BANK I his duties and responsibilities LESTER MADDOX, Governor w. M. JACKSON, Superintendent of Banks THE BANK DIRECTOR his duties and responsibilities STATE OF GEORGIA CONTENTS Page Foreword by Governor Lester Maddox______________________________ 3 Preface _ __ 4 Care and Diligence_________________ __ 5 Statutory Provisions Directors' Qualifications Directors' Meetings Directors' Borrowings Statutory Liabilities Loan Limitations General Loan Supervision Investments . . Cash Reserves Real Estate .___ ..__.. __ _ ._____ . ._.________________ 7 7 8 8 9 10 11 ..__ 11 12 Directors Should Direct Overall Board Committees . The Individual Director Board Functions Directors' Meetings .__. Loan Policies _ 13 .__ 13 0 14 . .___ 16 . _. 17 17 Investment Policies ..__. . 19 Trust Department _. . ._____________________________ 20 Personnel -_____________________ 21 Earnings, Expenses, Dividends . 23 Audits and Controls ..... . .. .____________ 25 Bankers Blanket Bond Coverage 31 Credit Life Insurance . ... ._..._.. ... 32 Directors' Examinations ._ _.. . .__. .____ 32 2 FOREWORD My congratulations and best wishes are extended to bank directors, those citizens of Georgia who have been complimented by being elected to positions of high trust and honor ,in their communities. Election as a bank director implies the highest confidence of the stockholders in the citizen's integrity, business morality, ability, responsibility and public trust. This booklet has been compiled by the Department of Banking for the use of directors of State chartered banks. It contains a digest of the laws relating to election and duties of directors and of those governing a bank's operations. It is hoped that it will be of benefit to the newly elected director and of interest also to the experienced director. It does not purport to be all inclusive on the subjects presented, but points out the basic principles of directors' responsibilities and covers some questions with which directors are most frequently confronted. March, 1967 3 PREFACE This booklet was prepared by the Department of Banking from material gathered and experience gained over the years. There have been similar publications on the subject of directors' duties and responsibilities. The need, however, was felt for a presentation based on court decisions and statutory laws directly governing the approximately 338 banks chartered by the State of Georgia. The emphasis placed on the prerogatives of directors, as such, as distinguished from those of executive officers of their banks, should not be taken as a reflection on the latter. Rather, it is believed, the level of competence, conscientiousness, knowledgability and devotion to duty among Georgia bankers is higher than ever before and compares favorably with those of other jurisdictions. It is further believed that bank officers recognize that their effective operations are greatly enhanced by directors who are well informed and appreciative of their duties and responsibilities. w. M. JACKSON, Superintendent of Banks 4 CARE AND DILIGENCE To be selected by the stockholders of a bank to serve as a director is an honor. It implies confidence on the part of the stockholders in the ability and integrity of the individual so selected. Moreover, it reflects the reputation of the individual as successful in his own affairs, as public spirited, and as entitled to confidence in the care of funds entrusted to the bank by the depositors. To accept the honor fixes legal responsibilities to exercise ordinary care and diligence in the administration of the bank's affairs. Any failure to exercise this degree of care and diligence which results in losses to the bank or its depositors gives rise to a cause of action for the losses sustained. Here are a few Georgia court decisions which illustrate this point: "The general rule in this State is that directors of a bank must exercise ordinary care and diligence in the administration of its affairs. The active management of the bank may be delegated to certain officers authorized to manage its business. The directors, however, must exercise a reasonable supervision over such officers." (Woodward vs Stewart, 149 Ga. 620) "A director of a bank has duties to perform more essential than that of allowing his name to be printed on the bank's stationery, and negligent ignorance is sometimes equivalent to knowledge." (Marietta Trust Company vs Faw, 31 Ga. Ap. 508) "Unfortunately, some directors appear to think that they have fully discharged their duties by acting as figureheads and dummies; but this is a mistake, and a delusion from which some of them are now and then awakened by a judgment for damages arising from allowing the corporation to be looted while they sat negligently by and looked wise." (McEwan vs Kelly, 140 Ga. 720) "If by reckless inattention to the duties confided to them by their corporation, frauds and misconduct are perpetrated by officers, agents, and co-directors, which ordinary 5 care on their part would have prevented, then I think it may be said with truth that it is now elementary law to be found in all the books, that directors are personally liable for the losses resulting." (From a Federal Case cited in Shannon vs Mobley, 166 Ga. 430) These decisions are not based on statutory laws of the State, but upon the view of the common law that a bank director is a trustee and responsible for using, in good faith, ordinary care, diligence and prudence in administering the bank. This does not mean that directors are held to the highest degree of care and diligence, nor that they can be held liable for every loss or for errors of judgment. Banks sustain losses at times when there is no lack of diligence, care or prudence. The important thing is that the director be informed and that he use judgment in the decisions he is required to make, even though his judgment was wrong but reasonable under the circumstances then present. The courts have never gone so far as to require the highest degree of judgment. They recognize that directors are mortals. Instances that have resulted in judgments against directors are failure to attend directors' meetings; ignorance of the condition of the loans or other assets of the bank; acquiescence in violation of legal loim limits; failure to create committees called for by the bylaws and to see that they function; failure to take action for the bank's best interests against borrowers; failure to investigate and deal with questionable acts on the part of officers and employees; and failure to require proper bond coverage on officers and employees. There have been many more, but all were instances of failure to exercise ordinary care, diligence and prudence. There should be added this observation pertaining to Federal Deposit Insurance. When a bank closes and the Federal Deposit Insurance Corporation makes payments of insured amounts to depositors, the Corporation, by law, becomes subrogated to the rights and claims of the depositors against the bank. These include any rights that may develop against directors of the bank for losses considered due to their failure to exercise care and diligence required by law in the operation of the bank. These rights are freely asserted by the Corporation when investigations covering a period of years prior to the closing indicate lapses in prudence, diligence, and care on the 6 part of directors. Bank failures since 1933 have been comparatively few and most of them have resulted from defalcations or embezzlements in amounts exceeding the surety coverage provided. Some of these cases have gone to court while others were negotiated and settled out of court, resulting in recovery by the Corporation of some millions of dollars from directors. STATUTORY PROVISIONS Directors' Qualifications As regards directors, the Banking Laws of Georgia specifically require that: Every director be a citizen of the United States; at least 60 % of the board be citizens of Georgia and residing in the city or town where the bank is located or within 40 miles. Every director own in his own right, unpledged and fully paid for, capital stock of the bank of at least $1,000 par value; except that if the capital stock does not exceed $25,000, the minimum par value to be owned is $500. Directors be elected annually at meetings held at times fixed by the bylaws; the number of directors be not less than three nor more than 25, the