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Appeal of Composite Rating of 4 and Several Component Ratings - (Third Quarter 1998)

Background

A bank formally appealed its composite CAMELS rating of 4.  The Uniform Financial Institutions Rating System is used to rate six components of a bank's performance:
capital, asset quality, management, earnings, liquidity, and sensitivity to market risk (CAMELS) in a combined composite rating.  Management cited several reasons for the appeal, including:

  • Factual errors in the Report of Examination (ROE);
  • A feeling on the part of the board of directors and management that the examiner was overzealous, and came into the bank with a predetermined conclusion to downgrade the bank's overall condition;
  • General statements were made in the ROE that did not have backup, or could be considered improper statements; and,
  • The CAMELS component ratings were not justified based on the ROE and condition of the bank, and the overall conclusions were therefore inappropriate.  Management acknowledges that many of the deficiencies identified in the ROE are legitimate and corrective action has been implemented.  However, they state that they are at a loss as to why the rating dropped from a 2 to a 4 with no changes in management or operations.
Discussion and Conclusions

The bank's ROE stated the following reasons for the composite rating downgrade from a 2 to a 4:

  • The overall condition of the bank deteriorated significantly as a result of deficient management supervision and board oversight.  Risk management systems are inadequate, and the level of problems and risk exposure is excessive.
  • Management and board supervision has not been effective.
  • Capital is deficient relative to the bank's increased risk profile, earnings have deteriorated and are poor, asset quality and credit administration need improvement, sensitivity to market risk is moderate, and liquidity is satisfactory.
  • Supervision of management bank information systems is unsatisfactory.

The supervisory office acknowledges that certain factual errors were made in the ROE; although the errors are regrettable, none of the errors affected the examination conclusions.  In the appeal letter, the board of directors stated they believed the examiner-in-charge was overzealous and had predetermined that the bank's rating should be downgraded.  As examiner objectivity and professionalism are fundamental elements in effective bank supervision, this contention was taken seriously. 

After review of related documentation and discussions with all parties involved, the ombudsman did not find evidence that the examiner-in-charge nor members of his staff were biased toward the bank.  However, certain aspects of the communication of the examination findings could have been handled more effectively.  Bank management noted a number of general statements in the ROE that they considered to be unsupported and improper.  The statements referenced were primarily those that contained adjectives such as "material, significant, and substantive" in describing various identified weaknesses.  Since management considers the examination conclusions and ratings to be inappropriate, their objection to the adjectives used to describe the identified deficiencies and exceptions is understandable.  The following discussion and conclusions regarding the assigned ratings will help resolve management's objection to the referenced statements.

Capital

The bank's capital ratios declined significantly between examinations, primarily the result of purchasing a large amount of deposits from another bank that was closing a branch.  Losses identified during the examination also contributed to the decline in the bank's capital ratios.  The result of the aforementioned events caused the bank's capital ratios to fall to the "adequately capitalized" category, and the examination resulted in capital being rated a 4.  While it is apparent the capital ratios declined significantly, implicit in a 4 rating is concern about the viability of an institution, which was not the situation in the case of this bank.  Further, it is reasonable to assume management's projections for profitability are attainable, and that earnings should return to a level sufficient to supplement capital.  Therefore, the ombudsman concluded that a capital rating of 3 was appropriate.  A rating of 3 indicates a less than satisfactory level of capital that does not fully support the institution's risk profile.  The rating indicates a need for improvement, which is evident in this case.

Asset Quality

The level of classified assets remains high at over 60 percent of Tier 1 capital plus the allowance for loan and lease losses (ALLL).  There is little improvement from the level of classified asset to capital ratio recorded at the previous examination.  The level of classified assets has been high for the past three examinations.  While some of the credit administration issues in the ROE may individually be mitigated, collectively they represent a concern. 

As defined, a rating of 3 is assigned when asset quality and/or credit administration practices are less than satisfactory.  Trends may be stable; however, the level of classified assets is elevated, indicating a need to improve risk management practices.  The ombudsman concurred with a 3 component rating for asset quality.

Management

The ROE is very critical of "deficient management supervision and board oversight."  The ROE states that problems and significant risks have not been adequately identified, measured, monitored, or controlled.  A number of deficiencies were identified in the examination that support that conclusion; i.e., accounting errors that materially overstated earnings and capital, ineffective strategic/ capital planning and budgeting, and weaknesses in internal controls, audit, and management information systems. 

