OFFICE OF FINANCIAL REGULATION
STATE OF FLORIDA
Table of Contents
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The board of directors of a financial institution is
ultimately responsible for the conduct of the
institution's affairs. The board controls the
institution's direction and determines how the
institution will operate. The board must hire capable
management to ensure board-adopted policies are
fully implemented and strictly adhered to. While day-
to-day operations are delegated to management,
the board is responsible for making sure operations
are carried out in compliance with applicable laws
and regulations and consistent with safe and sound
practices. The board monitors the institution's
operations and makes sure management can meet
the challenges created by growth, increased
competition and a changing marketplace.
This book is designed to provide financial institution
directors with a brief overview of their fiduciary
duties, as well as significant legal, administrative
and policy issues affecting financial institutions.
I. RESPONSIBILITIES OF THE BOARD OF
A. Select Competent Management
Quality management is the single most important
element in a profitable and soundly run institution.
Capable management has the industry expertise to
assist the board in long-term planning in a changing
marketplace. Management must have the technical expertise to design and administer the necessary systems and controls to carry out the board's policies and to ensure compliance with applicable laws and regulations. The quality of an institution's management team may mean the difference
between success and failure in difficult economic times. The importance of quality management increases as financial institutions face the challenges of an increasingly competitive and highly complex marketplace. Occasionally, the board may find it necessary to dismiss officers for poor performance, dishonesty, or other reasons. In these circumstances, the failure to act timely and prudently may represent a breach of the board's
responsibilities to the institution, its shareholders, the OFR, and the deposit insurance fund.
B. Formulate Appropriate Plans and Policies
The board should develop a long-term strategic plan that contains a statement of the board's general philosophy and defines the board's vision for the future. Short-term business plans must also be formulated, translating goals into specific, measurable targets. Adherence to the business plan should be evaluated at regular intervals. Any significant departures from the plan should be carefully considered and approved in advance by the board.
The board should adopt specific operational policies concerning areas such as loans, AML/BSA,
personnel administration, and investments. The policies must be consistent with the institution's
long-term and short-term strategic plans. By adopting policies, the board defines what practices and levels and types of risk are acceptable. Policies direct management on selecting risks and rewards and are implemented by management through
internal operating procedures. Clear written policies are especially important in the increasingly competitive financial service marketplace. All major activities must be covered by policies and new activities should not be undertaken without appropriate policies in place.
Loan Policy - A loan policy should establish
parameters for the overall loan portfolio. The policy should define what portion of the institution's funding sources may be used for lending, what types of loans may be made and what percentage of the overall portfolio each loan type should be. Geographic lending areas should be identified and limits on purchased loans should be established. Guidelines governing loans to insiders also need to be adopted.
The loan policy should address credit requirements, loan underwriting criteria and loan application requirements. Approval authority needs to be defined and delegated based on individual loan officer expertise. Guidelines for loan administration should also be established.
The board should be particularly aware of
circumstances such as the following when
considering the institution's lending activities:
? Failure to have systems that properly monitor compliance with legal limits.
? Inadequate loan administration.
? Relaxed standards or terms on loans to insiders.
? Over-reliance on character or collateral factors
resulting in poor selection of credit risks.
? Uncontrolled asset growth or increased market
? Purchase of participations in out-of-area loans
without independent review, evaluation, and
Loan Review Program - A comprehensive
independent internal loan review program is critical
to the board's ability to monitor the quality of the
institution's assets and to protect against losses.
The loan review program should provide for periodic
reviews of the loan portfolio by persons who are not
responsible for the institution's credit decisions and who report their findings directly to the board or the loan committee. A loan watch list should be
developed and regularly updated listing past due
loans and other loans with identified weaknesses.
The loan review function serves as an early warning
system helping to identify poor loan administration
and problem loans. It assesses the adequacy of and
adherence to internal loan policies and procedures,
identifies potential problem loans, and provides the
board and management with an objective
assessment of the overall quality of the loan portfolio.
Allowance for Loan and Lease Losses - Financial
institutions are required to maintain adequate loan
and lease loss reserves (LLLR). To ensure an
adequate reserve for loan and lease losses, the board should adopt a system that requires at least a quarterly review of the LLLR level to determine whether it is sufficient to absorb projected losses, including identified exposures to losses and an estimate of unidentified potential losses. Information received from the internal loan review should be used to determine identified losses. Unidentified losses should be estimated based on factors such as economic conditions, portfolio growth, past collection rates, exposure concentrations, and other factors that might have an impact on the ultimate collectibility of certain credits.
