The OCC's
position on making provisions to the ALLL states the ALLL must be
maintained at a level that is adequate to absorb all estimated
inherent losses in the loan portfolio. One of the objectives of the
examination is to evaluate the soundness of management's allowance
determination process.
While the bank's historical loss experience was a reasonable
starting point for the analysis, adjustments for various qualitative
factors to reflect current conditions are also prudent. As defined in the
Comptroller's Handbook booklet, ''Allowance for Loan and
Lease Losses'' (June 1996), these factors
include:
- Changes in
lending policies and procedures, including underwriting standards
and collection, charge-off, and recovery
practices.
- Changes in
national and local economic and business conditions and
developments . . . , including the condition of the various market
segments.
- Changes in
the nature and volume of the portfolio.
- Changes in
the experience, ability, and depth of lending management and
staff.
- Changes in
the trend of the volume and severity of past due and classified
loans; and trends in the volume of nonaccrual loans, troubled debt
restructurings, and other loan modifications.
- Changes in
the quality of the institution's loan review system and the degree
of oversight by the institution's board of
directors.
- The
existence and effect of any concentrations of credit, and changes
in the level of such concentrations.
- The effect
of external factors such as competition and legal and regulatory
requirements on the level of estimated credit losses in the
institution's current portfolio.
The
examination found that management's analysis did not provide prudent
adjustments for qualitative factors. The analysis the supervisory
office provided to bank management included adjustments to the
historical loss percentage for the various qualitative factors. However, in several of the
qualitative areas, the supervisory office included duplicate
adjustments for underwriting weaknesses. Additionally, the
supervisory office analysis inappropriately included adjustments for
types of loans when the historical loss percentage was
adequate.
The ombudsman
concluded that correcting these adjustments reflected a need for a
provision of a lesser amount.
The bank was directed to re-file the bank's Call Report to
reflect these changes.
Capital Adequacy
(3-rated)
Discussion
and Conclusion
The bank's
submission noted that ''In view of the bank's maintenance of strong
capital levels, significantly in excess of all 'well-capitalized'
benchmarks during all recent periods, the assignment of a 3 capital
rating is unwarranted as well as unsupported by the ROE. The ROE bases the downgrade
of the bank's capital rating solely on highly debatable and
completely subjective assertions regarding the high
risk.''
The ROE stated
that their assessment of capital was based on the high-risk profile
of the bank and the generally inadequate risk management
systems. The ROE
further stated that the burden of providing a reasonable return on
equity has ultimately led to subsequent increases in risk, which had
not been preceded, or even accompanied, by commensurate improvements
in risk management.
While the
''well capitalized'' definitions refer specifically to prompt
corrective action, the OCC is authorized under 12 USC 3907 (a) (2)
to establish higher minimum capital requirements, in light of the
particular circumstances at a bank. Adequate capital levels
should be maintained commensurate with the risk profile of the
institution and management's ability to implement effective risk
management systems.
The ombudsman
determined that while there were risk management weaknesses in
different areas of the bank, the primary risk in this institution
was credit risk. As
such, the risk to capital, posed by the banks lending activities,
should also consider the risk of loss in the event of default. Comments in the ROE
acknowledged that excessive credit losses were mitigated by the
documented value of real estate collateral. Additionally, comments in
the ROE acknowledged management's prior success in raising capital
when warranted. The
ombudsman concluded that when these factors are properly weighed,
the banks capital position was more appropriately represented by the
2 rating.
Earnings
(2-rated)
Discussion
and Conclusion
The appeal
stated that ''an assignment of a 2 rating was unwarranted, as the
bank had recorded strong earnings and increased earnings in each of
the last five years. In
the face of the bank's consistent earnings results and historically
low charge-offs, the ROE asserts that a combination of higher ALLL
provisions mandated by the OCC, less than satisfactory asset
quality, and purportedly high credit risk may impact the
sustainability of earnings performance.''
The ROE stated
that earnings performance was satisfactory due, primarily, to high
loan yields and fees and well below-average operating cost. It also stated that while
the quantity and trend of earnings appear satisfactory to strong,
earnings were actually lower than reported and there were several
factors that may affect the sustainability of earnings. Earnings were negatively
affected by a reversal of a significant discount that was recognized
as income in conjunction with the modification of a then problem
loan and the need to increase the ALLL to an adequate level.
The ROE also
discussed issues involving the sustainability of earnings, which
included credit risk concerns, and a significant repricing imbalance
caused by funding commercial loans, which reprice in three to five
years, with wholesale funding, which reprices over the next 12
months. The earnings
component is designed to reflect the quantity, trend, and quality of
earnings generated by the institution. Management had been
successful in generating a significant level of fee income and
purchasing loans at a discount to elevate earnings performance. The level of earnings for
the period was negatively affected by the reversal of income on the
previously noted problem loan and a required provision to the
ALLL. Additionally,
there were risk management issues that will require financial
resources to properly develop and implement. In considering all of these
factors, earnings were sufficient to support operations and maintain
adequate capital and allowance levels, even after considering the
risk management issues that need to be
addressed.
