The Board`s Role In Making Loans

Theodore Reich, the chairman of Jersey Shores State Bank, likes to keep his lending business local. “We have an advantage,” Reich says. “We can touch our collateral. We can see our collateral. We can kick the tires of our collateral.”

In fact, he relates that just that morning on his way to work, he had spotted a broken-down truck by the side of the road. The truck belonged to one of Mr. Reich’s commercial loan customers. “I took the opportunity to call the customer on my car phone and ask if he was aware that one of his trucks was broken down on the road,” he says. “It happened that he was. But we might have a lien on that truck, and I wanted to make sure things were all right.”

But the story has another point: It was a member of the Jersey Shores’ board loan committee who brought that loan customer to the bank, which is in Jersey Shores, Pa. and has $307 million in assets. Reich recruits directors with a broad variety of acumenu00e2u20ac”and deep roots in the area’s commercial life. “We try to get a cross-section of the community,” he says, “so we have expertise in a number of different fields.”

Directors offer bank management a window on the community. Jay Tejera, a banking analyst with Dain Rauscher Wessels in Minneapolis, puts it this way: “They know whose strategies are working and whose aren’t. They have a finger in every pie.”

The loan committee “is one of the highest and best uses of a director’s time,” adds Martin R. Sorenson, chief executive of North Valley Bancshares in Redding, Calif. “Our directors understand the market intimately, and they know all the significant players.”

Faced with ever-fiercer competition from an expanding array of rivals, the role of directors in the lending processu00e2u20ac”always criticalu00e2u20ac”is becoming even more crucial. Lending margins account for a substantial portion of the bottom line, and those profits are under threat as giant securities firms and nonbank finance companies lure away customers by offering cut-rate corporate credit while making up the difference in fees. Management relies on directors serving on the loan committee to help establish new lending relationships and, by the same token, to make sure those relationships conform to established policies and meet credit quality criteria.

Barometric pressures

After the better part of a decade during which relentless economic expansion took some of the pressure off directors to pull in big commercial loans, loan committees find themselves once again facing the possibility of a shift in the economic cycle. At successful banks, management and directors alike acknowledge that an economic downturn would complicate the loan committee’s job. Meanwhile, regulators are looking over their shoulders to make sure that increased competition does not result in inappropriate loosening of credit standards during harder times.

Regulators at the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of Thrift Supervision all have issued warnings in recent months against too-great relaxation of underwriting standards.

The Fed ordered bank examiners in June to pay close attention to loan quality, and the OTS has cautioned real estate lenders to guard against a buildup of excessive loan-to-value mortgage ratios.

The number of problem banks currently under scrutiny by the FDIC is extraordinarily low. “We’ve only got about 70 problem banks, and out of about 9,000, that’s not very many,” observes Mark Schmidt, associate director of the operations section of the FDIC’s division of supervision. “But it’s about as low as it’s going to get.”

Regulators are concerned that the possibility of an economic downturn and a shift toward more aggressive lending practicesu00e2u20ac”like the subprime lending that was blamed by the FDIC in the July failure of BestBank, a privately held Boulder, Colo. institution with about $230 million in assetsu00e2u20ac”could quickly lead to problems for banks. “It’s still pretty small on an absolute basis,” Schmidt says of the number of banks the FDIC is watching. “But it is on the increase. Our objective is to keep that upswing from worsening.”

Donna Tanoue, the FDIC chairman, said in an address to a September meeting of the National Bankers Association that regulators are concerned by the confluence of a weakening economy and an apparent relaxation of underwriting standards. “Recent banking industry practices give us cause for concern,” Tanoue told bankers at the Philadelphia meeting. “That concern is only heightened by current economic developments.”

Putting directors to work

For this article we talked to top managers and board members from a number of banks that, like Jersey Shores and North Valley, had midyear rates of return on assets that put them among the top 5% of banks under $1 billion in assets, according to SNL Securities. Nearly all these directors and CEOs say that, for directors serving on the loan committee, these big-picture shifts have real impact at the everyday levelu00e2u20ac”ranging from an increased awareness of the vital role of rainmaker to the sometimes uncomfortable necessity of requiring greater financial disclosures from prospective customers to whom directors might have unrelated social ties.

