PowerPoint-presentatie

Supervisory framework for assessing conduct and culture in the financial sector

Femke de VriesDe Nederlandsche Bank

June 17th, 2014 nr.DNBGood morning, my name is Femke de Vries. Im a division director at DNB, the prudential supervisor on the financial sector in the Netherlands. First, I would like to thank Ellen for the invitation. Its an honour to be part of the programme during your seminar. I will focus mainly on a very specific and rather new element of our supervision of the financial sector: the supervison of conduct and culture. Before I start with a general introduction on the reason behind this new form of supervision, I would like to show you a short example that underlines the necessity of looking at behaviour and culture.1The Asch Experiment

nr.DNBThis is a short film of a famous psychological experiment that was conducted over 50 years ago but the results have been confirmed by various similar experiments ever since. Were going to see a group of actors and one test person. The test person of course does not that his fellow test persons are in fact actors. Lets take a look at what happens. This experiment has been repeated multiple times ever since and it turns out that 3 out of 4 people confirm to the opinion of the group at least once. So only 25% of the test persons remains independent. This experiment underlines how human beings tend to act in a group. This behaviour might even be emphasized in case of a group that has its own dynamic of hierarchical structure. It can be even more difficult to stay with your opinion if your boss and more senior colleague has a different view. This wil probably sound familiar to all of you. This was to emphasize the effect of group or social structures on our behaviour and the quality of our decision making. I will now turn to the reasons we had as a supervisor to start with looking into conduct and culture of financial organizations under our supervision.2Pre-crisis supervision

nr.DNBAs you all know from 2008 on the financial sector was struck by a severe crisis. This is what financial supervision looked like before the financial crisis. It was:Mainly backward lookingMainly focused on financial risks and systems and controlsThe financial crisis triggered developments in legislation and regulation. But due to the crisis financial supervisors also took a critical look at their own performance and asked themselves whether their way of working was still appropriate and whether it would be enough to prevent a new financial crisis. One of the lessons learned from the crisis was that supervisors were often to late to change the course of events once the financial reports already showed a deteriorating financial situation of for instance a bank. In the Netherlands DNB therefore concluded that its supervision on the financial sector should become more forward looking to be able to intervene before the financial position deteriorated. This resulted in a new focus of supervision.3Post-crisis supervision

nr.DNBIn this picture we see a shift towards a more forward looking approach and overall a more complete assessment of risks, not only focusing on financial but also on non financial risks. For instance focusing on business models, board effectiveness, conduct and culture. As well as using different methods like benchmarking, in depth thematic investigations. These changes both methodological as well as content driven should enable us to detect problems in the financial sector or in individual institutions in an early stage.With the Asch experiment weve just seen weve already had a small preview into the necessity of looking the conduct and culture of financial organizations. And will now go into that reason a bit more.4One of the causes of the crisis: not so much inadequate governance structures, but board and management behaviour within these structures

People determine a companys performance

Risks relating to behaviour may already be apparent, while financially everything seems okay: Behaviour has predictive value with respect to future financial performance Early intervention may prevent future problems

More rules alone will not prevent the next crisis Why supervision on culture & behaviour? nr.DNBAfter the crisis various committees and experts looked into the causes of the crisis. And inadequate governance of financial institutions was a potential cause. These reports concluded however that the crisis was not so much the result of inadequate governance structures but had been the result of the behaviour of people in charge of the financial institution within these structures. We all know that eventually people determine a companys performance and the quality of its decision making. And since the financial crisis we also know that conduct and culture within a company or part of society can cause severe problems. An interesting insight for a supervisor is that the risks relating to behaviour may already be apparent in an early stage while the company still seems to be financially sound. And we know from international research that theres a direct relationship between behaviour and future financial performance. Therefore early intervention may prevent future problems.5

Methodology nr.DNBBut how did we proceed?6Conduct and culture is one of the pieces of the puzzle nr.DNBI want to stress that Supervision on behaviour and culture is not an independent, separate supervisory topic. It is one of the pieces of our supervisory jigsaw puzzle. We use its insights alongside, not instead of, prudential supervision. We assess to what extent behaviour contributes to or impedes the performance of the company. And in that manner we use it to strengthen our supervisory objectives: financial solidity of financial institutions. As you can see on this slide the supervision on conduct and culture is not conducted by our regular staff. We think that the nature of this supervision requires a different kind of skill set. We therefore hired (organizational) psychologists to develop our methodology and to do the field and desk work. I will now go into the methodology we use.7CultureLeiderschap: voorbeeldgedrag en bespreekbaarheidBesluitvorming: evenwichtig en consistentCommunicatie: transparant

nr.DNB8We often use the iceberg as a metaphore. Part of the culture of a financial institution can be seen above the waterline. But most of it cant. The part that can not easily been seen has at least as much influence on the companys performance.The formal organisation consists of: structures, rules, procedures, reporting linesThe informal organisation: coalitions, power, conflict, informal leadership, social codes and perceptions. To identify risks for the future performance of an organisation its important to look into both the formal and the informal organisation. So both the visible behaviour and the underlying group dynamics, behavioural patterns and mindset.Supervision on culture and behaviourHet toezicht van DNB is gericht op het identificeren en voorkomen van risicos die kunnen voortvloeien uit cultuur en gedrag.

Het toezicht van DNB is gericht op het benvloeden van instellingen om deze risicos te verkleinen of elimineren.

Naast traditioneel toezicht (solvabiliteit en liquiditeit) en niet in plaats van.

