Why is it important?

Anti-Money Laundering (AML):

Money laundering remains a central concern for the Financial Conduct Authority (FCA) and is a key item on its agenda of actions for the forthcoming year. The FCA’s 2023-24 Business Plan (Business Plan 2023/24 | FCA) emphasises this ongoing commitment, introduces a strengthening of their direct supervision and ensures that supervision by other professional bodies remains effective. Additionally, the publication of a ‘Dear CEO’ letter to payment services firms highlights the FCA’s ongoing efforts around thematic reviews aimed at highlighting sector-specific AML risks and identified weaknesses.

As part of this continued focus on AML, key updates were made to the UK Money Laundering Regulations between 2022-23. 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 the UK and other 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, compounded by the introduction of a ‘strict liability civil offence’ for sanctions breaches under the Economic Crime Act 2022. 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. In particular, data-led approaches are imparting a shift to the way the FCA’s supervisory work is performed.

What’s new?

Anti-Money Laundering (AML):

The Money Laundering and Terrorist Financing (Amendment) Regulations 2022 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.

Additionally, the FCA issued two important fines in January 2023 in relation to AML failings. Both highlighted failures concerning risk assessment and the due diligence of higher risk customers, as well as failure to implement timely and effective enhancements to AML risk management frameworks.

Sanctions:

The FCA has introduced significant enhancements to its ability to detect weaknesses in firms’ sanctions risk management frameworks. This includes a new analytics-based tool rolled out in 2022, that can test firms screening systems more efficiently. The tool uses FCA-generated test data of circa 100,000 entities, which firms will be required to run through their systems. It is anticipated that this approach to sanctions compliance testing will be effective in identifying how well firms’ sanctions screening systems are operating.

This approach has been further strengthened through active collaboration with other agencies to support intelligence gathering and enforcement efforts against circumvention attempts. The other agencies the FCA is collaborating with are: the Office of Financial Sanctions Implementation (OFSI), the National Economic Crime Centre (NECC) and the Office for Professional Body Anti-Money Laundering Supervision (OPBAS). As with AML compliance, the FCA maintains 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?

Authors: Katie Jackson, Angela Molloy 

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 government legislation (e.g., UK corporate reforms and the failure to prevent fraud offence) 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?

As part of the (former) Department for Business, Energy & Industrial Strategy’s (BEIS) corporate reforms, 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”.

In addition to the corporate reforms, the UK government has set out the new ‘Failure to Prevent Fraud’ legislation that will make it a criminal offence for large organisations to demonstrate sufficient prevention and detection activities (e.g., fraud risk assessments, assurance, monitoring, training, etc.) following a material fraud. Similar to the scope and application of the UK Bribery Act, the new legislation will make it easier to prosecute organisations where a fraud is committed by an employee or ‘agent’, for the organisation’s benefit. With the potential for unlimited fines, the expectation is that this legislative change will drive a major shift in corporate culture to help reduce fraud.

What should internal audit be doing?

Authors: James Meadowcroft, Andreas Kozis

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 in 2023 and beyond. 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 in 2022/23 on third-party risk that have broadened requirements for most firms. Since 31 March 2022, Prudential Regulation Authority (PRA) regulated firms are required to comply with the PRA’s Supervisory Statement (SS) 2/21, ‘Outsourcing and third-party risk management’ which makes it more explicit that firms are expected to assess the risks and materiality of all third-party arrangements, including those that do not fall within the definition of ‘outsourcing’. It clearly articulates that 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.

In July 2022, HM Treasury introduced a discussion paper articulating a new regulatory oversight regime for supervisory authorities to set resilience standards, a testing approach, and enforcement powers for critical third-parties, which are non-regulated firms that pose a systemic concentration risk to the financial services sector.

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).

For Financial Market Infrastructures (FMIs), supervisory statements were issued on the topic of outsourcing and third-party risk management to provide guidance as to how the Bank of England expects FMIs to meet their regulatory obligations. The Code of Practice sets out more specific requirements and expectations compared to the Principles for Financial Market Infrastructures (PFMI). There are separate supervisory statements for Recognised Payment System Operators (PRSO) and Specified Service Providers (SSPs), Central Counterparties (CCPs) and Central Securities Depositories (CSDs).

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:

Authors: Sonia Verbeeck

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.
• There are no specific UK regulatory requirements on operational resilience and third-party risk management for digital assets, but broader regulatory requirements do apply. The Prudential Regulation Authority (PRA) has made it explicit that banks should fully understand the impact that offering digital assets products could have on their operational resilience.
• 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.

Source: Banks active in the UK: 2023 priorities (bankofengland.co.uk)

What should internal audit be doing?