The ombudsman
concluded that the assigned 2 rating for the earnings component was
appropriate at the time of the examination.
Internal Audit
Discussion
and Conclusion
The appeal
stated that ''many of the ROE conclusions about the bank's risk
management are based on flawed findings about the internal audit
function. The ROE
incorrectly concludes management had dismantled the internal audit
function, when in fact the bank had continued the engagement of a
highly respected audit firm to conduct the internal audit for the
third consecutive year.''
The ROE stated
that the internal audit function-- temporarily improved in response
to a ''Matter Requiring Board Attention'' comment contained in the
previous ROE-was again unacceptable, having been dismantled prior to
completion of even one 18-month cycle. Additionally, it noted the
external audit lacked the scope required to adequately compensate
for the absence of an internal audit function in such a high-risk
bank.
The
ombudsman's review found that the supervisory office's supporting
work papers on the bank's internal audit function did not fully
support the conclusion that the internal audit had been dismantled,
as stated in the ROE.
However, a review of the audit schedule, the completed
audits, and discussion with the firm contracted to perform the
internal audit function revealed that some audits were not performed
in a timely fashion.
The ombudsman concluded that at the time of the examination
these symptoms were more indicative of a ''partially acceptable''
internal audit function.
Management
(3-rated)
Discussion
and Conclusion
The appeal
stated that an assignment of a 3 rating was unwarranted because of
the bank's successful financial performance. The appeal also noted that
the management team had continually improved processes and
procedures but was most capable because of its
"hands on'' process.
Management asserted that knowing the customer at the
ownership level and personally having a senior officer visit every
business site represented the most valuable component of their
lending process.
The ROE
stated, ''Management is less than satisfactory, as the overall risk
profile remains high and risk management remains deficient. Management remains overly
focused on the upside potential of business strategies at the
expense of prudent considerations and control of the downside
risk.'' The ROE further
stated, ''Management and the board have failed to ensure the bank
has a long-term well-defined business plan. And while management had
made changes in response to previous supervisory concerns, the
changes lack durability and integrity to alleviate the
concerns.''
The management
rating reflects the board and management's ability as it relates to
all aspects of banking operations. The bank's senior management
team had been successful in growing the bank, raising capital to
support growth, and exiting product lines that were deemed
unprofitable. However,
at the time of the examination, concerns included credit risk
activities that did not provide comprehensive oversight of the loan
portfolio, an internal audit function that was only partially
acceptable, compliance management weaknesses, interest rate risk
monitoring systems that needed improvement, and liquidity management
activities that required enhancements.
Many of these
risk management concerns were highlighted in the previous ROE. The board and management had
initiated actions to strengthen risk management systems after the
conclusion of the examination.
However, senior management had not demonstrated a willingness
to maintain risk management systems commensurate with the growth and
activities of the bank.
Therefore, the ombudsman concluded that at the time of the
examination a
''3'' rating
for management component was appropriate and
justified.
Composite Rating (3-rated)
and
Assessment of the Bank's Risk
Profile
Discussion
and Conclusion
The ROE stated
the condition of the bank had deteriorated and is less than
satisfactory. Comments
in the ROE noted the deterioration resulted from elevated risk
levels combined with risk management systems that remain ineffective
in relation to the level of risk.
The appeal
stated that ''an assignment of a 3 composite rating and ''high and
increasing''risk profile is unwarranted based on objective facts and
measurements.
The
common thread
used by the supervisory office throughout the ROE to justify
downgrading the bank component and overall rating was that the risk
profile of the bank is high and increasing.'' While acknowledging the
risks inherent in their mix of lending, management stated in the
appeal that the primary test should be their experience in
controlling losses, which they point out, had been exemplary. Given the general risk
management weaknesses in the bank, which have been described
throughout this summary, the risk profile of the bank would be
appropriately categorized as high and increasing, particularly given
the concerns in asset quality, liquidity, and sensitivity to market
risk.
The overriding
regulatory concern in the bank was management's unwillingness to
establish and, more importantly, maintain risk management systems
appropriate for the activities of the bank. In considering the composite
rating definitions contained in OCC Bulletin 97-1, financial
institutions that exhibit some degree of supervisory concern in one
or more of the components; and, management that lacks willingness to
effectively address the weaknesses in appropriate time frames
generally receive a 3 rating.
Therefore, the ombudsman concluded that the 3 rating was
appropriate, at the time of the examination.
Pattern of Vindictive
Treatment
The ombudsman
views a charge of a pattern of vindictive treatment as a serious
matter that always warrants careful and comprehensive review and
investigation. The
ombudsman reviewed the previous ROEs and there was a common thread
in that each report had essentially dealt with criticisms by the
supervisory office on identified weaknesses in risk management
activities. Management
initiated corrective action following each ROE and the supervisory
office had accepted their response as an indication of their intent
to address the issues.