The use of a loan grading/rating/classification system to ensure monitoring of problem loans and permit more accurate quarterly assessments of the adequacy of the loan valuation reserve and provision for loan losses is strongly recommended. The loan grading methodology must be governed by a written policy, which is reviewed annually by the board and revised when circumstances warrant. It is guided by a definitive written procedures manual or set of review instructions, which outline minimum standards for setting reporting documentation and loan grading criteria. Since the board is responsible for the accuracy of the institution's financial statements, it is imperative that the LLLR be reviewed regularly for adequacy. In addition, the board needs to
periodically review the methodology used to calculate the LLLR and adjust as necessary. The Interagency Policy Statement on Allowance for Loan and Lease Losses (ALLL) is a document that should become familiar to every director.
One of the primary methods used to gage potential losses within the loan portfolio is through a credit grading system. Generally, each credit is graded (by the loan officer but an independent third-party
reviewer is preferred) on a numerical scale ranging from 1 (the highest quality) to 7 (considered a loss and uncollectible). Each grade is assigned a percentage corresponding to the loss potential (0% for a 1 to 100% for a 7). The cumulative dollar amount of all credits would be the total assessment of the risk in the loan portfolio.
Anti-Money Laundering Policy - The Bank Secrecy
Act (BSA) is a comprehensive anti-money laundering statute which was enhanced by the enactment of the USA PATRIOT Act (Act). Title III of the Act is the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001. The Act is far reaching in scope, effectively expanding BSA standards, and applying to a broad range of financial activities and institutions not previously included. The BSA requires depository institutions and other industries vulnerable to money laundering to take a number of precautions against financial crime, including reporting cash transactions over $10,000 (CTR) and filing suspicious activity reports (SAR).
Banks must have policies and procedures in place to achieve compliance. The board must determine the level of risk they will tolerate in the bank’s customer
base, manual or automated systems in use, and standards provided in implementing regulations. Further, policies must set criteria for customer identification, documentation requirements for know your customer (KYC), customer due diligence (CDD), and enhanced due diligence (EDD) based on the level of risk identified.
Each bank must have a designated BSA compliance officer for day to day operations; internal policies, procedures and controls; appropriate training for all
staff; and independent testing of all facets of the program. The Office of Financial Regulation requires de novo banks to submit a BSA officer for approval prior to opening.
In addition to filing CTRs and SARs, the BSA
establishes several prohibited practices such as opening, maintaining, administering, or managing correspondent accounts with “shell” banks; requires anti-money laundering records to be maintained and available for review and use by regulatory and law enforcement agencies; and implements appropriate due diligence for private banking and correspondent accounts of non-United States persons.
A comprehensive interagency examination manual was released in 2005 (an update will be released in mid 2006) within which directors may find extensive additional information on BSA issues and practices. It can be found on the FFIEC website at
http://www.ffiec.gov/bsa_aml_infobase/default.htm. Other sources include www.fincen.gov and www.fatf-gafi.org.
Asset-Liability Management or Funds
Management Policy - Asset-liability management
refers to the overall control of the composition of balance sheet accounts to attain key objectives. These key objectives are to generate optimum levels of quality earnings and to maintain adequate liquidity to meet both predicted and unexpected cash needs. The increasing volatility in funding sources and market rates resulting from the removal of interest rate limitations and rapid fluctuations in the economy have made effective funds
management essential to successful operations. The policy should establish parameters within which
management can pursue earnings and growth
objectives. In addition, the policy should address the institution's off-balance sheet activities and a
contingency plan that specifies how the institution
will raise necessary cash in case of unusual liquidity pressures.
The following practices or conditions should trigger board scrutiny:
? Excessive growth objectives.
? Heavy dependence on volatile liabilities or
? Gaps between asset and liability maturities or
between the volume of rate sensitive assets and
rate sensitive liabilities at various maturity time
? Asset/liability expansion (on or off-balance sheet)
without an accompanying increase in capital
? Failure to diversify asset risks or funding sources.
? Inadequate controls over securitized asset
? Lack of expertise or control over highly technical
risk reduction techniques, such as swaps, futures
Risk Management Policy - Although banks are in
the business of taking risks in order to make a profit,
the board of directors is expected to manage and
control the amount of risk the bank is willing to