The term "intervention" can cover a range of actions, including requirements that a supervised financial institution strengthens its controls or governance, strengthens its financial resources, introduces changes to aspects of its business, or limits or discontinues some part of its business.
This Toronto Centre Note and accompanying podcast assists supervisors in formulating focused supervisory interventions which comply with sound principles of intervention. It has a somewhat different format from other Notes, providing a series of examples and inviting readers to develop what they would regard as effective supervisory interventions in each case.
Speaker:
Paul Wright, Program Leader, Toronto Centre
Host:
Demet Çanakçı, Senior Program Director, Toronto Centre
Read the transcript here. Read their biographies here.
Listen to the podcast here.
Read the TC Note:
TABLE OF CONTENTS
Summary of Principles of Supervisory Intervention
The Principles of Supervisory Intervention in More Detail
Integration with Supervisory Processes
From Supervision to Enforcement
Case 1: Capital and Capital Planning
Case 2: Weak Insurance Underwriting Controls
Case 3: Weak Corporate Governance
Case 4: Unresolved Risks in Group Supervision
Annex 2: Assessments of Intervention Plans and Suggested Improvements
Case 1: Capital and Capital Planning
Case 2: Weak Insurance Underwriting Controls
Case 3: Weak Corporate Governance
Case 4: Unresolved Risks in Group Supervision
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PRINCIPLES FOR EFFECTIVE
SUPERVISORY INTERVENTION
Introduction1
In its programs and country engagements Toronto Centre places considerable emphasis on the importance of supervisory intervention. The term ‘intervention’ can cover a range of actions, including requirements that a supervised financial institution:
- Strengthens its controls or governance
- Strengthens its financial resources – for example by holding additional capital
- Introduces changes to aspects of its business (such as the information it provides to its customers, its distribution model, or its targeted customer base)
- (In more extreme cases) limits or discontinues some part of its business
In conducting risk-based assessments supervisors identify and assess the severity of the risks embodied in a financial institution’s significant activities. They then make an assessment of the effectiveness of the institution’s management and controls in mitigating these risks (and hence the levels of ‘net’ risk it is running) and of the institution’s financial strength. Where it is judged that controls and/or financial resources are not sufficient to mitigate the risks to an acceptable level supervisors should require the kind of measures listed above.2 The detailed assessment of risks is important, but only as a step towards focused and appropriate actions that may be necessary to mitigate significant and unacceptable risks.
Intervention may also refer to a wider range of activities such as enforcement action designed to place additional pressure on a financial institution to adopt risk-containing measures, to punish that institution, or to send a signal to the industry regarding unacceptable practices However this Toronto Centre Note focuses on intervention designed specifically to remediate what are judged to be excessive levels of net risk. It does not deal with enforcement but with ‘business as usual’ supervision.
This Note is intended to assist supervisors in formulating focused supervisory interventions which comply with sound principles of intervention (summarized below). In setting out in detail ways in which interventions can be made as effective as possible, the Principles are fully consistent with frameworks such as ‘ladders of intervention’ which document the link between levels of risk and types of intervention at a more generic level. The Note has a somewhat different format from other Toronto Centre Notes in that it provides (in Annexes) a series of examples and invites readers to develop what they would regard as effective supervisory interventions in each case.
Summary of Principles of Supervisory Intervention
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The Principles of Supervisory Intervention in More Detail
Assumptions/Preconditions
- It is assumed in the following that the supervisory authority operates a risk-based framework for assessing the risks inherent in financial institutions’ activities; the effectiveness with which these are controlled and managed; the effectiveness of governance; and the adequacy of financial resources.
- Is a result of their risk assessment supervisors are able to identify net risks which may be judged to be excessive, and/or to identify that the institution’s holdings of financial resources (capital or liquidity) may be insufficient to support the level of risk being undertaken. The processes involved in this and the concept of net risk are summarized in the following box.3
Net risk and supervisory intervention:
- As part of their risk-based assessment, supervisors identify and assess the levels of inherent risk embedded in the significant activities undertaken by a financial institution.
- They then assess the effectiveness with which these inherent risks are controlled through systems and controls, risk management and the wider management and governance of the institution. It is important that proper attention is paid to the effectiveness of controls (how they actually mitigate risk in practice), as opposed to their ‘characteristics’ (what they look like on paper or in theory).
- This assessment of inherent risks and the effectiveness with which they are controlled and managed is the basis for assessing net risk. This assessment is made at the level of each significant activity and for the institution as a whole.
- Supervisors will then assess the adequacy of the institution’s financial resources (in relation to the assessed level of net risks).
- The goal of supervisory intervention is to reduce net risks in the institution to levels that are acceptable to the supervisor. It may involve some or all of the following elements:
- Actions to increase the effectiveness of controls, management or governance.
- An increase in financial resources (capital or liquidity) to align these more closely to the level of net risk being undertaken.
- Actions to reduce the inherent risks being run by the firm (focused on its business activities or model) – though supervisors will, in general, only press for such changes when it has not been possible to achieve the necessary reduction in risk with the measures in the first two bullets.4
- It is assumed that the supervisory authority has undertaken the necessary internal exercise to identify its risk tolerance. This involves identifying the range of risks to its supervisory objectives, weighing these and taking decisions about how it will use its limited resources to address them. The resulting decisions about risk tolerance need to drive the authority’s supervisory strategy, including its approach to intervention.
Supervisors will often have a threshold of concern below which they may not require supervisory interventions. Identified issues that do not meet this threshold will not require a full-scale response (although these concerns may be expressed less formally to the financial institution concerned). However, concerns that are above the threshold generally do warrant intervention. It may be decided, for example, that all (net) risks identified as being Medium High or above in institutions above a specified impact level will require formal remediation.5
Supervisory intervention is unlikely to be fully effective if these three pre-conditions are not in place, because it may:
- Not be properly focused, for example requiring remediation of risks which are not the most significant, or failing to require remediation of risks that are significant.
- Involve a non-optimal use of scarce supervisory resources, contrary to the goal of risk-based supervision which is to direct resources to the areas of greatest risk to supervisory objectives
- Involve responses which are disproportionate – either in terms of the supervisory authority’s own risk tolerance or in requiring financial institutions to undertake remedial measures that are not proportionate to the risks identified.
Effective supervisory intervention therefore requires a considerable investment on the part of supervisors in the risk-based framework which supports it and in the intervention mechanisms themselves. Effective intervention does not ‘just happen’ and simply outlining supervisors’ concerns or indicating desired supervisory ends without being clear about the means by which these are to be achieved are unlikely to be effective.
This supervisory framework needs to be supplemented with a degree of judgement and common sense. On completing the risk assessment and formulating their requirements for remediation supervisors should ‘step back’ and ask themselves “can I be confident that my proposed supervisory intervention will actually achieve the outcome I am seeking?”
The Principles
In what follows it is assumed that the supervisory authority meets the three pre-conditions set out above. Supervisors should therefore have a clear idea about the expected outcome that is being sought based on a comprehensive assessment of risk. There may exist various routes to achieving the outcome, but there should be no doubt or ambiguity about the goal itself. The following Principles should then be applied.
- Supervisors need to identify all material risks to their supervisory objectives.
Supervisory frameworks should be sufficiently risk sensitive to allow supervisors to identify all material risks, bearing in mind that ‘risks’ are defined in terms of the potential inability of supervisory authorities to achieve their (statutory) objectives and that ‘material’ risks are those that have the potential to be unacceptably high (in terms of the authority’s ‘tolerance’ for risk – see pre-condition (iii) above). There also needs to be clarity about the mechanisms by which identified risks may crystallize. - Supervisors need to look beyond immediate problems to potential wider ‘root causes’ when determining the expected outcome.
