Conduct-related risk and associated litigation costs
Institutions should take into account that conduct-related risk, as part of legal risk under the scope of operational risk, arises because of the current or prospective risk of losses from the inappropriate supply of financial services and the associated litigation costs, including cases of wilful or negligent misconduct.
In their stress testing, institutions should assess the relevance and significance of the following exposures to conduct-related risk and associated litigation costs:
the mis-selling of products, in both the retail and the wholesale markets;
the pushed cross-selling of products to retail customers, such as packaged bank accounts or add-on products that customers do not need;
conflicts of interest in conducting business;
the manipulation of benchmark interest rates, foreign exchange rates or any other financial instruments or indices to enhance an institution’s profits;
unfair barriers to switching financial products during their lifetime and/or to switching financial service providers;
poorly designed distribution channels that may result in conflicts of interest with false incentives;
unfair automatic renewals of products or exit penalties; and
the unfair processing of customer complaints.
When measuring conduct-related risk, institutions should consider (a) the uncertainty around provisions or expected losses originating from conduct-related events; and (b) extreme losses associated with tail risks (unexpected losses). Institutions should assess their capital needs under such events and scenarios and should also take into account the reputational effect of conduct losses. In principle, expected losses from known conduct-related issues should be covered by provisions and included in the P&L account, whereas unexpected losses are quantified and covered by capital requirements from the institution. The possible excess of amounts after projection of stressed conduct losses should be included in the institution’s assessment of potential capital needs.
In order to capture the risk that the provisions are insufficient or timely inconsistent, institutions should assess expected losses from conduct-related risk in excess of existing accounting provisions and factor these into their projections. Where appropriate, institutions should assess whether or not future profits will be sufficient to cover these additional losses or costs in the scenarios and incorporate this information into their capital plans.
Institutions should collect and analyse quantitative and qualitative information about the extent of their business in relevant, vulnerable areas. Institutions should also provide information to support material assumptions underlying their estimates of conduct-related costs.
In rare cases where an institution is unable to provide an estimate for an individual material conduct-related risk because of the extent of uncertainty, the institution should clarify that this is the case and provide evidence and assumptions supporting its assessment.
Stress testing should also, where appropriate, be used to assess extreme losses associated with tail risks (unexpected losses) and whether or not additional capital should be held under Pillar 2.
Institutions should form a view on the unexpected losses that may originate from conduct-related events based on a combination of:
judgement;
historical loss experience (e.g. the institution’s largest conduct-related loss over the past five years);
the level of expected annual loss for conduct-related risk;
conduct-related scenarios where potential exposures over a shorter time horizon (e.g. five years) are considered; and
losses experienced by similar entities or by entities in similar situations (e.g. in cases of litigation costs).