Authors: Alex Dawson, Ben Thornhill, Maria Morales

Why is it important?

A “booking model” describes the product mix, client base, risk management and operating practices across a bank’s legal entity structure. Trades are “booked” into particular legal entities which then manage the risk. A booking model is an overall framework which describes what should be done (with a rationale), where it should be done (booked in which legal entity), how it should be done (to manage risk), and who should do it.

Remote booking is a type of booking model in which the trading desk within one legal entity is taking positions or managing risk in other legal entities under different jurisdictions. This is more prevalent in global and international banks undertaking trading business in different locations: they manage risk centrally by transferring individual legal entity risks to other jurisdictions and derive several benefits relating to capital efficiency, staffing and operations.

Regulators are conducting thematic reviews of banks’ booking arrangements. Banks often find challenges in meeting the following expectations:

• providing regulators/internal stakeholders with transparency over booking arrangements;
• establishing effective governance and oversight for cross-border activities;
• ensuring there is management information and appropriate escalation across the suite of financial and non-financial risks; and
• calibrating preventative and detective controls over permissible booking arrangements.

What’s new?

• Booking models and remote bookings have been on supervisors’ agendas for a long time. Regulators have published their supervisory expectations around booking models in the EU, US and UK in 2018, 2019 and 2021 respectively. However, recent scrutiny and the complexities of Brexit have forced some banks to improve their approaches around booking arrangements to focus on simplicity and transparency.
• The Prudential Regulatory Authority (PRA) in Supervisory Statement (SS) 5/21 clearly stated that for large-sized global investment banks which have global risk management hubs, such as in the UK, it is essential to provide visibility to regulators of remote booking risks in the relevant global business and demonstrate how these affect the risk profile of the UK operations.
• Regulators expect to understand the risk profile of an entity in the context of the global business lines which that entity is a part of.
• In PRA SS5/21, the UK regulator expects international banks operating in the UK as a ‘Subsidiary’ or ‘Branch’ to clearly document their UK booking arrangements, demonstrating sufficient coverage and detail so that the role of the international bank within the group’s booking arrangement is clear. The regulator also expects the policies and procedures to be subject to an internal audit assessment (PRA SS5/21, chapter 4 para 4.24 Box 2: The PRA’s expectations for booking arrangements).

What should internal audit be doing?

Authors: Vidushi Thirani 

Why is it important?

In the UK, the Prudential Regulation Authority (PRA) published its consultation (CP) on the UK implementation of Basel 3.1 in late 2022. Initially anticipated to be implemented by 1 January 2025, the PRA recently delayed the implementation of Basel 3.1 by six months to 1 July 2025, to align with proposals in the US. The PRA has also announced that it will publish its near-final rules in two tranches, in Q4 2023 and Q2 2024.

In the EU, the European Parliament and the Council of the European Union are nearing the finishing line in finalising CRD6/CRR3, the EU’s banking package that implements the revised Basel 3 framework. In early March 2023, both institutions began trialogue negotiations to produce final versions of the new directive and regulation.

What’s new?

As expected, the UK PRA’s proposed approach adheres more closely to the Basel Committee on Banking Supervision (BCBS) final framework document than the equivalent EU proposals. This will result in considerable divergence between the UK and EU rulebooks. Key elements of the PRA’s approach include:

• disapplying some supporting factors that are currently in the capital requirements regulation;
• requiring the use of a non-granular risk weighting approach for dependent (buy to let) mortgages, which will result in stepped risk weights that change significantly when crossing boundaries in loan to valuation ratios for Standardised approach risk weight calculations;
• withdrawing the ability to use internal rating models for sovereigns and income producing real estate exposures and imposing new floors and caps on the parameters used in calculating capital using internal models;
• easing the qualifying criteria for the “simpler regime” for smaller firms and allowing a transitional regime that will ensure qualifying firms that opt into it do not have to implement Basel 3.1 before the simpler regime is finalised;
• setting a more prescriptive trading book/banking book boundary;
• applying the output floor at the highest level of consolidation for UK-headquartered groups, although ring-fenced banks will have to apply the output floor on a sub-consolidated basis;
• setting the internal loss multiplier for the operational risk regime to one for all UK firms;
• disapplying the Credit Valuation Adjustment (CVA) exemptions for sovereigns, non-financial corporates and pension fund exposures, although the value of “alpha” for these exposures is set to one; and
• re-casting existing EUR and USD thresholds into GBP.

Although the PRA has sought input from numerous areas throughout the CP it is still finalising its approach. The intended 1 July 2025 implementation date means that firms should use the PRA’s CP as the basis for the design and implementation of their Basel programmes in order for them to be ready in time.