An immediate problem that is identified may often have wider and deeper root causes that only become apparent with wider scrutiny. In an ideal world these root causes would always be identified in the course of the risk assessment, but this may not be the case in practice. Before formulating interventions supervisors should always consider whether such root causes are present.
Illustration of looking to root causes:
- The immediate issue is that conduct risk in an institution is rated as medium high because controls over sales practices (customer take-on procedures) are weak. This may be the ‘narrow’ issue. The solution is to strengthen these controls.
- It may also be the case that the way sales staff are remunerated incentivises them to disregard or seek to undermine the controls. This is a potentially wider issue. The solution is to require changes to remuneration practices.
- Or it may be that the culture of the institution is such that staff feel they will be recognized and rewarded for maximizing sales rather than treating customers fairly. This is a considerably wider issue. The solution requires the sales culture to be addressed.
- If the issue is a cultural one it may be that this pervades the whole institution, creating an environment which rewards profit and risk taking over prudent or customer-focused behaviour. This is an even wider issue. The solution requires the enterprise-wide culture to be addressed.
As covered in Principle 4 (below) supervisors need to be proportionate and risk-based in their response and cannot always hunt down all wider contexts for problems. But they should be alert to the possibility that problems may have deeper root causes and that if these are not addressed the immediate problems are likely to recur. - Supervisors need to be clear about the expected outcome of intervention.
In the course of their risk assessment supervisors may have identified many issues that ‘do not look right’ or ‘do not conform with generally observed practice’. Such observations are not in themselves sufficient to warrant intervention. The overarching question that needs to be asked is ‘why does this matter in terms of risks to our supervisory objectives?’ The expected outcome should be couched in terms of the reduction or mitigation of risk and may involve reduced net risks or increased financial resources. The means of achieving such outcomes is the subject of later Principles. - Supervisors need to intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance.
Meeting the pre-conditions set out above should help to ensure that intervention is proportionate; directed at the areas of highest risk (based on the risk assessment); and represents an efficient use of supervisory resources (consistent with the identified risk tolerance).6 The measures should also be proportionate for the supervised entity. While necessary adjustments will usually involve supervised institutions in some costs these should be justifiable in terms of the scale of the risks being addressed. There should be scope for discussion on how the institution can achieve the expected outcome in the most efficient way but without compromising the outcome itself. - Supervisors need to be clear about the pathways or intermediate steps to the expected outcome.
In addition to being clear about the expected outcome being sought it is also necessary to recognize that the achievement of this may involve a number of intermediate steps. In some cases there will be a single, unambiguous pathway, while in others the path may be quite complex.
Illustrations of pathways/intermediate steps:
- A simple pathway. The identified risk may be that the institution is susceptible to being used as a channel for money laundering and that a key factor in this is its failure to appoint a qualified Money Laundering Reporting Officer (MLRO). In this case the solution is straightforward (to have an effective MLRO), and the means of achieving it equally so (to appoint a suitable individual to this role). Such simple mappings from means to supervisory ends will often tend to be associated with compliance issues: ‘the detailed requirement is X. You do not meet it so you must take the necessary (prescribed) steps to do so’.
- A more complex pathway. An institution may be running excessive strategic risk because of insufficient oversight and leadership by an ineffective board of directors. The goal is to reduce the strategic risk to an acceptable level. The means of achieving this will include strengthening the board and making it more effective. This could require any or all of a range of measures, for example a review of board procedures and effectiveness; retraining board members; replacing individual directors; strengthening board committees; changing terms of reference; restructuring board meetings; or improving reporting arrangements from management to the board.
The necessary mix of measures will vary from institution to institution and one size will, in general, not fit all. In all cases it is necessary to specify the intermediate steps clearly, together with a timetable for these.
- Supervisors need to ensure that there is a shared understanding with the financial institution about the expected outcome and the steps to achieving this.
Once the supervisory assessment and proposed remediation have been agreed within the supervisory authority – for example in a supervisory panel7 - the expected supervisory outcome itself needs to be communicated clearly to the institution. This will usually be part of a letter to the board or senior management summarizing the risk assessment, the issues to be addressed, and the expected outcomes. This kind of communication may help secure the institution’s buy-in to the remediation, while the discipline of having to communicate their concerns about risk and expected outcomes can itself be helpful in focusing supervisors’ own thinking.
There will usually be scope – and a need – for discussion between the supervisor and the institution about the intermediate steps required to achieve the expected outcome. In many cases supervisors should not specify the intermediate steps but should ask the institution to develop its own plan. This can draw on management’s greater knowledge of the business and may increase buy-in (particularly of the board and senior management). Supervisors should only agree to the plan if they are convinced that it will deliver the expected outcome. If this is not the case the financial institution should be required to develop a more credible plan, or supervisors should themselves mandate the steps that need to be taken. The focus should always remain on the expected supervisory outcome as the means of achieving this are being developed and implemented. - Supervisors need to specify clearly the timetables for intermediate steps and the expected outcome.
In cases where there is a single pathway to the desired outcome this is straightforward. For example, in the first illustration from Principle 5 the requirement would be ’you must appoint a qualified MLRO by date Y’. Where there are several possible pathways it is necessary to be clear about intermediate timescales and milestones. In the second illustration from Principle 5 a typical requirement might be: ‘as part of the strengthening of corporate governance you will: commission an external report (completed by date X); you will then formulate a plan and agree it with the supervisor (by date Y); you will take the agreed steps under the plan (phased but completed by date Z); and you will then undertake a further review to provide assurances that the necessary strengthening of corporate governance has taken place (completed by date Z + 6 months)’ - Supervisors need to decide on the most appropriate way of monitoring progress.
Remedial programs will often extend over quite protracted time periods. The approach to monitoring progress is itself a risk-based decision for the supervisor who needs to trade-off the time and resource involved in direct ‘checking’ against the possibility that the remedial program may not be effective unless it is subject to close scrutiny. The trade-off will depend on a number of factors including:
- The potential impact of the institution and the risk being addressed (should it crystallize).
- The length and complexity of the remedial program.
- The extent to which the supervisor feels they can have confidence in the institution to deliver what is required. - Supervisors need to consider whether to impose restrictions or other requirements while remediation is under way.
Remedial programs may take many months to come to fruition in the sense of effectively limiting the unacceptable risk that has been identified. It may therefore be necessary to put in place other measures to limit or contain the risk while the program is being implemented. These might include temporary increases in capital or liquidity, or restrictions on parts of the business. Such restrictions have the dual role of: a) providing an incentive to the institution to implement the necessary longer-term remediation; while b) providing a ‘buffer’ against risk crystallizing before the full program has been implemented.8 These temporary measures can be reviewed (and potentially relaxed or removed) once the remedial program has been successfully completed. - Supervisors need to seek firm evidence that the expected outcome has been achieved.
Once the remedial program has been completed the question for supervisors and financial institutions should be ‘how can we be confident that the intervention has been successful in reducing what was assessed as being an unacceptable level of risk?’
The least resource-intensive way of establishing this is to ensure that the area of risk concerned is a focus of the next round of risk assessment. Alternatively it may involve the use of self-standing KPIs and other measures which will demonstrate that the remediation has been effective in achieving its risk reduction goals. There may also be a case for a focused review some months after a remediation program has been completed to check on its effectiveness.
The Principles in Practice
For purposes of illustration this section sets out a ‘model’ remedial program and demonstrates how this complies with the Principles.
