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

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.

Supervisory Council members should regularly review the following liquidity leading indicators for signs of increasing liquidity risk.

Net loans/deposits —indicates the extent to which a bank’s deposit structure funds the loan portfolio. The higher the ratio the more reliance that a bank has on non-deposit sources to fund the loan portfolio.

Net short-term liabilities / total assets —calculated by taking the difference in short-term assets from short-term liabilities and dividing by total assets. The ratio indicates the degree of exposure assumed by funding assets with short-term liabilities, also referred to as rollover risk. Generally, the higher the number, the more vulnerable the bank is to funding sources rolling out. This requires the bank to find new funding sources for existing assets.

On-hand liquidity / total liabilities —calculated by dividing net liquid assets by total liabilities. This ratio measures the bank’s ability to meet liquidity needs from on-hand liquid assets. The lower the ratio, the greater the likelihood that the bank will need to sell less liquid assets or use market funding sources to meet incremental liquidity needs.

Reliance on wholesale funding —calculated by dividing all wholesale funding by total funding. This measures the portion of the bank’s total funds that are from wholesale sources. Banks with high volumes of wholesale funding need to make sure they have up-to-date contingency funding plans.

Liquidity Red Flags:

Significant increases in reliance on wholesale funding.

Significant increases in large certificates of deposit or deposits with interest rates higher than the market.

Mismatched funding —funding long-term assets with short-term liabilities or short-term assets with long-term liabilities.

Significant increases in borrowings.

Significant increases in dependence on funding sources other than core deposits.

Reduction in borrowing lines by correspondent banks.

Increases in cost of funds.

Declines in levels of core deposits.

Significant decreases in short-term investments.

Members of Supervisory Council can identify growth patterns by comparing historical and budgeted growth rates for assets, capital, loans, volatile liabilities, core deposits, and income and expenses. Comparing the bank’s growth rates with those of its peers may also indicate whether the bank is growing inordinately.

Growth Red Flags:

Growth that is not consistent with the bank’s budget or strategic plan.

Growth that is not accompanied by an increasing level and sophistication in risk management controls.

Introduction of new products or activities with little or no expertise or inadequate risk management controls.

Growth that is significantly greater than that of peer banks, even if projected in the bank’s budget or strategic plan.

Higher risk profile than forecast.

Declining capital levels or ratios.

Reliance on unstable or short-term funding sources.

Loan Portfolio Management

Supervisory Councils that effectively manage the loan portfolio understand and control the bank’s risk profile and its credit culture. To accomplish this, members of Supervisory Council have a thorough knowledge of the portfolio’s composition and its inherent risks. The members of Supervisory Council should also understand the portfolio’s industry and geographic concentrations, average risk ratings, and other lending characteristics. They also ensure that the bank has appropriate staffing and expertise for all of its lending activities and that management board is capable of effectively managing the assumed risks.

The members of Supervisory Council should identify adverse trends in the loan portfolio and judge the adequacy of the allowance for loan provisions by reviewing the loan reports. The board, or a credit committee of directors, should receive information on new and renewed loans, past-due and nonperforming loans, other real estate owned (OREO), problem loans and trends in risk ratings identified by management and examiners, charge-offs and recoveries, management’s analyses of the adequacy of the loan loss provisions, composition of the loan portfolio, concentrations of credit, credit and collateral exceptions, and customers with large total borrowings. Comparative and trend data may be best presented in graph form.

Members of Supervisory Council may review:

Risk rating reports —summarize the total amount of loans in each risk rating category, often by division or product. This report is especially useful to monitor risk rating trends. In addition to the problem loan categories, banks may develop its own internal multiple “pass” (non-problem) rating grades so that negative trends in overall loan quality can be identified quickly.

Problem loan reports —identify problem or watch credits and quantify the bank’s potential loss on each significant problem credit. The bank’s internal loan classifications should be updated and summarized periodically and should be easily translatable to the NBU classification system (pass, watch, substandard, doubtful, and loss). Effective members of Supervisory Council should understand why a loan is a problem and what action management is taking to strengthen it.

Past-due and nonaccrual reports —show seriously delinquent borrowers and tell the percent of loans past due by loan category (i.e., commercial, installment, real estate). Effective members of Supervisory Council should understand the reasons for delinquencies.

Renegotiated and restructured loan reports —identify loans whose original terms or structure has been modified. High levels of renegotiated or restructured loans can signal an attempt by a loan officer or management to mask the true number and amount of past-due loans. Effective members of Supervisory Council should understand why a loan was restructured or terms were renegotiated.

