Appeals of Material Supervisory Determinations: Guidelines
SARC-2005-01 (August 5,
Background *** Bank (“Bank”), “City, State”, filed an appeal with
the FDIC’s Supervision Appeals Review Committee (“Committee”) on May 27,
2005. The Bank is appealing a decision issued by the FDIC’s Division of
Supervision and Consumer Protection (“DSC”), on April 28, 2005. DSC denied
the Bank’s request for upgrades of the Asset Quality and Management
component ratings, as well as the Composite rating, as set forth in an August 2, 2004, joint FDIC/”State Banking Regulator”
Report of Examination. DSC also denied the Bank’s request for an upgrade of
certain loan classifications.
The Bank’s representatives asked for an opportunity to
appear before the Committee to present their views in person. The Committee
granted the request and met with the Bank’s representatives on July 12th.
Chairman and CEO “A”, President “B”, and Directors “C” and “D” spoke on
behalf of the Bank. DSC senior staff members, both previously involved in
the examination of the Bank and involved in reviewing the Bank’s request for
review of material supervisory determinations, spoke on behalf of DSC.
In accordance with the
Guidelines for Appeals of Material Supervisory Determinations1the Committee reviewed the appeal
for consistency with the policies,
practices and mission of the FDIC, and the overall reasonableness of, and
the support offered for, the respective positions advanced.
The scope of the Committee’s review was limited to the facts and
circumstances as they existed at the time of the examination.
After carefully considering all of the written and oral
submissions and the facts of this case, the Committee has determined to deny
the Bank’s appeal.
Common Themes Raised by the Bank
The Bank’s appeal contains a number of general comments
challenging DSC’s April 28th decision. The Bank contends that
the DSC decision is based on incomplete analyses, incorrect facts,
unsupported assumptions, improper procedure, and is unresponsive to the
Bank’s arguments. These concerns were considered by the Committee in the
context of the material supervisory determinations challenged by the Bank.
This Decision does not attempt to discuss each of the assertions made by the
Bank, but they were considered as part of the Committee’s review. Overall,
we find that the conclusions set forth in the examination report are
consistent with FDIC policy and existing examination guidance, sufficiently
supported, and appropriate given the facts available at the time of the
Rating Criteria The Uniform Financial Institutions Rating System
provides that the Asset Quality component rating is based upon an assessment
of certain qualitative and quantitative factors including, but not limited
to, the following:
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 sheet transactions.
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
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.
A rating of 2 indicates
satisfactory asset quality and credit administration practices. The level
and severity of classifications and other weaknesses warrant a limited level
of supervisory attention. Risk exposure is commensurate with capital
protection and management'sabilities.
Identified The Asset Quality component
was assigned a 3 rating in the examination report. The examination report
noted improvements in the Bank’s asset quality but concluded that it was
still less than satisfactory. The report cited concerns regarding the level
of classified assets and the level of nonaccural and past due loans, other
real estate owned (“ORE”), concentrations, and construction loan risks.
The Bank responded – with
regard to classified assets and past due loans – that the loans were older
loans and were not representative of the Bank’s portfolio, that they
presented low probability of further loss, that the level of past due assets
was attributable to specific collection strategies, and that, in any event,
the assets were well supported by reserves and capital even in a worse case
scenario. The Bank asserted that its methodology of evaluating and writing
down ORE properties to appropriate levels had been sufficiently successful
such that the FDIC should be convinced that the ORE portfolio did not
subject the Bank to additional risk. The Bank stated that DSC presented no
evidence to support the “purported ‘higher risk’ nature of construction and
land development lending.” The Bank claimed that its loan portfolio was
diverse and short-term, which should lessen overall risk. The Bank also
rejected DSC’s peer group analyses.
Discussion ORE. DSC
acknowledged that the Bank's methodology for evaluating and writing down ORE
properties has resulted in minimal losses in the past. At the same time, we
concur with DSC’s view that ORE holdings are nonearning assets and are
detrimental to bank performance and condition. It is also reasonable to
conclude, as DSC did, that the Bank's success in liquidating ORE properties
during a period of strong appreciation in commercial and residential real
estate nationwide does not necessarily mean that it will be successful in
less favorable markets.
Representative Loan Portfolio.
