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BANK SUPERVISION

Federal Reserve Bank of St. Louis




BANK SUPERVISION




Published by
F e d e r a l R e s e r v e B a n k o f S t . L o u is

1963

Fe d e r a l R e s e r v e Ba n k

of

S t. Lo u i s

P. O. B o x 4 4 2

S t . Lo u i s 6 6 , M i s s o u r i

RRY A. S H U F O R D
PRESIDENT

December 16, 1963

This booklet consists of papers which were
delivered at a staff conference of this Bank on March 15,
1963. It is presented, not as a statement of Federal
R eserve policy nor as a manual of techniques, but, rather,
in the hope that it may contribute to better understanding
of an important public service on which relatively little
m aterial is available.
The Bank is grateful for the review and commen­
tary of Dean W illiam H. Baughn, P rofessor Lewis E. Davids,
and P rofessor E lm er Wood, all of the University of M issouri.
Needless to say, their kindness does not commit them to r e ­
sponsibility for the views herein.




FOREWORD
by
J. L. R o b e r t s o n , Member of the Board of Governors
of the Federal Reserve System, Washington, D. C.

W

ITH thirty years of active work in the field of bank supervision
behind me, I was privileged to attend the conference at which
this group of papers was presented. As I listened to each of the
participants, I was impressed by the grasp each had of his subject.
The presentations were clear and concise. In addition, they consisted
of fundamentals that form the warp and woof of the fabric of knowl­
edge that clothes the “ good” examiner.
It occurred to me at the time that it was unfortunate that informa­
tion of this type was not available to those members of the public
who have reason to be interested in this technical but important
phase of public service. One can search libraries from coast to coast
without finding information in one place — or, for that matter, in
any place — which presents a picture of bank supervision as accurate
and well-rounded as that to be gleaned from these papers.
Consequently, news of the decision to publish the material was
not only welcome; it also aroused in me a desire to publicly commend
the individuals whose efforts made the decision possible — which
I hereby do.
I am certain that this material will prove helpful to those young
people who might be considering a career in this field. It will be
educational for those who have an academic — or even a general cur­
iosity — interest in how banks are supervised in the United States. It
will prove invaluable to those members of bank supervisory forces —
State or national — who have not been privileged to attend sessions
of the School for Examiners which the Federal Reserve System and
the Federal Deposit Insurance Corporation conduct as a part of their
training programs.
Needless to say, bankers themselves will be found poring over this
volume in the hope — a hope which can be fulfilled — of finding ways
to improve their banks by learning the “ what's” and the “ why's” of
the bank examination process.




T A B L E OF CONTENTS
Page
T h e G e n e r a l N a t u r e o f B a n k S u p e r v isio n

Orville O. Wyrick, Vice-President................................................. 1
T

he

L e g a l B a s is

of

B a n k S u p e r v is io n

Gerald T. Dunne, General Counsel and Assistant Secretary......... 6
A llo c a t io n o f S u p e r v iso ry R e s p o n s ib ility T o d a y

Joseph C. Webnan, Jr., Assistant Chief Examiner.......................11
T e c h n iq u e s o f B a n k E x a m in a tio n

Earl H. Chapin, Assistant Chief Examiner................................... 21
R e v ie w an d A p p r a isa l

Wilbur H. Isbell, Chief Examiner.................................................27




The General Nature of
Bank Supervision
by
O r v il l e 0 . W

y r ic k

ANKS differ from most other corporations in several respects.
Most of these differences are related to the unique position of
banks in the national economy. They are the custodians of the bank
deposits that form the bulk of the nation's means of payment, its
money supply. There is strong public interest in the safety and mobil­
ity of bank deposits, and this has both a general and a specific ap­
plication for it is the effective operation of the individual banking
institutions which is essential to the orderly functioning of the whole
banking system. The current financial needs of commerce, industry
and agriculture are met partly through loans and investments made
by individual banks and the bulk of the nation’s payment is made
through the checking deposits resulting from these lending activities.
Failure of banks to meet their liabilities can reach far beyond de­
positors and borrowers and the immediate territory that the banks
serve. The business of banking, therefore, has long been regarded by
the Federal Government, the States, the public generally and the
bankers themselves as one that is properly subject to government
supervision.
As a government activity, bank supervision encompasses a wide
variety of technical functions relating to the operation of banks. These
concern: (1) the issuance and enforcement of supervisory and other
regulations; (2) the organization and chartering of banks; (3) the
periodic examination of banks and the requiring of steps by bank
management to correct unsatisfactory or unsound conditions found
through such examination; (4) the review and analysis of periodic
reports of conditions and earnings and expenses; (5) the rendering of
counsel and advice on bank operating problems when requested, par­
ticularly in the case of smaller banks; (6) the approval of proposed
changes in the scope of corporate functions exercised by individual
banks and of proposed changes in their capital structures; (7) the
authorization of establishment of branches and of the exercise of

B




1

trust powers; (8) the approval of bank mergers and consolidations;
(9) the organization and regulation of bank holding companies; (10)
the regulation of bank service corporations; and (11) the liquidation
of banks. The four supervising agencies do not each perform all of
these functions, but all are the responsibility of one or another. For
instance, only the Comptroller of the Currency and the State Super­
visory Authorities have the statutory power to charter or close banks,
while the Board of Governors of the Federal Reserve System has the
sole Federal Supervisory responsibility for the regulation and super­
vision of bank holding companies.
As the history of banking and bank supervision bears out, one of
the prime requisites for effective supervision is control over entrance
into the banking business. Formerly, the belief was held rather gen­
erally that any group of men with the minimum amount of capital
required had the right to establish a bank, and over a long period of
time, charters were granted rather freely. This resulted in the charter­
ing of a large number of uneconomic units often with incompetent
management. “ Too many banks and not enough bankers” has often
been said to have been one of the causes for the great number of
failures during the twenties and early thirties. The general aim of
the chartering authorities today is to grant charters only where there
is demonstrable need for the bank and reasonable assurance of its
success. However, it might be significant to note that there were 178
new banks opened for business in 1962, 63 National and 115 State
banks, topping the previous high totals of 136 in 1946, and 109 in 1961.
Of perhaps equal importance as the authority to control entrance
into the banking system is the authority of supervising agencies to
control bank expansion through the establishment of branches, merg­
ers and consolidations, or bank holding companies. The power to
limit undue concentration of banking resources and thereby contribute
to a healthy, effective and competitive banking system is one of the
best possible protections of the economic interest and public well­
being.
The broad objective of all supervisory agencies is to foster and
maintain sound banking conditions and so to protect the public
interest. In relation to the individual banks, the objective is to foster
the maintenance of each institution in sound and solvent condition
under good management in order to protect the depositor and to
enable the bank to serve adequately the needs of the community. In
stating that the objective of supervision is the maintenance of sound




