Blog post by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB
20 July 2023
The failure of Silicon Valley Bank in the United States sent shock waves through the financial world and triggered much reflection on its causes. In the Federal Reserve’s in-depth report on the factors underlying the bank’s failure, one of the key takeaways is that “Silicon Valley Bank’s board of directors and management failed to manage their risks”.[1] This underscores a fundamental point: a bank’s management body, particularly its senior executives and board of directors, is ultimately responsible for risk management within the organisation.
Effective governance is a key element underpinning several of the Basel Committee on Banking Supervision principles that guide prudential supervisors around the world. In banking supervision, we see all too often that the root cause of various vulnerabilities in banks lies in ineffective management bodies. And given our mission to keep European banks safe and sound, we assess the effectiveness of banks’ management bodies. Earlier this year, we conducted a targeted review of management bodies in a sample of 20 banks across Europe. We focused on structural deficiencies in management bodies and on the oversight of board committees, such as those for audit, remuneration and nomination. We drew on a wide range of supervisory tools, including occasionally attending a number of board and committee meetings to gain a better understanding of how management bodies operate in practice. In this blogpost I would like to share some of the findings of this review.
Management body effectiveness as an integral part of the SSM supervisory priorities
Banks’ governance has been on the ECB’s supervisory radar since the early days of the SSM. Indeed, most of the findings and recommendations we present in our annual supervisory review and evaluation process (SREP)[2] have to do with internal governance. In the 2022 SREP, for instance, 73% of institutions were assigned a score of 3 out of 4 for internal governance[3], indicating that most banks we supervise need to improve in this area. A major driver behind enduring weaknesses in governance is management bodies’ lack of effectiveness in terms of their composition, collective suitability and oversight role.
In around one-third of supervised banks, less than half of the board is made up of independent non-executive directors. Why is this an issue? Because non-executive directors ensure that executives are being constructively challenged with a fresh and independent perspective from someone who does not come from inside the bank. Constructive challenge means asking the right question at the right moment, with the right intent and in the right tone and continuing to do so until one receives a satisfactory answer. In essence, non-executive directors are on the one hand a trusted partner of management and are, on the other hand, expected to challenge them constructively.
Another concern is that although policies describing the roles and responsibilities of committees and boards exist, they are not always effectively implemented in practice. The status quo of management body functioning is therefore just not good enough, which is why the ECB made management body effectiveness one of our main supervisory priorities[4] for 2022-24.
Good and bad practices from the targeted review of banks’ management bodies’ effectiveness
So, what have we learned from our targeted review of the management body effectiveness of banks in the banking union? In a nutshell, our analysis showed a mixed picture, with some good and some bad practices. As a bad practice, we found that in many banks the CEO or Chair tends to have a dominant role, which hampers independent debate and constructive challenge. In 55% of the banks in our sample, executive directors are systematically present in all meetings of the internal control functions and committees tasked with providing an independent perspective. However, some frontrunner banks have introduced closed committee sessions for non-executive directors only. This is good practice and ensures that non-executive directors can have an independent debate and constructively challenge executives.
Another telling example was the nomination process for new managers. As a bad practice, the head of the nomination committee would simply sign off on a manager’s appointment after receiving a call from the CEO. This shows that many banks still lack a sound process for suitability and succession planning, which includes the different candidates being scrutinised by the nomination committee. Conversely, as a good practice, some banks’ nomination committees maintain and update a list of potential successors for critical functions and have developed tools for succession planning, such as talent pool heat maps. In other frontrunner banks, the nomination committee actively challenges the individual and collective suitability of board members and assesses whether the appointees have the required skills and can commit sufficient time to perform their roles. Nomination committees are encouraged to make use of the suitability matrix developed by the European Banking Authority[5], which we implemented in our fit and proper questionnaire[6]. This tool enables gaps in the collective suitability of the management body to be identified through an assessment of different areas of expertise and experience. As with any point-in-time evaluation, the assessment of collective suitability considers the knowledge, qualities and skills of other existing board members. Therefore, the suitability matrix could be employed both in the nomination process and in succession planning.
Supervisory follow-up
Overall, our targeted analysis highlighted that there are still some long-term structural deficiencies in the functioning of management bodies. For the sake of sound governance, as supervisor we must continue our efforts to strengthen banks’ management body effectiveness. To do so, it is vital to maintain our ongoing dialogue with banks in order to broaden their understanding of our supervisory expectations. A good example of this is our recent high-level seminar with the industry, which brought together more than 90 participants, mainly non-executive directors of banks.
The good practices observed in our targeted review clearly show that the key ingredients for enhancing management body effectiveness are already well known. But banks are in the driving seat when it comes to putting these good practices into action. Our supervisory teams are in constant dialogue with each bank to discuss how the observed good practices could guide improvements in their specific case. But let me be clear: if we see that critical findings are not being properly remediated, we will use all measures in our supervisory toolkit to ensure compliance. In the first instance, this includes imposing clear qualitative SREP requirements with time-bound milestones for remediation. If the requirements are not met, supervisory escalation will occur, which may include enforcement measures such as periodic penalty payments.
Effective management bodies are the bedrock of well-run banks. And well-run banks are the bedrock of a stable banking system. That means safer banks for the people of Europe, which is our mission as European banking supervisor.
