Risk-Based Supervision Does it Work? By Ali Hassan

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1 Risk-Based Supervision Does it Work? By Ali Hassan

2 Describe the Rationale and its relevance to securities regulators Identify the Pitfalls Discuss the Approach Adopted by the DFSA Share Experiences and Thoughts

3 Canada (Late 1990s) 1980s Failure of 2 banks 1990s numerous financial institutions fail bringing down a major life insurance company OSFI (Canadian Office of the Superintendent of Financial Institutions) had been established in 1980s but needed more integration (banking and insurance) Demand for interventionist approach; drive cultural change Also to optimise resource allocation and enhance effectiveness United Kingdom (1990s) Australia (Early 2000s) APRA (Australian Prudential Regulatory Authority) formed in 1998 as an integrated Federal prudential regulator (Banking and Insurance) March 2001 HIH Insurance collapse More intervention, higher risk focus, efficiency Ireland (2011) Systematic risk based supervision as best route to protecting financial stability and consumers FSA (Financial Services Authority) formed in 1997 Failures of BCCI and Barings, the collapse of Equitable Life Address complexity in firms Encourage new cohesive culture Seek a systematic approach that could defend the institutions from attack by politicians IOSCO (2009) Report: Guidelines on continuous risk based supervision of market intermediaries

Regulatory failure Judgement Shift to a more proactive stance Resources allocated to greatest effect Complexity in firms Cohesiveness & Consistency Specialist expertise utilisation Response to

4 Regulatory failure Judgement Shift to a more proactive stance Resources allocated to greatest effect Complexity in firms Cohesiveness & Consistency Specialist expertise utilisation Response to Regulatory failure - systematic approach to ward off political interference and blame IOSCO a move away from rules-based to an approach reliant on judgement and discretion. Demanding a tougher supervisory culture more challenge Shift to a more proactive stance to intervene and prevent financial stability and investor protection issues crystallising Resources allocated to greatest effect with a focus on the higher risks a demand for efficiency and effectiveness IOSCO-complexity in firms and products demands a more sophisticated risk management approach by regulators with capacity to respond quickly to market developments Framework that provides a basis for analysis and action and facilitates valid comparisons across sectors and firms (supervisory response) A capability to involve subject matter experts on components of a modular risk framework

6 Misalignment with senior management/board strategy Process Centric Another Form of Tick Box, with loss of outcomes Lose sight of Systemic/Macro Risks e.g. supervision of banks in the UK Miss changes in risk profile Neglect firms identified as low risk Gaming scores derived to support approach Resources stubborn to alignment to risk Supervisors challenged and not supported

Safeguards In Implementing a Risk Based Approach Enterprise wide risk management Board articulation of risk appetite Risk Inventory Inputs into Business Planning Quality Assurance Supervisory risk

7 Safeguards In Implementing a Risk Based Approach Enterprise wide risk management Board articulation of risk appetite Risk Inventory Inputs into Business Planning Quality Assurance Supervisory risk committee Internal audit of risk ratings Continuous process improvement Supervision Risk analysis tool aligned to international standards The right metrics to identify where risks lie Guidance for supervisors Quality of supervisors Monitoring risk using intelligent systems

8 PROBABILITY Insignificant Minor Moderate Major Catastrophic IMPACT Board Risk Appetite Creating a risk map for regulatory action Risk Appetite Key 3 (5) Extremely concerned (4) Significant concerns 2 (3) Concerned (2) Some concerns 1 (1) Comfortable if this occurs Rare Unlikely Possible Likely Almost Certain

9 Risk Scenario (18) Related Risk Appetite Brokerage firm branch (5) Extremely concerned A brokerage firm, which is a branch of a UK FSA regulated entity, is rated as low risk by the DFSA and so is subject to lower supervisory scrutiny with risk assessment cycles out to 5 years. During the period between risk assessments it transpires that a representative of the firm had been conducting unauthorised trades for client accounts. 5 clients have lost US $100,000 in aggregate. (4) Significant concerns (3) Concerned (2) Some concerns (1) Comfortable if this occurs

10 Solicit wider views from senior regulators across the organisation Articulate a risk and allocate it to one of 4 categories (Regulatory, Operational, External, and People) setting out nature, cause and effect Whole group votes on all risks submitted scoring an impact and probability with a 1-5 range Produce a top 20 of risks by ranking and ratification by the Board Risk Committee Agree mitigating actions and incorporate into the business planning process

11 Enterprise wide risk approach Board Risk Appetite Bottom-up Risk Inventory Business Planning Align Regulatory Risks with Strategic Planning

12 Impact Metrics Which firms are more risky? Significant Political Sensitivity (Controller, Clients, Connected Persons) Annual Revenue Total Capital in DIFC Number of DIFC Employees Entity Holds Client Monies Risk Profile of Clients Nature of Financial Services Contagion Potential

Ownership 1 2 3 4 5 Ownership Ownership Ownership Ownership Clients diversified (e.g. through a public listing).

may include a low number of PEPs majority based in medium to low risk jurisdictions.

