What are the Three Lines of Defense in a Compliance Management System?

Written by Ncontracts | Jul 24, 2019 2:00:00 PM

Interested in learning more about how to define a strong compliance management system, and details on those three lines of defense? This post is for you. It's one of the hottest topics in compliance, and yet, one of the more challenging: how to implement three lines of defense in your compliance management system.

In this post, we'll cover the basics: what is a CMS, what are the lines of defense generally, and what are the three lines of defense.

This post is designed to provide helpful details for people with both introductory and moderate experience in building three lines of defense in a compliance management system. If you believe that we overlooked something significant, please let us know!

Let's get started.

1. What is a Compliance Management System?

In simple terms, a compliance management system, or CMS, is the interconnected system that helps manage your compliance.

According to the regulators, a strong CMS must include these two key parts:

Board of Directors and Management Oversight: Communicate clear expectations, adopt clear policies, and define an appropriately staffed compliance function.
A Compliance Program: A formal, written compliance program. This should include:
- Policies/procedures,
- Training,
- Monitoring, and
- Consumer complaint response.

A CMS that doesn't include these items (oversight and program, including the four pieces of a compliance program) will likely be considered deficient.

The FDIC provides even more detail in the compliance exam manual. They note that a compliance management system is how a financial institution:

"Learns about its consumer compliance responsibilities;
Ensures that employees understand these responsibilities;
Ensures that requirements are incorporated into business processes;
Reviews operations to ensure responsibilities are carried out and requirements are met; and
Takes corrective action and updates materials as necessary."

Every CMS is different, because it's customized to the unique needs of each institution. Your compliance management system should be crafted to fit your financial institutions size, branches, employees, history, existing risk, business structure, and strategy, among other factors.

2. What are the Lines of Defense?

In a compliance management system, the lines of defense are related to the areas (departments) of the financial institution responsible for different aspects of risk management.

Broadly speaking, a line of defense includes the employees, their policies, procedures, and practices, and the lines of reporting and escalation.

In the past, the compliance and management were considered the two key lines of defense, but for the last decade, that has been changing. We'll talk more about that next.

Remember, CMS technology does exist to help support everyone involved in compliance and risk management.

3. What are the Three Lines of Defense?

Compliance is a team sport. A successful compliance management system and culture cannot be dependent upon a single compliance officer, department, or committee. Successful compliance requires both informal and formal teamwork.

One effective approach is leveraging the “Three Lines Model” (formerly known as the “Three Lines of Defense”), which focuses on governance, collaboration, and the role of risk management in
creating and protecting value.

Working together under the guidance of management and the board, the Three Lines implement and oversee activities and controls that ensure the organization is working towards its strategic
objectives while remaining within its risk tolerance. However, each line has unique roles and responsibilities.

As regulatory compliance management has evolved, having three lines of defense has become more important.

Here is an overview of the three lines of defense:

First Line: The first line of defense is operational management and the employees of the financial institution who are involved in the creation and selling of products and services, or operationally supporting customers, products, and services. It includes both sales roles and operational roles, like Wire Transfers and Customer Service. It is their responsibility to understand their roles and responsibilities, create and apply internal controls, and respond to risks that their work, sales, and interactions may present.
Second Line: The second line of defense is the financial institution's compliance- and risk-related functions. They are responsible for providing guidance and oversight of the first line of defense. Additionally, they are responsible for proactively testing and monitoring high risk areas to ensure policy, procedures and processes implemented by the first line are working as intended to comply with rules and regulations. They are also responsible, in most institutions, for fostering relations between the first and third line of defense, and providing some reporting to the Board and Senior Management.

Compliance is responsible for identifying applicable laws and regulations, interpreting them, and then developing and enforcing policies and procedures to support them through a compliance
management system (CMS). It should work hand-in-hand with risk management to ensure risk assessments are thorough and up to date. Risk management and compliance are also responsible, in most institutions, for fostering relations between the first and third lines and providing reporting to the board and senior management. While different institutions will divvy up these responsibilities in different ways and to different areas, the bottom line is that
compliance plays an essential role in ensuring effective risk management.
Third Line: The third line of defense is the external and internal auditors who independently evaluate the compliance risks and controls. They are also responsible for reporting to the Board and Senior Management's oversight functions.

If only one line of defense is working well, it can present risks to the other lines as well as the institution.

4. Applying the Three Lines of Defense to Compliance

Compliance officers are an integral part of every financial institution’s Three Lines Model. The best ones are strategic partners that protect the institution while looking ahead towards tomorrow’s
challenges and opportunities.

Each financial institution might have its own definitions for its "lines," but the basic tenet is the same. Formal lines with set responsibilities create a structure where ownership of compliance is
shared well beyond the compliance department, and the compliance function empowers others to help manage compliance risk. If only one line is working well, it can present risks to the other lines
as well as the institution.

To implement the Three Lines Model, a financial institution needs a strong culture of compliance with management setting the tone from the top. Management must commit to implementing the
Three Lines Model and enforce expectations for each line. That means compliance can’t be viewed as a “necessary evil.” Management must understand that compliance is a part of doing good
business.

One of the most-cited challenges with implementing Three Lines Model is getting the engagement of the first line. In some cases, the front line doesn’t understand that compliance is the responsibility of the entire institution, not just the compliance department. It’s important to explain that the compliance department doesn’t “do” compliance, it manages it. The first line “does” the complying by adhering to policies and procedures.

This is a natural part of the evolution of creating Three Lines Model. While the goal is to have all responsibilities clearly defined, it takes time.

It's clear that many institutions are still working towards building three strong lines of defense in their CMS.

That said, regulators have been talking about the three lines of defense since 2008. It's important that you prioritize the evolution toward three strong lines of defense in your compliance management system.

There are distinct challenges, but the rewards are more efficient compliance risk management and a stronger culture of compliance overall.

The best compliance management systems evolve to accommodate changing risk factors and exposure. As you work to improve yours, keep in mind that it will probably need to change over time, and consider how such change is managed.

Taking the Next Step in Building a Strong CMS

Building a robust Compliance Management System (CMS) with a well-implemented Three Lines Model isn’t just about compliance—it's about creating a resilient, agile institution that can adapt to changing risks and regulations. By empowering each line of defense, your organization positions itself to effectively manage compliance, reduce risk, and foster a culture where compliance isn’t an afterthought but a part of everyday operations.

As you strengthen your CMS, remember that it’s a living framework. The best systems evolve to meet new challenges and regulatory expectations. Regularly review and adjust your approach, ensuring it continues to meet your institution’s needs and goals.

By embracing the Three Lines Model, you’re not only protecting your institution but also setting it up for future success. Now is the time to move from compliance as an obligation to compliance as an asset, enabling smarter, stronger operations across the board.

Want to learn more on why your FI needs a CMS? Download our whitepaper, What is a CMS and Why Does Your FI Need One? today.

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