Investment management, pensions et private equity

Why is it important?

Anti-Money Laundering (AML):

Money laundering remains a central concern for European (EU) Regulators and is a key item on their agenda for the forthcoming year.

As part of this continued focus on AML, key updates were made to the EU Money Laundering Regulations. With these changes, it is important that organisations continue to review and make appropriate enhancements to their AML frameworks to remain compliant with an ever-changing AML regulatory landscape.

Sanctions:

The past few years have been marked by the industry’s strengthening of sanctions screening and monitoring capabilities particularly as a direct result of Russia’s ongoing occupation of Ukrainian soil, which resulted in ongoing and intensified sanctions imposed by many countries. Firms now face a strong increase in the number of Special Designated Nationals and Blocked Persons.

These measures have had a significant impact on companies’ sanctions risk management frameworks. Under these rules, there are significant fines for non-compliance and the possibility of companies being ‘named and shamed’ even when no penalty is imposed.

We see the present and immediate future characterised by a shift to supervision and enforcement. This is to ensure that the financial sector has made appropriate enhancements to its sanctions risk management frameworks in order to minimise breach or circumvention risk.

What’s new?

Anti-Money Laundering (AML):

EU Regulators have instigated key changes to money laundering risk management in the financial sector:

• Enhancements designed to assess and mitigate the proliferation of financing risks. Expected actions will include proliferation financing as an item in a firm’s annual risk assessment, as well as policies, procedures and controls designed to mitigate any identified or potential risks effectively;
• Additional criteria needed when performing due diligence on trusts as customers;
• Enhanced due diligence criteria for customers incorporated in higher risk third countries or with respect to relevant transactions where either of the involved parties is incorporated in a higher risk third country; and
• Increase in the management of processes required for discrepancy reporting, in relation to both persons of significant control as recorded on the Companies House register, and beneficial owners recorded on the newly introduced register of overseas entities.

Sanctions:

EU Regulators have introduced significant enhancements to its ability to detect weaknesses in firms’ sanctions risk management frameworks.

As with AML compliance, EU Regulators maintain a hardened stance against firms found to be non-compliant, whether wilfully or by not committing appropriate efforts and resources to the management of sanctions risk.

What should internal audit be doing?

Why is it important?

Fraud represents an important reputational and financial risk, with the average organisation losing an estimated 5% of their annual revenues to fraud, according to the Association of Certified Fraud Examiners (ACFE). Given the evolving threat landscape, we are seeing increasing requirements on organisations to prevent, detect and deter fraud. With new legislations on the immediate horizon, it is important that organisations and senior stakeholders oversee the implementation of robust fraud prevention measures, and strengthen their anti-fraud culture. For the incoming regulations, financial services organisations will need to especially focus on potential frauds that their employees and agents could commit for the benefit of the organisation.

What’s new?

Organisations will need to take steps to enhance their fraud risk management framework, in particular:

• Fraud risk assessment: “Actions may include undertaking an appropriate fraud risk assessment and responding appropriately to identified risks”.
• Training and communication: “Promoting an appropriate corporate culture and corporate values”.
• Implementing controls: “Ensuring appropriate controls are in place and operating effectively”.
• Board-level reporting: “Require Directors to report on the steps they have taken to prevent and detect material fraud”.

What should internal audit be doing?

Why is it important?

No organisation operates in isolation, and we are seeing a trend where there is increasing reliance on third and fourth parties. By outsourcing or buying third-party services, firms benefit from leveraging specialist expertise, reduced operational overhead costs and greater assurance over delivery through defined SLAs. This enables them to focus on their core business activities. However, when these relationships and dependencies are not managed proactively and effectively, they can bring undue risks to the organisation.

The financial impact of a failure in this ecosystem through operational losses, fines or reputational damage is costly. In addition, increased regulatory scrutiny and prescriptive requirements (part of third-party and operational resilience regulations) have rapidly increased focus on third-party risk, especially as firms are seeing an acceleration of digitisation across entire operations. This has meant traditional services and operating models require unprecedented changes to meet new ways of working in a short space of time.

Regulators are providing more clarity and greater harmonisation of third-party risk regulations. They have strengthened the linkage between third-party management and operational resilience and heightened data security requirements, including the use of cloud and Information Communication Technology (ICT) providers. In our experience, firms that acknowledge the cross-functional nature of third-party risks, that implement third-party oversight in a holistic manner and are enabled through technology, achieve far greater clarity and consistency compared to firms that assess individual third-party risks in siloed teams.

What’s new?

While financial services internal audit functions will be aware of some regulatory requirements, there have been significant regulatory developments on third-party risk that have broadened requirements for most firms. Materiality, outsourcing and risk must be independently assessed and considered as part of a proportionate and risk-based approach and it also implements the European Banking Authority’s (EBA) guidelines on outsourcing arrangements and expands on certain sections such as data security, business continuity and exit plans.

The Digital Operations Resilience Act (DORA) was published in the EU’s Official Journal on 27th December 2022 and entered into force on 16th January 2023 and affects all EU-based financial services firms. A 24-month implementation period will precede the full application in 2025. The DORA introduces a unified regulatory and supervisory rulebook for ICT operational resilience in the financial sector, pushing financial services (FS) firms to make substantial investments to improve their resilience to digital and cyber risk disruptions. One of its main objectives is to harmonise FS firms’ management of ICT third-party risks. This is through mandatory contractual terms for outsourcing and the requirement to assess concentration risks when outsourcing affects Critical or Important Functions (CIFs).

What should internal audit be doing?

For internal audit functions considering performing an audit in the area of outsourcing or third-party risk management, we recommend the following topics are considered for inclusion in the scope:

Why is it important?

The crypto and digital asset landscape has continued to expand over the last 18 months, as more banks are further exploring the use of distributed ledger technologies. Some are partnering with established crypto natives to build their own solutions, or have begun investing in native crypto-custodians to gain exposure to, or build a product or service offering in this market.

A number of firms are looking to onboard new virtual asset service providers (VASPs) in order to begin their offering into the digital asset space, as well as existing firms with a presence in the market looking for new virtual asset service providers.

