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specific legislative support been provided for a number of regulatory initiatives which we have taken under our more general authority to address unsafe and unsound banking practices. At this juncture, I should emphasize that I am confident of the dedication and ability of our bank examiners. This point is of special importance because of belief in some quarters that lax bank examination has led to widespread and serious problems in the banking system. This is not true. Moreover, it is grossly unfair to the men and women who examine banks. To the degree that problems have arisen, they may have resulted from a lack of clear direction, not from a lack of will or commitment on the part of the bank examiner.
The results of this survey, other studies, our experiences and that of the other agencies with various regulatory strategies may help to identify those issues where there is a genuine difference of views as to the appropriate course of public policy, as well as any real problems in our supervisory apparatus. This effort should enable us to develop regulatory options which are effective without being unduly burden
Indeed, in addition to taking appropriate action with respect to abuses uncovered by the survey, I have directed the staff to review systematically our approach to insider abuse in order to determine what should be strengthened and what should be discarded.
Notwithstanding my view that there is considerable need to analyze the survey data further and to develop new regulatory approaches, I am convinced that Congress and the agencies can take immeidate steps which will go far to eliminate insider overreaching which does exist.
First, it should be noted that both the Office of the Comptroller of the Currency and the FDIC have proposed for comment a policy statement and revised regulation respectively which make clear that preferential treatment of bank insiders is inappropriate and will not be tolerated by the agencies.
The proposed policy statement of the Office of the Comptroller of the Currency emphasizes that abusive transactions by bank insiders have been a cause of continuing concern to the Comptroller of the Currency and the other bank regulatory agencies and indicates our intention to issue a series of policy statements focusing on specific types of insider transactions which are deemed by our Office to be abusive. The statement makes clear that corrective measures will be taken when abuse is found, including the requirement of reimbursement by insiders.
The proposed revision of the FDIC's regulation takes a more general approach declaring that an insider transaction is an unsafe or unsound banking practice “if the transaction is preferential and results in, or is likely to result in, loan loss, excessive cost, undue risk, or other economic detriment to the bank.” The proposed revised regulation sets forth that an insider transaction would be preferential if, “in light of all the circumstances, an insider or person related to an insider obtains a benefit or advantage which would not be afforded in a comparable arm's length transaction to a noninsider of comparable creditworthiness or otherwise similarly situated.”
For my own part, I have not concluded which of the two approaches is preferable or whether some combination or both would be more appropriate. We should carefully study the experience of the two agencies in the coming months to make that determination. In any event, I fully expect that both agencies will have in place a policy statement or regulation along these lines in the very near future.
Second, the supervisory powers legislation passed by the Senate and now pending in the House should be enacted as soon as possible along with certain other provisions pending before the House Banking Committee. As you know, this legislation would remedy significant gaps in our powers and would generally enhance our ability to deal with abuses.
Third, I have recommended passage of legislation which would grant the banking agencies authority to disapprove changes in bank control. Although we have rigid controls over the ability of individuals to enter banking through the chartering mechanism, there exist absolutely no restrictions upon the ability of individuals to acquire control of banks. In my judgment, this fundamental inconsistency significantly diminishes our ability to supervise effectively the banking system. Accordingly, I believe that this gap in our regulatory apparatus should be eliminated. Although this power would be rarely used, it would, if properly employed, enable the agencies to anticipate and avoid problems. The mere presence of such a power would go far to minimize the potential for insider abuse.
Fourth, the fact that interest cannot now be paid on correspondent balances leads to a haziness in pricing resulting in a real potential for abuses. Moreover, restrictions and controls which interfere with the market mechanism are inefficient and often lead to undesirable and unanticipated side effects. Abuses arising out of the use of correspondent balances to support bank stock loans are an example of such side effects. Allowing the payment of interest on these balances would help minimize the potential for abuses in this area. Congress should give immediate consideration to this approach.
Fifth, the Office of the Comptroller of the Currency is already following up on those instances of abuse which have been uncovered by the survey. In this respect, we are scrutinizing the survey results carefully and are especially mindful of any instances in which existing supervisory mechanisms did not uncover the abuses.
Sixth, the Office of the Comptroller of the Currency will continue to make greater use of formal enforcement mechanisms in instances in which abuses are flagrant or repeated. Also, we are considering whether repeated instances of misconduct in the face of normal supervisory procedures may warrant the use of public rather than private enforcement proceedings against recalcitrant bank officers and directors. These approaches to repeated or especially abusive offenders will obviate the need to impose draconian rules on those in the banking industry who have maintained high ethical standards.
