Behaviour and culture in financial supervision: why, what and how?

Wijnand Nuijts, head of department, Expert Centre Governance, Behaviour and Culture, De Nederlandsche Bank on how regulators have responded to the financial crisis by including aspects of behaviour and culture in their supervisory approach.

In response to the financial crisis, the Dutch prudential supervisor, De Nederlandsche Bank (DNB) decided to include aspects of behaviour and culture into its supervisory approach. This article explains why the DNB has done so, what it has done so far and what results this new branch of supervision yielded.

The DNB’s supervision of behaviour and culture is based on a number of basic principles, which are underpinned by scientific evidence as well as (our own supervisory) practice.

The first of these principles is that organisational performance is to a large extent determined by human behaviour and that such behaviour is the underlying root cause of various supervisory issues in many instances.

Organisational performance is to a large extent determined by human behaviour, which is also the underlying root cause of various supervisory issues and often precedes problems and failures. As such, it seems logical and effective to pay attention to behaviour as a financial supervisor.

A second principle is that ineffective behaviour often precedes problems and failures. As such, it seems logical and effective to pay attention to behaviour as a financial supervisor. It helps to realise our supervisory objectives by safeguarding financial stability and responsible risk taking.

Focusing on behaviour also enables us to act in a preemptive manner. Identifying and “intercepting” ineffective behaviour at an early stage helps to prevent their translation into financial problems. A final reason to pay attention to behaviour and culture as a supervisor is the fact that more rules and enforcement alone will not be enough to prevent future problems. Adding behaviour and culture based approaches not only enhances the supervisor’s traditional toolbox, but also directly addresses the above-mentioned root causes of supervisory problems.

A pre-emptive approach

The significance of behaviour and culture is underscored by international rules and regulations (for example the EBA Guidelines on Internal Governance or the FSB report on risk culture). These frameworks reflect the growing awareness of the importance of behaviour in the context of effective governance, like i) sound, independent and objective judgment of the board, ii) the behaviour of the chair of the board, iii) effective decision-making of the board (as well as good interaction between the Management and Supervisory Board), and iv) constructive challenge during decision-making in the board.

Identifying ineffective behavioural patterns

The DNB has developed several instruments to identify ineffective behavioural patterns and their risk. Before discussing these, it is important to note that financial institutions themselves are ultimately responsible for their behaviour and culture. The DNB does not prescribe what is ‘good’ or ‘bad’ behaviour: what is effective in one situation may be counterproductive in another. Nor is the DNB of the opinion that one culture may be superior to another: each culture has its virtues and risks. As supervisors it is our role to identify these risks and it is the institution’s responsibility to mitigate them.

Board effectiveness

Many boards shy away from conflict because they are afraid it will harm relationships, cooperation or the quality of decisions.

One of the most important aspects of our framework is board effectiveness. This on-site approach aims to determine if, and to what extent, behavioural patterns (regarding leadership, quality of decision-making, communication, group dynamics and mindset at senior management level) negatively impact organisational and risk performance. In the course of our supervision we have been able to identify several important behavioural patterns.

Quality of board challenge

An important and often recurring pattern relates to the quality of challenge between members of boards during decision-making. Our examinations often demonstrate that such challenge is inadequate, which may be the result of ineffective leadership styles, for example.

In this respect it is important to note that not only dominant leaders may suppress debate, a laissez faire leadership style may cause inadequate discussions. On another note, group dynamics like the strain for consensus or status differences in groups may also hamper good discussions and hence effective decision-making.

Constructive conflict

The same holds true for the group’s attitude towards conflict. Many boards shy away from conflict because they are afraid it will harm relationships, cooperation or the quality of decisions. Yet, groups that are able to engage in constructive conflict, aimed at deepening dialogue without engaging in personal attacks, may reap the benefits of such an exploration of diverse perspectives.

Building mutual trust, commitment to engage in constructive conflict and facilitative leadership styles aimed at group-wide participation are important elements to organize challenge and improve decision-making. Such good practices may also lead to meaningful involvement and contributions of key persons (i.e. risk and compliance functions) into the decision making process, again contributing to the diversity of perspectives.

 

Since 2010, the DNB has performed around 70 examinations on behaviour and culture in financial institutions. These examinations have demonstrated that we are not only able to identify ineffective behavioural patterns and their risks, but are also able to influence institutions to change these ineffective behavioural patterns.

Overall, our examinations lead to increased awareness of the effects and risks of their behavioural patterns. Most institutions have taken forceful measures following our examinations, for example by enhancing constructive challenge during board decision-making, and by organising (self-)reflection on individual and group behaviour. Although these are positive signs, it is obvious that sustainable change is a matter of stamina and persistence. As a supervisor, the DNB will monitor and influence the efforts of institutions to realise such lasting change.


‘The Governance Trap: Tracking Behaviour and Change’ is the second event in a series of collaborations between Solvency II Wire and the Centre for Analysis of Risk and Regulation (CARR) at the London School of Economics.

The event was held in London on 3 November 2016, hosted by   Dentons.
If you’d like to learn more about or read articles from the first event in this series, The Governance Trap and the Future of Regulation, please click here.

To receive the next article in the series directly to your inbox and subscribe to the Solvency II Wire mailing list for free, click here.

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