actual number fixed by resolution of the stockholders at an annual meeting and remain so fixed until changed in like manner; vacancies occurring between elections be filled by the board of directors. Each director, when elected, take an oath that he will, so far as the duty devolves upon him, diligently and honestly administer the affairs of the bank; that he will not knowingly violate or willingly permit to be violated, any of the banking laws or the bank's bylaws; and that he is the owner in good faith, and in his own right, stock of the required par value standing in his own name on the books of the bank. Directors' Meetings As regards meetings of boards of directors, the banking laws specifically require that: Regular meetings be held at least monthly at such times as fixed by the bylaws; special meetings be subject to call 7 by the president or any two members of the board; a majority of the members constitute a quorum for the transaction of business; correct written minutes be kept in wellbound permanent books signed by the chairman and secretary of the board and showing the names of the directors present; minutes of the preceding meeting be read, corrected and approved. The board of directors, at first meeting after the annual election, elect one of their members president, also elect one or more vice-presidents, a cashier and such other officers as provided by the by-laws or as required for prompt and orderly discharge of the business of the bank. The board of directors fix the amount of bond to be given with a qualified surety company by all officers and employees having custody, control or handling of the bank's funds, the amount to be subject to approval by the Superintendent of Banks. Directors' Borrowings The Georgia Banking Laws restrict borrowings from the bank by its directors, officers or employees. No director, officer or employee of a bank may borrow from the bank, directly or indirectly, for himself or any firm or partnership of which he is a member, without the express written approval of a majority of the directors or an authorized committee of the board. Such a borrower may not participate in any way in passing on any loan or discount in which he may be interested. No bank shall lend to any of its directors, officers or agents any amount except on good collateral or other ample security. Statutory Liabilities The directors of any bank who shall approve or permit any loan to be made in excess of the limit fixed by law shall be personally and individually liable and responsible to the bank for such loan if it is not paid by the borrower. Any director not in favor of such loan may have his dissent or disapproval recorded in the minutes of the meeting at which such loan is authorized, or at the next meeting held 8 after he has discovered it to have been made, and be relieved of personal liability. Every president, director or other officer "shall be deemed to possess such a knowledge of the affairs of the bank as to enable him to determine whether any act, proceeding, or omission is a violation of the charter." (Sec. 13-9913). If he is present at the meeting when the violation occurs, he is deemed to have concurred in it unless his dissent is entered in the minutes. If he was not present, but remains on the board for three months and does not within that time require his dissent to be entered in the minutes, he is deemed to have concurred in the violation. Any director who participates in declaring a dividend, except from the net earnings, or in other misuse of its capital funds, has responsibility under the criminal laws. The same is true of a director, officer or employee accepting a fee, commission or gift for obtaining a loan from his bank. Loan Limitations No bank is allowed to lend to anyone person, firm or corporation more than 20 % of its capital and unimpaired surplus. There are exceptions to this rule involving discount or purchase of commercial paper, advances against commodities or products having ready sale in the open market, loans fully secured by obligations of the United States or State of Georgia and loans covered by commitments to take over made by the United States Government or any agency thereof. This is all dealt with in Section 13, Article 19 of the Georgia Banking Law which is interpreted and clarified by regulation of the Superintendent of Banks. Loans exceeding 10% of the capital and surplus must be fully secured and have the prior written approval of the board of directors or duly authorized loan committee. An exception to the requirement of full security is made in the case of loans to a county, municipality or political subdivision authorized to levy taxes or to a county board of education extended under certain provisions of State laws. In figuring whether loans to anyone person exceed either the 20% or the 10% limitation of capital and surplus, all loans made to the person and to firms and partnerships of which he is a member are included. 9 There are special provisions of the law relating to loans on real estate. These are contained in Section 15, Article 19 and are interpreted and clarified by a regulation of the Superintendent of Banks. The basic provisions are that not more than 50% of the market value of the underlying real estate can be loaned by a commercial bank, except that 75 % of the market value may be loaned on basis of a regular amortization; and that the aggregate amount of real estate loans may not exceed the total of savings and time deposits or the total of capital and surplus whichever is greater. Loans insured, guaranteed or committed by Government agencies, construction loans and loans made for business purposes and not exceeding $3,500, are excluded from the limitation as to total. General Loan Supervision The fact that directors' prior written approval is required only on loans exceeding 10% of capital and surplus and on loans to directors, officers and employees, should not give rise to the thought that all other loans can be properly left entirely to the consideration and judgment of the loan officers. This is what the court said: Loans of less than 10% - "As to loans of less than 10 %, which under the rules and regulations of the bylaws might be made by designated agents and officers of the bank, it is nevertheless incumbent upon the directors in the exercise of ordinary care and diligence, to retain a general supervision over the acts and doings of such agents and officers in making such loans, and to keep sufficiently informed about them to enable them to pass intelligently on the value of such loans and the condition of the bank which they are charged with supervising. Accordingly, directors are not justified in absolutely relinquishing to any officer or agent unlimited discretion, and thereafter acquiescing blindly in all that he does, but under the general duty devolving upon them to manage the bank's affairs, they must retain and exercise reasonable control and supervision over such officers, amounting to the exercise on their part of ordinary care and diligence. Thus should it appear that the directors had absolutely surrendered and relinquished their control and supervision ... in the making of such loans, there would be a failure on their part to perform the functions devolving upon them by law, 10 which would necessarily amount to a lack of ordinary care and diligence on their part as directors." (Mobley vs. Faulk, 42 Ga. Ap. 314) lnvestments Banks, except for those doing a savings business only, are prohibited from investing in stocks, There are exceptions granted in the case of stock of the Federal Reserve Bank of Atlanta, of an agricultural credit corporation organized under special laws of the State, of a small business investment company organized under Acts of Congress, or of a subsidiary corporation organized to own banking premises. Banks may invest without limitations in obligations of the United States and those guaranteed as to principal and interest by the United States; in obligations of the State of Georgia and those of State Authorities secured by leases with the State or a Department thereof; or in obligations of Federal Land Banks, Federal Home Loan Banks, Federal Intermediate Credit Banks and those of five U. S. Government-organized Credit Corporations which are specifically designated in the Banking Law. Investments in Water and Sewer Revenue Certificates of Georgia