2

banking conditions, there is no intent to overemphasize the powers of
supervision. That supervision has not always been successful in at­
taining its broad objective, as is apparent from the several major
upheavals in the nation's banking history, does not make the broad
objective a less desirable one, or even an unachievable one. It is fully
recognized that supervision, even at its best, is no substitute for
intelligent and competent bank management, and that of itself it
cannot insure the maintenance of a sound banking system. It can only
contribute to that end.
Obviously bank supervision comprehends more than the examina­
tion of banks. Although, according to popular usage, “ bank supervi­
sion" and “ bank examination" have come to be used interchangeably,
and although bank examination is the very foundation of bank super­
vision, “ supervision" is a much broader term than “ examination"
and embraces many additional activities. Here at the Federal Reserve
Bank, bank supervision entails other important duties in addition to
bank examination. These include: (1) processing of reports of condi­
tion, and income and dividend reports of member banks; (2) analyzing
reports of examination of national banks received from the Comp­
troller of the Currency; (3) maintaining analytical information with
respect to condition of all member banks; (4) processing branch and
merger applications; (5) processing applications to organize or expand
bank holding companies; (6) administration and interpretation of
laws and regulations; and (7) the processing of applications of State
banks for membership, or termination of membership of banks in the
Federal Reserve System.
Bank examination is the fact finding function of bank supervision.
Its purpose is to develop information that will disclose the current
asset condition of the individual bank, its ability to meet demands of
its depositors and other creditors, the adequacy of its capital structure,
its earning ability and future prospects; to evaluate and appraise the
competence of its management; and to ascertain whether it is com­
plying with applicable laws and regulations.
Before discussing the role of the bank examiner, I would like to
point out a few things that bank examination and supervision do not
include. An examination of a bank does not generally include an
audit of it. As you perhaps know, an examination concerns itself
primarily with appraisal, while an audit concerns itself primarily with
verification. Naturally there are certain audit aspects to an examina­




3

tion and the extent to which an examination approaches an audit
properly varies from bank to bank, depending on the extent of internal
controls, personnel and other relevant factors in the particular insti­
tution. It is one of the functions of an examination to determine
weaknesses in safeguards and controls in each bank so that these
may be discussed with the management with a view to obtaining cor­
rective action. Bank supervision does not engage in the management
or operation of banks. It cannot play the role of both umpire and
player. The responsibility for the management and operation of a
bank rests with its board of directors. It is the responsibility of bank
i supervision to evaluate the capabilities of bank managements and to
seek to strengthen or replace it in those situations where it is deter­
mined that it is inadequate to cope with the situation in which it
finds itself and the safety of the bank’s depositors is involved. Finally,
bank examination is not a tool of monetary policy. Since the Board of
Governors, in addition to its supervisory responsibilities, is concerned
with national credit and monetary policies, it is sometimes mistakenly
believed by some that one of the objectives of Federal Reserve exam­
ination is that of credit control. However, this is not the case. In all
phases of examination and supervision there is full recognition of the
distinction between the Federal Reserve System’s responsibilities re­
lating to bank supervision and those pertaining to monetary policy.
Examinations are not made with a view of implementing the mon­
etary policy in effect at the time, but with the purpose of determining
whether the bank under examination is being so operated as to warrant
the belief that if now in sound condition, it will so continue; and, if
not, that it will soon attain such a condition.
Since supervisory policy is administered largely through the process
of bank examination, the role of the bank examiner is indeed an
important one. His function is to inquire honestly and as carefully
and impartially as possible into the affairs and management of a bank
as revealed by the records of operation. In performing his duties he
is required to verify and appraise all assets; to verify liability accounts
as shown by its general books, insofar as this may be practicable
through comparing subsidiary record totals with general ledgers con­
trol accounts, or through direct verification with creditors; to check on
the observance of laws, rules and regulations; to appraise the qualifica­
tions of directors and the competence of officers, and to some extent
employees; to appraise overall operations, to observe trends, and to
submit a report with comments, criticisms, and recommendations.




4

In the light of the facts developed by the examiner in the field, the
officers in charge of supervision are in a position to prescribe any
necessary requirements regarding corrections and formulate expres­
sions of supervisory policy. Moreover, the supervisory officers take
the important facts and experiences developed by examiners regarding
not just one bank, but all banks supervised, and temper supervisory
action regarding the individual institution by the experience derived
from all. The extent of correction required or advice given naturally
varies with the specific situation.
Supervision of the larger percentage of our member banks amounts
to little more than making routine examinations and requiring the
submission of condition and earnings reports. Unfortunately there do
develop situations where drastic supervisory action is required. These
are usually the result of speculative or incompetent managements
and in such cases the duties of supervision are clear — a strengthening
or change of management. Between the well managed and the haz­
ardously managed groups is a relatively small group of banks whose
operations are not all that might be expected or desired. Supervision
can and does render its best service to such institutions by acquainting
them with the prevailing practices of sound banking and by arousing
the interests of the managements to make corrections of a fundamental
nature. The timing and extent of corrective measures to be instituted
in respect to specific situations is a judgment which must be carefully
arrived at by the supervisor. To be effective he must scrupulously
avoid imposing conditions “ too quickly and too great” , but he must
be even more alert to avoid committing the unpardonable sin of bank
supervision of doing “ too little, too late” .
The foregoing is the general nature of bank supervision. It is as you
can see only a means to an end and has been adapted in times past
to meet changed or changing conditions. Its broad objective, the
maintenance of a sound banking system, is well established, but the
question of what procedure, practices and allocations of responsibilities
are needed to make supervision more effective in the accomplishment
of this purpose, not only with respect to individual banks and their
particular problems, but also with respect to problems affecting the
banking system as a whole, continues to be debated by supervisors,
bankers, economists and legislators.




5

The Legal Basis of Bank Supervision
by
G e r a ld

T.

D unne

ACK in the days of World War II, it was the custom at one
naval station to accompany the promotion of enlisted men to the
rank of midshipmen in the United States naval service with the
reading of a letter from John Paul Jones on the subject of command
at sea. The gist of the message was that while an American warship
might fight for democracy and freedom, her company would experience
comparatively little of those conditions.
Something of a parallel of this apparent contradiction (which is
really a summary of cause and effect) is suggested by the subject of
the legal basis of bank supervision. Commercial banking as we know
it is not only representative of private, rather than governmental,
allocation of resources, but it is absolutely indispensable to the entire
private enterprise system. Yet, as Mr. Wyrick has already suggested,
and as the remarks of our subsequent speakers will amplify, it would
be difficult to find a sector of the economy more subject to govern­
mental regulation and restraint.
Entry into banking is highly restricted and granted only on proof
of the public's need for service and the applicant's capacity to fill it.
The cost of the principal commodity, money, is hedged on both the
supply and demand sides with legal — as distinguished from economic
— limitations. The areas of choice in both loans and investments are
elaborately circumscribed. There are restrictions on persons who may
be associates in the business and on the place where business may be
conducted. The ability to combine with similar enterprises or to
dispose of it to a corporate buyer is sharply conditioned. The enter­
prise itself may be closed down or its personnel ousted from office in
comparatively summary fashion. And, finally, both as part of the
pattern of regulation, and, so to speak, the cutting edge of the regula­
tory blade, there is a continuous process of compulsory disclosure. One
part of this process is submission of reports on the business, not only
to the authorities, but to the public at large. The second, and, by far
the more important, is unannounced, uninvited, and unexpected onthe-spot verification of the affairs of the bank.

