Full text of Federal Reserve Bank of New York Circulars : The Basic Elements of Bank Supervision

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J u ly 15,

To:

1994

The Chief Executive Officers of all Member Banks and U.S.
Branches and Agencies of Foreign Banks in the Second Federal
Reserve District

I
am pleased to enclose a book of lectures titled,
Basic Elements of Bank Supervision".
The lectures were delivered
by Senior Officials of the Federal Reserve to The Academy for
Advanced Studies in Banking and Finance at Fairfield University
in July 1993, as part of the Russian-American Bankers Forum.
While the lectures were aimed at a group of Russian Bankers who
had come to the United States to study modern banking practices
in a market-oriented economy, I believe that they provide a
useful perspective on the principles of bank supervision as they
are practiced in the United States today.
Additional copies of the book can be obtained by
contacting our Public Information Department by phone at
212-720-6134, or by writing to the Federal Reserve Bank of New
York, 33 Liberty Street, New York, N.Y. 10045.
Sincerely,

Chester B. Feldberg

Enclosure




"The

THE

BASIC

E L E M E N T S

OF

BANK

S U P E R V I S I O N

E D IT E D
F R E D E R IC K

C.

BY
S C H A D R A C K

AND
LEON

FEDERAL




RESERVE

K O R O B O W

BANK

OF N E W Y O R K

THE BASIC ELEMENTS
OF BANK SUPERVISION
LECTURES DELIVERED AT

THE RUSSIAN AMERICAN BANKERS FORUM
ACADEMY FOR ADVANCED STUDY IN
BANKING AND FINANCE
AT FAIRFIELD UNIVERSITY
FAIRFIELD, CONNECTICUT
JULY 9 AND 12, 1993

EDITED BY
FREDERICK C. SCHADRACK
AND
LEON KOROBOW

FEDERAL RESERVE BANK OF NEW YORK




CONTENTS
FOREWORD......................................................................................................... i
E.

Gerald Corrigan

INTRODUCTION...................................................................................................iii
William J. McDonough
CHAPTER 1

Overview of Supervisory Elem ents..................................................................... 1
By Frederick C. Schadrack
CHAPTER 2

The Role of Deposit Insurance...........................................................................

11

By Richard Spillenkothen
CHAPTER 3

The Bank Licensing Process: Its Role in Maintaining the
Stability of the Banking System.........................................................................

19

By J. Virgil Mattingly, Jr.
CHAPTER 4

The Development and Administration of Key Prudential P olicies............. 29
By Chester B. Feldberg
CHAPTER 5

The Collection of Banking Statistics................................................................. 45
By Susan F. Moore
CHAPTER 6

Off-Site Monitoring of Banking Organizations................................................. 51
By J. Andrew Spindler
CHAPTER 7

The Bank Examination Process........................................................................... 55
By Roberta J. Puschel
CHAPTER 8

The Credit Review P ro c e s s ................................................................................. 65
By Robert A. O’Sullivan
CHAPTER 9

The Structure and Supervision of Foreign Banking Organizations
Operating in the U.S................................................................................................ 77
By Feon Korobow
CHAPTER 10

Resolving Problem Bank Situations.................................................................. 85
By Frederick C. Schadrack
CHAPTER 11

Bank Failures in a Sound E co n o m y................................................................. 93
By John P. FaWare




M

CHART INDEX
CHART 4-1

The Simple Leverage Ratio Does Not Distinguish Among
Assets Bearing Different Degrees of Risk and Does Not
Apply to Off-Balance-Sheet Item s ............................................................................... 32
CHART 4-2

Summary of Risk Weights and Examples of Assets in
Each Risk C a te g o ry ....................................................................................................... 34
CHART 4-3

Components of Risk-Based C a p ita l........................................................................... 35
CHART 4-4

Calculation of Risk-Based Assets ............................................................................. 36
CHART 4-5

Capital Categories for Prompt Corrective Action......................................................38
CHART 4-6

Heavy Loan Losses Weaken Bank A’s Loss Reserves
and E q u ity ........................................................................................................................ 40
CHART 4-7

Heavy Loan Losses and Need for Increased Loss Reserves
Put Bank A in the Significantly Under Capitalized C a te g o ry .............................. 41
CHART 5-1

Statistics Function Processing Flow........................................................................... 48
CHART 7-1

Composite Rating Summary for Banks.......................................................................58
CHART 7-2

Simplified Liquidity Analysis........................................................................................ 61
CHART 8-1

The Asset Rating System ...............................................................................................69
CHART 8-2

The Weighted Classified Assets R a tio .......................................................................71
CHART 8-3

Examiner Guidelines for Asset Quality Ratings........................................................ 72
CHART 9-1

Foreign-Held Banking Institutions and Assets in the United States
June 30, 1993.................................................................................................................. 79
CHART 9-2

Geographic Distribution of Foreign-Held Banking Assets in the
United States by Country of Foreign Holder.............................................................. 81
CHART 9-3

United States Branches and Agencies of Foreign Banks by
Federal Reserve District .............................................................................................. 82




$4

/O

FOREWORD

The lectures collected in this volume were originally prepared for delivery
at The Academy for Advanced Studies in Banking and Finance (Academy) at
Fairfield University in July 1993. The Academy was organized under the
umbrella o f the Russian-American Bankers Forum (RABF). The RABF had
been created in the spring o f 1992 at the request o f Boris Yeltsin, President of
the Russian Federation, to assist in the development o f a contemporary bank­
ing and financial system in Russia. W hile the R ABF’s initiatives produced
valuable progress on a number o f fronts, they were purposely confined to a
small number o f Russian financial institutions.
In late 1992, it was decided to broaden these efforts through the develop­
ment o f the Academy, which was designed to reach a critical mass o f Russian
banks and bankers. Thus, some 250 Russian bankers, from all sections o f the
country, came to the United States in June 1993 to participate in an eight week
program o f intensive studies in banking and finance. The Academy had sev­
eral objectives. The first objective was to give the Russian bankers the oppor­
tunity to learn and absorb the essential aspects o f banking and finance to better
equip them to perform their duties at home and to prepare them for expanded
responsibilities in their banks in the future. The second, and most important,
objective was to give these bankers a broad understanding o f the culture of
banking. The emphasis here was on understanding the special role o f banks in
the econom y and financial system and, consequently, on understanding their
special and important responsibilities as bankers.
The first five weeks o f the program were spent in residence at Fairfield Uni­
versity in Fairfield, Connecticut, where the Russian bankers studied modem
banking and financial methods under the tutelage o f experienced and talented
practitioners in these fields. Given the objectives of the program, the univer­
sity phase o f the program consisted o f two principal components. One part
covered instruction in specific disciplines, such as the fundamentals of
accounting, the basics o f credit, consumer lending, and project finance. The




i

M ioI xQ-

other part centered on subjects of broad general interest, such as monetary pol­
icy, the role o f international financial institutions, and bank supervision. The
latter was the source of the lectures presented in this book.
The Russian bankers were then divided into teams o f two people each, and
spent the final three weeks o f the program visiting one of some 116 U.S. com ­
mercial banks. The host banks ranged from giant money center institutions to
small community banks, located in thirty-nine different states. Here, the Rus­
sian bankers, with the assistance o f U.S. bankers, had the opportunity to see
and participate in the practical application of the lessons learned at Fairfield.
This phase o f the program also gave the Russian bankers the chance to see dif­
ferent parts o f the United States, and to develop friendships with American
bankers and their families. This experience was obviously beneficial to all
concerned.
Upon completing the Academy program and returning home, the Russian
bankers were expected to be agents of change, passing along to their col­
leagues the ideas and methods learned in the United States. It was expected
that their experience could help to energize Russian banks, making them not
only strong and profitable, but also capable of providing the full range o f bank­
ing services so essential to a growing and prosperous economy. Subsequent
developments, including a follow up meeting in M oscow of Academy students
and faculty last December, suggest that these expectations are beginning to be
fulfilled.

E. Gerald Corrigan

Co-Chairman, Russian-American Bankers Forum, and
Chairman, International Advisers, Goldman, Sachs & Co.
July 20, 1994

n




Prf- /O70-a^_

INTRODUCTION

The Federal Reserve System has played a key role in the work o f the
Russian-Am erican Bankers Forum (RABF) and o f the Academ y for
Advanced Studies in Banking and Finance (A cadem y).
This effort
involved not only E. Gerald Corrigan, the former President o f the Federal
R eserve Bank o f N ew York, and one o f the founders o f the RABF, but also
senior officials from the Board o f Governors o f the Federal Reserve S ys­
tem, the Federal Reserve Bank o f N ew York, and several other Reserve
Banks who have contributed materially to the R A B F’s work since it was
founded. M ost recently, officers and staff o f the Federal Reserve Bank o f
N ew York played a key role in the organization and administration o f the
Academy. In addition, they, along with senior officials from the Board o f
Governors and other Reserve Banks, served as part o f the A cadem y’s faculty.
This book consists o f a series o f lectures presented at the Academy by cur­
rent and former senior officials o f the Board o f Governors and o f the Federal
Reserve Bank o f New York. These lectures were delivered at Fairfield Univer­
sity on July 9 and 12, 1993, under the general topic o f the “Safety and Sound­
ness o f the Banking System .” Their focus is on the tools and techniques that
bank supervisors use to uncover and correct weaknesses in the banking system
and to prevent bank failure from causing broader difficulties in the financial
system. The Federal Reserve believes that effective bank supervision plays a
critically important role in the healthy evolution of market-based econom ies
and is a key central banking function in support o f soundly conceived policies
designed to promote sustainable econom ic growth.
Since its inception in 1913, the Federal Reserve has placed great emphasis
on its Congressional mandate to “establish a more effective supervision of
banking in the United States.” Experience since that time has clearly indicated
the value o f central bank involvement as a supervisor at the center o f the bank­
ing and payments systems. Time and again as crises have threatened the finan­
cial markets, the Federal Reserve has played a crucial role in resolving those




crises, minimizing damage to the financial system, while protecting public
confidence in banking.
Thus the lectures collected in this volume reflect the Federal Reserve’s com ­
mitment to bank supervision and its recognition o f the key role such supervi­
sion can play in developing and sustaining a sound banking and financial
system. Since much o f the material included here is not otherwise readily
accessible, we decided that it would be useful to make it available in book
form.
We hope that it may prove helpful to government officials who are seeking
to develop an official bank supervision capability to accompany the privatiza­
tion o f their banking system. We also hope that it will provide a useful view of
the supervisory process for those who are just entering the bank supervision
profession or who would like a better understanding o f how this process
works.

William J. McDonough

President, Federal Reserve Bank of New York
July 20, 1994

IV




CHAPTER 1

Overview of Supervisory Elements
By Frederick C. Schadrack*

Although banks are operated by their management to generate profits, and their
shareholders expect a reasonable return on their investment, it is widely recog­
nized that banks are different from other profit-seeking businesses. Because banks
play a key role in the financial system and in the national economy, there are
strong public interest considerations in their operations.
First, banks provide the principal repository for the public’s liquid funds. The
safety and ready availability of these funds for transactions and other purposes are
essential to the stability and efficiency of the financial system. Second, banks
employ these funds to make loans and investments, thereby serving to allocate
scarce savings to productive uses within the economy. In a market economy, this
process should work to channel funds to the economic sectors that can use them
most efficiently and productively. Third, banks serve as the main conduit between
the central bank and the economy for monetary policy. A strong and adaptable
banking system is needed to transmit the impulses of monetary policy without
friction and delay to the whole financial system and ultimately to the econom y at
large. Fourth, commercial banks provide the backbone o f the national payments
mechanism. A reliable and efficient payments mechanism is a necessary com po­
nent o f an advanced industrial economy. At the same time, a breakdown in the
payments mechanism can have grave and widespread consequences given the
highly interrelated nature of modem financial and business systems.
For all of these reasons, banks throughout the world are generally accorded a
higher degree o f official supervision and regulation than are other types o f busi­
nesses. At the same time, banks are also provided with important elements o f offi­
cial protection. For example, the central bank usually acts as a lender o f last resort
to protect commercial banks against a temporary liquidity drain. This protection is
The author is a financial consultant and was formerly an Executive Vice President in charge of the
Bank Supervision Group of the Federal Reserve Bank of New York.




1

The Basic Elements of Bank Supervision

an important component o f the official safety net backstopping the banking sys­
tem. Another major aspect of that safety net in the United States is the deposit
insurance fund, created by federal law in the 1930s to guarantee bank depositors
that they will get their money back in the event of a bank failure.
W hile the specifics of bank supervision vary from country to country, reflecting
each country’s unique historic development, the broad goals and purposes o f such
supervision are generally similar. First, it is important to maintain public confi­
dence in the banking system. Second, a related goal is to protect depositors’ funds
and, if a bank should fail, to minimize the losses to be absorbed by the deposit
insurance fund. Depositor protection is, of course, an important element in main­
taining confidence in the banking system and in avoiding bank “runs.” A strong,
well-managed bank is the depositor’s basic source of protection and, as just noted,
fostering the development o f such banks is one o f the fundamental goals o f bank
supervision.
Nevertheless, banks do fail for one reason or another and the U.S. deposit insur­
ance fund covers depositor losses up to $100,000 per account. In view of the sub­
stantial potential for losses to the insurance fund, it is an important supervisory
goal to minimize the fund’s loss by limiting excessive risk taking. This goal trans­
lates into prompt intervention by the bank supervisors to ensure that a bank takes
timely and effective remedial measures in emerging problem situations. Deposit
insurance is discussed in some detail in the next chapter.
A third goal of bank supervision is to foster an efficient and competitive bank­
ing system that is responsive to the public’s need for high quality financial services
at reasonable cost. Hence, the general thrust of banking law and regulation is to
encourage com petition and to prohibit monopoly and anticom petitive practices.
The fourth, and final, goal of bank supervision is to insure compliance with
banking laws and regulations. This is a very difficult assignment in the United
States because the banks are subject to such a wide range o f laws, covering every­
thing from bank capital requirements and dividend limitations to consumer pro­
tection and fair employment practices.
In seeking to achieve these objectives, the United States over the years has
developed a very complicated structure of bank supervision and regulation,
involving a number of official supervisory agencies, often with parallel and som e­
times with overlapping responsibilities.
In this regard, it should be noted that all of the chapters in this book have been
prepared by current or former senior officials of one particular supervisory
agency— the Federal Reserve System. Thus, they reflect bank supervision as it is
practiced in the Federal Reserve. At the same time it should be emphasized that
the basic supervisory techniques do not vary greatly from agency to agency, and
that the use o f these techniques as described below is not limited to the Federal
Reserve.

2




Overview of Supervisory Elements

In all supervisory agencies in the United States, bank supervisors utilize a num­
ber o f interrelated techniques to try to achieve their goals.
These techniques
range from conditions for opening new banks to procedures for dealing with fail­
ing banks. The remaining sections of this chapter will summarize these techniques
and discuss how they are related. This will serve as an introduction to the topics
that will be covered later in the book.

Licensing Banks
First is the process of licensing, or chartering, banks. In most developed coun­
tries banks must acquire a charter in order to undertake a banking business. The
situation is complicated in the United States by the fact that banks may be char­
tered not only by the federal government (the Office o f the Comptroller o f the
Currency), but also by each of the fifty states. In some countries, such as the
United States, official permission is also required to obtain a controlling interest in
an existing bank.
In the United States, the process of obtaining a charter to open a new bank
involves filing a detailed application with state authorities or the Comptroller o f
the Currency. The applicant must submit a coherent business plan demonstrating
that the new bank will be able to service the business and credit needs o f its trade
area and, in due course, be able to sustain profitable operations. The applicant
must be prepared to raise sufficient equity capital to ensure that the new bank will
be strongly capitalized and must demonstrate that the prospective management is
competent in the field of banking and is of good moral character.
The reasons for these licensing requirements vary from country to country, but
they are generally designed to keep dishonest or inexperienced individuals from
establishing or acquiring banks. In some instances they have been adopted to pre­
vent “overbanking.” In either case, licensing laws and regulations are designed to
prevent bank failures and depositor losses, thereby helping to maintain public
confidence in the banking system.
O f course, if bank chartering policies are too restrictive, seriously limiting the
establishment o f new banks, the banking system as a whole may becom e less than
fully competitive, and inefficient banks may be protected from more efficient
banks that would like to enter the market. Thus, bank chartering policy must be
carefully calibrated to encourage efficiency without at the same time engendering
instability in the banking system. Chapter 3 covers the bank licensing process.

Development of Prudential Policies
The second important supervisory technique involves the development and
administration o f key prudential policies. For example, all o f the developed coun­
tries have laws or regulations defining minimum capital ratios that must be main­
tained by their banks and liquidity ratios that must be observed, and most have




3

The Basic Elements of Bank Supervision

limits on the size of loans that may be made to any one borrower or single indus­
try group. The general thrust o f these laws and regulations is to limit imprudent
risk taking by the banks in order to prevent bank failures and deposit losses.
In the United States, long hard experience has shown that some banks, in the
hope o f generating greater profits, have a tendency to undertake more risk than is
prudent from the point of view of the public’s interest in a safe and stable banking
system. For this reason, the United States has enacted many laws and promulgated
many supervisory policies that are designed to ensure that banks are well man­
aged and to limit imprudent risk taking in all o f their lending, investment, and
trading activities. It should be added that prudential policy is not intended to
micromanage banks or eliminate all risk, but rather to ensure that bank manage­
ment has adequate control over its risk exposures.
These prudential policies must, of course, be changed and adapted over time as
the nature o f the banking business changes and as new banking activities and
practices are introduced. This poses a serious challenge to bank supervisors who
must carefully assess the risks involved in new bank activities and where appro­
priate introduce new regulations or modify existing regulations. Given the
dynamic nature of banking today— with change and innovation occurring contin­
uously— the need to review the effectiveness of prudential policies is an ongoing
responsibility for the bank supervisor.
For example, the international group o f bank supervisors that meets in Basle,
Switzerland, has after careful study proposed extending its original bank capital
requirements, which focused on credit risk, to cover the market risks involved in
banks’ securities trading activities. The development o f supervisory policies is
discussed more fully in Chapter 4.

Banking Statistics
A third important element o f bank supervision centers on the regular collection
and publication of banking statistics. In most developed countries, banks must
provide the supervisors with regular reports covering their income and expenses
and their balance sheets in a format and in the detail specified by the supervisors.
In the United States, these very detailed “Condition” and “Income” Reports
(known as the “call report”) must be filed with the supervisors quarterly by all
commercial banks, and are also made available to the public. These reports pro­
vide extensive information on the structure and maturity of a bank’s assets, liabil­
ities, and capital, as well as on its sources of revenues and expenses, and on
income and dividends. They also provide regular information on a bank’s nonper­
forming and potential problem assets. The collection o f such statistics by the bank
supervisors is described in Chapter 5.
Another important source of information is the series o f regular financial
reports that must be filed with the Securities and Exchange Commission (SEC),

4




Overview of Supervisory Elements

the agency that monitors the finances o f all companies which have sold shares to
the public. The SEC requires all publicly traded companies to provide their stock­
holders and the public with annual and quarterly reports o f their current earnings
and overall financial performance.
The public, including financial analysts, can use the information in all o f these
reports to assess the financial condition of the banks on an ongoing basis. Such
assessments are reflected in the analysts ratings o f banks’ securities and in their
recommendations to the public to buy, sell, or hold a particular bank’s stocks or
bonds.
Thus, the statistics and other information provided to the public by the banks
play an important role in bringing “market discipline” to bear on banking organi­
zations and their management. For example, if a bank reports a high level o f non­
performing loans, or excessive costs, or weak earnings it may find its stock sub­
ject to downward price pressure in the equity market and may w ell find it difficult
or im possible to raise new capital in that market.

In-House Monitoring
Bank statistics also play a pivotal role in another key technique of bank super­
vision— that is, in-house monitoring o f the banks’ financial condition by the
supervisors. It is essential for bank supervisors to track the financial condition of
their banks on a continuing basis and between on-site examinations because
increases in risk exposure and consequent losses can occur quickly in today’s
highly volatile financial markets.
A ll U. S. banks are subject to supervisory off-site monitoring. Experience dem­
onstrates that potential problem banks often can be identified early through inhouse surveillance. However, the analytical routines that are good for identifying
problem banks will sometimes identify as weak a bank that in fact is strong, or
will understate the magnitude o f a bank’s problems, or will indicate that there is a
problem without providing reliable clues as to the nature o f the problem. For those
reasons, in-house surveillance must be viewed as a complement to on-site field
examinations, not as a substitute for them.
The principal technique for monitoring the activities and financial condition o f
a bank from an outside vantage point is to make use of the detailed financial state­
ments that have already been discussed— the quarterly Condition and Income
Reports, as w ell as the SEC’s various stockholder reports. Regular meetings
between the supervisors and a bank’s senior management may also provide
important information on the bank’s current condition and plans. In addition,
when banks develop significant problems, they will be required to report addi­
tional detailed financial information to their supervisors on a quarterly, or monthly
or even on a weekly, basis.
This information flow, including the special reports provided by problem banks,




5

The Basic Elements of Bank Supervision

represents a huge body o f information that is analyzed to identify the various pat­
terns and trends that may indicate actual or impending weakness in a bank’s finan­
cial condition. The supervisory analyst works closely with the examining staff,
and if the monitoring process suggests the emergence o f serious problems, the
next scheduled on-site examination may be accelerated, or a special examination
may be immediately initiated. Chapter 6 reviews the off-site monitoring process
in some detail.

