4th May 2017

Why ESMA and the EBA must refine their guidance on internal governance, or else risk bank boards becoming talking shops

Written by Stilpon Nestor, Managing Director, Nestor Advisors Ltd

It’s clear that the ESMA and EBA’s recently published draft Suitability Guidelines and the EBA’s draft Internal Governance Guidelines will significantly influence banks’ governance arrangements.

While they offer important clarification on what supervisors should expect to see in terms of the composition and key responsibilities of bank boards, they would benefit from revisions and clarifications in a number of areas.

While constructive challenge is indeed key for board effectiveness, boards should not become talking shops. Challenging executive thinking should take place in the run-up to a board decision or in the context of executive evaluation — not by second-guessing decisions that have been properly delegated to management.

The distinction between unitary and two-tier boards needs to be more accurately calibrated in both sets of draft guidelines, especially in the area of establishing and monitoring internal control frameworks. These should clearly be the primary responsibility of management. The board’s role, through its audit committee, should be to make sure that the internal control system is adequate and effective.

The EBA’s draft Internal Governance Guidelines should not impose “expert-only” composition of risk committees as this will negatively impact the board’s overall capacity to lead and might increase its size. The Guidelines should prohibit multiple committee chairmanships by the same person only if there is a risk of conflicts of interest.

The draft Internal Governance Guidelines seem to suggest that there should be one master governance policy, a governance “bible”, so to speak, where all individual bank and group governance aspects would be dealt with. We believe firms should be given a choice between such a holistic approach and a more decentralised practice of having multiple policy documents — including a separate Group Governance Policy, which seems to have been the supervisor’s best practice standard until now.

ESMA’s draft Suitability Guidelines need to be more flexible in their requirement for director independence, allowing some discretion for boards to waive parts of the formal independence requirements by providing convincing explanations to supervisors.

Both regulators must clarify the meaning of independence of the compliance function, focusing on independence from front-line business units as opposed to independence from all executive functions of the bank.

Finally, given the number and variety of suitability and effectiveness assessments/reviews in both sets of draft guidelines and in national corporate governance codes, it would be useful for the EBA and ESMA to clarify the relationship between these different exercises, allowing firms some scope for their efficient combination.

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