NOVEMBER 2, Federal Reserve Proposal Sets Out New Expectations for Boards of Directors

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1 promontory.com INFOCUS NOVEMBER 2, 2017 BY JULIE WILLIAMS, WILLIAM LANG, AND ALAN MICHAEL Federal Reserve Proposal Sets Out New Expectations for Boards of Directors The Federal Reserve Board in August issued a long-in-the-making proposal that puts the spotlight on board directors performance and the relationships between boards and management. 1 The proposal revises existing guidance to better delineate the duties of boards and sets out detailed supervisory expectations for boards at large banking organizations. Certain aspects of the proposal are applicable to bank and savings-and-loan holding companies with total consolidated assets of $50 billion or more, as well as to systemically important nonbank financial firms, while other aspects apply to holding companies of all sizes. While the proposal is subject to change, the final policy is likely to be broadly consistent with the expectations issued for public comment. By thoroughly analyzing the Federal Reserve s newly articulated set of expectations for boards, banking organizations can begin adapting to the coming policy changes. In issuing this proposal, the Federal Reserve recognized that its policy and practice had placed overly expansive demands on boards of directors. As a result, boards at banking organizations have been diverting time and attention from their central strategic functions. The Federal Reserve is not lowering its expectations for boards, but rather is focusing supervisory attention on areas that are the appropriate functions of the board, while drawing sharper distinctions between the duties of the board and senior management. The proposal will require boards of large bank and savings-and-loan holding companies to raise their level of effectiveness. The proposal establishes, for the first time, a set of clear and detailed Federal Reserve expectations for these large organizations. Importantly, the Federal Reserve also intends to implement a new rating framework for large bank holding companies, certain large savings-and-loan holding companies, and U.S. intermediate holding companies of foreign banking organizations, that explicitly incorporates supervisory assessments of board effectiveness as a key factor in a rating of governance and controls. 2 This raises the stakes for large banking organizations in understanding and meeting the newly articulated Federal Reserve expectations for boards. 1 Proposed Guidance on Supervisory Expectation for Boards of Directors, Board of Governors of the Federal Reserve System, Federal Register (Aug. 3, 2017). 2 Along with the proposal on expectations for boards, the Federal Reserve simultaneously issued a separate proposal to replace the existing holdingcompany rating system for large financial institutions with a new rating system that better aligns Federal Reserve ratings with its post-crisis supervisory framework for LFIs. See Large Financial Institution Rating System; Regulations K and LL, Federal Reserve, Federal Register (Aug. 3, 2017). Board effectiveness will be a contributing factor in the governance-and-control component of the new rating proposal.

2 Proposal Would Clarify Supervisory Expectations and Change Existing Guidance The Federal Reserve and other financial regulators have cited board ineffectiveness at large banking companies as a central contributor to the financial crisis. In response, examiners have paid increasing attention to the functioning of bank boards, and it has become standard for regulatory guidance to include specific expectations for boards. But the Federal Reserve never comprehensively spelled out its board-related expectations, which were instead contained in wide-ranging supervisory guidance related to individual issues from capital planning to vendor management. Over time, it became increasingly clear that there were significant problems with the Federal Reserve s patchwork approach. Bankers and Federal Reserve officials observed that supervisory policies were undermining the effectiveness of boards by pushing them to take on managerial functions. Former Federal Reserve Gov. Daniel Tarullo noted this concern in a June 2014 speech: It has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. 3 While the process of developing regulatory policy to address these problems has been slow, the Federal Reserve s proposal provides clear and focused supervisory expectations for boards. A Comprehensive Set of Expectations for Boards The proposal consists of three parts. The first part includes proposed supervisory guidance addressing board effectiveness at large bank and savings-and-loan holding companies (which the Federal Reserve s notice refers to as the proposed BE guidance ). The second part proposes to revise or eliminate existing Federal Reserve supervision and regulation letters that create inappropriate expectations for boards of bank and savings-and-loan holding companies of all sizes. The third part, also applicable to holding companies of all sizes, would revise Federal Reserve policy on supervisory communications. The revised policy would assign responsibility for addressing supervisory findings (e.g., matters requiring immediate attention and matters requiring attention) to senior management rather than the board, except where the findings directly relate to board functioning or where senior management has failed to address existing supervisory findings. SPECIFIC GUIDANCE FOR BOARD EFFECTIVENESS AT LARGE BANKS The BE guidance represents the first time the Federal Reserve has proposed a comprehensive set of expectations for board effectiveness at large financial institutions. These expectations would apply to bank and savings-and-loan holding companies with total consolidated assets of $50 billion or more, as well as to nonbank financial companies designated as systemically important by the Financial Stability Oversight Council. 4 3 Daniel K. Tarullo, Corporate Governance and Prudential Regulation, Federal Reserve (June 9, 2014). 4 The proposed BE guidance would not apply to U.S. intermediate holding companies of foreign banking organizations established pursuant to Regulation YY. The Federal Reserve anticipates proposing guidance on board effectiveness for IHCs at a later date. PROMONTORY Sightlines InFocus NOVEMBER 2,

