Ensuring financial firms have good people doing right things during perilous times

Fitness and propriety assessment

Tuesday, 1 December 2020

Since there is no mechanism to measure a person’s integrity and honesty it is important to enforce rigorous fitness and propriety criteria without any compromise

The COVID-19 pandemic has compelled financial institutions to be a significant part of the solution rather than being a part of the problem as happened during the previous financial turmoil. 

Allocating capital to the real economy to keep businesses and livelihoods of individuals afloat till they reach a safe shore is a key role expected from financial entities at this critical juncture. They are also required to devise innovative business strategies to provide seamless services to customers using technological infrastructures during this extremely challenging period. 

This is a time financial institution are expected to revisit their institutional purposes. This is a time financial systemic resilience and market integrity need to be safeguarded by the players in the system without frequent directions from regulators. The pandemic has taught us that businesses, individuals, financial entities, economy, society and environment are closely interconnected elements of a one large fabric. Therefore, every stakeholder needs to understand the mutually-reinforcing possibilities for each other.

In the context of rapidly-evolving challenges, imposing regulations applicable to every transaction, every market innovation and every business scenario will have practical difficulties. This will increase the regulatory burden and the pressure to promote a culture of compliance with the letter of law on the part of financial institutions. 

Eventually, taking business decisions during crisis periods in compliance with applicable rules and regulations will be in the hands of Boards of Directors (BODs) and Key Management Personnel (KMP) of such institutions. Their fitness and propriety to hold such positions should, therefore, be a foremost requirement which needs to be emphasised in any given circumstance. It assumes even greater importance in times of crisis. 

No amount of regulations will ensure that public deposits are safe unless the decisions pertaining to management of such money are taken by individuals who are honest, well-qualified and experienced acting with integrity. It is not only robust systems and procedures but also the quality and competence of individuals that have a huge impact on effective governance in financial firms. 

This article sheds light on the significance of efficient enforcement of regulations applicable to fitness and propriety of BODs and KMP of financial institutions in order to have robust risk governance structures during a crisis like the Covid-19 outbreak. 

Fitness and propriety requirements applicable to licensed banks and finance companies in Sri Lanka 

The Director of Bank Supervision of the Central Bank of Sri Lanka (CBSL) is required to assess the fitness and propriety of the BOD/KMP to be appointed to licensed banks in terms of the criteria stipulated under the Banking Act No.30 of 1988 of Sri Lanka. The suitability assessment of BOD/KMPs of licensed finance companies is carried out in terms of stipulations in the Finance Business Act No.42 of 2011 of Sri Lanka. 

These persons are required to disclose their educational and professional qualifications, experiences in the financial services sector, and other information pertaining to conflicts of interests, if any, by way of affidavits in accordance with the directions issued under the said laws. 

Since there is no mechanism to measure a person’s integrity and honesty it is important to enforce rigorous fitness and propriety criteria without any compromise. Providing accurate and timely information is also equally important to ensure an effective suitability assessment exercise. Furnishing inaccurate information is an offence punishable under the aforementioned laws.

International best practice 

In terms of the guidelines issued by the Basel Committee, BODs of banks should comprise individuals with a balance of skills, diversity and expertise who collectively possess the necessary qualifications commensurate with the size, complexity and risk profile of the bank. Modern management places a high premium on cognitive diversity associated with factors, such as gender and background. 

It needs to be reiterated, however, that irrespective of the size of a financial entity, integrity, criminal and civil records need to be examined in appointing BOD/KMPs. Technical knowledge and experience may be varied according to the business scope, risk appetite and corporate structure of a firm. However, honesty and integrity are essential characteristics for every person at every financial institution.

 

Senior managers and certification regime – UK

In terms of the ‘Senior Managers and Certification Regime’ of the UK, individuals intending to carry on certain specified senior management functions at UK banks are required to obtain prior approval from the Prudential Regulatory Authority (PRA) or the Financial Conduct Authority (FCA), as applicable. 

The approval of the regulators is given only if they are satisfied that the candidate is a fit and proper person to carry out the senior management function for which the approval is sought. A person’s honesty, integrity, competence, capability and reputation as well as financial soundness are considered in this exercise. 

PRA and FCA also expect banks to carry out extensive referencing and due diligence prior to recruiting a person by checking the relevant person’s suitability for the post, criminal records and other required qualifications. PRA and FCA are empowered to interview prospective candidates performing senior management functions at banks prior to approving their fitness and propriety. 

Although CBSL does not conduct such interviews during the process of fitness and propriety assessment, it is emphasised that relevant nominations for the BOD/KMP posts need to be approved by the ‘Nomination Committee’ of the relevant bank/finance company. What is of paramount importance in carrying out this regulatory exercise by the CBSL is its independence to decide the fitness and propriety of a person. The regulator should be able to conduct the assessment free from political or any other interference. In the event decisions pertaining to fitness and propriety assessment are subject to such influences, guaranteeing suitable appointments for financial institutions becomes difficult. 

