Chapter 7 - Governance Flashcards
What is corporate governance?
A framework of rules and practices that guide how a company is directed and managed, focusing on accountability, transparency, fairness, and managing risk.
What is the role of the Board of Directors in a bank?
Sets the overall direction and strategy, oversees senior management, delegates duties, and retains ultimate accountability.
What is the importance of clear roles and responsibilities in corporate governance?
Ensures a clear division of duties between the board, management, and internal control functions, avoiding conflicts of interest.
What is the focus of risk management in banks?
To identify, assess, and manage risks effectively within the governance framework.
Why is compliance essential in banking operations?
Ensures the bank adheres to laws, regulations, and internal policies to protect depositors and the financial system.
What does transparency mean in the context of banking?
Banks need to be transparent with stakeholders, involving clear financial reporting and disclosure of material risks or issues.
What are the Basel III requirements?
Require banks to hold more capital of higher quality and have sufficient liquid assets to cover outflow of funds.
What is the King Code on Corporate Governance?
A set of recommendations for corporate governance in South Africa, which includes various versions since 1994.
What is the difference between ‘comply or explain’ and ‘comply or else’ governance codes?
‘Comply or explain’ allows for flexibility in governance practices, while ‘comply or else’ enforces strict compliance.
What are the three key elements espoused by the King IV Code?
- Leadership
- Sustainability
- Good corporate citizenship
What is the primary moral and economic imperative of the 21st century?
Sustainability.
Fill in the blank: An integrated report explains how a business creates value to its external environment in the context of its _______.
[strategy, governance, performance and other prospects]
What is the significance of trust in the banking system?
Trust is essential for the efficient mobilisation and allocation of funds; when it fails, the system collapses.
What is the impact of effective corporate governance on the cost of capital?
Reduces the cost of capital for all market participants, increasing capital formation and productivity growth.
What does the UK Corporate Governance Code emphasize?
- Effective board leadership
- Accountability with transparent risk management
- Effective remuneration policies
- Open relationships with shareholders
What are the key governance objectives for banks?
- Setting the bank’s objectives
- Protecting customer deposits
- Overseeing daily operations
- Setting strategy for all stakeholders
True or False: Corporate governance is only an issue for banks.
False.
What were some significant bank failures in South Africa in the last 25 years?
- Trust Bank (1991)
- Saambou (2002)
- BOE (2003)
- African Bank (2014)
- VBS (2018)
What is the implication of having a robust corporate governance regime in banks?
It lowers the cost of capital, increases capital formation, and enhances national prosperity.
What is the relationship between corporate governance and societal development?
Banks are recognized for their importance in providing financing and facilitating the transmission of funds, integral to societal development.
Fill in the blank: Good governance is viewed as effective, _______ leadership.
[ethical]
What is the purpose of integrated reporting according to King III?
To enable stakeholders to make a more informed assessment of the economic value of a company.
What does corporate governance in banking aim to manage?
Risk throughout the economic cycle and under volatile market conditions
Is there a universal bank corporate governance model?
No, differences exist by regulatory jurisdiction and institution type
What are the key elements of a robust corporate governance framework according to the World Bank?
- Well-articulated corporate strategy
- Clear assignment of responsibilities
- Strong financial risk-management function
- Adequate corporate values and codes of conduct
- Financial and managerial incentives
- Transparent information flows
What is the role of the board in corporate governance?
To engage with management and oversee the implementation of strategic objectives
What principle emphasizes board qualifications and composition?
Board members should be qualified and able to exercise sound judgment
What does Principle 4 state about senior management?
They should manage the bank’s activities consistent with approved policies
What is the responsibility of the board regarding risk management?
To ensure an effective independent risk management function exists
True or False: The board of directors is responsible for overseeing compliance risk.
True
What is the purpose of the internal audit function in banking?
To provide independent assurance on risk governance and controls
What is the focus of Principle 12 regarding governance?
Disclosure and transparency to shareholders and stakeholders
What key theme did the Walker Committee identify regarding bank boards?
