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Forging a European banking market

Posted by on 03 December 2019
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How can supervisors and banks promote a strong governance and ethical behaviour? Opening the Global Risk Regulation Summit at RiskMinds International, Stefan Walter, Director General, European Central Bank, addresses this question while exploring the connection between governance, culture, and ethics.

When we consider the development of a governance framework for financial markets, we can look at two main components: regulation and supervision. While the regulatory environment is vast and complex, the supervisory programmes and activities are undertaken in a realm that can be opaque and contains significant challenges in implementation and oversight. However, supervisory bodies and banks can promote a culture of strong governance and ethical behaviour that will guide market interactions in both domestic and international markets.

The weaknesses that are apparent in governance, risk culture, and behaviours are diverse, from money laundering, rogue trading, corruption, fraud, and cyber risk incidents to issues around risk management (market risk, operational risk) and idiosyncratic factors related to the risk profiles and business models of individual firms. Looking beyond financial market activity in isolation, institutions must also grapple with external challenges, including new regulations, geopolitical uncertainties, and digitalisation.

From a supervisory perspective, a key question is: “How can we design frameworks and cultures that help institutions adapt to new risks and strategic challenges effectively?”

First, governance, culture, and ethics defined

Before evaluating how the supervisory system should work, some basic terms should be defined. Governance can be seen as the hardware of the system – denoting how firms organise themselves, how responsibilities are allocated, and how the various components – boards and senior management – interact.

Extending the technological analogy, Culture is the software of the system, formed by the soft rules that people play by in their daily interactions. Finally, the term Ethics represents the application of values, integrity, and fairness with respect to the behaviours seen in the business environment.

One of the goals for stakeholders in this system lies in reducing downside risk from human conduct. Tools for achieving this goal include checks and balances in decision-making processes, and leveraging diverse skill sets and perspectives within the firm. Then, in developing a comprehensive risk appetite framework (RAF), we can ask, “Is the RAF balanced and consistent throughout the firm?”

Historically, when thinking about risk, there has been great emphasis on capital, credit, interest rate, and liquidity risk, but due to revelations of the financial crisis, it is clear that risks in financial markets are even more fundamental and center on business models, culture, and governance. Managing such complexity requires a holistic approach that encompasses quantitative capital and liquidity measures, but also supervisory measures, which are more qualitative in nature.

The main dimensions of governance

At the executive level, the composition and functioning of boards and senior management serve to create the tone from the top, having a strong impact on the culture of the firm. Assessing accountability for risk focuses includes the three essential lines of defense, oversight of the group structure, and support for a culture of challenge. Further, is an active effort to drive risk-conscious and ethical perspectives in decision making, partly achieved through effective RAF implementation, and underpinned by close evaluation of incentives and sanction of unethical behaviours. Finally, closing the loop are risk reporting and data aggregation, where key considerations involve the quality of data and risk reports, the use of escalation and alert mechanisms, and the integrity and management of the IT infrastructure at the firm.

These practices within and across firms are augmented by external supervision including on-site inspections, deep dives, thematic reviews, with direct activities including assessment of board documentation, meeting with key function holders, and periodic board attendance (at least annually) as observers. One growing theme centers on how governance needs to adapt to the digital environment. Here, Stefan Walter noted, “We expect banks to have IT skills at the board level, especially in larger institutions. Those who do, perform better in surveys than those who don’t have board members with expertise in this space.”

Although the environment for financial markets has great complexity, there are best practices, tools, and insights that can help us navigate this dynamic landscape. In recent years, emerging issues have been seen in the insufficient attention to non-financial risks (IT, cyber, conduct, sustainability) and risk that arises from rapidly changing business models and external factors.

In spite of the many challenges, Stefan Walter asserts, “Governance, culture, and ethics are areas where progress can still be made in order to improve banks’ resilience and public trust towards them…The journey towards improving governance and culture in banks is a long one. Supervisors will continue promoting progress on governance and risk culture through peer benchmarking, clarification of sound practices, and continuous industry dialogue.”

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