Understanding and addressing the drivers of conduct risk is fundamental in further developing standards of behavior. The sources of conduct risks can be categorized into:
- Inherent factors
- Governance and business processes
- Economic and environmental factors
Let’s understand these factors/ sources of conduct risks in detail.
Various inherent factors are causing the conduct risks in different businesses and industries. These factors can be seen as the combined effect of failures of the suppliers and weakness of customers. The situation caused by these factors becomes worse when the customers are not financially strong enough to buy the goods sold by the supply market. Moreover, these factors communicate with the already existing management, which is mixed completely with the financial market, creating conflicts of interest and causing conduct risks.
There are three inherent factors which are:
- Information asymmetries: The situation occurs when one of the two, i.e., sellers and customers, have more or less knowledge regarding the product. Mostly the sellers try to hide information in front of the customers, which results in a lack of symmetry.
- Biases, rules of thumb, and mental shortcuts: This is when buyers make decisions based on influence by the financial advisors, even if they have the complete information about the product. Here the customer makes decisions based on bias, available news or reviews, overconfidence in a brand, and framing.
- The growing importance of financial capability: when customers take decisions beyond their financial capabilities, conduct risks occur. A financial capability that can lead to unwanted results is a lack of confidence, understanding, knowledge, motivation, etc.
Governance and business processes
The conduct risks caused by governance and business processes of sellers fall in this category. The organizations’ structures, management, operations, and governance framework are executed to make the organization profits. These are not executed keeping in mind the customer benefits, resulting in bad customer feedback. This can be further broken into three factors:
- Conflicts of interest: disagreement between the interests of seller and customer is one of the severe threats to good conduct. Conflicts of interest cause conduct risks when the interests of sellers do not match with the interests of customers.
- Culture and incentives: A firm’s culture or the incentive model often causes disagreement of interest, causing conduct risks.
- Ineffective competition: When preliminary competition arises in the market, conduct risks are most likely to occur. The inadequate competition happens when the sellers sell their goods and services at much higher rates to earn enormous profits. This causes customers to switch the brand; hence firms lose valuable customers.
Economic and environmental factors
The economic and environmental factors play an important role in the decisions taken by the firm and customers. From time to time, changes along with new technologies affect these decisions even more. The financial market’s development greatly impacts the products and services offered by the firms — macro-economic developments that can affect financial markets and, in turn, the drawn-out requirements of consumers. Firms incapably reacting to these pressures can prompt poor conduct outcomes. These factors are those which are the cause of conduct risks but uncontrollable by the firms or customers. The economic and environmental factors can be categorized as:
- Economic and market trends: When the economy and the financial market evolves, it affects the products and services provided by the financial organizations, customer’s needs, and profits earned by selling the products.
- Technological development: In the financial industry, technological evolution has changed the way it operates. Now, everything from initiating a transaction to check transaction history is available online. This evolution has benefited the customers. However, the advancement of technology has created many risks related to financial services. The customers’ information is exposed online, fraudulent cases risen, etc., are few conduct risks caused by technology development.
- Regulatory and policy change: Regulatory and policy change must happen promptly to ensure the financial market’s development. The motive of structural changes in the financial market is to achieve better results for the consumers served by the banking institutions.
Conduct risk is available in practically all parts of a monetary foundation, driven by a company’s methodology, item, administrations, and sales lifecycle. Thus, there is no one-size-fits-all approach to manage conduct risk; each firm should handle it differently. In any case, firms can quantify and oversee conduct risk feasibly by catching risk data to foster a broad viewpoint on traditional sources and pointers of potential lead conduct risk failures.