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A bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the supervisory office's (SO) conclusions communicated in the most recent report of examination (ROE). Specifically, the bank appealed the following:
The appeal acknowledges that the bank had not completed certain elements of the EA when the examination began; however, the appeal asserts that the ROE does not present an accurate picture of the significant efforts the bank undertook before the examination to comply with the EA.
The appeal contends that the ROE's depiction of the bank being in noncompliance with the articles of the EA does not conform with OCC Bulletin 2018-41, "OCC Enforcement Actions: OCC Enforcement Action Policies and Procedures Manuals," and implies that the bank has irrevocably failed to meet the EA's requirements. The appeal contends that the ROE should instead note "compliance" or "not in compliance" when assessing compliance with the EA articles. In addition, the appeal made the following statements about the assessment of noncompliance for nine articles of the EA:
The appeal asserted that the SO's characterization of the events leading to the transfer of a low-quality asset to the bank's balance sheet resulted in a violation of 12 USC 371c was not correct. The appeal argued that the transferred loan was not a purchase of a low-quality asset but the conclusion of an agreement that was part of a transaction solely to help the bank during the financial downturn.
The appeal asserted that the SO directed loan charge-offs and the reversal of interest income, which resulted in refiling the call report and the 12 USC 161 violation. The SO's actions, the appeal added, did not align to the OCC's guidance related to the COVID-19 pandemic.
The appeal stated that the current credit risk assessment does not reflect the bank's considerable efforts to improve credit administration and is not consistent with the OCC's risk-based approach to evaluating small community banks.
The appeal disagreed with the 3-rated component ratings for asset quality, earnings, and IT. The appeal asserted that 4-rated management is not reflective of factual findings and the progress bank management made to address concerns in the EA.
The appeal asserted that the bank made significant progress with the EA articles and no longer met the definition of "troubled condition" per 12 CFR 5.51.
The Ombudsman conducted a comprehensive review of the appeal using the following supervisory standards in effect at the time of the examination:
The Ombudsman concurred with the SO on all issues appealed but revised various sections of the ROE for clarity and accuracy and to acknowledge actions taken by the bank's board and management. The revisions made several changes to the status sections of the articles of the EA to better illustrate steps taken by the board and management in an effort to comply with the EA.
The Ombudsman agreed with the SO that the bank did not comply with the articles of the EA and was therefore in noncompliance with the EA. The appeal itself noted that the bank had not completed certain elements of the EA. OCC Bulletin 2018-41 states:
When an article is designated in compliance, the bank has adopted, implemented, and adhered to all of the corrective actions set forth in the article; the corrective actions are effective in addressing the deficiencies; and the OCC has verified and validated the corrective actions. An article must not be deemed in compliance simply because the board and management have made progress or a good faith effort toward complying with the article.
The ROE stated only two articles were verified.
The Ombudsman agreed with the SO and its use of the term "noncompliance" in the ROE, as it is substantively similar and has the same legal effect as the phrase "not in compliance." Noncompliance is defined as "a state of not being in compliance." OCC policies sometimes use the term "noncompliance" with the EA to refer to a bank being "not in compliance" with one or more of the articles of an EA.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Management/Board Oversight article. The board did not meet its commitment for this article to have competent staff in place, and the bank experienced several staffing changes in key executive management positions. At the time of the examination, many key executive officer positions either remained vacant, were filled recently, or filled by employees who lacked sufficient time in the positions to demonstrate effectiveness.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Strategic and Capital Plan articles but pending validation. The SO provided a determination of no supervisory objection (NSO) to both plans in the ROE. According to these articles, the board cannot implement the strategic and capital plans until the SO provides its NSO. Therefore, the SO correctly noted the articles as noncompliance-pending validation due to additional time needed for management to fully implement and demonstrate adherence to the plans.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Asset Quality article as board and management had not addressed several article requirements at the time of the examination. The SO correctly confirmed that the board submitted a loan policy but it was not effectively implemented. Weaknesses were noted in the pre-funding analysis of purchased loan participations, compliance with approval authority, loan exception reporting, and minimum underwriting/policy exception rate limits. The SO noted a significant number of financial exceptions in the loan sample during the examination. Finally, the SO appropriately considered the size, complexity, and risk profile of this institution when assessing compliance with this article.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Concentration article and is past due, as the board and management had not addressed several requirements of this article as of the examination. The Concentrations of Credit Policy lacked several requirements of this article including a written analysis of all concentrations of credit, appropriate concentration sublimits, and portfolio-level concentration stress tests.
The Ombudsman agreed with the SO that the bank is in noncompliance with all sections of the ALLL article and is past due. The ALLL balance is not properly supported by a sound methodology that is consistent with generally accepted accounting principles (GAAP). Refer to OCC Bulletin 2006-47. The methodology is lacking support for impairment analyses, historical loss rates, and qualitative adjustments to historical loss rates. The ALLL policy does not address the specifics of the bank's impairment processes and is silent on the bank's approach regarding commercial loans adversely classified as substandard or worse. Further, management is not timely recognizing problem loans or conducting impairment analysis to allocate provision expenses to remedy deficiencies in the ALLL in the quarter the need for a provision expense is discovered.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Problem Loan Identification article as they have not developed an effective program to ensure lending officers timely and accurately identify problem loans. The bank's lending staff's assignment of risk ratings is the first line of defense for accurate loan risk ratings. Refer to OCC Bulletin 2020-50. The SO correctly noted that bank personnel failed to identify loan downgrades and changes to accrual status. This included four downgrades initiated by the SO and six downgrades initiated by the external loan review.
The Ombudsman agreed with the SO that the bank is in noncompliance with the Problem Loan Identification article and is past due as more actions are needed. The loan review scope does not include testing of retail loans, assessing the bank's credit analysis and effectiveness of problem loan workout plans, as well as conclusions on the identification and amount of nonaccrual loans, credit analysis and documentation, and overall credit administration practices such as extension and renewal practices and troubled debt restructurings.