Scenario:
A life insurance company (LifeX) offers long-term savings products. Customers are invited to save a sum of money each month which is then invested with the promise that a payment will be made in the event of the death of the policy holder or, if the policy holder survives the term, a lump sum will be paid at the end of the contract. Contracts have the following characteristics:
- They have durations ranging from five to fifteen years depending on customers’ stated needs and preferences.
- Prior to entering into an agreement customers are assessed in terms of their attitude to and appetite for risk. On this basis they are offered products which are low, medium or high risk.
- It is made clear to customers that returns are not guaranteed but depend on market conditions. Attention is drawn to the company’s track record in providing stable and profitable returns, but it is made clear that the savings products carry some market risk.
Risk assessment:
As part of the supervisory risk discovery process it emerged that the company had received a number of complaints from customers concerning ‘hidden’ charges and commissions that had been applied late into contracts and on maturity. Several customers who had taken out ten-year products complained that a year before maturity unexpected ‘management charges’ had been levied and that on maturity they had faced additional ‘administration charges’. The charges had been withheld from the proceeds of the savings products and had amounted to between five and ten percent of the maturity value.
Customers’ complaints were:
- That their attention had not been drawn to the existence of these charges when they had entered into the contracts concerned. The life insurer’s response had been to point to a small section in the detailed text of the contracts concerned which “permit the company to levy such charges as might be necessary during the contract to allow them to meet administrative costs”.
- The charges were excessive and seen as unreasonable.
- The charges had not been reflected in the ‘past performance’ illustrative tables that customers had been provided with on taking out the contracts.
Supervisory intervention
One of the objectives of the supervisory authority in LifeX’s country of domicile is to reduce harm to consumers as a result of misconduct, including the mis-selling of products. On examining LifeX’s sales practices supervisors concluded that the company had behaved, and continued to behave, incorrectly and unfairly in its treatment of the customers concerned. The problem was particularly insidious because the charges had not been applied until a considerable time after the contracts had been entered into. The problem seemed to be exacerbated by remuneration arrangements which rewarded sales staff on the basis of the number of contracts sold. As part of a wider risk assessment, net conduct risk (taking account of the effectiveness of controls) was assessed as Medium High (MH). Supervisors considered whether the company should be subject to enforcement action. In the meantime however they undertook supervisory intervention to limit the risk.
The detailed steps involved in this intervention and their conformity with the Principles set out above were as follows:
- At an internal supervisory meeting (a ‘supervisory panel’) it was agreed that there was a clear and unacceptable risk to the supervisory objective of ‘protecting customers from harm as a result of misconduct on the part of supervised institutions’. [Principle 1: Identify all material risks to supervisory objectives.
- The supervisory risk assessment had found that the company’s internal processes and compliance around disclosures of fees and commissions were weak. It also appeared that compensation of sales staff had been (and continued to be) heavily weighted towards bonuses based on the volume of savings products sold. It was agreed (and subsequently communicated to the company) that remuneration practices would be included in any remedial program. [Principle 2: Look beyond immediate problems to potential wider ‘root causes’ when determining the expected outcome].
- It was agreed that the expected outcome of the supervisory intervention would be to reduce conduct risk to an ‘acceptable’ level (that is, a level which, in terms of the supervisor’s internal guidelines, would be rated at Medium Low or below). Principle 3: Be clear about the expected outcome of intervention].
- The internal supervisory panel confirmed the rating of conduct risk as MH and that the expected outcome was a reduction in conduct risk to an acceptable level. The panel had agreed that this met the threshold for intervention (established in earlier internal discussions of the authority’s risk tolerance). This conclusion was subjected to, and confirmed by, a ‘common sense’ test of whether the issue warranted the use of supervisory resources and whether a requirement for significant remediation would be proportionate for the institution. [Principle 4: Intervene in a way that is proportionate, risk based and consistent with the supervisor’s risk tolerance].
- It was obvious to supervisors and the institution itself (which broadly accepted the findings) that a full remediation program would be complex and take some time. It would be necessary for the institution to have an extensive review of sales practices (undertaken by a third party). This was likely to recommend measures such as changes to contract terms to remove the scope for mis-selling; changes to remuneration arrangements to reduce the incentives for mis-selling; and improved reporting to sensitize management and the board to consumer protection issues.9
A meeting was held with the senior management of the company in which the outcome (reduced risk of misconduct) and the broad steps for achieving it (as discussed above) were spelled out. The company was instructed to revert with a detailed plan for addressing the issues (which had been agreed by the board) within four weeks. [Principle 5: Be clear about the pathways or intermediate steps to the expected outcome]. - As requested the company reverted with a draft plan which included timings/milestones for the steps involved. An important element of this was the appointment of external experts to review sales practices. The plan was discussed with the supervisors and, with some amendments, approved by them. The expected outcome of the remediation, timetable for the review and subsequent remedial steps as agreed with the supervisors are set out in the table below. [Principle 6: Ensure that there is a shared understanding with the financial institution about the expected outcome and the steps to achieving this. Principle 7: Specify clearly the timetables for intermediate steps and the expected outcome.]
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Review and follow up and timings: |
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Overall approach: Short-term 1. There will be a short-term, focused review of customer communication and customer recourse mechanisms leading to the identification and immediate cessation of any practices seen as being clearly detrimental to customers. Longer-term 2. A longer-term review of all sales practices and remuneration will be conducted by external advisers on the basis of terms of reference agreed with the supervisor. Recommendations arising out of the longer-term review will be discussed by the board and agreed with supervisors. 3. Based on steps 2 and 3, a detailed remediation program will be agreed and implemented. 4. On completion of the remediation program sales practices will be closely monitored (by LifeX’s board and supervisors on the basis of agreed KPIs) to provide assurance that conduct risk has been effectively reduced. |
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Actions |
Timings (T = date of the letter agreeing the program) |
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Short-term focused review and actions (step 1 of the overall approach) |
Completed by T + 4 weeks |
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Longer term review (steps 2 to 4 of the overall approach) |
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T + 4 weeks |
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T + 10 weeks |
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T + 12 weeks |
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T + 18 weeks (subject to review in light of detailed findings) |
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T + 30 weeks (tentative, depending on detailed findings and measures to be reconfirmed with supervisors) |
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Ongoing monitoring (step 5 of the overall approach) to check that the outcome of reducing conduct risk has been achieved. |
T + 30 weeks onwards |
- Supervisory relations with LifeX have generally been positive and constructive in the past. The company has been willing to share issues with supervisors and has been responsive to supervisory concerns and requirements. Current management argued convincingly that the conduct risks identified were the result of legacy arrangements in a group company acquired three years ago and appeared committed to putting things right. Supervisors therefore judged (and the internal panel agreed) that a reasonable level of trust could be placed in the management. Monitoring would therefore be rigorous but proportionate [Principle 8: Decide on the most appropriate way of monitoring progress]. In this case:
- Management will confirm that the immediate, focused review has taken place and report the changes in sales practices resulting from it.
- The review conducted by the external advisers and the proposed remediation stemming from it will be discussed fully with the supervisors.
- The timetable for the longer term remedial plan will be agreed with the supervisors.
- Monthly progress reports will be provided to the supervisors.
- KPIs will be agreed to provide confirmation that the conduct risk has been reduced.
- · It was agreed that while the immediate, focused review is under way the management of LifeX would be vigilant in ensuring that customers are communicated with fully and that additional information would be provided to new and existing customers setting out the maximum fees and commissions (in monetary terms, not percentages) that would be applicable over the life of each contract. This went beyond formal regulatory requirements but was judged to be appropriate and necessary in this case. [Principle 9: Consider whether to put in place restrictions or other requirements while remediation is under way].
