Appeals of Material Supervisory Determinations: Guidelines
(February 26, 1998)
Your appeal of material supervisory determinations has
been decided. Rulings not in favor of your institution were made by the
Supervision Appeals Review Committee (“Committee”) of the Federal Deposit
Insurance Corporation (“FDIC”) on February 26, 1998, and are conveyed in
this letter. The appeal issue related to the liquidity component rating was
resolved by Nicholas J. Ketcha Jr., Director, Division of Supervision. Mr.
Ketcha’s findings are conveyed in a separate letter.
The Committee’s findings on each material supervisory
determination appealed by the [Bank] (“Bank”) is presented below along with
an explanation of the reason for the decision.
Loan Classification The Committee concluded that the Substandard
classifications assigned to the two loans listed in the Bank’s appeal are
appropriate for the reason noted below.
1. Customer A—While credit is given to
management’s market valuation of livestock, the remaining balance is not
adequately protected by the additional collateral held. Accounts
receivable, feed inventory and machinery and equipment are far less
liquid. Additionally, bank valuations for this collateral are not
supported. Other weaknesses are the significant continuing losses,
negative cash flow, and increasing debt. The market values of the real
estate owned by Company X and the … residences are acknowledged in the
report of examination. However, none of these properties are collateral
for the loans. The Bank’s references to the perceived noncompliance with
the FDIC’s policy on the Analysis and Classification of Agricultural
Credits were also reviewed. This policy addresses the need for proper
collateral controls and the importance of reviewing all areas that affect
repayment. In addition to the collateral weaknesses, we must consider the
deteriorating financial trends and the significant increase in the
financial leveraging of the … businesses.
2. Customer B—Both the X and the Y
loans are speculative in nature and neither Customer B nor the principals
have the capability or liability (in the case of the Y loan) to repay the
debt. The lack of viable sales prospects also adds risk to these loans.
The Bank has placed undue reliance upon these properties’ appraised values
in lieu of an adequate initial assessment of debtor’s repayment ability.
Other Real Estate
The Bank’s stated 7.3 percent return on book value on the Z
properties is not sufficient for such a high-risk asset. The high degree of
risk exists for a number of reasons. Income to the Bank remains volatile as
it is based on the merchandising activities of the lessee, not fixed
payments. If the lessee chooses not to renew its lease, it is uncertain
whether or not a new lessee could be found, or, if found, whether the same
amount of income could be generated. Value is questionable because of a
number of deficiencies noted in the appraisal. Even if the $8.7 million
appraised value is a fair representation of current market value (which is
not demonstrated to be the case due to appraisal deficiencies and limited
marketability) the margin of protection is insufficient for these
properties’ high degree of risk and the marginal rate of return. The Bank
has been unable to dispose of the properties for over ten years and there is
still apparently no buyer interest. The property is leased on a
year-to-year basis and the lessee is apparently not interested in entering
into a long-tem lease arrangement or in purchasing the properties.
Substantial loss exposure is present.
Capital Adequacy Rating According to the Uniform Financial Institutions Rating
System, adopted by the Federal Financial Institutions Examination Council on
December 19, 1996, a Capital component rating of “2” indicates “a
satisfactory capital level relative to the financial institution’s risk
profile. A rating of “1” indicates a strong capital level relative
to the institution’s risk profile [emphasis added].”
Adversely classified assets currently
represent 78 percent of the Bank’s Tier 1 capital plus the allowance for
loan and lease losses. The Bank’s investment in the adversely classified Z
properties equals nearly one-half of its Tier 1 Capital. Supervisory
experience has shown that even a high level of capital can quickly dissipate
during times of economic reversal when an institution’s assets and
underlying economic base are not diversified. After giving consideration to
the risks to capital posed by the level of adversely classified assets, the
concentration of the local economic base in agriculture and the operations
of …, the underwriting and administrative weaknesses identified, and the
noted management deficiencies, the Committee concludes that a Capital
rating of “2” is appropriate.
Asset Quality Rating Under the Uniform Financial Institutions Rating System an
Asset Quality component “3” rating 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
The Committee believes a “3” rating to be appropriate
given the Bank’s high level of adversely classified assets and deficient
credit administration practices.
Management Rating The Uniform Financial Institutions Rating System provides
the following guidance on the Management component rating:
“The capability of the
board of directors and management, in their respective roles, to
identify, measure, monitor, and control the risks of an institution’s
activities and to ensure a financial institution’s safe, sound, and
efficient operation in compliance with applicable laws and regulations is
reflected in this rating….Sound management practices are demonstrated by:
active oversight by the board of directors and management; competent
personnel; adequate policies, processes, and controls taking into
consideration the size and sophistication of the institution; maintenance
of an appropriate audit program and internal control environment; and
effective risk monitoring and management information systems.”