Onboarding any new third party comes with inherent third-party risks. With digital assets the perceived level of risk is increased due to:

• The limited number of third-party options available that are fully compliant with local laws and regulations; and
• The technology is quickly evolving, and global regulatory regimes are still catching up.

As the ecosystem continues to grow, clients will turn to professional service providers to support them with the onboarding of VASPs as well as the evaluation of providers and risk management. Deloitte can support in a suite of areas especially risk identification, risk management and controls.

What’s new?

• Emerging clarity of regulatory requirements is leading to greater interest around digital assets.
• The EU’s Digital Operational Resilience Act (DORA) has entered its two-year implementation period. DORA is an ambitious European regulatory initiative on operational resilience, cyber security and third-party risk management of financial services firms. Firms will have to comply with all its requirements by 17 January 2025. DORA introduces new rules on: (1) information and communications technology (ICT) risk management and operational resilience strategy; (2) ICT incident reporting and cyber threat identification; (3) resilience testing and advanced threat-led penetration testing; and (4) third-party risk management. Where relevant, in-scope firms – including banks – will need to ensure their digital assets activities meet the DORA’s requirements. A key area of focus across the industry will likely be reviewing and enhancing capabilities to manage the risks of third-party relationships that support their services.

What should internal audit be doing?

Why is it important?

Digital asset custody is the safe keeping of digital assets. Digital asset custody providers are often third parties who provide safekeeping of assets for institutions, who in turn offer digital asset services to their clients.

Distributed ledger technology (DLT) has the power to re-platform financial services across the value chain, transform capital markets and impact traditional market structure in custody. There is wide variance of custody offerings across jurisdictions owing to technological, regulatory and legal standards, and each different offer might be better for a particular use case.

The use of DLT is not limited to cryptocurrencies, it also includes a wide variety of assets that are being represented on-chain in the tokenization of existing asset classes and digitally native assets such as equity and debt instruments, tokenized real estate, tokenized commodities, tokenized deposits, stablecoins and other representations of tokenized real-world assets.

Custody is important as private keys which are used to conduct transactions or access crypto holdings are complex and thus difficult to remember and can be hacked or stolen. For individual holders of digital assets, the risk lies in losing one’s own assets, but for institutions, the risk is losing client’s assets.

When entering the world of custody of digital assets, the new technology continues to affect existing risk domains. In parallel, many existing risk domains will undergo fundamental changes as DLT comes into play, and new risks will emerge.

What’s new?

Key crypto custody regulatory framework developments:

• The EU’s Markets in Cryptoassets (MiCA) regulation entered into force in June 2023. Overall, MiCA will expand and harmonise the EU regulatory perimeter to cover– subject to certain exceptions – the issuance and servicing of most cryptoassets not covered by existing financial services legislation. MiCA will cover firms providing custody services for in-scope cryptoassets. These firms will need to be MiCA-compliant from 30 December 2024, subject to certain transitional measures.
• In December 2022 the Basel Committee on Banking Supervision (BCBS) published its final proposals on the prudential treatment of cryptoasset exposures. The final version of the BCBS proposals excluded custody as a qualifying activity for capital treatment, however this is subject to local regulatory interpretation. Early indications from the US through the Securities and Exchange Commission (SEC) Staff Accounting Bulletin 121 (SAB121) suggest that custody may be included within the US jurisdiction. The proposals define four groups of cryptoassets with varying available regulatory approaches to calculating capital depending on the underlying profile of the cryptoasset. The classification conditions contained within the proposals are likely to create internal audit activity, particularly in the first instance as many firms will be seeking assurance on their classification decisions. Also contained within the regulation are specific provisions for the regulator to continue exploring quantitative approaches to measuring the risk profile of a cryptoasset. This is likely to lead to internal audit work given firms may have to undertake significant efforts to evidence compliance with future quantitative testing.

What should internal audit be doing?

Why is it important?

Models serve many important strategic purposes for financial services firms, in the EU and beyond, which are relied upon as part of the regulatory framework. However, they can pose risks for both financial services firms and the regulators monitoring them. In a policy environment that is broadly supportive of model use, firms must seek to build supervisory confidence in their models amid increasing regulatory scrutiny.

Firms need to demonstrate to supervisors that model risk is being managed across all stages of the model lifecycle. Overall, we expect supervisors to attach most importance to;

• the board’s oversight and challenge of the model;
• effective, independent model validation; and
• the organisation’s model risk management framework which enable these.

Firms that implement model risk management frameworks that satisfy both regulatory requirements and supervisors’ practical concerns, and operate at a commercially viable cost, are, in our view, well-positioned to find a supportive policy environment for the use of models.

What’s new?

Banks with existing internal model permissions already have significant ongoing effort in their modelling teams, with work underway in several areas, including:

• implementing remaining model changes from the Internal Ratings Based-Approach (IRB) roadmap;
• reviewing and revising IFRS 9 models;
• incorporating climate into modelling approaches for risk management and stress testing; and
• preparing for the implementation of Basel 3.1.

Banks will have to address a number of challenges in meeting their obligations around Model Risk Management (MRM):

• Designing and implementing a revised model governance process that retains existing capabilities and adds the capacity and expertise to oversee the significant expansion of models subject to oversight.
• Designing a multi-tiered validation process that provides a review and validation regime that is fit-for-purpose for a significantly broader model population.
• Ensuring that appropriate reporting on the breadth of the model inventory is available and shared with executive management and the board (or a board sub-committee).
• Identifying similarities and/or commonalities across the streams of model work underway.

EU Regulators see model risk as a risk that should be treated in the same way as other material risks in firms: it should be part of risk appetite and should be monitored and managed as seriously as any other material risk. The EU Regulators intent in putting the principles for MRM into the supervisory framework is to drive a change in culture around MRM.

What should internal audit be doing?

Why is it important?

Identification of opportunities for work that delivers common benefits across Internal Ratings repair, IFRS9 and Basel 3.1. Internal audit could play a key role in providing a holistic view across teams to identify any commonalities. More widely, opportunities exist across climate and MRM. Firms that identify similarities and exploit them to reduce the workload for their scarce model resource will reap benefits.

