On August 7, 2012, Canada's federal financial institutions regulator, the Office of the Superintendent of Financial Institutions (OSFI), released for comment a draft of its long-awaited revised Corporate Governance Guideline (the Revised Guideline). The draft Revised Guideline sets forth OSFI's expectations for corporate governance of federally-regulated financial institutions (FRFIs). Like the current Guideline, it would apply to all FRFIs except foreign bank branches and foreign insurance company branches.
Consistent with the direction and themes signaled in recent speeches of the Superintendent, the draft Revised Guideline would impose a number of significant new requirements. The draft Revised Guideline is intended to:
- ensure that FRFIs have prudent corporate governance practices and procedures that contribute to their safety and soundness;
promote industry best practices in corporate governance;
- be consistent with and complement: the respective FRFI statutes and related regulations; and
- OSFI's Supervisory Framework (most recently revised in 2011) and Assessment Criteria; and
- address international standards as articulated by a number of international organizations.
To best meet those goals, the Revised Guideline focuses on (i) enhancing the effectiveness of boards by providing clarity on board responsibilities and competencies; (ii) strengthening FRFIs' risk governance by requiring the development of a "Risk Appetite Framework" (RAF) to guide risk-taking activities; and (iii) improving the overall internal control framework of FRFIs by clarifying the roles of the Chief Risk Officer and audit committee.
The Revised Guideline is open for stakeholder comments until September 14, 2012. Given the significant new requirements, FRFIs and their boards will want to carefully consider the particular implications of the draft Revised Guideline for their institution and whether they wish to comment on the draft Revised Guideline.
Background and Overview
OSFI's original Corporate Governance Guideline was published in 2003. Since then, corporate governance best practices have evolved significantly, including in response to the financial crisis of 2008 and onward. Further, a number of domestic regulators, international standard setters and various commentators have recently published lengthy reports highlighting best practices and standards for effective corporate governance of financial institutions. Accordingly, OSFI believed it appropriate to update its own guidance in the area.
OSFI also established a dedicated Corporate Governance Division in 2010 to review FRFI practices and ensure FRFI compliance with the original Guideline. The draft Revised Guideline reflects the results of a comprehensive cross-sector review of the corporate governance practices of the larger FRFIs by the new OSFI Division in 2010/2011, as well as review and comment on prior drafts of the Revised Guideline by select FRFI directors.
Overview of the Revised Guideline
The key sections of the Revised Guideline, namely Section III, IV and V, focus, respectively, on three fundamental components of corporate governance for FRFIs:
- the role of the Board;
- risk governance, described as a distinct and crucial element of corporate governance for FRFIs; and
- the role of the audit committee.
As noted above, the Revised Guideline would apply to all FRFIs other than foreign bank branches and foreign insurance company branches. Branches do not have boards of directors and, accordingly, the specific provisions of the Revised Guideline would not apply directly to branch operations. Instead, OSFI looks to the Chief Agent or Principal Officer of a branch to oversee the management of the branch, including corporate governance matters. Those individuals are recognized as having overall responsibility for their respective branches and, therefore, should be aware of the contents of the Revised Guideline. The Chief Agent or Principal Officer of branches should refer to OSFI Guidelines E-4A or E-4B, as appropriate.
In addition to complying with the Revised Guideline, OSFI expects FRFI boards and senior management to be proactive, and to be aware of corporate governance best practices applicable to their institution. According to OSFI, this is achievable through director orientation and training, self-assessments and independent third party reviews. OSFI also recognizes that individual FRFIs may have differing corporate governance practices depending on their size, ownership structure, nature, scope and complexity of operations, corporate strategy and risk profile.
A FRFI's board and senior management are ultimately accountable for the FRFI's safety and soundness and compliance with law. In the Revised Guideline, as in OSFI's Supervisory Framework, the roles of the board and senior management are purposively distinguished. The board is made responsible for providing stewardship, including direction-setting and oversight of the management and operations of the entire FRFI. Senior management is ultimately accountable for implementing the board's decisions and for directing and overseeing the effective management of the operations of the FRFI.
