Chapter 19: Bank Management

Banks set goals for several things. They set a goal for profitability while keeping in mind a large group of
factors that play a role “good or bad” in the pursuit of that profit goal.

Some have slightly different influences that play a part in their approach, but several of the factors are
things they all have to deal with.

Deposits: The banks primary source of funds are ”loanable funds” you and everyone else provide. Loans
to the bank from their customers.

The bank looks for ways to invest these funds and will have a greater or smaller appetite for deposits
depending whether they think they have somewhere to put the money to create a spread.

The greater the opportunity, the more likely the bank will pursue hotter or more costly money.

The first choice of most banks is to invest in loans because of the greater spread opportunities.

The point of last resort is usually FED Funds because of their historically low yield. They are good for
Liquidity, but not where you want funds to stay very long. This is a spot you might Park money
overnight, or in anticipation of a quick need for cash, ( i.e. a large group of CDs are coming due at the
same time)

Loans: The life blood of commercial banking, as well as for the commercial businesses of all
communities.

Loans come in basically three categories, Commercial, Consumer, and Real Estate, with a lot of overlap
between Commercial and Real Estate. Home loans may also overlap, but often fall in a separate category
we will discuss later.

The largest total dollar amount will be in the Real Estate category. Some banks may have as much as
75% in the real estate section. That is usually their favorite collateral.

Consumer loans are normally largely auto loans, but do include boats, campers, etc. ad well as
unsecured and student loans.

Commercial loans cover a wide variety from small inventory loans to very large Commercial Paper
Loans.

Many banks will make what they call Working Capital Commercial Loans which are secured by blanket
liens on all tangible assets (inventory, equipment, and accounts receivables). This is not the first choice
of collateral because it is very hard to monitor, and even more difficult to reposes.

Most of these type loans wind up being what they call a working line of credit, which allows the
customer to draw money when needed, pay it back with cash flow, and not have to re-apply each time
they need money.
I am sure you realize Auto dealers (new & used) have a lot of money tied up in inventory. They will
commonly use a commercial loan line of credit called a “dealer’s floorplan” where they can buy cars
they draw, when they sell cars they pay it down.

The purpose of this review of a few types of loans is to show that the loan portfolio of a bank will often
tell you the management philosophy of a particular bank. The higher the loan to deposit ratio a bank
carries, usually means the more profit driven, and the more willingness to take risk.

Two more factors to consider when talking review of a bank’s loan portfolio are loan loss reserve and
examinations.

Loan loss reserve is a required balance sheet contra account that acknowledges that some loans will go
bad, and some worse than others. (Look for a bank to hold at least 1% but probably not more than 2% in
reserve) I will explain a little about why those amounts.

Every bank is going to make bad loans. The examiners know this and understand that things happen.
What they will not allow is that banks don’t prepare for that event, or they try to make believe that they
will not have losses.

When the loan loss reserve is too high (like over 2%) they feel the bank is artificially hiding income by a
less than honest “provision for loan loss”.

The management of all commercial banks are charged with the task of rating all loans between 1-5
(sound familiar?) with a 1 being no problems, and a 5 being worthless. And the loan loss reserve
provision each month must reflect those ratings.

Then you need to address “charge offs” which starts a whole new discussion.

In small banks the loan officer and the loan committee will rate the loans, in larger banks they have
departments charged with the task of review and ratings. The idea is to be prepared for any loss or
trouble with no surprises. But they also do the ratings to stay ahead of the Bank Examiners!

Bank Examiners come in several forms State Bank Department examiners, FDIC Examiners, FED
Examiners (Comptroller of the Currency), and then specialty examiners like compliance and CRA
examiners.

State Bank department examiners: Lowest priority, but the most frequent. What I mean is, they have
the least power but they come around often. You will see them every year if you are a good bank, and
all the time if you are a 3-5 rated bank. Also, this is where most examiners get their start, and they will
often try to show how tough they are on the banks.

FDIC Examiners: High priority because they can exert more power if they so choose. The banks
insurance premium is based, at least partly, upon what they write in their final report, so it can make a
difference to the bottom line.

These examiners are usually more experienced, and understand how to ask question to determine how
well the loan officers, or the bank management understands the quality of assets the bank is holding.

Normally each examiner will pick a portion of the loan portfolio, review it based upon past due loan,
defaults, patterns, and pick a group of loans to ask the officers about, or the loan review staff in larger
banks. It is important for the bank staffer being ask to be familiar with the loan in question, because if
they are not the examiner will realize it is a weak spot and dig even deeper. This means it is a weak loan
(slow pay, weak collateral, incomplete documents) and the bank staffer is aware of that and says they
are working on it now, it goes a lot better. However, if they catch you off guard or unprepared they get
excited, and go in for the kill.

This is where the loan officer or loan review person does not want the examiner to say they will have to
take that loan to the banks management or the board.

The buck stops with the top management and the board of directors. The loan officer can make
mistakes, and even lose their job for bad loans, but the top management and board can be fined and
even worse, if they don’t stop a problem or try to cover it up.

Fed examiners: (Comptroller of the Currency) These guys and gals don’t play. If you are a member of
the FED or a nationally chartered bank you will on occasion have a FED exam. Normally they will just
review the exam from the state or FDIC and leave you alone. However, if the review is not good, or they
see some weakness they can make the bankers life difficult.

First they will do an “on site” review of the bank’s assets and reserves, which can take a while. The
biggest problem with this is that the bank still has customers to deal with, and past due loans to collect.
It always seemed ironic that the very thing they were there to review became more difficult to control
while they were there.

Bottom line with the FED examiners is that they only make life hard if a bank is really in trouble, and we
will discuss how they approach this a little bit later in the class.

Specialty Examiners: (Compliance and CRA) These examiner look at specific things like disclosures and
discrimination. The examiners that review asset quality pay no attention to diversity or whether or not
the bank disclosed the right APR*. These examiners care not if is a good loan or a bad loan, but that it is
fair to all who apply, and that it is available to the entire community the bank serves.

“If the bank is willing to ask the entire community to deposit their money, the bank must be willing to
loan money fairly throughout the entire community.”

*APR- The actual cost of a loan to a customer as opposed to the rate stated on the contract.