Understanding Three Lines of Defence in financial services | The fundamentals

In recent years, the accelerated adoption of new technologies has transformed the way we work and interact. As a result, managing risk and ensuring regulatory compliance has become crucial, particularly for financial institutions.

The three lines of defence (3LoD) model has emerged as a powerful tool for achieving these objectives but implementing and maintaining a robust defence can be challenging. In our new article series, Understanding Three Lines of Defence in Financial Services, we explore the 3LoD model and how financial institutions can effectively implement it to manage risk and strengthen their resilience.

This article explores the fundamentals of 3LoD and why it’s important to consider implementing the model into your organisation.

What is the three lines of defence model?

The 3LoD model, as the name implies, involves three critical lines of defence:

First Line of Defence: Operational Management

This includes front line staff who are responsible for identifying, assessing, and managing risks. Financial institutions can reinforce this front line by conducting risk assessments, designing and implementing risk management frameworks, and providing training and ongoing support to front-line staff.

Second Line of Defence: Risk Management and Compliance

This includes the individuals and teams responsible for overseeing and monitoring the effectiveness of the risk management and control processes. They ensure that the first line of defence has adequate risk management processes and controls in place, while guaranteeing compliance with relevant laws, regulations, and internal policies.

Third Line of Defence: Internal Audit

This includes the individuals and teams responsible for providing independent and objective assurance to the Board and senior management on the effectiveness of risk management, control, and governance processes. They provide an independent evaluation of the effectiveness of the first and second lines of defence.

Why would you need to implement the three lines of defence model?

The 3LoD model is crucial to establish effective risk management and governance practices. It also enhances the institution’s ability to identify, assess and mitigate risks by distributing responsibilities across different lines of defence.

As financial institutions operate in a highly regulated environment, implementing the 3LoD model helps to:

  • Ensure compliance with laws, regulations and industry standards, and identify areas for improvement
  • Identify, assess and manage credit risk, market risk, operational risk, and legal risk practices and provides assurance on risk mitigation
  • Prevent and detect potential fraudulent activities, and strengthens anti-fraud measures
  • Develop and maintain effective cybersecurity controls and practices, such as secure network configurations, establishing cybersecurity policies and procedures to monitor cyber threats, and employee awareness training.

How does it work?

The three lines of defence are interconnected and regularly work together, making it more appropriate to view them as different levels of activity and accountability rather than separate operational lines. Implementing the 3LoD model in a practical manner ensures each level can carry out its unique activities and distinct responsibilities without affecting the other’s ability to do so too.

Governing bodies and senior management sit above the three lines of defence and determine the organisational goals, devise plans to achieve them, and establish frameworks to control and manage risks.

How do you start the implementation process?

Although they are not part of your organisation, external auditors and regulators can still play a significant role in assessing governance and control systems, particularly in relation to financial reporting. In the case of regulated entities, the regulators often establish specific governance and risk management requirements. They may also conduct their own independent assessments of controls, which can provide additional assurance.

BDO’s recommendation is to appoint a specialist adviser to provide an independent expert review on the design and operating effectiveness of your 3LoD model.

Questions? Contact us.

The next article in our new series on 3LoD will cover the challenges of implementing 3LoD and what to consider during the process. Our team is well equipped to assist your organisation with the implementation of 3LoD, for more information, contact us.