Three Lines of Defense: How did we get here, and how will it impact your bank?
Risk Management Solutions Group
RMSG provides risk, regulatory compliance, data analytics, and credit consulting services to financial institutions.
The Three Lines of Defense (3LOD) model is a fundamental framework in contemporary risk management practices. Originating from the necessity for an organized approach to managing organizational risks, the 3LOD model departs from previously varied and often disjointed risk management frameworks. Traditionally, many organizations employed a siloed risk management model, confining this function to specific departments or units without a cohesive overarching strategy. This approach led to fragmented risk management practices and a failure to manage and understand organizational risks.
These traditional methods demonstrated significant areas for improvement, particularly in their inability to manage complex and interconnected risks efficiently. It was most evident when banks managed operational risks separately from strategic or financial risks. Dividing them can lead to uncoordinated responses to risk events. Prior models frequently needed more clarity in defining roles and responsibilities across the organization for risk management.?
The traditional models often fail to adequately integrate risk management into the strategic and operational decision-making processes. This led to banks sidelining risk considerations rather than incorporating them into core planning and execution processes. Consequently, many organizations faced regulatory penalties or significant losses due to inadequate risk management practices that failed to clearly delineate risk ownership, management, and assurance functions, as suggested by the 3LOD model.
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In response to these challenges, the transition to the 3LOD model aimed to offer a more comprehensive and integrated approach to risk management. This model emphasizes distinct roles and responsibilities, aligns risk management with business objectives, and enhances communication and coordination across different organizational sectors.
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The FDIC's Proposed Addition to Part 364 on Corporate Governance and Risk Management
The FDIC's Proposed Addition to Part 364 on Corporate Governance and Risk Management (Guidelines) shows a significant stride in standardizing the 3LOD model. The proposed Guidelines target banks with assets between $10 billion and $50 billion, raising expectations for formal risk management programs. It requires more precise definitions and coordination of the 3LOD model, guiding financial institutions to augment their risk monitoring and reporting processes, which could cause staffing and training challenges for more extensive, sophisticated risk management programs.
The FDIC's Guidelines underline the adoption of the 3LOD model as a framework for risk management, reflecting a regulatory move toward a more structured and universally acknowledged approach within banking institutions. It stresses the need for distinct separations between front-line units (the first line), independent risk management functions (the second line), and internal audit (the third line).
The Guidelines emphasize the board of directors' role in overseeing the implementation of the 3LOD model, suggesting that boards ensure effective governance structures, including establishing appropriate risk committees. Banks are expected to implement comprehensive risk management programs aligned with the 3LOD model principles, including well-defined risk appetite statements, policies, and regularly updated procedures. The Guidelines also highlight the necessity for robust systems for risk monitoring, reporting, and addressing risks, acknowledging that the application of the 3LOD model should be proportional to the size and complexity of the institution.
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How will the Three Lines of Defense model work for these banks?
For banks with total assets between $10 billion and $50 billion, adapting the 3LOD model requires a scalable approach. It's crucial to tailor risk management frameworks to align with the bank's unique profile and risk appetite rather than adopting a one-size-fits-all model. Banks might need to adapt specific aspects of the lines of defense to fit their context, especially where resources are more limited.
Technology
Banks should consider leveraging risk management software and automation tools to enhance the model's efficiency and effectiveness.?
Committee
Banks could also utilize risk committees that draw members from various parts of the organization, promoting a more integrated approach to risk management.
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Culture?
Building a risk-aware culture and providing training on the specifics of the 3LOD model is essential for cohesive and effective implementation.?
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Especially for mid-sized banks, third-party support and consultation for firms like RMSG can offer valuable expertise and resources. It's also critical to continuously monitor and adapt to changing risk landscapes or internal organizational changes, as is ensuring that the implementation of the 3LOD model aligns with regulatory requirements and facilitates effective reporting. A skilled risk management consulting firm can help you with these things.?
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Benefits of Enhancing Risk Management
Here are some benefits of enhancing risk management through the 3LOD model:?
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By clearly defining roles and responsibilities, the 3LOD model can lead to more efficient operations, reducing duplication of efforts and ensuring that banks conduct risk management activities by skilled personnel. A solid risk management framework also positions organizations to adapt to future challenges, including changes in the market, technology, and regulatory environment.
The proactive enhancement of risk management programs is crucial. The evolution of the 3LOD model and the FDIC's proposed additions represent a significant shift in risk management practices. Third-party risk management partners, like RMSG, can be instrumental in this transition, offering expertise and support in adapting to these evolving regulatory expectations.?
Banks that successfully adjust and enhance their risk management frameworks will comply with regulatory expectations and position themselves for sustainable growth and stability in an ever-changing financial landscape.
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Sources:
The FDIC's Proposed Addition to Part 364, FDIC's Financial Institution Letters (FIL-55-2023).
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Debevoise & Plimpton LLP, “Key Takeaways from the FDIC’s Proposed Guideline for Corporate Governance and Risk Management,” (by Courtney M. Dankworth, Satish M. Kini, Gregory J. Lyons, Caroline N. Swett, October 19, 2023)
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Deloitte, "Modernizing The Three Lines of Defense Model," (by Peter Astley and Adam Regelbrugge)
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Enterprise Risk Management Academy, "Three Lines of Defense," (by Antonius Alijoyo)
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Transformational Nonconformist-It is time to Think Differently about Risk. "It didn’t take guts to follow the crowd, that courage and intelligence lay in being willing to be different" Jackie Robinson
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