The Imperative of Behavioural Risk – a response to the UK Government Call for Evidence on it’s Financial Services Growth and Competitiveness Strategy

davidjamesgrosse
Dec 12, 2024
18 min read

On the 14th November 2024 the UK Government issued a Call for Evidence on it’s Financial Services Growth and Competitiveness Strategy.

This coincided with the Mansion House speech of Rachel Reeves in which she noted that many of the regulatory changes introduced to eliminate risk after the financial crisis had “gone too far” and had led to unintended consequences.

Although she did not reveal a raft of de-regulatory measures, the speech seems to set the tone for how the government will likely approach regulation going forward.

Nonetheless, in the Call for Evidence paper it also highlighted that:

Central to the success of UK Financial Services are both the stability and resilience of individual institutions and the strength of the wider industry to withstand systemic risks, and;

One of the key contributing factors to the economic and political headwinds faced over the last 17 years was the fall-out from the Great Financial Crisis.

It is essential to square this circle as we move into a deregulatory cycle, and ensure we are not replaying the same old movie seen before, especially when we know how it ends.

In this context, applying new insight and approaches is key, especially as:

The current regulatory environment still pays insufficient regard to the underlying behavioural risks prevalent in both individual firms and across the industry;

There is inadequate understanding, capability, expertise and assessment of behavioural risks within the regulators, at board and senior management level, and throughout the majority of regulated firms.

This is a significant blind spot given the centrality of behaviour and decision-making to many of the banking issues that surfaced over the last 20 years, including the GFC, conduct scandals and the 2023 bank failures.

In summary:

As the Government finalizes the concluding stages of the post-crisis Basel 3.1 reforms to capital requirements, and reassesses specific post-crisis regulations, it is clear the momentum is towards easing requirements and increasing competitiveness.

As part of this process is imperative that better behavioural risk management, insight and capabilities are developed within the UK Financial Services industry, and to understand how this approach can mutually re-enforce the current priorities of performance, resilience and proportionate regulation and risk management within the sector.

________________________________

My full response to the Call for Evidence on the Financial Services Growth and Competitiveness Strategy, as submitted on 9th December 2024:

I encourage all interested parties to make your own representations.

To: Financial Services Strategy

HM Treasury

1 Horse Guards Road

SW1A 2HQ

To Whom it May Concern

Responding to the Call for Evidence on the Financial Services Growth and Competitiveness Strategy

In response to the call for evidence on the Financial Services Growth and Competitiveness Strategy as published on the 14th November 2024[i]

The financial services sector is of huge importance to the UK, accounting for nearly 10% of the economy and playing a vital role in the lives of all companies, organizations and individuals, and facilitating the efficient use of capital, job creation, tax generation, and economic development.

As such, I welcome the Government’s renewed focus on the sector, including through the Financial Services Growth & Competitiveness Strategy; and the wider long-term plan for growth and the commitment to restoring stability, increasing investment and reforming the economy to drive up prosperity and living standards across the UK.

Central to the success of Financial Services are both the stability and resilience of individual institutions and the strength of the wider industry to withstand systemic risks.

As acknowledged in the call for evidence paper, one of the key contributing factors to the economic and political headwinds faced over the last 17 years was the fall-out from the Great Financial Crisis (GFC).

This reminded us that crises are hugely costly, with impacts on business and household wealth and confidence, and long term impacts on growth. The risks and damage are magnified in the UK, given the size and significance of banking and other financial services to the wider economy.

In reviewing and revisiting UK financial regulation, to ensure that it is proportionate and supportive of economic growth, it is therefore essential that perceived shorter terms gains are not prioritized over longer term resilience and performance, without due consideration of the knock on impacts of these decisions. Whether that is through the process of:

Finalizing and delivering the concluding stages of the post-crisis Basel 3.1 reforms to bank capital requirements;
Reassessing specific post-crisis regulations, such as those surrounding the SMCR and Ring-Fencing.

