Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-2005-01 (August 5, 2005)

Background

*** Bank (“Bank”), “City, State”, filed an appeal with the FDIC’s Supervision Appeals Review Committee (“Committee”) on May 27, 2005. The Bank is appealing a decision issued by the FDIC’s Division of Supervision and Consumer Protection (“DSC”), on April 28, 2005. DSC denied the Bank’s request for upgrades of the Asset Quality and Management component ratings, as well as the Composite rating, as set forth in an August 2, 2004, joint FDIC/”State Banking Regulator” Report of Examination. DSC also denied the Bank’s request for an upgrade of certain loan classifications.

The Bank’s representatives asked for an opportunity to appear before the Committee to present their views in person. The Committee granted the request and met with the Bank’s representatives on July 12^th. Chairman and CEO “A”, President “B”, and Directors “C” and “D” spoke on behalf of the Bank. DSC senior staff members, both previously involved in the examination of the Bank and involved in reviewing the Bank’s request for review of material supervisory determinations, spoke on behalf of DSC.

In accordance with the Guidelines for Appeals of Material Supervisory Determinations¹ the Committee reviewed the appeal for consistency with the policies, practices and mission of the FDIC, and the overall reasonableness of, and the support offered for, the respective positions advanced. The scope of the Committee’s review was limited to the facts and circumstances as they existed at the time of the examination.

After carefully considering all of the written and oral submissions and the facts of this case, the Committee has determined to deny the Bank’s appeal.

Common Themes Raised by the Bank
The Bank’s appeal contains a number of general comments challenging DSC’s April 28^th decision. The Bank contends that the DSC decision is based on incomplete analyses, incorrect facts, unsupported assumptions, improper procedure, and is unresponsive to the Bank’s arguments. These concerns were considered by the Committee in the context of the material supervisory determinations challenged by the Bank. This Decision does not attempt to discuss each of the assertions made by the Bank, but they were considered as part of the Committee’s review. Overall, we find that the conclusions set forth in the examination report are consistent with FDIC policy and existing examination guidance, sufficiently supported, and appropriate given the facts available at the time of the examination.

Asset Quality

Rating Criteria
The Uniform Financial Institutions Rating System provides that the Asset Quality component rating is based upon an assessment of certain qualitative and quantitative factors including, but not limited to, the following:

• The adequacy of underwriting standards, soundness of credit administration practices, and appropriateness of risk identification practices.
• The level, distribution, severity, and trend of problem assets.
• The adequacy of the allowance for loan and lease losses and other valuation reserves.
• The credit risk arising from or reduced by off-balance sheet transactions.
• The existence of asset concentrations.
• The adequacy of loan policies, procedures, and practices.
• The ability of management to properly administer its assets.
• The adequacy of internal controls and management information systems.

As defined under the Uniform Financial Institutions Rating System,

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.

A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management's abilities.

Issues Identified
The Asset Quality component was assigned a 3 rating in the examination report. The examination report noted improvements in the Bank’s asset quality but concluded that it was still less than satisfactory. The report cited concerns regarding the level of classified assets and the level of nonaccural and past due loans, other real estate owned (“ORE”), concentrations, and construction loan risks.

The Bank responded – with regard to classified assets and past due loans – that the loans were older loans and were not representative of the Bank’s portfolio, that they presented low probability of further loss, that the level of past due assets was attributable to specific collection strategies, and that, in any event, the assets were well supported by reserves and capital even in a worse case scenario. The Bank asserted that its methodology of evaluating and writing down ORE properties to appropriate levels had been sufficiently successful such that the FDIC should be convinced that the ORE portfolio did not subject the Bank to additional risk. The Bank stated that DSC presented no evidence to support the “purported ‘higher risk’ nature of construction and land development lending.” The Bank claimed that its loan portfolio was diverse and short-term, which should lessen overall risk. The Bank also rejected DSC’s peer group analyses.

Discussion
ORE. DSC acknowledged that the Bank's methodology for evaluating and writing down ORE properties has resulted in minimal losses in the past. At the same time, we concur with DSC’s view that ORE holdings are nonearning assets and are detrimental to bank performance and condition. It is also reasonable to conclude, as DSC did, that the Bank's success in liquidating ORE properties during a period of strong appreciation in commercial and residential real estate nationwide does not necessarily mean that it will be successful in less favorable markets.

