STATE OF WEST VIRGINIA Preliminary Performance Review of the

Board of Banking and Financial Institutions

OFFICE OF LEGISLATIVE AUDITOR
Performance Evaluation and Research Division
Building 1, Room W-314
State Capitol Complex
CHARLESTON, WEST VIRGINIA 25305
(304) 347-4890

Background

The Board of Banking and Financial Institutions operates within the Department of Tax and Revenue. Its statutory authority is in West Virginia Code 31A-3. The Board consists of seven members (see Appendix A), including the Commissioner of the Division of Banking which is also under the Tax Department. By statute, the Commissioner of Banking is chairperson of the Board and is required to provide the Board with necessary office space and personnel assistance. The Commissioner provides the equivalent of one full-time staff person to the Board. Total expenditures for the Board for FY 1996 was $69,836. By statute, the Board meets quarterly, and over the past four years (1994-1997) it has always had a quorum.

The Board's jurisdiction consists only of State chartered institutions (see Appendix B). Banks, credit unions, and savings and loans may obtain a charter to do business from either the State or Federal government. When an institution is chartered by the federal government, the institution is called a national bank, national credit union or a federally chartered savings and loan. These institutions are regulated by a federal regulatory agency. State chartered institutions come under the regulations and supervision of the Division of Banking. By law, the Commissioner of Banking must conduct an examination of the financial records of State chartered institutions at least once every eighteen months. At the start of 1997, there were 38 national banks, 75 state banks, 126 federal credit unions, 13 state credit unions, and 9 federal savings and loans. There are no state savings and loans.

Issue Area 1:The Board of Banking and Financial Institutions Operates Effectively but Has Failed to Implement the Statute Requiring Economic Analysis for Branch Banking Decisions.

The general duties of the Board of Banking and Financial Institutions are primarily to advise the Banking Commissioner in all matters of her jurisdiction, and to provide oversight for some of the Commissioner's responsibilities. The Board's ultimate goal is to promote sound and dynamic financial institutions. This outcome is to be achieved through the mandated approach of reviewing State bank applications that request approval from the Board to either establish a new bank, establish a branch bank, merge with another bank, purchase the assets of another bank, or form a bank holding company. The Board also has emergency powers to conduct hearings and enter orders in other matters, such as restricting the withdrawal of deposits when the protection of creditors and depositors are affected, revoke a state banking institution's license to do business in the State for failure to comply with an order of the Banking Commissioner, and suspend or remove a director or employee of a financial institution who is dishonest, incompetent or fails to comply with an order of the Banking Commissioner. The Board operates effectively, with one exception being that a portion of the analysis of branch bank applications is inconsistent with statutory criteria. This area of the analysis requires an assessment of local conditions to determine if a proposed branch and the existing institutions in the area will have reasonable promise of success after the proposed branch is established. The Board does not adequately assess local conditions for branch bank applications.

In reviewing State bank applications, the Board must consider statutory criteria in rendering its decisions. The criteria, in general, are designed to ensure that the business transaction is financially sound, the organizers of the transaction are responsible and experienced in banking, the transaction will promote public convenience and advantage, competition will not be lessened, and that local conditions will assure reasonable success for the proposed entity and existing banks in the community. Table 1 shows the number of bank applications received by the Board from 1993 through 1997. The Board receives between 20 and 30 applications a year.

Table 1
Bank Applications Received by the Board
1993 1994 1995 1996 1997 Totals
New Bank Applications 0 1 6 1 1 9
New Branch Bank Applications 6 4 9 11 6 36
Applications to Establish Branches by Mergers, Purchases, or Assumption 3 10 5 6 5 29
Applications to Acquire Bank Assets 9 6 4 3 3 25
Other Applications 3 9 2 0 2 16
Totals 21 30 26 21 17 115

The Bank Application Process

The bank application process comprises five steps, as illustrated in the boxes below. When the Division of Banking receives an application, it is logged in and reviewed for completeness. An application is not formally accepted (Step 2) until it is complete. If important information is missing the analyst will work with the applicant to acquire all necessary documents to accept the application. Once the application is accepted, an analysis of the data is conducted resulting in a Summary of Transaction (Step 3). This summary provides an analysis and recommendation by staff based on statutory criteria which must be considered by the Board in making a decision on an application. When the Summary of Transaction is completed, copies are sent to Board members prior to the board meeting for their review (Step 4). If the Board approves the application, an order is written reflecting the Board's decision (Step 5). The order briefly reiterates the findings of facts for each statutory criteria based on the Summary of Transaction.

1
Bank Applications Received
2
Complete Applications are Formally Accepted
3
Analysis of Application results in a Summary of Transaction
4
Summary of Transactions are sent to Board Members in Preparation for Board Meeting

Statutory Criteria

The following are general statutory criteria used by the Board to decide approval or disapproval of bank applications for new banks, branch banks, mergers, or acquisitions of bank assets.

Public convenience and advantage will be promoted (31A-4-6 (b) (1)). Local conditions will assure reasonable promise of successful operation for the proposed bank (or branch) and those banks (or branches) already established in the community (31A-4-6 (b) (2)), (31A-8-12). The proposed capital structure is adequate (31A-4-6 (b) (3)). The proposed officers and directors have sufficient banking experience, character and standing to assure reasonable promise of successful operation (31A-4-6 (b) (4)). No merger or acquisition shall result in a monopoly or a substantial reduction of competition in any section of the State (31A-8A-5), (31A 8-12). No merger or acquisition shall be permitted that results in the control of Statewide deposits in excess of 25% of depository institutions (31A-2 12a (c)). Does the institution have a good record of meeting the credit needs of the local community, consistent with the Community Reinvestment Act (31A-8B)?

Risk Factors Affecting the Board's Effectiveness

There are three primary risks to the Board's effectiveness in this process:

1) Are applications approved or denied without the Board's authority?
2) Are applications reviewed within statutory time frames?
3) Are applications investigated according to statutory criteria?
Risk Factor One: Are applications approved or denied without the Board's authority?

Since some of the Banking Commissioner's responsibilities are subject to the Board's approval by statute (31A-2-4), it is important to determine if the Commissioner is not making decisions on applications that are required to be made only by the Board. There is little or no incentive for the Commissioner of Banking to circumvent the application process for personal gain by approving a bank application without the Board's approval. By statute, four Board members are executive officers of financial institutions who could become aware of a transaction that did not receive Board approval, as well as the Commissioner's staff. The Board's agenda for each meeting is circulated to every financial institution in the State. Therefore, other financial institutions could detect a bank transaction in their area that did not go through the Board. Also, banks have little or no incentive to pursue an illegal approval of an application because banks go through the Federal Depository Insurance Corporation (FDIC) to receive insurance on their deposits. The FDIC would require documentation that the bank or branch is legally established.

With respect to denying an application without the Board's authority, there is risk of this occurring, but the evidence suggests that the risk is minimized. The risk exists during the phase of reviewing the application for acceptance or during the analysis of the application. On occasion, the analyst may detect material weaknesses in the application which will make it difficult for the analyst to recommend approval to the Board. It is possible that in discussing some of the material weaknesses with the applicant, the analyst could give the impression that the Board will not approve the application, or discourage the applicant enough to cause the application to be withdrawn. This possibility is acknowledged and addressed in the Banking Division's Applications Procedures Manual. The manual states:

The goal is to get commitments or amendments which will make it possible for you to recommend approval. Work to make it work! If, however, you determine that you cannot recommend approval, try to persuade the applicant to withdraw the application or continue the application until the next Board meeting if additional information may come to light which would assist you in making a recommendation of approval....Avoid telling an applicant that the application will not be approved as that authority rests with the Board. You may disclose what your recommendation will be and/or that the "Board may not look favorably" upon an issue. Never recommend denial of an application without discussing problems with the Commissioner, the division's legal counsel, and the applicant. [Emphasis included]

The procedures manual encourages the analyst to work with the applicant to remove any problems in the application. The analyst is also instructed not to convey a decision of denial which only the Board can make. Furthermore, as Table 2 indicates, most applications received by the Banking Division are investigated, accepted and approved by the Board. Only four applications have been withdrawn over the past five years.

