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Bank Directors Should Not Personally Approve Loans

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Partners Jim McAlpin and Ken Achenbach joined me in the podcast studio to discuss the common community bank practice of having boards of directors approve particular loans.

While our initial approach was going to be to engage in a debate on the merits of this practice, none of us ultimately wanted to take the side of justifying the practice; for different reasons, many of which are expressed on the podcast, we all believe that it is a bad idea for bank directors to personally approve loans.

This spark that started this podcast was the recent BankDirector piece titled “77 Percent of Bank Boards Approve Loans. Is That a Mistake?” As I’ve written previously on BankBCLP.com, bank directors should not be approving individual loans, and banks should not be asking their directors to approve individual loans.

In addition to the podcast and the blog post, we also have a white paper titled Why Your Board Should Stop Approving Individual Loans.  That white paper analyzes what the board’s role should be in overseeing the bank, and why approving individual loans threatens this oversight. If boards keep approving loans, we’re next going to have to look into how to address our concerns via Instagram, courrier pigeon, or smoke signals.

During the podcast, I also mention our efforts to make the FDIC “podcast” on the financial crisis more accessible.

Please click to subscribe to the feed on iTunes, Android, Email or MyCast. It is also now available in the iTunes and Google Play searchable podcast directories.

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77 Percent of Bank Boards Commit this Mistake

Last week, Bank Director published a piece titled “77 Percent of Bank Boards Approve Loans. Is That a Mistake?”

In case you didn’t get it from the title of this blog post, I think the answer is absolutely, 100 percent, yes! Bank Directors should not be approving individual loans, and Banks should not be asking their Directors to approve individual loans.

77 percent of executives and directors say their board or a board-level loan committee plays a role in approving credits, according to Bank Director’s 2019 Risk Survey. And Boards of smaller banks are even more likely to be involved in the loan approval process. According to the survey, almost three quarters of banks over $10 billion in assets do not have their directors approve loans, but over 80% of banks under $10 billion in assets continue to have board-approval of certain loans.

These survey results generally conform to our experience. Two weeks ago, Jim McAlpin and I had the pleasure of leading five peer group exchanges on corporate governance at the 2019 Bank Director Bank Board Training Forum. The issue of board approval of loans came up in multiple peer groups, but the reaction and dialogue were radically different based on the size of the institutions involved. In our peer group exchange involving the chairmen and lead directors of larger public institutions, one of the chairman phrased the topic along the lines of “is anyone still having their directors approve individual loans?” Not one director indicated that they continued to do so, and several agreed that having directors vote on loans was a bad practice.

A few hours later, we were leading a peer group exchange of the chairman and lead directors of smaller private institutions. Again, one participant raised the issue. This time the issue was raised in an open manner, with a chairman indicating that they’d heard from various professionals that they should reconsider the practice but so far their board was still asking for approval of individual loans. A majority of the directors in attendance indicated concurrence.

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Why Your Board Should Stop Approving Individual Loans

In this the new era of banking, our clients are continually looking for ways to enhance efficiency and effectiveness at all levels of their organizations. This line of thinking has led to the revolution of the bank branch and the adoption of many new technologies aimed at serving customers and automating or otherwise increasing process efficiency. Perhaps most importantly, however, banks have begun to focus on optimizing their governance structures and practices, particularly at the board level.

(A print version of this post if you’d like to print or share with others is available here.)

As we discuss this topic with our clients, the conversation quickly turns to the role and function of the bank’s director loan or credit committee, which we refer to herein as the “Loan Committee.” We continue to believe that Loan Committees should move away from the practice of making underwriting decisions on individual credits absent a specific legal requirement, and here we set forth the position that this change should be made in order to enhance Board effectiveness, not just to avoid potential liability.

Ensuring Board Effectiveness

Whenever we advise clients with regard to governance, our fundamental approach is to determine whether a given course of action helps or hinders the Board’s ability to carry out its core functions. Defining the core functions of a Board can be a difficult task. Fortunately, the staff of the Board of Governors of the Federal Reserve System recently outlined its view of the core functions of a bank Board. We agree with the Federal Reserve’s outline of these functions as set forth in its proposed guidance regarding Board Effectiveness applicable to large banks, which was based on a study of the practices of high-performing boards. Based on our experiences, many of the concepts expressed in that proposed guidance constitute board best practices for banks of any asset size. The proposed guidance indicates that a board should:

  • set clear, aligned, and consistent direction;
  • actively manage information flow and board discussions;
  • hold senior management accountable;
  • support the independence and stature of independent risk management and internal audit; and
  • maintain a capable board composition and governance structure.

We believe that an evaluation of the board’s oversight role relative to the credit function is a necessary part of the proper, ongoing evaluation of a bank’s governance structure. As it conducts this self-analysis, a board should evaluate whether the practice of underwriting and making credit decisions on a credit-by-credit basis supports its pursuit of the first four functions. We believe that it likely does not.