Bank Examinations
As just noted, in-house monitoring is a complement to, but not a substitute for,
on-site examinations. Indeed, the on-site examination lies at the heart o f the
supervisory process. Only through an actual presence in a bank can a supervisor
gain the detailed knowledge o f the bank’s operations, procedures, controls, and
management that is needed to reach an informed judgment about the bank’s over­
all financial condition and its compliance with banking laws and regulations.
During an on-site examination, the examiner carefully evaluates the bank’s
overall risk exposure with particular emphasis on the adequacy o f its capital,
credit risk and asset quality, the quality o f its management and internal control
procedures, the strength o f its earnings, and the adequacy o f its liquidity. In the
United States, this system o f evaluation has the acronym “CAMEL.” Banks in the
United States are usually examined at least once a year, and more frequently if
they have serious problems.
The conduct o f an on-site examination requires a significant amount o f prepara­
tion and the assignment o f an examination team comprised of individuals possess­
ing a wide range of financial skills. Once on site, the examiners will break up into
small groups to investigate specifically assigned aspects o f the bank’s condition.
The examiners in each o f the assigned areas, after careful study and review, pre­
pare their reports in the field and submit them to the examiner-in-charge who
reviews and pulls together each o f the segments into a final “Examination
Report.” The Report is then reviewed by senior supervisory personnel, after
which it is forwarded to the management and directors o f the examined bank for
such remedial action as may be necessary.
For a major money center bank, this whole examination process is very labor
intensive, requiring as many as 3,000 examiner days and over four months to
complete. And the completed Examination Report submitted to the bank may total
100 pages or more.
Any significant financial problems or violations of banking laws or regulations
that are found in the course of the examination will be highlighted and detailed in
the Examination Report. Indeed, a special Summary Report will be submitted to a
bank’s directors for signature if it has serious problems. Bank management is then
expected to act promptly to resolve any such problems or violations. This reme­
dial action will be tracked closely by the examiners and the in-house supervisory

6




Overview of Supervisory Elements

analysts until it is successfully completed. The examination process is reviewed in
Chapter 7.
However, the credit review process is such an important part o f the examination
that it is covered separately in Chapter 8. In this chapter, the procedures examiners
use to review and rate (or “classify”) individual credits on a bank’s books are fully
described. As a result of the examiner’s review, each credit is placed into one of
five possible rating categories: Pass, Special Mention, Substandard, Doubtful, and
Loss. These individual credit ratings are then fed into the bank’s asset quality
evaluation. In addition, the importance o f a bank’s formal loan policies, and the
need for a strong, independent credit review function, are stressed since they pro­
vide the foundation for the effective control o f the bank’s credit risks.

Supervision Is a Coordinated Process
The key elements o f supervision that have just been described naturally work
best when they are coordinated with one another. One o f the most basic require­
ments is ensuring that the banking industry provides sufficient information to sup­
port the ongoing analysis and monitoring of all banking organizations by the
supervisory authorities. These activities in turn help to ensure that bank examina­
tion resources are allocated where they are needed most urgently and that bank
examiners will be briefed and prepared to carry out their assignments on-site in an
efficient manner. In turn, the information obtained in on-site examinations is
important in issues that go beyond the individual bank. For example, the licensing
process, the formulation o f prudential policies, and the development o f remedial
programs all require in-depth, accurate information about the health of banks, the
condition o f the banking system, and the performance o f personnel who hold
responsible positions in the banking industry.

Supervising Foreign Banks in the United States
This subject is the only one in the book that was not covered as a lecture at the
Academy for Advanced Study in Banking and Finance at Fairfield University.
Nevertheless, it is included here, in Chapter 9, because o f the increasing impor­
tance o f foreign banks, not only in the U. S. market, but in all o f the world’s prin­
cipal banking markets. Its inclusion here thus reflects widespread interest in the
supervision of foreign banks. It is also included because it discusses the important
changes in the supervision o f foreign banks in the United States that resulted from
the Foreign Bank Supervision Enhancement Act o f 1991. O f course, the basic
techniques of supervision, as discussed elsewhere in this book, generally apply to
the U.S. operations of foreign banks as well as to those o f domestic institutions.

Resolving Problem Situations
Despite the best efforts o f the bank supervisors, banks occasionally do develop
serious problems and show up on the supervisors’ dreaded “problem bank list.”




7

The Basic Elements of Bank Supervision

Usually, serious deterioration in a bank’s financial condition can be traced to weak
management policies and poor internal controls, including inadequate supervision
o f the bank’s activities by senior management and the board o f directors.
Studies o f problem and failed banks have consistently shown that such banks
lacked well-designed policies and procedures setting limits for risk taking and
guiding bank lending staff in maintaining a sound, profitable loan portfolio. These
weaknesses often result in overly rapid growth, excessive pursuit o f loans with
risky characteristics, high loan concentrations, poor liquidity, and sometimes
fraudulent activities involving bank management.
M ost banks willingly cooperate with their supervisors in correcting any such
problems and deficiencies that may arise. In these cases, particularly where the
problems do not threaten the survival of the bank, supervisory enforcement action
can be transmitted to the bank via an informal memorandum or supervisory letter
which does not have to be disclosed to the public.
When bankers are unwilling to take the necessary corrective measures voluntar­
ily, or when a bank’s capital is inadequate, the supervisors will have to use formal
remedial measures. These measures can include the issuance o f cease and desist
orders, capital directives, and orders to suspend or remove individuals from the
bank. Such actions are enforceable in federal courts and their disregard may result
in fines and/or imprisonment. The primary goal o f such actions is the timely cor­
rection o f problems and violations before further deterioration occurs in the
bank’s financial condition.
Unfortunately, the problems o f some banks become so deep-rooted before they
are discovered that remedial supervisory measures are unsuccessful and failure
becom es inevitable. In this situation the supervisors will try to encourage the
merger o f the failing bank into a sound institution. These efforts are usually futile
because sound banks don’t want to take on a failing bank’s problems.
At this point, the deposit insurance fund may step in to facilitate the merger by
indemnifying the acquiring bank against the failing bank’s losses. Alternatively,
the fund may absorb the failing bank’s bad assets, leaving the acquiring bank with
the failing bank’s good assets and all of its deposits. When arrangements o f this
type can’t be worked out, the deposit insurer may in exceptional cases recapitalize
the bank and revamp its management. Otherwise, it will have to close the bank,
pay off its depositors, and liquidate its assets, absorbing the failed bank’s losses.
W hile the failed bank’s insured depositors are likely to com e out whole in this
situation, its stockholders will be wiped out, its management and directors may be
subject to personal financial liability, and its bondholders and uninsured deposi­
tors may well take substantial losses. The resolution o f problem bank situations is
covered more fully in Chapter 10.

8




Overview of Supervisory Elements

Causes and Consequences of Bank Failures
Of course, bank supervisors are always concerned about the possibility that
bank failures could undermine confidence in the banking system more broadly
and cause depositor “runs” on other banks. The avoidance o f such systemic prob­
lems is one o f the supervisors’ principal objectives. All o f these considerations are
brought to bear in the final chapter of this book as the causes and consequences of
the failures o f two major U. S. banking organizations— one in Chicago in 1984
and one in Boston in 1991— are reviewed. These two case histories make clear the
potential vulnerability o f banks, particularly if asset quality deteriorates, and the
need for strong and effective supervisory actions to contain their problems. They
also point up the need to take into account possible systemic consequences in
dealing with failing banks.




9

The Basic Elements of Bank Supervision

10




CHAPTER 2

The Role of Deposit Insurance
By Richard Spillenkothen

)|C

This chapter describes the principal features o f a deposit insurance system and
some of the lessons we have learned from our experience in the United States.
Deposit insurance systems are in place in many countries throughout the world
and have brought many well-recognized benefits. I would like to emphasize from
the outset, however, that I do not intend to discuss the merits o f adopting a deposit
insurance system in any particular country. That is an issue to be decided by that
country, based not only on an assessment o f the benefits and risks o f deposit insur­
ance but also on many other relevant considerations. Instead, my comments will
be more general and will focus on the basic principles o f deposit insurance, how it
works in practice, and how it affects both the banking industry and government
oversight o f that industry.

The Function of Deposit Insurance
A deposit insurance system is designed to minimize or eliminate the risk that
depositors placing funds with a bank will suffer a loss. Deposit insurance thus
offers protection to the deposits o f households and small businesses, which may
represent life savings or vital transactions balances. Deposit insurance allows
these households and businesses to “go about their business” with some assurance
that their funds are secure, which in turn supports the stability and smooth opera­
tion o f the economy.
This sense o f public assurance is important. Public concerns about the safety of
deposits— whether based on fact or only on rumor— can lead, and have led, to
damaging “bank runs” that can cause banks that are otherwise sound to fail. Sim i­
larly, concerns about one bank have at times led to concerns about others, leading
to so-called “contagion runs.” Public confidence in the safety o f bank deposits, in

The author is Director of the Division of Banking Supervision and Regulation of the Board of
Governors of the Federal Reserve System.




11

The Basic Elements of Bank Supervision

contrast, promotes the stability o f individual banking institutions. Public confi­
dence reduces the likelihood that depositors o f an individual bank will panic and
withdraw funds suddenly if concerns arise about the condition o f that bank.
Deposit insurance thus works together with the other elements o f the “safety net”
to contain certain potential threats to individual institutions or groups o f institu­
tions. In this way, deposit insurance supports econom ic stability by helping to
avert abrupt interruptions in bank liquidity and credit availability that could other­
wise result from disruptive bank runs or bank failures.
Let me emphasize that a deposit insurance system does not, and should not,
prevent all bank failures. Like any business, a bank that makes poor business deci­
sions does, and should, face the risk o f failing. This risk o f failure provides an
important discipline to any business owner, and some degree o f market discipline
is essential to the proper operation of a banking system.
Deposit insurance can be backed either by a privately run fund or by a state or
central government-backed agency. Experience has shown that, in times o f finan­
cial stress, loss of confidence by the public or depositors in the strength o f the
fund can lead to a similar loss of confidence in, and runs on, depository institu­
tions backed by the fund.
History clearly shows that bank failure can occur under circumstances that sug­
gest that depositors may be acting out o f panic and not on a thoughtful appraisal
o f the bank’s condition. Banking panics, such as occurred in this country in the
late 1800s, can be very damaging even to strong banks and certainly to the econ­
omy. Although the economy and our society have advanced a great deal since
then, it is clear that the risk o f contagion, and the value of credible deposit insur­
ance, remain very real today. In the 1980s, when it became clear that private
deposit insurance funds in Ohio and Maryland were insolvent, depositors aggres­
sively withdrew their funds from institutions insured by these funds and caused
some institutions to fail.
On balance, the presence o f a deposit insurance system has had an unmistak­
able and positive effect on the rate of bank failures in the United States. The
United States Federal Deposit Insurance Corporation was established in 1933,
during the Great Depression, after a massive and damaging series o f depositor
runs contributed to the failure o f some 9,000 banks between 1930 and 1933. Since
the adoption o f deposit insurance, the number o f bank failures has been greatly
reduced, and in those cases depositors have received the protection intended under
the plan. More important, bank runs and fear o f “contagion runs” have been con­
tained, supporting the stability of the financial system.
In order to achieve the full benefit o f public confidence, o f course, it is impor­
tant that depositors understand the terms, conditions, and limitations of the
deposit insurance system. Generally, deposit insurance systems place a limit on
the total amount of each deposit that is to be guaranteed. The degree o f coverage
is an important policy decision and will be discussed at greater length later in the

12




The Role of Deposit Insurance

chapter. There may be a certain maximum insured deposit amount, or some per­
centage o f loss that would be covered, or both. In addition, deposit insurance is
not designed to protect against other types o f risk faced by depositors, such as ero­
sion in the buying power o f deposits due to inflation; price indexation o f deposit
balances is an entirely different matter and is beyond the scope of this chapter.

Deposit Insurance in Practice
From a global point o f view, deposit insurance provides many benefits and,
over the long term, appears to be an essential component o f a viable modem bank­
ing system. Some form o f deposit insurance system exists in most major devel­
oped countries, attesting to these benefits. There are some circumstances, of
course, under which the merits o f a deposit insurance system may be less clear. In
some countries with a tradition of government ownership of banks, for example,
public confidence may be linked to that ownership and the presence o f insurance
may offer little additional benefit. Alternatively, in those countries with very few
banks, a bank experiencing problems would be supported by the others and would
typically be considered too important to the economy for the supervisory authori­
ties to allow it to fail. For both reasons, a deposit insurance system might offer
only a minor incremental benefit.
Where deposit insurance systems exist, the basic elements are similar. More­
over, the similarities have grown in recent decades as events have caused some
large countries to develop more formal arrangements for depositor protection than
previously had been in place. Flowever, these insurance systems still vary in many
important details. Thus, the deposit insurance fund is administered by the national
government in the United States, Britain, Canada and, to some extent, in Japan.
On the other hand, the fund is administered by the industry in Germany, France,
and Italy. Deposit insurance systems also differ in other ways, including the level
o f coverage and the manner in which deposit insurance is funded.
Outside o f the United States, deposit insurance systems have rarely been called
upon to make good on obligations for a failed bank. There are notable exceptions,
such as the failure o f the Bankhaus Herrstatt in Germany in 1974. Still, the United
States appears to be the exception rather than the rule. To some extent, this may be
an accident o f history, reflecting the larger number o f banks in the United States or
the trend toward consolidation within the industry. There are also important dif­
ferences in the willingness o f countries to permit market forces to cause a bank to
fail, as well as many other ways in which the structure o f the banking systems dif­
fer among countries.

Deposit Insurance and Supervision
Providing the benefits o f deposit insurance requires that the deposit insurance
system— generally backed directly or indirectly by the government— guarantee
insured deposits in the case o f bank failure. Since this guarantee can expose the




13

The Basic Elements of Bank Supervision

government to loss, deposit insurance programs have increased the need for gov­
ernments to supervise banks. At its most basic, supervision entails an assessment
o f the financial condition o f banks as well as their operating practices and con­
trols, and the establishment of minimum required levels o f owner investment or
capital. Our experience in the United States has shown that simply monitoring
financial statements is not sufficient to assess the condition o f the bank. In partic­
ular, supervisors need to know about the strength o f internal procedures and
underwriting standards. Reports from internal or external auditors are a valuable
assessment tool, but in the United States we have found no adequate substitute for
on-site examinations.
On-site examinations and other review procedures are thus essential to assess­
ing financial conditions and management practices at each bank. Specific tech­
niques for the supervisory evaluation o f banks are discussed in other chapters of
this volume, so that only a synopsis will be offered here. In the United States, we
use a supervisory rating system that is summarized in the acronym “CAM EL,”
which represents the key elements of a bank’s financial and operating condition:
Capital adequacy, Asset quality, Management skill, Earnings strength, and
Liquidity.
The CAMEL system reflects our approach to the general problem of how to
supervise banks and is an effort to structure, rather than limit, the scope o f an
examination. In addition to developing the formal rating score under CAMEL,
supervisory authorities review the bank’s policies and procedures in great detail.
Whether evaluated under CAMEL or any other system, the principal areas of
supervisory concern are basically the same:

• Credit risk, that is, the risk that the bank will not be able to collect
funds it has advanced to others,

• Liquidity risk, that is, the risk that the bank will be unable to make
payment on an obligation when it comes due because it cannot raise
the funds,

• Market risk, or the risk that the market value o f assets will deteriorate,
• Operational risk, or the risk that the normal operations of the bank may
generate significant losses,
• Finally, adequate documentation and financial reports are required to
meet the information needs of examiners, bank customers, and the public.

Balancing Supervision and Market Forces
Under any circumstances, there is some need for government supervision of
banks to assure that they properly perform their critical functions in the economy,
and that need is greater when a deposit insurance system is in place. Even so, it is

14




The Role of Deposit Insurance

important to recognize the limitations o f bank supervision and to take account of
the market incentives (or disciplines) that already exist in the form o f oversight by
stockholders and reactions by creditors o f banks to encourage proper management
actions.
Supervisory authorities should be careful not to blunt these market-based incen­
tives. M ost important, supervision (and the deposit insurance system) should not
prevent bank owners and managers from suffering losses when a bank fails; insur­
ance should protect only the depositor and, under specific circumstances, other
bank creditors. Owners and management will thus have much at stake if the bank
fails. Members o f the bank’s management stand to lose their livelihood, and bank
owners or shareholders stand to lose all of their investment, if the bank fails.
In any case, the supervision required by deposit insurance— and the deposit
insurance system itself— does not come without a cost. Some o f that cost is
incurred through more rigorous bank supervision, which is needed in part because
o f the government’s exposure through the insurance guarantee. Other costs are
incurred as banks actually fail. The principal and most obvious outlay is the cost
to compensate insured depositors when a bank fails. Depositors may be com pen­
sated directly for their loss up to the insurance maximum, or the deposit insurance
fund may subsidize the purchase o f the failed bank by another bank that then
assumes the full deposit liabilities of the failed bank. In the United States, the
costs o f failures have at times been large; a large number o f U.S. savings and loan
institutions failed in the 1980s at a cost to the American taxpayer o f well over
$100 billion.
A second and more subtle cost arises from changing behavior on the part o f
depositors. Specifically, because their funds are guaranteed, depositors become
unconcerned about the safety of their bank (that is, they w on’t do their own
“credit analysis”). In this situation the insurance enables a risky bank to retain
access to funds and continue to grow even as its condition worsens. That growth,
in turn, can increase the eventual losses to the insurance fund or public. With con­
tinued funding, banks that become desperate may be inclined to decide explicitly
to take high risks in order to increase earnings substantially. Banks may take risks
in such circumstances, for example, by speculating on the direction o f interest
rates or on high-risk ventures.
All o f these factors make the supervisory process more important. In addition,
there may be a tendency for the extent o f insurance coverage to expand over time.
Coverage may expand through increases in maximum coverage per account; this
occurred in the United States in the early 1980s, when maximum coverage per
account was increased from $40,000 to $100,000. In addition, expanded coverage
may occur through the introduction of new market instruments designed to maxi­
mize coverage, such as brokered deposits. There may be very legitimate reasons
to expand coverage at any point; however, the greater the tendency to extend pro­




15

The Basic Elements of Bank Supervision

tection to all deposit balances, the greater the likelihood o f these adverse conse­
quences. However, coverage at too low a level can just as clearly dilute the
benefits of deposit insurance.
In setting the maximum coverage, as in other aspects of administering a deposit
insurance system, a nation’s policy on deposit insurance must achieve a proper
balance between allowing the market to function and government efforts on eco­
nomic stabilization. Different countries will find that balance at different points.
For example, there are considerable differences in the maximum level o f deposit
insurance coverage for an individual depositor. The maximum coverage is rela­
tively low in Britain (75 percent o f the first $30,000), while much higher in Ger­
many (one-third of the bank’s capital) and the United States ($100,000 per
account per bank, to a maximum o f four accounts per bank).

The Central Role of Management and Capital Adequacy
Another critical element o f a balanced approach to deposit insurance is that the
responsibility for the safe and prudent operation o f an individual institution
should rest principally with its owners and management. To reinforce this respon­
sibility, as I mentioned earlier, the supervisory authority should ensure that own­
ers have a substantial investment in the bank (that is, that the bank is well
capitalized) and that there are adequate reserves against future loan losses. These
resources allow a bank to absorb unexpected losses without failing, and thereby
avoid exposing the deposit insurance fund to losses.
Having a substantial investment at risk, the owners and management o f a bank
may be less inclined to take excessive risks. Government-imposed capital stan­
dards are aimed at requiring banks to hold sufficient capital. As a critical element
o f assuring capital adequacy, and to minimize market distortions, capital stan­
dards should approximate the level o f capital that market discipline would require
if there were no deposit insurance. In this way, standards for capital adequacy pro­
vide supervisory protection while achieving the benefits o f a market-based sys­
tem, that is, efficient allocation o f resources, competitiveness, healthy innovation,
and stability.
In general, such capital standards have historically required banks to increase
their capital positions. Stronger capitalization has brought many benefits, princi­
pally a more resilient banking system. More capital can even enhance a bank’s
profitability, since it will be perceived as reducing the risk to other creditors and
thus may enable the bank to borrow at lower rates of interest. For both com peti­
tive purposes and to guard against systemic risks, however, capital standards for
internationally active banks should be comparable, if not uniform, worldwide.

16




The Role of Deposit Insurance

Conclusion
Deposit insurance has been tested by time and has brought great benefits to
many countries. History suggests that it has helped to protect depositor savings,
promote the stability of individual banking institutions, contain bank runs, and
generally provide for a stronger and more responsive banking system. For a
deposit insurance system to be successful, however, depositors must have confi­
dence that the insurer will meet its obligations, and the guarantee must be pru­
dently structured in order to avoid creating improper incentives for banks.
Operating an effective deposit insurance program requires active and thorough
oversight by the appropriate supervisory authority and an adequate level o f owner
capital. Both aspects of supervision should seek to assure that management has a
strong interest in operating the bank in safe and efficient manner.




17

The Basic Elements of Bank Supervision

18




CHAPTER 3

The Bank Licensing Process:
Its Role in Maintaining the Stability
of the Banking System
By J. Virgil Mattingly, Jr. *

I
will first discuss the importance o f the bank licensing process in maintaining a
stable and efficient banking system. Then I will outline the procedures used in the
United States to obtain a bank license.

Purpose of the Licensing Process
Banks are, at one level, merely corporations like manufacturing or retailing
firms. However, they are subject to much more extensive regulation in the United
States because, unlike most commercial firms, the failure of a bank affects more
than the fortunes o f its shareholders and creditors. A bank failure deprives the
local econom y o f a source o f credit and can adversely affect the whole country in
the form o f deposit insurance costs and a destabilized economy. We have seen
these adverse effects in the United States over the last several years as large num­
bers o f bank failures have caused significant losses to the deposit insurance funds
and credit unavailability.
Banks fail for a variety o f reasons, including insider fraud and mismanagement.
Irreparable damage to a bank can occur quickly as a result o f these developments,
so supervisory authorities cannot always detect and correct improper activities
before the bank is beyond salvation. In order to minimize the occurrence o f such
failures, the bank licensing process in the United States attempts to prevent desta­
bilizing factors (such as inadequate financial resources, unqualified management,
or excessive competition) from entering the banking system in the first place.

The author is the General Counsel of the Board of Governors of the Federal Reserve System.




19

The Basic Elements of Bank Supervision

Although the licensing process cannot guarantee that a bank will be well run after
it opens, it has proven to be an effective method for reducing the number o f unsta­
ble institutions that enter the banking system.
The United States learned a hard lesson about the need for a stringent bank
licensing procedure from our experiment with laissez-faire bank licensing in the
m id-1800s, known as the “free banking” era. During this period, the individual
states were the only bank licensing authorities; the federal government was not
involved in licensing banks.
Under most o f the “free banking” statutes, standards for new charters were
relaxed considerably and legal barriers to entry into banking were low. Unlike our
current licensing regime, a potential banker or group o f bankers in a “free bank­
ing” state did not have to convince any government authority that a bank was
needed at a particular location or that they were competent to run it. In many
states, access to bank charters became almost automatic; if a group o f individuals
was able to post the threshold amount of capital required by statute, they were
generally granted a charter.
Unfortunately, many o f the people who took advantage o f these statutes did not
have the qualifications we require for bankers today. Speculators were attracted to
the banking industry in the hopes o f quick profit. Typically, they were unwilling to
commit more than a minimal amount o f their own money to the new banking ven­
tures and operated the institutions without sufficient financial resources to support
the banks when economic downturns occurred. The absence o f a regulatory
licensing process allowed these unqualified individuals into the banking system.
The “free bank” systems were not generally successful and bank failures were
widespread. For example, in Michigan, nearly all the banks set up under the free
banking law o f 1837 were in liquidation within a year and the law was repealed
within two years. Even in N ew York, which had one o f the more conservative and
well-administered free banking systems, twenty-nine o f the free banks had failed
within five years of the passage of the free banking statute, and individuals who
entrusted their funds to the banks were returned only 74 cents on the dollar.
The “free banking” era ended in the United States in 1863 with the enactment
o f the National Bank Act. However, we must not forget these lessons from history.
In the 1970s, application standards were relaxed and a large number of bank
licenses were issued. As a consequence, we saw numerous bank failures in the
1980s.