B




6

There are perhaps three salient characteristics of both the overall
pattern of regulation and its specific apparatus of examination. For
one thing, it exists under the laws of every state as well as those of the
Federal Government. Secondly, while these laws involve considerable
diversity in context and — as Mr. Welman will show — in application,
they also have a core of common ideas and procedure. And, finally,
most of them are fairly old laws, that is to say, they were adopted
during periods when the idea of governmental regulation of, and
intervention in, economic enterprise were not the rules but very much
the exceptions. Only the FDIC supervision and examination authority
(Section 10 of the FDIC Act) is rooted in fairly recent history. Contrarywise, we are now approaching the golden anniversary of the
Federal Reserve Act and its Section 11 which authorizes the Board
of Governors “ to examine at its discretion the accounts, books and
affairs . . . of each member bank . . . . ” We have already passed the
centennial of the national bank counterpart of such legislation, both
in general and with specific reference to examining authority first
given by Section 54 of the National Currency Act of 1863. Finally,
and to take Missouri laws as typical of state legislation, we might note
that while most Missouri banking statutes date from 1907, a legislative
tradition of bank regulation; including examination, has been in effect
in this state since 1837.
Perhaps we might pause for a brief look at the present Missouri
“ examination” statute1because its form not only sets out the business
of supervision in fairly comprehensive and systematic fashion, but
does so in language which suggests the legal background and tradition
involved. Omitting unnecessary material, it reads as follows:
361.160. Examination of banks and trust companies
1. The commissioner, at least once each year, either
personally or by deputy or examiner appointed by him, shall
visit and examine every bank . . . doing business under the
laws of this state . . . .
2. The commissioner, or the deputy or examiners desig­
nated . . . shall have power to examine any such corporation
whenever, in his judgment, it may be deemed necessary or
expedient . . . .
3. He and his deputy and examiners shall have power to
administer oaths to any person whose testimony may be re­
quired in such examination . . . and to compel. . . attendance
of any person for the purpose of any such examination . . . .
Section 361.160 Rev. Stat. Mo. (1949).




7

4.
On every such examination inquiry shall be made as to
the condition and resources of such corporation, the mode of
conducting and managing its affairs, the actions of its direc­
tors or trustees, the investment of its funds, the safety and
prudence of its management, the security afforded to its
creditors, and whether the requirements of its charter and of
law have been complied with in the administration of its
affairs, and as to such other matters as the commissioner
may prescribe.
When the Missouri legislature passed this law, it did not take
either its ideas or its language out of a vacuum. Rather, it drew on
not one, but two, legal traditions, which stretched back almost a
thousand years. Specifically, when it proposed that the commissioner
should “ visit” every bank, it meant no inference whatsoever of
neighborliness or sociability. Rather, the word “ visit” comes verbatim
out of the part of Blackstone’s Commentaries2 which refers to the
royal prerogative in England of inquiring into the affairs of certain
corporations, and this lineage of sovereign prerogative also is sug­
gested by Section 5240 of the Revised Statutes which provides:
No (national) bank shall be subject to any visitorial powers
other than such as are authorized by law, or vested in the
courts of justice or such as shall be or shall have been exer­
cised or directed by Congress, or by either House thereof
or by any committee of Congress or of either House duly
authorized.
Again, we must place this concept in context and note that it
emerged in the same historical process which made a man’s home his
castle and developed the thought that while the snow and wind might
come through the doorway of a house, the King of England could not
enter without permission. But this latter idea referred only to private
persons and private homes. It did not apply to corporations subject
to the royal prerogative. For these the King’s officers needed no writ,
no warrant, no court order to subject them to inquisitorial exam­
ination.
But this right of royal visitation is only half the legal tradition
and it deals with method rather than content. For the substance of
bank supervision we must turn to another venerable legal concept and
this is the “ business affected with a public interest.” In its most
general sense, this concept means that the activities of certain enter­
2Blackstone’s Commentaries, 108 (Ehrlich ed. 1956).




8

prises involve responsibilities and consequences which require, or at
least justify, extensive governmental regulation. This idea has been
worked particularly hard and the courts have held that a legislative
declaration that a business is “ affected with a public interest" does
not necessarily make it so. Indeed, Justice Oliver Wendell Holmes of
the Supreme Court went so far as to suggest that in many cases
this was merely a fiction intended to beautify what is disagreeable
to the sufferers.
Yet, without entering into an analysis of where the line need be
drawn, there is general agreement that widespread consequences of
misconduct or bad judgment in certain businesses are such as to
require governmental rather than market sanction. Moreover, as in
the case of the prerogative of royal visitation, this is a very old con­
cept. Almost a century ago Chief Justice Waite noted that with respect
to its application “ it has been customary in England from time im­
memorial, and in this country from its first colonization, to regulate
ferries, common carriers, hackmen, bakers, millers, wharfingers, inn­
keepers, etc........To this day statutes are to be found in many of the
States upon some or all of these subjects; and we think it has never
yet been successfully contended that such legislation came within
any of the constitutional prohibitions against interference with pri­
vate property."3
It is worth pointing out one omission in the Chief Justice’s list,
and that is the business of banking. Certainly even from the earliest
times the failure of a banker involved consequences far more serious
than the collapse of a miller or a baker. Yet, while the justification
for the public regulation had early origins, the recognition of the
relevance of the concept to the enterprise was a long time in coming.
Indeed, the opposite point of view prevailed with extraordinary
tenacity and as late as 1839, Chief Justice Taney could look back at
the Anglo-American legal history and assert that “ at common law, the
right of banking in all its ramifications, belonged to individual citizens
and might be exercised by them at their pleasure."4
Yet, we can almost write the history, both legal and economic,
of the first three centuries of American monetary experience as the
slow turnabout of this attitude in the tediously emerging preception
that the public welfare was immeasurably harmed by a completely
haphazard system in which the monetary medium consisted of the
3Munn v. People of Illinois, 94 U.S. (4 Otto) 113, 125 (1876).
A
Bank of Augusta v. Earle, 38 U.S. (13 Peters) 519, 596 (1839).