The Ombudsman agreed with the SO that the bank is in noncompliance with the CFP article and is past due. The SO correctly noted that the CFP does not include quantified projected effects of the stress scenarios on cash flow. The stress scenarios do not address potential regulatory ratings changes, the loss of Prompt Corrective Action well-capitalized status, or the potential impact from the retention of deposits subject to rate cap restrictions and other volatile sources of funding as required by the article.
The Ombudsman agreed with the SO that the bank violated 12 USC 371c when the balance of a problem loan was transferred back to the bank's balance sheet. A member bank and its subsidiaries may not purchase a low-quality asset from an affiliate unless the bank, pursuant to an independent credit evaluation, committed itself to purchase such asset before the asset was acquired by the affiliate. The appeal acknowledged that the bank purchased the loan from an affiliate and that it was a low-quality asset. There is no evidence of a written contract or agreement that the loan was originally sold subject to a repurchase agreement or with recourse.
The Ombudsman agreed with the SO that the 12 USC 161 violation is supported. Management must recognize the loan charge-offs noted by the SO in the proper period. In addition, management must allocate a corresponding provision expense and refile the call report for the same period and any subsequent periods that are affected by these adjustments. The OCC's COVID-19 related guidance states the OCC would not criticize efforts to accommodate customers in a safe and sound manner; however, the guidance does not preclude management's responsibility to ensure that loans are assigned the proper risk rating and accrual status. The SO's conclusions were not contrary to this guidance. Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets are not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value; however, banks should not maintain an asset on the balance sheet if realizing its value would require long-term litigation or other lengthy recovery efforts. Losses should be recorded in the period an obligation becomes uncollectible. Refer to the "Rating Credit Risk" booklet.
The Ombudsman determined the misstatement of financial statements was an overstatement of earnings, and as a result, retained earnings and ultimately tier one capital. The "Regulatory Reporting" booklet addresses materiality and when regulatory reports, including the call report, should be refiled. The booklet refers to the FASB's Concepts Statement No. 8, "Conceptual Framework for Financial Reporting," which states, "Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity."
The Ombudsman agreed with the SO's credit risk assessment of high quantity of risk, weak risk management, and high and increasing aggregate risk. The moderate classified levels, ineffective problem loan identification, an unidentified concentration, elevated credit losses, and high nonperforming asset levels, loan losses, and credit and collateral exceptions support a high quantity of credit risk. New and recurring deficiencies in management and board oversight of asset quality functions represented significant supervisory concerns and weak credit risk management. The aggregate level of credit risk is high, based on high quantity and weak credit risk management. Examiners should consider both the quantity of credit risk and the quality of credit risk management to derive the conclusions for aggregate level of credit risk. Refer to Appendix A of the "Community Bank Supervision" booklet. The SO's assessment of increasing direction of credit risk is supported. There is a potential for unidentified risk and losses in the loan portfolio due to an unreliable internal problem loan identification system, as well as the potential for an inadequately funded ALLL balance due to an inadequate methodology.
The Ombudsman agreed with the SO's rating of 3 for the asset quality component rating. A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. There is generally a need to improve credit administration and risk management practices. Refer to the Uniform Financial Institutions Rating System section of the "Bank Supervision Process" booklet. The SO correctly noted weaknesses in multiple key credit risk management and administration functions that require improvement. The examination found risk management weaknesses in concentration risk management, untimely and unreliable problem loan identification, an unsupported ALLL balance and methodology, external loan review, reviewing appraisals for participations purchased, and a violation of 12 USC 371c.
The Ombudsman agreed with the SO's rating of 3 for the earnings component. A rating of 3 indicates earnings that need to be improved. Earnings may not fully support operations and provide for the accretion of capital and allowance levels in relation to the institution's overall condition, growth, and other factors affecting the quality, quantity, and trend of earnings. Refer to the Uniform Financial Institutions Rating System section of the "Bank Supervision Process" booklet. While recent earnings are positive, the SO properly concluded that earnings rely on a nonrecurring source of income and newly established sources of income that have not yet demonstrated sustainability and stability.
The Ombudsman agreed with the SO's rating of 3 for the IT component. A rating of 3 indicates that financial institutions and service providers exhibit some degree of supervisory concern because of a combination of weaknesses that may range from moderate to severe. The SO properly noted that the bank exhibits some degree of supervisory concern because of a combination of moderate weaknesses. New IT matters requiring attention (MRA) cited in the ROE are valid and align to standards in the FFIEC IT Examination Handbook. While each MRA by itself may not support a rating of 3, the following deficient practices, when combined, illustrate moderate to severe weaknesses that warrant supervisory attention to ensure satisfactory corrective actions.
The Ombudsman agreed with the rating of 4 for the management component. A rating of 4 indicates deficient management and board performance or risk management practices that are inadequate considering the nature of an institution's activities. Refer to the Uniform Financial Institutions Rating System section of the "Bank Supervision Process" booklet. The bank experienced significant changes in key executive management positions throughout the supervisory period in the form of either vacancies remaining unfilled for a prolonged period of time or high turnover in the positions within a short period of time. This resulted in lack of continuity in senior management, failure to timely and adequately implement corrective actions to resolve supervisory concerns, and deterioration in existing risk management and operational processes.
The Ombudsman agreed with the SO that pursuant to 12 CFR 5.51, the bank's troubled condition designation continues to be supported by the supervisory record. The SO accurately noted the following safety and soundness concerns underlying the designation: significant issues with bank management and board oversight, credit administration, asset quality, corporate governance, and IT. The board also made insufficient progress in addressing the articles of the EA.