Current Bank Licensing in the United States
N ow I will discuss the current bank licensing process in the United States. In
this country, a group must receive a license, called a “charter,” from a government
authority before it can open a bank. The United States has a “dual banking sys­

20




The Bank Licensing Process: Its Role in Maintaining the Stability of the Banking System

tem,” which means charters can be obtained from either o f two sources: the fed­
eral government, through the Office of the Comptroller o f the Currency (OCC)
under the National Bank Act (for national banks), or one o f the individual state
governments, under its banking law (for state banks). Both types o f banks have
basically the same banking powers. In addition to a charter, banks also usually
apply for and obtain federal deposit insurance coverage from the Federal Deposit
Insurance Corporation (FDIC). In reviewing an application for deposit insurance,
the FDIC generally applies the same factors applied by the chartering agency for a
bank license.
Along with the authority to engage in banking, a bank charter also imposes
broad new responsibilities on the institution and its management. Because the
banking system is an important factor in the country’s econom ic stability and
growth, banking in the United States is a highly regulated industry with a complex
system o f laws that govern all facets o f its operations and expansion. The bank
licensing process is the first step in the supervisory scheme. By obtaining a char­
ter, the bank and its management also become subject to the extensive supervisory
powers o f the bank’s regulators. As will be discussed elsewhere in this program,
these supervisory powers cover a wide spectrum, including removal o f the bank’s
management and revocation o f a bank’s charter.

Phases of the Process
The bank licensing process in the United States generally consists o f three
phases:

1. An informal pre-filing stage (where staff o f the chartering authority
meet with the organizing group to discuss the requirements for
obtaining a bank charter, the licensing process, and the feasibility
o f the proposal),
2. The application stage (where the organizing group submits a formal
application to the licensing authority and receives preliminary
approval to organize a bank), and
3. The organizing stage (where the organizing group implements its
preliminary approval by hiring the remainder o f its management,
establishing its banking premises at the proposed site, raising its
capital, developing its banking systems and procedures, and finally,
receiving its charter to open for business).
O f these stages, the application stage is the core o f the bank licensing process.
Now, I would like to discuss some o f the factors the chartering authorities con­
sider when evaluating a charter application and the types of information they
require in order to make a decision on an application.




21

The Basic Elements of Bank Supervision

Factors Evaluated by the Chartering Authorities
In evaluating a charter application, the chartering authority generally considers
four factors:
1. The bank’s prospects for future earnings (i.e., whether it will be
successful and profitable),
2. The qualifications o f the bank’s proposed management,
3. The adequacy of the bank’s capital structure, and
4. The convenience and needs of the community to be served by
the bank.
Regulators attempt to ensure that these factors are covered by requiring an
organizing group to submit as part of the charter application:
• An operating plan,
• Personal and financial information on the proposed management
for background investigations,
• Pro forma financial statements and projections for the proposed
bank, and
• Information on the demand for banking products and services and
existing competition in the proposed market.
It is important to keep in mind that evaluation o f an application is not a
mechanical process. Rather, the decision to grant or deny a charter to a new bank
is based on a combination o f the above factors considered unique to each individ­
ual application. A group’s deficiencies under one factor may be compensated by
strengths in one or more o f the other factors. For example, a chartering authority
may be more willing to charter a bank to conduct business in a relatively risky
environment if it has especially strong and experienced management. If apparent
deficiencies are not compensated adequately by strengths in other areas, the char­
tering authority may deny the application.
I
will explain in a little more detail how the chartering authorities commonly
make judgments on these factors.

Future Earnings Prospects: the Operating Plan
First, we should look at the new bank’s prospects for future earnings. The char­
tering authority will evaluate the chances of a proposed bank’s success in the tar­
geted market based primarily on an “operating plan” submitted by the organizing
group. The operating plan is basically the organizing group’s outline o f its overall
strategy for succeeding in the market. It explains to the regulator what activities
they will engage in, how they will be conducted, and the resources available to the
group that will give their plan a reasonable possibility of success. A poorly con­

22




The Bank Licensing Process: Its Role in Maintaining the Stability of the Banking System

ceived and developed operating plan will result in disapproval o f the application.
The operating plan must describe the market area from which the bank expects to
draw the majority o f its business and the types o f banking products used in that
area. The market area is commonly a local economic unit and may be centered
around a political subdivision, such as a town or city. It is important that the oper­
ating plan contain a realistic market area. In past cases, the OCC has denied appli­
cations because it determined that the operating plans described market areas
larger than the area from which a new bank is normally able to draw business.
The operating plan should describe the market in terms o f econom ic character­
istics, such as its size, average household income, and industry and housing pat­
terns. The OCC has denied applications because the operating plan did not
adequately address economic factors which would have an effect on the growth
and success o f the proposed bank, such as a high level o f unemployment.
Second, the plan must analyze the competition in the market. The chartering
agency will not allow additional competitors into a market that cannot support
them because such competition can cause excessive bank failures. Therefore, the
operating plan should describe the competition currently in the market and
whether there is room in the market for another competitor. In addition, the oper­
ating plan should consider whether institutions outside the market could reason­
ably be expected to enter the market in the foreseeable future. In describing the
competition, the plan should give more than just bare statistics, such as assets,
deposits, and number of branches. It also should analyze the strengths and weak­
nesses o f the institutions in the market and make a judgment as to whether they
will be significant competitors of the new bank in the particular product markets
that the latter will enter.
Finally and most importantly, the plan must explain the business strategies the
proposed bank will follow to capture a share of each product market and the pro­
jected results. This final section puts the other pieces o f the plan together and
explains how the new bank’s resources will be used to fill, on a profitable basis, an
existing demand in the market.
The chartering agency evaluates whether the operating plan, and the assump­
tions on which it is based, accurately reflects, and is tailored to, the realities o f the
target market. For example, on some occasions the OCC has questioned the accu­
racy o f an operating plan when the new bank’s projected performance varied dra­
matically from the performance of other banks currently in the market area. In
such instances, the operating plan must explain why the organizers expect their
bank to outperform the other banks in the market.
Operating plans from experienced organizing groups applying for a bank char­
ter in an area with a strong, growing local economy and weak competition are
usually reviewed only to determine if they present a reasonable strategy for suc­
cess. If the market analysis is reasonable and the strategy is clear and within the
reach o f an average bank, no further analysis normally is needed.




23

The Basic Elements of Bank Supervision

Operating plans for areas where the economy is weak, or the competition is
strong, will require a more intensive review by the chartering authority. Experi­
ence shows that when econom ic conditions in a market deteriorate, the number of
charter applications filed with the chartering authorities declines and the percent­
age o f applications that the agencies deny usually rises. It is generally the policy
o f the chartering authorities to promote competition in the banking industry. H ow ­
ever, an agency will grant a charter to a proposed bank only if the operating plan
is able to convince the agency that the organizers and proposed management have
seriously considered the problems inherent in opening a new bank and have com e
up with realistic solutions to these problems

Qualified Management
The second factor the chartering agency evaluates is the qualifications o f the
organizers and the proposed management of the new bank. “Management” for this
purpose includes the proposed directors, executive officers, and principal share­
holders. The chartering agency will consider several qualifications, including each
individual’s banking experience, other business experience, and financial
resources. However, above all else, the agency must be convinced that the pro­
posed management o f the bank is comprised o f people o f integrity and responsi­
bility.
The chartering authority will conduct background investigations o f the organiz­
ers, directors, executive officers, and controlling shareholders. If the investiga­
tions reveal information that indicates a particular individual is unsuited for a
position o f trust, the agency may require the organizing group to find a suitable
replacement or may deny the charter application. As part o f these background
investigations, the regulator may contact federal and state law enforcement, tax
and regulatory authorities to uncover past illegal or unethical conduct by any
member o f the organizing group or proposed management.
Credit checks may also be performed on all organizers and proposed manage­
ment. Personal wealth is not a prerequisite to being an organizer or a director, but
the results o f the credit check must show that the individual has shown a sense o f
financial responsibility in the past. For example, the OCC has denied a charter
application in part because five o f the twelve organizers had been involved with
loans that were classified or charged off at another institution. The OCC viewed
these facts as casting doubt on the financial integrity o f these individuals.
In addition to the general character and integrity o f the proposed management,
the chartering agency evaluates whether the officers and directors have the appro­
priate experience to operate the proposed bank in a safe and sound manner so that
the bank will have a reasonable likelihood o f success. A majority of the proposed
directors should have banking or business experience. Organizing groups whose
previous banking experience is tied to failed or problem financial institutions will
be closely scrutinized and generally will result in denial absent extenuating cir­

24




The Bank Licensing Process: Its Role in Maintaining the Stability of the Banking System

cumstances. Over and above the basic requirements for the proposed manage­
ment, the chartering agency usually views the proposed chief executive officer as
one o f the most important elements in a new bank’s chance o f success. The fol­
lowing are some general characteristics that the chartering authorities look for
when evaluating a potential CEO:
• He or she must possess skills that complement the directors’ skills and
fit the needs o f the new bank (i.e., be able to compensate for weaknesses
in the rest o f the management team),
• He or she must be thoroughly familiar with the operating plan,
• He or she should have managed a bank or similar financial institution
successfully or have had successful experience as an officer in an area
relevant to the proposed bank’s marketing strategy and needs,
• He or she should have executive experience in banking operations or
administration, and
• His or her character and integrity must be above reproach.
If the chartering agency discovers that the CEO is unqualified in any way to
operate a bank, it may require the organizing group to select a suitable replace­
ment or it may disapprove the application altogether.

Capital Adequacy
The third factor the chartering agency evaluates is the capital adequacy o f the
new bank. Organizers are expected to raise a minimum level o f capital in addition
to all organizational expenses. For example, the initial capital for national banks
normally should be in excess o f $1,000,000, net of any organizational expenses.
However, the level o f capital also must be sufficient to support the projected vol­
ume and type o f business planned. Factors that the chartering authority considers
in determining the adequacy o f capital include:
• The new bank’s earning prospects,
• Economic and competitive conditions in the community to be served by
the new bank,
• The experience and competence o f the new bank’s management,
• The risks inherent in the expected asset and liability mix o f the new
bank,
• The amount o f fixed asset investment in the new bank, and
• M ost importantly, the dependability o f plans to raise, or the ability of
directors to supply, additional capital when needed after the new bank
opens for business.
The more risk involved in any o f these issues, the more likely it is that the char­




25

The Basic Elements of Bank Supervision

tering agency will require the organizing group to raise additional capital.
The organizing group will be required to submit pro forma financial statements
to support its capital proposal. The pro formas must be based on reasonable
assumptions for raising capital, both at start-up and for subsequent growth. The
organizing group must also be able to justify the amount o f proposed capital based
on market factors, the bank’s proposed strategies, and anticipated expenses. A
high level o f capital is also important to ensure the proposed management’s finan­
cial commitment to the success of the new bank. Regulators have found that a
bank’s management is more likely to conduct the affairs o f the bank in a prudent
manner if their own funds are at risk. As illustrated by the recent problems with
thrift institutions in this country, the absence of an adequate financial stake by
management in a financial institution can have disastrous consequences.

Community Convenience and Needs
The fourth factor the chartering agency considers is whether the proposed bank
meets a need in the community it will serve and will, therefore, have the support
o f the community. Local community support is important to the long-term success
o f a bank because of the need for reliable “core” deposits to fund the bank’s oper­
ations. Therefore, the organizing group must usually demonstrate that it has a
strategy for attracting and maintaining community support for the new bank. The
organizing group must evaluate the community’s needs as part o f the operating
plan and demonstrate that the services to be offered will be responsive to those
needs, will be convenient to customers, can be provided by the bank profitably,
and will be consistent with the safe and sound operation o f the bank. Widespread
shareholding in the local community can demonstrate probable community sup­
port for the bank. For example, the OCC has revoked a new bank’s preliminary
approval because the organizing group was unable to raise the capital assumed in
its operating plan and the OCC viewed this as an indication that the bank lacked
the community and investor support that is a basic test for the success o f de novo
banks.
The organizing group also is usually required to publish a notice in a newspaper
o f general circulation in the community it will serve when it files its charter appli­
cation. The newspaper notice usually must include the names of the organizers
and the fact that the group intends to establish a new bank at the selected location.
For a period o f time (usually thirty days) from the date of the notice, any inter­
ested member o f the public may submit comments to the chartering agency sup­
porting or opposing the application or requesting a public hearing to discuss the
application. The agency can use these comments to gauge the public support for
the proposed bank and its management.

26




The Bank Licensing Process: Its Role in Maintaining the Stability of the Banking System

Summary
The bank licensing process in the United States is the first step in maintaining
the stability o f this country’s banking system by preventing banks with potentially
destabilizing weaknesses, such as unqualified management or insufficient capital,
from entering the system in the first place. Thereafter, annual examinations and
close supervision over expansion into new markets and activities are utilized to
ensure the bank’s continued stability and profitable service to the community.




27

The Basic Elements of Bank Supervision

28




CHAPTER 4

The Developm ent and Adm inistration
of Key Prudential Policies
By Chester B. Feldberg*

My assignment is to discuss with you our approach to prudential supervision.
But to understand why we have extensive prudential regulations governing the
business o f banking in the United States, it is helpful to understand a little about
our turbulent banking history.
The first U.S. bank was chartered back in 1781. Many more followed in the
early days o f the United States as the nation struggled to make the transition from
an agricultural society to a commercial and industrial nation. Enormous amounts
o f capital were needed to support economic development. Many new banks—
chartered by individual states— sprang up to meet these needs. And the growth o f
the U.S. econom y and o f the banking industry in these early days was vigorous.
At the same time, banking was largely unregulated, leading some historians o f the
period to characterize the banking practices o f the day as “wildcat banking”— or
in other words “anything goes.” There were frequent financial panics and bank
failures, with losses to depositors and business firms and frequent disruptions o f
business and econom ic activity.
The high instability in banking became widely recognized as a major obstacle
to econom ic progress and by the middle o f the nineteenth century led to the first
major piece o f banking legislation at the federal level. This legislation provided
for federal chartering, regulation, and examination o f a new class o f banks, called
“national banks.”
Since that time, the bank regulatory structure o f the United States has evolved
through a steady stream o f major legislative initiatives. The most recent legisla­
tive initiative is the Federal Deposit Insurance Corporation Improvement Act o f
1991, which I will refer to later and about which you will be hearing more today.
* The author is an Executive Vice President in charge of the Bank Supervision Group of the Federal
Reserve Bank of New York.




29

The Basic Elements of Bank Supervision

I should point out that much o f the prudential legislation over the years was in
one way or another responsive to the spread of overly risky, unsound, or fraudu­
lent banking practices. Such practices included weak and ineffective management,
fraud, insider dealing, excessive risk taking, and otherwise poor banking prac­
tices.
Historically, we have seen a tendency for at least some banks to underestimate
or even ignore the risks they take— often in pursuit o f overly rapid growth. This
tendency is most evident during periods of buoyant econom ic activity, which can
lead to an atmosphere of overoptimism. There can be a tendency at such times for
banks:
• To price their products with insufficient allowance for an adequate risk
premium,
• To pursue marginal loan business too aggressively,
• To becom e too illiquid by acquiring an excessive volume of long-term
assets,
• To concentrate too heavily in particular assets or activities,
• To provide too thin a cushion of capital and loss reserves to protect
against inevitable errors in credit judgement or a downturn in econom ic
activity, and finally,
• To operate with inadequate internal controls, especially in engaging in
new financial activities or in offering new financial products.
It is important to keep in mind that prudential regulations are not intended to
encourage supervisors to manage the banks under their jurisdiction. That has tra­
ditionally been the job o f bank management and the bank’s board of directors, and
must continue to be if we are to maintain our free enterprise system. Prudential
regulations are intended instead to play a supportive role; they are designed to
assure that our banks are operated safely and soundly and in a manner that serves
the credit needs o f their communities.
Prudential regulations cover a broad spectrum of banking activities and play an
important part in assuring the effectiveness o f our supervisory process. There are
five key areas where we have implemented extensive prudential policies. These
are: Capital Adequacy, Loan Loss Reserves, Asset Concentrations, Liquidity,
and Risk Management and Internal Controls. I will focus the balance o f my
remarks on our prudential policies in each of these five critical areas.

Capital Adequacy
Capital is first on our list and, to my mind, should always be at the top of any
good bank supervisor’s list. The most basic form o f capital is equity capital,
which is the stockholders’ financial interest or net worth. Equity capital serves

30




The Development and Administration of Key Prudential Policies

several purposes: it provides a permanent source o f funding for the bank, it is
available to cushion losses, it provides a base for further growth o f the bank, and it
constitutes the stockholders’ stake in ensuring that the bank is soundly managed.
All new banks, whether chartered by the federal government or by individual
state governments, must have a minimum amount of paid-in equity capital to
com mence operations. In addition, the Federal Reserve requires that relatively
new banks maintain a substantially higher capital ratio than required for banks
that have established themselves over time as viable and profitable institutions.
In the United States, the development o f workable supervisory standards for
capital adequacy has been a long, evolutionary process. For many years, the bank
regulatory agencies did not have explicit power to enforce capital regulations and
for practical reasons enforcement o f capital guidelines had to be pursued indi­
rectly, largely through the applications process. Thus, banks wishing to merge, or
otherwise expand their operations, would not be permitted to do so unless the reg­
ulators determined that their capital was adequate to support the expansion.
Finally, in 1983, a new law directed the federal bank regulatory agencies to
establish specific minimum levels o f capital for most of our banking institutions.
In implementing this legislation, the standard was set at a uniform 5 1/2 percent of
total assets on the balance sheet. I should emphasize that there was no magic in
this number; it simply reflected the best guess at the time as to the maximum
amount that a bank should leverage its capital.
However, it soon became apparent that our capital standard was deficient in two
important ways:
First, it failed to distinguish between assets having different degrees o f credit
risk (such as between relatively high-risk commercial loans and relatively risk­
free U. S. Government securities). As a result, the banks had no real incentive to
hold low-yield, low-risk, highly liquid assets.
Second, the simple leverage ratio was based only on the balance sheet assets
and did not take into account a bank’s off-balance-sheet operations, which— par­
ticularly for the larger banks— involved a significant and growing risk exposure.
As you can see in Chart 4-1, two hypothetical banks, Bank A and Bank B, each
have the same amount o f total assets ($200 million) and under our simple leverage
ratio each would have been required to hold a minimum o f 5 1/2 percent of total
assets (or $11 million) in the form of equity capital.
However, as you can also see, the riskiness of Bank B ’s activities is consider­
ably greater than that o f Bank A’s because o f its significantly larger volume of
higher-risk commercial loans ($138 million vs. $68 million) and its substantial
amount o f off-balance-sheet activities in the form o f standby letters o f credit and
foreign exchange contracts.
I should point out that interest in linking capital requirements more closely to
the actual risks being taken by a bank’s management was not just a growing con-




31

CHART 4-1

The Simple Leverage Ratio Does Not Distinguish Among Assets Bearing
Different Degrees of Risk and Does Not Apply to Off-Balance-Sheet Items
Bank A
Assets____________
Cash:

$17

(* in millions)

Deposits:

Assets__________________Liabilities + Equity

$154

$17

Deposits:

$154

Market Borrowings:

U.S. Gov’t
Sec.:

30

State and
Local Gov’t
Sec.:

10

Home Mortgages:

10

30

25

Market Borrowings:

State and
Local Gov’t
Sec.:

Home Mortgages: 25
Commercial
Loans net of loss
reserves:

68

(Loss Reserves:

Subordinated
Debt:

30

5

2)




Cash:

60

U.S. Gov’t
Sec.:

Total:

Bank B

Liabilities + Equity

200

Equity
Capital:

11

Commercial
Loans net of loss
reserves:
138
(Loss Reserves:

Total:

200

Equity
Capital:

5

11

2)
Total:

200

Off-Balance-Sheet Items: 600

Standby Letters
of Credit:
200

Total:

Off-Balance-Sheet Items: 0

I
Leverage Ratio = 11 = 5.5%
200

Subordinated
Debt:

200

5.5%
Leverage Ratio = 11 —
200

Foreign Exchange
Contracts Over
One Year’s
Maturity:
400

The Development and Administration of Key Prudential Policies

cem in the United States in the mid-1980s. This issue was also under consider­
ation in several other major countries. Moreover, there was growing interest in
establishing common international capital adequacy standards, since absent such
common standards, banks from countries with relatively low capital requirements
had a significant competitive advantage in the global marketplace. These issues
were discussed extensively by the G-10 central banks under the sponsorship o f the
Bank for International Settlements (BIS); and in 1988 the present risk-based capi­
tal standard was agreed on internationally.
As you can see in Chart 4-2, the risk-based standard defines four classes of
assets according to their relative credit risk and assigns weights o f zero, 20 per­
cent, 50 percent and 100 percent, with the higher-risk assets (such as commercial
loans) weighted at 100 percent and the lowest risk assets (such as cash or Govern­
ment securities) weighted at zero.
Under the new standard, the credit risks related to off-balance-sheet transac­
tions, such as standby letters of credit, loan commitments, interest-rate swaps and
foreign exchange contracts, are also factored into these risk classes. The resulting
aggregate risk-weighted assets can then be compared to actual bank capital to
determine if a bank’s capital is adequate in relation to the risks being taken.
The BIS agreement defined two types of capital, which can be seen on Chart 4-3.
The first is Tier I capital— the bank’s core capital— which is comprised o f perma­
nent equity capital and retained earnings and must equal at least 4 percent of total
risk-based assets. And the second is Tier II capital, which is comprised o f several
types o f less permanent funds— such as subordinated debt capital, convertible
debt securities, and a limited portion o f the reserves the bank must set aside to
cover expected future loan losses. Under the BIS rules, Tier I plus Tier II capital
must equal at least 8 percent o f total risk-based assets, with Tier II contributing
not more than 50 percent o f the total.
Since each o f the agreeing countries has some discretion in applying the BIS
standard, the United States has chosen to retain— at least for a while— a separate
leverage requirement, under which Tier 1 capital must be at least 4 percent o f total
balance sheet assets. The primary purpose o f the leverage standard is to limit the
amount o f interest rate risk a bank might become subject to as a result of heavily
leveraged purchases o f riskless assets, such as U.S. Government securities, which
do not require any capital support under the risk-based rules.
You can see the workings o f the risk-based capital approach in Chart 4-4. You
will recall that Banks A and B both had simple leverage ratios o f 5.5 percent. If
we apply the BIS risk-based standard to both banks, Bank A has a 12.7 percent
Tier I ratio and a 7.1 percent Tier II ratio, while Bank B, in contrast, has only a 3.1
percent Tier I ratio and a 2.0 percent Tier II ratio. Bank A meets the minimum
risk-based requirements o f 4 percent Tier I, and 8 percent Tier I and Tier II com-




33

OJ




CHART 4-2

Summary of Risk Weights and Examples of Assets
in Each Risk Category
Category 1: Zero Percent Weight

•

Cash, U.S. Government securities

Category 2: 20 Percent Weight

•
•
•

Cash items in the process of collection
General obligation bonds of state and local governments
Securities of U.S. Government-sponsored agencies

Category 3: 50 Percent Weight

•
•

Loans secured by 1 to 4 family residential property
Industrial bonds of state and local governments

Category 4: 100 Percent Weight

•
•

Unsecured commercial loans
Industrial development bonds




CHART 4-3

Components of Risk-Based Capital

Tier 1
•
•

Common equity (including retained earnings)
Noncumulative perpetual preferred stock

Tier 2
•
•
•
•

Subordinated debt
Limited life preferred stock
Convertible debt securities
Loan loss reserves

CHART 4-4

Calculation of Risk-Based Assets
($ in millions)

Bank A
$75

Cash and U.S. Gov’t Sec.:

X

0.00 =

Bank B
$42

X

0.00 =

0.0

State and Local
Gov’t. Sec.:

10

X

.20 =

2.0

10

X

.50 =

5.0

0.0

Cash and U.S. Gov’t Sec.:

State and Local
Gov’t. Sec.:

30

X

.20 =

6.0

Home Mortgages:

25

X

.50 =

12.5

Home Mortgages:

Commercial Loans (net):

68

X

1.00 =

68.0

Commercial Loans (net):

138

X

1.00 =

138.0

86.5

Standby Letters of Credit:

200

X

1.00 =

200.0

400 x .05

X

.50 =

10.0

Total Risk-Based Assets:

Foreign Exchange
Contracts Over
One Year’s
Maturity:
Total Risk-Based
Assets:

355.0

=11 =
86.5

12.7%

Tier I Ratio =

Tier II Ratio* = 6.1 =
S53

7.1%

i ter jl Katie) — / — z.u /o
i
355

Tier I Ratio

Total Tier I + II

= 19.8%

Total Tier I + H

* Loan loss reserves included cannot exceed 1-1/4 percent of risk-based assets.




