BANK DIRECTORS FACE BIG CHALLENGES IN 2000

Introduction

The prognosis on the economy is mixed. Some bank regulators continue to issue warnings about weakening credit underwriting standards, weak risk management systems, and Year 2000 compliance risks, sometimes accompanied by threats of enforcement action.

Doubts have arisen as to whether the rate of growth in bank profitability can continue. Net interest spreads have narrowed, Allowance for Loan Losses continue to fall relative to capital, and weaknesses in certain categories of credit are surfacing.

How should bank directors respond in 2000 to these events? What other issues do bank directors need to address in the coming year?

Regulatory Warnings

How to respond to bank regulatory warnings is a subject which we have addressed in recent articles. Once a bank regulator has issued a warning, whether it is in a report of examination of a bank director’s bank or in a press release for all to read, it is essential that a bank, through its Board of Directors and management, thoroughly address the issue raised by the regulator. The criticism may not have any relevance to a bank, particularly if it is the subject of a press release; nevertheless, bank directors need to address the warning adequately, determine how to protect the bank from any risks involved, and document how the Board responded.

Year 2000 Compliance

Meeting the timetable imposed by the banking agencies to be fully Y2K compliant by January 1, 2000 is essential. I have no doubt that banks will be placed in receivership or conservatorship if they are not able to function effectively on or after January 1, 2000. This area demands the attention of management and the Board of Directors.

Credit Underwriting Standards and Risk of Recession

Whether or not a bank has loosened its credit underwriting standards over the past several years, it is appropriate for the Board of Directors to satisfy itself in 1999 that the current standards are satisfactory. Boards of Directors and management should begin to assess whether the bank’s underwriting standards will serve them well if an economic slowdown were to occur, and scrutinize their loan portfolio to identify those credits that may exhibit weakness if a recession ensues.

Risk Management System

Bank supervisors have recently pointed out the risks in deficient risk management systems. The temptation in good times is to cut back on costs associated with non-income producing expenses. Yet the costs of an adequate risk management system are small compared to the losses that may result from inadequate risk management systems.

Particularly for those banks that have cut back resources for risk management systems, 2000 is the year to evaluate the adequacy of this area.

Strategic Planning and Sources of Fee Income

In recent years, growth in some traditional banking products has been lackluster. Banks increasingly have relied on non-banking products, many fee-based, to bolster earnings. Large banks have largely succeeded in creating significant sources of fee-based income, but smaller banks have lagged behind, and still rely heavily on traditional banking products.

As the trend towards the commoditization of many banking products continues, bank directors will need to pay more attention to the need to provide additional income sources for their institutions. Banking agencies have expanded the non-banking services that banks and their subsidiaries and affiliates may offer. In 2000, banks will have an array of choices to enter a new business, whether directly on a de novo basis or by acquisition, through a variety of third party providers under contract, or through a joint venture. The entry into any new business needs to be done prudently by thoroughly evaluating the alternatives prior to any commitment.

Technology Planning

As banks and the public becomes more dependent on technology, bank directors will need to focus more on how their banks will develop the information technology necessary to carry on their business.

AABD’s 1998 Survey of Bank and Savings Institution Directors indicates that 72% of respondents stated that their bank Boards participate in the planning, evaluation, and implementation of new technologies. AABD encourages ALL bank Boards in 2000 to be engaged in technology issues facing their banks.

Composition of the Board of Directors

AABD has long advocated the importance of an independent Board of Directors, while also emphasizing that the Board of Directors should supervise, not manage the institution.

However, the 1998 Survey of Bank and Savings Institution Directors reflects signs that bank Boards are not doing all that they can to insure an independent and qualified Board of Directors.

Ninety percent of the respondents stated that the renomination of directors is not subject to any formal review process. Only twenty-four percent have a nominating committee. Almost two-thirds have a Chairman who is also an officer of the bank. New director candidates are identified primarily by the bank’s CEO.

To assure an independent and qualified Board, AABD advises that (1) there be a formal review process involved in the nomination of bank directors; (2) the Board have a nominating committee which consists solely of outside directors; (3) the Chairman be an outside director or, if the Chairman is not an outside director, an outside director have functions similar to a Chairman in setting the agenda and officiating over certain Board meetings; and (4) the nominating committee, or if there is no nominating committee, the full Board of Directors, identify and select Board nominees.

