What Directors Should Watch For

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Corporate Governance Program for CEOs and
Directors of Indian Banks December 16,
2005 Mumbai, India

What Directors Should Watch For
John R. Price Senior Advisor to the Institute of
International Finance
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• Accounting Disclosures Have Led to Collapse or
  Crippling of Companies
• Many Firms Have Rebounded From Impact of Scandals
• With Heightened Scrutiny and Emphasis on
  Financial Statements Accuracy, It Is Time for
  Back to Basics for Company Directors

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Degrees of Difficulty

• Are Boards At The Mercy Of Management?
• HEALTH SOUTH
• Outright Fraud

• Do Boards Pull The Wool Over Their Own Eyes?
• ENRON
• Repeated Violations of the Boards Own Policies
  and Procedures
• Creation of Special Purpose Vehicles With
  Management Self Interested

• Compensation and Conflicts
• FNMA
• Earnings managed to compensation incentive goals?
• Do They Ignore Warning Signs?
• CHICAGO FEDERAL HOMELOAN BANK

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Fannie Mae Common Stock
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Chicago Federal Home Loan Bank
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Key Areas To Monitor

• Financial Performance- Sums Them All Up
• Credit Portfolio
• Liquidity
• Interest Rate Risk
• Investment Portfolio
• Derivatives Or Off Balance Sheet Activities
• Audits And Internal Control
• Compliance
• Asset Management
• Management Information Systems

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I. Financial Performance

• These ratios and results are highly dynamic- They
  reflect the interaction between
• Capital
• Asset Quality
• Earnings
• Liquidity
• Market Risk
• Balance Sheet Growth
• In all of these, attention should be paid to
• Trends
• Comparisons With Prior Years, the Budget, and
  Projections
• Peer Group Comparisons
• For Example In Capital, worry if the capital
  growth rate is less than the total asset growth
  rate or if dividend payout ratios are much higher
  than peer group banks.

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II. Credit Portfolio

• Ask For
• Managements Risk Rating Reports- including
  grades above loans the examiners express concern
  about Rating Migration.
• Problem Loan, Past Due, and Non-Accruals Reports
• Renegotiated or Restructured Loan Reports
• Concentration (by borrowers, region, etc.)
• Policy Exceptions
• Watch Out For
• Rapid Growth in Total or Particular types of
  Loans
• Large or Increasing Numbers of Policy Exceptions,
  or Credit/ Collateral Exceptions
• Reporting Lines of Underwriters (Credit Review
  Personnel) Must be Independent of the Lending
  Function
• Compensation of Loan Officers Volume Without
  Credit Quality Attributes
• Changes in Scope and Frequency, or Delinquent
  Internal Loan Reviews
• Problem Loans Lingering and Not Resolved

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III. Liquidity Management

• Ask For
• Fund Providers
• Projected Needs (Dynamic)
• Cash Flow or Funding Gap Report
• Contingency Funding Plan
• Watch Out For
• Rollover Risks- Short Term Liabilities/ Long
  Term Assets
• Negative Earnings Asset Quality, Which Could
  Affect Perception of the Banks Credit
• Higher Funding Costs
• Elimination or Reduction in Credit Lines from
  Correspondents
• Rapid Asset Growth Funded with Borrowed or
  Brokered Funds, or Shifting Sources
• Concentration of Funding- Single Source, Common
  Rate, or Credit Sensitivity

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IV. Interest Rate Risk

• Ask For
• Gap Reports- the difference between rate
  sensitive assets and rate sensitive liabilities
  shows how net interest income can be affected by
  interest rate changes
• Simulation Models
• Economic Value Sensitivity Models- assets,
  liabilities, and off balance sheet items in
  differing interest rates (Present Value
  Computation)
• Long-term Assets/ Total Assets gives an
  indication of Repricing risk
• Non-Maturity Deposits/ Long Term Assets
• Watch Out For
• High or Growing Volume of Either Assets OR
  Liabilities with Embedded Options
• Lack of or Non-compliance with, or exceptions to,
  risk limits

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V. Investment Portfolio

• Ask For
• Maturity Breakdowns and interest rate risk
• of portfolio in every credit rating category by
  rating agencies
• Cost and Market for Both Held To Maturity and
  Available For Sale (unrealized gain or
  loss in Other Comprehensive Income)
• Watch Out For
• Yield Chasing (above market or peer group)
• Shift and Sale of Securities from HTM, or
  Transfer from HTM to AFS
• Purchase of Securities in Excess of Concentration
  Limits or Frequent Policy Exceptions
• Large Amounts of Low or Non-Rated, or Out of Area
  Bonds
• Absence of a Credit Risk Assessment for the
  Safekeeping Agent

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VI. Derivatives And Off Balance Sheet Activities

• Ask For
• Credit Risk Exposures for Counter Parties credit
  limits and collateral requirements
• Compliance with Risk Policies and Risk Limits
• Results of Stress Testing
• Impact on Income from Derivatives The FAS 133
  Dragon
• Watch Out For
• Staff Qualifications
• Concentration of Credit Exposure to Counter Party
• Concentration of Trades With One Firm
• Absence of Enforceable Netting Agreements
• Unilateral Collateral Posting
• Off-Market Derivatives- Loan to Counter Party

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VII. Audit and Internal Controls

• To Be Covered by Other Presenters
• But, Watch Out For
• Unresolved Significant Audit or Compliance Audit
  Findings

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VIII. Compliance

• Ask For
• Regular Reports on Litigation and Customer
  Complaints
• Regulatory or Compliance Audits by Outside
  Reviewers (e.g.HUD in US on
  Mortgages)
• Watch Out For
• Uncorrected Deficiencies in Compliance Reviews
• Lack of Evidence of Compliance Training For
  Employees
• Increase in Customer Complaints to the Bank or
  Regulator

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IX. Asset Management

• Ask For
• New Business/ Lost Business Reports
• Investment Performance Reports
• Fiduciary Audit Reports
• Watch Out For
• Unexplained Shifts in Business Strategies
• Major Changes or Growth in Account Types, or
  Balances, or Products
• Lots of Activity- Switched Mutual Funds,
  Exchanged Annuities, Accounts Quickly Closed
  After Being Opened
• Assets of a Kind Where There is Expertise Lacking
  to Manage it
• Purchase or Sale of Assets Between the Bank and
  Fiduciary Accounts
• Frequent Changes in Service Providers or Auditors

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X. Management Information Systems

• Ask For
• Business Continuity Plan
• Timely, Accurate, Secure, Relevant, and
  Consistent Systems to Generate Management and
  Financial Reports
• Watch Out For
• MIS Systems Allowing Disclosure of Customer
  Information, or Not Securing Privacy
• Systems that Crash as New Products or Business
  Lines Are Introduced
• Systems Problems of Integration, as with
  Acquisitions
• Increasing Fraud Losses
• A System that Cannot be Explained or Diagrammed
  Easily by Management
• Reports that are Irrelevant or are too Cluttered

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Conclusion

• Trust, But Verify
• -Ronald W. Reagan