11 = 3.1%
355

= 5.1%

The Development and Administration of Key Prudential Policies

bined, with a lot to spare, but Bank B is well below the minima, largely because of
its relatively high volume of commercial loans and its sizable off-balance-sheet
risks.
It is important to bear in mind that the current international risk-based approach
to capital adequacy deals primarily with credit risk. In the United States, our capi­
tal standard currently is in the process o f being amended to take specific account
o f interest rate risk and certain other market risks. This issue is also under active
review by the BIS Bank Supervisors Committee, and further changes in the inter­
national standard are almost certain.
Before leaving the subject o f capital, I should note that the risk-based capital
standard now plays a central role in our supervision of banks in the United States,
under a program called “Prompt Corrective Action”— which was mandated by the
legislation I mentioned earlier— the Federal Deposit Insurance Corporation
Improvement Act of 1991. The capital standard is effectively the triggering mech­
anism for increasingly severe supervisory action in the event a bank slips below
the minimum required level o f capital.
Under the prompt corrective action guidelines— which are listed on Chart 4-5—
Bank A qualifies as a well-capitalized bank because its total risk-based ratio, that
is, Tier I plus Tier II, exceeds 10 percent, Tier I exceeds 6 percent, and the Tier I
leverage ratio exceeds 5 percent.
In contrast, Bank B is significantly undercapitalized because its total risk-based
ratio is under 6 percent. In these circumstances, Bank B will be subject to supervi­
sory action in the form o f a capital directive which will prohibit the payment of
cash dividends and could involve a wide range o f supervisory actions. For exam ­
ple, under the law, Bank B would have to submit a plan to restore its capital to a
more appropriate level and, in the interim, would also have to comply with a vari­
ety o f supervisory restrictions on the growth of its assets, the opening o f new
offices or the expansion into new businesses.
In addition, the authorities, if deemed necessary, can place further restrictions
on such things as the salaries of senior officers. If conditions are bad enough, they
can even require the sale or termination o f particular activities, the dismissal of
directors or senior officers, or force a merger o f the bank with another institution.
O f course, the thrust o f our supervision is to catch problems early enough to
prevent material slippages o f capital and to work with bank management to rem­
edy identified weaknesses in a cooperative manner. You will hear more later in the
day about this subject also.

Loan Loss Reserves
Let me turn now to our prudential policies regarding loan loss reserves, which
tie in closely to capital. Loan loss reserves arise as a result o f deductions taken




37

oo

CHART 4-5

Capital Categories for Prompt Corrective Action
( in percent)

Total RiskBased Ratio

Tier 1 RiskBased Ratio

Tier 1
Leverage Ratio

Well Capitalized

10 or above &

6 or above &

5 or above

Adequately Capitalized

8 or above &

4 or ab ove &

4 or above

Under Capitalized

Under 8 or

U nder 4 or

Under 4

Significantly
Under Capitalized

U nder 6 or

Under 3 or

Capital Directive/Other

Under 3

Critically
Under Capitalized




Ratio o f tangible
equity to total
assets o f 2
or under

Not subject to
a capital directive

Subject to
capital directives
and other
discretionary
supervisory action

The Development and Administration of Key Prudential Policies

from a bank’s income; the theory is that the reserves will be available to absorb
losses that, based on experience, are likely to be embedded in the bank’s current
loan portfolio. They are a form o f capital which is not included in core capital, but
can be included in Tier II capital to a limited extent.
The reason for the special treatment o f loss reserves is that these funds play an
especially important role in ensuring that the bank is taking account regularly—
through deductions from current earnings— o f future losses that are statistically
predictable on the basis o f its past experience. With proper loss reserving, the
bank’s reported net income should be a reasonably accurate indication o f the
bank’s basic earning power; that is, the bank’s earnings represent a return to
equity capital net o f likely losses. In contrast, absent adequate loss reserving, a
bank’s earnings are likely to be overstated and could mislead both stockholders
and the market as to the bank’s underlying financial strength.
Because of the importance of maintaining adequate loss reserves, our examin­
ers require that banks have a sound methodology for determining their reserves,
based on their own historic loss experience. The examiners will also evaluate the
adequacy o f that reserve based on our own studies of likely losses given the nature
o f the bank’s problem assets. If our examiners find the loss reserves insufficient,
they will insist on increased deductions from current income or if necessary
directly from equity capital to bring the reserves up to an appropriate level.
I realize that this is a fairly complicated subject. So let me try to give you an
example o f how the reserving process works and how it can affect a bank’s capital
position and capital ratios. Let’s go back to Chart 4-1 for a moment and look at
Bank A again. You will note that Bank A had loan loss reserves o f $2 million,
equity capital o f $11 million, and a leverage ratio of 5.5 percent.
Let’s now assume that our examiners conduct a new examination o f Bank A
and determine that the bank has $4 million in uncollectible loans that should be
written off its books. As you can see in Chart 4-6, the write-off o f $4 million of
assets reduces Bank A’s loan loss reserves from $2 million to zero, and also
reduces equity capital by $2 million. The effect of this is to reduce Bank A’s lever­
age ratio from 5.5 percent to 4.5 percent.
Now, lets go one step further and assume the examiners also determine that
Bank A’s method o f establishing its loss reserves is inadequate. To remedy the sit­
uation, the examiners direct Bank A to establish a new loan loss reserve o f $4 m il­
lion. As you can see in Chart 4-7, this action effectively reduces Bank A’s capital
further to $5 million and lowers Bank A’s leverage ratio to only 2.6 percent. N eed­
less to say, the reduction in Bank A’s equity capital from $11 million to $5 million
will also significantly lower the bank’s risk-based capital ratios. The bottom line is
that Bank A, which had looked just fine on Chart 4-1, now has a leverage ratio of
under 3 percent; like Bank B, it, too, is significantly undercapitalized and it, too,
will be subject to a capital directive!




39

CHART 4-6

-&
•
o

Heavy Loan Losses Weaken Bank A’s Loss Reserves and Equity
($ in millions)

Bank A
Assets
Cash:

Liabilities + Equity
$17

Deposits:

$154

U .S . G ov’t Sec.:

60

Market Borrowings:

30

State and Local G ov’t Sec.:

30

Subordinated Debt:

5

Home Mortages:

25

Commercial Loans:
(Loss Reserves:

66
0

Equity Capital:

9

(-2)
(-2)

Total:
Total:




198

4.5%

198

(-2)

CHART 4-7

Heavy Loan Losses and Need for Increased Loss Reserves Put Bank A in
the Significantly Under Capitalized Category
($ in millions)

Bank A

Assets
$17

Cash:
U. S. G ov’t Sec.:

60

State and Local G ov’t Sec.:

25

Commercial Loans:
(Loss Reserves:

62
4

$154
30

30

Home Mortages:

Deposits:

Liabilities + Equity

Market Borrowings:

Subordinated Debt:

Equity Capital:
(+4)

Total:
194

Total:

Leverage Ratio =




5 = 2.6%
194

5

)

194

(-4)

The Basic Elements of Bank Supervision

Asset Concentrations
Let me now turn to another favorite subject o f bank supervisors, and that is the
risks associated with asset concentrations. In one form or another, asset concentra­
tions have been at the heart o f most significant bank failures in the United States
for a very long time. E xcessive concentration o f credit risk has long been recog­
nized in U.S. banking law through a statutory limit on loans to individual borrow­
ers, which is currently set at 15 percent of bank capital. However, concentrations
o f risk can take many other less obvious forms. Let me cite four examples.
First, loan concentrations can occur by industry, as evidenced by the problems
we have seen in recent years in the energy, agriculture, shipping and commercial
real estate sectors. Second, concentrations can arise by geographic region, as we
saw a while ago in the U.S. Midwest, where there is a large concentration of
heavy industry, and in certain parts o f our Southwest region which is heavily
dependent on the energy sector. Third, concentrations can occur as a result of
risks common to a particular type of borrower. The financial and econom ic diffi­
culties shared by many less developed debtor nations over the past several years is
a clear case in point. And, finally, I would note that concentrations can also result
from a common vulnerability to future external events. A good example o f this
latter type o f potential concentration was the explosive growth we saw in lever­
aged buyouts, and other types o f highly leveraged financing in the 1980s.
Many U.S. banks have experienced one or more o f these four types o f concen­
trations in recent years. And, as I noted, most o f our bank failures have been
related either directly or indirectly to these types of concentrations. When we
detect rising levels of a potentially troublesome concentration, we will focus bank
management’s attention on it. Our experience with highly leveraged transactions
(HLTs) is a good case in point.
We identified a potential for concentration problems in the mid-1980s when
banks were just beginning to make significant amounts o f such loans. Our concern
was that all highly leveraged borrowers— by virtue o f their heavy debt servicing
burden— share common risk characteristics and a common vulnerability under
adverse market and economic conditions. Initially, we requested those banks with
rapidly expanding HLT portfolios to set realistic limits on the aggregate amount of
such transactions, given their common risk exposure; when the banks set limits
that we felt were still too high, we asked that they be lowered further. These
actions had the intended effect of putting a brake on the growth o f this type of
lending, although it did take some time to persuade the banks to modify their
expansionary instincts.
Looking forward, we continue to evaluate ways to detect potential new types of
asset concentration that could at some future point become a threat to our banks.
This is a difficult problem and banks themselves have not been able to find an
easy way to identify potential future areas of concentration risk. The 1991 federal

42




The Development and Administration of Key Prudential Policies

legislation that I referred to earlier requires, among many other things, that the
bank regulatory agencies devise a way to incorporate concentration risk in the
risk-based capital standard, and we are hard at work attempting to develop a prac­
tical method to do so. It has not been an easy task.

Liquidity
Adequate liquidity is the next key area o f prudential policy on my list. Clearly,
it is fundamental to sound banking— and to public confidence in the banking sys­
tem as a whole— that banks be in a position to honor their obligations to deposi­
tors as they fall due. Banks can, of course, undermine their liquidity position by
allowing the maturity profile o f their assets and liabilities to becom e excessively
mismatched. Thus, it is critical that banks and their supervisors closely monitor
the extent o f their maturity mismatching and that they have well thought out con­
tingency plans for covering unanticipated deposit outflows in times o f financial
stress. The very important subject o f liquidity is discussed further in Chapter 7.

Risk Management and Internal Controls
Finally, let me turn to the last prudential policy area on my list— that is, risk
management and internal controls. Strong risk management systems and effective
internal controls are among the most important defenses a bank can have against
mismanagement, fraud, and ultimately, failure. Accordingly, we expect a bank’s
management to have the following:
•

Clearly established policies defining the bank’s tolerance for different
types o f risk,

•

Effective management information systems and internal control
procedures to monitor and limit those risks, and

•

A strong, independent audit staff to assure that bank policies and
procedures are adhered to strictly.

In Chapters 7 and 8 there is further discussion o f how our examiners test the ade­
quacy o f a bank’s risk management systems and internal controls in the course of
their annual examinations.
In concluding, I would like to emphasize a point I made earlier— that prudential
regulations generally are intended to create a proper environment for banks in
which risks can be controlled and managed profitably. It is clearly not our intent to
eliminate risk entirely, for that would not serve the public’s interest in having a
banking system that is responsive to the credit needs of a growing economy.
Bank regulators must strike a careful balance between the requirements o f pru­
dential regulations and the legitimate prerogatives of bank management. This is
not an easy task, nor one that can be managed without sound experience and con­




43

The Basic Elements of Bank Supervision

sidered, deliberate judgements by the supervisor, reinforced by open and ongoing
discussions with bank management.
Regulators must also balance the importance o f safety and soundness versus the
need for banks to be responsive to the credit needs of the communities they serve
and to assume a reasonable degree o f risk. Regulators face a difficult balancing
act. Today, for example, with many people believing that there is a shortage of
credit available in the United States, bank regulators are being pressed to ease
some o f our prudential rules to encourage banks to lend more actively, particularly
to small business firms. W hile we are sympathetic to the needs that underlie these
requests, we are also mindful that we don’t want to be sowing the seeds for the
next banking crisis somewhere down the road.
The point I would like to leave with you is that the administration o f prudential
regulations is an evolutionary process; it requires a substantial amount o f judg­
ment, patience, and good sense o f what is in the best interests o f the econom y and
the nation— both over the short run and over the long haul.

44




CHAPTER 5

The Collection of Banking Statistics
9|C

By Susan F. Moore

I’m going to review with you the process o f collecting and processing statistics
on the activities o f banking organizations and, importantly, how we make sure
those statistics are accurate.
In order for the Federal Reserve to adequately do its job o f overseeing and
supervising banks— that is to ensure the financial health o f the banking system
and o f the institutions that it regulates— it is essential that the Federal Reserve do
several things. Among them are:
First, to send examiners into the banks on a periodic basis to look carefully at
their operations, records, and controls; and
Second, to have access to statistical reports that show the banks’ activities on a
more frequent basis so they can keep track o f what’s going on between these on­
site visits.
In order to accomplish the second task, the Federal Reserve (and other regula­
tors) have adopted a number o f reports that banking organizations must prepare
and submit. These reports are designed to capture different aspects o f the organi­
zations’ business and are collected on varying frequencies, although once each
calendar quarter is the most typical.
As you have heard, our banking system is composed o f a variety o f different
organizational structures. Different agencies have the primary regulatory respon­
sibility for different types o f banking organizations. The Federal Reserve is the
principal supervisor of state-chartered commercial banks who are members o f the
Federal Reserve System, bank holding companies (BHCs), and Edge Act and
Agreement Corporations. It also has jurisdiction over the U.S. offices o f foreign
banks. There are four other primary federal regulators: the Office o f the Comptrol­
ler o f the Currency, the Office o f Thrift Supervision, the Federal Deposit Insur­
ance Corporation and the National Credit Union Administration. Each o f these
agencies collects similar reports for the institutions they supervise.

* The author is a Vice President in the Statistics Function of the Federal Reserve Bank of New York.




45

The Basic Elements of Bank Supervision

To give you an idea of how many institutions w e’re talking about that must file
some statistical reports with their regulator, there are just over 28,000 depository
institutions in the United States: 11,500 commercial banks, 2,600 savings banks
and savings and loan associations, 13,600 credit unions, and 600 agencies and
branches o f foreign banks. In addition there are about 6,000 BHCs regulated by
the Federal Reserve.
There are some twenty-five different regulatory reports that the Fed collects
from the institutions it supervises. However, every institution does not file every
report. Which reports they are required to submit depends upon: (1) the organiza­
tional structure o f the institution (for example, whether it is a BHC or a commer­
cial bank), and (2) the size o f the organization. In general, the larger the institution
and the more varied its activities, the more reports it must file. And, those reports
are more frequent and contain more detail than those required o f smaller institu­
tions.
For example, a large bank holding company with foreign as well as domestic
subsidiaries— for whom the Fed is the regulator— will have to file some twelve or
more different reports each year— capturing data for different organizational lev­
els within the holding company. The more subsidiaries the holding company has,
the more reports it must file. By way o f contrast, a small BHC which has only
domestic activities and perhaps owns only one or two banks may only need to file
four different reports. Similarly, there are a series of reports that commercial
banks and other types o f depository institutions must submit, and I’m going to
walk you through an example o f the processing o f one o f the most important of
these, the so-called “call report,” which consists o f detailed condition and income
statements. But first, I want to comment on some characteristics that the most
important o f the supervisory reports share.
• M ost supervisory reports include a balance sheet and income statement
that provide information on the overall financial condition o f the institu­
tion in one comprehensive set of tables.
• More detailed information on specific items on the balance sheet is then
provided in a series o f supporting schedules— for example, deposits are
broken out by type o f owner, such as individuals and corporations, or
U.S. Government, or commercial banks, etc. Loans are also categorized
by type and purpose, such as secured by real estate or commercial and
industrial, and securities are reported by type of issuer.
• In addition to the more traditional banking activities that are represented
on the balance sheet, banks also engage in other types o f activities that
are not directly reflected on the balance sheet because the financial
impact o f such activities is not certain. Foreign currency and interest
rate options or letters of credit that the borrower may never utilize are
examples. Nevertheless, these activities can have a substantial impact
46




The Collection of Banking Statistics

on the institution’s financial health in the future and so, as supervisors,
we need to be able to track the volume o f such off-balance-sheet activi­
ties over time. Additional schedules are used to capture these statistics.
• Separate schedules are also required for specific information needed to
verify the institution’s compliance with regulatory requirements, such as
assessments for deposit insurance and capital adequacy as defined by
the internationally agreed-upon standards put forth by the Bank for
International Settlements.
Before I take you through an example o f how we process a single call report, I
can illustrate how much importance the Federal Reserve puts on the need for
detailed and accurate statistical information by showing you how many people are
devoted to this activity. In the New York Reserve Bank, there are some 135 people
working full time on statistical reports— o f these, about forty are devoted to the
regulatory reports I’ve been referring to; the others are working on reports
designed to assist the monetary policy aspect o f the Fed’s work. For the Federal
Reserve System as a whole— that is, all twelve district banks plus the Board of
Governors in Washington— the number o f people allocated to all statistical pro­
cessing is on the order o f 625, with an estimated 200 o f those for regulatory
reports. Thus, this statistical collection is considered to be an essential ingredient
in both the Fed’s supervisory and monetary policy work.
N ow I want to take you through the actual process o f collecting, compiling, and
ensuring that the data are as correct as possible for a typical supervisory report—
the call report which is filed by virtually all institutions with their regulator. This
report contains a summary balance sheet and income statement with a whole vari­
ety o f additional schedules that provide more detailed information on particular
items as I mentioned earlier. The report is filed once each calendar quarter as of
the last business day of March, June, September, and December.
The process as a w hole is shown in Chart 5-1. It begins when we send a set
o f forms and instructions to all banks whom we regulate approxim ately three
to five days before the end o f the quarter together with a letter highlighting
any changes that might have been made since the last report. The reports are
due back to the Reserve Bank thirty days after the quarter-end report dates.
And as the chart shows there are several different ways the banks can get the
com pleted call report to us:
1. They can transfer a file electronically from a personal computer
through a commercial data processing provider to the
Federal Reserve,
2. They can use the regular postal service, or
3. They can hand deliver the reports to the Reserve Bank or use some
special messenger service.




