Appeals of Material Supervisory Determinations: Guidelines
SARC-99-07 (December 10, 1999)
Your appeal of material supervisory determinations set forth in the April
5, 1999, joint safety and soundness examination was denied by the
Supervision Appeals Review Committee (“Committee”) of the Federal Deposit
Insurance Corporation (“FDIC”) on December 7, 1999.
The State of California Department of Financial Institutions (“the
State”) was provided a copy of your letter of appeal; Deputy Commissioner
James E. Brodie has responded that the State concurs with the ratings and
overall findings of the Report of Examination (“Report”).
Before deciding your appeal, the Committee considered your request to
appear in person before the Committee for purposes of presenting witnesses
and evidence in support of your appeal. Based upon the comprehensive nature
of your October 18, 1999, appeal letter, the Committee concluded that the
record relating to your appeal was sufficiently complete and that an oral
presentation would not be productive.
The Committee has given careful consideration to the issues raised in
your letter. After review, the Committee has concluded that the rating of
“3” assigned to the Asset Quality component, the rating of “4” assigned to
the Management component, the rating of “3” assigned to the Liquidity
component, the rating of “3” assigned to the Sensitivity to Market Risk
component, and the Composite rating of “3” are appropriate as reflected in
the Report. The Committee also found that the apparent violation of Part 309
of the FDIC Rules and Regulations and the [Bank] (“Bank’s”), designation as
a troubled institution are appropriate.
Although the Committee recognizes the generally satisfactory financial
indicators regarding capital and earnings, serious deficiencies remain that
warrant the CAMELS component and composite ratings assigned. The Committee
recognizes that you have filed a Safety and Soundness Compliance Plan with
the Regional Office, which addresses steps to correct some of the
deficiencies noted in the Report. The Committee urges you to implement the
Plan, and to take steps to correct the other deficiencies noted in the
The Committee’s conclusions regarding the issues appealed by the Bank are
presented below along with an explanation of the reason for the decision.
The Uniform Financial Institution Rating System’s (“UFIRS”) definition of an
Asset Quality component rating of “3” follows:
“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.”
Asset quality has deteriorated since the previous examination, which is
evidenced by, among other things, an increase in the severity of
classifications, with loans totaling $237,000 classified Doubtful and
$512,000 classified Loss versus no Doubtful and only $67,000 classified Loss
at the previous examination. While total classifications have decreased from
$7 million at the previous examination to $6 million, the Committee notes
that a major part of the decline in total adversely classified assets was
due to the transfer of $1,400,000 in Other Real Estate (“ORE”) to a newly
created Bank affiliate following the 1998 examination.
Regarding the *** ORE property, at the time of the examination, the Bank
had been unsuccessful in obtaining final approval to develop the property
due to access and easement problems. The Committee recognizes that the Bank
has been attempting to resolve the problems. However, without resolution of
these issues, the property cannot be developed and the potential value
cannot be realized, therefore, there is a realistic possibility of loss.
Accordingly, the Committee believes that the property meets the definition
of Substandard as provided in the Division of Supervision (“DOS”) Manual and
was appropriately included as a classified asset.
Deteriorating asset quality trends, in conjunction with the weaknesses in
credit administration, underwriting, and the allowance for loan and lease
losses (“ALLL”) methodology detailed in the Report warrant a “3” Asset
The UFIRS’s definition of a Management component rating of “4”
“A rating of 4 indicates deficient management and board performance or
risk management practices that are inadequate considering the nature of an
institution’s activities. The level of problems and risk exposure is
excessive. Problems and significant risks are inadequately identified,
measured, monitored, or controlled and require immediate action by the
board and management to preserve the soundness of the institution.
Replacing or strengthening management or the board may be necessary.”
Serious management weaknesses were noted in the Report, including the
following (repeat criticisms from past examinations are in bold):
• An objectionable concentration of authority with Chairman***.
• Lack of board independence.
• Staffing concerns/inadequate management depth, and resulting
inadequate segregation of duties.
• Recurring conflicts of interest.
• Excessive employee turnover.
• The payment of excessive and unsubstantiated fees and expenses to
Chairman ***, and the payment of questionable expenses to Advisory
• Incomplete official board minutes.
