Appeals of Material Supervisory Determinations: Guidelines
SARC-2004-03 (June 15, 2004)
On March 1, 2004, “Bank” filed an appeal with Michael J.
Zamorski, Director, Division of Supervision and Consumer Protection (“DSC”).
The Bank contested ratings assigned in the July 7, 2003 joint report of
examination to the Capital, Asset Quality, and Management components, as
well as the assigned Composite rating. The Bank also contested the
Substandard classification accorded the credit relationship of ***, et. al.
The Bank filed additional materials in support of its appeal on March 31st
and April 8th.
Mr. Zamorski declined to grant the Bank’s appeal. The
appeal was then automatically referred to the Committee as required by the
Guidelines for Appeals of Material Supervisory Determinations, 60 Fed. Reg.
15923 (March 28, 1995). On April 26th, the Bank’s President, ***, advised
that the Bank’s representatives wished to appear before the Committee to
present their views. The Committee granted the Bank’s request. A hearing was
held on May 11th. Appearing on behalf of the Bank at the May 11th meeting
were Bank Chairman and CEO “A”, “B” and “C”.
The Committee has carefully considered the written
submissions made by the Bank and DSC, as well as the oral presentations made
at the May 11th meeting. In accordance with the Guidelines, the scope of the
Committee’s review was limited to the facts and circumstances as they
existed at the time of the examination. No consideration was given to any
facts or circumstances that developed after the examination.
The Uniform Financial Institutions Rating System provides
that the capability and performance of management and the board of directors
is rated based upon, but not limited to, an assessment of the following
• The level and quality of oversight and support of all
institution activities by the board of directors and management.
• The ability of the board of directors and management,
in their respective roles, to plan for, and respond to, risks that may
arise from changing business conditions or the initiation of new
activities or products.
• The adequacy of, and conformance with, appropriate
internal policies and controls addressing the operations and risks of
• The accuracy, timeliness, and effectiveness of
management information and risk monitoring systems appropriate for the
institution’s size, complexity, and risk profile.
• The adequacy of audits and internal controls to
promote effective operations and reliable financial and regulatory
reporting; safeguard assets; and ensure compliance with laws, regulations,
and internal policies.
• Compliance with laws and regulations.
• Responsiveness to recommendations from auditors and
• Management depth and succession.
• The extent that the board of directors and management
is affected by, or susceptible to, dominant influence or concentration of
• Reasonableness of compensation policies and avoidance
• Demonstrated willingness to serve the legitimate
banking needs of the community.
• The overall performance of the institution and its
As defined under the Uniform Financial Institutions Rating
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 Management component was rated “3” at the examination.
The Bank’s appeal sets forth the position that management is effective and
that issues raised by examiners, if viewed in the proper context, do not
indicate performance that is less than satisfactory. Such issues included
inappropriate lending activities and inaccurate loan risk ratings, apparent
violations, and the lack of loan committee minutes and effective
communication with the board.
However, the Bank’s appeal does not present new facts or
information, available during the examination, that would contradict the
information assessed or dispute many of the underlying facts relied upon by
examiners. While a number of corrective measures have been undertaken, the
following matters discussed in the Examination Report indicate that board
and management performance needs to improve.
• The business strategy resulted in a significant
concentration of capital comprising higher-risk commercial real estate
credits. A small number of relationships comprised approximately 50
percent of the entire loan portfolio, despite reported efforts to reduce
exposures. Allowing such large relationships to develop is indicative of a
flaw in risk management and analysis.
• Credit monitoring and risk assessment practices need
improvement. Examiners took exception to a number of the Bank’s assigned
risk ratings. The failure to identify the degree of risk in the *** line
is noteworthy due to the attention paid to this relationship during late
2002 and 2003, as well as the relative significance of the relationship,
which approximated 20 percent of capital and reserves as of March 2003.
Yet, the loans were not reflected on the watch list or subject to
higher-risk allocations within the allowance for loan losses. In addition,
neither administrative nor internal audit personnel identified the failure
to deposit rent receipt during the period of December 2002 to May 2003,
despite the renewal and modification in February and March of 2003,
respectively. The administrative and managerial weaknesses noted are all
the more important in light of the Bank’s concentration in commercial real
• The failure to maintain loan committee minutes,
particularly given the discoveries of irregular lending activity, is
indicative of the need for enhanced overall supervision of the Bank’s
activities. The Bank’s board essentially abdicated its fundamental
responsibilities to the loan committee. That committee minutes were not a
standard, documented part of board meeting deliberations is a lapse in
effective supervision by the Bank’s board.
• The control structure and audit procedures need
improvement. The Bank’s Audit Policy inappropriately inserts operating
management into the planning, conduct, and reporting of the audit function
by requiring submission of written reports to management, requiring
management approval of annual risk assessments, and requiring management
approval of audit planning memoranda. Allowing management to present
internal audit reports to the board interferes with the independence of
the internal audit team, demonstrating a weakness in board oversight.
