The Office of the Superintendent of Financial Institutions (OSFI) has released for comment a draft revised Corporate Governance Guideline (Draft Guideline). The Draft Guideline proposes a number of significant changes to the current version of the Corporate Governance Guideline, which was released in 2003 (2003 Guideline). These changes reflect heightened international corporate governance and risk management expectations for financial institutions, which have developed in response to the global financial crisis. The Draft Guideline includes refinements and clarifications in the areas of: (a) Board effectiveness, including responsibilities, competencies and composition, (b) risk governance, including risk appetite and the role of the Chief Risk Officer (CRO), and (c) the role of the Audit Committee. Beyond this, OSFI expects Boards and senior management to identify proactively corporate governance best practices based on the attributes of their specific institutions. Our comments highlight the key differences between the 2003 Guideline and the Draft Guideline.
While many of the changes proposed in the Draft Guideline have been previously articulated by OSFI, these changes, taken together, significantly raise the bar in terms of the governance and risk management expectations applicable to federally regulated financial institutions (FRFIs). Although some larger and more sophisticated institutions will likely already have adopted many of the practices addressed in the Draft Guideline, many medium and smaller institutions will likely find it challenging to comply with the new expectations.
It is fair to say that the duties of Boards and senior management of FRFIs have increased in recent years. The “oversight” by Boards in particular has increased noticeably based on a combination of requiring Boards to be even more proactive and thorough in all of their corporate governance and risk management functions and requiring direct reporting relationships for finance, actuarial, internal audit, compliance and risk management. Furthermore, the Draft Guideline requires Boards to obtain independent third party reviews and reports on the effectiveness of (a) Board and Board committee practices, (b) oversight functions and processes, and (c) risk management systems and practices. Clearly, the results of these reviews and reports will only further raise the expectations and standards for Boards and Board committees.
Comments on the Draft Guideline are to be provided by September 14, 2012.
Board Responsibilities and Effectiveness
As in the 2003 Guideline, OSFI recognizes that Boards and senior management play critically distinct roles in the governance of a FRFI. In providing oversight and direction for the management and operations of a FRFI, the Board must approve the institution’s overall business and risk strategy. This includes the approval of enterprise-wide business objectives, and strategic, capital, financial and liquidity plans as well as a Risk Appetite Framework (discussed below).
The Draft Guideline states that the Board of a FRFI should collectively possess expertise, experience, skills and perspectives reflective of the FRFI’s business and risk profile to provide independent and objective guidance to, and oversight of, senior management. In this regard, the two key competencies for the Board should be financial industry and risk management expertise. To this end, the Board should engage in a “skills evaluation process”, which should be reviewed on an annual basis. As well, directors should obtain in particular sufficient training to understand risks.
Board independence is key to effective governance and so a separation of the roles of Board Chair and CEO is necessary. While the Board is not responsible for the implementation of its decisions, the Board should “probe, question and seek assurances” from senior management that any decisions, plans or policies being undertaken by senior management are consistent with Board-approved business strategy and the risk appetite of the FRFI. The Draft Guideline also recommends that the Board should periodically conduct an independent third-party review to assess the effectiveness of the Board’s practices.
As detailed in OSFI’s Supervisory Framework, a FRFI’s oversight functions (financial, compliance, actuarial, risk management and internal audit) should be overseen by the Board or an appropriately mandated Board Committee. Through assurances from senior management and the Board’s own verification processes, the Board should ensure that the oversight functions are appropriately mandated and structured, and sufficiently resourced to fulfill their duties. The Board should have access to the heads of these functions independent of senior management, and should approve the selection, performance management and compensation of those heads. The Board should commission and review independent third-party reports on the effectiveness of the oversight functions. The important point not to be missed is that, to ensure the independence of these vital oversight functions, they must be independent of operational management and not unduly influenced by senior management or business unit executives.
The Board is also responsible for approving the FRFI’s overall internal control framework and monitoring its effectiveness. Internal or external audit, actuarial reports, and legal or regulatory opinions may assist in evaluating effectiveness. The correction of material control deficiencies or breaches must be monitored by the Board.
Requiring FRFIs to identify, assess and mitigate risks has been OSFI’s approach since it introduced the Supervisory Framework. The Draft Guideline refines this approach by introducing the concept of a Risk Appetite Framework (RAF). FRFIs are to have a Board-approved RAF that determines the amount of risk the FRFI is willing to accept and guides the development of the FRFI’s policies and business strategy accordingly. The RAF should be enterprise wide and should be tailored to the FRFI’s domestic and international business activities. It should contain a “risk appetite statement” that reflects the level of aggregate risk that a FRFI is willing to assume and manage in the pursuit of the FRFI’s business objectives and contains qualitative and quantitative elements. Areas in which a risk appetite could be specified include a FRFI’s classes of business, liquidity preferences, operational controls or hedging strategies. The RAF is also to set out “risk tolerance limits” that reflect the level of risk that a FRFI is willing to bear in respect of specific categories of risk to achieve its objectives. Risk tolerance limits would often be expressed in quantitative terms.
The Draft Guideline provides that, depending on the nature, size, complexity and risk profile of a FRFI, FRFIs should have a Board Risk Committee responsible for overseeing risk management on an enterprise-wide basis. Guided by the RAF, the FRFI’s Board Risk Committee should have a sound understanding of the types of risk to which the FRFI is exposed and the techniques to identify, monitor, mitigate and report on these risks. The Board Risk Committee should have a clear mandate and be independent of senior management. An adequate number of members of the Board Risk Committee should have sufficient knowledge in the risk management of financial institutions.
The Draft Guideline formally articulates OSFI’s expectations regarding the CRO, which is a role that OSFI has emphasized in recent years. The CRO is to be independent from operational management and have a direct reporting line to the Board or the Board Risk Committee. The CRO and the risk management function should not be directly involved with either the revenue-generation or the management and financial performance of any business line of the FRFI. The CRO should provide regular reports to the Board, the Board Risk Committee and senior management to allow them to understand the risks being assumed by the FRFI and in particular should provide an independent view to the Board Risk Committee and the Board on whether the FRFI is operating within the RAF.
The Role of the Audit Committee
As is the case in the 2003 Guideline, the Draft Guideline sets out OSFI’s expectations of the Audit Committee. These expectations include ensuring that the FRFI’s audit plans are appropriate, risk-based, and address all relevant activities over a measurable cycle, putting in place a governance framework to address concerns raised about the external auditor’s independence and establishing criteria for determining whether an external auditor can provide non-audit services to the FRFI.
The chief internal auditor, the chief financial officer and, for an insurance company, the appointed actuary should have a direct reporting line to the Audit Committee. The Audit Committee should hold regular meetings with these officers without other senior management present to discuss the effectiveness of internal controls and the adequacy of reserving and reporting practices. Where the internal audit function is outsourced, the Board remains responsible for overseeing the performance of that function. The Audit Committee is responsible for approving external audit fees and the scope of the audit engagement.
The Board and OSFI Supervision
A FRFI’s Board must understand the regulatory environment affecting the institution and its subsidiaries. The Board should be informed about the results of OSFI’s and other regulators’ reviews. Regulatory recommendations or findings and senior management’s plans to address deficiencies should be reviewed by the Board. OSFI notes that regulatory findings should be considered by the FRFI Board in evaluating senior management performance recognizing that the Board and senior management are primarily responsible for identifying weaknesses and addressing them. OSFI will engage with the Board and senior management to confirm that appropriate corporate governance processes are in place and are operating effectively.