Bank boards and supervisory expectations

Introductory remarks by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the Florence School of Banking & Finance Online Seminar “Bank Boards and Supervisory Expectations”

Frankfurt am Main, 3 December 2020

It is a pleasure for me to join you today for the first seminar of the FBF Bank Board Academy for Non-Executive Directors. I welcome the FBF’s initiative to bring together professionals from the financial industry to exchange views on the challenges faced by bank boards and discuss how they can most effectively oversee the management of banks.

Sound governance of euro area banks is one of the main priorities for ECB Banking Supervision too. In my remarks today, I will discuss some of the most pressing governance issues, including in the context of the coronavirus (COVID-19) pandemic. I will present our supervisory expectations of bank boards and board members in ensuring good governance and resilience.

It is fitting that we are considering the issue of good governance in Florence, the home of the great Medici family. The first to use double-entry bookkeeping and letters of credit on a large scale, the Medici must have had strong arrangements in place to ensure that they retained ultimate control over activities across the many branches they held all around Europe by the end of the 15th century, from Venice to London, via Geneva, Barcelona and many other European cities.

Good governance, resilient banks

As the Medici must have realised, good governance and effective controls are key to responsible decision-making. And they become all the more important in times of crisis, like the one we have been experiencing since the pandemic broke out in March. Governance has been one of the key areas of supervisory focus since ECB Banking Supervision was first set up. A bank’s resilience and its likelihood to withstand a crisis are ultimately determined by checks and balances at all levels together with a clear organisational structure, with well-defined lines of responsibility and effective risk management practices.

Undeniable progress has been made in Europe since 2015 with regard to bank governance, with ECB Banking Supervision raising the bar in terms of what is expected of bank boards, supervisory committees and internal control frameworks and policies, to name just a few examples. And yet, there is still plenty of room for improvement in governance in euro area banks. Indeed, our supervisory recommendations in last year’s supervisory cycle mainly concerned governance issues. The current COVID-19 environment is making it all the more important for banks to address some of these shortcomings, as they can seriously compromise their overall resilience. Let me give you some examples.

First, risk data aggregation is still deficient in many banks, and the accuracy and timeliness of internal reporting needs to be enhanced. Naturally, this deficiency limits a management body’s capacity to take the right strategic decisions. It hampers the holistic monitoring of material risks – which it is essential to get right in the current circumstances. Ideally, management bodies should not only focus on the material aspects of the pandemic, but also be able to recognise the nuances in the challenges they face, so that they can adjust their strategy when needed. And to do that, they need to have access to risk aggregation data that incorporate such insights. For example, management bodies should have a clear overview of the credit risk data and whether the tools and methods used are fit for purpose, and ensure management is making appropriate adjustments to reflect the effects of the pandemic. Flexibility in reprioritising projects and optimising working from home and digital opportunities are other examples of best practices.

Second, we are observing how, in some banks, control functions have been insufficiently proactive in adapting to the COVID-19 environment, in revising their risk appetite frameworks to align them with strategic goals or in making their decision-making processes more agile. Particularly in times of crisis, the board of directors needs to effectively challenge the functioning, work plans and priorities of the control functions to ensure that they are adequately fulfilling the bank’s risk management, measurement and monitoring responsibilities.

An effective board of directors requires strong support structures and should be able to demonstrate evidence of its independent oversight of the control functions – risk, compliance AML and internal audit. To do so, the board needs to have full and direct access to the heads of these control functions. In other words, the interaction between the board and the heads of risk, compliance, AML and internal audit should not be filtered through an interposed level of executive management. Likewise, internal control heads should report regularly to the board and its relevant committees. Board reporting should be supported by agile internal systems capable of producing reliable information, thus fostering meaningful discussion and effective decision-making processes. In this context, it may be necessary to overhaul legacy IT systems and integrate bank subsidiary systems and head office infrastructure to strengthen the support structure and eliminate gaps or inaccurate information. Finally, effective boards should have access to independent research, as well as the right to initiate such research, even outside the bank’s regular channels. Depending on the size and structure of the bank, we have seen some cases where a dedicated and well-staffed secretariat or governance function is augmenting the power of the board to challenge and exercise effective oversight. In other cases, an internal function that oversees the most pressing priorities within the bank’s organisational structure can significantly improve the strategic ability of boards to steer.

