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Ellis State Bank

FEDERAL DEPOSIT INSURANCE CORPORATION

IN RE: Ellis State Bank Ellis, Ellis County, Kansas

Application Pursuant to Section 24 of the Federal Deposit Insurance Act for Consent to Engage as Principal Through a Majority Owned Subsidiary in a Real Estate Activity That May Not Be Permissible for a Subsidiary of a National Bank

STATEMENT

Pursuant to the provisions of section 24 of the Federal Deposit Insurance ("FDI") Act, Ellis State Bank, Ellis, Kansas (the "Bank") has filed an application with the Federal Deposit Insurance Corporation ("FDIC"). The applicant requests the FDIC's consent to engage as principal indirectly in a real estate investment activity through a wholly-owned subsidiary of the Bank (the "Subsidiary").

The activity of holding real estate investment properties may not be a permissible activity for a National bank or a subsidiary of a National bank. State chartered FDIC-insured banks may not engage as principal in an activity prohibited to nationally chartered banks unless they obtain consent from the FDIC. Consent may not be granted unless the bank is in compliance with applicable capital standards and the FDIC determines that the activity poses no significant risk to the deposit insurance fund. Kansas State law permits the holding of real estate investment properties by commercial banks, and their subsidiaries, under specific circumstances and the Kansas State Banking Commissioner has granted express permission to the Bank to conduct the activity subject to this application.

The Bank proposes to develop two low to moderate income single family homes in their immediate market area, one at a time, with the second house to be built on a pre-sold basis. The Bank intends for this activity to benefit both the community and the Bank.

Investments in real estate, at any stage of the development process or even completed properties, can be generally characterized as quite risky in that there is a high degree of variability or uncertainty of returns on invested funds. The cyclical downturn in the real estate market in the late 1980s and early 1990s, and the impact of that downturn on financial institutions, provides an illustration of the market risk presented by real estate investment. In addition to the high degree of variability, real estate investments possess many risks that, while not entirely unique, are not readily comparable to typical equity investments (e.g., common stock). Real estate markets are for the most part localized, investments are normally not securitized, financial information flow is often poor, and the market is generally not very liquid.

Real estate investment risk is higher than for most traditional bank assets, such as loans or debt securities. Real estate investment can increase interest rate risk; optimum investment periods are typically long-term; real estate is relatively lacking in liquidity; and real estate is subject to specialized risks such as environmental liability. In addition, real estate investment is of questionable benefit in the diversification of a financial institution's portfolio of assets. The experience and expertise of management is a critical factor, and there is much anecdotal evidence to suggest that the lack of adequate management creates a significant level of risk of loss.

Due to these risks, real estate investment activities appear suitable to a financial institution only on a very limited scale and under restrictive conditions designed to control the various risks posed to the financial institution and the deposit insurance fund.

The FDIC has reviewed available information and has also taken into consideration the financial and managerial resources and future earnings prospects of the Bank. The FDIC also considered the risks associated with real estate investment activities and the risks associated with the development of residential properties.

In determining if a significant risk to the fund exists in the proposal, the FDIC evaluated the specifics of the Bank's application. In evaluating a Section 24 real estate activity application, the FDIC considers the types of real estate investment activity proposed to determine if any activity is unsuitable for an insured depository institution. The proposed subsidiary structure and its management policies and practices are reviewed to determine if a bank is adequately protected from litigation risk. Capital adequacy is analyzed to ensure the Bank first devotes sufficient capital to its more traditional banking activities. Capital adequacy is determined by the Bank's "consolidated" and "bank only" leverage and risk-based capital ratios, with all investments in real estate investment subsidiaries excluded from capital in the "bank only" capital calculation. Limitations on investment in a subsidiary engaged in real estate investment activity are evaluated in order to assure that the maximum risk exposure is nominal. Policies relating to extensions of credit to third parties for subsidiary related transactions are evaluated to determine if they protect the Bank from concentrations of risk.

The Bank's policies on engaging in transactions in which insiders are involved are reviewed to determine if they protect the Bank from potential insider abuse. A bank's policies relating to the conditioning of loans on the purchase of real estate from the subsidiary and the extending of credit by the Bank to third parties for the purpose of acquiring real estate from its subsidiary are reviewed to determine if they prevent undesirable tying relationships and to determine if they are adequate to ensure that sound credit underwriting is maintained. Having reviewed these areas, the FDIC is imposing conditions for prudential reasons due to the volatility and other risks which are inherent in the subject real estate activity, as well as to mitigate any potential insider conflicts of interest and to reduce risk to the insurance fund.

