Board Effectiveness: The Fed’s Guidance Speaks to Resiliency

On February 26, 2021, the Board of Governors of the Federal Reserve System (FRB) in the United States issued expectations for boards of large financial institutions as a standard for its regulators when they assess board effectiveness. The guidance applies to all domestic bank holding companies and savings and loan holding companies with total consolidated assets of $100 billion or more, with certain exceptions, as well as systemically important nonbank financial companies designated by the Financial Stability Oversight Council for FRB supervision. The FRB’s focus on board effectiveness applies to the board’s role in maintaining the firm’s safety and soundness and its responsibility for sustaining financial and operational resilience. As resilience has proven to be a key differentiator in separating the market’s winners and losers over the past year, the FRB’s principles-based guidance on the key attributes of effective boards — while only required for certain financial institutions — merits consideration by boards in other sectors and other countries as well.

Specifically, the guidance outlines five principles:

The board advises management in formulating strategy. An effective board reviews and approves significant policies, programmes and plans based on the firm’s strategy, risk appetite, risk management capacity and structure (e.g., the firm’s capital plan, recovery and resolution plans, and liquidity risk management policies, among other things). These items may be presented to the board in summarised form in sufficient detail and context for directors to make an informed decision. Understanding relevant policies, programmes and plans provides a useful context when considering a new line of business, expansion into a new jurisdiction, and growth strategies within current businesses and products.

The board should provide direction to senior management regarding the sufficiency, quality, timing, reliability and structure of information and data directors need to make well-informed decisions and consider potential risks. The board should also seek information through channels other than the executive team about the firm and its activities, ongoing and emerging risks, personnel, compensation, and other matters. Finally, the lead independent director or independent board chair and committee chairs should take an active role in setting board and committee meeting agendas.

An effective board oversees and holds senior management accountable for effectively implementing the firm’s strategy, consistent with its risk appetite. To facilitate accountability, the board should allocate sufficient board meeting time to have candid and open discussions that encourage diverse views. The board should regularly evaluate senior management performance and compensation and consider whether and how compensation programmes implemented by senior management promote the firm’s risk management goals. It also sufficiently empowers independent directors who serve as an effective check against senior management, including firm executives who sit on the board overseeing the development and execution of CEO succession plans.

Through its risk and audit committees, the board assesses and supports the stature and independence of the firm’s independent risk management and internal audit functions. This means the lines of business should not unduly influence either of the two functions.

Based on factors such as the firm’s asset size, complexity, scope of operations, risk profile and changes over time, an effective board establishes a process to identify and select potential director nominees with a diverse mix of skills, knowledge, experience and perspectives. This process should consider a potential nominee’s expertise, availability, integrity, and potential conflicts of interest, and be open to a diverse pool of potential nominees, including women and underrepresented minorities. An effective board also has the capacity to engage third-party advisers, when appropriate, and, on an ongoing basis, evaluate the performance of its respective committees.

Although banks have their unique characteristics, many of the FRB’s board effectiveness fundamentals have broad applicability to other sectors. Boards need to think about their role in setting strategy, establishing boundaries and limits, clarifying accountability for results, supporting risk management and internal audit, and periodically evaluating composition and governance structure in changing markets. Accordingly, while only certain qualifying financial institutions in the United States must follow the FRB’s guidance, there are sound practices embodied in these five principles worthy of consideration by boards serving smaller banks and those serving companies in other sectors across the world.

For a summary of the takeaways from the FRB guidance that every board should consider, read the article here.

(Board Perspectives: Risk Oversight — Issue 138)