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Appeal of Composite Rating and Component Ratings, Loan Classifications, Matters Requiring Attention, and Violations of Law (Third Quarter 2012)


A community bank appealed the composite rating and component ratings for capital, asset quality, management, and earnings as assigned at the most recent examination. Ratings were changed from the previous examination as follows: composite, capital, and management from 2 to 3, earnings from 3 to 4, and asset quality remained a 3. The bank also appealed the risk rating classifications of four commercial loan relationships and eight Matters Requiring Attention (MRAs) related to audit, strategic planning, succession planning, capital planning, call report, problem loan identification, the Allowance for Loan and Lease Losses (ALLL) methodology, and concentration of credit risk monitoring. The bank further appealed violations of the call report under 12 U.S.C. § 161(a) and Regulation O under 12 C.F.R. § 215.8(b)(2).


Loan Classifications

The appeal stated the Report of Examination (ROE) contained many inaccuracies and errors. The bank asserted that the four commercial loan classifications (ranging from substandard/accrual to loss) were inappropriate.

Relationship (1) consisted of a line of credit secured by used cars downgraded from pass to substandard/accrual based on the lack of curtailments, inspections, and financial analysis. The supervisory office found numerous loans extended without principal reductions. The appeal asserted the loan was not established as a floor plan and should be rated pass based on the longevity of the relationship, the volume of turnover, and the borrower’s ability to utilize his own funds to prepare the autos for resale.

Relationship (2) consisted of two notes secured by machinery downgraded from pass to substandard/nonaccrual based on insufficient cash flow and an overly liberal repayment program. The appeal asserted the loan should be rated pass because, while the borrower was struggling, liquidation of the debt was not jeopardized, the borrower was willing to pay, and the bank board was actively monitoring the credit on an informal watch list.

Relationship (3) consisted of a revolving line of credit secured by real estate and internally rated substandard/nonaccrual. The supervisory office directed the loan to be charged off based on a lien search, which revealed no collateral support due to an existing subordination agreement. The appeal asserted the charge off was premature. At the time of the examination, the bank was in litigation with the participating bank. Subsequent to the exam, the bank gained access to the real estate. The appeal asserted the bank should have been allowed to rebook the loan.

Relationship (4), related to Relationship (3) above, consisted of a term note and a line of credit secured by real estate internally rated substandard/nonaccrual. The supervisory office directed the loans to be charged off based on the same reasons listed above. Bank management disputed that the supervisory office directed the charge off. The appeal asserted that bank management itself informed the examiners about circumstances which rendered the relationship uncollectible and directed the charge off during the examination.

Matters Requiring Attention (MRAs)

Three MRAs appeared in the ROE as repeat issues (audit, problem loan identification, and the ALLL methodology). The appeal asserted, however, that these MRAs were corrected after the previous examination, and the statement that management has not demonstrated the ability or willingness to address MRAs was incorrect. During the appeal review, the supervisory office discovered it had erroneously included the audit MRA as a repeat issue. Therefore, this MRA was disregarded and the Ombudsman requested the supervisory office to correct its records. Regarding problem loan identification, the supervisory office based this MRA on the four loan downgrades noted above, representing 29% of the number of loans reviewed, and deficient credit analysis. The appeal asserted a new credit analysis form was developed with numerous analyses performed. Regarding the ALLL methodology, the supervisory office based this MRA on problem loan identification weaknesses, ineffective loan review, and lack of compliance with regulatory guidance that required identification of impaired loans and adjustments to the historical loss percentages for qualitative factors. The appeal claimed this MRA was inaccurate because a change in ALLL templates used to complete the analysis yielded only an immaterial difference in the required ALLL balance.

In its appeal, the bank disagreed with the need for succession planning, strategic planning, and capital planning MRAs. The supervisory office supported these MRAs based on a minimum number of board members, lack of formal board and management succession plans, lack of a well-conceived strategic plan coupled with low loan demand, and earnings and capital erosion. The appeal asserted these findings were unfounded because the board held informal discussions regarding these plans and attempted to increase board membership and cross-train staff.

The appeal further asserted disagreement with the need for an MRA on concentration of credit risk monitoring. The supervisory office found the bank was not calculating concentrations by loan segments with similar risks, but rather by collateral code and numerous loan categories. The appeal asserted it was not accurate to state the bank did not identify or monitor concentrations of credit or the risk posed. As a bank primarily concerned with agriculture-based lending, the bank claimed that weather is the primary risk factor, which is mitigated by crop insurance and the assignment of government checks; therefore, industry classifications are not necessary.