Table 2
Bank Applications Received & Approved Applications
Received Applications Approved Withdrawn Applications
1993 21 21 0
1994 30 27 3
1995 26 25 1
1996 21 21 0
1997 17 17 0

Risk Factor Two: Are applications reviewed within statutory time frames?

There are statutory time frames for which the Board must complete its examination and investigation of a bank application. For new bank applications, the Board must complete its investigation within 90 days from the date it receives the agreement of incorporation of the bank (31A-4-7). For branch banks, the investigation must be complete within 90 days from the date the application has been received (31A-8-12). The investigation of applications for acquisitions of bank assets must be complete within 120 days of receiving the application (31A-8A-6).

In general, the Board is timely in completing its examination and investigation of bank applications. For the last two years, the Board has been well within the statutory time frame, as indicated in Table 3. Every application reviewed except one met the appropriate time standard.

33 days
Table 3
Time Between Accepting & Approving Bank Applications
1997 Average Time Between Accepting and Approving Application
Branches (10) 46 days
New Bank (1) 172 days *
Acquisitions (2)
1996
New Branches (17) 45 days
New Bank (1) 81 days
Acquisitions (3) 36 days
* Application was held in abeyance at request of Applicant. ( ) Denotes number of Applications

Risk Factor Three: Are applications investigated according to statutory criteria?

In general, the Board's staff provides an adequate analysis of each application, with one exception being that the assessment of local conditions to determine reasonable promise of success for branch bank applications is inadequate. Other aspects of the analysis of branch bank applications are performed adequately.

The Legislative Auditor reviewed 22 Summary of Transactions (SOT) for new bank charters, new branch charters, acquisitions, and mergers. The summaries represent applications filed in years between 1993 and 1997. The summaries provide a description of the request the applicant is seeking approval from the Board. Following the description, the analysis addresses the appropriate statutory criteria required to be examined, including citing the applicable code. The analyst conducts interviews with proposed officials referred in the application, reviews the floor plans of proposed facilities, and on occasion the analyst may conduct on site visits of the facilities or local areas. For merger applications, the Board's staff uses a measure developed by the U.S. Department of Justice for antitrust purposes to determine if competition will be lessened.

However, the Board's assessment of whether local conditions will provide reasonable promise of success for a proposed branch and existing banks and branches is inadequate. It is reasonable to expect that to determine if there will be promise of success, at least the following variables would be examined:

1)the annual return on assets for existing banks in the area for the last few years;
2)the average rate of growth in deposits, total assets, and net operating income for existing banks in the area for the last few years;
3)the number of banks and the area's unemployment rate, per capita income, and population growth compared to the State average.

Judging from branch bank applications, there is no consistency in terms of what group of economic statistics are examined. In reviewing seven SOT's for branch applications, the analysis included the unemployment rate, the number of banks in the area, and the growth in county deposits for six of the seven SOT's. However, only three mentioned the county's per capita income, and none of the SOT's mentioned changes in county population. Furthermore, there is no apparent correlation between the economic statistics and a recommendation of approval. For example, reviewing economic statistics for the seven branch applications, each were approved regardless if population was declining or deposit growth, per capita income or unemployment rates were significantly above or below the statewide averages.

In a written statement, the Chairperson of the Board acknowledged that the staff's analysis for assessing local conditions for establishing branch banks is "cursory." In short, the analysis of local conditions for branch banks does not intend to answer any part of the question: "Will local conditions assure reasonable success for the proposed branch bank and existing banks or branches?"

On the other hand, new bank applications included all of the above mentioned economic statistics and more, such as housing and poverty statistics for the area. New bank applications are given a closer examination of local economic conditions to determine if the new bank will operate with success. In fact, new bank applications are required to provided projections on how the bank will perform in the first three years of operations. Of the seven new bank applications reviewed by the Legislative Auditor, one recommended disapproval partially because, as the SOT indicated: "Economic conditions do not assure reasonable promise of successful operation of the new bank." The application was later withdrawn by the applicant. Yet, a year and a half earlier a new branch bank application of another applicant was approved for the same city even though the unemployment rate was higher than when the new bank application was considered.

