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A bank formally appealed five of its six individual component ratings (all but Sensitivity to Market Risk), as well as its overall composite rating of 3. All component ratings were rated a 3 except for the Earnings component, which was rated a 2. Management believed that the Report of Examination's (ROE) numerical ratings were not adequately supported by the examiners' written narrative, and did not accurately reflect the bank's operations, management, earnings, capitalization, and overall state of affairs.
The appeal highlighted the bank's position on each of its individual component ratings as well as the board of directors' belief that the bank was not receiving objective and balanced treatment from the OCC's supervisory and field office personnel. In this appeal summary, we will discuss and opine on each component individually, followed by an overall discussion and opinion on the composite rating.
The bank appealed the capital rating of 3 based on their capital levels and objective capital ratios-total risk based capital/risk-weighted assets have been in excess of 10 percent every quarter in 1997. Also, the bank was deemed "well capitalized" for prompt corrective action purposes. The bank denoted that their capital strength was competitive to the average ratios of their principal correspondent banks, and that unlike their correspondent banks, they had no off-balance-sheet exposure to exotic swaps or risky derivatives. All of their investments were in U.S. Treasury bills.
The bank believed that the examiners completely ignored the objective capital ratios, choosing instead to focus on the subjective elements. The bank disagreed with the ROE's comments that the wholesale funding strategy and relatively high appetite for credit risk had elevated the overall risk profile of the bank.
The ROE stated that although capital ratios exceeded regulatory minimums, they did not support the bank's risk profile. As of March 31, 1997, total risk-based capital was marginally above 10 percent. A further concern was that failure to maintain total risk-based capital of at least 10 percent would restrict access to the brokered funds market further elevating liquidity risk. The bank had experienced significant growth over the last year, approximating 80 percent. Execution of the 1995 through 1998 strategic and capital plans was accelerated. The total asset projections contained in the plan had been exceeded, while total capital projections had not, despite successful capital raising efforts. As a result, the present capital levels were below projections. The OCC did recognize the demonstrated ability of management and the board to raise capital on three separate occasions.
The Office of the Ombudsman (ombudsman) reviewed and noted that the bank's capital levels/ratios over the last two years had remained at slightly above the minimum requirements, and at times, had been slightly below. Since the examination, the bank's capital posture had strengthened through the continued retention of earnings and a small capital injection in December 1997.
The ombudsman reviewed the capital levels in relation to the bank's overall risk profile and risk management controls/processes, and agreed with the ROE conclusion that at the time of the examination, although the capital ratios exceeded regulatory minimums, a rating of 3 was appropriate. Per OCC Bulletin 97-1 (attachment, 61 FR p. 67026), 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, even if the institution's capital level exceeds minimum regulatory and statutory requirements."
The bank appealed the rating based on the improved asset quality indicators, the quality of the investment portfolio, the adequacy of the allowance for loan and lease losses, and the decline of past-due and nonperforming loans. Also, adversely classified assets as a percent of Tier 1 capital were reduced in half from the prior exam. The bank also pointed out that of the 29 lending relationships reviewed during the examination, only two loans were reclassified. In response to a ROE comment regarding the bank's shift toward larger commercial credits, the bank indicated that it is trying to fill in a vacuum left by large commercial banks exiting the small business market lending arena in their service territories.
The bank did implement several of the recommendations made in the ROE.
The examination rating of 3 was based on the loan and overall asset quality which remained less than satisfactory. Most loan quality indicators had improved since the last asset quality review. However, while the improvement was encouraging, all qualitative indicators remained much worse than average and the aggregate level of loans with one or more negative underwriting characteristics remained high. Particularly of concern, was that these negative underwriting characteristics were present in new loans made by the bank since the previous examination. Past dues had been high and averaged approximately 7 percent during 1997. Classified assets were above 30 percent. Investment quality was good; however, the investment portfolio comprised a very small percentage of assets, while the loan and lease portfolio comprised over 80 percent.
The level of credit risk remained high and increasing. The aggregate credit risk was not limited, managed, or controlled. Management and the board continued to focus on individual credit relationships while ignoring the aggregate risk presented by a portfolio of sub-prime credits. Furthermore, the tolerance for credit risk limits had not been established. Credit risk continued to increase as the percentage of assets comprised of loans with one or more negative underwriting characteristics increased and the loan mix shifted toward larger commercial credits.
Credit administration practices needed improvement. Areas where weaknesses were noted included the following: loan policy exceptions, problem loan identification reliant on past due status, lack of a system for tracking financial statements, lack of a system for monitoring concentrations of credit, and lack of a system for monitoring expired UCC filing.