DSC acknowledged that the three largest classified relationships may not be
representative of the overall quality of the portfolio. That being
said, the loans in question comprise 57 percent of Tier 1 capital and
reserves and clearly present an elevated risk of loss. In addition, the
nonclassified loans in the portfolio are indeed concentrated in construction
and land development and contain higher inherent risk.
Peer Group Analyses.
As noted in the report, the examination team created a custom peer group to
utilize as one component of their financial analyses. This peer group
included all insured commercial banks with total assets of $300 million to
$1 billion, resulting in a peer group of 1,308 banks. When the DSC team in
Washington, D.C., conducted its independent review, it refined the
examination team’s criteria to create a peer group to utilize as an
additional component in their financial analyses. DSC’s refined peer group
included commercial banks having total assets of $300 million to $1 billion
and having construction and land development loan portfolios that comprise
at least 25 percent of gross loans, resulting in a smaller peer group. We
believe it was appropriate for the examination team to utilize the peer
group they selected in analyzing the financial condition and performance of
the Bank and, in light of the Bank’s unique characteristics, we believe it
was appropriate for DSC to create a refined custom peer group for purposes
of furthering their analyses of the Bank’s condition, and that the criteria
used in both circumstances was reasonable. Under either approach, the
Bank’s performance was less than satisfactory.
Level of Classified Assets and Past Due Loans.
The examination report acknowledged improvements in the Bank’s asset
quality. In spite of these improvements, the Bank remained at the bottom of
its peer group in several loan quality categories, including the ratio of
current loans to total loans, the ratio of ORE to Tier 1 capital, and the
ratio of charge-offs to loans. In addition, the DSC found that the Bank's
Total Adversely Classified Items Coverage Ratio2was among the *** highest in its custom peer group. No bank in that
peer group that had a coverage ratio equal to or higher than the Bank
received an Asset Quality rating of 2. We believe that the Bank's capital
and reserve levels do not significantly mitigate asset quality concerns
given current levels of nonaccrual loans and the existing concentration and
anticipated growth in higher-risk construction and land development loans.
DSC appropriately considered a
variety of qualitative and quantitative information in assigning the Bank's
asset quality rating including the level of nonperforming loans, the level
of classified assets, the adequacy of underwriting standards, the soundness
of credit administration procedures, the appropriateness of risk
identification practices, the diversification of the loan portfolio, and the
existence of asset concentrations. The Bank's asset quality rating reflects
varying weaknesses in each of these areas. We agree with DSC that, given
the level and severity of classifications, the level of noncurrent loans,
and the level of ORE, a rating of 2 is not appropriate. The Committee
agrees with the assigned rating of 3.
Rating Criteria The Uniform Financial Institutions Rating System lists
the factors to be considered by examiners when evaluating the capability and
performance of management and the board of directors. These factors are
designed to illuminate the quality of board and executive management and
specifically encompass risk management processes. They include, but are not
limited to, 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.
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 authority.
Reasonableness of compensation policies and
avoidance of self-dealing.
The overall performance of the institution and its
Based upon its review of the Bank, and in light of the
foregoing factors, the examination report assigned a Management rating of
3. As defined under the Uniform Financial Institutions Rating System,
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 Bank contends that it should have been assigned a
Management rating of 2. As defined under the Uniform Financial Institutions
A rating of 2 indicates
satisfactory management and board performance and risk management practices
relative to the institution’s size, complexity, and risk profile. Minor
weaknesses may exist, but are not material to the safety and soundness of
the institution and are being addressed. In general, significant risks and
problems are effectively identified, measured, monitored, and controlled.
The examination report cited
a variety of weaknesses in support of the 3 rating. Among other concerns,
the report notes that the Bank’s risk management practices were less than
satisfactory, and that the board and management were affected by the
dominant influence and concentration of authority in the Chairman and CEO.
The Bank contends that the
examination report did not take into account management's accomplishments
since the 2003 examination, and that these accomplishments alone support a
rating upgrade. With regard to criticism of the Bank’s risk management
practices, the Bank asserts that many recommended practices were already
implemented; that the Bank sought assistance from the FDIC but none was
available; and that the benefits of some recommendations were unclear and
the Bank was therefore continuing its dialogue with regulators before
implementation. The Bank suggests that the level of influence exerted by
Chairman A is no different from that exerted by any other individual in a
similar position. The Bank questions whether an individual's influence
should be viewed negatively if the individual does not abuse his/her
authority. The Bank also takes exception to examination report comments
related to actions of the Special Committee, a committee created by the
board to independently investigate lending and other activities of a former
Chairman and anyone acting with him.