Board-level engagement in risk supervision should be increased
What is the first line of defence in a bank’s risk management framework?
Line management staff in the business units
Fill in the blank: The second line of defence involves the _______ and the risk management team.
[Chief risk officer (CRO)]
What is the primary responsibility of the board in the third line of defence?
To set the tone at the top and determine risk culture
What does the Companies Act (2008) require for most entities in South Africa?
An audit committee and a social and ethics committee
What is the significance of King IV in South Africa?
It builds on King III with a focus on transparency and inclusive capitalism
What does the UK Corporate Governance Code emphasize?
Relationships between companies, shareholders, and stakeholders
What is the purpose of the UK Stewardship Code?
To set high standards for institutions managing money on behalf of UK citizens
What is the role of the compliance function in banks?
To ensure adherence to all relevant laws and regulations
What role does the audit function play in relation to financial statements?
To provide assurance that the statements are free of material misstatement
True or False: The first line of defence is responsible for risk ownership in banking.
True
What is the primary aim of the Companies Act 2006 in the UK?
To modernize and simplify corporate law and improve shareholders’ rights
What is the main focus of the risk management function in a bank?
To provide independent oversight of risk management activities
What are the three lines of defence in banking operations?
- First line: Line management staff
- Second line: CRO and risk management team
- Third line: Board and audit function
What is the primary responsibility of auditors regarding financial statements?
To provide reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud.
Auditors issue a report that includes their opinion on the financial statements.
Why do banks listed on UK and SA stock exchanges rotate audit firms?
To ensure independence and mitigate reputational risk.
There are strict rules limiting the type of consulting work audit firms may do for their audit clients.
What is the role of the board in a banking operation?
To supervise management, agree on strategic objectives, and monitor performance.
The board does not manage the business directly; that is the role of management.
List key responsibilities of a bank’s board.
- Agree on vision, values, and strategic objectives
- Appoint leadership team
- Ensure management development and succession
- Oversee remuneration of management and employees
- Establish governance structures
- Monitor execution of strategy
- Engage with external stakeholders
What are the three common forms of board structure in banking?
- Unitary Board
- Two-Tier Board
- Mixed System
True or False: The structure of a bank’s board has a direct impact on its ability to survive a crisis.
False.
The effectiveness of the board is more critical than its structure.
What is a key feature of the unitary board structure in the UK and South Africa?
Separation of duties between the Chairman of the Board and the CEO.
An independent non-executive typically fills the Chair role.
What is the average number of board members at European banks?
11.8 members.
Countries with larger or smaller boards experienced similar banking crises.
What does the effectiveness of a board depend on?
The board’s ability to address necessary activities while being small enough to react to emerging issues.
Larger boards may offer diverse representation but can be unwieldy.
What is the purpose of the audit committee in a bank?
To provide oversight of independent assurance and compliance.
All members must be independent non-executive directors.
What is the role of the risk committee in a bank?
To oversee risk management and risk appetite, including capital management.
This committee may also handle compliance.
Fill in the blank: The _______ committee is responsible for executive remuneration and HR matters.
Remuneration
What is the function of the governance committee in a bank?
To review governance processes and ensure effective functioning of the board.
This includes recruitment and performance reviews of board members.
What is the purpose of the social and ethics committee?
To ensure the bank acts as a good corporate citizen and addresses HR, environmental, and diversity issues.
This committee is required by the South African Companies Act.
What is the executive committee (Exco) in a bank?
An executive committee that delegates operational responsibility and accountability.
Led by the CEO, it typically does not include non-executive directors.
What is the importance of the IT committee in a bank?
To ensure oversight of the stability and robustness of the bank’s IT operations.
Highlighted as critical by the King III report.
What are ad hoc committees in banking governance?
Committees established to address specific issues quickly as they arise.
Examples include committees formed for regulatory issues post-2008 and during the Covid pandemic.
What does a board charter ensure in a banking governance structure?
That the responsibilities and accountabilities of the board are clear.
It is guided by a written mandate reviewed by an oversight body.
What are key principles of corporate governance outlined by the King Committee?