The Role of the Board
In Section III of the Revised Guideline, OSFI outlines the following essential duties that boards must discharge, in addition to the roles and responsibilities stipulated in the applicable FRFI statutes. The section also differentiates between matters to be approved by the board and matters to be reviewed and discussed by the board.
The board should approve the FRFI's:
- short-term and long-term enterprise-wide business objectives, strategy and plans, including the RAF (discussed further below);
- significant strategic initiatives;
- internal control framework;
- appointment, performance review and compensation of the CEO and other members of senior management including the heads of oversight functions;
- succession plans; and
- external audit plan.
The board should review and discuss the FRFI's:
- significant operational and business policies;
- business and financial performance relative to the board-approved business strategy and RAF;
- compensation policy for all human resources, to be consistent with the Financial Stability Board Principles for Sound Compensation and related Implementation Standards;
- implementation of internal controls;
- organizational structure; and
- compliance with applicable laws.
The draft Revised Guideline notes that the latter functions are primarily the responsibility of senior management. However, through review, discussion and debate, the board has a critical role in providing high-level guidance to senior management. The board should establish processes to periodically verify the assurances provided to them by senior management, but the board is not responsible for the on-going and detailed operationalization of its decisions and strategy - these are for senior management to consider. While senior management should have regular interaction with regulators with respect to the overall operations of the FRFI, the board should ensure that regulators are promptly notified of substantive issues affecting the FRFI.
In respect of board effectiveness, the Revised Guideline sets out a number of new recommendations/requirements, including that the board should periodically commission independent third-party reviews to assess the effectiveness of board and committee practices and that boards should have a skills evaluation process for themselves, including incorporating tools such as a competency matrix. At a minimum, this matrix should be reviewed annually and updated by the appropriate board committee. Directors should seek internal or external education/training opportunities in order to fully understand the risks undertaken by their FRFI. The Revised Guideline notes that relevant financial industry and risk management experience are key competencies for the board and there should be reasonable representation of these skills at the board and committee levels.
In respect of board independence, the Revised Guideline views demonstrable board independence to be the core of effective FRFI governance. Beyond the principle of separating the roles of Chair and CEO, OSFI does not view any one board structure or process as guaranteeing independence. The Revised Guideline also recommends that the board should document and approve a director independence policy that takes into consideration the specific ownership structure of the institution. Where appropriate, director tenure should also be factored into the independence policy.
In respect of the board chair, the Revised Guideline newly recommends that the role of chair should be separated from that of CEO, as this is critical in maintaining the board's independence and executing its mandate.
The Revised Guideline notes that in order for the board to fulfill its duties, the board relies upon the advice and opinions of the various oversight functions within the FRFI. Thus, the board should ensure, through assurances from senior management and their own verification processes, that the persons discharging the oversight functions have the appropriate mandate, resources and organizational structure to fulfill their duties. As well, the board should ensure that these persons are independent from operational management, and are not unduly influenced by senior management and other business unit executives.
Further, the heads of the oversight functions should have unimpeded access to the board, including in camera meetings with the board and its relevant committees (including the new risk committee, as described below). The board should approve and play an active role in the oversight functions, including the selection, performance management and compensation of the heads of these functions (eg. Chief Financial Officer, Chief Risk Officer, Chief Compliance Officer, Chief Internal Auditor and Appointed Actuary) and the evaluation of their performance and compensation.
Meanwhile, rather than establishing specific oversight functions, boards and senior management of small, less complex FRFIs are expected to ensure that other internal or external functions or processes provide the required level of controls or independent enterprise-wide oversight.
In a further new recommendation, the Revised Guideline indicates that the board should develop a plan to periodically commission independent third-party reviews to assess the effectiveness of the FRFI's oversight functions and processes.
