Appeals of Material Supervisory Determinations: Guidelines
(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.
The Committee’s conclusions regarding the issues appealed by the Bank are
presented below together with a discussion of the reasons underlying the
The Uniform Financial Institution Rating System’s definition of a
“Management” rating of “3” follows:
“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,
Several management weaknesses were noted in the Report,
including the following (repeat criticisms from past examinations are in
• Objectionable loan administration practices,
including failure to adhere to Loan
• Staffing concerns with the credit
card collection function
• Poor loan review system
• Inadequate ALLL
• Less than satisfactory capital and earnings
• Weak internal controls and audit of credit card
• Apparent violations of law or regulations
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 Uniform Retail Credit Classification and Account Management Policy (the
“Retail Credit Policy”) issued to institutions through
Institutions Letter -17-99 on February 19, 1999, provides guidelines for
classification of retail credit loans. In general, open-end and closed-end
retail loans past due 90 cumulative days from the contractual due date
should be classified Substandard. Closed-end retail loans that become past
due 120 cumulative days and open-end retail loans that become past due 180
cumulative days from the contractual due date should be charged off.
However, the Retail Credit Policy states that there may be instances that
warrant exceptions to the general classification policy. It further provides
that the Retail Credit Policy does not preclude examiners from classifying
individual retail credit loans that exhibit signs of credit weakness
regardless of delinquency status.
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
The ALLL required a provision of between $190,000 to $290,000 to fund the
ALLL to a level that was adequate to absorb estimated credit losses. Most of
the shortfall was determined to be related to the subprime credit card
portfolio. However, due to the inadequate loan review system, reserves for
traditional loans were also deficient. Internal grading of problem loans was
not accurate as approximately 28 percent of the dollar volume of traditional
loans classified by examiners were correctly identified on the Bank’s watch
list. The examiners recommended the Bank modify its methodology for
determining the ALLL by changing its charge-off criteria for subprime credit
card loans from 120 days to 90 days and providing a margin on current
subprime credit card loans (10 percent rather the 3.5 percent reported loss
factor). The margin is deemed appropriate to account for unknown risks in
the subprime portfolio because of questionable delinquency reporting and
re-aging of delinquent accounts and the unproven effectiveness of the
in-house collection program.
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:
“[E]stimated credit losses should reflect
consideration of the institution’s historical net charge-off rate on pools
of similar loans, adjusted for changes in trends, conditions, and other
relevant factors that affect repayment of the loans in these pools as of
the evaluation date.”
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 Report listed apparent violations involving Part 323 and section
326.8(b) of the FDIC’s Rules and Regulations
12 C.F.R. Part 323 and §
326.8(b), and the Administrative Rules of South Dakota 20:07:03:12. The
apparent violations concerning Part 323 involved real estate appraisals and
were deemed appropriate by the Committee. The Report describes five loans
requiring appraisals as defined in Part 323. Appraisals were not acquired
and used in the credit decision making process prior to the loans in
question being approved and funded. Two of the five appraisals were obtained
during the examination. These appraisals were dated three and five months
after the respective loan dates. One appraisal had not yet been obtained and
the other two appraisals were in the file but were dated nearly eight months
and 11 months after the respective origination dates.
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
Adequacy of Internal Controls
The Report accurately identified a number of internal controls weaknesses,
including infrequent account reconcilement, inadequate control over
negotiable instruments and cash, and numerous issues involving the credit
card operation. Many of these weaknesses had been identified at previous
examinations and audits. While it is understood that Bank acquisitions and
Year 2000 (“Y2K”) issues consumed a significant amount of management’s time,
the board is ultimately responsible to ensure that management is maintaining
proper internal controls. The Committee therefore found these criticisms
were appropriately cited by the examiners. The addition of an internal
auditor to the Bank’s staff is a positive step towards addressing this
The Uniform Financial Institution Rating System’s definition of a “Capital”
rating of “3” follows:
“A rating of 3 indicates a less than satisfactory level
of capital that does not fully support the institution’s risk profile. The
rating indicates a need for improvement, even if the institution’s capital
level exceeds minimum regulatory and statutory requirements.”
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
The Uniform Financial Institutions Rating System’s definition of a Composite
rating of “3” follows:
“Financial institutions in this group exhibit some
degree of supervisory concerning 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 in significant 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.” (emphasis added).
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
In accordance with the Guidelines for Appeals of Material Supervisory
Determinations, the scope of this review was limited to the facts and
circumstances that existed at the time of the examination; no consideration
was afforded to any changes occurring after that date or to any subsequent
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.