There is no better source of guidance for directors than the OCC publication The Director’s Book: The Role of the National Bank Director (the “Book”). The Book urges directors to focus their time and attention on major policy areas. From this simple perspective, sound business judgments can be made. Suggestions by the authors regarding the major issues facing the institution in crisis are noted below.
(a) Loan Portfolio Management. The board should oversee the management of the loan portfolio to control risks and maintain profi table lending operations. While lending traditionally has been at the core of a bank’s activities, providing the greatest single source of earnings and accounting for the largest volume of assets, it also has posed the greatest single risk to the bank’s safety and soundness. Whether due to lax credit standards, inadequate loan review practices, or weaknesses in the economy, loan portfolio problems have been a major cause of bank losses.
Not surprisingly, most failures are the result of bad loans. But a key question is whether they were made by “bad bankers.”
(b) Loan Policy. A bank’s loan policy should address the composition of the loan portfolio as a whole and should have standards for individual credit decisions. Risk tolerances and limits should be specifi ed. These elements of a sound loan policy set parameters for the loan portfolio, including:
- The portion of the bank’s funding sources that may be used for lending.
- The types of loans to be made
- The percentage of the overall loan portfolio that should constitute each type of loan.
- The geographic trade area in which loans will be made.
Commercial real estate and land development loan losses are at the heart of the crisis, and the regulators focus on the concentrations in those categories. In addition, the “sunshine states” and Illinois have seen the most failures.
(c) Loan Review Program. Attention to this area is key. Resources must be developed by the bank at the board’s direction for this function to do its job.
(d) Allowance for Loan and Lease Losses. The board must ensure that the bank has a program to establish and regularly review the adequacy of its allowance for loan and lease losses (ALLL). Regulators have recently focused very heavily on inadequate provisioning. Where they will draw the line on director culpability is unclear.
Regulators will be very critical of management that fails to use sound judgment on provisions, write-offs and appraisal practices.
The Book provides particular advice in terms of urging board attention to certain loan activities as areas of concern and the key red fl ags are:
- Failure to have systems that properly monitor compliance with legal lending limits.
- Relaxed standards or terms on loans to insiders and affi liates.
- Failure to institute adequate loan administration systems.
- Overreliance on collateral or character to support credit decisions.
- Uncontrolled asset growth or increased market share.
- The purchase of participations in out-ofarea loans without independent review and evaluation.
- Generating large volumes of loans for resale to others.
When a bank relaxes standards or terms on loans to insiders, culpability may follow. Other key areas to monitor are uncontrolled asset grown and out-of-area loans, especially when coupled with brokered deposits.
(e) Funds Management Policy. When considering funds management activities, the following practices or conditions should trigger additional board scrutiny:
- Excessive growth objectives. This is particularly hazardous when coupled with high risk loan programs and/or more risky or complicated investment strategies.
- The recent heavy reliance by some institutions on CRE pools and bank trust preferred securities pools has been a real problem. This is especially so when very risky subordinated tranches were purchased.
- Heavy dependence on volatile liabilities. Excessive holdings of violate liabilities, such as large certifi cates of deposit, out-of-area funding sources, brokered deposits, and other interest-rate-sensitive funding sources may pose a problem to a bank. Liquidity concerns triggered by the sudden withdrawal of such deposits can require the costly liquidation of assets. In addition, a bank typically must pay a higher interest rate to attract out-of-area funds, thereby lowering net interest margins on loans and investments made with those funds. Lower margins can create pressures on management to seek higher yielding, and potentially riskier, loans and investments to maintain earnings.
- Gaps between asset and liability maturities or between rate-sensitive assets and liabilities at various maturity time frames.
- Asset/liability expansion, both on- or offbalance- sheet, without an accompanying increase in capital support.
- Failure to diversify assets or funding sources.
- Inadequate controls over securitized asset programs.
- Lack of expertise or control over off-balancesheet derivative activities or other complex investment or risk management transactions.
Liquidity management has become a vital issue for banks in crisis. As regulatory ratings drop, access to brokered deposits becomes more diffi cult. Reliance on other sources (e.g., Federal Home Loan Banks, state funds) is put at risk due to declining capital and ongoing operational issues.