On August 20, 2015, the Office of the Superintendent of Financial Institutions (OSFI) released Draft Guideline E-21:Operational Risk Management (Draft Guideline) for comments. With the Draft Guideline, OSFI aims to provide a “comprehensive view of operational risk management and related OSFI guidance, across all FRFIs” and fill what it perceives to be a gap in existing guidance.
Pursuant to the Draft Guideline, all federally regulated financial institutions (FRFIs), other than branch operations of foreign banks and foreign insurance companies, would be expected to establish and maintain an enterprise-wide framework of operational risk management controls. The FRFIs’ approach to operational risk management is to be informed by four “guiding principles” set out in the Draft Guideline. Although the Draft Guideline makes some distinction between small and large FRFIs, if the Draft Guideline becomes effective in its current form it will impose a significant additional regulatory burden on all FRFIs, especially the mid-sized and smaller ones.
SCOPE OF OPERATIONAL RISK
The Draft Guideline defines operational risk as “the risk of loss resulting from people, inadequate or failed internal processes and systems, or from external events.” These sources of loss are each to be interpreted broadly but exclude strategic and reputational risk, among other things. The scope of a FRFI’s operational risk extends to outsourcing arrangements as well. OSFI proposes to evaluate the FRFI’s management of operational risk as part of its ongoing supervisory activities.
Four Principles Informing a FRFI’s Approach to Operational Risk Management:
Principle #1: Operational risk management is fully integrated within the FRFI’s overall risk management program and appropriately documented.
FRFIs would be expected to have a documented framework for identifying and dealing with operational risk (Framework). The Draft Guideline sets out several elements that the Framework “should consider”, including clear accountability and ownership for operational risk management; the risk assessment and reporting tools used by the FRFI and how they are used effectively within the FRFI; and the governance structures used to manage operational risk.
OSFI states that the final form of the Framework will depend on the nature, size, complexity and risk profile of the FRFI, but does not provide guidance regarding which elements may be more appropriate for smaller FRFIs or whether it would be acceptable if a FRFI did not address some of the listed elements.
Principle #2: Operational risk management serves to support the overall corporate governance structure of the FRFI. As part of this, FRFIs develop and utilize an operational risk appetite statement.
The Draft Guideline would require FRFIs to develop and maintain a risk appetite statement (Statement). The Draft Guideline states that the Statement should be a component of the FRFI’s overall board-approved risk Framework but smaller, less complex FRFIs with a demonstrated low operational risk profile could satisfy this expectation with only limited consideration of their operational risk exposure within their overall Statement.
The Statement would need to include a measurable component that gives an indication of the level of operational risk that is considered acceptable within the FRFI and the level at which operational risk events or cumulative patterns should be escalated to senior management or the board of the FRFI. The Draft Guideline sets out elements to consider when developing a Statement and identifies specific responsibilities that senior management has in respect of the Statement. The FRFI’s board and senior management would also be expected to regularly review the appropriateness of the Statement and confirm whether it remains reasonable and appropriate.
Principle #3: FRFIs ensure effective accountability for operational risk management. A “three lines of defence” approach, or appropriately robust structure, serves to separate the key practices of operational risk management and provide adequate independent overview and challenge. How this is operationalized in practice in terms of the organizational structure of a FRFI will depend on its business model and risk profile.
The “three lines of defence” structure is identified as one possible way to achieve accountability for the management of operational risk, although the Draft Guideline does not expressly state that other structures are permitted as alternatives and several other principles lean on the three lines of defence. The Draft Guideline explains the role and responsibilities of each line of defence. OSFI acknowledges that depending on the nature, size, complexity and risk profile of a FRFI, some overlap of responsibilities between the first and second lines of defence may be acceptable but the third line of defence must remain independent.
- First Line of Defence: The business line that has ownership of risk and is responsible for planning, directing and controlling the day-to-day operations of a significant activity and for identifying and managing the inherent operational risks in products, activities, processes and systems for which it is accountable.
- Second Line of Defence: Oversight activities that independently identify, measure, monitor and report operational risk on an enterprise basis. A key function of the second line of defence is to challenge the first line of defence’s input to and outputs from the FRFI’s risk management and reporting tools to ensure they are adequately complete and well-informed.
- Third Line of Defence: An internal audit function that provides an independent review and testing of the FRFI’s operational risk management controls, processes, systems and the effectiveness of the first and second lines of defence. The scope of the third line of defence’s review and testing coverage is broad and should evaluate the appropriateness and effectiveness of the operational risk management Framework given the size, complexity and risk profile of the FRFI.
Principle #4: FRFIs ensure comprehensive identification and assessment of operational risk through the use of appropriate management tools. Maintaining a suite of operational risk management tools provides a mechanism for collecting and communicating relevant operational risk information, within the FRFI and to relevant supervisory authorities.
The Draft Guideline lists several tools that OSFI expects to be generally used, such as developing an operational risk taxonomy; conducting risk and control assessments; scenario analysis and stress testing and comparative analysis. The Draft Guideline indicates which of the three lines of defence should be responsible for each tool. The tools a FRFI uses to identify and assess operational risk will depend on its nature, size, complexity and risk profile. The Draft Guideline expressly states that larger, more complex FRFIs are expected to have a robust suite of operational risk tools at their disposal whereas smaller, less complex FRFIs with demonstrated low risk profiles may be able to rely on only a few well-implemented tools. The Draft Guideline does not propose a hierarchy among the various tools or indicate which tools would be appropriate for different types of FRFIs.
The Draft Guideline repeatedly states that the nature, size, complexity and demonstrated risk of a FRFI will shape its approach to operational risk management and suggests that OSFI will accept different approaches, if appropriate. The accompanying Guideline Impact Analysis Statement further stresses that “OSFI supervisory expectations will have greater flexibility for smaller, less-complex institutions with demonstrated low operational risk profiles.” The degree to which the OSFI will actually be flexible remains unclear. FRFIs choosing to modify the steps set out in the Draft Guideline will likely be expected to justify such modifications and closely document the decisions informing the modifications. Smaller FRFIs might be expected to implement all components of the Draft Guideline, albeit on a smaller scale by way of compromise.
If the Draft Guideline comes into effect in its current form, it will represent another major set of risk management and governance expectations imposed on FRFIs by OSFI. The Guideline Impact Analysis Statement states that the Draft Guideline is intended to consolidate existing guidance and thus simplify the governance process for FRFIs, but FRFIs will likely find that it significantly expands rather than streamlines their obligations in respect of risk management.
FRFIs interested in sending comments on the Draft Guideline to OSFI may do so until October 9, 2015.