Against the liabilities the bank must hold an equal amount of assets, otherwise the bank is insolvent and must close its doors. If we go into a restaurant for luncheon we are not satisfied merely to read the bill-of-fare; we want to try some of the dishes for ourselves. If we order chicken soup and the waiter brings us a bowl of warm water, we refuse to accept it, no matter if the proprietor insists that it is chicken soup that has been set before us. But when a man wishes to purchase the stock of a bank or deposit money with it, he cannot personally test for himself the quality or quantity of the assets set forth on the bank's statement and thus assure himself that the bank is sound. There may be no intention whatever on the part of the bank to deceive or defraud. The bank itself may be deceived in its ability to pay the amount of the deposit on demand just as borrowers often honestly overestimate their ability to repay a loan when it is due. Therefore the law provides an official examiner who "tests the soup" for the general public who may deposit or invest their money in the bank.
The purpose of bank examination is twofold; first, to see that the institution is solvent, having a dollar of assets with which to pay every dollar of liabilities; and, second, to ascertain that the bank is obeying the law. From the examiner's viewpoint the principal reason for insisting upon a strict observance of the law is that the bank may continue to be solvent. The nature of these laws will be explained in the final chapter.
Bank examinations are of four kinds, two of which may be said to be internal and two external. In the first class are examinations by a committee of the directors and examinations by certified public accountants whom the directors may employ to make this audit and examination for them. The official Federal, or State examinations, and clearing house examinations may be classed as external examinations. The internal examinations are, of course, not unexpected by the officers of the bank, who, with the directors, arrange for them. The official or external examinations are never announced in advance, and hence they may be said to be more effective if there should exist any condition due to fraud or weakness that might be covered up temporarily.
It is rather difficult to draw the line clearly between an audit and an examination; yet the examination by directors or accountants for the directors is more in the nature of an audit than an examination. It is the duty of the auditor of a bank to see that all settlements are properly made by the various clerks and departments, to check all cross entries on the books, to prove interest calculations, to reconcile accounts with other banks and to supervise the entire accounting system generally. In small banks one of the officers has charge of this work. When the directors make their annual or semi-annual examination they certify to the correctness of all transactions as of a certain day. Their examination includes a proof of the cash and a checking up of the loans and discounts. In very large banks they usually have the assistance of the clerks who are interchanged so that the same men will not be used in proving any books or cash to which they have previously had access. Bank directors make their examinations to assure themselves that the bank's affairs are in proper condition. Although they may commit the operation of the bank to the authorized officers, the directors cannot thus escape their responsibility or liability under the law for the safe administration of the institution. The employment of a certified public accountant to do this work is a more thorough way of making an internal examination, since the accountant and his assistants are trained men and have the advantage of a disinterested point of view.
The National or State examiners make their visits without notice; usually just after the bank has closed for the day. The settlement for that day's business is then checked and all cash, checks and securities are put under seal so that no substitution can be made over night. The examination then proceeds the following days until every detail of the business is investigated and accounted for. The general policy of the bank is taken into consideration, as indicated by the nature of the loans, the borrowing habits of the customers, the methods of accounting used and the general observance of safe and conservative business rules. Like the physician who examines a patient, the official examiner bases his methods upon the assumption that there may be something wrong which it is his duty to detect and remedy.
The clearing house examination plan is a sort of combination between the directors' examination by certified accountants and the official examination. The clearing house examiner is employed jointly by all the banks of a city and his examination is made for them, but in his power of criticism and in the timing of his visits he is independent. His examination is just as thorough as that made by the Federal or State examiner, in fact, in some cities the two examinations are conducted jointly. Where the clearing house examination differs is in the attention given to the loans and discounts. The clearing house examiner makes a record of all loans over a certain amount in every bank in the Association, so that he is able to base an intelligent opinion on the true value of the bank's largest group of assets. This information is kept under lock and key by the examiner and is used by him as credit memoranda. He is thus able to advise the banks if any local dealer is borrowing more heavily than his business warrants. The official examiners are limited in their powers of criticism to infringement of the laws, but it is the duty of the clearing house examiner to act in an advisory capacity, and to seek to prevent any unsound condition from arising. The Federal Reserve Act provides for special examinations of member banks for the purpose of informing the reserve banks of the lines of credit being extended by member banks. In principle, these special examinations are similar to clearing house examinations.
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