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The Importance of Effective Corporate Governance
by Kevin Moore, Senior Vice President, Supervision and Risk Management Division, Federal Reserve Bank of Kansas City

Since 2009, I have served as the chair of a Federal Reserve System group known as the Community Banking Organization Management Group (CBOMG). This group was established a number of years ago to promote consistent and effective implementation of supervision programs and policies for community banking organizations. Members of the CBOMG include senior leaders with responsibility for community bank supervision from each of the Reserve Banks and the Board of Governors. The group meets regularly to share information about banking conditions and emerging risks. It also provides a platform for promoting best practices and enhancing communication and coordination within the Federal Reserve System, as well as with our federal and state banking supervision partners.

 

As the senior vice president of the Supervision and Risk Management Division at the Federal Reserve Bank of Kansas City and the current chair of the CBOMG, I have had a unique opportunity to observe how the financial crisis affected community banks and gain an appreciation for some of the causes of the crisis.

 

Simply stated, the recent financial crisis was fueled largely by the housing boom. Consumers, small businesses, and financial institutions took on excessive leverage to finance this growth. When economic conditions changed dramatically, many consumers and small businesses defaulted on their loans, and the largest banks faced severe liquidity constraints and a loss of market confidence, in large part due to their involvement in securitization and derivatives markets. Meanwhile, a number of community banks with large exposures in land and construction lending suffered severe losses and failed. So what went wrong for these banking organizations? In short, I would argue that the boards of directors of many of these banks were not sufficiently engaged or informed to question the adequacy of capital and risk management programs needed to enable their banks to weather a prolonged downturn.

 

In most cases, if a bank failure results in a significant loss to the Deposit Insurance Fund (DIF), the Office of Inspector General of the respective federal banking agency is required to conduct a material loss review. The purpose of these reviews is to determine, among other things, why problems at the bank resulted in losses to the DIF. In many of the recent reviews, the Office of Inspector General criticized failed banks' boards of directors and management for embarking on growth strategies without sufficient consideration of the risks involved and for not ensuring that these banks' risk management processes, internal controls, and capital were sufficient to mitigate the increased risk exposure.

 

The crisis therefore demonstrated that one consequence of a bank having weak corporate governance — the framework of rules and practices set by the board to ensure that the bank operates in a safe and sound manner — could be significant losses or even bank failure. The board of directors not only helps lay out the bank's risk limits and strategic goals but provides oversight as well. For that reason, I would like to spend the rest of this article talking about this important topic.

 

Corporate Governance

Effective director oversight is crucial in any industry, but why is it the central element of a financially sound and well-managed bank? More specifically, what does effective corporate governance look like in a community banking organization?

 

Board and management oversight is the fundamental element of ensuring a safe and sound bank. Put another way, director oversight is the primary driver that keeps a bank moving in a positive direction, and it is a critical component of a bank's success. The Federal Reserve and other banking regulators have long recognized the importance of having strong director independence and collaborative board interaction. This is reflected in many supervisory policies and examination manuals used by examiners at the federal banking agencies.

 

Among the board's many responsibilities, four areas are especially crucial to the bank's successful performance:

 

1. Establishing the bank's risk philosophy, including both the aggregate level of risk and tolerance for risk;
2. Ensuring that the bank has an appropriate risk management framework to manage and mitigate risk;
3. Setting the bank on the right course by determining the bank's overall business strategy; and
4. Monitoring implementation of the strategy to ensure that the bank's strategic objectives are being accomplished within the parameters of its risk management framework

 

I will discuss the importance of these four primary responsibilities, followed by some additional thoughts regarding director qualifications, director independence, and how directors can enhance their overall understanding of supervisory expectations. Within the context of this discussion, I will share some examples that illustrate the types of questions directors should be asking to ensure that they are fulfilling the four key responsibilities noted above.

 

1&2: Risk Philosophy and Framework

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) provides a useful overview in a 2009 paper titled "Effective Enterprise Risk Oversight: The Role of the Board of Directors." ¹ The paper notes that a key element of strategic goal-setting is first having a clear understanding of the organization's risk philosophy and making sure that the bank's risk appetite aligns with this philosophy. Because directors represent the views and expectations of the bank's shareholders and other key stakeholders, management should have an active and collaborative discussion with the board to establish a mutual understanding of the bank's overall risk appetite. Directors should inquire about existing risk management policies and practices and require management to demonstrate the effectiveness of those policies in identifying, assessing, and managing the bank's most significant risk exposures. In cases where the primary shareholders of the bank also hold senior management positions, the approach to discussions about risk philosophy and risk management may vary, but it remains the responsibility of all directors to ensure that strategic goals and risk management are properly aligned.

 

3: Setting Strategic Objectives

The COSO paper also notes that management is accountable to the board and that the board's focus on effective risk oversight should be applied within the framework of a strategy, formulating appropriate objectives and approving resource allocations consistent with effective implementation of the strategy. So an important question directors should ask is whether the bank's strategy is appropriate, clear, and convincing. Is it realistic and attainable? The board's responsibility is to make sure that the bank implements a strategy that is consistent with its risk philosophy and risk management framework and can be implemented by management and staff with sufficient expertise and resources. For example, prior to the crisis, we observed a number of community banks located in rural areas that elected to engage in a growth strategy by expanding into urban areas to increase commercial real estate lending. In many cases, this strategy was implemented without ensuring that the bank had adequate expertise to understand local and regional risks related to this new lending, which subsequently exposed the bank to a level of risk exceeding its internal risk tolerance.

