corporate governance: basel ii and beyond corporate governance program for bank directors of indian...

Corporate Governance: Corporate Governance: Basel II and BeyondBasel II and Beyond

Corporate Governance Program for Corporate Governance Program for

Bank Directors of Indian BanksBank Directors of Indian Banks

MumbaiMumbaiDecember 14, 2005December 14, 2005

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Regulation Breeds InnovationRegulation Breeds Innovation

andand

Innovation Breeds RegulationInnovation Breeds Regulation

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Supervisory Interest inSupervisory Interest inCorporate GovernanceCorporate Governance

Bank SupervisorsBank Supervisors

Securities SupervisorsSecurities Supervisors

Law EnforcementLaw Enforcement

OthersOthers

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Directors’ Role(s)Directors’ Role(s)

OversightOversight

ManagementManagement

– Complementing or Conflicting?Complementing or Conflicting?

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Corporate Governance and Basel IICorporate Governance and Basel II

It’s a marriage …It’s a marriage …

It’s an ideal ….It’s an ideal ….

It depends ….It depends ….

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Mid-Year TextMid-Year Text

Pillar OnePillar One::The Board of Directors (BOD) must:The Board of Directors (BOD) must:– Approve all Approve all materialmaterial aspects of the rating and aspects of the rating and

estimation processesestimation processes– Possess a Possess a generalgeneral understanding of the understanding of the

bank’s risk rating system and bank’s risk rating system and detaileddetailed comprehension of its associated management comprehension of its associated management reportsreports

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Pillar Two:Pillar Two:The BOD must/should:The BOD must/should:– Fulfill its responsibility for setting the bank’s tolerance for Fulfill its responsibility for setting the bank’s tolerance for

riskrisk

– Ensure that management Ensure that management

establishes a framework for assessing all risks,establishes a framework for assessing all risks,

develops a system to relate risk to capital, anddevelops a system to relate risk to capital, and

establishes a method for monitoring compliance with establishes a method for monitoring compliance with internal policiesinternal policies

– Adopt and support strong internal controls and written Adopt and support strong internal controls and written policies/procedures that are communicated effectively by policies/procedures that are communicated effectively by management throughout the bankmanagement throughout the bank

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Pillar ThreePillar Three::The BOD must:The BOD must: – Ensure alignment of disclosures with how banks’ risks are Ensure alignment of disclosures with how banks’ risks are

assessed and managedassessed and managed– Approve the bank’s disclosure policy for determining what Approve the bank’s disclosure policy for determining what

disclosures the bank will make and the internal controls over disclosures the bank will make and the internal controls over the disclosure processthe disclosure process

Some U.S. PerspectiveSome U.S. Perspective– Areas of required disclosures are quite explicit. Open issues are Areas of required disclosures are quite explicit. Open issues are

granularity, format, and placegranularity, format, and place– ‘‘Takeaway’ for directors of U.S. banks: BODs must approve disclosure Takeaway’ for directors of U.S. banks: BODs must approve disclosure

policies consistent with P3 principles and ensure adherence through policies consistent with P3 principles and ensure adherence through appropriate control setsappropriate control sets

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Draft U.S. Supervisory GuidanceDraft U.S. Supervisory Guidance

The current draft guidance sets forth The current draft guidance sets forth standards identifying the BOD’s role in standards identifying the BOD’s role in ensuring:ensuring:– The effectiveness of the IRB system (i.e., design and The effectiveness of the IRB system (i.e., design and

proper functioning)proper functioning)– That the capital calculations accurately reflect the risk That the capital calculations accurately reflect the risk

profile of the bankprofile of the bank– That the components of the IRB, including the control That the components of the IRB, including the control

framework, are evaluated and approved at least framework, are evaluated and approved at least annuallyannually

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Draft U.S. Examination ProceduresDraft U.S. Examination Procedures

Policies/procedures/process measured Policies/procedures/process measured against guidance standards:against guidance standards:– Does the BOD ensure that capital calculations Does the BOD ensure that capital calculations

accurately reflect the bank’s risk profile?accurately reflect the bank’s risk profile?– Does the BOD approve the IRB components annually, Does the BOD approve the IRB components annually,

including the control framework?including the control framework?– Does the BOD evaluate the effectiveness of the IRB Does the BOD evaluate the effectiveness of the IRB

system as part of the annual approval?system as part of the annual approval?– Has the BOD established specific accountability for Has the BOD established specific accountability for

the overall performance of the IRB system?the overall performance of the IRB system?

