Examining Bank Director Practices: Red flags for Commercial Banks, Study notes of Law

Download Examining Bank Director Practices: Red flags for Commercial Banks and more Study notes Law in PDF only on Docsity! Duties and Responsibilities of Directors Effective date November 1995 Section 5000.1 INTRODUCTION Directors are placed in a position of trust by the bank’s shareholders, and both statutes and com- mon law place responsibility for the affairs of a bank firmly and squarely on the board of direc- tors. The board of directors of a bank should delegate the day-to-day routine of conducting the bank’s business to its officers and employ- ees, but the board cannot delegate its respon- sibility for the consequences of unsound or imprudent policies and practices, whether they involve lending, investing, protecting against internal fraud, or any other banking activity. The board of directors is responsible to the bank’s depositors, other creditors, and shareholders for safeguarding their interests through the lawful, informed, efficient, and able administration of the institution. In the exercise of their duties, directors are governed by federal and state banking, securities, and antitrust statutes, as well as by common law, which imposes a liability on directors of all corporations. Direc- tors who fail to discharge their duties com- pletely or who are negligent in protecting the interests of depositors or shareholders may be subject to removal from office, criminal pros- ecution, civil money penalties imposed by bank regulators, and civil liability. Title IX of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Comprehen- sive Thrift and Bank Fraud Prosecution and Taxpayer Recovery Act of 1990 greatly en- hanced the enforcement powers of the federal bank regulatory agencies, including the Federal Reserve Board. Section 5040 of this manual, ‘‘Formal Corrective Actions,’’ describes those enforcement powers in greater detail. DIRECTOR SELECTION The affairs of each state member bank are overseen by its board of directors. The initial directors are elected by the shareholders at a meeting held before the bank is authorized to commence business. Thereafter, they are elected at meetings held at least annually on a day specified in the bank’s bylaws. The directors hold office for a stated tenure, generally ranging from one to three years, or until their successors are elected and have qualified. No state member bank is to have less than five or more than 25 directors as specified in section 31 of the Banking Act of 1933. Various laws govern the election, number, qualifications, oath, liability, and removal of directors and officers, as well as the disclosure requirements for their outside business interests. Other laws pertain to certain restrictions, prohibitions, and penalties for secu- rities dealers serving as directors, officers, or employees; director interlocks; purchases of assets from, or sales to, directors; commissions and gifts for procuring loans; embezzlement; abstraction; willful misapplication; false entries; political contributions; and other matters. The examiner must be familiar with these laws and the related regulations and interpretations. DIRECTOR INDEPENDENCE Directors must exercise their independent judgment when managing the bank’s affairs. A responsible board will not merely rubber-stamp management’s recommendations, but will review them carefully before deciding whether they are in the bank’s best interests. A board that is excessively influenced by management, a single director, or a shareholder, or any combination thereof, may not be fulfilling its responsibilities to depositors, other creditors, and sharehold- ers. Diversification of the board of directors is important and can be accomplished by including directors with no ownership or family-ownership interest in the bank and who are not employed by the bank. A bank’s board of directors may include one or more advisory directors. Advisory directors generally do not vote but may provide additional information or advice to the voting directors. An advisory director who functions in that capacity is generally not subject to the same regulatory requirements as voting members and has less liability for the board’s actions. However, if an advisory director exercises a degree of influence or control over the board or the bank that is not commensurate with that status, it is appropriate for examiners to subject that individual to the same standards as voting directors. Such a person might also be subject to the same liability standards as a voting director. Commercial Bank Examination Manual November 1995 Page 1 DIRECTORS’ RESPONSIBILITIES Directors play a critical role in overseeing the affairs of the bank. Directors should understand that if they neglect to carry out their fiduciary duties and responsibilities, they may be finan- cially liable if the bank fails or experiences loss. An examiner sometimes has to remind bank directors of the extent of their duties and respon- sibilities. Unless bank directors realize the importance of their positions and act accord- ingly, they are failing to discharge their obliga- tions to the shareholders, depositors, other credi- tors, and the community. Selection of Competent Executive Officers One of the board’s most important duties is to select and appoint executive officers who are qualified to administer the bank’s affairs effec- tively and soundly. The board is also responsible for removing officers who do not meet reason- able standards of honesty, competency, execu- tive ability, and efficiency. The responsibility for selecting executive officers also entails retaining them and ensuring that competent successors can be promoted or hired to fill unanticipated voids. The board is responsible for evaluating the performance of the chief executive officer and approving the CEO’s compensation. In many banks, the board also approves compen- sation for other executive officers. A state member bank that has been chartered or undergone a change of control within the last two years, that is not in compliance with the minimum capital adequacy guidelines or regu- lations of the Board, or that is in an otherwise troubled condition must provide 30 days’ writ- ten notice to its regulating Reserve Bank before it can add a director, promote an internal staff member to senior executive officer, or employ a new senior executive officer. Effective Supervision of Bank Affairs The type and degree of supervision required of a bank’s board of directors to ensure a bank is soundly managed involve reasonable business judgment and competence and sufficient time to become informed about the bank’s affairs. Directors ultimately are responsible for the soundness of the bank. If negligence is involved, a director may be personally liable. The respon- sibility of directors to supervise the bank’s affairs may not be delegated to the active exec- utive officers or anyone else. Directors may delegate to executive officers certain authority, but not the primary responsibility of ensuring that the bank is operated in a sound and legal manner. Adoption and Adherence to Sound Policies and Objectives The directors’ role is to provide a clear frame- work of objectives and policies within which the chief executive officer can operate and adminis- ter the bank’s affairs. This framework is often accomplished through the use of strategic plans and budgets. The strategic plan would discuss long-term, and in some cases, short-term goals and objectives as well as how progress toward their achievement will be measured. The objec- tives and policies should cover all areas of the bank’s operations. The board of directors is responsible for establishing the policies that govern and guide the day-to-day operations of the bank, so they should review and approve them from time to time. These policies are primarily intended to ensure that the risks under- taken by the banks are prudent and are being properly managed. This means that the board of directors must, as a group, have a fundamental understanding of the various types of risks associated with different aspects of the banking business, for example, credit risk, foreign- exchange risk, or interest-rate risk, and define the types of risks the bank will undertake. Some of the more important areas in which policies and objectives must be established include investments, loans, asset and liability manage- ment, profit planning and budgeting, capital planning, and personnel. Directors are also responsible for adopting policies and procedures required by law or regulation, such as real estate lending policies, a security program, an inter- bank liabilities policy, and a Bank Secrecy Act program. The examination of these policies is covered in other sections of this manual. Avoidance of Self-Serving Practices A bank’s directors bear a greater than normal responsibility for upholding safe and sound 5000.1 Duties and Responsibilities of Directors November 1995 Commercial Bank Examination Manual Page 2 example, between regular meetings. An executive committee is usually found in large institutions, where it relieves the full board of the burden of reviewing the details of financial statements and operational activities. • Audit Committee—typically monitors compli- ance with bank policies and procedures, and reviews internal and external audit reports and bank examination reports. Because it is responsible for ensuring compliance, accu- racy, and integrity throughout the organiza- tion, the audit committee should consist only of outside directors. The audit committee may supervise the bank’s internal auditor and his or her staff directly by hiring personnel, eval- uating their performance, and setting their compensation. • Loan Committee—may be established to moni- tor underwriting standards and loan quality, and to ensure that lending policies and proce- dures are adequate. In most banks with loan committees, all new loans are reviewed by the loan committee either before or after funding, with the threshold for prior approval being the amount of either the loan or the aggregate debt to the borrower. The loan committee may also be responsible for the loan review function and for maintaining an adequate reserve for loan losses. • Investment or Asset-Liability Management Committee—monitors the bank’s investment policies, procedures, and holdings portfolio to ensure that goals for diversification, credit quality, profitability, liquidity, community investment, pledging requirements, and regu- latory compliance are met. In some banks whose complexity warrants it, asset-liability management committees have been estab- lished to replace or supplement investment committees. An asset-liability management committee monitors the bank’s balance sheet and external forces, notably interest rates, to help coordinate asset acquisition and funding sources. • Other Committees—depending on the nature and complexity of the bank’s business, the board may establish other committees to moni- tor such areas as trust, branching, new facili- ties construction, personnel/human resources, electronic data processing, and consumer compliance. Minutes of all major actions taken by com- mittees that play a significant role in managing the bank should be kept and meet the same minimum standards used for minutes of meet- ings of the full board. COMPLIANCE WITH FORMAL AND INFORMAL ADMINISTRATIVE ACTIONS Bank directors must ensure that management corrects deficiencies found in the bank. Instruc- tions to do so may come from the Federal Reserve as a formal or informal administra- tive action, depending on the severity of the problem. Formal actions, which include cease-and- desist orders and written agreements, are nor- mally exercised when banks have serious prob- lems. For less serious problems, the Federal Reserve issues informal actions such as a ‘‘memorandum of understanding.’’ Informal actions are an agreement between the Reserve Bank and the bank that sets forth the required corrective actions. The Reserve Banks are gen- erally responsible for monitoring compliance with both types of administrative actions. To assist in that process, the Reserve Bank nor- mally receives and evaluates periodic progress reports from the bank. In addition, information is provided by the examiner who checks the bank’s compliance with the action. The Reserve Banks may initiate additional supervisory action against the bank or individuals associated with it when compliance is insufficient. Or, if the bank’s compliance with the action is satisfactory, the Reserve Banks may recommend modifying or terminating the enforcement action. Examiners should briefly discuss compliance with any enforcement actions on the Examina- tion Conclusions and Comments page and direct the board of directors’ attention to the Compli- ance with Enforcement Actions page of the examination report. The type and date of the action or resolutions and parties to the action should be listed. In addition, the examiner should generally list each provision requiring action by the bank and provide a comment addressing compliance with that provision. The examiner should comment on how the bank accomplished compliance or the problems that have prevented compliance. While certain information might be better discussed in the confidential section of the report, it is appropriate to make all salient negative comments on the Compliance with Enforcement Actions page to ensure that the Duties and Responsibilities of Directors 5000.1 Commercial Bank Examination Manual November 1995 Page 5 directors are made aware of any deficiencies and/or exceptions that may exist. The Reserve Bank may recommend termina- tion or modification of a formal administrative action whenever it determines that such re- straints have satisfactorily served their purpose and should be removed or modified. In these cases, the Reserve Bank will send a memoran- dum with the appropriate explanation to the Board’s Division of Banking Supervision and Regulation (BS&R) for review and evaluation. BS&R and the Board’s Legal Division, when appropriate, will prepare the documents neces- sary to terminate or modify the existing admin- istrative action. DEPOSITORY INSTITUTION MANAGEMENT INTERLOCKS ACT Under the Depository Institution Management Interlocks Act (Interlocks Act) as implemented by Regulation L, interlocking relationships of management officials of various nonaffiliated depository institutions are prohibited, depending on the asset size and geographical proximity of the organizations. The enforcement of the inter- lock provisions of the Interlocks Act encom- passes full cease-and-desist powers. The intent of the Interlocks Act is to foster competition among various depository institu- tions by prohibiting interlocking relationships of management officials. The prohibitions, how- ever, do not generally apply to the following organizations and their subsidiaries: • a depository institution that does not do busi- ness in the United States except as an incident to its activities outside the United States; • an Edge or agreement corporation; • a depository organization in formal liquida- tion or a similar type situation; • a credit union being served by a management official of another credit union; • a state-chartered savings and loan guaranty corporation; or • a Federal Home Loan Bank or other bank organized solely for the purpose of serving depository institutions or solely for the pur- pose of providing securities clearing services and related services related to other depository institutions. In addition, five other exceptions are permit- ted, with Federal Reserve Board approval, based on the public benefit that is derived from the interlocking relationship and on the competitive nature of the institutions involved. These excep- tions are for— • institutions located in low-income areas or controlled or managed by members of a mi- nority group or by women, • newly chartered institutions, • institutions facing conditions endangering safety and soundness, • institutions sponsoring a credit union, and • institutions affected by loss of management officials due to changes in circumstances. 5000.1 Duties and Responsibilities of Directors November 1995 Commercial Bank Examination Manual Page 6 Duties and Responsibilities of Directors Examination Objectives Effective date November 1995 Section 5000.2 1. To determine whether the board of direc- tors fully understands its duties and responsibilities. 2. To determine if the board of directors is discharging its responsibilities in an appro- priate manner. 3. To determine whether the board of directors has developed adequate objectives and policies. 4. To determine the existence of any conflicts of interest or self-dealing. 5. To determine compliance with laws and regulations. Commercial Bank Examination Manual November 1995 Page 1 tion, make an inquiry to determine that the interested director did refrain from voting. c. Read and summarize the minutes of the board’s annual organization meeting and— • list standing committees and their members, • have examiners who are examining areas which have standing-committee supervision read and summarize the minutes of those committees, and • prepare a list of major areas of opera- tion which are not monitored by spe- cific committees. d. Read and summarize the minutes of any stockholders’ meetings. The summary should include a list of directors elected at the annual meeting, the number of shares present and voted, individuals acting as proxies, and specific action approved by shareholders. e. Ascertain during the review of sharehold- ers’ meeting minutes that (1) sharehold- ers’ approval has been received; (2) the bank’s charter amended, if necessary; and (3) compliance with appropriate state or federal statutes has been met for the following: • any establishment of or change of a branch location • any issuance of preferred stock • any increase in capital stock, either through sale or a stock dividend • any reduction in capital stock (and ascertain whether the resultant capital is not below what is required by the capital adequacy guidelines) • any stock split • any bank pension plan established since the preceding examination • any bank involvement in a conversion, merger, or consolidation • all other matters subject to vote f. Determine the date of the annual share- holders’ meeting and if it was in compli- ance with the bylaws. g. Review the charter and/or bylaws for quorum requirements of shareholder meetings. Ascertain that, at any meeting, the quorum requirements were satisfied according to recorded requirements or by having more than one-half of the eligible shareholders represented. h. Review any stock option or stock pur- chase plan adopted since the preceding examination, and review such action for compliance with the various condi- tions involving charter and shareholder approval. i. Determine if any candidate was nomi- nated for director, other than the slate nominated by bank management, and review for compliance with the appropri- ate state statute. 7. Determine that the directors have accepted their responsibility for selecting competent officers by— a. determining that the board or a commit- tee thereof reviews, at least annually, the chief executive officer’s performance in attaining or progressing toward attaining specific objectives or goals set by the board, b. determining if a policy statement on personnel exists and ascertaining what provisions the board has made for suc- cessor management, c. determining if any management con- tracts exist and, if one does, obtaining a copy, summarizing the pertinent points, and determining the reasonableness of terms, d. determining by inquiry how the remu- neration of executive officers is set and who makes decisions concerning execu- tive salaries, and e. listing any titled individual who, by action of the board, is specifically excluded from being an executive officer. 8. Determine compliance with laws and regu- lations by— a. reviewing workpapers of other examina- tion areas or discussing compliance with other examiners to determine any viola- tions of laws or regulations concerning directors that were disclosed in these examination areas, b. reviewing the nature and extent of vio- lations discovered at prior examinations to determine if similar violations have occurred at this examination, and c. correlating information obtained from the minutes of board meetings to the reports of officer borrowings which have been prepared at and forwarded from other banks to determine that all such borrowings have been reported to the board. Duties and Responsibilities of Directors: Examination Procedures 5000.3 Commercial Bank Examination Manual May 2001 Page 3 9. Determine compliance with the Foreign Corrupt Practices Act (15 USC 78dd-1 and -2) by— a. reviewing the bank’s policy prohibiting improper or illegal payments, bribes, kickbacks, etc., to any foreign govern- ment official or other person or organi- zation covered by the law; b. determining how that policy has been communicated to officers, employees, or agents of the bank; c. reviewing any investigation or study done by, or on behalf of, the board of directors on the bank’s policies and operations concerning the advance of funds in pos- sible violation of the act; d. reviewing the work done by the exam- iner assigned to Internal Control to deter- mine whether internal/external auditors have established routines, to discover improper or illegal payments; e. analyzing the general level of internal control to determine whether there is sufficient protection against the inaccu- rate recording of improper or illegal payments on the bank’s books; f. requesting that examiners working in other areas of the bank be alert for any transactions that might violate the provi- sions of the act; g. compiling any information discovered throughout the examination on possible violations; and h. performing procedures on suspected criminal violations as outlined in section 5020.3, ‘‘Overall Conclusions Regarding Condition of the Bank: Examination Procedures.’’ 10. Answer the following questions. (This ques- tionnaire is intended to be a quick review for determining that all laws and regulations pertaining to directors have been complied with. Questions should be answered ‘‘no’’ and sub-questions should be answered ‘‘yes.’’ Any deviation from this pattern indicates a violation or potential violation. Situations which are not judged to be vio- lations require comments stating the basis for that judgment.) a. Is the number of directors less than 5 or greater than 25 (section 31, Banking Act of June 16, 1933)? b. Have any directors failed to qualify by reason of insufficient stock ownership (12 USC 72)? c. Are any directors noncitizens of the United States (12 USC 72)? • If so, has the citizenship requirement been waived? d. Do more than one-third of the directors fail to reside in the state, territory, or district in which the bank is located, or within 100 miles of the bank’s head office (12 USC 72)? e. Did more than one-third of the directors fail to reside in the state, territory or district in which the bank is located, or within 100 miles of the bank’s head office for one year before election (12 USC 72)? f. Are any transactions with directors or their related interests on more favorable terms than those offered to other custom- ers (Regulation O (12 CFR 215))? g. Do the deposit accounts of directors receive greater interest than those of other customers (section 22(e), Federal Reserve Act (12 USC 376))? h. Have any provisions of a cease-and- desist agreement or order been violated (Rules of Practice for Hearings (12 CFR 263))? i. Has any director, officer, or employee been convicted of a crime involving a breach of trust or act of dishonesty (sec- tion 8(g) of the Federal Deposit Insur- ance Act (12 USC 1829))? • If so, has the FDIC approved his or her membership on the board or employment? j. Have any tie-ins of services been autho- rized by the board (Regulation Y (12 CFR 225.4(d))? k. Were any loans to bank examiners dis- closed (Criminal Code—18 USC 212 and 213)? l. Has the bank made any political contri- butions (Federal Election Campaign Act (12 USC 441b))? m. Have any employees been found to have misappropriated funds, made false entries, or otherwise defrauded the bank (18 USC 656)? n. Has an officer of the bank failed to make appropriate written reports when an embezzlement, misapplication, or simi- lar transaction occurred (SR-579)? o. Have any extortionate extensions of credit been discovered (18 USC 892 through 894)? 5000.3 Duties and Responsibilities of Directors: Examination Procedures May 2001 Commercial Bank Examination Manual Page 4 p. Have any checks been certified against uncollected funds (18 USC 1004)? q. Have unauthorized obligations of the bank been issued (18 USC 1005 and 1006)? r. Has there been a change in control (Regu- lation Y (12 CFR 225.41–225.43))? • If so, was the Federal Reserve noti- fied and was the application approved? s. Have any purchase-money loans been made which are secured by 25 percent or more of the stock of another secured bank (Regulation Y (12 CFR 225.41))? • If so, have the appropriate authorities been notified? t. Has the bank failed to maintain records of directors, executive officers, and prin- cipal shareholders and the related inter- est of those persons (Regulation O (12 CFR 215.7))? u. Are management officials of the bank, or its holding company or holding com- pany affiliates, management officials of an unaffiliated depository institution or depository holding company (Regula- tion L (12 CFR 212))? If so— • was such relationship established prior to November 10, 1978, and previously permitted by section 8, Clayton Anti- Trust Act (15 USC 19)? • was prior approval of the Federal Reserve obtained for a relationship that was developed since Novem- ber 10, 1978? • does the interlocking relationship meet the criteria of one of the exceptions permitted by Regulation L (12 CFR 212)? • is the management relationship with an institution whose— — principal offices or branches, excluding electronic terminals, are located in a different SMSA from the bank’s or its holding compa- ny’s offices or branches (does not apply if either institution has assets of less than $20MM)? — principal offices or branches, excluding electronic terminals, are located in another city, town, or village not contiguous or adjacent and 10 miles or more apart? • if the bank or its holding company has assets exceeding $1 billion, does the interlocking management relationship exist with a nonaffiliated depository institution holding company with assets of $500MM or less? v. Have any loans to officers been uncov- ered which were not reported to the board (Regulation O (12 CFR 215) and 12 USC 503)? w. Has a majority of the board failed to preapprove extensions of credit to any of the bank’s executive officers, directors, or major shareholders and their interests when the total loans to the individual exceeds the amount prescribed in Regu- lation O? x. Has the bank notified executive officers and principal shareholders of their report- ing requirements (Regulation O (12 CFR 215))? 11. Determine compliance with administrative actions by— a. reviewing provisions of the document and b. reviewing bank records and perform- ing necessary procedures to isolate noncompliance. 12. Evaluate the bank’s compliance with formal or informal administrative actions and pre- pare comments for page one of the exami- nation report (SR-82-8). 13. Determine compliance with conditions imposed in the approvals of corporate fil- ings for— a. branches and relocation applications, including— • capital plans or capital injections, • fixed-asset limitations, and • CRA plans; b. subordinated debt, operating subsidi- aries, and interim bank applications, including— • capital plans and • prior review and appropriate clearance of disclosures. 14. Based on the information obtained by per- forming the foregoing procedures, or any other procedures deemed appropriate, evalu- ate the adequacy and effectiveness of the board of directors. The evaluation should include, but is not limited to— a. the frequency and effectiveness of meetings; b. the effectiveness of board committees; c. the director’s role in establishing policy; d. the adequacy of the policies and major inconsistencies therein; Duties and Responsibilities of Directors: Examination Procedures 5000.3 Commercial Bank Examination Manual May 2001 Page 5 bank has an inflow of new personnel at various levels and that training procedures and advance- ment policies will keep the organization viable and dynamic. The examiner must be concerned with salary levels within the bank and must review infor- mation collected during the examination about the bank’s employee benefits program. Salaries paid and benefits provided should be compared with those offered by an appropriate peer group, and inquiry should be made to determine the relationship between the bank’s payroll struc- ture and that offered by competitors for the same caliber personnel. The examiner must judge the appropriateness of asset distribution in view of the bank’s sources of funds. The examiner must evaluate the adequacy of the bank’s capital position and expectations in view of asset quality and plans for growth and expansion. The overall manage- ment evaluation should bemade by the examiner- in-charge, because he or she is in the best position to identify weaknesses and inconsisten- cies in policies. Although examiners-in-charge will rely heavily upon the information received from assisting examining personnel in various areas under review, it is their task to assemble all of such information into a composite picture of the quality of management. Senior management is responsible for the quality of all bank personnel and for planning its own replacement. A bank’s recruiting, training, and personnel development activities are vital to the development and continuity of a quality staff. The examiner must evaluate those areas to determine the quality of overall management. Some features of good personnel management are: • An organizational structure. • Detailed position descriptions. • Carefully planned recruiting. • Appropriate training. • Performance review. • Salary administration. • Provision for communication. The examiner should identify and interpret trends that can reveal flaws in policy either as written or as practiced. The examiner should question the quality of management in any area in which he or she finds serious shortcomings or makes significant criticisms. The examiner should be alert for situations in which top management dominates the board or where top management acts solely at the direc- tion of either the board or a dominant influence on the board. Although it is extremely important for the directors to assume their appropriate role in setting objectives and formulating policy consistent with their responsibilities to the depositors, shareholders and regulators, dia- logue with top management must occur. In banks where both directors and senior manage- ment recognize and assume their appropriate duties and responsibilities, areas for conflict are greatly reduced. 5010.1 Management Assessment March 1994 Commercial Bank Examination Manual Page 2 Management Assessment Examination Objectives Effective date March 1984 Section 5010.2 1. To determine the consistency of written objectives, policies, and procedures in the various asset, liability, and operational areas. 2. To determine that policies are being adhered to throughout the system. 3. To determine that management plans adequately for future conditions and developments. 4. To evaluate the adequacy of the bank’s personnel practices as they relate to manage- ment continuity. 5. To evaluate management experience and depth. 6. To determine that management has estab- lished systems which facilitate efficient operation and communication. 7. To evaluate the propriety and soundness of management decisions. 8. To project the impact of management on the future condition of the bank. Commercial Bank Examination Manual March 1994 Page 1 Management Assessment Examination Procedures Effective date March 1984 Section 5010.3 In the following procedural steps examiners should attempt to utilize already developed material from internal or external audit sources. Also, the examining resources and circum- stances of the bank must be weighed in perspec- tive to set the depth of scope for this area. 1. Obtain the following, if available: a. Organization chart. b. Management plan. c. Administrative and personal manuals. d. Marketing plan. e. Resumes for all executive officers and department or division heads which have not been obtained in previous examinations. f. A list of the salary of and other compen- sation paid to each executive officer. g. A list of the salary ranges for other officers of the bank broken down by position. h. A description of other employee benefits. 2. Become familiar with the quality of key personnel by: a. Updating management briefs for all exec- utive officers and department or division heads. b. Distributing the updated management briefs to appropriate examining person- nel and requesting that they be returned upon completion. 