Also, although the allowance for loan and leases losses balance was adequate, the methodology was not reflective of the inherent risk in the portfolio.
The ombudsman acknowledged the bank's comments regarding the improvement in the qualitative factors of the loan portfolio. However, as noted in the ROE, the indicators still reflected an increased level of concern, particularly given the significant growth over the last few years, the more aggressive underwriting characteristics present in loans made since the previous examination, and credit administration that warranted improvement. Furthermore, although the credit administration issues noted in the ROE might have been individually mitigated, collectively they presented an increased level of concern. Per OCC Bulletin 97-1 (attachment, FR 61 p. 67027), a rating of 3 is assigned "when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate . . . an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices."
The ombudsman agreed that at the time of the examination, a rating of 3 was appropriate. He acknowledged that since the examination date, management had implemented several of the recommendations made during the examination. These included approval of loan limits/ parameters, and a revised loan committee infrastructure whereby the loan committee will approve loans greater than $200,000 and loans with policy exceptions.
The bank appealed this rating based on the knowledge and experience level of their officers. The individuals averaged more than 20 years of banking experience in their specialized areas of operations. The bank also indicated that they were actively involved in executing the board's strategic initiatives on a daily basis. As an example, a particular loan officer personally called on the majority of all past-due accounts and talked directly to the customers regardless of the size of the loan. Also the chairman had successfully raised capital on three separate occasions. Management and employees demonstrated their commitment to the bank and its customers by using principally their own personal funds to acquire more than 25 percent of the bank's outstanding stock. Management's extensive equity investment and coinciding representation on the board of directors was a benefit, not a detriment to the bank's customers, shareholders, and overall safety and soundness.
The examination team based the 3 rating on management and board supervision, which was deemed less than satisfactory. This resulted primarily from continuing increases in the quantity of risk inherent in the bank's operations and strategies combined with risk management systems that were not adequate in relation to the quantity of risk. The ROE acknowledged management's positive accomplishments, such as their experience levels, success at raising capital on three occasions, improvement in the asset quality indicators, and improvement in the bank's earnings posture. The ROE stated that although bank management concurred with some of the recommendations and/or weaknesses noted in the examination, and in fact had implemented some of these recommendations, overall, management had not been timely or proactive in improving risk management systems, particularly, in higher risk areas.
Also, independent risk control systems (i.e., loan review, internal audit, compliance management) needed improvement. On different occasions, management and the board have attempted to compensate for this by retaining consultants to provide the services. The success of these attempts has been sporadic because of unanticipated events affecting the service providers, to which management and the board have been slow to make alternative arrangements.
The ombudsman recognized, respected, and appreciated management's depth and tenure of experience, the positive efforts in raising new capital and the steps taken to implement corrective measures recommended during the examination. However, as noted in OCC Bulletin 97-1, a rating of 3 may be assigned when risk management practices are less than satisfactory given the nature of the institution's activities. At the time of the examination, the management team had not implemented risk management processes that adequately identify, monitor, and control risk in various key areas of the bank. Also independent risk control systems (i.e., loan review, internal audit, compliance management) needed improvement. Therefore, a rating of 3 was appropriate. The rating should not be viewed as a reflection of management or the board's abilities or skills, but rather of risk management practices that needed improvement.
The bank appealed the 2 rating. Management believed the bank's earnings were outstanding and should have been rated a 1 based on the objective numbers, primarily, the net interest margin above 7 percent, the annualized return on average equity in excess of 20 percent, and the annualized return on average assets above 1 percent. The bank indicated that earnings had more than doubled in each of the last three years, and that this pattern was likely to repeat again in 1997.
During the examination, the bank's earnings performance was considered good. Performance had improved as a result of continued strength in the net interest margin and improved efficiency. Earnings performance was fee sensitive, with fees relating to lending and leasing activities approximating 20 percent of total interest and fees. Also, despite the noted improvement, efficiency and overhead expense ratios remained very high.
The ability to sustain the trend in earnings performance was somewhat questionable in view of the need to manage the risks associated with present business strategies more effectively, and potential earnings exposure to interest rate, credit, and liquidity risks. Budgeting and forecasting processes have stalled; thus no budget and earnings forecasts were prepared for 1997. Also, the ROE recommended a review of the officer compensation practices. Commissions were paid for originating and/or purchasing loans and leases with no qualitative controls such as independent reviews of the assets and/or performance benchmarks, which precede commission awards.
