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The reason we were concerned about this in 1976 was that our study of failed banks showed that poor management practices left banks inordinately vulnerable to the economic fluctuations that precipitated the increase in the number and size of failures in the early 1970s. Thus, even though a bank's financial condition may not immediately reflect bad management, the bank is nonetheless in a situation that could ultimately imperil its condition.

Equating management competence to a bank's financial condition, though an important measure, still can be misleading, as we found in our current case studies. In one of them, for example, the bank originally was designated as warranting special attention as the result of an October 1975 examination, cited for poor asset quality, poor liquidity, and insider loan abuses. No particular emphasis was placed on the causes of the problems, and the bank was removed from a program of increased supervision once its financial condition had improved.

However, in September 1978, when an examination revealed that the condition had deteriorated again, the bank was once more listed as requiring closer attention. Poor assets, low liquidity, and insider abuses were cited again by examiners, just as they had been in 1975. But this time the examiners directly cited and emphasized the causes--poor policies and lax implementation of them--and the agency required the bank to correct them.

In our sample of 105 banks, we noted that examiners cited situations warranting attention in those banks well before their conditions dictated selecting them for special attention. However, though the examiners did cite some management weaknesses before that point, their overall evaluations of management were still closely linked to the banks' financial conditions. For example, some kind of management policy and procedural problems were cited as early as three examinations before the banks were designated as needing closer supervision in 64.4 percent of those examinations. But, by the time the banks were considered to be of supervisory concern, the agencies were identifying these management problems 84.5 percent of the time.

Moreover, the Federal Reserve identified management concerns later than the Comptroller and FDIC did. Three examinations prior to the banks being regarded as institutions in need of closer attention, the Federal Reserve cited management policy and procedural weaknesses in 48.0 percent of the cases, compared to 60.6 percent and 81.2 percent for the Comptroller and FDIC, respectively. In the examination just before the banks were designated to be of supervisory concern, the Comptroller and FDIC both recognized management deficiencies about 88.0 percent of the

time, while the Federal Reserve pointed out the same types of problems in 76.7 percent of its banks.

In the statistics cited above, the management-type problem noted the most by examiners three examinations prior to special attention designation was inadequate internal routines and controls, singled out in over half the cases. The other indicators of poor management cited in examinations we reviewed were incompetent or inexperienced management, inadequate staff, poor responsiveness to problems, dishonesty, and poor asset/liability management. As the following figure shows, as the banks' conditions deteriorated to the point at which they were designated as being of special concern, criticisms of management increased.

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Since the poor loan policy criticism can be compared directly to a specific effect, classified loans, we analyzed how often each was cited hy examiners in examination reports. Two examinations before the banks were cited as needing close attention, the three agencies were citing classified loans without commenting on inadequate loan policies 27.6 percent of the time. Both poor loan policies and classified loans were identified in 38.1 percent of

the cases. But only 6.7 percent of the time did the agencies identify the poor loan policies before the effects (classified loans) were criticized.

In the examination immediately preceding "close attention" designation, a similar situation existed, though by this time more policy criticisms were made. Concerns about classified loans without concern for loan policy were disclosed 35.2 percent of the time, while classified loan levels and poor loan policies together were revealed in 51.4 percent of the banks. Again, the agencies identified poor policies alone in only 5.7 percent of the cases.

After the banks were designated as being of supervisory concern, loan policy was cited in even fewer cases. In the examination following designation, the regulators criticized classified loans without mentioning loan policy concerns 43.4 percent of the time. Both the existence of classified loans and inadequate loan policies were identified in 37.3 percent of the cases. Poor loan policies without classified loans were cited 6.0 percent of the time.

The Comptroller's staff was the most aggressive of the three agencies in identifying loan policy problems before loans actually deteriorated. In the examinations conducted just before banks were designated as warranting special attention, only his staff criticized loan policies without also criticizing actual bad loans (six cases). In the examination preceding this, examiners from the Comptroller's office considered loan policies to be inadequate in five out of the seven cases in which the cause alone was mentioned, as compared to one case each for the other two agencies. After problem designation, the Comptroller's examiners identified poor loan policies in four out of the five cases in which the cause alone was mentioned.

As one other measure of the equation of management to financial condition, we compared the ratings given to bank managers by the agencies to ratings given to financial aspects of their banks. 1/ In 87.5 percent of our cases, management was rated the same as the financial elements three examinations

1/The agencies, using a standard internal system, rate each bank

in five areas: capital adequacy, asset quality, management, earnings, and liquidity. The rating scale is from 1 to 5, 1 being the best. The agencies also prepare a composite rating for each bank, which employs the same i to 5 rating scale.

before the banks were designated as being of supervisory concern. Once the banks were considered to be in need of closer supervision, the management rating reflected the other ratings 75.7 percent of the time, while in 22.3 percent of the cases management was rated more harshly than the financial elements.

In the examination after the banks were considered to be in need of closer supervision, management was rated poorer than the other elements 27.7 percent of the time, as compared to the above-mentioned 22.3 percent. For the examination following that, managers received a lower rating 30.6 percent of the time. Therefore, as the banks' conditions weakened over time, the regulators evaluated management generally more harshly.

As part of the questionnaire we sent to bankers, we asked them to rate the effectiveness of the Federal examination process in performing a number of examination functions. The list of functions encompassed major evaluations and reviews that examiners perform to determine the condition of a bank and quality of its management. Some of the functions are "effectsoriented" in that they are used as tools to find current problems but do not usually address underlying causes. Most of the remaining functions serve as a means to pinpoint the source of problems (e.g., bad management).

These latter functions we have labeled "cause-oriented.

A majority of bankers perceive the evaluations of causeoriented functions as effective, though less so than other examination functions. Officials at 75.9 percent of the commercial banks we surveyed thought that examiners' evaluations of management were "effective" or "very effective," and 65.4 percent thought evaluations of internal controls were in the same categories. Although encouraging, these results are lower than opinions of some effects-oriented and other examination functions. For example, 85.5 percent of the bankers thought that evaluations of asset quality were "effective" or "very effective, and 90.3 percent thought that examinations were effective or better at assuring compliance with laws and regulations. The following figure compares all the effects, and cause-oriented functions we asked bankers about.

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Assurance that insider loan limits

and reporting provisions of FIRA are being met

93.1

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