Reports on disposal of property — details efforts to dispose of each piece of other real estate owned (generally foreclosed properties) and show if appraisals are current for all parcels.

Exception reports —list exceptions to loan policies, procedures, and underwriting standards. The reports should include the trend in number and r amount of loans approved that are exceptions to policy as well as the percentage of loans that are exceptions to policy. Members of Supervisory Council require that management explain these exceptions and determine whether to re-enforce or revise loan policies.

Allowance for Loan and Lease Losses

The allowance for loan losses is a valuation reserve charged against the bank’s operating income. Members of Supervisory Council must ensure that the estimates are reasonable and the allowance covers all estimated inherent loan and losses. Members of Supervisory Council should review the following information to determine whether the loan loss provision is adequate:

Management’s quarterly evaluation of the adequacy of the loan loss provision

Management’s problem loan list.

Charge-off and recovery experience.

A reconcilement (or movement) of the loan loss provision for the current period and previous year-end.

Any independent analysis of the loan loss provision (e.g., external loan review).

Loan Summary

Members of Supervisory Council can find out what types of loans the bank is making and management’s lending practices by looking at lists of new credits approved, loans renewed, concentrations of credit. Management board and the Supervisory Council together should establish the limits for the loans detailed in those reports.

Loan Portfolio Red Flags:

Large or increasing volume of loans granted or renewed with policy exceptions.

Large or increasing volume of credit/collateral exceptions.

Loans remaining on the problem loan list for extended periods of time without improvement.

Loan review personnel reporting to a person(s) other than the Council or a Council committee.

Delinquent internal loan reviews or late identification of problem loans.

Large concentrations of credit to individuals or industries with or without prior Council approval.

Loans to members of Council, significant shareholders, management board, and other insiders (including third parties performing services for the bank, external accountants, auditors, and marketing firms).

Loans to affiliates.

Excessive out-of-territory lending.

Loans to borrowers who appear on the overdraft or uncollected funds reports.

Rapid growth in total loan volume or particular types of lending.

Growth in the loan loss provision that is significantly greater or less than the percentage growth in total loans over a given period.

Non-performing or problem loans as a percentage of total loans increasing at a greater rate than the loan loss provision.

Loan officer compensation that is tied to growth or volume targets.

High or increasing yield on the loan portfolio.

Significant shifts in the bank’s risk rating profile or increase in the number or amount of problem or watch loans as a percent of loans, in aggregate, or for loan types.

The Supervisory Council’s primary duties are establishing and guiding the bank’s strategic direction and tolerance for liquidity risks electing senior managers who will have the authority and responsibility to manage liquidity risk; monitoring the bank’s performance and overall liquidity risk profile, and ensuring that liquidity risk is identified, measured, monitored, and controlled. The following reports should assist members of Council in assessing the bank’s liquidity risk:

Liquidity risk report – shows the level and trend of the bank liquidity risk by a variety of appropriate measures. Report should indicate how much liquidity risk the bank is assuming, whether management is complying with risk limits, and whether management’s strategies are consistent with the Council’s expressed risk tolerance.

Funds provider report – lists large funds providers and identifies funding concentrations. These reports should include consolidated information from all commonly owned banks.

Funds flow analysis – reflects trends of balance sheet line items, in money terms, which have a significant impact on liquidity. Changes over time can be useful in developing a “source and use analysis ” to more clearly show where money is coming into and going out of the bank.

Cash flow or funding gap report – shows future time frames when funds may be needed to pay for deposit withdrawals, or other decreases in liabilities, or increases in assets. The funding gap is a shortfall (or excess) of funds that is caused at certain points in time by a funding mismatch.

Contingency Funding Plan (CFP) – may incorporate the funding gap report or be considered an outgrowth of it. The plan forecasts funding needs and funding sources (and therefore gap) under varying market scenarios resulting in rapid liability erosion (usually due to increasing customer concerns about the asset quality of the bank), or excessive asset growth.

Liquidity Risk Red Flags:

Liquidity risk that exceeds risk limits established by the Supervisory Council.

A negative trend or significantly increased risk in any area or product line, particularly a decline in indicators of asset quality, or a decline in earnings performance or projections.

Concentrations in either assets or liabilities indicating undue reliance.

