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\ F ederal deposit In su ran ce corporation WASHINGTON 25 ADVANCE -- FOR RELEASE A.M. PAPERS TUESDAY, JULY 27, 195^ ADDRESS OP HONORABLE H. EARL COOK CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION, BEFORE THE SCHOOL OF BANKING OF THE NATIONAL ASSOCIATION OF BANK AUDITORS AND COMPTROLLERS ( "AUDIT CONTROL AND BANK ASSETS" MADISON, WISCONSIN JULY 26, 195L ADDRESS OF HONORABLE H. EARL COOK, CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION BEFORE THE SCHOOL OF BANKING OF THE NATIONAL ASSOCIATION OF BANK AUDITORS AND COMPTROLLERS MADISON, WISCONSIN ADVANCE — JULY 26, 195^ FOR RELEASE A.M. PAPERS -- TUESDAY, JULY 27, 195^ "AUDIT CONTROLS AND BANK ASSETS" Mr. Chairman and students of the NABAC School-? As you know, we of the Federal Deposit Insurance Corporation think highly of continued education in specialized fields within the broad field of banking. Eight years ago our Board of Directors inaugurated an educational program which has seen more than 1500 courses completed by our examining personnel, including diplomas. 70 graduate banking school This is a continuing program, designed to augment the traditional on-the-job training which all newly appointed examiners receive. Aristotle long ago described education as "an ornament in prosperity and a refuge in adversity." We know that you will make good use of your learning as you progress in your careers, and hope that you never will have to rely upon its consolation as the result of adversity. The present sound condition of the insured banks is the result of many factors working together. There have been favorable economic conditions; there has been close control of chartering, so that we are not over-banked; there have been marked increases in the effectiveness of bank supervision and progressive forward strides in the quality and training of bank management. Also, there has risen in the Nation a new and vital interest in bank audits and internal controls of which this Association is the constant champion. The relations between the Federal Deposit Insurance Corporation and the National Association of Bank Auditors and Comptrollers have ever been cordial and productive* Your members helped to establish uniform reports of condition and of earnings. Your advice was NABAC — 2 frequently solicited on the question of accounting for insurance assessments. At the same time, the Corporation has championed its belief in better audit controls with, I am confident, mutually beneficial results. The health, the soundness and the prosperity of any bank depend basically upon the character, the capacity and vision, the training and the integrity of its operating management. That is the factor that creates the greatest challenge to you in the auditing and accounting profession. Although you cannot audit managerial Judgment, proper audit controls are of material assistance to management. I^t us begin with the question of human frailty — more bluntly put, the opportunities for, and the incidence of dishonest acts in banks. Much has been said and printed during recent years about bank defalcations and embezzlements. These breaches of faith within banks have occurred, and they are unfortunate. They possibly will continue to occur occasionally, despite the best efforts of men in your profession and the vigilance of bank examiners. Thanks to the auditors and their never-ending vigilance in installing better audits and internal controls temptations to the weak are being lessened as time goes on. It would be helpful and far more informative if the stories set these occasional bank defalcations in their proper perspective. In only 125 of the k22 insured banks which Federal Deposit Insurance Corporation has been called upon to' ai& has defalcation been a major cause of the difficulty, and these all occurred in comparatively small banks -- banks of such size that could not afford internal audits, etc. This is a provocative statistic. Let us see what happened in the other 297 cases. Many factors contributed to the several bank closings. Our liquidation records show numerous instances where failure allegedly was due to disaster in the community. In one case a heavy concentration or loans on orchards resulted in frozen loans and accumulated other real estate as the result of several successive crop failures. Drought conditions in certain localities proved too great a strain in the late 1920’s and early 1930's for banks which were entirely dependent upon annual crops for liquidation of loans. In one of the earlier cases where the Federal Deposit Insurance corporation was called upon to protect depositors we found a banking house absorbing more than 220 percent of the bank's capital. The hooks showed the item at $380,000. A wholly owned subsidiary of the NABAC — 3 Trank was the legal holder of the supposed equity in this hanking house. Prior liens amounted to $275*000 in bonds. The building was constructed on -leasehold ground — property subject to two leases with approximately 90 years to run. Included in the assets of the bank were notes of the subsidiary totalling $31*570, and all of the stock of the company, carried at $20,000. Furniture and fixtures were carried at $86,000 Add these figures up and they amount to $793*000. Capital accounts of the bank added up to only $358*000. Prudent management and skilled auditors could have prevented this development. Fortunately, bankers are not as prone as they were in past years to erect monumental buildings to house everyday banking activities. Today the trend is toward functional construction. At the time another insured bank was closed by its supervisory authority the book value of its assets exceeded $9*000,000. However, these included more than $ 600,000 of forged mortgages placed in the institution by a member of the family owning and operating the bank. An alert auditor, using direct verification, could have exposed the forgeries. In one small bank "kiting" operations resulted in a loss of nearly $78,000. The president and cashier were active in the operations and were aware that they were permitting withdrawals from uncollected funds without security to protect the bank, Internal audit would have shown the large number of drafts issued to the customer involved and might have saved the bank had the auditor been able to report directly to the Board of Directors. Another midwestera case that required financial aid from the Corporation was found by our examiners to have l) impairment of capital stock; 2) no current financial statements and credit information to support loans; 3) no inclination to