The Bank states in its application that its investment in the Subsidiary will be limited to $70,000, or 1.82% of its equity capital as of December 31, 1995. This level is within acceptable risk standards. Additionally, the Bank indicates that they will construct only two properties, with the second to be completed on a pre-sold basis. The FDIC has determined that it is appropriate to limit the Bank's maximum investment to 2% of Tier 1 capital and the activity shall be limited to construction of the two houses. In order to ensure the Bank's capital is sufficient to support both traditional banking activities and real estate investment activities, the FDIC will also require that the Bank's capital, after deducting the Bank's aggregate investment in the Subsidiary, equal or exceed the level required for a "well capitalized" institution pursuant to Part 325.103(b)(1) of the FDIC's Rules and Regulations.

In order to promote the concept that real estate investment activities should be conducted in a separately and adequately capitalized subsidiary and to ensure that the appropriate insurance fund is adequately compensated for, and sufficiently protected from, additional risk in the event that "bank only" capital levels fall below "well-capitalized" levels, the Bank's capital category for purposes of Prompt Corrective Action will be determined, and the Bank's risk adjusted deposit insurance premium will be assessed, based on "bank only" capital ratios except for the purposes of determining if the Bank is "critically undercapitalized".

Given the high risk present in real estate investment activities, the FDIC has also imposed a condition requiring that transactions between the Bank and the Subsidiary shall be made in accordance with the restrictions of Section 23A and 23B of the Federal Reserve Act to the same extent as though the Subsidiary were an affiliate of the Bank as defined under Sections 23A and 23B. An exception to this restriction is that the collateral requirements and investment limitations of 23A shall not apply to loans made by the Bank to finance bona fide sales of assets to third parties, provided that: 1) any such loans are consistent with safe and sound banking practice; 2) do not involve more than the normal degree of risk of repayment; and 3) the loans are extended on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions. Any such loans made by the Bank would be reviewed by examiners at each regular safety and soundness examination conducted by the FDIC.

For the reasons outlined above, including the imposition of conditions, the Board of Directors has concluded that the retention of interest in real estate does not pose a significant risk to the Bank Insurance Fund, provided the conditions are observed, and therefore approval of the application, subject to such conditions, is warranted.

THE BOARD OF DIRECTORS


FEDERAL DEPOSIT INSURANCE CORPORATION

IN RE: Ellis State Bank Ellis, Ellis County, Kansas

Application Pursuant to Section 24 of the Federal Deposit Insurance Act for Consent to Engage as Principal Through a Majority Owned Subsidiary in a Real Estate Activity That May Not Be Permissible for a Subsidiary of a National Bank

ORDER

The Board of Directors has fully considered all available facts and information relevant to Section 24 of the Federal Deposit Insurance Act, 12 U.S.C. 1831a, and Part 362 of the Federal Deposit Insurance Corporation Rules and Regulations, 12 C.F.R. Part 362.4, relating to an application by Ellis State Bank, Ellis, Kansas (the "Bank"), for consent to engage as principal through a majority owned subsidiary in an activity that is not permissible for a subsidiary of a national bank, and has concluded the application should be approved subject to certain conditions.

Accordingly, it is hereby ORDERED, for the reasons set forth in the attached Statement, that the application submitted by Ellis State Bank for consent to engage as principal through a majority owned subsidiary in an activity that is not permissible for a subsidiary of a national bank be and the same hereby is approved subject to the following conditions:

1. That the Bank shall take the necessary actions to establish the Subsidiary, and operate the Subsidiary in a manner so as to ensure that it has a separate corporate existence as a majority owned subsidiary which:

(a) is adequately capitalized,

(b) is physically separate and distinct in its operations from the operations of the Bank,

(c) maintains separate accounting and other corporate records,

(d) observes separate formalities such as separate board of directors' meetings,

(e) maintains a board of directors with one or more independent, knowledgeable outside directors and management expertise capable of conducting activities in a safe and sound manner,

(f) contracts with the Bank for any service on terms and conditions comparable to those available to or from independent entities, and

