Financial Stability Board Issues Final Guidelines Regarding Development of a Risk Management Framework and Proposed Guidelines on Supervision of a Financial Institution’s Risk Culture

The Financial Stability Board (the “FSB”), a group of representatives from central banks, finance ministries and financial supervisors from the Group of 20 leading economies, Hong Kong, the Netherlands, Singapore, Spain and Switzerland, issued final guidelines for financial institutions (“FIs”) entitled “Principles for An Effective Risk Appetite Framework” (the “Final Guidelines”) and proposed guidelines on promoting a strong risk culture within an FI.  The proposed guidelines (the “Proposed Guidelines”) are entitled “Guidance on Supervisory Interaction with Financial Institutions on Risk Culture.”

The Final Guidelines

In the Final Guidelines, the FSB discusses the key elements of: (1) an FI’s risk appetite framework (“RAF”); (2) an FI’s risk appetite statement; (3) an FI’s risk limits; and (4) the roles and responsibilities of an FI’s board of directors and senior management.  The Final Guidelines are focused on risk management issues for systemically important financial institutions (“SIFIs”), but the FSB states that they “are also relevant” for the supervision of other FIs and that, for non-SIFIs, supervisors may apply the Final Guidelines “proportionately so that the RAF is appropriate to the nature, scope and complexity of the activities of” the applicable FI.

After defining key risk management terms, the Final Guidelines discuss the development and establishment of an FI’s RAF, which, the FSB states, should be “an iterative and evolutionary process” that “requires buy-in across the organization.”  An effective RAF should be driven by both top-down board leadership and “bottom-up involvement of management at all levels.…”  The RAF should be adaptable to changing business and market conditions and “evaluate opportunities for appropriate risk taking and act as a defense against excessive risk-taking.…”

The Final Guidelines then discuss the key elements of an FI’s risk appetite statement, which, the FSB declares, should be easy to understand.  The FSB says that an FI’s risk appetite statement, among other things, “should be directly linked to the [FI’s] strategy, address the [FI’s] material risks under both normal and stressed market and macroeconomic conditions, and set clear boundaries and expectations by establishing quantitative limits and qualitative statements.”

In addition, the Final Guidelines state that an FI should establish specific and measurable risk limits that allocate the FI’s risk appetite statement among the FI’s business lines, legal entities, specific risk categories and asset or other areas of concentration.

Finally, the FSB provides a specific list of responsibilities with respect to an FI’s RAF for the FI’s: (1) board of directors; (2) chief executive officer; (3) chief risk officer; (4) chief financial officer; (5) business line leaders and legal entity-level management; and (6) internal auditors.

The Proposed Guidelines

The FSB issued the Proposed Guidelines to discuss the manner in which regulatory supervisors formally assess an FI’s risk culture, “particularly at SIFIs.”  The FSB states that to assess an FI’s risk culture, a supervisor must understand whether the FI’s risk culture “supports appropriate behavior within a strong risk governance framework.”  To better understand an FI’s risk culture, a supervisor, says the FSB, should increase its interactions with an FI’s board of directors, the intensity of those interactions and the level of seniority of those interactions.

In the first section of the Proposed Guidelines, the FSB describes the foundational elements of an FI’s sound risk culture and in particular, risk governance, risk appetite and compensation practices.  In the second section, the Proposed Guidelines describe what the FSB considers the key elements of an FI’s sound risk culture: (1) the tone from the top; (2) accountability; (3) an environment that promotes effective challenge; and (4) financial and non-financial incentives.

In the third and final section of the Proposed Guidelines, the FSB provides detailed guidance on how supervisors can assess each of the four risk culture indicators identified in the second section.  The FSB stresses that “assessing risk culture entails identifying the root cause of why there are supervisory findings—not just what the findings are.  It includes identifying practices, behaviors or attitudes that are not supportive of sound risk management and intervening early to address these culture observations and thereby potential excess build-up of risk.”  The Proposed Guidelines also emphasize the need for an FI to document thoroughly the elements of its risk culture.

Comments on the Proposed Guidelines are due to the FSB by January 31, 2014.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.