A rating of 2 indicates earnings that are satisfactory and sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings. The rating was appropriate given the bank's earnings posture and the budgeting and forecasting processes that have stalled.
The bank informed the ombudsman that the bank had revised the compensation practices, and that the board of directors' executive committee will review officer compensation practices at least annually. Thus far, they are satisfied that current compensation levels are in relation with the return to shareholders, capital, and overall risk profile of the bank.
The bank appealed the 3 rating based on growth of approximately $15 million in assets since 1994 which they indicated had been well-managed and prudent. They also stated that the growth had come within their geographical market in conservative products (residential mortgages, commercial loans, and equipment leases). They did not have any exotic investments, hedges, swaps, or other derivatives. They do not pay above market rates for brokered deposits and have retained more than 20 percent of these customers and cross-sold them on other bank products. Certificates of Deposit and Federal Home Loan Bank Board advances are only two of the five primary sources of funding; others include local customer deposits, credit union direct purchases, and loan sales and participations. The bank had taken steps to improve the overall risk management.
Liquidity was rated a 3 based on a high and increasing level of liquidity risk combined with ineffective liquidity risk management practices. Rapid asset growth since 1994 was funded without a defined contingency funding plan. Also, the loan-to-deposit ratios were very high with the loan-to-deposit ratio in excess of 95 percent, and the loan-to-core-deposit ratio slightly above 100 percent. The $2 million investment portfolio, which was 76 percent of that pledged on March 31, 1997, provided nominal secondary liquidity.
The elevated risk profile had not been accompanied by an increase in the quality of liquidity risk management. There were no liquidity risk limits and no contingency funding plans. While management had enjoyed recent success in selling loans and developing relationships with the financial institutions that had purchased the loans, the potential risk associated with this strategy of employing wholesale funding sources to originate, purchase, and then sell loans had not been well-identified, monitored, managed, or controlled.
The ombudsman concurred with the 3 rating based on the funds management practices, discussed above, which are in need of improvement. Per OCC Bulletin 97-1 (attachment, FR 61 p. 67029), institutions rated a 3 "evidence significant weaknesses in funds management practices."
The bank appealed the composite rating primarily on their appeal of the above component ratings. The board of directors believed that supervisory and examination personnel had lost their ability to provide impartial, balanced supervisory oversight over the bank's operations. The bank further indicated that they felt they were suffering from retribution for its successful appeal of its examination ratings in early 1995.
As mentioned throughout the discussion of the component ratings, the bank was rated a 3 primarily as a result of a continued increase in the quantity of risk inherent in the bank's operations and strategies, combined with risk management systems that needed improvement. The ROE did acknowledge management's success in increasing fee income resulting in an improved earnings performance, the successful cultivation of relationships with institutions eager to purchase different types of loans, and management's ability to raise additional capital when needed. However, the bank had not implemented effective risk management systems commensurate with the increased risk. Effective risk management includes established limits on the level of acceptable risk, controls systems, and adequate management information systems.
In January 1997, the OCC in conjunction with the other federal supervisory agencies issued a revised rating system that reflects an increased emphasis on risk management practices. The issuance, OCC Bulletin 97-1, "Uniform Financial Institutions Rating System and Disclosure of Component Ratings," contains explicit language emphasizing management's ability to identify, measure, monitor, and control risks. The federal agencies recognize that management practices, particularly as they relate to risk management, will vary considerably among financial institutions depending on their size and sophistication, the nature and complexity of their business activities, and their risk profile. However, each institution may properly manage its risks and have appropriate policies, processes, or practices in place that management follows and uses.
The fundamental issue during any examination, and in particular this examination, is the accurate assessment of the bank's risk profile and the processes and controls in place to manage that risk. The ombudsman carefully reviewed the issues highlighted in the bank's appeal letter, the Report of Examination, and supporting documentation. Also, lengthy discussions were held with bank management, OCC supervisory personnel, and with key managers from the core policy unit of the OCC's Bank Supervision Policy group. The ombudsman concurred that at the time of the examination, the risk management processes in place in key areas of the bank were in need of improvement, particularly, in loan portfolio management, liquidity, and sensitivity to market risk. The growth in the bank over the last two years coupled with the strategy of purchasing and selling loans necessitated a more comprehensive risk management system. As the risk profile of the bank increased, management did not sufficiently enhance the bank's processes and controls. Since the examination, management had implemented several of the recommendations made in the ROE.
The ombudsman's opinion on the various issues of this appeal was as follows: