Bank Board Members Need to Know More

Recent problems in the banking industry have led regulatory agencies to expect much more from bank directors.

Today's bank director needs to understand the risk/return dynamics of banking operations in enough detail to intelligently discuss these issues with examiners without management being present.

This is a critical time to look at the role of the director in the balance-sheet management process.

To control or direct any organization's activities, a director must, at a minimum, fully understand the cornerstone issues. These include the risk/return tradeoffs; the profit/loss statement and its key variables; the regulatory and competitive environments; the necessary organizational structure; and the quality, types and numbers of people required to manage the business.

Few bank directors have ever been exposed to the profit dynamics of a financial intermediary - which what a bank is, in essence. They need to better understand such basics as:

* The main business of banking is buying and selling money.

* Buying and selling money involves taking credit, interest rate, and liquidity risk. Such risk can be managed, but it cannot be avoided if the bank is to fulfill its role as an intermediary and provide shareholders with a reasonable return.

* When comparing a bank to any other business, assets equal products and produce the revenue; liabilities equal raw materials and create expense; net interest income equals gross profit margin; and excess liquidity equals excess inventory.

In the current environment, the regulators' views on the risk/return profile of the business may differ from those of management and the board.

Bank directors should be able to answer the following questions:

* What is the asset quality of the bank? Are reserves adequate to cover foreseeable loan losses? (These issues require that the director track delinquencies, foreclosures, loan writeoffs, and the adequacy of the loan-loss provision. Understanding trends and credit concentration is also important.)

* What is the interest rate risk position of the bank? Should the key focus be earnings exposure or market value? (A director should know why gap reports do not accurately reflect the position of the bank. Directors need to be able to discuss earnings exposure to changing interest rates and understand the key components of the exposure - namely, mismatch and basis risk.)

* What is the bank's liquidity position? Is it adequate? (Directors need to know why such traditional measures of liquidity as loan/deposit ratios and cash flow as a percentage of deposits are no longer appropriate. Most important, they need to understand how the pricing of liabilities affects the level of liquidity and its costs.)

In short, the days of a rubber-stamp board are gone forever. Management should help directors understand the banking business better and should provide meaningful reports from which the health and ongoing viability of the bank can be monitored.

Mr. Darling is the president of Darling Consulting Group, Newburyport, Mass., which advises on asset/liability management.

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