Considering Individual Credit Decisions May Hinder the Committee’s Ability to Set Overall Direction for the Credit Function.

We have observed time and time again Loan Committee discussions diving “into the weeds” and, in our experience, once they are there they tend to stay there. In most Loan Committee meetings, the presenting officer directs the committee’s attention to an individual credit package and discusses the merits and challenges related to the proposal. Committee members then typically ask detailed questions about the particular financial metrics, borrower, or the intended project, assuming that any discussion occurs at all prior to taking a vote.

While it may sometimes be healthy to quiz officers on their understanding of a credit package, focusing on this level of detail may deprive the Loan Committee of the ability to focus on setting direction for the bank’s overall loan portfolio. In fact, in many of the discussions of individual credits, detailed questions about the individual loan package may in fact distract from the strategic and policy questions that really should be asked at the board level, such as “What is the market able to absorb with regard to projects of this type?” and “What is our overall exposure to this segment of our market?”

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Counterpoint: Why Sane People Serve as Bank Directors

Bank directors have played a crucial role in the turnaround of the banking industry, an accomplishment that deserves recognition in light of the fact that it has been done under tremendous regulatory burden and tepid economic growth.  Given that, why do we continue to question why the country’s most respected business people would be willing to serve as bank directors?  Respected attorney and industry commentator Thomas Vartanian recently asked in an opinion piece in The Wall Street Journal, “Why would anyone sane be a bank director?”  Well, sane people are serving as bank directors every day, and in doing so they are benefiting the economy without exposing themselves to undue risk.

(A print version of this post if you’d like to print or share with others is available here.)

The regulatory environment for bank directors is clearly improving. The Federal Reserve’s recent proposal to reassess the way in which it interacts with boards is appropriate if overdue, and the other banking agencies should follow the path that the Federal Reserve has set forth.  We also witnessed the FDIC acting very aggressively in pursuing lawsuits against directors of failed banks in the wake of the financial crisis.  However, suggesting that the FDIC relax its standards for pursuing cases against bank directors is not only unrealistic, it misses the greater point for the industry in that it needs to continue to refine its governance practices in order to provide for better decision-making by bank directors and to enhance protections from liability for individual directors.

In order to fully understand the point of this position, it is important to clear up a couple of commonly-held misconceptions.  First, when the FDIC sues a bank director after a bank failure, it does so for the benefit of the Deposit Insurance Fund, which is essentially an insurance cooperative for the banking industry.  As a result, the FDIC should be viewed as a purely economic actor, no different from any other plaintiff’s firm in the business of suing corporate directors.  Lawsuits by FDIC should not be given any higher profile or greater credibility than any number of other suits against corporate directors that inevitability occur during market downturns.  There should be no additional stigma, and certainly no additional fear, with regard to a claim by the FDIC on the basis that it is “the government.”

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Regulators Tackle Board Effectiveness and Overdrafts

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On the latest episode of The Bank Account, Jonathan and Ken Achenbach discussed the Federal Reserve’s proposed supervisory expectations for boards of directors.

Before digging into the Federal Reserve’s proposed guidance, Jonathan and Ken first discussed the CFPB’s statistical analysis of frequent overdrafters.  As noted in the CFPB’s analysis, “very frequent overdrafters account for about five percent of all accounts at the study banks but paid over 63 percent of all overdraft and NSF fees.”  They also touched on the CFPB’s prototype model forms for overdrafts.   As might be expected from the CFPB, the sample forms do a good job of highlighting the economic consequences of utilizing overdrafts, but not mention the potentially significant benefits (tangible and psychological) that can be provided by allowing such payments to proceed.

As noted by Jonathan and Ken, the Federal Reserve’s proposed supervisory guidance identifying expectations for boards of directors of banking holding companies would only apply to institutions with consolidated assets of $50 billion or more.  However, we believe the guidance is appropriate for all bank directors to look at, particularly as it draws on the Federal Reserve’s experience with approaches that improve bank governance.

Per the Federal Reserve guidance, effective boards are those which:

  1. set clear, aligned, and consistent direction regarding the firm’s strategy and risk tolerance;
  2. actively manage information flow and board discussions;
  3. hold senior management accountable;
  4. support he independence and stature of independent risk management (including compliance) and internal audit; and
  5. maintain a capable board composition and governance structure.

We believe this Federal Reserve guidance is consistent with our advice that boards need to get out of the weeds and focus on the big picture, a topic we have addressed on earlier podcasts as well.

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Public Banks and Proxy Advisors

the-bank-accountOn the latest episode of The Bank Account, Jonathan and I were joined by our colleague, Kevin Strachan, to discuss the role and importance of the various proxy advisory services.  Corporate governance continues to be a hot topic in the industry, and the proxy advisory services have a significant sway in determining what provisions are deemed “acceptable” by many institutional investors.

Within the podcast, we look at the two primary proxy advisory services, Institutional Shareholder Services (ISS, not to be confused with ISIS, although we have them pronounced identically by some frustrated boards) and Glass Lewis.  We look at the differences between the two services, where they’ve historically focused, and ways in which they sometimes have diminished power and sometimes enhanced power.

