24 April 2012

FSA/Sants: "Delivering effective corporate governance - the financial regulator's role"

In relation to the regulator’s role in delivering effective corporate governance, Mr Sants addresses three questions:

• What do we mean when we say we want firms to have ‘effective boards’?
• What does this mean for the regulator’s Significant Influence Function process – often referred to as the ‘SIF’ process? And
• To what extent can the regulator incentivise the right behaviour and culture in firms?

Mr Sants highlights three key components of effective governance:

Firstly, and most importantly, there needs to be an effective board that ‘sets the right tone’ from the top. An effective board is one which, crucially, understands the circumstances under which their firm would fail and constantly asks the ‘what if’ questions. To do this well, a board needs to understand its business model, understand and focus on the material risks, and challenge the executive on the execution of a strategic plan. Done well, this should result in a firm that not only delivers shareholder returns but one which is prudentially robust and delivers a fair deal to its customers.

Secondly, it is the Chair’s role to construct and manage a board that has the appropriate and relevant skills and experience to enable it to function effectively.

Mr Sants' third point on board effectiveness is the importance of the board’s role in signing-off the strategic plan and ensuring that the executive team execute to that plan. To do this effectively, the board needs to see and demand management information (MI) that relates to that plan directly. For the board to be able to exercise effective oversight there needs to be a flow of relevant information. All too often supervisors still see the board being swamped with reams of standard template MI which in reality obscures the key issues and hampers clarity of debate. Boards need to recognise when this is happening. Boards must ensure they are focused on what matters.   

The regulator assesses this effectiveness on a continuous basis. It does this through many tools such as board effectiveness reviews, regular supervisory discussions with the Chair, senior independent director, and key executives. Enforcement will also be used when absolutely necessary. However, the principal and earliest intervention the regulator can make is through the SIF authorisation process.

A SIF is the regulatory term for roles that can exercise material influence over the running of a firm in relation to the regulator’s objectives, in particular in relation to a firm’s safety and soundness and to its fair treatment of customers. The assessment by the FSA of whether individuals are suitable for these roles is a continuous process. However, in reality authorisation is the crucial decision point and an important gateway of regulation. Let us remind ourselves of the underlying objectives of the SIF process. The core purpose is to work with the firms to ensure a balanced and effective working board and senior executive team.

Central to good governance is a firm’s culture. Mr Sants has spoken a number of times on culture explaining that he does not believe a regulator should prescribe what the ‘right’ culture is. Rather, a regulator should ensure that the right enablers are present to incentivise a culture that delivers the right outcomes.

In conclusion Mr Sants highlights four points:

• The role of a regulator is to create boundaries within which firms take responsibility for their own decisions. In the past the capital and liquidity boundaries for banks were nearly non-existent and thus management were not sufficiently constrained in their judgements. The new capital and liquidity standards will address these shortcomings but will not remove the necessity for management to make good judgements and the need for regulators and shareholders to hold those firms to account.
• Central to a regulator’s role in promoting effective boards is the utilisation of the authorisations process to encourage firms to make the right appointments. History clearly demonstrates the importance of a regulator having a proactive approach to judging the suitability of directors, in particular their competence. This proactive approach must be focused only on those key roles, and has to be a judgement not just about the effectiveness of individuals, but about the board as a whole.
• Good governance and a strong culture are a necessity for maximising the likelihood of the right judgements being made by management. Regulators have a role to play in ensuring that firms have the right governance and culture. But Mr Sants stresses that it is not for the regulator to determine the culture. Ultimately, however, even a successful regulatory regime will not be sufficient to ensure good outcomes. Crucially, firms need to have an appropriate culture and one which is focused on the firm delivering the right long-term obligations to society. The right cultures are rooted in strong ethical frameworks and the importance of individuals making decisions in relation to principles rather than just short-term commercial considerations. In particular, this means that when a regulator expresses a clear instruction then firms should not continue to resist for reasons of expediency and short-term gain.
• Nevertheless, history tells us that we cannot rely on the motivation of individuals alone and that we need credible enforcement to require individuals to be driven by principles rather than just commercial expediency. Commercial success should not place an individual above the law.

Full speech

© FSA - Financial Services Authority