3 The proposed guidance describes five categories of attributes of effective boards. The board sets clear, aligned, and consistent direction regarding the firm s strategy and risk tolerance by: Developing and approving the firm s strategy, setting the types and levels of risk it is willing to take, and ensuring the strategy and risk tolerance are aligned. Ensuring the strategy has sufficient detail to enable senior management to identify the firm s strategic objectives; develop implementation strategies and plans for each business line; and establish effective audit, compliance, and risk management and control functions. Considering the increased risks and expanded control requirements when expanding into a new business line or jurisdiction for consistency with the risk management framework. Assessing whether the firm s significant policies, programs, and plans align with the firm s strategy, risk tolerance, and risk management capacity, prior to approving them. The board actively manages information flow and discussions between directors, so that the board can make well-informed decisions that meaningfully account for risks and opportunities by: Requiring senior management to provide timely and accurate information that allows the board to make sound decisions, while not overwhelming board directors with excessive detail. Establishing practices and processes to evaluate information flows and engaging senior management to improve those flows. Setting meeting agendas so that the content, organization, and time allocated to each topic allow the board to discuss strategic tradeoffs and make wellinformed decisions. Seeking information about the firm and its activities, risk profile, talent, and incentives outside of routine board and committee meetings. The board holds senior management responsible for implementing the firm s strategy and risk tolerance and maintaining a strong risk management and control framework by: Actively engaging senior management by, for instance, allotting sufficient time in board meetings for frank discussion and debate of information presented and considering whether senior management s assessments and recommendations support the approved strategy and risk tolerance. Evaluating the performance and compensation of senior management. Actively inquiring into drivers, indicators, and trends related to current and emerging risks. Empowering independent directors to serve as a check on senior management by, among other things, establishing and approving clear financial and nonfinancial performance objectives for the chief executive officer, chief risk officer, and chief audit executive as well as approving and periodically reassessing succession plans for the CEO and, as needed, the CRO and CAE. PROMONTORY Sightlines InFocus NOVEMBER 2,

4 The board, through appropriate committees, supports the independence and stature of independent risk management and internal audit by: Communicating directly with the CRO on material risk management issues and providing independent risk management direct and unrestricted access to the board s risk committee. Directing the appropriate inclusion of representatives of the independent risk management function on senior management-level committees. Meeting directly with the CAE regarding the internal audit function, organizational concerns, and industry concerns. Supporting internal audit s budget, staffing, and systems to ensure they are commensurate with the firm s asset size and complexity and keep pace with technological and other changes. Identifying specific instances or decisions where the independence and stature or lack thereof of independent risk management and internal audit have materially impacted business deliberations, decisions, practices, and/or the firm s strategy. The board s composition, governance structure, and established practices support firmwide governance commensurate with the asset size, complexity, scope of operations, and risk profile of the organization by: Establishing a board composed of directors with a diversity of skills, knowledge, experience, and perspectives. Creating a governance structure including board committees and management-to-committee reporting lines that enables the board to oversee and promptly address significant issues as they arise. Maintaining a capacity to engage third-party advisers and consultants when appropriate. Establishing strong processes to self-assess board strengths and weaknesses including the performance of board committees; particularly the risk, audit, and other key committees and adapting its structure and practices to address identified weaknesses, deficiencies, or evolving needs resulting from a change in the strategy or risk profile of the organization. Board effectiveness is one of the central factors in the rating of overall governance and controls under the proposed new rating system for large financial institutions. Examiners evaluation of these five attributes will be an input that the Federal Reserve will use to assess board functioning under the governance-and-controls component of this new rating system. RESCINDING OR REVISING CURRENT EXPECTATIONS FOR BOARDS In addition to establishing expectations for boards of large bank and savings-and-loan holding companies, the Federal Reserve is undertaking a review of existing supervisory expectations for the boards of holding companies of all sizes with the goal of removing or revising policies that place inappropriate, unclear, or irrelevant expectations on boards. The review will be conducted in two phases. First, the Federal Reserve is reviewing its own existing supervision and regulation letters PROMONTORY Sightlines InFocus NOVEMBER 2,