Violations of Law

Based on the reasons above, the appeal asserted the bank did not violate 12 U.S.C. § 161(a) as it relates to errors in the ALLL methodology, weak problem loan identification, and failure to recognize losses in a timely manner. Likewise, the appeal asserted the related call report MRA was inappropriate. The supervisory office cited the violation and issued an MRA not only for the weaknesses noted above, but also due to two deficiencies in call report preparation and material errors in call report schedules for two quarters.

The supervisory office cited a violation of 12 C.F.R. § 215.8(b)(2) when bank management failed to produce documentation of a loan made to an insider. The appeal admitted the bank erred in its retention of loan records, but this was due to an employee mistake. The bank was unaware that it had to notify examiners that an insider loan had been made.

Composite and Component Ratings

The appeal further contended that the composite rating downgrade based upon deficient board supervision and other weaknesses (risk management practices, problem loan identification, ALLL methodology, and call report), was not accurate. The appeal asserted the board is very informed and involved. The appeal also stated the asset quality rating was inaccurate because the bank did not experience an increase in problem loans since the previous examination, loans were properly risk rated, the supervisory office disregarded pertinent information about the loans, and loan review was effective. The appeal further asserted that earnings and capital ratings were inaccurate based on inappropriate examiner classifications and charge-offs.


The ombudsman reviewed the information submitted by the bank and the supervisory office. The Uniform Financial Institutions Rating System as defined in the Comptroller’s Bank Supervision Process Handbook was used as the standard for determining the appropriate composite rating and component ratings for capital, asset quality, management, and earnings. The ombudsman also relied on 12 C.F.R. § 215.8; 12 U.S.C. § 161; the Comptroller’s Floor Plan Loans, Rating Credit Risk, and Concentrations of Credit Handbooks; and OCC Bulletin 2006-47, “Allowance for Loan and Lease Losses,” as standards for the analysis.

Loan Classifications

With respect to Relationship (1), the ombudsman found the loan relationship exhibited well-defined weaknesses and concurred with the substandard/accrual rating. The borrower did not demonstrate an ability or willingness to abide by the loan agreement, which was lax in terms of renewals, curtailment, and payoff requirements, nor did the bank require compliance. Other weaknesses included a lack of thorough, independent, and regular collateral inspections. A review of floored automobiles revealed an increase in permanent working capital with stagnant vehicles that should have already been paid off. The loan also exhibited several structural weaknesses including an overly liberal repayment plan, inadequate financial analysis, and weak or waived covenants.

With respect to Relationship (2), the ombudsman found the loan relationship exhibited well-defined weaknesses and concurred with the substandard/nonaccrual rating. Well-defined weaknesses included significant net losses and cash flow deficiencies. Collateral value was sufficient, precluding a worse rating. The inability to pay principal and interest and increasing principal balances warranted nonaccrual status as the full collection of principal and interest was in doubt.

With respect to the credit risk rating of loss for Relationships (3) and (4), the ombudsman found both relationships exhibited loss characteristics and concurred with this rating. When the bank entered into a subordination agreement with a participating bank, the collateral was rendered uncollectible. Therefore, both relationships warranted charge off during the examination or possibly earlier. Subsequent to the exam, the bank gained access to some of the collateral securing Relationship (3); however, the loan was not eligible to be rebooked because it should have been charged off during a much earlier period. Any proceeds from the sales of collateral must be treated as a recovery.

Matters Requiring Attention (MRAs) and Violations of Law

With respect to the strategic plan and succession plan MRAs, the ombudsman found them to be appropriate. Part of the management rating is the ability of the board and management to plan for and respond to risks that may arise from changing business conditions or new activities or products. Management’s informal strategic planning process fails to address the bank’s deteriorating financial condition, eroding capital base, product line development, growth targets, etc. Likewise, management exhibits weaknesses in its board and management succession planning.

With respect to the capital plan MRA, the ombudsman found it to be appropriate. Despite the short turnaround times, the MRA only required the bank to draft a capital plan by April 30th. The Formal Agreement requirement to reach a certain level of capital by June 30th is not an appealable matter. Likewise, granting extensions to meet Formal Agreement requirements is beyond the purview of the Ombudsman’s Office.

With respect to the call report MRA, the ombudsman found parts of the MRA were appropriate. Material errors identified in Schedules RI, RC-C and RC-K of the call report support the MRA. However, the statement in the ROE that management failed to accurately report the ALLL was inaccurate. In addition, the statement that management filed amendments to the call report to correct the ALLL-related error was also inaccurate. The bank made the required changes to the ALLL prior to filing the call report.

With respect to the violation of 12 U.S.C. § 161(a), the ombudsman found there was a call report violation based on material discrepancies with Schedules RI, RC-C, and RC-K. However, references to an inaccurate ALLL, failure to identify problem credits and losses, and overstated loan balances, inasmuch as they impact the accuracy of certain call reports, were inaccurate. As stated above, that particular call report was accurate for the ALLL and loan balance items. The ombudsman requested the supervisory office correct the supervisory record to reflect these changes.