Next, I would like to turn my attention to effective challenge processes. As supervisors, we expect non-executive directors to constructively challenge executive directors. We sometimes hear non-executive directors express concerns of two varieties: first, that the supervisor expects directors to provide so much oversight that it makes it look as though directors regularly step into management roles. And second, that management sometimes characterises directors’ efforts to understand and steer as blurring the separate roles of management and directors – resulting in management resisting them.

These are two sides of the same coin, and context provides the backdrop for responding to these concerns. In every context, we expect non-executive directors to serve as a compass for the bank, providing strong, constant direction in both calm and rough waters by ensuring independent oversight of management proposals and decisions. In normal times, such oversight mitigates financial and reputational risks. This requires board members to be given adequate insight into detailed information. In times of stress or crisis, effective non-executive directors – especially those in key board positions such as lead independent directors and members of risk and audit committees – are often called upon to provide even more intensive steering of the ship. In the COVID-19 environment, this translates into strong oversight to avoid credit risk opacity and to deliver clarity on the trajectory of capital resulting from macroeconomic developments. It also means thinking about strategic plans regarding the best positioning for the bank in the context of the landscape as a whole. This entails providing strategic direction in navigating the consequences of the lockdowns for the economy, together with the associated impact on borrower creditworthiness, balance sheets, capital and operations in the face of restrictions. Consolidation is one area that would allow banks to strengthen their positioning.

The ECB’s revised guide to fit and proper assessments

To live up to the task of navigating, the board as a whole must have the right expertise and diversity of experience. I recall here that the Medici’s success was based on diversification from more than size and was very different from earlier Italian banks. Board members need to have the gift of versatility, and should not be comprised only of experts from similar backgrounds. Broadening perspectives and crafting outcomes that might not be imagined if group think takes over comes from drawing on a myriad of backgrounds and experiences. Often persons with high ethics and common sense are the most valuable directors and may not solely be those with only typical bank board member backgrounds. Gender diversity is important too — it brings different valuable dynamics into the board room. And, in these days, the pandemic has driven technology and digitalisation to the fore; space needs to be made for members who understand both the opportunities and the risks that this creates.

ECB Banking Supervision conducts the final quality control over the appointment of board members. We work closely with national banking supervisors to ensure that board members comply with minimum quality standards. In 2021 the ECB will implement a stricter and more intrusive approach to fit and proper assessments. The Board and its individual members need to internalise their responsibility, including legal responsibility.

We will closely scrutinise matters that may impair a board member’s suitability, such as previous criminal convictions or ongoing legal proceedings. We also intend to examine the individual accountability of board members more closely. Directors who are guilty of misconduct, or who turn a blind eye to misconduct by their peers, should not be able to hide behind the collective responsibility of the board. Finally, we also plan to pay closer attention to reassessments during ongoing supervision, particularly when the emergence of new facts raises material concerns about the suitability of existing bank directors.

In 2021 we will publish a revised guide on fit and proper assessments clarifying our expectations on the suitability of bank directors. This guide allows for closer scrutiny of the individual accountability of board members. It will also clarify when and how the emergence of new material facts might result in the ECB reassessing bank directors.

We are also making fit and proper processes more efficient and accessible by setting up an online portal where applications for prospective directors can be submitted. Banks will be encouraged to submit their applications before individuals take up their positions, which will enable us to frontload our assessment of candidates. The ECB has also established a dedicated fit and proper department and an enforcement and sanctioning committee to streamline the process further.

But while the aim is for rigorous fit and proper criteria to be applied equally across all euro area banks, unfortunately the implementation of these criteria is not currently harmonised across all euro area countries. The EU legal framework applicable to fit and proper assessments is still fragmented, reflecting varied implementation of the Capital Requirements Directive across Member States. Diverging national standards should not undermine supervisory efforts to pursue stronger governance structures in supervised banks. We need fully harmonised fit and proper criteria and increased clarity on the fit and proper process in order to ensure a level playing field. Ideally, this would come through a directly applicable EU regulation.

Conclusion

In times of crisis, the role played by boards becomes all the more important. They need to be attuned to the possibilities of the future and aware of the risks of the present and, through it all, carry out effective oversight of the management function. And they must ensure that strong control functions and a sound risk appetite framework are in place at all times – but all the more so during a crisis, where good governance can mean the difference between a bank that merely wobbles and a bank that ultimately collapses.

After all, it was precisely a lack of strong control over the strategic direction of their banking empire that led to the decline and fall of the Medici themselves.