On January 28, 2013, the Office of the Superintendent of Financial Institutions (OSFI) released its final Corporate Governance Guideline (Final Guideline) for federally regulated financial institutions (FRFIs). A draft Guideline (Draft Guideline) was first released on August 7, 2012 for industry and public comment and OSFI received over 30 submissions on the Draft Guideline. With the publication of the Final Guideline, OSFI also made available a summary of the key comments received on the Draft Guideline and an explanation as to how these issues were dealt with by OSFI. The Final Guideline updates the Guideline that was originally published in 2003 (2003 Guideline).
The Final Guideline imposes key deadlines. By May 1, 2013, FRFIs have to complete an assessment of their compliance with the Final Guideline and develop a plan to rectify any deficiencies (not just material deficiencies). The results of the assessment and the FRFI's action plan to deal with deficiencies have to be submitted to the FRFI's relationship manager by this date. Full implementation of the Final Guideline is to be completed no later than January 31, 2014. OSFI also indicated that OSFI will be running seminars on the Final Guideline for small and medium-sized FRFIs in the spring and will be reaching out to Boards of Directors (Boards) with details.
In this bulletin, we identify and consider the key changes from the 2003 Guideline and, where applicable, also note any material changes from the previously published Draft Guideline.
The Final 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 generally 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.
The Final Guideline reflects OSFI's current strong focus on risk management and enterprise governance and controls, and takes into account the reviews conducted by OSFI's Corporate Governance Unit, best practices that have been identified by OSFI and comments received on the Draft Guideline and is intended to better align Canadian practices with recognized international standards.
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
- 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
- boards should, on occasion, retain external parties to review board practices and oversight systems
- FRFIs should establish a dedicated Risk Committee and appoint a Chief Risk Officer (CRO) or equivalent
- the Audit Committee should have regular private meetings with the internal auditor (in addition to those it has with the external auditor) and should approve the appointment and reappointment, as well as the fees and scope of the engagement of the external auditor.
There have been several key changes from the Draft Guideline. OSFI had initially included several recommendations with respect to the use by the Board of external reviewers to assess the FRFI's risk management and oversight practices. While the Final Guideline still contemplates some involvement, the expectation has been softened, as discussed below. With respect to two corporate governance recommendations (relating to the establishment of a Risk Committee and the position of the CRO), the Final Guideline now specifically sets out expectations relating to smaller, less complex FRFIs and this additional guidance was not included in the Draft Guideline. OSFI has also removed the Annex entitled "Board Responsibilities and Subsidiaries of FRFIs" from the Final Guideline and replaced it with more focused language with respect to OSFI's expectations regarding the governance of subsidiaries. In addition, in response to comments on the Draft Guideline, the independence requirements for members of the Risk Committee and the Audit Committee have been changed in the Final Guideline so that the expectation is no longer that all of the members of each of these Committees be independent. Finally, OSFI has amended language with respect to the Board's general responsibilities with respect to the FRFI's oversight functions to confirm that OSFI expects the Board to have an oversight role over these functions. The language in the Draft Guideline suggested a more operational role. All of these changes are discussed in more detail below.
Board Experience, Competencies and Independence
The 2003 Guideline provided that the Board should, collectively, have an appropriate balance of expertise, skill, experience and perspectives but does not identify any specific competencies. The Final Guideline now specifically provides that the Board of an FRFI should have reasonable representation of financial industry and risk management expertise among its members. The intent is to promote more informed discussions between the Board and senior management about core risks.
The Final Guideline does not set out any specific requirements with respect to the nature or level of 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. It is not clear, for example, whether the expectation has to be sector-specific or whether past experience on the boards of other financial institutions is sufficient. In any event, these new experience expectations will need to be factored into an FRFI's director recruitment and succession planning practices.
Other new recommendations with respect to Board competencies include: (1) establishing a formal skills and competency process (to be reviewed annually) to assess the skills and experience of Board members, as well as any competency gaps, (2) directors seeking internal and external education opportunities to develop risk management knowledge, and (3) adopting a policy establishing guidelines for evaluating and determining the independence of directors, which the Final Guideline specifically notes should consider whether the length of the directors' tenure should be factored into such a determination.
Separation of Chair of Board and CEO
The 2003 Guideline emphasized the importance of an independent board to effective corporate governance. The Final 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. The Final 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.