Within the EU, we expect negotiations to run until the latter part of 2023. Provided that the final package is adopted by the end of 2023, banks are likely to have roughly one year to implement the new rules ahead of an expected 1 January 2025 implementation deadline.

• The positions of the EU Council and the European Parliament both largely maintain the European Commission’s original “EU specific adjustments” approach of including several long transitional periods and other Basel framework deviations that cumulatively will have a substantial mitigating effect on the package’s overall capital impact.
• There are, nevertheless, many important differences between the two positions that will have to be addressed in the upcoming negotiations. The application of the Basel Standardised Output Floor (OF) remains a key open issue, as well as the design of several transitional periods including the one for exposures to unrated corporate entities. The treatment of specialised lending, exemptions to the large exposure regime, and the prudential treatment of exposures to cryptoassets will also receive attention. Agreements reached on these issues could have implications for the capital impact on certain business lines in banks when they are implemented.

Banks should make careful use of the rest of 2023 to enhance their risk-weighted asset (RWA) calculation and risk modelling capabilities. The final details of the regulations will have limited specific impact on the enhancements required to operational capabilities. This means that there is little reason for banks to delay the enhancement programme. Taking early action will put banks in a better position to be ready for a short implementation period.

What should internal audit be doing?

Authors: Rod Hardcastle

Why is it important?

As part of the Woolard review (in February 2021), the Financial Conduct Authority (FCA) highlighted a number of areas of concern in respect to potential customer detriment in the un-regulated interest free Buy Now Pay Later (BNPL) market. This specifically related to the FCA’s concerns in respect of; how these products are advertised and promoted, customer understanding of the product, lack of affordability and creditworthiness assessments being undertaken and the treatment of customers in financial difficulty. Further, in August 2022, the FCA issued a ‘Dear CEO’ letter to firms and merchants offering BNPL agreements confirming that despite these agreements being currently unregulated, firms are still required to take actions to ensure that their financial promotions meet applicable regulatory requirements.

In October 2022, and in response to the Woolard review, His Majesty’s Treasury (HMT) announced its intentions to bring BNPL products within the scope of the Consumer Credit Act (CCA) 1974 and regulation by the FCA. In doing so, HMT outlined expectations for the regulatory regime applicable to BNPL providers to cover requirements in a number of areas, including:

• Advertising and financial promotions of BNPL agreements being subject to the financial promotions regime;
• Pre-Contract credit Information requirements;
• Form and content of credit agreements;
• Improper execution and enforceability of credit agreements;
• Creditworthiness assessments;
• The treatment of customers in financial difficulty;
• Consumer Protection under Section 75 of the CCA 1974; and
• BNPL customers having the right to make complaints to the Financial Ombudsman Service (FOS).

What’s new?

HMT released the draft legislation for BNPL agreements on 14 February 2023, seeking industry views on the proposed draft legislation that will bring BNPL products into FCA regulation. The draft legislation reconfirms the applicable regulatory requirements that will fall within the scope of BNPL agreements, as outlined within the October 2022 consultation. HMT’s draft legislation also confirms the following additional expectations:

• BNPL agreements will fall into the scope of the Consumer Duty rules and requirements. This means that BNPL providers will need to demonstrate that they are delivering good outcomes for their customers on an ongoing basis and throughout the customer journey; and
• HMT is proposing the introduction of a Temporary Permissions Regime (TPR). Firms that are currently unauthorised and providing an un-regulated BNPL product, the TPR will allow these firms to continue to operate while they apply for FCA authorisation. These firms will need to register for the TPR within a set time period, provide the required information to the FCA and pay a non-refundable registration fee. Firms in the TPR will be deemed authorised under Part 4a of the Financial Services and Markets Act 2000 (FSMA) and will need to comply with relevant FCA rules, requirements and expectations. For firms that are already authorised for regulated lending but currently provide an unregulated BNPL product, these firms will not need to apply for authorisation, however, will need to transition their existing arrangements over this product offering to ensure compliance with the FCA’s regulatory requirements and expectations.

The HMT consultation period on the draft legislation closed on 11 April 2023. Once HMT has digested stakeholder feedback and published a consultation response, it estimates to publish final legislation at the end of 2023 towards early 2024. Following the publication of the final legislation and as outlined by the FCA in its 2023/24 Business Plan, the regulator intends to start consulting on its rules for the sector, including its plans for authorisation, supervision and enforcement.

