In his last appearance as head of the FSA, Hector Sants discussed three questions:
• What do we mean when we say we want firms to have ‘effective boards’?
• What does this mean for the regulator’s Significant Influence Function process – often referred to as the ‘SIF’ process? And
• To what extent can the regulator incentivise the right behaviour and culture in firms?
“I would highlight three key components:
Firstly, and most importantly, there needs to be an effective board that ‘sets the right tone’ from the top. An effective board is one which crucially, understands the circumstances under which their firm would fail and constantly asks the ‘what if’ questions…
…Secondly, it is the Chair’s role to construct and manage a board that has the appropriate and relevant skills and experience to enable it to function effectively…
…My third point on board effectiveness is the importance of the board’s role in signing -off the strategic plan and ensuring that the executive team execute to that plan. To do this effectively, the board needs to see and demand management information (MI) that relates to that plan directly.”
The FSA’s Significant Influence Function
“Let us remind ourselves of the underlying objectives of the SIF process. The core purpose is to work with the firms to ensure a balanced and effective working board and senior executive team. The FSA does this by assessing the suitability of a candidate to undertake a role, and crucially, by ensuring an appropriately robust and rigorous appointment process is undertaken by the firm….
… The current concerns around whether the SIF interview process has become too intrusive and cumbersome should not obscure this basic truth. The senior executives of financial institutions and the non-executives who hold key oversight functions have to be technically competent or it is just not possible for them to do their job properly…
… over the last two years the FSA has determined 653 applications, following one or more SIF interviews. Of these 48 were withdrawn; 39 of which were demonstrably due to serious concerns identified by the FSA interview panel. So it is clear that we are having an impact.”
Culture and behaviour in regulated firms
“Many of the issues [around behaviours] can be traced back to the measures on which the board focuses. Incentives have been set that have made it rational for the executive to focus on increasing revenue, profit, assets and leverage rather than on capital, liquidity and asset quality. Senior executives’ annual remuneration in the past has tended to be heavily influenced by operating profit, EPS growth and return on equity as distinct from return on assets and prudent management of leverage. Significant progress has already been made in this area but there is still room for improvement…
… There is, nevertheless, an important question to be asked by all of us: individuals, boards, regulators and society as a whole. Should all of our conduct and behaviour be driven by pure financial incentives? Should there not be some level of expectation that people entrusted with the leadership of financial services organisations ultimately are driven by the desire to ‘do the right thing’. It is called integrity and it is what we all, as users of the financial services, expect of the leaders of the sector. It should not solely be about how much we earn but also about how much we care for the markets’ users and their well-being.”
“• The role of a regulator is to create boundaries within which firms take responsibility for their own decisions. In the past the capital and liquidity boundaries for banks were nearly non-existent and thus management were not sufficiently constrained in their judgements. The new capital and liquidity standards will address these shortcomings but will not remove the necessity for management to make good judgements and the need for regulators and shareholders to hold those firms to account.
• Central to a regulator’s role in promoting effective boards is the utilisation of the authorisations process to encourage firms to make the right appointments. History clearly demonstrates the importance of a regulator having a proactive approach to judging the suitability of directors, in particular their competence. This proactive approach must be focused only on those key roles and has to be a judgement not just about the effectiveness of individuals, but about the board as a whole.
• Good governance and a strong culture are a necessity for maximising the likelihood of the right judgements being made by management. Regulators have a role to play in ensuring that firms have the right governance and culture. But I should stress that it is not for the regulator to determine the culture. Ultimately, however, even a successful regulatory regime will not be sufficient to ensure good outcomes. Crucially, firms need to have an appropriate culture and one which is focused on the firm delivering the right long-term obligations to society. The right cultures are rooted in strong ethical frameworks and the importance of individuals making decisions in relation to principles rather than just short-term commercial considerations. In particular, this means that when a regulator expresses a clear instruction then firms should not continue to resist for reasons of expediency and short-term gain.
• Nevertheless, history tells us that we cannot rely on the motivation of individuals alone and that we need credible enforcement to require individuals to be driven by principles rather than just commercial expediency. Commercial success should not place an individual above the law.”