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Week in Risk & Compliance: Top News & Events

Explore the top 10 risk and compliance news stories that shaped the week's agenda. Delve into behavior economics, intraday liquidity risk, Basel III, and more. Stay informed with expert insights.

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Week in Risk & Compliance: Top News & Events

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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

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