47

The Basic Elements of Bank Supervision




CHART 5-1

Statistics Function Processing Flow

The Collection of Banking Statistics

W hile some reports can be sent to us by facsimile machine, this method is not
acceptable for the call report. Because it is very important to the supervisors at the
Federal Reserve that these reports be submitted on time, we monitor the receipt o f
the data carefully and can impose monetary fines on banks whose data are late.
Next, the data have to be entered into our computer system. That happens either
directly if the banks sent the data electronically as a computer file or we manually
key in the data. Every Reserve Bank uses the same computer software or program
to process the data.
N ow I will turn to what I consider to be the most important part o f our work:
that is to be sure that the data are as accurate as possible. To compare what we do
to a manufacturing process, we are in the quality control business. The computer
system assists us in this work by performing what we refer to as “edits” on the
data. These edits are of two basic types.
(1) Validity edits which generally mean that the numbers do not add right so
something must be wrong— either the bank sent in some wrong numbers or possi­
bly we miskeyed some numbers. These edits are performed first and our staff has
to fix the errors by proofreading their keying and/or by calling the bank to get cor­
rected data.
Another source o f a validity edit is if the same item appears on the balance
sheet as well as one of the supporting schedules, that number must be the same in
both places or there is an error.
(2) The next set of edits are called quality edits and these typically consist of
comparing the values for an item between this reporting period and the last period.
If the change between the periods exceeds a certain amount— either in dollars or
percentages— the computer program will mark that item to bring it to the analysts’
attention. They will then normally call the bank to find out why the item changed
so much. If there is a good explanation for it— that is, an explanation that makes
sense from both a business and a reporting perspective— that explanation is noted
and the number left as is. Not infrequently, however, such a question will result in
the bank finding it had made an error and it will then give us “revised” data.
There are other types o f quality edits as well as period-to-period comparisons.
For example, the same data item may appear on completely different reports filed
by an institution, and if we find a difference in the reported values, again we will
contact the bank to get an explanation or a revision. This editing process is, in my
view, clearly the most important part of our work— and where our staff spend
most o f their time— because this is how we try to make sure the data that the
supervisors will look at is as correct as possible. And to do this part of the job
properly requires staff who are knowledgeable about financial market conditions,
products, and innovations. Consequently, we hire only college graduates to do this
work— it is not just a repetitive, clerical kind of process.
The next step is to transmit the data via computer to the Board of Governors




49

The Basic Elements of Bank Supervision

where it is combined on a nationwide data base with comparable statistics from
the other eleven Reserve Banks. As I said earlier, the banks have to get the reports
to us thirty days after the quarter-end. We then have twenty-five days to complete
all the editing and verification o f the data and send it to the Board for use by the
supervisors. The data are also available to the examiners in each Reserve Bank as
soon as w e receive the report from the institution, but we prefer they don’t rely on
those reports until we have had a chance to check them for correctness.
Finally, in addition to the data themselves, we also provide the supervisory staff
with business explanations for large fluctuations in the numbers. In this way, we
provide qualitative information to the supervisors about financial developments
that can assist them in assessing what’s going on in the individual banks and the
banking industry in general. In the next chapter there will be a full discussion of
how the supervisors use these data.

50




CHAPTER 6

Off-Site Monitoring of
Banking Organizations
By J. Andrew Spindler*

Off-site surveillance is one of the key techniques of bank supervision. The topic
o f surveillance is closely related to the preceding discussion on regulatory report­
ing, because surveillance relies heavily on the data that banks submit in their reg­
ulatory reports.
Let me begin, however, by outlining the three key objectives o f off-site surveil­
lance. The first is to identify banking institutions that, while currently basically
healthy, may face problems in the short to medium term. Through forward-look­
ing surveillance techniques, the supervisor can address problems before they
become critical or unmanageable. Surveillance is particularly important in the
United States, where on-site examinations are generally spaced apart by about a
year, and the potential for problems to develop and expand between bank exam i­
nations is great.
The second major objective is to monitor very closely banking institutions
already identified as having significant problems. This improves the supervisor’s
ability to prevent existing problems from growing. It also provides the supervisor
with the information necessary, on a continual basis, to help the institution work
through its problems (or to resolve the situation through a sale or closure).
The third objective is to assess broader patterns and trends in the banking sec­
tor. It is particularly important for bank supervisors to be cognizant o f nationwide
econom ic trends in order to be able to develop policy positions that are both rele­
vant and beneficial.
To conduct surveillance work effectively, we rely on a number o f sources of
information. Our primary information sources are financial statements and reports
The author is Managing Director of the Financial Services Volunteer Corps and formerly was a
Senior Vice President in charge of the Banking Studies and Analysis Function and Payments Sys­
tem Studies Staff of the Federal Reserve Bank of New York.




51

The Basic Elements of Bank Supervision

prepared by the banks. The most important of these, for surveillance purposes, are
the bank regulatory reports, and in particular the bank call report. Another vital
source o f information for the surveillance analyst is information obtained from
field examiners. Examiners sometimes uncover issues during the course o f an
examination that are then passed along to surveillance staff to explore more in
depth.
We also maintain direct contact with the institutions themselves in order to stay
abreast o f their activities. This is done principally through meetings with manage­
ment on a regular basis to discuss performance. On occasion, our analysts may
also obtain information from contacts at the institutions who alert us to develop­
ments that may be o f supervisory concern.
We also utilize other reports, such as monetary policy reports submitted to the
Federal Reserve that include, for example, weekly reports o f condition for the
largest banks in the country. Surveillance analysts also scrutinize banks’ quarterly
and annual reports that are issued under the auspices o f the Securities and
Exchange Commission.
Finally, the surveillance analysts review secondary market information to learn
more about developments at the banks. Analyzing market data, such as stock price
movements relative to a peer index, or debt instrument yield spreads over an index
(e.g., spreads over U.S. Treasury securities), can provide extremely beneficial
insights as to how the markets view the performance and condition o f an organi­
zation. Other important sources of secondary information include reports and
assessments by debt and equity analysts employed by banks and investment
banks, and analyses and ratings by the rating agencies.
Assimilating all o f these data and producing coherent analyses require the right
kinds o f tools to assist analysts in their monitoring efforts. In the Federal Reserve,
we use several such tools. These include the Uniform Bank Performance Report
(UBPR), which is a computer-generated, quarterly report that manipulates the
financial information contained in the call report and presents the data in a format
that allows the in-house analyst to assess the bank’s condition. (Versions o f this
report are available to the public.) The UBPR provides detailed financial ratios
about four key areas o f a bank’s financial condition. “Acceptable” ratios for these
measures vary among types o f banks and among banks from different countries.
These ratios are:
• Capital adequacy measures, including risk-based capital and leverage
ratios,
• Asset quality indicators, such as the ratio of past due loans to total loans
or concentration measures (e.g., the ratio of real estate loans to total
loans),

52




Off-Site Monitoring of Banking Organizations

• Earnings measures, such as income-to-total-assets and income-to-equity
ratios, and
• Liquidity measures such as the deposit-to-loan ratio.
The UBPR contains historical financial information that allows the analyst to
ascertain trends in a bank’s performance over time. The UBPR also compares the
bank’s ratios with those o f its peers nationwide, giving the analyst a sense o f the
bank’s relative performance compared to similar banks. (Peer groups are deter­
mined principally by size o f the institution.) Finally, the UBPR also provides bal­
ance sheet and income statement highlights.
Another type o f tool we use involves electronic screens that highlight outlier
banks. The principal screen we use is a computer-based statistical model called
the SEER model (System to Estimate Examination Ratings), which attempts to
estimate a bank’s composite examination rating based on the most current infor­
mation available from regulatory reports and past examinations. The model high­
lights those institutions that appear to have suffered the most significant
deterioration in financial condition.
We also have more specific screens that focus on certain sectors or activities to
identify outliers. For example, real estate screens show banks’ concentrations in
different sectors o f the real estate markets, which have been depressed for the past
several years. Another example is insider loan screens, which measure the level of
a bank’s loans to affiliated persons (e.g., bank officers) relative to the bank’s total
loans. A high ratio may be indicative o f unsafe practices and, possibly, regulatory
violations.
Other tools we use include analytic tables, which were developed by analysts to
pull together information on small groups o f highly visible banks from regulatory
reports, bank press releases, stock price results, examination findings, and rating
agency publications. These tables provide a different focus than that of the UBPR
for a select group o f banks. We have also developed various market tables that, for
example, show changes in bank stock prices over time and compare movements in
bank stock prices among peers and relative to market indices.
Let me now turn to the role of the in-house analysts. The surveillance staff
reviews and analyzes the information produced through the available tools and
sources described above to determine which banks appear most likely to have
serious problems. This analysis is critical because some institutions that appear to
have problems based on the screen results, for example, may, upon further investi­
gation, not be considered problems. On the other hand, analysts may determine
that an institution is problematic even if at first glance it does not appear to exhibit
signs o f weakness. A second responsibility o f the in-house monitoring staff is to




53

The Basic Elements of Bank Supervision

identify and report to senior management on broad trends and patterns in the
banking sector.
Third, in-house analysts must coordinate closely with the examinations staff.
In-house staff notifies examiners immediately o f banks that appear to be poten­
tially problematic, so that appropriate follow-up action can be taken. Thus, con­
tact between in-house surveillance staff and field examiners is close and ongoing.
Based on the information received from the analysts, the examiners may choose to
accelerate the next scheduled on-site examination or to initiate immediately a spe­
cial examination focusing on the problem area(s) identified through the surveil­
lance process.
For banks that are identified as having problems, the in-house staff initiates a
special monitoring program. This program includes keeping a close watch on the
performance and condition o f problem institutions through increased reporting
and frequent meetings. It also involves developing comprehensive plans to help
banks work through their problems. Finally, the in-house staff must work closely
with field examiners to ensure that banks comply with those plans.
In conclusion, in-house monitoring is a vital part o f the overall supervisory pro­
cess. It requires analytical expertise to interpret large amounts o f raw data that
may not be informative by themselves. In-house monitoring provides a necessary
complement to on-site examinations by enabling supervisors to track the condi­
tion o f institutions on a continual basis in today’s volatile markets. It also allows
supervisors to focus efforts on problem banks without detracting from ongoing
examinations responsibilities.
Aside from information on individual institutions, in-house analysis presents
the supervisor with a broader perspective on issues and trends in the banking sec­
tor. This perspective is critical for developing rational bank regulatory policies
and for identifying emerging problems in the banking sector that may have
adverse systemic consequences.

54




CHAPTER 7

The Bank Examination Process
By Roberta J. Puschel*

The On-Site Examination
The on-site examination is a critical part o f the supervisory process. It is impor­
tant that you understand the focus, concepts used, and the procedures involved in
an on-site examination.
Only through an actual presence in a bank can a supervisor gain the detailed
knowledge o f the bank’s operations, procedures, controls, and management that is
needed to reach an informed judgement about the bank’s overall financial condi­
tion and its compliance with banking laws and regulations. During an on-site
examination, which we conduct at least annually at every institution we supervise,
the examiner carefully evaluates a number of critical areas including the bank’s
strength o f capital and loss reserves, its overall risk exposure, particularly asset
quality, the quality of its management, including internal control procedures, and
earnings and liquidity. Examiners rate the bank in each o f these critical com po­
nents and develop an overall composite rating that summarizes the bank’s condi­
tion.
I will first review with you the basic framework within which a typical on-site
examination occurs. Then I will discuss in more detail several o f the components
o f the examination to give you an idea as to what it is that we look for and what
steps we take when we don’t like what we find.
Because o f the variety o f activities that examiners must review, the team is
comprised o f individuals with a wide range o f skills. For a medium-sized bank of
$5-10 billion in assets, we would expect to have three to five very seasoned exam ­
iners. At least one examiner would be skilled in the analysis o f credit quality,
another in liquidity and asset/liability management issues, and others in derivative
products, capital adequacy, loan loss reserves, and earnings. Many o f our key
The author is an Executive Vice President in the Bank Supervision Group of the Federal Reserve
Bank of New York.




55

The Basic Elements of Bank Supervision

examiners are skilled in several o f these areas and our senior examiners can super­
vise all aspects o f the examination. Where needed, we can staff the team with
examiners having special expertise in particular areas such as commercial real
estate or interest rate swaps. In a typical medium sized bank, the experienced staff
is supported by approximately five more junior examiners who carry out specific
tasks under the guidance o f our senior personnel.
The team is lead by a senior examiner whom we call the examiner-in-charge.
The examiner-in-charge is responsible for the complete conduct o f the on-site
examination. This person has considerable examination experience and has per­
formed most, if not all, o f the tasks assigned to examiners in the field.
The conduct o f an on-site examination requires significant preparation. In plan­
ning an examination, examiners review the report o f the prior examination, as
well as available information on the bank’s performance since that time to deter­
mine if problems or weaknesses have surfaced between examinations. For a
medium-sized bank, it usually takes at least a week or two to assign the examina­
tion team and to prepare for the examination. The examiner-in-charge is responsi­
ble for developing the main focal points for investigation by the team.
As an example, the focus for an examination o f a medium-sized bank experi­
encing some difficulty might be:
• Asset quality, since credit quality deterioration is more often than not
the source of the problem,
• The adequacy of capital, with a special focus on the sufficiency o f the
loan loss reserve and methodology employed,
• Corrective actions that have been taken to date by management to
address the weaknesses or issues identified by the bank supervisors,
accountants, or internal audit staff,
• Overall effectiveness of the bank’s internal controls and leadership,
• Potential for loss of public confidence in the bank and the bank’s
contingency funding and liquidity plans, and
• Further corrective actions needed to put the bank on the road to
recovery.
Several weeks before beginning the examination, to help expedite the examina­
tion, we send the bank a letter— which we call our First Day Letter— informing
the bank’s management o f the date that the examination team is scheduled to
arrive and listing for the bank the records and other information that the bank
should have available for the examiners upon their arrival. Such records would
include, among other things, a list o f the names o f all senior officers o f the bank
and a description o f their responsibilities, a list o f the bank’s directors, a com pila­
tion o f the bank’s policy directives, its manuals o f procedures, its balance sheet

56




T h e B ank E x a m in a tio n P rocess

and income statements for the latest quarter and fiscal year, current files pertaining
to outstanding loans, management information reports from all internal and exter­
nal audits and information on all current lawsuits in which the bank is involved.
When the examination team arrives on the bank’s premises, the team is divided
into smaller groups that specialize in specific aspects o f the examination. As I
mentioned in the beginning o f my remarks, the five principal areas reviewed by
the examiners are Capital, Asset quality, Management, Earnings, and Liquidity.
Special attention is also focused on the bank’s internal audit and control proce­
dures, which are highly critical to a successful operation. These areas o f investi­
gation vary in the amount of time and examiner resources required to complete
the assessment, with the majority of examiner time in a typical medium-sized
bank normally devoted to reviewing asset quality.
The examiner analyzes and evaluates these five essential aspects o f the bank. At
the conclusion o f the examination, each of these areas is rated by the examiner on
a scale o f one to five, where “ 1” represents the highest or best rating, and “5” the
lowest.
After evaluating the five critical areas o f the bank through separate ratings, a
“com posite” rating ranging from 1 to 5 is established, which provides an overall
judgment o f a bank’s financial condition and soundness (see Chart 7-1). Banks
rated “1” are sound in every respect, while those rated “5” are likely to fail in the
absence o f immediate and substantial corrective action and external support. The
com posite is not determined by calculating a simple average o f the separate com ­
ponents. Rather, it is the result o f a comprehensive assessment by the examinerin-charge of the overall condition o f the bank, generally in consultation with his or
her superior. The composite includes additional considerations, such as the bank’s
competitive position, including its future prospects and trends in its financial per­
formance. Thus, the summary rating provides a broad measure o f the exam iner’s
findings regarding a bank’s overall financial condition and immediate prospects.
Before turning to a more detailed description of several o f the specific areas
covered in the examination, let me mention that throughout the process there are
ongoing discussions between the examiners and the management and staff at the
bank under examination. At the conclusion o f the examination, a detailed report is
prepared that describes the findings and, where necessary, recommends action to
be taken by management to correct deficiencies. In extreme situations, where seri­
ous problems are found to exist, the examiner prepares a special Summary Report
to the bank’s directors. This Report sets forth in clear and concise language a sum­
mary o f the bank’s major deficiencies and problems, the corrective action
required, and a specific period of time within which the recommended actions
must be taken. The purpose of this Report is to ensure that the bank’s directors
understand the gravity o f the situation and are alerted to their responsibilities to
see to it that bank management responds promptly.




57

L /l
OO




CHART 7-1

Composite Rating Summary for Banks

• Rating 1 - Strong
B ank is fundam en tally sound.

• Rating 2 - Satisfactory
B ank is fu ndam en tally sound, but m ay sh o w m o d est w ea k n ess.

• Rating 3 - Fair
B ank has a com bin ation o f w ea k n esses ranging from fair to m od erately severe.

• Rating 4 - Marginal
B an k has an im m oderate volu m e o f financial, operational and
m an agerial w ea k n esses.

• Rating 5 - Unsatisfactory
B an k is in im m in en t danger o f failure.

T h e B ank E xam in atio n Process

When a bank is in serious trouble, its capital is likely to have been eroded to the
point where it becomes subject to a capital directive under the Prompt Corrective
Action Program. Our recommendations, therefore, will require a plan for capital
improvement, after recognition o f losses, and include restrictions on dividends
and growth and steps to improve internal control and audit programs. Our clear
preference is to work with a bank and its management to resolve the problem
informally, and most of the time we can. Sometimes more forceful and more for­
mal supervisory action must be taken to achieve the results we believe are neces­
sary for the survival of the bank.
Now, turning to the basic elements o f an on-site examination, two o f the most
important are the assessment o f the bank’s capital and asset quality. Bank capital
has already been discussed in some detail in Chapter 4, so I will not go into that
here, and asset quality will be covered in the next chapter. So I will focus my
remarks on the examiners’ review o f earnings, liquidity, and management and

internal controls.
Let me start with earnings. For most established banks, the principal source of
new equity capital is retained earnings— that is, net profits after taxes and divi­
dends. Profits, or the lack thereof, can also have an important impact on public
confidence in a bank. For these reasons, an analysis of earnings is an essential part
o f a bank examination.
The bank’s earnings position is assessed from the viewpoint o f whether it pro­
vides a reasonable return on the capital employed, how its return on capital com ­
pares with other banks o f similar size, and the proportion o f its earnings that are
retained for future growth rather than paid out in dividends to the shareholder.
Profitability is evaluated by analyzing a bank’s return on assets and return on
equity relative to its peers both for the current year and over time.
Return on assets alone does not always present a reliable picture o f a bank’s
earnings. For example, examiners look for circumstances such as inadequate loan
loss provisions, which can mean that income is being overstated. Heavy reliance
on nonrecurring or unstable sources of income can also overstate the bank’s
underlying earning power. Examples would include gains realized through the
sale o f assets or subsidiaries and other special, one-time transactions, unusually
strong foreign exchange and securities trading profits, or substantial tax credits. In
short, the examiner looks behind the bank’s reported numbers in order to evaluate
the bank’s basic, sustainable earning power on a continuing basis.
Another key element o f the on-site examination is an assessment o f the bank’s
liquidity— a measure o f a bank’s ability to meet deposit withdrawals and the
credit needs o f customers without the forced sale o f portfolio assets. Examiners
are concerned with a bank’s funding profile and its liquidity position since the
inability to meet its obligations as they com e due can cause a loss o f public confi­
dence and a depositor run on the bank. Since banks of varying sizes operate under




59

The Basic Elements of Bank Supervision

vastly different circumstances, no simple formula can provide an adequate mea­
sure of, or standard for, a bank’s liquidity. The examiner must evaluate the bank’s
current liquidity position and determine how liquidity would be affected by
adverse changes. These would include a significant increase in credit demand,
including heavy calls under various loan commitments, a sharp reduction in the
level o f deposits, a shock in the money market, or a significant change in domestic
or foreign interest rates.
Such an analysis, simplified, is shown in Chart 7-2 for a medium-sized bank
whose business is geared largely to its local or regional trade area. The examiner
has made an estimate o f the prudent amount o f liquidity the bank should hold
against each type o f requirement based on his or her study o f the fluctuations in
the bank’s deposits and lending business. In this case, the bank has a substantial
portfolio o f U.S. government securities, all in the under-one-year maturity cate­
gory. As a result, the bank has a liquidity surplus up to one year, but liquidity def­
icits for over one year. It has a large volume o f time deposits due after two years.
Here, the bank has adequate short-term liquidity, but needs a plan to cover the
longer-term gaps. For example, if it should have difficulty renewing all o f its twoyear time deposits, it could face a significant liquidity squeeze.
In assessing liquidity, the examiner must carefully review the level and trend of
funding and borrowing patterns, the level of reliance on the more volatile, confi­
dence-sensitive sources o f funds such as large certificates o f deposit with short
maturities, overnight interbank borrowings, and other forms of large denomina­
tion, short-term obligations. Other liquidity concerns include the availability of
short-term, liquid assets that are readily convertible into cash, the level and cost of
access to the money markets, and the reputation of the bank in the marketplace. A
contingency funding plan is essential to address emergencies and should round
out effective asset-liability management strategies.
The examiner must also assess the character and performance o f the bank’s
management, including the board o f directors. The quality and depth o f the man­
agement team and the active involvement of the board o f directors in the affairs of
the institution are key ingredients to a successful banking operation as the caliber
o f management directly impacts all aspects of a bank’s performance and condi­
tion. In essence, the competency and integrity o f management will play a major
role in determining the eventual success or failure of the bank.
Management’s performance is evaluated against a variety o f objective and
subjective factors. The general condition o f the bank clearly has an important part
to play in the examiner’s assessment o f management. In addition to evaluating
performance in the light o f asset quality, capital, earnings, and liquidity, manage­
ment is evaluated with respect to its leadership and administrative ability, adher­
ence to prudent policies and strategies, the effective training o f subordinates and
compliance with banking laws and regulations. The involvement o f the board of

60




CHART 7-2

Simplified Liquidity Analysis
($ in millions)

Liquidity Need by Maturity
Under 1 year

Over 2 years

200
500
200
900

300
200
500

400
100
500

Cash on deposit at other banks
Government securities
Firm commitments for sales of loans
Expected maturities of loans

(I)

1-2 years

200
400
300
100
1,000

300
100
400

100
100
200

Surplus + or deficit

+100

-100

-300

L iquidity Uses
Demand deposits
Time deposits
Loan demand/commitments

(II) L iquidity Sources

ON




(II) minus (I)

The Basic Elements of Bank Supervision

directors in providing effective oversight and guidance and in developing impor­
tant policies and strategic plans is also key.
The quality o f the bank’s internal audit and control environment is also a
critical indicator of management performance. Our experience with problem and
failing banks clearly indicates that weak internal controls and/or failure to observe
existing controls is one o f the most important causes o f bank problems and failure.
For that reason, our on-site examinations contain a special segment designed to
review, in detail, the bank’s internal control environment, specifically the operat­
ing policies and procedures relating to internal controls. The purpose o f this
review is to determine if the bank has a comprehensive set o f policies and proce­
dures designed to control the risks inherent in all phases o f the bank’s activities
and to evaluate whether these policies and procedures are adhered to faithfully.
The review o f internal controls is centered on the bank’s audit coverage and its
audit department. Four key factors determine the overall effectiveness o f a bank’s
audit coverage, namely:
1. Comprehensiveness o f the audit program,
2. Independence of the auditors from areas that are subject to audit,
3. Soundness o f the audit procedures and competence o f the auditors,
and
4. The follow-through o f the bank’s board o f directors and management
in implementing important audit recommendations. A strong internal
audit program should be bolstered by periodic reviews by an
independent, external auditor.
The examiners perform an intensive review o f audit coverage, both internal and
external. This includes evaluating the scope and frequency o f audits, the adequacy
o f audit procedures, the nature and content of internal audit reports submitted to
senior management and/or the bank’s board of directors, and senior management
or the board’s response to audit findings with particular emphasis on the correc­
tive action to be taken. Significant audit exceptions will be followed-up by the
examiners during the course of their review. The examiners also assess the quality
o f the work papers to ensure that they properly support the audit findings.
Internal control reviews are also made o f significant noncredit operations,
such as m oney transfer and electronic data processing (EDP). Since automation
plays so important a role in a modern banking organization today, our examiners
conduct an EDP examination where appropriate. The purpose is to evaluate
whether these operations are conducted in a manner that is secure and does not
expose the bank to losses through system errors, loss o f important data, fraud, or
breakdown o f the system. Our examiners will evaluate whether the bank’s EDP
program has strong and knowledgeable management, capable system program-

62




T h e B ank E x a m in a tio n Process

ming and operations staff, and a viable contingency plan in the event o f unex­
pected system s failure.
Before concluding, I want to emphasize that our objective is to maintain ongo­
ing contacts with the management of the banks subject to our supervision so that
there are as few surprises as possible. For example, we hold quarterly meetings
with all the money center and major regional banks to discuss their earnings per­
formance and their estimate of the most likely results over the near term. We also
hold periodic meetings with a wider group o f banks under our jurisdiction to deal
with specific issues as they arise. We require that a bank supervisory officer be
present at the meeting with bank management at the conclusion o f an examination
and an officer from bank supervision be present when the examination findings
are presented to the bank’s board o f directors. Our philosophy is to get to know
and work with bank management. In the long run, we believe that effective super­
vision should be a cooperative process, although we are always prepared to back
up our recommendations with formal orders if the situation requires that type o f
action.
We want to turn now to the issue o f asset quality, since it is one o f the most fun­
damental considerations in determining the financial condition of a bank. How
well a bank executes the credit review process will likely determine the ongoing
financial health o f that bank. This aspect o f the on-site examination is covered in
the next chapter.