- Board composition and mandate
- Appointments and maximum term for executives
- Executive and non-executive compensation disclosure
- Frequency of board meetings
- Balanced annual reporting
- Effective auditing
- Affirmative action and codes of ethics
What is the role of non-executive directors in the board of directors?
Non-executive directors challenge, question, and monitor the CEO and senior management.
They are not involved in day-to-day management and should act independently.
What are the key principles covered in the King II report?
- Board composition and mandate
- Appointments to the board
- Executive and non-executive compensation
- Frequency of board meetings
- Balanced annual reporting
- Effective auditing
- Affirmative action and codes of ethics.
Revisions in King II (2002) included responsibilities of directors, risk management, internal audit, integrated sustainability reporting, and accounting.
What major changes were introduced in King III (2009)?
- Integrated governance, strategy, and sustainability
- Alternative dispute resolution
- Risk-based internal audit
- Shareholder approval of non-executive directors’ compensation
- Evaluation of board and director performance
- IT governance
- Business rescue
- Transactions affecting director responsibilities during mergers.
King III has been applicable since March 2010.
How many principles does King IV contain compared to King III?
King IV has 17 principles, reduced from 75 in King III.
King IV emphasizes inclusive capitalism and transparency in corporate governance.
True or False: The King IV code is enforced through legislation.
False.
Many King II principles are included in the Companies Act of South Africa of 2008.
What is the board’s responsibility regarding risk management according to the King Committee?
- Annual review of key risk indicators
- Dedicated committee for risk management process
- Disclosure of risk management in the annual report
- Independent assurance from internal audit on controls
- Compliance with applicable regulations.
These responsibilities support effective governance.
Fill in the blank: The board should comprise a balance of knowledge, skills, experience, and _______.
[diversity].
This is emphasized in Principle 7 from King IV.
What is a primary difference between executive and non-executive directors?
- Executive directors are involved in day-to-day management.
- Non-executive directors are not involved in management and need to act independently.
This distinction affects the governance structure.
What criteria can disqualify a non-executive director from being classified as independent?
- Significant provider of financial capital
- Participates in share-based incentives
- Owns material securities in the company
- Employed as an executive manager in the last three years
- External auditor in the last three years.
Additional criteria include being a significant adviser or executive of a significant customer or supplier.
What skills are essential for non-executive directors on a bank’s board?
- Understanding the financial structure and performance drivers
- Knowledge of operational structures and risks
- Marketing and business development strategy
- Legal and regulatory framework comprehension
- Guiding remuneration policy development.
Financial literacy is particularly important.
What is the purpose of a risk appetite statement?
To define the bank’s tolerance for various risk exposures in qualitative and quantitative terms.
It should be owned by the board and guide the bank’s risk culture.
What does the executive committee of a large bank typically include?
- Group CEO
- COO
- CFO
- CRO
- Chief compliance officer
- Chief IT officer
- Audit executive
- Other executives.
The structure supports the execution of the bank’s strategy.
What is a key role of senior management in corporate governance?
Execution of strategy within the governance structure agreed with the board.
Senior management must also ensure accountability, transparency, and timely reporting.
True or False: A strong and dominant CEO is an indicator of good corporate governance.
False.
Effective governance relies on a firm culture that encourages challenge and openness.
What is the relationship between the executive committee and the board?
The executive committee manages operations and acts on behalf of the board.
They are responsible for executing the board’s policies.
What is the primary function of the ALCO?
To manage the inherent mismatch between assets and liabilities on the bank’s balance sheet
The ALCO is crucial for liquidity risk management.
List the responsibilities of the executive committee (Exco).
- Managing the operations of the company
- Acting on behalf of the board
- Conducting research into new trends
- Managing workplace culture and change management
- Making decisions quickly
- Developing and implementing strategy, operational plans, policies, and procedures
- Driving and monitoring operating and financial performance
- Assessing and controlling risk
- Prioritising and allocating resources
The Exco meets more often than the board to ensure effective management.
What are the board’s responsibilities?