3. Review administrative manuals and: a. Extract any policy statements contained therein. b. Extract any general information consid- ered relevant in appraising management. c. Analyze the manual(s), in general, as useful management tools. 4. Review management plan and extract infor- mation concerning: a. Areas of bank where increased or decreased officer staffing is planned. b. Number of officers to be added or removed. c. Qualification requirements for planned additional officers. 5. Establish the hierarchy of the organization by determining the functional responsibility levels of various officers and whether lines of authority are drawn in accordance with the organization chart. 6. Review the bank’s marketing plan for spe- cific programs being planned and general applicability to the institution. 7. Review the bank’s schedule of salaries and make comparisons with similar informa- tion from an appropriate peer group. If deemed appropriate, compare salaries paid and benefits received in the bank to those of other institutions with which it competes directly. Determine whether the bank is paying salaries or bonuses to inactive offi- cers or directors and, if so, determine that such payments have been disclosed to shareholders. 8. Determine whether any executive incentive compensation plans (performance bonuses) have been established and, if so; a. Review specific provisions of the plans and determine the beneficiaries. b. Review controls established to prevent the beneficiary(s) of the plan from understating noncash expenses (accrual expense accounts, provision for possible loan losses, etc.) or overstating noncash income (accrual income accounts). 9. Review the bank’s activities with regard to developing personnel for senior manage- ment succession. At a minimum, this review should include: a. An assessment of the quality of lower levels of management and the potential for advancement. b. An assessment of the bank’s officer hir- ing policies to determine that it is appro- priate to meet the bank’s current and future needs. 10. Obtain and analyze daily or other periodic reports submitted to executive management with the view of determining the usefulness of the reports in monitoring the condition and operation of the bank. 11. As the evaluation of the various areas of examination interest are being completed, discuss with assisting personnel: a. Any of their observations indicative of the general morale level. b. The technical proficiency of officers in their area. c. The level of direct impact that officers have on the condition of their areas. 12. Review the section on ‘‘Analytical Review Commercial Bank Examination Manual March 1994 Page 1 Management Assessment Internal Control Questionnaire Effective date March 1984 Section 5010.4 1. Does the bank have an organizational chart? 2. If not, have lines of authority and reporting responsibility been formally established? 3. Does the bank have a full-time personnel manager? 4. Does the bank utilize written personnel manuals? 5. Does the bank utilize a system of written job descriptions, including descriptions for supervisory personnel? 6. Does the bank actively recruit personnel? 7. Does the bank perform background investi- gations of new employees? 8. Does the bank have a formal training program? 9. Does the bank utilize other than on-the-job training? 10. Does the bank utilize a graded salary scale? 11. Does the bank consider competition in preparing a salary range? If so, in what manner? 12. Does the top management at least annually review lower management? 13. Does the bank prepare or utilize a long- range forecast of economic conditions ger- mane to its trade area? 14. Does top management consult with direc- tors for their opinion of future condition? 15. Does the bank either employ an economist or utilize the services of an outside eco- nomic advisor? 16. Does senior management propose to the directors areas for policy decision? 17. Does the bank have a management succes- sion plan? 18. Does the bank employ a marketing manager and/or outside marketing consultant? 19. Does senior management receive: a. A brief statement of condition daily? b. A daily liquidity report? c. A listing of assets subject to quality limitations at least monthly? d. An earnings statement on a comparative basis at least monthly? 20. Does the bank’s auditing function audit the officer’s adherence to general policy? 21. Are staff meetings held on a regular basis? 22. Are minutes kept for staff meetings? 23. Does the bank use a system of progress reports on specific projects? 24. Does the bank have a tax department or a tax consultant? Commercial Bank Examination Manual March 1994 Page 1 Overall Conclusions Regarding Condition of the Bank Effective date May 2002 Section 5020.1 Throughout this manual, the examiner is encour- aged to use objective criteria in evaluating various areas of the bank. However, there will always be a need for subjective judgment in an examination. Formulating an overall conclusion regarding the present and future condition of the bank requires the use of both objective criteria and subjective judgment. As experience is essential in evaluating information in areas requiring subjective judgment, the procedures in this section should be performed by the examiner-in-charge. In performing those proce- dures, the examiner’s primary concerns are— • to make the ultimate determination as to— — the solvency of the bank and its ability to meet maturing and unusual demands in the ordinary course of business, — adherence to safe and sound banking practice, — adherence to the law, and — the continued viability of the institution; and • to communicate the results of the examination to the Federal Reserve System and the direc- tors of the bank. The evaluation of the overall condition of the bank is based on conditions found throughout the institution. Considerations include internal control and policy exceptions, violations of law and regulations, quality of management, ade- quacy of earnings and capital, quantities of criti- cized assets, and other identified deficiencies or irregularities. An evaluation of the future con- dition of the bank is based on the analysis of— • management’s plans as expressed by operat- ing plans, the capital plan, and other projections, • factors such as competition and economic conditions, and • the overall present condition of the bank. The primary information for evaluating the present condition of a bank is the findings and conclusions of the assisting personnel. The examiner-in-charge should weigh the impor- tance and significance of all criticisms, excep- tions, and deficiencies in attempting to discover any unfavorable trends or situations. Through review of the examination process, insight can be gained into such central issues as— • present asset quality; • current liquidity position; • present capital adequacy; • quality and performance of management; • earnings performance, both past and present; and • sources and applications of funds. The examiner-in-charge usually will include remarks regarding those areas in the examina- tion report. Although procedural areas of this manual deal specifically with each of those key items, the examiner-in-charge should use information from all phases of the examination. For example, when reviewing the bank’s present capital position, the examiner-in-charge may use knowledge of the bank’s asset and manage- ment quality to modify the conclusions of assist- ing personnel. The important point is that the examiner-in-charge is in the best position to assess all information provided by the examina- tion process. Factors affecting the future condition of the bank can generally be categorized as internal or external. The examiner’s review of current con- dition flows naturally into an evaluation of internal factors affecting the institution’s future prospects and condition. Among the items pro- viding insight into future conditions are— • earnings trends, • successor management plans, • the budget or profit plan, • the capital plan, and • any other internally generated projections or forecasts. Many banks will not have formal written plans or projections. In such cases, the examiner- in-charge must obtain from senior management or the board of directors information on their plans for matters such as— • growth and expansion, • capital, • changes in size and mix of assets, and • changes in sources of funding. In addition, examiners should remind senior management that any change in the general character of a bank’s business or the scope of the corporate powers it exercises requires the prior approval of the Board under Regulation H. The examiner should recommend that banks Commercial Bank Examination Manual May 2002 Page 1 that do not have formal plans or projections take advantage of any externally available tools to aid them in formulating these plans. In today’s competitive market, strategic planning is a necessity for almost all banks, but especially for banks that are losing their market share or in which inefficiencies are depressing profitability. If banks prepare budgets or profit plans, insight can be gained into the accuracy of balance-sheet and earnings projections by com- paring actual and projected account balances. It also is beneficial to compare original projec- tions with current projections to determine that adjustments are made on a timely basis. When four- or five-year projections are made, banks often formulate several forecasts based on dif- ferent sets of assumptions. In such a situation, the examiner should attempt to determine the bank’s most likely future course. The examiner should attempt to gain access to any official material or internal workpapers that document or illustrate the bank’s rationale in planning its future. The goal is to review the institution’s decision-making process. Banks are turning increasingly to off-balance- sheet activities to deliver services, effect pay- ments, generate income, and hedge interest-rate risks. Banks have introduced a wide variety of new products and services to complement their more traditional activities. Although such new activities are useful and profitable, they contain an element of risk. Many of these new activi- ties involve a contingent liability or other risk that is not reflected on the bank’s balance sheet and, indeed, may not even be fully recognized by the bank. The examiner should be aware of how the bank manages and controls its off- balance-sheet risks. Examples of off-balance- sheet activities include— • electronic funds transfer systems, • nontraditional lending activities (including the sale and servicing of mortgage- and government-guaranteed loans), • innovative applications for standby letters of credit, and • a wide variety of investment-security activi- ties (including futures and forwards, puts and calls, and short sales). Risk can be distinguished primarily as credit risk, funding risk, rate risk, or risk resulting from internal-control deficiencies. Examiners must be aware of the nature and extent of off-balance-sheet risks. The risks that affect capital, liquidity, and compliance with laws should be evaluated for their potential effect on the safety and soundness of