In light of the above considerations and in preparation of BNPL agreements coming into the FCA perimeter, it is important for firms (both regulated and un-regulated) to consider their business model / proposition offering in this area. They should determine if an application for authorisation is required and undertake a detailed assessment of how the FCA’s existing Consumer Credit rules and regulatory requirements apply, together with the level of actions required to demonstrate regulatory compliance and the delivery of good customer outcomes in this area.

What should internal audit be doing?

Authors: Sarn Saundh, Priyesh Kotadia 

Why is it important?

Consumer habits continue to increase the use of digital payments. This has resulted in further innovation in the payments sector with new and existing businesses, as well as an influx of ‘big tech’, as consumer sector organisations move towards offering payments services. In addition to this, banks providing payment services continue to face challenges in adopting and complying with complex regulatory requirements. ISO20022 for example, which will update SWIFT messaging, transitioning to the New Payments Architecture (NPA), and continued compliance with Payment Services Directive 2 (PSD 2) requirements (such as Strong Customer Authentication (SCA)), consumer duty and operational resilience requirements.

There is increased regulatory focus on Payments Institutions (PIs), E-Money Institutions (EMIs) and Registered Account Information Service providers (RAISPs). In particular, the Financial Conduct Authority (FCA) has expressed concern around the adequacy of controls in place that support how firms manage the risk of harm to their customers and how they support the integrity of financial systems. The FCA has re-emphasised the need for existing firms, and those operating under the temporary permissions regime (TPR) whilst undergoing the FCA application process, to put in place appropriate governance arrangements. This includes an operational Three Lines of Defence model, and where issues are identified, the FCA has committed to act earlier in dealing with firms and redacting licenses or issuing sanctions where standards are not met.

What’s new?

Due to the increased activity in the sector, the continued risk of consumer harm and the risk of compromising the integrity of the financial system, several FCA communications have been issued to the sector detailing expectations for firms to strengthen their risk and control frameworks. Below we note some of the key publications by the FCA over the last year:

• Dear CEO letter on priorities for Payments firms (March 2023) - The growing numbers and types of non-bank payment firms, complexity of the payments transaction chain, and reliance on outsourcing have resulted in an increased regulatory focus on PIs, EMIs and RAISPs. The FCA’s Dear CEO letter raises three key outcomes, requiring firms to i) ensure consumer money is safe, ii) ensure firms do not compromise financial system integrity, and iii) deliver high quality and innovative products through a focus on implementing consumer duty requirements. The letter highlights a few focus areas specifically around: the need for ongoing adequacy of internal controls, leadership and governance arrangements for firms in a fast paced and innovative environment; how firms ensure safeguarding of customer funds; Prudential risk management practices; operational resilience considerations for business models; Anti-Money Laundering (AML) / Fraud considerations; wind-down planning; and the implementation of Consumer Duty. The focus on these areas demonstrates regulatory expectations to prevent consumer harm (in line with the FCA strategy released during April 2023), and the FCA expects firms to be able to demonstrate how they are managing and controlling these risks.
• Dear CEO letter on implementing Consumer Duty in Payments firms (February 2023; implementation date – July 2023) - The FCA has set out higher expectations for the standard of care that PIs, EMIs and RAISPs provide to their customers. The letter focuses on the application of the Duty across all products offered to retail customers along with considerations for firms having a material influence over customer outcomes (including firms selling products via distributors) and not just those with a direct customer relationship. The FCA is currently developing a strategy to embed the Consumer Duty in their supervision work and expects PIs, EMIs, and RAISPs of all sizes to be ready for FCA to include them in engagement.
• Discussion paper on impacts of Big Tech entry and expansion in financial services (October 2022) - The FCA published a discussion paper (DP 22/5) focussing on the potential impact on competition arising from the expansion of Big Tech firms in the payments, deposit taking, consumer credit and insurance sectors. The paper forms part of a broader set of policy initiatives relevant to digital markets that the FCA is developing with other financial services and cross-sector regulators. These include the proposed oversight regime for critical third parties and the FCA's joint work with the Digital Regulation Cooperation Forum on online and algorithmic harms. A feedback statement from FCA was issued in July 2023 with the actions including a timeline to review the regulatory supervisory approach for Big Tech firms.
• Other continuing key focus areas for Payments firms:

- Swift Customer Security Programme (CSP) – An annual independent assessment against the Customer Security Controls Framework (CSCF) triggered by a series of security breaches at banks via SWIFT messaging networks, continues to be a key focus area. The set of mandatory security controls required by firms have been expanded in 2023 to now also include customer environment protection.

