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Toward Effective Governance of Financial Institutions

By Richard BakerOctober 22, 2012 | Print

Richard Baker, a U.K.-based consultant specializing in corporate governance and risk management, reviews a recent report on governance by the Group of Thirty (G30). Using his experience working with large financial organizations and his Policy Governance training and experience, he has much to say about governance in financial institutions from a Policy Governance perspective.

IT IS FAIR to say that Policy Governance has been adopted far less in the corporate for-profit sector than the nonprofit one. I often ask myself why that is. Is it really not suitable? Does it not work for the large size of some of these organizations? How much has it been tried?

My belief is that, in fact, the need for Policy Governance applies in both sectors and, in the for-profit sector, particularly to larger organizations. From a governance perspective, larger for-profit organizations have something important in common with the nonprofit sector in the level of the accountability they need to provide to external owners.

So I am encouraged by the recent developments in corporate governance guidance, including the report covered by this review, as I see more and more in common with Policy Governance rather than less. These developments include themes such as the need for clear distinction between governance and management, the potential conflicts of interest involved in having executives on the board and in particular a CEO who is also chair of the board, the board as a collective rather than a number of individuals, the need for the board to clearly set risk limits (risk appetite), and the imperatives for rigorous board evaluation and commitment to good governance. Nevertheless, we still have a long way to go to achieving the level of clarity and integrity of board process that Policy Governance provides.

Background

Established in 1978, the G30 is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. In their newly released report, Toward Effective Governance of Financial Institutions, they draw on lessons from the financial crisis to call on boards of directors to do more to strengthen governance.1

It is nearly five years since the beginning of the financial crisis that we are still dealing with today. Back in 2007, Northern Rock Bank’s inability to repay its loans resulted in a run on the bank, the first in 150 years in the United Kingdom. As this report acknowledged, much has been done to highlight poor governance since then, particularly in relation to the taking of undue risk. The report refers directly to the causes of the financial crisis identified by Lord Turner, chair of the U.K. Financial Services Authority, and suggests that the critical subtext to these is “a pervasive failure of governance” at all levels.2

The G30 gives these reasons for producing this report:

  • Highly functional governance systems take significant time and sustained effort to establish and hone, and one should not presume that financial institution governance is now fixed.
  • Given the social externalities of financial institutions, good corporate governance is of critical importance, and business leadership represents a large concentration of power.
  • Prior reports, with a few exceptions, come from a national rather than international perspective.

The report goes on to offer forty-four “insights and recommendations for enhancing governance effectiveness” across seven themes, and although I do not see much that hasn’t been said before, my sense is that the emphasis on function, and not just form, or in G30’s use of the word software (meaning people, skills, and values) and not just hardware (for example, organization structures and processes), is a welcome one. One may agree, for example, on the need for a particular committee to help the board monitor particular issues, but it is not the having of one that makes it effective. Rather, as the report notes, “The software makes the hardware function.”

Call to Action

The report’s call to action aims to encourage financial institution boards to continue to give effective governance the highest priority. This will seem like a statement of the blindingly obvious to readers of Board Leadership steeped in Policy Governance. However, in my experience, the fact that a continuous focus on their system of governance is needed unless the board is to become distracted by management issues is not well understood in many organizations. In fact, there is sometimes resistance to spending time on governance on the grounds that this time would be better used on management issues. Therein lies the vicious, rather than virtuous, cycle all too familiar to boards.

More specifically the G30’s call to action urges:

  • Better methods of assessing governance and behaviors and approaches that make governance work well, including board evaluation.
  • Thought on how to achieve and measure high performance, not just on what good governance looks like.
  • Regulators who understand governance effectiveness.

The second point goes to the heart of what Policy Governance provides by setting out how to achieve and measure governance excellence, on which the other two points depend.

Key Themes

The report is based around seven themes, and below I touch on each, offering some thoughts from a Policy Governance perspective.

Addressing the Essential Question of Function

Well-implemented governance structures and processes are important, but whether and how well they function are the essential questions.

This rightly points out the distinction between software and hardware mentioned earlier, along with the need to tailor a specific governance model for each financial institution and the recognition that effective boards depend on people and their interactions, in addition to the structures they operate in. However, this report also takes the position that because each organization is unique, each needs a unique governance approach too. From a Policy Governance perspective, I agree only that each firm has to develop its own policy content, but the Policy Governance model itself, I would argue, is proof positive that the fundamentals are universal.

I welcome the distinction between function and form, but this report does not set out how governing excellence can be comprehensively achieved in either. Questions such as, “Does the board engage with and challenge management?” and, “Are interactions open and transparent?” fall far short of providing a principled, integrated approach to governance process.

The Vital Role of Boards of Directors

Boards of directors play the pivotal role in financial institution governance through their control of the three factors that ultimately determine the success of the financial institution: the choice of strategy; assessment of risk taking; and the assurance that the necessary talent is in place, starting with the CEO, to implement the agreed strategy.

From a Policy Governance perspective, the board’s job of defining what the success of the financial institution should look like is the most “pivotal” decision of all. If the “necessary talent” is indeed in place, then that talent should be able to choose the best strategy (with advice from whomever they wish) to achieve that success. The assessment of risk taking is obviously part of establishing a comprehensive set of Executive Limitations covering what must be avoided even if it would achieve the Ends.

