On Aug. 9, 2017, the Board of Governors of the Federal Reserve System published proposed guidance that would address supervisory expectations for boards of directors of banks and holding companies, as applicable.1 The proposal results from a multiyear review of practices of boards of directors, particularly at the largest banking organizations, which assessed, among other things, factors that make boards effective, the many challenges boards face, and how boards influence the safety and soundness of their enterprises and promote compliance with laws and regulations. Findings from the review, as noted in the preamble to the proposal, suggest what many bank and bank holding company board members have noted for some time: that supervisory expectations for boards and senior management have become increasingly difficult to distinguish, boards often devote significant time to noncore tasks, and boards are disadvantaged by information flow challenges.
The proposal is comprised of three parts: (1) guidance addressing effectiveness of boards of directors at large institutions with total consolidated assets of $50 billion or more (larger firms); (2) a refocusing of existing supervisory guidance applicable to boards at both bank and savings and loan holding companies (BHCs and SLHCs) of all sizes; and (iii) clarification of the FRB's expectations of boards relating to supervisory findings, such as matters requiring attention (MRAs) and matters requiring immediate attention (MRIAs).
What Type of Institution is Covered?
As discussed below, the proposal prescribes which of its three parts would be applicable to a particular type of institution: holding companies, FRB-regulated banks, or both. The proposal only states explicitly that boards of both FRB-supervised holding companies and FRB-supervised banks would be covered by the refocused expectations under SR letter 16-11 and the revised guidance clarifying expectations relating to supervisory findings. The FRB indicated that the proposed board effectiveness guidance (BE guidance) would only apply to boards of holding companies. Presumably, the refocused supervision and regulation letters (SR letters) would apply on a case-by-case basis as prescribed in the revised letters. Any revised interagency guidance would likely be applicable to boards of bank subsidiaries.
As a practical matter, however, all FRB-supervised institutions — including state member banks, bank holding companies, savings and loan holding companies, and foreign banking organizations — should take notice of the proposal's expectations of boards, regardless of whether the proposal suggests it would apply to the holding company, bank, or both. Absent further clarification in the release of final guidance, all FRB-supervised institutions should consider treating the concepts drawn from the proposal as a set of best practices for their boards.
Proposed Board Effectiveness Guidance
The first proposed part — which would apply only to boards of domestic BHCs and SLHCs with total consolidated assets of $50 billion or more (excluding intermediate holding companies of foreign banking organizations established pursuant to the FRB's Regulation YY) and systemically important nonbank financial companies designated by the Financial Stability Oversight Council for enhanced supervision by the FRB — is intended to better distinguish the supervisory expectations for boards of directors from those of senior management by detailing five attributes of effective boards.
- Set Clear, Aligned and Consistent Direction: An effective board guides the development of and approves the firm's strategy and sets the types of levels of risk it is willing to take.
- Actively Manage Information Flow and Board Discussions: An effective board of directors actively manages its information flow and its deliberations, so that the board can make sound, well-informed decisions in a manner that meaningfully takes into account risks and opportunities.
- Hold Senior Management Accountable: An effective board of directors holds senior management accountable for implementing the firm's strategy and risk tolerance and maintaining the firm's risk management and control framework. An effective board of directors also evaluates the performance and compensation of senior management.
- Support the Independence and Stature of Independent Risk Management and Internal Audit: An effective board of directors, through its risk and audit committees, supports the stature and independence of the firm's independent risk management and internal audit functions.
- Maintain a Capable Board Composition and Governance Structure: An effective board has a composition, governance structure and established practices that support governing the firm in light of its asset size, complexity, scope of operations, risk profile, and other changes that occur over time.
The FRB proposes to utilize these attributes as a framework for assessing the effectiveness of boards and their committees. The preamble to the proposal notes that consistent with supervisory expectations in other areas of an enterprise's operations, the proposed BE guidance is written flexibly to allow for variations in the level of direct board responsibilities depending on the financial institutions' activities, risk profiles and complexity. Moreover, the preamble states that the proposed BE guidance will allow FRB examiners to more flexibly evaluate boards of directors by "focus[ing] on five key attributes of an effective board rather than on process-oriented supervisory expectations that do not directly relate to the board's core responsibilities."
Importantly, the proposed BE guidance permits institutions to provide self-assessments of its boards of directors' effectiveness relative to the five attributes, but does not prescribe how such a self-assessment should be conducted or documented.
Refocusing Existing Guidance
The second proposed part would refocus supervisory guidance in existing SR letters for boards of BHCs and SLHCs of all sizes by revising guidance to realign the FRB's supervisory framework and eliminate redundant, outdated or irrelevant supervisory expectations. In the first phase of this refocusing effort, the FRB has preliminarily identified 27 SR letters for potential elimination or revision, collectively affecting more than 170 supervisory expectations for holding company boards. The FRB also identified SR letters that have supervisory expectations unrelated to boards of directors that remain relevant, and stated that only board-specific portions will be revised. A complete list of the identified SR letters is provided as Table A of the proposal.
Importantly for smaller firms, the preamble indicated that the FRB will tailor expectations based on asset size of the institution. Larger firms would be subject to the BE guidance, and supervisory expectations for smaller firms would be revised to align with the supervisory expectations set forth in SR letter 16-11, "Supervisory Guidance for Assessing Risk Management at Supervised Institutions with Total Consolidated Assets Less than $50 Billion."