Cities and Counties are subject to the 10% limitation of a bank's capital and surplus for the obligations of anyone obligor. The 10% limitation also applies to obligations of U. S. Government Corporations not guaranteed as to principal and interest by the United States. Investments in general and direct obligations of political subdivisions of the State of Georgia are subject to the limitation of 25% of capital and surplus for the obligations of anyone obligor. These limitations do not apply to banks with capital and surplus of over $1,000,000. Other than the above, banks are restricted in their investments to those classed as "Investment Securities" as defined by regulation of the Superintendent of Banks and the total amount of such securities may not exceed 50 % of the bank's capital and surplus. This limitation does not apply to banks with capital and surplus of over $1,000,000. Cash Reserves A bank is required to maintain a reserve of 15 % of its total demand deposits and 5% of the amount of its savings and time deposits. Reserve funds may consist of currency on hand and moneys on deposit subject to call with other banks ap- 11 proved as depositories by the Superintendent of Banks. However, the reserves against savings and time deposits may consist of bonds of the United States or the State of Georgia at the market value thereof. A bank that is a member of the Federal Reserve System may, in lieu of complying with these rules, keep such reserves as are required of it as a Federal Reserve Member. The Superintendent of Banks has issued regulations clarifying the rules for computing required reserves. The Banking Law provides that if a bank's reserves fall below the level required, it is unlawful for the bank to make any new loan or declare a dividend. Further, if the Superintendent of Banks notifies a bank whose reserve is short of the requirements to make good such reserve, and, if the bank fails within 30 days to do so, the Superintendent of Banks may take charge of the business and assets of the bank. Real Estate A bank may acquire real estate only for banking house purposes or in satisfaction of debt previously contracted. That acquired in satisfaction of debt must be disposed of within five years unless the period is extended by the Superintendent of Banks. As to real estate acquired for banking house purposes, the amount, including furniture and fixtures, may not exceed 50 % of capital and surplus, except that the Superintendent of Banks, upon application, may allow a greater sum invested. Investment with the approval of the Superintendent of Banks in all of the capital stock of a subsidiary corporation holding the bank's banking. house property is considered as banking house investment. But the amount so invested, along with the bank's direct investment in land, buildings and furni- ture and fixtures, may not exceed 50 % of capital and surplus, except with the approval of the Superintendent of Banks. 12 DIRECTORS SHOULD DIRECT Overall It is true that most bank directors are principally occupied with their own businesses. Except for those few who are also active officers and paid for their full time, they can spend only limited time at the bank. They cannot be expected to see to details for the bank's operations, but they are bound to know what goes on generally without impeding the executive management in carrying out its duties. Directors should direct and set the policies and executive management should execute the policies and carry out the details. Although, as we. have seen from the court decisions, a director can be held individually liable for lack of care and diligence, a board of directors should act collectively in setting policies and in supervision of the active management. The directors, as a board and as equals, derive their authority from the stockholders and should act as a board and not as individuals in carrying out such authority. Proper procedure requires that this be done at meetings of the board and as the result of decisions made there by a majority. Board Committees As a practical matter, it is advisable for the board to appoint committees of the board to carry out specific functions. As a minimum in a small bank, there should be a Loan Committee, an Investment Committee and an Examination Committee. The number of committees increases with the size of the bank, the diversity of its activities and added departments; for instance, a trust department. The Loan Committee can be given authority to pass upon loans exceeding 10 % of capital and surplus; to loans to directors, officers and employees of the bank; and to such other loans of amounts and types as the board sees fit. Approvals and disapprovals should be :In writing and a report of the actions taken should be made to the board at each meeting and made of record in the minutes. The Loan Committee or any 13 individual member can take over the making of appraisals of real estate and other property offered as security to loans. All appraisals, whether made by the Loan Committee, an individual member or an outside appraiser, should be in writing and placed with other papers pertaining to the loans. It is to be hoped that the appraisals be rea-listie and not tailored to fit the size of the loan applied for. Needless to say, every loan application should be considered in the light of the restrictions imposed by the State Banking Law as previously outlined; also of general policies of the board as regards loans. The Loan Committee can also function with the Examination Committee in making board examinations of the bank whether such examinations are made by board members, the bank's auditors or outside auditors employed to make examinations. Further, it is very beneficial for the Loan Committee to be present at loan reviews made by State and Federal Examiners in their examinations of the bank. The Investment Committee should oversee the bank's investment account, approve purchases and sales of securities and periodically consider whether investment holdings are in line with the bank's need for quality, safety, liquidity, income, secondary reserves and tax considerations. The relative size and composition of the investment account varies greatly from bank to bank, depending on the type of community, proportion of deposits in time and savings, availability of good loans, degree of liquidity and turnover in the loan account, and seasonal and other fluctuations in the demand deposits. Both committees discussed above should, of course, keep in mind the statutory restrictions as to types and amounts permitted for the loan and investment account; also the policies set by the board. The Examination Committee will be discussed further on. The Individual Director A great number of bank directors, when they are first elected, have no technical knowledge of banking and feel that they must depend on someone who does. This should not become a habit. The managing officer of the bank, if he is the right kind, wants directors who are thoroughly familiar with the bank's affairs and will take active part in making policies and decisions. It makes his work easier and lightens his ten- 14 sions. It helps to keep the bank progressive, sound and profitable. A man selected to be a bank director should have a background of successful business experience, preferably experience with credits. He should have ideas of his own and backbone to express them. He should have available time for the bank. Sometimes the director gives too much weight to the prestige he achieves by becoming a director. Sometimes the bank gives too much weight to the prestige it achieves by adding prominent names to the board. Many professional men do not make good directors, however high they stand professionally. They do not have the time and many do not have the needed background of business experience. A man should not be selected as a director if he is likely to embarrass the bank with his own borrowing requirements and those of his business interests. A director ought to have enough stock in the bank to have a stake in its successful operation. But control by a very small group, one man or one family, is not always good. Very often it is good until illness or death brings about changes that turn out badly. Also, some boards are too large. This usually results from efforts to obtain business in a strongly competitive situation. If there are too many directors, the board is hard to organize, to keep interested in the bank's affairs and working out real decisions. It may be hard to get a quorum for meetings. A bank needs a working board if it is to achieve its proper place in the community, but the work should consist of much more than getting business for the bank, though that is important, too. Generally speaking and summarizing somewhat: 1. The director should have thorough knowledge of the duties and responsibilities of his office. 