Part 3: Best Practices for Bank Boards

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team-row.jpgOver the past several years we have seen the regulatory agencies become much more focused on board oversight and performance.  This is a natural point of focus for regulators in a time of crisis in the banking industry.  The fiduciary and oversight obligations of members of boards of directors are well established, and there is a road map in the corporate records for following the actions and deliberations of a board.  I would suggest, however, that a board could receive a gold star for the quality of its minutes and its adherence to the established principles of corporate governance, and yet fall well short of being an effective working group.

This is the third in a series of articles of best practices for bank boards.  Over the past several decades my partners and I have worked with hundreds of bank boards.  Regardless of the size of the entity we have noticed a number of common characteristics and practices of the most effective boards of directors.  In this article, I will discuss three additional best practices—meeting in executive session, making use of a nominating committee and director assessments and participating in the examination process.

Best Practice No. 6 – Meet in Executive Session

It is not uncommon for the most passionate and meaningful discussions among board members to occur in the parking lot of the bank following a board meeting.  Much more time is spent in these parking lot sessions discussing a possible sale of the bank and the compensation and performance of the bank CEO than ever takes place in the board room.  The most effective boards of directors move these conversations to the board room by means of executive sessions.  Whether monthly or quarterly, the independent (i.e., non-management) directors meet in executive session and set their own agenda for those meetings.

I have found that CEOs who welcome and facilitate such executive sessions never regret doing so.  Executive sessions provide a structured forum for the independent directors to meet as a group and speak freely regarding matters of interest and concern to them.  Many positive ideas and discussions can result from these sessions.  If the CEO is also chairman of the board, a “lead director” can chair the executive sessions.  A best practice is for the chairman or lead director to meet with the CEO following an executive session and report on the substance of the matters discussed.

Best Practice No. 7 – Make Use of a Nominating Committee and Director Assessments

No director has a “right” to sit on a board.  Members of the most effective boards of directors have an active desire to serve the bank, which is evidenced by a high level of engagement, preparation and participation.  There should be a transition from the typical practice of automatically re-nominating existing board members to a process of conducting annual director assessments coupled with a nominating committee for director elections.

The CEO should not be involved with either director assessments or the nominating committee—these are board functions and should be managed by the board under the direction of the chairman or the lead director.  Annual director assessments could initially be done by means of self-assessments, coupled with a one-on-one meeting between each director and the chairman.  These one-on-one meetings can serve as the basis for discussion of the director’s enthusiasm for and participation in the activities of the board.

The process of implementing an active nominating committee and annual director evaluation process is also about risk management going forward.  In these times of continued economic uncertainty and increased regulatory scrutiny, it is important that banks have active and engaged directors.

Best Practice No. 8 – Actively Participate in the Examination Process

Members of the board should be involved in the regulatory examination process.  The regulators really do want and expect the board to be involved in and understand the issues which the regulators believe may be facing the bank.  Involvement of the entire board or key members of the board from the first management meeting with the examiners to the exit meeting is tangible evidence that the board is actively engaged in oversight of the bank.  It can also be beneficial for members of the board to hear the concerns of the regulators directly, and to observe management’s interaction with the examiners.

I recently attended an exit meeting with bank management following conclusion of an exam.  Several of the bank’s directors were present because they wanted to get a preview of the exam findings on asset quality.  During the exit meeting the lead examiner raised concern about a risk management issue of potentially significant magnitude.  The issue clearly took the bank’s CEO by surprise, but the presence at the meeting of the board’s chairman had a calming effect.  The chairman looked across the table at the lead examiner and said in a convincing tone, “We will fix this immediately.”  The issue was then quickly resolved, and the final examination report commented favorably on that action.  The end result may well have been the same without the presence of board members at the exit meeting, but I believe their presence was very helpful and reflected well on the bank.

Directors and the Exam Process: Get Involved Early

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life-perserver.jpgMy colleagues and I frequently meet with bank boards that have received very sobering reports from their bank’s examiners.  While the directors’ responses to bad examination reports vary greatly, there is one emotion that is nearly universal: a feeling of helplessness.  As a result, directors almost always express a desire to get involved in the exam process after they receive negative feedback from the examiners, whether through requesting meetings with higher-level regulators, appealing the exam findings, or fighting a proposed enforcement action.  Unfortunately, those actions, particularly if taken after a final examination report is issued, seem to have little positive impact on the examination process and may even prove to be harmful to the bank.

The good news, however, is that there is a way for directors to get involved in the regulatory examination process that can have a meaningful positive impact.  Discussed below is our top recommendation for directors to be involved in the examination process.  We believe early, proactive involvement can positively impact the outcome of a regulatory examination and also enhance the board’s understanding of regulatory criticism.

While most directors’ first contact with examiners is at the examiners’ exit meeting with the board, we suggest director involvement earlier in the examination process.  There should be one or more outside directors present at the examiners’ preliminary exit meeting with management.  During this meeting, the examiners will present their preliminary findings from the examination.  In addition to highlighting the engagement and availability of the bank’s directors, attending this meeting allows the directors to understand the key issues in the examination.  By hearing the examiners deliver their findings first hand, the directors will have a better sense of the seriousness of the issues being identified.  Finally, directors will be able to ask questions of the examiners that might not be easily asked by members of management; e.g., asking for an interpretation of a regulation.

By attending this preliminary exit meeting, directors are also able to ensure that the bank’s board has a timely understanding of the issues presented by the examiners.  Members of the bank’s executive management team have a natural tendency to relay examination criticisms to the board through their own point of view.  Management may fear adverse action by the board as a result of regulatory criticisms or may feel so strongly about their point of view that they tend to “water down” the comments of the examiners.  By having outside directors attend the meeting, those directors can deliver an independent report of the regulatory criticisms to the board.

In addition, by identifying key regulatory issues, and particularly disagreements, bank directors have the greatest likelihood for influencing the examination process.  It is at this time, after preliminary findings are made but before a final examination report is delivered to the bank, that a bank and its directors should present additional information and viewpoints that might alter the findings in the final examination report.  We have found that examiners are willing to review additional information at this juncture and, where appropriate, the examiners will alter their conclusions in response to such information.  Ideally, such information is presented prior to the examiners’ exit meeting with the full board.  Our experience tells us that this approach is much more effective and timely than a formal appeal of final examination findings. 

By inserting themselves into the regulatory examination process, we believe directors can have a positive influence on the regulatory examination process.  While we would not recommend having the full board involved in functions that are typically left to management, having an independent point of view involved early in the examination process can be very helpful.  Not only can directors display their involvement in the oversight of the bank’s operations, they can also help with strategy for dealing with regulatory issues at a time when conclusions have not yet been formed.  Finally, directors can better understand regulatory feedback and can track management’s progress toward addressing regulatory concerns.