Improved Communications Between Bank directors and adherence to established policies and procedures. (See app. VIII.) Appendix I Objectives, Scope, and Methodology As discussed in chapter 1, we had the following five objectives for this review: • Determine the frequency of various insider activities at selected failed and open banks and the potential impact of insider activities on the safety and soundness of bank operations. Evaluate the effectiveness of the regulators of federal financial institutions to identify and supervise insider activities at banks. • Determine the underlying causes of insider problems, specifically whether there is an association between insider problems and broader managerial or operational problems in failed and open banks. • Determine the overall extent of loans to insiders at failed and open banks. Compare state banking laws and regulations with federal Regulation O and analyze state examination policies and procedures governing insider activities. More detailed information on our scope and the methodologies we used to address the first, third, fourth, and fifth objectives follows. For our first objective, we collected the information on the 286 banks that failed in calendar years 1990 and 1991 on a two-part form, or data collection instrument (DCI), that we designed and pretested. To address the requesters' question about the frequency of insider activities, we completed part I of the DCI for 286 bank investigations. Part I focused on the reasons for a bank's failure. These reasons include an assessment by the investigator as to whether insider problems played a major role in the bank's failure; the types and nature of the insider problems, as identified by the investigator; and the extent to which recoveries from directors, officers, and others are likely. We then completed part II only for those cases where investigators identified insider problems as being a factor in the failure of the bank. We collected specific information on the types of insider activities identified by the investigator and the other management and economic problems that led to the failure of the banks.1 We also collected the same information from the examination reports and accompanying workpapers of the 175 banks for the 3 years before the banks failed. To design part I of the DCI, we reviewed examination reports from prior studies to develop a comprehensive list of insider activities and 'In addition to wanting to capture all of the reasons a bank may have failed, we focused on other problems. We also focused on specific problems of insider abuse, insider fraud, loan losses to insiders, and insider violations because field testing of our DCI indicated they were important. Objectives, Scope, and Methodology management problems. We field tested this DCI at two FDIC field offices. FDIC officials at these offices reviewed our list of insider activities and management problems. On the basis of their comments, we refined our list as necessary. Our explanations of insider activities are generally consistent with those discussed in the Office of the Comptroller of the Currency's (OCC) study of bank failures.2 Explanations of the major insider activities and management problems we focused on are as follows. Operating Losses. Operating losses refer to losses associated with the pricing of products, the processing of bank transactions, or unusually high personnel costs. For example, a bank that has an antiquated computer system may experience delays in processing transactions, which increases costs to the bank when cash cannot be deposited immediately. Excessive Growth. For a bank, growth generally refers to its loan portfolio, either through increased lending or through acquisitions of other banks' assets (i.e., loans). A bank may grow rapidly without experiencing excessive growth if the bank's systems and staffing also grow to keep pace with the growth of the loan portfolio. Excessive Dividends. Dividends paid to shareholders are excessive when the bank has insufficient profits to pay them. High-Risk Exposure. High-risk exposure occurs when a bank's loan portfolio is concentrated in high-risk loans, such as those in commercial real estate made on land alone. Poor and/or Negligent Management. This is failure of management to exercise due care in the management of the bank. Passive and/or Negligent Board. This is caused by failure of the board to properly oversee management's operation of the bank. Failure to Respond to Regulatory Criticism. This condition is present when the regulator repeatedly has cited the same problems at a bank and the bank's directors took only partial, little, or no action to correct the problems. Lack of Expertise of the Board or Management. Although individual board directors need not have a thorough knowledge of the intricacies of 2Bank Failure: An Evaluation of the Factors Contributing to the Failure of National Banks Office of the Comptroller of the Currency, (Washington, DC: 1988). Objectives, Scope, and Methodology banking, the board as a whole should have sufficient expertise to oversee management's operations. Management should have the expertise to manage the lines of business of the bank. For example, if the management of a small bank decided to enter the derivative products market but the bank had no staff experienced in this complex product line, the bank could have problems because of the staff's lack of expertise. Dominant Board Member/Dominant Executive. This term refers to a director, officer, or small group who unduly influences the decisionmaking process within the bank to the extent that dissenting voices were either not allowed or not heard. Insider Abuse/Insider Fraud. There are clear distinctions between insider abuse and insider fraud. Insider abuse is abuse that falls short of being a criminal act. It occurs when an insider (as defined by Regulation O) benefits personally from some abusive action he/she takes as part of his/her position at the bank. Not all insider violations are necessarily abusive; the violation must be accompanied by personal gain to the insider to be considered abusive. Insider fraud is a criminal act. Such action includes embezzlement, falsifying documents, and check kiting. The actions must have been perpetrated by an insider, as defined in Regulation O. However, unlike insider abuse, insider fraud does not have to benefit the individual perpetrating the crime. For example, if a bank president falsifies loan documents to improve the apparent creditworthiness of a borrower, this is fraud-even if no personal gain by the president can be identified. Lack of or Inadequate Systems to Ensure Compliance With Laws and Regulations. This is present when the bank is criticized for lacking a system or program to identify and avert potential violations of law or regulation. Also, this may indicate a failure of the board or management to properly assign responsibility for correcting deficiencies cited by examiners. Lack of or Inadequate Lending Policies, Lax Lending Practices, and Inadequate Credit Administration. There are clear distinctions among these terms. A bank should have in place specific lending policies to cover the various types of lending it does. The policies serve as instructions for the lending officers. Lax lending practices deal with the issuance of loans, whether they are made on a sound basis, and whether the bank obtained adequate credit information on the borrower before deciding to lend. The composition of a bank's loan portfolio can also indicate lax lending Objectives, Scope, and Methodology practices. For example, if a bank's loan portfolio is highly concentrated in a specific type of loans (e.g., commercial real estate) or if there are a lot of loans to uncreditworthy borrowers, it indicates that the bank has lax lending practices. Inadequate credit administration refers to how the bank manages its loans after they have been made. Such criticisms as failure to maintain current appraisals, failure to obtain periodic credit information on borrowers, and inadequate documentation in the loan files all point to inadequate credit administration. Loans to Insiders. Loans to insiders refer to loan losses to individuals defined as insiders by Regulation O. Tellers and loan officers generally do not meet the definition of insider for Regulation O purposes. Excessive Compensation. This refers to compensation to officers or board members that an investigator or examiner has identified as beyond what is typical for the bank, considering its financial situation and comparing it to other similarly sized and located banks. Improper Affiliate Transactions. These are violations of section 23A and 23B of the Federal Reserve Act. As part of our review of the examination histories of the 175 banks with insider problems, we also reviewed any enforcement actions taken by the regulators against the banks. So that we could have complete information, we also obtained from FDIC, occ, the Federal Reserve, and the Securities and Exchange Commission (SEC) information on the enforcement actions they had taken against the former officers and directors after the failures of all 286 banks.3 To better understand the issues related to potential recoveries from negligent officers and directors, we also talked with representatives of insurance companies that offer directors and officers (D&O) liability insurance policies. After we had completed our data collection efforts on the failed banks, we contacted the DOL investigators in charge for 18 randomly selected banks to verify that as their investigations continued, the conclusions they presented in the post-closing reports as to the reasons for the banks' failures had not changed. 3SEC, although not a bank regulator, can propose post-failure enforcement actions when it determines that such parties violated the antifraud, reporting, and internal accounting provision of federal securities laws. |