Fed proposal won’t let boards off easy, but here’s why that’s OK

The Federal Reserve Board issued an important, long-awaited proposal on Aug. 3 designed to revise and clarify expectations for boards of directors at Fed-supervised institutions. The Fed has noted that board ineffectiveness at large banks was a central contributor to the financial crisis, but clear Fed guidance in this area has been slow in coming.

Following the crisis, regulators in practice increased scrutiny of large-bank boards, but the demands became too expansive, diverting board time and attention away from their central function of setting a bank’s strategic path. The new Fed proposal is welcome news for the industry since it would redirect supervisory expectations more squarely toward senior management.

Initial press reports highlighted the proposed narrowing of board responsibilities so board members can concentrate on strategic issues. Superficially, this may appear to be the case, but it would be a misreading of the Fed’s objectives to interpret the proposal as an overall lowering of supervisory standards for boards at large financial institutions. Banks shouldn’t mistake a clearer statement of expectations as an easing of standards. Indeed, by establishing more focused expectations — the new proposal provides five main measures for assessing board effectiveness — supervisors will have better tools to hold boards accountable.

Andrew Harrer/Bloomberg News

From a supervisory perspective, setting clearer criteria of what the Fed expects from board members will help correct weaknesses in board oversight of their institutions. Clearer direction from regulators is all the more important as memories of the crisis increasingly fade. Strong implementation of these supervisory policies will give the public more confidence about the financial industry’s safety and stability.

For banks, a more focused articulation of Fed expectations is good news in light of how the less formal supervisory policy coming out of the crisis led to substantial misplaced demands on board time and attention.

But have no doubt: The new requirements will require large banks to do some substantial legwork. They face significant regulatory risk if they only concentrate on the narrowing of Fed demands for boards and fail to properly address the new expectations.

Yet the new expectations appear aimed at effecting real improvements in board operation.

For example, the proposal promotes improvement in how management communicates with the board. Communications to the board should be sharply focused on key strategic and trend information that allows directors to prioritize their strategic role. The far too common practice of bank management producing voluminous data-laden board materials needs to be overhauled to better enable directors to home in on key information.

The proposal also prominently discusses the role of board self-assessments both as a way to support board effectiveness and as a method to provide significant information to examiners. The Fed has long viewed strong self-assessment processes as important for management but explicitly extending these expectations to the board is new. This aspect of the proposal provides positive incentives for banks to establish strong self-assessment processes that can be a dynamic tool for maintaining board effectiveness.

The five measures for effective boards laid out in the proposal are: providing clear direction on a firm’s strategy and risk tolerance; managing information flow; holding management accountable; supporting the independence of risk management and audit functions; and maintaining “a capable board composition and governance structure.”

The Fed simultaneously issued a related proposal that outlines a new rating system for large financial institutions to better align supervisory ratings with the Fed’s post-crisis regulatory framework. As part of the rating system, a bank’s governance and controls will be among the rated components. The proposal makes clear that the assessment of board effectiveness will be a central element of that component.

This reflects the Fed’s determination that boards of large financial institutions must effectively align firm strategy and firm risk tolerance. Implementing the new rating system will be a major step to interrelate the various responsibilities of boards to fulfill enhanced supervisory requirements on governance, strategy, risk tolerance, capital, liquidity, and for the very largest firms, recovery planning.

In the wake of these new proposals, banking organizations should educate boards and senior management on the Fed’s expectations and more generally review the adequacy for board training; assess board policies in light of the five proposed measure of board effectiveness; and review the board’s process for self-assessments.

Unfortunately, the Fed proposal is limited to central bank’s policies, putting off to a later date interagency guidance for banks boards, which can be applied consistently across institution types. Addressing requirements across multiple agencies is still a challenge for the industry. Banks will need to conduct a thorough analysis of how the Fed’s proposals line up with the Office of the Comptroller of the Currency’s “heightened standards” and other relevant requirements to ensure compliance with all policies while avoiding redundancies.

Yet the Fed proposal is a much-needed clarification of supervisory expectations of boards that will benefit both banks and the public.