- Supervisors immediately entered into a dialogue with the management of LifeX to identify metrics and KPIs that would be used after completion of the program to demonstrate that it had been effective in achieving the outcome of reducing conduct risk. This would include annual reviews of customer complaints, trends in fees and commissions received, and MI provided to management and the board on a range of ‘treating customers fairly’ metrics. [Principle 10: Seek firm evidence that the expected outcome has been achieved].
Integration with Supervisory Processes
In order to be fully effective all supervision, including intervention, needs to be supported by an internal ‘infrastructure’ designed to promote consistent, proportionate and appropriately focused supervisory action.10
- The Principles of effective intervention should form part of training and supervisory capacity building. Supervisors are usually given quite extensive training on the use of risk based frameworks for assessing risk. The development of effective interventions aimed at mitigating identified risks should be an essential adjunct to this.
- Many supervisory authorities have found it useful to develop and publish frameworks for supervisory intervention. These are sometimes referred to as ‘intervention ladders’ which set out a number of levels of concern (typically 4-5) corresponding to the perceived level of risk in supervised institutions, alongside the broad types of supervisory action that it will expect to take at each level.11 An institution about which there are ‘no significant concerns’ for example might warrant only routine reporting and monitoring. As the perceived levels of risk increase supervisors may require the use of remedial measures, the development (and possible implementation) of recovery plans and increased holdings of capital, all of which will be subject to increasingly close monitoring by supervisors.
Such frameworks promote consistency, transparency and predictability in supervisory responses to risk and are of considerable value. The supervisory actions described in them however are inevitably high-level and generic in that they are linked to the overall risk rating of supervised institutions and broad categories of supervisory action. The Principles of intervention proposed in this Note which apply to specific risk issues are entirely consistent with the development of such frameworks and are designed to provide guidance in formulating more focused and targeted supervisory interventions. - Many supervisors also make use of internal supervisory or case review panels aimed at ensuring the consistency of supervisory judgements and actions across supervised firms.12 Such panels should consider whether the Principles have been applied.
- Quality assurance (QA) functions may also be used to check that internal supervisory processes are being adhered to and applied consistently. Checking that the Principles of intervention are being consistently applied can be a valuable part of QA’s role.
From Supervision to Enforcement
This Note has focused mostly on intervention in what might be termed a ‘business as usual’ context – actions that are an integral part of Risk Based Supervision aimed at reducing or mitigating identified net risks. In some cases supervised institutions may persistently fail to agree or undertake necessary remedial measures requiring supervisors to take more formal enforcement action. In most cases this is seen as a distinct step beyond routine supervision, to be taken when cooperative arrangements (usually the preferred mechanism) fail to achieve required outcomes. Enforcement will often involve the use of a separate specialist team.
Other Toronto Centre Notes have set out in some detail the issues faced by supervisors when taking enforcement action.13 Enforcement action will often be challenged by the institutions to which it is directed, making it imperative that supervisory authorities are confident that they have the necessary powers, and that their use of these powers, the rationale for this and all communications with the institution are fully documented. It is also essential that enforcement does not displace normal supervisory activities which need to continue while the (often protracted) enforcement processes are under way.
Case Studies/Exercises
The remainder of this Note consists of mini case studies designed to illustrate strengths and common weaknesses in supervisory intervention. The cases are fictitious but reflect issues that are commonly encountered by supervisors. In each case the reader is presented with an example in which there is judged to be a need for supervisory intervention and a description of how a supervisory authority has approached this. The task is to assess how well the chosen approach embodies the ten Principles of Intervention.
- Annex 1 contains scenarios and examples of intervention programs. Readers are invited to form a view about the compliance of the proposed interventions with the Principles and, by implication, how effective the interventions are likely to be. They are also invited to develop ‘improved’ interventions.
- Annex 2 contains suggested ‘answers’. It outlines the shortcomings of the interventions suggested in Annex 1 and sets out the elements of ‘improved’ interventions.
Conclusion
The principal task of supervision is to provide assurance that risks being run by financial institutions (reflected in the risks to supervisory objectives) are at an acceptable level. The assessment of risk is an essential first step in this, but this needs to lead to supervisory intervention when risks are judged to be unacceptably high.
Effective supervisory intervention does not happen by itself. It is not usually sufficient for supervisors merely to state their concerns to institutions’ managements and boards. Statements of high-level desired outcomes will also be unlikely to be effective without proper regard being paid to the intermediate steps that will often form part of a complex intervention program.
This Note has set out a number of Principles that should govern supervisory interventions. Embedding these within supervisory processes and structures will help to make supervisory intervention more focused and effective.
Annex 1: Mini Case Studies
Introduction
This Annex sets out four mini-cases designed to illustrate the application of the Principles. In each case you are invited to assess the effectiveness of the proposed supervisory intervention against the Principles set out above. You might wish to do this in each case using the Table below. You might want to work through all four cases, or choose the ones that are the most relevant for you - they can be considered independently of each other. Annex 2 then discusses whether the proposed supervisory intervention meets each of the Principles, and sets out a suggested supervisory intervention that aims to meet all of the Principles.
The cases deal with the following topics:
- Capital and capital planning
- Weakness in insurance underwriting controls
- Weak corporate governance
- Risks in group supervision
You may wish to use the following template to assist in your assessment of the proposed intervention. You can then compare your assessment against that provided in Annex 2.
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Principle |
Assessment of whether each Principle has been met |
| 1. Identify all material risks to supervisory objectives |
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| 2. Look beyond immediate problems to potential wider root causes when determining the expected outcome |
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| 3. Be clear about the expected outcome of intervention |
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| 4. Intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance |
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| 5. Be clear about the pathways or intermediate steps to the expected outcome |
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| 6. Ensure that there is a shared understanding about the expected outcome and the steps to achieving this |
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| 7. Specify clearly the timetables for intermediate steps and the expected outcome |
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| 8. Decide on the most appropriate way of monitoring progress |
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| 9. Consider whether to impose restrictions or other requirements while remediation is under way |
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| 10. Seek firm evidence that the expected outcome has been achieved |
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Overall assessment: |
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Case 1: Capital and Capital Planning
Background
Bank X has come very close to breaching its minimum capital requirement (which includes a Pillar 2 add-on14) twice in the past twelve months.
On investigation supervisors find that Bank X has a very unsophisticated approach to capital planning. An annual exercise is undertaken in which the capital requirement for the coming year is estimated very approximately, mostly on the basis of recent trends in loan book losses modified by ‘management discretion’. The annual exercise is undertaken against the background of a general wish of the board and management of Bank X to minimize any ‘excessive’ holdings of capital, which are seen as costly.
Supervisory intervention
On completing their investigation the supervisors communicate their findings (in the form of a letter) to the board and management of Bank X as follows:
‘It is our assessment that Bank X remains vulnerable to shortfalls in its capital. We require you to put in place, as a matter of urgency, arrangements to avoid any possibility of future capital shortfalls’.
How would you assess the effectiveness and adequacy of these requirements in the context of the Principles outlined in this Note? You might use the table provided at the beginning on this Annex. Once you have made your assessment you can compare your findings against those in Annex 2.
Developing an improved program
Taking into account any deficiencies you have identified in the proposed remediation program, can you set out an improved program which adheres more closely to the Principles, starting with a restatement of the expected outcome? You can compare your conclusions against a suggested program that conforms more closely with the Principles set out in Annex 2.
Case 2: Weak Insurance Underwriting Controls
Background
Insurer Y specializes in providing insurance to automobile owners covering them against theft of vehicles, the costs of repairing damage or replacement resulting from accidents, and legal claims from other drivers. The company has experienced an unexpectedly large increase in claims over the past twelve months which required an infusion of solvency support from the parent of the wider insurance group (GroupCover) of which it is part.
