"Perspectives on the role of the INED" - Mary-Elizabeth McMunn, Director of Credit Institutions

Remarks prepared for KPMG INED webinar - 25 February 2021

Introduction

At a similar INED event early in 2020 I started by saying to those in attendance that, as supervisors, we place great importance on the role and work of INEDs. With the year that has gone by, that has not changed. Your role as an INED as part of a well-functioning board is crucial to the good governance of banks, and I’m sure you have been a key part in your bank’s response to the pandemic. Your role also remains important to the broader restoration of trust in the financial system, which is an ongoing project.

My comments today will cover a number of topics:

1. Firstly the Central Bank’s vision for the financial system, the guiding principles of our approach and current priorities;
2. How we see role of the INED, touching on culture and challenge;
3. The role of the board in meeting the challenges of the future, to include references to climate, digital/innovation, and achieving business model sustainability; and
4. Distressed debt, including debt arising from the pandemic and our expectations of board oversight.

That’s a busy agenda so I will touch on some of those subjects only in brief, but perhaps we can pick up on them in Q&A.

The Central Bank’s vision for the financial system and the guiding principles of our approach

You will be familiar through your engagement with the Central Bank of Ireland with its mission, that is, serving the public interest by safeguarding monetary and financial stability and working to ensure that the financial system is operating in the best interests of consumers and the wider economy.

Our ambition for the financial system is that it is resilient and trustworthy and that it sustainably services the needs of the economy and its consumers, and is one in which firms and individuals adhere to a culture of fairness and high standards. This reflects the nature of our mandate as a prudential and conduct supervisor and also our responsibilities to ensure financial stability – complementary aspects which position us well to deliver for the public.

We work towards achieving this ambition through high quality regulation, purposeful engagement, effective gatekeeping, assertive supervision and robust enforcement.

At a high level there are four things that we care about and that underpin how my teams, many in conjunction with colleagues from Frankfurt, carry out their work:

1. Firstly, firms must have sufficient financial resources, including under a plausible but severe stress;
2. Secondly, firms must have sustainable business models which can generate capital over the long term;
3. Thirdly, firms are well-governed, have appropriate cultures, effective risk management and control arrangements in place; and
4. Fourthly, firms can recover if they get into difficulty, and if they cannot, are resolvable in an orderly manner without significant externalities or taxpayer costs.

These four factors are to the forefront of our minds when we carry out supervision and, they are the North Star in conducting our assessment of risk within firms.

Much of the Central Bank’s focus over the last year has naturally been on mitigating the effects of the pandemic and that will continue to be a feature in the year ahead. Deputy Governor Sibley last week outlined some of our financial regulation strategic priorities for 2021, which I will also mention now:

1. The first of these is - maintaining our supervisory focus on financial and operational resilience of firms and markets to ensure they continue to support households and business through the economic disruption caused by COVID-19; and can support the recovery from it;
2. Secondly, seeking to improve governance and risk management capabilities in firms and markets to improve culture and decision-making and ensure that risks are identified and effectively mitigated, including the risks from disruptive change such as climate change;
3. Thirdly, seeking to ensure that detrimental consumer outcomes are identified, prevented or mitigated, including those arising from the pandemic; and
4. Fourthly, resolving both pandemic related and longer term distressed debt in the system, ensuring the fair treatment of borrowers in financial distress and preserving financial stability. I will come back to this.

It aligns closely with the priorities of the European Central Bank’s Single Supervisory Mechanism, which for those of you who are board members of Significant Institutions, is of particular importance.

So how do we see the role of the INED?

Some brief reflections:

Culture is of particular interest to the Central Bank and that this will continue to be the case. Effective culture is rooted in values of ‘doing the right thing’ and creating an environment where people can speak up and are comfortable in expressing their views. A truly independent NED helps foster a good culture and can help challenge aspects of culture which may not be optimal. INEDs can be a positive influence, shaping the values, behaviours and standards the bank aspires to achieve. An area where you can have a positive influence is in relation to the Risk Mitigation Programmes we put in place for your banks. Frequently, we see responses to these which do not address the root cause. Where these come to you as board member, I would ask you to consider whether the remediation actions proposed get to the core of the issues and where they do not, to challenge the executive in this regard.