2. The director should have a genuine interest in his office, attending all meetings regularly and keeping well informed of the affairs of his bank at all times. 3. The director should be well known and respected in the community, with unquestioned reputation for integrity. 4. The director should give undivided loyalty to his office and not loyalty split with some interest adverse to the bank. 15 5. The director should possess the integrity not to use his office for personal benefits through information gained by virtue of his position. 6. The director should be capable of retaining confidences and refrain from divulging confidential information gained through his position. 7. The director should be a successful businessman in his own right and a leader in the community, as demonstrated by affiliation with such community projects as growth, development, civic and religious affairs. 8. The director must be capable of recognizing facts as distinguished from prejudices or personal interest in reaching sound, independent decisions. 9. The director should be capable of distinguishing between policy matters and management matters and be willing to refrain from entering into management functions. 10. The director should not lose sight of his primary responsibility, which is to protect the depositors who have placed their trust in him. Board Functions 1. Appoint officers, designate their duties and fix salaries; appoint the chairman and secretary of the board. Designate the committees of the board; decide on fees for board attendance and compensation for committee members devoting considerable time to their duties. 2. Set the amount of bankers blanket bond coverage and periodically consider the adequacy of coverage of fidelity, burglary, robbery and other risks. 3. Set policies and standards for loans and investments. 4. Fix interest rates to be charged on various types of loans and those paid on time and savings deposits. 5. Consider earnings, expenses, losses to be taken, bonuses, dividends, transfers to surplus, adequacy of capital funds, adequacy and suitability of banking quarters. 6. Set procedures for verification and evaluation of assets, proof of deposits and other liabilities, control of earnings 16 and expenses, whether by the board, a board committee, an inside auditor reporting directly to the board, or an accounting firm making periodic audits. 7. Consider and take measures for management succession to assure adequate replacement of officers dying or retiring. 8. Consider advisability of setting up pension benefits for retiring officers and employees, also contributing to life insurance and health insurance programs. 9. Take measures to insure good public relations, consider advertising services; contribute to civic welfare and financial progress and development. Directors' Meetings Performance of directors cannot be adequate if they are uninformed or if they tend to defer unduly to the chief stockholders or the managing officers; or if there is not an orderly and systematic program adopted for directors' meetings. Under these circumstances, board meetings are apt to take on the character of social gatherings, while the executive officer is left free and perhaps encouraged to assume prerogatives of the directors and make all policies and decisions and carry them out. To an extent, this can be avoided if a regular program is followed at all meetings. The procedure should include reading and approving minutes of the preceding meeting; receiving reports of committees and individual directors; receiving reports of the bank's condition with analysis and comparison with condition at previous dates; having report on overdue loans and other loans of doubtful collectibility, slow loans, large loans, loans to directors and officers and all loans made since the previous meeting; reviewing securities transactions in the investment account; having report and analysis of bank expenses and income; considering and taking action on reports of examination and correspondence from the examining authorities and other matters such as listed under "Board Functions" above. Loan Policies Bank credit, like a stream of water, should flow and not stagnate. To be sound, loan policies should be set with the view of having every loan that is put on the books get off the books 17 by a time that is mutually understood and agreed upon between the borrower and the lender. What is the purpose of the loan? How are the proceeds to be used? Where is the money coming from to repay the loan? Is the project practical, is it sensible and does it represent good judgment? Is there some margin for error or miscalculation or bad luck so that the bank may still get its money back if things don't go just as projected? With every approved loan application, there should be good answers to these questions. Assuming that the good answers are there, there still is the matter of supervising the loans and seeing them paid. Loans that were well made can deteriorate and become problems if renewed time after time as a matter of habit. Bank credit is not properly used to furnish capital for the borrower. It can only be soundly used to meet the present specific needs of the borrower who will be able to repay from his earnings or proceeds of contemplated transactions. The board should form a policy as to the limit of total loans in relation to total deposits with. consideration, too, of totals of demand deposits and time and savings deposits and degrees of fluctuations in each. There have been cases of acute embarrassment where banks confronted with increased loan demands, undertook to meet them and found themselves seriously over-loaned. Sometimes this was done without consideration of the volume of work the officers and employees were equipped to handle, the result being overall deterioration, stagnation and development of large losses. Loan policies should also define limits as to various types of loans which it makes, real estate loans, automobile loans, business loans, and personal loans. Quality and safety in bank lending has been greatly improved through the still growing tendency to place all loans possible on a regular installment basis for repayment. Properly administered, this system gives the bank flexibility in raising or lowering its loan volumes and gives greater margins of safety. It also helps the borrower who has brought to his mind the necessity to apply monthly a set portion of his income to reduce the debt. Banks considering .going into new types of lending on a considerable scale, should look into proper methods and standards of setting up and administering such a program. Take for example automobile purchase loans. In many cases, banks have 18 leapt into this field without any particular plan, without stand ards and lacking trained personnel and systems of records and supervision. The results have been bad and particularly so in those banks which purchased paper from dealers without investigating the credit quality. The bank's city correspondent which has the benefit of having the bank's reserve funds on deposit, will gladly furnish expert help in setting up a loan system. Credit files should be maintained on borrowers, particularly in connection with sizeable unsecured loans. Current financial statements should be on hand when the loans are applied for; also operating statements in the case of business concerns. They should be kept up to date. Judgment of a loan application can be no better than the information at hand. General knowledge of a borrower is no substitute for a detailed statement of his assets and liabilities and can be faulty and misleading. While conservative loan policies are to be held and carried out, this does not mean that reasonable risks should not be taken. Lending operations involve risks that are necessary in properly serving the community and losses should be recognized when they occur. There