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Federal Deposit
Insurance Corporation

Each depositor insured to at least $250,000 per insured bank

Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-2004-03 (June 15, 2004)

On March 1, 2004, “Bank” filed an appeal with Michael J. Zamorski, Director, Division of Supervision and Consumer Protection (“DSC”). The Bank contested ratings assigned in the July 7, 2003 joint report of examination to the Capital, Asset Quality, and Management components, as well as the assigned Composite rating. The Bank also contested the Substandard classification accorded the credit relationship of ***, et. al. The Bank filed additional materials in support of its appeal on March 31st and April 8th.

Mr. Zamorski declined to grant the Bank’s appeal. The appeal was then automatically referred to the Committee as required by the Guidelines for Appeals of Material Supervisory Determinations, 60 Fed. Reg. 15923 (March 28, 1995). On April 26th, the Bank’s President, ***, advised that the Bank’s representatives wished to appear before the Committee to present their views. The Committee granted the Bank’s request. A hearing was held on May 11th. Appearing on behalf of the Bank at the May 11th meeting were Bank Chairman and CEO “A”, “B” and “C”.

The Committee has carefully considered the written submissions made by the Bank and DSC, as well as the oral presentations made at the May 11th meeting. In accordance with the Guidelines, the scope of the Committee’s review was limited to the facts and circumstances as they existed at the time of the examination. No consideration was given to any facts or circumstances that developed after the examination.

Management Rating"3"
The Uniform Financial Institutions Rating System provides that the capability and performance of management and the board of directors is rated based upon, but not limited to, an assessment of the following evaluation factors:

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 Management component was rated “3” at the examination. The Bank’s appeal sets forth the position that management is effective and that issues raised by examiners, if viewed in the proper context, do not indicate performance that is less than satisfactory. Such issues included inappropriate lending activities and inaccurate loan risk ratings, apparent violations, and the lack of loan committee minutes and effective communication with the board.

However, the Bank’s appeal does not present new facts or information, available during the examination, that would contradict the information assessed or dispute many of the underlying facts relied upon by examiners. While a number of corrective measures have been undertaken, the following matters discussed in the Examination Report indicate that board and management performance needs to improve.

In light of the identified weaknesses, risk management practices are not considered sufficient relative to the Bank’s size, complexity, and risk profile. The Committee concurs with the examination’s assessment of the Management component and with the assigned rating of “3.”

Asset Classification "3"
As described in the Manual of Examination Policies, loan classifications express differing degrees of the risk of nonpayment. Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Additional guidelines are also provided in classifying troubled commercial real estate loans, which supplement the uniform guidelines discussed above; the supplemental guidelines are to be applied in instances in which the obligor is devoid of other reliable means of repayment, with support of the debt provided solely by the project. The supplemental guidelines provide that well-defined weaknesses include a project’s lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project’s failure to fulfill economic expectations.

With respect to he Substandard classification of the ***; et. al. relationship, the Bank’s appeal indicates that four of the ten adversely classified loans have been paid, with recoveries realized in all four instances. The Bank’s appeal also notes that the Bank’s agreement to sell the remaining assets will result in a significant recovery, which will be in addition to the recoveries of $3.5 million on the thirteen notes paid to date; together, the Bank’s appeal contends that these events or developments validate the Bank’s internal analysis and prior charge-offs, demonstrate the strength of the pledged collateral, and brings into question the Substandard classification.

However, the Bank’s appeal presents no factual inaccuracies in the Examination Report and provides no new information that was available during the examination but not considered by examiners. The Examination Report noted that the subject credits were more than 300 days overdue, and in nonaccrual status, and that the Bank was pursuing collection through foreclosure, among other actions. In addition to noting the distressed conditions under which the properties would be marketed, the Examination Report also noted the potential risk in the central sponsor’s bankruptcy proceedings, risk in obtaining title to the properties, and uncertain settlement costs to clear mechanics liens.

The possibility of loss in the classified assets continued subsequent to the examination, and the proposed third-party acquisition of the remaining assets had not yet been completed. The Committee concurs with the examination’s assessment of the relationship and with the assigned Substandard classification.

Asset Quality Rating"3"
The Uniform Financial Institutions Rating System provides the following qualitative and quantitative factors bearing on the Asset Quality component rating:

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.

The Asset Quality component was rated “3” at the examination; the Bank’s appeal describes management efforts to provide for satisfactory asset quality and credit administration practices, citing efforts to address problem credits, reduce sponsor concentrations, maintain staffing, and provide for analysis of loan requests. The Bank’s appeal contends that the increase in classified assets is concentrated in three credit relationships that present extraordinary circumstances, are not reflective of portfolio quality, and have a low probability of future losses.

The Committee recognizes the Bank’s efforts to address problem relationships and other matters. Nonetheless, the asset quality and credit risk management practices are less than satisfactory.

The weaknesses are most evident in the level of adverse classifications, which rose to 73 percent of capital and the allowance for loan and lease losses, and the overdue loan ratio of 13.8 percent as of June 30, 2003. The increased level of classified or troubled credit relationships, regardless of the underlying cause, is immoderate.

