On August 3, 2017, the Board of Governors of the Federal Reserve System (“Federal Reserve”) released proposed supervisory guidance1 and a notice of proposed rulemaking (“NPRM”)2 that would change: (i) the supervisory expectations for corporate governance at bank and savings and loan holding companies and systemically important nonbank financial companies; (ii) the Federal Reserve’s approach to supervisory communications to bank, savings and loan, and intermediate holding companies, state member banks, US branches and agencies of foreign banks, and systemically important nonbank financial companies; and (iii) the framework for supervisory ratings for large bank and savings and loan holding companies and for all intermediate holding companies. The intent of the proposals is to focus boards of directors on core governance and oversight functions by relieving them of responsibility for matters better handled by management.
The proposed supervisory guidance addresses three significant issues. First, it would clarify that boards of directors of all bank and most savings and loan holding companies with total consolidated assets of $50 billion or more and systemically important nonbank financial companies (“Large US Institutions”) should focus their energies on: (i) setting a clear and consistent strategic direction for the institution as a whole, (ii) supporting independent risk management and (iii) holding the management of the institution accountable.3 Second, it would revise or rescind supervisory expectations for the roles and responsibilities of boards of directors at all bank and savings and loan holding companies that were originally defined in 27 Supervision & Regulation letters (“SR letters”) that the Federal Reserve issued between 1990 and 2016. Third, the proposed guidance would clarify that examiners should typically communicate findings (e.g., MRAs and MRIAs) to senior management, instead of to the board of directors, unless the matter related to a board governance issue or the failure of senior management to correct a material issue.
The NPRM complements the proposed guidance by establishing a new supervisory rating system (the “Large Financial Institution Rating” or “LFI Rating”) that would apply to US bank and savings and loan holding companies with $50 billion or more in total consolidated assets and US intermediate holding companies (“IHCs”) of foreign banking organizations operating in the United States. The LFI Rating would be consistent with the proposed supervisory guidance and other post-financial crisis regulatory techniques and would focus on an institution’s (i) capital, (ii) liquidity and (iii) the effectiveness of its governance and controls.
The proposed supervisory guidance and NPRM would apply only to institutions regulated by the Federal Reserve. Accordingly, neither document would change supervisory expectations for national banks, state non-member banks, or federal or state savings banks, and those institutions’ boards of directors would continue to be governed primarily by the supervisory expectations of the Office of the Comptroller of the Currency (“OCC”) or the Federal Deposit Insurance Corporation (“FDIC”). It remains to be seen whether the OCC or the FDIC will follow the Federal Reserve’s lead by issuing similar proposals or allowing their regulated institutions to informally adopt the Federal Reserve’s guidance as “best practices.”
The Federal Reserve has requested that the public submit comments on the proposed supervisory guidance by October 10, 2017, and on the NPRM by October 16, 2017.
- I. Proposed Changes Related to Board Effectiveness
Over the past few years, the Federal Reserve has been conducting a review of the practices of boards of directors. The results of that review indicate that (i) it has become challenging for institutions to distinguish between supervisory expectations for boards and for senior management and (ii) boards spend a significant amount of time on supervisory expectations unrelated to their core responsibilities and may be overwhelmed by the quantity and complexity of information that they receive. The Federal Reserve hopes that by clarifying and better distinguishing the roles and responsibilities of a board of directors and senior management, it will be able to enhance corporate governance practices.
- A. Attributes of an Effective Board of Directors
The proposed guidance would establish five “Board Effectiveness” attributes for boards of Large US Institutions: (i) setting clear, aligned and consistent direction; (ii) actively managing information flow and board discussions; (iii) holding senior management accountable; (iv) supporting the independence and stature of independent risk management and internal audit; and (v) maintaining a capable board composition and governance structure.
These attributes would become the new basis by which the Federal Reserve would assess the boards of directors of Large US Institutions and IHCs under the proposed LFI Rating system. The proposed guidance also indicates that a board may provide supervisors with a self-assessment of its effectiveness based on these five attributes during the evaluation process, although the proposal does not define the procedures or format for such an assessment.
- B. Revamping Existing SR Letters
The proposed guidance would also clarify the different roles and responsibilities of boards and senior management at all bank and savings and loan holding companies by revising or rescinding all or parts of 27 SR letters issued between 1990 and 2016. In particular, the Federal Reserve stated that it is identifying outdated supervisory expectations for boards of directors in the 27 SR letters.
The proposed guidance indicates that the Federal Reserve will: (i) rescind in their entirety SR letters that are outdated or no longer relevant, (ii) delete portions of SR letters that are duplicative or irrelevant, (iii) modify portions of SR letters to clarify and differentiate the roles and responsibilities of boards and senior management and (iv) align the SR letters with the proposed board effectiveness guidance or SR letter 16-11.4 As an example of a potential change, the guidance explains that if an existing supervisory letter assigns the board and senior management the same roles and responsibilities, then the Federal Reserve would likely revise that letter to refer only to senior management having those roles and responsibilities.