The Draft Guideline introduced new best practices involving external reviews. The Superintendent had previously noted 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. Specifically, the Draft Guideline recommended that Boards engage, on a periodic basis, external reviewers to assess the effectiveness of: (1) Board and Board Committee practices and whether they reflect existing corporate governance best practices; (2) the FRFI's oversight functions and processes; and (3) the FRFI's risk management systems and practices. These review findings were to be submitted directly to the Board.
In response to many concerns communicated to OSFI (including with respect to the lack of qualified reviewers, the lack of clear, objective criteria and duplication of internal and external auditor function), the recommendations with respect to external reviews have been softened in the Final Guideline. Instead of engaging external reviewers to undertake the assessment on a periodic basis, the Final Guideline now provides for the occasional use of external reviewers to provide assistance with the assessment of Board practices and the FRFI's oversight functions. Further, the Final Guideline does not refer at all to the involvement of third-party reviewers in the assessment of the FRFI's overall risk management approach. This recommendation has been removed. Nevertheless, we expect that OSFI will continue its practice of requiring individual institutions to undertake an external review where OSFI has a concern specific to the governance or controls of the FRFI.
Risk Appetite Framework
The Final 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 intent of the RAF is to further embed risk awareness and management in the FRFI's culture and values.
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 (including compensation programs). While the Draft Guideline provided that the RAF should consider all types of risk, the language in the Final Guideline is less onerous and refers to all material risks. This change was made in response to comments received by OSFI on the Draft Guideline.
The following are specific components of the RAF identified in the Final Guideline: (1) a risk appetite statement which sets out the risks that the FRFI is willing to accept; (2) an identification of risk limits, which is explained as an allocation of the risk appetite statement to different categories (i.e., type of risk, business unit, business line, etc.); and (3) a framework for supervision of implementation of the RAF (i.e., allocation of specific oversight responsibilities). Annex B of the Draft Guideline sets out the RAF requirements in more detail. With respect to the risk appetite statement, the Final Guideline recommends that the statement should be linked to the FRFI's short- and long-term plans (as well as compensation programs) and should include both qualitative and quantitative measures and examples of such measures have been included.
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.
The Final Guideline now formalizes 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, including the Chair of the Committee, will be formed entirely of non-executives (i.e., Board members who do not have management responsibilities). The Draft Guideline had provided that all of the Risk Committee members would be independent. It was communicated to OSFI however that the independence requirement would rule out individuals who were members of the FRFI group and whose knowledge with respect to risk specific to the FRFI was critical.
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, where appropriate, some Committee members should have technical knowledge in risk disciplines that are material to the FRFI.
The Final Guideline further provides that the Risk Committee should have a clear mandate and its specific duties should specifically include: (1) seeking assurances from the CRO that risk management oversight is not carried on by the management who directs and controls day-to-day operations (i.e., Operational Management); (2) that risk management activities are allocated sufficient resources and have sufficient prominence at the FRFI and (3) providing input in respect of the approval of material changes in the FRFI's strategy/risk appetite. The Draft Guideline provided only that the Risk Committee should be aware of material changes.
Another key change from the Draft Guideline is that the Draft Guideline provided that the Risk Committee should approve the mandate and assess the performance of the Chief Risk Officer (CRO). This recommendation was removed from the Final Guideline on the basis that these responsibilities reside with the Board. The Board could, however, delegate this function to one of its committees, such as the Risk Committee or the Human Resources Committee.
With respect to smaller, less complex FRFIs, the Final Guideline provides specifically that instead of establishing a separate Risk Committee, the Board should ensure that, collectively, it has sufficient skills, time and information to provide effective risk oversight. Specific recommendations for smaller FRFIs were not included in the Draft Guideline.
Chief Risk Officer
It is a recommendation in the Final Guideline that all FRFIs should appoint a CRO (or equivalent senior officer) who will lead the risk management function at the FRFI. The CRO should be independent from operational management and ensure that there are processes and controls in place to verify risk information provided by business lines. In terms of independence, OSFI expects that the CRO should not be directly involved in any revenue-generating activities. The Final Guideline also includes a new expectation, not included in the Draft Guideline, that the CRO's compensation should not be linked to performance of specific business lines.
The Final Guideline provides also that the CRO should provide regular reports to the Board and should 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. The CRO should also be meeting with the Board and Risk Committee without senior management on a regular basis, and providing his or her view as to the FRFI's performance against the RAF.
