Corporate Governance

Corporate Governance Dr John Hedges

Overview • Importance within ARROW and pillar 2 Assessments • The Framework • Inputs into governance • Outputs of effective governance • The concept of a firm’s governance architecture • Testing the governance architecture • Conclusion

ARROW 2 Grid • A2 grid tries to mirror the organisation of a firm • Risk is analysed by • Front Office (Customer, Products, Markets) • Back Office (Business process) • Prudential • Complemented by controls specific to these issues • Plus overall controls including governance and oversight plus capital and liquidity • Generating net risk

ARROW 2 Methodology • The concept of net risk • Focus on inherent business risk to get some idea of the gross risk and then an assessment of the controls to offset that risk • The overall controls of • Governance • Compliance • Risk management • Internal Audit • Clarity on the role of capital

Governance • Review of ARROW2 talk in October • A big driver of the risk score • Important to have a framework that provides meaningful feedback to the industry. • What makes for effective governance?

Importance of Governance • Management versus governance • Important issues seem to fall back on governance • In many instances good governance becomes the golden solution for all ills but difficult to define what is meant by good governance and conversely poor governance. • The search for a framework

Importance of Frameworks • A place to put facts/impressions and assists with analysis of and an understanding of the facts • Assists with a common language • Provides continuity when reviewing an issue • Can be developed as knowledge of the issues improves

The Inputs of Governance • The governance framework defines effective governance as: • The correct mix of- • Structure (A & O, committees, org. charts) • Process (e.g. escalation processes) • Management information • Culture (the most nebulous) Taking each in turn

Structure: types of issue covered • A and O structure/authority/reporting lines • One of the most important components of structure • Business Unit Committees • By business line • Cross unit committees • By region • Legal entity boards • Audit Committees

Structure: Comment • Committees • Clear terms of reference • Clear authority • Clear line of accountability • Not a talking shop Organisation Charts Transparency Reflection of real reporting lines The problem of matrix management

Process; types of issue covered • New product • Reputation risk • Conflicts review • Infrastructure review • Controls: self assessment • Operational risk • Risk and capital planning

Process: Comment • How do things get done? • The issue of escalation • Control side • Business side The issue of flexibility (speedy and safe decision making) The issue of anticipation (what happens if something goes wrong)

Management Information: types of information covered • Financial • Business Risk • Compliance • Controls • Transactions • Liquidity

Management Information: Comment • Should reflect what is going on in the business • The Score Board; accurate; up to date; transparent (i.e. we can see at a glance what is going on in the business). • Off the shelf and not tailor made • The Use test

Culture: types of issue covered • A Nebulous topic • Business accountability • Multiple elevation • Remuneration process • Transparency of decisions • Understanding of what is acceptable

Culture: Comment • Do you know it when you see it? • The issue of sharing information at the right level • Silo management and the issue of convergence • The issue of advertising for an Ethics Director • Remuneration and the balanced scorecard

Governance: Recap • The Framework so far • Inputs Structure plus Process plus Management Information plus Culture Equals • Outputs Effective governance but what are the outputs of effective governance?

Outputs of Effective Governance • Ensures Effective Controls • Ensures Legal Entity integrity • Ensures franchise and other regional risks managed • Ensures client interface risk managed across the business • Ensures infrastructure can support the business

Example: Effective Control • Compliance • Profile within business • Appropriate resourcing • Span of operation • Advisory • Surveillance • Spectrum of legal (advisory) compliance (surveillance) and internal audit

Legal Entity Integrity • The purpose of legal entities • Accountability • Settlement • Corporate identity in the market Adequacy of settlement and accounting infrastructure Adequacy of regulatory capital

Protecting the Franchise • Importance of franchise/reputation • The risk is largely a function of product type and the number of markets dealt in • What is acceptable in the markets and is this clearly understood within the firm? • Constant review of what issues might harm the franchise.

Client risk • Protecting the firm from the client • A coordinated response to the client across business lines and markets • Importance of appointing a central point of contact within a firm • Potential friction within the firm in achieving this

Infrastructure • Which comes first ; the business or the infrastructure to support the business? • Infrastructure is likely to be behind the business • The importance of MI in measuring the stretch factor or gap in support • High cost of management time if things go wrong and rectification

Recap • The Framework • Inputs: the correct mix of- Structure plus Process plus Management Information plus Culture Equals • Outputs : Effective controls, Legal entity integrity, Protecting the franchise, Client risk, and Effective Infrastructure support for the business

The concept of Architecture • The corporate governance of a firm can be viewed rather like a building; it identifies the business; gives it a presence to third parties and protects it from the weather of business risks • The framework just described gives some guide on measuring the adequacy or otherwise of the firm’s governance or the architecture of the firm’s governance building

Verification Framework • Governance architecture compared to Firm’s operations • Firm’s use of KPIs to measure the outputs of effective governance (top down approach). • Verification on the ground of how the firm is managed in delivering the outputs of good governance (bottom up approach).

Governance Architecture • Is the governance architecture we see what we would expect of the firm; does it complement its operations? • To continue with the architecture analogy we’d expect a house to have four walls a roof and a floor; are our expectations met and if not why not?

Top Down Approach

Governance Architecture • The first point of testing is the governance architecture what we would expect of the firm; how does its operations match the framework of governance by: • Structure (e.g. committee structure profile/authoririty) • Process (escalation; control and business) • MI (reflects the business activity) • Culture (transparency, remuneration)

Measuring the outputs : KPIs • Firm’s KPIs for: • Effective controls (reconciliation breaks; fails) • Internal Audit Review points; (risk limit breaches) • Legal entity integrity (regulatory capital breaches; booking errors; regulatory reporting failures -e.g. transaction reporting breaches; market/regulatory fines). • Protecting the franchise (complaints-client market, regulatory authority; poor press; entering new markets; introducing new products/new processes)

Measuring the Outputs (cont.) • Client risk (AML processes robust: reports of suspicious transactions; one point of contact at the firm nominated; aware of all client’s activities and exposure to the firm (cross selling data per client; effective conflict management- information wall referrals and crossings) • Infrastructure complements the business (management stretch-number of reporting lines per manager; adequate planning budget for implementation of IT and training: measures of effective IT and training-delivery according to spec and competencies achieved against budget)

Verification from the ground up – bottom up approach

Verification from the ground up • Checks/ verification on the outputs can be conducted by firm’s own resources (internal audit, compliance and where independent of the business lines, risk management). • Checks /verification are matched to the particular financial activity of the firm, including for example: • Corporate Banking • Private Banking • Investment banking • Asset Management

Checks/ verification continued: items that might be included • Corporate Banking (lending mandates and covenants) • Private Banking (Account opening, PEPS and AML) • Investment banking (Trading controls limits, fails, booking valuation; and conflict management) • Asset Management (client mandate adhered to ; protection of assets; valuation of assets)

Conclusions • A framework that can be developed • A framework that uses common language within the firm and between the firm and third parties • A framework that can establish the status quo in a firm and establish targets to move to • A framework that attempts to articulate what good governance is and how it might be tested • A framework that is scalable (applicable to both large and small firms).

Questions and Debate

Corporate Governance