- C. Altering the Delivery of Supervisory Findings
The Federal Reserve also is proposing to alter the process by which supervisory findings, typically in the form of MRIAs and MRAs, are communicated to all Federal Reserve-regulated institutions under SR letter 13-13. Currently, SR letter 13-13 creates an expectation that all MRIAs and MRAs would be presented to the board of directors to allow the board to ensure that senior management devotes appropriate attention to addressing these matters. According to the guidance, however, this approach has caused boards to believe that they must be directly involved in resolving the findings.
Under the proposed guidance, Federal Reserve examiners and supervisory staff would direct most MRIAs and MRAs to senior management for corrective action except in limited instances. For instance, examiners would continue to direct MRIAs and MRAs to the board for corrective action when they implicate its corporate governance responsibilities or when senior management fails to take necessary remedial action. In addition, the board would retain responsibility for holding senior management accountable for instituting corrective action to remediate MRIAs and MRAs.
- II. Proposed LFI Rating System
The Federal Reserve is developing a proposed LFI Rating system as a means of evaluating and communicating a Large US Institution or IHC’s financial and operational condition.5 The LFI Rating would replace the existing RFI/C(D) rating system, which has been used with all bank holding companies since 2004. According to the NPRM, the LFI Rating is designed to align the rating system with the Federal Reserve’s supervisory programs and practices for large institutions while achieving core objectives such as reducing risk and enhancing supervisory clarity.
The framework of the LFI Rating system would be composed of three components: (i) Capital Planning and Positions, (ii) Liquidity Risk Management and Positions and (iii) Governance and Controls. Each component evaluates a particular capability. The Capital Planning and Positions component focuses on the effectiveness of governance and planning processes used to determine the amount of capital needed to cover risks and exposures. The Liquidity Risk Management and Positions component emphasizes the effectiveness of governance and risk management processes used to determine the amount of liquidity needed to cover risks and exposures. The Governance and Controls component includes, among other evaluations and assessments, an evaluation of the effectiveness of an institution’s board of directors and an assessment of the institution’s effectiveness in aligning strategic business objectives with risk tolerance and management capabilities.
Reflecting post-financial crisis regulatory techniques, the LFI Rating would incorporate the annual Comprehensive Capital Analysis and Review (“CCAR”) exercise into the Capital Planning and Positions component, the annual Comprehensive Liquidity Analysis and Review (“CLAR”) exercise into the Liquidity Risk Management and Positions component, and the recovery planning process of the eight US bank holding companies in the Large Institution Supervision Coordinating Committee (“LISCC”) portfolio into the Governance and Controls component.
The NPRM also describes a new multi-level scale that would be used with the LFI Rating to measure an institution’s condition and performance based on the different components. The potential ratings would be (i) Satisfactory, (ii) Satisfactory Watch, (iii) Deficient-1 and (iv) Deficient-2. Satisfactory would mean the institution is safe and sound and generally satisfies supervisory expectations. An institution under Satisfactory Watch would have certain issues that, if not timely resolved, would put the institution’s safety and soundness at risk. A Satisfactory Watch rating would not be intended to be used for a prolonged period, and institutions with this rating would be given a specified timeframe (no longer than 18 months) to fully resolve the issues leading to the rating. Importantly, institutions with this rating would in practice either resolve the issues noted, moving them to Satisfactory or fail to resolve the issues and face a deficiency rating. A Deficient-1 rating would denote that financial and/or operational deficiencies threaten the institution’s safety and soundness, although the current condition is not materially threatened. Deficient-2 would indicate that financial and/or operational deficiencies materially threaten the safety and soundness of the institution or the institution is already in an unsafe or unsound condition. According to the NPRM, institutions with less than satisfactory ratings may be subject to limited access or higher fees in attempting to access the Federal Reserve’s discount window or intraday credit, and institutions with a Deficient-2 rating should expect to be subject to a formal enforcement action and deemed to be “in troubled condition.”
1 82 Fed. Reg. 37,219 (proposed Aug. 9, 2017) [hereinafter Proposed Supervisory Guidance], available at https://www.gpo.gov/fdsys/pkg/FR-2017-08-09/pdf/2017-16735.pdf.
2 82 Fed. Reg. 39,049 (proposed Aug. 17, 2017) [hereinafter NPRM], available at https://www.gpo.gov/fdsys/pkg/FR-2017-08-17/pdf/2017-16736.pdf.
3 This part of the proposed guidance would not apply to savings and loan holding companies with assets of $50 billion or more that are engaged in significant commercial or insurance activities. Also, IHCs will be addressed in a separate piece of guidance to be issued at a later date.
5 The LFI Rating system initially would not be applied to systemically important nonbank financial companies, but the Federal Reserve has indicated that it intends to apply the LFI Rating to such institutions at a later date.