This continued gloomy credit outlook presents serious challenges for both consumers and firms. Borrowers face high inflation (although there are some early signs that this may be beginning to level off), higher interest rates and associated cost-of-living challenges. Supervisors will expect firms to have the capacity, skills and resources in place to deal with rising insolvencies and distressed borrowers, whilst managing balance sheet impacts proactively.

• Lenders face considerable risk of increased impairments in the rest of 2023 and beyond.
• Borrowers are facing significant pressure: retail borrowers primarily from increased interest rates and the cost-of-living crisis; commercial borrowers from increased input costs, higher interest rates and demand side challenges due to purchasers trying to trim their budgets as much as possible.
• If lenders restrict borrowing as a result of economic conditions, rather than using their capital buffers, we expect regulators to press for review of the buffer framework.

It has been clear for some time that rising credit risk is a significant issue, albeit one where the oft-threatened wave of defaults has yet to break. But the credit outlook now appears increasingly bleak owing to a combination of economic supply and demand-side challenges for businesses.

Retail customers face increasing or high levels of inflation, higher interest rates and the associated cost-of-living and debt service challenges, and pent-up credit pressure (including latent credit risk developed during COVID-19). This may start to translate into increased impairments for firms.

What’s new?

Rising interest rates
Interest rates have continued to increase throughout 2023, with the European Central Bank taking measures to stem the increasing rate of inflation. As inflation rises show early signs of tailing off, the expectation is that interest rates will remain high and could increase further before declining. Whilst nominal rates are nowhere near the levels of the 1990s, many borrowers are taking on mortgages at high income multiples, with the result that mortgage payments represent a significant portion of household incomes.

Notwithstanding the requirement for lenders and insurers to undertake affordability assessments, significant increases in interest rates, when combined with other inflationary pressures, are leaving households with limited or no surplus income. Firms will need to ensure that their affordability assessments keep pace with changes in the economy. In lenders’ residential mortgage portfolios, the prospect of material falls in house prices implies the potential challenge of dealing with customers in negative equity.

Dealing with increased risk of defaults
Lenders, as well as other firms that are significant holders of issued debt or other assets with elements of credit risk, face a period of considerably increased risk of defaults and non-payment. This could manifest in an increase in the base level of IFRS 9 impairment allowances (expected credit losses) in stages one and two. Increased flow into stage three (default), a traditional measure of credit risk, will likely follow in subsequent years, but the financial impact on balance sheets will start earlier, reflecting the forward-looking nature of the accounting standards.

All this will happen as firms seek to bring back into their capital positions the deferred impairments arising from the COVID-19 related International Financial Reporting Standards (IFRS) 9 transitional arrangements. Firms will need to ensure that they can demonstrate to supervisors and auditors that the underlying parameters in their IFRS 9 models accurately reflect the risk in their balance sheets.

Credit concerns exist in many sectors. This is seen as being more costly than at any time since 2009, during the credit crunch, with a resultant increase in expectations that cost control – including reducing hiring expectations – will be a key business priority in 2023 and beyond. As commercial and corporate customers face reduced revenues and profits, the likelihood of layoffs is considerable, and increased unemployment will exacerbate the pressures on retail customers.

Insurers and investment funds
Insurers and investment funds hold significant volumes of issued debt instruments, as well as investments in property and other assets, as part of their management of premiums and client investments. Changes in asset values have already led to challenges to some business models, and insurers and investment funds may face further asset price and credit-related pressures in their existing portfolios.

Insurers and investment managers are increasingly seen as potential investors for Environmental, Social and Governance (ESG) and infrastructure projects, given the longevity of cashflows those projects generate. Some insurers and investment managers may need to strengthen their credit teams to ensure that any investments made during a recessionary period meet long-term expectations. For EU insurers, as part of Solvency II reform, we expect EU Regulators to adopt a more granular approach to credit risk within the matching adjustment (MA) calculation for life insurers that use it to reflect the increased sensitivity of long-term productive asset classes that are more long dated and illiquid.

What should internal audit be doing?

Why is it important?

As net zero remains high on governments’ agendas, regulators expect the financial services sector to play a significant role in tackling climate change. Several sustainability reporting requirements in the EU are due to be rolled out over the coming months and years. These aim to increase transparency with the underlying objective of preventing greenwashing in the industry. This is not limited to sustainable products but will cover a range of matters such as an organisations’ approach to diversity and inclusion and sustainability initiatives reflected in public reporting. As such, it is imperative for internal audit functions to challenge their firms’ readiness and responses to ensure accurate reporting against mandatory requirements. In doing so, internal audit can help firms to prevent adverse environmental effects; retain a customer base that is more and more climate-conscious; and gain confidence in an area of increasing regulatory and governmental focus. Firms need to be aware of associated risks and opportunities and internal audit functions should work with their businesses so that they are ready for the raft of regulatory changes we expect to come into force soon.

What’s new?

There are several recent and upcoming changes to the regulatory landscape regarding sustainability disclosures. They include:

Corporate Sustainability Reporting Directive (CSRD):

• In November 2022, the EU adopted the Corporate Sustainability Reporting Directive (CSRD), replacing the Non-Financial Reporting Directive (NFRD). The requirements cover many financial services firms with rollout expected to begin from January 2024.
• Whilst the regulation requires firms to publish information that is needed to understand their wider business performance, there is a focus on mandatory reporting on firms’ sustainability strategies, as well as wider Environmental, Social and Governance (ESG) factors.
• Furthermore, the CSRD will bring an obligation for external verification of published sustainability information, with penalties in scope for firms that do not comply.

Sustainable Finance Disclosure Regulation (SFDR):

• In March 2021, the Sustainable Finance Disclosure Regulation (SFDR) became applicable in the EU for financial services firms. The aim of this regulation is to ensure firms provide greater transparency for the makeup of financial products, especially the factors that make them ESG aligned. Broadly, it requires firms to label their financial products as article 6, 8 or 9, depending on how ESG friendly they are. Disclosures are based under which article firms decide to label their products.
• The SFDR requires two levels of disclosure: level 1, was applicable from March 2021 and focussed on principles-based disclosures. In January 2023, level 2 became applicable, bringing additional specific mandatory disclosures for firms selling financial products in the EU. The deadline for reporting the level 2 disclosures for the first time was 30th June 2023.