(g) conducts business pursuant to separate policies and procedures designed to inform customers and prospective customers of the subsidiary that the subsidiary is a separate organization from the Bank, including the placement of specific language on any debt instrument or contract with a third party disclosing that the Bank itself is not responsible for payment or performance;

2. That the Bank's indirect real estate investment in the Subsidiary, including equity interests, debt obligations of the Subsidiary held by the Bank, Bank guarantees of debt obligations issued by the Subsidiary, extensions of credit or commitments of credit from the Bank to the Subsidiary, and any extensions of credit to any third parties for the purpose of making a direct investment in the Subsidiary or making an investment in any investment in which the Subsidiary has an interest (defined collectively as "Real Estate Investment"), shall be limited to 2% of Tier 1 leverage capital. However, Real Estate Investment shall not include loans made by the Bank to finance bona fide sales of assets which meet the requirements of paragraph 10(b);

3. That the Bank's capital level, after deducting all Real Estate Investments in the Subsidiary, shall equal or exceed the level required for a "well-capitalized" institution pursuant to Part 325.103(b)(1) of the FDIC's Rules and Regulations;

4. The Bank shall, on a quarterly basis, perform the capital adequacy calculations described in paragraph 3 for the purpose of ascertaining its capital level, and that in the event the Bank falls below the level required for a "well capitalized" institution pursuant to Part 325.103(b) (1) of the FDIC's Rules and Regulations, the Bank shall notify the FDIC within 15 days and submit to the FDIC an acceptable plan for restoring capital to a level required for a "well capitalized" institution;

5. That henceforth, notwithstanding Parts 325 and 327 of the FDIC's Rules and Regulations, 12 C.F.R. Parts 325 and 327, the Bank's capital category for purposes of prompt corrective action and Bank's risk adjusted deposit insurance premium shall be calculated based on the Bank's capital after deducting all Real Estate Investments, except that such deductions shall not be made when determining whether the Bank is "critically undercapitalized" as defined under Part 325;

6. That the Bank shall continue to meet all applicable capital standards;

7. That any extensions of credit to any third parties for the purpose of making a direct investment in the Subsidiary, making an investment in any investment in which the Subsidiary has an interest, or any acceptance of any debt obligation of or equity interest in the Subsidiary as collateral security for a loan or extension of credit to any third party by the Bank shall be clearly disclosed to the Bank's board of directors prior to approval of the extension of credit and documented in the board's minutes.

8. That prior to the consummation of a transaction between the Subsidiary and any of the Bank's customers, any potential conflicts of interest be identified, be appropriately resolved, and be clearly disclosed to the board of directors and documented in the board's minutes;

9. That the Bank shall not engage directly or indirectly through the Subsidiary in any real estate investment activity or other transaction with insiders or their related interests without the prior written consent of the FDIC's Director of the Division of Supervision or the Director's designee;

10. That the Bank shall:

(a) Not condition any loan on the purchase or rental of real estate from the Subsidiary, and

(b) Not extend credit to any borrower to acquire real estate from the Subsidiary unless it is consistent with safe and sound banking practice and does not involve more than the normal degree of risk of repayment and the credit is extended on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions;

11. That transactions between the Bank and the Subsidiary shall be made in accordance with the restrictions of Section 23A and 23B of the Federal Reserve Act, 12 U.S.C. 371c and 371c-1, to the same extent as though the Subsidiary were an affiliate of the Bank as defined under Sections 23A and 23B, with the exception that the collateral requirements and investment limitations of 23A shall not apply to loans made by the Bank to finance bona fide sales of assets to third parties consistent with safe and sound underwriting requirements contained in paragraph 10(b) above;

12. That the Bank shall restrict the real estate investment activity to the construction of two residential dwellings as described in the business plan submitted in conjunction with the application; and

13. That the consent granted herein is based on the facts and circumstances presented or otherwise known to the FDIC in connection with these requests. The Bank shall notify the FDIC of any significant change in facts or circumstances. If the facts and circumstances change significantly, the FDIC shall have the right to alter, suspend, or withdraw its approval.

Dated at Washington, D. C., this day of , 1996.

BY ORDER OF THE BOARD OF DIRECTORS

Jerry L. Langley
Executive Secretary



Last Updated 03/24/2011 Legal@fdic.gov