Institute of International Finance, Inc

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Corporate Governance Program for CEOs and Directors of Indian Banks December 16, 2005 Mumbai, India What Directors Should Watch For John R. Price Senior Advisor to the Institute of International Finance

 Accounting Disclosures Have Led to Collapse or Crippling of Companies  Many Firms Have Rebounded From Impact of Scandals  With Heightened Scrutiny and Emphasis on Financial Statements’ Accuracy, It Is Time for Back to Basics for Company Directors 2

Degrees of Difficulty

Are Boards At The Mercy Of Management?

HEALTH SOUTH

•Outright Fraud Do Boards “Pull The Wool Over” Their Own Eyes?

ENRON

•Repeated Violations of the Board’s Own Policies and Procedures •Creation of Special Purpose Vehicles With Management Self Interested Compensation and Conflicts

FNMA

•Earnings managed to compensation incentive goals?

Do They Ignore Warning Signs?

CHICAGO FEDERAL HOMELOAN BANK

3

Fannie Mae Common Stock

4

Chicago Federal Home Loan Bank

Key Areas To Monitor

• • • • • • • • • • Financial Performance- Sums Them All Up Credit Portfolio Liquidity Interest Rate Risk Investment Portfolio Derivatives Or Off Balance Sheet Activities Audits And Internal Control Compliance Asset Management Management Information Systems 6

I.

Financial Performance

• • • • • These ratios and results are highly dynamic- They reflect the interaction between: Capital Asset Quality Earnings Liquidity Market Risk • • • • Balance Sheet Growth In all of these, attention should be paid to: Trends Comparisons With Prior Years, the Budget, and Projections Peer Group Comparisons

For Example: In Capital, worry if the capital growth rate is less than the total asset growth rate or if dividend payout ratios are much higher than peer group banks.

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II. Credit Portfolio

• • • • • Ask For: Management’s Risk Rating Reports- including grades above loans the examiners express concern about: “Rating Migration.” Problem Loan, Past Due, and Non-Accruals Reports Renegotiated or Restructured Loan Reports Concentration (by borrowers, region, etc.) Policy Exceptions • • • • • • Watch Out For: Rapid Growth in Total or Particular types of Loans Large or Increasing Numbers of Policy Exceptions, or Credit/ Collateral Exceptions Reporting Lines of Underwriters (Credit Review Personnel); Must be Independent of the Lending Function Compensation of Loan Officers: Volume Without Credit Quality Attributes Changes in Scope and Frequency, or Delinquent Internal Loan Reviews Problem Loans Lingering and Not Resolved 8

III. Liquidity Management

• • • • Ask For: Fund Providers Projected Needs (Dynamic) Cash Flow or Funding Gap Report Contingency Funding Plan • • • • • • Watch Out For: “Rollover” Risks- Short Term Liabilities/ Long Term Assets Negative Earnings & Asset Quality, Which Could Affect Perception of the Bank’s Credit Higher Funding Costs Elimination or Reduction in Credit Lines from Correspondents Rapid Asset Growth Funded with Borrowed or Brokered Funds, or Shifting Sources Concentration of Funding- Single Source, Common Rate, or Credit Sensitivity 9

IV. Interest Rate Risk

• • • • Ask For: Gap Reports- the difference between rate sensitive assets and rate sensitive liabilities: shows how net interest income can be affected by interest rate changes Simulation Models Economic Value Sensitivity Models- assets, liabilities, and off balance sheet items in differing interest rates (Present Value Computation) Long-term Assets/ Total Assets – gives an indication of “Repricing risk” • • • Non-Maturity Deposits/ Long Term Assets Watch Out For: High or Growing Volume of Either Assets Options

OR

Liabilities with Embedded Lack of or Non-compliance with, or exceptions to, risk limits 10

V.

Investment Portfolio

• • • • • Ask For: Maturity Breakdowns and interest rate risk % of portfolio in every credit rating category by rating agencies Cost and Market for Both Held To Maturity and Available For Sale (unrealized gain or loss in Other Comprehensive Income) • • • Watch Out For: Yield Chasing (above market or peer group) Shift and Sale of Securities from HTM, or Transfer from HTM to AFS Purchase of Securities in Excess of Concentration Limits or Frequent Policy Exceptions Large Amounts of Low or Non-Rated, or Out of Area Bonds Absence of a Credit Risk Assessment for the Safekeeping Agent 11

VI. Derivatives And Off Balance Sheet Activities

• • • • Ask For: Credit Risk Exposures for Counter Parties credit limits and collateral requirements Compliance with Risk Policies and Risk Limits Results of Stress Testing Impact on Income from Derivatives: The FAS 133 Dragon • • • • • • Watch Out For: Staff Qualifications Concentration of Credit Exposure to Counter Party Concentration of Trades With One Firm Absence of Enforceable Netting Agreements Unilateral Collateral Posting “Off-Market” Derivatives- Loan to Counter Party 12

VII. Audit and Internal Controls

To Be Covered by Other Presenters

But, Watch Out For

Unresolved Significant Audit or Compliance Audit Findings 13

VIII. Compliance

• • Ask For: Regular Reports on Litigation and Customer Complaints Regulatory or Compliance Audits by Outside Reviewers (e.g.HUD in US on Mortgages) • • • Watch Out For: Uncorrected Deficiencies in Compliance Reviews Lack of Evidence of Compliance Training For Employees Increase in Customer Complaints to the Bank or Regulator 14

IX. Asset Management

• • • Ask For: New Business/ Lost Business Reports Investment Performance Reports Fiduciary Audit Reports • • • • • • Watch Out For: Unexplained Shifts in Business Strategies Major Changes or Growth in Account Types, or Balances, or Products Lots of Activity- Switched Mutual Funds, Exchanged Annuities, Accounts Quickly Closed After Being Opened Assets of a Kind Where There is Expertise Lacking to Manage it Purchase or Sale of Assets Between the Bank and Fiduciary Accounts Frequent Changes in Service Providers or Auditors 15

X. Management Information Systems

• • Ask For: Business Continuity Plan Timely, Accurate, Secure, Relevant, and Consistent Systems to Generate Management and Financial Reports • • • • • • Watch Out For: MIS Systems Allowing Disclosure of Customer Information, or Not Securing Privacy Systems that Crash as New Products or Business Lines Are Introduced Systems Problems of Integration, as with Acquisitions Increasing Fraud Losses A System that Cannot be Explained or Diagrammed Easily by Management Reports that are Irrelevant or are too Cluttered 16

Conclusion

“Trust, But Verify” -

Ronald W. Reagan