63

The Basic Elements of Bank Supervision

64




CHAPTER 8

The Credit Review Process
j|{

By Robert A. O’Sullivan

Introduction
There is no question that a timely and accurate assessment o f asset quality is
central to the examination process and critical to the final judgment as to a bank’s
overall financial condition. Not surprisingly, examiners devote the largest portion
o f their time during an examination to the review and analysis o f the many differ­
ent dimensions o f the bank’s credit-granting process. To quantify this for you, this
effort usually represents more than half the time and resources used in an on-site
examination. As further background, you should also keep in mind that commer­
cial banking is a business that by its very nature involves assuming and managing
risk while getting proper compensation. Our job, as bank supervisors, is to make
certain that the risks being assumed are well understood and prudent and that they
are effectively controlled.
To reach an informed judgment on the general soundness o f a bank’s credit or
lending business, examiners must evaluate all facets of its lending program. The
four stages o f the evaluation process are:
1. A careful review and assessment o f the bank’s written lending
policies— these policies reflect the lending strategies and
philosophy o f both bank management and the board o f directors,
2. An evaluation of the bank’s lending procedures and the quality of
internal operating controls, and management’s adherence to those
procedures and controls,
3. A detailed review and financial analysis of the individual borrowers
who make up a bank’s loan portfolio, and
4. An assessment o f the adequacy o f the bank’s loan loss reserves—
that is, the adequacy or reasonableness o f the reserves relative to the
risks identified in the portfolio.

* The author is a Senior Vice President in the Domestic Bank Examinations Function of the Federal
Reserve Bank of New York.




65

The Basic Elements of Bank Supervision

In our many years of examining banks, we have found that poor credit quality is
usually the major culprit leading to serious problems and bank failures. How well
a bank’s management executes the credit underwriting and review process ulti­
mately determines the ongoing financial health o f that bank. I would like to go
through the credit review process in some detail by following the steps that exam ­
iners take in a typical examination so they are in position to make the informed
judgments I spoke of relative to the asset quality assessment and rating.

Asset Quality Evaluation—the “A” in the CAMEL Rating
What is involved when we ask examiners to thoroughly review all facets o f a
bank’s lending program? The procedures used during the course o f this review
will vary according to the bank’s size and general condition, but the basic princi­
ples o f analysis and judgment used by examiners are applied consistently across
all institutions. The examiner begins the asset quality review by carefully evaluat­
ing the bank’s written lending policies and procedures. These policies and proce­
dures are the structural guidelines upon which each bank extends credit. They
provide the examiner with a clear perspective on the bank’s basic lending philoso­
phy. The guiding principles determine the types and sizes of loans the bank will
make, the types and sizes o f borrowers that will be accommodated, and how bank
management expects its loan function to determine the creditworthiness o f pro­
spective borrowers. Once this initial assessment has been made, it sets the stage
for the examiners’ evaluation or appraisal of individual credits.

Loan Policies and Procedures
It is particularly important to our overall asset quality assessment to review a
bank’s formal loan policies and management’s adherence to those policies. With­
out prudent loan policies, there is a danger that lending officers may make inap­
propriate or excessively risky loans.
Among other things, bank lending policies set general guidelines for total loan
volume relative to bank assets and capital. They also set limits on the total expo­
sure allowed for different types o f industries or borrowers. The policies outline
the credit approval process and criteria for granting loans, the collateral require­
ments, documentation standards, and repayment terms. And, finally, the loan poli­
cies set the specifics for each loan officer’s lending authority and responsibilities.
The examiners look for evidence that the bank’s lending standards require the
borrower to furnish complete, current financial statements and other appropriate
documentation (e.g., tax returns), that the bank has its own internal credit rating
system that incorporates assessments made by the lending officers, and that the
bank has an independent monitoring system to verify the accuracy of the internal
ratings. If the bank’s loan policies appear to be sound in concept, examiners seek
to determine if the policies are being adhered to faithfully. This means that all the

66




T h e C red it R e v ie w Process

elements o f the credit decision process should be documented in the loan file, with
a clear indication of the factors that led to the approval o f the loan. Examiners
seek to determine the extent to which actions taken by lending officers are regu­
larly monitored and evaluated by both credit administration and the bank’s inde­
pendent loan review function.
A key ingredient of a good lending function is a strong and independent credit
administration department. This department’s functions require independent ana­
lysts charged with the review and analysis of borrowers’ financial condition and
prospects. The department also evaluates loan performance and adherence to loan
covenants, reviews statistical data and trends in the portfolio, and identifies excep­
tions to policies and procedures. Much of this information is regularly shared with
senior management and, where necessary, with the board of directors. The internal
review should also focus on the types o f credit being extended, the level o f risk
concentration in particular areas, the loss experience in various segments o f the
portfolio, and the need for changes in credit standards and guidelines.
The extent to which lending to a particular borrower or group o f borrowers
would raise the bank’s exposure to an uncomfortable level— the concentration
issue— is another important factor for the bank to consider as part o f its overall
credit review and monitoring process. Loan concentration is an issue that is care­
fully assessed by the examiners.
Concentrations o f credit can arise in a variety o f ways, namely through heavy
lending to a particular industry, or related group of industries, or within a geo­
graphic market area, or by type of borrower. Problems o f this nature have arisen in
recent years through individual bank’s heavy lending, for example, to the energy
industry, agriculture, shipping, and commercial real estate. Substantial nonlocal
lending activity into certain high-growth regions o f the United States, loans to less
developed nations, and loans to finance leveraged buy-outs or highly leveraged
transactions are other examples o f asset or loan concentrations. The lesson here is
that concentrations can be very dangerous. Supervisory policies in this area are
intended to encourage banks toward prudent risk diversification.

The Credit Review Process
The actual credit review or loan appraisal process— that is, evaluating the qual­
ity o f individual loans— is the core o f the process that provides the examiner with
a true picture of the condition o f the bank’s loan portfolio. Analyzing individual
credits or loans is the most time consuming and labor intensive portion o f the
examination because upwards of 60 percent of a bank’s assets typically are in the
form o f loans, the asset category that is most susceptible to deterioration in qual­
ity.
To make a qualitative assessment regarding a bank’s underlying asset quality,
the examiners conduct a detailed review o f the bank’s outstanding loans and com ­




67

The Basic Elements of Bank Supervision

mitments, as well as their associated documentation files. The objective is to
determine the relative financial health and creditworthiness o f each borrower.
Examiners will need to express a view as to the borrower’s capacity to repay the
debt as scheduled.
The process that examiners follow entails a careful review, analysis, and rating
o f each o f the credits. (We call this process “reading” loans.) The aim is to iden­
tify problem loans and emerging problem loans. Examiners will also seek to
determine the extent to which weaknesses in the bank’s lending policies and pro­
cedures and other basic internal controls may have contributed to the problems.
In reviewing individual credits, examiners look at a number o f financial and
related factors. Some o f the more important ones are:
• The purpose of the loan and source(s) of repayment.
• The borrower’s financial statements— i.e., the balance sheets and
income statements— for at least the last three years. This information is
extremely valuable for both the bank and the examiner in determining if
the actual or proposed level o f borrowing can be fully supported. Recent
financial history and trends also help in evaluating and understanding a
borrower’s financial position and prospects.
• The ability of the borrower to generate a sufficient cash flow to repay
the debt in accordance with the terms o f the loan.
• The borrower’s business history and past performance with other credi­
tors.
• Where appropriate, whether there is adequate collateral or other forms
o f reliable support, such as guarantees from a financially strong and
responsible third party.
The vast majority of this information and data that I have outlined is located in
the credit file that the bank has for each borrower. Additional information, if nec­
essary, is sought from the loan or account officers and senior management.
Based on their review and analysis of the individual credits, the examiners esti­
mate the degree o f risk in each credit arrangement and assign a rating. Essentially,
there are five rating categories— pass or noncriticized, special mention, substan­
dard, doubtful, and loss. These categories are shown on Chart 8-1, along with a
brief description of the characteristics o f each one. Generally, most assets are
“passed” by the examiner; that is, they are deemed to be performing in a satisfac­
tory manner. When a credit is not passed, it is usually because the borrower is
experiencing some financial difficulty. Such problems can range from the appear­
ance o f adverse trends, in the case of special mention, to more serious and funda­
mental problems. Problems usually take the form of heavy leverage on the part of
the borrower (too much debt), weak operating performance, poor earnings, or

68







CHART 8-1

The Asset Rating System
Pass
•
•
•

Reasonable credit risk
Payments are current
No evident adverse trends

Special Mention
•
•

Adverse trends or characteristics
Credit risk relatively minor, yet unwarranted

Substandard
•
•

Well-defined credit weaknesses
Bank may sustain some loss if deficiencies are not promptly corrected

•
•

Collection in full is highly questionable
Possibility of significant loss (though not readily defined) is extremely high

•

Uncollectible

Doubtful

Loss

The Basic Elements of Bank Supervision

even losses and/or inadequate cash flow. These factors have a bearing on the bor­
rower’s current or prospective ability to meet the terms o f the loan contract.
It is the examiner’s responsibility to determine the severity o f the problems or
weaknesses; this assessment would involve an analysis o f all o f the factors affect­
ing the borrower’s financial health, including general economic conditions and the
industry environment in which the borrower operates, and a determination o f the
probability that the borrower will be able to service the debt. Based on this evalu­
ation, those credits that are determined to involve more than a normal level o f risk
are assigned to one o f four criticized rating categories.
Those credits that fall into the rating categories o f substandard, doubtful, or
loss are said to be “classified.” These loans represent the greatest credit risk to the
bank and must be monitored carefully and continuously by management. In fact,
those exposures, or portions thereof, that the examiner has designated as “loss”
would be expected to be charged off in the current accounting quarter, thus reduc­
ing the book balance o f the exposure by the amount charged off as a loss.
Assets that are assigned a special mention rating generally have some degree
o f weakness, but the deficiency is not yet so pronounced that it warrants a more
severe classification. We have found that these credits, if the problems are allowed
to persist, can evolve into a more serious matter, and this rating is a way of alert­
ing bank management to this potential so that appropriate action can be taken.
To provide us with a benchmark for the probable loss that the level o f classified
assets poses to a bank’s capital resources, the examiners compute what is called a
“weighted classified assets ratio.” Chart 8-2 indicates what this ratio means and
how we use it. The weighted ratio is intended to be a guideline for the examiners,
rather than a rigid determinant o f asset quality.
To arrive at the weighted classified assets ratio, the classified assets are first
weighted according to their degree o f risk: substandard assets are weighted at 20
percent, doubtful assets at 50 percent and loss assets at 100 percent. The sum of
the weighted classified assets is then divided by the bank’s Tier 1 capital plus loan
loss reserves. This ratio has proven over time to be a fairly reliable estimate of the
potential impact of problem assets on a bank’s capital and loan loss reserves. This
ratio represents our principal tool for determining a bank’s asset quality rating—
the lower the ratio, the lower the level of risk to the bank’s capital resources. Sim ­
ilarly, a higher ratio is presumed to indicate a higher level of risk to the bank’s
capital. Chart 8-3 shows the quality rating generally assigned to the different
ranges that this ratio may cover— from a “ 1” asset quality rating, the strongest, for
a weighted ratio below 5 percent, to a “5” rating, the weakest, for a ratio that is
over 50 percent.
I would note here that in assigning an asset quality rating, examiners would also
consider recent trends in the portfolio relative to past due and nonperforming
loans, whether the problems are receding or growing and the qualitative judg-

70







CHART 8-2

The Weighted Classified Assets Ratio

Asset Classification

Weight

• Substandard

.20

• Doubtful

.50

• Loss

Ratio =

1.00

(Substandard x .20) + (Doubtful x .50) + (Loss x 1.00)
Tier 1 Capital plus Loan Loss Reserves

CHART 8-3

to




Examiner Guidelines for Asset Quality Ratings

Rating

Weighted Classified Assets Ratio

1

Under 5%

2

5% to 15%

3

15% to 30%

4

30% to 50%

5

Over 50%

The Credit Review Process

ments I spoke o f earlier regarding the bank’s loan policies and procedures and
management’s adherence to them. It is obvious that a “5” rating for asset quality is
very severe and indicates a very serious problem that could cause a bank to fail.
From a procedural standpoint, it is not necessary for examiners to analyze every
single credit on the books o f the bank, since a fairly reliable picture can be
obtained by analyzing the bank’s largest and most important credits. In general,
we aim to evaluate a minimum o f 50 percent o f the dollar amount o f a bank’s loan
portfolio, generally the commercial loan portfolio. At banks with recognized
problems, we would seek an even higher level of coverage, perhaps up to 80 per­
cent. To achieve the appropriate level of coverage, we establish a minimum dollar
amount o f a loan to an individual borrower or group of related borrowers. This
minimum is called the “line limit.” It normally would equal 1/2 percent to 1 per­
cent o f the bank’s total capital funds. Once the line limit is established, examiners
will read and evaluate all loans at or over that minimum amount.
In relatively small banks, the line can be as low as $10,000; in the largest insti­
tutions, the minimum line amount would typically be $10 million. In addition to
loans at or above the line limit, all previously identified problem loans and all
high risk credits, including those seriously past due or delinquent, would be eval­
uated.
In the larger banks, we also rely on several other programs to assist in our credit
review, namely the Shared National Credit Program and the results o f the review
o f country risk by the Interagency Country Risk Exposure Committee:
• The Shared National Credit Program is a coordinated effort by the prin­
cipal bank regulatory agencies that evaluates large syndicated credits (in
which many banks may have portions or participations) at the agent (or
lead) bank. The results of these evaluations are used by all three o f the
federal bank regulatory agencies and many state banking departments to
uniformly classify these large credits shared among participating banks.
This program is conducted annually and has been a very significant
labor saving technique.
• The Interagency Country Risk Exposure Committee meets regularly to
assess, on a country-by-country basis, the economic, political, and other
factors that could affect the collectibility— o f international cross-border
exposures. The results of the Committee’s findings are also distributed
to federal and state bank supervisors to aid in the evaluation of interna­
tional exposures.
In cases where we have confirmed that a bank has a well-developed and effec­
tive internal loan review function, we also employ a statistical sampling program.
In this program, a random sample of credits in the bank’s loan portfolio is consid­
ered; this sample is sufficiently large to provide a high degree o f confidence that it
is representative of the entire loan portfolio. The credits are then read and the




73

The Basic Elements of Bank Supervision

examiners’ rating of each loan is compared with the bank’s internal risk rating for
the same credits. If the examiners’ ratings agree with the bank’s, we use the
bank’s internal risk reviews to round out our review o f the bank’s loan portfolio.

Adequacy of Loan Loss Reserves
Another very important aspect of our on-site examination is the assessment of
the adequacy o f the loan loss reserve. This is a difficult assignment that cannot be
done with precision. It is a combination o f science and art. The volume and qual­
ity o f a bank’s loans and related exposures are the principal influencing factors as
to the appropriate size o f the loan loss reserve. Primary responsibility for deter­
mining and maintaining an adequate loss reserve rests with each bank’s manage­
ment and board.
At the same time, examiners have a responsibility to evaluate the effectiveness
o f the bank’s reserve methodology and policies for adding to loss reserves. We
need to make certain that the reserves in place provide sufficient coverage for the
risks in the portfolio, namely the anticipated or probable losses. As a guide, the
examiners use as a reserve estimate measure a weighting system similar to the
asset quality measure I discussed earlier. This system is built on data we have
compiled over many years on the historical loss experience concerning criticized
assets. This measurement system provides us with a reference point or “comfort
zone” for an adequate reserve. However, it is not intended to supplant the bank’s
own internal system if such is considered prudent and appropriate by our examin­
ers. As bank supervisors, we look for not only the full coverage o f the loss poten­
tial associated with problem assets, but also for an excess or cushion to cover
unforeseen losses.

Conclusions
Overall judgments about the reasonableness or effectiveness o f a bank’s credit
underwriting and review process cannot be made without insight into the practical
consequences o f this process, namely, examiners’ findings regarding underlying
credit quality. As the examination proceeds, information about the bank’s credit
review and control systems is blended with examiners’ asset quality findings to
arrive at a complete picture o f the bank’s effectiveness in extending credit. The
issue is to determine whether the bank’s credit process is being conducted on a
prudent and profitable basis, with loan losses kept within tolerable limits.
Based on our experience, the leading underlying causes o f severe bank prob­
lems are:
• Management’s appetite for risk— uncontrolled quest for growth and
market share, with a reaching for earnings,
• Weak loan administration that allows problem situations to arise and
flourish,

74




The Credit Review Process

• Weak to nonexistent internal controls exemplified by numerous excep­
tions to loan policies and procedures, and
• Loan concentrations that inevitably result in increased risks and costs,
both to earnings and capital.
In virtually all cases, the root causes o f these kinds o f problems are poor senior
management supervision, poor internal controls, and weak oversight on the part of
the bank’s board o f directors. And our experience shows that strong management
supervision and strong board oversight are what make internal controls effective.
Over the course o f an examination, examiners analyze and evaluate the five
critical aspects of each bank’s operation: Capital, Asset quality, Management,
Earnings, and Liquidity. Each of these is important, but, in my view, asset quality
lies at the heart o f the overall assessment of a bank’s financial health and, conse­
quently, the com posite rating assigned to a bank.
From a supervisory perspective, it is essential for us to recognize negative asset
quality trends early and take appropriate action, before the problems becom e too
serious. To do this most effectively, I believe, requires at a minimum an annual
full-scope on-site examination. These examinations rely heavily on examiners’
knowledge and experience, as well as good judgement and common sense, to pro­
duce an accurate, in-depth assessment o f the bank’s financial condition. It also
requires an effective off-site surveillance and monitoring program that can accu­
rately track the bank’s performance in the period between examinations, to detect
emerging problem situations at the earliest possible stage.




75

The Basic Elements of Bank Supervision

76




CHAPTER 9

The Structure and Supervision
of Foreign Banking Organizations
Operating in the U.S.
By Leon Korobow

9|e

Introduction
The U.S. banking system has been greatly influenced in the past decade by the
increased presence o f foreign corporations that operate banking offices in the
United States. These companies are for the most part foreign banking corporations
that operate branches, agencies, representative offices, Edge Act and Agreement
corporations, or N ew York Article XII investment companies in the United States
and/or own or control U.S. banks, operating them as subsidiary corporations.
W hile we focus on the U.S. operations of foreign banks in this section, it should
be kept in mind that such operations are generally subject to the same supervisory
concepts and techniques that are applied to banks chartered in the United States.
Moreover, the standards for regulatory compliance and safety and soundness that
are applied to foreign banking organizations (FBOs) are the same as those that are
applied to U.S. banks and bank holding companies.
Under the mandates o f the Foreign Bank Supervision Enhancement Act of
1991 (part o f the Federal Deposit Insurance Corporation Improvement Act of
1991), the supervision o f each FBO must take into account a number o f factors
relating to its entire organization. These factors are the strength and stability o f the
overall U.S. presence (since many FBOs have banking operations in more than
one state), the condition o f the FBO ’s worldwide organization, and the status of
comprehensive consolidated supervision of the FBO in its home country.
An important distinction in the supervision o f U.S. branches and agencies of
foreign banks is that these offices are not free standing entities. They are an inte* The author is an Adviser in the International Bank Examinations Function of the Federal Reserve
Bank of New York.




77

The Basic Elements of Bank Supervision

gral part o f the operations o f their foreign head offices and, therefore, do not have
any capital o f their own and do not have a U.S. corporate charter. Supervision of
these offices must focus on the degree to which the office is operated in accor­
dance with U.S. laws and regulations, on asset quality, on the strength o f internal
systems and controls, particularly risk management, and on the overall level of
competence and integrity of management.
U.S. bank subsidiaries, Edge Act and Agreement corporations, and N ew York
Article XII investment companies that are held by foreign corporations are in the
first instance U.S.-chartered banking entities. These entities are supervised in the
same manner as any U.S.-owned bank, Edge Act corporation or N ew York Article
XII company, by the regulatory agency which has jurisdiction, i.e., the Federal
Reserve, the Office of the Comptroller o f the Currency (OCC), the Federal
Deposit Insurance Corporation (FDIC), or a state banking department.

