Here is something we haven’t seen much of in recent years: a proposal under consideration by the Board of Governors of the Federal Reserve seeks to ease the burden placed on the directors it oversees.
The plan would refocus supervisory expectations for the largest firms’ boards of directors on their core responsibilities.
The proposed guidance “would clarify the role of boards of directors and place more responsibilities back onto management instead,” says Elizabeth Khalil, a former federal banking regulator at the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation and now of the law firm Dykema. “This breaks with a trend over the past several years in which regulators have urged more and more active, and seemingly granular, involvement from bank boards.”
Don’t pop the cork and celebrate deregulation just yet, however. It remains to be seen how the plan works in real-life and to what degree it diverges from the expectations of other regulators
In August, the Federal Reserve began seeking public comments on a corporate governance proposal intended to enhance the effectiveness of boards of directors.
The proposal addresses supervisory expectations for boards of directors of bank holding companies, savings and loan holding companies, state member banks, U.S. branches and agencies of foreign banking organizations, and systemically important non-bank financial companies designated by the Financial Stability Oversight Council. The Fed will accept comments on the proposal through Oct. 10.
MATTERS REQUIRING ATTENTION
The following is from an Aug. 30 speech by Federal Reserve Governor Jerome Powell at the Large Bank Directors Conference in Chicago.
An effective board should have a composition, governance structure, and set of established practices that are appropriate in light of the firm's size, complexity, scope of operations, and risk profile. Boards need to be aware of their own strengths and weaknesses, and to ensure that directors bring an appropriately diverse range of skills, knowledge, experience, and perspective. Significant events, such as an unexpected loss or compliance failure, should cause boards to reflect and reassess their structure, composition, and processes. An effective board takes a preventative approach and engages in probing self-assessments regularly and systematically.
Before I conclude, let me say a few words about an aspect of the proposal that has attracted some attention, which is the reversal of a relatively recent practice of directing all examination and inspection findings, what we call “matters requiring attention” (MRAs) and “matters requiring immediate attention” (MRIAs), to the board as well as to management. The practice resulted in boards of directors reviewing and signing off on management's compliance with every MRA and MRIA. When we began that practice in 2013, our intention was to ensure that directors were in a position to hold management accountable in addressing risk management shortcomings.
By 2014, we realized that the practice was “almost surely distracting from strategic and risk-related analyses and oversight by boards.” For perspective, a large banking firm may have one hundred or more MRAs outstanding at a given time, many of which are at a level of granularity that is more appropriate for management to remediate, with board oversight. The new proposed framework is designed to make boards more effective in holding management accountable in these efforts. While we have proposed that most MRAs and MRIAs be addressed in the first instance to management and not to the board, the board would continue to receive MRAs where board practices are at issue or where management has failed to promptly and adequately take the required actions.
The board would also continue to receive copies of examination and inspection reports, including formal communications with the institution. In the parlance of the proposed guidance I just outlined, we fully expect the board to actively manage the information flow related to MRAs and to hold management accountable for remediating them. In doing so, a board may choose to track progress and closure of MRAs through an appropriate board committee, rather than getting into the granular detail on every individual MRA.
Source: Federal Reserve
The proposed guidance “better distinguishes” the supervisory expectations for boards from those of senior management, and describes effective boards as those which:
Set clear, aligned, and consistent direction regarding the firm’s strategy and risk tolerance;
Actively manage information flow and board discussions;
Hold senior management accountable;
Support the independence and stature of independent risk management and internal audit; and
Maintain a capable board composition and governance structure.
For the largest domestic bank and savings and loan holding companies and systemically important non-bank financial companies, the proposal would establish principles regarding effective boards of directors, focused on the performance of a board’s core responsibilities. It would also better distinguish between the roles and responsibilities of an institution’s board of directors and those of senior management.
For domestic banks and savings & loan holding companies, the proposal also would eliminate or revise supervisory expectations contained in certain existing Federal Reserve Supervision and Regulation letters, which would be aligned with existing or proposed guidance for boards depending on the size of the firm.
The corporate governance pitch identifies the attributes of effective boards of directors, such as setting a clear and consistent strategic direction for the firm, supporting independent risk management, and holding the management of the firm accountable. For the largest institutions, Federal Reserve supervisors would use these attributes to inform their evaluation of a firm’s governance and controls.
