On August 7, 2012, the Office of the Superintendent of Financial Institutions (OSFI) released for public comment draft revisions to its Guideline on Corporate Governance (Draft Guideline) for Federally-Regulated Financial Institutions (FRFIs). A copy of the Draft Guideline can be accessed here. Industry participants wishing to comment must do so by September 14, 2012.
Since the financial crisis, corporate governance has become an increased area of focus for regulators in the financial services industry both internationally and domestically. For example, since 2008, each of the Financial Stability Board, the Organization for Economic Cooperation and Development (OECD), and the Basel Committee for Banking Supervision has either launched examinations to identify corporate governance weaknesses among financial institutions, and/or issued guidance on ways to enhance corporate governance practices following the crisis. In 2010, OSFI joined these efforts by establishing a Corporate Governance Unit to review the corporate governance practices of certain large Canadian banks and insurance companies.
The Draft Guideline updates the original version of the guideline, first published in 2003 (Former Guideline), and reflects developments in international standards, as well as OSFI’s experience and observations. Although the Draft Guideline introduces some new requirements (such as the RAF discussed below), for the most part, the amendments build on the principles articulated in the Former Guideline and are a codification of industry best practices and OSFI’s existing expectations (see for example OSFI’s statements regarding corporate governance in its recently released Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures and its current corporate governance expectations for new entrants).
Set out below is a discussion of the significant themes of the Draft Guideline.
The Draft Guideline notes that given the unique nature, systemic importance and inherent risks associated with financial institutions and their business and activities, risk governance is a distinct and crucial element of corporate governance for FRFIs. Similar to its predecessor, the Draft Guideline recognizes that one of the primary functions of the board of directors of a FRFI is to establish the institution’s overall business and risk strategy. The Draft Guideline, however, goes beyond its predecessor and introduces the concept of a board-approved risk appetite framework (RAF). The purpose of the RAF is to guide the amount of risk that the FRFI is willing to accept in pursuit of its strategic and business objectives. It is an enterprise-wide benchmark to be followed at all levels of the FRFI’s business and operations. OSFI notes that it should be forward looking, consider all types of risks (including reputational risks), and should be consistent with the FRFI’s business model, overall philosophy, and all operational, financial and corporate policies, practices and procedures.
To supplement the RAF, the Draft Guideline requires, among other things, (i) the establishment of a dedicated risk committee to oversee the FRFI’s risk management on an enterprise-wide level; (ii) the appointment of a chief risk officer who has a direct and independent communication line to the board, and who is charged with overseeing the risk committee and ensuring controls are in place to ensure compliance with the RAF; and (iii) both the board and senior management to have sufficient risk management and financial industry experience to ensure a full understanding of the risks attendant to the FRFI’s business model.
Effective oversight is an important element of corporate governance. As noted in the Draft Guideline, the role of the board of directors is to provide stewardship, including direction setting and oversight of the management and operations of the entire institution, while senior management is accountable for implementing the board’s decisions and overseeing the direct management of the FRFI’s operations. OSFI notes that in order for the board to provide meaningful oversight of the FRFI, it must have the requisite skills to be able to understand, probe and challenge the recommendations and assumptions made by senior management; senior management, must in turn, have sufficient knowledge and proficiency to be able to implement the board’s decisions, particularly in the area of risk management. The Draft Guideline expands on the general principles set out in the Former Guideline which require the board to have the appropriate collective balance of skills and expertise and specifically notes that relevant financial industry and risk management expertise are key competencies for effective oversight of a FRFI. While the Draft Guideline does not prescribe any other specific director qualifications, it requires the board to self assess, on at least an annual basis, its collective skills and prepare a competency matrix which identifies any apparent gaps in such knowledge or expertise.
The Draft Guideline also builds on the oversight procedures described in the Former Guideline, including the establishment of certain “Oversight Functions” (such as internal audit, finance and actuarial compliance), which are overseen by the board through an appropriate committee and which are responsible for providing independent enterprise-wide oversight of operational management. The Draft Guideline specifically includes risk management as a type of oversight function and contemplates the appointment of a dedicated Chief Risk Officer (CRO).
Independence is a theme that runs throughout the Draft Guideline. Like the Former Guideline, the Draft Guideline recognizes that demonstrable board independence is at the core of effective FRFI governance. The Draft Guideline provides for the explicit separation of the roles of the Chairman of the Board and the CEO (a best practice which has been adopted by many larger FRFIs for quite some time now).
It also contemplates direct reporting lines to the board by executives of the oversight functions such as the chief internal auditor and chief financial officer; imposes requirements that the audit committee and the risk committee be composed solely of independent directors (including independent chairs); allocates responsibility for setting external auditor fees and the scope of the audit engagement to the audit committee instead of senior management; and endorses the separation of the function of certain key oversight executives, such as the chief risk officer, from the revenue-generation and financial performance of the FRFI.
The Draft Guideline also sets out OSFI’s expectation that the board establish a director independence policy which emphasizes the independence of the board’s members from senior management and which takes into account among other things, specific shareholder/ownership structure and director tenure.
Third Party Review
Consistent with the theme of independence, the Draft Guideline contemplates the commission of third party reviews to provide the board with an objective evaluation of the FRFI’s systems and procedures, including reviews of (i) board and board committee corporate governance practices, (ii) oversight functions and processes, and (iii) risk management systems and practices.
According to the Draft Guideline, the board should review and discuss the findings and reports of such benchmarking reviews, and develop appropriate action plans to address any deficiencies or gaps identified.
OSFI expects the board to be pro-active and to regularly review (or oversee reviews of) its policies and practices to ensure that they remain appropriate and effective in light of changing circumstances and risks.
According to the Draft Guideline, the board should also receive regular reports on the general operations of the FRFI and its financial condition, the performance of risk management and other control systems and any ineffectiveness or significant breaches of these controls, the institution’s code of conduct or with laws and regulations.