As a second phase, the FRB announced that it also plans to review interagency guidance and certain FRB regulations to determine whether modifications are necessary. Due to the time required to effect such changes, the FRB indicated that proposed revisions to interagency guidance and regulations would be released at a later date.
Clarifying Expectations Relating to Supervisory Findings
Finally, the FRB proposes to issue revised guidance, which would supersede SR letter 13-13/CA letter 13-10, clarifying supervisory communications to institutions concerning examination and inspection findings requiring corrective action, such as MRAs and MRIAs. The revised guidance would apply to all FRB-supervised institutions, including BHCs, SLHCs, state member banks, U.S. branches and agencies of foreign banking organizations, and systemically important nonbank financial companies designated by FSOC for enhanced supervision by the FRB.
The most significant revision proposed in the revised guidance is the removal of the general requirement for FRB examiners to direct all MRAs to boards of directors or executive board-level committees. Instead, the revised guidance provides that, except for two instances, FRB examiners and staff will typically direct senior management to take corrective action relating to MRAs and MRIAs. The two instances in which the revised guidance requires directing MRAs and MRIAs to boards of directors for corrective action are: (1) where significant weaknesses in an institution's board governance structure and practices are identified; or (2) when senior management fails to take or ensure appropriate action is taken to correct material deficiencies or weaknesses.
After evaluation of the proposal, interested financial institutions and directors may consider submitting comments to the FRB. The FRB is inviting comments to the following specific questions with respect to the proposal:
- The Federal Reserve is considering applying the proposed BE guidance to U.S. intermediate holding companies of foreign banking organizations. How should the proposed BE guidance and refocusing of existing supervisory guidance be adapted to apply to boards of the U.S. intermediate holding companies of foreign banking organizations and state member banks?
- What other attributes of effective boards should the FRB assess?
- Should boards of firms subject to the proposed BE guidance be required to perform a self-assessment of their effectiveness and provide the results of that self-assessment to the FRB? If so, what requirements should apply to how the board performs the self-assessment? Should such self-assessments be used as the primary basis for supervisory evaluations of board effectiveness?
- Would any parts of this proposal conflict with effective governance of insurance and commercial savings and loan holding companies? If so, what adjustments to the proposal would be warranted?
- Is the proposed guidance on the communication of supervisory findings clear with respect to the division of responsibilities between the board and senior management
- What Federal Reserve supervisory expectations for boards are not included in Table A, yet interfere with a board's ability to focus on its core responsibilities and should be included in the proposal? Should such expectations be rescinded or revised? If revised, how?
In addition, the FRB has invited comments on all other aspects of the proposal. In light of the importance of this subject to directors, financial institutions and their boards should evaluate whether the proposal adequately addresses the issues boards face, and, in particular, whether the proposal goes far enough in clarifying board responsibilities. All comments must be submitted no later than Oct. 10, 2017.
Potential Impact of the Proposal
Beyond the opportunity to comment and to address the specific questions above, interested parties should consider the impact the proposal would have on their enterprise as a whole, and financial institution subsidiaries. While the ultimate scope and effectiveness of the proposal will depend upon the level of its supervisory implementation by Reserve Bank examiners and staff, the potential benefits of the proposal should be a welcome development for boards of directors. At a minimum, boards would be provided with a standard set of expectations they could rely on to frame their responsibilities and approaches to governance. The proposal would also push down oversight responsibility for certain day-to-day business issues to senior management, allowing boards to focus on their core oversight responsibilities.
In evaluating the proposal, financial institutions and their boards should consider the practical consequences of such guidance. For example, for larger institutions, what will be the impact of a permissible self-assessment of your board's effectiveness? Will the submission of such self-assessments develop into an industry best practice? If so, consideration should be given to the development of a well-thought-out process for conducting and documenting such self-assessments. In advance of final guidance, boards of directors at large institutions may also consider using the BE guidance as a guidepost to evaluate how they would fare under the new expectations.
Smaller institutions (below $50 billion in assets) may benefit more immediately as the FRB has explicitly pointed to the existing guidance in SR letter 16-11 as the currently effective guidance for the boards of such institutions. Many smaller institutions, particularly those considered midsize ($10 billion-$50 billion in assets) or near mid-size, have had the same experience of larger institutions regarding bank examiners blurring the lines of expectations on boards and management. The FRB's emphasis on SR letter 16-11 as the basis for aligning supervisory expectations, rather than proposing a new set of guidelines or having the proposed BE guidance apply to such smaller institutions, provides smaller institutions with immediate guidance for engaging in new dialogue with their examiners on board expectations.
With respect to the revised guidance related to supervisory findings, although the proposed guidance would require FRB examiners to direct certain MRAs and MRIAs to senior management for corrective action, financial institutions should be mindful that the proposed guidance will not eliminate the board's oversight responsibilities. The preamble states clearly that boards would remain responsible for holding senior management accountable for remediating supervisory findings. Accordingly, financial institutions should consider developing tailored internal policies governing the flow of supervisory information that best fit their institution.
1 Proposed Guidance on Supervisory Expectations for Boards of Directors, 82 Fed. Reg. 37219 (Aug. 9, 2017).
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