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March 199S


s s uEs

Fed Issues Safety and Soundness
Federal Reserve Bank of St. Louis

News and Views
for the Eighth District

Reflecting recent legislation
and comments from bankers,
the safety and soundness
standards mandated by FDICIA
have been issued by the Fed
and other banking agencies
as guidelines rather than
regulations. The guidelines,
which apply to banks (but
not bank holding companies)
represent the standards now
used by the agencies to assess
the operational and managerial
quality of an institution. As
such, most guidelines closely
follow the standards initially
proposed and do not represent
a change in policies or examination practices.

The proposed standard that
generated the most comments
was the requirement for an
internal audit system. This
standard was misinterpreted by
many bankers as requiring a
separate internal audit function.
The guidelines clarify that the
standard of independence and
objectivity can be met by ensuring that the person conducting
the review is independent from
the function under review and
is able to report findings directly
to the board of directors or to
a designated directors' audit
While last year's Riegle
Community Development and
Regulatory Improvement Act
permitted the standards to be
in the form of guidelines rather
than regulations, the agencies
retain the authority to require
an institution to submit an
acceptable compliance plan as
well as the ability to pursue
more severe enforcement
remedies where necessary.
For state member banks,
the following guidelines will
soon be sent to bankers as an
appendix to Regulation H.

Operational and
Managerial Standards
Internal Controls and
Information Systems
An institution should have
internal controls and information systems that are appropriate
for the size of the institution
and the nature and scope of
its activities, and provide for:
1) an organizational structure
that establishes clear lines of
authority and responsibility
for monitoring adherence
to policies;
2) effective risk assessment;
3) timely and accurate financial,
operational and regulatory
4) adequate procedures to
safeguard and manage
assets; and
5) compliance with applicable
laws and regulations.
Internal Audit System
The internal audit program
should be appropriate for the
size and complexity of the
institution and provide for:
(continued on next page)

Safety and Soundness Guidelines
(amtinuedfrom front page)

1) adequate monitoring of the
system of internal controls.
For an institution whose size,
complexity or scope of aperations does not warrant a full
scale internal audit function,
a system of independent
reviews of key internal
controls may be used;
2) independence and objectivity;
3) qualified persons;
4) adequate testing and review
of information systems;
5) adequate documentation of
tests and findings and any
corrective actions;
6) verification and review of
management actions to
address material;
7) review by the institutions'
audit committee or board
of directors of the effectiveness of the internal audit
Loan Documentation
An institution should establish
and maintain loan documentation practices that:
1) enable the institution to
make an informed lending
decision and to assess risk,
as necessary on an ongoing
2) identify the purpose of
a loan and the source of
repayment, and assess the
ability of the borrower to
repay the indebtedness in
a timely manner;
3) ensure that any claim
against the borrower is
legally enforceable (note
that a legal opinion is not
4) demonstrate appropriate
administration and monitaring of a loan; and
5) take account of the size
and complexity of a loan.
Federal Reserve Bank of St. Louis

Credit Underwriting
An institution should establish and maintain prudent
underwriting practices that:
1) are commensurate with the
types of loans the institution
will make and consider the
terms and conditions under
which they will be made;
2) consider the nature of the
markets in which the loans
will be made;
3) provide for consideration,
prior to credit commitment,
of the borrower's overall
financial condition and
resources, the financial
responsibility of any guarantor, the nature and value
of any underlying collateral,
and the borrower's character
and willingness to repay
as agreed;
4) establish a system of independent, ongoing credit
review with appropriate
communication to management and to the board of
5) take adequate account of
concentration of credit risk;
6) are appropriate to the size of
the institution and the nature
and scope of its activities.
Interest Rate Exposure
An institution should:
1) manage interest rate risk in
a manner that is appropriate
to the size of the institution
and the complexity of its
assets and liabilities; and
2) provide for periodic reporting
to management and the
board of directors to assess
the level of risk.
Asset Growth
Asset growth should be prudent
and consider:

1) the source, volatility and use

of the funds that support
2) any increase in credit risk or
interest rate risk as a result
of growth; and
3) the effect of growth on the
institution's capital.
Compensation, Fees
and Benefits
An institution should maintain safeguards to prevent the
payment of compensation, fees
and benefits that are excessive
or that could lead to material
financial loss to the institution.