The new year is a good time to evaluate how to improve the system by which the Board selects its director nominees.

Personal Liability Concerns

As some of the banking agency representatives become more strident in their warnings to bank directors and officers, some directors will act out of fear of personal liability, rather than in the best interests of the bank. For example, in response to threats that enforcement action will be taken if banks do not tighten credit underwriting standards, some Boards of Directors will react by tightening credit to such an extent that many good credits will not be extended, thus precipitating a credit crunch.

In 2000, we can expect more warnings and risks. It will be a challenge, but a necessary one, for bank directors to act in the best long term interests of the bank, and not to try to avoid substantially all risk so as to protect themselves against personal liability. Banking entails risks, and such risks must be assumed for a bank to be successful.

Next year, the American Association of Bank Directors will actively seek a rollback of certain laws which grant federal banking agencies too much power – more than they need to supervise banks and their insiders effectively. Examples include $1 million a day fines on bank directors and officers, and other civil money penalties that can be imposed by the agencies without proving that the director or officer knowingly violated the law. So long as these statutes are on the books, many bank directors will make decisions based on avoiding potential liability, not based on serving the best interests of the institution.

These draconian laws also discourage qualified persons from serving as bank directors. AABD surveys since 1990 have found that a sizable number of qualified persons will refuse to serve as directors because of personal liability risks. According to the 1998 Survey, for those institutions that had director candidates decline a position, twenty-three percent indicated that the refusal was based on personal liability concerns.

AABD hopes that in 2000, bank directors will join us in strongly urging the U.S. Congress to repeal the objectionable laws.

AABD will also request that the federal banking agencies support our legislative agenda. Although it is rare that federal agencies support a diminution in powers, AABD is hopeful that the agencies will realize that excessive powers can be detrimental to the overall safety and soundness of the banking system.

The 1998 Survey revealed that only 35% of the respondents have excluded or limited the liability of directors in their Articles of Incorporation or Bylaws. Moreover, only 53% indicated that there are indemnification agreements or indemnification provisions in the bank’s Articles or Bylaws. Virtually all state laws allow indemnification agreements or provisions, and most state laws permit corporations, including banks, to limit director liability. Bank Boards should evaluate their Articles and Bylaws prior to the next annual meeting of stockholders to determine whether a limitation of liability provision and indemnification provisions should be added to the documents.

Director Compensation

In 2000, Boards of Directors should address the "disconnect" between bank director compensation and expectations of bank director performance reflected in the 1998 Survey.

Over 83% of the respondents expected bank directors to generate new business, but 95% reported that there is no compensation paid to provide incentives for directors to generate new business.

In addition, as more and more CEOs and other bank officers receive compensation based in part on financial performance, bank directors overwhelmingly are compensated without regard to how well or poorly the bank performed. Only 18% of the respondents offered stock options or warrants to bank directors, and most did not vary director compensation or fees based on bank financial performance.

AABD urges bank Boards of Directors to consider incentives in 2000 for directors based on individual efforts, and director compensation based at least in part on financial performance of the institution.

Insider Dealings

A little under 37% of the respondents stated that their bank does not have a Code of Ethics or Conflicts of Interest Policy that applies to bank directors.

For those banks that do not have such a policy, 2000 is the time to consider one. Insider abuse is still one of the "hot buttons" for banking agencies and examiners. All insider transactions are heavily scrutinized. Good written policies may prevent violations of law or violations of conflict of interest principles imbedded in corporate law. They also represent a statement by the Board of Directors that it takes seriously its commitment to supervise the bank in a manner that is not self-serving.

Board Review of CEO Performance

In a dead heat, half of the respondents complete an annual performance appraisal of the CEO and the other half do not, according to the 1998 Survey.

AABD has long advocated Boards of Directors to conduct a thorough annual performance appraisal of their CEO. The Board should not manage a bank; it needs to let the CEO and other managers manage the institution. But to allow the CEO the broad discretion necessary to manage the bank effectively, the Board needs to assure itself that the CEO is doing a good job. AABD urges Boards of Directors who do not conduct annual performance appraisals of their CEO to begin such appraisals beginning in 2000.