Corporate Governance And Controls: The Federal Reserve’s .
Corporate Governance and Controls: The FederalReserve’s Governance and Management Proposals—Application to a Large U.S. Financial InstitutionVisual MemorandumJune 5, 2018Davis Polk & Wardwell LLP 2018 Davis Polk & Wardwell LLP 450 Lexington Avenue New York, NY 10017This communication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and shouldnot be relied upon as legal advice. This may be considered attorney advertising in some jurisdictions. Please refer to the firm's privacy policy for further details.
Table of ContentsClick on an item to go to that pageBackground and Overview3Federal Reserve Corporate Governance Review6Proposed Board Effectiveness Guidance7Proposed Guidance on Communication of Supervisory Findings14LFI Rating System – Governance and Controls Component15Supervisory Expectations – Senior Management17Supervisory Expectations – Business Line Management22Supervisory Expectations – IRM and Controls30Davis Polk Contacts41For in-depth discussion of the Federal Reserve’s proposed LFI rating system, pleasesee our companion visual memorandum2
Background and Overview The Federal Reserve has proposed new supervisory guidance on corporate governance(Governance Proposal) that would apply to large U.S. financial institutionsAs discussed in our companion visual memorandum, the Federal Reserve in August alsoproposed a new supervisory rating system for large financial institutions (LFIs) The LFI rating system includes a Governance and Controls component that wouldevaluate the effectiveness of a firm’s board of directors, its management of business lines,its internal risk management, its internal controls and, for U.S. G-SIBs, its recoveryplanningThe Federal Reserve released proposed supervisory guidance for senior management,business line management, independent risk management (IRM) and internal controls for LFIsin early January 2018 (the Management Guidance)Although there were certain variations among the proposals, each generally set applicabilitythresholds at asset sizes of 50 billion or greater. We expect that, in light of the passage ofthe Bipartisan Banking Act, the final versions of the proposals will adjust those thresholdsupwards. Our visual memorandum on the Bipartisan Banking Act is available hereClick here to return to table of contents3
Background and Overview The comment deadline for the August proposals was extended to February 15,2018 and the comment deadline for the January proposal was March 15, 2018. In the Management Guidance, the Federal Reserve states that it “expects tofinalize the proposed guidance for use in assigning initial ratings under the LFIrating system beginning in 2018.”For additional commentary on the Governance Proposal, please see our public clientmemorandum from August, available hereFor additional commentary on the Management Guidance, please see our blog postfrom January, available hereClick here to return to table of contents4
Background and Overview The Governance Proposal was informed by the Federal Reserve’s multi-year review ofthe practices of boards of directors, particularly at the largest banking organizations Jerome Powell, President Trump’s nominee to be the next Chair of the FederalReserve, stated in the spring of 2017 that boards must be able to “focus on settingthe overall strategic direction of the firm, while overseeing and holding seniormanagement accountable” rather than being distracted “by an overly detailedchecklist of supervisory process requirements.”The Governance Proposal consists of three components: A proposed process for a comprehensive review of supervisory expectations andregulatory requirements The proposed board effectiveness guidance; andThe proposed guidance on communication of supervisory findingsClick here to return to table of contents5
Federal Reserve Corporate Governance ReviewComprehensive Review of All Existing Supervisory Expectations and RegulatoryRequirements As part of its proposal, the Federal Reserve is conducting a comprehensive review ofall existing supervisory expectations and regulatory requirements relating to boardsof directors of all BHCs and SLHCs so that “unnecessary, redundant or outdated”expectations may be revised or eliminatedThe first phase of the Federal Reserve’s corporate governance review has identified 27SR letters for revision or eliminationThe second phase of the Federal Reserve’s review will focus on regulations andinteragency guidance This phase will take more time to complete, and proposed changes would bereleased for notice and comment at a later dateClick here to return to table of contents6