5 that communicate guidance to boards. To date, the Federal Reserve has identified 27 SR letters for potential elimination or revision letters that collectively include more than 170 supervisory expectations for holding-company boards. Supervisory expectations that apply to bank and savings-and-loan holding companies over $50 billion would be revised to align with the expectations contained in this proposed guidance. Supervisory expectations that apply to smaller bank and savings-and-loan holding companies would be revised to align with SR letter 16-11: Supervisory Guidance for Assessing Risk Management at Supervised Institutions with Total Consolidated Assets Less than $50 billion, 5 which includes the Federal Reserve s expectations of boards related to risk management. Among the SR letters likely to receive especially close review are SR 08-8/CA 08-11: Compliance Risk Management Programs and Oversight at Large Banking Organizations with Complex Compliance Profiles ; 6 SR 08-9/CA 08-12: Consolidated Supervision of Bank Holding Companies and the Combined U.S. Operations of Foreign Banking Organizations ; 7 and SR 12-17/CA 12-14: Consolidated Supervision Framework for Large Institutions. 8 These SR letters provide the Federal Reserve s overall framework for compliance and safety-and-soundness supervision for banking organizations (including FBOs) of various sizes and complexity and contain numerous expectations for boards of directors. In the second phase, the Federal Reserve will review requirements and supervisory expectations for boards set forth in its own regulations or in guidance issued on an interagency basis. As the proposal notes, revisions to regulations, as well as efforts to revise interagency guidance, will take considerable additional time. Therefore, the Federal Reserve is moving ahead with changes only to its own guidance in this proposal. REVISED GUIDANCE ON COMMUNICATING SUPERVISORY FINDINGS The new proposal would also revise guidance set forth in SR 13-13/CA 13-10: Supervisory Considerations for the Communication of Supervisory Findings, 9 which is applicable to bank and savings-and-loan holding companies of all sizes. Federal Reserve examiners and supervisory staff would direct most MRIAs and MRAs to senior management for corrective action. The MRIAs and MRAs directed to the board for corrective action would be those that concern the board s governance responsibilities or situations where senior management fails to remediate supervisory issues. This change will help boards and management delineate their respective responsibilities. How Banking Organizations Can Prepare The proposed BE guidance is principle-based and calls on boards to evaluate the specific characteristics of their individual firms. Financial organizations commonly display several gaps in areas of board effectiveness relative to the expectations outlined in the Federal Reserve s proposal. 5 SR 16-11, Federal Reserve (June 8, 2016). 6 SR 08-8/CA 08-11, Federal Reserve (Oct. 16, 2008). 7 SR 08-9/CA 08-12, Federal Reserve (Oct. 16, 2008). 8 SR 12-17/CA 12-14, Federal Reserve (Dec. 17, 2012). 9 SR 13-13/CA 13-10, Federal Reserve (June 17, 2013). PROMONTORY Sightlines InFocus NOVEMBER 2,

6 Common gaps include: Board information packages contain voluminous amounts of detailed, management-level information that confuses the distinction between performing management functions and the board s proper role of holding management accountable. Many banking organizations will need to fundamentally rethink board/management communications in light of the new Federal Reserve proposal. Board agendas and discussions are not focused on the key strategic and oversight functions of the board. Banks insufficiently demonstrate the board s role in holding senior management accountable or demonstrating board support for the independence and stature of independent risk management and internal audit. To demonstrate board independence and management accountability, some firms will need to consider changes in board membership, board structure, or board processes, with a particular focus on the role of independent directors. Boards lack sufficient diversity or subject-matter expertise to enable the board to fully consider strategic options and provide an effective challenge to management. Boards can prepare for the forthcoming guidance by conducting strong and comprehensive selfassessments or by enhancing self-assessment processes already in place. While the Federal Reserve s proposal stops short of requiring self-assessments, it places particular emphasis on them and states that boards may provide supervisors with self-assessments that they would take into consideration in evaluating board effectiveness. Moreover, the Request for Comments section of the proposal (which may foreshadow items to be included in the final guidance) invites comment on whether boards of firms subject to the BE guidance should be required to perform self-assessments and provide the results to the Federal Reserve. In summary, banking organizations will benefit from undertaking a thorough analysis of the Federal Reserve s proposal, comparing it with other relevant regulatory requirements (like the Office of the Comptroller of the Currency s heightened standards 10 ), and developing a plan for adapting to the coming changes in supervisory expectations. To prepare for the final version of the guidance, banking organizations can take a number of important steps, such as educating the board and senior management on the contents of the proposal; assessing current board policies and structure in light of the Federal Reserve s five elements for board effectiveness; developing implementation plans to address existing gaps in these areas; and reviewing board self-assessment processes and enhancing them where needed. 10 OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches; Integration of Regulations, Office of the Comptroller of the Currency (Sept. 2, 2014). PROMONTORY Sightlines InFocus NOVEMBER 2,

7 About the Authors Julie Williams is a managing director who leads Promontory s domestic advisory practice and advises clients on government expectations that shape regulatory and compliance requirements. William Lang is a Promontory managing director and leading authority on financial risk management, quantitative analysis, bank supervision, and stress testing. Alan Michael is a senior principal at Promontory and advises clients on enterprise risk management, governance, and conduct and culture risks. PROMONTORY Sightlines InFocus NOVEMBER 2,

8 Contact Promontory For more information, please call or your usual Promontory contact or: Arthur Angulo Managing Director, New York William Lang Managing Director, New York Alan Michael Senior Principal, Washington, D.C Julie Williams Managing Director and Director of Domestic Advisory Practice, Washington, D.C To subscribe to Promontory s publications, please visit promontory.com/subscribe.aspx Follow Promontory on Promontory Financial Group, an IBM Company, excels at helping clients resolve critical issues, particularly those with a regulatory dimension. Promontory professionals have unparalleled regulatory experience and insight, and provide our clients with frank, proactive advice informed by best practices and regulatory expectations. Founded in 2001 by Chief Executive Officer Eugene A. Ludwig, former U.S. comptroller of the currency, Promontory became a wholly owned subsidiary of IBM in th Street, NW, Suite 1100, Washington, DC Telephone Fax promontory.com 2017 Promontory Financial Group, LLC. All Rights Reserved.