Representative Loan Portfolio. DSC acknowledged that the three largest classified relationships may not be representative of the overall quality of the portfolio. That being said, the loans in question comprise 57 percent of Tier 1 capital and reserves and clearly present an elevated risk of loss. In addition, the nonclassified loans in the portfolio are indeed concentrated in construction and land development and contain higher inherent risk.

Peer Group Analyses. As noted in the report, the examination team created a custom peer group to utilize as one component of their financial analyses. This peer group included all insured commercial banks with total assets of $300 million to $1 billion, resulting in a peer group of 1,308 banks. When the DSC team in Washington, D.C., conducted its independent review, it refined the examination team’s criteria to create a peer group to utilize as an additional component in their financial analyses. DSC’s refined peer group included commercial banks having total assets of $300 million to $1 billion and having construction and land development loan portfolios that comprise at least 25 percent of gross loans, resulting in a smaller peer group. We believe it was appropriate for the examination team to utilize the peer group they selected in analyzing the financial condition and performance of the Bank and, in light of the Bank’s unique characteristics, we believe it was appropriate for DSC to create a refined custom peer group for purposes of furthering their analyses of the Bank’s condition, and that the criteria used in both circumstances was reasonable. Under either approach, the Bank’s performance was less than satisfactory.

Level of Classified Assets and Past Due Loans. The examination report acknowledged improvements in the Bank’s asset quality. In spite of these improvements, the Bank remained at the bottom of its peer group in several loan quality categories, including the ratio of current loans to total loans, the ratio of ORE to Tier 1 capital, and the ratio of charge-offs to loans. In addition, the DSC found that the Bank's Total Adversely Classified Items Coverage Ratio² was among the *** highest in its custom peer group. No bank in that peer group that had a coverage ratio equal to or higher than the Bank received an Asset Quality rating of 2. We believe that the Bank's capital and reserve levels do not significantly mitigate asset quality concerns given current levels of nonaccrual loans and the existing concentration and anticipated growth in higher-risk construction and land development loans.

Conclusion. DSC appropriately considered a variety of qualitative and quantitative information in assigning the Bank's asset quality rating including the level of nonperforming loans, the level of classified assets, the adequacy of underwriting standards, the soundness of credit administration procedures, the appropriateness of risk identification practices, the diversification of the loan portfolio, and the existence of asset concentrations. The Bank's asset quality rating reflects varying weaknesses in each of these areas. We agree with DSC that, given the level and severity of classifications, the level of noncurrent loans, and the level of ORE, a rating of 2 is not appropriate. The Committee agrees with the assigned rating of 3.

Management Rating

Rating Criteria
The Uniform Financial Institutions Rating System lists the factors to be considered by examiners when evaluating the capability and performance of management and the board of directors. These factors are designed to illuminate the quality of board and executive management and specifically encompass risk management processes. They include, but are not limited to, the following:

• The level and quality of oversight and support of all institution activities by the board of directors and management.
• The ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the initiation of new activities or products.
• The adequacy of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities.
• The accuracy, timeliness, and effectiveness of management information and risk monitoring systems appropriate for the institution’s size, complexity, and risk profile.
• Compliance with laws and regulations.
• Responsiveness to recommendations from auditors and supervisory authorities.
• Management depth and succession.
• The extent that the board of directors and management is affected by, or susceptible to, dominant influence or concentration of authority.
• Reasonableness of compensation policies and avoidance of self-dealing.
• The overall performance of the institution and its risk profile.

Based upon its review of the Bank, and in light of the foregoing factors, the examination report assigned a Management rating of 3. As defined under the Uniform Financial Institutions Rating System,

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.

The Bank contends that it should have been assigned a Management rating of 2. As defined under the Uniform Financial Institutions Rating System,

A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the institution’s size, complexity, and risk profile. Minor weaknesses may exist, but are not material to the safety and soundness of the institution and are being addressed. In general, significant risks and problems are effectively identified, measured, monitored, and controlled.

Issues Presented
The examination report cited a variety of weaknesses in support of the 3 rating. Among other concerns, the report notes that the Bank’s risk management practices were less than satisfactory, and that the board and management were affected by the dominant influence and concentration of authority in the Chairman and CEO.