In particular I would highlight the following factors that are crucial to profitability, resilience, risk management and decision making, and that are currently neither sufficiently understood nor invested in, at both the UK regulatory and individual firm level.

1) Behavioural Risk Management Background

The business of banking is the business of behaviour, with the centrality of trust and the multiple actions and decisions of individuals, firms, customers, regulators, management, staff and other stakeholders.

At the macro level the systemic risks within the financial system are created by people and institutions interacting with each other in the form of endogenous risk[ii]. At the company level behavioural risks can manifest through the response of counterparties and deposit holders, when there is a loss of confidence, and through the day to day actions and decisions of customers, boards, management and employees.

The GFC of 2007/08[iii] included predatory lending, excessive risk-taking, and inadequate regulatory oversight; and underpinning that were perverse incentives, conflicts of interest and behavioural blind-spots. The multiple conduct issues over the last 15 years likewise had their roots in the confluence of behavioural risks, opportunity and motivated reasoning.

The centrality of human behaviour to the financial system was further reinforced in 2023 with the series of failures and bankruptcies that took place, primarily in the United States. This necessitated a swift response by banks and regulators to prevent contagion.

Whilst technical and proximate causes of these recent failures can be identified, such as the mis-management of interest rate risks and the concentration of deposit holders, the ultimate sources of these issues were entwined in wider problems of governance, behaviour and decision making.

In Switzerland the emergency takeover of Credit Suisse by UBS was presaged by a long running series of issues and scandals that weakened their position and led to their near collapse as systemic risks spread.

Although the events of 2023 had limited impact on UK financial institutions it would be naïve to assume that some of the root causes are not also present domestically, or that UK based firms and regulators have a markedly more advanced approach to their understanding and action on addressing the underlying behavioural risks.

2) Behavioural Risk Management Capabilities

Whilst risk management capabilities in firms and regulators are well advanced in most areas that are perceived as technical; such as credit risk, market risk, liquidity risk, cyber security and technology risk, they are less developed in their approach to, and understanding of, the underlying behavioural risks.

These risks can be the root cause of, and manifest in, other domains; such as the liquidity risk issues suffered by Silicon Valley Bank in 2023. They can also directly impact a variety of other areas such as conduct, operational risk, resilience and financial crime.

As a counterpoint, behavioural risk management[iv] applies the insights from psychology, behavioural science, physiology and related disciplines to assess the organizational landscape, identify areas of interest, investigate and address.

It evaluates those underlying drivers that underpin behaviours and decision making and which lead to both desirable and undesirable outcomes. In identifying and assessing these drivers it takes full consideration of organizational, social and individual factors, recognizing that traditional approaches that focus excessively on reward and control are incomplete and can be misleading.

Many financial service firms currently have an immature or haphazard approach to these risks, conflating work on aspirational culture statements, training and topic specific work (such as that around diversity and inclusion) as a proxy for wider work on behaviour.

Furthermore efforts can be dispersed across different functions, such as the Business, HR, Risk, Compliance and Audit without a common approach nor understanding.

The capabilities and focus of Executive and Non Executive management of Financial Services firms to identify, analyse and act on these risks is limited, and further hindered by the lack of insight and expertise being provided from within their firms.

I perceive similar issues existing at the UK regulatory level, which leads to them having restricted ability to give clarity and direction on their expectations to the wider financial services industry.

Whilst I applaud the recent valuable work of the UK FCA on Non Financial Misconduct[v] it needs to be recognized that this is addressing a subset issue, specific to personal behaviour, and is not synonymous with addressing wider behavioural risks associated with the GFC, the industry conduct issues and the events of 2023. Although there may be overlap between these topics a more thorough understanding of the organizational environment, context and structures is needed.

I also note the FCA approach to Consumer Duty, in setting higher standards of client protection across financial services, includes the need for a deeper understanding of how consumers actually behave. This infers a recognition of the importance of firms identifying and acting upon the drivers of human behaviour, and is a valuable insight that it is essential is applied equally to the internal dynamics within companies.

