Managing risk in the first line – why your team should be true entrepreneurs
24 September 2018
There is a tension between two sets of business objectives. On the one hand, we have the ‘three lines of defence’ model of risk management, where the first line is management, the second is risk control and compliance, and the third is independent assurance or audits. On the other hand, large firms often urge the revenue earners and business managers who constitute the first line of defence to act like entrepreneurs, to motivate them and signpost the desire for creative and money-making initiatives and behaviours.
That should work in theory, because according to another model, the ‘entrepreneurial triangle’, an entrepreneur is supposed to balance cost, revenue and risk. But in practice these internal entrepreneurs tend to concentrate on the two elements that they can easily understand and control – cost and revenue – and neglect the third element. Risk tends to get ‘outsourced’ to the second line of defence, or else there’s a pass-the-parcel game to decide who owns the risk. So your first line of defence stops working properly.
Why does this happen? A major factor is with the way individuals are rewarded. Often they stand to gain (through bonuses and so on) if their decisions increase profitability, but (except in extreme cases) they do not stand to lose core remuneration if their decisions lead to losses. And, after all, offloading risk to someone else is part of the way the financial services industry works – with the difference that when another firm accepts our risk onto its book, we pay them for it.
Internal offloading of risk causes problems, because it means that the individuals’ objectives are not in line with those of the company as a whole, or with the interests of its customers. The approach is also at odds with the increasing trend for regulators to hold individuals responsible for their actions.
How can this issue best be addressed? We’d argue that it’s time for firms to start treating the front line more like real entrepreneurs who need to balance all three elements of the triangle, albeit within the firm’s overall strategy. That means holding senior individuals to account for their actions, and framing risk positively as part of all front-line roles, not just something to be outsourced to compliance or transferred to someone else in the firm.
The first steps to a culture change in accountability is to overhaul your remuneration structure so that senior staff are properly exposed to all the risks – including regulatory risks – associated with their actions.
This way, you can begin to restore the first of your three lines of defence while also reaping the full benefits of entrepreneurial behaviour. At the same time, you’ll become more client-centric because your decision-makers will be motivated by focusing on what is best for the clients, with a risk lens as well as pure revenue and cost.
Please get in touch if you’d like to discuss how well your firm’s current approach to risk governance and reward encourages genuine entrepreneurship and reinforces your management of risk.