Controls on data:

• EU Regulators expect firms to explain how they identify significant data gaps and how they plan on closing them. Firms should expect continued assessments on the effective management of climate risks, including the accurate and complete use of data in ESG disclosures.

What should internal audit be doing?

Why is it important?

EU Regulators view effective governance as key to enable sound decision making in firms to achieve desired outcomes, with both increasingly focusing on diversity and inclusion. Diversity, when part of an inclusive culture, enables different perspectives and views to be shared, resulting in better judgements and decision making, mitigating against the risks of groupthink, and promoting innovation. There has been some progress in improving diversity and inclusion in financial services over the past decade, however the pace of change has been slow. Overall, the ability to assess the problem and track progress is limited by poor quality data on many aspects of diversity, with most data focused on gender, some on ethnicity, and very little on other protected or diversity characteristics.

What’s new?

• It is important that firms scrutinise the findings to identify which areas require improvement within their own approach to diversity and inclusion, as these findings provide insight to the EU Regulators’ expectations on diversity and inclusion and indicate the future direction of travel in this space.

What should internal audit be doing?

Why is it important?

Regulatory bodies continue to drive the need to prioritise the embedding of a strong internal control framework in the 1st line of defence and to demonstrate effective management of key risks. A strong internal control framework, underpinned by a risk-based controls testing capability, provides the basis for accountable leaders to attest to the effective design, implementation, and operation of controls.

The basic foundations of a strong internal control environment are:

• A clear definition of what a ‘control’ is in the context of managing the organisation’s most material risks;
• Adoption of common terminology across the organisation for key control management processes;
• An education and stakeholder engagement programme so that everyone understands the roles played by controls in the management of material risks;
• Clarity on the level at which risks are assessed according to the organisation’s risk management framework, so controls can be defined at the right level of granularity;
• A control library made up of the minimum expected controls required to mitigate the risks defined with an organisation’s taxonomy of the most material risks; and
• A simple accountability model for key roles across the control lifecycle.

Without clarity on these components, it is often difficult to define and communicate who is responsible for what across 1st line management teams, internal control teams, and the 2nd line.

What’s new?

There is one primary driver behind the renewed focus we’re seeing organisations have on getting the internal control model right:

• Cost reduction is a key focus area for organisations across all sectors. Manual, time intensive tasks are being assessed based on the value they create and streamlining the control environment is a key use case for the identification of efficiency savings. Organisations are having to be creative in how they strengthen their control environment and deliver cost savings at the same time.

As a result of this driver, organisations are actively reviewing their current levels of maturity in relation to internal control. They are having to understand their current level of maturity at a more detailed level, and in cases of rapid growth, focus on defining the path to a maturity level that is in line with their wider strategic ambitions.

What should internal audit be doing?

Why is it important?

The number of ‘green’ and ‘sustainability-related’ financial products has increased exponentially over the last couple of years as firms grapple with rising demand from consumers and regulators to demonstrate how they positively contribute to the planet and its people. However, with varying definitions of what is considered ‘green’, universal regulations and labelling systems such as the Sustainable Finance Disclosure Regulation (SFDR) have become more important.

There is a growing concern that consumers may be misled as firms rush to promote green products in order to strengthen their perception in the market, without robust governance and understanding over the product lifecycle. Ensuring that financial products meet and continue to meet advertised Environmental, Social and Governance (ESG) criteria will be a key focus area for regulators going forward, with renewed emphasis on positive consumer outcomes.

What’s new?

Regulators are focussing more and more on the compliance of ‘green’ and ‘sustainability-related’ financial products, using green taxonomies and green labels, to ensure customers are able to understand the sustainability of products they may buy.

What should internal audit be doing?

Why is it important?

Enterprise recovery refers to an organisation’s ability to successfully prepare for, respond to, and recover from a catastrophic cyber event. Any financial services organisation could suffer significant enterprise-wide impacts because of such an event. With digitisation continuing to drive technology into the core of all business processes, the unavailability of critical technologies can prevent delivery of critical business services, severely impacting key areas or the entirety of the organisation. To keep pace, most financial institutions are strengthening their security controls and looking for ways to uplift their cyber maturity.

What’s new?

We have continued to see an increase in high-profile major cyber incidents across 2023, which, when coupled with the following cyber trends, creates an increased risk of an enterprise-wide event.

• Digital Operational Resilience Act (DORA): The EU’s DORA aims to strengthen the financial services sector’s resilience to technology related incidents. With the implementation period concluding in 2024, relevant financial services organisations will need to comply with the new requirements around Information and Communications Technology (ICT) risk management and ICT-related incident reporting.
• Geopolitical tensions: Heightened geopolitical tensions due to the war in Ukraine are intensifying the risks and impact of cyber warfare between nation states. The banking industry is a key example of a critical infrastructure sector that is frequently targeted by adversaries in such attacks.
• Advanced tactics: Ransomware groups continue to advance their data exfiltration tools and techniques to carry out extortion. These tools help ransomware groups more efficiently steal data from target organisations before encryption. The threat of publishing this stolen data is then used to extort victims.
• Remote working: Initial Access Brokers (IABs) are cyber threat actors (CTAs) that sell access to corporate networks to other CTAs as a service. With the continued increase in remote working, IABs are now increasingly targeting remote accesses for onward sales. The insurance sector is perceived to be of particularly high value, given the sensitivity of information which is attractive to a variety of threat actors.
• Vulnerable exploits: Cybercriminal groups are likely to exploit operating system vulnerabilities to bypass secure processes. This allows cybercriminal groups to maintain persistence in the network and steal credentials. The financial services sector is highly targeted because of its obvious access to accounts and funds.
• Supply chain: As organisations increasingly shift operations and applications to the cloud, attackers continue to exploit weaknesses in third-parties, supply-chain, and cloud hosting solutions to gain access to networks.
• Phishing attacks: Phishing-as-a-Service (PaaS) platforms capable of bypassing Multi-Factor Authentication (MFA) are being increasingly used in attacks. These platforms help threat actors gain initial access to target organisations with strict MFA policies in place without needing to develop sophisticated capabilities themselves.

