Full text of The Work of Examining Banks

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MAY 31

TM

, 1923.

WQJUK Gi? SXJBiUttJd B A i&S

BY
J. a.

JiA»4t&£,

ESASUlUflOS DIVISION, F. B. AGKMT'S BaPA-SSIO?,
Fg&gftfc

m m & w bmk

of sr. louis.

{Copies h&naed to rtessrs# ii&rtin, Attebery, Stevearl, Uovy,
Glasgow, Bailer/. Wittenberg, tiei^er aim

uteii^in# ]

la an examination, three considerations are of paramount importance* First
is the baiK solvent? Second, are the depositors* interests properly safeguarded?
Third, is the law being duly observed? In determlning these matters, it is assumed
that a sufficient amount of the bank*s assets are liquid in order to provide for
usual demands in the ordinary course of business* Insolvency is distinguished from
impairment of capital, the former occurring only after capital, surplus and profits
have been entirely eliminated or in other words, «&ts the bank no longer has good
assets sufficient to pay off all liabilities except those to stockholders. A task
may be forced to close its door®, iblli solvent, due to froiien assets and inability
to Maintain sufficient cash reserves to take care of demands made upon it . Go the
other hand, it is possible for a bank to continue operations, even tho insolvent,
if sufficient reserves are maintained, provided that fact is hidden from the
authorities*
foo often, personal and selfish interests dictate policies to the detri­
ment of the bank's welfare* ^ride in a large amount of business, the desire for a
greater re turn on investment, and efforts to satisfy dividend expectations of
other stockholders, are frequently factors in swaying the judgment of managing offi­
cers from fundamental principles involving investment of the funds of others. Even
when conditions are dangerous, directors hesitate to suspend dividends, fearing
the public will form an unfavorable opinion concerning the bank*s condition and
withdraw funds*
In nearly every hank are to be found at least one or more favored borrotsers
who, through personal magnetism or some lapse on the part of management, are using
more than their share of the bank*g funds* Hats the management of the hauls regards
itself in the role of a trusted custodian of the funds of others, and not merely
conducting their own private enterprise for profit, there is little probability
that toe hank will become dangerously involved, even under unfavorable conditions
or during times of stress* they should realise that the nursing of local infant in­
dustries and even the legitimate financial needs of the community are of secondary
importance, if their promotion threatens the security of funds entrusted to the
hank by its customers*
She examiner canperform one of the most important duties of his ofrice
in the directors* meeting* It is the directors who bear the responsibility of the
bank's welfare, and if conditions are unsatisfactory, they should be minutely in­
formed regarding unsound practices or dangerous tendencies# Usually a bank is
dominated by one or two directors through ownership of a considerable portion of
stock, yet other directors may not deny m equal share of responsibility because
of this fact#
During the course of the meeting, it should prove beneficial to ask each
director some question regarding the bank's affairs, to stimulate his interest and
determine his knowledge concerning its condition* Ask several directors if there
are any conditions or practices prevalent of which they do sot approve, and, if so,
sghy they have not insisted upon a correction* There may be criticisms present, un~
& m m to examiner, shich wiii be brought to light, if directors are encouraged to
discuss the bank’ s affairs freely*
■hen serious conditions are revealed, it is usually the plea of one or
more directors that they were unaware of true conditions, or that, If they had mis­
givings, they permitted themselves to be overruled without gerious protest* Urge
them to n ea ter activity in the performance of their duty, ire they permitting
the active officers to usurp their authority? It Is unfair to all concerned that



