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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC- 98-01 (February 26, 1998)

Your appeal of material supervisory determinations has been decided.  Rulings not in favor of your institution were made by the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) on February 26, 1998, and are conveyed in this letter. The appeal issue related to the liquidity component rating was resolved by Nicholas J. Ketcha Jr., Director, Division of Supervision.  Mr. Ketcha’s findings are conveyed in a separate letter.

The Committee’s findings on each material supervisory determination appealed by the [Bank] (“Bank”) is presented below along with an explanation of the reason for the decision.

Loan Classification
The Committee concluded that the Substandard classifications assigned to the two loans listed in the Bank’s appeal are appropriate for the reason noted below.

1. Customer A—While credit is given to management’s market valuation of livestock, the remaining balance is not adequately protected by the additional collateral held.  Accounts receivable, feed inventory and machinery and equipment are far less liquid.  Additionally, bank valuations for this collateral are not supported.  Other weaknesses are the significant continuing losses, negative cash flow, and increasing debt.  The market values of the real estate owned by Company X and the … residences are acknowledged in the report of examination.  However, none of these properties are collateral for the loans.  The Bank’s references to the perceived noncompliance with the FDIC’s policy on the Analysis and Classification of Agricultural Credits were also reviewed.  This policy addresses the need for proper collateral controls and the importance of reviewing all areas that affect repayment.  In addition to the collateral weaknesses, we must consider the deteriorating financial trends and the significant increase in the financial leveraging of the … businesses.

2.  Customer B—Both the X and the Y loans are speculative in nature and neither Customer B nor the principals have the capability or liability (in the case of the Y loan) to repay the debt.  The lack of viable sales prospects also adds risk to these loans.  The Bank has placed undue reliance upon these properties’ appraised values in lieu of an adequate initial assessment of debtor’s repayment ability. 

Other Real Estate Classification 
The Bank’s stated 7.3 percent return on book value on the Z properties is not sufficient for such a high-risk asset.  The high degree of risk exists for a number of reasons.  Income to the Bank remains volatile as it is based on the merchandising activities of the lessee, not fixed payments.  If the lessee chooses not to renew its lease, it is uncertain whether or not a new lessee could be found, or, if found, whether the same amount of income could be generated.  Value is questionable because of a number of deficiencies noted in the appraisal.  Even if the $8.7 million appraised value is a fair representation of current market value (which is not demonstrated to be the case due to appraisal deficiencies and limited marketability) the margin of protection is insufficient for these properties’ high degree of risk and the marginal rate of return.  The Bank has been unable to dispose of the properties for over ten years and there is still apparently no buyer interest.  The property is leased on a year-to-year basis and the lessee is apparently not interested in entering into a long-tem lease arrangement or in purchasing the properties.  Substantial loss exposure is present.

Capital Adequacy Rating
According to the Uniform Financial Institutions Rating System, adopted by the Federal Financial Institutions Examination Council on December 19, 1996, a Capital component rating of “2” indicates “a satisfactory capital level relative to the financial institution’s risk profile.  A rating of “1” indicates a strong capital level relative to the institution’s risk profile [emphasis added].”

Adversely classified assets currently represent 78 percent of the Bank’s Tier 1 capital plus the allowance for loan and lease losses.  The Bank’s investment in the adversely classified Z properties equals nearly one-half of its Tier 1 Capital.  Supervisory experience has shown that even a high level of capital can quickly dissipate during times of economic reversal when an institution’s assets and underlying economic base are not diversified.  After giving consideration to the risks to capital posed by the level of adversely classified assets, the concentration of the local economic base in agriculture and the operations of …, the underwriting and administrative weaknesses identified, and the noted management deficiencies, the Committee concludes that a Capital Component rating of “2” is appropriate.

Asset Quality Rating
Under the Uniform Financial Institutions Rating System an Asset Quality component “3” rating 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.”

The Committee believes a “3” rating to be appropriate given the Bank’s high level of adversely classified assets and deficient credit administration practices.

Management Rating
The Uniform Financial Institutions Rating System provides the following guidance on the Management component rating: 

            “The capability of the board of directors and management, in their respective     roles, to identify, measure, monitor, and control the risks of an institution’s   activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations is reflected in this rating….Sound management practices are demonstrated by: active oversight by the board of directors and management; competent personnel; adequate policies, processes, and controls taking into consideration the size and sophistication of the institution; maintenance of an appropriate audit program and internal control   environment; and effective risk monitoring and management information  systems.”

A Management 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 risk may be inadequately identified, measured, monitored, or controlled. 

Given the overall condition of the Bank and management’s historical performance, the assigned composite “3” rating appears appropriate.  Management has performed less than satisfactorily with regard to:

  • Oversight activities.
     
  • Response to risk from changing business conditions.
     
  • The accuracy, timeliness, and effectiveness of management information, and risk
    reporting systems.
     