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Draft U.S. Examination ProceduresDraft U.S. Examination Procedures

Suggested review items: reports and Suggested review items: reports and submissions on IRB effectiveness submitted submissions on IRB effectiveness submitted to the BODto the BOD

As part of supervisory testing phase: review As part of supervisory testing phase: review of board minutes to verify that directors are of board minutes to verify that directors are receiving/reviewing independent receiving/reviewing independent reviews/audit findings and approving the reviews/audit findings and approving the IRB components annuallyIRB components annually

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BCBS Consultative DocumentBCBS Consultative Document

““Enhancing Corporate Governance for Banking Enhancing Corporate Governance for Banking Organizations”Organizations”

A consultative document on which the industry A consultative document on which the industry has commentedhas commented

Revision of 1999 principlesRevision of 1999 principles

In keeping with other corporate governance In keeping with other corporate governance guidance for BODs (not bank specific)guidance for BODs (not bank specific)

Limited direct reference to Basel IILimited direct reference to Basel II

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BCBS Consultative DocumentBCBS Consultative Document

The BOD has an obligation to: The BOD has an obligation to: – understand the risk profile of a bankunderstand the risk profile of a bank– ensure that capital levels adequately reflect such riskensure that capital levels adequately reflect such risk– (particularly for banks adopting the advanced (particularly for banks adopting the advanced

approaches) ensure that the use of complex risk approaches) ensure that the use of complex risk models is subject to effective oversightmodels is subject to effective oversight

Specific reference to Pillar 2 and Pillar 3 Specific reference to Pillar 2 and Pillar 3 responsibilities for overall capital adequacy, responsibilities for overall capital adequacy, integrity of controls and risk management integrity of controls and risk management procedures, and appropriate level of disclosure procedures, and appropriate level of disclosure as another ‘control’ (i.e., market discipline)as another ‘control’ (i.e., market discipline)

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Moody’s Special CommentMoody’s Special Comment

Special Comment entitled “Don’t Bank on Special Comment entitled “Don’t Bank on Strong Governance: Observations on Strong Governance: Observations on Corporate Governance in the U.S.”Corporate Governance in the U.S.”A tally sheet for the industry with insights A tally sheet for the industry with insights from 27 banksfrom 27 banksNot specific to Basel II, but implications …Not specific to Basel II, but implications …Progress noted:Progress noted:– Stronger regulationStronger regulation– Board/Committee focus on key exposuresBoard/Committee focus on key exposures– More emphasis/formalization on successionMore emphasis/formalization on succession

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Areas for Improvement:Areas for Improvement:Control failures still prevail; Board response?Control failures still prevail; Board response?

Bank board composition is not optimalBank board composition is not optimal– Financial competency?Financial competency?– Degree of independence?Degree of independence?– Too localized?Too localized?– Too large?Too large?

Boards within boardsBoards within boards

Mergers create oversight challengesMergers create oversight challenges

Risk oversight challenges bank boardsRisk oversight challenges bank boards

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““Risk oversight provides a distinct challenge to bank boards, Risk oversight provides a distinct challenge to bank boards, particularly in light of Basel II”particularly in light of Basel II”

Financial innovation may move ahead of risk management, Financial innovation may move ahead of risk management, where the BOD has critical responsibilities for policy-setting where the BOD has critical responsibilities for policy-setting and implementation and implementation

A key area for improvement for many banks is “the quality of A key area for improvement for many banks is “the quality of risk-reporting to the board and its committees; we believe that risk-reporting to the board and its committees; we believe that this stems from sub-optimal, although improving, risk-reporting this stems from sub-optimal, although improving, risk-reporting across the organization.” across the organization.”

““Too few banks use risk-adjusted metrics for motivating senior Too few banks use risk-adjusted metrics for motivating senior management.”management.”

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Real World ChallengesReal World Challenges

How can supervisors assess the effectiveness of How can supervisors assess the effectiveness of BODs in discharging their duties relative to Basel II?BODs in discharging their duties relative to Basel II?

How can supervisors gauge the How can supervisors gauge the truetrue level of director level of director understanding of/involvement in critical issues facing understanding of/involvement in critical issues facing the bank?the bank?

How much reliance do/should the directors place on How much reliance do/should the directors place on senior management as their primary source of senior management as their primary source of information?information?

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Real World QuestionsReal World Questions

What is the extent of [your] involvement in Basel II What is the extent of [your] involvement in Basel II so far?so far?

What should be the nature and extent of [your] What should be the nature and extent of [your] involvement as [your bank] moves toward involvement as [your bank] moves toward qualification and implementation?qualification and implementation?

Have [your] supervisors looked at BOD minutes? Have [your] supervisors looked at BOD minutes? Audit or Risk Committee minutes? Agendas? Audit or Risk Committee minutes? Agendas? Presentations by internal or external sources?Presentations by internal or external sources?

What level of granularity is likely to be provided by What level of granularity is likely to be provided by the final local supervisory guidance and examination the final local supervisory guidance and examination procedures on corporate governance for Basel II?procedures on corporate governance for Basel II?

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Other Things to Think AboutOther Things to Think About

What other sources of information or What other sources of information or guidance might be useful here? guidance might be useful here?

2020

Thank you!Thank you!

John HeinzeJohn Heinze

Federal Reserve Bank of New YorkFederal Reserve Bank of New [email protected]@ny.frb.org

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