have been cases where refusal to meet reasonable local credit needs have resulted in successful moves to organize new banks in competition. In one such case the managing officer, a majority stockholder of the existing bank, had been in the habit of boasting that he had not had a loan loss in.the twenty years or so that he had been in charge. With the bulk of the bank's funds carried in government securities, about all he had to offer was a safe place for deposits. And while a safe place for deposits is a fine thing, it does not take care of other needs just as important. Transfers to a reserve for loan losses account can, to a certain extent, be made free from income taxes. This should certainly be taken advantage of, with all realized losses promptly charged to the reserve account. There should be some recoveries to re-credit to the account and with this in view, the charged off loans should be carried in a separate ledger and kept under review for collection efforts. Investment Policies No less than with loans, a bank's investment policy is the responsibility of the board of directors though authority for 19 specific transactions may be delegated to the Investment Committee and officers in charge of investments. The size of the investment account represents what is available for investment after deducting loans and discounts, cash reserves and fixed assets. A portion of the account should be designated as secondary reserves and invested in highly liquid securities that can be quickly turned into cash with minimum risk of market loss. These consist usually of U. S. Treasury obligations maturing in less than a year. The amount of secondary reserves to be carried will vary with the ratio of demand deposits to time and savings, the degree of liquidity in the loan account and seasonal variations. The remainder of the investment account can be placed in quality securities of longer maturities and higher yields. The maximum maturity is a matter to be determined and set forth in the investment policies of the board. The maturities should be spaced over the years more or less evenly. Then in the normal course, if the maximum maturity is, say ten years, approximately a tenth of the total will mature each year and be converted to maturities within the maximum. It is not intended to suggest that ten years is the ideal period to be set for maximum maturities, either in general or for the individual bank. It will depend on a number of factors such as the amounts of cash reserves and secondary reserves normally carried, the degree of liquidity in the loan account, proportion of time and savings to total deposits and yield requirements for paying interest on time and savings deposits, to name some. Management of a sizeable investment account, to get the best results, requires skills and knowledge of the money market not ordinarily present in smaller banks. For this reason, it is recommended that the bank have investment counsel in setting investment policies and also in individual transactions. Such expert counsel can usually be obtained from the bank's city correspondent which has the benefits of being the bank's depository. Trust Department A soundly managed trust department calls for a high degree of legal and technical competence. The amount of work 20 detail and the costs are such that the department loses money unless a large volume of trust business is available. Some smaller banks feel they are losing deposit business by not being in a position to accept trust accounts and are inclined to undertake to qualify. Before doing so, both sides of the question should certainly be investigated. Consult your city correspondent bank. There may end up an arrangement to direct local trust accounts to the corresponding bank, with the local bank acting as intermediary, carrying out local contacts and getting the deposit business associated with the accounts. Personnel The board of directors, as elected by the stockholders, constitutes the bank for all legal purposes. The directors are responsible to the stockholders, to the depositors and to the regulatory authorities to see that the bank is operated with prudence, diligence, care and a reasonable degree of ability. The directors elect the president and the other officers, but ordinarily delegate authority to the officers to select the other personnel. The latter, however, are also employees of the board and accountable to it. The directors should, therefore, take an interest in the bank's personnel. In numerous embezzlement cases, it developed that the embezzler had been living high, had been gambling, had been speculating or had been leading an immoral life. All of these created personal financial problems and in some cases, brought on blackmail. In small communities where many of these cases arose, it should have been simple and easy for the directors to know that all was not well with the individual and to take steps to develop the full facts. In larger banks, the personnel officer can take steps to keep well enough posted on the personal life and habits of employees to know of any serious financial and other problems. The directors should see to it that the bank pays salaries that compare favorably with those elsewhere in the area for similar kinds of work. The best people available should be employed and promotions should be on the basis of performance rather than family relationships. There should be a set policy for annual vacations for all personnel. Banking authorities are in agreement that each officer and employee should be ...required to be continuously 21 absent from the bank's premises for a minimum period of two consecutive weeks each year. Aside from the well-being of the individual, this is also an important item in safeguards against manipulation of customers' accounts. To promote incentive, well-being, good morale and the feeling of security, banks now offer a variety of fringe benefits to officers and employees. These are mainly retirement plans, medical and hospitalization programs and life insurance. These can be provided outright by the bank or a share of the cost contributed. Health and life insurance can be set up on a group basis with cheaper rates than to an individual. As to retirement or pension plans, these can be set up on a collective basis. A bank with small or medium number of employees can well consider using the services of the trust department of its city correspondent in devising the plan and operating it. Along with the other benefits of the establishment of a retirement plan, there will be included the fixing of the mandatory retirement age for officers and employees. This has been a difficult and touchy matter in many banks and left unsolved, with the result that they have continued under management which had passed the age of energy and effectiveness. While on the subject of retirement, there should not be overlooked the need' for directors to retire gracefully from active participation at a certain age and make way for selection of active and vigorous successors. There can be set up an arrangement whereby the retired members continue their association by being designated "Honorary Director" or "Advisory Director", attending such board meetings as they wish, but having no vote. Banks can greatly benefit by providing officers and employees the advantage of education along banking lines. The American Institute of Banking has chapters set up in several Georgia cities where courses are offered those who can attend. classes in person. The same courses, and more besides, are given by the Institute by correspondence from New York. These courses are specialized by subject and cover the entire field of banking. Graduate study is provided at the Graduate School of Banking at Rutgers University in New Jersey, and at the School of Banking of the South at Louisiana State University. Enrollment in these graduate schools is for two weeks each summer over three years. 