A new director of insurance was appointed to Insurer Y eighteen months ago. This individual is known to favour very aggressive sales strategies and since the appointment Insurer Y has targeted increasingly risky customers. Insurance cover had previously been restricted to drivers between the ages of 25 and 65 with sound driving records. Over the past twelve months cover has been offered much more widely, including to younger and older drivers and those with past driving convictions. The company has adopted the marketing slogan “If you’ve been turned down by other insurers, Y has the cover for you”. The new director of insurance has a record of implementing aggressive sales strategies in other firms, usually circumventing the board in doing so.
Supervisory intervention
On completing their risk assessment of Insurer Y supervisors found that controls over the writing of insurance underwriting had failed to keep pace with the more aggressive approach to marketing. Specifically:
- There had been no review of limits to align these with the wider range of customers including many riskier ones.
- Pricing of cover had not been adjusted to take account of the fact that many customers being targeted are now higher risk.
- There had been little analysis undertaken of projected claims resulting from the new strategy and the implications of these for profitability and reserves.
In the light of these findings supervisors sent a letter to the CEO of Insurer Y stating:
‘We require you to undertake a review of underwriting limits and policies in the automobile insurance business. Specifically we expect you to do the following:
- Review the categorization of policy holders (for example by age and driving record) and the underwriting limits applied to these groups.
- Undertake a review of pricing of insurance on the basis of the risks insured.
- These reviews will be completed within 10 weeks of the date of this letter.
- Increase reserving levels by 10% within six weeks of the date of this letter.’
How would you assess the effectiveness and adequacy of these requirements in the context of the Principles outlined in this Note? You might use the table provided at the beginning on this Annex. Once you have made your assessment you can compare your findings against those in Annex 2.
Developing an improved program
Taking into account any identified deficiencies in the proposed remediation program, can you set out an improved program which adheres more closely to the Principles, starting with a restatement of the expected outcome? You can compare your conclusions against a suggested program that conforms more closely with the Principles set out in Annex 2.
Case 3: Weak Corporate Governance
Background
Fund manager Z (FMZ) is part of a financial group, Megagroup, which also contains a bank and an insurer. The group has no cross border operations. As a legal entity in its own right FMZ is required to have its own board. In practice nearly all of its board members are drawn from the parent (Megagroup) board, none of whom has fund management experience and most of whom were recruited from among the ‘great and the good’ (former industrialists, politicians and civil servants) with little detailed knowledge of the financial sector. The only ‘specific’ FMZ board member is a single non-executive director, a former senior manager in another fund management firm who retired from full time employment fifteen years ago.
The CEO of FMZ is well known throughout the financial sector for setting aggressive growth targets, being generally ‘anti regulation’ and prone to cutting corners in areas such as compliance, AML, and customer take-on/suitability rules. While there appear to be no current compliance problems in FMZ, significant conduct and financial crime risks have been identified in the past.
Supervisory intervention
As part of their regular risk assessment of FMZ supervisors drew on the expertise of a recently established ‘horizontal’ team in the supervisory authority whose specific task is to assess the effectiveness of corporate governance against industry-wide sound practice. The team concluded that corporate governance in FMZ was largely ineffective, because the board asked few questions and provided little meaningful guidance on strategy or risk management. There was no real accountability of the CEO who frequently circumvented the board, withheld significant information, and was able to introduce radical changes to the business without challenge.
In the light of these findings the supervisors wrote to the CEO and board chair of FMZ along the following lines:
‘We find that corporate governance in FMZ does not meet the required standards to ensure the soundness and stability of the company. Board members lack fund management expertise, independence and the ability or willingness to challenge management. We therefore require you to take the following steps towards the goal of having a board which interacts effectively with senior management and provides challenge and guidance in the key areas of strategy and risk management:
- Strengthen board members’ understanding of fund management business through a combination of training and the appointment of new members.
- Ensure that the board has the appropriate level of independence from the board of Megagroup, for example through the appointment of at least one additional independent non-executive director (INED).
- Improve information flows from the management of FMZ to the board and increase management’s accountability.
It is expected that the necessary changes will be implemented no later than eight months from the receipt of this letter. At that time the board chair should communicate in writing the steps that have been taken to achieve the necessary strengthening of governance’.
How would you assess the effectiveness and adequacy of these requirements in the context of the Principles outlined in this Note? You might use the table provided at the beginning of this Annex. Once you have made your assessment you can compare your findings against those in Annex 2.
Developing an improved program
Taking into account any identified deficiencies in the proposed remediation program, can you set out an improved program which adheres more closely to the Principles, starting with a restatement of the expected outcome? You can compare your conclusions against a suggested program that conforms more closely with the Principles set out in Annex 2.
Case 4: Unresolved Risks in Group Supervision
Background
HomeBank is part of a cross border conglomerate called FinanceGroup. The group is domiciled in Home country (its Head Office is located there) and its structure in Home country comprises a holding company, a bank (HomeBank), a life insurance company (HomeInsure), and a fund manager (HomeFM). The bank, insurer and fund manager are all subsidiaries of the holding company and separate legal entities within Home country.
Each of the operating entities in Home country has a subsidiary in Host country as shown in the diagram below (HostBank, HostInsure and HostFM). The insurer in Host country also has a subsidiary called HostFinance which is unregulated because it is not thought to undertake business that is covered by the statutes governing supervision in Host country.
HostFinance is however a source of supervisory concern because: a) there is no clarity about what it actually does; b) it is judged that if it were to fail or come under severe stress other entities in FinanceGroup could suffer reputational damage by association; and c) it recently came to light that HostInsure remitted a substantial amount of funds to HostFinance when the latter’s solvency was reported to be under pressure. HostInsure was then obliged to draw on a line of credit that was quickly arranged from HomeBank.
Supervisory intervention
Supervisors in Home country recently held a college meeting with their opposite numbers in Host country. Each country has a single, integrated supervisory body. Communications between the Home country and Host country supervisors are generally constructive and open. The Home country supervisors posed the following questions to their Host country counterparts as shown below, together with the answers given.
|
Question (from Home country) |
Answer (from Host country) |
|
What does HostFinance actually do? |
We are not sure. It is mostly involved in providing consumer credit which we do not regulate/supervise. But it also seems to engage in some trading activities. We have asked about these but because we do not supervise it their management are not very communicative. |
|
Are you sure it cannot be taken into supervision? |
Pretty sure. They have legal opinions saying that they do not undertake regulated business. Some changes are under way to our supervisory remit but these involve legislation and could take years. |
|
Were you concerned about the support provided to HostFinance by HostInsurer? |
Yes, we were. It was unexpected. The support really came indirectly from your HomeBank. We need to find out whether that was provided on commercial terms (the same as for any other entity) or on special, ‘intra group’ terms. |
HostFinance is currently unregulated and there is no prospect of it being regulated or supervised in the near future. And it is a potential source of risk to the group. In the light of this it was decided that each supervisor would write to the FinanceGroup entities for which it was responsible saying the following:
‘We are concerned about the risks posed to FinanceGroup and its group entities by HostFinance. For this reason we are prohibiting supervised FinanceGroup entities in our jurisdiction from engaging in any further transactions with HostFinance which would create a financial exposure. Recognizing that existing financial commitments will take time to wind down, the requirement is that each group entity’s gross exposure to HostFinance should be reduced to zero within nine months of this notice.’
Focusing on the Host country supervisory authority, how would you assess the effectiveness and adequacy of these requirements in the context of the Principles outlined in this Note? Once you have made your assessment you can compare your findings against those in Annex 2.
