In March 2008, the Bank of Italy issued a supervisory regulation regarding Italian banks' and bank holding companies' internal organisation and corporate governance. The regulation was an implementation of guidelines set in August 2004 by the minister of economic affairs on the principles banks and other financial intermediaries should follow when adopting the governance systems introduced in the 2004 corporate law reform. In fact, since 2004 Italian stock corporations have been given the option to adopt, in addition to the traditional Italian model (based on a board of directors and a board of statutory auditors with technical oversight powers), either a one-tier or two-tier governance and supervisory structure..

The regulation aims both to provide guidance to banks on how to implement the governance model and to safeguard the sound and prudent management of banks. The deadline to adopt the new principles is June 30, 2009. The level of detail and the prescriptive nature of the provisions have been criticised by commentators because of the significant restrictions imposed on the banks' ability to freely implement the governance systems provided for under Italian corporate law.

The Bank of Italy has set forth a number of innovative positions, in particular regarding the two-tier governance system in which the risk of overlaps between the management and control bodies is particularly acute.

The regulation focuses on the concept of 'functions' with which corporate bodies or their members need to be entrusted and identifies three fundamental functions: (i) strategic supervision; (ii) management; and (iii) control. Which specific corporate body would perform one or more of such functions varies depending on the governance system adopted by a bank. The regulation seeks primarily to draw a clear distinction between the three functions and defines each of them with the goal of guaranteeing a clear division of responsibilities, checks and balances and a proper hierarchy of control.

According to the regulation, banks will choose the corporate governance model that is most likely to ensure efficiency of operations and effectiveness of controls. The choice shall be made on the basis of a self-assessment process considering different aspects, which include the bank's ownership structure and openness to capital markets. The final choice must be explained in a 'corporate governance plan', which banks are expected to file with the Bank of Italy.

Where the 'strategic supervision' and 'management' functions are assigned to different bodies, the tasks and responsibilities of each body must be clearly identified, with (i) the strategic supervision body being responsible for deciding the bank's strategy and monitoring its implementation; and (ii) the management body being in charge of the bank's management.

Similarly, the regulation requires that a clear distinction be drawn between the powers and roles of the individuals within the corporate bodies to which both supervisory and management functions are entrusted. In particular, the chairman of the board is vested with a key role with regard to fostering the debate within the board and ensuring an adequate balance of powers. As regards banks that adopt the two-tier model, a similar function is vested in the chairman of the body in charge of strategic supervision, be it the supervisory board or the management board, as indicated in the by-laws. In the two-tier system, if the strategic function has been entrusted to the supervisory board, the chairman of this body must ensure a neutral stance among the functions attributed to him, so as to guarantee their objective and impartial integration.

Furthermore, the regulation requires that: (i) the scope of the powers delegated to the members of the management body be set out in a clear and precise fashion, especially with regard to quantitative limits; (ii) certain activities – in addition to those set forth by Italian corporate law – not be delegated to individual members or committees; (iii) the simultaneous presence within a board of directors of an executive committee and one or more CEOs must be justified by the size and complexity of the bank's operations; (iv) the chairman of the board of directors and, in the two-tier model, the chairman of the management board – when the supervisory board does not perform the strategic supervision function – have a non-executive role and not be involved, even de facto, in the current business of the company, except for exceptional circumstances, and provide a balance of power vis-a-vis the CEO or other executive directors; and (v) the entrustment to the supervisory board of the strategic supervision function does not lead to the involvement of the supervisory board in the management of the bank, thus changing its nature as a control body and limiting the independence of the management body.

The regulation emphasises the importance of the body exercising the control function and contains a set of rules aimed at providing controlling bodies under the two-tier and one-tier models (respectively, the supervisory board and the audit committee) with a degree of autonomy and independence. The control body is responsible for the monitoring of the internal control system, the risk control and management. Moreover, the control body shall monitor the procedures in place to determine the capital adequacy of the bank and will also be responsible for verifying the adequacy of and compliance with the internal capital adequacy assessment process.

Banks adopting the one-tier or two-tier model are required to adopt, in their by-laws, rules and organisational measures to prevent the controls from being flawed as a result of the coexistence of control and management or control and strategic supervision tasks, as applicable, within the same body. Also, in the two-tier system, if strategic supervision has been entrusted to the supervisory board or this body has more than six members, an ad hoc committee must be established within the supervisory board to act as a reference body for the internal control function and staff. The Bank of Italy has introduced a new and controversial prohibition whereby members of control bodies may not sit on corporate bodies (other than control bodies) at other companies of the same group, financial conglomerate or companies in which the bank holds a strategic participation.

The regulation also establishes rules regarding: (i) reporting to the control body; (ii) co-ordination among the control bodies within the same group; and (iii) coordination with the external auditors.

The regulation highlights the importance of non-executive and independent directors, as well as special committees within the body performing the supervision function.

Rules are also provided to ensure that compensation and incentive mechanisms will not generate interests that may conflict with the long-term profile of the bank, particularly by requiring shareholders' meeting approval and the creation of specific committees composed of a majority of independent members. Furthermore, limitations are provided for compensation schemes intended for members of internal control bodies as well as non-executive directors.

Finally, the regulation sets forth guidelines that banks should follow to ensure complete, timely and precise information flows between the corporate bodies and functions as well as among the members of a given body.

Giuseppe Scassellati-Sforzolini is a partner in Rome and Valentina Zadra an associate in Milan at Cleary Gottlieb Steen & Hamilton.

ItalyJune2008