the bank. In judging such controversial areas as capital adequacy and liquidity, the examiner should remember that, under ideal circumstances, man- agement should be the expert on the bank’s capitalization and liquidity position. Judgments on such matters should be generated internally, based on insight only management can possess. It is management that should know the bank’s competitive situation, the economics of the service area, and the anticipated impact of those and other factors on its plans for growth and expansion. It is also management that has the greatest interest in the success of the bank. Accordingly, management and the directorate should choose a level of capitalization and liquidity consistent with their perception of the bank’s situation rather than reacting to com- petitors or relying on pressures from regulators. However, specific judgments by the examiner are required, particularly in situations where a capital or liquidity position has fallen below what examiners consider to be acceptable norms. Objective justification for lower levels of capital or liquidity must be obtained and analyzed. To properly evaluate the future prospects of a bank, the examiner must review external factors affecting the institution. Significant among those factors are the characteristics of a bank’s area. Area refers to the bank’s primary service area, which is defined as that area from which the bank receives approximately 75 percent of its deposits. Demographics of the area generally are available, and every bank should accumulate such information to aid in analyzing its current operations and planning for future operations. The absence of such information in an up-to- date form should be considered a deficiency. Included under examination procedures for this section is a listing of minimum information required to ascertain the demographics of a service area. The examiner-in-charge should make sure that information is compiled and should analyze it to determine whether manage- ment expectations appear justifiable in the circumstances. In dealing with competitive factors, the exam- iner should review or compute the share of market for the bank under examination. Con- tinuing records in that area establish an analyz- able trend. Consideration also should be given to changes in the bank’s statutory and regulatory environment, such as— 5020.1 Overall Conclusions Regarding Condition of the Bank May 2002 Commercial Bank Examination Manual Page 2 civil money penalty, the Board is required to consider the size of the financial resources and good faith of the respondent, the gravity of the violation, the history of previous violations, and such other matters as justice may require. Examiners are responsible for the initial analy- ses on potential civil money penalties. Civil money penalties should be proposed for serious violations and for violations which, because of their frequency or recurring nature, show a general disregard for the law. After the examiner has reviewed the facts and decided to recom- mend a civil money penalty, he or she should contact the Reserve Bank for advice on proper documentation and any other assistance. CRIMINAL REFERRAL PROCEDURES On April 2, 1985, an agreement was signed by the federal financial institutions supervisory agencies and the U.S. Department of Justice that requires the agencies to work toward improving the federal government’s response to white- collar crime in federally regulated financial institutions. The primary goal of the agreement is to ensure full cooperation in the sharing of relevant information among the agencies, sub- ject to existing legal restrictions, so that all available information may be used in criminal, civil, and administrative proceedings. In keep- ing with that goal, the agreement sets forth procedures for the use of a uniform criminal referral form by all of the supervisory agencies and by the financial institutions regulated by them. Summary of the Criminal Referral Form The Federal Reserve System’s version of the Criminal Referral Form, FR 2230, has been designed so that one form can be used for all reports. The form is to be used by all state member banks, bank holding companies, non- bank subsidiaries of bank holding companies, Edge Act and agreement corporations, U.S. branches and agencies of foreign banks, and Federal Reserve Banks in accordance with the Board’s guidelines. Suspected criminal violations of any section of the United States Code or state law (except bank robbery) involving less than $10,000 and not involving an executive officer, director, or principal shareholder of the institution can be reported by simply completing the first two pages of FR 2230. If the suspected criminal violation involves an actual or probable loss of $10,000 or more or, in any case, involves an executive officer, director, or principal share- holder of the institution, all items on the form must be completed. The instructions on the Criminal Referral Form direct the filing institu- tion to send a copy to the local FBI office, the nearest office of the U.S. attorney, the Reserve Bank, and, in certain instances, the Secret Service. The Criminal Referral Form describes the mandatory and optional reporting requirements, which, along with applicable dollar thresholds, have been changed. In outline form, they are as follows: • A Criminal Referral Form must be filed— — if a financial institution suspects criminal activity by its employee, officer, director, or agent (e.g., an insider) involving any amount; — if a financial institution suspects criminal activity involving a loss of $1,000 or more, the financial institution can identify a suspect, and the suspect is not an employee, officer, director, or agent (e.g., a non-insider); — if a financial institution suspects criminal activity involving a loss of $5,000 or more and it cannot identify a suspect; or — if a financial institution suspects criminal activity involving a violation of the bank secrecy and related money laundering laws and regulations. • A Criminal Referral Form may be, but is not required to be, filed— — if a financial institution suspects criminal activity involving a loss of less than $1,000, the financial institution can iden- tify a suspect, and the suspect is not an employee, officer, director, or agent of the financial institution (e.g., a non-insider); or — if a financial institution suspects criminal activity involving a loss of less than $5,000 and it cannot identify a suspect. The Enforcement Section of the Division of Banking Supervision and Regulation has pri- mary responsibility for the criminal referral Overall Conclusions Regarding Condition of the Bank 5020.1 Commercial Bank Examination Manual May 1997 Page 5 process, including coordination with Federal Reserve Banks, U.S. attorneys, the Department of Justice and the FBI, and tracking and record- ing of all criminal referrals. ‘‘SR’’ letters have been distributed within the Federal Reserve System, including SR-85-22 (FIS), SR-86-7 (FIS), and SR-88-9 (FIS), and reference should be made to them in connection with any inquiry in this area. Examination Objectives To determine if the institution has established internal procedures to ensure the prompt and accurate submission of all reports of suspected criminal activity to appropriate authorities. Examination Procedures 1. Determine whether the institution has a pol- icy of reporting suspected criminal activity. 2. Determine how the policy has been commu- nicated to officers and employees. 3. Determine whether a person(s) or department in the bank has been designated as being responsible for the filing of the Criminal Referral Form, FR 2230. Reporting Suspected Criminal Violations If, during the course of an examination, an examiner uncovers a situation that is known or suspected to involve a criminal violation of any section of the United States Code or state law and no referral of the matter has been made by the bank or an inadequate referral was made, details should be reported immediately to the Reserve Bank. If the situation warrants a tele- phone call to the Reserve Bank, this should be done and followed by a detailed report. The report should be in the form of a memorandum, and must be written in such a way as to fully apprise the Reserve Bank of the situation. All of the information contained in the Criminal Refer- ral Form, FR 2230, should be embodied in the memorandum. Copies of the pertinent exhibits should be attached. The examiner’s report should be confined to clear-cut statements of fact and must not contain opinions as to the probability of indictment, conviction, or related matters. In all reports and workpapers, the examiner should be as specific as possible (e.g., rather than indicating ‘‘it is reported’’ or ‘‘the bank indicates’’) and he or she should identify who reported the matter and how it occurred. On each transaction that is to be reported, copies of all documentation should be obtained and placed in a separate file detailing who handled the transaction in the bank. The reporting of the matter within the bank should be chronologically referenced throughout the documentation. The copies of documentation should be initialed and dated by the examiner in case the original is destroyed. The documenta- tion is extremely important to proving a particu- lar transaction. The examiner’s initial notification of sus- pected criminal violations to the Reserve Bank and the transmittal of data should be accom- plished without informing bank personnel. Only the Reserve Bank or a designated representative should inform bank personnel or its board of directors of a suspected criminal violation that had not been reported by the bank or inad- equately reported by bank personnel. After reviewing the information submitted by the examiner, the Reserve Bank will decide whether the facts support the examiner’s con- tention that a possible unreported violation of the criminal statutes exists. If the Reserve Bank discovers that in a particular instance a bank failed to report the suspected criminal violation using the Criminal Referral Form, FR 2230, or made an inadequate referral, and upon request, still fails to make a report, the Reserve Bank itself must then complete a Criminal Referral Form, FR 2230. Appropriate comments relating to a bank’s failure, if any, to make all necessary criminal referrals in an accurate and timely manner should be made in the report of examination of the bank. Repeated or serious problems in this area should be directed through the Reserve Bank to the Enforcement Section of the Division of Banking Supervision and Regulation. 5020.1 Overall Conclusions Regarding Condition of the Bank May 1997 Commercial Bank Examination Manual Page 6 Overall Conclusions Regarding Condition of the Bank Examination Objectives Effective date March 1984 Section 5020.2 1. To reach conclusions regarding the present condition of the bank. 2. To reach conclusions regarding the future prospects of the bank. 3. To determine the bank’s ability to meet demands in the ordinary course of business or reasonably unusual circumstances. 