SARC-2004-02 (April 12, 2004)

At a meeting on March 30, 2004, the Federal Deposit Insurance Corporation’s (FDIC) Supervision Appeals Review Committee (Committee) considered the appeal filed by [Bank] (Bank), on February 2, 2004. In its appeal, the Bank contested certain material supervisory determinations, including the Asset Quality and Management component ratings and Composite rating set forth in the FDIC’s September 8, 2003 Report of Examination (Report of Examination).

The Committee consensus was that the Bank continues to be an institution that is well managed and continues to operate at a high level of performance. Nevertheless, after careful deliberation and consideration of all relevant information, the Committee concluded the Bank’s appeal should be denied. The Committee found that the conclusions contained in the Report of Examination accurately reflected the condition of the Bank, and that those conclusions were adequately supported by the facts and findings in the Report of Examination. The Committee determined that the Asset Quality and Management component ratings and the Composite rating were consistent with the FDIC’s practices.

The scope of the Committee’s review was limited to the facts and circumstances as they existed at the time of the examination. Although events that occurred after the examination and any subsequent corrective actions were not considered as part of the Committee’s review, they will be reviewed during future onsite supervisory activities.

The bases for the Committee’s decision are discussed more fully below.

Asset Quality Rating
The appeal requested that Asset Quality component rating be changed to a “1” rather than “2” rating assigned by the Regional Office.

The Federal Financial Institutions Examination Council’s (FFIEC) Uniform Financial Institutions Rating System states, in part, that an Asset Quality rating of “1” reflects strong asset quality and credit administration practices. While the volume, level, and trend relating to virtually all of the Bank’s qualitative Asset Quality measures present minimal concern, examiners identified noteworthy loan underwriting and administration deficiencies throughout the construction and development and permanent commercial real estate portfolios at the September 2003 examination. These weaknesses are particularly evident in the loans listed as Special Mention. The three relationships listed for Special Mention exhibited underwriting and administration deficiencies, including the absence of, or ineffective analysis of, the principal borrowers’ and/or guarantors’ financial capacities as well as weaknesses in loan review and monitoring. The Committee notes that some of these same loan underwriting and administration deficiencies were also discussed in the FDIC’s July 11, 2000 Report of Examination.

Construction and development lending, whether related to a “spec” home or a multi-unit condominium project, is a higher-risk activity requiring sound credit underwriting and administration to mitigate risk. This is particularly true for real estate markets that have seen a rapid escalation in values, as has the greater Boston market. That weaknesses of the nature and type identified are allowed to continue is not indicative of “strong” credit administration practices. The Committee concludes that the “2” Asset Quality component rating assigned is appropriate.

Management Rating
The appeal requested that the Management component rating be upgraded to a “1” from the “2” rating assigned. The Committee believes the loan underwriting and administration weaknesses, as well as weaknesses relating to information technology, anti-money laundering efforts, and interest rate risk management, reflect only satisfactory management performance. Management has not consistently and effectively identified, measured, monitored and controlled all significant risks, an important characteristic of “1” rated managements teams. The Committee acknowledges management’s commitment to respond to examination comments, concerns, and suggestions. Nonetheless, management’s commitment to address weaknesses related to fundamental risk management and loan administration practices is viewed as reactive rather than proactive. The Committee concludes that the “2” Management component rating assigned is appropriate.

Composite Rating
The appeal request that the Bank’s Composite rating be upgraded to “1” from the “2” rating assigned.

The Committee, however, agrees that the numerous material loan underwriting and administration weaknesses identified, many of a repeat nature, have both increased credit risk at the Bank and heightened the Bank’s overall risk profile. Furthermore, the Report of Examination enumerates a number of information technology, interest rate risk management, and anti-money laundering weaknesses. The Committee also observes that the Bank’s capital levels provide only adequate support to the Bank’s risk profile. The Committee recognizes the improvements in earnings and liquidity; however, the impact of these improvements on the Bank’s overall risk profile is more than offset by the loan administration and underwriting weaknesses detailed in the Report of Examination.

The Division of Supervision and Consumer Protection’s (DSC) Manual of Examination Policies states that “… management’s ability to respond to changing circumstances and to address risk 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.” Although construction, development, and commercial real estate lending are not new to the Bank, the Bank’s involvement with this type of lending has increased significantly in recent years without corresponding improvements in underwriting policies and procedures and loan administration. The Committee believes one hallmark of strong management teams (and banks) is their proactive implementation of policies and procedures that serve to mitigate risks associated with certain business lines or assets. Rather than proactively implementing sound risk management policies and procedures for the growing construction, development, and commercial real estate segments of the Bank’s loan portfolio, the Bank’s Board/management has continued to rely on risk management policies and procedures that are more suitable for lower-risk residential lending.

The FFIEC’s Uniform Financial Institutions Rating System states that banks rated Composite “1” are basically sound in every respect. The Bank’s financial condition clearly remains satisfactory, but its overall risk profile is sufficiently heightened by weaknesses in the administration of the construction, development, and commercial real estate segments of the Bank’s loan portfolio that some supervisory concern is warranted. The Committee concludes that the Composite “2” rating assigned is appropriate.

Other Issues Raised in the Appeal
The appeal also contains detailed comments related to “as is” appraisals and reserves for off-balance sheet items. The Committee agrees with DSC’s recommendations regarding these issues. Validation of the Estimate Site Values (or “as is” values) listed in Uniform Residential Appraisal Reports that underlie one-to-four family construction loans will allow for enhanced collateral analysis and stronger underwriting. The validation process is especially important in markets that have experienced a rapid escalation of property values (as has the greater Boston area). Similarly, the Committee agrees that considering unfunded loan commitments in the Bank’s ALLL analyses will enhance the Bank’s overall risk management program. Admittedly, there will be situations where reserves for unfunded commitments are unnecessary; but there will also be situations where reserves for unfunded commitments are warranted and prudent. To clarify, reserving for unfunded commitments was one of several factors examiners considered in determining that there was a small reserve shortfall at the 2003 FDIC examination.

Conclusion
For the reason’s set forth above, the Bank’s appeal is denied. This decision is considered a final supervisory decision by the FDIC.

By direction of the FDIC’s Supervision Appeals Review Committee.