- Strong customer authentication - The PSD 2 Regulatory Technical Standard (RTS) for SCA mandates that the implementation of the security measures be documented, periodically tested, evaluated, and audited by operationally independent auditors with expertise in IT security and payments. Unless there are other external assurance arrangements in place, the regulators expect that such reviews are conducted by internal audit functions.

- ISO 20022 migration – This is inherently complex, posing significant challenges for impacted firms. The impact on banks will be very significant across business, operations and technology, requiring careful and comprehensive consideration, including significant impact to bank technology stacks. It is expected that significant pressure will be placed on technical resources. With an overall migration timeline of 2025, firms should ensure a smooth transition to business as usual (BAU) process.

What should internal audit be doing?

Authors: Sarn Saundh, Nikhil Kulkarni, Disha Thakkar

Why is it important?

Models serve many important strategic purposes for financial services firms, in the UK 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?

The Prudential Regulation Authority (PRA) has published its policy statement (PS6/23) on model risk management (MRM). The policy and accompanying supervisory statement (SS1/23) come into force on 17 May 2024. Initially this policy statement relates specifically to the banking sector, but we would encourage all sectors using models to take note of the content and to align their frameworks accordingly, with a view to any future requirements being imposed by regulators.

The definition of a model and the high-level principles have not changed from the consultation paper (CP6/22). Changes to the detailed content of the principles generally reduce prescriptiveness and increase the proportionality of requirements, although there is one significant change: the policy will only initially apply to banks with an internal model approval for regulatory capital purposes. Once it has progressed its policy on simpler-regime firms, the PRA will clarify how the policy on MRM will apply to banks without internal model approvals, although it notes that all firms, regardless of size, are expected to manage the risks associated with models where they are used.

Implementing the changes required to comply with the supervisory statement will be a challenge for modelling teams and model governance processes that are already under considerable pressure. Firms that are able to identify common requirements that can be delivered across multiple modelling workstreams will be best placed to implement the MRM principles as well as the wide range of modelling work already under way.

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 IRB roadmap;
• reviewing and revising IFRS 9 models;
• incorporating climate into modelling approaches for risk management and stress testing;
• preparing for the implementation of Basel 3.1; and
• assessing the model risk implications of the Consumer Duty.

Banks will have to address a number of challenges in meeting their obligations around 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.

The PRA sees 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 PRA’s intent in putting the principles for MRM into the supervisory framework is to drive a change in culture around MRM.

More detail on this can be found in in the following article:

From Principle to Practice: Model Risk Management takes effect, Rod Hardcastle, David Strachan, Ian Wilson, Richard Tedder (deloitte.com)

What should internal audit be doing?

Authors: Rod Hardcastle 

Why is it important?

The UK Corporate Governance reform (the Code) represents the biggest shake-up of the UK’s corporate governance and audit framework in years and is evolving at a rapid pace. The government and the Financial Reporting Council (FRC) are continuously evaluating the opportunities to strengthen corporate governance through the introduction of enhanced rules and regulations around risk management and internal controls.

There are two key aspects to the reforms:

• Measures to be introduced through changes to the Corporate Governance Code applicable to Premium Listed Entities (PLE) and entities that voluntarily apply the UK Corporate Governance Code. These include the following proposed requirements:

   

  • Board declaration on the effectiveness of risk management and internal controls: a declaration of whether the board can reasonably conclude that the company’s risk management and internal control systems have been effective throughout the reporting period and up to the date of the annual report. It should include an explanation of the basis for the declaration, a description of any material weaknesses identified, and remedial actions taken.
  • Regulatory framework for Audit Committees: Audit, Reporting and Governance Authority (ARGA) will be established to replace the FRC and will be given the power to set minimum requirements on audit committees in relation to the appointment and oversight of auditors.
  • Audit market opening measures: managed shared audits will be introduced on a phased basis, exemptions regime will operate and powers will also be available for ARGA to operate a ‘market share cap’.
  • Malus and clawback: a focus on greater transparency about malus and clawback arrangements in the Code so remuneration can be withheld or recovered from directors for misconduct, misstatements, and other serious failings, including:

     

    • the minimum circumstances in which malus and clawback provisions could be used;
    • a description of the minimum period for malus and clawback and why the selected period is best suited to the organisation;
    • whether the provisions have been used in the last reporting period and, if provisions have been used, a clear explanation of the reason;
    • and the use of malus and clawback provisions in the last five years.