reduce excessive loans to legal limits; and k) no competent executive officer to take charge of the active management of the bank. We can cite case after case where managerial judgment could have been improved had the auditor or comptroller been consulted. There is in our records a case of recent date where two bookkeepers of a large bank concealed for several years overdrafts that grew to more than $2,500,000, most of which was in one account. This was made possible by inadequate internal controls and audits. The largest losses the Corporation has been called upon to assume during its period of operations have been the result of poor managerial judgment, just as in years gone by. Some banks do not recognize the element of risk present in each asset they acquire. Consequently, they do not adjust for it in their rates on loans, their purchases of securities, and their provisions for losses. Even their best efforts frequently fall short of the mark when economic NABAC — k conditions become adverse. Many loans that are good when made and some that are subsequent renewals become slow, doubtful and frequently losses because of lack of attention during the interim. The banker’s job is not an easy one. He must serve the credit needs of his community, yet he must not take unjustified risks. He must be the confidant of all his customers, yet a careful analyst. He must have faith in his employees' abilities and honesty, yet set up safeguards around them. He must reconcile the frequently conflicting needs of Government and individuals for financing. Above all, he must have constantly in mind the welfare of his depositors, for his is essentially a trustee responsibility. We in Federal Deposit Insurance Corporation are gratified that, of the $327*000,000 we have disbursed to protect depositors, about 92 percent has been recovered. But that does not tell more than a fraction of the story. From 1865 through 1933* our research has shown, losses on assets of commercial banks totaled $12,313*000,000. Of these, $8 billion were net ^charge-offs to surplus and other capital accounts. During that period stockholders lost $2.5 billion and depositors lost $2.2 billion. Since 193^* when Federal deposit insurance became effective, net losses, charge-offs and transfers from reserves in insured banks have amounted to $^,83^,000,000. Here the auditor has an important role. An asset, just because it is charged off, is not necessarily worthless. Proper servicing and proper follow-up can salvage many a dollar. The file of charged-off assets, in my opinion, should be one of the most closely scrutinized in your bank. Management of any bank has three principal responsibilities: First, selection and training of competent personnel; second, selection of sound assets; and third, proper servicing of those assets after they are acquired. The first of these responsibilities is basic and its fulfillment will lead naturally to the adequate discharge of the second. All too often, however, we find a tendency to slight the third. Complacency develops on the theory that the first two are all that are necessary and a mistaken belief arises that if a loan appears sound when it is made it will always remain sound. Many bankers have learned by bitter experience that the job is only partly done when a loan is placed on the books, and satisfactory repayment depends on the servicing. NABAC — 5 Auditors and comptrollers have many avenues to promote proper servicing of assets. Regular appraisal of collateral is the first approach they should recommend. Amortization on a regular basis has come to be recognized as necessary and desirable for the majority of mortgage and personal loans, yet it is disregarded in many:institutions. This fundamental should be stressed constantly to every bank board of directors. It has been demonstrated that active work on unsound loans can liquidate them. Government agencies such as Production Credit Administration, and Home Owners' Loan Corporation made good loans out of paper the lending banks thought bad. New management in many stagnant banks has produced the same effect. Bank management, through its careful selection of personnel, through its interest in training promising employees and officers, through AIB courses and the growing number of specialized courses, such as this, can meet ably the first of the responsibilities. It is the privilege of banks to be custodians of their depositors' funds. It is the responsibility of the banks to guard the safety and the liquidity of these funds that are placed in their care. Good management will follow a policy of diversified assets. Loans and securities that represent varied obligors and intermittent maturities; the farm, the home, the business enterprise, the local governmental unit, the financial needs of the United States Government, all deserve consideration. With quality and diversification, our banks continue to prosper. Once a deposit is made and the officers of the bank have determined the use of these funds, the responsibility of you men begins. Do you, reporting independently to your board of directors, recommend direct verification of deposit accounts? Do you check income and expense items against a norm? These are the fundamentals of your job, and they will save supervisors a lot of time and labor If they are done well. In summary, then, I should like to restate the factors we of Federal Deposit Insurance Corporation consider essential for a healthy financial front: Directors in every insured bank must be aware of their responsibilities and willing to fulfill them. Capable bank management must learn that modern operating procedures and improved credit standards will benefit the community, the bank and its depositors. It will also choose and train personnel for each job and reward them with what the job merits, including NABAC — 6 provisions for health Benefits and retirement. Auditors and comptrollers in each hank are neededtto initiate and establish sound methods of accounting and control and see that they are observed. Should these measures.fail, we at Federal Deposit Insurance Corporation are ready to step in and take care of the depositors. We want depositors free from concern for the safety of their deposits. We want a sound and stable banking system. We want adequate managerial selection of assets and personnel. These factors, together with proper audit control and the supervision and counsel that we are able to give, will result in reduction in charge-offs and stock holders' losses and, consequently, reduction in depositors' losses. * # #
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