Europe: financial supervision in the European Union - the de Larosière report

The European High Level Group on Financial Supervision in the European Union, chaired by Jacques de Larosière, was formed in October 2008 to consider reforms to the European financial regulation and supervision framework (click here for its full mandate). The Group's report was published yesterday; it is wide ranging and contains many recommendations. 

The report states that corporate governance "is one of the most important failures of the present crisis" (p. 29; see also paras. 23 and 24 in chapter one) and notes that "the financial system at large did not carry out its tasks with enough consideration for the long-term interest of its stakeholders" (p. 30). Two recommendations are made which deal specifically with corporate governance:

Recommendation 11: ... compensation incentives must be better aligned with shareholder interests and long-term firm-wide profitability by basing the structure of financial sector compensation schemes on the following principles: [a] the assessment of bonuses should be set in a multi-year framework, spreading bonus payments over the cycle; [b] the same principles should apply to proprietary traders and asset managers; [c] bonuses should reflect actual performance and not be guaranteed in advance. Supervisors should oversee the suitability of financial institutions' compensation policies, require changes where compensation policies encourage excessive risk-taking and, where necessary, impose additional capital requirements under pillar 2 of Basel 2 in case no adequate remedial action is being taken.

Recommendation 12: With respect to internal risk management, the Group recommends that: [a] the risk management function within financial institutions must be made independent and responsible for effective, independent stress testing; [b] senior risk officers should hold a very high rank in the company hierarchy, and [c] internal risk assessment and proper due diligence must not be neglected by over-reliance on external ratings. Supervisors are called upon to frequently inspect financial institutions' internal risk management systems.

These matters are already being considered by the UK's Financial Services Authority. Last year the FSA began work exploring remuneration and today published a draft code on remuneration policies. The proposal that senior risk officers should hold "a very high rank in the company" may suggest a board role or, perhaps, greater prominence for board risk committees. The role of bank board risk director is common. But it is important to remember that the board has collective responsibility for the company. Indeed, the Combined Code provides the following principle (section A.1):

"The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed".