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Striking the right balance: How the board acts as the fifth line of defense 

Board directors have a significant share in the responsibility for overseeing implementation of the regulatory reforms that have been sweeping the global financial services industry. At the same time, they are to assist their organizations to lead businesses under challenging global conditions. Mary Filippelli, National Financial Services leader, Canada, and Frank Ellenbürger, Global Head of Insurance, discuss the need to strike the right balance.

The Boards of financial services institutions are facing an especially challenging time. Not only do they have to ensure the organizations they lead have the right strategies to perform well in the face of difficult economic conditions, but they also have to cope with regulatory reforms that directly address how boards deliver their oversight duties and their stewardship role.


These reforms place an explicit – and increased – emphasis on accountability to ensure that, as a collective body, a board has the appropriate skills, knowledge and experience to perform its role effectively. In particular, there is a significantly increased emphasis on good risk governance, which requires that boards define their firm’s risk appetite, understand the risk-return drivers of new products and the consequences of leverage and set a clear ‘tone at the top’ to help embed a risk culture throughout the organization – all of which requires a full appreciation of the risks being taken.


As a result, the responsibilities, accountabilities and even personal liabilities of non-executive board members (non-executive directors or NEDs) have seen a dramatic change in recent years. And even as the legal pressures mount, the issues they have to grapple with are becoming more difficult as the volatility and complexity of the business environment increases.


Against this backdrop of change, it is more important than ever that boards maintain their vital role as ‘the fifth line of defense’ behind  the business, the control functions (risk, compliance, and finance), internal audit and senior management oversight. This means not just careful attention to the risk of information overload, but also to the composition of the board and its committees.

Avoiding overload

The business judgment rule effectively means that directors are protected if their decisions turn out to be wrong as long as they took account of all the available information, prioritized the arguments and took a decision  in good faith while acting in what they believed to be the best interests of the organization. Inevitably, therefore, board members are finding themselves at the end of an increasingly vast information flow designed to keep them on top of industry and regulatory issues and knowledgeable about operations.


Certainly, boards need appropriate information so they can provide strategic challenge on technical issues, such as emerging and correlated risks, which are a feature of today’s complicated environment. And directors have an obligation to ensure they have the knowledge to understand the contextual aspects of the information they are looking at so they can evaluate its implications for the strategy and operating model of the business. But equally, there is a heightened need for management to provide information that is actionable, forward-looking, concise and presented in a way that is accessible to a board with a broad range of skills and backgrounds.


KPMG has seen a variety of board level reporting styles at leading global financial institutions. Industry practices vary from a strong focus on key performance indicators and metrics to a greater emphasis on qualitative and explanatory narrative. In our experience, though, all effective reporting exhibits certain characteristics, such as dashboards that highlight and prioritize management and board focus areas and use of plain language to analyze and discuss risks. But it is apparent the industry is not there yet and the drive for more efficient and effective reporting remains a priority.

Board composition comes under scrutiny

As markets become more volatile and interconnected and regulation from Dodd- Frank, to Solvency II, to Basel III comes into play, the ideal board composition to navigate a regulatory and economic landscape that is both problematic and subject to rapid change comes to the forefront of good governance. Regulatory demands apart, the business still has to be run – and run well – to survive and prosper into the future.


The board’s role is not, however, to be the embodiment of technical expertise. Nor do the directors need to be better at risk management than the firm’s risk experts. Rather, they need to be able to place risk in the broader strategic context and, on that basis, engage senior management in constructive debate that enhances all aspects of the business. In terms of board composition, this means balancing technical skills in finance, risk, technology and legal with strategic insights, industry knowledge and, to an extent, experience in softer areas like customer relationship management and sales.


Diversity of background, culture and approach is also desirable in today’s highly interconnected markets. With the European Commission favoring a strict minimum limit on the proportion of women on boards, gender  is a particular consideration. Geography is another important factor, at least for the bigger players who are looking for talent from around the world.


Increasingly, becoming an NED is a demanding job in itself. We are already seeing board executives in mid-career switching to roles as full-time chairpersons or pursuing a portfolio of NED positions. As a result, remuneration is emerging as another important consideration. If non-executive board members are expected to be engaged fully, they will expect to be remunerated accordingly.

Recalibrating governance

Continued dialogue between the regulators, central banks, boards and management of financial organizations will be essential if the evolution of the board’s role as the ‘fifth line of defense’ is to continue in a constructive manner. However, there are a number of dangers to be avoided. In particular, such discussions must not compromise the  need for absolute clarity on the allocation of  responsibilities and accountabilities between the various parties. Nor should the line between senior management and board oversight become blurred, nor the role of the NED be regulated to the extent that their ability to represent the interests of shareholders  is significantly weakened. These dangers apart, with ongoing dialogue, the roles and responsibilities of financial services boards can be reviewed and potentially streamlined to help them become more effective.


However, no amount of oversight, regardless how effective, will prevent problems if executives allow a culture that turns a blind eye to unethical behavior. The board must appoint senior managers who have integrity as well as technical and business skills. These executives must be empowered to create a culture of ethics and compliance throughout the organization. Ultimately, after all, these are issues about behavior and doing the right thing.

Importance of working towards the same goal

All financial services firms are facing up to the realization that things will not go back to where they were. The pressure for boards in the financial services industry to be more engaged and knowledgeable will continue and boards will have to deal with more information and regulatory involvement.


Ultimately, all of the stakeholders involved should be looking for the same thing: a better- informed, more effective board that delivers sound oversight of financial services institutions to complement a well-regulated system. The secret of success will lie in identifying and focusing on the critical success factors of good governance that make for high performance and ensuring any changes are made not simply to meet regulatory drivers, but also to enhance overall effectiveness and improve the prospects of the organization as a whole.


Achieving that goal will continue to be a balancing act. The role of the board at a financial institution is, in fact, a series  of fine balancing acts: between detail  and perspective; between the risk-return interests of shareholders and the safety and soundness interest of regulators; and  between an NEDs deep commitment to the work and the traditional desire not to let it become a full-time role.


Fine-tuning this balance is critical to evolving a board governance model fit for the new realities financial institutions are facing – and to enhancing the board’s role as the 'fifth line of defense'.




By:


  • Frank Ellenbürger, KPMG in Germany
  • Mary Filippelli, KPMG in Canada

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