4. To determine the bank’s adherence to safe and sound banking practices. 5. To formulate recommended action, when appropriate, based on those conclusions. 6. To communicate conclusions and recommen- dations both orally and in the examination report. Commercial Bank Examination Manual March 1994 Page 1 c. Earnings • Are earnings static or moving down- ward as a percentage of total resources? • Is there a trend of decreasing income before security gains and losses as a percentage of total revenues? — If so, is such a trend expected to continue? — If so, has management determined causes for any deterioration and taken action to reverse the negative trend? • Has the ratio of operating expenses to operating revenues been increasing? • Are earnings trends consistent? • Has a decreasing spread between interest earned and interest paid developed? • Are the bank’s earnings significantly vulnerable to changes in interest rate levels? — If so, what are management’s plans and prospects for altering the vulnerability? • Are there any significant structural changes in the balance sheet which may impact earnings? • Has the bank experienced increasing actual loan losses and/or loan loss provisions? • Is there any evidence that sources of interest and other revenues have changed since that last examination? — If so, is that attributed to an unsound emphasis for increased earnings? • Are earnings deemed inadequate to provide increased capitalization com- mensurate with the bank’s growth? d. Capital • Has the bank been unable to maintain a normal growth rate for capital? • Do the ratios of loans to capital, depos- its to capital or total assets to capital exhibit a trend to abnormal increases? • Is capital deemed inadequate to sup- port the present volume of business, including the volume of off-balance- sheet activities, in view of the amount of criticized assets, the competency of management, etc.? e. Liquidity • Is there a trend toward decreasing bank liquidity? • Has the bank been forced to increase abnormally dependence on borrowed funds to support existing assets? • Does the bank depend excessively on purchased funds? • Is there a trend toward investing inter- est sensitive liabilities in non-interest sensitive assets? • Do the present quantity and maturity of non-interest sensitive assets repre- sent a dangerous or potentially danger- ous situation? f. Off-Balance-Sheet Risk Loans Sold or Serviced • Is the bank involved as the lead or agent in loan participations, syndica- tions, or servicing activities to the extent that management expertise is inadequate, or to the extent that the volume exceeds the level which man- agement can capably handle? • Does the bank’s record of pending or threatened litigation indicate any instances where the bank, as lead or agent in a loan participation or syndi- cation, has willfully misrepresented the credit to the other participants, or otherwise acted with gross negligence in handling the credit? — If so, is there any indication that the participants intend to hold the bank liable for any loss incurred on the credit? • Did the examination reveal a practice of improper origination and packaging of loans sold or serviced which could cause: — The bank being compelled to repurchase the package, or — In the case of government guaran- teed loans, the complete or partial dishonor of the guaranty? Overall Conclusions Regarding Condition of the Bank: Examination Procedures 5020.3 Commercial Bank Examination Manual March 1994 Page 3 • Has the bank previously repurchased participations when a loss was incurred, although it was not legally required to do so? Letters of Credit • Is there a trend toward increasing the issuance of standby letters of credit or other similar credit instruments? — If so, has the bank failed to con- sider the full impact of funding a significant percentage of those instruments? • Are letters of credit excluded from the bank’s internal loan review program? • Does the internal evaluation of letters of credit include consideration of coun- try and currency risk as well as credit risk? • Is there a declining trend in the credit quality of letters of credit? • Are standby letters of credit issued for purposes not covered in the bank’s lending policy, or for which manage- ment does not have the expertise to handle? • If not authorized in the bank’s lending policy, were proper approvals obtained prior to issuance? Wire Transfer Department • Do internal control deficiencies in the wire transfer department pose a threat for large potential losses through fraud or error? • Are there internal control deficiencies in the receiving and conveying of mes- sages for other parties which may expose the bank to litigation for improper handling of the messages? Data Processing Department • Are internal controls inadequate in the bank’s data processing area? — Are control deficiencies such that the accuracy and/or timeliness of data is questionable? — Are deficiencies such that the bank, in performing data processing ser- vices for others, could be liable for misplacement or other improper handling of source data? • Are the bank’s computer hardware and software systems inadequate to sup- port the present and anticipated level of operations? — Are deficiencies such that hard- ware and systems will require replacement or upgrading in the short term? Settlement Procedures • If the bank is a member of CHIPS, Fedwire or other clearinghouse sys- tem, are procedures inadequate for the proper monitoring of incoming and outgoing wire transfers so that the bank is occasionally unprepared for settlement? — Would earnings be significantly affected if the immediate acquisi- tion of funds is required to meet settlement? — Is the bank aware of the creditwor- thiness and ability of the other clearinghouse participants to make settlement? • Are customers’ daylight overdrafts allowed to exceed established credit limits or are they otherwise being im- properly monitored? • Is there a history of daylight overdrafts which have not been covered before the close of business? Investment Securities • Are there significant internal control deficiencies associated with the bank’s handling of ‘‘when issued’’ trades, futures contracts and forward placements? — Is management’s knowledge of interest rate hedging techniques insufficient to support such activity? • Does the bank ac t as agen t on securities or repurchase agreement transactions? — If so, does the customer agreement specifically designate liability for failure or performance? 5020.3 Overall Conclusions Regarding Condition of the Bank: Examination Procedures March 1994 Commercial Bank Examination Manual Page 4 Miscellaneous • Did the analytical review of income and expenses disclose any additional off balance sheet activities for which management does not exhibit the nec- essary expertise and does not have adequate internal controls to handle the service? • Does a review of legal actions against the bank indicate any pattern of prac- tices which are caused by deficient internal controls? — If so, have the deficiencies been corrected? • Is the potential liability arising from pending litigation considered signifi- cant in terms of capital adequacy and liquidity, considering the level of other contingent liabilities? • Are any of the bank’s affiliates or subsidiaries experiencing unprofitabil- ity or liquidity problems which may affect the soundness of the bank? • Are operating lease liabilities and annual lease payments significant in terms of the bank’s other funding requirements? • Is potential restitution resulting from Truth in Lending Act violations signif- icant relative to capital and liquidity? • Is the bank’s level of loan commit- ments, standby letters of credit, com- mitments to purchase securities and futures/forward contracts imprudent in light of overall circumstances within the bank? g. Internal Controls and Audit Procedures • Have internal controls deteriorated since the last examination? • Do any of the following exist at the bank? — Low compensa t i on l eve l o f internal auditors. — Internal or external auditor who reports directly to other than the board of directors or a committee thereof. — Internal auditors who perform orig- inal work versus monitoring the efforts of others. — Abnormally low percentage of internal auditors to total personnel. — Inadequate training or supervision of internal auditors. — Questionable independence of external auditors. — Inadequate management response to deficiencies cited by auditors. If so, do these or other pertinent fac- tors indicate a less than adequate situ- ation in internal or external audit? • Are internal controls and audit pro- grams deemed inadequate? h. Ownership • Have there been significant changes in ownership since the last examination? — If so, could the change be detri- mental to the soundness of the bank? • Does any situation exist wherein one individual is capable of controlling the bank? — If so, is that detrimental to the bank’s soundness? • Is there any evidence of an impending proxy fight? • Are ownership interests using bor- rowed funds to carry the bank’s stock? — If so, is there an indication that undue pressure for increased earnings is being applied by the owners? — If such pressure is being applied, does that have a detrimental impact on the general characteristics of asset composition, as it exists, and asset composition, as it is expected to develop? i. Miscellaneous • Does the bank exhibit a high depen- dence on purchasing or participating in loans originated and managed by others? — If so, is that attributable to a lack of local loan demand or to a failure of the bank to service its trade area? • Is there an increasing trend toward making loans and/or accepting depos- its from outside of areas in which the bank maintains offices? Overall Conclusions Regarding Condition of the Bank: Examination Procedures 5020.3 Commercial Bank Examination Manual March 1994 Page 5 4. Avoid self-serving practices 5. Be informed of the bank’s financial condition and management policies 6. Maintain reasonable capitalization 7. Observe banking laws and regulations B. Adequacy and effectiveness of policies and procedures 1. Lending 2. Investments 3. Asset/liability management 4. Personnel 5. Operations C. Adequacy and accuracy of bank’s reporting systems 1. Reports of the board and committees 2. Management reports to the board 3. Management information systems 4. Regulatory reports D. Condition of the bank/results of the examination 1. Asset quality 2. Violations of law, evidence of self- dealing 3. Capital 4. Management 5. Liquidity 6. Earnings 7. Internal controls and audit coverage 8. Future prospects 9. Relationships with bank holding company E. Required corrective action on problems and board commitment III. Summary of overall conclusions IV. Questions from the board Procedural Issues In general, meetings with the full board are preferable. In certain cases, however, a Reserve Bank may determine that meeting with a board committee, such as the executive or audit com- mittee, will fulfill the Reserve Bank’s supervi- sory objectives. Any person connected with the bank, such as an