Before the onset of the financial crisis, bank regulators left governance arrangements to the discretion of individual institutions. Very few jurisdictions had devised extensive bank-specific governance requirements. It did not matter how boards governed their banks, as long as they met substantive prudential requirements.

No more. In the wake of the financial crisis, there is a policy scramble to identify potential governance failings; and to make supervisors directly responsible for assessing bank governance. Following the Walker Review, the UK Financial Services Authority (FSA) has significantly beefed up its 'fit and proper' screening of bank directors.

The new EU capital adequacy directive has introduced mandatory arrangements on risk and remuneration. In its July 2010 green paper currently in consultation, the EU Commission is tackling some pretty radical stuff: prohibiting chief executive officers from becoming chairmen; changing the fiduciary duty of bank directors to specifically address long-term solvency issues; and giving supervisors the right to "check the correct functioning of the board".

A good sample of regulatory thinking across jurisdictions is provided by the Basel Committee's principles for enhancing corporate governance. There is much to commend in these draft principles: a focus on the board's responsibility for setting risk appetite; a requirement for a strong and independent group risk function; a requirement for the boards of large banking groups to better understand their corporate structure and distribution of decision-making authority.

However, the principles also give a good example of the regulatory pitfalls. There are two particularly dangerous ones. First, the principles seem to view senior management as implementer rather than leader. But the reality is that boards cannot lead banks. They are there to support the executive leadership, including through constructive challenge, and to decide on issues on which the executives face significant conflicts. The leadership onus - and concomitant regulatory scrutiny - should remain mostly on the executive team. If the board's busy part-timers were asked to decide on too many things, more risks might fall through the cracks as a result of rubber stamping.

Regulatory overstretch

The second pitfall has to do with the 'how to' bit, the tools that supervisors should use to assess and remedy governance failings. While the requirement that existing and prospective board members should meet fit-and-proper criteria is sound, it is only effective with matters of probity and integrity, areas where judgements are usually obvious. Even sophisticated supervisors such as the FSA (which now employs a panel of senior experts to conduct director interviews) will have a hard time challenging the competence of the heavyweight players who generally sit on top tier - the most systemically important - bank boards. Most importantly, this process risks confusion over the crucial responsibility for board appointments, which currently lies with shareholders. Who is to be held accountable if a bank board fails under the leadership of a chairman (or a committee chairman) that 'passed the competence test'?

The principles also ask the regulators to "regularly perform a comprehensive evaluation of a bank's overall corporate governance policies and practices". Yet, can regulators avail themselves of the staff-level expertise or the resources to engage in comprehensive governance assessments of so many financial institutions without falling into box-ticking?

A different approach

More effective alternatives for the supervisory assessment of governance, especially in important banks, do exist. Here are two ideas:

First, banks should be required to undergo a regular (for example, every two or three years) external assessment of their governance by qualified external experts, along the lines of the UK Corporate Governance Code. The conclusions and recommendations of the assessment should be discussed by the board and then be communicated to the regulator along with the board's action plan for implementing agreed changes.

Second, there should be annual meetings between the leadership of the supervisory authority and the boards of the largest, systemically important banks. The meeting would focus on the bank's strategy, risk appetite and governance. The involvement of the supervisory leadership would be necessary to ensure sufficient clout. The meeting might also prove to be an important source of information for the supervisors on macro-prudential issues. In addition, the process would put pressure on boards to develop an explicit point of view on key strategic, risk and governance issues.

There is no doubt that some boards failed to steer their banks away from the tempest of poor-quality credit, from business models too exposed to the funding vagaries of the wholesale market and from incentives that rewarded recklessness. But it is also true that board lethargy was often induced by a false sense of security: as long as the bank follows regulatory ratios, all will be well. Instead, we should be vigilant that regulatory requirements are not designed in a way that weakens the sense of responsibility of boards and management. After all, there is no such thing as perfect regulation.

Stilpon Nestor is managing director of Nestor Advisors, a corporate governance consultancy specialising in the banking sector

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