Eventually the integrity of the financial system and the safety of public funds will be at risk as persons who are not fit and proper end up performing managerial functions at financial institutions. This should be applicable to state owned institutions as well. It is important to ensure suitable persons are nominated for state owned banks by political authorities to enable the regulator to grant the required approvals through independent assessments. 

 

Senior managers’ accountability regime

In terms of this scheme, applications for approval for individuals to perform a senior management function need to be submitted along with a statement of responsibilities assigned to the respective candidate. Banks are also required to produce a ‘responsibilities map’ describing the firm’s governance and management arrangements. 

When a specific responsibility map is available, supervisors and regulators can identify the wrongdoers in the event of a violation of applicable rules and regulations. It will improve genuine accountability in financial firms by removing ambiguous bureaucratic structures with unclear lines of responsibility. This mechanism will lead to increased duty of responsibility as well. 

During the statutory examinations, supervisors can bring a claim of misconduct specifically against the responsible person. It will also help pierce the corporate veil to create an effective deterrence effect against non-compliances and misconduct. Conducting investigations into regulatory breaches is also less difficult when there is a ‘specific responsibility map’ of a financial entity. 

This should not be mistaken as regulatory intervention in business decisions in a manner of micromanaging. What is emphasised under this accountability regime is the requirement to ensure compliance with internal controls as well as regulatory parameters when business decisions are taken by the responsible individual. Having a precise responsibilities map is advantageous not only for regulatory examination but also for internal management of a financial firm. 

In terms of the rules and regulations issued under existing Banking Act of Sri Lanka, there is a requirement to assess the fitness and propriety of continuing BOD/KMPs. This assessment can be executed effectively if specific responsibility maps are available. The provisions of section 51 of the Finance Business Act No.42 of 2011 of Sri Lanka provide for taking action against unlawful gain/ undue losses incurred by an employee of a licensed finance company. Identifying such misconduct will also be easier using the accountability statements. 

According to Megan Butler, when we talk about being fit and proper…we are not merely talking about financial decision making but also in terms of culture…we do not compartmentalise what makes people fit and proper. Making fitness and propriety assessments in a very holistic manner is, therefore, of paramount importance in fostering a sound compliance culture in financial firms in Sri Lanka as well.

 

Suitability assessment in the European Union 

In granting approvals for appointments of BOD of banks in the EU, the European Central Bank and national competent authorities consider fitness and propriety of relevant persons in terms of five main criteria i.e. experience, reputation, conflict of interest and independence of mind, time commitment and collective suitability. Clean criminal record, history of fiscal or administrative irregularities, pending legal proceedings as well as the adequacy of diversity of the board are also taken into account by the EU. 

It would be prudent to introduce these requirements to the Sri Lankan regulatory regime as well. According to the suitability guidelines issued by the European Banking Authority, member states of the EU are required to ensure that board members of their financial institutions be of sufficiently good repute and possess sufficient knowledge, skills and experience at all times to perform their duties. 

 

Exchange of information within sectors

It is important to establish a mechanism to exchange information between regulators in assessing the suitability of BOD/KMP of financial institutions through a harmonised approach. Inter regulatory coordination will have to be given priority in modern day financial regulatory agendas. A person who has been disqualified by one regulatory authority should not be allowed to join another sector in a financial system. Maintaining a comprehensive database of disqualified persons will be very vital for the purpose of exchanging information. 

The global financial crisis, as well as the failures in domestic financial institutions in Sri Lanka, have revealed that poor governance structures and misconduct of employees were among the root causes of crises. Fitness and propriety assessment should, therefore, be given a prominent place in regulatory frameworks and carried out in an unbiased independent manner with a view to ensuring improved risk oversight and resilience of financial institutions.

 

Providing induction and training to BOD/KMPs for proper organisational behaviours

Financial institutions should be required to establish appropriate training policies to educate newly appointed, as well as continuing BOD/KMPs, about evolving financial market structures, fintech, cybersecurity and other technological advances as well as human resources and corporate governance policies. Enhancing their knowledge and skills to cope with crisis situations like the current pandemic is a very important element of sustainability agendas. Appropriate training will empower BOD/KMP to lead by example to find a novel institutional purpose, particularly in a time of unprecedented crisis like what the world is experiencing at present. 

As former Governor of the Bank of England, Mark Carney, stated ‘inclusive capitalism’ should be embedded in the novel institutional purposes of financial institutions. Right minded competent people are needed for the financial services industry to achieve such goals. Customised training programs commensurate with the needs of each financial firm should be organised to inculcate a broad and practical knowledge in the minds of their employees.

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