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Clearing House Bank Examinations Att Address By James B. Forgan President The First National Bank of Chicago at the Fifteenth Annual Dinner of the Bankers Club of Detroit, Saturday Evening December 7, 1912 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Clearing House Bank Examinations Chicago was the pioneer in clearing house bank examinations. They were inaugurated there in 1906 after the failure of a national bank and two state banks. These institutions were under the direct management of one man who was president of the three. The condition of their affairs when disclosed sur prised and appalled the other Chicago bankers. The liabilities of the private ventures of the president had gradually accumu lated in the three banks until they had absorbed the entire capital and surplus of all three, amounting to $3,500,000, and 44% of their aggregate deposits of $27,000,000, one-third of which was public funds. The condition in the national bank had developed through a period of years during which the Comptroller of the Currency, through the semi-annual reports of his examiners, had been kept fully advised of what was going on. Among the assets were found nineteen fictitious loans for $90,000 each represented by so-called memorandum notes. Each memorandum note pur ported to be secured by $100,000 of second mortgage bonds of the Wisconsin and Michigan Railway Company. This road was controlled by the bank president, and the bonds proved worth less. The first mortgage bonds of the same road, $952,000 of which (being almost the entire issue) were also among the assets of the banks, were finally disposed of at about twentythree cents on the dollar. These memorandum notes did not, on the face of them, even pretend to be the obligations of bona fide borrowers. The ostensible signatures on them, although in different names, were all in the handwriting of the clerk who filled them out and who wrote plainly in red ink across the face of each the words “Memorandum Note.” They could not deceive anyone who saw them and they did not deceive the national bank examiners who reported to the Comptroller the facts in connection with them. Another of the irregularities discovered was that so-called certificates signed by the treasurer of one of the president’s railroads, purporting to call for $2,000,000 of its bonds when issued, had been treated and reported as bonds on hand. All the bonds permissible under the conditions of the mortgage https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 securing them had previously been issued and sold and there could be no further issue of them until a contemplated extension of the road was completed. Some grading for this extension had been done but the work was abandoned and the bonds called for by the so-called certificates were never issued. Up to the time of their failure all three banks paid substantial dividends to their shareholders, the national bank 12% regular and 3% extra and the state banks 10% and 8% respectively, besides which they showed substantial growth in their surpluses. The market quotation for their' stocks was $380, $350 and $240 per share and there were sales at these prices. Although cognizant of these irregularities and of the accumu lating obligations in the bank of the president’s private enter prises the Comptroller apparently could not or at all events did not take measures to stop them by other means than those of expostulation and reproof until matters became so bad that they simply could not be permitted to go further. When at last drastic measures were decided upon the Comp troller and the State Auditor, acting together on a Saturday afternoon after the vaults of the three banks had been closed with time locks set for Monday morning, notified our Clearing House Committee that unless provision were made for payment in full of the deposits none of the banks would be permitted to open for business on Monday morning and they would be put in the hands of receivers. Business conditions were strained and the time was therefore particularly unfavorable for permitting the failure of three prominent banks. The effects of such a calamity it was feared would have extended far beyond the confines of Chicago. With but a superficial statement from the president of the condition of his various ventures, some of which were in course of construction, and with only a vague knowledge of the realizable value of their obligations the Clearing House Com mittee hurriedly made a tentative estimate of the realizable value of the assets of the three banks and of the deficiency in them to meet their deposit liabilities. These estimates have since proved remarkably near the final outcome. To prevent a panic the remaining Chicago banks, facing an inevitable heavy loss, assumed the deposit liabilities of the three banks and took over their assets under a limited guaranty of the directors. This action besides providing for payment of the depositors in full, relieved the bondsmen of their responsibility https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 4 for the $8,200,000 of public funds in the bank and the share holders of their double liability on their stock. These three classes of vitally interested individuals will probably never fully appreciate what the action of the associated banks meant for them. Subsequent developments have shown that in liquidation the assets of the three banks plus the double liability of their shareholders, had it been collected, would have been insufficient to pay their deposit liabilities. The situation was thus protected from a general disturbance of public confidence, but it was done at the cost of a very heavy loss, foreseen at the time and since realized by the participating banks. The statements of the national bank made five times a year to the Comptroller’s department, copies of which were rendered to the Clearing House Committee and on which it had implicitly relied, failed to disclose these conditions. I have given you these details of this unfortunate affair because they show so clearly the limitations of governmental supervision of banks under our national banking law as it has been interpreted by the courts and by the legal advisers of the Comptroller’s department. Let me draw your attention to a few of the legal restrictions which limit the Comptroller’s power to act in such cases. 1. Under the National Bank Act no obligation due a bank is considered bad until interest is past due six months and not then if it is secured or in process of collection. 2. The Comptroller may appoint a receiver when he con cludes that a bank is insolvent. But here again he has been hampered by the legal definition of insolvency, which is “inability to pay current debts as they mature.” 3. The making of a national bank report to the Comptroller so long as it is in accordance with the bank’s books, however erroneous it may be as to actual values, which alone disclose a bank’s true condition, cannot be construed as a misdemeanor. These legal restrictions are presumably the reason why some banks have been permitted to persistently publish to the public the figures of their statements as rendered to the Comptroller of the Currency after they are known to have met with heavy losses and have failed to provide for them by charging them to profit and loss. That this has been permitted in some cases is notorious. The case of the Chicago National Bank and a recent one in a large central city are conspicuous examples because of https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 5 their size. Undoubtedly as a rule the published statements of the banks are reliable, but there are a few exceptions, with which, in view of the legal restrictions which govern his action, the Comptroller finds himself unable to cope. These exceptions however frequently result in failures and catastrophes. The Comptroller cannot legally take drastic measures with such banks until they perform some act of insolvency or when he believes their capitals to be impaired, which being a matter of judgment in regard to the realizable value of their assets, is frequently difficult to prove. Clearinghouses as a rule are voluntary associations established primarily for the convenience of their members in effecting their daily exchanges. In this process however the members have to trust each other for large amounts in the shape of daily balances payable in cash. Each bank member therefore becomes interested in the integrity of all and all in each. But beyond this, in view of the awful calamities caused by bank failures and of the fact that the failure of one clearing house bank affects the confidence of the community in all, they become vitally interested in the maintenance among themselves of con servative management and proper business methods. Hence, only such banks as can stand a satisfactory preliminary exam ination are admitted to membership and only those whose condition continues to be satisfactory to a duly appointed com mittee can enjoy clearing house privileges. Members and non member banks clearing through members are required to render to this committee copies of the statements they make to the Comptroller or to the State Auditor five times a year. These disclosures in connection with the failures of these three banks showed the associated banks of Chicago that state ments so rendered, which up to that time had been all the Clearing House Committee had to rely upon and which, as published, form the basis of the standing and credit of banks with the public, could not be implicitly relied upon. It was therefore unanimously resolved to adopt a system of supervision, under which there would be some assurance that such conditions could never again develop in any bank connected with the Chicago Clearing House Association. There was therefore organized a bureau of examination in connection with the Clearing House. The strength of this bureau lies in the fact that it was thus evolved by the voluntary action of the associated banks for their individual benefit and protection. We were fully aware https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 6 that external supervision under whatever authority it may be exercised does not absolutely guarantee sound and safe banking in individual cases. Honorable and intelligent initiative man agement can alone be relied on for the ultimate success of individual banks. But judicious and intelligent supervision in the mutual interest of all fosters and encourages conservative management in each. We further saw that it would not do to have the entire business of the individual banks disclosed to a committee made up of competitors in the business. We there fore devised the plan of appointing a competent examiner with a sufficient force of assistants to make as thorough an examina tion as possible of each bank at least once a year and report his findings in full detail to its directors. In this way as thorough an examination is made of each bank as would