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  1. P age |1 InternationalAssociationofRiskandCompliance Professionals(IARCP) 1200GStreetNWSuite800Washington, DC20005-6705USATel:202-449-9750www.risk-compliance-association.com Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext DearMember, IreallyenjoyedthispaperfromtheFinancialConductAuthorityinUKwithtitle: “ApplyingbehaviouraleconomicsattheFinancialConductAuthority” WOW!NowIknowwhatwasmissingfromtheoldFSA!Theydeservedtodie. Ilovebehaviouraleconomics. Thisisoneofthefewareaswecanexplainthateverybody(outsidethefinancialservicesindustryofcourse)istoostupidorhaslosthismind,soitisnotlikelytounderstandwhatwedo. Mysummaryofthepaper:Afoolandhismoneyaresoonparted.Itisscience,ofcourse. And,itisareallyexcellentpaper,andyoushouldstudyit.Itcould becomethemanualforeveryexpertwitnessinthefinancialservices.Allthegoodexcusesarethere. Itthispaper,oneofthequestionsis:Whyconsumerchoiceinretailfinancialproductsandservicesisparticularlypronetoerrors? InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  2. P age |2 Someanswers: Manyproductsareinherentlycomplexformostpeople. {Myunderstanding:Mostpeoplearetoosmall,toopoor,toostupid}Toaddinsulttotheinjurythepapercontinues: “Facedwithcomplexity,consumerscansimplifydecisionsinwaysthatleadtoerrors,suchasfocusingonlyonheadlinerates” Decisionsmayrequireassessingriskanduncertainty.Peoplearegenerallybad(eventerrible)intuitivestatisticiansandarepronetomakingsystematicerrorsindecisionsinvolvinguncertainty. {Myunderstanding:Peoplearegenerallybad(eventerrible)statisticians,ok,butcanstatisticianpredictthefutureusingthe“historyrepeatsitself”assumption?} Someproductspermitlittlelearningfrompastmistakes. {Myunderstanding:Evenwhenpeoplecanlearnfrompastmistakesin thefinancialmarkets,wecanalwaysmakedifferentmistakes.} Readmore(abouthownottoexploitcontinuouslythefactthattheothersarestupid)atNumber2. Again,itisanexcellentpaper. IloveFigure5–especiallywhatdescribestheMARKET Ithasnevercrossedmymindthatwecandescribethemarketinthisway: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  3. P age |3 Also… WhatisIntradayLiquidityRisk? WehavetheofficialdefinitionfromtheBaselCommitteeonBankingSupervision(BCBS) “IntradayLiquidityRiskistheriskthatabankfailstomanageitsintradayliquidityeffectively,whichcouldleaveitunabletomeetapaymentobligationatthetimeexpected,therebyaffectingitsownliquiditypositionandthatofotherparties.” Yes,wehaveafinalrule,theintroductionofmonitoringtoolsforintradayliquidity.UnderPillar2. WhyPillar2? Accordingtothepaper(atNumber1below),thetoolsarebeingintroducedformonitoringpurposesonly. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  4. P age |4 Internationallyactivebankswillberequiredtoapplythesetools.Nationalsupervisorswilldeterminetheextenttowhichthetoolsapplyto non-internationallyactivebankswithintheirjurisdictions. However,“banksandsupervisorsarenotrequiredtodisclosethesereportingrequirementspublicly. Publicdisclosureisnotintendedtobepartofthesemonitoringtools”.Fortheeyesofthesupervisorsonly…Pillar2…theseBaseliiisecrets…Butalso: “Nationalsupervisorswilldeterminetheextent…” Anothernationaldiscretion…anotheropportunitytosaybye-byeharmonizedapproachtoimplementBaselIII. ReadmoreatNumber1below. WelcometotheTop10list. BestRegards, GeorgeLekatisPresidentoftheIARCP GeneralManager,ComplianceLLC 1200GStreetNWSuite800, WashingtonDC20005,USA Tel:(202)449-9750 Email:lekatis@risk-compliance-association.com Web:www.risk-compliance-association.com HQ:1220N.MarketStreetSuite804,WilmingtonDE19801,USA Tel:(302)342-8828 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  5. P age |5 BIS:BaselCommitteeonBankingSupervision(BCBS) Monitoringtoolsforintradayliquiditymanagement-finaldocument,April2013 ThisdocumentisthefinalversionoftheCommittee'sMonitoringtoolsforintradayliquiditymanagement. ItwasdevelopedinconsultationwiththeCommitteeonPaymentandSettlementSystemstoenablebankingsupervisorstobettermonitorabank'smanagementofintradayliquidityriskanditsabilitytomeetpaymentandsettlementobligationsonatimelybasis. ApplyingbehaviouraleconomicsattheFinancialConductAuthority April2013 KristineErta,StefanHunt,ZannaIscenko,WillBrambley Arapidlygrowingliteratureonbehaviouraleconomicsshowsthatsomeerrorsmadebyconsumersarepersistentandpredictable. Thisraisestheprospectoffirmsdesigningbusinessmodelsthatdonotfocusoncompetingonpriceandquality. Behaviouraleconomicsenablesregulatorstointerveneinmarketsmoreeffectively,andinnewways,tocountersuchbusinessmodelsandsecurebetteroutcomesforconsumers. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  6. P age |6 ThematicpeerreviewontheFSBPrinciplesforReducingRelianceonCreditRatingAgency(CRA)Ratings ThegoalofthePrinciplesistoendmechanisticrelianceonCRAratingsbybanks,institutionalinvestorsandothermarketparticipants. Stresstestingbanks–whathavewelearned? SpeechbyMrBenSBernanke,ChairmanoftheBoardofGovernorsoftheFederalReserveSystem,atthe“Maintainingfinancialstability:holdingatigerbythetail”financialmarketsconference,sponsored bytheFederalReserveBankofAtlanta,StoneMountain,Georgia APRAreleasesconsultationpackageondisclosureofcompositionofcapitaland remuneration TheAustralianPrudentialRegulationAuthority(APRA)todayreleaseda consultationpaperanddraftprudentialstandardrelatingtoPillar3disclosuresonthecompositionofcapitalandonremunerationbyauthoriseddeposit-takinginstitutions(ADIs)inAustralia. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  7. P age |7 ESMA2013RegulatoryWorkProgramme ESMAhaspublishedits2013Regulatory WorkProgrammewhichisbasedonits2013WorkProgramme,publishedinOctober2012,andprovidesadetailedbreakdownoftheofthe individualworkstreamsasoutlinedinthe2013WorkProgramme. IslamicfinanceandtheEuropeanchallenge OpeningaddressbyMrIgnazioVisco,GovernoroftheBankofItaly,attheIFSBForum“The Europeanchallenge”,organizedbytheIslamic FinancialServicesBoard(IFSB)andhostedbytheBankofItaly,Rome,9April2013. COMMODITYFUTURESTRADINGCOMMISSION,SECURITIESANDEXCHANGECOMMISSION IdentityTheftRedFlagsRules Jointfinalrulesandguidelines. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  8. P age |8 DepartmentofHomeAffairsSUMMARYOFRESPONSESTOTHECONSULTATIONONTHEMONEYLAUNDERINGANDTERRORISTFINANCINGCODE2013 TheDepartmentofHomeAffairs(DHA)issuedtheMoneyLaundering andTerroristFinancingCode2013withaviewtoreplacingtheProceedsofCrime(MoneyLaundering)Code2010andthePreventionofTerroristFinancingCode2011. RegulationofCross-BorderOTCDerivativesActivities:FindingtheMiddleGround ByChairmanElisseWalter,U.S.SecuritiesandExchangeCommission,AmericanBarAssociationSpringMeeting,WashingtonD.C. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  9. P age |9 • BIS:BaselCommitteeonBankingSupervision(BCBS) • Monitoringtoolsforintradayliquiditymanagement-finaldocument,April2013 • ThisdocumentisthefinalversionoftheCommittee'sMonitoringtoolsforintradayliquiditymanagement. • ItwasdevelopedinconsultationwiththeCommitteeonPaymentandSettlementSystemstoenablebankingsupervisorsto • bettermonitorabank'smanagementofintradayliquidityriskandits • abilitytomeetpaymentandsettlementobligationsonatimelybasis. • Overtime,thetoolswillalsoprovidesupervisorswithabetterunderstandingofbanks'paymentandsettlementbehaviour. • Theframeworkincludes: • thedetaileddesignofthemonitoringtoolsforabank'sintradayliquidityrisk • stressscenarios • keyapplicationissues • thereportingregime • Managementofintradayliquidityriskformsakeyelementofabank'soverallliquidityriskmanagementframework. • Assuch,thesetofsevenquantitativemonitoringtoolswillcomplement thequalitativeguidanceonintradayliquiditymanagementsetoutintheBaselCommittee's2008PrinciplesforSoundLiquidityRiskManagementandSupervision. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  10. P age |10 Itisimportanttonotethatthetoolsarebeingintroducedformonitoringpurposesonlyandthatinternationallyactivebankswillberequiredtoapplythem. Nationalsupervisorswilldeterminetheextenttowhichthetoolsapplyto non-internationallyactivebankswithintheirjurisdictions. BaselIII:TheLiquidityCoverageRatioandliquidityriskmonitoringtools(January2013),whichsetsoutoneoftheCommittee'skeyreformstostrengthengloballiquidityregulationsdoesnotincludeintradayliquiditywithinitscalibration. Thereportingofthemonitoringtoolswillcommenceonamonthlybasisfrom1January2015tocoincidewiththeimplementationoftheLCRreportingrequirements. Anearlierversionoftheframeworkofmonitoringtoolswasissuedfor consultationinJuly2012. TheCommitteewishestothankthosewhoprovidedfeedbackandcommentsasthesewereinstrumentalinrevisingandfinalisingthemonitoringtools. MonitoringtoolsforintradayliquiditymanagementApril2013 Introduction 1.Managementofintradayliquidityriskformsakeyelementofabank’soverallliquidityriskmanagementframework. InSeptember2008,theBaselCommitteeonBankingSupervision(BCBS)publisheditsPrinciplesforSoundLiquidityRiskManagementandSupervision(theSoundPrinciples),whichprovideguidanceforbanksontheirmanagementofliquidityriskandcollateral. Principle8oftheSoundPrinciplesfocusesspecificallyonintradayliquidityriskandstatesthat: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  11. P age |11 “Abankshouldactivelymanageitsintradayliquiditypositionsandriskstomeetpaymentandsettlementobligationsonatimelybasisunderboth normalandstressedconditionsandthuscontributetothesmoothfunctioningofpaymentandsettlementsystems.” 2.Principle8identifiessixoperationalelementsthatshouldbeincludedinabank’sstrategyformanagingintradayliquidityrisk. Thesestatethatabankshould: havethecapacitytomeasureexpecteddailygrossliquidityinflowsandoutflows,anticipatetheintradaytimingoftheseflowswherepossible,andforecasttherangeofpotentialnetfundingshortfallsthatmightariseatdifferentpointsduringtheday; havethecapacitytomonitorintradayliquiditypositionsagainstexpectedactivitiesandavailableresources(balances,remainingintradaycreditcapacity,availablecollateral); arrangetoacquiresufficientintradayfundingtomeetitsintradayobjectives; havetheabilitytomanageandmobilisecollateralasnecessarytoobtainintradayfunds; havearobustcapabilitytomanagethetimingofitsliquidityoutflowsinlinewithitsintradayobjectives;and bepreparedtodealwithunexpecteddisruptionstoitsintradayliquidityflows. InJanuary2013,theBCBSpublishedBaselIII:TheLiquidityCoverageRatioandliquidityriskmonitoringtools,whichsetsoutoneoftheCommittee’skeyreformstostrengthengloballiquidityregulations. TheobjectiveoftheLiquidityCoverageRatio(LCR)istopromotetheshort-termresilienceoftheliquidityriskprofileofbanks,butdoesnot includeintradayliquiditywithinitscalibration. TheBCBS,inconsultationwiththeCommitteeonPaymentandSettlementSystems(CPSS)hasdevelopedasetofquantitativetoolsto enablebankingsupervisorstomonitorbanks’intradayliquidityriskand InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  12. P age |12 theirabilitytomeetpaymentandsettlementobligationsonatimelybasisunderbothnormalandstressedconditions. ThemonitoringtoolswillcomplementthequalitativeguidanceintheSoundPrinciples. 5.Giventhecloserelationshipbetweenthemanagementofbanks’intradayliquidityriskandthesmoothfunctioningofpaymentandsettlementsystems, 4thetoolswillalsobeofbenefittocentralbankorotherauthoritiesresponsiblefortheoversightofpaymentandsettlementsystems(overseers). Itisenvisagedthattheintroductionofmonitoringtoolsforintradayliquiditywillleadtocloserco-operationbetweenbankingsupervisorsandtheoverseersinthemonitoringofbanks’paymentbehaviour. Itisimportanttonotethatthetoolsarebeingintroducedformonitoringpurposesonly. Internationallyactivebankswillberequiredtoapplythesetools. Thesetoolsmayalsobeusefulinpromotingsoundliquiditymanagementpracticesforotherbanks,whethertheyaredirectparticipantsofa large-valuepaymentsystem(LVPS)oruseacorrespondentbanktosettle payments. Nationalsupervisorswilldeterminetheextenttowhichthetoolsapplytonon-internationallyactivebankswithintheirjurisdictions. Consistentwiththeirbroaderliquidityriskmanagementresponsibilities,bankmanagementwillberesponsibleforcollatingandsubmittingthemonitoringdataforthetoolstotheirbankingsupervisor. Itisrecognisedthatbanksmayneedtoliaisecloselywithcounterparts,includingpaymentsystemoperatorsandcorrespondentbanks,tocollatethesedata. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  13. P age |13 • However,banksandsupervisorsarenotrequiredtodisclosethesereportingrequirementspublicly. • Publicdisclosureisnotintendedtobepartofthesemonitoringtools. • 8.Thefollowingsectionsofthisdocumentsetout: • Thedefinitionsofintradayliquidityandintradayliquidityriskandtheelementsthatconstituteabank’sintradayliquiditysourcesandusage • Thedetaileddesignoftheintradayliquiditymonitoringtools • Theintradayliquiditystressscenarios • Thescopeofapplicationofthetools • Theimplementationdateandreportingfrequency • II.Definitionsandsourcesandusageofintradayliquidity • A.Definitions • 9.Forthepurposeofthisdocument,thefollowingdefinitionswillapplytothetermsstatedbelow. • IntradayLiquidity:fundswhichcanbeaccessedduringthebusinessday,usuallytoenablebankstomakepaymentsinrealtime • BusinessDay:theopeninghoursoftheLVPSorofcorrespondentbankingservicesduringwhichabankcanreceiveandmakepaymentsinalocaljurisdiction • IntradayLiquidityRisk:theriskthatabankfailstomanageitsintradayliquidityeffectively,whichcouldleaveitunabletomeetapaymentobligationatthetimeexpected,therebyaffectingitsownliquiditypositionandthatofotherparties. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  14. P age |14 • Time-specificobligations:obligationswhichmustbesettledataspecifictimewithinthedayorhaveanexpectedintradaysettlementdeadline. • B.Intradayliquiditysourcesandusage • 10.Thefollowingsetsoutthemainconstituentelementsofabank’sintradayliquiditysourcesandusage. • (Thelistshouldnotbetakenasexhaustive.) • (i)Sources • Ownsources • Reservebalancesatthecentralbank; • Collateralpledgedwiththecentralbankorwithancillarysystemsthatcanbefreelyconvertedintointradayliquidity; • Unencumberedassetsonabank’sbalancesheetthatcanbefreely • convertedintointradayliquidity; • Securedandunsecured,committedanduncommittedcreditlinesavailableintraday; • Balanceswithotherbanksthatcanbeusedforintradaysettlement. • Othersources • PaymentsreceivedfromotherLVPSparticipants; • Paymentsreceivedfromancillarysystems; • Paymentsreceivedthroughcorrespondentbankingservices. • (ii)Usage • PaymentsmadetootherLVPSparticipants; • Paymentsmadetoancillarysystems; • Paymentsmadethroughcorrespondentbankingservices; • Securedandunsecured,committedanduncommittedcreditlinesofferedintraday; • Contingentpaymentsrelatingtoapaymentandsettlementsystem’s • failure(egasanemergencyliquidityprovider). InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  15. P age |15 • 11.Incorrespondentbanking,somecustomerpaymentsaremadeacrossaccountsheldbythesamecorrespondentbank. • Thesepaymentsdonotgiverisetoanintradayliquiditysourceorusageforthecorrespondentbankastheydonotlinktothepaymentandsettlementsystems. • However,these‘internalisedpayments’dohaveintradayliquidityimplicationsforboththesendingandreceivingcustomerbanksandshouldbeincorporatedintheirreportingofthemonitoringtools. • III.Theintradayliquiditymonitoringtools • 12.Anumberoffactorsinfluenceabank’susageofintradayliquidityin paymentandsettlementsystemsanditsvulnerabilitytointradayliquidityshocks. • Assuch,nosinglemonitoringtoolcanprovidesupervisorswithsufficient informationtoidentifyandmonitortheintradayliquidityriskrunbyabank. • Toachievethis,sevenseparatemonitoringtoolshavebeendeveloped(seeTable1). • Asnotallofthetoolswillberelevanttoallreportingbanks,thetoolshavebeenclassifiedinthreegroupstodeterminetheirapplicabilityasfollows: • CategoryA:applicabletoallreportingbanks; • CategoryB:applicabletoreportingbanksthatprovidecorrespondentbankingservices;and • CategoryC:applicabletoreportingbankswhicharedirectparticipants. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  16. P age |16 A.Monitoringtoolsapplicabletoallreportingbanks (i)Dailymaximumintradayliquidityusage 13.Thistoolwillenablesupervisorstomonitorabank’sintradayliquidityusageinnormalconditions. Itwillrequirebankstomonitorthenetbalanceofallpaymentsmadeandreceivedduringthedayovertheirsettlementaccount,eitherwiththecentralbank(ifadirectparticipant)orovertheiraccountheldwithacorrespondentbank(oraccounts,ifmorethanonecorrespondentbankisusedtosettlepayments). Thelargestnetnegativepositionduringthebusinessdayontheaccount(s),(iethelargestnetcumulativebalancebetweenpaymentsmadeandreceived),willdetermineabank’smaximumdailyintradayliquidityusage. Thenetpositionshouldbedeterminedbysettlementtimestamps(ortheequivalent)usingtransaction-by-transactiondataovertheaccount(s). Thelargestnetnegativebalanceontheaccount(s)canbecalculatedaftercloseofthebusinessdayanddoesnotrequirereal-timemonitoringthroughouttheday. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  17. P age |17 14.Forillustrativepurposesonly,thecalculationofthetoolisshowninfigure1. Apositivenetpositionsignifiesthatthebankhasreceivedmorepaymentsthanithasmadeduringtheday. Conversely,anegativenetpositionsignifiesthatthebankhasmademorepaymentsthanithasreceived. Fordirectparticipants,thenetpositionrepresentsthechangeinitsopeningbalancewiththecentralbank. Forbanksthatuseoneormorecorrespondentbanks,thenetpositionrepresentsthechangeintheopeningbalanceontheaccount(s)withitscorrespondentbank(s). InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  18. P age |18 Assumingthatabankrunsanegativenetpositionatsomepoint intraday,itwillneedaccesstointradayliquiditytofundthisbalance. Theminimumamountofintradayliquiditythatabankwouldneedtohaveavailableonanygivendaywouldbeequivalenttoitslargestnegativenetposition. (Intheillustrationabove,theintradayliquidityusagewouldbe10units.) Conversely,whenabankrunsapositivenetcumulativepositionatsomepointintraday,ithassurplusliquidityavailabletomeetitsintradayliquidityobligations. ThispositionmayarisebecausethebankisrelyingonpaymentsreceivedfromotherLVPSparticipantstofunditsoutgoingpayments. (Intheillustrationabove,thelargestpositivenetcumulativepositionwouldbe8.6units.) Banksshouldreporttheirthreelargestdailynegativenetcumulativepositionsontheirsettlementorcorrespondentaccount(s)inthereportingperiodandthedailyaverageofthenegativenetcumulativepositionovertheperiod. Thelargestpositivenetcumulativepositions,andthedailyaverageofthepositivenetcumulativepositions,shouldalsobereported. Asthereportingdataaccumulates,supervisorswillgainanindicationofthedailyintradayliquidityusageofabankinnormalconditions. (ii)Availableintradayliquidityatthestartofthebusinessday 18.Thistoolwillenablesupervisorstomonitortheamountofintradayliquidityabankhasavailableatthestartofeachdaytomeetitsintradayliquidityrequirementsinnormalconditions. Banksshouldreportboththethreesmallestsumsbyvalueofintradayliquidityavailableatthestartofeachbusinessdayinthereportingperiod, InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  19. P age |19 andtheaverageamountofavailableintradayliquidityatthestartofeach businessdayinthereportingperiod. Thereportshouldalsobreakdowntheconstituentelementsoftheliquiditysourcesavailabletothebank. DrawingontheliquiditysourcessetoutinSectionIIBabove,banksshoulddiscussandagreewiththeirsupervisorthesourcesofliquiditywhichtheyshouldincludeinthecalculationofthistool. Wherebanksmanagecollateralonacross-currencyand/orcross-systembasis,liquiditysourcesnotdenominatedinthecurrencyoftheintradayliquidityusageand/orwhicharelocatedinadifferentjurisdiction,maybeincludedinthecalculationifthebankcandemonstratetothesatisfactionofitssupervisorthatthecollateralcanbetransferredintradayfreelytothesystemwhereitisneeded. Asthereportingdataaccumulates,supervisorswillgainanindicationoftheamountofintradayliquidityavailabletoabanktomeetitspaymentandsettlementobligationsinnormalconditions. (iii)Totalpayments 21.Thistoolwillenablesupervisorstomonitortheoverallscaleofabank’spaymentactivity. Foreachbusinessdayinareportingperiod,banksshouldcalculatethetotaloftheirgrosspaymentssentandreceivedintheLVPSand/or,whereappropriate,acrossanyaccount(s)heldwithacorrespondentbank(s). Banksshouldreportthethreelargestdailyvaluesforgrosspaymentssentandreceivedinthereportingperiodandtheaveragedailyfigureofgrosspaymentsmadeandreceivedinthereportingperiod. (iv)Time-specificobligations 22.Thistoolwillenablesupervisorstogainabetterunderstandingofabank’stimespecificobligations. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  20. P age |20 Failuretosettlesuchobligationsontimecouldresultinfinancialpenalty,reputationaldamagetothebankorlossoffuturebusiness. 23.Banksshouldcalculatethetotalvalueoftime-specificobligationsthattheysettleeachdayandreportthethreelargestdailytotalvaluesandthe averagedailytotalvalueinthereportingperiodtogivesupervisorsanindicationofthescaleoftheseobligations. B.Monitoringtoolsapplicabletoreportingbanksthatprovide correspondentbankingservices (i)Valueofpaymentsmadeonbehalfofcorrespondentbankingcustomers Thistoolwillenablesupervisorstogainabetterunderstandingoftheproportionofacorrespondentbank’spaymentflowsthatarisefromitsprovisionofcorrespondentbankingservices. Theseflowsmayhaveasignificantimpactonthecorrespondentbank’sownintradayliquiditymanagement. Correspondentbanksshouldcalculatethetotalvalueofpaymentstheymakeonbehalfofallcustomersoftheircorrespondentbankingserviceseachdayandreportthethreelargestdailytotalvaluesandthedailyaveragetotalvalueofthesepaymentsinthereportingperiod. (ii)Intradaycreditlinesextendedtocustomers 26.Thistoolwillenablesupervisorstomonitorthescaleofacorrespondentbank’sprovisionofintradaycredittoitscustomers. Correspondentbanksshouldreportthethreelargestintradaycreditlinesextendedtotheircustomersinthereportingperiod,includingwhethertheselinesaresecuredorcommittedandtheuseofthoselinesatpeakusage. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  21. P age |21 C.Monitoringtoolapplicabletoreportingbankswhicharedirectparticipants (i)Intradaythroughput 27.Thistoolwillenablesupervisorstomonitorthethroughputofadirectparticipant’sdailypaymentsactivityacrossitssettlementaccount. Directparticipantsshouldreportthedailyaverageinthereportingperiodofthepercentageoftheiroutgoingpayments(relativetototalpayments)thatsettlebyspecifictimesduringtheday,byvaluewithineachhourofthebusinessday. Overtime,thiswillenablesupervisorstoidentifyanychangesinabank’spaymentandsettlementbehaviour. IV.Intradayliquiditystressscenarios ThemonitoringtoolsinSectionIIIwillprovidebankingsupervisorswithinformationonabank’sintradayliquidityprofileinnormalconditions. However,theavailabilityandusageofintradayliquiditycanchangemarkedlyintimesofstress. Inthecourseoftheirdiscussionsonbroaderliquidityriskmanagement,banksandsupervisorsshouldalsoconsidertheimpactofabank’sintradayliquidityrequirementsinstressconditions. Asguidance,fourpossible(butnon-exhaustive)stressscenarioshavebeenidentifiedandaredescribedbelow. Banksshoulddeterminewiththeirsupervisorwhichofthescenariosarerelevanttotheirparticularcircumstancesandbusinessmodel. Banksneednotreporttheimpactofthestressscenariosonthemonitoringtoolstosupervisorsonaregularbasis. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  22. P age |22 Theyshouldusethescenariostoassesshowtheirintradayliquidityprofileinnormalconditionswouldchangeinconditionsofstressand discusswiththeirsupervisorhowanyadverseimpactwouldbeaddressedeitherthroughcontingencyplanningarrangementsand/ortheirwiderintradayliquidityriskmanagementframework. Stressscenarios (i)Ownfinancialstress:abanksuffers,orisperceivedtobesufferingfrom,astressevent Foradirectparticipant,ownfinancialand/oroperationalstressmayresultincounterpartiesdeferringpaymentsand/orwithdrawingintradaycreditlines. This,inturn,mayresultinthebankhavingtofundmoreofitspaymentsfromitsownintradayliquiditysourcestoavoidhavingtodeferitsown payments. Forbanksthatusecorrespondentbankingservices,anownfinancialstressmayresultinintradaycreditlinesbeingwithdrawnbythecorrespondentbank(s),and/oritsowncounterpartiesdeferringpayments. Thismayrequirethebankhavingeithertoprefunditspaymentsand/ortocollateraliseitsintradaycreditline(s). (ii)Counterpartystress:amajorcounterpartysuffersanintradaystresseventwhichpreventsitfrommakingpayments 32.Acounterpartystressmayresultindirectparticipantsandbanksthat usecorrespondentbankingservicesbeingunabletorelyonincomingpaymentsfromthestressedcounterparty,reducingtheavailabilityofintradayliquiditythatcanbesourcedfromthereceiptofthecounterparty’spayments. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  23. P age |23 (iii)Acustomerbank’sstress:acustomerbankofacorrespondentbanksuffersastressevent 33.Acustomerbank’sstressmayresultinotherbanksdeferringpaymentstothecustomer,creatingafurtherlossofintradayliquidityatitscorrespondentbank. (iv)Market-widecreditorliquiditystress Amarket-widecreditorliquiditystressmayhaveadverseimplicationsforthevalueofliquidassetsthatabankholdstomeetitsintradayliquidityusage. Awidespreadfallinthemarketvalueand/orcreditratingofabank’sunencumberedliquidassetsmayconstrainitsabilitytoraiseintradayliquidityfromthecentralbank. Inaworstcasescenario,amaterialcreditdowngradeoftheassetsmay resultintheassetsnolongermeetingtheeligibilitycriteriaforthecentralbank’sintradayliquidityfacilities. Forabankthatusescorrespondentbankingservices,awidespreadfallinthemarketvalueand/orcreditratingofitsunencumberedliquidassetsmayconstrainitsabilitytoraiseintradayliquidityfromitscorrespondentbank(s). Bankswhichmanageintradayliquidityonacross-currencybasis shouldconsidertheintradayliquidityimplicationsofaclosureof,oroperationaldifficultiesin,currencyswapmarketsandstressesoccurringinmultiplesystemssimultaneously. Applicationofthestressscenarios Fortheownfinancialstressandcounterpartystress,allreportingbanksshouldconsiderthelikelyimpactthatthesestressscenarioswould haveontheirdailymaximumintradayliquidityusage,availableintraday InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  24. P age |24 liquidityatthestartofthebusinessday,totalpaymentsandtime-specificobligations. Forthecustomerbank’sstressscenario,banksthatprovidecorrespondentbankingservicesshouldconsiderthelikelyimpactthat thisstressscenariowouldhaveonthevalueofpaymentsmadeonbehalfofitscustomersandintradaycreditlinesextendedtoitscustomers. Forthemarket-widestress,allreportingbanksshouldconsiderthelikelyimpactthatthestresswouldhaveontheirsourcesofavailableintradayliquidityatthestartofthebusinessday. Whileeachofthemonitoringtoolshasvalueinitself,combiningtheinformationprovidedbythetoolswillgivesupervisorsacomprehensiveviewofabank’sresiliencetointradayliquidityshocks. Examplesonhowthetoolscouldbeusedindifferentcombinationsbybankingsupervisorstoassessabank’sresiliencetointradayliquidityriskarepresentedinAnnex3. V.Scopeofapplication 41.Banksgenerallymanagetheirintradayliquidityriskona system-by-systembasisinasinglecurrency,butitisrecognisedthat practicesdifferacrossbanksandjurisdictions,dependingontheinstitutionalsetupofabankandthespecificsofthesystemsinwhichitoperates. Thefollowingconsiderationsaimtohelpbanksandsupervisorsdeterminethemostappropriatewaytoapplythetools. Shouldbanksneedfurtherclarification,theyshoulddiscussthescopeofapplicationwiththeirsupervisors. (i)Systems 42.BankswhicharedirectparticipantstoanLVPScanmanagetheirintradayliquidityinverydifferentways. