop and consult on supplementary misconduct-related guidance for existing compensation standards and recommendations for consistent national reporting and collection of data to address misconduct by end-2017
- In parallel, the Working Group on Governance Frameworks will take stock of efforts to address misconduct and will potentially develop a supervisory toolkit or guidance for strengthening such governance frameworks
Improving standards of market practice.
- The International Organization for Securities Commissions (IOSCO) will publish a final report of its Market Conduct Task Force in January 2017, including a detailed regulatory toolkit for wholesale market conduct regulation
- The Foreign Exchange Working Group of the Bank for International Settlements (BIS) will issue its complete Global Code of Conduct for the Foreign Exchange Market and adherence mechanisms in May 2017
Reforming financial benchmarks.
- The FSB will issue a final progress report on Reforming Major Interest Rate Benchmarks by end-2017
- IOSCO is also assessing the degree of implementation of the Principles for Financial Benchmarks by benchmark administrators operating in IOSCO jurisdictions and by end-2016, will finalise guidance on the content of the statements of compliance that administrators are expected to publish
The FSB will publish a third progress report on its misconduct work plan in advance of the next G20 Leaders’ meeting in July 2017. Meanwhile, where does that leave Boards of financial institutions?
The answer is simple – the conduct agenda is not going away!
In fact the reversal of regulatory focus, from producers to customers, is in many ways a reasonable and overdue change, recognising customers’ real needs.
This conduct approach explicitly requires producers to turn their own compliance lenses inside out, or more accurately outside in, after decades of introspection and self-certified assurances.
For the Board this means taking appropriate steps to prevent, stop and/or remedy conduct failures. But directors can only do this if they are in touch with “what actually happens” day-to-day in their firm.
The Board emphasis needs to shift from econometrics to include greater engagement and more observation for directors to be satisfied that governance arrangements will safeguard their firm against customer detriment, a breakdown of market integrity and/or a distortion of competition.
Some questions the Board might consider:
- Does each member of the Board understand and distinguish between behavioural risk and conduct risk; biases and behaviours; risks and uncertainties? Does the Board understand collective and individual responsibilities, documenting them and exercising governance at a level that regulators expect? Is it adequately addressed under SMR?
- Has the Board established a working definition of conduct risk in the firm that is in line with latest best practice in the subsector? Is this evident in customer and business strategies?
- Who on the Board has direct authority over strategic response to customer complaints? How does the firm use conditioning (rewards/sanctions) to promote best conduct with customers? What corrective actions are available against persistent ‘rule-gamers’? How have these been used?
- What is the Board’s process for keeping up to date its definition of ‘acceptable and expected behaviour’ in the firm? How are personal expectations of staff behaviours and attitudes changing? What methods are used to track external changes in expectations?
- Is each member of the Board satisfied that the firm has identified and engaged with conduct risk within the overall risk framework, not merely as box-ticking, and to a standard that will satisfy the regulator?
- What forms of regular analysis does the Board commission to validate its claims to good conduct? (such as customer feedback, trends in enforcement, peer-provider comparison)
- In what practical ways does the firm put “customers at the heart of its business” and promote behaviours that consistently support this across all product and service lines?
- How does it make explicit its risk decision process in designing products and services to balance profit with due care for customers? Can it demonstrate equal concern for new and existing customers, and over the whole life and range of products and services?
- Which qualitative and quantitative indicators does it see as most effective in shaping how the firm engages with conduct risk? (For example: how incentives are affecting staff behaviour in practice; rates of change in fraud, absenteeism, staff retention, complaints or frequency of account closures)
- How does the Board identify business activities with the greatest behavioural risk? Who on the Board has the primary task of focusing on behavioural risk exposures? How does the Board hold executives and managers to account for the resulting conduct risks?
- For every fine paid by the firm, what is the true cost sustained by the time other costs are taken into account including restitution payments, professional fees, staff displacements, re-hiring and placating investors?
- How does the Board inform itself about “What Actually Happens” in the customer-facing functions of their firm? Does it take governance comfort from conventional checklists of compliance and financial transaction data, or do you use newer forms of insight such, as a behavioural lens or conduct analysis?
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.