one am bear all the responsibility for the bank*s loans and investments*
Chief among the examiner*s attributes should be foresight and intuition*
I f , when confronted with unwise tendencies, he hangs out a reft flag, or, more import­
ant, if he has eloquence enough to awaken the directors to full realisation and action
he has performed a valuable service* In a bank of quickened conscience, it is im­
probable that the examiner will discover Many excessive loans or large lines of credit
payment of which hangs upon the slender thread of remote possibility*
If examiner is to secure the best results, he should have some ability at
character reading and retain, if possible, the banker*s confidence. As conclusions
are based to a large extent upon what the official tells him, it la unwise to anta­
gonise the official unnecessarily* Some men are more sensitive to criticise than
others end few are free to admit losses, so the examiner's attitude must be con­
genially inquisitory i f he is to avoid congealing the fount of information at its
main source•
Directors should welcome the examiner as their test source of information
Concerning the true condition of the bank. It provides a check on their officers,
which, owing to their own lack of experience with banking details* they could not
make even in their own Oorsmittee &x«ain&tion. Although an examination by directors
is usually perfunctory as to details, the clerical work frequently being done by
officers and employees, it is very important, especially in regard to credits*
through their knowledge of local borrowers they should be in 'better position in many
ways to uet* rmine bad loans than the examiner, who, through lack of financial state­
ments and ot »er credit information, may be altogether dependent on the officer*s
estimates of net worth. It should prove very beneficial when examiner can arrange
for a committee of directors to assist in the examination, particularly with regerd
to consideration of the loans*
Wmn bank arrives at a dangerous and critical condition, it is usually
due to inefficient management aid a difficult task confronts the examiner. Exper­
ienced exaniaers agree that seldom does a bank recover and prosper under thesame
management that is responsible for its downfall, it is usually very difficult to
make directors realise the necessity of a change, and often when that point is reach­
ed it is too late to saw the bank* It is no doufct a natural impulse for a board of
directors to reseat criticism of their chosen representative, coworker for m a y
years perhaps, especially when the examiner is a stranger, although he comes vested
with governmental autnorlty* It probably does seem presumptuous to the lay mind and
many directors come within this classification for an outsider to suddenly appear
within their midst and after a few hours investigation, confront them with startling
disclosures and demands regarding tneir institution.
Such corrections as can be made immediately should be made during examina­
tion*
Minutes of directors meetings, among other things, should show approval of
all loans, preferably by mentioning numbers* ^his is important where state law makes
directors liable for violations of the loan limit in case of loss* Minutes should
also set out such matters as dividend declarations, charge-offs authorized, salaries
of officers, etc. It is often advantageous to state in report the date on which re­
gular monthly meetings of the Board are held.




Be port should set out examiner's opttnion as to solvency, unimpairment of

capital and surplus* liquidity of assets! ele®u nts of danger and unsound, tendencies,
if m g f sad general comment as to capability of management* Utaa criticisms are
mad*, take care to see that they are just beyond question and. be prepared to defend
then? in ease exceptions are ta&en. iixaminer should also be prepared to offer a
remedy for conditions criticised*
Bernards concerning an individual officer should be reserved for the con­
fidential section of report. Words of high praise for an official or employee nould
prove embarrassing, sh uld said official eventually prove to be an embezzler or
forger.
9hil« the examiner*s duties do not priie&rily include those of a detective*
yet verification of details should be carefully made* individual ledger accounts of
officers and employees should be scrutinized for transactions exceeding their
apparent means. If they are heavy borrowers, actual interest payments can be checked
to the journal* i)efaults lire frequently brought to light during the culprit*s en­
forced or volunt&rjr vacation; and if examiner's suspicions become aroused, the matter
of annual vacations may be taken into consideration* Is the bond covering officers
and employees large enough? too often* no. men in a m all bank, a large at® may be
abstracted before disclosure; and in the great majoeity of cases of misapplication,
the amount of bond has been «?oefully insufficient* Burglary insurance should be
sufficient to cover all cash and securities on hand* including safekeeping items.
In the detection of criminality* it «©uid see®, in view of the number of
cases wfaerf shortages are carried for perhftp* years before discovery, that examiner
can render a substantial service by reccmnenaing proper bookkeeping systems and
internal checks that should automatically uncover fraud.
Federal Heserve Examiners have authority to examine officers, directors
and employees of member ban&s on oath* *his power is not ordinarily exercised*
However, state examiners in Missouri place directors on oath at each meeting held
with them*
•Examiner should call for last report of state or clearing house examiner,
also copies of correspondence fro: supervising authorities in regard to criticisms,
and see nhether all requirements have bc-en met satisfactorily®
Have conditions of membership been fulfilled?
fully investigated by examiner while he is in the banic*