We believe that more can and should be done to eliminate insider abuse in its various forms. At the same time, the tools chosen to accomplish that end must be carefully selected to insure that they involve the least possible government intervention in private decision-making. Such an approach should be both effective and involve the least cost. We know of your commitment to these ends and look forward to working with you in this endeavor.
POLICIES OF THE COMPTROLLER'S OFFICE Throughout the history of the Office, examination procedures and supervisory directives to national banks have addressed different types of insider problems.
The failure of United States National Bank of San Diego caused examiners and supervisors throughout the country to focus upon the difficulties which may be brought on by significant insider abuses. A number of steps were taken by the Comptroller's Office to improve the detection of such abuses and to achieve correction, by direct supervisory actions when necessary.
During 1974 and 1975, the Comptroller's Office drafted and implemented 12 CFR Part 23, entitled Statements of Business Interest of Directors and Principal Officers of National Banks. This regulation requires that all directors and principal officers file lists of all business enterprises in which they or their spouses or minor children own in aggregate 10% or more. Extensions of credit, including overdrafts, to these designated interests which do not appear on the bank's books as associated with a director or officer must also be reported. The primary purpose of the regulation was to provide a reviewable record for boards of directors and examiners to identify the insider interests in significant transactions.
In June 1976, the Comptroller's Office affirmed a uniform policy on insider transactions by issuing Examining Circular 142. That circular provided instructions for the uniform review and treatment of extensions of credit to directors, officers, principal shareholders and their interests. The term extension of credit includes overdrafts. In that circular the examiner was instructed, among other things, to:
(1) Ascertain that the proper persons have filed Statements of Business Interest (Form CC 9030-29) required under 12 CFR 23.
(2) Determine the existence of principal shareholders through review of the ownership records of the designated bank or bank holding company.
(3) Through inquiry of management or review of a written policy statement, determine the bank's policy with respect to extensions of credit to directors, officers, principal shareholders, and their interests.
(4) Prepare a listing or, when appropriate, request a listing from the bank of all significant extensions of credit to directors, officers, principal shareholders, and their interests.
(5) Transcribe to the Examiners Line Sheet all appropriate information obtained orally or from the bank's records relating to outstanding indebtedness.
(6) For all extensions of credit deemed to be significant (see definitions of significant) or within the purview of law, transcribe, review and analyze all information concerning the debt, the debtor, collateral, and financial support for the obligation.
(7) Determine the existence of any preferential treatment with respect to rate, collateral, repayment terms, advances beyond paying capacity, or any general lessening of normal credit standards.
(8) While reviewing other extensions of credit, be watchful for any relationships with directors, officers, principal shareholders, and their interests which have not been previously made known. În instances where information is developed detecting interests of reporting persons not properly listed on the reporting form the examiner should notify the Regional Administrator of a possible violation of criminal statutes applicable to certain kinds of false statements (18 U.S.C. 1001 and 1005).
(9) Through review of minutes of the Board of Directors or Committees thereof, determine whether directors have abstained from participating in discussion of and voting on transactions involving them on their interests.
In addition, the circular guided the examiner on what to do when an extension of credit was subject to some form of criticism. The examiner was told:
“In the event that a significant transaction with a director, officer, principal shareholder, or his interest is found to be delinquent, subject to comment or criticism, not supported by current and satisfactory financial information, exhibiting collateral documentary exceptions, or of a preferential nature, the examiner will meet with the Board of Directors for the purpose of informing them of his findings in this area and eliciting their commitment for positive action to eliminate the criticism or correct any deficiencies. Regardless of whether deficiencies are found, the examiner is expected to review the bank's policy with respect to such extensions of credit at all called meetings with the Board of Directors. Direct communication with the Regional Administrator should precede discussion with the Board of Directors on serious matters of criticism.
“All violations of law, deficiencies in policy, collateral or credit exceptions, failure of directors to abstain from participating in disucssion of or voting on transactions involving themselves or their interests or evidence preferential treatment and any promised corrective action are to be the subject of comment (in the Report of Examination). . . . [A]ll significant extensions of credit, as defined, to directors, officers, principal shareholders or their interests are to be detailed ... [in the Report of Examination].”
In addition, the responsibility of the bank's board of directors to review and police such practices has been emphasized in the Comptroller's new examination procedures implemented in the Fall of 1976 and Spring of 1977. A much stronger emphasis by the examiners is now being placed on verifying the establishment and adherence to the policies, practices, procedures and controls established by the directors and management. The examiner is directed specifically to review the accounts of officers and directors for any exceptions to standard policies on service charges and interest that would suggest self-dealing or preferential treatment. In addition, significant overdrafts are analyzed as extensions of credit to determine quality and the borrower's ability to repay.