Identifies risks that may emanate from behavior and culture: both risk based and at random

Risk based in case of: Incidents (financial or non financial) Lot of changes in the board or sr management in short period of time Financial problems High risk appetite Non compliant behaviour

Assesses these risks to cause institutions to eliminate these risks Focus on the question whether leadership, group dynamics and decision making contributes to the (economical) performance of a firm

We will intervene in case of riskfull behavior or lack of follow up

nr.DNBThe goal of the supervision is to identify risks that may lead to future problems within the organization. The companies that are subjected to a conduct and culture review are selected both risk based (on the basis of earlier knowledge about the organization we have come by as a supervisor) and random.Reasons to select an organization can for instance be: a serious incident (loss of a considerable amount due to investment policies), numerous changes in the board, signals of conflicts within the board etc

The purpose of the supervision is to identify risks in the culture of the organization and to assess whether they consist a threat to the future performance of the organisation. When looking at organisations we focus on:Leadership, Board dynamics and decision making processes.

After the assessment of individual companies we engage in a dialogue with the board on our findings. However in case of serious riskfull behaviour we will intervene directly.

Emphasis on site inspectionUp close and personalWe integrate quantitative and qualitative researchmethodsScientific term = Triangulation (Jick, 1979; Jonker & Pennink, 2000)Intense challenge of research teamDiverse perspectives and backgroundsAvoid assessment pitfalls9Discussion of findingsReportsFirst intervention Start of second intervention = tracking follow up

Methodology nr.DNBRisks are often reflected in decision making. We therefore focused on decision making and board effectiveness. In each case we selected a certain decision e.g acquisition, certain investment decision, strategic development. And we assessed the process of decision making and board effectiveness.

The assessment consists of desk research, interviews, employee survey and board observations. So we attend one or several board meetings to observe the group dynamics.10What is your opinion?Culture cannot be translated into audit standards

Assessment of culture and behaviour should be part of any SAI risk analysis

SAIs can play an important role in stimulating neccessary culture changes in public sector organisations

nr.DNB

Results nr.DNB

Case-Findings nr.DNBOver the past years weve conducted over 40 assessments on conduct and culture. What have we found?

Dominant leadership of CEO and following board members/senior managementDoes not leave room for dissenting opinionsDependence on one key player and his opinionRisk for unbalanced decision making (as we have seen in the Asch experiment, group conformity may not lead to the right outcome)

Unsatisfactory adherence to (strategic) objectives Risky decisions with financial loss as a resultNo strategic direction: opportunistic decision-making

Culture of informal decision making renders formal organisation obsoleteMay lead to a situation wherein Key people/relevant disciplines not involvedAnd to the Absence of sound judgment, balanced risk analysis, balanced decision making or open discussion

Proposals are insufficiently challenged/discussed at Board level (and as a result no countervailing power towards CEO)13Case-Supervisory approachReport (on paper) Send to management and supervisory board => supervisory board and shareholder become involved, leading to several actions Bank itself replaces CEO and CFO and look for new CRO. DNB is involved in short list and selection Intensive follow up with respect to leadership, group dynamics and decision-making New board is receiving coaching on behavioural change.

nr.DNBHow do we proceed in individual cases and what results did we obtain? I would like to illustrate this with a case. In this specific case we reported our findings to the MB of a small bank. Feedback to management board First reaction MB: we do not understand, this is not true

A week later: again Second reaction CEO: if this comes out, I am not sure of my position

Report (on paper) Send to management and supervisory board => supervisory board and shareholder become involved, leading to several actions Bank itself replaces CEO and CFO and look for new CRO. DNB is involved in short list en selection Intensive follow up with respect to leadership, group dynamics and decision-making New board is receiving coaching on behavioural change. 14Key areasCulture change requires permanent attention of directors and auditors

nr.DNBBased on the findings of our assessments over the last years, DNB expects financial institutions to work on the following four key areas:

Organize self-reflection: Directors and supervisory board members must therefore set aside enough time to reflect on their own conduct and/or the dynamics within the senior management group;Organize sound judgment: structure the decision making process so as to enhance balanced and consistent decision making Organize constructive challenge within the organisationFlexible leadership style : facilitating leadership style in stead of a dominant leader

15General impact of supervision on culture & behaviour

Actual changes we see:governance and staffing: changing board compositionchanges in decision making processes:more structured decision-making processes, better preparation of decisions, more involvement of key control functions, evaluation of complex decision making, organizing constructive challenge and debatemore facilitative leadership stylesbetter information-sharing between the management and supervisory board nr.DNBBoards (both executive and non executive board members) show increased awareness of their group dynamics and the influence of behavioural patterns on the business. This awareness is needed for sustainable behavioural change.

An important side effect of supervision on culture and behaviour: our supervisors acquire a more comprehensive overview of the (root) causes of many supervisory issues relating to the institution . This increases the options to intervene and interventions become more effective.

Actual changes we see in the organisations we have assessed:governance and staffing: changing board compositionchanges in decision making processes: more structured decision-making processes, better preparation of decisions, more involvement of key control functions, evaluation of complex decision making, organizing constructive challenge and debatemore facilitative leadership stylesbetter information-sharing between the management and supervisory board

16Final commentsEvery organization and every group may be affected by leadership problems or adverse group dynamics

DNB has found risky situations pertaining to culture & behavior and has caused the institutions to eliminate these risks

We also found good examples

However, there is still a lot more awareness needed and improvements to be made, which will take a lot of effort and time (change takes time!)

Permanent Board commitment and attention for culture & behavior within financial institutions remains required to prevent adverse effects from behavior and insufficiently considered decisions

nr.DNBWhat is your experience?Our SAI is committed to an ethical culture and behaviour within our own organisation

Our SAI has invested in facilitative leadership

Our SAI systematically organises internal and external challenge, dialogue and debate

Our SAIs decision making process is frequently evaluated

nr.DNB