What should internal audit be doing?

Internal audit functions continue to play a key role in ensuring their organisations have a robust approach to cyber risk. We have set out below the topics internal audit may wish to consider when scoping an audit in this area. Functions will also want to consider whether they have access to the necessary skills to perform such assurance.

Why is it important?

The post-pandemic era has seen a rebound in the investment of digital transformation and strategic change across all financial services industry sectors. Management at organisations of all shapes and sizes see new digital services as key in attracting new customers and in engaging more meaningfully with existing ones. By making investments into new digital services, management intend to deliver long term value and generate additional revenue opportunities.

Organisations, therefore, see the creation of a common, strategically linked language and methodology for digital transformation as a commercial imperative. For many organisations to deliver swiftly on change, the approach needs to be internally led with minimal external dependencies because of continued competition for talent and the evolving skills landscape. This in-house approach creates new areas of risk and opportunity to streamline governance and control processes. Internal audit should engage with the business early in the lifecycle and, in turn, manage risks proactively.

What’s new?

• The emergence of new digital technologies creates an opportunity for organisations to prepare and integrate them with their current environment, developing value propositions and use cases for existing and new customers.
• Agile methodology and tools have been gaining popularity, and we’re seeing more and more organisations adopting these in their operations and audit plans. These tools aim to improve collaboration across the organisation. The use of Agile, combined with continuous monitoring, are making programme delivery quicker and more efficient.
• Data analytics is one of the domains gaining popularity, driven by the need to maintain transparency and visibility, and to better manage programme inter-dependencies. Analytics is also being used to support better decision-making and it’s use cases are only growing by the day.
• In addition to change programmes that aim to reduce operational costs, we’re seeing a greater and sustained focus on service and product strategy, design, digital consumer engagement and innovation. These are ultimately aimed at attracting new customers and providing better services to the existing ones through continuous support throughout the customers’ digital service lifecycle.

What should internal audit be doing?

Why is it important?

With the anticipated integration of Generative Artificial Intelligence (GenAI) into business functions, artifical intelligence (AI), and GenAI risk management will continue to be a hot topic for internal audit teams throughout 2023, into 2024 and onward. GenAI is a subset of AI in which machines create new content in the form of text, code, voice, images, videos, or processes. It has been the Large Language Model (LLM) powering an easily accessible chat interface that enabled GenAI to have its breakthrough moment and surprise even specialists in the field.

There are performance and operational risks that enterprises should keep in mind as they pursue the use Gen AI models – with a summary of pertinent risks in the context of LLMs summarised as:

• Ethical use and unintended consequences: Is the GenAI being used in a manner consistent with the purpose of the overall exercise?
• Privacy and intellectual property infringement: GenAI applications leverage global data, which raises legal questions related to privacy, copyrights, trademarks, or other intellectual property rights.
• Uncertainty: How sure are you that this is the right answer?
• Explainability: Where did you get that information?
• Bias: Are we learning from the “wrong” or undesirable source?
• Environmental impact: Is this worth the environmental costs?
• Adversarial behaviour: Inputs that are specifically designed to fool a GenAI model or attempt to introduce malicious data into the training dataset.

To mitigate and minimise these risks, organisations are actively investing in developing controls to innovate with confidence. Control considerations include regulatory and principle-based guidance to ensure responsible development and use – such as considerations for embedding controls and mitigations through the GenAI development lifecycle. Reference considerations include AI specific regulatory developments, other principle-based approaches such as Deloitte’s Technology Trust Ethics (TTE) Framework or industry risk frameworks.

What’s new?

With the recent release of GenAI systems such as ChatGPT in November 2022, Bard by Google in March 2023, and Amazon’s release of its open source LLM called Falcon in June 2023, the interest around GenAI has increased, with both organisations and individuals exploring how they can utilise the tools. Further, there have been changes this year to the AI regulatory landscape, with guidance being published to aid organisations in navigating the use of all forms of AI, including GenAI.

EU AI act (latest development from June 2023) – The AI Act uses a risk-based approach and classifies AI systems as either prohibited, high-risk, or low risk based on their potential for harms to society and individuals’ health, safety or fundamental rights.

ISO AI risk management framework (published in February 2023) – ISO published this document to provide guidance for organisations that are developing and deploying AI products but also to support with the risk management of these products.

In conjunction with the publication of the regulations and guidance above, the pace of AI development and deployment for the EU may become rapid.

NIST framework (published in January 2023) - The National Institute of Standards and Technology (NIST) has collaborated with organisations from both public and private sectors to develop the NIST AI risk management framework. The guidance is voluntary and aims to help organisations understand the considerations that should be made during the design, development, use, and evaluation of AI systems.

What should internal audit be doing?

As AI technology advances, internal audit teams must stay abreast of the developments and ensure they have the required skills and capabilities to provide the necessary insight to senior leadership teams.

Why is it important?

Investment in strategic change rebounded rapidly in 2022 and 2023 after the impact of COVID-19.

Many organisations are now investing in long-term growth, digital strategies and attracting new business again rather than reacting to short term operational challenges.

The prevailing industry response indicates that now is the right time to invest in technology, risk reduction, and digital solutions to enable future services, increase efficiency and attract the workforce of the future.

The next logical step for decision-makers considering how to invest in change and transformation is to assess how they deliver transformation and change.

The blockers are not always financial, as businesses often have financial resources available to invest in transformational change. What we see is programmes failing to deliver on their stated intentions due to inadequate planning, communication, and decision-making processes.

What’s new?

From working across the financial services landscape, we have identified trends that are driving change and transformation that we believe should be on internal audit’s radar.