I would therefore recommend that the UK Government ensures the financial regulators:

Have sufficient internal behavioural risk management capability and expertise, and that it is an area that their supervisory teams are mandated to pursue with regulated firms;
Ask regulated firms about their own behavioural risk capabilities and encourage their advancement. There are areas of good practice in the UK and globally that can be referred to in order to help firms develop[vi].

In keeping with the desire from the UK Government to ensure regulatory burdens are minimized and proportionate:

I would not recommend detailed regulations in relation to behaviour and culture, insofar as the specifics should remain the responsibility of individual firms, and to avoid perverse outcomes from firms working to a comprehensive rule book rather than abiding by principles.
Expectations on expertise and capability should be balanced in line with the size and importance of financial service firms and their criticality to the wider UK economy.

3) Behavioural Risk Management Opportunities

In encouraging the development of behavioural risk management insight and capabilities it is important to note how this approach can mutually re-enforce the current focus on performance, resilience and proportionate regulation and risk management.

Properly implemented, a more thorough and informed consideration of behaviour and decision making can help identify areas where excess process, control and regulation can usefully be trimmed without any detrimental effect.

The traditional approach of incremental and additive control, surveillance, headcount and infrastructure and the attendant costs can be reevaluated with an understanding of where these are ineffective in shaping human behaviour and can lead to perverse outcomes, and what alternative methods may be more successful.

Similarly a fuller understanding of how to encourage internal cooperation, challenge and transparency within a firm can help with their financial performance through increased speed, innovation and removing barriers and duplication.

If the competitive pressure continues to focus the attention of the UK Government, Regulators and Financial Services companies on the need to reform the bank capital requirements and to ease regulations, then the alternative insights gained from a behavioural approach will be invaluable.

Properly implemented the implications for financial services firms are strongly positive. Where additional capability and expertise is required these can be small and targeted, and outweighed by the savings in ineffective bureaucracy, processes and resource. Furthermore the insights are equally as important to long term performance and resilience as they are to risk management.

4) International co-operation

Given the globally interconnected nature of financial services I urge the UK Government to continue to work with the Financial Policy Committee (FPC), overseas governments and financial sector regulators, and with international partners, such as the Financial Stability Board (FSB), to help develop best practice, secure the resilience of the wider financial system, mitigate vulnerabilities and respond to instances of financial instability as and when they arise.

In addition to the current toolkit and focus of regulation it is imperative that this best practice also includes explicit coverage on the need for behavioural risk capability, expertise, understanding and action in both regulators and regulated firms.

Taking a leading role in this in the UK will further strengthen the domestic Financial Services sector and help position the country at the forefront of leading international approaches.

Further Details

Further details in line with the specific Consultation Questions are as detailed in the attached Appendix to this response.

Yours faithfully,

David Grosse

Director

Behavor Ltd

APPENDIX

Responding to the Call for Evidence on the Financial Services Growth and Competitiveness Strategy

Consultation Questions

Stakeholder Information

Question 1: Which of the following statements best describes you as an individual or as an organisation:

h) Other – please specify

I am the founder and director of a company that provides behavioural risk consulting services to Banks and other organizations. My career has included over 30 years working inside Financial services firms in London, Hong Kong and Singapore and having senior roles in the Business, Risk and Audit.

Additional Questions for Financial Services Organisations – 2 through 7

N/A

Chapter 3 – Objectives and Approach

Objectives and Approach:

Question 3.1: Do you agree with the proposed objectives set out in paragraph 3.6?

Yes, with the important caveat that providing long term stability should be explicitly stated in 3.6 as one of the Government's proposed key objectives, rather than set out in a separate paragraph 3.7, albeit noted as a pre-requisite.

Growth and Competitiveness:

Question 3.2: [For Financial Services Organisations] For firms operating in more than one jurisdiction, what are the main drivers affecting your decisions on where to invest?

N/A

Future of Financial Services:

Question 3.3: What do you consider to be the most important trends or changes likely to affect the financial services industry over the next 10 years?