Shis matter should be care­

CASH* She first step in an examination is usually ra; de by counting the
cash on hand* This can be done by cheeking and verifying items against cash 'balance
sheet of teller* f±otal cash should of course agree with amount shown on daily state­
ment* It is not considered necessary to count each bill in a package of small de­
nomination currency, such as l{s , 2*a and 5*s. One package can be verified and other
packages of like content inspected and compared* Ifeckages containing bills of larger
denetsiafeitiens should be carefully counted, although this rui.e may be modified in the
case of bank# of large size. Silver stacked In tray can be aceusately figured by
comparison; and silver in sacks can be satisfactorily estimated by comparative weight*
Shortages in cash have occasionally been switched to ledgers or other accounts after
examiner maicea his appearance* ffhis can be usually discovered by observing the
average mount of cash on hand for the past several days. If any great change appears



on date of examination, the cause should be determined* although it may have been
regularly caused by payroll or other unusual demand* Particular care should be ex­
ercised if the daily statement and general ledger are not kept posted up to date*
In a number of cases* this work has been pnrposely neglected, in order that false
entries sight be made in case of an unexpected examination* In one bank* cashier
had been showing a large amount of cash on hand and books were not .posted to date.
J&en examiner appeared* a switch isas made to "Due toom Banks** showing mail remittan­
ces. Zonedlately after examiner left* wire transfers were ordered and credits
followd* reconcilement appearing regular. fl?here are so many ways to hide discrep­
ancies in books and accounts, however, thrt examiner is fortunate to locate a cash
shortage on a clever manipulator* unless totals misapplied have grown so large that
he nas become confused or careless,
C3LEASiaG8. fracer blanks are usually enclosed with items and packages
placed under seal. Totals say be verified by drawee bank, and space is provided for
list of, and reasons for, checks returned. Uhere the nans of cheeks is not too large,
examiner say inspect larger items with an executive officer of the bank, and ^kites’*
possibly discovered in this manner. A shortage was brought to light in a St# Louis
bank by this methods Ssployee received savings deposits and made entries in ledgers.
#1*000# vrns charged to ah inactive savings account and money deposited is another
bank* fi»ployee was purchasing liberty bonds personally at a discount fro® customers
of the bank* Uhen ex miners appeared* employee had on hand some liberty bonds parchased with bank’ s money and to hide the irregular purchase, took these out and in­
serted M s own check on another bank in the clearings for a substantial amount, The
check was good and m s honored, but after the, discovery of an employee*s check for a
large amount in the clearings, close investigation disclosed the shortage in savings
account.
1*01113 USD BI^OGUafii. An this item usually includes the ma$or part of the
banks assets* and solvency depends upon their collectibility, examiner will spend the
greater part of his time in an appraisal of same. Consideration should be given as
to the general character of loans and vimther they are neil distributed* both as to
classes of borrowers and amounts. 5!he principal industries of the community* crop
and business conditions* and local situation generally should be ascertained* If
baak is in an extended condition, particular attention should be given to advances
made to non-customers of the bank. This can be largely determined by inspecting in­
dividual ledgers to observe average balances carried, if m y*
Loans to directors, officers and employees and their enterprises should be
carefully scrutinized* as they are in position to abuse the borrowing privilege.
It
is to toe assumed that directors ar« chosen because of their financial ability and
standing in the community* but this should not excuse them froracomplying with custo­
mary requirements and safeguards governing extensions of credit* The name fact of
being a director appears to give that person, in some banks, a right-of-way to not
less and frequently ©ore than the maximum amount of credit contemplated by law. She
boneyard of banks contains the ghastly remains of many an institution* whose townfall
was caused by unwise loans to its officers and directors.
'Seme directors appear to
hesitate before objecting to the unwarranted loans of other directors, perhaps because
he himself desires further credit at a later date and desires to avoid a too close
scrutiny of his own demands* Inasmuch as directors are presumed to be chosen on
account of some financial standing, among other possible qualifications, there would
seem to be no just reason why directors should not completely secure their own indebted*




