Challenges in governance – managing the ever increasing complexity

In the aftermath of the Global Financial Crisis, regulators and legislators around the world tried to make sense of its causes and then implement rules to stop it happening again. In the UK, the resulting regulation introduced by the Financial Conduct Authority, FCA, was the Senior Managers Certification Regime, which in its current state, carries strong sanctions for non-compliance. Ensuring that the right “tone from the top” is set and that it is part of the fabric of a firm is paramount for regulatory authorities.

Today, conducting effective and robust governance remains crucial within the financial services industry. For a self-stye aggressive and intrusive regulator supervising the UK, it is about reducing systemic risk, maintaining a functioning market and preventing consumer harm. While good governance remains the cornerstone of all successful and sustainable businesses, boards need to evidence that its oversight is effective, complies with cross-cutting regulations and provides material challenge to its executive.

Moreover, investment firms should broaden their focus, from solely on shareholder returns, to ensuring stakeholders interests are considered, their underlying risks managed, and the good practices implemented.

Regulatory and supervisory authorities, in all major financial services jurisdictions, are actively scrutinising the governance practices of investment firms, focusing on three main aspects:

1. Exercising material oversight over outsourced services
2. Preventing and/or mitigating conflicts of interest
3. Stopping money laundering

Outsourcing oversight framework

In the UK, firms using third-party providers must organise and control their affairs responsibly and effectively. Regulators are keen to see that effective governance actions are in place and that there is material challenge from investment management board, particularly when considering operational resilience. Therefore, boards must be able to prove that they are exercising their responsibilities and fiduciary duties. A diverse and curious board has been shown to be most effective when overseeing and challenging those third parties to whom functions are delegated. The reliance on outsourced service by external third parties (service providers and/or delegates) often result in fragmented and opaque processes with high complexity. Addressing governance issues in this context requires a holistic, cross-cutting approach that considers not only the internal dynamics of the organisation but also acknowledges any potential opaqueness, introduced by outsourcing arrangements. Ensuring that the board has the necessary transparency and understanding of these fragmented processes is vital as it directly influences the ability of boards to maintain accountability and regulatory compliance. The FCA SYSC (Senior Management Arrangements, Systems, and Controls) Sourcebook provides guidance on outsourcing oversight within investment firms.

The Central Bank of Ireland (CBI) revealed in its recent study that certain Irish asset managers could not prove the required substance of operations or monitoring of the delegated investment management function. Several asset managers faced challenges in providing robust evidence that they had conducted the requisite level of due diligence on their delegates. A notable portion of these asset managers failed to review delegates’/ service providers’ policies and procedures comprehensively, verifying their suitability for application within the organisation. This has led to a necessary re-evaluation of governance frameworks, prompting the need for better protocols as well as the recruitment of highly skilled professionals for crucial roles at operational roles as well as at Board level, to ensure proper oversight of the delegates’ network.

The governance and outsourcing oversight framework continues to be of importance for regulatory bodies globally, as highlighted by the CBI’s review. While newer entrants generally meet compliance requirements, longer-standing entities failed to prove the substance of operations, often relying on outsourcing arrangements and falling short in implementing regulatory requirements. This deficiency has prompted regulatory bodies to demand a minimum number of full-time employees for even the smallest entities, highlighting the need for enhanced regulatory compliance.

Other issues related to the overall poor controls on the delegation/ outsourcing network, such as insufficient due diligence, inadequate delegate reports, and deficiencies in documentation and recordkeeping, have further underscored the necessity for immediate improvement. The CBI worryingly identified problems with nearly 30% of asset managers’ independent directors, raising concerns about their effectiveness in challenging appointed portfolio managers. This could result in losing direct control over delegated functions due to a too much fragmented internal process and increasing reliance on the delegates/ service providers.

Consequently, a number of regulatory bodies have initiated compliance and thematic reviews, alongside supervisory measures, reflecting a broader trend of increased scrutiny of governance structures across the investment management industry.

Conflict of interest

The FCA regulates the conduct of non-executive directors and SMF directors through the COCON code, part of the official FCA Handbook. Managing and avoiding conflicts of interests has been high on the list of regulatory expressed concerns, particularly any overlapping directorships between an investment management firm and their delegated counterparts. This potential conflict of interest emphasises the need for impartiality by the board, in matter such as fund value assessments. Firms often rely on third parties to provide valuations for their funds, and if these valuations are biased due to a lack of segregation of duties, or inappropriate influence, in a scenario where directorship mandates overlap, it could call into question the fairness of the valuation, leading to investors making uninformed decisions or even holding unsuitable investments.

With a more intrusive FCA, firms need to reassess whether their conflict of interest policies are robust enough to manage the risks associated with any potential overlapping directorships or any undue inputs, especially in the context of delegated/outsourced functions. These policies should include clear guidelines, periodic skills testing and relevant disclosures for board members on how to manage, mitigate or avoid, where necessary, potential conflicts, as well as the mechanisms to show regulatory compliance.

Preventing money laundering

The current governance landscape for asset managers leads to a complex network of third-party entities, making it vulnerable to the risks of money laundering and terrorism financing (ML/TF). The Luxembourg National Risk Assessment (NRA) on Money Laundering and Terrorist Financing (2022) highlights that a robust governance framework is a crucial mitigating factor in addressing financial crime risks. The identified threats include a lack of visibility into the operations of third parties and the challenge of monitoring their activities, especially when spanning diverse jurisdictions or navigating complex business structures.

As a result, a well-defined governance framework enhances efficiency and effectiveness in addressing risks by streamlining processes, ensuring consistent application of risk-based principles, and fostering effective communication and collaboration among relevant stakeholders. This streamlining reduces operational redundancies, eliminates unnecessary delays, and optimises resource allocation, thereby enhancing the speed and effectiveness of detection and prevention measures.

Conclusion

Investment management boards continue to have an increasing workload when it comes to exercising their governance functions for regulated activities.  Intersecting and cross cutting legislation and regulation only adds to the complexity of this workload. Therefore, it is imperative that boards equip themselves with a holistic yet robust approach that evidences the comprehensive internal and external mechanisms they use to support their scrutiny of both in house business functions and outsourcers; helping to follow regulations in multiple jurisdictions and across complex business structures. By embracing doing so, boards can not only mitigate any risks of their regulatory non-compliance but also contribute to the success and operational efficiency of the firms they oversee.

References

• https://www.centralbank.ie/news-media/press-releases/central-bank-publishes-outcome-of-thematic-review-of-fund-management-companies-20-october-2020$
• https://www.fca.org.uk/news/speeches/regulatory-perspective-drivers-culture-and-role-purpose-and-governance
• mj.gouvernement.lu/dam-assets/dossiers/blanchiment/en-nra-import-version-2982022.pdf