In looking at future trends that will affect financial services it is vital to also consider the ongoing Banking, Regulatory and Financial cycles that will continue to play out and recur in the coming decade.

There is a danger in focussing excessively on new developments, such as those from advanced technology and AI, to the detriment of ensuring that traditional sources of risk, at both the firm and systemic level, remain in view.

With the drive to deregulate in the USA, UK and other jurisdictions, together with the growth of alternative financial centres, the most important trend will be to understand where excessive risk taking and concentration is building within the financial system leading to increased fragility.

Further consideration and focus should be applied to Shadow Banking, where non-bank financial institutions operate with less oversight but are deeply interconnected with traditional banks.

Chapter 4 – Policy Pillars

Question 4.1: Do you agree with the list of policy pillars that the government intends to focus on? Are there other areas that should be included?

Broadly I would agree with the policy pillars, albeit long term stability could usefully be identified as a specific pillar, rather than as a sub-point under Regulatory Environment.

Question 4.2: Please rank the list of pillars in order of importance to your business or organisation for i) day-to-day operations and ii) longer term plans for investing in the UK:

1. Innovation & Technology

2. Regulatory Environment

3. Regional Growth

4. Skills & Access to Talent

5. International Partnerships & Trade

No answers provided

Question 4.3: How well is competition currently working in the financial services sector, and how can it be improved?

No answers provided

Innovation & Technology

Question 4.4: What is your assessment of how effectively the UK supports innovation and the adoption of new technology? What could be improved in the financial services sector?

No answers provided

Question 4.5: Which technologies do you think have the most potential to transform financial services over the next 10 years? And in which financial services sectors or functions do you see these being applied most effectively?

The main technologies that will transform financial services will likely arise from a confluence of artificial intelligence and machine learning, blockchain and distributed ledger technology, and big data analytics.

From an internal risk management and regulatory perspective it will be important to:

· Use big data analytics and AI to better understand and assess the risks attendant in complex and interconnected environments, such as the internal dynamics within banks, and the systemic risks across organizations, rather than focussing predominantly on individual actors or isolated risks.

· Not assume that there are solely technical solutions to perceived technical risks. A good example being in the current operational resilience expectations on banks from both UK and International Regulators. Understanding human behaviour, decision making and dynamics is critical to resilience, and is not currently given the specific focus or prioritization it warrants.

The development of Quantum computing may also be felt in the coming decade and which may have profound implications both from a business and risk management perspective.

Regulatory Environment

Question 4.6: What is your assessment of the UK’s current regulatory environment?

Whilst I broadly welcome the secondary objectives of the UK regulators to facilitate international competitiveness and growth of the UK economy, it is important to ensure that through political and industry pressure, in conjunction with motivated reasoning, that potential conflicts of interest with the primary objectives do not:

· Encourage an excessively light-touch approach reminiscent of the pre-GFC situation;

· Result in regulatory arbitrage, where standards are lowered to attract business, potentially increasing systemic risks and harming the UK's reputation for robust regulation;

· Prioritize short-term economic gains over long-term resilience, increasing the financial system's vulnerability to shocks

Specific to my area of focus, I do not believe the UK’s current regulatory environment pays sufficient regard to the underlying behavioural risks prevalent in both individual firms and across the industry.

There is insufficient understanding, capability, expertise and assessment within the regulators, at board and senior management level and throughout the regulated firms.

This is a significant blind spot given the centrality of behaviour and decision making to many of the banking issues over the last 20 years, including the GFC, conduct scandals and the 2023 bank failures.

Question 4.7: How can regulation support responsible and informed risk-taking?

The traditional approach of incremental and additive control, surveillance, headcount and infrastructure and the attendant costs can be re-evaluated with an understanding of where these are ineffective in shaping human behaviour and can lead to perverse outcomes, and what alternative methods may be more successful.

Regional Growth

Question 4.8: [For Financial Services Organisations] What are the three most important factors, ranked in order, that you consider when making an investment location decision within the UK?