9

obligations of anyone who wished to call himself a banker and regula­
tion of the industry proceeded accordingly. Finally, it was this slowly
emerging concept of banks as belonging to the class of businesses af­
fected with a public interest which furnished bank supervision with
still a third legal — or, more precisely, constitutional — base. This is
power vested in every national sovereignty to define, protect, and
regulate its monetary medium. It would make for a tidy and sym­
metrical treatment if we might establish for this particular aspect of
supervision the same sort of legal family tree, so to speak, as we did
with the other two. However, this is simply not the case and this
notwithstanding the flashes of insight on the part of early judges. Thus,
in 1758, an English judge held that the notes of private bankers dif­
fered from every other kind of property because “ by the general
consent of mankind . . . they are as much money as . . . any . . . cur­
rent coin . . .” 5
Yet, such penetrating conclusions were the exception rather than
the rule, and indeed we can find the rule in the second quotation from
Chief Justice Taney with respect to common-law right of free banking.
Once there came recognition that “ by the general consent of mankind”
bank notes and bank credit did the work of gold and silver, there
followed in inevitable consequence a particular type of governmental
concern, attention, and action. This reaction was not so much in­
volved with the governmental responsibility for the public safety and
welfare which underlay the “ public interest” concept. Rather, it was
a governmental concern for the exercise of its sovereign prerogative
of the money power. We now approach the fiftieth anniversary of the
first comprehensive and systematic recognition of this situation. It is
particularly relevant to the general topic of bank supervision to recall
how this subject was involved in this process by noting the four
specific objectives singled out by the preamble to the Federal Reserve
Act — the organization of Reserve Banks, the furnishing of an elastic
currency, the rediscount of commercial paper and the “ more effective
supervision of banking in the United States.” 6
5Miller v. Race, 1 Burr. 452, 457 (1758).
638 Stat. 251.




10

Allocation of Supervisory
Responsibility Today
by
Josep h

C.

W e lm a n , J r.

F YOU were to examine a chart designating the present allocation
of supervisory responsibilities, you would probably assume that at
some point in time the Congress enacted this allocation as it presently
exists. Perhaps you would wonder how such a diversification of duties
was conceived. Not as a defense, but as an explanation, we should
examine the network of supervisory relationships and see how they
chronologically evolved. Excluding a discussion of the controversial
First and Second Banks of the United States, which functioned some­
what as central banks and somewhat as commercial banks, the first
purely commercial banks were State-chartered institutions subject
only to a nominal amount of supervision from the State authorities
(Exhibit I).
The lingering agrarian distrust of the First and Second Banks of
the United States somewhat offset by the need for funds to finance
the war effort brought about the passage of the National Currency
Act of 1863 which provided for Federally-chartered “ National” banks
which would be privately owned but subject to the supervision of the
Comptroller of the Currency (Exhibit II).
Although the term has been recently subject to vehement disputes
regarding definition, probably it may be said that at this point in time
we had a “ dual” banking system — that is, we had a system of Statechartered banks subject to supervision by State authorities and a sys­
tem of Federally-chartered banks subject to supervision by a repre­
sentative of the Federal Government, the Comptroller of Currency.
As we progressed through the industrial revolution and the rapid
urbanization of the country, the inelasticity of our individual National
Bank Note currency and the need for a source of additional liquidity
brought about the passage of the Federal Reserve Act in 1913, which
its preamble states was an “ Act to provide for the establishment of
Federal reserve banks, to furnish an elastic currency, to afford means

I




11

ALLOCATION OF AUTHORITY TO EXAMINE PRIOR TO 1863

STATE
SUPERVISORY
AUTHORITIES

STATE
BAMS

POWER TO EXAMINE




EXHIBIT I

12

ALLOCATION OF AUTHORITY TO EXAMINE F O 1863 to 1913
RM

COMPTROLLER
OF TEE
CURRENCY

STATE
SUPERVISORY
AUTHORITIES

NATIONAL
BANKS

STATE
BANKS

— 11




POWER TO EXAMINE

EXHIBIT II

13




ALLOCATION O AU O ITY T EXAM E F O 1913 to 1933
F
TH R
O
IN R M

P W R TO EXA IN
O E
M E
--------------- -------- ------ P W R TO EXAM E AUTHORIZED, B T N T ORDINARILY EXERCISED
O E
IN
U O

of rediscounting commercial paper, to establish a more effective super­
vision of banking in the United States, and for other purposes.”
It is important that we note here that the preamble specifically
states the Act is to establish “ a more effective supervision of banking” .
However, since the Federal Reserve Act provided for membership of
all National banks and the voluntary membership of State-chartered
banks and since the ultimate goals of the Comptroller of the Currency
might not have been the same as the goals of the Federal Reserve
System, Congress apparently felt it best to vest in the Federal Reserve
System the powers of regulation and supervision over all member
banks. The creation of the Federal Reserve System created another
class of State-chartered institutions, which we refer to as State
member banks, which were subject to the supervision of the Federal
Reserve System and continued to be subject to the supervision of the
State authorities. In addition, because all National banks are members
of the Federal Reserve System, the Federal Reserve has the seldom,
if ever, exercised power to examine National banks (Exhibit III). At
this point, National banks and State-chartered member banks became
subject to supervision by a body other than the chartering agency. If
we seek to find a beginning for the so-called tiers of supervision, it
may well be here with the passage of the Federal Reserve Act.
The great depression and the attendant banking crisis brought
about many additional statutory limitations on banks and an addition
to the Federal Reserve Act called deposit insurance to be under­
written by an instrumentality of the United States Government — the
Federal Deposit Insurance Corporation. Originally, after July 1, 1936,
only banks which were members of the Federal Reserve would be
insured by the F.D.I.C. The effective date of this requirement was
postponed from time to time, banks with deposits of less than one
million dollars were exempted by the Banking Act of 1935 and the
requirement was repealed entirely by the Act of June 20, 1939.
Thus, the statute allowed the acquisition of Federal Deposit Insurance
by banks which were not members of the Federal Reserve System.
Once again Congress created another class of State-chartered banks,
which we refer to as insured nonmember banks, which are subject
to the supervision of the Federal Deposit Insurance Corporation and
continue to be subject to supervision by the appropriate State author­
ities. Since any bank which is a member of the Federal Reserve
System automatically has its deposits insured by the Federal Deposit
Insurance Corporation, the F.D.I.C. has the seldom, if ever, exercised




