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Appeals of Material Supervisory Determinations: Guidelines & Decisions
SARC-2005-01 (August 5,
The Bank’s representatives asked for an opportunity to
appear before the Committee to present their views in person. The Committee
granted the request and met with the Bank’s representatives on July 12th.
Chairman and CEO “A”, President “B”, and Directors “C” and “D” spoke on
behalf of the Bank. DSC senior staff members, both previously involved in
the examination of the Bank and involved in reviewing the Bank’s request for
review of material supervisory determinations, spoke on behalf of DSC.
After carefully considering all of the written and oral submissions and the facts of this case, the Committee has determined to deny the Bank’s appeal.
Common Themes Raised by the Bank
As defined under the Uniform Financial Institutions Rating System,
A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or 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.
A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management's abilities.
The Bank responded – with regard to classified assets and past due loans – that the loans were older loans and were not representative of the Bank’s portfolio, that they presented low probability of further loss, that the level of past due assets was attributable to specific collection strategies, and that, in any event, the assets were well supported by reserves and capital even in a worse case scenario. The Bank asserted that its methodology of evaluating and writing down ORE properties to appropriate levels had been sufficiently successful such that the FDIC should be convinced that the ORE portfolio did not subject the Bank to additional risk. The Bank stated that DSC presented no evidence to support the “purported ‘higher risk’ nature of construction and land development lending.” The Bank claimed that its loan portfolio was diverse and short-term, which should lessen overall risk. The Bank also rejected DSC’s peer group analyses.
Representative Loan Portfolio. DSC acknowledged that the three largest classified relationships may not be representative of the overall quality of the portfolio. That being said, the loans in question comprise 57 percent of Tier 1 capital and reserves and clearly present an elevated risk of loss. In addition, the nonclassified loans in the portfolio are indeed concentrated in construction and land development and contain higher inherent risk.
Peer Group Analyses. As noted in the report, the examination team created a custom peer group to utilize as one component of their financial analyses. This peer group included all insured commercial banks with total assets of $300 million to $1 billion, resulting in a peer group of 1,308 banks. When the DSC team in Washington, D.C., conducted its independent review, it refined the examination team’s criteria to create a peer group to utilize as an additional component in their financial analyses. DSC’s refined peer group included commercial banks having total assets of $300 million to $1 billion and having construction and land development loan portfolios that comprise at least 25 percent of gross loans, resulting in a smaller peer group. We believe it was appropriate for the examination team to utilize the peer group they selected in analyzing the financial condition and performance of the Bank and, in light of the Bank’s unique characteristics, we believe it was appropriate for DSC to create a refined custom peer group for purposes of furthering their analyses of the Bank’s condition, and that the criteria used in both circumstances was reasonable. Under either approach, the Bank’s performance was less than satisfactory.
Level of Classified Assets and Past Due Loans. The examination report acknowledged improvements in the Bank’s asset quality. In spite of these improvements, the Bank remained at the bottom of its peer group in several loan quality categories, including the ratio of current loans to total loans, the ratio of ORE to Tier 1 capital, and the ratio of charge-offs to loans. In addition, the DSC found that the Bank's Total Adversely Classified Items Coverage Ratio2 was among the *** highest in its custom peer group. No bank in that peer group that had a coverage ratio equal to or higher than the Bank received an Asset Quality rating of 2. We believe that the Bank's capital and reserve levels do not significantly mitigate asset quality concerns given current levels of nonaccrual loans and the existing concentration and anticipated growth in higher-risk construction and land development loans.
Conclusion. DSC appropriately considered a variety of qualitative and quantitative information in assigning the Bank's asset quality rating including the level of nonperforming loans, the level of classified assets, the adequacy of underwriting standards, the soundness of credit administration procedures, the appropriateness of risk identification practices, the diversification of the loan portfolio, and the existence of asset concentrations. The Bank's asset quality rating reflects varying weaknesses in each of these areas. We agree with DSC that, given the level and severity of classifications, the level of noncurrent loans, and the level of ORE, a rating of 2 is not appropriate. The Committee agrees with the assigned rating of 3.
Based upon its review of the Bank, and in light of the foregoing factors, the examination report assigned a Management rating of 3. As defined under the Uniform Financial Institutions Rating System,
A rating of 3 indicates management and board performance that need improvement or risk management practices that are less than satisfactory given the nature of the institution’s activities. The capabilities of management or the board of directors may be insufficient for the type, size, or condition of the institution. Problems and significant risks may be inadequately identified, measured, monitored, or controlled.
The Bank contends that it should have been assigned a Management rating of 2. As defined under the Uniform Financial Institutions Rating System,
A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the institution’s size, complexity, and risk profile. Minor weaknesses may exist, but are not material to the safety and soundness of the institution and are being addressed. In general, significant risks and problems are effectively identified, measured, monitored, and controlled.
The Bank contends that the examination report did not take into account management's accomplishments since the 2003 examination, and that these accomplishments alone support a rating upgrade. With regard to criticism of the Bank’s risk management practices, the Bank asserts that many recommended practices were already implemented; that the Bank sought assistance from the FDIC but none was available; and that the benefits of some recommendations were unclear and the Bank was therefore continuing its dialogue with regulators before implementation. The Bank suggests that the level of influence exerted by Chairman A is no different from that exerted by any other individual in a similar position. The Bank questions whether an individual's influence should be viewed negatively if the individual does not abuse his/her authority. The Bank also takes exception to examination report comments related to actions of the Special Committee, a committee created by the board to independently investigate lending and other activities of a former Chairman and anyone acting with him.
