On August 7, 2012, the Office of the Superintendent of Financial Institutions (OSFI) made available for comment a draft Guideline on Corporate Governance (Draft Guideline) for Federally-Regulated Financial Institutions (FRFIs). After industry and public comment, the Draft Guideline will update the Guideline that was originally published in 2003 (2003 Guideline). Prior to circulation, OSFI obtained preliminary comments on the Draft Guideline from select directors in the financial services sector. OSFI has requested that any industry comments be submitted by September 14, 2012.
In this bulletin, we identify and consider the key amendments proposed in the Draft Guideline. Once the Draft Guideline is finalized, these amendments will need to be considered carefully by FRFIs, as they assess whether their practices meet OSFI's new expectations and, where appropriate, plan for the adoption of new practices, policies and governance structures that reflect OSFI's new guidance. The length of the implementation period is not set out in the Draft Guideline. FRFIs that will need time to implement the changes should be sure to comment to OSFI on the implementation period necessary for them.
The Draft Guideline, like the 2003 Guideline, sets out OSFI's general expectations with respect to corporate governance practices at FRFIs and all FRFIs – other than branches of foreign banks and foreign insurance companies – will be subject to the Draft Guideline once implemented. As with the 2003 Guideline, the Draft Guideline is not prescriptive in that it does not set out detailed requirements with respect to processes or controls. This is consistent with OSFI's view that there is no "one-size-fits-all" approach to corporate governance.
Since the advent of the global financial crisis, OSFI, like other regulators, has made corporate governance a key area of focus. A Corporate Governance Unit was established by OSFI in 2010 to specifically review and compare corporate governance practices of the "big six" banks and three big life insurance companies. OSFI has started organizing meetings, at least once a year, with the entire Board of select large financial institutions. OSFI has also established a Corporate Governance Advisory Committee which includes industry participants with diverse financial services experience.
The changes proposed to the Draft Guideline reflect the reviews conducted by the Corporate Governance Unit and best practices that have been identified by OSFI. The changes will also better align Canadian practices with recognized international standards (including those set out by the Financial Stability Board, the Organization for Economic Cooperation and Development, the Basel Committee for Banking Supervision and the International Association of Insurance Supervisors).
As with the 2003 Guideline, although the Draft Guideline does not apply directly to branches of foreign banks and foreign insurance companies, OSFI expects the Chief Agent or Principal Officer of a branch to be aware of OSFI's guidance on corporate governance.
While the Draft Guideline has been substantially reorganized and revised so that it appears to be an entirely new document, the majority of the substantive content in the 2003 Guideline remains unchanged and the key amendments introduce the following new regulatory expectations:
- Boards and committees should have appropriate financial industry and risk expertise so that they are better positioned to evaluate and discuss information provided by management and engage management with respect to key issues facing the FRFI;
- Boards should arrange for independent third-party reviews to benchmark the FRFI's corporate governance practices;
- the roles of the Chair of the Board and the CEO should be separated to further increase the independence of the Board;
- FRFIs should develop a formal Risk Appetite Framework that will guide risk management across the organization;
- FRFIs should establish a dedicated Risk Committee and appoint a Chief Risk Officer; and
- the Audit Committee should have regular in camera meetings with the internal auditor (in addition to those it has with the external auditor) and should approve the fees and scope of engagement of the external auditor.
These changes are consistent with recent remarks of the Superintendent, including her presentation to the Toronto Board of Trade on April 5, 2012 with respect to the Draft Guideline, except that the Superintendent had signalled that OSFI might introduce an expectation that the Audit and Risk Committees be independent (i.e., separate membership for each committee, at least in complex institutions), but there is no such recommendation in the Draft Guideline.
Board Experience and Competencies
The 2003 Guideline provides that the Board should, collectively, have an appropriate balance of expertise, skill, experience and perspectives but does not identify any specific competencies. The Draft Guideline now specifically provides that the Board of an FRFI should have reasonable representation of financial industry and risk management expertise among its members. OSFI has already begun discussing these new experience expectations with FRFIs.
The Superintendent noted in her April remarks that the rationale for specific financial industry and risk management experience is that it will help avoid knowledge gaps at the Board level and should promote more informed discussions between the Board and senior management about the FRFI's core risks and risk management. More financial industry and risk management expertise should strengthen Boards by better positioning them to test and, where appropriate, challenge management's assumptions and recommendations. One small but perhaps notable drafting change is that the 2003 Guideline referred to the Board having a general understanding of the risks facing the FRFI whereas the Draft Guideline now provides that the Board should have a full understanding of these risks.