be made if the directors of their own initiative employed an outside expert to examine their banks and report to them. The examiner’s complete report of each bank is sent to its president, the directors are all notified of its existence and are asked to per sonally peruse it and to acknowledge to the examiner the receipt of his notice. If, in the course of his examination, the examiner finds any bad debts, depreciated assets or other losses unprovided for, so that at a fair valuation the assets do not offset the liabilities, including the capital, surplus and undivided profits, as shown in the balance sheet, or if he dis covers any irregularities in connection with the bookkeeping or management he reports such findings to the Clearing House Committee. The Committee does not see the examiner’s com plete report as rendered to the directors. All that is found satisfactory is so reported to the Committee without detail. If conditions are so bad aS to make it necessary the Committee has the right to call for a copy of the complete report so that it may deal intelligently with the case, but this is only when bad business so permeates the bank as to render its condition precarious. Thus, as nothing but bad and undesirable busi ness comes to the Committee’s attention, the members of it have no advantage through their position in competiton with the other banks for desirable business. Neither the examiner nor the Committee is hampered with restrictive rules and regulations. The examiner simply ex amines and reports upon the condition of each bank as he finds it the same as any other expert examiner would do if employed by the directors for the purpose. Anything affecting the integ rity of a bank’s statement as rendered under oath to the https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 7 Government and to the Clearing House and as published is report ed to the Clearing House Committee. This is the whole matter in a nutshell. We have simply established two rules applicable to all banks connected with our Clearing House Association and even these are unwritten. The first is that our statements as made and published must reveal the true conditions of our banks on the basis of their assets at a fair valuation being sufficient to offset their, liabilities including capital, surplus and undivided profits. In other words their capital, surplus and undivided profits must always be represented by the approximate value, reasonably estimated, of their assets in excess of the amount of their liabilities to the public. The second is that from an ethical standpoint the management of our banks must be honorable and straight, and their records and reports reliable. The Clearing House Committee, duly elected once a year, are with the exam iner’s reports to guide them the judges as to whether the state ments rendered to them by the banks five times a year are reasonably correct from the standpoint of these two unwritten rules. As already stated, we are not hampered with technical rules or regulations or even with legal definitions or interpret ations. We investigate and treat all on a reasonable business basis. Our Committee might find difficulty in defining a bad debt while they could recognize one if they saw it. They might regard as a bad debt an obligation on which interest had been paid six months in advance instead of having to wait until it is six months past due before they can so consider it. They regard the making and publishing of erroneous statements of a bank’s condition as morally wrong, and therefore not permissible among banks associated together for their mutual benefit and, protection, even if the making of such is not legally regarded as a misdemeanor. And they do not have to wait until a bank is actually insolvent in a legal sense before they can call it to time. A bank’s statement must, on the basis of the examiner’s report, be found reasonably accurate by the Committee or it cannot continue to enjoy clearing house privileges. As to the ability of an examiner to pick out and report on bad debts and depreciated assets he soon acquires a sufficient knowl edge of local conditions to enable him to do so with reasonable accuracy. He subscribes to the commercial agencies and has the entire banking fraternity with which to consult as to the standing of any obligor or as to the value of any security. The longer he is on the job the more information he acquires and the more proficient he becomes. Besides having been for several years https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 8 a bank inspector myself I have had considerable experience with bank auditors and examiners and my observation is that anyone of ordinary intelligence with a bank training and with adequate sources of information at his command can very soon classify a bank’s assets with reasonable accuracy. It has been my practice to divide bank assets into five classes and for convenience to name them in dairy terms such as cream, sweet milk, skim milk, sour milk and sediment. The cream con sists of such prime investments, whether in notes or bonds, as can be relied on to be paid at maturity or as can be readily sold and converted into cash. The sweet milk is that line of desirable loans made to good customers who keep satisfactory average balances and whose legitimate business requirements the banker is under obligation to consider and must consider in order to keep their business. The skim milk is represented by business which is not quite as good as it was thought to