In light of the identified weaknesses, risk management
practices are not considered sufficient relative to the Bank’s size,
complexity, and risk profile. The Committee concurs with the examination’s
assessment of the Management component and with the assigned rating of “3.”
Asset Classification As described in the Manual of Examination
Policies, loan classifications express differing degrees of the risk of
nonpayment. Substandard loans are inadequately protected by the current
sound worth and paying capacity of the obligor or of the collateral pledged,
if any. Loans so classified must have a well-defined weakness or weaknesses
that jeopardize the liquidation of the debt and are characterized by the
distinct possibility that the bank will sustain some loss if the
deficiencies are not corrected.
Additional guidelines are also provided in classifying
troubled commercial real estate loans, which supplement the uniform
guidelines discussed above; the supplemental guidelines are to be applied in
instances in which the obligor is devoid of other reliable means of
repayment, with support of the debt provided solely by the project. The
supplemental guidelines provide that well-defined weaknesses include a
project’s lack of marketability, inadequate cash flow or collateral support,
failure to complete construction on time or the project’s failure to fulfill
With respect to he Substandard classification of the ***;
et. al. relationship, the Bank’s appeal indicates that four of the ten
adversely classified loans have been paid, with recoveries realized in all
four instances. The Bank’s appeal also notes that the Bank’s agreement to
sell the remaining assets will result in a significant recovery, which will
be in addition to the recoveries of $3.5 million on the thirteen notes paid
to date; together, the Bank’s appeal contends that these events or
developments validate the Bank’s internal analysis and prior charge-offs,
demonstrate the strength of the pledged collateral, and brings into question
the Substandard classification.
However, the Bank’s appeal presents no factual
inaccuracies in the Examination Report and provides no new information that
was available during the examination but not considered by examiners. The
Examination Report noted that the subject credits were more than 300 days
overdue, and in nonaccrual status, and that the Bank was pursuing collection
through foreclosure, among other actions. In addition to noting the
distressed conditions under which the properties would be marketed, the
Examination Report also noted the potential risk in the central sponsor’s
bankruptcy proceedings, risk in obtaining title to the properties, and
uncertain settlement costs to clear mechanics liens.
The possibility of loss in the classified assets continued
subsequent to the examination, and the proposed third-party acquisition of
the remaining assets had not yet been completed. The Committee concurs with
the examination’s assessment of the relationship and with the assigned
Asset Quality Rating The Uniform Financial Institutions Rating System
provides the following qualitative and quantitative factors bearing on the
Asset Quality component rating:
• The adequacy of underwriting standards, soundness of
credit administration practices, and
appropriateness of risk
• The level, distribution, severity, and trend of
• The adequacy of the allowance for loan and lease
losses and other valuation reserves.
• The credit risk arising from or reduced by off-balance
• The existence of asset concentrations.
• The adequacy of loan policies, procedures, and
• The ability of management to properly administer its
• The adequacy of internal controls and management
As defined under the Uniform Financial Institutions Rating
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.
The Asset Quality component was rated “3” at the
examination; the Bank’s appeal describes management efforts to provide for
satisfactory asset quality and credit administration practices, citing
efforts to address problem credits, reduce sponsor concentrations, maintain
staffing, and provide for analysis of loan requests. The Bank’s appeal
contends that the increase in classified assets is concentrated in three
credit relationships that present extraordinary circumstances, are not
reflective of portfolio quality, and have a low probability of future
The Committee recognizes the Bank’s efforts to address
problem relationships and other matters. Nonetheless, the asset quality and
credit risk management practices are less than satisfactory.
The weaknesses are most evident in the level of adverse
classifications, which rose to 73 percent of capital and the allowance for
loan and lease losses, and the overdue loan ratio of 13.8 percent as of June
30, 2003. The increased level of classified or troubled credit
relationships, regardless of the underlying cause, is immoderate.
The Examination Report also raised a number of issues
relative to credit administration. Internal risk ratings were inaccurate in
one-third of the relationships reviewed by examiners, which brings into
question the reasonableness of the Bank’s watch list, the sufficiency of
loan review and monitoring, and the adequacy of the allowance for loan
The Bank’s appeal asks for a lower level of supervisory
concern regarding the Bank’s concentrations, noting the geographic
diversification within the loan portfolio, the relatively short-term nature
of the portfolio and its disbursal by product type, and the reduction of
sponsor concentrations in number and degree. The Bank’s appeal also argues
that, based on historical loss rates, the commercial real estate sector
presents less risk than commercial and industrial loans.
The Manual of Examination Policies states that
concentrations add a dimension of risk which management should consider when
formulating plans and policies. In formulating these policies, management
should, at a minimum, address goals for portfolio mix and limits within the
loan and other asset categories. However, the Bank’s loan policy lacks
parameters that serve as effective limitations, as nearly 50 percent of the
loan portfolio is composed of 9 borrowers, and 98 percent is composed of
loans categorized as commercial real estate. The high concentration is
exacerbated by the proportion of the Bank’s balance sheet resources invested
in outstanding loans; as of March 2003, the ratio of net loans to total
assets comprised 80 percent of the Bank’s assets.
