SARC-2000-03 (December 15, 2000)

Your appeal of material supervisory determinations set forth in the May 8, 2000, joint safety and soundness examination was denied by the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) on December 12, 2000.

The State of California Department of Financial Institutions (“State”) Commissioner Donald R. Myer was provided a copy of your letter of appeal; Assistant Deputy Commissioner Debie M. Abella has responded that the State concurs with the ratings and overall findings of the Report of Examination (“Report”).

The Committee has given careful consideration to the issues raised in your letter. After review, the Committee has concluded that the Management rating of “3,” the Liquidity rating of “3,” the Sensitivity to Market Risk rating of “3,” and the Composite rating of “3” are appropriate as reflected in the Report.

Although the Committee recognizes the generally satisfactory financial indicators and some improvement in management at [Bank] (“Bank”) since the previous examination, material deficiencies remain that the warrant the CAMELS component and composite ratings assigned. The Committee urges you to take steps to correct the deficiencies noted in the Report.

Findings Appealed
The Committee’s conclusions regarding the issues appealed by the Bank are presented below along with an explanation for the reason for the decision.

Management Rating
The Uniform Financial Institution Rating System’s definition of a Management rating of “3” follows:

“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.”

Several management weaknesses were noted in the Report, including the following (repeat criticisms from past examinations are in bold):

• At previous examinations, the Bank has been asked to better document and justify business expenses incurred by Bank officers and directors, yet the Chairman of the Board claimed reimbursement for expenses totaling nearly $78,000 in 1999 alone, many of which violate Bank policy;

• Despite recurring recommendations to do so, the Bank has not established adequate policy for the control of “step-up” notes;

• Internal loan grading remains inadequate;

• The Bank’s asset/liability management analysis is not reviewed by the Board of Directors;

• Board involvement in the strategic planning and budgeting process is lacking;

• The strategic plan contains errors and inconsistencies;

• The internal audit program remains inadequate;

• The Audit Committee, while improved, is still not independent;

• Violations of laws or regulations persist; and,

• Internal routine and control weaknesses persist, including:

- an ineffective certification program,
- poor accounting controls,
- poor escheatment practices,
- lack of adequate job rotation and training programs, and
- inadequate wire transfer procedures.

The Committee acknowledges some improvement in management, most notably the addition of outside directors to the board and its committees and the implementation of some recommendations from the prior examination. This improvement is reflected in the upgrade of the Bank’s management rating from a “4” at the last examination to a “3” at this examination. However, several risk management deficiencies persist and must be corrected. Board oversight is still considered less than satisfactory, and management has failed to establish a proper control environment. The Committee is 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 deficiencies in the management of liquidity and interest rate risk, inadequate internal routines and controls, and inadequate segregation of duties. These weaknesses warrant a component rating of “3” for Management and require your immediate attention.

Liquidity Rating
The Uniform Financial Institution Rating System’s definition of a Liquidity rating of “3” follows:

“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 management practices.”

Continued weaknesses in the Bank’s liquidity position are demonstrated by the continued non-core funding dependence and decreasing federal funds sold. However, perhaps more importantly, management’s liquidity and funds management practices need improvement. Management has failed to address issues from the prior examinations, such as short-term securities minimums, establishment of contingent liquidity lines, monitoring of volatility in large deposit accounts, and pre-purchase analysis/ongoing rate shocking monitoring for “non-standard or complex securities.” Policies and procedures for these items have been established by the board but not followed. Given these risk management weaknesses and deterioration in the Bank’s liquidity position, the Liquidity component warrants a “3” rating.

Sensitivity to Market Risk Rating
The Uniform Financial Institution Rating System’s definition of a Sensitivity to Market Risk rating of “3” follows:

“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 level of market risk accepted by the institution. The level of earnings and capital may not adequately support the degree of market risk taken by the institution.”

There are significant weaknesses in the Bank’s asset/liability and interest rate risk management practices, many of which are repeat criticisms. Although the Bank’s interest rate risk position is currently satisfactory, the Uniform Financial Institutions Rating System gives considerable weight to the overall quality, or lack thereof, of bank management’s practices in the sensitivity to market risk component rating. Management has failed to establish an appropriate risk management system to measure, monitor, and control interest rate risk. Several criticisms and recommendations in the Report remain unresolved from prior examinations, including the following:

• Establish limits for step-up notes;

• Establish formal procedures for ascertaining and monitoring the marketability of step-up notes; and

• Establish formal tolerance limits for price volatility of step-up notes.

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 documents significant risk management weaknesses that warrant a “3” rating for the Sensitivity to Market Risk component.

Composite Rating
The Uniform Financial Institutions Rating System’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 less than satisfactory risk management practices in investment, liquidity, asset/liability management, and IRR areas; internal loan grading; strategic planning; internal audit programs; internal routines and controls; staff retention and segregation of duties; expense reimbursement documentation; and adherence to applicable laws or regulations. Many of the criticisms contained in the Report are repeat criticisms from one or more examinations, indicating indifference for regulatory recommendations and prudent banking practices. Given the foregoing, the Report findings comport with the definition of a composite “3.”

Other Matters
The Committee did not specifically consider the bank’s continued allegations of bias on the part of Regional Office staff. However, the specific examination findings on which the Bank premised its allegations were independently reviewed and are addressed above.

Summary
In accordance with the Guidelines for Appealing Supervision Determinations, 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.

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.