The prospect of a worsening economy means more of the same for the loan committee at Pinnacle Bank, according to Robert E. Lee III, an insurer who succeeded his father as an outside director at the $265 million institution in Elberton, Ga. For more than a decade, the bank has sponsored semiannual educational seminars for its directors.

“Even during the boom times, we’ve always been told of our responsibilities and liabilities, and I expect that to continue,” Lee says.

But the threat of a downturn has already begun to have an impact on Pinnacle’s loan operations. “We have been more demanding of our customers for financial statements, instead of taking the good old boy’s word for it,” Lee says. “At times, that’s meant they’ve even gone to the bank down the street.”

L. Jackson McConnell, Pinnacle’s chairman and chief executive, says the loan committee, which is made up of four directors and four senior officers, reviews the bank’s credit portfolio twice a year and meets as needed to consider any loan over $500,000. A loan evaluation is based on an analysis of the prospective borrower’s assets, liabilities, and historical and projected income and sales as well as the backgrounds and financial status of the principals in the business. Collateral is described and analyzed, and appraisals are presented.

The increasing sophistication of loan evaluation packages in the last several years has made directors more comfortable with assessments they are asked to make on the basis of the data. “There may not be any more information, as far as the number of papers in there, but I think it’s better information than we have had at any time before,” Lee says, adding that this, in turn, has enabled the board to ask tougher questions of management.

“We’re not scared of anybody over us or of hurting anybody’s feelings,” he says, though that is not necessarily how it was in the past.

The loan committee at Bar Harbor Banking and Trust Co., which consists of two bank officers and a revolving slate of six to eight directors from among the board’s 15 outside directors, has responded to rising competition in its resort-centered service area with a new willingness to challenge presentations by credit officers, according to Sheldon F. Goldthwait Jr., president and CEO of the $368 million-asset institution. “Occasionally, a director will say, ‘I don’t think this is a good idea,’ and vote against a loan,” Goldthwait says. “In the past, the board’s votes were usually unanimous.”

Bar Harbor Banking regularly asks its directors, who represent geographically dispersed areas of its service territory, for comments on loan proposals from entrepreneurs in their communities. For any new lending relationship over $200,000, the loan committee also considers the borrower’s financial statements, tax returns, business plan, and personal statements along with the credit officer’s writeup and the local director’s input.

The board loan committee also is more aware than ever, as it sees competition mount, of its mandate for vigilant oversight of credit standards, says Lynda Z. Tyson, who heads a Bar Harbor marketing communications firm and serves as an outside director for Bar Harbor Banking.

“It is true that management screens loans before they get to the loan committee,” Tyson says. “But I think directors ask questions that management doesn’t always ask. And in a lot of cases, directors who represent certain geographic areas will have information about a prospective loan customer that management or the loan officer doesn’t have. So it brings a third perspective to the equation.”

For another Bar Harbor director, Peter Dodge, president of an insurance agency in Blue Hill, Maine, the increasingly aggressive competition in southern Maine has highlighted directors’ need for accurate information and analysis on which to base loan decisions. “I place a lot of reliance on management,” Dodge notes pointedly, “and I indicate to bank officers that I am looking to them for technical information on a loan.”

More vigilance needed

The demise of BestBank, which Tanoue called the FDIC’s first significant bank failure in two years, has also brought the issue of directors’ liability for questionable lending policies and oversight back to the forefront.

At the educational seminars held by Pinnacle Bank for its board members, liability discussions get as specific as case studies of loans that resulted in lawsuits against directors. “He’ll tell us, ‘Don’t make this mistake,’” Lee says of the consultant who leads the seminars.

Reich regularly reminds Jersey Shores’ nine board members, who are asked to sign off on any loan over $300,000, of a lender liability lawsuit against another bank in which the judgment went against the directors. “One of the board members was in the hospital in a coma when that decision was made, but he was included in the judgment,” Reich says. “I tell my board about that from time to time.”

Reich agrees that the loan committee’s job could become more difficult if the economy takes a turn for the worse. “We could see more delinquencies than we have in the last 10 years,” he says. “And if we do, then the directors will get nervous, because their own assets are at risk.”

Virtually all the chief executives say they would not be doing their jobs if they failed to keep an eye on the larger economy, even if, in many cases, they believe their own banks to be insulated from the ebb and flow of global commerce.