Developing an improved program
Taking into account any identified deficiencies in the proposed remediation program, can you set out an improved program which adheres more closely to the Principles, starting with a restatement of the expected outcome? You can compare your conclusions against a suggested program that conforms more closely with the Principles set out in Annex 2.
Annex 2: Assessments of Intervention Plans and Suggested Improvements
Case 1: Capital and Capital Planning
|
Principle |
Assessment of whether each Principle has been met |
| 1. Identify all material risks to supervisory objectives |
Not met. The assessment identifies a risk but not in the context of the supervisor’s objectives (i.e. why it matters). |
| 2. Look beyond immediate problems to potential wider root causes when determining the expected outcome |
Not met. The issue is as much the absence of an effective capital planning framework as a shortage of capital. This is not spelled out explicitly. |
| 3. Be clear about the expected outcome of intervention |
Met. The ultimate requirement (of avoiding future shortfalls) is clear, although this is not linked to supervisory objectives. |
| 4. Intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance |
Probably met. |
| 5. Be clear about the pathways or intermediate steps to the expected outcome |
Not met. The detailed steps required to achieve the final goal are not spelled out. |
| 6. Ensure that there is a shared understanding about the expected outcome and the steps to achieving this |
Partly met. The expected outcome has been communicated to the institution but there is no shared understanding about the steps required to achieve this. |
| 7. Specify clearly the timetables for intermediate steps and the expected outcome |
Not met. There is no timetable – ‘… as a matter of urgency…’ is not precise. |
| 8. Decide on the most appropriate way of monitoring progress |
Not met. No arrangements have been put in place for monitoring the final goal or the intermediate steps. |
| 9. Consider whether to impose restrictions or other requirements while remediation is under way |
Not met. There is no mention of temporary steps or requirements and the proposed remediation is ambiguous about whether an immediate injection of capital is required. |
|
10. Seek firm evidence that the expected outcome has been achieved |
Partly met. Supervisors will know if the institution fails to meet its capital requirements but there are no metrics on whether the capital planning designed to avoid this has improved. |
|
Overall assessment: the supervisory requirement was reasonably clear about the expected outcome but this was not linked to supervisory objectives and the requirement lacked any appreciation of the wider issues involved (poor capital planning); detail about intermediate steps; timetables; and monitoring arrangements. Given the importance attached by the bank to minimizing its capital holdings relatively close monitoring would be warranted. |
|
A possible adverse scenario
The supervisory intervention as originally formulated did not comply with many of the Principles set out in this Note. The following adverse scenario could have resulted from a failure to formulate the intervention correctly:
As a result of the deficiencies in the program there was no effective follow up by the supervisors once they had spelled out their high level requirement. In the course of a conversation with the CEO about another matter six months later it came to the supervisors’ attention that no additional capital had been put in place and shortly afterwards the capital position came under strain once again. On being questioned about this, Bank X’s management said that they had been awaiting the right opportunity to communicate to shareholders that the dividend will be reduced for the next 2-3 years to allow them to use retained earnings to build up the capital position.
|
An improved intervention plan: Supervisory requirement ‘Bank X needs to strengthen its capital planning framework to a level that meets sound industry practice and maintain sufficient additional capital to enable it to avoid shortfalls in its capital position – and hence risks to its prudential soundness. As an interim measure it needs to increase its capital by x million within the next three months to provide what is judged to be a reasonable buffer over the regulatory minimum.’ [Principles 1, 2, 3, 4] |
||
|
Actions |
Timings (T = date of the letter agreeing the program) |
Principles |
|
1. An interim increase in capital of x million (to create a buffer over the regulatory minimum judged sufficient to enable the bank to withstand plausible losses) |
To be in place by T = 9 weeks. Subject to review on completion of the program. |
7, 9 |
|
2. Undertake a review of the capital planning process; agree recommendations with the board and the supervisors; and take the necessary steps to bring this to an acceptable standard.
|
Reviewers to be appointed within T + 4 weeks Review to be completed by T + 10 weeks Review findings and recommendations to be discussed by Bank X’s board by T + 12 weeks Internal remediation plan to be agreed with supervisors and put in place by T + 14 weeks Remediation program to be completed by T + 20 weeks |
2, 5, 6, 7 |
|
3. Monitoring [Note here that Bank X has not been very cooperative in its dealing with the supervisor. It was slow to inform the supervisor of the capital strains; has adopted a generally confrontational attitude; and shows every sign of interpreting (albeit unclear) supervisory instructions in a way which is most favourable to itself. In the light of this the supervisory monitoring arrangements need to be extensive.] |
|
|
|
Monitoring measures: |
|
|
|
Audited evidence of capital injection |
|
8 |
|
Copy of review to be sent to, and discussed with, the supervisor |
|
|
|
Recommendations and plan to be communicated to the supervisor, together with the minutes of the board discussion of them |
|
6 |
|
Detailed internal remediation plan to be discussed/agreed with supervisors |
|
6 |
|
Board letter to the supervisors on completion of the remediation plan attesting to its completion and board satisfaction and evidence that capital management is now at an acceptable standard |
|
10 |
|
External review (at institution’s expense) no more than 30 weeks after completion/implementation of the plan reporting on the effectiveness of the changes based on agreed KPIs. |
|
10 |
Case 2: Weak Insurance Underwriting Controls
|
Assessment of whether each Principle has been met |
|
| 1. Identify all material risks to supervisory objectives |
Not met. The solvency of the supervised entity is at risk because insurance risk is excessive but this is not spelled out. |
| 2. Look beyond immediate problems to potential wider root causes when determining the expected outcome |
Not met. There is clearly a cultural issue arising out of the aggressive sales strategy. This is not being addressed. |
| 3. Be clear about the expected outcome of intervention |
Not met. The desired outcome - an acceptable and manageable level of claims - is implicit in the required actions but not spelled out. |
| 4. Intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance |
Not obviously met. Jumping straight to an increase in reserving levels may be disproportionate and no rationale is provided. |
| 5. Be clear about the pathways or intermediate steps to the expected outcome |
Partly met. The reviews of underwriting and pricing are important intermediate steps but the link between these and the expected outcome is not spelled out. There are no steps relating to the implementation of actions stemming from the review. |
| 6. Ensure that there is a shared understanding about the expected outcome and the steps to achieving this |
Partly met. There is clarity about some of the intermediate steps but these are incomplete (see above) and there is no clarity about the expected outcome. The supervisors’ letter is sent to the CEO not (apparently) to the board. |
| 7. Specify clearly the timetables for intermediate steps and the expected outcome |
Partly met. Timetables are set out for the intermediate steps but not for the final outcome. |
| 8. Decide on the most appropriate way of monitoring progress |
Not met. No arrangements have been put in place for monitoring the final goal or the intermediate steps. |
| 9. Consider whether to impose restrictions or other requirements while remediation is under way |
Met. The increase in provisions may provide temporary risk mitigation but no rationale is provided for this and it is not clear whether this is a permanent or temporary measure. |
|
10. Seek firm evidence that the expected outcome has been achieved |
Not met. This is because the expected outcome - in terms of an acceptable and manageable level of claims - has not been spelled out. |
|
Overall assessment: nearly all of the focus in the program is on the intermediate steps of reviewing underwriting policies and pricing. These are important steps but the desired outcome – an acceptable and manageable level of claims resulting in a sustainable P&L and reserving levels to maintain solvency – are not spelled out. There is no attempt to address the wider cultural issue involved or to engage the board, and no rationale is provided for the required increase in reserves or any indication of whether this is a temporary (pending the outcome of the reviews) or permanent measure. |
|
A possible adverse scenario
The supervisory intervention as originally formulated did not comply with the Principles set out in this Note. The following adverse scenario could have resulted from a failure to formulate the intervention correctly:
Insurer Y undertakes the required reviews and introduces modest changes to its underwriting and pricing policies. On this basis, together with the increase in reserves, it is judged that the supervisory requirements have been met and the identified risks have been addressed. In reality, however: a) the changes to underwriting and pricing policies are not commensurate with the risks; and b) these are regularly undermined/circumvented because of the continued emphasis on the volume of sales and the failure of the board to get a grip on the firm’s culture. Profitability and reserves continue to come under strain as a result.