• Inadequate Audit Program. Among other problems, the internal audit
does not cover most major operational areas. The Bank lacks an internal
accounting control system.
• Lack of an independent and adequately staffed audit committee.
• Inadequate internal loan review.
• Weaknesses in implementing the credit policy; including weaknesses in
credit administration, underwriting, collection practices, and the
existence of conflicts of interest.
• Approval of loans by officers who do not have lending authority.
• Apparent violations of law.
• Inadequate interest rate risk management, including inadequate
policies and limits for interest rate risk.
• Inadequate liquidity and funds management policy.
• Inadequate oversight and poor internal controls governing the use of
brokered deposits (brokered deposits were booked in 1998 without
• Inadequate oversight of the risk management program.
• Inadequate wire transfer environment and controls.
The board and operating management evidence deficiencies that expose the
Bank to risk and must be corrected. Board oversight continues to be weak,
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 conflicts of interest by Chairman ***. These
weaknesses warrant a component rating of “4” for Management and require your
The UFIRS Policy Statement provides the following description for a
Liquidity component rating of “3”:
“A rating of 3 indicates liquidity levels or funds management practices
in need of improvement. Institutions rated 3 may lack ready access to
funds on reasonable terms or may evidence significant weaknesses in funds
Deterioration in the Bank’s liquidity position since the last
examination, as evidenced by deposit runoff and increased reliance on
noncore funding sources, is a concern. However, perhaps more importantly,
management’s liquidity and funds management practices need improvement. The
Report details the specific concerns regarding liquidity policy weaknesses,
which include lack of consideration of large deposit relationships, reliance
on noncore funding sources, or unfunded commitments. Additionally, control
over brokered deposits was noted as lax. Moreover, it does not appear that
the implications of the Bank’s liquidity position were thoroughly considered
prior to engaging in the Bank’s strategy to increase the Bank’s low
loan-to-deposit ratio in response to criticism of its low ratio at a January
1998 compliance examination. Given these risk management weaknesses, and the
deterioration in the Bank’s liquidity position, the Liquidity component
warrants a “3” rating.
Sensitivity to Market Risk
The UFIRS Policy Statement provides the following description for a
Sensitivity to Market Risk component rating of “3”:
“A rating of 3 indicates that control of market risk sensitivity needs
improvement or that there is significant potential that the earnings
performance or capital position will be adversely affected. Risk
management practices need to be improved given the size, sophistication,
and market risk accepted by the institution. The level of earnings may not
adequately support the degree of market risk taken by the institution.”
There are significant weaknesses in market risk management practices,
poor board oversight of the area and management’s failure to address several
weaknesses in risk management practices that were identified at the previous
examination. A notable repeat criticism is that the interest rate risk
policy fails to address several key components required by the Joint Agency
Policy Statement on Interest Rate Risk. These components are establishing
acceptable interest rate risk ranges, a regular structure for reporting
interest rate risk exposure to the board, acceptable measurement systems to
estimate risk exposure to earnings and capital, and procedures to be
followed when exposure exceeds approved limits. Also, the complexity of the
Bank’s asset structure has increased since the previous examination, as the
Bank increased ite investment in callable step-up notes, which grew from 23
percent of Tier 1 capital at the previous examination to 88 percent of Tier
1 capital. These investments are subject to greater price volatility in
rising interest rate environments, but the Bank does not have adequate
monitoring systems in place to measure this risk.
The “3” rating definition for sensitivity to market risk focuses on two
areas, the potential that a bank’s level of market risk may impact earnings
or capital or whether risk management practices need improvement. The
Report details significant deficiencies in risk management practices that
warrant a “3” rating for the Sensitivity to Market Risk component.
Apparent Violations of Section 309.6 of the FDIC’s Rules and
The Bank copied individual members of Congress and the General Accounting
Office (“GAO”) on its appeal of the 1998 examination. Since the appeal
contained confidential supervisory information, the Bank was cited for an
apparent violation of Section 309.6 of FDIC Rules and Regulations, which
prohibits disclosure of confidential supervisory information, without the
prior approval of the FDIC.
Section 309.5(g)(8) prohibits from disclosure all “[r]ecords that are
contained in or related to examination, operating, or condition reports
prepared by, on behalf of, or for the use of the FDIC.” Information in the
1998 appeal that related to the examination, including ratings and excerpts
from examination reports, clearly falls under the disclosure prohibition and
the Committee denies the Bank’s appeal.
Regarding the Bank’s contention that Part 309 is not clear, and that
banks, not the FDIC “own” the privilege associated with the regulation, the
Bank overlooks the fact that – as displayed prominently on the front of the
Report as well as in the regulation – reports of examination are property of
the FDIC, and only the FDIC can authorize disclosure of information
contained therein. Likewise, the bank examination and other privileges that
protect information in the reports belong to the FDIC, not the Bank, and
therefore can be waived only by the FDIC. The statement in your appeal
attributed to Associate Director Mark Schmidt is incorrect. Mr. Schmidt
indicated that the regulation protects banks from unauthorized disclosure of
information, not that the “privilege” associated with the regulation belongs
The Bank’s contention that Section 309.6 is an unconstitutional prior
restraint on speech is not meritorious. Nothing in the First Amendment or
any other provision of the United States Constitution prohibits the FDIC
from restricting the disclosure of proprietary information obtained during
or resulting from the examination process and belonging to the FDIC. The
Bank’s assertion that Part 309 conflicts with 12 U.S.C. Section 4806, the
statute establishing the supervision appeals process is also without merit.
Nothing in that statute suggests that Congress in any way sought to overturn
or modify the restrictions on disclosure of exempt records set forth in Part
Troubled Institution Designation
Section 32 of the Federal Deposit Insurance Act (“FDIC”) requires troubled
institutions to provide the FDIC with 30 days written notice prior to the
appointment of any director or senior executive officer. Section 303.101(c)
of the FDIC Rules and Regulations defines a troubled institution as one with
a composite rating of “4” or “5,” or subject to a formal enforcement action
Order or Notice to Issue an Order, or “is informed in writing by the FDIC
that it is in troubled condition for purposes of the requirements of this
subpart on the basis of the bank’s most recent report of condition, report
of examination, or other information available to the FDIC.”
The San Francisco Regional Office notified the Bank that it is in
troubled condition, based on the findings of the April 5, 1999, examination.
Given the significant weaknesses in management noted in the Report, the
Committee believes that it is appropriate to designate the Bank as troubled
in order to monitor the management situation at the Bank.
The UFIRS’s definition of a Composite rating of “3’ follows:
“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.” (Emphasis added).
Deficiencies cited in the Report revolve around an inadequate board that
has failed to implement appropriate controls, including lax supervision of
operating management with a very dominant chairman, whose stewardship
features transactions which represent or appear to represent conflicts of
interest. Many of the criticisms contained in the Report are repeat
criticisms from one or more examinations, indicating a disregard for
regulatory recommendations and prudent banking practices.
The Report acknowledges that the capital and earnings positions are
adequate at this time. However, the CAMELS rating system is designed to be
prospective, as it considers not only financial condition, but also risk
management practices. Risk management practices are clearly inadequate, and
indeed are the driving forces behind the deterioration in asset quality,
liquidity, and market risk noted at this examination. Given the foregoing,
the Report findings comport with the definition of a composite “3.”
The Bank’s allegations of bias, discrimination, and retaliation by Regional
Office staff were not specifically considered by the Committee. However, the
specific examination findings on which the Bank premised its allegations
were independently reviewed and are addressed above. The Office of the
Ombudsman will review and respond to these allegations, independent and
separate from the Supervision Appeals Review Committee process.
The Appeal further requests that the FDIC Board of Directors review the
decision of the Office of the Ombudsman regarding the Bank’s 1998 appeal.
This request has also been forwarded to the Office of the Ombudsman.
The Bank’s request for any response to the appeal given by the Regional
Office and any evidence offered in opposition to the appeal by the Regional
Office will be processed pursuant to the provisions of the Freedom of
Information Act and you will receive a response from the office responsible
for handling such requests under separate cover.
In accordance with the Guidelines, the
scope of this review was limited to the facts and circumstances that existed
at the time of the examination; no consideration was afforded any changes
occurring after that date or to any subsequent corrective action. However,
the San Francisco Regional Office will consider any such efforts in its
determination of the proposed supervisory response.
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.