During the July 12th meeting, the Bank’s representatives conceded that the business model pursued by the Bank is risky. They indicated that the Bank developed its multi-state presence in construction lending in order to diversify but conceded that they could not be certain whether such diversification would mitigate risks and suggested that only time would tell. We concur with the examination report finding that, because of its concentration on commercial real estate development lending, the Bank may be less capable of withstanding business fluctuations and is more vulnerable to outside influences than other, well diversified financial institutions.
The report acknowledges that risk management practices had improved since the 2003 examination but found that enhanced risk management practices should be implemented. The areas that remained to be addressed included the methodology to stratify risk within the loan portfolio; credit administration practices and identification of risks relating to individual loans; risks relating to construction loans; identified loan underwriting and credit administration deficiencies; appropriate capital adequacy methodology. The report also refers to a Memorandum of Understanding (“MOU”) - proposed subsequent to the 2003 examination - and describes the recommendations that have not been fully addressed by the Bank. These include implementation of a system to monitor all loans with capitalized interest, implementation of an appropriate monitoring system, and completion of a capital adequacy analysis. The Bank points out that the MOU was never signed and there was no requirement to fulfill the recommendations. However, DSC explained in its April 28th decision that the provisions of the draft MOU corresponded to weaknesses examiners identified in the 2003 examination. An MOU is not enforceable but it is a means to draw a bank's attention to perceived deficiencies. Recommendations contained in the draft MOU appear both reasonable in light of the Bank’s size, complexity, and risk profile and relatively simple to accomplish. The Bank’s failure to adequately address examiner recommendations, whether contained in an executed MOU or not, does not reflect positively on Bank management.
Corporate Governance. DSC stated in its April 28th letter that corporate governance failures identified in the examination report exacerbated concerns related to the Bank's real estate development concentration. These governance failures included the Chairman/CEO’s dominance of, and influence over, all short- and long-range planning, policy making, and decision making; the turmoil and turnover at the board level; the Special Committee's failure to complete its investigation within a reasonable period; and the Bank's continued marginal financial performance. The Bank counters that Chairman A does not exert significant influence over the affairs of the Bank; that he showed considerable deference to members of the Special Committee; and that his actions were reasonable.
Chairman A serves as the Bank's chairman, chief executive officer and controlling shareholder. He developed and oversees the Bank's multi-region construction and development lending business strategy. Since the 2003 examination, he removed three independent directors who voiced an opinion contrary to his, and he acted to curtail the scope of an internal investigation. The board is now composed of his spouse, his former attorney, the Bank's president, and a former consultant to the Bank. We believe it is reasonable to conclude that the scope of Chairman A's managerial responsibility, his role as the Bank's chief strategist, the size of his investment in the Bank, his actions related to the Special Committee, and his actions to remove certain independent directors, support the contention that he exerts a dominant influence over both the Bank’s board and its affairs.
The Bank contends that it had sufficient and reasonable grounds for removing the three independent directors. The examination report acknowledges that the Bank produced plausible reasons for removing these directors and goes on to explain: “For example, Directors E and F were removed from the Special Committee because they would not accept [what Chairman A felt were reasonable] time limits and cost constraints to conclude the Special Committee’s investigation so that the action on the investigation could be turned over to the full board.” The examination report details the history of the Special Committee, and we can appreciate the level of frustration that accompanied the board’s efforts to bring the Special Committee investigation to fruition. At the same time, we must acknowledge DSC’s view that Chairman A's introduction of the resolution prescribing time/budget constraints and his participation in the subsequent discussion and vote is problematic, given the possibility that Chairman A also may have been the subject of the Special Committee investigation
Conclusion. The Committee agrees that the assigned Management rating of 3 is appropriate. The Committee considers both the examiners’ findings and methodology appropriate and the resultant rating well supported. The examiners appropriately applied outstanding policy guidance in the evaluation of the Bank’s management. Both the examination report and April 28th decision acknowledge management's accomplishments. However, such actions are insufficient to support a rating of 2 especially in light of the Bank’s appetite for risk and the totality of weaknesses identified in the Bank.
Available Corporate Governance Guidelines
DSC cited several factors supporting a 3 rating in its April 28th decision:
Given the facts and circumstances existing at the time of the examination, the Bank's overall financial condition was less than satisfactory. The Committee agrees that the assigned Composite rating of 3 is appropriate.
This decision is considered a final supervisory decision by the FDIC.
By direction of the Supervision Appeals Review Committee of the FDIC dated
August 5, 2005.
Valerie J. Best
Assistant Executive Secretary
1 The Guidelines are set out at 69 Fed. Reg. 41479, 41486 (July 9, 2004), and in FDIC Financial Institution Letter (“FIL”) 113-2004 (Oct. 13, 2004).
The “Adversely Classified Items Coverage Ratio” is the
ratio of total adversely classified
items to Tier 1 Capital and the ALLL (before adjustments for Loss
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