|
An improved intervention plan: Supervisory requirement “Insurer Y needs to strengthen its underwriting and pricing policies to align these with the heightened inherent risks resulting from its change in target customer base. This will reduce risks to the insurer’s financial soundness. Corporate governance needs to be strengthened to allow the board to provide more effective challenge and clearer direction on strategy, risk management and to create the required culture to support these” [Principles 1, 2, 3, 4] [Note: the remainder of this ‘model’ answer focuses on the underwriting and pricing policies only. This is for reasons of brevity and because similar governance issues are covered in Case 3 below]. |
||
|
Actions |
Timings (T = date of the letter agreeing the program) |
Principles |
|
1. An interim increase in reserves of X% (to provide a margin over the regulatory minimum judged sufficient to enable Insurer Y to withstand plausible losses). |
In place within T + 6 weeks. It will be subject to review on completion of the supervisory program |
4, |
|
2. Undertake Commission an external review of underwriting and pricing policies – to contain recommendations for bringing claims and loss levels to an acceptable and sustainable level. The conclusions and recommendations of the review are to be agreed upon by the board and with supervisors.
|
Terms of reference of review to be agreed with supervisors within T + 2 weeks Review completed T + 10 weeks Findings and recommendations discussed with board and supervisors and proposed remediation plan agreed T + 12 weeks Remediation plan implemented T + 14 weeks Remediation plan completed T + 25 weeks Supervisory review of plan outcome and required reserve levels T + 30 weeks |
5, 6, 7 |
|
3. Monitoring [Note here that Bank X has not been very cooperative in its dealing with the supervisor. It was slow to inform the supervisor of the capital strains; has adopted a generally confrontational attitude; and shows every sign of interpreting (albeit unclear) supervisory instructions in a way which is most favourable to itself. In the light of this the supervisory monitoring arrangements need to be extensive.] |
|
|
|
Monitoring measures: |
|
|
|
Audited evidence of the increase in reserves |
|
8 |
|
Meeting with supervisors to agree terms of reference of review |
|
6, 8 |
|
Monthly verbal updates (meetings or phone calls) reporting on the progress of the review |
|
8 |
|
Agreement with supervisors on the detailed remediation plan and milestones |
|
6 |
|
Monthly verbal updates (meetings or phone calls) reporting on progress of remediation plan |
|
8 |
|
Meetings before conclusion of remediation plan to discuss post plan KPIs (for example claims levels) with: a) director of insurance; and b) chair of board risk committee |
|
10 |
|
Six monthly reports on agreed post program KPIs |
|
10 |
Case 3: Weak Corporate Governance
|
Principle |
Assessment of whether each Principle has been met |
| 1. Identify all material risks to supervisory objectives |
Met – the soundness and stability of the company are mentioned together with the link between this and weak governance. |
| 2. Look beyond immediate problems to potential wider root causes when determining the expected outcome |
Partly met – the program does not look fully into the root causes of the board’s deficiencies. But if the necessary measures are taken these may be addressed. |
| 3. Be clear about the expected outcome of intervention |
Met – the goal of stronger governance and the link to financial soundness are spelled out clearly. |
| 4. Intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance |
Not known – although the fact that the supervisory authority has created a specialist team suggests that it takes this risk seriously. |
| 5. Be clear about the pathways or intermediate steps to the expected outcome |
Partly met – for example by specifying training, new recruitment and so on. But the risk is that the supervisor has: a) not allowed for other possible measures; and b) has not specified the need for the measures taken to be shown to be effective in practice (much of the focus is on ‘characteristics’ rather than ‘effectiveness’). |
| 6. Ensure that there is a shared understanding about the expected outcome and the steps to achieving this |
Partly met - although the supervisor has been prescriptive about the detailed means of achieving the goal and has not asked FMZ itself to come with a plan (which would be based on detailed knowledge, could increase buy-in, and which may address other issues not identified by supervisors). |
| 7. Specify clearly the timetables for intermediate steps and the expected outcome |
Not met. A timetable has been set for the final outcome but not for the detailed steps. |
| 8. Decide on the most appropriate way of monitoring progress |
Not met. There seems to be no monitoring of the intermediate steps. Neither is there any monitoring to show that any changes have been effective. |
| 9. Consider whether to impose restrictions or other requirements while remediation is under way |
No such restrictions or requirements. But it is not clear that any were needed. |
|
10. Seek firm evidence that the expected outcome has been achieved |
Not met. The risk is that FMZ goes through the motions of making changes which have the right ‘characteristics’ but which in practice do not result in strengthened governance. |
|
Overall assessment: the remediation program looks on the surface to be well articulated. The expected outcome is specified along with a number of key intermediate steps. However the supervisors may have been too prescriptive with regard to intermediate steps and not sought sufficient input from FMZ itself. The supervisor’s requirements can be met with ‘cosmetic’ changes which in practice may not prove effective. |
|
A possible adverse scenario
Although this program is considerably more detailed than those for cases 1 and 2, it still has a number of shortcomings in relation to the Principles. The following adverse scenario could have resulted from a failure to formulate the intervention correctly.
Eight months after receiving the supervisor’s letter the board chair writes to the supervisory authority to report that the board undertook a self-assessment of its own effectiveness on the basis of which: a) board members undertook an on-line training program on fund management provided by an outside supplier; b) an additional INED was recruited; c) the MI pack for the (six-weekly) board meetings was reviewed and ‘improved’ (in unspecified ways); and d) a new organization chart was created with additional dotted lines from Internal Audit to the board’s audit committee and from the CEO to the board’s risk committee. While these measures appear positive, no evidence was produced by FMZ – or sought by the supervisor – to show that they were effective in practice in achieving the desired outcome of strengthened governance in practice.
