Killing governance with governance

JP 1Jan Parner, deputy director general, Danish Financial Supervisory Authority, on the perils of overreliance on governance as a kneejerk reaction to organisational failings in the financial sector.

A well-functioning financial sector relies on the trust of its stakeholders, which among others include companies and consumers. Without sufficient levels of trust the size of the financial sector would be limited as it would deter stakeholders from investing in financial assets and taking out pensions, for example, impacting not just the sector, but the economy as a whole.

This is why entities such as banks and insurance companies are often considered to be of public interest, and also one of the reasons behind the extensive regulation of the financial sector. Any failures have the potential to impact not only private consumers and companies but also financial stability, and sometimes even require a taxpayer bail-out.

A focus on governance in insurance regulation

Within the regulation of the financial sector in Europe, insurance regulation (the Solvency II framework) is one of the most consulted on. The European Commission and European insurance supervisors have spent more than 12 years developing the framework that went live on 1 January 2016.

Compared to the regulation of other parts of the sector, Solvency II has a more extensive reliance on governance and market discipline to promote sound and robust behaviour.

Learning governance from industry

Already in the early days of Solvency II, lessons learned from large companies were taken on board as inspiration on how to regulate the system of governance.

It was acknowledged that several large firms had proven successful in managing and reducing risks by implementing well-defined and articulated governance systems.

Trying to either promote or discourage a particular behaviour through regulation has, naturally, proven to be more difficult in practice than in theory.

Following a number of failures during the early 2000’s and in particular as the financial crisis hit in 2008, the perception of the importance of regulating governance grew and inspired other frameworks such as CRD IV for banks.

It was also during the beginning of the financial crisis that the ORSA – the company’s Own Risk and Solvency Assessment – got its label as “the heart of Solvency II”.

The limits of regulating governance

Regulating governance aims to impose a certain structure on how mandates within a firm are delegated and to assign specific individuals with certain roles. These elements could also be considered as parts of a prescribed structure for a command-and-control system.

In addition, certain human behaviour that is considered sound and robust is sought by setting up selected checks and balances and specific rules such as: “you should do this…” or “you should not do that…”.

Trying to either promote or discourage a particular behaviour through regulation has, naturally, proven to be more difficult in practice than in theory.

Two situations are observed frequently: One is where an employee is aware of a rule but does not comply, and the other is where all the paperwork supporting compliance is filled in correctly and completely but there is a different behaviour on the ground.

Understanding culture – the key to governance

These two situations are good examples of what supervisors really need to grasp: understanding the underlying company culture.

GT_Jan Parner_LandscapeFinancial companies face the same trap. A typical conclusion they draw after an unwanted or unexpected consequence, say a financial loss or materialisation of unidentified risks, is that this must be due to insufficient governance. Hence, further controls are inserted or additional independence is ensured for people dealing with the second or third line of defence (the oversight function and independent assurance, respectively).

As a result we see people whose task it is to control those that are already controlling the real control in the system. Or functions that are so independent that they receive no information. On paper this might look good but in reality it does not work.

Misunderstood conclusions

The conclusion that more regulation of governance is needed often relies on our first perception of cause and effect and less on a more thorough understanding of the underlying problems that lead to the undesirable outcome.

We need to understand that you can kill governance with governance.

For example, in the case of remuneration the general perception is that if you pay certain risk takers a high salary, that is linked to their achievement, they are more likely to take on more risk to make short-term gains rather than aim for long-term, more sustainable results.

Such policies tend to be made on a case-by-case basis, but are not backed by appropriate research. We see potential incentives as the causes of future failures and create regulation of remuneration policies without knowing if inappropriate remuneration is in fact the cause for excessive risk taking.

By not understanding the true cause of certain behaviours fully, there is a dual danger that the failures will not only recur, but that in the process we would curb necessary levels of risk taking for economic growth.

Killing governance with governance

To develop more effective systems of governance we need to further develop our understanding of the human nature that gives rise to intentional and unintentional behaviour. This will help us to apply proportional regulation that will be suitable for small and medium size undertakings. We need to understand that you can kill governance with governance.

The views expressed in this article are the author’s own and not necessarily shared by Solvency II Wire.

‘The Governance Trap and the Future of Regulation’ is a collaboration 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 03 March 2016 and hosted by DWF LLP.   dwf

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