The Nine Building Blocks of Corporate Governance

By June 27, 2014Articles

Co-authored with Nancy Schell 

Bank directors are facing relentless challenges in this rapidly changing environment. They are caught in a web of shareholder needs, community expectations, changing customer requirements, and, of course, unprecedented regulatory demands, searching for answers to a new set of questions that focus directly on Board effectiveness and sound corporate governance.

Fortunately, these challenges are creating vital opportunities for individual directors and Boards to create an approach, a framework, and a system for dynamic governance by focusing on their time-tested roles of direction, risk management, and oversight. Effective governance addresses the issues surrounding how the Board meets these responsibilities while avoiding the natural temptation to wander into the role of management.

By employing a functional governance framework, the nuances of individual directors’ personalities, backgrounds and experiences, tenure, and stock ownership give way to a shared commitment to working within a framework of successful governance and collaboration. The fundamental responsibilities of Board governance impact both long- and short-term business objectives, such as business model sustainability and brand relevance. These responsibilities, depicted in the diagram below, reflect the logical sequence of performance rather than their priorities as they are of equal importance.

This framework also aligns the modern-day management responsibilities for strategy development, enterprise risk management (ERM), and information reporting with the Board governance responsibilities as follows:

The direction is developed and executed within the strategic process. By definition, the evolution of effective strategy is an ongoing business activity involving the appropriate roles of both management and the Board. The resulting strategic plan documents the rationale, choices, and interrelationships of the strategic direction, goals and objectives, as well as a clear description of the nuances of the business and management models.

The highest and best use of strategy is the creation of a framework for decision-making.  In the normal execution of the Board and committee agendas, such as decisions involving operational and transactional issues, as well as business opportunities, employee relations, and capital management are not just evaluated based on the attributes of what is being considered, but in the context of the directional choices embedded in the strategy.

Strategy and risk management have always been interconnected in sound corporate governance. The emergence of ERM in recent years has elevated risk management to an even higher level of importance. ERM addresses the nature and amount of risk the organization is willing to accept in the pursuit of its strategic objectives. It not only addresses what could go wrong (i.e., loss) but what must go right in order to operate a successful organization. ERM starts by clearly defining the company’s desired financial outcomes. Next, management develops a detailed document that describes the organization’s risk appetite relative to the strategic objectives, risk philosophy, broad risk tolerances, and overall direction of the company to be approved by the Board. The acceptance forms the basis for the Board and management getting “on the same page” of the future risk/reward approach.

Subsequently, management prepares an assessment of the actual level of risk-taking throughout the company. A comparison of the preferred level of risk as described in the risk appetite statement and actual levels of management’s assessed levels of risk by category leads to the final component of ERM: the risk response. Management designs detailed action plans to balance the risk appetite and assessment. ERM, as an essential tool for effective governance, develops clear agreement between the Board and management concerning earnings and capital performance, with the expected level of risk-taking required to achieve consistent financial results.

The result is summarized in a useful report format that promotes efficient Board oversight. The report also contains management’s progress in achieving the strategic and risk objectives combined with financial performance. This reporting function enables the directors to clearly understand the financial performance levels, track the success of the key business initiatives, and comply with the predetermined risk tolerance ranges. Effective monitoring of performance by management and the Board is an essential component of the risk mitigation embedded in the ERM framework and further promotes the healthy collaboration and cooperation of both groups.

The creation and utilization of efficient policies predate the introduction of strategic planning and ERM by the banking regulators and remain relevant today. Competent policy formation produces clear choices concerning management’s construction of the business model and related risk tolerances. Effective policies in a usable format enable ease of use, clarity of purpose, and consistent execution, which contribute to competent Board oversight.

Effective governance creates a positive atmosphere in the boardroom, and competency and consistency among directors in their collaborative work. The three fundamental responsibilities of corporative governance contribute to meeting the wide-ranging needs of the various corporate constituencies by keeping the directors and management on the right page.