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Appeals of Material Supervisory Determinations: Guidelines & Decisions
SARC-2000-02 (December 1, 2000)
On November 29, 2000, the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) considered the appeal of material supervisory determinations filed by [Bank] (the “Bank”).
After carefully considering the issues raised in your appeal letter dated September 11, 2000, together with all supporting information submitted by the Bank, the Committee concluded that the Management rating of “3”, the Capital Adequacy rating of “3”, and the composite rating of “3”, reflected in the FDIC’s April 17, 2000, Report of Examination (“Report”) are appropriate. The Committee also found that the classification of the subprime credit card portfolio, the determination concerning the adequacy of Allowance for Loan and Lease Losses (“ALLL”), the citation of apparent violations of laws or regulations, and the determination concerning the adequacy of internal controls are appropriate. The Committee therefore concluded that the Bank’s appeal should be denied.
Although the Committee recognizes the generally satisfactory financial indicators regarding asset quality, liquidity, and sensitivity to market risk, serious deficiencies remain that warrant the CAMELS component and composite ratings assigned. The Committee urges you to take steps to correct the deficiencies noted in the Report.
Several management weaknesses were noted in the Report, including the following (repeat criticisms from past examinations are in bold):
The board and operating management evidence deficiencies that expose the Bank to risk and must be corrected. Board oversight is considered less than satisfactory, and management has failed to establish a proper control environment. The Committee is very concerned that similar criticisms were noted at previous examinations. This demonstrates a lack of regard for regulatory recommendations and prudent banking practices. Of particular concern at this examination are continuing criticisms of internal controls and recurring instances of apparent violations of law, poor administration of the subprime credit card portfolio, an under funded ALLL, and an ineffective loan review system. These weakness warrant a component rating of “3” for Management and require your immediate attention.
Classification of Subprime Credit Card Portfolio
The Bank’s subprime credit card portfolio is characterized by high delinquency and loss rates. As of December 31, 1999, and March 31, 2000, the total delinquency ratio approximated 18.4 percent and 13.2 percent, respectively. Further, the Bank’s migration analysis indicates credit card loans in the 30-59 day and 60-89 day delinquency periods generally have a 30 percent and 50 percent loss exposure, respectively. These loss exposures present will-defined concerns that warrant classification. Management did not adequately monitor servicer activity. Loan losses during 1999 were exacerbated by the Bank failing to charge-off accounts in prior periods due to a programming fault that did not accurately identify delinquent accounts. Internal audit has not yet been expanded to cover the credit card area.
Based on the subprime portfolio’s poor quality, management’s weak administration thereof, and lack of audit coverage, examiners exercised the flexibility that the Retail Credit Policy provides and appropriately classified these loans.
Allowance for Loan and Lease Losses
Examiners also recommended providing for an additional two months of historical losses in the subprime portfolio. Guidance for the maintenance of the ALLL is provided in the Interagency Statement of Policy on the Allowance for Loan and Lease Losses (“Guidance”) dated December 21, 1993. Concerning estimated credit losses, this Guidance states:
The Guidance further states: “[W]hen determining the level for the ALLL, management’s analysis should be conservative so that the overall ALLL appropriately reflects a margin for the imprecision inherent in most estimates of expected credit losses.” The additional two months losses recommended by examiners is appropriate to account for the factors and inherent imprecision described in the Guidance.
The board is urged to adopt an appropriate ALLL methodology and to periodically assess the effectiveness of the methodology. Moreover, the board must ensure that the Bank implements an effective loan review system (which includes an effective credit grading system) that identifies, monitors, and addresses asset quality problems in an accurate and timely manner.
Apparent Violations of Law and Regulation
The apparent violation involving section 326.8(b) concerns independent testing of the Bank Secrecy Act (“BSA”) program used by the Bank and was deemed appropriate by the Committee. This regulation requires that independent testing be conducted at least annually and test procedures be thoroughly documented. The Report found no evidence that independent testing of the Bank’s BSA program had been completed since the October 27, 1997, FDIC examination. Furthermore, the BSA review in process during the examination was not adequate in scope and documentation.
The apparent violation of the Administrative Rules of South Dakota 20:07:03:12 concerns the Bank holding a non-permissible investment and was found to be appropriate by the Committee. While the Bank charged-off the investment in a non-rated security in August 1999, this action did not correct the apparent violation. Examination guidance contained on page 4.5-3 of the FDIC’s Manual of Examination Policies states, in part, “An illegally held or acquired asset is still illegal at its original amount, whether or not it has been partially or completely charged-off the bank's books.” Apparent violations of this nature should continue to be cited until such time as the security is either upgraded to investment grade quality, called, redeemed, or the bank otherwise divests of its interest in said security. Therefore this violation is, in fact, a correctable situation.
Adequacy of Internal Controls
The Report thoroughly addresses the Bank’s risk profile and qualitative factors such as level and trend of capital, volume and trend of problem assets, adequacy of ALLL, quality of management, strength of earnings, plans for growth, access to capital and other sources of capital. The subprime credit card portfolio continues to pose a significant risk to the Bank, representing 111 percent of the Bank’s Tier 1 capital as of the examination date. Although the size of the portfolio is declining, the reduction has occurred primarily from charge-offs, which impact earnings. The ALLL is not adequately funded, and risk monitoring systems such as loan review are not properly assessing the risk in the loan portfolio. Furthermore, management has not provided adequate oversight of the subprime credit card portfolio, has increased commercial real estate lending without proper loan administration controls and risk rating, has not implemented effective internal controls, and has failed to comply with laws and regulations. Overall, these weaknesses warrant a rating of “3” for the capital component.
Deficiencies cited in the Report, summarized herein, revolve around inadequate board and management oversight of the subprime credit card operations, lax loan underwriting and administrative practices, an under funded ALLL and ineffective loan review system, apparent violations of law, and poor internal controls. While asset quality is marginally satisfactory, large credit card losses, and high overhead expenses render earnings performance unsatisfactory. Although the holding company injected capital during the first quarter of 2000, capital remains unsatisfactory and the Bank’s risk profile has been elevated by deterioration in the credit quality of commercial loans, continued losses in the subprime credit card portfolio, unsatisfactory earnings, and poor risk management practice’s.
Many of the criticisms contained in the Report are repeat criticisms from one or more examinations, indicating a lack of concern for regulatory recommendations and prudent banking practices. Given the foregoing, the Report findings comport with the definition of a composite “3.”
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.
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