Consistent with the rest of the Draft Guideline, there are no specifics in terms of the nature or level of expertise – i.e., Does the experience have to be sector-specific? Is past experience on the Boards of other financial institutions sufficient or is there an expectation that there be more direct, operational financial industry expertise? – or what constitutes reasonable representation and, accordingly, FRFIs will have to determine on their own how to evaluate the quality and suitability of a director's experience.
These new experience expectations will need to be factored into an FRFI's director recruitment practices. Initiatives could also be taken to develop the knowledge base of existing directors and internal or external training is recommended in the Draft Guideline as an option available to the Board to develop Board members' understanding of risks facing the FRFI. Further, OSFI also suggests that third-party advisers could present to the Board on certain topics (i.e., new products, risk management practices) so that the Board can have the benefit of a separate, and perhaps different, viewpoint than that of management. With respect to the training recommendation, query whether in some cases internal training of Board members could adversely affect Board independence.
Other new recommendations with respect to Board competencies include (i) establishing a formal skills assessment process (including some form of competency matrix) to identify the skills and experience of Board members, as well as any competency gaps and (ii) a policy establishing guidelines for evaluating and determining the independence of directors, which the Draft Guideline specifically notes should consider whether the length of the directors' tenure should be factored into such a determination. These new recommendations build on the expectation set out in the 2003 Guideline that Boards have self-assessment programs in place.
Separation of Chair of Board and CEO
The 2003 Guideline emphasizes the importance of an independent Board to effective corporate governance but the Draft Guideline goes further and specifically provides that the role of the Chair of the Board and the CEO should be separated, although it does not go so far as to require the Chair to be an independent director. While such a separation is a widely accepted best practice followed by public companies, this may be difficult for smaller institutions. The Draft Guideline also sets out OSFI's expectations with respect to the Chair position, including that the Chair should engage frequently with, and be able to influence, other directors and senior management and will be expected to devote more time to Board matters than other directors. There is also an expectation that the Chair will engage regularly with regulators.
A new best practice introduced in the Draft Guideline is that Boards engage, on a periodic basis, third-party reviewers to assess the effectiveness of:
- Board and Board Committee practices and whether they reflect existing corporate governance best practices;
- the FRFI's oversight functions and processes; and
- the FRFI's risk management systems and practices.
The review findings should be submitted directly to the Board so that the Board can discuss any recommendations or issues identified in the reviews and consider any remedial action if necessary. In her April remarks, the Superintendent indicated that it was OSFI's view that third-party reviews provided FRFIs with a means to benchmark their corporate governance practices and to identify, before OSFI does, any gaps in practices.
Again, the Draft Guideline is not prescriptive and does not specify what the qualifications or experience of the third-party reviewers should be or the frequency of reviews. OSFI may want to consider who FRFIs will engage to conduct these reviews. If the Canadian financial services industry ultimately relies on a small group of professional third-party corporate governance reviewers, then there is the risk that FRFIs will not have available to them a sufficient diversity of viewpoints with respect to corporate governance matters and a set of accepted "third-party reviewer standards" may develop without direct input from OSFI.
Risk Appetite Framework
While OSFI recognizes that determining risk appetite for an organization is a challenging endeavour (especially for large, complex organizations), the Draft Guideline contains a new recommendation that Boards approve an enterprise-wide Risk Appetite Framework (RAF) that sets out "basic" goals, benchmarks and limits with respect to the FRFI's risk appetite.
The expectation is that the RAF will serve as a forward-looking guide to determine the FRFI's level of risk exposure (at an enterprise-wide level and also at more specific levels), and that the RAF should be reflected in the FRFI's overall risk policies and practices. The Draft Guideline provides that the RAF should consider all (emphasis is OSFI's) types of risk including, specifically, reputational risk, and take into account operational and macroeconomic factors. The intent of the RAF is to further embed risk awareness and management in the FRFI's culture and values.
The following are specific components of the RAF identified in the Draft Guideline:
- risk appetite statement;
- risk tolerance limits; and
- framework for supervision of implementation of the RAF (i.e., allocation of specific oversight responsibilities).
Annex C of the Draft Guideline sets out the RAF requirements in more detail, although in our view the difference between the risk appetite statement and the risk tolerance limits could be clarified.
OSFI's further expectations include the establishment of control systems to monitor and assess compliance with the RAF. Further, the Board and senior management should receive regular compliance reports and updates with respect to the effectiveness of the RAF containing actual comparisons of the FRFI's performance against the measures described in the RAF.