Talent and skills

• Arguably, the biggest challenge facing all firms is competition for talent – specifically attracting and retaining the right skills and expertise to deliver business priorities and simultaneously drive change.
• The intensity of competition for talent has been amplified by the fact that companies do not own all the specialist human capital they need. Companies continue relying on the market and outsourced solutions, rather than investing in long-term skills and capabilities in-house.
• The demand for new skills in digital technology and agile change across the industry places a high price on those with ‘ready-made’ skills and experience who can adopt senior roles without the need for further development and training.

Evolving operating environment

• As businesses continue to operate in this highly uncertain political and economic environment there is still an appetite to invest in scalability, resilience and more flexibility.
• The need to get solutions to the market quickly and ahead of the competition is accelerating, to demonstrate value to stakeholders and shareholders as early as possible.
• Factors consuming management’s attention include competition for the right talent, an excess of prioritisation options, and the constant “change in change.”
• On top of all of these factors, change leaders are responding to internal prioritisation processes, which impacts their direct control over internal resources, supply chains and their own development journeys.

Digital transformation

• Technology advances are creating greater choice in solutions and an increased desire for automation. Most organisations are choosing to improve internal processes as well as review the way they interact with customers and suppliers. This holistic adoption of digital solutions adds complexity but brings an opportunity to pool capabilities.
• Supply chain and resource constraints create an operational imperative for change. We are seeing organisations pivot away from offshore outsourcing arrangements, instead seeking to leverage reduced cost to digital solutions to improve customer experience and really drive value from automation where possible.
• Cloud adoption is still the preferred channel for an organisations’ technology strategy. Some regulatory barriers (e.g. privacy concerns) have been overcome to enable greater online interactions, however consent and use of data is still a major challenge.
• These drivers have pushed businesses to offer digital first products in their portfolio and to digitise internal operations ahead of any organisational reform, which impacts decision making on hiring plans and development.

Regulation and market activity

• Operational and business resilience has been at the forefront of business leaders' and regulators' minds due to extending supply chains, resource constraints, and uncertainty across global markets.
• Given the short timelines for executing resilience programmes and the complexity of transformation, organisations need to act quickly to mobilise change teams for interim changes over the next year, forcing the use of agile methods.
• Market uncertainties continue to drive transactional activity to consolidate or ring fence operations, while firms who have recently done deals often take years to consolidate their acquisitions, impacting forecasts for change and opportunities to plan ahead.

What should internal audit be doing?

Auditing change delivery capability and change activities is not new, and such reviews are common across most audit plans. We would encourage teams to overlay any traditional approach to project auditing by taking a strategic view across the change landscape and business demand, including the investment case and overall strategic intent of the change. The success or failure of any one project can have a significant impact on the organisation's reputation and stakeholder, however by looking at the whole picture, internal audit can determine if risk lies in delivery, or in the direction of travel.

Why is it important?

Internal audit functions are frequently constrained by the number of auditors at their disposal, who are still using predominately manual and time-consuming ways of working. Whilst many leaders have recognised the need for digital fluency, resulting in analytics and visualisation training becoming a staple on the learning and development menu, very few have seen it as an opportunity to rethink the status quo and truly innovate.

Through the use of technology, internal audit has an opportunity to reimagine their ways of working, not just to gain efficiencies but to increase agility and enhance the quality of issues identified. For example, are cyclical coverage strategies, audits that provide a ‘point in time’ assessment, or the use of limited non-statistical sampling methods sufficient in today’s world? Is it right that teams frequently spend more time on discovering issues than understanding root cause and helping management think through solutions? Should it really take weeks and sometimes months to issue and finalise reports? Are functions leveraging their collective knowledge, or are they still reliant on retained knowledge within key individuals?

Digitalisation of the internal audit function offers both hope and new possibilities.

What's new?

There have been significant improvements in the quality and functionality of audit management systems, many of which now have high levels of integration and Application Programming Interface (API) capabilities to connect with other applications. This allows internal audit functions to create customised technology environments within their organisational context, and tailored visualisation layers. The software has also evolved to suit functions of a broader range of sizes, meaning it is no longer the reserve of only the largest functions.

Organisations themselves are also providing more opportunities for internal audit through greater investment in data and technology, and by taking a more strategic approach to information management. As the quality, reliability and availability of data in organisations improves, so does the opportunity for internal audit to leverage this through their assurance.

Over recent years automation technologies have become more accessible through low and no-code solutions, and over the past year, the potential for artificial intelligence (AI) has been observed through the release of large language models and other generative AI tools into the mainstream population. For example, some functions are using AI and machine learning to mine data in audit reports to identify themes and commonly reported issues across thousands of reports; others have applied a similar approach to risk assessment and used AI to highlight common areas of risk using minutes from stakeholder meetings. Other examples include automated audit committee reporting, the use of AI to generate the first draft of an audit report, automated working papers, predictive text for descriptions of risk and controls and QA chatbots. The opportunities are vast.

Whilst generative AI technologies are still in their proof-of-concept phase for a small number of functions, their potential to increase the productivity, quality, and impact of internal audit is clear.

Whether this is driven by growing stakeholder demand, cost reduction, productivity, or to help attract top talent (by enabling people to focus on more purpose driven and meaningful work), functions that do not engage with the digitalisation agenda now will quickly find themselves left behind. They will be lacking in agility to; respond to emerging risks; redirect resources; delivery efficiency; and in improve the quality of their insights.

What should internal audit be doing?

Be clear on your purpose - Digitalisation of internal audit is not the goal, but a means to help the function achieve its purpose through more intelligent ways of working that yield higher impact and value. By having clarity on the function’s purpose and vision, internal audit leaders can better identify, define, and prioritise their investment in digitalisation.

Make a start - Perhaps you have limited data sources and only a handful of tools. Consider what you can do with what you have and build from there. We’ve found that taking the first step helps functions gain momentum and start building a culture of innovation.

Set a digital strategy – Once the function’s digitalisation priorities have been set around deliberate outcomes, be clear on your roadmap to achieve the strategy and how you will measure progress.

Collaborate – Whilst many functions now have capable data analytics teams, some with data scientists, internal audit teams don’t typically have the full breadth of technology skills and capabilities required to digitalise all aspects of the lifecycle within their teams. In our experience, those functions who work closely with technology teams have been able to accelerate their digital strategies.

