Systemic operational risk: the UK payment protection insurance scandal

ABSTRACTMay 2011 was a very bad month for UK banks. In the previous month, a longrunning legal case was resolved when the UK High Court ruled against the British Bankers' Association, which had petitioned for a judicial review of regulatory action concerning mis-selling of payment protection insurance (PPI) products. Following the ruling, the four major UK banks announced provisions totaling over £6 billion to cover restitution to buyers of their PPI products. Some of the banks also decided to exit the PPI business. At first glance, PPI appears to be a standard insurance product. For an up-front or monthly premium, an insurer will sell protection to a borrower against being unable to make loan repayments, as a result of illness or unemployment, for example. Before the market collapsed, the main distributors/ arrangers of PPI contracts were the largest UK banks, often using their affiliated insurance subsidiary as the insurer. The underlying problems that generated the so-called PPI scandal should not have come as a complete surprise to the banks. For several years prior to the ruling, consumer advocacy groups had been complaining loudly about banks selling PPI products to customers who did not fully understand the policies and, in many cases, did not need the protection provided. Yet, having seemingly taken on a life of its own, the practice of selling PPI policies continued and grew rapidly in all major banks. Various official inquiries found that the "people" involved, including frontline bank staff, lending managers and insurers, simply did not exercise the due diligence necessary to check the suitability of PPI for many customers. Prudence seems to have been diluted or even abandoned in a chase for increased product volume across the whole UK retail banking sector. This paper argues that the losses incurred as a result of the PPI scandal were, in most part, precipitated by systemic operational risk, particularly people-related risks. Using examples from official inquiries, this paper identifies some of the people risk that went unmanaged in this part of the UK retail banking sector system, until the PPI market seized up in 2011. The paper then suggests proactive approaches to people risk management that should help to detect and minimize the impact of similar scandals in the future. This topic is important as the demographic shift toward longer periods of retirement and the prevalence of the "universal banking model" means that nontraditional banking products such as insurance, pensions and investments will be increasingly sold through banks, raising the specter of further mis-selling scandals in the future.