The Examination Report also raised a number of issues relative to credit administration. Internal risk ratings were inaccurate in one-third of the relationships reviewed by examiners, which brings into question the reasonableness of the Bank’s watch list, the sufficiency of loan review and monitoring, and the adequacy of the allowance for loan losses.

The Bank’s appeal asks for a lower level of supervisory concern regarding the Bank’s concentrations, noting the geographic diversification within the loan portfolio, the relatively short-term nature of the portfolio and its disbursal by product type, and the reduction of sponsor concentrations in number and degree. The Bank’s appeal also argues that, based on historical loss rates, the commercial real estate sector presents less risk than commercial and industrial loans.

The Manual of Examination Policies states that concentrations add a dimension of risk which management should consider when formulating plans and policies. In formulating these policies, management should, at a minimum, address goals for portfolio mix and limits within the loan and other asset categories. However, the Bank’s loan policy lacks parameters that serve as effective limitations, as nearly 50 percent of the loan portfolio is composed of 9 borrowers, and 98 percent is composed of loans categorized as commercial real estate. The high concentration is exacerbated by the proportion of the Bank’s balance sheet resources invested in outstanding loans; as of March 2003, the ratio of net loans to total assets comprised 80 percent of the Bank’s assets.

Overall, the conditions evident during the examination raise financial and operational concern, regardless of the underlying causes of loan problems and despite efforts to reduce concentrations. The noted administrative and qualitative issues weigh on the asset quality rating determination and heighten supervisory concern regarding the significant and continuing weakneses in the Bank’s control environment, including the administrative and control failures involving the *** Relationship and the lack of loan committee minutes, among others. The Committee concurs with the examination’s assessment and with the assigned Asset Quality rating.

Capital Rating
The Uniform Financial Institutions Rating System provides that the capital adequacy of an institution is based on an assessment of the following factors:

As defined under the Uniform Financial Institutions Rating System,

A rating of 2 indicates a satisfactory capital level relative to the financial institution’s risk profile.

The Bank’s appeal contends that capital warrants an assigned rating of “1.” The Bank notes that the September 2003 capital measures place the Bank in the upper quartile of the standard peer group and in the top ten percent of institutions included in the self-prepared custom peer group. In part, the Bank’s appeal attributes these rankings to the Bank’s internal methodology, which resulted in minimum leverage and total risk-based capital thresholds of 8 and 11 percent, respectively. Further, the board adopted regulatory recommendations to maintain an additional amount of capital over the thresholds, which led the Bank to establish goals for the leverage and total risk-based measures of 9 and 12.5 percent, respectively. The Bank’s appeal also notes that the board opted to temporarily increase capital levels above the minimum thresholds due to the problem loans identified.

However, the comparisons to a custom peer group are flawed, given that the selected group includes institutions under $2 billion in total assets. Importantly, the Bank’s methodology fails to fully address the unique risk profile of the institution, such as:

Approximately 46 percent of the 2002 capital injection was depleted due to the operating losses emanating from the asset deterioration and related matters. Since March 2002, capital measures have been maintained, in large part, by asset shrinkage of more than 19 percent. In addition, other factors bearing on the Management and Asset Quality components increase the institution’s overall risk profile.

The Committee concurs with the examination’s assessment and the assigned Capital rating.

Composite Rating
The Uniform Financial Institutions Rating System requires that Composite ratings be based on a careful evaluation of an institution’s managerial, operational, financial, and compliance performance. Under the Uniform Financial Institutions Rating System, a composite “3” rating is defined as 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.

The Bank’s appeal contends that management and the board have been successful in overcoming extraordinary adversities and have operated in a very safe and sound manner. In support, the Bank’s appeal summarizes efforts or results that are worthy of a composite rating no worse than “2,” including:

However, the Bank’s appeal does not identify any facts that were available but not considered during the examination. Moreover, the Bank’s appeal fails to sufficiently mitigate several significant concerns that existed at the time of the rating determination. Weaknesses, some of a continuing nature, are evident in oversight and risk management practices, and Bank practices and policies are weak or otherwise less than satisfactory given the institution’s size, complexity, and risk profile.

The facts and circumstances known at the time of the examination support that management has been reactive to adverse events rather than maintaining a proactive risk management stance. The level of adversely classified or troubled assets is immoderate and the trend is unfavorable; an elevated degree of supervisory concern is warranted by the increase in troubled assets, which, when combined with the significant concentration of credit, results in the Bank being more vulnerable to adverse economic trends and conditions. The concentration of credit also detracts from quantitative benchmarks of capital adequacy.

In summary, the examination concerns and supervisory recommendations relate to fundamental weaknesses and the Bank’s elevated risk profile, which are appropriately reflected in the assigned ratings.

The Committee concurs with the examination’s assessment and the assigned Composite rating.

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

The Bank’s appeal also contends that it would be inappropriate to assign the Bank to a Supervisory Subgroup reflective of the supervisory rating assigned by the Regional Office. While this matter cannot be appealed under the Guidelines, the Bank may pursue a separate appeal process. Please refer to the Financial Institution Letter titled Determination of Assessment Risk Classifications to the Assessment Appeal Committee, November 28, 2003 (FIL-90-2003).

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

By direction of the Supervision Appeals Review Committee of the FDIC dated June 15, 2004.

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