Prohibition on
Compensation that
Constitutes an Unsafe
and Unsound Practice
Excessive Compensation
Excessive compensation is
prohibited as an unsafe and
unsound practice. Campensation shall be considered
excessive when the amounts
paid are unreasonable or
disproportionate to the services
performed by an executive
officer, employee, director
or principal shareholder,
considering the following:
1) the combined value of all
cash and non-cash benefits
provided to the individual;
2) the compensation history
of the individual and other
individuals with comparable
expertise at the institution;
3) the financial condition of
the institution;
4) comparable compensation
practices at comparable
institutions, based upon
such factors as asset size,
geographic location, and
the complexity of the loan
portfolio or other assets;

5) for post-employment benefits,
the projected total cost and
benefit to the institution;
6) any connection between the
individual and any fraudulent act or omission, breach
of trust or fiduciary duty, or
insider abuse with regard
to the institution; and
7) any other factors the Board
determines to be relevant.
Compensation Leading to
Material Financial Loss
Compensation that could
lead to material financial loss
to a bank is prohibited as an
unsafe and unsound practice.
Other Standards
The agencies did not prescribe
a minimum ratio of common
stock market value to book
value, finding such a ratio to
be infeasible.
The agencies have proposed
for public comment that the
ratio standards initially set for
asset quality and earnings be
replaced by monitoring and
reporting systems to identify
emerging problems and corrective actions to resolve them.

Bank Consolidation Increases in 8th District States
ver the four years
between July
1989 andJune
1993, five of the
seven Eighth
District states-Missouri,
Mississippi, Illinois, Indiana,
and Tennessee-relaxed
prohibitions against statewide
branching. Trends in these
five states indicate that banking
consolidation was well underway by 1994. One measure of
consolidation is the percentage
of state deposits controlled by
the ten largest banking organizations. By this measure, banking concentration increased in
these five states that liberalized
branching laws. For example,
in Indiana the largest ten banking organizations controlled
28.6 percent of statewide banking deposits in 1980. By 1993,
the percentage had more than
doubled to 60.4 percent. Even
in Illinois, the Eighth District
state exhibiting the smallest
rise in concentration, the
largest banking organizations
increased market share from
from 41.7 percent to 47.8
percent of statewide deposits
over the fourteen-year span.
Most of the increase in concentration, however, occurred
in the early and mid 1980s,

before the
recent liberalization of
branching laws.
Between 1980 and 1988,
for example, the largest ten
Mississippi banking organizations increased market share
from 45.4 to 60.7 percent of
statewide deposits. In contrast,
the number rose by only 2.5
percentage points over the next
six years. Though the largest
Missouri banking organizations
increased control of the state's
total deposits from 54.4 percent
in 1980 to 63.2 percent in 1988,
these banking organizations
added only 1.2 percentage
points to market share in the
following six years. Moreover,

State By State Trends In District Bank Consolidation
Concentration Ratio

Growth Rate

(Percentage of Deposits Controlled by the Largest 10 Banking Organizations)












Federal Reserve Bank of St. Louis

in four of the five states, no
sharp change in concentration
followed the liberalization in
statewide branching laws.
Indeed, Tennessee permitted
statewide branching in March
1990 yet the percentage of
statewide deposits controlled by
the largest ten Tennessee banking organizations was actually
lower in 1991 (67.2 percent)
than in 1989 (69.1 percent).
Only in Indiana did banking
concentration increase dramatically. Following liberalization
of branching laws in May 1991,
the largest ten Indiana banking
organizations increased market
share from 52.9 to 61.7 percent
of total deposits.
In short, bank consolidation
in Eighth District states over
the last fourteen years was
independent of the relaxation
in statewide branching rules.
On the basis of this evidence,
passage of the Riegle- eal
Interstate Banking and
Branching Act may not accelerate the trend in the district.
By Mark D. Vaughan, a Senior
Manager in Supervisory Policy
Analysis at the Federal Reserve
Bank ofSt. Louis.