15

power to examine both National and State member banks (Exhibit IV).
At this point in time, we come to four different readily definable
classes of banks — National banks which are automatically members
of the Federal Reserve with deposits automatically insured by the
F.D.I.C., State-chartered banks which choose to become members of
the Federal Reserve and automatically obtain F.D.I.C. insurance,
State-chartered banks which choose only to become insured by the
F.D.I.C., and finally, State-chartered banks which are not associated
with any of the three Federal agencies.
The first four exhibits show the exercised and the normally un­
exercised power to conduct examinations. It will be noted that banks
first of all are examined by their chartering authority. National banks
are chartered by the Comptroller of the Currency and State banks are
chartered by the various State authorities. In addition, any State
bank whose deposits are insured will be examined by representatives
of the Federal Deposit Insurance Corporation unless the bank has
chosen to become a member of the Federal Reserve, in which case the
Federal Reserve will examine the bank in place of the F.D.I.C.
However, the supervisory function is not limited to examination.
Some of the more significant of the other supervisory functions and
their present allocations are shown by Exhibit V. It might be well for
us to pause for a moment and consider several of these allocations.
A bank is subject to the regulations of and must submit reports to
its chartering authority plus any Federal agency of which it is a mem­
ber. In addition, State banks which are members of the Federal
Reserve are subject to the regulations of the Comptroller of Currency
regarding investment securities.
Reserve requirements are established by the Federal Reserve and
the State authorities. Therefore, National banks are subject to the
reserve requirements of the Federal Reserve. State-chartered banks
which are members of the Federal Reserve System are subject to the
reserve requirements of the Federal Reserve and may be subject to
the requirements, if any, of the State authorities, although State
member banks in the Eighth Federal Reserve District are exempted
from the State reserve requirements. Finally, State-chartered banks
which are not members of the Federal Reserve are subject to the
reserve requirements, if any, of the State authorities.
Trust powers are authorized by the chartering authority, that is,
the Comptroller of the Currency or the appropriate State authority.
However, State-chartered banks which are members of the Federal




16




ALLOCATION OF AUTHORITY TO EXAMINE SUBSEQUENT TO 1933

— P W R T EXAM E
O E O
IN
— P W R TO EXAM E AUTHORIZED, B T N T ORDINARILY EXERCISED
O E
IN
U O




18

Reserve must seek permission of the Board of Governors to exercise
any trust powers not being exercised at the time of its admission
to membership. Also, State-chartered nonmember banks whose de­
posits are insured by the F.D.I.C. must obtain the consent of the
F.D.I.C. to exercise any trust powers not exercised at the time of
the issuance of the certificate of insurance.
Mergers are approved by the State if the resulting bank is a State
bank. In addition, any merger involving insured banks must have the
approval of the Federal agency which will actually examine the
resulting bank after receiving the views of the two other Federal
supervisory agencies and the Attorney General. Bank holding com­
pany formations and acquisitions may need State approval but must
have the approval of the Federal Reserve; and branches need the ap­
proval of each supervisory agency which actually examines the bank.
Any corporation which acquires control of a bank which is a member
of the Federal Reserve, regardless of whether it is a National or State
bank, must apply to the Board of Governors of the Federal Reserve
for a permit before it can vote the stock of the member bank.
All banks are subject to the limitations of the regulation of the
Federal Reserve regarding loans which are secured by stock and are for
the purpose of purchasing or carrying stocks registered on a National
Securities Exchange.
Any “ Bank Service Corporation” or any other corporation or in­
dividual which performs bank services for any insured bank must
give assurances, in addition to those given by the bank, that the
performance of the services will be subject to the regulation and
examination of the Federal supervisory authority which actually ex­
amines the bank for which the services are performed.
Finally, National banks are closed by the Comptroller of Currency,
but are liquidated by the F.D.I.C. and State-chartered banks are
closed and liquidated by the State supervisory authority, although
upon request of the State authority the F.D.I.C. may act as receiver
for insured State banks.
Now that we have examined the statutory duties of each of the
Federal Supervisory agencies, it would be well to look for a moment to
see who actually does the administrative chores.
Each of the three Federal agencies has a Washington office, with
staff members engaged in various aspects of supervisory work. The
Comptroller of the Currency has a Regional Chief National Bank
Examiner with a staff of examiners in each of the fourteen National




19

bank regions. The F.D.I.C. has twelve district Supervising Examiners
with their respective staffs. Each of the twelve Federal Reserve Banks
has an examination department, headed by a Vice President, which is
charged with the responsibility of supervising the member banks in
that particular district. The National bank regions and the F.D.I.C.
districts are not co-terminus with the Federal Reserve districts since
there are no split States in the former. Also, the National bank regions
and the F.D.I.C. districts are not co-terminus since they do not in­
clude the same States. To give you a somewhat extreme example of
this, if a National bank in Evansville, Indiana, — which would be
subject to the regulations of all three Federal agencies — desired an
explanation of a certain regulation, a National bank regulation would
be explained by the Regional Chief National Bank Examiner in
Cleveland, Ohio; a Federal Reserve regulation would be explained
by the Vice President in charge of examination at the Federal Reserve
Bank of St. Louis, Missouri; and an F.D.I.C. regulation would be
explained by the F.D.I.C. District Supervising Examiner in Madison,
Wisconsin.
As a rule, the central office of each supervisory authority directs
in general and reviews in detail the process of examination as a part
of its supervisory activity. The offices coordinate the activities of the
district offices with a view to uniformity of procedures. The district
offices may operate with a greater or lesser degree of autonomy, more
marked in the case of Federal Reserve Banks, and take steps to secure
some corrections without direction from the central office. Through
the district offices the operations of field examiners are coordinated
with a view to uniformity.
Thus, the allocation of supervisory responsibilities today was not
created in its present state by one all-encompassing statute. Much
of the enabling legislation was enacted under the pressure of economic
crisis and reflects the varying needs and beliefs of a span of over
100 years.




20

Techniques of Bank Examination
by
E arl

H.

C h a p in

T

HE objective of bank examinations is the appraisal of individual
banks. It is reached by the technique of verifying that the books
show all assets and liabilities at correct, or at least prudent, valuation,
checking compliance with applicable laws; assessing the adequacy of
capital and managerial ability and capacity. Examination, therefore,
is essentially a finding of facts and an expression of judgment. It is not
an audit nor, contrary to popular opinion, is it a search for embezzle­
ments. While some defalcations may be disclosed by an examination
such discovery is generally incidental and often accidental.
Disclosure, however, is often the result of surprise and this element
has an important place in examining techniques. Thus, morning starts
are preferred because of this condition and also because the examiner
is better situated to establish effective control over the assets and the
records that may be subject to manipulation. Normally, this entails
the sealing of all vaults or vault compartments containing cash,
securities and similar valuables, and taking physical control of counter
assets, deposit ledgers, and the like. Generally, however, the time
element restricts morning starts to the smaller banks. In the medium
sized and larger banks the volume does not permit establishment of
appropriate controls by the time the bank opens its doors for normal
business. Consequently, the majority of our starts are after closing
hour in the afternoon. This permits the examiner to work as long as
necessary to complete the verification of items the bank needs for the
opening of business the following morning. With control effected, ver­
ification then goes forward, and while it might be repeated that an
examination is not an audit, it does follow auditing methods and
procedures in proceeding through a systematic review of balance
sheet items.