Proposed Board Effectiveness GuidanceBoard Effectiveness The board effectiveness guidance would clarify supervisoryexpectations for boards as distinct from expectations for seniormanagement and identifies five key attributes of effectiveboards that would be used to assess the board of a large financialinstitutionNo One-Size-Fits-All The Federal Reserve acknowledges that applying standardizedexpectations for boards fails to take into account differences infirms’ operations, risk profiles and complexity, and potentiallyprevents a board from achieving maximum effectiveness inmeeting its core responsibilitiesFive Key Attributes1.Set clear, aligned and consistentdirection regarding firm’sstrategy and risk tolerance2.Actively manage information flowand board discussions3.Hold senior managementaccountable4.Support the independence andstature of the firm’s independentrisk management and internalaudit functions5.Maintain a capable boardcomposition and governancestructureInteraction with OCC Requirements The Governance Proposal applies only at the bank holdingcompany level The proposal’s interaction with OCC requirements fornational bank boards is uncertain; this is a key issue formany U.S. G-SIBs because the boards of many BHCs andtheir national banks overlapClick here to return to table of contents7
Proposed Board Effectiveness GuidanceTHE ROLE OF BOARD SELF-ASSESSMENT Under the Governance Proposal, a board is encouraged to provide a self-assessmentof its effectiveness, which the Federal Reserve would take into consideration in itsevaluation The Federal Reserve requested comment regarding whether boards should berequired to perform a self-assessment and provide the results to the FederalReserveA number of industry comment letters requested that the Federal Reserve not requireself-assessments or submission of such self-assessments to the Federal Reserve Responsible banking boards already conduct self-assessments in a manner thatbest suits the firm’s nature and culture, recognizing that a proper self-assessmentis a highly sensitive exercise that balances candor with respect Requiring a self-assessment will lead to an overly prescriptive de facto standardand requiring that the results be shared with the Federal Reserve may chill candorand undermine the effectiveness of the self-assessmentClick here to return to table of contents8
Proposed Board Effectiveness GuidanceATTRIBUTE #1 – SET CLEAR, ALIGNED AND CONSISTENT DIRECTION An effective board guides and approves the firm’s strategy and sets its risk tolerance The strategy and risk tolerance should be clear and aligned, and include a long-term perspective on risksand rewards that is consistent with the capacity of the firm’s risk management frameworkThe firm’s strategy should be detailed enough for senior management to: Identify the firm’s strategic objectives; Establish effective audit, compliance, and risk management and control functionsCreate effective operating structures (including implementation strategies, plans and budgets) for eachbusiness line; andThe firm’s risk tolerance should be detailed enough for the chief risk officer (CRO) and the independent riskmanagement function (IRM) to set firm-wide risk limitsPrior to approving the firm’s “significant policies, programs and plans,” the board should assess whetherthey are consistent with the firm’s strategy, risk tolerance and risk management capacitySignificant policies, programs and plans include the following: Liquidity risk management policies Compliance risk management program Incentive compensation and performancemanagement programsCapital planRecovery and resolution plansAudit planEnterprise-wide risk management policiesClick here to return to table of contents9
Proposed Board Effectiveness GuidanceATTRIBUTE #2 – ACTIVELY MANAGE INFORMATION FLOW AND BOARDDISCUSSIONS An effective board actively manages its information flow and itsdeliberations so it can make sound, well-informed decisions in amanner that meaningfully takes into account risks and opportunities Board should direct senior management to provide information thatis timely and accurate, with the appropriate level of detail andcontext to enable the board to make sound, well-informeddecisionsBoard should have practices and processes in place to evaluateinformation flows and engage senior management onimprovementsDirectors may seek additional information about the firm and itsactivities, risk profile, talent, and incentives outside routine board andcommittee meetingsDirectors should take an active role in setting board meetingagendas such that the content, organization, and time allocated toeach topic allows the board to discuss strategic tradeoffs and to makesound, well-informed decisionsClick here to return to table of contents10How to Obtain AdditionalInformation? Special sessions of theboard Outreach to staff otherthan the Chief ExecutiveOfficer and his or herdirect reports Discussions with seniorsupervisors Training on specializedtopics