Limitations on Transfers and Holdings
of DPC Assets
ecent inspections
of District bank
holding companies indjcate that
assets acquired in
the process of collecting a debt
previously contracted (DPC
assets) are often transferred
at other than fair market
value and retained beyond the
applicable holding period. In
these instances, examiners will
cite a violation of Regulation Y
and ask that the company take
corrective action which may
include making reimbursement
to the bank for transfers at less
than fair market value and
requesting regulatory approval


for holding periods beyond two
years. Following are guidelines
for transferring and holding
these assets.
Transfers of DPC Assets
Transfers or purchases of DPC
assets to or within a holding
company must be made at the
fair market value of the asset at
the time of the transfer and the
transfer must be made on an
arm's-length basis.
Holding Period
Under the Banking Holding
Company Act and Section
225.22(c) (1) of Regulation Y,
these assets may be acquired
without regulatory approval if
the DPC asset is divested within
two years. The holding period
begins when any entity within
the organization acquires the
asset. Transfers of DPC assets
within the holding company do
not extend, or begin anew, any
period for required divestiture.

of 10 years for real estate and
five years for all other assets,
provided requests are made
before the holding period
expires. Despite the extension,
bank holding companies are
expected to continually make
good faith efforts to achieve

If the initial two-year period
has expired, examiners will
look for evidence that this
Reserve Bank has granted an
extension to hold any DPC assets
covering the current period.
The examiners will also review
documentation evidencing the
transfer or purchase of the
asset, supporting the carrying
value and demonstrating efforts
to dispose of the property. Since
DPC assets are generally nonearning, they will usually be
adversely classified as substandard. The amount of book
value in excess of fair market
value will be classified as loss.

Extensions of the Holding
The Reserve Bank may, upon
request, extend the holding
period for up to a maximum

Regulation 0:
and Answers
on Related
Federal Reserve Bank of St. Louis


nsiders," as they are
defined by Regulation 0,
consist of all executive officers,
principal shareholders, and
directors and thei,r related
interests. However, based on
questions and inquiries received
at this Reserve Bank, identifying
a "related interest" is sometimes
difficult. To apply both the
individual and aggregate lending limits in Regulation 0,
banks must aggregate all

extensions of credit to insiders
and thei,r related interests.
The individual lending limit
is generally the bank's legal
lending limit to one borrower,
while the aggregate lending
limit for insiders as a class
is 100 percent of the bank's
equity capital and valuation
reserves (200 percent in certain
instances for small banks).
The following questions and
answers clarify when an insider's

relationship with another
entity is a "related interest."
Do related interests
include more than
business corporations?
Yes, related interests include
all corporations and partnerships, joint ventures and sole
proprietorships controlled by
(continued on back page)

Trends in District Concentration
he passage of
the Riegle-Neal
Interstate Banking
and Branching
Efficiency Act of
1994 has increased interest
in industry consolidation.
Recent trends indicate that
larger institutions hold a greater
percentage of banking assets.
While this implies increased
concentration, competition
among the largest institutions
may have also increased.
In the Eighth District, the
number of commercial banks
with assets less than $100
million dropped from 1,139
banks in 1986 to 858 banks
in September 1994. As illustrated in Figure 1, most of this
decline occurred at banks with
assets of less than $50 million.
Acquisitions accounted for
the bulk of the decrease in
the number of small banks,
followed by asset growth and
bank failures.


Figure I: Number of Small District Banks
by Asset Size
Number of Banks
900- , - - - - - - - - - - - - - - - - - - - - ,










Federal Reserve Bank of St. Louis

$0-SO Million


$S0-100 Million

Figure 2: Percentage of District Assets
by Asset Size
4S.00% - , - - - - - - - - - - - - - - - - ~

