Corporate Governance: Basel II and Beyond Corporate Governance Program for Bank Directors of Indian Banks Mumbai December 14, 2005

2 Regulation Breeds Innovation and Innovation Breeds Regulation

3 Supervisory Interest in Corporate Governance Bank Supervisors Securities Supervisors Law Enforcement Others

4 Directors’ Role(s) OversightManagement –Complementing or Conflicting?

5 Corporate Governance and Basel II It’s a marriage … It’s an ideal …. It depends ….

6 Mid-Year Text Pillar One: The Board of Directors (BOD) must: –Approve all material aspects of the rating and estimation processes –Possess a general understanding of the bank’s risk rating system and detailed comprehension of its associated management reports

7 Mid-Year Text Pillar Two: The BOD must/should: –Fulfill its responsibility for setting the bank’s tolerance for risk –Ensure that management establishes a framework for assessing all risks, develops a system to relate risk to capital, and establishes a method for monitoring compliance with internal policies –Adopt and support strong internal controls and written policies/procedures that are communicated effectively by management throughout the bank

8 Mid-Year Text Pillar Three: The BOD must: –Ensure alignment of disclosures with how banks’ risks are assessed and managed –Approve the bank’s disclosure policy for determining what disclosures the bank will make and the internal controls over the disclosure process Some U.S. Perspective –Areas of required disclosures are quite explicit. Open issues are granularity, format, and place –‘Takeaway’ for directors of U.S. banks: BODs must approve disclosure policies consistent with P3 principles and ensure adherence through appropriate control sets

9 Draft U.S. Supervisory Guidance The current draft guidance sets forth standards identifying the BOD’s role in ensuring: –The effectiveness of the IRB system (i.e., design and proper functioning) –That the capital calculations accurately reflect the risk profile of the bank –That the components of the IRB, including the control framework, are evaluated and approved at least annually

10 Draft U.S. Examination Procedures Policies/procedures/process measured against guidance standards: –Does the BOD ensure that capital calculations accurately reflect the bank’s risk profile? –Does the BOD approve the IRB components annually, including the control framework? –Does the BOD evaluate the effectiveness of the IRB system as part of the annual approval? –Has the BOD established specific accountability for the overall performance of the IRB system?

11 Draft U.S. Examination Procedures Suggested review items: reports and submissions on IRB effectiveness submitted to the BOD As part of supervisory testing phase: review of board minutes to verify that directors are receiving/reviewing independent reviews/audit findings and approving the IRB components annually

12 BCBS Consultative Document “ Enhancing Corporate Governance for Banking Organizations” A consultative document on which the industry has commented Revision of 1999 principles In keeping with other corporate governance guidance for BODs (not bank specific) Limited direct reference to Basel II

13 BCBS Consultative Document The BOD has an obligation to: –understand the risk profile of a bank –ensure that capital levels adequately reflect such risk –(particularly for banks adopting the advanced approaches) ensure that the use of complex risk models is subject to effective oversight Specific reference to Pillar 2 and Pillar 3 responsibilities for overall capital adequacy, integrity of controls and risk management procedures, and appropriate level of disclosure as another ‘control’ (i.e., market discipline)

14 Moody’s Special Comment Special Comment entitled “Don’t Bank on Strong Governance: Observations on Corporate Governance in the U.S.” A tally sheet for the industry with insights from 27 banks Not specific to Basel II, but implications … Progress noted: –Stronger regulation –Board/Committee focus on key exposures –More emphasis/formalization on succession

15 Moody’s Special Comment Areas for Improvement: Control failures still prevail; Board response? Bank board composition is not optimal –Financial competency? –Degree of independence? –Too localized? –Too large? Boards within boards Mergers create oversight challenges Risk oversight challenges bank boards

16 Moody’s Special Comment “Risk oversight provides a distinct challenge to bank boards, particularly in light of Basel II” Financial innovation may move ahead of risk management, where the BOD has critical responsibilities for policy-setting and implementation A key area for improvement for many banks is “the quality of risk-reporting to the board and its committees; we believe that this stems from sub-optimal, although improving, risk-reporting across the organization.” “Too few banks use risk-adjusted metrics for motivating senior management.”

17 Real World Challenges How can supervisors assess the effectiveness of BODs in discharging their duties relative to Basel II? How can supervisors gauge the true level of director understanding of/involvement in critical issues facing the bank? How much reliance do/should the directors place on senior management as their primary source of information?

18 Real World Questions What is the extent of [your] involvement in Basel II so far? What should be the nature and extent of [your] involvement as [your bank] moves toward qualification and implementation? Have [your] supervisors looked at BOD minutes? Audit or Risk Committee minutes? Agendas? Presentations by internal or external sources? What level of granularity is likely to be provided by the final local supervisory guidance and examination procedures on corporate governance for Basel II?

19 Other Things to Think About What other sources of information or guidance might be useful here?

20 Thank you! John Heinze Federal Reserve Bank of New York