     

   

• New reporting measures to be implemented through legislation which would be applicable to Large Public Interest Entities (Large PIEs). These have been defined as UK Corporates with greater than 750 employees and greater than £750m turnover at the UK Company or Group level. These measures include the following new disclosure requirements:

   

  • Audit and Assurance Policy (AAP): a policy is to be developed covering key reporting data and information and explaining the nature of assurance to be obtained and the rationale for this determination.
  • Resilience statement: a statement to report on matters which could materially challenge resilience over the short, medium and long term.
  • Material fraud reporting: directors will have to disclose and explain activities taken to prevent and detect material fraud. Fraud is as per definition in the Fraud Act 2006, and it is considered “material” when it could reasonably be expected to influence shareholder investment decisions.
  • Distribution policy and distributable reserves: directors will be required to disclose distributable reserves and provide narrative explaining the board’s long-term approach to the amount and timing of returns to shareholders, and how this policy has been applied in the year. Additional information about distributable profits, distributions and purchase of own shares should also be disclosed.

   

The proposed measures are indicated to come into force from 1st January 2025 for PLEs and a year after for other Large PIEs. Many of the changes require early dialogue with key stakeholders within the organisation. For each proposal, firms must decide whether to track in line with proposed timelines or accelerate to become early adopters. We are expecting additional guidance on some of the key aspects, however given the volume of upcoming change, there are some ‘no regrets’ activities that the organisations in-scope would benefit from starting now.

Internal audit has a role to play in providing assurance to the Board in respect of their organisation’s governance, risk and controls as well as programme assurance in respect of their firm’s compliance projects. In addition, internal audit functions can play an integral role in the programme steercos by providing real time challenge but also driving assurance related workstreams such as the AAP.

What’s new?

In July 2022, the FRC released its Position Paper on the UK Corporate Governance Code. This followed the Government’s response to the Department for Business, Energy and Industrial Strategy (BEIS) White Paper on strengthening the UK’s Corporate Governance, Corporate Reporting and Audit systems (UK Corporate Reform) published in March 2021.

In May 2023, the FRC launched a consultation paper on changes to the UK Corporate Governance Code in which it reconfirmed that the revised Corporate Governance Code will apply to accounting years commencing on or after 1st January 2025 to allow sufficient time for implementation.

In July 2023, the Department for Business and Trade (DBT) published the draft regulation on the new reporting measures to be implemented through secondary legislation following a debate in parliament.

The key next steps are summarised as follows:

• Draft bill to establish ARGA, change PIE definition and introduce new enforcement regime – King’s Speech Autumn 2023
• Measures come into force from 1st January 2025 for PLEs and a year after for other Large PIEs.

Whilst the proposed measures are not likely to come into effect until 2025 at the earliest, the emerging requirements are now becoming increasingly clear, and the impact on organisations is likely to be felt across the enterprise due to the pervasive nature of the requirements. It is therefore important that organisations begin to consider their responses and readiness plans as soon as possible.

What should internal audit be doing?

The UK Corporate Governance reforms present internal audit with an exciting opportunity to support their organisations to further develop and embed enhanced governance, effective risk management and internal controls. Whilst the new reforms will not be effective until 2025, much of the required readiness activity will need collaboration and alignment across the organisation and, as a result, will take time to co-ordinate and deliver. Internal audit should engage executive leadership on these factors as soon as possible.

Authors: Ololade Adesanya

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, both in the UK and 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.

UK Sustainability Disclosure Requirement (SDR):

• The Financial Conduct Authority (FCA) is finalising its consultation period on a set of regulations which will aim to provide comparable reporting requirements for UK asset managers as SFDR does for the EU.
• The FCA intends to publish a policy paper on its new Sustainability Disclosure Requirement (SDR) in Q3 2023, with an expectation that most of its rules come into force throughout 2024, and with entity-level disclosure requirements being rolled out from 2025 onwards.

Annual FCA diversity and inclusion on firms’ boards and executive management (PS22/3):
For the financial year starting on or after 1 April 2022 firms must seek to meet the new diversity targets and include a statement in their annual financial report stating whether they have satisfied the following:

• At least 40% of the individuals on its board of directors are women;
• At least one of the senior positions on the board of directors is held by a woman – the Chair, the Chief Executive, the Senior Independent Director, or the Chief Financial Officer; and
• At least one individual on the board of directors is from a minority ethnic background. In cases where a firm has not met all these targets, it should state the targets it has not met and the reasons for not meeting those targets (comply or explain basis).

Firms are also expected to publish numerical data on the sex or gender identity and ethnic diversity of the board, senior positions, and executive management.

Controls on data:

• Based on findings from the SS3/19 responses obtained from banks and insurers regarding embeddedness of climate-related financial risks, the Prudential Regulation Authority (PRA) has noted that several firms had significant data gaps related to ESG reporting.
• The PRA expects firms to explain how they identify such 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?