N/A

Question 4.9: How can we capitalise on synergies between different regional financial services hubs to support growth?

No answers provided

Skills & Access to Talent

Question 4.10: What is your assessment of the UK’s ability to attract global talent to the financial services sector?

The UK still has a very strong ability to attract global talent given it’s position as a global leader in finance; albeit there are some headwinds, for example following the end of free movement with the EU that has created additional barriers for European professionals who once comprised a significant portion of the financial services workforce.

It is important to ensure that the focus on UK attractiveness is not predominantly about the twin levers of 1) remuneration levels and 2) regulatory requirements (such as SMCR) that largely impact senior management.

A more balanced approach needs to plan for the future, to ensure that the industry remains attractive to the younger generation who may be considering the finance sector in comparison to other careers.

Factors therefore also should include: 1) the adequacy of infrastructure, affordable housing and transport links in financial hubs; 2) the promotion of innovation to foster fintech and other new initiatives to attract tech-savvy professionals, 3) strengthening education links with universities to align curricula and industry needs, 4) links to wider environmental and societal expectations.

Question 4.11: What is your assessment of the UK’s ability to effectively upskill and reskill domestic workers for roles in the financial services sector?

Broadly speaking the UK has the resources required in the domestic workforce to support the financial services sector, albeit with a continuing need to adjust for new skills such as those needed for advanced digital, technological and data proficiency.

Nonetheless it will be vital to ensure that there is a suitable balance of those attracted to, and employed in, the financial services sector, especially with recruitment across different disciplines, backgrounds and generations.

If financial services is excessively dominated by a cohort with a similar background and skillset, drawn principally from technical areas (economics, accounting, legal, technology etc) whilst they may have deep subject-matter expertise they are more likely to have similar approaches, biases and blind spots that can exacerbate fragility and risks in the sector.

The need for a diverse and inclusive workforce in financial services is important and well recognized. However, it is vital to ensure that this diversity also includes attributes of experience, expertise and academic disciplines.

Further advanced skills in areas such as organizational psychology, behavioural science, anthropology, organizational network analysis, physiology are an important addition to the existing skillsets, both in centres of expertise and more broadly as an area of training and understanding that penetrates further in the wider financial services workforce.

International Partnerships & Trade

Question 4.12: What barriers do international financial services firms face in either establishing and operating in the UK, or using UK markets?

The main barriers include:

· Post-Brexit regulatory and market access uncertainty, including loss of EU passporting rights, potential divergence and fragmentation of rules and equivalence challenges.

· The UK, and particularly London, having a high cost of living, expensive real estate, and elevated salaries, making it costly to establish and maintain operations.

Whilst there are also challenges for overseas firms in navigating UK-specific regulations, which may involve duplicative reporting requirements and compliance overheads, I would caution against regulatory arbitrage, where standards are lowered to attract business. The high standards and long term stability of the UK Financial Services sector is an important factor in it’s continued success.

Question 4.13: What opportunities should the government seek to advance through its international financial services relationships?

The Government should seek to ensure that the regulatory environment and the practice of those Financial Services firms that operate in the country remains robust.

Given the globally interconnected nature of financial services the UK Government must continue to work with overseas governments and financial sector regulators, and with international partners, such as the Financial Stability Board (FSB), to help develop best practice, secure the resilience of the wider financial system, mitigate vulnerabilities and respond to instances of financial instability as and when they arise.

Taking a leading role in this in the UK will further strengthen the domestic Financial Services sector and help position the country at the forefront of leading international approaches.

Chapter 5 – Priority Growth Opportunities

Question 5.1: Do you agree with the priority opportunities that have been identified?

No answers provided

Question 5.2: Which of the following business areas and activities do you

see:

a) For financial services firms: As high growth opportunities for your firm?

N/A

b) For other organisations/individuals: As high growth opportunities for the sector?

No answers provided

Please rank the below from 1 to 11, where 1 is the highest growth potential.