  • Responsiveness to recommendations from supervisory authorities.
     
  • Management depth and succession.
     
  • The extent that the board and management is affected by, or susceptible to, dominant
    influence or concentration of authority.
     
  • The overall performance of the Bank and its risk profile.

Examples of less-than-satisfactory management performance are replete throughout the report and include significant credit administration and underwriting deficiencies, the continued reluctance to adopt a formal strategic plan, questionable management depth and succession plans, and the lack of adherence to the terms of the outstanding Cease and Desist Order.

Earnings Rating
Under the Uniform Financial Institutions Rating System 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.

The Committee believes a “3” rating to be appropriate given the Bank’s below average earnings performance.  While it is recognized that the Bank’s community has suffered through a severe drought, which could have negatively impacted the Bank’s performance, on average the Bank’s earnings performance has been significantly inferior to that of other area banks.  The potential negative impact of the high level of adversely classified assets on future earnings is also a factor.

Sensitivity to Market Risk Rating
Under the Uniform Financial Institutions Rating System a rating of “2” indicates that Market Risk Sensitivity is adequately controlled and that there is only moderate potential that the earnings performance or capital position will be adversely affected.  Risk management practices are satisfactory for the size, sophistication, and market risk accepted by the institution.  The level of earnings and capital provide adequate support for the degree of market risk taken by the institution.

The Committee believes a “2” rating to be appropriate given the Bank’s moderate level of commodity price risk and its less than satisfactory earnings performance.

Composite Rating
The Uniform Financial Institutions Rating System provides the following definition of a Composite “3” rating:

            “Financial institutions in this group exhibit some degree of supervisory concern in one or more of the component areas.  These financial institutions exhibit a combination of weaknesses that may range from moderate to severe; however, the  magnitude of the deficiencies generally will not cause a component to be rated  more severely than 4.  Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames.  Financial institutions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2.

            Additionally, these financial institutions may be insignificant noncompliance with laws and regulations.  Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile.  These financial institutions require more than normal supervision, which may include formal or informal enforcement actions.  Failure appears unlikely, however, given the overall strength and financial capacity of these institutions.”

          The Uniform Financial Institutions Rating System also provides:

            “…Each component rating is based on a qualitative analysis of the factors          comprising that component and its interrelationship with the other components.       When assigning a composite rating, some components may be given more weight than others depending on the situation at the institution….The ability of   management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating a financial institution’s overall risk profile and the level of supervisory attention warranted.  For this reason, the management component is given special consideration when assigning a     composite rating.  The ability of management to identify, measure, monitor, and control the risks of its operations is also taken into account when assigning each component rating.”

The Uniform Financial Institutions Rating System Statement of Policy makes it clear that the composite rating should bear a close relationship to the component ratings assigned.  It is also noted that the ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating a financial institution’s overall risk profile and the level of supervisory attention warranted.  For this reason, the management component is given special consideration when assigning a composite rating.  Viewed from that perspective, the assigned Composite rating of “3” appears more than amply supported.  As noted above, the Management, Earnings, and Asset Quality components are appropriately rated “3” and greatly influence the assignment of an overall “3” Composite rating.  Also, the inability to achieve compliance with outstanding Cease-and-Desist Order and the continuing need for an ongoing corrective program are clear indications that the Bank requires more than normal supervisory attention.

Termination of Cease-and-Desist Order
The Committee concludes that it would be inappropriate to terminate the Order without a corrective program in place to address the major outstanding, unresolved items.  Adoption by the Bank’s board of the newly proposed Memorandum of Understanding prepared by the Dallas Regional Office and the State of New Mexico Regulation and Licensing Department would achieve that objective.  Once the Bank’s board agrees to adopt and execute the document, the existing Cease-and-Desist Order could be terminated.

The Bank’s charge of age discrimination and the possibility of retaliation, abuse or retribution by the examiner were not considered by the Committee, although the findings on which the Bank premises its belief were considered and are addressed above.  The FDIC’s Office of the Ombudsman is available to individuals or institutions who believe the FDIC policy or procedure has been unfairly or erroneously applied or that the policy or procedure itself is unfair.  The Bank may also file a complaint with the Office of the Ombudsman if it believes or has any evidence that it has been subject to examiner retaliation, abuse, or retribution because of its appeal of a material supervisory determination.  You may contact the FDIC’s Dallas Office of the Ombudsman by calling (214) 754-6100.

The scope of this review was limited to the facts and circumstances that existed at the time of the examination and no consideration was afforded any changes occurring after that date or to any subsequent corrective action.  In any proposed supervisory response to the Report of Examination, the FDIC’s Dallas Regional Office will address the Bank’s actions since the examination.

This determination is considered the Federal Deposit Insurance Corporation’s final supervisory decision.

By direction of the Supervision Appeals Review Committee of the Federal Deposit Insurance Corporation.


Last Updated 06/30/2005 Legal@fdic.gov