The FICO banking analytics blog discussed recently the topic of “Conduct Risk”:  What is the relevance to Basel III?

Over the financial crisis we saw increasing focus on capital and liquidity management, and Basel III rules were written so that the financial system could better withstand shocks in the future. While Basel III has been center stage, its “brother” has been taking form in the wings. There has been a significant structural shift in the level of expectation regulators have in terms of how banks conduct their business activities, typically referred to as ‘conduct risk.’ The ‘conduct risk’ agenda is the regulatory response to growing concerns over widely cited examples of customer detriment and is designed to enhance market integrity.

Conduct risk was defined well by one regulator as “any action of a bank or the banking industry that leads to customer detriment or negatively impacts market stability.” Conduct risk is explicitly addressed in the Financial Conduct Authority’s Risk Outlook for 2013.

It’s easy to see why regulators are expecting banks to embed conduct risk solutions within both their operational activities and governance procedures, and make conduct risk considerations fundamental to their strategic planning. In the UK, the Payment Protection Insurance (PPI) scandal has cost banks almost £19bn(c$30bn) in provisions, and this amount is still increasing. The LIBOR scandal, where banks were found to be guilty of trying to move systemically important interest benchmarks for their own benefit, has already caused fines worth several billion dollars.

Failure to execute business activities in the correct manner can have disastrous effects on the bank’s financial health and reputation. So while Basel III compliance will play a vital role in increasing the safety of the banking system, this is only one part of the puzzle. Bank conduct — executing with integrity and discipline — is also fundamental, because misconduct can unwind a lot of the increased resilience that Basel is looking to achieve, and reduce the banks competitive position in the market place.

At the same time, with the rise of social media and mobile, consumers’ expectations are higher. They want fast, excellent service and they are more able and willing to complain when they are not completely satisfied. Ultimately, regulators are assessing banks against these elevated customer expectations.

Managing conduct risk introduces a challenging scenario for many lenders, as restrictions around what rates can be offered or which customers can be targeted with a particular product can impact profitability. That’s why banks need to be able to implement and operationalize systematic conduct risk practices — for example, tracking customer satisfaction and product suitability not only on an ex-post basis, but also under what-if scenarios and during the entire product lifecycle. Increased regulatory and consumer expectations create a notable opportunity for banks to differentiate themselves and enhance the standard of service they provide their customer.

Banks are taking steps at an operational level to systematically address conduct risk. For example, the most advanced firms are recognizing that conduct risk management does not just refer to retrospective issues, and hence are using predictive analytics to factor in various parameters, such as how human behavior or economic conditions may change the suitability of a product to an individual. This ‘look forward’ approach facilitates a proactive approach to conduct risk mitigation.

Such is the complexity of interaction with consumers that banks are no longer able to rely on manual assessments based on expert judgment alone to assess the suitability of a product. Instead, banks are looking to utilize tools such as link analysis,  which can factor in numerous data points across sales activities and customer interactions, allowing the bank to dedicate resources to potential conduct risk issues before they become systemic. In addition, decision models can be developed that include a broad range of conduct risk inputs and other variables to identify decision strategies that balance profit, regulation and customer satisfaction.

Much like Basel, conduct risk is not a temporary regulatory hot topic. It is here to stay and will impact the strategic direction of banks and how they execute their business for the long term.