Review Proposes Fundamental Changes to Strengthen UK Bank Governance

On July 16 the Walker review of corporate governance of UK banks and other financial institutions (BOFIs) released a consultation paper on the future of corporate governance in the UK financial services sector (the Review).
We have recommended substantial changes to the way the boards of BOFIs function in particular through boosting the role of non-executives in the risk and remuneration process.

We recommend strengthening bank boards, making rigorous challenge in the boardroom a key ingredient in decisions on risk and measures to encourage institutional shareholders to play a more active role as engaged owners of BOFIs.

Sir David said “These proposals are designed to improve the professionalism and diligence of bank boards, increasing the importance of challenge in the board environment. If this means that boards operate in a somewhat less collegial way than in the past, that will be a small price to pay for better governance.”

Five key themes of the Review are as follows:

First, the Combined Code of the Financial Reporting Council (FRC) remains fit for purpose. Combined with tougher capital and liquidity requirements and a tougher regulatory stance on the part of the Financial Services Authority (FSA), the “comply or explain” approach to guidance and provisions under the Combined Code provides the surest route to better corporate governance practice in BOFIs. The relevant guidance and provisions require amplification and better observance but there are no proposals for new primary legislation.

Second, principal deficiencies in BOFI boards related much more to patterns of behaviour than to organisation. The right sequence in board discussion on major issues should be presentation by the executive, a disciplined process of challenge, decision on the policy or strategy to be adopted and then full empowerment of the executive to implement. The essential challenge step in the sequence was missed in some board situations and must be unequivocally embedded in future. The most critical need is for an environment in which effective challenge of the executive is expected and achieved in the boardroom before decisions are taken on major risk and strategic issues. For this to be achieved will require close attention to board composition to ensure the right mix of both financial industry capability and critical perspective from high-level experience in other major business. It will also require a materially increased time commitment from non-executive directors (NEDs), from whom a combination of financial industry experience and independence of mind will be much more relevant than a combination of lesser experience and formal independence. In all of this, the role of the chairman is paramount, calling for both exceptional board leadership skills and ability to get confidently and competently to grips with major strategic issues. With so substantial an expectation and obligation, the chairman’s role will involve a priority of commitment that will leave little time for other business activity.

Third, given that the core objective of a BOFI is the successful arbitrage of risk, board-level engagement in the high-level risk process should be materially increased with particular attention to the monitoring of risk and discussion leading to decisions on the entity’s risk appetite and tolerance. This will call for a dedicated NED focus on risk issues in addition to and separately from the executive risk committee process and there should be full independence in the group risk management function. The chief risk officer should have clear enterprise-wide authority and independence, with tenure and remuneration determined by the board.

Fourth, there is need for fund managers and other major shareholders to engage more productively with their investee companies with the aim of supporting long-term improvement in performance. Boards, in turn, should be more receptive to such initiative. The Institutional Shareholders’ Committee (ISC), the FRC and the FSA should play a larger role in promoting such enhanced engagement by owners on the basis of principles of stewardship with which fund managers should be expected to conform on a “comply or explain” basis. The recommended disclosure should ensure that prospective clients know whether a fund manager in pitching for their business operates a model that includes engagement with a view to long-term performance improvement.

Fifth, against a background of defective control and serious excess in some instances, substantial enhancement is needed in board level oversight of remuneration policies, in particular in respect of variable pay, and in associated disclosures. The remit and responsibility of board remuneration committees should be extended beyond board members to cover the remuneration framework for the whole entity. Through insistence on deliberate and sufficient focus on the long-term, the remuneration committee should be a major countervailing force to any short-term pressure from shareholders or the executive. To ensure better alignment of interests, performance conditions and deferment in respect of variable pay for executive board members and other senior executives should be materially more demanding than industry norms hitherto. Not less than half of expected variable remuneration should be on a long-term incentive basis with vesting, subject to performance conditions, deferred for up to five years.

Specific proposals in the consultation paper include:

Sir David said “Failures in governance in banks and other financial institutions made the financial crisis much worse. Many boards inadequately understood the type and scale of risks they were running and failed to hold the executive to high standards of sustainable performance. Bonus schemes contributed to excessive risk-taking by rewarding short-term performance. And shareholders failed to exercise proper stewardship.

“Taken alongside the arrangements being proposed by the FSA, the recommendations on remuneration are as tough or tougher than anything to be found elsewhere in the world. An important and urgent challenge is to promote adoption of similar approaches internationally.”

These recommendations should bring substantial improvement in the governance of banks. They will not guarantee that failure will be avoided in future but will greatly mitigate the risk.

The consultation paper proposes that most of the recommendations are enforced through inclusion in the Combined Code on Corporate Governance, which operates on a “comply or explain” basis. It would be for the FRC, which is currently reviewing the Combined Code, to decide exactly how this would be done.

The full consultation paper can be downloaded here; further information about the Walker Review can be found here.