Examiners are required to comment on all extensions of credit to officers, directors and 10% shareholders and their families. Particular emphasis is given to the comparability of rates and terms given to those insiders with terms on similar loans to the public. If abusive self-dealing is indicated, the examiner makes this comment with appropriate supportive facts in the examination report. Further, the examiner must bring the situation to the attention of the full board of directors and elicit their plan for correction and prevention of these abuses. The work done by the examiners is now documented in writing in working papers so that other examiners in succeeding examinations will have a continuing record of work previously performed and results of that work.
Because the new examining procedures have been so drastically revised, many examiners are still on a learning curve. Recent events, however, have heightened the awareness of insider activities and correspondent relationships, and we believe that the examiners are more closely investigating these activities.
More recently, our Office has taken additional steps to increase the awareness and sensitivity of bank directors to the potential for abuse in imporperly controlled insider transactions.
In December 1977, we published for comment a proposed policy statement addressing a variety of preferential insider transactions deemed to warrant supervisory correction. The proposed Policy Statement, which we expect to revise and clarify in response to the comments, speaks to specific types of insider transactions which are deemed by the Comptroller to be an abuse of bank assets, a violation of fiduicary responsibilities at common law and under 12 U.S.C. $ 73, and in some cases a violation of other federal statutes. When such abusive insider transactions are detected by bank examiners, the transactions will be criticized and correction will be requested. Corrective measures proposed in the statement range from requiring (a) adoption of definitive written policies and procedures designed to police and place responsibility for such transactions, to (b) reimbursement by insiders or approving directors of unwarranted monetary benefits conferred on an insider. The following are specific types of insider credit extension transactions discussed in the policy statement which have proved to be recurring and thus, in my judgment, warrant the special attention of bank directors.
1. Extensions of credit on preferential terms to executive officers
Extensions of credit to executive officers on preferential terms, ie., terms more favorable than those extended to borrowers of comparable credit standing, are prohibited by 12 U.S.C. § 375a. The terms "extension of credit" and "executive officer” as used in this statute are defined in Federal Reserve Requlation 0, 12 C.F.R. 215, and accompanying interpretations. Overdrafts are specifically identified as credit extensions in Regulation 0.
Preferential terms can include unusually favorable interest rates, liberal repayment programs and maturities, reduced collateral requirements and extensions of credit not supported by current financial worth or capacity to repay.
For the purposes of the policy statement a significant shareholder was defined as one who directly or indirectly owns or controls more than 10 percent of the bank's outstanding shares. 2. Extensions of credit on preferential terms to directors, signifcant shareholders, or
Unlike loans to executive officers, loans to directors or significant shareholders or companies they control are not governed by a specific federal statute. Nevertheless, common law fiduciary principles do apply. The proposed statement reiterates the view of the officer that such extensions of credit on terms more favorable than those accorded non-affiliated borrowers of comparable credit standing are unwise and may expose a bank board of driectors to liability for breach of its fiduciary obligations.
The statement also notes that the availability of loans on preferential terms may encourage a director or significant shareholder to seek extensions of credit he may not need or for which he is not eligible, with the result that both the borrower and the bank may become overextended. Additionally, the perception of a bank as a source of easy credit for insiders does not comport with its obligations to serve the whole community or with the public trust in the bank's operation. 3. Extensions of credit on preferential terms to immediate families
Extensions of credit on preferential terms to members of the immediate families of executive officers, directors or significant shareholders or their business interests are identified as an abuse of bank assets where such terms would not have been granted but for the influence of the insider. 4. Reciprocal lending arrangements
The statement notes that preferential term loans on a reciprocal basis between banks to each other's directors and executive officers carry essentially the same potential for unsound extensions of credit as is present in the case of direct loans to insiders. Such transactions frequently commit bank assets on the basis of considerations of benefit to individual insiders rather than on the basis of proper credit judgments and bank profitability. The statement declares that when the transactions are made on preferential terms, they will be deemed by the Comptroller's Office to be an abuse of the assets of the lending bank.
