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SUMMARY OF EC COMMISSION GREEN PAPER ON CORPORATE GOVERNANCE IN FINANCIAL INSTITUTIONS

Background

The European Commission (“EC”) will introduce additional mandatory laws on corporate governance for banks and other financial institutions. The relevance of this for GCC banks is wide-reaching, given that:

  • the questions asked by EC of its regulators and banks are equally relevant to GCC banks and should therefore be addressed by GCC regulators and banks;
  • similar conclusions would be reached by GCC banks as by EC banks;
  • once the EC has raised minimum regulatory standards, GCC regulators will inevitably follow;
  • it provides the perfect opportunity to learn from the mistakes of others: GCC banks should harness and use to their advantage the facts revealed by EC;
  • there is no commercial advantage to GCC banks in abstaining from action; the profits will not be increased nor will the risk management be enhanced by inaction.

The weaknesses identified by EC are widespread in GCC. The GCC banks should take the initiative and exploiting the Basel Committee Principles for Enhancing Corporate Governance and the EC Green Paper, move to bring their own corporate governance practices into line with evolving international standards and derive the benefits that flow from this. The skill is to identify which core EC and Basel recommendations should be adapted and adopted into their own corporate governance framework.

At Majlis Partners we have the expertise to assist clients with this exercise in a cost- effective and pragmatic manner.

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Preliminary Findings and Draft EC Recommendations

In June 2010, the European Commission launched a wide-ranging public consultation on corporate governance in financial institutions to (i) examine corporate governance rules and practice within financial institutions in the light of the financial crisis, determining whether the existing corporate governance regime was deficient or fit for purpose but poorly implemented, and (ii) where appropriate, make recommendations in order to remedy identified weaknesses in the corporate governance system.

The consultation was prompted by the scale of the financial crisis which had led many governments around the world to question the effectiveness of corporate governance within financial institutions, and the suitability of their regulatory and supervisory systems. The EC wanted to learn the lessons of the financial crisis and to prevent it happening again.

1. Corporate governance and the crisis

Although not a direct cause of the crisis, corporate governance (or rather a lack of) was a major contributor, primarily through the absence of effective control mechanisms. This contributed to excessive risk-taking. The crisis revealed that:

  • Boards of directors, and
  • supervisory authorities,

rarely comprehended either the nature or scale of the risks they were facing.

The highlighted deficiencies and shortcomings are very worrying. The EC is calling for concrete solutions to improve corporate governance practices in financial institutions, ensuring real change in the behaviour of the relevant actors through a combination of new regulatory and non-regulatory requirements and more effective financial supervision.

2. Adequacy of the existing principles of corporate governance?

The current corporate governance principles (the OECD principles, the recommendations of the Basel Committee and national legislation) already cover many of the problems highlighted by the financial crisis. However, in spite of this coverage, the financial crisis revealed the lack of genuine effectiveness of corporate governance regimes.

Why did the existing corporate governance approach fail?

The Commission felt there were numerous contributory reasons, including:

  • the existing principles were too broad in scope and insufficiently precise, thereby giving financial institutions too much scope for interpretation; they proved difficult to put into practice, leading to a purely formal application (i.e., a tick-box exercise), with no real qualitative assessment;
  • there was a lack of a clear allocation of roles and responsibilities with regard to implementing the principles, within both the financial institution and the supervisory authority;
  • the non-binding nature of corporate governance principles;
  • the problem of neglect of corporate governance by supervisory authorities;
  • the weakness of relevant checks;
  • the absence of deterrent penalties.

3. Boards of directors

Preliminary Finding

Central to the financial crisis was the inability of the Boards (i) to identify, understand and control the risks to which their financial institutions were exposed and (ii) to act as the principal decision-making body.

Consequently, Boards were unable to exercise effective control over senior management and unable to challenge the proposals and recommendations that were submitted to them for approval.

Why did Boards fail?

The EC felt there were many reasons for failure at Board level, including:

  • members of Boards of directors, in particular non-executive directors, devoted neither sufficient resources nor time to the fulfilment of their duties;
  • faced with a chief executive officer who was omnipresent or authoritarian, non-executive directors felt unable to raise objections to, or even question, the proposed guidelines or recommendations due to a lack of technical expertise and/or confidence;
  • a lack of diversity and balance across the Board in terms of gender, social, cultural and educational background;
  • a failure to carry out a serious performance appraisal either of their individual members or of the Board of directors as a whole;
  • Boards were unable or unwilling to ensure that the risk management framework and risk appetite of their financial institutions were appropriate;
  • corporate governance issues were rarely on the Board agenda.

EC draft recommendation on Board composition

  • The basis for quality in a Board of directors lies in its composition. Boards must ensure the right balance between independence and skills. Recruitment policies should identify with precision the skill and individual qualities needed on the Board and should seek to ensure the objectivity and independence of each member’s judgment and their ability to monitor management effectively.
  • Limiting the number of Boards on which a director may sit enables each member to devote sufficient time to perform their duties effectively.
  • The procedure for evaluating the Board of directors' performance must be formalised; in particular, the role of external evaluators should be defined and supervisory authorities and/or shareholders be supplied with the results of any evaluation so that they can judge the capabilities and effectiveness of the Board.
  • A specialised risk supervision committee should be created to strengthen the duties and responsibilities of the Board on risk management.
  • The respective roles and responsibilities of the various decision-makers within the financial institution, particularly those of the members of the Board and the senior management, must be clarified. This will ensure that clear responsibility structures are put in place across the entire organisation, including subsidiaries, branches and other related entities.
  • The chairman plays a crucial role in organising the work of the Board; it is paramount that his/her skills, role and responsibilities are clearly defined, in order to drive the Board evaluation process.