The Bank contends that the examination report did not take into account management's accomplishments since the 2003 examination, and that these accomplishments alone support a rating upgrade. With regard to criticism of the Bank’s risk management practices, the Bank asserts that many recommended practices were already implemented; that the Bank sought assistance from the FDIC but none was available; and that the benefits of some recommendations were unclear and the Bank was therefore continuing its dialogue with regulators before implementation. The Bank suggests that the level of influence exerted by Chairman A is no different from that exerted by any other individual in a similar position. The Bank questions whether an individual's influence should be viewed negatively if the individual does not abuse his/her authority. The Bank also takes exception to examination report comments related to actions of the Special Committee, a committee created by the board to independently investigate lending and other activities of a former Chairman and anyone acting with him.

Discussion
Management of Risk. As indicated in the examination report, the Bank's business model is unique and intrinsically carries more risk than a traditional diversified balance sheet. Lending activities are almost entirely focused on commercial real estate, and residential and commercial real estate development. Products include short- and medium-term financing for development, re-development, and other purposes. Deposits are generated on a nationwide basis and consist primarily of time deposits, including brokered deposit accounts. In addition to its main office and *** branches in ***, the Bank operates loan production offices in ***, ***, and ***.

During the July 12^th meeting, the Bank’s representatives conceded that the business model pursued by the Bank is risky. They indicated that the Bank developed its multi-state presence in construction lending in order to diversify but conceded that they could not be certain whether such diversification would mitigate risks and suggested that only time would tell. We concur with the examination report finding that, because of its concentration on commercial real estate development lending, the Bank may be less capable of withstanding business fluctuations and is more vulnerable to outside influences than other, well diversified financial institutions.

The report acknowledges that risk management practices had improved since the 2003 examination but found that enhanced risk management practices should be implemented. The areas that remained to be addressed included the methodology to stratify risk within the loan portfolio; credit administration practices and identification of risks relating to individual loans; risks relating to construction loans; identified loan underwriting and credit administration deficiencies; appropriate capital adequacy methodology. The report also refers to a Memorandum of Understanding (“MOU”) – proposed subsequent to the 2003 examination – and describes the recommendations that have not been fully addressed by the Bank. These include implementation of a system to monitor all loans with capitalized interest, implementation of an appropriate monitoring system, and completion of a capital adequacy analysis. The Bank points out that the MOU was never signed and there was no requirement to fulfill the recommendations. However, DSC explained in its April 28^th decision that the provisions of the draft MOU corresponded to weaknesses examiners identified in the 2003 examination. An MOU is not enforceable but it is a means to draw a bank's attention to perceived deficiencies. Recommendations contained in the draft MOU appear both reasonable in light of the Bank’s size, complexity, and risk profile and relatively simple to accomplish. The Bank’s failure to adequately address examiner recommendations, whether contained in an executed MOU or not, does not reflect positively on Bank management.

Corporate Governance. DSC stated in its April 28^th letter that corporate governance failures identified in the examination report exacerbated concerns related to the Bank's real estate development concentration. These governance failures included the Chairman/CEO’s dominance of, and influence over, all short- and long-range planning, policy making, and decision making; the turmoil and turnover at the board level; the Special Committee's failure to complete its investigation within a reasonable period; and the Bank's continued marginal financial performance. The Bank counters that Chairman A does not exert significant influence over the affairs of the Bank; that he showed considerable deference to members of the Special Committee; and that his actions were reasonable.

Chairman A serves as the Bank's chairman, chief executive officer and controlling shareholder. He developed and oversees the Bank's multi-region construction and development lending business strategy. Since the 2003 examination, he removed three independent directors who voiced an opinion contrary to his, and he acted to curtail the scope of an internal investigation. The board is now composed of his spouse, his former attorney, the Bank's president, and a former consultant to the Bank. We believe it is reasonable to conclude that the scope of Chairman A's managerial responsibility, his role as the Bank's chief strategist, the size of his investment in the Bank, his actions related to the Special Committee, and his actions to remove certain independent directors, support the contention that he exerts a dominant influence over both the Bank’s board and its affairs.

The Bank contends that it had sufficient and reasonable grounds for removing the three independent directors. The examination report acknowledges that the Bank produced plausible reasons for removing these directors and goes on to explain: “For example, Directors E and F were removed from the Special Committee because they would not accept [what Chairman A felt were reasonable] time limits and cost constraints to conclude the Special Committee’s investigation so that the action on the investigation could be turned over to the full board.” The examination report details the history of the Special Committee, and we can appreciate the level of frustration that accompanied the board’s efforts to bring the Special Committee investigation to fruition. At the same time, we must acknowledge DSC’s view that Chairman A's introduction of the resolution prescribing time/budget constraints and his participation in the subsequent discussion and vote is problematic, given the possibility that Chairman A also may have been the subject of the Special Committee investigation

Conclusion. The Committee agrees that the assigned Management rating of 3 is appropriate. The Committee considers both the examiners’ findings and methodology appropriate and the resultant rating well supported. The examiners appropriately applied outstanding policy guidance in the evaluation of the Bank’s management. Both the examination report and April 28^th decision acknowledge management's accomplishments. However, such actions are insufficient to support a rating of 2 especially in light of the Bank’s appetite for risk and the totality of weaknesses identified in the Bank.