Also, the SOT's generally do not make references to financial data that describe the financial condition of individual existing institutions in the local area, such as net operating income, and annual return on assets. All of the seven new bank applications reviewed by the Legislative Auditor had the level of deposits for existing banks in the area, three of them had the rate of growth in deposits from the previous year. However, other important financial data for existing bank institutions are not part of the analysis for new banks or branch bank applications. In essence, the SOT's do not give an impression through the use of key financial statistics on how well existing banks or branches in the area have performed over the last several years. Generally the analysis contains a standard statement that existing institutions in the area will not be adversely affected by the proposed branch because they are well established. Acknowledging that existing institutions are well established without reviewing financial data for individual institutions may overlook the possibility that existing branches or banks are performing below a criteria for reasonable promise of success. A proposed new branch may only make the situation worse.

The philosophy behind the Board's distinction between a branch and a bank with respect to assessing local conditions is that if a proposed branch does not meet with success, the bank can withdraw from the market and absorb any expenses and losses without threat to their overall stability. Of course, if a proposed bank cannot operate successfully in the area, the entire organization is lost. The following written statement from the Chairperson of the Board reflects the approach the Board has taken with respect to reviewing branch applications:

We have made proposals to the Board that the state law be amended and formal application procedures for establishing branches be eliminated for banks in sound financial condition. We propose such banks be allowed to simply notify the Commissioner of Banking of their plans, fulfill any public notice requirements and proceed if the Commissioner raises no objections within a stated period of time. A primary reason for our recommendation is that we have increasingly relied on an open competitive market and the judgement of the bank's management to be the primary determinant in whether or not a proposed new branch has a reasonable promise of success. Banks in sound condition have the resources that will allow them to enter new markets and take the risk that a new branch will not be successful. If the branch is not successful, they may withdraw from the market and absorb any expenses and losses without threat to their overall stability. If we are indeed relying on the resources and judgement of the bank's management, it is unreasonably burdensome and pretentious to require an extensive regulatory approval process.

The proposed simplified procedure for branch banks described above is similar to the process used by the Federal Depository Insurance Corporation (FDIC). Generally, a branch bank application submitted to the Board is also submitted to the FDIC for the purpose of acquiring deposit insurance. The FDIC simply requires a bank to notify it of the proposed branch by letter. The letter must contain basic information, such as the branch location, the impact the branch will have on traffic patterns, and services that will be provided.

The Legislative Auditor asserts that the law clearly requires the assessment of local conditions to be the same for branches and for banks. Furthermore, the legislative intent is a system that promotes successful branch banks, not a system that operates on the premise that if a branch bank is unsuccessful the bank can simply withdraw from the market and absorb the losses. In addition, the Board has relied on bank management to make a determination that the Legislature intended the Board to make, that is, determining if local conditions will promise reasonable success for a proposed branch and the existing branches and banks. Therefore, the Board's approach violates statute. It is the Legislative Auditor's contention that changing the intent of the legislation is under the Legislature's authority, not the Board's. Therefore, the Board should propose to the Legislature amendments to the statute.

Causes for the Lack of Assessing Local Conditions

With regard to the economic analysis of local conditions for the purpose of predicting success of a branch bank, a written statement from the Commissioner of Banking indicated the following:

The Board's policy over the years may indeed have moved away from requirements for extensive analysis and established criteria on this particular point. Staff analysis prepared for the Board today focuses instead on the bank's overall financial condition and management performance.

In summary, the Commissioner cited four reasons for not complying with the section of the code that requires such assessment for branch bank applications. Those reasons, as elaborated on below, include the lack of data to develop a criteria; the current policy has worked; it would not be in the best interest of bank management; and it would not be in the best interest of citizens of the state.

...it has not always been possible, nor in the future will it be possible, for the Division staff to do a credible analysis on the "reasonable promise of success" criteria in a particular community. There is no earnings/profit information available on only branches of banks located in a certain community of the state....

Secondly, even if local performance data was available, it would be difficult for state government to dictate criteria for the establishment of a branch in West Virginia which would work in the marketplace as well as the Board's general "open competition for healthy banks" policy has worked. We have now, and have had for many years, a banking system among the healthiest in the nation with branches established by our state chartered banks (and national banks) if and where they believe they can effectively compete. Few of our banks have failed since branching became legal and none has failed due to competitors establishing branches in their market nor due to their own decision to establish a branch....