The plan would clarify that for all supervised firms, most supervisory findings should be communicated to the firm’s senior management for corrective action, rather than to its board of directors. It also identifies existing supervisory expectations for boards of directors that could be eliminated or revised.
The reconsideration of board duties was informed by a multi-year review by the Federal Reserve of practices of boards of directors, particularly at the largest banking organizations. It assessed, among other things, the factors that make boards effective, the challenges directors face, and how boards influence the safety and soundness of their firms and promote compliance with laws and regulations.
GRANULAR OR BIG PICTURE?
Regardless of what the Federal Reserve does regarding a proposed corporate governance framework for bank directors, board members are always going to have a difficult job.
“The banking regulators have always said that the board is ultimately responsible for the financial institution’s compliance,” says Elizabeth Khalil, a former federal banking regulator now of the law firm Dykema. “The question us what does that all mean? How granular does it need to be? Is it oversight of how management handles the day-to-day managing the financial institution? Or, are directors themselves expected to get down into those weeds? In the past several years, it seems like the expectations were more like the latter.”
“If you are going to be a successful director and have effective oversight over management you are still going to have to have get into the weeds to some extent,” Khalil says. “You need to understand the complex, sometimes esoteric, subject matter that management has to deal with. If you don’t understand it yourself, it is going to be that much harder to maintain effective oversight. It’s a very tough job and there is an incredible amount of liability. My hat is off to those willing to serve.”
Another big next question: what will other banking regulators do? Will they follow the Federal Reserve’s lead, harmonize their own plans, or maintain the status quo?
“We could be faced with a situation where there are different standards for directors at different types of financial institutions, depending on who regulates them,” Khalil warns. “Depending on how big those differences are that could be problematic.”
Among other things, the results of the review and discussions with independent directors suggest that supervisory expectations for boards of directors and senior management have become increasingly difficult to distinguish.
“Greater clarity regarding these supervisory expectations could improve corporate governance overall, increase efficiency, support greater accountability, and promote compliance with laws and regulations,” the Fed wrote.
“The results of the review also suggest that boards often devote a significant amount of time satisfying supervisory expectations that do not directly relate to the board’s core responsibilities,” it added.
These include guiding the development of the firm’s strategy and the types and levels of risk it is willing to take, overseeing senior management and holding them accountable for effective risk management and compliance among other responsibilities, supporting the stature and independence of the firm’s independent risk management and internal audit functions, and adopting effective governance practices.
Boards completing such non-core tasks “may do so at the expense of sufficiently focusing on their core responsibilities, which when exercised effectively promote the safety and soundness of the firm,” the proposal says.
The Fed’s review suggests that boards of large financial institutions face significant information flow challenges, especially in preparing for and participating in board meetings.
“Absent actively managing its information flow, boards can be overwhelmed by the quantity and complexity of information they receive,” the Fed wrote. “Although boards have oversight responsibilities over senior management, they are inherently disadvantaged given their dependence on senior management for the quality and availability of information.”
The proposed guidance would facilitate the execution of boards’ core responsibilities by clarifying expectations for communicating supervisory findings to an institution’s board of directors and senior management. The proposed guidance would indicate that the Federal Reserve expects to direct most Matters Requiring Immediate Attention (MRIAs) and Matters Requiring Attention (MRAs) to senior management for corrective action.
This recent reassessment could be especially good news for outside directors, Khalil says.
“Outside directors of financial institutions have always had a challenging role,” she explains. “By definition, they are not part of bank management and are not involved in day-to-day bank operations, and they often are not bankers by trade.”
Piled onto boards’ overflowing plates are cyber-security worries and international demands, including Basel capital and liquidity regulations.
Khalil warns that directors should not view the proposal as a go-ahead to ease up on oversight, however.
“People can’t help but first think that this might be a lessening of expectations because it does look like such a change in course from what we’ve seen during the past several years from the Federal Reserve and all the other regulators,” she says. “This seems to be a sea change from the trend, but it really is too soon to say exactly what it is going to mean. At this point it offers more questions than it answers.”