- Acting on behalf of stakeholders
- Appointing and monitoring the chief executive
- Being knowledgeable of the company and industry
- Delegating to management
- Establishing the organisation’s vision, mission, and purpose
- Providing financial oversight
- Creating and monitoring the execution of the strategy
- Ensuring legal and regulatory compliance
- Enhancing public trust
- Endorsing programmes
The board’s role is distinct from that of management.
True or False: Control functions like finance, risk, and compliance are independent of business executive teams.
True
Their independence is crucial for effective governance.
What does the internal audit function typically report to?
The board audit committee
Its key function is to assess the effectiveness of internal control systems.
What is the role of the risk committee?
To provide oversight on all risk and control issues
It also interfaces with regulators on risk matters.
Fill in the blank: The _____ committee is responsible for monitoring compliance with legislative and regulatory requirements.
[compliance]
This includes issues like anti-money laundering and consumer protection.
What is the purpose of the audit committee?
To oversee the internal and external audit processes and ensure adequacy of internal controls
It must be chaired by an independent non-executive director.
List the main management risk committees typically found in a bank.
- Asset-liability committee (ALCO)
- Credit risk committee
- Market risk committee
- Operational risk committee
Each committee addresses specific risk types.
What is the main responsibility of the credit risk committee?
To monitor credit risk exposures, expected asset impairments, and associated provisions
It ensures compliance with the approved risk appetite.
What does the Model Risk and Validation committee do?
Oversees model risk management and independent validation of regulatory capital models
It includes reviewing model risk tolerance statements and monitoring model issues.
What is a key focus of the remuneration committee?
To ensure a balance between short- to medium-term profit growth and long-term sustainability of earnings
This includes scrutiny of C-suite remuneration.
True or False: The board of directors has overall responsibility for all risks of the bank.
True
This includes setting strategy, policy, and limits.
What is the function of the IT committee?
To address IT-related issues like cybercrime and system upgrades
IT issues have become increasingly important for banks.
What is the significance of effective governance in banks?
It is critical for the proper functioning and stability of the bank and the banking system
Governance structures may differ based on the size of the bank.
What role does the audit committee play in relation to the external auditor?
Recommending the appointment of the external auditor and overseeing the external audit process
This is part of ensuring adequate internal controls.
Fill in the blank: The _____ committee is responsible for overseeing all aspects of balance sheet structure.
[ALCO]
This includes capital and asset/liability management.
What should the credit risk management department (CRMD) be responsible for?
- Measuring risk and enforcing limits
- Constant oversight of the credit portfolio
- Credit performance monitoring and reporting
The CRMD must be adequately staffed and resourced.
What is the role of the executive members in the model risk management committee?
To understand the impact of model risk and model failures and provide effective technical and business challenge of model validation outcomes
The committee includes the CRO, Head of Model Risk Management, and representatives from areas that use models.
Who does the IT committee report to?
The board
The IT committee focuses on IT-related issues, which have become increasingly important in recent years.
What are the key responsibilities of the IT committee?
To assist the board with information technology projects, focusing on cybersecurity and strategic planning
Responsibilities may also include data governance, IT system controls, and overseeing third parties.
What is a significant risk that the IT committee must address?
Increased competition from fintech start-ups
Fintech start-ups are gaining market share in core banking services.
Fill in the blank: The IT committee assists the board with establishing strategic plans, principles, and _______.
[policies relevant to information technology]
True or False: The IT committee is solely focused on cybersecurity.
False
While cybersecurity is a key focus, the committee also addresses other IT-related responsibilities.
What does the IT committee do in relation to disaster and recovery planning?
They implement and monitor IT related projects
This includes ensuring the bank is prepared for IT disruptions.
What kind of knowledge is required from members of the IT committee?
Sufficient software and market knowledge
This knowledge helps articulate risks and defend against competition.
What has prompted the need for upgrades in legacy systems?
Exposure to cybercrime and the need for improved efficiencies
Automation is also a factor in freeing up resources.
List three areas of responsibility for the IT committee.
