Corporate governance in banks and financial institutions: change ahead

As a result of the banking crisis of 2008/09 the question of how the industry can guard against future failures has attracted substantial comment from the press, experts and regulators. One area of focus is the need for greater transparency in the industry, particularly with regard to remuneration in the sector, and how boards of banks and financial institutions might improve their corporate governance procedures to limit the chances of a repeat of the credit crunch. The recent publication of Sir David Walkers consultation paper, reviewing corporate governance in UK banks and other financial institutions (the Review), marks a significant step in this process. Banks and financial institutions, together with their respective boards and advisers, should pay close attention to the corporate governance proposals made in the Review. SCOPE OF THE WALKER REVIEW In February 2009 HM Treasury (HMT) commissioned Walker to conduct a review of and recommend measures to 2 improve the corporate governance of UK banks, particularly with regard to risk management. HMT requested that the Review focused on the following areas:
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the effectiveness of risk management at board level, including the incentives in remuneration policy to manage risk effectively; the balance of skills, experience and independence required on the boards of UK banking institutions; the effectiveness of board practices and the performance of audit, risk, remuneration and nomination committees; the role of institutional shareholders in engaging effectively with companies and monitoring of boards; and whether the UK approach is consistent with international practice and how national and international best practice can be promulgated.
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The Review focuses on larger and listed institutions. As a result, the proposals are likely to impact significantly on larger banks and financial institutions with similar board size, composition and qualifications. That said, all banks and financial institutions must be aware of the corporate governance issues raised in Walkers proposals. The recommendations may well trickle down to all banks and financial institutions, for example through the Combined Code on Corporate Governance (the Code) (to which all publicly listed companies are subject) and/or through enhanced regulation from the Financialf Services Authority (FSA), and voluntary adoption as best practice. The Review itself asserts that the Code, which sets out the framework for corporate governance within all publicly listed companies, remains an appropriate standard. In addition, the Codes comply or explain framework, with which listed companies must comply, is deemed to be the surest route to better corporate governance. The Review suggests that this will be enhanced by a tougher stance from the FSA, including the regulators encouragement of authorised firms to follow equivalent best practice. KEY THEMES: RISK MANAGEMENT AND INVESTOR/INVESTEE ENGAGEMENT Key themes to emerge from the Review include those of enhanced risk management and greater levels of engagement by investors. For example, in relation to establishing risk management procedures within banks and financial institutions, the Review recommends the following.

Establishment of a board-level risk committee

Banks and financial institutions should establish a board-level risk committee to complement existing audit committees. Walker proposes that the risk committee would focus on risk strategy and management, free from any conflict with demands placed on audit committees. The Review would expect the risk committee to report regularly (as part of the annual report) on risk strategy and risk management. The risk committee would be expected to use external advice to test its risk management assumptions, particularly in the context of risk associated with significant company transactions. Walker acknowledges that around half of FTSE 100 financial companies have already established a risk committee but suggests that senior management within all financial institutions should review whether their corporate governance would be enhanced by a risk committee.

Appointment of a chief risk officer

This individual should be independent of individual business units, reporting to both the risk committee and internally to the chief executive or financial director.

Expanded remit of the remuneration committee

The Review suggests that the remit of the existing remuneration committee, which is required under the Code, ought to be expanded to cover all aspects of remuneration policy on a firm-wide basis with particular emphasis 5 on the risk dimension. The Review also proposes that this committee is charged with reviewing all executive pay expected to exceed that of the median board level pay. In a bid to reduce the perceived excessive risk-taking within banks and financial institutions, this committee will also be expected to approve the links between performance targets and pay or bonus structures. In addition to enhanced risk management procedures within banks and financial institutions, the Review stresses the need for institutional investors to engage more productively with their investee companies to support longterm improvement in performance. Proposals include the following.

The promotion of enhanced engagement as a core element of banks and financial institutions obligations to investors
Diverse and engaged shareholder representation may be laudable, but it is easy to foresee that it may also pose problems, and not only for boards. Investors may be reluctant to engage because their priority is to protect the share price of the organisation in which they have invested. Fund managers, who owe legal duties to their underlying clients, may also be reluctant to put their heads above the parapet and perhaps risk breaching those duties.

Endorsement of Institutional Shareholders Committee (ISC) Statement of Principles 2007

The principles, appended to the Review, set out best practice for institutional shareholders (including pension funds, insurance companies, investment trusts and other collective investment vehicles) and their agents in relation to their responsibilities in respect of investee companies. The Review considers these principles to provide a sound foundation for engagement policy, and suggests that the Financial Reporting Council (FRC) ratify them. The principles should become the basis for principles of stewardship, subject to annual review by the ISC and FRC. The Review also recommends that FSA-authorised businesses undertaking investment business:

confirm their commitment to the principles of stewardship; be required to describe their policies on engagement; and explain how they will discharge the responsibilities that arise.

The Review envisages that the FSA would require asset management firms commitment to these principles on a comply or explain basis equivalent to that under the Code. This should also form part of the process by which firms obtain FSA authorisation. COMMENT Whether the Review recommendations become best practice or part of the FSA authorisation process remains to be seen. The responses to the consultation, which ended on 1 October, will inevitably suggest changes. Final recommendations are expected to be published next month. However, an expectation of enhanced corporate governance within banks and financial institutions is a certainty. For that reason alone, senior managers of companies that operate at all levels of the financial sector are advised to consider the recommendations and how they might apply them to their organisation. By Antony Corsi, partner, and Stephen Elam, senior associate in the disputes practice, Fulbright &Jaworski International LLP. E-mail:acorsi@fulbright.com; selam@fulbright.com. notes 1. Walker Review consultation paper dated 16 July 2009: A review of corporate governance in UK banks and other financial industry entities. 2. 3. 4. 5. http://www.hm-treasury.gov.uk/d/walker_review_consultation_160709.pdf. HM Treasury press release dated 9 February 2009: http://www.hm-treasury.gov.uk/press_10_09.htm. HM Treasury press release dated 9 February 2009: http://www.hm-treasury.gov.uk/press_10_09.htm. At Annex 4, the Review lists 17 banks, financial services companies, and life and non-life companies as the subject of its focus. 6. 7. The FSA has published its recommendations: Reforming Remuneration Practices in Financial Services. http://www.fsa.gov.uk/pubs/policy/ps09_15.pdf. The Walker Reviews proposals in this area are intended to be consistent with the FSAs approach.