2017 is here! Now is the time for new resolutions, renewed plans for success and… if you’re in compliance, now is the time for new compliance risk assessments. As we have discussed in previous blogs, the risk assessment is often discussed and sometimes reviled as a meaningless regulatory requirement. When attempting to prepare a risk assessment, a frequent question is presented; what are the essential items in my risk assessment? Per regulatory guidance produced by the Federal Reserve:
“Principles of sound management should apply to the entire spectrum of risks facing an institution including, but not limited to, credit, market, liquidity, operational, compliance, and legal risk.”
This guidance applies to general principals of risk assessment preparation. The compliance risk assessment is something of a different animal because questions of market risk, credit risk and liquidity risk are relatively minor concerns when considering risks in compliance. The focus instead should be on compliance, transactional, strategic, financial and reputational risks associated with compliance activity.
Think of the risk assessment as a matrix – not the type where you get to choose a red pill or a blue pill, just a square with several blocks. There is a formula that you can use to complete an effective risk assessment. The basic formula is INHERENT RISK (minus) INTERNAL CONTROLS (equals) MITIGATED RISK.
Inherent risk is the risk associated with the products, customers and overall compliance structure at your bank.
An inherent risk is a risk category that really relates broadly to the activities and operations of a company without considering necessarily the company. For example, unsecured lending is inherently more risky than secured lending. If I were auditing an institution that was primarily involved in unsecured lending, then I would have a higher assessment of inherent risk in that organization than, let’s say, secured lending. And that’s a fairly simple example, but that type of a risk assessment is done for each critical business component1
When considering the level of inherent risk at your institution, consider all the products that you offer and the worst-case scenarios lurking in the background. For example, supposed you are considering the inherent risk associated with consumer lending. The inherent risk might look something like this:
Consumer Loans- Inherent Risk/Type of Risk Comment
Compliance Risk -The risk associated with the regulatory requirements for making consumer loans, e.g. disclosures, accurate calculations, etc.
Transactional Risks- The risks associated with the systems in place that are being used to support offering the product. Can your core support the loan types being offered?
Reputation Risks-The risk that the products will result in consumer complaints, UDAAP violations or potential fair lending concerns.
Strategic Risk -Are your products really meeting the credit needs of the community you serve?
The point of this part of the exercise should be to determine the level of risks that are part of offering the products at all. This level of risk doesn’t consider anything of your compliance program.
One you have identified the risks inherent in the products you offer, the customers you serve and the overall current compliance program, the next step is to review the steps your institution has taken to address them. This is where your policies, procedures, training and independent audits come in. There is really an opportunity to self-reflect and simultaneously project your aspirations during this part of the risk assessment. It is one thing to note you have policies and procedures in place. It is a far different consideration to determine how effective they are. Are the policies and procedures written and updated on an annual basis? How much of the policies and procedures are internally developed and how much have been “borrowed” from other institutions? (Note: This is not to imply that borrowing is a bad thing, if the information truly reflects the situation at your institution). The risk assessment should contain an analysis of the current state of the internal controls. What would excellent controls look like and what would it take for the compliance department to get there? These considerations should be included.
Your overall assessment of how well the internal controls at your institution address the possibility of problems is the mitigated risk. For the risk assessment to be a most effective tool, it is necessary for this process to truly consider potential proems with internal controls. Written policies and procedures, for example, can be comprehensive and up to the minute accurate, but totally ineffective if staff don’t use them. Training is an area often taken for granted. The online training that most institutions offer is a great start for training. However, for a full in-depth understanding, additional training that includes case-studies is a best practice.
For the banking industry in general regulators have put strategic risk at the forefront. For example, its semiannual risk perspective for spring 2016, the OCC noted that strategic risk is a concern:
“Banks are several years into the risk accumulation phase of the economic cycle. The banking environment continues to evolve, with growing competition among banks, nonbanks, and financial technology firms. Banks are increasingly offering innovative products and services, enabling them to better meet the needs of their customers. While doing so may heighten strategic risk if banks do not use sound risk management practices that align with their overall business strategies, failure to innovate to meet evolving needs or financial services may place a bank at a competitive disadvantage.”2
As the risk assessment process is completed this year, it is important to consider whether your institution is keeping up with trends in technology and innovation. The financial industry is being disrupted in a way that will significantly impact the relationship between customers and institutions. Without the right technology and business plan, it will be easy to be left behind. Make sure that your risk assessment considers strategic risk.
James DeFrantz is the Principal of Virtual Compliance Management Services LLC. He can be reached directly at JDeFrantz@VCM4you.com