Calling for the board to choose the organization’s strategy also seems at odds with the report’s other call for the board to “respect the distinction between the board’s direction setting, oversight, and control, and management’s responsibilities to run the business,” a distinction familiar to any Policy Governance advocate.

Many of the board’s more detailed primary responsibilities suggested in this report seem at first glance to fall more neatly into the Policy Governance system. For example, “ensuring all stakeholder interests are appropriately represented and considered” would seem to fit under the need for the board to be the link with owners. But where is the distinction between owners and other stakeholders? Rather more clearly, “obtaining reasonable assurance of compliance with regulatory, legal, and ethical rules and guidelines and that appropriate and necessary risk control processes are in place” seems to fit under Executive Limitations and the monitoring of them. What does not fit in at all is the report’s assertion that a primary board responsibility is “providing advice and support to management based on experience, expertise, and relationships.” The fact that this notion is so prevalent in the for-profit sector is a major barrier to respecting “the distinction between the board’s direction setting, oversight, and control, and management’s responsibilities to run the business” and to real CEO accountability.

Risk Governance: A Distinctive and Crucial Element of Financial Institution Governance

Those accountable for key risk policies in financial institutions, on the board and within management, have to be sufficiently empowered to put the brakes on the firm’s risk taking, but they also play a critical role in enabling the firm to conduct well-managed, profitable risk-taking activities that support the firm’s long-term sustainable success.

The board’s role in governing risk has been one of the key areas of improvement from all the major analyses since the crisis, so this theme comes as no surprise. It is also an area where I believe Policy Governance has an enormous amount to offer using the concepts of encompassment and Executive Limitations. Having written about this in Board Leadership, I will not repeat myself but I will say that having worked with major financial institutions on the issue of risk appetite, I know how useful these concepts can be.3

Deep Commitment to Governance: A Requirement from Management

Management needs to play a continuous proactive role in the overall governance process, upward to the board and downward through the organization.

This theme covers management’s role in supporting the board, including a commitment to implementing board policy throughout the firm, bringing major issues to the board early, and an open and transparent relationship with directors. The fact that managers are often also directors in for-profit organizations serves to confuse issues here. And of course, although a number of for-profit boards now have “schemes of delegation” and the like, the definition of what is and is not a major issue is far less clear than it is within Policy Governance.

The Role and Responsibility of Supervisors.

Supervisors that more fully comprehend financial institution strategies, risk appetite and profile, culture, and governance effectiveness will be better able to make the key judgments their mandate requires.

By “supervisors,” this report means regulators, who would indeed benefit from understanding governance and therefore how to hold the organizations under their aegis to account.

Relationships Between Financial Institution Boards and Long-term Shareholders

Long-term shareholders can and should contribute meaningfully to effective financial institution governance.

Policy Governance is explicit about the need to engage with owners, legal and moral, as the board’s first job. You will note the distinction of “long-term shareholders” as opposed to short-term ones, who, I would argue, generally do not fall into the category of owners. Day traders are certainly very differently motivated than long-term investors are. In any case, what matters in my opinion is not whether the shareholders have held their shares for a long time but whether they are committed to the organization’s fulfilling long-term goals, a difficult thing to ascertain.

The Impact of Values and Culture on Behaviors and Decisions

Values and culture may be the keystone of financial institution governance because they drive behaviors of people throughout the organization and the ultimate effectiveness of its governance arrangements.

This theme, which has been growing in strength in the for-profit sector, covers issues such as honesty, integrity, openness, independence, and trust. In Policy Governance, such values may be stated in a board’s Governance Process policies and enforced in Executive Limitations policies. More important and meaningful is that they are not only given expression in all the Policy Governance board says in policy but also all it does in practice.

Conclusion

Studying this report has reinforced my view that Policy Governance brings together all the fundamental aspects of governance into a coherent model in a way that can be practically applied.

In fact, I had the feeling I wanted to turn up outside The Old Lady of Thread-needle Street herself (the nickname for the Bank of England in the heart of the financial district in London) and start preaching, “I have some answers—a model that will do what you’re asking for,” but, alas, I suspect that wouldn’t be well received!

Richard Baker can be contacted at richard. baker@caerusconsulting.co.uk

Notes

1. G30 Working Group. Toward Effective Governance of Financial Institutions. Washington, D.C.: G30 Working Group, 2012.

2. Turner, A. The Turner Review: Regulatory Response to the Global Banking Crisis. London: Financial Services Authority, 2009.

3. See my article: “Incorporating Risk Appetite Concepts in Board Governance,” Board Leadership, no. 114 (March-April 2011).

CONSIDER THIS …

“Landmark legislation [brought] wholesale reinvention of disclosure, financial controls, and board oversight, [yet] ten years after Enron, boards still remain buffaloed by complexity, and too intimidated to ask CEOs tough questions. Somewhere, the ghost of [Enron’s] Ken Lay is smiling.”

Ralph Ward, Boardroom Insider,

February 6, 2012

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