Case 4: Unresolved Risks in Group Supervision
|
Principle |
Assessment of whether each Principle has been met |
| 1. Identify all material risks to supervisory objectives |
Not met. There is an awareness of a generalized risk but the nature and severity of this, the mechanism through which it could crystallize and the link to objectives are not clear. |
| 2. Look beyond immediate problems to potential wider root causes when determining the expected outcome |
Not met. The use of an unregulated company may represent supervisory arbitrage involving an incentive for businesses to evade supervision – and the scope for doing so. This has not been considered in framing the intervention. |
| 3. Be clear about the expected outcome of intervention |
Partly met. The required outcome (no intra group exposures to HostFinance) is clear, but it is not clear that this is the ‘right’ outcome to mitigate the risks |
| 4. Intervene in a way that is proportionate, risk-based and consistent with the supervisor’s risk tolerance |
Not met. The nature and scale of the risks are not fully understood. The intervention may not represent a proportionate response and may prove destabilizing. |
| 5. Be clear about the pathways or intermediate steps to the expected outcome |
Not met. The requirement is that intra-group funding stops. There is no consideration of the intermediate steps necessary to achieve this. |
| 6. Ensure that there is a shared understanding about the expected outcome and the steps to achieving this |
Not met. The required outcome (cessation of intra-group funding) is clear but the rationale for this and the necessary steps to achieving it are not. |
| 7. Specify clearly the timetables for intermediate steps and the expected outcome |
Met. The timetable for achieving zero funding and the timetable for this are clear. |
| 8. Decide on the most appropriate way of monitoring progress |
Not met. There is no mention of checking on the expected outcome (which is not spelled out) or the steps to achieving it. |
| 9. Consider whether to impose restrictions or other requirements while remediation is under way |
Not met. The cessation of intragroup funding itself constitutes a restriction on the business but not a temporary one. No consideration has been given to other short term measures such as an increase in Pillar 2 capital for the bank while it takes effect. |
|
10. Seek firm evidence that the expected outcome has been achieved |
Not met. Zero funding may be achieved in the timetable but it is not clear that this will achieve the goal of removing all the risks posed by HostFinance. |
|
Overall assessment: although it complies with some of the Principles, this looks like a badly thought out measure. No attempt has been made (for example through discussions with the group) to establish the true nature and extent of the risk posed by HostFinance, why the group has chosen to use an unregulated entity, or whether other, more proportionate, responses are available. Cutting off funding could destabilize HostFinance (if it is unable to fund itself elsewhere) and the wider group and HostFinance may remain a source of risk even if intra-group finance is removed from it. |
|
A possible adverse scenario
The intervention program has a number of shortcomings. A possible result of it is that the cessation of financial links with the rest of the group has the effect of rendering HomeFinance insolvent, prompting its failure. The failure could be disorderly in the sense that the company is unable to meet its commitments to other financial counterparties and customers. Because there is a widespread recognition that it is part of FinanceGroup its failure may create significant reputational damage to the rest of the group so that other entities’ liquidity is impaired. These problems arguably stem from the supervisors’ failure: a) to understand the risks posed by HostFinance; b) to explore better targeted and proportionate measures; and c) to anticipate the likely consequences of their (fairly extreme) actions.
|
An improved intervention plan ‘The supervised companies comprising FinanceGroup are required to demonstrate that all risks resulting from financial linkages with HostFinance are understood, monitored, conducted at arms length and subject to rigorous management. Supervisors and group management are to have the necessary assurance that HostFinance does not pose unacceptable risks to the soundness of the group and its constituent entities.’ [Principles 1, 2, 3, 4] |
||
|
Action |
Timings (T = date of the letter agreeing the program) |
Principles |
|
Note: HostFinance is not regulated and the Holding Company does not undertake regulated activity. If necessary, pressure may need to be applied to HostInsure (as a regulated entity) to secure necessary information if unregulated entities are not cooperative. |
|
|
| 1. College members to seek a meeting with the senior management of HostFinance (unsupervised) to understand: a) the full range of its activities; and b) its financial linkages with other FinanceGroup entities. |
Within T + 4 weeks |
4, 5, 6 |
| 2. College members to seek meetings with the Group Holding Company and senior management of the HostInsure parent to establish: a) what they know about HostFinance’s activities; b) the nature and extent of financial linkages with HostFinance; c) the risk management applied to these (for example whether they are at arms length and subject to normal third party disciplines); and d) (from HostInsure) the rationale for having this subsidiary. |
Within T + 4 weeks |
4, 5, 6 |
|
The next steps in the program depend on what is discovered at these meetings. Scenario A: HostFinance management are uncooperative and evasive. FinanceGroup and HostInsure management are also uncooperative, insistent (without evidence) that HostFinance’s activities fall outside of supervision and complacent about the risks from financial linkages which ‘are managed informally from day to day’. |
||
|
Supervisory response: |
|
|
|
Scope and reviewer to be agreed with supervisors by T + 4 weeks Review to be completed by T + 10 weeks |
4, 5, 6 |
|
By T + 14 weeks |
5, 6 |
|
By T + 16 weeks
|
5, 6 |
|
|
4 |
|
Interim restrictions in place by T + 2 weeks (subject to review on completion of program) |
9 |
|
Monitoring [Note: the uncooperative attitude of the entities concerned mean that little reliance can be placed on them to buy-in to the remediation]. |
|
|
|
|
|
|
Scenario B HostFinance management are somewhat cooperative in describing their business but also very aware of their unsupervised status and not fully forthcoming. The Holding Company and HostInsure are initially uncooperative but become more helpful on being reminded that their stance and level of cooperation will be a key driver of the supervisory response (that is if they want to avoid the kind of close direction and monitoring in Scenario A). On this basis it is discovered that financial linkages with HostFinance are monitored and generally subject to normal limits and processes (in other words the same disciplines as applied to other, third party counterparties). However there are some gaps: a) there is ambiguity about whether any FinanceGroup entity would provide liquidity or capital support in circumstances of extreme stress; and b) Group Risk Management recognize that they have an ‘incomplete’ grip on the full range of risks being run and posed by HostFinance. |
||
|
Supervisory response: |
|
|
|
To report results of review to FinanceGroup board and supervisors within T + 4 weeks. |
5, 6 |
|
Position clarified and reported intra-group and to supervisors within T + 7 weeks |
5, 6 |
Monitoring. In this case the entities involved have been slightly more cooperative (though not fully so). As a result supervisors feel able to provide a degree of reliance on them – for example in formulating the group support and risk management policies. |
Review completed, reported to supervisors and recommendations implemented within T + 10 weeks |
8 |
|
Expected outcome Whichever scenario is applicable, FinanceGroup management will be able to demonstrate to the college that it has a full understanding of HostFinance operations and that financial and other linkages with it and the risks associated with these are managed effectively. Within T+10 weeks. |
|
|
References
Toronto Centre. Risk Based Supervision. March 2018a.
Toronto Centre. Risk Based Supervision: A Guide for Senior Managers. July 2018b.
Toronto Centre. Turning Risk Assessments into Supervisory Actions. August 2019.
Toronto Centre. Risk Based Supervision for Securities Supervisors (And Other Supervisors of Small Firms). February 2020a.
Toronto Centre. Pillar 2 and Beyond: Issues for Supervisors in Implementing Basel II and Basel III. June 2020b.
Toronto Centre. Supervisory Intervention by Retail Conduct Supervisors. April 2024a.
Toronto Centre. Supervision of Financial Institutions’ Business Models. December 2024b.
1 This Toronto Centre Note was prepared by Paul Wright. Please address any questions about this Note to
2 Net risks may be excessive as a result of choices made by the supervised institution regarding its business model, controls or management, or because of ‘external’ events such as an economic downturn or pandemic where the institution has failed to make the necessary internal adjustments (for example strengthening controls or adjusting its business model).
3 The fundamentals of Risk Based Supervision are set out in detail in Toronto Centre (2018a).
4 For a more extensive discussion of this see Toronto Centre (2024b).
5 As noted in several other TC Notes, small firms may require different (‘thematic or horizontal’) approaches to risk assessment and intervention. See for example Toronto Centre (2018a) and (2020a).
6 A key tenet of risk-based supervision is that supervisory resources are directed at the areas of greatest risk. It is not possible or desirable to eliminate all risks and supervisors should not seek to do so. Supervisors therefore need to establish parameters governing which risks are ‘acceptable’ and which are not. These parameters specify a supervisory authority’s risk tolerance. For more on this see Toronto Centre (2018b).
7 For a discussion of supervisory panels see Toronto Centre (2018a).
8 See Toronto Centre (2020b).
9 There was also a discussion within the supervisory authority about whether customers should receive financial compensation, but it was agreed that this would be included in a separate enforcement action.
10 For a fuller discussion of this see Toronto Centre (2018a and 2024a).
11 The use of guides to supervisory intervention of this kind is described in more detail in Toronto Centre (2019 and 2024a).
12 Toronto Centre (2018a).
13 Toronto Centre (2024a).
14 See Toronto Centre (2020b).