1. Asset Management

2. Financial Advice

3. Financial Market Infrastructure

4. FinTech

5. Insurance/Reinsurance

6. Investment Banking

7. Mutual/Cooperative

8. Payment Services

9. Pensions

10. Retail Banking

11. Sustainable Finance

12. Other (please specify)

No answers provided

Fintech

Question 5.3: What do you see as the most important ingredients for a thriving UK fintech sector in coming 10 years?

No answers provided

Question 5.4: Which are the critical factors for success that are specific to the fintech sector to enable innovative businesses to succeed?

In working to ensure that the fintech sector can succeed it is important not to seek exemptions in the name of speed and innovation that could exacerbate systemic risks resulting from the sector's rapid expansion, reliance on technology, and evolving regulatory landscape.

Where fintech firms operate in less-regulated spaces compared to traditional banks, this may allow systemic risks to build unnoticed, for example shadow banking risks where firms engage in quasi-banking activities.

Sustainable Finance

Question 5.5: In the UK’s sustainable finance framework, as set out in the Chancellor’s Mansion House package, do you see barriers or gaps that would support the growth and competitiveness of the UK sustainable finance market?

In developing the growth and competitiveness of the UK sustainable finance market it will be essential to not focus exclusively on the environmental considerations, without due regard to the societal and governance requirements. A better understanding of the cultural and behavioural landscape within firms should be a core part of this.

Question 5.6: What do you think should be the UK’s priority when engaging with the global sustainable finance agenda, both bilaterally and at a multilateral level?

No answers provided

Question 5.7: What are the opportunities and barriers for the financial services sector in developing the products and/or services necessary to facilitate investment into the net zero transition?

No answers provided

For each opportunity, please provide an indication of the type of intervention required, for example developing guidance, or supporting the development of further capabilities

No answers provided

Capital Markets (including retail investment)

Question 5.8: Are there any barriers to growth in capital markets that are not being targeted by existing government reforms? How can private and public markets be grown so that they best support UK growth?

No answers provided

Question 5.9: Are there any barriers to retail participation in UK capital markets? What more can be done to encourage consumers to invest in capital markets to a longer-term time horizon?

No answers provided

Insurance & Reinsurance Markets

Question 5.10: What are the barriers to insurers and reinsurers to growing their businesses and share of international markets?

No answers provided

Question 5.11: What are the barriers to innovation in the UK’s insurance markets?

No answers provided

Asset Management & Wholesale Services

Question 5.12: What are the barriers to setting up and conducting business as a UK asset manager or conducting wholesale services in the UK?

No answers provided

Question 5.13: In what ways could the regulatory landscape for asset management or wholesale services adapt to the needs of organisations over the next 10 years?

No answers provided

References

[i] https://www.gov.uk/government/calls-for-evidence/financial-services-growth-and-competitiveness-strategy

[ii] Endogenous Risk - https://www.systemicrisk.ac.uk/endogenous-risk. Systemic Risk Centre – Research at the LSE: https://www.systemicrisk.ac.uk/

[iii] Foster, J. B., & Magdoff, F. (2009). The great financial crisis: Causes and consequences. NYU Press.

[iv] Scholten, W & Chesterfield, A (2024). Dear CRO: Behavioural Risk Management is the new thing for you. Journal of Risk Management in Financial Institutions, Vol 17 No 4, August 2024. https://www.henrystewartpublications.com/jrm/v17

[v] FCA publishes results of Non-Financial Misconduct survey. 25/10/2024. https://www.fca.org.uk/news/press-releases/fca-publishes-results-non-financial-misconduct-survey

[vi] Scholten, W & Chesterfield, A (2024). As above. Also Wood (2021) Thomson Reuters -Behavioural science gains traction as more banks seek to mitigate employee risk. https://www.thomsonreuters.com/en-us/posts/investigation-fraud-and-risk/behavioral-science-bank-risk/

The Imperative of Behavioural Risk – a response to the UK Government Call for Evidence on it’s Financial Services Growth and Competitiveness Strategy

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