In risk management and compliance circles, the three lines of defense model has long been the go-to approach. Widely adopted by banks, corporations, and institutions, it’s often presented as a structural safety net, separating operational roles, risk oversight, and audit functions to create checks and balances. When rigidly followed or implemented superficially, this model risks becoming less of a defense and more of a façade, a created fake sense of security based on historic data in risk registers, outdated risk assessments and boxes checked.
The Basics of the Three Lines of Defense Model
In theory, this model sets up three distinct layers within an organisation:
- First Line: Operational management, those closest to the business who identify and manage risks.
- Second Line: Risk management and compliance functions, overseeing and guiding the first line, ensuring policy adherence.
- Third Line: Internal audit, providing independent assurance of the effectiveness of the first and second lines.
When effectively implemented, each layer is designed to create oversight and prevent risks from slipping through unnoticed; and when they do, the last line can only do one thing: “Issue a finding”.
In a Ponzi scheme, money from new investors is used to pay returns to earlier investors, creating a cycle that only sustains itself as long as there are sufficient new investments. Although the Three Lines model was never intended to defraud, there are critical parallels in how it sometimes functions—and why it will ultimately come tumbling down.
1. A created, false illusion of control
Just as a Ponzi scheme creates the illusion of returns, the Three Lines of Defense can create the illusion of control. When these layers are improperly aligned or inadequately empowered, each line may report that “all is well” without anyone truly examining the fundamentals. In a Ponzi scheme, false returns are presented as proof of financial health, hiding deep structural risks. Similarly, in the weak Three Lines model, formalistic reports or unchecked assumptions can mask underlying vulnerabilities, giving a false sense of security.
2. Misaligned incentives and blind spots
Ponzi schemes rely on people’s desires for quick gains and the fear of missing out. Likewise, the Three Lines model can fall victim to misaligned incentives. For example, the first line might prioritise operational targets over risk management due to performance pressures. The second line often lack sufficient power to challenge this and is seen as an “obstruction” to business, while the third line struggle to remain genuinely independent. The result? An environment in which risk controls are more symbolic than substantive and responses totally reactive, creating institutional blind spots.
3. Dependence on ongoing resources
Both a Ponzi scheme and the Three Lines model need continuous resources to operate effectively. For a Ponzi scheme, that’s new investors; for the Three Lines, it’s staffing, time, and data. When resources are constrained, the effectiveness of each line deteriorates. Staff reductions, limited training, or lack of data access can transform a robust framework into a fragile one. The first line, particularly, lacks basic risk management skills and sufficient training, hindering its ability to identify risks early.
4. Escalating risk exposure, exponentially
A Ponzi scheme escalates risk by drawing in more investors to maintain the cycle, effectively increasing exposure as more capital is “owed” to participants. The Three Lines model, can escalate exposure similarly. Without a dynamic risk culture where employees feel ownership over risk, a static model may hide rather than mitigate risks, leading to a cascading effect where critical issues endogenously multiply.
The Tipping Point: When “Defense” Becomes Dangerous
At its breaking point, a Ponzi scheme collapses. Similarly, the Three Lines model will become a liability. Consider these warning signs that the model is failing:
- Check-the-box Mentality: Layers exist, but they lack substance—reports, based on historic data and personal perceptions, are generated, but real issues remain untouched. Emerging risks are completely ignored and the sole function of the Second Line is to produce a (mostly useless) Risk Report.
- Pass-the-Buck Culture: Each line sees risk management as “someone else’s job,” with individuals deflecting responsibility. It just becomes layers of “policemen” with no real value added to the effective management of risk and taking opportunities for reward.
- Fragmented Communication: The “lines” work in isolation, defined “independence” is promoted and results in large gaps in communication that lead to unrecognised risks. Executives spend hours debating what colour a R-A-G-rating should have been, at the end of the previous business quarter.
Ultimately, the structure will implode under the weight of unidentified risks and unresolved issues, like a Ponzi scheme running out of new investors. When risks materialise, the organisation will find itself lacking the structural resilience to respond effectively to the combined built-up of unrecognised risks, “Grey Rhinos” and “Black Swans”.
Building an effective Risk Culture
To avoid this “Ponzi Paradox,” organisations must move away from an outdated and purely mechanical model and invest in Building an effective Risk Culture where:
- Risk is Everyone’s Job: Encourage employees across levels to accept that risk is part of their role, bridging silos and integrating risk into daily decision-making.
- Continuous Communication and Feedback Loops: Facilitate transparency and cross-functional communication to address gaps and identify emerging risks before they grow. The risks outside of your business are the obvious ones that will put you “out-of-business”
- Regular Evolution of Controls: Revisit and adapt controls regularly. A static model quickly becomes obsolete—especially in a fast-evolving business landscape.
Defend against the illusion of safety
An effective risk culture goes beyond any number of “Lines of Defense”, integrating real ownership, adaptability, and proactive communication. The real risk is in relying too heavily on the model’s structure alone, trusting it will “hold up” under pressure. Like a Ponzi scheme, it will all come tumbling down if critical challenges remain unaddressed. Only by embedding a deeper sense of risk responsibility at all levels can organisations hope to have a truly resilient and effective risk management framework.
In an effective risk culture, people care enough to think about the risks associated with their jobs every day. Strong cross-functional teamwork is evident and employees who apply sound judgement in the management of risk. A small central risk management advisory team that understands the enterprise fully supports the business at all levels. Every employee will constantly evaluate, control and optimise risks to make informed decisions and build sustainable competitive advantage for the organisation and individual performance measures are fully aligned and risk sensitive. Every employee is a risk manager and knowledge and skills are upgraded continuously.
To address the “Ponzi Paradox” of the Three Lines of Defense model, you can apply the Four Pillars of Risk Culture Building, hit “contact us” to share your needs and we will send you our Practical Survival Guide to Escape the ‘Risk Ponzi’