Overall, the conditions evident during the examination
raise financial and operational concern, regardless of the underlying causes
of loan problems and despite efforts to reduce concentrations. The noted
administrative and qualitative issues weigh on the asset quality rating
determination and heighten supervisory concern regarding the significant and
continuing weakneses in the Bank’s control environment, including the
administrative and control failures involving the *** Relationship and the
lack of loan committee minutes, among others. The Committee concurs with the
examination’s assessment and with the assigned Asset Quality rating.
The Uniform Financial Institutions Rating System provides that the capital
adequacy of an institution is based on an assessment of the following
• The level of capital and the overall financial
condition of the institution.
• The nature, trend, and volume of problem assets, and
the adequacy of allowances for loan losses and other valuation reserves.
• Balance sheet composition and concentration risk.
• Risk exposure represented by off-balance sheet
• The quality and strength of earnings.
As defined under the Uniform Financial Institutions Rating
A rating of 2 indicates a satisfactory capital level
relative to the financial institution’s risk profile.
The Bank’s appeal contends that capital warrants an
assigned rating of “1.” The Bank notes that the September 2003 capital
measures place the Bank in the upper quartile of the standard peer group and
in the top ten percent of institutions included in the self-prepared custom
peer group. In part, the Bank’s appeal attributes these rankings to the
Bank’s internal methodology, which resulted in minimum leverage and total
risk-based capital thresholds of 8 and 11 percent, respectively. Further,
the board adopted regulatory recommendations to maintain an additional
amount of capital over the thresholds, which led the Bank to establish goals
for the leverage and total risk-based measures of 9 and 12.5 percent,
respectively. The Bank’s appeal also notes that the board opted to
temporarily increase capital levels above the minimum thresholds due to the
problem loans identified.
However, the comparisons to a custom peer group are
flawed, given that the selected group includes institutions under $2 billion
in total assets. Importantly, the Bank’s methodology fails to fully address
the unique risk profile of the institution, such as:
• A business strategy that presents inherently higher
risk due to the large proportion of assets devoted to loans. As of March
2003, net loans comprised nearly 80 percent of total assets.
• A loan portfolio that has historically been
concentrated in the commercial real estate sector, with approximately 54
percent of gross loans designated as construction and development
relationships as of March 2003.
• An overdue loan ratio of 13.8 percent as of June 2003,
a significant increase during the prior 12 months, compared to the peer
group ratio of 1.95 percent.
• An allowance for loan losses that was a marginal 0.61
times nonaccrual loans as compared to the peer group multiple of 7.51
• A level of loan commitments that was nearly double the
level reported by the peer group.
Approximately 46 percent of the 2002 capital injection was
depleted due to the operating losses emanating from the asset deterioration
and related matters. Since March 2002, capital measures have been
maintained, in large part, by asset shrinkage of more than 19 percent. In
addition, other factors bearing on the Management and Asset Quality
components increase the institution’s overall risk profile.
The Committee concurs with the examination’s assessment
and the assigned Capital rating.
The Uniform Financial Institutions Rating System requires that Composite
ratings be based on a careful evaluation of an institution’s managerial,
operational, financial, and compliance performance. Under the Uniform
Financial Institutions Rating System, a composite “3” rating is defined as
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 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.
The Bank’s appeal contends that management and the board
have been successful in overcoming extraordinary adversities and have
operated in a very safe and sound manner. In support, the Bank’s appeal
summarizes efforts or results that are worthy of a composite rating no worse
than “2,” including:
• Maintaining substantial capital and profitability
• Proactively, diligently, and effectively dealing with
asset quality issues;
• Addressing prior regulatory concerns;
• Proactively communicating with regulators regarding
issues facing the bank;
• Maintaining staffing, policies, and procedures.
However, the Bank’s appeal does not identify any facts
that were available but not considered during the examination. Moreover, the
Bank’s appeal fails to sufficiently mitigate several significant concerns
that existed at the time of the rating determination. Weaknesses, some of a
continuing nature, are evident in oversight and risk management practices,
and Bank practices and policies are weak or otherwise less than satisfactory
given the institution’s size, complexity, and risk profile.
The facts and circumstances known at the time of the
examination support that management has been reactive to adverse events
rather than maintaining a proactive risk management stance. The level of
adversely classified or troubled assets is immoderate and the trend is
unfavorable; an elevated degree of supervisory concern is warranted by the
increase in troubled assets, which, when combined with the significant
concentration of credit, results in the Bank being more vulnerable to
adverse economic trends and conditions. The concentration of credit also
detracts from quantitative benchmarks of capital adequacy.
In summary, the examination concerns and supervisory
recommendations relate to fundamental weaknesses and the Bank’s elevated
risk profile, which are appropriately reflected in the assigned ratings.
The Committee concurs with the examination’s assessment
and the assigned Composite rating.
For the reasons set forth above, the Bank’s appeal is denied.