22 The Georgia Bankers Association sponsors the Georgia Banking School at the University of Georgia. Enrollment is for one week each summer over three years. The School offers a special opportunity for Georgia bank personnel. Considerable attention is devoted to development of the executive viewpoint in the student, as well as to practical instruction on banking operations. The objective is to give a training experience bridging the area between American Institute of Banking and the graduate banking schools. Earnings, Expenses, Dividends To be sound, a bank must be profitable in its operations. Directors should be very much concerned with a reasonable return to shareholders, and this involves consideration of operating income, expenses, net income and their interrelation. After provision for adequate cash reserves, all available funds should be kept in use. Aside from interest and discount income, there are other important sources which are overlooked. Rather, they are ignored because it has been the practice for so long to furnish the services free; and either through inertia or fear of customer attitudes, nothing has been done about it. The principal one of these overlooked sources of income is service charges on checking accounts. Personal checking accounts that are active, carry no balances of consequence and are sometimes overdrawn, involve considerable expense to the bank. A reasonable system of service charges should be imposed against these accounts with the aim that either they be put on a profitable basis or be closed out. Then there are checking accounts of business firms that draw dozens or hundreds of checks each month and deposit a volume of checks on out-oftown banks but draw on the proceeds before they can be collected by the bank. As the result, the bank is actually advancing money to the depositor though no overdraft is shown on the books. There is always the danger, too, that out-of-town checks may be returned unpaid, leaving the bank holding the bag. Active business accounts, involving little or no actual collected balances, should have service charges imposed that will compensate for the bank's costs. A service charge system charges the depositor proportionately to the activity in the account with charges offset in part or in full in proportion to the balances maintained in the 23 account. Official statistics show that all banks in the nation on the average collect 5% % of their operating revenue from deposit account service charges. Banks that have not set up service charge arrangements or that need to improve the arrangements they have, should consult their city correspondent bank for help and advice in devising a system that is fair to the bank and the customer alike. Other leaks from legitimate income or absorbed costs are in the fields of collection fees, payroll services and safe deposit box rentals. There are no doubt others to be found by investigation. Proper board supervision calls for careful scrutiny of all expenses. The largest item is salaries, which should be adequate to attract and hold good people but in line with the services rendered by each individual. Interest on time and savings deposits is the second largest outlay in many banks. Aside from the legal limits imposed by the supervisory authorities, determination of the rates to be paid should involve consideration of the opportunity for profitable employment of the funds, as well as competition with other institutions. An important expense in bank operations is for occupancy, use and maintenance of banking quarters and equipment. Banking quarters can be adequate, suitable and dignified without being lavish. Some banks have tended to handicap their earnings potential unduly by tying up too great a proportion of their capital funds in fixed assets; while others have put out large sums without taking future growth and expansion prospects into consideration. As previously stated, fixed assets costs are limited by statute, but costs may be exceeded with the prior approval of the Superintendent of Banks. Where such approvals are given, they are conditioned on initial charge-offs of part of the costs or on agreement for annual special chargeoffs over and above tax-allowable depreciation rates until book values are within the statutory limit. Sometimes there is a combination of initial charge-off and continued extra chargeoffs. Banks contemplating new quarters in the foreseeable future would do well to set aside a fund from earnings with the view to its use in absorbing land and building costs and reducing the carrying values. Taxes are, of course, an important expense item, particularly income taxes, though they vary from bank to bank. Some 24 banks are in position to mInImIZe income taxes by leaning toward obligations of States, Counties and Municipalities in managing the investment account. Other expense costs to be watched by the directors include office supplies, stationery, advertising, insurance, fees for legal and other services, dues and donations. Excessive expense charges for attendance at conventions, entertainment and the like should be guarded against. Directors will find it of interest and benefit to compare the bank's operations as to income and expenses with those of other banks. This can be done by using the banking statistics published annually by the Department of Banking. These statistics afford interesting comparison between all Georgia State banks and your bank of percentage relationships of the various categories of income and expenses to total income. Banks with capital funds on the low side, considering the volume of business, will do well to limit or omit cash dividends until the situation is corrected by addition of earnings. Those experiencing growth and having growth prospects should do the same. This might hit some stockholders as objectionable, but there can be explained to them the advantages to the individual stockholder of accumulating surplus to be later used for stock dividends. Stock dividends are exempt from federal income taxes, while cash dividends are not. It can be explained further that the alternative would probably be that they will be faced in the future with making cash subscriptions for new capital stock after having paid income taxes on the cash dividends over the intervening period. As a final thought pertaining both to the bank's income tax liabilities and to the payment of dividends, all items on the bank's books that can be considered worthless or doubtful of collection, should be charged off before the close of each tax year and before declaration of each dividend. This is also a good thought for directors whose names appear on the bank's published statements. Audits and Controls Although official governmental examinations include some elements of audit and verification, they are not audits of the bank's operations. Their purpose is rather to determine whether the bank's assets are adequate to cover all liabilities 25 and that all laws applicable to the bank and its operations are being observed. Bank directors cannot meet their duties and responsibilities in the field of audits and controls by reliance on governmental examinations, nor can they rely on fidelity bond coverage in this regard. At the same time, it is true that many boards of directors do not include competent accountants. Also, in banks of size, it is not practical for directors to perform audits, considering the time involved, though directors with accounting experience can well represent the board as an Audit Committee to oversee audit functions. Thus, it devolves on the directors of most small banks to have outside help - an accountant or a firm experienced in bank auditing. Banks in some areas have grouped together to employ auditors on a revolving basis, thus reducing the expense. Also, some city correspondent banks regularly assist their small bank customers in audit arrangement and functions. Although not preferable, an outside auditor can use personnel of the bank in performing some of the audit work. If this is done, it must be arranged that no individual undertakes to list, prove or verify records, property or transactions with which he or she has had connection and this is often not possible in a small bank. Banks of medium size employ an inside auditor on a full time basis to make regular or continuing audits. Such an auditor is accountable to and makes regular reports to the board or the Examination Committee and not to the principal executive officer. In the large banks, the auditor becomes comptroller or manager of the Audit Department. Some banks, both large and small, add to this by employing firms of certified public accountants to make regular audits. There follows a check list which is in use in examination reports made by the Georgia Department of Banking. It illustrates basic principles of routine safeguards but may not include all functions of any individual bank. It can be expanded or changed to fit the individual bank. The more "yeses" and the fewer "nos" that can be recorded, the better the safeguards. A "no" answer indicates an unsatisfactory condition which should be corrected and reference to such answers may be noted under "comments". 