Cash
A physical count of cash is made in the presence of each individual
teller. The results are recapped on a cash sheet with a description of
any balancing items in the teller’s cage, after which his cash is placed
under seal. This is done, of course, to prevent his cash from being




21

substituted to cover a shortage elsewhere. After all tellers are balanced
and the reserve cash is counted the examiner checks the total re­
sulting figure with the bank’s general control. Even after the cash is
balanced it is usually desirable to leave it under seal until the following
morning.

Clearings and Cash Items
The total of checks on other local banks which are being processed
for clearing and collection the following day are noted and later
checked with the Reserve Bank’s daily statement. All return items are
scrutinized for the next few days to determine that all checks were
paid or, if returned, the reasons therefor. Other cash items, including
those not in process of collection (i.e., return items, bookkeepers’
kickbacks, checks held to avoid overdraft, and so on) are singled out
for special attention. Frequently, they include “ loss” items and they
must be described by the examiner in sufficient detail so their disposi­
tion may be checked at a later date.

Due from Banks
These are deposits carried with other banks and include the reserve
account. Statements are obtained from those banks in order that the
accounts may be reconciled. All open items must be accounted for,
and all return items intercepted and reviewed for a period of four or
five days. The counterpart liability of this account is Due to Banks.
These are deposits made by other banks. Statements are sent each
bank together with a request for verification. After the account has
been reconciled, the form is signed by an officer and returned to the
examiner. Open items on these accounts must also be accounted for.

Deposit Ledgers
Trial balances are recapped and balanced against the general ledger
control. Overdrafts, large balances and public funds are listed and
accounts scanned for income accounts, accounts with unusual activity
in the form of large deposits and withdrawals but with only a small
daily balance representing possible payment against uncollected funds.
Determination is made as to whether dormant accounts are properly
segregated and controlled. Where internal controls are weak or in­
adequate there are various procedures that are occasionally used to
detect irregular practices.

Securities
All banks have a bond ledger containing a complete description of
every issue held. This information is transcribed on bond line cards by




22

the examiner and balanced against the general ledger control. A phys­
ical count is then made of the bonds on hand and those not on hand
are accounted for by direct verification with holder. Issues acquired
since the previous examination are checked for proper recordation.
At this point we might briefly note the Uniform Agreement
which the three Federal supervisory agencies and many State Banking
Departments adopted for the establishment of uniform standards and
classifications for loans and investments. Bonds are classified by
quality and the Agreement stipulates the manner in which deprecia­
tion in the account is to be treated. This is a key part of the examiner’s
work for proper or prudent valuation of an asset is essential. As part
of this analysis schedules are made of maturities, classes and ratings.
The examiner also checks for legal eligibility, concentration of issues
and trading for profit. Under the Uniform Agreement, the treatment
of securities profits in bank examinations provides that “ Until losses
have been written off and adequate reserves established, the use of
profits from the sale of securities for any purpose other than those,
will not be approved” .

Loans (In General)
This brings us to the most important part of the examination where
the ability of management is especially tested. Here, as in the case of
investments, present standards of appraisal are based on the Uniform
Agreement and here again a large element of the examiner’s work will
be valuation — that is, requiring a loan to be written off or carried
at a reduced value where circumstances so justify.

Instalment Loans
This is a highly specialized volume operation for which traditional
credit yardsticks are not applicable, and our techniques are shaped
accordingly. Briefly, we look at (1) general credit policies as reflected
in down-payments, terms, delinquencies, repossessions and losses; (2)
collection policies (i.e., bank's practice for follow-up on past due
notes) and (3) whether adequate internal safeguards and controls are
provided. Preliminary to this appraisal, we obtain control of notes
and payment cards, list the outstandings and balance to the control.

Real Estate Loans
By this I mean loans secured by real estate which is the largest
single class of loans held by our State member banks. They constitute
over one-fourth of total loans outstanding. Here the technique is to




23

balance to the general ledger control, transcribe individual loans on
line cards and to review the supporting papers, including mortgages,
certificates of title, insurance policies, and appraisals.

Collateral Loans
These vary considerably with the locale. In country banks collateral,
other than real estate, consists principally of liens on livestock, farm
machinery or crops; in the city banks, stocks and bonds, assigned life
insurance, deeds of trust and like property. These loans are transcribed
on line cards, collateral checked and valued or quality estimated.
Loans on stock and bond collateral require special attention for
compliance with the particular — and often complex — provisions
of law relating to such security.

Unsecured Loans
As would be expected, the examiner generally devotes most of his
time in developing information on and the analysis of unsecured loans
since such loans generally constitute the greater risks to the bank.
Normally, after the loans are run and balanced, the examiner will
review the “ liability ledger” from which he will establish the lines of
credit to be posted on his line cards. The liability ledger is one of the
most important records in the bank. It contains the borrowing history
of each of the bank's borrowers. It indicates whether the loan is new,
old, seasonal or continuous, its high and low point and whether or not
borrower has other indebtedness to the bank.
After transcribing the information from the liability ledger, the
examiner then posts the individual notes to his line cards, taking off
pertinent information. He then releases the notes and begins his
review of the credit files, which vary considerably from bank to bank
and are often supplemented by information supplied by the banker.
In the larger banks, the credit files usually contain all the necessary
facts and figures to support the credit. This information, in most
instances, is sufficient to enable the examiner to “ pass” many loans
without further review.
With all available loan information in hand, the examiner will make
his preliminary review of all loan line cards. He ties in related lines,
recaps past due loans, flags concentrations and “ passes” those lines
in which, in his opinion, the ultimate repayment seems reasonably
assured. Weaker credits, inadequately secured loans, or those develop­
ing unfavorable trends are held out for further discussion with the
bank's officers.




24

Bank Premises and Furniture and Fixtures
Transactions affecting these fixed asset accounts are transcribed
and the former is checked for compliance with law. The investment is
viewed in the light of the bank's capital position, whether adequate
depreciation is being taken and if the bank has adequate insurance
coverage in relation to the value of the asset.

Other Assets
These assets are the “ catch-all” accounts and frequently include
items of questionable value. Hence, they require particular attention
and careful review to determine whether or not they represent sound
value.