Authors: Hetty van der Wal, Sarah Cook and Phillip Holt 

Why is it important?

The Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) 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. On 25th September 2023 both the PRA and FCA issued consultation papers on their plans for regulation and oversight of diversity and inclusion for regulated businesses.

What’s new?

• Firms should now be incorporating a statement in their annual financial report on whether they have satisfied the FCAs diversity targets as set out in Policy Statement 22/3.
• Following on from the joint Bank, PRA, and FCA diversity and inclusion discussion paper published in 2021 (DP2/21), the FCA completed a data survey on a sample of 12 firms across multiple sectors to understand approaches to diversity and inclusion in firms. The FCA published its findings to provide visibility of the current state of diversity and inclusion in financial services and to encourage further action and used these to help the development of its future supervisory approach.
• It is important that firms scrutinise the consultation papers from 25th September 2023 to identify which areas require improvement within their own approach to diversity and inclusion, so that early action can be taken. The regulations will require many firms to revisit their approach to diversity and inclusion, the quality and breadth of the metrics they use to measure progress as well as their activities to change the underlying numbers.
• For further information on the consultation papers please refer to our latest blog.
• Once the final policies are published in 2024, firms are likely to have 12 months to comply.
• The PRA and FCA have issued a discussion paper (DP1/23) to review the Senior Managers and Certification Regime (SMCR) and separately the Government has launched a Call for Evidence on the regime in the same timeframe. These reviews will collect information on the regime's effectiveness, scope, and proportionality, and seek views on potential improvements and reforms to assess the need for further policy proposals.
• The Financial Reporting Council has launched a public consultation on its proposed revisions to the Corporate Governance Code. The proposed changes are focused on internal control, assurance, and resilience, although also include changes related to diversity and inclusion.

What should internal audit be doing?

Authors: Lauren Underwood and Stuart Batigan

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 are two primary drivers 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.
• UK Corporate Governance Reform: Organisations caught by the latest UK Corporate Governance proposals will need to comply with a number of new requirements, including an explicit declaration by Directors on the effectiveness of risk management and internal control systems.

As a result of these drivers, 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?

Authors: Rob Dighton and Adithya Ravi 

Why is it important?

The Financial Conduct Authority’s (FCA) Consumer Duty (the Duty) went live for open book products on 31 July 2023 (PS22/9 and FG22/5) and is due to go live for closed book products on 31st July 2024. It has been described by the FCA as setting higher and clearer standards of consumer protection across financial services and requires firms to put their customers' needs first, fundamentally improving how firms serve consumers. The Duty focuses on consumers receiving good outcomes by firms delivering products, customer journeys and communications that meet the needs of their target market and are priced to deliver fair value. Implementation of the Duty has been a material regulatory change programme for a number of firms in 2023 and in 2024, firms will have to move to embedding those changes resulting in, what will become, the annual Board report which will opine on whether firms have met the requirements of the Duty.

What’s new?

The Duty introduced four customer outcomes. These are:

• Products and services – products and their features and benefits should meet the needs of the target market;
• Price and value – customers should derive value from products and their features and that should be reasonable relative to price;
• Customer understanding – customers should understand the risks, features and benefits of the product to make an informed judgement on whether it is appropriate for them and continues to be so; and
• Customer support – where customers need it, they should receive timely and sufficient information to make an informed choice. The ‘cost of living’ challenges has brought this into key focus.

The four outcomes are underpinned by a new Consumer Principle (which replaces principle 6) that requires firms to act to deliver good customer outcomes and defines three cross-cutting rules to:

• Avoid causing foreseeable harm;
• Enable customers to pursue their financial objectives; and
• Act in good faith.

Having delivered on the functional elements of the Duty in 2023, we expect firms to be embedding the Duty by focusing on:

• Cultural shift – firms should be focusing on ‘people and leadership’ activity to ensure all staff understand their roles and responsibilities and expectations of them to deliver good customer outcomes;
• Embedding change – refining product governance and fair value frameworks as well as continuing to improve customer journeys that may cause foreseeable harm and being able to evidence that customers are adequately informed to make timely decisions;
• Closed book products - firms should now be looking at how they ensure successful implementation of the Duty for closed book products ahead of the 31 July 2024 deadline; and
• Third party oversight – where a firm has outsourced customer support functions to a third party, it should be reviewing and monitoring whether third parties have delivered on the Duty as communicated in their programme updates and considering whether approach and outcomes align to internal standards and expectations of the Duty.

What should internal audit be doing?

Authors: John Lonen

Why is it important?

