Appeals of Material Supervisory Determinations: Guidelines
(April 12, 2004)
At a meeting on March 30, 2004, the Federal
Deposit Insurance Corporation’s (FDIC) Supervision Appeals Review Committee
(Committee) considered the appeal filed by [Bank] (Bank), on February 2,
2004. In its appeal, the Bank contested certain material supervisory
determinations, including the Asset Quality and Management component ratings
and Composite rating set forth in the FDIC’s September 8, 2003 Report of
Examination (Report of Examination).
The Committee consensus was that the Bank continues to be
an institution that is well managed and continues to operate at a high level
of performance. Nevertheless, after careful deliberation and consideration
of all relevant information, the Committee concluded the Bank’s appeal
should be denied. The Committee found that the conclusions contained in the
Report of Examination accurately reflected the condition of the Bank, and
that those conclusions were adequately supported by the facts and findings
in the Report of Examination. The Committee determined that the Asset
Quality and Management component ratings and the Composite rating were
consistent with the FDIC’s practices.
The scope of the Committee’s review was limited to the
facts and circumstances as they existed at the time of the examination.
Although events that occurred after the examination and any subsequent
corrective actions were not considered as part of the Committee’s review,
they will be reviewed during future onsite supervisory activities.
The bases for the Committee’s decision are discussed more
Asset Quality Rating
The appeal requested that Asset Quality component rating be changed to a “1”
rather than “2” rating assigned by the Regional Office.
The Federal Financial Institutions Examination Council’s (FFIEC)
Uniform Financial Institutions Rating System states, in part, that an Asset
Quality rating of “1” reflects strong asset quality and credit
administration practices. While the volume, level, and trend relating to
virtually all of the Bank’s qualitative Asset Quality measures present
minimal concern, examiners identified noteworthy loan underwriting and
administration deficiencies throughout the construction and development and
permanent commercial real estate portfolios at the September 2003
examination. These weaknesses are particularly evident in the loans listed
as Special Mention. The three relationships listed for Special Mention
exhibited underwriting and administration deficiencies, including the
absence of, or ineffective analysis of, the principal borrowers’ and/or
guarantors’ financial capacities as well as weaknesses in loan review and
monitoring. The Committee notes that some of these same loan underwriting
and administration deficiencies were also discussed in the FDIC’s July 11,
2000 Report of Examination.
Construction and development lending, whether related to a
“spec” home or a multi-unit condominium project, is a higher-risk activity
requiring sound credit underwriting and administration to mitigate risk.
This is particularly true for real estate markets that have seen a rapid
escalation in values, as has the greater Boston market. That weaknesses of
the nature and type identified are allowed to continue is not indicative of
“strong” credit administration practices. The Committee concludes that the
“2” Asset Quality component rating assigned is appropriate.
The appeal requested that the Management component rating be upgraded to a
“1” from the “2” rating assigned. The Committee believes the loan
underwriting and administration weaknesses, as well as weaknesses relating
to information technology, anti-money laundering efforts, and interest rate
risk management, reflect only satisfactory management performance.
Management has not consistently and effectively identified, measured,
monitored and controlled all significant risks, an important characteristic
of “1” rated managements teams. The Committee acknowledges management’s
commitment to respond to examination comments, concerns, and suggestions.
Nonetheless, management’s commitment to address weaknesses related to
fundamental risk management and loan administration practices is viewed as
reactive rather than proactive. The Committee concludes that the “2”
Management component rating assigned is appropriate.
The appeal request that the Bank’s Composite rating be upgraded to “1” from
the “2” rating assigned.
The Committee, however, agrees that the numerous material
loan underwriting and administration weaknesses identified, many of a repeat
nature, have both increased credit risk at the Bank and heightened the
Bank’s overall risk profile. Furthermore, the Report of Examination
enumerates a number of information technology, interest rate risk
management, and anti-money laundering weaknesses. The Committee also
observes that the Bank’s capital levels provide only adequate support to the
Bank’s risk profile. The Committee recognizes the improvements in earnings
and liquidity; however, the impact of these improvements on the Bank’s
overall risk profile is more than offset by the loan administration and
underwriting weaknesses detailed in the Report of Examination.
The Division of Supervision and Consumer Protection’s
(DSC) Manual of Examination Policies states that “… management’s ability
to respond to changing circumstances and to address risk 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.” Although construction, development, and commercial
real estate lending are not new to the Bank, the Bank’s involvement with
this type of lending has increased significantly in recent years without
corresponding improvements in underwriting policies and procedures and loan
administration. The Committee believes one hallmark of strong management
teams (and banks) is their proactive implementation of policies and
procedures that serve to mitigate risks associated with certain business
lines or assets. Rather than proactively implementing sound risk management
policies and procedures for the growing construction, development, and
commercial real estate segments of the Bank’s loan portfolio, the Bank’s
Board/management has continued to rely on risk management policies and
procedures that are more suitable for lower-risk residential lending.
The FFIEC’s Uniform Financial Institutions Rating System
states that banks rated Composite “1” are basically sound in every respect.
The Bank’s financial condition clearly remains satisfactory, but its overall
risk profile is sufficiently heightened by weaknesses in the administration
of the construction, development, and commercial real estate segments of the
Bank’s loan portfolio that some supervisory concern is warranted. The
Committee concludes that the Composite “2” rating assigned is appropriate.
Other Issues Raised in the Appeal
The appeal also contains detailed comments related to “as is” appraisals and
reserves for off-balance sheet items. The Committee agrees with DSC’s
recommendations regarding these issues. Validation of the Estimate Site
Values (or “as is” values) listed in Uniform Residential Appraisal Reports
that underlie one-to-four family construction loans will allow for enhanced
collateral analysis and stronger underwriting. The validation process is
especially important in markets that have experienced a rapid escalation of
property values (as has the greater Boston area). Similarly, the Committee
agrees that considering unfunded loan commitments in the Bank’s ALLL
analyses will enhance the Bank’s overall risk management program.
Admittedly, there will be situations where reserves for unfunded commitments
are unnecessary; but there will also be situations where reserves for
unfunded commitments are warranted and prudent. To clarify, reserving for
unfunded commitments was one of several factors examiners considered in
determining that there was a small reserve shortfall at the 2003 FDIC
For the reason’s set forth above, the Bank’s appeal is denied. This decision
is considered a final supervisory decision by the FDIC.
By direction of the FDIC’s Supervision Appeals Review