Earnings
The bank's income and expense accounts and related capital and
reserve accounts are transcribed and carefully analyzed. In the lan­
guage of the examiner this is “ working the earnings” . To me, this has
always been one of the more interesting and satisfying tasks. For, with
the greatly varying accounting systems in use in banks, it is always a
challenge to analyze and balance the earnings schedule which is pre­
pared from the operating accounts. The respective items of income
and expense are carefully compared with previous years' figures for
operating trends and the resulting ratios of that bank are then com­
pared with the average ratios of other banks of comparable size. The
bank's dividend policy is reviewed and checked for compliance with
the law.
There are many other steps to be taken to complete the examina­
tion, including a review of the bank's fidelity insurance coverage,
directors' minutes, salaries of personnel, an analysis of stockholdings
and a review of the economic characteristics of the community and
of the competitive situation.
Now comes the intermediate analysis — loans are discussed with
the bank's executive officers and classification of assets determined.
The results are carefully weighed in the light of capital protection,
with investment in fixed assets receiving appropriate consideration.
Earnings and dividends are considered in relation to capital adequacy.
Retained earnings are assessed in the light of growth and other cor­
porate responsibilities. A very important aspect of consideration is
the analysis of the bank's liquidity position (i.e., cash and short-term
securities of investment quality) in relation to the deposit structure.
As we progressed through the examination, each step provided some




25

indication of the capacity of management in the light of its resource­
fulness in handling problem situations as well as indicating the ade­
quacy or inadequacy of records, systems and internal controls.
These conclusions provide the yardstick for the measurement of the
bank’s overall condition and for comparing the results with those of
Other banks. Problems, if any, have been determined and the examiner
is now prepared to discuss his findings with the bank’s directors with
whom rests the responsibility for the formulation of the bank’s policies.
This is a practice of long standing with this Reserve Bank. It gives
the directors first hand information as to the examiner’s conclusions
and an opportunity to take action without waiting for receipt of the
report of examination. If no action is required, the directors are always
interested in discussing ways and means of improving the bank’s
operations. On the other hand, it is generally the only contact the
examiner has with this group and it affords him an opportunity to
appraise their qualities and the support they give the active man­
agement.
As I mentioned earlier, the examiner is concerned with facts and
estimates based on fact. Sometimes adverse findings of fact can be
and are immediately corrected. Needless to say, there are many situ­
ations where the opposite is true and which require more extended
effort by the supervisory authorities.




26

Review and Appraisal
by
W ilb u r

H.

Is b e ll

I Appraisal

A

PPRAISAL begins when the field examiner and his assistants
_ commence an examination and is a process that continues
during the examination, and until the report is mailed to the bank
and the Board in Washington. In fact, it does not end at that point.
The Board’s Division of Examinations has a staff of review examiners
and experienced specialists which review the reports and transmittal
correspondence. As has been previously brought out, the authority
for supervision is vested in the Board of Governors. The Board de­
termines broad supervisory policies. The bank examination function
has been delegated to the Federal Reserve Banks. The reports and
results of examination activities are reviewed and appraised by the
Board’s staff to assure the Board that its responsibility in the field of
bank supervision is being faithfully discharged.
The field examiner appraises the assets of a bank, the qualifications
of its officers, directors and employees, trends in the bank’s operations
and compliance by the bank with the laws, rules and regulations to
which it is subject. He then must prepare and submit a report con­
taining factual schedules, comments, criticisms, recommendations and,
of course, any commitments obtained from the bank’s officers and
directors to strengthen weak loans or to eliminate unsatisfactory
conditions or trends that may have been disclosed during the exam­
ination.
The examiner’s report must be accurate and contain a clear sum­
mary of his appraisal of the condition of a bank as of the close of
business on a given day. His responsibility in the preparation of a
report is a grave one since it is the prime source of information upon
which the officials in supervision rely and becomes their tool, or basis,
for seeking corrective action from banks or taking disciplinary action
against them.
Notwithstanding the qualifications, competence and responsibilities
of the bank examiner, there is still a major area left for the examination
officers of the Reserve Bank. A supervisor would be the first to ac-




27

knowledge that an experienced examiner, particularly in problem
situations, makes his job easier and often has presented the needs of
the bank in such a way that there is little need for action other than
active support for the corrective measures suggested before the ex­
aminer left the bank. However, all areas of action involving an exer­
cise of judgment are not clearly definable. All the banks accept de­
posits and pay checks but the forms of deposit tickets and checks are
not alike or standardized. Likewise, do the operations of these banks
and their assets vary in quality — all the way from practically riskless
to worthless. The term practically riskless is used because banking is
risk taking. If we were to attempt to classify all the risk — and in
examination language to “ classify" is to mark as substandard or
worse — we would classify all the loans. We do note, however, those
in which there seems to be more than an ordinary banking risk. Re­
viewing officers also keep a sharp eye on the capital account and
ascertain that profits are being conserved as it is this account that
will have to absorb the “ real" risk in the loan account sooner or later.
Review arid appraisal continues in the Examination Department at
the Reserve Bank. This may be done by a senior examiner, a review
examiner, a junior officer, or by the Vice-President in charge. Reports
of examination prepared by the bank examiner are critically reviewed
to determine the adequacy and appropriateness of his summary and
to inform the Department's officers concerning the characteristics of
the bank's assets, its liabilities, its trust and other corporate respon­
sibilities, its management — as well as its history and prospects, its
customers and community. The reviewing officers look for im­
portant facts or developments, weigh them against the performance of
all banks and come to a judgment as to supervisory action, if any,
that is required in a particular situation.
In making an appraisal of a bank's condition the supervisory officer
gives much attention to the bank's loans, its lending procedures, its
collection program in trying to determine the soundness of its lending
function. We have noted that banking is risk taking. Aside from large
defalcations, banks only infrequently experience large losses in trust
department operations, from bad checks, forgeries, even bond ac­
counts (except where it is advantageous tax-wise to do so) but
this is not the case in the loan operation. (Just last month the
newspapers carried accounts of an $800,000 “ sick" loan on a
shopping center development which a local bank was trying to
collect, and in the face of $250,000 in mechanics Hens, which are




28

always prior to the real estate mortgage liens). Loans, therefore, are
the heart of the banking business.
In appraising the lending operation, of course, an attempt is made
to determine its present status, and then to watch for evidences of
change in lending policies and trends. In making such critical analyses,
supervision is sometimes tagged as being against loans. Of course, this
is not so; a sound profitable lending operation in every bank is the
hope and goal of all bankers, and bank supervisors. Every competent
examining officer must “ concede the dog some fleas” and seek to
avoid becoming bogged down in inconsequential. Accordingly,
there is no excitement when a weak loan or two shows up in the
examination report of a bank where the management knows what it is
doing and probably had a good reason for making the loan. In this
situation examiners would ordinarily expect to not see these loans in
the succeeding report. They would probably be reduced in amount
or additional security or support obtained. If, however, the next
report showed no change in these credits and a few additional loans
subjected to examiner criticism, we would sharpen our appraisal and
try to determine whether there had been a weakening in the loan
servicing procedures or in the bank's basic lending policies. Thus, it is
one thing for a credit to deteriorate and quite another to find the
bank is making weak loans. For if the bank has made a weak loan,
policy is reflected, whereas, if a credit went bad an entirely different
set of circumstances is involved.
During the past year the investment or securities account has re­
ceived increasingly important scrutiny in the review and appraisal
process as the banks reached for higher yields. This may well be the
inevitable consequence of a previous decision to go into the market
and literally purchase money for investment, in the form of savings
and other time deposits. Some banks have been very selective in
acquiring municipal securities to obtain tax free income and thus
enhance gross operating revenues. Unfortunately, a few have just
purchased all or a part of a bond salesman's inventory and with little
thought as to quality or grade of municipal issues, whether such
obligations have widespread or limited distribution and with little
regard as to whether these, like other bank investments, must provide
appropriate primary and secondary reserves against the deposit liabil­
ities. These two asset categories— loans and investments— command
the most attention in review as they are the principal sources of both
income and RISK.