Create an innovation culture to drive digital – Taking a leaf from agile development approaches can benefit functions in a digital environment which is often dynamic and quick to change. Creating an innovation culture where leaders encourage teams to challenge the status quo and explore new ways of working, is key to identifying opportunities and addressing any issues that emerge from digitalisation.

Get tech savvy – Internal audit functions do not need to have large teams of technologists and data scientists who understand the inner workings of the latest generative artificial intelligence or be experts in technology architecture. However, having digital fluency and a basic understanding of technologies can help both leaders and their teams consider the art of the possible, spot potential use cases and translate their requirements to specialist teams who can help functions digitalise.

Why is it important?

The application of ‘Agile’ in internal audit has come about from a recognition that it can evolve and upgrade the profession, and deliver better insights, more efficiently and with greater employee engagement. In doing so internal audit can have a greater impact and be more proactive in responding to change. Agile in internal audit is centred around intentional engagement with audit stakeholders, which in turn, strengthens relationships.

Looking ahead, the breadth of demand on internal audit and the pace and scale of innovation in the profession, means there is a need to consider leading with agility to enable functions to be purpose driven, leverage automation, and embrace digital technologies.

What do we mean by leading with agility? It’s about getting deeper into the agile mindset, culture, and behaviours and applying these across audit delivery, as well as the operations of the entire internal audit function. This will enable learning, prioritisation, and the ability to pivot in increasingly complex and interrelated risk environments.

While some organisations have considered Agile and may have developed a framework, rarely do we see this fully implemented in terms of the shift in mindset, culture and behaviour and as such the benefits of agile are not yet being realised.

Embedding agile is also dependent on having the right support network, such as experienced scrum masters, agile champions, an agile centre of excellence (COE), etc. Without this it’s very difficult for an organisation to progress from “Doing” agile, to inhabiting the agile mindset, culture, and the behaviours associated with “Being” agile.

There is no one-size-fits-all approach for Agile, and here we provide the opportunity for you to reflect on your existing agile practices and identify ways to take these to the next level.

What’s new?

With regards to agile in internal audit, it is not so much about what is new or what has changed but how it is evolving. The profession has made a great start and achieved marked progress, but there are some common observations which can contribute to functions progressing to the next level in their agile journey – and this will be by leading with agility.

Go back to your why

Functions experience challenges when they are not clear about why they are applying agile and ignore the notion of aligning to its organisation’s purpose, vision, and strategy. This prevents them from developing a purpose driven approach, which in turn results in having the application of agile frameworks as the end goal, which will not always realise all the potential benefits.

Where functions are clear on the outcomes that they want to realise from embedding agile, they can appropriately tailor the agile framework in a way that works for their specific function. Tailoring the framework should be a collaborative exercise based on the lived experiences on those applying it together with your agile support network.

Evolving agile in internal audit

There is a common misconception that the implementation of agile is complete once the “agile framework” has been rolled out. Agile is intentionally designed to be incomplete and to be further tailored to your function and stakeholder environment as it grows and matures. The recognition of this enables functions to continuously customise their agile ways of working though assessing and adapting against specific measurable outcomes on an ongoing basis.

In addition, functions have taken the approach of classifying support structures (such as experienced scrum masters, agile champions, an agile centre of excellence (COE), etc.) as activities of transformation projects. Where support networks are dissolved for example post project completion, it negates their importance in maintaining and sustaining a new business as usual (BAU), resulting in functions having stalled or regressed in their ways of working

Leading with agility everywhere

Functions who have applied agile ways of working may have initially started with audit delivery, but few functions have progressed beyond this point. Agile is rarely applied across the whole audit function (such as portfolio activities, annual planning process, quality assurance, learning and development, etc.). There has also been a lack of focus on leadership training and live coaching, to support leaders to create the environment for the new BAU to emerge or be sustained.

What should internal audit be doing?

Why is it important?

Expanding stakeholder demands, and the increasing breadth and scope of risks continue to challenge internal audit functions. Leading functions have developed a clear vision and strategy, setting out how they will respond to these demands to maintain relevance and maximise their impact. The real leaders amongst these functions are those that are purpose-driven.

What’s new?

The revised draft Institute of Internal Auditors (IIA) Global Standards call for internal audit functions to develop a vision and strategy that support the organisation’s strategic objectives and meet the expectations of key stakeholders. A purpose statement that articulates internal audit’s value in supporting the organisation’s success is also required.

Purpose has become increasingly important for organisations and their stakeholders. Purpose-driven organisations have reaped benefits over the last 12 months in the form of strengthened brand recognition, faster growth and return on equity, increased employee engagement and the ability to attract top talent.

There is an opportunity to align internal audit’s role and remit with the organisation’s purpose, and a need to articulate the value the function creates for the organisation. This is a new orientation for many functions.

The need for functions to deliver more with less, whilst continuing to innovate and stretch themselves, continues to present a challenge. Functions need to be selective over their investments and define return on investment criteria to help assess whether existing and proposed strategic initiatives will drive achievement of internal audit’s purpose and vision. Those that don’t should not be taken forwards.

What should internal audit be doing?

Why is it important?

In March 2023, the Institute of Internal Auditors launched a public consultation on the proposed International Professional Practices Framework (IPPF), specifically seeking feedback on the revised Global Internal Audit Standards (“the Standards”) that will apply to all internal audit professionals and functions across all industries and sectors. Additional ‘Guidance’ to support the Standards and ‘Topical Requirements’ (i.e., practice aides for auditing specific risk domains) have been outlined and are planned to be released at a later date. The new Standards are expected to be finalised in Q1 2024 with a 12 month grace period for functions to demonstrate conformance.

The proposed structure of the new Standards is organised around five domains, comprising 15 Principles and 56 Standards. Each Standard includes requirements, considerations, and suggested evidence to demonstrate conformance.

The proposal represents an update and consolidation of existing Standards and supplementary guidance, rather than a drastic overhaul. However, as drafted there is a trend to a more rules-based approach indicated by a significant increase in the number of mandatory requirements (moving from 126 to 304 ‘musts’) for Chief Audit Executives (CAE), their functions and stakeholders.