attorney, auditor, or holding company representative, may attend the board of directors meeting at which the overall find- ings and conclusions of the examination are discussed. The attendance of any such party should be noted in the minutes of the meeting. However, the examiner may excuse such per- sons during any portion of his or her presenta- tion if deemed appropriate. Attendance by honorary directors to participate in discussions and review the examination report is also permitted. Generally, at least one member of a Reserve Bank’s official staff is expected to represent the Federal Reserve at meetings with directors of banks. However, for meetings with the directors of banks that have less than $500 million in assets, Reserve Banks are granted the discretion to have senior examination staff represent the Reserve Bank. The participation of Reserve Bank presidents in meetings with directors is left to the discretion of the Reserve Bank. To the extent possible, meetings with the boards of directors of state member banks should include representatives of the relevant state banking authority. A meeting with the directors of a bank that is owned by a holding company may be held at the same time as a meeting with the directors of the holding company, when appropriate. Whenever a meeting is held between an examiner and a board, the examiner should prepare written comments on the meeting for examination workpapers. MEETINGS WITH BOARDS OF PROBLEM BANKS AND BANKS EXHIBITING SIGNIFICANT DETERIORATION When an examination reveals that a bank has significant problems, Federal Reserve policy requires that a meeting be held with its board of directors. The policy further requires that a written summary of examination findings— separate from the complete examination report—be distributed to each director in such cases. A senior Reserve Bank official also must participate in communicating and presenting examination findings on problem banks to their boards of directors. This policy’s objective is to ensure that each director of a state member bank considered to be a problem or to have a signifi- cant weakness clearly understands the nature and dimension of the problems, as well as the joint and several responsibility of the directors to effect correction. Criteria Requiring Meetings with Problem Banks A meeting with the board of directors is to be 5030.1 Meetings with Board of Directors May 1995 Commercial Bank Examination Manual Page 2 held after any full-scope examination in which a state member bank is assigned a CAMELS composite rating of 4 or 5. A meeting is also required if a bank is rated composite 3 and its condition appears to be deteriorating or has shown little improvement since a previous examination in which it received a composite 3 rating. Furthermore, a meeting should be held after a targeted examination if deemed appropri- ate and desirable by the Reserve Bank. An official of the Reserve Bank and the examiner- in-charge should also meet with a board if any of the following conditions exist: • The bank is entering into a formal written agreement with the Federal Reserve, a cease- and-desist order is being issued, or the bank is being placed under a memorandum of understanding. • The bank is already operating under a super- visory action but is in noncompliance with significant provisions or has experienced sig- nificant deterioration since the action was initiated. • Self-serving activities or other unsafe and unsound practices exist in the bank. • Any other condition or practice that places, or could place, the bank in a seriously weakened or extended condition has been identified during the examination. Additional Guidelines Senior Reserve Bank officials are expected to participate in meetings with the directors of problem banks, with the seniority of the partici- pating official determined by the condition and size of the bank. The larger the organization or the more serious its problems, the more senior the Federal Reserve official should be. A meeting with the board of directors of a problem or deteriorating bank should include a formal, structured presentation with a clear state- ment that the bank is considered a ‘‘problem institution’’ or is about to become a problem institution if existing conditions deteriorate. The presentation should further make clear the nature of problems confronting the bank, citing exami- nation findings such as the following: • deficiencies in capital, asset quality, earnings, or liquidity • violations of law • inadequacies in policies, practices, and report- ing systems necessary for proper risk manage- ment and organizational administration • lack of well-documented lending, collection, investment, asset/liability management, and risk-management policies or the failure to ensure that such policies are being followed • failure of management to address previously discussed deficiencies • lack of reporting systems sufficient to keep senior management and the board of directors fully informed • failure of the board of directors to ensure the active management of the organization MEETINGS WITH BOARDS OF MULTINATIONAL AND MAJOR REGIONAL BANKS A meeting with the board of directors is required after every full-scope examination of a multi- national organization or major regional organi- zation with assets in excess of $5 billion. Reserve Banks also are encouraged to conduct such meetings after every full-scope examination of a regional bank with assets in excess of $1 billion. MEETINGS WITH BOARDS OF DE NOVO BANKS After the approval of a membership application, but before a de novo bank is opened, Reserve Bank staff should meet with the full board of directors to discuss applicable statutes, regula- tions, policies, and supervisory procedures. As with all meetings with directors, the agenda for this meeting should be tailored to the individual circumstances of the bank. At a minimum, the Reserve Bank should apprise the directors of their responsibilities and emphasize their need to adhere to sound operating policies. DIRECTOR’S SUMMARY OF EXAMINATION FINDINGS In addition to the report of examination, Federal Reserve Banks must provide written reports to directors summarizing the examination findings for all banks rated composite 3, 4, or 5, and for those rated composite 1 or 2 that show signs of Meetings with Board of Directors 5030.1 Commercial Bank Examination Manual May 1997 Page 3 significant deterioration in condition or apparent violations of law. The summary reports should focus on identified problems—rather than on the strength of the organization—and present the bank’s deficiencies succinctly and clearly. In all cases, the types of actions directors and man- agement should take to address identified prob- lems should be specifically stated. Directors of institutions rated 4 or 5 are to be told their banks are ‘‘problem’’ institutions that warrant ‘‘special supervisory attention.’’ Directors of banks rated 3 are to be informed that the bank’s condition is ‘‘not satisfactory,’’ that the bank is subject to ‘‘more-than-normal supervision,’’ and that the bank may become a ‘‘problem’’ if weaknesses are not addressed adequately. Summary reports should emphasize the responsibilities of the directors to ensure that corrective actions are taken to address all defi- ciencies noted in the pages of the full bank examination report entitled ‘‘Matters Requiring Board Attention’’ and ‘‘Examination Conclu- sions and Comments.’’ In addition, the organi- zation, style, and content of the summary report should be similar, if not identical, to the text of these report pages. Summary reports should be sent directly to the bank’s management for distribution to each director. The transmittal letter to the bank should state the report is a summary of identified problems and contemplated supervisory actions and direct bank management to distribute the summary report to each director. The letter should further instruct each director to read the report, sign the introductory statement attesting to having read the report, and return the report to management. Management should keep copies of the directors’ signed statements on file, but should destroy all but one file copy of the summary report itself. The summary report must be completed and distributed before any meeting between Reserve Bank officials and the bank’s board of directors, to provide the directors with prior notice of deficiencies to be discussed. Reserve Banks should also make every effort to distribute the complete examination report to management before meeting with a board of directors. 5030.1 Meetings with Board of Directors May 1997 Commercial Bank Examination Manual Page 4 Formal and Informal Corrective Actions Effective date May 1996 Section 5040.1 INTRODUCTION The Federal Reserve Board has a broad range of enforcement powers over both domestic and foreign financial institutions and over the indi- viduals associated with them. Generally, formal or informal enforcement actions are taken after the completion of an on-site bank examination. These examinations include commercial, trust, electronic data processing, consumer, or other types of examinations. Formal or informal enforcement actions may also be taken when the Reserve Bank becomes aware of a problem at a bank that warrants immediate attention and correction. Many of the Board’s enforcement powers were initiated or enhanced by title IX of the Financial Institutions Reform, Recovery, and Enforcement Act and the Bank Fraud Act.1 The Board’s jurisdiction over individuals asso- ciated with financial institutions—‘‘institution- affiliated parties’’—includes any officer, direc- tor, employee, controlling shareholder, or agent of a financial institution, and any other person who has filed or is required to file a change-in- control notice. The term ‘‘institution-affiliated party’’ also includes any shareholder, consult- ant, joint-venture partner, or any other person who participates in the conduct of the affairs of the financial institution, as well as any indepen- dent contractor, including attorneys, appraisers, and accountants, who knowingly or recklessly participates in any violation of law or regulation, breach of fiduciary duty, or unsafe or unsound practice that causes (or is likely to cause) more than a minimal financial loss to, or a significant adverse effect on, a financial institution.2 The Board’s jurisdiction over an institution-affiliated party extends for up to six years after the party’s resignation, termination of employment, or sepa- ration caused by the closing of a financial institution, provided that any notice (such as a notice of intent to remove from office and of prohibition) is served on the party before the end of a six-year period. FORMAL SUPERVISORY ACTIONS The following statutory tools are available to the Board in the event formal supervisory action is warranted against a state member bank or any institution-affiliated party. The objective of formal action is to correct practices that the regulators believe to be unlawful, unsafe, or unsound.3 The initial consideration and determi- nation of whether formal action is required usually results from examination findings. Work- paper documentation is important to support all recommendations for both formal and informal actions. Types of Corrective Actions Generally, under 12 USC 1818, the Board may use its cease-and-desist authority and civil money penalty authority against any state member bank and any institution-affiliated party that meets the statutory criteria for issuing such an order. Prohibition and removal actions may be taken against any institution-affiliated party who meets the statutory criteria to bring such an action. Cease-and-Desist Orders Generally, under 12 USC 1818(b), the Board may use its cease-and-desist authority against a state member bank and any institution-affiliated party when it finds that a bank or party is engaging, has engaged, or is about to engage in a violation of law, rule, regulation, a condition imposed in writing by the Board in connection with the granting of any application or any written agreement, or in an unsafe or unsound practice in conducting the business of the insti- 1. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was enacted on August 9, 1989; the Comprehensive Thrift and Bank Fraud Act (the Bank Fraud Act) was enacted on November 27, 1990. 2. The Board is authorized to issue regulations further defining which individuals should be considered institution- affiliated parties. Similarly, the Board may determine whether an individual is an institution-affiliated party on a case-by- case basis. 3. An unsafe or unsound practice is defined as any action that is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the agencies administering the insurance fund. Commercial Bank Examination Manual May 1996 Page 1 tution. Under 12 USC 1818(s), the Board must initiate a cease-and-desist action against a bank when it has failed to establish Bank Secrecy Act procedures required by the Board’s Regulation H or has failed to correct any previously noted deficiencies related to these procedures. A cease-and-desist order may require the bank or person subject to the order to (1) cease and desist from the practices or violations or (2) take affirmative action to correct the viola- tions or practices. Affirmative actions might include returning the bank to its ‘‘original con- dition’’ before the practice or violation. Affir- mative actions may also include restrictions on growth, debt, and dividends; the disposition of any loan or asset; rescission of agreements or contracts; employment of qualified officers or employees; restitution, reimbursement, indem- nification, or guarantee against loss if the bank or person was unjustly enriched by the violation or practice, or if the violation or practice involved a reckless disregard for the law or applicable regulations or a prior order; and any other action the Board determines to be appropriate. When Board staff, in conjunction with the appropriate Reserve Bank, determines that a cease-and-desist action is necessary, the bank or person is generally given an opportunity to ‘‘consent’’ to the issuance of a cease-and-desist order without the need for the issuance of a notice of charges and a contested administrative hearing. Generally, Board staff draft a proposed cease-and-desist order and, with Reserve Bank staff, present it to the bank or individual for their consent before submitting the case to the Board. Banks or individuals are advised that they may have legal counsel present at all meetings with Board or Reserve Bank staff concerning formal corrective actions. If the parties voluntarily agree to settle the case by the issuance of a consent cease-and-desist order, the proposed consent order will be presented to Board offi- cials for ratification and formal issuance of the order, at which time the order will be final and binding. When a bank or person fails to consent to a cease-and-desist order, the Board may issue a ‘‘notice of charges and of hearing’’ to the bank or party. The notice of charges contains a detailed statement describing the facts constitut- ing the alleged violations or unsafe or unsound practices. The issuance of the notice of charges and of hearing starts a formal process that includes the convening of a public administra- tive hearing4 conducted before an administrative law judge, appointed by the Board. After the hearing, the judge makes a recommended deci- sion to the Board. A hearing must be held within 30 to 60 days of service of the notice of charges, unless a later date is set by the administrative law judge. After the Board considers the record of the proceeding, including the administrative law judge’s recommended decision, it deter- mines whether to issue a final cease-and-desist order. Banks and individuals who are subject to cease-and-desist orders that were issued as a result of contested proceedings may appeal the order to the appropriate federal court of appeals. Temporary Cease-and-Desist Orders In the event that a violation or threatened violation of law, rule, or regulation, or the engagement in an unsafe or unsound practice specified in the notice of charges, is likely to cause the bank’s insolvency, cause significant dissipation of the bank’s assets or earnings, weaken the bank’s condition, or otherwise preju- dice the interests of depositors before the comple- tion of the proceedings (initiated by the issuance of the notice of charges), the Board may, in conjunction with issuing a notice of charges, issue a temporary cease-and-desist order against the bank or any institution-affiliated party to effect immediate correction (pursuant to 12 USC 1818(c)). The Board may also issue a temporary order if it determines that the bank’s books and records are so incomplete or inaccurate that the Board is unable to determine, through the nor- mal supervisory process, the bank’s financial condition or the details or purpose of any transaction that may have a material effect on its condition. The temporary order may require the same corrections as a formal cease-and-desist order. The advantage of issuing a temporary cease-and-desist order is that it becomes effec- tive immediately after it is served on the entity or individual. Within 10 days after being served with a temporary order, however, the entity or individual may appeal to a U.S. district court for relief from the order. Unless set aside by the district court, the temporary order stays in effect until the Board issues a final cease-and-desist order or dismisses the action. 4. A private hearing may be held if the Board determines that holding a public hearing would be contrary to the public interest. 5040.1 Formal and Informal Corrective Actions May 1996 Commercial Bank Examination Manual Page 2 Written Agreements When circumstances warrant a less severe form of formal supervisory action, a written agree- ment may be used. A written agreement may be with either the Board or with the Reserve Bank under delegated authority (12 CFR 265.11(a)(15)). All written agreements must be approved by the Board’s director of the Division of Banking Supervision and Regulation and the general counsel. The provisions of a written agreement may relate to any of the problems found at the bank or to any problems involving institution-affiliated parties. Prohibition and Removal Authority The Board is authorized by 12 USC 1818(e) to remove any current institution-affiliated party of a bank for certain violations and misconduct and to prohibit permanently from the banking indus- try any current or former institution-affiliated party from future involvement with any insured depository institution, bank or thrift holding company, and nonbank subsidiary.5 The Board is authorized to initiate removal or prohibition actions in the following situations: • The institution-affiliated party has directly or indirectly— — violated any law, regulation, cease-and- desist order, condition imposed in writing, or written agreement; — engaged in any unsafe or unsound prac- tice; or — breached a fiduciary duty. • The Board determines that, because of the violation, unsafe or unsound practice, or breach— — the institution has suffered or will prob- ably suffer financial loss or other damage; — the interests of depositors have been or could be prejudiced by the violation, prac- tice, or breach; or — the institution-affiliated party has received financial gain or other benefit from the violation, practice, or breach. • A violation, practice, or breach— — involves personal dishonesty or — demonstrates a willful or continuing dis- regard for the safety or soundness of the institution. In 1992, 12 USC 1818(e) was amended to authorize the Board to initiate removal or pro- hibition actions against (1) any institution- affiliated party who has committed a violation of any provision of the Bank Secrecy Act that was not inadvertent or unintentional, (2) any officer or director of a bank who has knowledge that an institution-affiliated party has violated themoney- laundering statutes and did not take appropriate action to stop or prevent the reoccurrence of such a violation, or (3) any officer or director of a bank who violates the prohibitions on man- agement interlocks. These removal or prohibi- tion actions do not require a finding of gain to the individual, loss to the institution, personal dishonesty, or willful or continuing disregard for the safety or soundness of the institution. Like a cease-and-desist order, a removal or prohibition order may be issued either by con- sent or after an administrative process initiated by the issuance of a notice of intent to remove and prohibit. In the event that an institution-affiliated par- ty’s actions warrant immediate removal from a state member bank, the Board is authorized to suspend the person temporarily from that bank pending the outcome of the complete adminis- trative process. An institution-affiliated party presently associated with a bank may also be suspended or removed for cause based on actions taken while formerly associated with a different insured depository institution, bank holding com- pany, or ‘‘business institution.’’ Business insti- tution is not specifically defined in the statute so that it may be interpreted to include any other business interests of the institution-affiliated party. Under 12 USC 1818(g), the Board is autho- rized to suspend from office or prohibit from further participation any institution-affiliated party charged or indicted for the commission of a crime involving personal dishonesty or breach of trust that is punishable by imprisonment for a term exceeding one year under state or federal law if the continued participation might threaten either the interests of depositors or public con- fidence in the bank. The Board may also sus- pend or prohibit any individual charged with a violation of the money-laundering statutes. The suspension can remain in effect until the crimi- nal action is disposed of or until the suspension 5. This is distinct from the Board’s authority under prompt corrective action to dismiss senior officers from a particular bank. Formal and Informal Corrective Actions 5040.1 Commercial Bank Examination Manual May 1996 Page 3