As with so many issues, obtaining the right corporate governance for any individual bank or holding company is not something that should simply be taken off a shelf (or off a podcast).  Instead, we encourage interested parties to engage experienced counsel, such as Bryan Cave LLP, to identify the best individualized approach for the specific situation.

You can also always follow us on Twitter.  Jonathan is @HightowerBanks, Kevin is @KevinStrachan, and I’m @RobertKlingler.

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Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence

In today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.

So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.

Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.

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The Link Between Board Diversity and Smart Business

Our time is one of rapid technological and social change. The baby boom generation is giving way to a more diverse, technology-focused population of bank customers. In conjunction with the lingering effects of the Great Recession, these changes have worked to disrupt what had been a relatively stable formula for a successful community bank.

Corporate America has looked to improve diversity in the boardroom as a step towards bringing companies closer to their customers. However, even among the largest corporations, diversity in the boardroom is still aspirational. As of 2014, men still compose nearly 82 percent of all directors of S&P 500 companies, and approximately 80 percent of all S&P 500 directors are white. By point of comparison, these figures roughly correspond to the percentages of women and minorities currently serving in Congress. Large financial institutions tend to do a bit better, with Wells Fargo, Bank of America and Citigroup all exceeding 20 percent female board membership as of 2014.

However, among community banks, studies indicate that female board participation continues to lag. Although women currently hold 52 percent of all U.S. professional-level jobs and make 89 percent of all consumer decisions, they composed only 9 percent of all bank directors in 2014. Also of interest, studies by several prominent consulting groups indicate that companies with significant female representation on boards and in senior management positions tend to have stronger financial performance.

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Ownership Succession for Family-Owned Banks: Building the Right Estate Plan

For a number of community banks, the management and ownership of the institution is truly a family affair. For banks that are primarily controlled by a single investor or family, these concentrated ownership structures can also bring about significant bank regulatory issues upon a transfer of shares to the next generation.

Unfortunately, these regulatory issues do not just apply to families or individuals that own more than 50 percent of a financial institution or its parent holding company. Due to certain presumptions under the Bank Holding Company Act and the Change in Bank Control Act, estate plans relating to the ownership of as little as 5 percent of the voting stock of a financial institution may be subject to regulatory scrutiny under certain circumstances. Under these statutes, “control” of a financial institution is deemed to occur if an individual or family group owns or votes 25 percent or more of the institution’s outstanding shares. These statutes also provide that a “presumption of control” may arise from the ownership of as little as 5 percent to 10 percent of the outstanding shares of a financial institution, which could also give rise to regulatory filings and approvals.

Upon a transfer of shares, regulators can require a number of actions, depending on the facts and circumstances surrounding the transfer. For transfers between individuals, regulatory notice of the change in ownership is typically required, and, depending on the size of the ownership position, the regulators may also conduct a thorough background check and vetting process for those receiving shares. In circumstances where trusts or other entities are used, regulators will consider whether the entities will be considered bank holding companies, which can involve a review of related entities that also own the institution’s stock. For some family-owned institutions, not considering these regulatory matters as part of the estate plan has forced survivors to pursue a rapid sale of a portion of their controlling interest or the bank as a whole following the death of a significant shareholder.

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A Director’s Guide to Corporate Governance 101

The day when the board’s focus was limited to approving loans and marketing the bank in the community is long past. Today’s boards face a wide array of complex tasks, and, accordingly, the composition, structure and organization of the board must all be geared to facilitate the board’s performing its duties and functioning properly. This process today is lumped under the heading of “corporate governance.”

(For a printer-friendly version of this post, including a sample Director Self Assessment form, please click here.)

The concept of functioning properly, of course, is in the mind of the beholder, but it clearly includes the board’s performing its primary duties of enhancing shareholder value, selecting, compensating and overseeing management and implementing risk management policies.

Boards of publicly traded banks are now fairly well acclimated to the issues comprising corporate governance, and bank regulators are now bringing many of these issues into the community bank board rooms. The regulatory exam almost always includes as its foundation an assessment of the strength of the board, whose oversight is considered critical to the proper functioning of a healthy bank. As a result, it is important for community bank directors to understand corporate governance principles, which fall under three broad categories.

  • Board Assessment—Is the board properly structured to provide optimal oversight to the bank?
  • Director Independence—Is the board able to effectively review management recommendations and make its own independent decisions regarding the bank’s strategy?
  • Management Review and Compensation—Does the bank have the right management team, and are those individuals compensated in a way that incentivizes them to implement the bank’s strategy?

Board Assessment

A review of hundreds of regulatory memorandums of understanding (MOUs) and consent orders has produced a clear starting point: Virtually every formal action begins with the requirement that the board increase its involvement and conduct an assessment of the performance and composition of management. The board’s assessment function, however, begins with the directors themselves. This self-assessment by the board is a logical starting point to ensure top board performance.

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