Appeal of Supervisory Office Decision to Assign the Troubled Bank Designation During the Examination (Fourth Quarter 2009)
A bank appealed to the Ombudsman the decision by the supervisory office (SO) to assign a troubled condition designation during the examination. The appeal stated the troubled condition designation was not appropriate based on the condition of the bank at that time.
The appeal states the troubled condition designation was based on incomplete analysis of the bank's condition. The troubled condition letter was received by the bank before management had several in-depth discussions with the examination team and before the bank's legal counsel sent two written submissions to the SO. The appeal states the meetings and written materials contained critically important information the examiners had not reviewed when the troubled condition letter was sent.
Additionally, the bank does not believe the legal standard for troubled condition was met. At the beginning of the examination, the bank was rated 2 and no one on the examination team stated or implied that the bank deserved a 4 or 5 rating. Further, no one stated or implied formal enforcement action was the only remedy under consideration.
Finally, the appeal asserted that the bank's overall performance exceeded that of its peer group in all but one category based upon the Uniform Bank Performance Report. While the Tier I ratio was less than peer, the bank was still well-capitalized. The level of classified and criticized assets requiring increased provisions to the allowance for loan and lease loss were manageable and resulted in the bank being more conservatively reserved than its peers.
The appeal asserts the stress the bank is under results from difficult economic conditions and not any systemic failure in credit risk management.
The SO stated sufficient information was obtained early in the examination process to determine that the condition of the bank had deteriorated and it was likely to be a problem bank. The examiners were contemplating a composite 3 rating with component downgrades in management, asset quality, and earnings. Decisions on liquidity and capital component ratings were not finalized yet.
The SO further stated capital was strained because of significant loan growth and lower earnings. Tier I capital/average assets ratio declined for 3 consecutive examinations. The bank had a strong net interest margin (NIM); however, overhead expense significantly impacted net income. It was unlikely that management would achieve its budgeted net income for year-end 2009. Dividends to the bank holding company also negatively affect retained earnings.
The SO stated classified assets increased to 79% of Tier 1 capital plus the ALLL compared to 27% at the previous examination. Special mention assets increased to 49% compared to 3% at the previous examination. Combined classified and special mention assets represented 128% of capital. The SO cited credit risk management concerns because the bank was operating without a chief credit officer, risk grading differences were identified in 19% of the credits reviewed, and additional downside risk was present in the commercial real estate portfolio.
The bank's methodology to analyze ALLL adequacy did not provide for an adequate ALLL; thus, two immediate provisions were required - one planned by the bank, the other directed by the examiners. These provisions were significant to the allowance and to earnings.
The Ombudsman reviewed the guidelines in 12 CFR 5.51 and determined the SO is technically correct in its ability to issue a troubled condition designation to the bank during the examination. According to 12 CFR 5.51, the troubled condition designation can be applied in three ways: (1) if the bank is 4 or 5 rated; (2) if a formal enforcement action is entered into with the bank; and (3) if notified in writing by the SO as a result of an examination.
As part of his review, the Ombudsman questioned if the SO's application of the regulation is consistent with the intent of the regulation. He questioned if the anticipation of downgrading the bank's composite rating to 3 and entering into a formal agreement was a sufficient reason to issue a troubled condition designation letter prior to the examination's conclusion.
The issuance of the troubled designation letter during the examination put the bank on notice about the severity of issues found but also served to invoke 914 and golden parachute restrictions. However, the letter did not specify why it was important to invoke these restrictions prior to the conclusion of the examination.
The reasons stated in the letter from the SO relate only to the bank's financial condition. The letter did not identify any circumstances that created an urgency to invoke the 914 and golden parachute restrictions.
The SO did not clearly communicate why issuing the troubled condition designation was necessary at that time. The preliminary conclusions indicated the composite rating would be downgraded to 3 and a formal enforcement action would be recommended. This would have resulted in the automatic occurrence of the troubled condition designation. Issuing the letter prior to the exam process running its course essentially says there was danger that management would initiate golden parachute payments (if they have them) or hire unfavorable personnel.
The Ombudsman further stated that although the SO's troubled condition designation letter did not communicate the reasons for the urgency; neither the regulation nor OCC policy required the letter to do so. However, the letter did support the troubled condition designation based upon the bank's financial position at that time. Accordingly, the Ombudsman concluded it was within the SO's discretion to issue the troubled bank designation letter during the examination.