A Management 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 risk may be inadequately identified, measured, monitored, or
Given the overall condition of the Bank and
management’s historical performance, the assigned composite “3” rating
appears appropriate. Management has performed less than satisfactorily with
Response to risk from changing business conditions.
The accuracy, timeliness, and effectiveness of management
information, and risk
Responsiveness to recommendations from supervisory
Management depth and succession.
The extent that the board and management is affected by, or
susceptible to, dominant
influence or concentration of authority.
The overall performance of the Bank and its risk profile.
Examples of less-than-satisfactory management
performance are replete throughout the report and include significant credit
administration and underwriting deficiencies, the continued reluctance to
adopt a formal strategic plan, questionable management depth and succession
plans, and the lack of adherence to the terms of the outstanding Cease and
Earnings Rating Under the Uniform Financial Institutions Rating System
a rating of “3” indicates Earnings that need to be improved.
Earnings may not fully support operations and provide for the accretion of
capital and allowance levels in relation to the institution’s overall
condition, growth, and other factors affecting the quality, quantity, and
trend of earnings.
The Committee believes a “3” rating to be appropriate
given the Bank’s below average earnings performance. While it is recognized
that the Bank’s community has suffered through a severe drought, which could
have negatively impacted the Bank’s performance, on average the Bank’s
earnings performance has been significantly inferior to that of other area
banks. The potential negative impact of the high level of adversely
classified assets on future earnings is also a factor.
Sensitivity to Market Risk Rating Under the Uniform Financial Institutions Rating System
a rating of “2” indicates that Market Risk Sensitivity is adequately
controlled and that there is only moderate potential that the earnings
performance or capital position will be adversely affected. Risk management
practices are satisfactory for the size, sophistication, and market risk
accepted by the institution. The level of earnings and capital provide
adequate support for the degree of market risk taken by the institution.
The Committee believes a “2” rating to be appropriate
given the Bank’s moderate level of commodity price risk and its less than
satisfactory earnings performance.
Composite Rating The Uniform Financial Institutions Rating System
provides the following definition of a Composite “3” rating:
“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 insignificant 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
The Uniform Financial Institutions Rating
System also provides:
“…Each component rating is based on a
qualitative analysis of the factors comprising that component and
its interrelationship with the other components. When assigning a
composite rating, some components may be given more weight than others
depending on the situation at the institution….The ability of management
to respond to changing circumstances and to address the risks 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 and the level of supervisory
attention warranted. For this reason, the management component is
given special consideration when assigning a composite rating.
The ability of management to identify, measure, monitor, and control the
risks of its operations is also taken into account when assigning each
The Uniform Financial Institutions Rating System
Statement of Policy makes it clear that the composite rating should bear a
close relationship to the component ratings assigned. It is also noted that
the ability of management to respond to changing circumstances and to
address the risks 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 and the level of
supervisory attention warranted. For this reason, the management component
is given special consideration when assigning a composite rating. Viewed
from that perspective, the assigned Composite rating of “3” appears
more than amply supported. As noted above, the Management, Earnings, and
Asset Quality components are appropriately rated “3” and greatly influence
the assignment of an overall “3” Composite rating. Also, the
inability to achieve compliance with outstanding Cease-and-Desist Order and
the continuing need for an ongoing corrective program are clear indications
that the Bank requires more than normal supervisory attention.
Cease-and-Desist Order The Committee concludes that it would be inappropriate to
terminate the Order without a corrective program in place to address the
major outstanding, unresolved items. Adoption by the Bank’s board of the
newly proposed Memorandum of Understanding prepared by the Dallas Regional
Office and the State of New Mexico Regulation and Licensing Department would
achieve that objective. Once the Bank’s board agrees to adopt and execute
the document, the existing Cease-and-Desist Order could be terminated.
The Bank’s charge of age discrimination
and the possibility of retaliation, abuse or retribution by the examiner
were not considered by the Committee, although the findings on which the
Bank premises its belief were considered and are addressed above. The
FDIC’s Office of the Ombudsman is available to individuals or institutions
who believe the FDIC policy or procedure has been unfairly or erroneously
applied or that the policy or procedure itself is unfair. The Bank may also
file a complaint with the Office of the Ombudsman if it believes or has any
evidence that it has been subject to examiner retaliation, abuse, or
retribution because of its appeal of a material supervisory determination.
You may contact the FDIC’s Dallas Office of the Ombudsman by calling (214)
The scope of this review was limited to
the facts and circumstances that existed at the time of the examination and
no consideration was afforded any changes occurring after that date or to
any subsequent corrective action. In any proposed supervisory response to
the Report of Examination, the FDIC’s Dallas Regional Office will address
the Bank’s actions since the examination.
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.