40.00% - + - - - - - - - - - - - - --

~ -- -


20.00% ---+-::==-------" - - - - - - - - - - - - - - - - - - - 1

S.00% 1 - - - - - - - - - - - - - - - - - ~
1986 1987 1988 1989 1990 1991 1992 1993 1994





$100-300 Million

Not surprisingly, the percentage of assets held by banks
with assets under $100 million
has decreased as well-from
36.2 percent of total Eighth
District assets in 1986 to 24.2
percent in September 1994.
As shown in Figure 2, in the
late 1980s, banks with assets
of less than $100 million held
a greater percentage of District
assets than banks over $1 billion, a condition which has
reversed in the 1990s.
In 1986, the District had
13 banks with over $1 billion
in assets; these banks held
32 percent of District assets.
In 1994, the 20 banks with
over $1 billion in assets held
41 percent of District assets.
While these data do not provide
conclusive evidence of increased
concentration, the trend is
clearly toward larger banks.
The other asset categories in
Figure 2, in general, showed




$300Mil.- 1Bil.
Over $1 Billion

either minimal growth or
slight declines over the decade.
While the assets controlled
by large banks in the District
has increased, concentration in
the nation as a whole is much
higher. From 1986 to 1994,
assets of commercial banks
over $1 billion grew from 67
percent to 74 percent of all U.S.
banking assets. In short, even
with geographic limitations,
banks were able to consolidate.
Whether branching across state
lines will accelerate that trend,
however, is an open question.
By Andrew P. Meyer, an Associate
Economist in Supervisory Policy
Analysis at the Federal Reserve Bank
oJSt. Louis.

Regulation 0: Q & A
(continuedfrom page four)

the insider. In addition, other
entities such as trusts (business
or otherwise) , associations, or
incorporated organizations,
and political campaigns controlled by, or for the benefit of,
executive officers, directors and
principal shareholders are also
related interests.
When does an insider
control a related interest?
Definite control is established
if the insider directly or indirectly (or acting in concert
with others) meets any of the
following three tests:
1) owns, controls or has power
to vote 25 percent or more of
any class of voting securities;
2) controls in any manner the
election of a majority of the
directors; or
3) has power to exercise
controlling influence over
management or policies of
the company.
In addition, a presumption
of control exists if an insider:

1) is an executive officer or

director of a company and
has 10 percent ownership; or
2) has 10 percent ownership
and holds no other position
in the company, but no other
person has a higher ownership of that class of voting
An insider may rebut a
presumption of control by
submitting written materials
demonstrating an absence
of control to the appropriate
federal banking agency. If the
agency agrees, then no control
exists and the restrictions will
not apply.
If a bank's director is the
grantor or trustee of a
trust, is the trust a related
interest of the director?
Yes. If the director is a trustee
of a trust or has power to sell or
dispose of the assets, terminate
the trust or replace the trustee,
the director is considered to
control the trust.

What if the insider is
only the beneficiary of
a trust?
The trust would not be a
related interest. However, if
the insider is a beneficiary of
the trust and his or her interest
is 25 percent or more, then a
loan to the trust would be
considered to be made for
the benefit of the insider
and counted as part of the
lending limit applicable to
the insider.
Would borrowings by an
insider-controlled trust be
included in determining
a bank's compliance with
the "individual lending
limit" and "aggregate
lending limit"?
Yes. If the trust were considered a related interest of the
insider, its borrowings would be
considered a loan to the insider.
Which would be included in
determining compliance with
these limitations.


Post Office Box 442
St. Louis, Missouri 63166
U ~ L l .tH{AK Y
CA:?.QT! TH~ Y'1'"1N

Supervisory Issues is published
bi-monthly by the Banking Supervision and Regulation Division of
the Federal Reserve Bank of St. Louis.
Views expressed are not necessarily
official opinions of the Federal Reserve
System or the Federal Reserve Bank
of St. Louis. Questions regarding
this publication should be directed
to Sarah F. Casanova, editor,
(314) 444-4634.
Federal Reserve Bank of St. Louis


Our director owns 30
percent of company A,
which in tum owns 30
percent of company B.
Is company B considered
to be a related interest
of our director?
Yes. Aperson is considered
to control any company he or
she directly or indirectly owns,
controls, or has power to vote
25 percent or more of any
class of voting securities.
Do the additional
restrictions on loans
to executive officers,
generally $100,000,
also extend to executive
officers' related interests?
No, although they may
apply to certain partnerships
of which the executive officer
is a member.
By Gary Juelich, a Superoisory
Examiner at the Federal Reseroe
Bank oJSt. Louis.