The deteriorating condition of the bank is undeniable, and there is no question that deficiencies in board and management supervision have been a factor in that decline.  However, the bank's capital and earnings problems are largely attributable to the deposit acquisition and the ALLL allocation made at the examination in question.  The large ALLL allocation should not reoccur since it was attributable to a change in the ALLL analysis process, and it is reasonable to assume that the net interest margin should improve as the bank is able to gradually employ a greater percentage of the acquired deposits into higher yielding loans. 

The ombudsman recognized the steps management had taken to implement corrective measures.  The bank's supervisory record with the OCC indicates that the board and management team have been cooperative and there is no reason to believe they cannot implement corrective action with respect to the weaknesses noted at this examination.  However, the deteriorating condition of the bank is undeniable, evidencing a need for improved risk management.  The ombudsman concluded that a component management rating of 3 was more appropriate than the assigned 4.  The 3 management component rating clearly acknowledges that overall management and board supervision warrant improvement.

Earnings

Most of the earnings problems are attributable to onetime adjustments and the temporary impact of the deposit acquisition.  The bank achieved a small profit for the year despite the adjustments made, and management is projecting a return on average assets of 0.75 percent for this year.  While many of the bank's earnings problems are attributable to a one-time adjustment, improvements in the quality of earnings are also needed.  Earnings have declined for four consecutive years, and even if the bank meets its current projections and achieves a return on average assets of 0.75 percent, earnings performance would remain below average. 

Per OCC Bulletin 97-1, a rating of 3 indicates earnings that need to be improved.  Discounting the one-time adjustment and deposit purchase, earnings may not fully support operations and provide for the accretion of capital and ALLL levels.  The ombudsman concluded that a component earnings rating of 3 was more appropriate than the assigned 4.

Liquidity

While there were several statements in the ROE that the bank disagreed with, there was no disagreement regarding the component rating.  Based on the ROE and the bank's response thereto, improvements could be made in the accuracy of information provided in the funds management/liquidity area.  Liquidity is satisfactory and the rating of 2 remains unchanged.

Sensitivity to Market Risk

The primary reason for the 3 component rating in the ROE was "the bank's poor earnings and deficient capital do not support the current level of IRR" [interest rate risk].  While the ombudsman acknowledges the bank's level of interest rate risk is moderate when compared to other banks, this is not the case relative to the bank's capital and unsatisfactory earnings.  The ombudsman found the rating of 3 remained appropriate.

Composite CAMELS Rating

The ombudsman agreed that the bank has significant deficiencies in its risk management processes, which have contributed to deterioration in the bank's overall condition.  However, the deterioration was not to the point that failure is a distinct possibility.  Management has already addressed many of the issues identified during the examination and, with the OCC's guidance, the bank can be returned to sound financial footing. 

The composite CAMELS rating of 4 were upgraded to a 3.  As stated in the Uniform Financial Institutions Rating System, institutions rated 3 exhibit some degree of supervisory concern in one or more of the component areas.  Such financial institutions exhibit a combination of weaknesses that may range from moderate to severe.  Their management may lack the ability or willingness to effectively address weaknesses within appropriate time frames.  Financial institutions in such a group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2.  Additionally, financial institutions rated 3 may be in significant noncompliance with laws and regulations.  Risk management practices may be less than satisfactory relative to the institution's size, complexity, and risk profile.  Such financial institutions require more than normal supervision, which may include formal or informal enforcement actions.  Failure would appear unlikely, however, given the overall strength and financial capacity of 3-rated institutions.

Appeal of a Composite 3 CAMELS Rating - (Third Quarter 1998)

Background

A bank formally appealed the composite CAMELS rating of 3 that was confirmed a second time during a follow-up visit to the bank.  Six months prior to this visit, a full-scope examination was performed that initially resulted in a composite rating of 3.  The major reason for the first 3 composite rating was the board's and management's failure to correct several ongoing credit administration and risk management deficiencies.  The credit administration and risk management deficiencies were particularly troubling because the bank sustained 50 percent growth during the past year.  Classified assets were relatively high, at slightly over 50 percent of capital.  Earnings performance was below average and recent trends were negative. 

The above-mentioned risks resulted in several "Matters Requiring Board Attention" (MRBA) comments relating to loan staffing and credit administration, loan review, compliance, and internal audit, in the Report of Examination.  At the time of the examination, capital was not considered a major issue, in part because of plans to inject a large amount of capital during the following year.  The bank did not disagree with the findings of the initial examination. 