The capital markets sector is noted for the technically complex products which firms produce and handle daily. They are often only understood by a limited number of subject matter experts (SMEs), with relative opacity to senior management on occasion. As such employee conduct is held in high regard – with conduct risk frameworks fundamental for the successful prevention, monitoring, and resolution of potential misconduct.

Some of the principal controls that conduct risk managers need to operate effectively include front office supervision, where supervisors need to review team trading (cancel and corrects, late bookings, physical access, historical rate rollovers for example), as well as ensuring policies and procedures are in place and are communicated, and that training is provided and understood. Further, there are requirements around operating effective trade surveillance, covering areas such as communications controls (e-comms and a-comms), trade analysis and associated regulatory reporting (e.g. Suspicious Transaction and Order Report (STOR).

Conduct managers also have a responsibility to effectively monitor conduct within the business at a senior level, including high quality Management Information (MI) being requested, produced and understood. Connected to conduct risk are the effects that poor conduct can have, including various forms of market abuse within the sector, such as insider dealing and market manipulation.

This in turn is an area of continued focus for the Financial Conduct Authority (FCA) as it is linked directly to one of their key objectives (protect the integrity of the UK financial system) and is fundamental to two of the commitments made in their three-year plan, part of their 2022/23 business plan (Business Plan 2022/23 | FCA).

What’s new?

Conduct risk is a core area of focus for the FCA and will continue to be as it is built into their three-year strategy, contained in their 2022/23 business plan (Business Plan 2022/23 | FCA).

We note that an increasing number of firms are being fined by the FCA for breaches in their conduct risk model. An example of this would be an organisation failing to properly implement the Market Abuse Regulation (MAR) trade surveillance requirements relating to the detection of market abuse.

In addition, a number of firms have received increased scrutiny from the FCA due to their senior management having insufficient oversight and control over their conduct risk appetite. This shows a shifting attitude from the regulator; a higher level of understanding and demonstrating that direct action is being taken is required by senior managers at capital market firms.

In connection with this shift, the FCA is becoming increasingly focused on firm culture – moving away from prescribed policies and procedures based on attestations and instead fostering a workplace culture where speaking up is encouraged and good behaviours are rewarded. It will be incumbent on senior management to create and roll out this new approach. The FCA will expect to see evidence of actions taken by firms to enhance and improve their culture.

A recent regulatory development is Section 53 of the upcoming Financial Services and Markets Bill, connected to the consultation that the Treasury launched in July 2021 in relation to the Senior Managers and Certification Regime (SMCR). Section 53 creates an SMCR that could then be applied to financial market infrastructure firms. This shows an increasing focus from government and regulators on conduct and accountability of senior managers in the market more widely.

Furthermore, there have been multiple developments in the digital assets (incl. crypto, CBDCs, NFTs) and ESG (incl. Greenwashing) space over the last year which has greatly increased the waterfront of conduct risk to which capital market firms are subject to. This increases the pressure and importance of having an effective and well managed conduct risk framework in place.

What should internal audit be doing?

Authors: Daniel Harker, Sherene Vaver, Simon Crawley, Neil Cowie

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.

Authors: Nick O’Kelly and Ivelina Koleva 

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?

Authors: Sofia Triantafyllou

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 GeneAI 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. Whilst initial use was mainly by individuals, our research has shown more than 4 million people in the UK have used GenAI for work and organisations are investing heavily in enterprise use cases. 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.

AI regulation: A pro-innovation approach white paper (published in March 2023) – This whitepaper is the outcome of a collaboration of multiple UK government departments, contributing to the governments overall National AI Strategy. The whitepaper outlines an innovation focussed approach to AI development by investing in the long term needs of AI ecosystems, supporting the transition to an AI enabled economy, and ensuring the national and international governance of AI technologies is right. The paper outlines the government’s plans to regulate AI, identifying it as a critical technology. This new framework will encourage innovation in a responsible manner to drive growth and public trust, making the UK a global leader in AI.

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 UK 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. Read more on the NIST framework.

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.

Lead authors: Lukas Kruger

Contributing authors: Lewis Keating and Michelle Lee 

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.

Internal audit digital and analytics survey 2023 | Deloitte UK.

Authors: David Tiernan and Nanette Scott 

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?

Authors: Alexandra Rodrigues, Aestrid Solberg and Katie Jones

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) 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?

Authors: Emma Gauntley and Owen Jackson

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?

Whilst many new requirements look to codify what is already considered good industry ways of working, the new Standards do not necessarily provide a stretch target for leading functions. Notwithstanding this, demonstrating conformance to the new requirements has the potential to be onerous 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?

Authors: Dan Wright and Owen Jackson 

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?

Authors: Jamie Lee