m ss* ftae moral obligation to do so is considered even greater than in the case
of the outside borrovi?er*
If examiner believes smwamtiBilon loans are held for the purpose of
ev. ding the loan limit, credits- should be check, e& to the individual ledgers, this
has also been done where it m s desired to evade the 10^ rediscount limit, although
the combined loans did not exceej. the state loan liir.it* Interest payments on notes
at random and officers and directors obligations may be traced to the j o u r n a l or
profit account.
Some banks attempt to require that balances be maintained in proportion
to the amount loaned. Ihile balances thus carried cannot be regarded as an absolute
proof of the full collectibility of loan, yet im inspection of some may give examiner
some i n s i s t into the activity of borrower’ s business and his resources.
An estimate of the amount of paper eligible for rediscount will throw some
light upon the question of liquidity and bank*s ability to meet unusual demands*
should occasion require.
Examiner should ascertain whether proper records are kept in this depart­
ment, such as discount register, maturity tickler, liability ledger, interest received
journal, rediscount record, etc.
ffae ability to detect forgeries is either a fine art or m example of rare
good fortune* if doubt arises* reference can be made to the signature card or check
file .
Extension Of notes
interest payment is objectionable, especially so when
directors are not given an opportunity to pass upon such renewal. Indorsements may
also become invalid through carelessness in this connection# Ssaminer should condemn
this practice and recommend that new notes be taken*
It would appear to be a short sighted policy to concentrate loans among a
few large borrowers, aside fro® the risk involved* when a wider distribution would
better serve the cor/*nunity ana permit the needs of a larger number of customers being
met. iron a selfish standpoint, it would appear frequently to be a loss, as the
larger borrowers f reuuently carry the smaller balances, especially in agricultural
communities*
So bahti is too small to keep on file some kind of credit information* and
it is yecasing more customary to require financial statements on large borrowers. Ivea
in moat rural sections, the prejudice against asking for these statements is being
gradually overcome.
In considering loans, the two big overside questions to be considered are;
HOW and V,Hiu3 will they be liquidated. If the answers can be correctly ascertained*
conclusions follow easily. If correctly applied, all of the paper held by the bank
can be classified without serious difficulty.
One definition of a “capital** loan is viiere it is necessary for borrower to
sell a fixed asset in order to liquidate current indebtedness; or reversely, where ther



-6-

are not enough quicic assets to accomplish the smm re salt* Oapital loans are fre­
quently "slow” and if so* should be described under that classification* fhere are
cases# however, whert this is not true, as in the case of liquid collateral or
sufficient endorsement securing the line* where a loan can be liquidated upon short
notice from whatever source# it cannot m termed "slow* although it may fee criticised
shea, because of long standing, it assumes the aspect of a permanent loan* She hold­
ing of a reasonable amount of capital loans# not slow# if properly distributed both
as to olass and amount# would not seem subject to special criticism# if the just needs
of other borrowers were properly served*
fhere are many loans which are oinriously ”slowtr but it is not always easy
t» vietermine this classification* fhe time element is not always made a fixed rule
and may vary according to the character of business* If one year was set as the point
beyond which loans would be classed as slow, it can be seen that in rural communities,
in ti e of crop failure, practically all farmers* loans would be slow. It would seem
to be better policy to note whether under conditions existing# borrower is making ■
reasonable progress toward the liquidation of his debt* Where a loan is improperly
secured and ultimate payment depends upon moral risk# future success or other uncertain
possibilities, and where total loss would result in css# of matter's death# there may
certainly be said to be an element of doubt* rfhe estimation of a loss, when not ad­
mitted# and the classification of doubtful paper, are matters closely allied# and nay
distinction is frequently a fine point, classification depending upon the judgment of
the individual examiner* Whets paper is doubtful# it should be the attitude of a con­
servative management to remove or at least set up a substantial reserve against same#
as it cannot be with certainty relied upon to liquidate liabilities. It is sometimes
wise to use the terms "apparent” or ‘’probable%etc*# inhere an exact conclusion cannot
be reached, as examiner should not maSm positive statements that he cannot substantiate
it has been said that when baa&*s criticised assets {slow# doubtful and loss#
and bond depreciation) exceed the ;anount of capital, surplus and undivided profits,
a situation is disclosed which requires prompt action on part of the management and
close attention by supervising authorities; and this is an important point for examiner
to oear in mind.
A loan may m criticised although! not classified as slow# on account of its
being too large# or of a capital nature, or for other reasons.
In considering and classifying paper as slow, if it is under rediscount with
the Federal Heserve Same# it should be given special attention*
la consenting on unsecured loans* if no financial statement is on file , that
fact should he noted and m estimate secured of borrower's net worth*
By comparing financial statements of different periods and observing the up­
ward or downward progress of borrower's liabilities to the baas by reference to the
liability ledger, examiner can be assisted in his estimation of debtor’ s progress.
SfOOKS AJi) 90SD3* Securities are to be listed upon bond sheet# and present
ei-rket values obtained from financial publications or quotation books. If a sub­
stantial depreciation exists# some arrangement should be made to take care of same.