Six months later, the follow-up visit was performed to assess the bank's progress in correcting the MRBA comments included in the initial Report of Examination.  The revised policies, procedures, and systems in the lending area, the recently completed audit, loan review, and compliance reports were also reviewed.  The results of that visit were positive.  The examiners concluded that the board and management had substantially addressed all the deficiencies noted as MRBAs at the previous examination.  The examiners noted significantly improved risk management systems and stated the bank now had the personnel and systems in place to provide adequate coverage for audit, compliance, and loan review.  However, the previously assigned composite rating of 3 was maintained because of concerns regarding the adequacy and management of the bank's capital and earnings posture.  The bank had continued to grow rapidly between the examination and the visit.  While substantial capital injections had taken place (although short of the amount originally projected), management still had not developed a realistic capital plan. 

In the bank's appeal, bank management stated the OCC had committed to upgrade the composite rating to a 2, if the MRBAs were satisfactorily addressed.  The bank further stated the amount of equity capital injected was sufficient to keep the bank's capital ratios within the definition of well capitalized.

Discussion

Composite ratings are based on a careful evaluation of an institution's managerial, operational, financial, and compliance performance.  The six key components used to assess an institution's financial condition and operations are capital adequacy, asset quality, management capability, quantity, and quality of earnings, the adequacy of liquidity, and sensitivity to market risk.  The rating scale ranges from 1 to 5.  The composite ratings of 2 and 3 are defined as follows:

Financial institutions with a composite rating of 2 are fundamentally sound.  For a financial institution to receive this rating, generally no component rating should be more severe than 3.  Only moderate weaknesses are present and are well within the board of directors' and management's capabilities and willingness to correct.  These financial institutions are stable and are capable of withstanding business fluctuations.  These financial institutions are in substantial compliance with laws and regulations.  Overall risk management practices are satisfactory relative to the institution's size, complexity, and risk profile.  There are no material supervisory concerns and, as a result, the supervisory response is informal and limited. 

Financial institutions with a composite rating of 3 exhibit some degree of supervisory concern in one or more of the component areas.  These financial institutions exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than 4.  Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames.  Financial institutions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2.  Additionally, these financial institutions may be in significant noncompliance with laws and regulations.  Risk management practices may be less than satisfactory relative to the institution's size, complexity, and risk profile.  These financial institutions require more than normal supervision, which may include formal or informal enforcement actions.  Failure appears unlikely, however, given the overall strength and financial capacity of these institutions.  [From Federal Financial Institutions Council.  "Uniform Financial Institutions Rating System," Federal Register, December 19, 1996, Vol. 61, No. 245, p. 67026, attachment to OCC Bulletin 97-1.]

Conclusions

A fundamental issue during any examination is the accurate assessment of the bank's risk profile, and the processes and controls in place to manage that risk.  The deterioration in the bank's financial condition noted during the initial examination, coupled with substantive growth, warranted a more comprehensive risk management process than existed at the time.  The detailed MRBAs included in the initial examination helped guide management in improving the bank's risk assessment systems.  Improvement of the bank's risk management processes was evident during the follow-up visit by the supervisory office.  The major problems noted at the initial examination had or were being satisfactorily resolved.  Loan quality had improved, additional staff was in place, internal audit was satisfactory and administrative problems in the lending, and compliance areas were significantly improved.

Based on the bank's risk profile, it became very important for management to maintain an adequate capital base.  Equally important was the need for a capital plan, which provides various alternatives for the maintenance of satisfactory capital consistent with the bank's risk profile.  Management must also develop an overall strategic plan that includes a comprehensive focus on maintenance of adequate capitalization.  This is particularly important in light of the growth opportunities shared with the ombudsman's office during the visit to the bank.  The plan should include growth targets, capital projections, and a determination of the level of capital needed for the bank in both the short and long term.

After the ombudsman reviewed the issues noted in the bank's appeal letter, the initial ROE, the follow-up review, and discussions conducted with bank management and the OCC supervisory personnel, the ombudsman concluded that a composite rating of 2 was appropriate, as a result of the follow-up visit.  The improvements that occurred between the examination and the follow-up visit reflected positively on the ability of the board and management team to supervise the bank.  This was a major factor in the ombudsman's decision to change the rating.