A best-practice model for bank compliance

Tighter compliance regulations have challenged financial institutions in a variety of ways. Yet those who adapt best may enjoy a distinct competitive advantage.

Compliance risk has become one of the most significant ongoing concerns for financial- institution executives. Since 2009, regulatory fees have dramatically increased relative to banks’ earnings and credit losses. Additionally, the scope of regulatory focus continues to expand. Mortgage servicing was a learning opportunity for the US regulators that, following the crisis, resulted in increasingly tight scrutiny across many other areas (for example, mortgage fulfillment, deposits, and cards). New topics continue to emerge, such as conduct risk, next-generation Bank Secrecy Act and Anti-Money Laundering (BSA/AML) risk, risk culture, and third- and fourth-party (that is, subcontractors) risk, among others. Even though a lot of work has been done to respond to immediate pressures, the industry needs a more structural answer that will allow banks to effectively and efficiently mature their risk-and-control frameworks to make them more robust and sustainable over time.

The traditional compliance model was designed in a different era and with a different purpose in mind, largely as an enforcement arm for the legal function. Compliance organizations used to promulgate regulations and internal bank policy largely in an advisory capacity with a limited focus on actual risk identification and management. However, this model has offered a limited understanding of the business operations and underlying risk exposures, as well as of how to practically translate regulatory requirements into management actions. Even if a compliance testing program was established, it frequently borrowed heavily from the late-20th-centuryoperational-risk playbook by emphasizing a bottom-up, subjective process of control testing versus a more objective, risk-based monitoring of material residual risks. Frequently, business managers are left to their own devices to figure out what specific controls are required to address regulatory requirements, typically leading to a buildup of labor-intensive control activities with uncertain effectiveness. Many banks still struggle with the fundamental issues of the control environment in the first line of defense such as compliance literacy, accountability, performance incentives, and risk culture. Finally, compliance activities tend to be isolated, lacking a clear link to the broader risk-management framework, governance, and processes(for example, operational-risk management, risk-appetite statement, and risk reporting andanalytics). More often than not, the net result is primarily a dramatic increase in compliance-and-control spend with either limited or unproved impact on the residual risk profile of a bank.

• Developing and enforcing standards for an effective risk-mediation process (for example, root-cause analysis and performance tracking) to ensure it addresses root causes of compliance issues rather than just “treating the symptoms”
• Establishing standards for training programs and incentives tailored to the realities of each type of job or work environment
• Ensuring that the front line effectively applies processes and tools that have been developed by compliance
• Approving clients, transactions, and products based on predefined risk-based rules
• Performing a regular assessment of the state of the overall compliance program
• Understanding the bank’s risk culture and its strengths as well as potential shortcomings

Risk culture has a special place in the compliance playbook. Indeed, most serious failures across financial institutions in recent times have a cultural root cause leading to heightened regulatory expectations. Elements of “strong” risk culture are relatively clear (albeit not always explicitly articulated) and include timely information sharing, rapid elevation of emerging risks, and willingness to challenge practices; however, they are difficult to measure objectively. Use of tools such as structured risk-culture surveys can allow for a deeper understanding of nuances of risk culture across the organization, and their results can be benchmarked against peer institutions to reveal critical gaps. Consequently risk culture can be actively shaped, monitored, and sustained by committed leaders and organizations.

Effective execution of these expanded responsibilities requires a much deeper understanding of the business processes by compliance. There are a few practical ways to achieve this:

• Incorporating process walk-throughs into the regular enterprise compliance-risk assessments (for example, facilitated workshops with first line and second line to assess inherent risk exposures and how they affect business processes)
• Implementing a formal business-change-management process that flags any significant operational changes (for example, volumes, products, workflows, footprint, and systems) to the second line
• Developing a robust tool kit for objectively measuring risk (for example, quantitative measurement for measurable risks, risk markers for risks harder to quantify, common inventory of risky outcomes, and scenario analysis and forward-looking assessments)

Finally, the design of the compliance function’s operating model is becoming increasingly important. Thus, it demands a shift from a siloed, business-unit-based coverage to a model where business-unit coverage is combined with horizontal expertise around key compliance areas, such as BSA/AML; unfair, deceptive, or abusive acts or practices (UDAAP); mortgage (across all mortgage businesses); third-party and others.

Transparency into residual risk exposure and control effectiveness

One of the traditional industry practices for the second line’s engagement with the business has been to identify “high-risk processes” and then to identify “all the risks” and “all the controls” that pertain to each of them. This approach, however, falls short of creating a real and comprehensive transparency into material risk exposures and often becomes a merely mechanical exercise.

First, the lack of an objective and clear definition of a “high-risk process” frequently leaves this decision to the discretion of business lines, which can lead to the omission of risks that are critical from a compliance-risk standpoint but deemed less significant from a business standvpoint (for example, a low-volume collections process can seem an insignificant part of the overall business portfolio but can be a critical area for regulatory compliance). This approach also suffers from inconsistencies. As an example, an account-opening process may be deemed high risk in some retail units but not in others.

Second, the pursuit of documenting virtually “all risks” and “all controls” implies a significant amount of work and actually limits the first line’s ability to go deep on issues that truly matter, producing lengthy qualitative inventories of risks and controls instead of identifying material risk exposures and analyzing the corresponding process and control breakpoints and root causes.

The new approach focused on residual risk exposures and critical process breakpoints ensures that no material risk is left unattended and provides the basis for truly risk-based, efficient oversight and remediation activities. It addresses these challenges by directly tying regulatory requirements to processes and controls (that is, through the mapping of risks to products andprocesses), by cascading material risks down to the front line in a systematic and truly risk-based way, and by defining objective (and whenever possible quantitative) key risk indicators(KRIs) in the areas where the process “breaks” and creates exposure to a particular risk.

Thus, as illustrates, there are typically numerous controls associated with everyregulatory requirement throughout a given business process. Testing all of these controlsconsumes tremendous organizational time and resources. Each control is documented and itslevel of effectiveness qualitatively assessed (although the definition of “effectiveness” is oftenambiguous and varies from person to person). Unfortunately, the overall control-effectivenessscore resulting from this exercise is only loosely correlated with the outcome it’s not unusualto see critical audit findings in areas where the majority of controls have been deemed effective.

In contrast, the new approach starts by defining which risks apply to a given business processand identifying where exactly in the process they occur (known as “breakpoint analysis”).Informed by the identified process breakpoints, one can then design KRIs that directly measurethe residual risk exposure. This approach leads to far fewer items to test (in our example,two KRIs versus seven controls) and much more robust insights into what the key issues are.Moreover, it provides the essential fact base to guide and accelerate the remediation processand resource allocation.

Integration with the overall risk-management governance, regulatory affairs, and issue-management process

Compliance risks are driven by the same underlying factors that drive other banking risks, but their stakes are higher in the case of adverse outcomes (for example, regulatory actions that can result in restriction of business activities and large fines). Therefore, it’s only fitting that a modern compliance framework needs to be fully integrated with the bank’s operational-risk view of the world.

Integrating the management of these risks offers tangible benefits. First, it ensures the enterprise has a truly comprehensive view of its portfolio of risks and visibility into any systemic issues (for example, cross-product, cross-process), and that no material risk is left unattended.