Before the crisis broke out, supervision focused mainly on monitoring whether supervised institutions complied with the statutory requirements governing solvency, liquidity and controlled conduct of business. This continues to be crucially important, but the crisis has taught us that supervision must delve deeper. It should detect possible sources of future problems and tackle them before they get the chance to affect financial performance. This is necessary because the speed at which developments in the financial sector may escalate has increased. A first source of possible problems is the conduct and culture prevailing at financial institutions and a second one is business models and strategies.
Conduct and culture
Today's undesirable behaviour at financial institutions is at the root of tomorrow's solvency and liquidity problems. This is widely acknowledged and evidenced by the emphasis that international regulations place on it. The new Basel III supervisory framework for banks for instance pays explicit attention to the culture prevailing at risk management departments in banks.
DNB uses various methods for analysing institutional culture. We sometimes attend board meetings for instance and employ social behaviourists in order to explore dynamics that may be detrimental to an institution's stability. We analyse the minutes of risk committees and boards and hold surveys among staff employed by financial institutions. The results are by no means always encouraging. Executive directors do not always have sufficient eye for the culture prevailing at their organisation and the role they themselves play with respect to conduct and culture. We also frequently see risk cultures that do not fit the nature of the institution.
The question is what to do if this is the case. Imposing rules and monitoring compliance with those rules is less effective here. It is not a question of there being one single desired culture or set of behavioural rules. DNB does not act as the culture police, but rather wants to hold a mirror up to executives; we present our observations and ask them if they can identify with them. We also communicate the importance of culture in speeches, publications, and seminars, and we demonstrate the pivotal role that the management board plays with respect to culture. Consequently, new board members are also tested on the extent to which they reinforce the existing board and the culture prevailing at the institution as the composition of the board may significantly influence boardroom dynamics.
Cultural change requires time and patience. It starts with making executive directors aware of possible problems, followed by creating willingness to take action, and starting up what may prove to be a prolonged trajectory of cultural change at their own organisation. This makes demands on the stamina of the institution and the supervisory authority.
Business models also proved to be a determining factor for the extent to which banks have run into trouble during the financial crisis, and the international policy working groups have recognised this. In Europe for instance, the introduction of the new CRD IV capital requirements directive has made business model analysis an explicit component of supervision. DNB has also intensified its supervision of business models and strategies since the crisis broke out. Business models are being reviewed more frequently and more elaborately, starting with an institution’s application for authorisation. These reviews centre on the following two questions: “How sound is the manner in which the institution currently generates income?” and “Is this model sustainable in the longer term?” A major component of the review is an institution’s external environment. This is to a large extent determined by macro-economic conditions, but market position relative to competitors also plays an important role. A qualitative analysis looks at the extent to which the institution has a buffer in the form of a unique selling proposition, such as a unique product range, or an above-average reputation. The financial analysis also entails an in-depth analysis of the balance sheet and the profit and loss account.
These analyses generate important additional observations on the critical success factors of the different business models. An example of this is the thematic examination into the private banking sector that DNB conducted in 2013. Traditionally, scale has been considered essential to sustainable profitability. Our examination showed that economies of scale were indeed important with respect to keeping costs under control. Cost-efficient business operations are, however, also possible for smaller institutions, for instance if banks work with flexible and fairly straightforward systems and processes, while opting for a dedicated product range.
By discussing the analyses with the examined banks, their awareness of the strengths and weaknesses of their business models has increased. In some cases, we have asked for the institution's strategy to be adapted. In the past few years, DNB has specifically emphasised increasing the sustainability of funding profiles, and limitations have been imposed on attracting finance by means of covered bonds.
The attention for business models has not been limited to the banking sector. We for instance currently have a large-scale examination ongoing into business models in the life insurance sector. This examination was prompted by the question whether life insurance companies are adapting sufficiently to market trends, such as the shrinking market for individual life insurance policies. The examination most of all concentrates on developing a vision on future market size, earnings generating capabilities, and the necessary preconditions for sustainable successful operations. Based on our vision and a request for information, we then start up a dialogue with the examined insurance companies about their strategic plans, and subsequently map out our supervisory priorities for the months ahead.