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  • Supervision Newsletter

Strengthening smaller banks’ governance

18 May 2022

Sound governance and strong internal controls are crucial for fostering responsible decision-making and mitigating the risks that banks face during normal times – and even more so in times of crisis.” (Andrea Enria, 2021).

Governance has been a key area of focus for ECB Banking Supervision from its inception in 2014. Since then, many large banks – or “significant institutions” – under the ECB’s direct supervision have been experiencing a push to further promote a level playing field in line with European standards. These are laid down in the Capital Requirements Directive, in Guidelines issued by the European Banking Authority on internal governance and suitability and in the SSM supervisory statement on governance and risk appetite. Promoting further alignment has not been an easy task given national specificities and banks’ different governance arrangements. However, the ECB is not planning to take its foot off the pedal here: the effectiveness of banks’ management bodies is also part of the ECB’s 2022-2024 supervisory priorities.

Beyond the direct supervision powers for large banks, the ECB is also responsible for the indirect supervision of smaller banks, or ”less significant institutions”. As part of this oversight role, in 2021 the ECB carried out a thematic review of the governance arrangements of smaller banks in cooperation with the national supervisory authorities of the countries participating in European banking supervision. This was the first such review of smaller banks. It was co-led by the Banca d’Italia and involved, for example, data collection from a sample of more than 200 smaller banks across the 21 participating countries.

The thematic review covered a broad range of aspects related to smaller banks’ internal governance arrangements, including their supervisory bodies (i.e. the management body in its supervisory function – such as the board of directors or supervisory board), as well as the relevant national supervisory practices. Not surprisingly, governance has also been at the top of national supervisors’ priorities when fulfilling their mandate for the supervision of smaller banks in the past years.

Looking at the findings from the thematic review, some areas of attention related to the governance of smaller banks call for further improvements in the sector.

Primarily, there are important supervisory concerns about the functioning and the oversight role of the boards in their supervisory functions. For instance, it was found that internal control functions had partially insufficient direct access to the boards, and risk committee structures or alternative arrangements were not always in place.

Main findings on (supervisory) board functioning

Importance for board’s effectiveness

Heads of internal control functions do not have direct access to the board in some institutions.

Where the heads of internal control functions do not have direct access to the (supervisory) board, its oversight on risks can be hindered.

41% of sampled banks do not have a risk committee, in particular the smallest banks. The existence and structure of board committees vary across banks.

The need to establish a risk committee essentially depends on the size and complexity of the bank. Banks that are significant in terms of their size and activities should establish a risk committee. For smaller banks this varies according to the proportionality principle (and taking into account national regulatory specificities). Where no risk committee is established, sufficient discussions on risks should take place within the (supervisory) board.

The thematic review also revealed issues concerning the boards’ composition, in particular around the formal independence, experience and diversity of board members. Some of these areas of attention also concern larger banks, but they are even more pronounced in smaller banks:

Main findings on (supervisory) board composition

Importance for board’s effectiveness

On average, 48% of non-executive board members of sampled banks are formally independent (i.e. without any relationships or links that could influence their objective judgement and ability to take decisions independently), and several banks have board members with a very low level of independence.

For significant institutions, 59% of non-executive board members are formally independent.

Independent board members play a key role in challenging strategic decisions and providing the checks and balances which are crucial for sound decision-making.

On average, 22% of non-executive board members of sampled banks do not have any, or have very little, experience in banking, finance or economics (vs. 13% for large banks), with disparity across banks. The level of IT expertise also appears to be relatively low (10% on average, vs. 24% for large banks).

Board members should possess sufficient knowledge, skills and experience to ensure the collective suitability of the board.

Limited diversity: 49% of sampled banks do not have a diversity policy (vs. 20% of large banks). The share of female board members is on average 22% in the sampled banks (vs. 29% in large banks).

Diversity helps to counter the risk of groupthink and improves the quality of the debate in the board as well as increases the variety of views.

Sound governance arrangements are crucial for all banks, large or small – even more so in times of crisis. Supervisors will therefore follow up on the weaknesses the thematic review revealed in smaller banks’ governance, while of course applying the necessary proportionality and judgement when interpreting these results. Yet proportionality does not mean that smaller banks have weaker (supervisory) boards. It means that the governance arrangements should be commensurate with the bank’s size, complexity and riskiness, so that they always enable an adequate level of oversight of the bank.

The ECB and national supervisors will also continue to promote greater alignment with European supervisory expectations and standards for internal governance and address weaknesses where they were identified. The thematic review revealed a range of good banking and supervisory practices that will help strengthen this convergence towards more sound governance arrangements in European banking.

Finally, the thematic review highlighted once more the importance of a dialogue among supervisors, and between supervisors and bankers, on the boards’ composition and their effective functioning, in order to raise the bar on governance.

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