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  25. P age |25 • Somebanksmanagetheirpaymentandsettlementactivityonasystem-by-systembasis. • Othersmakeuseofdirectintradayliquidity‘bridges’betweenLVPS,whichallowexcessliquiditytobetransferredfromonesystemtoanotherwithoutrestriction. • Otherformalarrangementsexist,whichallowfundstobetransferredfromonesystemtoanother(suchasagreementsforforeigncurrencyliquiditytobeusedascollateralfordomesticsystems). • 43.Toallowforthesedifferentapproaches,directparticipantsshouldapplya‘bottom-up’approachtodeterminetheappropriatebasisforreportingthemonitoringtools. • Thefollowingsetsouttheprincipleswhichsuchbanksshouldfollow: • Asabaseline,individualbanksshouldreportoneachLVPSinwhichtheyparticipateonasystem-by-system-basis; • Ifthereisadirectreal-timetechnicalliquiditybridgebetweentwoormoreLVPS,theintradayliquidityinthosesystemsmaybeconsidered fungible. • AtleastoneofthelinkedLVPSmaythereforebeconsideredanancillarysystemforthepurposeofthetools; • IfabankcandemonstratetothesatisfactionofitssupervisorthatitregularlymonitorspositionsandusesotherformalarrangementstotransferliquidityintradaybetweenLVPSwhichdonothaveadirect technicalliquiditybridge,thoseLVPSmayalsobeconsideredasancillarysystemsforreportingpurposes. • 44.Ancillarysystems(egretailpaymentsystems,CLS,somesecuritiessettlementsystemsandcentralcounterparties),placedemandsonabank’sintradayliquiditywhenthesesystemssettlethebank’sobligationsinanLVPS. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  26. P age |26 Consequently,separatereportingrequirementswillnotbenecessaryforsuchancillarysystems. Banksthatusecorrespondentbankingservicesshouldbasetheirreportsonthepaymentandsettlementactivityovertheiraccount(s)withtheircorrespondentbank(s). Wheremorethanonecorrespondentbankisused,thebankshouldreportpercorrespondentbank. ForbankswhichaccessanLVPSindirectlythroughmorethanonecorrespondentbank,thereportingmaybeaggregated,providedthatthereportingbankcandemonstratetothesatisfactionofitssupervisorthatitisabletomoveliquiditybetweenitscorrespondentbanks. BankswhichoperateasdirectparticipantsofanLVPSbutwhichalsomakeuseofcorrespondentbanksshoulddiscusswhethertheycan aggregatetheseforreportingpurposeswiththeirsupervisor. AggregationmaybeappropriateifthepaymentsmadedirectlythroughtheLVPSandthosemadethroughthecorrespondentbank(s)areinthesamejurisdictionandsamecurrency. (ii)Currency Banksthatmanagetheirintradayliquidityonacurrency-by-currency basisshouldreportonanindividualcurrencybasis. Ifabankcanprovetothesatisfactionofitssupervisorthatitmanagesliquidityonacross-currencybasisandhastheabilitytotransferfundsintradaywithminimaldelay–includinginperiodsofacutestress–thentheintradayliquiditypositionsacrosscurrenciesmaybeaggregatedforreportingpurposes. However,banksshouldalsoreportatanindividualcurrencylevelsothatsupervisorscanmonitortheextenttowhichfirmsarereliantonforeignexchangeswapmarkets. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  27. P age |27 49.Whenthelevelofactivityofabank’spaymentandsettlementactivityinanyoneparticularcurrencyisconsidereddeminimiswiththeagreementofthesupervisor23areportingexemptioncouldapplyandseparatereturnsneednotbesubmitted. (iii)Organisationalstructure Theappropriateorganisationallevelforeachbank’sreportingofitsintradayliquiditydatashouldbedeterminedbythesupervisor,butitisexpectedthatthemonitoringtoolswilltypicallybeappliedatasignificant individuallegalentitylevel. Thedecisionontheappropriateentityshouldconsideranypotentialimpedimentstomovingintradayliquiditybetweenentitieswithinagroup,includingtheabilityofsupervisoryjurisdictionstoring-fenceliquidassets,timingdifferencesandanylogisticalconstraintsonthemovementofcollateral. Wheretherearenoimpedimentsorconstraintstotransferringintradayliquiditybetweentwo(ormore)legalentitiesintraday,andbankscan demonstratethistothesatisfactionoftheirsupervisor,theintradayliquidityrequirementsoftheentitiesmaybeaggregatedforreportingpurposes. (iv)Responsibilityofhomeandhostsupervisors 52.Forcross-borderbankinggroups,whereabankoperatesinLVPSand/orwithacorrespondentbank(s)outsidethejurisdictionwhereitisdomiciled,bothhomeandhostsupervisorswillhaveaninterestinensuringthatthebankhassufficientintradayliquiditytomeetitsobligationsinthelocalLVPSand/orwithitscorrespondentbank(s). Theallocationofresponsibilitybetweenhomeandhostsupervisorwillultimatelydependuponwhetherthebankoperatinginthenon-domesticjurisdictiondoessoviaabranchorasubsidiary. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  28. P age |28 • Forabranchoperation • Thehome(consolidated)supervisorshouldhaveresponsibilityformonitoringthroughthecollectionandexaminationofdatathatitsbankinggroupscanmeettheirpaymentandsettlementresponsibilitiesinallcountriesandallcurrenciesinwhichtheyoperate. • Thehomesupervisorshouldthereforehavetheoptiontoreceiveafullsetofintradayliquidityinformationforitsbankinggroups,coveringboth domesticandnon-domesticpaymentandsettlementobligations. • Thehostsupervisorshouldhavetheoptiontorequireforeignbranchesintheirjurisdictiontoreportintradayliquiditytoolstothem,subjecttomateriality. • Forasubsidiaryactiveinanon-domesticLVPSand/orcorrespondentbank(s) • Thehostsupervisorshouldhaveprimaryresponsibleforreceivingtherelevantsetofintradayliquiditydataforthatsubsidiary. • Thesupervisoroftheparentbank(thehomeconsolidatedsupervisor)willhaveaninterestinensuringthatanon-domesticsubsidiaryhassufficientintradayliquiditytoparticipateinallpaymentandsettlementobligations. • Thehomesupervisorshouldthereforehavetheoptiontorequire • non-domesticsubsidiariestoreportintradayliquiditydatatothemasappropriate. • VI.Implementationdateandreportingfrequency • Thereportingofthemonitoringtoolswillcommenceonamonthlybasisfrom1January2015tocoincidewiththeimplementationoftheLCRreportingrequirements. • SamplereportingtemplatescanbefoundinAnnex2. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  29. P age |29 Asnotedabove,thetoolsapplytointernationallyactivebanks. Nationalsupervisorswilldeterminewhetherotherbanksshouldapplythereportingrequirements. Banksshouldalsoagreewiththeirsupervisorsthescopeofapplicationandreportingarrangementsbetweenhomeandhostauthorities. 55.Ifcustomerbanksareunabletomeetthisimplementationdeadlinebecauseofdataavailabilityconstraintswiththeircorrespondentbank(s),considerationmaybegivenbysupervisorstophasing-intheirimplementationtoalaterdate(preferablynolaterthan1January2017). Annex1 Practicalexampleofthemonitoringtools Thefollowingexampleillustrateshowthetoolswouldoperateforabankonaparticularbusinessday. Assumethatonthegivenday,thebank’spaymentprofileandliquidityusageisasfollows: 1.Directparticipant Detailsofthebank’spaymentprofileareasfollowings: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  30. P age |30 PaymentA:450 PaymentB:100–tosettleobligationsinanancillarysystemPaymentC:200–whichhastobesettledby10am PaymentD:300–onbehalfofacounterpartyusingsomeofa500unit unsecuredcreditlinethatthebankextendstothecounterpartyPaymentE:250 PaymentF:100 Thebankhas300unitsofcentralbankreservesand500unitsofeligiblecollateral. A(i)Dailymaximumliquidityusage: largestnegativenetcumulativepositions:550unitslargestpositivenetcumulativepositions:200units A(ii)Availableintradayliquidityatthestartofthebusinessday:300unitsofcentralbankreserves+500unitsofeligiblecollateral(routinelytransferredtothecentralbank)=800units A(iii)Totalpayments: Grosspaymentssent:450+100+200+300+250+100=1,400unitsGrosspaymentsreceived:200+400+300+350+150=1,400units A(iv)Time-specificobligations: 200+valueofancillarypayment(100)=300units B(i)Valueofpaymentsmadeonbehalfofcorrespondentbankingcustomers: 300units B(ii)Intradaycreditlineextendedtocustomers:Valueofintradaycreditlinesextended:500unitsValueofcreditlineused:300units C(i)Intradaythroughput InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  31. P age |31 2.Bankthatusesacorrespondentbank Detailsofthebank’spaymentprofileareasfollowings:PaymentA:450 PaymentB:100 PaymentC:200–whichhastobesettledby10amPaymentD:300 PaymentE:250 PaymentF:100–whichhastobesettledby4pm Thebankhas300unitsofaccountbalanceatthecorrespondentbankand500unitsofcreditlinesofwhich300unitsunsecuredandalsouncommitted. A(i)Dailymaximumintradayliquidityusage:largestnegativenetcumulativepositions:550unitslargestpositivenetcumulativepositions:200units A(ii)Availableintradayliquidityatthestartofthebusinessday: 300unitsofaccountbalanceatthecorrespondentbank+500unitsof creditlines(ofwhich300unitsunsecuredanduncommitted)=800units A(iii)Totalpayments: Grosspaymentssent:450+100+200+300+250+100=1,400unitsGrosspaymentsreceived:200+400+300+350+150=1,400units InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  32. P age |32 A(iv)Time-specificobligations:200+100=300units InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  33. P age |33 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  34. P age |34 InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  35. P age |35 Annex3 Combiningthetools Thefollowingisanon-exhaustivesetofexampleswhichillustratehowthetoolscouldbeusedindifferentcombinationsbysupervisorstoassessabank’sresiliencetointradayliquidityrisk: Time-specificobligationsrelativetototalpaymentsandavailableintradayliquidityatthestartofthebusinessday Ifahighproportionofabank’spaymentactivityistimecritical,thebankhaslessflexibilitytodealwithunexpectedshocksbymanagingitspaymentflows,especiallywhenitsamountofavailableintradayliquidityatthestartofthebusinessdayistypicallylow. Insuchcircumstancesthesupervisormightexpectthebanktohaveadequateriskmanagementarrangementsinplaceortoholdahigherproportionofunencumberedassetstomitigatethisrisk. Availableintradayliquidityatthestartofthebusinessdayrelativetotheimpactofintradaystressesonthebank’sdailyliquidityusage Iftheimpactofanintradayliquiditystressonabank’sdailyliquidityusageislargerelativetoitsavailableintradayliquidityatthestartofthe InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  36. P age |36 businessday,itsuggeststhatthebankmaystruggletosettlepaymentsinatimelymannerinconditionsofstress. Relationshipbetweendailymaximumliquidityusage,availableintradayliquidityatthestartofthebusinessdayandthetime-specificobligations Ifabankmissesitstime-specificobligations,itcouldhaveasignificantimpactonotherbanks. Ifitweredemonstratedthatthebank’sdailyliquidityusagewashighandthelowestamountofavailableintradayliquidityatthestartofthebusinessdaywereclosetozero,itmightsuggestthatthebankismanagingitspaymentflowswithaninsufficientpoolofliquidassets. Totalpaymentsandvalueofpaymentsmadeonbehalfofcorrespondentbankingcustomers Ifalargeproportionofabank’stotalpaymentactivityismadebyacorrespondentbankonbehalfofitscustomersand,dependingonthetypeofthecreditlinesextended,thecorrespondentbankcouldbemorevulnerabletoastressexperiencedbyacustomer. Thesupervisormaywishtounderstandhowthisriskisbeingmitigatedbythecorrespondentbank. Intradaythroughputanddailyliquidityusage: Ifabankstartstodeferitspaymentsandthiscoincideswithareductioninitsliquidityusage(asmeasuredbyitslargestpositivenetcumulativeposition),thesupervisormaywishtoestablishwhetherthebankhastakenastrategicdecisiontodelaypaymentstoreduceitsusageofintradayliquidity. Thisbehaviouralchangemightalsobeofinteresttotheoverseersgiventhepotentialknock-onimplicationstootherparticipantsintheLVPS. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  37. P age |37 ApplyingbehaviouraleconomicsattheFinancialConductAuthority April2013 KristineErta,StefanHunt,ZannaIscenko,WillBrambley Arapidlygrowingliteratureonbehaviouraleconomicsshowsthatsomeerrorsmadebyconsumersarepersistentandpredictable. Thisraisestheprospectoffirmsdesigningbusinessmodelsthatdonotfocusoncompetingonpriceandquality. Behaviouraleconomicsenablesregulatorstointerveneinmarketsmoreeffectively,andinnewways,tocountersuchbusinessmodelsandsecurebetteroutcomesforconsumers. TheUKParliamenthascreatedtheFinancialConductAuthority(FCA)andhasgivenitanadditionalobjectiveanddutytopromoteeffectivecompetition,whichwebelieveshouldbeonpriceandquality(ratherthanonfalsefocalpointsorstrategiestoexcluderivalsatpoint-of-sale). Toachievethis,theFCAwillfirstneedtoundertakeintegratedanalysisofeconomicmarkets. Inotherwords,itwillneedtounderstandhowinformationproblems,consumers’behaviouralerrorsandfirms’competitivestrategiescombinetoproduceobservedmarketoutcomes. Thisinvolvessomechangefromtheexistingpracticeofmostconductregulators,withoneofthebiggestchangesrelatingtogreaterfocuson understandingconsumerbehaviour. Thispaperfirstsetsoutwhatbehaviouraleconomicstellsusaboutconsumerdecision-makinginfinancialmarkets. Thisisbasedonanextensivereviewoftheavailableliterature. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  38. P age |38 Itthendiscusseshowbehaviouraleconomicscanbe,andshouldbe,usedintheregulationoffinancialconduct. WhileIrecognisethatthisisanindependentpieceofresearch,thispaperisthefirstintheFinancialConductAuthority’sOccasionalPaperseries,andanimportantoneatthat. Ithereforeaddmysupportforthepaper. Ibelievethatusinginsightsfrombehaviouraleconomics,togetherwithmoretraditionalanalysisofcompetitionandmarketfailures,canhelptheFCAassessproblemsinfinancialmarketsbetter,choosemoreappropriateremediesandbeamoreeffectiveregulatorasaresult. Whileapplyingbehaviouraleconomicsalsobringsnewchallenges,Ibelievetheyaresurmountable. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  39. P age |39 Executivesummary Peopleoftenmakeerrorswhenchoosingandusingfinancialproducts,andcansufferconsiderablelossesasaresult. Usingbehaviouraleconomicswecanunderstandhowtheseerrorsarise,whytheypersist,andwhatwecandotoamelioratethem. Behaviouraleconomicsusesinsightsfrompsychologytoexplainwhypeoplebehavethewaytheydo. Peopledonotalwaysmakechoicesinarationalandcalculatedway.Infact,mosthumandecision-makingusesthoughtprocessesthatare intuitiveandautomaticratherthandeliberativeandcontrolled. Academicliteratureidentifies‘behaviouralbiases’—specificwaysinwhichnormalhumanthoughtsystematicallydepartsfrombeingfullyrational. Biasescancausepeopletomisjudgeimportantfactsortobeinconsistent,forexamplechangingtheirchoicesfortheworsewhenessentiallythesamedecisionispresentedinadifferentway. Inotherwords,ournormalhumanthoughtprocessescanleadustomakechoicesthatarepredictablymistaken. Marketforceslefttothemselveswilloftennotworktoreducethesemistakes,soregulationmaybeneeded. Agoodexampleispaymentprotectioninsurance(PPI). FirmswereabletoearnlargeprofitsonPPIproductsbecausemanybuyersfundamentallymisunderstoodPPIpricingandthelimitationsinitscoverage. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  40. P age |40 • HighPPIpricesallowedsellerstoattractmorecustomersbyofferingmortgagesatcheaperrates(whichconsumersfocusedonwhenchoosingaprovider). • Asaresult,nofirmhadanincentivetoadvertisethatPPIwasapoorproductformanypeopleandchargeappropriatemortgageandPPIprices. • Thiswouldhavemadethefirm’smortgagemoreexpensiveandthefirmuncompetitive. • Interventionwasneededtosolvethisproblem. • Whileitiscommonsensethatpeoplemakemistakes,behaviouraleconomicstakesusbeyondintuitionandhelpsusbepreciseindetecting,understanding,andremedyingproblemsthatarisefromconsumermistakes. • IntegratingbehaviouraleconomicsintotheFCAcanthereforehelpitbeaneffectiveregulator. • Thispaperhastwoparts. • InPartIwesummarisethemainlessonsfrombehaviouraleconomicsforretailfinancialmarkets: • howconsumersmakepredictablemistakeswhenchoosingandusingfinancialproducts; • howfirmsrespondtothesemistakes,and • howbehaviouralbiasescanleadfirmstocompeteinwaysthatarenot intheinterestsofconsumers. • InPartIIwedescribehowbehaviouraleconomicscan,andshould,beusedintheregulationoffinancialconduct. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  41. P age |41 • PartI:Lessonsfrombehaviouraleconomics • Whyaretheremorebehaviouralproblemsinfinancialservices? • Foranumberofreasons,consumerchoiceinretailfinancialproductsandservicesisparticularlypronetoerrors: • Manyproductsareinherentlycomplexformostpeople. • Financialproductsareabstractandintangibleandoftenhavemanyfeaturesandcomplexchargingstructures. • Thiscontrastswithmanyordinaryproductswhereconsumerscaneasilyunderstandwhattheyaregettingandtheproducthasasingle,simpleprice. • Facedwithcomplexity,consumerscansimplifydecisionsinwaysthatleadtoerrors,suchasfocusingonlyonheadlinerates. • Manyproductsinvolvetrade-offsbetweenthepresentandthefuture.Oftenpeoplemakedecisionsagainsttheirlong-terminterestsbecauseof • self-controlproblems,e.g.borrowingexcessivelyusingpaydayloans. • Decisionsmayrequireassessingriskanduncertainty. • Peoplearegenerallybad(eventerrible)intuitivestatisticiansandarepronetomakingsystematicerrorsindecisionsinvolvinguncertainty. • Soweoftenmisjudgeprobabilitiesandmakepoorinsuranceorinvestmentdecisions. • Decisionscanbeemotional. • Stress,anxiety,fearoflossesandregret,ratherthanthecostsandbenefitsofthechoices,candrivedecisions. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  42. P age |42 • Someproductspermitlittlelearningfrompastmistakes. • Somefinancialdecisions,suchaschoosingaretirementplanormortgage,aremadeinfrequently,withlittlelearningfromothers,andwithconsequencesrevealedonlyafteralongdelay. • Whichbiasesaffectconsumerfinancialdecisions? • Toidentifyandcorrectmistakesweneedtobeabletodetectbiases.Thetablebelowliststhemostrelevantbiasesforretailmarkets, • categorisingbiasesaccordingtohowtheyaffectdecisions: • preferences(whatwewant); • beliefs(whatwebelievearethefactsaboutoursituationandoptions);and • decision-making(whichoptiongetsusclosesttowhatwewant,givenourbeliefs). InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  43. P age |43 Categorisingbiaseslikethishelpsusconsiderwhetherpeoplearemakingmistakes. Errorsinbeliefsordecision-makingcanoftenbeclear-cut. Forexample,peoplemayhavebeliefsaboutthelikelihoodofanevent thatcontradictsobjectiveprobabilities. Butifpeople’spreferencesareinconsistent(andsonotfullyrational),itcanbedifficulttosaythatthesepreferencesarewrong;theyareafterallwhatpeoplewant,atleastatthetime. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  44. P age |44 Ifpeoplearenotmakingmistakes,interveningtopreventthemfromactingonthesepreferencescanmakethemworse-off. Howdobiasesaffectthestrategiesoffirms,competitionandothermarketproblems? Firmsplayacrucialroleinshapingconsumerchoices. Productdesign,marketingorsalesprocessescanexacerbatetheeffectsofbiasesandcauseproblems. Firmscanrespondtothedifferentbiasesinspecificways(wegivedetailedexamplesintheAnnex). Oneimportantresponseisthatfirmswilltendtoincreasenon-salientpricesanddecreasesalientprices. Forexample,ifconsumerstendtounderestimatehowmuchtheywillspendontheircreditcardinthefuture(becauseofprojectionbiasoroverconfidence),firmshaveanincentivetoofferlowratestodaywith higherrateslater. Anotherimportantresponseisthatfirmswilltendtoobfuscateunattractiveproductattributes,suchasexclusionsininsurancecontracts. Consumerbiasesthusaffectcompetition. Theycanleadfirmstocompeteinwaysthatarenotinconsumerinterests,e.g.byofferingproductsthatappealtotheconsumerbecausetheyplaytobiases. Biasescanalsocreatedefactomarketpowerinmarketsthatmightappearcompetitivebasedonthenumberoffirmsalone. Wemustbemindful,however,thatsometimesfirmsmightnotknowthat theircustomersaremakingmistakes. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  45. P age |45 Whatlookslikedeliberateexploitationmayactuallyjustbefirmsrespondingtoobservedconsumerdemandwithoutrealisingthatitisdrivenbybiases. Regardlessofwhatfirmsknow,inbadlyfunctioningmarketsbiasexploitationmaybetheonlywayforfirmstoattractandretainconsumersandthereforetostayinbusiness. Behaviouralbiasescanalsointeractwithothermarketfailureslikeinformationasymmetriesorexternalities. Theycanexacerbateotherproblemsormakeregulatoryinterventionsaimedataddressingproblemsineffectiveorevenharmful. PartII:ApplyingbehaviouraleconomicsattheFCA Wehavealreadybeguntoputbehaviouraleconomicsintopractice,butchangewillnotbeinstantaneous. Behaviouraleconomicsraisesimportantissuesforallstepsoftheregulatoryprocess. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  46. P age |46 Step1:Identifyingandprioritisingissues Howcanwespotpotentialconsumerdetrimentcausedbybiases? Biasesarerarelydirectlyobservable. Basedonevidenceonthecommonmistakespeoplemake,wesuggestasetofindicatorsthatcanhelpidentifywhereconsumerdetrimentfrommistakesmaybeparticularlyhigh. Theindicatorshighlightpotentiallyproblematicconsumerandfirmbehavioursandproductfeatures. Acomplementaryapproachtodetectingissuesistoidentify thetrueeconomicfunctionofaproductandthenevaluatewhether consumersactuallyusetheproductforthisfunction,orforanotherreason. Howcanweprioritisetheserisks? InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  47. P age |47 Wewillprioritiserisksarisingfrombehaviouralbiasesaswithotherissues. Sizeoftheproblemwillobviouslydrivepriority. Behaviouralproblemscancauselesssophisticatedconsumerstopaymorethanothers,effectivelycross-subsidisingthemoresophisticated,soprioritisationalsoneedstoconsiderthesedistributionaleffects. Step2:Understandingrootcausesofproblems Couldconsumersbechoosingreasonably?Ifconsumersarebiased,whatdotheytrulywantandneed? Whenanalysingproblemsweneedtodeveloppossibleexplanationsastotheunderlyingcauseandthenbuildevidence. Wemustinvestigatewhetherconsumersaremakingmistakes,andifsowhichbiasesmaybethecause. Crucialevidenceincludeshowconsumerschooseindifferentsettings (e.g.doconsumerschoosedifferentlyastheygainexperience?),theirawarenessofessentialproductinformationandtheirself-reportedneeds andobjectives. Howshouldweanalysefirm-specificissues? Forfirm-specificissues,behaviouralinsightscaninformwhatdialoguetohavewith,andwhatinformationtogatherfromthefirm. Qualitativeinformationmaybeenough,thoughdataonconsumerbehaviourmaybeneeded. Establishingwhethertheproductfeatureorpracticeiscommontomanyfirmsormarket-wideisimportant. Howshouldweanalysemarket-wideissues? InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  48. P age |48 Diagnosingmarket-wideissuesnaturallyrequiresagreaterlevelofevidence. Thismayincludecollectingfirst-handdatausingconsumerresearch,laboratoryexperimentsorfieldexperiments(alsocalledrandomisedcontrolledtrials,orRCTs). Analysismustconsiderthebroadcontextofthemarket,includinghowfirmscompete,whatothermarketandregulatoryfailuresarepresentand howconsumerbiasesinteractwiththesefactors. Step3:Designingeffectiveinterventions Whatinterventionsareavailabletoprotectconsumers? BehaviouraleconomicsoffersnewperspectivesoninterventionsthattheFCAcoulduse,forbehaviouralandotherproblemsinthemarket. Orderedfromleasttomostinterventionist,therearefourwaysinwhichtheFCAcouldsolvebehaviouralproblems: Provideinformation.Requirefirmstoprovideinformationinaspecificwayorprohibitspecificmarketingmaterialsorpractices. Changethechoiceenvironment.Adjusthowchoicesarepresentedtoconsumers. Controlproductdistribution.Requireproductstobepromotedorsoldonlythroughparticularchannelsoronlytocertaintypesofclients. Controlproducts.Banspecificproductfeaturesorwholeproductsthatappeardesignedtoexploit,orrequireproductstocontainspecificfeatures. Wecouldexpandourtoolkitbyusingmore‘nudges’—smallpromptsthat,ifdesignedwell,havelowcostsandcanleadtobetterdecisionsbybiasedconsumerswithoutrestrictingchoice. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  49. P age |49 Providinginformationorchangingthechoiceenvironmentcanbenudges. Astheselessinterventionistmeasuresdonotconstrainconsumerchoice,theyarepreferable,iftheyareeffectiveinpreventingmistakes. Understandinghowconsumersmakedecisionscanalsoimprovetheeffectivenessoftraditionalremedies,suchasdisclosure. Consumerpsychologyisnuanced,however,andspecificinterventionscansucceedorfailbasedonsmalldetails. Interventionsshouldthereforeideallybetestedinpracticebeforeimplementation,possiblyusingRCTs. Oftenconsumerbiasesarejustonepartofaproblem,andapackageofmarket-widemeasureswillberequired. Shouldweinterveneand,ifso,how?Howcanweassesstheimpactofinterventions? Applyingbehaviouraleconomicsalsobringsadditionalchallenges. Wewillhavetotackledifficultquestionslike:whatisinconsumers’bestinterests,whereshouldthelimitstoconsumerresponsibilitylie,andhoweffectivearelessinterventionistmeasures,suchasnudges,ormoreinterventionistmeasures,suchasproductbanning? Whenchoosingbetweendifferentmeasures,ornointerventionatall,weneedtoassesstheircostsandbenefits,totheextentthatthisispracticallypossible. Awidevarietyoffactorsshouldbeconsideredincluding whetherfirmscancircumventthemeasure, negativeandpositiveimpactsoninnovation, InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  50. P age |50 • transfersbetweendifferentgroupsofconsumers,e.g.themoreandthelesssophisticated, • theimpactonconsumers’incentivestolearnand • whethertheproblemisonefortheregulatororbestlefttotheGovernment. • Traditionalimpactassessmentapproaches,forexample,forestimatingbenefitstoconsumers,mayneedtobeadaptedwhenbiasesarepresent. • Conclusion • IntegratinginsightsfrombehaviouraleconomicswithtraditionalcompetitionandmarketfailureanalysishasmuchscopeforhelpingtheFCAchoosethebestinterventions. • Behaviouralinsightshaveimplicationsformanyfunctionsoftheorganisation: • policy–i.e.creatingourrulesandguidance; • analysingfirms’businessmodels,behaviourandproductswhenauthorisingorsupervisingfirms; • buildingevidenceforenforcementcases;and • shapingFCAandfirmcommunicationswithcustomers. • Webelievethatthechallengesaresurmountableandthispaper contributestothefoundationsfortheFCAtoundertakewide-ranging,integratedanalysisoffinancialmarketsandthenactontheresults. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com