An "Editor at Large" column last fall, "
The supervisors are justified in their concerns.
Given the complexities of banking and management responsibilities in the 21st century, current approaches deserve a thoughtful reconsideration.
While supervisors clearly need more forward-looking indicators, they are right to be cautious, because determining the suitability of management officials is fraught with potential unintended consequences that argue for great care. But with modest effort, the agencies can improve materially both their own supervisory practices and industry practices for evaluating and strengthening management.
The most important responsibility of the board of an insured institution is the selection and oversight of management.
The supervisory agencies have statutory responsibilities under which they evaluate the effectiveness of the board and management in maintaining a sound institution that complies with laws and regulations. With occasional exceptions in the context or licensing or enforcement-related approvals, the supervisors have deferred to the judgment of the board of directors about the suitability of management.
Even when the condition of the institution becomes a clear supervisory concern, the ensuing enforcement action will usually require the board to perform an evaluation of management or to commission such an evaluation from an independent third party.
An excessive expansion of supervisors' role in determining the suitability of sitting management could be an incursion on the traditional role of the board. It would also intensify an already fractious debate about the proper role of government in a market economy.
The Camels rating (an acronym for capital, asset quality, management, earnings, liquidity and sensitivity to market risk) summarizes the agencies' view of the health of each insured institution. A numerical composite rating for the institution is derived from separate ratings of each Camels component.
Unlike the other components, the M rating derives primarily from the conditions examiners find in the other examination work streams, rather than from a thorough assessment of management capabilities performed by the examination team. If expansionary economic conditions have masked poor underwriting and other risk management weaknesses, absent significant compliance issues, management of a profitable institution is likely to be rated favorably.
Far from the forward-looking indicator of trouble that supervisors are seeking, the M rating neither reflects management capability nor the likelihood that the institution will survive an economic downturn.
Assuming that the supervisory agencies were able to overcome any qualms they may have with regard to role appropriateness and take on the task of evaluating management more explicitly, what will they do upon identifying a management official whom they consider unsuitable? Presumably, their conclusion would be reflected in the report of examination, to which they would request a reply from the board.
Having received the agency's opinion relative to the individual in question, the institution's board will either acquiesce and remove the individual from his/her position or will decline to do so.
If it resists removing the manager, the board risks a supervisory enforcement action against the bank.
Paradoxically, if the board accedes to the agency's demand for a replacement manager, the agency could well be faced with litigation from the ousted manager, claiming that he/she was deprived of employment without due process.
The agencies' enforcement or litigation counsel is unlikely to relish cases in which the board of a financially healthy bank has a difference of opinion with the agency about the employment of a manager who has not engaged in personal dishonesty or a willful disregard for safety and soundness.
Moreover, the agencies have historically demonstrated a strong preference for using their examining resources to examine institutions rather than to prepare cases for litigation.
Our work with financial institutions reflects a broad divergence of practice in how boards evaluate management. Most often, the review is limited principally to the chief executive and arises in the context of a compensation assessment of whether annual performance targets were achieved. Today's management evaluations too often do not sufficiently assess whether:
- There are clear lines of authority among the management ranks.
- Policies, job descriptions and training provide effective guidance to staff.
- Key risk management activities are properly governed.
- Sound human resources practices are followed.
- Management and board reporting conveys clearly the information necessary for effective oversight.
Similarly, the persistent focus on annual financial results often crowds out careful consideration of whether managers possess not only the technical skills necessary to perform their responsibilities effectively, but the executive competencies most often associated with success: leadership, driving results (including risk management), talent development, strategic thinking, and relationship building.
The agencies typically provide the only independent rating of management. Without their own assessments, boards have relied on those supervisory ratings without fully understanding of the boundaries of agency practice.
The first step in improving the industry's performance in assessing its managerial talent is to reduce the reliance of boards on the supervisors' numerical ratings — as opposed to analysis-of management.
The agencies should themselves rely more on examiners' narrative discussion of management in the report of examination and consider whether providing boards with the numerical M rating continues to be of supervisory value.
In the medium term, the agencies might consider replacing the M rating with a rating for "Oversight": how effectively the board carries out its responsibilities and management supervises risk management functions. (Camels could become Solace.)
The second step to improving industry performance in this area is to enhance the board's involvement in ensuring that the institution's management is well suited to its needs.
In the absence of significant problems, it is unusual for supervisors to require a board to perform a rigorous assessment of management. Yet such an assessment, before the symptoms of financial stress have emerged, would provide just the forward-looking indicator of potential trouble that the supervisors desire.
A rigorous board assessment can timely identify management shortcomings to be addressed in the normal course of business.
With modest effort, the supervisory agencies can improve the evaluations of management across all insured institutions. Moreover, they can do so without usurping the role of the board, placing their examiners in untenable situations, or increasing their litigation risk. They have merely to issue guidance.
The agencies should describe what the directors' duty of care requires the board of directors to do with respect to evaluating management.
By spelling out what boards should consider, with respect to whom, and with what frequency, the agencies can align and materially improve current industry practice.
Instead of asking examiners to substitute their judgment on the quality of management for that of the board, the agencies should place more emphasis on examiners evaluating how well the board performed its management evaluation, using the agency guidance as the basis for judging the board's work. Such an approach respects the proper role of the board and better enables supervisors to ensure that the board is effectively performing its most important function.
