Good risk management is not just about good ideas

One might say that this is stating the obvious and that it is understood that implementation also matters.  A recent FCA enforcement case against Moneybarn would suggest that it is not so obvious after all.

Moneybarn is a lender that provides motor finance for used vehicles to ‘non-standard’ customers.[1] The case against them related to the regulatory expectations for treatment of and communication to customers that fall into financial difficulties, i.e. the exercise and communication of appropriate forbearance by the lender.  Here, we seek to tease out the implications of this case for the risk management activities of FCA regulated business.

1.  Appropriate policy design

As one would expect, policies need to cover the appropriate ground.  This can include articulating the appropriate range of options (in this case, for customers forbearance and resolution), the considerations that would be taken into account and the governance that would apply to different options. 

It is worth noting that in this enforcement case, it appears that the FCA had no obvious concerns about the relevant policies and procedures reviewed.  

2.  Implementation

The challenge is how these policies and procedures are translated in the business, e.g. whether the call scripts are consistent with the policies.  In some case, this means that calls would be far from “linear”.  Customer service agents will have to consider a range of options and guide the customer.  This would have implications for training and tools available for customer service agents. 

The FCA notes that “from the review of the sample the use of any other forbearance options”, other than clearing their arrears over a short period of time, “despite the fact that policies and procedures referred to other available options”.   

3.  Monitoring and assurance

There is usually a combination of first line monitoring and oversight by 2^nd and 3^rd line functions.  To some extent, who provides assurance becomes less important than whether assurance is provided.

It is important to recognise that assurance should be provided about the processes and about the outcomes.  Where the nature of the issue involves considering customers’ individual circumstances in response to financial difficulties, then it is important to evidence that the range of options set out in the policy have been delivered.   This is more challenging to monitor than following a process. 

It is interesting that in this enforcement note there are no references to assurance or to the role of 2^nd and 3^rd line functions.

4.  Regulatory relationship management

The FCA initial engagement starts with a seemingly low-profile review of a “limited number” of files and call records leading to a visit in July 2016 to assess forbearance and termination practices.  There were then several interactions with the FCA in September 2016 and January 2017, leading to a formal request for imposition of a requirement in June 2017 and eventually enforcement action.  One must wonder if a more proactive engagement with the FCA would have prevented the escalation to enforcement.

It is usually noted that proactive engagement with the FCA and the issues raised would have been expensive.  Hindsight may be a powerful tool but it is not clear that the cost of the proactive engagement would have been unlikely to exceed the enforcement costs, which ended up being very substantial – the fine of £2.7m, the impact on senior management’s time, and the £30.3m of compensation paid to customers potentially affected by these failings. 

This post is part of the materials discussed in episode 3 of RegNut Podcast.   If you found this post of interest, subscribe to RegNut.  You can also subcribe to the blog and receive further posts by email. See the box on the right-hand side of the blog's screen or click here.

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[1] Non-standard customers are those that cannot access finance from mainstream lenders because they have a poor or no credit history or past problems with credit due to unemployment, ill health or other adverse events.

The New and the Old in Risk Management

I have been writing about the new and the old in risk management over the past year. This starts with the slow pace of adoption of FinTech by incumbents in financial services. I have suggested that an important component of the change needed includes incumbents amending and enhancing risk management frameworks to reflect new FinTech innovations. (See my last post on the subject.)

Recently, I came across an article from McKinsey that makes a similar point in the context of model risk and the adoption of artificial intelligence (AI) and machine learning. It turns out I am in good company! 

McKinsey’s article notes that banks have developed and implemented frameworks to manage model risk, including model validation reflecting specific regulatory frameworks, in this case from the US Federal Reserve (here). They recognise that the implementation of these frameworks is not appropriate to deal with the model risk associated with AI and machine learning. Banks are therefore proceeding cautiously and slowly introducing new modelling approaches even when these are available.

The article then shows how a standard framework for model risk management is used to identify extra considerations required for this framework to cover appropriately AI and machine learning models.  The key message is that the challenge of adopting AI and machine learning can be addressed through a careful consideration of existing approaches. 

Two further thoughts from McKinsey’s article. Firstly, the article rightly refers to model management rather than validation. It is always useful to reiterate that model validation undertaken by the risk function is just a component of how models are managed in the business. Secondly, model management should not apply only to internal models used to calculate regulatory capital, but should apply more widely to models used in the business such as those used for pricing, valuation of assets and liabilities.

The article ends with a cautionary tale of an unnamed bank where the model risk management function took initial steps to ready itself for machine learning models on the assumption that there were none in the bank. It then discovered that an innovation function had been established and was developing models for fraud detection and cybersecurity.

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The Curse of Risk Appetite

In this post, I go back to one of the fundamental aspects of an ERM framework: risk appetite. ‘The Curse of Risk Appetite’ is part of the title of an interesting paper reviewing the misuses of risk appetite.[1] Some of the misuses described in the paper might sound familiar, but perhaps the key point to take away from the paper is that there is a potential for risk appetite to become synonymous with ‘a consideration of risk’. I am not sure this was ever the intention. 

The paper includes several useful suggestions to enhance risk appetite. They are focused on the long-run value of the firm and on the structure of risk appetite statements, reflecting a view that risk is the likelihood of falling below critical levels of performance. However, my attention was really caught by the authors’ suggestion to improve the organisational process for risk management. They suggest that a risk function’s role should be defined to include responsibility for evaluating the combined effect of strategic initiatives and capital budgeting on the firm’s overall risk profile.

On one level, this prescription is consistent with the view that the aim of the risk function should be to ‘protect and enable’, with the emphasis on the ‘enable’ aspect which sometimes gets overshadowed by ‘protect’. I am attracted to this suggestion because it turns a vision into a practical requirement that can be incorporated into an articulation of roles and responsibilities for a CRO or risk function. 

If, however, this was implemented literally in UK financial services, I suspect there would be an issue with regulators’ expectation about the independence of the risk function (second line of defence) from the business (first line). 

A similar outcome could be reached by clarifying that the role of the CRO/risk function includes providing a risk opinion in the early stages of the consideration of major strategic initiatives that have the potential to alter the business’s risk profile. The emphasis on timing is important. Providing a risk opinion only when major strategic initiatives are presented for approval is unlikely to add value. A CRO/risk function opinion in the early stages is likely to support consideration of the details of the initiatives and how they can be shaped to strike the appropriate balance between risk and return.

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[1] Alviniussen, Alf and Jankensgård, Håkan, The Risk-Return Tradeoff: A Six-Step Guide to Ending the Curse of Risk Appetite (May 7, 2018).