The
supervisory office had altered planned courses of action, and when
warranted, upgraded composite and component ratings in subsequent
examinations. However,
corrective action was not always fully implemented or did not
comprehensively address the concerns. Despite some comments in the
current ROE that lacked balance and had an aggressive tone, there
was no evidence that this represented a pattern of vindictive
treatment. The
ombudsman concluded that the lack of balance and aggressive tone
resulted from poor communications during the examination process by
both regulators and bankers coupled with the unwillingness of
management to sustain progress in developing and implementing
effective risk management systems.
During the
processing of the appeal, which included the visits to the bank, the
ombudsman had gained a healthy respect for management's business
model and core abilities.
However, based on the lack of follow-through on prior
commitments, he expressed disappointment that management had not
fully implemented a platform of effective and comprehensive risk
management systems, processes, and controls. He further reminded
management and the board that risk management activities were an
important component of operating any financial institution in a safe
and sound manner and were within management's control to develop and
implement.
In addition,
the ombudsman discovered that the supervisory office had not
completely fulfilled its obligation to adequately communicate
findings to the board and management during the examination. Thus the ombudsman also
shared with the supervisory office his view that the examination
should have been conducted in a manner that promoted greater
communication with senior management and the board of
directors.
Appeal of 3
Composite Rating
Background
The ombudsman
received a formal appeal from a bank that disagreed with their
assigned 3 composite rating.
The composite rating was assigned as a result of a full scope
onsite safety and soundness examination. As a result of the
examination, the bank entered into a Part 30 Safety and Soundness
Compliance Plan.
Subsequent to the full scope onsite examination, the
supervisory office conducted a review of the bank to assess
compliance with the plan.
At that time the bank was not in full compliance with the
plan and their composite rating remained unchanged. The bank's correspondence
outlined the following as the basis for the
appeal:
- The bank has
made significant progress in correcting and complying with the
areas of regulatory concern as outlined in the report of
examination and the plan.
- The bank is
well capitalized with good asset quality, and has experienced
management team with a long track record of
performance.
- The bank has
excellent earnings and sound liquidity.
The risk
associated with the acquisition of a high level of a particular type
of loan product from another financial institution was unprecedented
in the history of the bank.
The
OCC's
supervisory office had already provided the bank with appropriate
feedback on areas where more selective due diligence was warranted
as well as areas where more effective risk management practices for
these assets should be implemented. The most important dimension
of this situation was the aggressive approach taken by management to
work through the various risk related challenges associated with
this pool of assets.
Although
management had not anticipated or prepared for assuming the
multifaceted risks associated with booking these assets on the
balance sheet, the supervisory office commended the bank for the
strong efforts to improve the risk management infrastructure. Additionally, a
comprehensive action plan was developed to strengthen and improve
the credit risk management processes. This action plan was the
primary basis from which the supervisory office developed the
plan. Bank management
had taken notable action for achieving compliance with the Plan in a
relatively short period of time, but had not achieved full
compliance. The
articles not in full compliance were considered critical components
of the overall risk management processes.
Discussion
In the
attachment to OCC Bulletin 97-1, ''Uniform Financial Institutions
Rating System,'':
Composite
2-financial institutions in this group are fundamentally sound. For a financial institution
to receive this rating, generally no component rating should be more
severe than 3. Only
moderate weaknesses are present and are well within the board of
directors' and management's capabilities and willingness to
correct. These
financial institutions are stable and are capable of withstanding
business fluctuations.
These financial institutions are in substantial compliance
with laws and regulations.
Overall risk management practices are satisfactory relative
to the institution's size, complexity, and risk profile. There are no material
supervisory concerns and, as a result, the supervisory response is
informal and limited.
Composite
3-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. 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. 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.
Conclusion
The quality of
management is a key element in the operation of a national bank and
is usually the factor that is most indicative of how well risk is
identified, measured, monitored, and controlled. The bank's actions to
strengthen its risk management infrastructure and control the risk
associated with the acquired loans were reflective of a management
team that is able to respond to changing, and in this case
unprecedented, circumstances and business conditions. Such an infrastructure,
coupled with prudent banking practices, serves as the foundation
that supports sound financial institutions during periods of market
or economic stress, and was more appropriate given the bank's size,
complexity, and risk profile.
While many of the bank's actions had been reviewed during the
subsequent review, not all systems were in place at that time and
the effectiveness of the overall risk management process had not
been fully tested during an onsite examination.
Since an
onsite examination was scheduled to commence within 30 days of the
appeal, the ombudsman opted to have the risk management
infrastructure fully tested during that examination. Therefore, the composite
rating of 3 was upheld by the ombudsman.
Subsequent
Event
The
supervisory office assigned an overall 2 composite rating to the
bank at the next examination.