Management of Risk. As indicated in the examination report,the Bank's business model is
unique and intrinsically carries more risk than a traditional diversified
balance sheet. Lending activities are almost entirely focused on commercial
real estate, and residential and commercial real estate development.
Products include short- and medium-term financing for development,
re-development, and other purposes. Deposits are generated on a nationwide
basis and consist primarily of time deposits, including brokered deposit
accounts. In addition to its main office and *** branches in ***, the Bank
operates loan production offices in ***, ***, and ***.
During the July 12th
meeting, the Bank’s representatives conceded that the business model pursued
by the Bank is risky. They indicated that the Bank developed its
multi-state presence in construction lending in order to diversify but
conceded that they could not be certain whether such diversification would
mitigate risks and suggested that only time would tell. We concur with the
examination report finding that, because of its concentration on commercial
real estate development lending, the Bank may be less capable of
withstanding business fluctuations and is more vulnerable to outside
influences than other, well diversified financial institutions.
The report acknowledges that
risk management practices had improved since the 2003 examination but found
that enhanced risk management practices should be implemented. The areas
that remained to be addressed included the methodology to stratify risk
within the loan portfolio; credit administration practices and
identification of risks relating to individual loans; risks relating to
construction loans; identified loan underwriting and credit administration
deficiencies; appropriate capital adequacy methodology. The report also
refers to a Memorandum of Understanding (“MOU”)
- proposed subsequent to the 2003
examination - and describes the
recommendations that have not been fully addressed by the Bank. These
include implementation of a system to monitor all loans with capitalized
interest, implementation of an appropriate monitoring system, and completion
of a capital adequacy analysis. The Bank
points out that the MOU was never signed and there was no requirement
to fulfill the recommendations. However, DSC explained in its April 28th
decision that the provisions of the draft MOU corresponded to weaknesses
examiners identified in the 2003 examination. An MOU is not enforceable but
it is a means to draw a bank's attention to perceived deficiencies.
Recommendations contained in the draft MOU appear both reasonable in light
of the Bank’s size, complexity, and risk profile and relatively simple to
accomplish. The Bank’s failure to adequately address examiner
recommendations, whether contained in an executed MOU or not, does not
reflect positively on Bank management.
DSC stated in its April 28th letter that corporate governance
failures identified in the examination report exacerbated concerns related
to the Bank's real estate development concentration. These governance
failures included the Chairman/CEO’s dominance of, and influence over, all
short- and long-range planning, policy making, and decision making; the
turmoil and turnover at the board level; the Special Committee's failure to
complete its investigation within a reasonable period; and the Bank's
continued marginal financial performance. The Bank counters that Chairman A
does not exert significant influence over the affairs of the Bank; that he
showed considerable deference to members of the Special Committee; and that
his actions were reasonable.
Chairman A serves as the Bank's chairman, chief
executive officer and controlling shareholder. He developed and oversees
the Bank's multi-region construction and development lending business
strategy. Since the 2003 examination, he removed three independent
directors who voiced an opinion contrary to his, and he acted to curtail the
scope of an internal investigation. The board is now composed of his
spouse, his former attorney, the Bank's president, and a former consultant
to the Bank. We believe it is reasonable to conclude that the scope of
Chairman A's managerial responsibility, his role as the Bank's chief
strategist, the size of his investment in the Bank, his actions related to
the Special Committee, and his actions to remove certain independent
directors, support the contention that he exerts a dominant influence over
both the Bank’s board and its affairs.
The Bank contends that it had sufficient and reasonable
grounds for removing the three independent directors. The examination
report acknowledges that the Bank produced plausible reasons for removing
these directors and goes on to explain: “For example, Directors E and F
were removed from the Special Committee because they would not accept [what
Chairman A felt were reasonable] time limits and cost constraints to
conclude the Special Committee’s investigation so that the action on the
investigation could be turned over to the full board.” The examination
report details the history of the Special Committee, and we can appreciate
the level of frustration that accompanied the board’s efforts to bring the
Special Committee investigation to fruition. At the same time, we must
acknowledge DSC’s view that Chairman A's introduction of the resolution
prescribing time/budget constraints and his participation in the subsequent
discussion and vote is problematic, given the possibility that Chairman A
also may have been the subject of the Special Committee investigation
The Committee agrees that
the assigned Management rating of 3 is appropriate. The Committee considers
both the examiners’ findings and methodology appropriate and the resultant
rating well supported. The examiners appropriately applied outstanding
policy guidance in the evaluation of the Bank’s management. Both the
examination report and April 28th decision acknowledge
management's accomplishments. However, such actions are insufficient to
support a rating of 2 especially in light of the Bank’s appetite for risk
and the totality of weaknesses identified in the Bank.