 

4: Monitoring Performance

After establishing strategic goals and approving effective risk management policies, directors should receive ongoing information about how implementation of these goals and policies is working and make adjustments when needed. Periodic reviews of the bank's strategies and inherent exposure to risk by the board are necessary to understanding and assessing whether these strategies and exposures are consistent with the board's overall risk appetite. Risks are constantly evolving, so directors must receive timely and accurate information from management on key risk indicators in order for the board to effectively execute its fiduciary responsibilities and oversee the operation of the bank.

 

Board of Directors

Let me share some thoughts and provide some examples of why it is important to have qualified directors and an independent board. I will also briefly discuss some Federal Reserve resources that are available to help directors who want to improve their knowledge and qualifications.

 

Director Qualifications

Attracting and retaining qualified directors is a key component of maintaining an effective board. Although there is no one best set of minimum qualifications for directors, board members should be held to a high standard, and they should always keep the best interest of the bank in mind when establishing the strategic direction and risk management framework. Their ability to establish appropriate and effective policy guidance for the bank comes from having a thorough understanding of the bank's risk appetite and risk management framework.

 

Independence

Directors should be objective, independent thinkers and should be able to bring their specific knowledge, expertise, and experiences to board and committee discussions. They should also be willing and able to challenge senior management if necessary on matters related to the bank's strategy and execution and should be willing to commit sufficient time and energy to their responsibilities as directors. By acquiring some knowledge about banking and the regulatory environment in which banks operate, board members are better able to successfully set strategic direction, establish appropriate risk management parameters and policies, understand concerns and issues that may be raised by bank supervisors, and determine criteria for assessing the performance of executive officers of the bank.

 

Corporate Governance: Some Real-Life Examples

One area that can be challenging is when the chairman of the board of directors or a member of senior management (e.g., the chief executive officer) has a domineering leadership style. This can be especially problematic if the bank is engaged in risky business activities without appropriate risk management and oversight. This leadership style may stymie effective board discussion, leading to slow identification of problems and development of solutions, which can exacerbate the severity of a situation. For example, some boards have allowed a dominant chief executive officer or board chairman to spearhead an aggressive or highly concentrated growth strategy without ensuring that the bank has appropriate risk monitoring, processes, or tools to adequately manage these risks.

 

Based on what we have seen over the past several years, some possible red flags that the board or management may be leading the bank in the wrong direction include: (1) an aggressive growth strategy, which may lead to a concentration of risk or an increase in existing concentrations; (2) slow reaction to dynamic market conditions and recent regulatory guidance; (3) rapid expansion into new markets without thorough due diligence and/or the commensurate level of expertise; and (4) lack of effective management information systems or robust risk assessment programs necessary to identify and control specific risk areas (e.g., risk concentrations).

 

A diverse board composition with a balance of expertise, skills, perspectives, and experiences can promote robust and effective board interaction and can counter the influence of a dominant individual. Delineation between the responsibilities of the board and that of management is also important. It must be clear that the board sets direction and provides oversight and control, while management carries out board directives and manages the daily affairs of the bank. The board should ensure that it establishes a rigorous and robust compliance process that provides the board with the necessary information to ensure that the board and management fully understand the bank's objectives, risk appetite, and financial condition.

 

Even when a board is made up of a diverse group of individuals and when there is no dominant individual, we have observed through our bank examination and ongoing supervision activities that some directors are not sufficiently familiar with the business of banking. As a result, while their experience in other fields of business may provide them with a strong basis for skepticism and questioning, they may be hesitant to fully engage in discussions and decision-making. This can limit the effectiveness not only of the individual director but of the full board and the organization as a whole. In these cases, we strongly encourage directors to take advantage of training and tools that are available to help improve their knowledge and qualifications.

 

Federal Reserve's Bank Director Training

Recognizing the importance of having directors with appropriate skills and knowledge, the Federal Reserve System has developed a number of resources to help directors understand their responsibilities and to develop their knowledge and skills. One of the Federal Reserve System's director training resources is the Bank Director's Desktop - A Federal Reserve Resource.² This online tutorial provides a primer on the duties, responsibilities, and key roles of bank directors.

 

In addition to the online desktop training, the Federal Reserve System also offers a book, Basics for Bank Directors, which is the basis for the online tutorial and provides more detail on banking, the Federal Reserve's approach to supervision and regulation, and the roles and responsibilities of bank directors.³

 

A Few Final Thoughts

I hope that directors will find my comments about their important responsibilities helpful, and I encourage all directors to take advantage of the Federal Reserve's director resources. Community banks have a vital role to serve in both our nation's economy and their local communities. In future issues of this publication, you will hear from many of my colleagues about their perspectives on the challenges and opportunities facing community banking organizations.

 

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