“It’s always more difficult in a recession,” says Charles Snipes, president and chief executive of the Bank of Granite, in Granite Falls, N.C. Snipes says he had been warning his board, which has five outside directors along with him and another senior officer, for more than a year that a slowdownu00e2u20ac”or worseu00e2u20ac”was likely.

“Our board doesn’t like surprises,” he says. “If there’s even a chance that something might go sour, we try to get them involved early on.”

With the prospect of a weakening economy before them, bankers say they depend on their directors even more heavily for critical assessments of loan customers whose businesses or assets might suffer in the event of a recession.

Patricia Moss, president and chief executive of the Bank of the Cascades in Bend, Ore., says the bank’s directors remember the recession that ravaged their state in the 1980s. “That’s never been far from their minds,” she admits. “But successful lending depends on criteria you establish in good times.”

Cascade’s ad hoc loan committee, which comprises two outside board members unrelated to the loan, evaluates any proposal over $1.5 million based on a uniform set of data. “We have a loan committee [evaluation] form in a format that’s established,” she says. “So the board consistently sees the same kind of information.

“We generally do the obvious things: We consider the borrower’s financial net worth, loan-to-value ratios, the performance history of the company or the individual and, most importantly, the future ability to service the loan. But the key is that the committee has a consistent base of information on which to make its decisions.”

As shareholders, board members’ own money is on the line, notes Charles A. Webb, chief executive officer and one of four shareholders at the privately held Peak National Bank in Nederland, Colo., which has about $107 million in assets. “That’s the ultimate testu00e2u20ac”the first dollar lost belongs to the shareholders,” Webb said.

“We would like to think we’re brilliant in our credit analysis, but we know that it would have been hard to make a mistake on a real estate loan in our market in the last 10 years,” he continues. “We understand that values are not always going to go up, so we’re very conservative on loan-to-value ratios.”

Moss says it may be that the Bank of the Cascades, which makes principally income-based commercial loans, would be less vulnerable in an economic downturn than a collateral-based lender. “But there’s no question that if the country or the area suffered an economic downturn, everybody’s job would become more difficult,” she acknowledges.

At Mahaska State Bank in Oskaloosa, Iowa, Charles S. Howard, the vice chairman, says shifts in the economic cycle have had very little impact on underwriting standards. “We have maintained the same procedures in good times and bad,” Howard says. But, he says, loan committee members are expected to evaluate the standard financial data presented on a proposal in the light of their own familiarity with a prospective customer and his or her vulnerability to a downturn.

“They can either relate things to their own individual businesses, or they hear things on the street that the lender doesn’t,” Howard says. “They can bring a wealth of information to the meeting just from their own experiences.”

Relationships between members of a bank’s loan committee and loan customers also can be productive in the event that a loan does go bad. Jim Wake of Smith Wake Co., an agricultural services company in Mahaska, serves on Mahaska State Bank’s loan committee and says that as far as evaluating proposals for new loans, he is comfortable with the bank’s procedures and guidelines. It’s the problem loans that take the biggest toll on loan committee members’ time and emotional energy, according to Wake. “A lot of the ones that we struggle with are the ones that have been on the books, and we have to keep working with them, to keep working them down,” he says.

Loan committee effectiveness

Ultimately, the question of how effective loan committee members are in evaluating loans and setting and enforcing policy guidelinesu00e2u20ac”and representing their banks to service-area constituenciesu00e2u20ac”comes down to the free and well-regulated flow of information. Feedback must be provided both from directors to managementu00e2u20ac”so that officers can be confident that they are in fact implementing the board’s wishesu00e2u20ac”and from managers to directors.

“We constantly ask for input regarding what information we are presenting to the loan committee: Is it enough? Is it too much?” Mahaska’s Howard says. “Just within the last year, we started sending loan packets out 48 hours before meetings, because committee members asked for more time to review them. It used to be 24 hours, though occasionally we asked them to come in and take a look at something right then.”

Tejera, the Dain Rauscher Wessels analyst, calls information flow “one of the defining variables” between success and mediocrity. “If you have an active, shareholder-driven board, the flow of information moves in both directions. It’s where you have an insulated, uninvolved board that you run into problems.”