26 INTERNAL ROUTINE AND CONTROLS DESCRIPTION YES NO - - - - - - - - - - - - - - - - - - - - - - - - - ~--~ A. CASH 1. Does bank provide each teller with separate cash for which he or she is solely responsible throughout each day? 2. Does bank provide each teller with adequate vault space or strong box to which he has sole access? 3. Is each teller required to maintain an ink-posted or machine-posted daily cash book? 4. Is the cash of each teller verified at reasonably frequent intervals by another employee or officer without prior notice? 5. Is vault cash under dual control and are safeguards adequate? 6. Is it the bank's policy to show overdrafts, rather than to hold checks as cash items to prevent overdrafts? 7. Is a satisfactory and permanent daily record of cash items maintained? 8. Are all cash items approved by an officer of the bank? 9. Is exchange received credited daily regardless of amount, rather than held in a "kitty"? 10. Are teller differences transferred to general ledger daily? B. DUE FROM BANKS 1. Is a permanent and adequate reconcilement record of correspondent bank accounts maintained? 2. Are correspondent bank account reconcilements verified by another officer or employee? C. SECURITIES OWNED 1. Is an adequate bond register maintained? 2. Are purchase and sale invoices verified with book entries and filed? 3. Are bond premiums properly amortized? 4. Are custody safeguards adequate? 27 DESCRIPTION YES NO D. LOANS AND DISCOUNTS 1. Are loans and discounts proved at least monthly? 2. Are satisfactory liability ledger records maintained? 3. Are interest and discount calculations on loans rechecked for accuracy and traced to the general ledger by another person? 4. Does bank maintain satisfactory collateral files with adequate safeguards? E. DEPOSIT LIABILITIES 1. Are deposit ledgers periodically proved by persons who do not regularly post them? 2. Are deposit ledger bookkeepers rotated? 3. Are all employees prohibited from both receiving deposits and posting ledgers, except on key controlled posting machine operations? 4. Are dormant accounts segregated and under control of an officer of the bank? 5. Do entries to dormant accounts require the approval of an officer? 6. Are deposit ledgers proved to general ledger at least monthly? 7. Are statements issued regularly (at least semi-annually) on all individual accounts? 8. Are employees rotated when preparing monthly statements? 9. Are transfer and closed-out ledger sheets preserved and properly filed? F. OVERDRAFTS 1. Is approval of an officer required? 2. Is a satisfactory and permanent record of overdrafts maintained? G. GENERAL LEDGER 1. Are general ledger and its subsidiary records satisfactory and sufficiently detailed? 2. Are unlocated differences in all departments closed out daily through the general ledger ? 28 DESCRIPTION YES NO ------------------------1---- H. CHARGED OFF ASSETS 1. Are satisfactory records and control of charged off assets maintained? I. CERTIFICATES OF DEPOSIT, DRAFTS AND OFFICIAL CHECKS 1. Are certificates of deposits properly handled? 2. Are unissued forms properly safeguarded? 3. Are checks certified handled in proper manner? 4. Is proper register of all official checks maintained? 5. Are they proved periodically and independently? J. EARNINGS AND EXPENSES . 1. Is distribution of income and expense properly shown on records? K. SAFEKEEPING 1. Does bank accept items for safekeeping? If so, (a) Are satisfactory records maintained? (b) Are independent verifications made periodically? (c) Are proper receipts given and obtained? L. SAFE DEPOSIT BOXES 1. Does bank maintain safe deposit box facilities? If so, (a) Is guard key to safe deposit boxes under bank's absolute control? (b) Are proper visitation records maintained? (c) Are customer and custodian present when box door is unlocked and relocked? 29 DESCRIPTION YES NO M. DIRECTORS AND AUDIT RESPONSIBILITIES 1. Are directors meetings held as required by law? 2. Do all directors attend meetings regularly? 3. Does the bank have the full complement of directors, and does the number of directors conform with the by-laws? 4. Are all directors legally qualified? 5. Are the following accounts frequently examined by the board of directors, or committee thereof? (a) Expense Account? (b) Over and Short Account? (c) Overdraft Account? (d) Cash Items? 6. Do the minutes indicate action noted under No.5 above? 7. Have the directors made provision for an audit program by either, (1) A full time auditor or staff? (2) Annual audit by CPA firm? (3) Supervised internal audit by the directors? If answer is affirmative, indicate the method by numeral, . 8. Does the bank employ a full time auditor? If so, is he accountable only to the board of directors? N. MISCELLANEOUS 1. Does the bank have an enforced annual vacation program in effect? 2. Are night deposits always opened in the presence of two employees? 30 BANKERS BLANKET BOND COVERAGE Protection against dishonest acts of officers and employees is afforded by coverage in a standard form of Bankers Blanket Bond which also insures against losses from burglary, robbery, theft, forgery and certain other risks common to financial institutions. Fixing the amount of the coverage is the responsibility of the board. In this regard, some assistance is provided by a schedule of minimum amounts as recommended by the Insurance and Protective Committee of the American Bankers Association. The schedule of minimum amounts is related to total deposits after study of loss experiences of banks. Many boards have fixed the amount of the coverage higher than the schedule amount. The fixing of a smaller amount than recommended for the size of bank might entail some personal risk of liability on the part of the directors, should a loss occur beyond the limit of the bond. Several years ago, following a number of embezzlements of bank-breaking size, there evolved the Excess Bank Employee Dishonesty Blanket Bond, commonly termed "umbrella coverage", available if the bank has the minimum recommended or larger basic coverage as discussed above. With this bond, a bank acquires, at moderate cost, $1,000,000 dishonesty coverage over and above the basic coverage. No director anticipates dishonesty shortages of that range in his bank. At the same time, they do occur and, as often as not, they occur in small banks where, with "one man" domination, there is greater ease of concealment. The standard forms of bankers blanket bonds all include one provision that should not be forgotten. It is to the effect that the bond becomes cancelled as to any employee "as soon as the Insured shall learn of any dishonest act on the part of such employee". Some years ago the directors of a small bank in Georgia learned that the Assistant Cashier had converted several hundred dollars of the bank's funds to his personal use. He replaced the funds by borrowing from relatives, was permitted to remain in his position, and no information of the 31 matter was given to anyone outside the bank. Several years later, the Assistant Cashier was detected short in a heavy amount. Claim was made against the surety company and, in its investigation of the shortage, the company learned of the previous shortage and denied liability for the large one. Thereupon, the Superintendent of Banks called on the directors to make good the amount and they did so, recognizing their responsibility for the loss. Had they not done so, it would have been necessary to obtain new capital funds from the stockholders or place the bank in liquidation. In any case of misappropriation, however small, the offending employee must be relieved and the bonding company notified, whether claim for the loss is made or not. Violation of both federal and state criminal laws being involved, report should be made to the prosecuting authorities of each as well as to the Superintendent of Banks and the Federal Deposit Insurance Corporation or the Federal Reserve Bank of Atlanta if the bank is a member of the Federal Reserve System. Credit Life Insurance