Qomptroller*s instructions in regard to this matter iuve been to require a charge off
at each examination amounting to not less than 25$ of estimated depreciation*
n m u m HOUSE, PUIUISUXUS AIS»
fa*e steps to learn ufaether these
assets are carried on tne books at a fair valuation; also if a reasonable mount of
depreciation isi,provided for annually# figure rate of return on investment* allow­
ing a reasonable amount for boating roc®.
0BK&B fiiilL ISWtMMm A majority of the states provide that real estate
cannot be purchased outright, except for purpose of banning room# Beal Estate may
be acquired, however, through foreclosure proceedings under mortgage, or in the se­
curing of previous uebt, in which oases bank is usually prohibited from holding sane
for more than a certain period, usually g im years* In many Jurisdictions* so penalty
appears to attach, however for failure to dispose of umm within the required time
and although couiBlsgioHer may criticise, he usually grains further time in which to
eliminate same, if local conditions are not favorable for the sale of property at
book value# In a great many oases, management does not make vigorous efforts to dis­
pose of same.
M U i JyQaCfMSB* Beeoacllemcnt is mad® by making m copy of reconcilement at
end of previous month, then making a transcript of all debit and credit entries in
the account from the first of the month to date• Dates of entries and nature of items
should be shown, drafts issued should be listed separately and numbered# State­
ment is then obtained from correspondent bankand final reconcilement made, inceptions
not promptly adjusted and returned items should be given close attention,
GC&lM)nGB OS m m SZT j m m m . Items may be verified by tracer. Mxamine
recent Items for evidence of kiting* Where this practice is indulged in, it is a sure
sign of difficulty - either the officer or employee Is personally involved, or the
bank is la an extended condition.
d TOOK.
Proof of outstanding stock is made by listing number of
shares fro® stubs of stock certificate book. Certificates cancelled should be pro­
perly assigned, cancelled and attached to stubs. When a certificate has been lost or
stolen, affidavit and indemnifying bond should be taken from stockholder, and attached
to stub. See that no blank certificates have been removed from back of certificate
book. List number of shares held by directors, and observe Aether balance of stock
is well distributed or closely held.

m m n m n m m m AGom m , m m m sm m $ M m w m n* Ohec^ last report of
earnings and dividends. famine at least superficially expense distribution book.
List charge-offs and recoveries, also date, rate and amount of dividends paid. Hatre
previous dividends been legally paid, taking into consideration whether reserve was
sufficient on date paid arid whether earnings were sufficient considering possible
losses in loans, and should regain.r dividends be continued?
MMAMM 'PMQ3XT8* 1early all banks now use loose leaf posting machines for
keeping individual ledgers. Owing to the ease with which sheets may be abstracted,
ledgers should be proved as soon as possible during the examination. If the current
4&y#s m rk has not been posted, it Is sufficient to list balances and prove as of the
day before. It Als usually very difficult to discover a shortage in the individual