Rapid asset growth funded by wholesale, volatile liabilities. This may indicate poor credit underwriting standards.

Increased funding costs due to customer or counterparty concerns about increasing risk.

Oversight of investment portfolio activities is an important part of managing the bank’s overall interest rate, liquidity, and credit risk profiles. Members of Supervisory Council play a key role in overseeing the bank’s investment activities. They establish strategic direction and risk tolerance limits; review the portfolio’s activity, risk profile, and performance; and monitor compliance with authorized risk limits.

1.Selection of Securities Dealers

Some banks may rely on securities sales representatives, investment bankers, and brokers to recommend proposed investments, investment strategies, and the timing and pricing of securities transactions. Members of Supervisory Council should review and approve a list of securities firms with whom the bank is authorized to do business. They should also ensure that dealers used by the bank are financially stable, reputable, and knowledgeable.

As part of the process of managing a bank’s relationship with securities dealers, the Supervisory Council may also want to consider prohibiting employees who are directly involved in purchasing and selling securities for the bank from engaging in personal securities transactions with the same securities firm the bank uses for its transactions without specific Council approval and periodic review.

2.Categorization of Securities

When a bank purchases a security, it must decide under current accounting rules whether it intends to hold the security to maturity. If it does, the security may be classified as held-to-maturity and accounted for at amortized cost. Held-to-maturity securities may be sold prior to maturity only if credit quality deteriorates or if other rare situations occur. The bank must classify other securities as available-for-sale and carry them at fair value (essentially market value). For accounting purposes, changes in fair value are reflected in the bank’s capital or directly in income statement.

Members of Supervisory Council should ensure that bank management’s original classification decisions are reasonable and are adhered to. Improper sales of held-to-maturity securities may require some or all of the bank’s other held-to-maturity securities to be marked to fair value. If so and if the value of these securities has declined, the bank ’s capital could be greatly diminished.

Members of Supervisory Council are ultimately responsible for supervising a bank’s investment portfolio. A bank’s Council may delegate investment decision-making authority for all or a portion of their investment securities portfolio to a nonaffiliated firm or to an individual who is not an employee of the institution or one of its affiliates. Such a delegation of authority is intended to obtain a higher total return on the portfolio than the institution would realize if it managed the portfolio itself. Because bank management would no longer control the portfolio, held-to-maturity securities would no longer qualify as such under IFRS, and they would have to be marked to market. Sales of these securities would be recorded as available-for-sale transactions on ledgers independent of the decision-maker’s control.

3. Investment Reports

Directors find the following reports helpful in assessing the overall quality, liquidity, and performance of the investment portfolio:

Maturity breakdown and average maturity —shows each sector of the investment portfolio (Treasury bonds, municipal bonds, etc.) and the portfolio as a whole.

Distribution of credit ratings (if available) for all municipal and corporate securities – shows the percent of the portfolio in each rating category. This report provides useful information on the overall credit quality of the portfolio.

Adjusted cost for each security relative to its current market value – shows held-to-maturity securities’ appreciation or depreciation not recorded on the books. For depreciated available-for-sale securities, it shows the amount recorded as an unrealized loss or gain against capital for accounting purposes.

Purchases and sales – indicates the type of security, its par value, maturity date, rate, yield, cost and sales prices, as well as any profit or loss.

Sensitivity analysis of the value of the portfolio in different interest rate environments – compares the value in each interest rate scenario with the current portfolio value, illustrating the amount of portfolio risk. This report also provides a means of assuring that management has complied with the board ’s tolerance for risk.

Summary of investments by obligor, industry, related obligor, geographic area, etc – shows concentrations of investments that Supervisory Council should review.

Investment Portfolio Red Flags:

Purchase of individual securities that do not meet Supervisory Council guidelines on risk, quality, or quantity.

Securities purchased without pre-purchase analysis.

Securities purchased from only one securities dealer.

Significant changes in the type, quality, or maturity distribution of the portfolio.

Sale of securities previously designated held-to-maturity, or transfer of securities from the held-to-maturity account to the available-for-sale account.

High volume of purchases and sales.

Purchase of securities based only on yield.

Investment purchases from securities dealers not approved by the Council.

Investment returns that are well above or below the market or peer group average.

Significant depreciation in the market value of investments.

The classification of high-risk securities as held-to-maturity, and low-risk, short-term securities as available-for-sale.

Purchase of securities in excess of concentration limits.

Significant amounts of securities pledged for repurchase agreements.