29

On the basis of the examiner’s classification of assets, a close ap­
praisal of the trends in the assets acquired and progress made in
strengthening or eliminating weak credits and all measured against a
capital account which, as we said earlier, will eventually have to
absorb the “ real” risk, a judgment or appraisal will be made as to the
quality of the bank’s assets. A rating is placed on this factor and is
determined from the actual or potential seriousness of the problems
in the assets.
A closely related appraisal then requiring considerable attention
from supervisory officers is that of the adequacy of bank capital.
Always reviewed in every examination report passing through the
office is the adequacy of capital to (a) the volume of marginal and
inferior quality assets (b) volume of deposits and (c) volume of risk
assets. Here too, supervision is interested in the bank’s policies with
respect to providing and maintaining adequate capital protection. This
involves dividend policies, expense control, earnings retention and
the bank’s record in these important areas of operation. This analysis
will provide some basis as to whether the bank is providing, and may
be expected to provide, protection and backing for its operations
and future growth.
This in turn brings us to the appraisal of the management. The
order in which these appraisal factors have been presented in this
discussion are not indicative of their importance, because the manage­
ment factor is the most important. Logic, dictates, however, that it
be appraised in this order as the competency, ability and soundness
of management policies and decisions are all reflected in the asset
condition and in the capital protection that has been conserved and
built up to support the bank’s business. Management, from the
supervisory standpoint, is the board of directors. The banking laws
are essentially all the same in this respect and provide that “ the bank
shall be managed by a board of directors” . Usually a bank is less than
the best it could be, or should be, if it is “ run by any other” i.e., by a
competitor, influential depositor or even a one man banker. Of course,
a bank must have leadership and it normally comes from a president
or chairman elected from the board of directors and to which some of
its duties have been delegated. It will be noted that duties was em­
phasized as the courts, through the years, have scrupulously held that
directors cannot delegate responsibilities. A strong bank president
supported by an aggressive, interested board of directors is a great
and admirable combination in the banking world today.




30

Unfortunately, some active officers and some boards of directors
lack the competence to meet all their responsibilities or to cope with
the problems with which they are, or may likely become, confronted.
Also lacking in banking generally is adequate management succession;
particularly in the smaller unit banks which so characterize the non­
branching States in our district. Too, many directors are prone to read
about this subject, and even occasionally discuss it, but dismiss it
with the thought that this problem “ will not strike us” . We know
of course by now that it has struck and is striking in our district.

I I Action
Careful review and appraisal of the three important factors of
asset quality, capital adequacy and the ability of management in
administering the bank's affairs can be counted on to provide a trust­
worthy basis for a judgment as to the general condition of a bank.
Other factors which are never overlooked in analyzing bank condition
are: the composition of the loan account, the general quality of the
bank's clientele, any unusual developments in deposits, loans or in­
vestments and the economic environment in which the bank is oper­
ating. Seasonal variations are well known to us, we must be alert
to any economic risk in a particular community, and we must there­
fore appraise the nature of its industry and agricultural activity at
each examination.
Analysis then brings us to supervisory action. About half of the
letters accompanying reports of examination are routine transmittals
containing no requests or recommendations to the banks. Another
important total requests notification that an excess loan has been
reduced to comply with law, as promised, or that steps have been
taken to avoid a recurrence of a violation of a law or regulation, which
has been disclosed, governing the bank's operation.
It is with regard to the banks below these two groups that bank
supervisors “ earn their salt” and have opportunity to make a con­
tribution to banking. The severity of a bank's problems dictates action
taken and varies with the circumstances of each situation. A noticeable
increase in classified loans would result in a transmittal letter urging
the directors to review the bank's lending policies and to take such
action as is necessary to obtain additional security for weak loans,
reductions or definite repayment programs. However, if the primary




31

asset problem was severe and there were additional problems apparent
in large lines, bond concentrations, coupled with a heavy investment
in fixed assets, the urgency to improve the lending standards would
be emphasized. Should the asset condition be determined to be un­
satisfactory, the bank would be requested to make reports at 30- or
60-day intervals on the status of important criticized loans in order
that its progress in eliminating the unsatisfactory conditions could
be reviewed, appraised and followed.
In those few situations, but which unfortunately still develop, in
which the bank’s asset quality is viewed as hazardous, the directors
are called into conference, usually convened jointly with State bank­
ing authorities, at which time definite conditions are imposed as to
steps that must be taken to assure that any unsafe and unsatisfactory
practices will be discontinued, and to restore the operation to a more
conventional and sound basis as soon as possible.
In those cases where the examination disclosed a critical situation,
by reason of serious capital impairment or otherwise, the Board of
Governors is advised as to the general condition of the bank as soon as
practical and withowt waiting for the submission of the complete
report. Discussions follow with the officers in the Division of Exam­
inations, either over the telephone or when visiting the Board’s offices,
as to the progress being made toward eliminating unsatisfactory con­
ditions and the Board is kept advised of all significant developments.
Supervisory requirements and conditions in problem bank situa­
tions are subjected to close follow-up action. Reports on disposition of
loans are required and as to the status of each weak loan, often at 30day intervals. The most effective tool available for enforcing corrective
measures is the special examination. Bankers and bank directors,
especially in the smaller towns, do not like questions from their
customers as to why the examiners are in the bank so often. Aside
from this psychological factor, this procedure is also supervision work­
ing closely with a board of directors in a mutual problem and with the
directors who have the greatest interest in seeing the condition of
the bank show improvement". However, if improvement is not forth­
coming, if speculative tendencies, bad credit judgment or other man­
agement defections and weaknesses persist, it sometimes becomes
necessary to replace, or at least strengthen, the management. If this
is not possible by suasion, supervision is then obliged to avail itself of
the provisions of Section 30 of the Banking Act of 1933 which stipulate




32

procedure for the removal of directors and officers who have continued
to violate any law relating to the bank or shall have continued unsafe
and unsound practices in conducting the business of the bank, after
formal warning.
Finally, supervision seeks to foster an effectively functioning and
solvent banking system in which the public interest is properly safe­
guarded. Eddie Cantor, long ago reminded, after reading about a
defunct financial institution, that the public is more interested in the
return of its money than the return on its money. Supervision holds
that view. It is no substitute for good bank management, but it hopes
to make some contribution to it.




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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102