Boards should scrutinize managers, not hold their hands

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The golf legend Arnold Palmer once said, “The road to success is always under construction.” The phrase is as true for bank regulation — specifically bank board governance rules — as it is for the fairway.

Board members and executives have long sought to build a better road to governance success, but for a while they lacked the sufficient, balanced guidance from regulators needed to get there. Until now. If implemented, the Federal Reserve Board’s recent proposed supervisory expectations for boards will restore the independence of bank boards that is necessary to achieve effective management accountability.

Yet the proposal, somewhat surprisingly, has sparked criticism in certain quarters from voices who argue that the Fed is aiming to let board members off easy. This could not be further from the truth.

In The New York Times, Gretchen Morgenson wrote, rather than urge directors “to sharpen their scrutiny,” the proposal “would go in the opposite direction,” asserting that “big-bank board members need to take a load off.” Citing the views of other regulators, Morgenson claimed that the guidance would “very likely … reduce crucial interactions between bank examiners and bank boards.”

But on the contrary, the proposal will not reduce such interactions. Board members will not be sheltered from the strategically relevant information that supervisory examinations produce. In fact, it is precisely the truly “crucial” information from exams that will be pinpointed in agency communications to the board and separated from the chaff of routine operational details.

Too often in the past, supervisory guidance and examination conclusions have described expectations for boards of directors in conjunction with those of senior management — as if “senior management and the board” were one undifferentiated entity. A 2014 Federal Deposit Insurance Corp. study on “matters requiring board attention” illustrates repeated instances where the boards of well-rated institutions are required to undertake management duties such as loan grading, cash flow analysis and updating workout plans. The report also showed how the FDIC has lumped MRBAs in the compound “Board/Management” category. This has confused roles, wasted scarce board resources and compromised the independence of the board.

Meanwhile, enforcement orders that have doubled down on making directors the rubber stamps of management operating plans have not made board members better corporate leaders. Instead, they have made directors dig in to defend the managers whose policies they have previously approved, no matter how tangentially.

As the Fed now acknowledges, the best path to good governance is not to make the board a redundant form of management, but instead to make directors credible overseers of corporate strategy and management performance.

The proposed supervisory guidance articulates five waypoints for achieving governance success: set clear, aligned, and consistent direction; 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.

Consistent with this guidance, the Fed also proposes to conform its expectations with respect to reporting examination findings to boards, so that governance failures — not management minutiae — are the focus.

The guidance expressly obligates the board to affirmatively manage the flow of information from all sources (including its supervisor) that it needs to fulfill its responsibilities of providing clear strategic direction and holding senior management accountable. Outside directors will serve the role their appointment is intended to fulfill; they will ensure the integrity of the information sources, which will prevent the board from merely being co-opted by inside directors.

The suggestion in Morgenson’s article — as put forth by former FDIC Chair Sheila Bair — that boards could be “copied” on examination correspondence as a routine fail-safe would only undermine the efficiencies the proposal seeks to accomplish. Indiscriminate circulation of exam reports above senior management has never assured that directors make better decisions or more effectively hold management accountable.

Under the proposal, regulators are not taking a “load off” directors; they are exchanging one obligation (operations) for another (oversight) to encourage more efficient board governance practices. To realize the benefits of this realignment, banking agencies must discipline themselves to conduct examinations, identify findings and recommend remediation that differentiate the roles of staff, management and the board so that the road to success is constructively executed in accordance with the specifications for enterprise-wide risk management that regulators have long professed to support.

The Fed is not advocating for weaker scrutiny by the board. Tougher scrutiny, which is not the same thing as operational brawn, is precisely what the proposal encourages bank directors to better exercise.

Under the new guidance, boards can hone their scrutiny of management’s conduct by improving their primary oversight function along the following lines:

  • Use a common vocabulary in a common framework to enable employees, management and directors to discuss enterprise risk — so that expectations are clear, information flows effectively across the control structure, and performance measures are understandable and resist gaming.
  • Create a functional definition of materiality for gauging risk tolerances that captures the impact not only of financial shortfalls, but also shortcomings in meeting compliance requirements and corporate ethical standards.
  • Test the board’s perceived risk appetite against the prospect of public or supervisory exposure so that a willingness to accept risk at the margins of safe, sound, compliant or ethical behavior is not overestimated or miscommunicated through the lines of command.
  • Provide an expedited pathway for escalating ethical lapses to board oversight. When management staff games the risk management system, program failure has gone beyond human error, insufficient training or lax monitoring; the bank’s core values are compromised and the board must be engaged early and forcefully.

By pursuing these types of enhancements, directors will not become isolated, as some fear. They will actually be able to intervene more effectively when necessary.

Hopefully the other banking regulators will join the Fed’s initiative so that a unified supervisory policy will better delineate, and adhere to, the separate responsibilities of managers and directors in the governance process. This will allow management and boards to better serve their roles, subject to more focused supervisory monitoring. Agencies, banks, shareholders and customers should welcome the proposal as the best road to bank governance success.

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