Available Corporate Governance Guidelines As a point of general information, the FDIC and the
other banking agencies frequently publish and issue guidance for insured
institutions and their officers and directors to use to fulfill their
responsibilities. This information is available on the FDIC’s web site in a
special section called “Director’s Corner.” It includes Interagency Policy
Statements, Supervisory Guidance, and Financial Institution Letters on
various topics, including Corporate Governance Practices. The Corporate
Governance materials include the FDIC’s “Pocket Guide for Directors,” a
Statement of Policy entitled “Statement Concerning the Responsibilities of
Bank Directors and Officers,” and various regulations such as 12 CFR Part
364 entitled “Standards for Safety and Soundness.” The FDIC’s Risk
Management Manual of Examination Policies, Section 4.1 entitled “Management”
- also published on the internet - includes a discussion of the issues
facing directors of “One Man
Banks”. Finally, the FDIC offers the “Chicago
Region Director's College Program” that can be tailored to a bank’s
interests. The board may wish to take advantage of this program if they
have not already done so.
Loss Classification The Bank asserts that it was inappropriate to classify
as Loss $1.4 million in X loans because they were charged-off prior to the
examination. While it is true that the charge-offs were taken on July 2,
2004, and the examination began one month later, on August 2, 2004, the
asset review date for the examination was June 30, 2004. In its April 28th
decision, DSC stated that this treatment is consistent with typical
examination practice and is designed to ensure more meaningful ratio
calculations. DSC also indicated that,
even if the appealed classifications were upgraded to “Pass,” total
classifications would remain at a less than satisfactory level. The
Committee believes that DSC’s treatment of the loans, and the resulting
classifications, was reasonable and consistent with FDIC practices.
Composite Rating A 3 rating connotes an institution that exhibits some
degree of supervisory concern in one or more of the component areas. In
contrast, a 2 rating refers to an institution that is fundamentally sound,
but may reflect modest weaknesses correctable in the normal course of
business. The Bank asks that its Composite rating be upgraded from 3 to 2.
The Bank believes management and the board have overcome extraordinary
hurdles to operate a safe and sound financial institution. The Bank
contends that it has maintained substantial capital ratios; proactively
dealt with asset quality issues; addressed prior regulatory concerns; and
maintained effective staffing levels, policies, and procedures.
DSC cited several factors supporting a 3 rating in its
April 28th decision:
The nature and severity of management-related
deficiencies at the Bank are material.
These deficiencies, coupled with the Bank's
high-risk profile, raise questions as to whether the Bank could withstand
business fluctuations, as required for a 2 rating.
The dismissal of three directors raises questions as
to whether the Bank has the management team in place to address the
various financial and operational pressures that often accompany economic
The Bank's overall performance
and condition remains marginal.
Despite having capital ratios at the top of its peer
group, the Bank's capital position is barely adequate, given the high-risk
nature of its balance sheet, the large construction and land development
concentration, the fact that a substantial portion of the capital base is
comprised of capitalized interest reserves, and internal growth
projections that show loan growth that will reduce total risk-based
capital to 13.95 percent by June 30, 2005.
Given the facts and
circumstances existing at the time of the examination, the Bank's overall
financial condition was less than satisfactory. The Committee agrees that
the assigned Composite rating of 3 is appropriate.
For the reasons set forth
above, the Bank’s appeal is denied.
This decision is considered a final supervisory
decision by the FDIC.
By direction of the Supervision Appeals Review
Committee of the FDIC dated
August 5, 2005.
1The Guidelines are set out at 69 Fed. Reg. 41479, 41486 (July 9,
2004), and in FDIC Financial Institution Letter (“FIL”) 113-2004 (Oct.
2The “Adversely Classified Items Coverage Ratio” is the
ratio of total adversely classified
items to Tier 1 Capital and the ALLL (before adjustments for Loss