By Nancy Foster,2014-05-18 07:22
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Failure to consider pledging requirements in investment decisions. Lack of investment diversification. Trading in the investment portfolio.







    June 2006


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.



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


    Internal Review

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

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 Other sources include and

    Asset-Liability Management

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

    borrowed funds.

    ? 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

    and options.

    Risk Management

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

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