Internal audit functions will need to incorporate the new requirements as well as approaches to capture evidence to demonstrate conformance within existing quality assurance and improvement programmes.

Whilst the IPPF is yet to be finalised there are a number of ‘no regret’ decisions and activities that functions should consider and where necessary factor into team delivery plans across the course of 2024 to help ensure they are compliant with the new Standards in good time.

What’s new?

Many new requirements aim to codify what is already recognized as best practices within the industry. Notwithstanding this, demonstrating conformance to the new requirements has the potential to be demanding for all functions and may be a stretch for many, particularly smaller functions and those who are already heavily constrained by existing resourcing levels. Some of the key changes are outlined below:

• Domain 1: Purpose, introduces the purpose statement for internal audit for the first time, getting functions to link their purpose to that of wider organisation’s purpose.
• Domain 2: Ethics and professionalism, provides greater clarity on the evidence of conformance to the Code of Ethics and due professional care. This includes the requirement for all internal auditors to undertake a minimum of 20 hours continued professional development per year, including two hours focused on ethics; as well as the need for CAEs to produce a methodology for assessing ethical issues.
• Domain 3: Governing the internal audit function, places greater emphasis and requirements on Board oversight, responsibilities and involvement and new requirements around external quality assessments (EQA). Specifically:
  
  
  • Standard 8.1 Board interaction – prescribes several responsibilities for the Board including the frequency of communications with the CAE and having defined criteria for escalating issues.
  • Standard 8.3 Quality – includes a requirement for the Board to approve internal audit performance objectives annually that CAEs are required to develop to evaluate functionals performance (Standard 12.2).
  • Standard 8.4 EQA - the option to perform a self-assessment with independent validation in lieu of a full EQA is limited to every other EQA cycle (once every 10 years); and a requirement for EQA assessment team qualifications.
• Domain 4: Managing the internal audit Function introduces several new requirements for CAEs including requirements for:
  
  
  • Standard 9.2 internal audit strategy – Functions to develop a strategy
  • Standard 9.5 internal audit plan – The rationale to be included in internal audit plans when a high-risk area is not going to be subject to an assurance review
  • Standards 11.1 Building relationships and communicating with Stakeholders - The CAE to develop an approach for the function to build relationships and trust with key stakeholders
  • Standard 11.3 Communicating results - Functions to communicate ‘themes’ to the Board
• Domain 5: Performing internal audit services introduces the following new requirements:
  
  
  • Standard 13.4 Evaluation criteria - introduces the concept of having measurable ‘evaluation criteria’ for every audit.
  • Standard 14.3 Evaluation of findings - requires internal auditors to identify a root cause and rate / rank findings.
  • Standard 14.4 Recommendations and action plans - mandates functions to make recommendations.
  • Standard 14.5 Developing engagement conclusions - requires functions to develop an overall engagement conclusion which aligns to the organisations risk appetite and tolerance for all audit work.

What should internal audit be doing?

Why is it important?

Internal audit functions need to be thinking now about what skills they might need for the future to meet ever growing demands from stakeholders. In an increasingly uncertain risk landscape, internal audit teams are now expected to bring more business-oriented, enterprise-wide skills and perspectives to managing organisational risks, whilst at the same time being up to date with the latest regulation and industry practice. These skills of the future need to be considered whilst operating in an environment of constant change where resourcing and retention is becoming increasingly challenging. To support the organisation, internal audit needs to evolve and upskill at pace.

What’s new?

Key changes since 2022/23 include:

1. Focus on Purpose and Agility
The focus of purpose is not new, but the emphasis has become increasingly important with the release of the draft International Professional Practices Framework (IPPF) for consultation by the Institute of Internal Auditors (IIA). Within this draft purpose features as the focus of an entire domain. Increasing the emphasis on purpose is shifting the mindset of internal audit who now need to be more agile in their approach and mindset to auditing, adapting to the continuously changing landscape that their organisations operate in.

2. New proposed IPPF principles drive a focus on skills
The draft IPPF also raises the bar by requiring functions to perform a skills-needs-analysis to assess adequacy of their resources to deliver their plan. The draft standards tell us that there will be more focus on internal auditors demonstrating the knowledge, skills, and abilities to fulfil their roles and responsibilities successfully to drive quality in internal audit products.

3. Accelerating management of the more informed stakeholder
Increasingly informed stakeholders, with a deeper understanding of internal audit are seeking more value and quality from functions. Auditees too are more informed, invested and accountable. Strong communication and presentation skills and the ability to manage and negotiate with stakeholders are now not just skills for internal audit management, but the whole team. Internal audit also needs to be able to respond to Auditees' expectations for feedback on issues quickly and with deeper insights and practical opportunities for improvement.

4. Digitalisation
The internal audit function of the future will need to equip themselves digitally throughout the audit life cycle to demonstrate efficiencies, expand coverage, improve quality and share knowledge. They will need to make use of digital technologies, channels and ways of working to transform existing operational processes, and increase the value offered to stakeholders.

When it comes to the skills required by individual internal auditors, a basic understanding of IT general controls is now a pre-requisite, alongside data fluency.

5. Competitive labour market
Global events over the last three years have shifted the priorities of individuals and created challenges for recruiting and retaining the right talent for internal audit functions:

• Experienced and qualified internal auditors are more selective in their life and career choices, making it increasingly difficult to attract the best talent to role. Organisations increasingly need to demonstrate more than financial benefits, sustainable values and clear career pathways.
• There is a greater focus on functions to be able to develop skills and capabilities in-house, with more functions drawing on/realising specialist skills from guest auditors from the business, or creating role swaps and rotation programs which drive different learning and development needs of a function.
• Many functions are finding the resources particularly scarce for certain growing areas of organisational focus such as:
  
  
  • Environmental, Social and Governance (ESG);
  • Diversity, Equity and Inclusion (DEI) issues, and reputational risks;
  • Robotic Process Automation (RPA) and Artificial Intelligence (AI) applications; and
  • Health and Safety, Security and Regulatory changes.

What should internal audit be doing?