•>0»
books. What protection is thrown around the®? Do separate parties post ledger and
statements? Poes someone other than bookkeeper prove his ledger occasionally at ir­
regular intervals? One ©an carried & considerable shortage over a period of years
in a baric that used the passbook system# He held out deposits and always managed
to balance passbook of those accounts himself* He m s an officer and had access to
both cages and individual books* When an account which he had manipulated threaten­
ed to become overdrawn, anotner deposit was diverted to that account. At first
these irregularities were confined to a few l a r ^ accounts, but later on it spread
until about tiro hundred accounts were involveu, and keeping up with all of them be­
came a great burden. He was always on the job and never took a vacation. Finally,
during an enforced leave of absence, disclosures were rapid and startling* m at
rate of interest is paid on open accounts? Investigate the inactive ledgers, if any,
and see what safeguards are thrown around it.
C&KflFIOAfEa 0# XEftDSXE* Cancelled certificates are checked against re­
gister and open itenas listed to proof. r
l?his list is left with the bank under seal.
At time of next examination, certificates cancelled since date of last examination
are checked against list up to last item thereon, the remaining o i k s check ed against
certificate register. Open items are then listed to proof.
GASHIKR3 OmtMS, DIVIDEND UHilG&y AMD CKHTIFIED QHHGKu.
case of certificates of deposit.

Proceed as in the

BII&3 P&YABL& M3) MDZdOQUMTiSm Make list of separate notes, date, maturity,
amount, interest rate and detailed list of collateral, if any.
Verify with creditor
bank* A bank without borrowed money will seldom be found in trouble. On the other
hand, the bank with a large amount of borrowed money is seldom out of difficulty*
I f debts of this character exceed the ban*is capital, observe whether this is caused
by unusual demands against deposits, or from an expansion of loans or investments*
Inflation to a dangerous degree can always be considered as more or less of a
criticism against the management on account of poor distribution or non-liquidity of
loans. Bven in the case of crop failure or business depression, the careful banker
will usually weather the storm without serious difficulty. A moderate amount of
borrowed money should not be taken as an item of criticism, but the absence of it is
a favorable sign. Selaom does a bank find itself in a critical condition without a
very large amount of bills payable and rediscounts. Poor credit judgment and over
expansion seem to be twin brothers ?md go hand in hand.
SJWMISASIOiiS - 4UDX23* fi?h€ main difference is that one is primarily an
appraisal of assets, while the other is a verification of details. Examiner does not
have the time to make as thorough an audit of some items as a public accountant, therefore examiner should urge banic to have audits made periodically. It is a protection
that eveyydi rector, especially if he is inactive, should insist upon*
BQCK3 AMD CL&BIGiL V&RK. E&m im r should observe whether all books of re­
cord are in satisfactory form and properly kept. Proof of all resources and liability
accounts should be made by someone in the bank at least once a month* Examiner cannot
hope to detect all irregularities, but he should recommend any change which will provivt
a better internal check*
Determine whether bank holds the required amount of stock in the Federal
Beserve Bank* Check the last report of condition against the books.




-9-

SAIEOBPHIG* A great mmy francs do not provide a promr record of
items left for safekeeping. Borne ao not have any* The imtmer in which this
record is usually kept provides a great opportunity for misapplication. Sziminer
should insist upon a proper record and check simv with the custosi&ry care, whether
or not a control account is carried upon tne daily statement* i&es bond cover loss
from this source? it would appear that bank afcght as well assume full responsibility
for these items and provide for their full protection* as ban* will suffer loss of
prestige and possible asmage if they are not returned upon demand* If bank is
pledging its customers* bonds for its own liabilities* ascertain b e t t e r they have
been granted author!ty to do this* Hum a bank is forced to this means of securing
its bills payable, it does not on first consideration* reflect favorably upon the
liquidity or worth of its own assets.
TsUiM A0£X?r£!j»3* Set out powers granted, if any; and those exercised*
Check all trust assets against ledger* Give particular attention if bank guarantees
deposits of other banks, titles to real estate, issues surety bonds* etc*
It is sonetiiaes useful to prepare a list of comparative figures, showing
the trend of the main resources and liability accounts*
m U Y lS*
Ascertain whether reserve with Federal lieserve Bank is
sufficient; also A ether average for past thirty days was sufficient; and whether
any dividends have been paid or new loans made while reserve was deficiest*
OLATfOl ACT* Be% out in report the mimes of any directors, officers or
employees who are directors, officers or employees of other banks.
List in report any violations of law noted* Describe fully any lawsuits
in which the banK may be involved* J&feo ascertain if possible whether any director
or officer is personally involved in such a way as might reflect unfavorably upon
the bank.