Structure
Since 1975, when foreign corporations rapidly began to expand banking activi­
ties in the United States, the volume o f domestically booked banking assets of foreign-owned or controlled offices has grown more than eighteen-fold, reaching an
aggregate total o f over $900 billion by June 30, 1993 (see Chart 9-1). This expan­
sion is largely accounted for by the growth in the number of, and volume o f busi­
ness conducted by, U.S. branch and agency offices o f foreign banks.
Today, 591 branches and agencies have $692 billion in total assets, or 75 per­
cent o f all domestic assets held in all foreign-owned banking offices in the United
States. These branches and agencies also account for 18 percent of the domestic
assets and 16 percent o f the consolidated domestic and foreign office assets o f the
entire U.S. banking system as o f June 30, 1993. Further, these branch and agency
offices manage the assets of 150 offshore offices o f FBOs; these offices hold an
additional $325 billion of assets. The vast majority o f these offshore offices are
linked with branches located in the Second Federal Reserve District.
The U.S. branch and agency offices o f FBOs have been quite active in the U.S.
market for commercial and industrial loans. Such loans to corporations domiciled
in the United States account for nearly 50 percent of the loan portfolios o f all
branch and agency offices. Moreover, the dollar volume o f these loans represents
about 25 percent of all commercial and industrial loans extended both by U.S.
commercial banks and the U.S. branch and agency offices o f FBOs combined. If
the commercial and industrial loans extended to U.S. residents by the offshore
offices o f FBOs and U.S. commercial banks are added to the totals, the percentage
accounted for by U.S. branches and agencies o f FBOs is raised to 32 percent. The
branch and agency offices also extend a wide variety o f other types o f loans, e.g.,
loans to U.S. commercial banks, to other financial corporations, to securities bro­
kers and dealers, to state and to local governments, and to individuals. A small

78




CHART 9-1

Foreign-Held Banking Institutions and Assets in the United States
June 30,1993
($ in billions)

NUMBER

TOTAL ASSETS
DOMESTIC OFFICES

(1) Branches and Agencies
of Foreign Banks

591

$692

$692

(2) U.S. Bank Subsidiaries
of Foreign Banks*

120

220

238

27

5

7

241

0

0

$917

$937

(6) Total Banking Assets**

$3,932

$4,266

(7) Foreign in Percent
of Total Banking Assets

23

22

(3) Foreign-Held Edge
Act and Agreement and
N.Y. Article XII Companies
(4) Representative
Offices
(5) Total Foreign Assets

* Includes a small number of banks and volume of assets that are held by foreign nonbank corporations.
** Sum of assets of commercial banks, Edge Act and Agreement corporations, N.Y. Article XII companies,,
and U.S. branches and agencies of foreign banks.




TOTAL ASSETS
ALL OFFICES

The Basic Elements of Bank Supervision

number o f branch offices carry Federal Deposit Insurance Corporation deposit
insurance.
U.S. bank subsidiaries o f foreign banks account for a further 6 percent of
domestic assets and 6 percent o f consolidated U.S. banking assets. The assets of
other foreign-held subsidiary banks, Edge Act and Agreement corporations, and
N ew York Article XII investment companies all are relatively small.
At the end of 1993, the U.S. banking offices operated by foreign banks were
owned by 270 foreign banking corporations that represented the “top holders” or
overall parent organizations. These foreign top holders are headquartered in some
62 countries, with Japan and Western Europe each accounting for 42 percent of
the aggregate assets of foreign holders (see Chart 9-2). In a number o f cases, the
foreign top holders establish one or more U.S. subsidiary corporations through
which they conduct their U.S. banking operations. Counting all such subsidiary
parent organizations, there were 310 “direct foreign parent” companies operating
U.S. banking offices.
The U.S. branch and agency offices o f foreign banks, which as noted earlier
account for the great bulk o f the foreign bank presence in the United States, are
located throughout the country, but, as would be expected, there is a concentration
in the major financial centers. As can be seen in Chart 9-3, the N ew York Federal
Reserve District accounts for nearly half the number of branch and agency offices
and over three-quarters o f the assets held in those offices nationwide. The San
Francisco, Chicago, and Atlanta Districts follow in the representation o f foreign
banking organizations.
Foreign banks having banking offices in the United States also operate a large
number o f representative offices and nonbank subsidiaries. Many o f the nonbank,
nonfinancial subsidiaries conduct activities that are not normally open to U.S.
banks. This differential treatment is available only to foreign banks that meet cer­
tain conditions with regard to the worldwide distribution o f their banking and
nonbanking businesses, as discussed below.

Supervision and Regulation
Prior to passage of the International Banking Act o f 1978 (IBA), foreign banks
had to obtain a state license to operate a branch or agency office in the United
States. W hile federal licenses were not available, foreign banks had other advan­
tages, namely they could operate offices either through a branch or agency or sub­
sidiary bank at multiple locations throughout the United States, something U.S.
banks could not do at that time. In addition, their branch and agency offices were
not subject to Federal Reserve reserve requirements maintained for monetary pol­
icy purposes.
The IB A brought the rules governing the foreign banking community into
closer alignment with those that govern U.S. domestic banks and bank holding

80







CHART 9-2

Geographic Distribution of Foreign-Held Banking Assets
in the United States by Country of Foreign Holder
June 30,1993
($ in billions)

Aggregate Assets: $917*

* Assets o f U.S. branches and agencies of foreign banks plus the domestic assets o f foreign
held commercial banks, Edge Act and Agreement corporations and N.Y. Article XII companies.




CHART 9-3

United States Branches and Agencies of
Foreign Banks by Federal Reserve District
June 30,1993
($ in billions)
Number

Percent of
Total

Total
Assets

Percent of
Total

New York

284

48

$529

76

San Francisco

148

25

82

12

Chicago

51

9

52

8

Atlanta

68

11

19

3

All other

40

7

10

1

591

100

$692

100

Total

The Structure and Supervision of Foreign Banking Organizations Operating in the U.S.

companies with regard to chartering, branching across state lines, the holding of
required reserves, and the nonbank activities of the parent corporation. For the
first time, federal licenses for U.S. branch offices could be granted by the Comp­
troller o f the Currency, but foreign banks had to select a “home state,” which
restricted their ability to establish deposit-taking offices in other states. Further,
large branch and agency offices came under the Federal Reserve’s reserve mainte­
nance requirements.
For purposes o f regulation and reporting, a foreign banking organization is
defined as any foreign bank (or company organized under foreign law which owns
a foreign bank) that owns or controls a subsidiary U.S. bank or a U.S. commercial
lending company or operates a branch or agency office in any state in the United
States or in the District of Columbia. Some FBOs are classified as “qualifying for­
eign banking organizations” because their worldwide banking assets are held
mostly (more than 50 percent) outside the United States and their worldwide
activities are, on balance, predominately comprised o f banking activities as mea­
sured by income, assets, or revenues. Qualifying FBOs are not required to apply
to the Board o f Governors o f the Federal Reserve to engage in most nonfinancial
activities in the United States if the FBO is already engaged in these activities
overseas. These investments are exempted from the nonbanking restrictions of
Section 4 o f the Bank Holding Company Act. Nonconforming activities, mainly
securities, o f some other FBOs were grandfathered under the IBA.
Under the IBA, the supervision of FBO branch and agency offices in the United
States was largely the responsibility o f the licensing authority, namely the fifty
state banking departments in the United States or the OCC. The Foreign Bank
Supervision Enhancement Act o f 1991 (FBSEA) substantially altered the supervi­
sion and regulation of FBOs by making the Federal Reserve Board the primary
regulator with regard to entry into the United States, expansion, and cessation of
operations of one or more offices. It also gave the Federal Reserve overall respon­
sibility for the ongoing supervision and regulation o f all FBO offices in the United
States, both bank and nonbank.
In addition to obtaining a license from either the OCC or a state banking
department, an FBO must, under FBSEA, obtain the prior approval o f the Federal
Reserve Board to operate a branch, agency, representative office, or commercial
lending company in the United States. In assessing those applications, the Fed­
eral Reserve reviews and considers the overall financial and management condi­
tion o f the parent organization, its competence in international banking, whether
the home country supervisor conducts comprehensive consolidated supervision
o f its financial institutions, the foreign bank’s compliance with U.S. laws and reg­
ulations, the condition o f existing U.S. operations, and the degree to which the
FBO has supplied the Federal Reserve with sufficient information to evaluate the
application.




83

The Basic Elements of Bank Supervision

The Federal Reserve may terminate the activities o f any state-licensed branch
or agency office, or representative office o f an FBO for reasons relating to viola­
tions o f U.S. laws and regulations, unsafe and unsound practices, and inadequacy
o f home country supervision. The Federal Reserve may recommend similar action
to the OCC for offices licensed by that regulator.
As noted earlier, FBSEA gives the Federal Reserve the overall authority for the
supervision of the branches, agencies, representative offices, commercial lending
companies and nonbank subsidiaries o f foreign banking organizations operating
in the United States. The Federal Reserve is required to coordinate its examination
programs with the OCC, the FDIC, and the relevant state banking departments
whenever possible. FBSEA requires that branch and agency offices undergo an
on-site examination at least once every year. The Federal Reserve has the respon­
sibility to assure that such annual on-site examinations are conducted. Moreover,
the Federal Reserve must ensure that timely examinations are conducted o f all the
U.S. activities o f FBOs so that the financial and managerial condition and regula­
tory compliance of the FBO ’s entire U.S. presence can be assessed.
In order to implement FBSEA, the Federal Reserve had to expand its examina­
tion staff substantially to meet the annual examination mandate. Implementation
has also involved particularly close and frequent contacts with all the other U.S.
bank regulatory agencies and the development o f a new, comprehensive supervi­
sory program. This program has involved new rating systems for the U.S. offices
of FBOs, for the entire U.S. presence, and for the FBO itself. It has also required
new examination manuals, an extensive training program geared to a large num­
ber o f newly-hired professionals, and a plan for dealing with problem situations.
As the program advances, the Federal Reserve and other bank regulators are
devoting increased attention to evaluating the overall operations o f FBOs doing
business in the United States as well as the safety and soundness o f individual
offices.

84




CHAPTER 10

Resolving Problem Bank Situations
By Frederick C. Schadrack

)|e

Introduction
As should be apparent from the earlier chapters, bank supervision is regarded as
very serious and important business. In large measure, this reflects the key role of
banks in the financial system and in the economy. Banking is too important to
leave to the bankers!
At the same time, it reflects general concern arising from our unhappy experi­
ence regarding the potential volatility o f bank deposits and the dependence of
banks on depositor and creditor confidence. This is not just concern about the suc­
cess or failure of any individual bank, but is much broader. It is the concern that
the problems or failure o f one or a few banks may give rise to questions in depos­
itors’ minds regarding the safety o f their deposits in other banks. In such cases,
there is the possibility o f depositor “runs” on essentially sound banks, threatening
the viability o f the whole banking system. The avoidance o f such “systemic risk”
lies behind both the official “safety net,” consisting o f central bank credit facilities
and deposit insurance, and the development o f comprehensive bank supervisory
systems and techniques.
You should understand, however, that there are limits to the supervisory pro­
cess. M ost important, in a market-oriented, competitive banking system, bank
directors and management must have the leeway to set the bank’s overall course,
to seek to earn a reasonable profit, and to innovate and experiment with new bank­
ing activities and products. In other words, supervision cannot be so heavyhanded as to stifle competition and innovation in banking.
Thus, there is a continuing tension in the bank supervisory process between the
need to allow banks sufficient freedom to earn reasonable profits without, at the
same time, allowing them to take such large risks that their future could be endanThe author is a financial consultant and was formerly an Executive Vice President in charge of the
Bank Supervision Group of the Federal Reserve Bank of New York.




85

The Basic Elements of Bank Supervision

gered. The elaborate structure of banking rules and regulations that has been dis­
cussed in the preceding chapters represents an attempt to balance these
considerations and to set the “ground rules” as to what is and what is not permissi­
ble in banking in the United States.
The bankers’ ability to innovate relatively freely is one o f the reasons why it is
so important that bank managers and directors fully understand and control all of
the risks that their bank undertakes. New banking activities represent a challenge
in this respect since they often involve new types o f risks that may be very diffi­
cult to analyze and measure. Many of the so-called “derivative” products— such
as com plex currency swaps, interest rate swaps, and options on swaps, etc.—
introduced by the major banks in recent years fall into this category. W hile bank­
ers can, and do, work with the supervisors in assessing such risks, it is ultimately
the bankers’ responsibility to “get it right.” It is their responsibility to make sure
that their bank is operated not only in a profitable manner, but also in a sound
manner.

Problem Banks
Banks sometimes manage to get into trouble despite the good intentions of
bank management and the efforts o f bank supervisors. It may be useful to spend a
few minutes discussing why this happens. As we will see, newly organized banks
are particularly likely to run into serious difficulties.
Serious deterioration in a bank’s financial condition often results from inade­
quate supervision o f the bank by the board o f directors and senior management.
Studies have consistently shown that problem and failed banks lacked compre­
hensive policies and procedures setting limits for risk taking and guiding bank
loan officers in developing and maintaining a sound loan portfolio.
These failures may be attributed to the bank’s board o f directors because it is
the board’s responsibility to ensure that the bank’s management is capable and of
the highest integrity. The board must also work with management in developing a
strategic plan that defines the bank’s business goals and its programs for achieving
those goals. Significant departures from such financial plans may point to emerg­
ing problems that should not be allowed to get out o f hand. When the board o f
directors fails to meet these responsibilities, the bank is very likely to run into
serious problems.
Weak or deficient management, the most frequent cause o f bank failure, is often
reflected in poorly defined loan policies or in policies that are not adhered to faith­
fully by loan officers. The reason this type o f weakness is so critical is that a
bank’s loan policy sets limits on the scope and dimensions of the credit risks it is
willing to take. In the absence of such limits on risk, the door is open to losses that
can exceed the bank’s capital, with the result that the bank may fail. Related to
this aspect o f management weakness is the lack of a program to identify problem

86




Resolving Problem Bank Situations

loans at an early stage and to take corrective measures so that losses can be held to
a minimum.
Another important aspect o f management weakness is the absence o f an effec­
tive system o f internal controls to monitor the performance of key operating offi­
cials and to ensure that the bank’s policies and all applicable banking laws and
regulations are being strictly observed. Sometimes these problems can be traced,
usually in relatively small banks, to decisions made by one dominant individual,
such as the President or Chairman o f the bank. Such individuals, by force o f per­
sonality and/or a dominant ownership position, may override existing bank poli­
cies and procedures leading it into imprudent activities.
And frequently, these management deficiencies are characteristic o f newly
organized banks. In some new banks the managers and directors fail to put in
place and monitor an effective set o f internal controls. For this reason, it is the
policy o f the Federal Reserve to conduct an on-site examination o f each new bank
within six months of its opening for business to try to make sure that it is getting
off on the right foot.
Our experience with bank problems indicates that another important manifesta­
tion o f deficient management is excessively rapid loan growth. This is also often a
characteristic o f new banks seeking a quick expansion o f their business base. Such
aggressive growth is often responsible for the acquisition o f assets that cannot be
managed safely and effectively with the financial and managerial resources avail­
able to the bank. The result is an inability of the bank to assess accurately— both
initially and on an ongoing basis— the borrower’s financial condition and ability
to service the loan. In these circumstances, there is a high probability that loans
extended without careful analysis and attention to the risks involved will soon
becom e problems.
Another serious threat to bank safety is overconcentration o f bank lending to
one borrower or one industry. In the United States, banking laws generally limit
unsecured loans to a single borrower to 15 percent of the bank’s capital. In a com ­
petitive economy, individual borrowers can always encounter unforeseen, adverse
developments that might impede the borrower’s ability to service a loan.
And particular industries can be especially hard hit by an econom ic decline or
the loss o f an important market. Thus, the economy in the American Southwest
was devastated by the collapse o f energy prices in the mid-1980s and many banks
in the region were also devastated. At about the same time, hundreds of banks in
the M idwest suffered greatly from the weakness o f farm prices.
Other concentrations can be more subtle and difficult to evaluate, but they are a
constant source o f supervisory concern. For example, many major banks in the
1980s unexpectedly found that their loans to Latin American governments repre­
sented a concentration when none o f the principal borrowing countries could
repay their bank debts. This “sovereign risk” concentration in Latin America




87

The Basic Elements of Bank Supervision

resulted in serious difficulties for several large banks. For this reason, competent
and prudent bank management willalways seek to diversify the bank’s assets so
that the default or failure of one or a few borrowers will not fatally damage its
capital base.
Still another symptom o f weak management and control system s that contrib­
utes to severe bank problems is inadequate liquidity. More often than not, poor
liquidity arises from overly aggressive loan growth that cannot be funded by the
normal growth o f local deposits. In this situation banks may seek funding out­
side o f their regular service area through money brokers and wholesale money
markets.
Resort to such funding patterns can be fraught with danger. The suppliers of
such funds usually have no other relationship with the bank, have no identification
with its management, and no commitment to its success. This kind of “hot
m oney” is likely to flee the bank at the first sign o f adversity, thereby worsening
its problems. Thus, funding operations o f this kind require strict control systems
and highly knowledgeable personnel and are inappropriate for most banks serving
a local or a regional market.
The most difficult problem for bank supervisors to detect and prevent is fraud,
criminal activities, and self-dealing by a bank’s managers, directors, or em ploy­
ees. Since it is difficult to be forewarned o f any particular criminal violation, bank
supervisors place a great deal of emphasis on a bank’s internal management con­
trols and its audit processes to ensure that there are adequate safeguards against
fraudulent or criminal activities committed by one or more individuals. Regular
supervisory examinations are also seen as a deterrent to such activities. The integ­
rity o f senior management is particularly important in setting a high standard for
all other officers and em ployees to follow.

Remedial Supervisory Measures
If, for one o f the reasons just discussed, a bank develops serious problems, it
will have to adopt a remedial action program in consultation with the supervisory
authorities. W hile the specific content o f such a program will depend on the nature
o f a bank’s particular problems, there are usually several common elements in
these bank programs.
First, the bank will be required to develop a detailed capital and operating plan,
showing how the bank’s financial health will be restored. The plan will show not
only how the bank expects its income, dividends, assets, liabilities, and capital to
unfold over the next year or two, but also its best guess as to the development o f
nonperforming assets and loan charge-offs over the same period. Both the super­
visors and the bank’s directors can use these plans to structure the needed reme­
dial measures and to monitor the progress of the remedial program. This may be a
very lengthy process for a large bank with severe problems.

88




Resolving Problem Bank Situations

When a bank’s problems have eroded its capital base, the program will include
measures designed to restore its capital position. As noted, if a bank is undercapi­
talized as defined in the “Prompt Corrective Action Program,” it will be prohib­
ited from paying dividends and will be subject to other special supervisory
measures. Such measures may include raising new equity capital, selling profit­
able assets or businesses, and limiting growth and expansion. These corrective
action programs are also likely to include significant reductions in bank expenses
through personnel cutbacks, deferred capital spending, and other econom ies. Fre­
quent liquidity reports are also likely to be required by the supervisors who must
remain alert to the possibility of bank funding difficulties.
Supervisory corrective action programs can be either formal or informal in
nature. Formal programs carry legal sanctions, but these are usually not necessary.
Most bankers are quite willing to work with their supervisors in developing and
implementing a corrective action program. At the conclusion of an examination,
management and the examiner often will agree on such a program and a timetable
for its implementation. In such instances, remedial supervisory actions can be con­
veyed to the bank, along with the Examination Report, via an informal “memoran­
dum o f understanding” or supervisory letter. Banks prefer informal supervisory
actions because they do not have to be disclosed to the public, which could react
adversely to the disclosure. Supervisors are willing to use informal measures in
those cases where the bank’s problems are not life-threatening, and bank manage­
ment is cooperative and moves promptly and vigorously to deal with its problems.
In those cases where a bank is undercapitalized or where bankers are unwilling
to take the necessary corrective measures voluntarily, the supervisors will exercise
formal remedial actions. The primary goal o f such formal enforcement actions is
the restoration o f a bank’s capital position and the correction o f problems and vio­
lations before further deterioration occurs in the bank’s financial condition. A for­
mal corrective action program will frequently involve the whole range of possible
remedial measures, starting with a detailed operating plan, and requiring the
active participation of the bank’s directors. The program is also likely to become
increasingly comprehensive as the bank’s capital deficiency increases.
In the absence o f cooperation by the bank, the supervisor may take such formal
actions as the issuance of written agreements and cease and desist orders (which
order the bank and/or banker to stop engaging in a specified practice or violation
and to take positive corrective action). These actions may also include capital
directives and orders to suspend or remove individuals from the bank.
Formal actions are enforceable in federal courts, and failure to comply may
result in civil money penalties, criminal fines, and imprisonment. They are also
made public, which can be very embarrassing to the bank and its officers and
directors. A public airing of a bank’s problems may also cause it funding and
liquidity difficulties.




89

The Basic Elements of Bank Supervision

Dealing With Failing Banks
Unfortunately, the problems of some banks become so deep-rooted before they
are discovered that remedial supervisory measures are unsuccessful and failure
becom es inevitable. In these circumstances the supervisors will seek to protect the
insured depositors by making sure that their claims on the failing bank are hon­
ored in full. At the same time they will try to minimize the cost to the deposit
insurance fund of closing the bank and paying off the insured depositors. The
supervisors will also try to handle the closure o f a failing bank in a way that does
not impair public confidence in the banking system more generally. In order to
meet these three objectives, the supervisors have developed several techniques for
dealing with failing banks.
From the bank supervisors’ perspective, the most attractive approach is to try to
encourage the unassisted merger o f the failing bank into a sound institution. If
such a merger can be accomplished, the acquiring bank will assume the responsi­
bility for the failing bank’s deposits and will have to absorb its losses. This kind of
transaction is costless to the deposit insurance fund.
Obviously it is very difficult to orchestrate such mergers because sound banks
usually don’t want to take on a failing bank’s problems. However, there are som e­
times situations where a strong bank will be willing to take over a failing bank and
its problems. This may occur, for example, if it permits the acquiring bank to enter
a new banking market. This was the case in Texas in the late 1980s when several
failing Texas banks were acquired in unassisted mergers by banks from outside of
the state as a means o f entering the previously closed Texas market. Such mergers
are most likely where the acquiring bank is very large relative to the failing bank
and can absorb the latter’s losses without great difficulty.
When such an unassisted merger can not be arranged, the deposit insurance
fund may seek to facilitate a merger by indemnifying the acquiring bank against
the failing bank’s losses. In this case, the acquiring bank will be given some form
o f guarantee by the deposit insurance fund that it will not be subjected to any
direct losses as a result o f taking over a failing bank. Sometimes, such a guarantee
takes the form o f a “put option,” whereby the acquiring bank can sell any o f the
failing bank’s loans back to the deposit insurance fund at face value. In other
cases, the deposit insurance fund simply agrees to reimburse the acquiring bank
for the failing bank’s losses up to a fixed dollar amount. In either case, the acquir­
ing bank must pay for the failing bank’s deposits and viable assets. These transac­
tions are difficult to arrange, and usually involve protracted negotiations between
the deposit insurer and any potential acquiring banks regarding the terms o f the
guarantee and the size of the payments. If such a transaction is negotiated, the
deposit insurance fund is subject to losses as a result o f its guarantee or indemnifi­
cation agreements, but the failing bank’s depositors are protected as their deposit
claims are assumed by a sound acquiring bank.