Available Corporate Governance Guidelines
As a point of general information, the FDIC and the other banking agencies frequently publish and issue guidance for insured institutions and their officers and directors to use to fulfill their responsibilities. This information is available on the FDIC’s web site in a special section called “Director’s Corner.” It includes Interagency Policy Statements, Supervisory Guidance, and Financial Institution Letters on various topics, including Corporate Governance Practices. The Corporate Governance materials include the FDIC’s “Pocket Guide for Directors,” a Statement of Policy entitled “Statement Concerning the Responsibilities of Bank Directors and Officers,” and various regulations such as 12 CFR Part 364 entitled “Standards for Safety and Soundness.” The FDIC’s Risk Management Manual of Examination Policies, Section 4.1 entitled “Management” - also published on the internet - includes a discussion of the issues facing directors of “One Man Banks”. Finally, the FDIC offers the “Chicago Region Director's College Program” that can be tailored to a bank’s interests. The board may wish to take advantage of this program if they have not already done so.

Loss Classification
The Bank asserts that it was inappropriate to classify as Loss $1.4 million in X loans because they were charged-off prior to the examination. While it is true that the charge-offs were taken on July 2, 2004, and the examination began one month later, on August 2, 2004, the asset review date for the examination was June 30, 2004. In its April 28^th decision, DSC stated that this treatment is consistent with typical examination practice and is designed to ensure more meaningful ratio calculations. DSC also indicated that, even if the appealed classifications were upgraded to “Pass,” total classifications would remain at a less than satisfactory level. The Committee believes that DSC’s treatment of the loans, and the resulting classifications, was reasonable and consistent with FDIC practices.

Composite Rating
A 3 rating connotes an institution that exhibits some degree of supervisory concern in one or more of the component areas. In contrast, a 2 rating refers to an institution that is fundamentally sound, but may reflect modest weaknesses correctable in the normal course of business. The Bank asks that its Composite rating be upgraded from 3 to 2. The Bank believes management and the board have overcome extraordinary hurdles to operate a safe and sound financial institution. The Bank contends that it has maintained substantial capital ratios; proactively dealt with asset quality issues; addressed prior regulatory concerns; and maintained effective staffing levels, policies, and procedures.

DSC cited several factors supporting a 3 rating in its April 28^th decision:

• The nature and severity of management-related deficiencies at the Bank are material.
• These deficiencies, coupled with the Bank's high-risk profile, raise questions as to whether the Bank could withstand business fluctuations, as required for a 2 rating.
• The dismissal of three directors raises questions as to whether the Bank has the management team in place to address the various financial and operational pressures that often accompany economic cycles.
• The Bank’s overall performance and condition remains marginal.
• Despite having capital ratios at the top of its peer group, the Bank's capital position is barely adequate, given the high-risk nature of its balance sheet, the large construction and land development concentration, the fact that a substantial portion of the capital base is comprised of capitalized interest reserves, and internal growth projections that show loan growth that will reduce total risk-based capital to 13.95 percent by June 30, 2005.

Given the facts and circumstances existing at the time of the examination, the Bank's overall financial condition was less than satisfactory. The Committee agrees that the assigned Composite rating of 3 is appropriate.

Conclusion

For the reasons set forth above, the Bank’s appeal is denied.

This decision is considered a final supervisory decision by the FDIC.

By direction of the Supervision Appeals Review Committee of the FDIC dated

August 5, 2005.

_______________________________

Valerie J. Best

Assistant Executive Secretary

_______________________________

¹ The Guidelines are set out at 69 Fed. Reg. 41479, 41486 (July 9, 2004), and in FDIC Financial Institution Letter (“FIL”) 113-2004 (Oct. 13, 2004).
² The “Adversely Classified Items Coverage Ratio” is the ratio of total adversely classified items to Tier 1 Capital and the ALLL (before adjustments for Loss classifications).