In terms of smaller, less complex FRFIs, the Final Guideline acknowledges that the senior executive with responsibility for risk oversight may have other non‑operational roles. Again, this is a specific guideline added to the Final Guideline to address the concerns of smaller FRFIs
With respect to recommendations relating to the Audit Committee, there have been several changes from the Draft Guideline. First, the recommendation that the members of the Audit Committee all be independent (which was also included in the 2003 Guideline) was removed in response to comments received that the "full independence" requirement was not consistent with financial institution statutes, which require only that the Committee consist of non-employee directors, a majority of whom are not affiliated with the institution. Notwithstanding that the Guideline was amended, OSFI noted that the independence standard is an international best practice and that many FRFIs have adopted this standard.
Second, the Final Guideline no longer specifies that the Chief Internal Auditor, the Chief Financial Officer and, in the case of federally regulated insurance companies, the Appointed Actuary, should have direct and independent communication lines to the Audit Committee. Third, in terms of recommendations made by the Audit Committee to the shareholders with respect to the external auditor, the Final Guideline provides that the Audit Committee, and not senior management, should approve the appointment, reappointment, removal and remuneration of the external auditor, as well as the scope and terms of the audit engagement. The Final Guideline also recommends that the Audit Committee closely monitor the fees being charged. The Draft Guideline referred only to the Audit Committee's role in approving the fees of the external auditor and the scope of the audit engagement and appears to have inadvertently omitted the expectation that the Audit Committee make the recommendation with respect to the appointment of the external auditor (which was included in the 2003 Guideline). Finally, the Final Guideline also sets out a new recommendation that, on an annual basis, the Audit Committee report to the Board on the effectiveness of the external auditor.
In terms of key changes from the 2003 Guideline, the Final Guideline now expressly provides that the Audit Committee should have regular private 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. These include, but are not limited to, areas of risk for material misstatement, areas of significant auditor judgment, the external auditor's view as to whether estimates are aggressive or conservative and internal control deficiencies.
Consistent with the 2003 Guideline, the Draft Guideline provided that the Board should "approve and play an active role in the activities of the oversight functions." However, in response to concerns raised during the comment period that this language was too broad and suggested that the Board might have an operational role beyond its stewardship mandate, this language has been removed from the Final Guideline.
In terms of the Board's involvement with the oversight functions, the Final Guideline now specifies only that the Board should approve the mandate, resources and budgets of the oversight functions, including specifically the selection and compensation of the heads of these functions.
The Final Guideline also provides for the regular assessment of the effectiveness of the FRFI's oversight functions but does not go as far as recommending that such assessments be carried out by external reviewers, which was contemplated in the Draft Guideline. The Final Guideline provides only that the assessment process may involve the occasional assistance of external reviewers to conduct a benchmarking exercise.
Further, the Final Guideline now includes specific recommendations that were not included in the Draft Guideline to the effect that the heads of the oversight functions have appropriate stature and authority in the organization and that they have a direct reporting line to the Board or relevant Board Committee.
OTHER NOTABLE DIFFERENCES
The Board Responsibilities section of the Final 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.
The Final Guideline also now contains a broad recommendation that the FRFI should notify OSFI of any potential changes to the membership of the Board and senior management, in addition to any change in circumstances that might adversely affect the suitability of Board members and senior management. This recommendation was not included in the Draft Guideline.
Attached to the Draft Guideline was an Annex (Annex B) which set out certain general expectations with respect to Board responsibilities vis-à-vis subsidiaries of FRFIs and identified certain key areas warranting oversight. This Annex was consistent with language in the 2003 Guideline but has not been included with the Final Guideline. Instead, the Final Guideline includes a general statement to the effect that the Boards of parent companies should determine what structure for the Boards of the subsidiaries is most appropriate for ensuring oversight of the subsidiaries by the parent Board. OSFI has explained that the deletion of Annex B is to clarify its expectations, by referring to a general expectation, and to avoid suggesting that the Boards of all subsidiaries have to separately meet all of the requirements of the Guideline.
As noted in an earlier bulletin, the Superintendent had previously 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). This recommendation was not incorporated in the Draft Guideline or the Final Guideline.
SMALL AND WHOLLY OWNED FRFIs
As with the 2003 Guideline, the Final 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 Final Guideline provides some additional guidance (which was not set out in the Draft Guideline) in terms of how OSFI will take into consideration the needs and limitations of smaller and less complex FRFIs and wholly owned FRFIs, but this additional guidance is limited. However, OSFI has indicated in the letter accompanying the release of the Final Guideline that it will be organizing seminars for the directors of small and medium-sized FRFIs to discuss the Corporate Governance Guideline in the spring of 2013.