be when it was taken on and therefore requires special care and attention, although no loss on it is anticipated. The sour milk is business which has become so bad that at least partial loss can be reasonably anticipated on it which should be provided for. And the sediment is business so bad that a large per centage of loss on it is so inevitable that it can no longer be considered a legitimate or desirable bank asset and should be charged off. The cream and the sweet milk are readily recognizable, the skim milk will as a rule disclose some complications or other indications of conditions connected with it which make it undesirable as a bank asset at its face value. With these three classes segregated there are left the sour milk and the sediment. To keep a bank as sweet and clean as a model dairy these two last named classes of assets must be constantly eliminated. When discovered by the examiner they are re ported to the Clearing House Committee because if a bank’s statement is to disclose its true condition the loss on them should be provided for. There is little fear of the members of the Committee competing for such business. As to the practical working of clearing house examinations in Chicago during the six years of their existence I can only say that it has proved in every way most satisfactory and successful. There has been neither friction nor unpleasantness. Bank directors realize the great benefits derived and are unstinted in their praise of them. They are greatly assisted by these reports in keeping themselves informed on the condition of https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 9 their banks and they readily co-operate with the Clearing House Committee in the correction or elimination of anything open to criticism. Our experience has been that the banks have almost unanimously adopted every suggestion made by the Committee. I cannot of course discuss such details as would show its efficacy. I can only say that the results have been most satisfactory to all concerned and that much good has been accomplished for the Chicago banks individually and collectively. The organization being entirely voluntary partakes some what of the nature of a gentleman’s agreement, under which each bank binds itself to conduct its business under proper methods. The effectiveness of the method lies in the fact that they are all measured by the same standard, viz: that their statements as rendered to the Clearing House Association must be satisfactory to the Committee, in view of the examiner’s reports upon them, otherwise they cannot continue to enjoy clearing house privileges.' In no sense, however, does the Committee assume responsibility for the individual management of the banks or for the quality of all the loans current in them. This responsibility must always rest on the officers and directors of each bank. All the Committee undertakes is to pass judgment, based on the examiner’s report, on the reasonable integrity of each bank’s assets and the general reliability of its statement. In the fact that the members of the Committee are posted on local credits and financial affairs lies the superior efficacy of clearing house supervision. But the Committee is not omnipotent, it is only an ordinary human agency. It has no control of the initiative management of the banks under its supervision and under ordinary circumstances they are only examined once a year. The Committee fully realizes the heavy responsibility laid upon it. It has no easy problem to decide as to when or what action should be taken in connection with the condition of a badly managed bank. Conditions must become bad indeed and expostu lation must have been exhausted before any supervisory author ity, however constituted, will assume the responsibility of action that might lead to the closing of a bank’s doors. If it were otherwise and such action were taken simply because something of minor importance in the bank was considered unsatisfactory such authority would be accused of causing a solvent bank to close and would be blamed not only by its stockholders, but by its depositors in whose behalf the action would be taken. We https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 10 have had no difficulty in securing the co-operation of all our banks and it can now be relied on that no such conditions as caused us to organize our examination bureau can ever again develop in any bank connected with our clearing house. Bank supervision by examination on the part of a clearing house committee, while probably the best and the most effec tive external supervision possible, has its limitations, which should be recognized by the intelligent public, and should not be held to a degree of responsibility which it does not assume. Chicago’s lead in the inauguration of an examining bureau in connection with its Clearing House Association has been followed by Cincinnati, Cleveland, Columbus, Kansas City, (Mo.,) Los Angeles, Milwaukee, Minneapolis, St. Paul, New York, New Orleans, Nashville, Oklahoma City, Philadelphia, Portland, (Oregon,) San Francisco, St. Louis, and St. Joseph, (Mo.) Three of these cities, viz: Kansas City, Milwaukee and St. Joseph, instead of having their own examiners, employ certified public accountants to make their examinations. So far as I have learned, and I have heard from nearly all of these cities, clearing house bank examinations have proved eminently satisfactory to all the banks in them. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 11