Proposed Board Effectiveness GuidanceATTRIBUTE #3 – HOLD SENIOR MANAGEMENT ACCOUNTABLE An effective board holds senior management accountable for implementing the firm’sstrategy and risk tolerance and maintaining the firm’s risk management and control frameworkAn effective board should actively engage senior management by structuring sufficient time inboard meetings, encouraging diverse views and challenging senior management whenwarrantedIndependent directors should be sufficiently empowered to serve as a check on seniormanagementAn effective board should engage in robust and active inquiry into areas such as current andemerging risks; strategy and risk tolerance for relevant lines of business; material or persistentdeficiencies in risk management and controls; and performance and compensation programsthat encourage prudent risk takingAn effective board should evaluate the performance and compensation of seniormanagement Board should establish and approve clear financial and nonfinancial performanceobjectives that are aligned with the firm’s strategy and risk tolerance for the CEO, CRO andChief Audit Executive (CAE) and other members of senior management as appropriateAn effective board should approve and periodically reassess succession plans for the CEOand, as needed, the CRO and CAE Succession plans for other members of senior management, such as the CFO, may bewarrantedClick here to return to table of contents11Senior managementrefers to the coregroup of individualswho are directlyaccountable to theboard for the soundand prudent day-today management ofthe firm
Proposed Board Effectiveness GuidanceATTRIBUTE #4 – SUPPORT THE INDEPENDENCE AND STATURE OF IRM ANDINTERNAL AUDIT Risk and audit committees should support the independence and stature of the IRM andinternal audit functions An effective board should be able to identify instances where the independence andstature of IRM or internal audit have materially impacted business deliberations,decisions, practices, and/or the firm’s strategyRisk committee should: Communicate directly with the CRO on material risk management issues; Be able to effect changes that align with the firm’s strategy and risk toleranceReview IRM’s budget, staffing, and systems;Provide IRM with direct and unrestricted access to the risk committee;Direct the appropriate inclusion of IRM representatives on senior management-levelcommittees; andAudit committee should: Meet directly with the CAE regarding the internal audit function; Review the status of recommendations to remediate deficiencies and supervisoryfindingsSupport internal audit’s budget, staffing, and systems relative to the firm’s size andcomplexity and the pace of technological and other changes; andClick here to return to table of contents12Active engagementby directors on therisk committee andaudit committeeentails inquiring into(among other things): Material orpersistent breachesof risk appetite andrisk limits; Timely remediationof material orpersistent internalaudit andsupervisoryfindings; and Appropriateness ofthe annual auditplan
Proposed Board Effectiveness GuidanceATTRIBUTE #5 – MAINTAIN A CAPABLE BOARD COMPOSITION AND GOVERNANCESTRUCTURE An effective board has a composition, governance structure, and establishedpractices that are appropriate for the firm’s size, complexity, operations and riskprofile, as they change over timeDirectors should have a diversity of skills, knowledge, experience, andperspectives The process for identifying and selecting director nominees should consider apotential nominee’s expertise, availability, integrity, and potential conflicts ofinterest Board should engage third-party advisors and consultants, when appropriate,to supplement its knowledge, expertise and experienceGovernancestructure refers to thestructure of boardcommittees and toAn effective board’s governance structure should be capable of overseeing andmanagement-toaddressing issues arising from the firm’s size, operations, activities, risk profile, and committee reportingresolvabilitylinesAn effective board should conduct a self-assessment of its strengths andweaknesses, including the performance of the board committees, particularly therisk, audit, and other key committeesClick here to return to table of contents13As noted above, theindustry hasquestioned theappropriateness of defacto standards forself-assessments
Proposed Guidance on the Communication ofSupervisory Findings This proposed guidance would revise the process by which FederalReserve staff communicate supervisory findings to all firmsUnder the proposal, Federal Reserve supervisory staff wouldtypically direct MRIAs and MRAs to senior management,rather than to the board, and senior management would beresponsible for keeping the board informed of its efforts toremediate MRIAs and MRAsSupervisory staff would direct MRIAs and MRAs to the boarditself, or an executive-level board committee, only when either: The supervisory finding relates to significant weaknesses inthe board’s governance structure or practices; or Senior management has failed to take appropriate remedialaction with respect to a supervisory finding that wasoriginally addressed to senior managementClick here to return to table of contents14Supervisoryfindings meanMatters RequiringImmediateAttention (MRIAs)and MattersRequiring Attention(MRAs)
