Behaviour and culture can be the cause of many financial crises and scandals. Financial regulators should be looking to the DNB model of identifying and assessing the root causes of behavioural risk.
Failings in behaviour and culture were primary causes of the 2008 financial crisis and the recent wave of mis-selling scandals. According to the Bank of England’s report [PDF] into the failure of HBOS a major factor in its downfall were deficiencies in its management, culture and governance. In response to this industry wide problem, the Dutch Central Bank has, for the past five years, been undertaking in-depth behavioural reviews of their local banks, seeking to identify those with a high behavioural risk profile.
The rationale for the Dutch Central Bank’s approach is twofold [PDF]: many supervisory problems have behavioural root causes, and that rules and regulations have not proved effective ways in identifying and addressing behavioural problems. DNB examine how behavioural factors impact the quality of decision-making, at both the Board level and in the trading room, and how this affects the performance and strength of the bank. They have undertaken over 50 bank examinations on behaviour, in the majority of cases leading to the adoption of a risk mitigation plan by the bank being supervised.
Behavioural risk is recognised as a risk category in a number of international frameworks including CRD IV - Basel 3 [PDF]. These frameworks acknowledge the importance of the behaviour of the board for effective governance and emphasize the importance of sound, independent and objective judgment of the board, the need for effective decision-making and for constructive challenge during the decision-making in the board.
The Dutch approach combines the supervisory technical skills of central bankers working alongside organisational psychologists to examine both behavioural patterns and drivers of behavioural patterns. They undertake a desktop review of firm’s risk framework, as well as observations of the supervisory and management boards, to determine if, and to what extent leadership, group dynamics and quality of decision-making at senior management level impacts prudential judgment and risk performance.
They follow a three-stage process:
- Identification stage: they compile a risk score based on governance, behaviour and culture of the firm;
- Assessment stage: they examine on site – the board’s effectiveness, change culture (to see if the firm is able to implement organisational and cultural change programmes) and risk culture (to determine if and to what extent behavioural issues affect risk-taking in the trading department); and
- Mitigation stage: they apply a range of mitigants from raising awareness through to enforcement action, where they find evidence of clear breaches.
The DNB highlight [PDF] the following behavioural risk scenarios:
- Unsatisfactory adherence to strategic objectives: leading to opportunistic decision-making and no clear strategic direction;
- Decisions are insufficiently challenged at executive and board level: this may be due to dominant leadership and submissive board members/ senior management or due to various biases, whereby not all of the relevant information is shared at board level; and
- Insufficient change effectiveness: this may be due to absence of clear change strategy or to the change agenda being delegated to those who do not have sufficient authority to ensure it is fully implemented.
DNB has seen increased awareness in Dutch banks on the effects and risks of their behavioural patterns resulting in enhancements in the constructive challenge during board decision-making; increased risk awareness and discussion of risks and more organized reflection on complex decision-making and group dynamics. In several more extreme cases their reviews have led to the dismissal of key executives and board members.
They are also keen to address some common misconceptions; this is not an attempt to replace other forms of supervision, it is in an additional forward looking tool to help prevent or solve problems. They are not there to offer psychotherapy or coaching. They note that in many other industries including energy and transportation, there is widespread recognition of the need to assess behavioural risks as part of risk management.
The challenge to other regulators (including the PRA and FCA) faced with the huge ongoing economic costs of the aftermath of the Financial and Conduct Crises - why are they not giving more prominence to identifying and assessing the root causes of behavioural risk.
Alastair Tyler is the Module Co-ordinator for Financial Services: Commercial Environment and lecturer for Corporate Lending.