Third, if the Board were to establish some "bright line" earnings criteria in order to approve a branch application, it appears that it might be supplanting the shareholders in determining what the "right" earnings level or performance level must be in order for a bank to conduct business in a particular community. This is more appropriately a function of the bank's management, elected by the shareholders, rather than the function of the Board....

Fourth, if the Board were to establish performance criteria for a community and deny a branch application because an existing institution in the community did not have sufficient earnings or growth performance, clearly such a policy could result in state government protecting a poorly managed bank to the detriment of a well managed one that wishes to establish a branch. Further, the community may be trapped in that it can only be served by the poorly performing bank and its citizens get no choice to do business with the better managed bank, an outcome clearly not in the public interest.

The Potential Effect of the Board's Branching Policy Whether the legislative intent for branch banking decisions should be strictly implemented or whether the Board should follow a competitive market approach is a policy issue that should be decided by the Legislature. However, the potential effect of allowing bank management to determine the success of branching instead of the Board needs to be considered. The intention of the Legislature was to have the Board determine if local economic conditions will provide reasonable success for both the proposed branch and existing financial institutions. If branching becomes strictly a bank management decision, then the immediate effect is the loss of concern of whether existing banks and branches will succeed after a new branch is established, since banks generally do not care about the impact their decisions have on the financial conditions of other banks. Local markets that cannot support additional branches will eventually result in financial difficulties for new entrants or existing institutions.

There is evidence of banks withdrawing from markets by selling branches to other banks, and there is evidence of banks incurring operating losses attributed, in part, to high expenses of branch operations. Over the past four years, the Board has received eight applications (at least one each year) to purchase the assets and liabilities of another bank's branches. Also, there is a negative correlation between the average growth of deposits for each bank office and the number of bank offices in each county. The average deposit growth for each bank office in a county was calculated by dividing the six-year compounded growth rate in deposits for each county by the number of bank offices in the county. These figures were correlated with the number of bank offices in each county. The resulting correlation equaled -0.402. Following the same procedure for one-year deposit growth from 1995 to 1996 resulted in a correlation of -0.262. The correlation is low to medium, but it indicates that average bank deposits grow at a lower rate in counties with a larger number of bank offices. Thus, the more branches, the less growth rates and profits (unless the community is growing steadily); however competition will tend to give consumers greater choices and keep consumer costs down.

Report Conclusions Overall, the Board operates effectively. Bank applications are reviewed timely and the analysis in large part is adequate, with the one exception on branch banking. In the aggregate, the banking industry in West Virginia is in good condition. The number of financial institutions identified by the Division of Banking as problem banks declined from thirteen in 1992 to five in 1997. Only three state banks have failed in the past eighteen years, and as the Banking Commissioner indicated, "none has failed due to competitors establishing branches in their market nor due to their own decision to establish a branch." West Virginia typically ranks favorably against the national average in terms of annualized return on average assets. This is illustrated in Table 4. Also, for 1996, the state's branch banks per capita is close to the national average, with the U.S. at one branch bank per 4,630 individuals, and West Virginia at one branch bank per 3,940 individuals. Branch banks per capita for West Virginia is also similar to the five surrounding states.

Annualized Return on Average Assets (R.O.A.)
Table 4
West Virginia Return on Assets Compared to National Average
West Virginia Sept. 1997 Dec. 1996 Dec. 1995 Dec. 1994 Dec. 1993
1.68 1.48 1.39 1.36 1.33
National Rank 11th 12th 13th 14th 19th
National Average 1.3 1.24 1.16 1.16 1.16
Source: Sheshunoff Information Services Inc.

Part of the Board's approach to examining branch bank applications is a shift from legislative intent. This has been done without the authority of the Legislature. The Banking Commissioner has indicated that implementing the legislative intent with respect to assessing local conditions is not feasible because of the lack of data and because it is not in the best interest of bank management or to the citizens of the state.

Recommendation 1

The Board should fully implement the statute regarding branch banking or the Legislature should consider amending the statute.