Risk Committee and Chief Risk Officer
In the Draft Guideline, OSFI has now formalized an expectation that FRFIs have a dedicated Risk Committee of the Board that has responsibility for supervising risk management across the organization. OSFI expects that the Risk Committee will be formed entirely of independent Board members (including the Chair of the Committee). However, depending on the nature, size, complexity and risk profile of the FRFI and the size and composition of the Board, it may not be commercially practical for certain FRFIs to satisfy these expectations through a separate Committee.
In terms of qualifications, knowledge in the risk management of financial institutions should be represented on the Committee and OSFI provides some specificity here in terms of expectations by indicating that some Committee members should have technical knowledge in risk disciplines that are material to the FRFI.
The Draft Guideline further provides that the Risk Committee should have a clear mandate, which would specifically include ensuring that risk management oversight is not carried on by the management who directs and controls day-to-day operations (i.e., Operational Management), that risk management activities are allocated sufficient resources and have sufficient prominence at the FRFI and that the Risk Committee should approve the mandate and assess the performance of the Chief Risk Officer (CRO).
According to the Draft Guideline, all FRFIs should also appoint a CRO who will lead the risk management function at the FRFI. The CRO should be independent from Operational Management (and, specifically, should not be directly involved in any revenue-generating activities), ensure that there are processes and controls in place to verify risk information provided by business lines and have a direct and independent communication channel to the Board or the Risk Committee, although it is recognized that administratively the heads of oversight functions generally report to the CEO. It is expected that the CRO will meet with the Board and Risk Committee without senior management on a regular basis, and provide his or her view as to the FRFI's performance against the RAF.
Audit Committee Recommendations
OSFI made a few changes to the section of the Guideline that addresses the role of the Audit Committee. First, the Draft Guideline specifies that the Chief Internal Auditor, the Chief Financial Officer and, in the case of federally-regulated insurance companies, the Appointed Actuary, should all have direct and independent communication lines to the Audit Committee. The Draft Guideline also emphasizes that it is the responsibility of the Audit Committee, and not senior management, to approve the external auditor fees and the scope of the auditor's engagement. Further, it is expressly provided in the Draft Guideline that the Audit Committee should have regular in camera meetings with the internal auditor, in addition to the external auditor and, if applicable, the Appointed Actuary and now sets out specific areas of inquiry that an Audit Committee should consider when discussing audit results with senior management and the external auditor. Finally, the Draft Guideline does not contain any statement similar to the 2003 Guideline that the Audit Committee should make a recommendation with respect to the appointment of the external auditor, which appointment is required to be made by the shareholders of the FRFI.
Small and Wholly Owned FRFIs
As with the 2003 Guideline, the Draft Guideline continues to acknowledge that the approach to corporate governance may vary depending on the FRFI and now specifically recognizes the size, ownership structure and corporate strategy of the FRFI as additional factors for distinguishing between FRFIs (in addition to the nature, scope and complexity of the FRFI's operations and the FRFI's risk profile, which are the criteria set out in the 2003 Guideline). The Draft Guideline does not provide any new guidance in terms of how OSFI will take into consideration the needs and limitations of smaller and less complex FRFIs and wholly owned FRFIs. In remarks to the Trust Companies Association of Canada in May 2012, the Superintendent noted that the focus of smaller institutions should be on the principles of independence, rather than structure. However, smaller FRFIs and wholly owned FRFIs may want more direction from OSFI on how OSFI will accommodate them in respect of corporate governance best practices.
Other Notable Differences
The Board Responsibilities section of the Draft Guideline now contains a specific recommendation that the Board review and discuss the compensation policy of the FRFI, which compensation policy should be consistent with the Financial Stability Board Principles for Sound Compensation and related Implementation Standards.
As noted above, the comment period for the Draft Guideline ends September 14, 2012. Once the Draft Guideline is finalized, there will be an implementation period during which FRFIs will have time to adopt the best practices outlined in the Guideline. According to the Guideline Impact Analysis Statement that was circulated with the Draft Guideline, OSFI will consider the comments received in determining the appropriate implementation period so FRFIs that have specific concerns or expectations around the length of the implementation period should include these in their comments. During this implementation period, FRFIs will need to consider the competencies of their Boards and mandates of Board Committees, as well as review their policies and procedures to identify and assess any substantive gaps and develop a plan to comply with the recommendations of the new Guideline, as appropriate.
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