With respect to the problem loan identification MRA, the ombudsman found it to be appropriate. Problem loan identification was weak and needed improvement as evidenced by the downgrade of four of 14 loans reviewed or 29% of the sample, which is significant. Also, despite the use of a new credit analysis form, the analyses were insufficient.

With respect to the ALLL MRA, the ombudsman found it to be appropriate. Despite the use of various templates to construct the ALLL analysis, the ALLL methodology did not comply with the requirements of OCC Bulletin 2006-47, “Allowance for Loan and Lease Losses,” which requires banks to analyze loans for impairment and develop homogeneous pools, among other requirements. The bank’s inability to identify problem loans in a timely manner materially affected the ALLL analysis and balance.

With respect to the concentration of credit risk MRA, the ombudsman found it to be appropriate. Industry codes, in addition to some other methods, have been the standard for assessing concentration of credit for many years. Pools of loans that may perform similarly because of common characteristics or common sensitivity to economic, financial, or business developments have been the primary cause of credit-related stress. By coding only by collateral, the bank runs the risk of not identifying a particular sector of an industry that may pose significant risk.

12 C.F.R. § 215.8(b)(2) requires each bank to maintain records of extensions of credit to insiders of the bank, including the amount and terms of each credit. The ombudsman found the bank violated this regulation when it failed to maintain such records. Management admitted it erred in its lack of record retention. Failure to retain loan documentation, especially related to an insider, is evidence of serious internal control weaknesses.

Composite and Component Ratings

With respect to the asset quality rating of 3, the ombudsman found the bank’s asset quality and credit administration practices exhibited characteristics of this rating and were less than satisfactory. At the time of the examination, the level of classified assets was elevated. Total past dues and nonaccrual loans to total loans were high, increasing, and well above peer banks. Net losses, due to loan charge offs taken during the examination, were also very high and well above peer banks. In addition, credit administration practices were weak due to a deficient ALLL methodology, poor problem loan identification, liberal underwriting practices, poor loan structure, deficient credit analysis, high level of policy and underwriting exceptions, deficient concentration of credit monitoring, and ineffective loan review.

With respect to the earnings rating of 4, the ombudsman found the bank’s earnings exhibited characteristics of this rating and were deficient. Earnings were insufficient to support operations and maintain appropriate capital and the ALLL after significant charge-offs taken during the examination required an additional provision expense. This caused retained earnings to plummet, which negatively affected the bank’s capital position. Net interest margin was also low compared to peer and was negatively impacted by a sizeable portfolio of low yielding investments and nonaccrual loans. Despite classified assets declining after the charge-offs were taken, future earnings may be further hampered by a high level of nonaccrual and past due loans.

With respect to the capital rating of 3, the ombudsman found the bank’s capital position exhibited characteristics of this rating and was less than satisfactory. The bank’s level of capital at the time of the examination did not fully support the bank’s moderate/high and increasing risk profile. The bank suffered significant losses at the examination and during a recent prior year, causing a significant decline in the Tier 1 leverage ratio. Additional sources of capital are limited.

With respect to the management rating of 4, the ombudsman found board and management supervision exhibited characteristics of this rating and was deficient. Risk management practices were inadequate considering the moderate/high and increasing risk to the bank and the nature of its activities. Inadequate risk management practices stem from deficient systems, policies, procedures, or personnel and include poor strategic and succession planning in addition to the weaknesses mentioned under the asset quality rating above. The number and magnitude of problems at the time of the examination were excessive for a bank with limited staff and specialized expertise. In addition, these problems require more than normal supervision to correct.

With respect to the composite rating of 3, based on the collective facts as presented above, the ombudsman found the bank’s overall condition reflected this rating. At the examination, the bank exhibited several unsafe and unsound practices including serious financial and managerial deficiencies that raised supervisory concern. The bank exhibited moderate/high and increasing risk. Management has shown the inability or unwillingness to address weaknesses in the appropriate timeframes as evidenced by repeat MRAs and ongoing issues with several problem loans that were either not recognized as problems or were not charged off in a timely manner. Large charge offs taken during the examination and a previous year caused significant losses and capital erosion. The bank also violated call report and insider laws. In addition, several risk management practices were less than satisfactory including call report auditing, loan review, strategic planning, and capital planning. The bank exhibited further weaknesses in its credit administration practices and ALLL methodology. Therefore, the overall condition was less than satisfactory. The board and management were encouraged to work with their supervisory office to correct the identified deficiencies and violations of law and regulation raised in the examination.