Too often in recent times we have seen an optimism bias in senior levels in banks. Given the current profound uncertainty in the environment, this is unhelpful. An appropriately prudent approach to potential future developments is essential, and should form part of your challenge of the executive. Carolyn Rogers of the Basel Committee commented recently that we remain in a situation of almost “suspended reality”. As government support programmes expire, some businesses and households are going to fare better than others, there will be losses for banks, and the scale is unclear. The unwinding of the unprecedented level of support from authorities will impact on all of your institutions, regardless of your business model. You can expect ongoing challenge of your banks’ assumptions by us.For you, this should translate into strong oversight to avoid opaqueness around credit risk and to deliver clarity on the trajectory of capital resulting from macroeconomic developments. Reliance should not be placed upon the regulator to provide the challenge around potentially overly optimistic approaches.

Challenge – It’s important to perhaps say a little more about what we expect in terms of challenge. As INEDs, your value is in offering an independent, experienced review of all aspects of the bank’s business. You can and must ask the hard questions and critically evaluate the quality of information or reporting to the board, the strategic direction of the bank, the culture that prevails, the customer relationships, the emerging risks to the business model and much more. At F&P interviews, we receive heartening commitments around challenge, and we are keen to see this exhibited at board level on the full range of risks, not just those raised by regulators. This includes working to ensure ICAAPs, ILAAPs and recovery plans are living documents (and tools for you to constructively challenge business decisions) which form part of decision-making and not just seen as regulatory requirements.

I should also be very clear here about the limits of exactly what it is we expect. We see the INED role as clearly distinct from that of the executive members and from management more broadly. My colleague Elizabeth McCaul, at the ECB put this well when she said that:

“We sometimes hear non-executive directors express concerns of two varieties: first, that the supervisor expects directors to provide so much oversight that it makes it look as though directors regularly step into management roles. And second, that management sometimes characterises directors’ efforts to understand and steer as blurring the separate roles of management and directors – resulting in management resisting them. In every context, we expect non-executive directors to serve as a compass for the bank, providing strong, constant direction in both calm and rough waters by ensuring independent oversight of management proposals and decisions. In times of stress or crisis, effective non-executive directors – especially those in key board positions such as lead independent directors and members of risk and audit committees – are often called upon to provide even more intensive steering of the ship.”

My final point on this topic relates to the fitness and probity regime. At the outset I’d like to acknowledge that we see evidence that banks are considering diversity when candidates are being put forward for senior roles. This is very positive. Many of you will also sit on nomination committees. I highlighted this in early 2020 too, but it remains an issue that candidates being put to the Central Bank for approval under the F&P process are too often unprepared for such engagement and/or do not demonstrate the knowledge or experience necessary. These issues should have been identified in the banks’ due diligence processes and should have influenced consideration of the appropriateness of the nomination. Presentation of such candidates is a not a good reflection on the bank. In your roles as INEDs on nominations committees, you are well placed to influence the quality of candidates and ensure their skills, experience and characters align with the requirements of the roles they are being proposed for. We expect NomCos to review the due diligence performed by the business, ensure it influences your decisions and, where appropriate, make the hard decisions.

The role of the board in meeting the challenges of the future - climate, digital/innovation, and business model sustainability;

A crucial area as your banks navigate the pandemic and its consequences relates to business model sustainability and risk appetite. In our view it is critical that INEDs understand the mechanics of how their banks make money, including what activities are potentially revenue and capital depletive. What COVID-19 has exposed, in places, are vulnerabilities in banks’ business strategies and a concentration of revenue derived from a particular transaction or sector. Caution must be observed in relation to the potential to place reliance on opportunistic actions to increase revenue and indeed the bank’s capacity to successfully execute those plans. The role of the bank’s risk appetite is crucial here as your banks seek to identify new revenue sources. The Risk Appetite Statement, which the Board is responsible for setting, must be a guide for your strategic decision making.

Your banks are faced with issues relating to disruption, such as rapid change in how people are interacting with the financial system, disruption of traditional business models, complex technological issues such as continuous upgrades to your internal systems, threats of systems failure and cyber attack, and a society increasingly focused on values, convenience and addressing the climate emergency. An additional challenge is to find the expertise for your boards to assist you to meeting these challenges. My ECB colleague Pentti Hakkarainen gave a very clear articulation of the ECB’s view of the challenges related to digital challengers in a blog in May 2020 and a speech in February 2021, which I would urge you to read.

You will hear more and more from us on climate. Climate change effects and costs are with us today and will grow exponentially. Inaction by your bank today will impose severe costs in the future. In order to mitigate the risk and adequately position yourself to respond, you will need to understand the impact of climate related risks on the business environment in which the bank operates, your business models and your investments.  

On a more general basis I would ask you to ask yourself the following questions in relation to the future on an ongoing basis:

• How well is my board set up to challenge the executive on technology, digital transformation, cyber resilience and climate issues?
• Does the board have sufficient expertise on such issues?
• Is it receiving information in a format that it understands?
• Does the board have the diversity of perspectives needed to give a rounded view on such challenges?
• How comfortable am I that I have the information I need to make decisions?
• How do I satisfy myself that the bank’s policies and procedures are being followed and are effective?
• Am I in a position to understand the functioning, work plans and priorities of the control functions to ensure that they are adequately fulfilling the bank’s risk management, measurement and monitoring responsibilities?

The final topic I will address is distressed debt, including debt arising from the pandemic, and our expectations of board oversight.

The negative consequences of the pandemic on the economy, on businesses and on household incomes, are far reaching. Recovery will take time, it will be uneven and far from straightforward. Banks will have a central role in supporting the successful return of a functioning economy which benefits consumers and borrowers.

Innovative financial solutions and flexible strategies will test the quality of the governance and the effectiveness of the boards of banks. Decisions on how to address the increased levels of financial and borrower distress will be especially important for those of you on the boards of retail banks. The sentiments that follow are directed at retail bank INEDs, but there is a wider application also. And it goes without saying that your work in this area should be interlinked with your consideration of long term mortgage arrears.

An important application of good governance over coming months will be your approach to your bank’s distressed debt strategy. To deliver good customers outcomes, we expect INEDs to have a clear view these strategies. The relevant boards signed off on Strategic and Operational Plans and so should be very clear on how they are going to monitor the implementation of these and how they will be able to measure effective delivery of the objectives. Important questions we expect you ask yourself include:

• How confident am I that the bank has a clear and focused strategy which recognises the differing vulnerabilities and severity of COVID impacts on different customer groups?
• What are the risks which threaten the successful execution of this strategy?
• How satisfied am I with the quality the MI and reports I receive? Does it provide me with sufficient assurance around management’s approach across the different sectors or cohorts of borrowers? Is it sufficiently detailed?  If not, what am I doing to change that?
• To what extent are the low levels of requests for further borrower support  reflective of the level of government supports? What are we doing to manage the risks associated with borrower reliance on these supports and any cliff effect in terms of repayment capacity once they end?   

The effectiveness of lenders to transition from the widespread implementation of short term forbearance, to more sustainable, appropriate and longer term solutions is critical. This will require flexibility and innovation, particularly in supporting those viable, but still vulnerable borrowers and businesses. Boards have a vital role in challenging your bank’s activity in this regard and to understand if, or how, the existing and long standing suite of restructuring products currently available provide the expected level of flexibility and innovative supports needed. The Central Bank published a Financial Stability Note in September 2020 called “Resolving mortgage distress after COVID19: some lessons from the last crisis”. I would urge all board members of mortgage lenders to read this. Based on loan level data, it has a series of findings in relation to the consequences of unsuccessful short-term restructuring and notes that re-default rates are lower where deeper restructures are put in place.

Finally, while much of the focus in 2020 has been on the response to the pandemic, an ongoing supervisory priority is the resolution of longer-term arrears cases. While this will require additional system-wide initiatives, lenders continue to be central. We expect boards to understand how the pandemic has impacted upon their longer term NPLs, mortgage arrears strategies and plans. It is not immediately apparent from board reporting how carefully this has been considered to date, but our expectation is that this should be reflected more prominently in board reporting and discussions going forward.

Conclusion

I have covered a range of topics there, with messages on your role, culture, challenge, future sustainability and distressed debt oversight, but I’ll stop there and I look forward to our discussion.