Three Lines of Defence: A Robust Organising Framework, or Just Lines in the Sand?
| DOI | http://doi.org/10.1111/1758-5899.12568 |
| Date | 01 June 2018 |
| Published date | 01 June 2018 |
Three Lines of Defence: A Robust Organising
Framework, or Just Lines in the Sand?
Howard Davies and Maria Zhivitskaya
Sciences Po, Paris
Abstract
Global regulators agree there is a need to strengthen governance in financial firms. The failure of boards and senior manage-
ment to consider the risks inherent in their pre-crisis strategies is widely accepted as a crucial factor in the costly meltdown
whose consequences continue to be felt. Regulators have tried to strengthen governance mechanisms and, in particular, have
recommended a “three lines of defence”model to embed risk management throughout financial firms. Yet while this model is
now in use across the financial sector in many countries, its origins are opaque, and its effectiveness untested. Some argue
that diffusing the responsibility for risk management in this way in fact reduces accountability and effectiveness. And there is
little external validation of the controls firms put in place. Does the three lines of defence system provide a false sense of
security? Does it need to be rethought, or can it be enhanced?
Policy Implications
•The Financial Stability Board should commission a review of the operation and effectiveness of the three lines of defence
(3LoD) system in major banking and insurance groups, to identify good and poor practices in those firms.
•The Basel Committee, the International Association of Insurance Supervisors, should provide guidance for banks and insur-
ers on how best to design a 3LoD framework, to ensure that: (1) there is an understanding within each firm of the charac-
ter of the relationship between the three lines; (2) that the borderlines between the three lines are clearly defined; and (3)
that all risks are effectively covered by the system.
•Board risk committees should review the operation of 3LoD within their organisations to ensure appropriate oversight of
risk management.
Eight years on from the financial crisis the process of rereg-
ulating the financial sector continues. The periodic updates
provided to successive G20 summits by the Financial Stabil-
ity Board have mapped progress against the objectives set
by Heads of Government and Finance Ministers (FSB, 2017).
The most fundamental of these changes have affected the
capitalregimeforbanks.Thesinglebiggestlessondrawnby
regulators was that banks were operating with too thin a mar-
gin of equity capital. It proved inadequate to cope with the
losses many of them incurred in the crisis, requiring costly
recapitalisation, in some cases with funds provided by taxpay-
ers, so for internationally active banks capitalrequirements have
been raised to two or three times their previous size. The con-
cept of macroprudential regulation, whereby regulators may
increase capital requirements through the cycle when they
identify a build-up of risks in the system as a whole, has been
added to the authorities’toolkit. There have also been impor-
tant changes to market transparency, in order to strengthen
market discipline, and a plethora of other regulatory interven-
tions to address the structural weaknesses identified by the
analyses of why the financial system went into meltdown fol-
lowing the collapse of LehmanBrothers in September 2008.
All this strengthening of regulation is designed to con-
strain risk-taking by financial firms, and especially by those
banks which, because of their size and interconnectedness,
are considered to be too big to fail, and therefore to benefit
from an implicit taxpayer subsidy. The Trump administration
has announced its commitment to review some of the
reforms implemented in the Dodd Frank Act, notably the
Volcker rule, outlawing proprietary trading by banks, but it
remains unlikely that the increased capital requirements will
be rolled back. But, as Haldane (2012) has shown some
apparently well-capitalised banks failed, and some less well-
capitalised banks survived.
A further strand of analysis of the crisis suggests that
there were other causes of the reckless behaviour of many
financial firms, which go to the heart of their governance
model. Regulators previously operated on the implicit
assumption that profit-seeking firms had built-in incentives
to behave prudently with their own resources. Regulation
therefore did not focus much attention on the lending prac-
tices of banks. Banks appeared to have every incentive not
to lend to companies and individuals who might not repay
them. Yet in the run-up to the crisis lending disciplines
broke down. The sub-prime mortgage debacle in the US
was a case in point. Banks made loans to non-creditworthy
borrowers, then put together packages of mortgages of low
quality and marketed them aggressively to investors. They
©2018 University of Durham and John Wiley & Sons, Ltd. Global Policy (2018) 9:Suppl.1 doi: 10.1111/1758-5899.12568
Global Policy Volume 9 . Supplement 1 . June 2018
34
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