Peter Routledge, Superintendent of Financial Institutions shares how OSFI is working to encourage good governance, Starling Trust paper

In its Changing Banking for Good paper, the UK’s Parliamentary Commission on Banking Standards shined a spotlight on the importance of corporate governance in achieving prudential banking outcomes. In Canada, the Office of the Superintendent of Financial Institutions (OSFI) sets expectations in relation to corporate governance of federally regulated financial institutions (FRFIs) through our board oversight and communication on related key issues.

Following the global financial crisis of 2007-2008, OSFI saw a clear need for improvement in board effectiveness. A focus on the roles and responsibilities of boards of directors was an important first step towards strong corporate governance. To address the problem, OSFI revised its Corporate Governance Guideline in January 2013 (originally published in 2003). With this revision, OSFI elevated its expectations for corporate governance effectiveness to promote enhanced focus on sound prudential oversight by Boards of Directors in the Canadian federal financial system.

The guideline outlined the critical accountabilities of the board — including its composition and competencies — and the fundamental role of the Audit Committee. The guideline also required boards to define their risk appetite and risk limits, as well as related roles and responsibilities of management. Finally, it set expectations for financial institutions to design their compensation schemes in a way that encourages responsible risk management and avoids rewarding excessive risk-taking.

In any organization, unwritten rules, norms, and expectations exist alongside written rules and procedures. These unwritten rules, or what we call an organization’s culture, refer to the commonly held values, mindsets, beliefs, and assumptions that guide both what is important to an organization and how its people should behave. Culture can reinforce established rules and risk management disciplines, or it can lessen the effectiveness of them. Culture can be a competitive advantage, or a weakness. It can affect every aspect of an institution from its compensation practices to its control framework.

Boards and senior management of financial institutions must assume accountability for the culture of their institutions. In so doing, they must take a broader view of franchise value and ensure that their institutions serve not only common shareholders, but also their customers, employees, suppliers, and broader communities. Only this risk management mindset, informed by enlightened self-interest, will sustain their franchise values through the uncertainty and volatility of today’s complex financial system.

From 2013 to 2017, OSFI built the foundation of its approach for supervising culture risk, aimed at complementing its supervision of corporate governance. This work included reviews on compensation practices, as well as risk culture pilot reviews that focused on ‘tone from the top,’ accountability, challenge, and incentives. OSFI also conducted a review of retail sales practices across Canada’s six domestic systemically important banks with the Financial Consumer Agency of Canada, the conduct regulator for financial institutions in Canada. This review offered a bottom-up perspective to the impact of an organization’s cultural values.

In 2018, OSFI updated its Corporate Governance Guideline to harmonize and consolidate its expectations for board effectiveness in an outcomes-focused and principles-based guideline. But events obliged us to keep going.

Despite global regulatory reforms post-crisis, reputational risk in the financial services industry was on the rise. High-profile media stories of misconduct and regulatory breaches in the financial services industry arose. It became clear that prudential non-financial risks related to governance and culture, if left untended, could become financial risks.

OSFI responded to non-financial risks by creating a new division to lead its culture risk supervision efforts. This work started with an industry culture survey to understand the range of practice in Canadian financial institutions and the establishment of a Culture External Advisory Committee made up of key experts. OSFI developed supervisory tools to support risk assessment, including a culture risk taxonomy with key dimensions and attributes for supervision. OSFI conducted initial culture risk reviews, focused on decision-making, using a ‘test and learn’ approach. The insights generated by this supervisory work formed the basis of a draft Culture and Behaviour Risk Guideline for public consultation, released in February 2023. The draft guideline proposed OSFI’s formal expectations for governance and oversight of culture, including the design and development of FRFI culture. It also included expectations for the reinforcement of expected behaviours, and the identification and proactive management of risks emerging from behavioural patterns.

OSFI recognizes that the risk environment in which it operates is dynamic and requires an agile regulatory approach. Our objective is to act early in response to emerging risks, a habit we believe will strengthen public confidence in the Canadian financial system. Incorporating the need for proactive and ongoing management of FRFI culture and behaviour risks in assessing the effectiveness of corporate governance is an ideal path to supervision. Identifying risks arising from behavioural patterns is important for a FRFI’s board and senior management because it demonstrates how closely the actual culture of a FRFI is aligned to its desired culture.

While we are advancing in our journey to strengthen supervision of corporate governance and culture and behaviour risks, there is still more work ahead. This work is an important part of OSFI’s broader transformation – an enterprise effort to reinforce the resilience of federally regulated financial institutions in an era of great uncertainty. While remaining mindful of the delicate balance between regulatory burden and ensuring a resilient financial system, OSFI will supervise and regulate to strengthen the management of non-financial risks, including risks related to governance and culture, at FRFIs.

Good prudential supervision is important for effective operations of a financial system. That is why OSFI is presently taking steps to modernize our Supervisory Framework to better capture the impact of systemic and macro-centric risks on the risk profile of our FRFIs. We want to build in flexibility to accommodate new and unforeseen risks, the interplay between financial and non-financial risks, as well as non-traditional business models. Finally, we want to further leverage data and advanced analytics to promote a more risk-based approach to supervision and to inform our future data strategy. Our supervisory approach will aim to build capability and is best suited for the changes in the risk environment.

OSFI sees the ideal state of the financial environment as one that incorporates a cultural perspective, with strong corporate governance and culture risk management. Through our efforts, the expected outcomes include culture and behaviour that are designed and governed through clear accountabilities and oversight and that the desired culture and expected behaviours are proactively promoted and reinforced. This will also help to assure that risks emerging from behavioural patterns are identified and proactively managed. These important areas will not only strengthen the resilience of FRFIs but increase the confidence in the broader financial system. This approach can support sound decision-making, prudent risk-taking, and effective risk management.

Peter Routledge
Superintendent of Financial Institutions