13 Ownership Ownership Ownership Ownership Ownership Clients diversified (e.g. through a public listing). Linked to low risk jurisdictions may not include any PEPs and may all be based in low risk jurisdictions. Clients mostly diversified links to medium to low risk jurisdictions. may include a low number of PEPs majority based in medium to low risk jurisdictions. Clients linkages to third country (outside the GCC) national governments, high profile political or commercial figures links to medium to low risk jurisdictions. may include a low number of PEPs majority based in medium to low risk jurisdictions dependency on key individual for revenue revenues volatile or lower than forecast. Clients direct linkages to GCC Government, GCC Government Related Entities high profile GCC political, commercial or Royal figures. links to high to medium risk jurisdictions. significant number of PEPs (compared to overall client numbers) high number based in medium to high risk jurisdictions. Clients direct linkages to UAE Government, Dubai Government Related Entities (including DFSA and DIFC) high profile UAE political, commercial or Royal figures links to higher risk jurisdictions high number of PEPs (compared to overall client numbers), high number based in high risk jurisdictions.

14 Corporate Governance Business Strategy/Models Finance & Operational Risks & Soundness Conduct of Business Anti Money Laundering

15 1 Overall the firm s approach does not give rise to concerns 2 Minor concerns improvements required 3 Moderate concerns 4 Significant failings 5 Very significant failings Business Strategy Business Strategy Business Strategy Business Strategy Business Strategy Business Strategy is clear, well planned and well established. sector it operates in is not showing any particular signs of stress. the firm enjoys strong position in the market clients, products and services are diversified Straight forward, well established and succeeding plans to expand activities which may include new areas for the firm transaction spread across jurisdictions which may provide challenge to effective supervision rapid expansion or aggressive growth forecasts growth/expansion not matched with additional resources for controls. strategy has not gained traction strategy is under severe strain due to market conditions the Board and senior management may not be sufficiently engaged material aspects test the boundaries of the DFSA regime or Federal Law boundaries extended period of losses with imminent risk of financial failure significant and abrupt movement in strategic direction with no planning or rationale focus on extremely high risk clients/products/services

Supervisory Guidelines to Assist Supervisors Cover all 31 Risk Elements Considered in the Risk Matrix, the main supervisory tool for risk assessment Captures Subject

16 Supervisory Guidelines to Assist Supervisors Cover all 31 Risk Elements Considered in the Risk Matrix, the main supervisory tool for risk assessment Captures Subject Matter Expertise in each area Allows linkage to reference material and alignment with standard setting principles Opportunity to update to flex with regulatory developments

18 Grade Number of staff Avg. years of regulatory experience EXCO Directors Associate Directors Senior Managers Managers Total/ overall average

Data Capture Right Underlying Data; both financial and non-financial data from firms critical input in generating intelligence on changes in conduct and prudential risks Data Analysis Generation of

19 Data Capture Right Underlying Data; both financial and non-financial data from firms critical input in generating intelligence on changes in conduct and prudential risks Data Analysis Generation of flags and indicators that can help focus on potential material variations in a firm s risk profile Supervisory Judgement Management Information Set parameters to filter initial outputs and further refine the identification of firms for potential proactive supervisory action Set parameters to detect changing risk profiles

20 50 Total Number of Firms = High Risk Firms = 11 Medium Risk Firm = 165 Low Risk Firms = 117 Av. Risk Score = 15 Av. Risk Score without Rep Offices = High Risk Medium Risk Low Risk

21 Av. SUP Hours 300 Bubble size: No. of Firms PIB5 200 PIN PIB1 100 CRA PIB2 PIB3 PIB4 RO Low Med High Average Modified Risk Score

22 Risk Based Supervision Does Work Offers a structured method for identifying, assessing and managing risk Allows scrutiny, consistency, and comparability and specific alignment of business strategies to higher risks Has survived the global financial crisis of 2008 But Constant vigilance for tick box supervisory behaviours? Regular re-setting of regulatory compass: focus on regulatory outcomes are we focusing on the right risks? Experience of supervisors and support they are given Analysis of data critical element in identifying higher risks

23 Thoughts Experiences Questions

24 Thank You

Perpetual s Risk Management Framework

Perpetual s Risk Management Framework Perpetual s Risk Management Framework Context Perpetual Limited (Perpetual) is a diversified financial services firm, listed on the Australian Securities Exchange.