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Red flag guidance for members of Supervisory Councils of banks. Capital

Category: Corporate Governance

Good decisions begin with good information.

A bank’s Supervisory Council needs concise, accurate, and timely reports to help it perform its fiduciary responsibilities. This section of the material provides a detailed guidance on the examples of the information, generally found in reports to the members of Supervisory Council of the commercial bank.

It highlights red flags — «Indicators of possible concern» — ratios or trends that may signal existing or potential problems. Wherever possible, the source from which the ratios are derived is presented in the form of an extracts from the financial statements of the bank. For this purpose, the model illustrative bank financial statements were used.


Capital is the cushion that protects banks and their customers and shareholders against loss resulting from the assumption of risk. As a result, the adequacy of capital is very closely related to the individual risk profile of each bank. Overall capital adequacy of a bank is measured both quantitatively and qualitatively. The quantitative analysis focuses on risk-based and leverage ratios.

The qualitative assessment considers the quality and level of earnings, the quality of assets, the bank ‘s business strategy, the effectiveness of risk management, and management ‘s overall ability to identify, measure, monitor, and control risk. Management board and Supervisory Council determine how much capital the bank must hold. This determination may change over time based on the risk inherent in the bank ‘s business profile, dividend expectations of the bank’s shareholders, economic variables that affect the bank’s market or customer base, and other factors. Although banks must maintain minimum capital ratios established in risk-based capital guidelines, most banks are expected to maintain a capital ratio higher than those minimums.

Adequate capital supports future growth, fosters public confidence in the bank’s condition, provides for adequate capacity under the lending limit to serve customers’ needs, and protects the bank from unexpected losses. The following ratios can help directors evaluate the bank ‘s capital adequacy and monitor compliance with regulatory minimum requirements:

Tier 1 capital/adjusted average assets — the amount of capital supporting the bank’s loans and other assets. Tier 1 capital includes the purest and most stable forms of capital.

Tier 1 capital/risk-weighted assets (tier 1 risk-based ratio) and total capital/risk-weighted assets (total risk-based ratio)—the amount of capital in relation to the amount of credit risk associated with assets on and off the balance sheet. Total capital adds limited amounts of other capital to the tier 1 level.

Cash dividends/net income —the percentage of net income paid out to shareholders in dividends.

Equity growth rate versus asset growth rate —measures the extent to which capital growth is keeping pace with asset growth.

Capital Red Flags:

Ratios below «adequately capitalized.» (tier 1 capital is less then 8 %)

Declining capital levels or ratios.

Concentration in nontraditional activities.

The Supervisory Council’s review of earnings focuses on the quantity, trend, and sustainability or quality of earnings. A bank with good earnings performance can expand, remain competitive, augment its capital funds, and, at the same time, provide a return to shareholders through dividends. When a bank ‘s quantity or quality of earnings diminishes, the cause is usually either excessive or inadequately managed credit risk or high levels of market risk. High credit risk, which often requires the bank to add to its loan loss provision, may result in loan losses; high market risk may increase the volatility of an institution ‘s earnings from interest rate changes. The quality of earnings may also be diminished by undue reliance on extraordinary gains, nonrecurring events, or favorable tax effects. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, improperly executed or ill-advised business strategies, or poorly managed or uncontrolled exposure to other risks.

The level and trend of the following measures, compared with the bank’s previous performance and the current performance of peer banks, are important in evaluating earnings:

Earnings Red Flags:

Significant increases or decreases in non-interest income;

Significant variances from budgeted amounts on income / expense items and balance sheet accounts;

Significantly higher or lower average personnel expenses than peer banks;

Significant variances in the Return on Average assets, Return on Equity or Non Interest Margin from prior periods and as compared to peer group.

Earnings Red Flags:

Significant increases or decreases in noninterest income.

Significant variances from budgeted amounts on income/ expense items and balance sheet accounts.

Significantly higher or lower average personnel expenses than peer banks.

Significant variances in the ROAA, ROE, or NIM from prior periods and as compared to peer group.

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