In addition to the Policy Statement, we have addressed diversion of bank income from credit life premiums to select insiders rather than the bank or all of its shareholders, in a regulation which became effective January 1, 1978 (12 CFR 2). And, in my other statutory role as a director of the FDIC, I have vigorously supported proposals, now published for public comment, which would significantly strengthen the FDIC's insider regulation (12 CFR 337.3) in a number of ways, including a rather precise definition of the type of preferential insider transactions which will be regarded as unsafe and unsound and a further clarification of the direct responsibility of directors to insure that such transactions will not take place.
In addition to these initiatives, or use of formal enforcement remedies to achieve correction of insider abuses has continued to increase. During 1977 alone, formal administrative actions were taken by this Office on 55 occasions. Out of these actions, 30 dealt with insider transactions while 7 dealt with overdraft problems. Six dealt with the question of possible abuse of correspondent accounts.
Information developed through the Special Survey has already led to supervisory actions against some banks. For example, during our review of the survey results, we identified a bank having an overdraft to an insider interest in excess of the bank's legal lending limit. We immediately commenced an administrative action and have issued a Notice of Charges and a Temporary Cease and Desist Order against the bank, stopping any further use of the overdraft facility by this insider. We are presently engaged in an examination to determine the full extent of the problem in this bank.
These initiatives at the regulatory level need to be supplemented by new legislation which will improve our abilities to detect insider abuses and enforce the laws and our regulations.
We have previously discussed with the Committee the necessity of flexible scheduling of national bank examinations. While all national banks must, of course, be periodically examined, we should concentrate on those banks which have more serious problems, including insider abuses. For example, the banks which do not have firm policies as to overdrafts for all customers, including insiders, or which have management with known indifference toward these abuses would be candidates for more frequent examinations than those banks with adequate policies and procedures and without a history of preferential insider transactions.
Our letter to you of February 23, 1978, on flexible scheduling of examinations provides a fuller explanation and proposed amendatory language.
We also strongly support S. 71, which would significantly increase our ability to attack abuses. The additional threat of civil money penalties, for example, seems likely to deter certain practices by recalcitrant officers and directors. Similarly, the broadened statutory declaration against preferential transactions and the restrictions on, and requirements for advance approval of, insider loans contained in Section 103 of S. 71 will directly address some of the more egregious practices. This legislation will in particular dispel the lingering argument of some that the regulators have over reached their authority in some of our recent initiatives addressing these policies.
As I have stated earlier, we also support a provision to regulate change in control of banks. I am aware, however, that this provision is opposed by some who are of the opinion that it would interfere unduly with the right to sell private property and would make more difficult the raising of capital by the sale of bank stock. For this reason, the language of such a law must be carefully and thoughtfully worked out.
The results of this Survey, imperfect though they may be, clearly indicate to us that the enforcement and insider loans restriction provisions of S. 71 are needed immediately. If those tools prove insufficient, we will be back to consider other ways to assure that the totality of the banking industry is as ethical and responsive to the public needs as are the majority of its members.
The CHAIRMAN. Thank you, Mr. Heimann.
STATEMENT OF J. CHARLES PARTEE, MEMBER, BOARD OF GOVERNORS, FEDERAL
RESERVE SYSTEM I appreciate the opportunity to present today the views of the Board of Governors on the results of the survey on bank stock loans, insider loans and overdrafts that was recently conducted for this Committee. The Federal Deposit Insurance Corporation has provided summary data from the survey based on reports from 14,137 banks, representing about 98 percent of all insured commercial banks. Earlier this week, the three Federal bank supervisory agencies also forwarded to this Committee a joint staff analysis of the survey data. As this comprehensive analysis has been made available to the Committee, I will not review the results of the survey in any detail today. Instead, I want to focus on several of the major findings, including several that are cause for concern.
Before discussing the principal findings, I believe it important to caution that many banks experienced considerable difficulty in filling out the report form. The survey was very broad in scope, was conducted under extraordinarily tight time constraints and did not allow for the careful pretesting that is our standard procedure in survey undertakings. Due to the complexity of the survey questions, much of the information requested was not readily available from central records and had to be retrieved by hand from credit and collateral files. In addition, lack of familiarity with this one-time survey questionnaire undoubtedly caused difficulties in bank interpretations and responses. While very substantial efforts were made to identify and rectify such reporting problems, the Board believes the data to be a good deal lower in quality than most regularly collected banking data, and has serious reservations about its reliability.
Because of these and other shortcomings of a statistical approach to the subjects covered, the Board believes it is essential to go beyond the survey results before recommending any regulatory or legislative changes. The Federal Reserve plans to conduct promptly a follow-up investigation of those State member banks indicated by the survey returns to have engaged in possibly improper activities. We will be