4. Risk management

Preliminary Finding

Risk management is one of the key aspects of corporate governance, however in many banks the absence of a healthy risk management culture prevails at all levels and directors do not yet set a suitable example.

The main failures and shortcomings are:

  • financial institutions fail to take a holistic approach to risk management;
  • a lack of understanding of the risks on the part of those involved in the risk management chain and insufficient training for those employees responsible for distributing risk products;
  • a lack of authority and power on the part of the risk management function who are unable to curb the activities of risk-takers and traders;
  • a lack of expertise or insufficiently wide-ranging experience in risk management;
  • a lack of real-time information on risks;
  • inadequate IT.

EU recommendation

  • Strengthen the independence and authority of the risk management function, particularly by enhancing the status of the chief risk officer (CRO). In larger companies the CRO should have equal status to the chief financial officer and should be able to directly report any risk-related problem to the Board.
  • Improve the risk management function's communication system, in particular conflicts.
  • Establish the frequency and content of the risk reports to be submitted to the Board.
  • Update the IT infrastructure to develop substantially the financial institutions' risk management capabilities allowing risk information to be circulated in good time.
  • Adopt a policy to increase awareness of risk problems ('risk culture') for the benefit of all staff, including the Board.
  • Evaluate the underlying risks before launching any new financial products, market sectors or areas of activity.
  • Gain approval from senior management for an evaluation report on the adequacy and functioning of the internal control system, including risk.

5. The role of shareholders

The alignment of directors' interests with certain categories of shareholder has amplified risk-taking and contributed to excessive remuneration for directors, based on the short-term share value of the company/financial institution as the only performance criterion.

Concept

Do not assume that shareholders will drive corporate governance. Regulators face a real challenge to provide the appropriate incentive shareholders to fulfil their responsibilities.

Ideas include:

  • a strengthening of shareholder cooperation through the creation of discussion platforms;
  • the encouragement of disclosure by institutional investors of their voting practices at shareholder meetings;
  • the adherence by institutional investors to 'stewardship codes of best practice’;
  • the identification and disclosure of potential conflicts of interest by institutional investors;
  • the disclosure by institutional investors of the remuneration policy for intermediaries;
  • the provision of better information on risk to shareholders.

6. The role of supervisory authorities

Preliminary Finding

The limits of the existing supervision system were exposed. The supervisory authorities failed to establish best practices for corporate governance in financial institutions and to ensure that financial institutions' risk management systems and internal organisation were adapted to changes in their business model and financial products.

They also failed to adequately enforce strict eligibility criteria for members of Boards ('fit and proper test').

It highlighted problems linked to the supervisory authorities themselves, particularly the means of combating the risk of regulatory capture or the lack of resources.

EC recommendation

  • Redefine and strengthen the role of supervisory authorities in the internal governance of financial institutions whilst maintaining a clear delimitation of roles and responsibilities vis-à-vis the Board.
  • Create a duty for supervisory authorities to check the correct functioning and effectiveness of the Board and to inspect, on a regular basis, the risk management function, thereby ensuring its effectiveness.
  • Extend the eligibility criteria ('fit and proper test') for future directors to cover technical and professional skills, including those relating to risk, as well as candidates' individual qualities, in order to ensure better independence of judgment by directors.
  • Strengthen cooperation between supervisory authorities on corporate governance cross-border financial institutions, particularly within colleges of supervisors.

7. Responsibility and accountability

The main stakeholders in financial institutions (Boards, shareholders, senior management, etc.) should assume a higher degree of responsibility.

Concept

Effective and efficient sanctions on senior management create a legal accountability for the correct implementation of the corporate governance principles. This will await an in-depth study

8. The question of conflicts of interest

The questions raised by the issue of conflicts of interest and management of such conflicts are not new. Nonetheless, given the systemic risk, the volume of transactions, the diversity of financial services provided and the complex structure of large financial groups, the issue remains pressing. In order to safeguard both objectivity and independence of judgment by members of the Board, it seems necessary to strengthen measures intended to prevent conflicts of interest both within the Board and also within the financial institution in general. In particular, clear policies for managing conflicts of interest need to be put in place.

Concept

Conflicts of interest should be regulated by very clear rules rooted in law and by attributing a clearly defined role to the supervisory authorities in monitoring their correct application.

Caveat

The EC recognised that one size will not fit all. Corporate governance requirements must take account of a financial institution's type - retail bank, investment bank and size - and whatever principles emerge will need to be adapted in order for them to be effective.

Majlis’ conclusion

Driven by a determination to prevent a recurrence of the financial crisis, it is inevitable that the EC will take action. The areas of focus will be those identified in this Green Paper. It is too early to predict the precise corporate governance rules or principles which will become EC law but the direction of travel is clear.

The more novel areas, such as criminal sanctions on senior management for failing to apply corporate governance principles may proceed slowly or not at all, however the majority of recommendations are likely to be seen as non-controversial. In the meantime the Green Paper provides an invaluable checklist of areas of weak corporate governance against which both regulators and banks can test themselves.

Majlis would be delighted to assist with that review exercise.

For more information please contact the Corporate Governance Department of Majlis Partners