90




Resolving Problem Bank Situations

Alternatively, the insurance fund may absorb the failing bank’s bad assets, sell­
ing the acquiring bank only the failing bank’s good assets and its deposits. This
transaction is sometimes called a “clean bank” acquisition. Again, the deposit
insurance fund will be subject to losses as it tries to dispose of the problem loans
taken out o f the failing bank, while the bank’s depositors will be protected.
Assisted merger and acquisition arrangements o f the types discussed here tend
to minimize the adverse market impact o f bank failures because the failing banks’
depositors, and often other creditors as well, don’t suffer any losses in the process.
On the other hand, the failing bank’s management team is usually forced out, and
its stockholders lose all o f their investment in the bank. To that extent, there can
be some ripples in the markets for bank securities, particularly if bank failures
become widespread.
When merger arrangements of either the unassisted or assisted type can’t be
worked out, the deposit insurer may in rare cases decide to recapitalize, and
revamp the management of, the failing bank (see Chapter 11). Otherwise, it will
have no choice but to close the bank, pay off its depositors, and liquidate its
assets, absorbing the failed bank’s losses. While the failed bank’s insured deposi­
tors are likely to come out whole in this particular situation, its stockholders will
be wiped out, and its bondholders and uninsured depositors may well take sub­
stantial losses.
The need to close a bank and pay off its depositors is potentially the most dam­
aging to market confidence o f the various alternatives for dealing with failing
banks. This is true for several reasons. First, it may take the deposit insurer some
days to review the failed bank’s records to determine who are the insured deposi­
tors and to close their accounts and pay them off. In this interval the depositors do
not have access to their funds and their difficulties may raise concerns by deposi­
tors in other banks.
Second, the regular banking relationships o f both depositors and borrowers are
disrupted by closing a bank. Borrowers in particular may find it difficult to estab­
lish a relationship with a new bank, and may find existing projects threatened if
expected bank credits are not forthcoming.
Finally, under this scenario, the failing bank’s uninsured depositors and other
creditors are likely to suffer some losses on their deposits and other claims. Once
such losses becom e public knowledge, and this will not take long, confidence in
the banks more generally can be shaken. For this reason, the deposit insurer must
consider very carefully the options available to it for dealing with a failing bank.
It is worth noting in this context that Russia now has nothing comparable to the
deposit insurance systems characteristic of most Western countries. W hile depos­
its at Russia’s Savings Bank carry a government guarantee, those at commercial
banks have no official protection. Thus, there is the potential for systemic prob­
lems in Russia if commercial bank failures give rise to depositor losses and a gen-




91

The Basic Elements of Bank Supervision

eral weakening of confidence in the banks. In these circumstances, it might be
necessary for the government or the central bank to provide some means o f pro­
tecting depositors’ funds in order to restore confidence. Such a development may
be very unlikely, but the implementation of some form o f insurance for deposits in
Russian commercial banks would seem to be an important step in strengthening
the banking system. It would also improve the commercial banks’ competitive
position relative to the Savings Bank.

Conclusions
In any business, and certainly in banking, there are winners and losers. Winners
have competent management that sets well thought out goals and prudent stan­
dards and have effective programs to recognize and control risk. In this regard, it
should be emphasized that the burden of evaluating and managing a bank’s over­
all risk rests with its management and directors, not with the bank supervisors. At
the same time, bank supervisors have an obligation to be frank and forthcoming in
communicating to management and directors concerns they may have with
respect to the bank’s financial condition and risk profile.
W hile significant differences in view may emerge from this process, it seems
clear that bank management and its supervisors share a common aim: the w ell­
being o f the bank and, more broadly, o f the whole financial system. This is a
responsibility that can not be taken lightly and requires a continued close relation­
ship between the commercial banker and the bank supervisor. The banker should
feel free to discuss with the supervisor concerns about market developments and
practices as well as about factors affecting the bank’s own financial condition.
And the supervisor must work closely with the commercial banker when new
supervisory policies are under consideration. Such consultation and cooperation
can play an important role in the prudent and progressive development o f the
banking system.
W hile bank failures are a tragedy for all concerned— the banks’ shareholders,
management, employees, customers, and supervisors— it must be recognized that
they are inevitable in a competitive, market-oriented financial system. Bank fail­
ures represent the weeding out o f inefficient, poorly managed institutions. Thus,
bank failures can serve a useful purpose by rewarding strong managements and
penalizing weak ones. However, bank supervisors are always concerned about the
possibility that bank failures could undermine confidence in the banking system
and cause systemic problems. Thus, the avoidance of such systemic problems is a
critical part o f the supervisory agenda.
The considerations outlined in this chapter are illustrated and elaborated in the
follow ing chapter which discusses the actual failures of two major U.S. banks.

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CHAPTER 11

Bank Failures in a Sound Econom y
By John P. LaWare*

My assignment is to discuss the reasons why some banks fail, what the conse­
quences o f failure may be, how failures can be limited by constructive supervi­
sion, and why a strong, soundly managed banking system is critical to the
successful operation of a market economy.
First, I will explain why banks are special among all business enterprises in a
market economy. Second, I will discuss very briefly two failures of American
banks that failed for different reasons. Third, I will tell you what the consequences
o f those failures were and what they might have been. Finally, I hope to impress
upon you the importance o f maintaining a safe and sound banking system through
a managed program of supervision, regulation, and examination by a suitably
chartered government agency, whether it be the central bank or an agency set up
exclusively for supervision and regulation of the banks.
Well, then, what makes banks special? It is the unique role that they play in a
market economy. They are money managers in the sense that they match the needs
o f those who have excess funds with the needs o f those who require additional
funds. Banks are intermediaries between borrowers and lenders. Depositors lend
their money to banks in return for interest earned and services rendered by the
bank. The bank, in turn, lends the depositors’ money to borrowers who are in need
o f extra funds, whether the borrower is a government entity, a corporation, a part­
nership or an individual. The bank keeps the difference between what it earns
from lending and what it pays for deposits in order to pay its own expenses and
realize a return for those who have invested in the shares o f the bank— i.e., the
stockholders. Depositors provide funds to the bank, and the bank manages the
investment o f those funds in loans or securities. The bank manages the risk for the
depositor. The shareholder provides capital to the bank to absorb losses if manag­
ers of the bank make a mistake by taking too much risk. If the capital supplied by
The author is a member o f the Board of Governors of the Federal Reserve System.




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The Basic Elements of Bank Supervision

the stockholders is not sufficient to cover the mistakes o f management, then the
bank fails and both stockholders and depositors lose all or part of what they had.
If the bank is successful, the profits belong to the stockholders and the depositors’
money is safe.
What makes banks special is that they are using other peoples’ money. They
use depositors’ money to take risks and they use stockholders’ money to absorb
losses if they take too much risk. If the depositors and stockholders lose all or
most o f what they have because a bank fails, then they have less with which to
buy goods and services and make investments in other enterprises. If many banks
fail at the same time, the effect could be to damage the operation o f the whole
economy. That, in fact, is what happened in the United States between 1929 and
1933 and it had the effect o f making the Great Depression much deeper and
longer-lasting than it might otherwise have been.
The lesson of the failure o f thousands o f banks was not lost on the United States
Congress. In the 1930s, the Congress made several laws strengthening the super­
vision and regulation of banks and, perhaps most important, creating the Federal
Deposit Insurance Corporation (FDIC) to insure the deposits in banks. The pur­
pose was to prevent runs on solvent banks by depositors who were alarmed by bad
news about other banks and were trying to protect their money. No bank can sur­
vive a sustained run, because the assets, which are of essentially longer duration,
cannot be liquidated fast enough to pay all of the depositors in a matter of hours or
days.
With their deposits insured up to an amount that covered most individual
depositors completely, consumers maintained their confidence that they would not
be wiped out. From the m id-1930s until 1991, there were virtually no consumer
runs on nationally insured commercial depository institutions in the United States.
And there were very few failures o f nationally insured commercial banks between
1935 and 1985. This system o f deposit insurance is another thing which makes
banks special.
I will now briefly describe the failures of two large U.S. banks. The banks were
very different in structure and the methods for dealing with their failures by the
United States authorities were very different. The consequences o f their failures
were also potentially very different. One bank failed in Chicago, Illinois, in 1984;
the other bank failed in Boston, Massachusetts, in 1991.
The Illinois bank had assets in excess o f $40 billion in 1984. It operated in the
financial district of Chicago under the laws o f the State o f Illinois, which did not
allow banks to have branches. As a result, the bank had very few consumer depos­
its. That is to say, insured deposits. In fact, consumer deposits were only about 1012 percent o f all liabilities. The Illinois bank was primarily a wholesale bank.
That means it did most o f its lending to large corporations. And it funded its lend­
ing with large uninsured corporate deposits and funds in the form of negotiable

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certificates o f deposit, Eurodollars, and subordinated debt.
In the late 1970s and early 1980s, the management of the Illinois bank adopted
a corporate strategy that we now believe led to its later failure. Management
announced that it was the bank’s goal to become the largest lender to commerce
and industry in the United States. That meant it was setting out to take a share of
business held by others like Bank o f America, Citibank, Morgan, Chase, Chemi­
cal, and its nearby rival, First National Bank o f Chicago.
In order to take loan business from another bank or to get new loan business
that might otherwise go to a competitor, a bank must offer the borrower more
favorable terms. These may be in the form o f lower interest rates or easier repay­
ment terms. But there also may be lower credit standards that increase the risk in
the loan. In the case of the Illinois bank, there was also a delegation o f loan
approval authority to less experienced officers. These officers also interpreted
their opportunities for promotion and higher pay as depending more on the quan­
tity o f new loans they could produce than on the quality o f the loans.
This is an almost perfect formula for disaster: Relaxed standards in order to win
business; management emphasis on quantity rather than quality; and delegation of
lending authority to inexperienced loan officers.
The energy business was booming in the early 1980s and there was a tremen­
dous demand for oil exploration and production loans. Some o f the bank’s officers
established a close working relationship with a small bank in the oil-producing
section o f Oklahoma. The Illinois bank assumed the Oklahoma bank knew all
there was to know about oil loans and agreed to buy from the bank loans that the
Oklahoma bank could not keep on its own books. The Illinois bank also took par­
ticipation in the other bank’s loans in excess o f its legal lending limit.
The Illinois bank took loans from the Oklahoma bank without any significant
credit analysis o f its own and little attention to checking documentation. Again, I
must emphasize that one o f the key errors o f management in the case o f the Illi­
nois bank was to abandon good lending procedures and credit standards in a reck­
less pursuit o f new loans.
The Illinois bank’s troubles began to show up when the Oklahoma bank failed
due to losses on bad loans. Some o f those loans were also believed to have been
fraudulently made. Obviously, many o f the loans sold or participated to the Illi­
nois bank were also bad. And the Illinois bank was not the only victim. There
were several banks in other cities which also participated in loans made by the
Oklahoma bank or bought loans outright. Examiners found hundreds o f millions
o f dollars o f such tainted loans on the Illinois bank’s books. In addition, there
were many tens o f millions o f dollars of other bad loans. Energy loans and more
conventional commercial and industrial loans made under the same system of
inadequate credit policies, poor procedures, and unwisely delegated lending
authority.




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The Basic Elements of Bank Supervision

With the failure o f the Oklahoma bank it became widely known and reported in
the press that a lot o f the bank’s bad loans had gone to the Illinois bank. The
insured depositors at the Illinois bank were not concerned because the United
States government fully guaranteed the insurance that protected their deposits.
But the uninsured depositors, general creditors, and Eurodollar deposit holders
began to withdraw their support. When term deposits came due, they were not
renewed. Eurodollar contracts were closed out and the bank found difficulty in
raising funds in the interbank market.
The Illinois bank not only had a potential capital deficiency due to bad loans,
but also a very real liquidity crisis due to a corporate run on the bank by uninsured
depositors and general creditors. The bank borrowed heavily from the Federal
Reserve, as the central bank and lender of last resort, to meet the liquidity crisis,
but it soon became evident that the Illinois bank could not meet the demands o f its
creditors and capital was seriously impaired by realized and anticipated losses on
bad loans.
It might have been possible to close the Illinois bank and liquidate it in an
orderly fashion. That would mean paying off insured depositors and then selling
or collecting the remaining assets o f the bank with the uninsured depositors and
other creditors sharing whatever losses were realized on liquidation. But another
serious problem arose. The bank was one o f the nation’s leading correspondent
banks with deposit accounts from hundreds of banks all over the country, particu­
larly from banks in the states in the Middle Western United States near Chicago.
Many o f these were small banks that maintained large accounts at the Illinois
bank to facilitate check settlements, securities transactions, wire transfers, and
other routine business transactions. For several hundred o f these correspondent
banks the amount o f their deposits with the Illinois bank exceeded their capital. If
the Illinois bank was closed, they would have been insolvent. The prospect o f the
failure o f so many banks at one time was alarming. The result would have been
serious losses to the depositors and stockholders o f the smaller banks and disrup­
tion o f commerce in the communities they served. Furthermore, if the bank had
been closed by the authorities, many large companies and banks both in the
United States and in foreign countries would have lost large amounts as their cer­
tificates o f deposit, federal funds loans, Eurodollar contracts, and other claims
were not honored. This might well have created a crisis of confidence that would
have caused them to close out claims on other U.S. banks linked to the Oklahoma
bank. That would have seriously destabilized the entire banking system.
The Federal Deposit Insurance Corporation, the Comptroller o f the Currency,
and the Federal Reserve Board determined that the threat to the stability o f the
banking system was serious enough to declare the Illinois bank too big to fail.
Consequently the Federal Reserve loaned several billion dollars to the bank to
meet its liquidity requirements and the Federal Deposit Insurance Corporation

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injected several billion dollars of capital into the bank, in effect replacing the pri­
vate shareholders who were virtually wiped out. With the FDIC as the principal
stockholder, the bank was owned by a government agency, a fact that tended to
restore confidence. The FDIC then moved to replace the management and the sit­
uation was stabilized.
Under new management, the loan problems were addressed, the bank was sig­
nificantly reduced in size and gradually returned to profitability. It also paid off its
loans to the Federal Reserve. New capital was brought in and the FDIC eventually
sold off its interest in a secondary offering, returning the bank to private owner­
ship. In the process, a banking crisis was narrowly averted and many depositors
and institutions tied to the bank through the interbank market were spared very
large losses.
This history of the Illinois bank’s troubles illustrates the interdependence of
banks and the importance o f sound banks to the proper functioning o f the pay­
ments system and the economy as a whole. The failure o f the Oklahoma bank was
a direct cause o f the failure of the much larger Illinois bank and, had the Illinois
bank been closed by the authorities instead of taken over as a going concern, hun­
dreds o f other institutions might also have failed with very serious consequences
for the entire economy.
The other failure I want to describe to you is the failure of a banking company
in Massachusetts. It was a large regional bank holding company with about $24
billion in assets. The head office was in Boston, Massachusetts, but it also had a
large bank in Hartford, Connecticut, and subsidiary banks and branches over
much o f N ew England. The company had a proud tradition going back 150 years
or more and was the result o f the consolidation by merger and acquisition o f many
banks in the major cities o f the region.
This was also a case of mismanagement and careless, perhaps even negligent,
loan administration. In the 1980s, New England and California were the nation’s
most prosperous regions. The computer industry, defense contractors, health care
providers, insurance companies, banks and universities that were the core o f the
N ew England econom y were all booming. To support these prosperous industries,
real estate development blossomed. The demand for first class office space, hotels,
laboratories, manufacturing plants, and multifamily residential facilities seemed
to be insatiable. Several thousand hotel rooms were added in Boston alone in the
early 1980s and as soon as a new office building was completed it was filled.
Rents for first-class office space in Boston went from $15 per square foot per year
in 1978 to $35 per square foot by the mid-1980s. And prices for single family
houses quadrupled in ten years time.
To finance this real estate boom, banks entered into a highly competitive bid­
ding war to obtain the developers’ business. Banks were convinced that prices for
real estate could only go up and that a new building would be worth more than the




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cost to build it by the time it was completed. We had seen construction loans made
for 100 percent of the cost o f completion. Therefore, the developer or builder had
none of his own money in the project. In addition, banks would build into a loan a
contingency reserve of 5 to 10 percent to cover cost overruns and finally they
would lend the full interest to be paid on the loan up to the time o f completion.
Historically, banks would not finance speculative building projects. Instead
they would require either a commitment for permanent financing at the com ple­
tion o f the building or the acquisition of the building on completion by an individ­
ual or corporation o f high credit standing. These basic principles o f sound
construction lending were abandoned or compromised by many banks in the
1980s and the Massachusetts company, fighting to obtain a dominant market share
in real estate finance in the region, was one o f the most aggressive lenders to offer
favorable terms like those I have described in order to get the business. And they
succeeded. Too well. Their loan portfolio became overloaded with real estate
loans, bad ones as it turned out, and when the New England econom y went into
rapid decline in 1989 and 1990, real estate prices declined even faster. There was
an oversupply of available space. House prices declined as much as 15 or 20 per­
cent and first-class office space rent went from $35 per square foot back to $20 per
square foot.
As a result, the buildings on which banks had loans were unsold or unrented.
Developers were bankrupt and the loans on the buildings were now far in excess
o f their market value. The loans could not be serviced from income. They could
not be sold except at deep discounts that would result in heavy losses to the bank
holding the loan.
Perhaps hardest hit of all New England banks by these circumstances was the
Massachusetts bank. With its heavy concentration in real estate loans and real
estate-related loans it was particularly vulnerable to the turn of events. An inap­
propriate management strategy, bad credit policies, and a failure to make an accu­
rate judgment of market conditions and the risks in the marketplace all combined
to put the bank in deep trouble. Loan loss provisions to bring the loan portfolio
into some relation to actual value consumed earnings and invaded capital.
Early in the crisis the directors of the company assumed the lead in trying to
save it. They organized several special committees to oversee various parts of the
bank. They discharged the chairman and some other members of the senior man­
agement and brought in a new chief executive officer to try to work the bank out
o f trouble. He did a remarkable job. He sold assets, worked down the problem
loans, and tried to improve the capital position by negotiating with debt holders to
convert their debt to equity. He did reduce staff and shrink the bank to improve the
capital ratios and he stabilized the operation enough to pay off loans from the Fed­
eral Reserve, where the bank had been borrowing steadily for six months due to
the loss o f corporate deposits.
But, in the end, the wounds were too deep, the losses too great for the bank to

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survive. The end came in January 1991. In spite o f management’s valiant efforts
to keep it going, events conspired to bring it down. The N ew England econom y
continued to decline and as a result the weakness in the Massachusetts bank’s loan
portfolio spread from real estate to other loan categories. As losses mounted, cap­
ital was further depleted. Negotiations with debt holders collapsed. The final blow
was the failure o f the state deposit insurance system for credit unions in the
adjoining state o f Rhode Island. The press reports o f small depositors losing their
money created a panic among the Massachusetts bank depositors. Press reports o f
the bank’s problems combined with the Rhode Island mess resulted in the first
consumer run on a commercial bank in more than fifty years.
Between opening on a Friday and closing at noon on Saturday, consumers with­
drew nearly $1.5 billion even though their accounts were fully insured. Under the
circumstances, the authorities decided the bank was no longer viable. The Federal
Deposit Insurance Corporation seized the bank and requested bids from other
banks who wished to take over the bank’s franchise in New England subject to the
FDIC assuming responsibility for bad loans. The successful bidder was a Rhode
Island bank holding company that assumed responsibility for all deposits and
acquired some of the loans that its analysts judged to be sound.
Again the device of government takeover rather than liquidation was chosen by
the authorities because in their judgment the shutdown o f the Massachusetts bank
in an already seriously crippled New England economy would have been seri­
ously destabilizing. In addition, it might have impaired the ability o f other banks
in the region to fund their own operations.
The consequences of bank failures are serious no matter how small or how
large the bank and no matter how the failure is resolved— whether by liquidation
or purchase of assets and assumption o f deposit liabilities. In a small rural com ­
munity where the failed bank may be the only bank, the failure may virtually
bring commerce to a halt. Any failure imposes personal hardships on individuals
as well as corporations. Inevitably people lose employment. Some depositors lose
money. Stockholders lose their investment— usually all of it. Those who supplied
goods and services to the bank lose a customer. Those who used the bank as a
source of financial support must now establish sources o f that support with
another institution.
When one thinks of the consequences of the failure of a major money center
bank in New York, or London or Frankfurt or Tokyo, it is not difficult to understand
that there could be worldwide repercussions with the real possibility of widespread
financial panic. The whole rationale for supervision and regulation o f the banks is
to avoid such consequences— whether they be the localized effects of a small bank
failure or the earth-shaking reverberations from the fall of one of the giants.
All through history, the most important reason for bank failure has been bad
loans or bad investments— usually bad loans. Therefore, it is imperative that
bankers exert their best energies and judgment in managing the acquisition and




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The Basic Elements of Bank Supervision

administration of loans. Analysis of the borrower’s ability to repay must be thor­
ough and accurate. The loan must be constructed so that the borrower can service
it as to interest and principal without impairing his or her normal pace and scope
of activity. The risk inherent in the loan must be accurately reflected in the interest
and fees that the bank earns on the loan during its life. The bank should be paid
for the level o f risk it is assuming. And, since the best bankers sometimes make
mistakes, there must be sufficient capital to absorb losses and yet sustain the
bank’s viability. W hile all capital is always available to absorb losses, it is prudent
in good times to set aside reserves over and above operating capital to absorb
expected losses.
Since governments, businesses, and individuals are all dependent on banks to
facilitate payments and obtain credit, the safety and soundness o f the banking sys­
tem is critical to the proper operation of a nation’s economy. In order to assure that
banks are operating in a safe and sound manner, government must devise ways to
monitor the banks and create regulations for their operation that help them avoid
difficulties. In the United States, we have both national and state regulatory
authorities and at both levels of government we have established a monitoring
system which is based on periodic uniform reporting by the banks and on-site
examination o f the banks by the regulatory agencies. Some would argue that we
have overdone it and that our banks are over-regulated to the point o f being
smothered. Indeed, some moderation o f regulation is probably due here. But by
and large our system has worked well and others would do well to consider how it
might be adapted to their own situation.

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