In Section IV of the Revised Guideline, OSFI proposes several important new requirements with respect to risk management, including the adoption of a RAF, third-party risk management effectiveness reviews, the establishment of a Risk Committee and the designation of a CRO. Each of these is discussed below.
In a major new proposal, OSFI is recommending that each FRFI have a board-approved RAF that guides the amount of risk the FRFI is willing to accept in pursuit of its strategic and business objectives. The RAF should set basic goals, benchmarks, parameters and limits, and should consider all applicable types of risks. The RAF is intended to provide boundaries on the ongoing operations of the FRFI, and details of its proposed contents are contained in Annex C to the Revised Guideline. Proposed contents include a risk appetite statement, specific risk tolerance limits and processes for implementation of the RAF.
In respect of risk management generally, the Revised Guideline also newly suggests that the board should periodically commission independent third-party reviews to assess the effectiveness of the FRFI's risk management systems and practices. This appears to be in addition to the recommended independent third-party reviews, described above, of the FRFI's oversight functions and processes.
In addition, the Revised Guideline directs that, depending on the nature, size, complexity and risk profile of the FRFI, the board should establish a dedicated board risk committee to oversee risk management on an enterprise-wide basis. Guided by the FRFI's RAF, the risk committee should have a sound understanding of the types of risks to which the FRFI may be exposed and of the techniques and systems used to identify, measure, monitor, mitigate and report on those risks. The risk committee should have a chair that is independent of senior management and all committee members should be independent and an adequate number of committee members should have sufficient knowledge in the risk management of financial institutions. Where appropriate, the risk committee should include individuals with technical knowledge in the risk disciplines relevant to the FRFI.
The risk committee should be responsible for approving at least annually the mandate, competencies and resources of the CRO. It should approve the CRO's performance review and oversee the succession planning for the CRO position and other key positions within the risk management function.
In a further important new recommendation, the Revised Guideline recommends that each FRFI have a designated CRO, with sufficient stature and authority within the organization, and who is also independent from operational management. The CRO should have access to the board and risk committee without impediment, including a direct reporting line to the board or risk committee. (In a footnote, OSFI clarified that "direct reporting line" is intended strictly for functional purposes - administratively, the heads of oversight functions, such as the CRO, generally report to the CEO.)
The new emphasis in the Revised Guideline on the role and function of the CRO is consistent with recent speeches of the Superintendent. The Revised Guidelines notes that the CRO should provide an independent view to the risk committee and the board regarding whether the FRFI is operating within the RAF and should meet in camera with the risk committee on a regular basis.
The Revised Guideline also states that the CRO and risk management function should not be directly involved in revenue-generation or in the management and financial performance of any business line or product of the FRFI. While the CRO and risk management function should influence the FRFI's risk-taking activities, the on-going assessment of risk-activities by the CRO and risk management function should remain independent.
Role of the Audit Committee
The Revised Guideline also contains updated commentary on the role of the audit committee and includes a number of significant new related proposals, including that:
- all audit committee members should be independent;
- the Chief Internal Auditor, the Chief Financial Officer and the Appointed Actuary (for insurance companies) should have "direct reporting lines" to the audit committee (subject to the same clarification as above in relation to the CRO); and
- the audit committee, not senior management, should be responsible for approving external audit fees and of the scope of the audit engagement.
Supervision of the FRFIs
In Section VI of the Revised Guideline, OSFI describes the role of corporate governance in OSFI's supervisory process and notes that open communication between the board and regulators helps promote the mutual trust and confidence essential to the efficiency of the principles-based system of supervision that OSFI follows. OSFI notes that it will undertake a number of approaches, including discussions with the board and senior management, to assess the effectiveness of an FRFI's corporate governance processes and will seek evidence that the processes exist, are operating effectively and that the board is able to fulfill its roles and responsibilities.
As noted above, the draft Revised Guideline is open for comment until September 14, 2012.