Credit Life Insurance has become rather prevalent in connection with bank lending in recent years. Through it the bank realizes payment from the insurance in the event of the borrower's death during the term of the loan. The Georgia insurance laws prohibit a bank from acting as insurance agent and this function usually devolves either upon an insurance agency affiliated with the bank or upon the loan officer who may be appointed agent by the insurance company. No credit life insurance arrangements should be made except with the approval of the board of directors. If a loan officer acts as agent and personally benefits from the premiums or fees, it is to be hoped and guarded against that this will not affect his credit judgment, as has seemed to occur in a number of instances. Moreover, the board should require the officeragent to report annually on the premiums realized, the amount to be taken in consideration in fixing his salary paid by the bank. Directors' Examinations These general suggestions are made in connection with examinations made by the board of directors, the examining committee, accountants under the direction of the board or a 32 combination of these. The suggestions are not all inclusive and represent a scope that would be modified by the size of the bank and types of operations; also by the extent considered feasible for detailed audit of individual transactions. Examinations should be made without the personnel of the bank having prior information as to the time of starting. Cash should be counted and the total compared with the general ledger total or total shown by the balance sheet of the bank's assets and liabilities. Cash items should be carefully scrutinized and any improper items, such as unposted checks or other items held to conceal overdrafts, should be reported. Due from Banks. The bank's last reconcilements of accounts with correspondent banks should be compared with the books and exceptions checked out. Requests should be sent to the banks for statements for the period from the last statement to about 10 days after date of examination, but showing balance also as of date of examination. The new statements can then be reconciled, with the 10-day period allowing for clearance of exceptions. It should be determined whether cash reserves meet requirements of state law or Federal Reserve regulations and whether such requirements have been habitually met. Securities should be examined, totaled and compared with balance sheet totals. Those not on hand should be verified by receipts of the holders. Unless the receipts are unconditional as to time (require return of the receipt before delivery of the securities), the securities should be verified by correspondence. It should be ascertained whether the bank's holdings of securities, including any stocks, were legally acquired and are so held; and whether holdings are in accordance with investment policies set by the board of directors. An itemized list should be made showing book values compared with present market values. Loans and Discounts. Notes should be added and the total compared with the balance sheet. Genuineness, value and security of each note and of the collateral thereto should be determined. Any items considered as losses or doubtful of collection should be noted. The liabilities of each of the larger borrowers, including endorser liabilities and liabilities of affiliated interests, should be totaled and considered as to conformance with law as to legal limitations and required approvals of the board 33 or the loan committee. Report should be made on the distribution of loans as to types and kinds of collateral and whether in accordance with loan policies set by the board. Lists should be made of all loans made to or endorsed by directors, officers, employees or their affiliated interests, and showing whether any are lacking required approvals of the board or loan committee. It should be noted whether all notes are made to the bank or properly transferred to it, whether collateral notes and securities are properly assigned, whether mortgages are recorded and whether insurance policies for the bank's protection are on hand with loss payable to the bank. All overdue loans should be listed and commented upon as to collectibility and any recommendations for handling. Deposit Ledgers. Account balances should be added and totals compared with controls and the balance sheet of the bank's books. Overdrawn account balances should be compared with the overdraft record and the total of overdrafts shown in the balance sheet or shown as memorandum to the balance sheet. Extensive or habitual overdrafts should be noted and commented upon. Any estimated losses should be indicated. Certificates of Deposit, Cashiers Checks, Money Orders. Paid and cancelled certificates and checks should be checked from the registers and amounts of those outstanding added and compared with respective totals shown on the balance sheet. Income Accounts. If detailed audit of these accounts is not to be undertaken, there are nevertheless a number of test checks and reviews that are of value in forming opinion whether items of income are properly accounted for. For example, if an average interest rate can be estimated for the bank's entire loan portfolio, the average rate can be applied to the average total of loans over the past year and the result compared with actual collections of interest and discounts entered over the same period. The same can be done for categories of loans bearing different rates if they are carried under separate controls or the average totals can be estimated; for example, business loans, installment loans, mortgage loans. The same can be done with the investment account with sizeable purchases and sales during the year taken into account. If the bank is a non-par bank and deducts exchange in remitting for checks drawn on it, the rate of exchange can be applied 34 to total remittances for checks over a period for comparison with the book total shown for the same period. Service charges and collection fees should normally run steady from month to month though there may be seasonal variations, particularly in volume of drafts handled as regards collection fees. Again, as regards loan income, test checks can be made for anyone day or longer period of time by identifying the loans made and loans paid during the period, computing interest and discount that should have been collected and comparing the amounts with those entered on the books. Expense Accounts. Aside from a detailed audit, salary and other expense items carrying fixed rates can be figured over a period and results compared with expense account ledger figures. This is true provided the bank maintains a record of distribution of expense, as it should do. Other expense items should be supported by statements and should be examined with the view to determine that charges are proper. Interest paid on savings can be approximately computed by applying the savings rate to the total of savings accounts averaged over an interest period and the result can be compared with the amount entered for the period. The test for interest paid on certificates of deposit would need to be made differently, due to varying maturity dates. Also, if interest paid is all charged to one control and the bank has incurred interest costs for borrowed money, allowance would be made for these charges to the account. Entries made to the undivided profits account and "profit and loss" account should be examined and reported. Direct Verification. No system of examination and audit can be complete without some measure of direct verification, both with the individual borrowers and the individual depositors. Manuals showing how this can be best and most easily accomplished, together with' the forms to be used, are available through your city correspondent. In General. Arrangements of the working affairs of the bank should be looked into and compared with the set of tests given above under the heading of Audits and Controls. The report of examination should include statement of any matters deemed to affect the solvency, stability and prosperity of the bank. The report should be presented to the board, noted in the minutes as to action taken, preserved in the bank's files and shown to state and federal examiners at their next examinations of the bank for notation in their reports. 35