LFI Rating System – Governance and Controls ComponentOVERVIEWSupervisory Expectations The supervisory assessment of an LFI’s management of business lines and of IRM andcontrols would have three elements: Expectations for senior management with respect to both business lines and IRMand controls; Expectations for the management of business lines; and Expectations for IRM and controlsThe discussion on the following pages is based on the Management Guidance proposedby the Federal Reserve in January 2018 If the LFI rating system is finalized before the Management Guidance is finalized,firms would be evaluated using existing supervisory guidance until ManagementGuidance is finalizedClick here to return to table of contents15
Governance and Controls ComponentOVERVIEWEvaluationof BoardEffectivenessBoard of DirectorsRisk CommitteeAudit CommitteeSeniorManagementEvaluationof SeniorManagementChief RiskOfficerChief AuditExecutiveIndependent RiskManagementInternalAuditEvaluation ofIRM andInternal AuditEvaluationof BusinessLineManagementClick here to return to table of contentsBusiness Lines16
Governance and Controls ComponentSUPERVISORY EXPECTATIONS – SENIOR MANAGEMENTBoard of DirectorsRisk CommitteeImplement the firm’s strategy and risktolerance as approved by the boardMaintain andimplement aneffective riskmanagementframeworkEnsure resolution ofkey issuesChief AuditExecutiveOversee the management of business lines, IRMand controlsIndependent RiskManagementInternalAuditBusiness LinesClick here to return to table of contentsProvide to the board timely, usefuland accurate informationProvide timely, useful and accurateinformation to the board, escalatingwhen the firm’s activities may deviatefrom its strategy and risk toleranceSeniorManagementChief RiskOfficerAudit Committee17Promote prudent risktaking throughcompensation andperformancemanagement programs
Governance and Controls ComponentSUPERVISORY EXPECTATIONS – SENIOR MANAGEMENTImplementation of firm strategy and risk tolerance asapproved by the firm’s board Implement the strategic and risk objectives across the firm sothat they support the firm’s long-term resiliency and safetyand soundness, including the firm’s resilience to a range ofstressed conditionsEnsure that the firm’s infrastructure, staffing, and resourcesare sufficient to carry out the firm’s strategy and manage thefirm’s activities in a safe and sound manner, and incompliance with applicable laws and regulations, includingthose related to consumer protection, as well as policies,procedures, and limits.Identify when there is a risk that the firm’s activitiescollectively may deviate from the firm’s strategy and risktolerance and escalate such instances to the board ofdirectorsClick here to return to table of contents18Risk tolerance means theaggregate level and types ofrisk the board and seniormanagement are willing toassume to achieve the firm’sstrategic business objectives,consistent with applicablecapital, liquidity, and otherrequirements and constraints.Risk objectives are the leveland type of risks a businessline plans to assume in itsactivities relative to the leveland type specified in thefirmwide risk tolerance.
Governance and Controls ComponentSUPERVISORY EXPECTATIONS – SENIOR MANAGEMENTMaintenance and implementation of effective risk managementframework Ensure that the firm appropriately manages risk consistent with its strategyand risk toleranceEstablish clear responsibilities and accountability for identifying, measuring,managing and controlling riskInternal controls are thepolicies, procedures,systems and processesdesigned to providereasonable assuranceregarding: Effectiveness andefficiency of operations Reliability of financialreporting (including riskreporting)Develop and maintain the firm’s policies and procedures and system ofinternal controls, commensurate with the firm’s size, scope of operations,activities, and risk profile, to ensure compliance with laws and regulationsand consistency with supervisory expectations Compliance with lawsand regulations(including those relatedto consumer protection)Periodically assess the risk management framework as a whole to ensurethat it remains comprehensive and appropriate and has kept pace withchanges in the business line’s products, services, and activities as well aschanges in economic conditions and the broader market environment Safeguarding of assetsand information.Promote and enforce prudent risk-taking behaviors and business practices,including through the firm’s compensation and performance managementsystemsClick here to return to table of contents19
Governance and Controls ComponentSUPERVISORY EXPECTATIONS – SENIOR MANAGEMENTOversight and management ofbusiness lines and IRM and controlsFirms should have robust mechanisms in place that allow seniormanagemen
The Federal Reserve has proposed new supervisory guidance on corporate governance (Governance Proposal) that would apply to large U.S. financial institutions . its internal risk management, its internal controls and, for U.S. G-SIBs, its recovery
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The corporate governance of Ajinomoto Co., Inc. is described below. I. Basic Views on Corporate Governance, Capital Structure, Corporate Profile and Other Basic Information 1. Basic Views Our basic philosophy concerning corporate governance is set out in "Chapter 2: Basic Approach" of the Ajinomoto Principle on Corporate Governance.