- Data governance
- Protection of personal information
- Monitoring IT resources
What are the three key roles of shareholders in a banking operation?
- Ensuring that the elected board is both competent and engaged
- Holding the board and management accountable for outcomes
- Demanding appropriate levels of transparency in reporting of activities
The roles of shareholders have been emphasized in recent governance reviews such as the Walker Committee Report.
What challenges do shareholders face in exercising control and influence in banks?
Shareholders are diverse and dispersed, often preferring to leave governance to paid agents.
This has led to the rise of activist shareholders.
What is the Twin Peaks regulatory structure in South Africa?
- Prudential Authority for prudential supervision
- Financial Sector Conduct Authority for market conduct regulation
This structure is similar to that in the UK.
Define model risk in a banking context.
Model risk is the potential loss a bank may incur due to errors in the development, implementation, and use of models.
What are some areas where models are used in banks?
- Provisioning calculations
- Pricing loans and other assets
- Budgeting
- Stress testing
- Capital calculations
- Investment decisions
Model failures can cause significant financial and reputational damage.
What regulatory changes have occurred regarding model risk management since the global financial crisis?
Regulators have increased model risk management requirements, and banks have improved their model risk management functions, policies, and frameworks.
List the key roles defined in model risk management.
- Model owner
- Model developer
- Model validator
- Model approver
Roles may differ across organizations but are essential for model lifecycle management.
What does model materiality measure?
Model materiality measures the extent of use of a model or the potential financial loss or reputational damage from its failure.
Fill in the blank: A model life cycle typically includes _______.
- Initiation
- Development
- Validation
- Deployment
- Monitoring
- Adjustment
- Decommissioning
Each step requires proper documentation for governance.
What is the purpose of a model inventory?
A model inventory serves as a central depository of a bank’s models, including information on model usage and status.
What is model risk appetite?
Model risk appetite refers to the amount of model risk a bank is prepared to accept to meet its strategic objectives.
What new risks arise from AI/ML models in banking?
- Explainability risk
- Resilience risk
- Fairness risk
These risks require banks to enhance their governance frameworks.
What steps can be taken to ensure governance for AI/ML models?
- Develop an enterprise-wide AI/ML definition
- Enhance existing risk management frameworks
- Implement an operating model for responsible AI/ML adoption
- Invest in capabilities supporting AI/ML adoption
These steps help manage risks associated with AI/ML.
What is a black box model?
A black box model is one where access to its internal workings is restricted, often because it is proprietary.
What reasons might a bank have for purchasing a black box model?
- Time constraints
- Cost-effectiveness
- Lack of required specialist skills
Purchased models may also include periodic updates managed by the vendor.
True or False: All models used in a bank should be well documented online.
True
Undocumented models are often considered a red flag.
What is a ‘black box’ model?
A model where the internal workings are not accessible or understandable
What should be specified before purchasing a model?
The objective of the model
Why is understanding the model’s scope important?
To ensure appropriate application and avoid misalignment with portfolio characteristics
True or False: Ethics are usually a primary consideration in model building.
False
What can result from unethically built models?
Legal and regulatory action, reputational risk
What historical example illustrates the impact of bias in AI models?
Amazon’s AI model for sorting CVs
What are IFRS 9 ECL models used for?
To determine expected credit losses for banks’ financial reporting
What is a significant consequence of year-on-year increase in provisions under IFRS 9?
Reduction in net profits and retained earnings
Fill in the blank: IFRS 9 models need to be developed for each _______.
[credit portfolio]
What role does the model challenge committee play?
To robustly challenge proposed changes to models before approval
What is a key consideration in provisioning governance?
Overlay adjustments for model risk and event risk
What do forward-looking adjustments in IFRS 9 models rely on?
Statistically-driven macro-economic models
What was a major issue during the COVID-19 period affecting ECL estimates?
Historical data did not account for COVID-19 impacts
How often should management information be provided to the executive committee?
Monthly
What is the purpose of management information?
To assist in day-to-day decision making and assess performance against strategic objectives
What principle did BIS publish in 2013 regarding risk data aggregation?
BCBS 239
What is a critical component of effective corporate governance?
Transparency
What did the banking crisis of 2007-2008 reveal about boards of banks?
Failures in oversight and risk management
True or False: All banks that failed during the crisis had similar cultures and strategies.
False
What does the term ‘tail risk’ refer to?
The irrational confidence in mathematical models estimating risk in extreme events
What should be avoided when providing information to management?
Clutter and irrelevant information
Fill in the blank: The final provisions, including modelled results and adjustments, are discussed with the _______.
[credit risk management committee]
What is the role of the provisioning committee?
To govern the approval and release of model risk overlays
What should be documented to support the external audit of provisioning processes?
Data, models, macro-economic scenarios, model outputs, committee meeting minutes
What was a major factor behind the banking crisis of 2007–2008 according to Muradoglu?
The opacity of balance sheets reflecting the extent of assets such as securitisations and complex transactions.
This lack of transparency led to incorrect risk assessments by bank management.
What is the governance principle highlighted in the text regarding senior management’s assessment of risk?
An incorrect (usually optimistic) assessment of risk by senior management is a behavioural issue.
This emphasizes the need for better regulations to account for human nature.
What do De Bondt et al. (2010) suggest about current regulations and governance culture in banks?
They were not sufficient to prevent bank management from bending financial reports in their favour.
This indicates a need for stronger governance and controls.
What is accountability’s role in bank governance?
The more accountability is placed on the board, the more engaged it becomes, leading to a better governance framework.
This suggests that more detailed regulation may not be the solution.
What paradox is identified regarding the price behavior of financial assets?
Rising prices lead to rising demand for financial assets, contrary to other assets where rising prices lead to falling demand.
This behavior contributes to short-term decision-making in financial markets.
Why is ‘market share’ considered an inappropriate measure for banks?
Chasing market share without considering price/margin and risk can lead to higher losses during market corrections.
This is particularly evident in the failures of banks such as HBOS and Bradford & Bingley.
What was a key issue with boards during the 2008 financial crisis?
Boards congratulated themselves on appointing dynamic CEOs, losing sight of their role to challenge management.
This led to a breakdown of governance structures.
What should banks recognize as their fundamental role?
Banks are custodians of other people’s funds and should act consistently with this responsibility.
Putting these funds at risk is considered immoral.
What is the importance of communication for actuaries in banking?
Actuaries must explain technical concepts in an understandable manner to stakeholders, especially the executive committee and board.
This ensures that the impact of actuarial work on business is understood.
What must actuaries do when conflicts of interest arise?
They must disclose the conflicts to relevant stakeholders and should not continue with professional services.
This ensures objectivity and protects the profession’s reputation.
What is meant by ‘constructive challenge’ in the workplace for actuaries?
Actuaries may need to challenge the workings of others, ensuring they remain objective and respectful.
This is important for fostering a collaborative environment.
What is required of actuaries when they notice violations of the code of conduct?
They must blow the whistle and notify relevant bodies to address the issues.
This is crucial for maintaining professional integrity.
What are the eight key principles of effective corporate governance according to the Basel Committee?
- Board members should be qualified and exercise sound judgement.
- The board should approve and oversee strategic objectives.
- Clear lines of responsibility and accountability should be set.
- Appropriate supervision by senior management should be ensured.
- The board should utilise internal and external audit functions effectively.
- Compensation policies should align with corporate culture and objectives.
- Governance should be transparent.
- The board should understand the bank’s operational structure.
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These principles are essential for the effective governance of banks.
What are the three lines of defense typically used in banking?
- First line: Line-management staff own the risk in business activities.
- Second line: The CRO and risk management team oversee risk aspects.
- Third line: The board and audit function provide independent assurance.
Each line has a distinct role in managing risk within the bank.
Why do other banks not necessarily benefit from a bank’s bankruptcy?
Banks have contracts with each other, and one bank’s bankruptcy can lead to liquidity issues for others and reduce public confidence in the banking system.
This highlights the interconnectedness of banks in the financial system.
