Appeals of Material Supervisory Determinations: Guidelines and Determinations
SARC- 2006-01 (November 14, 2006)
This appeal arises from the Request for Review (Request) of the ***, (X,
or the Bank) of certain material supervisory determinations made by the
Dallas Regional Office (Regional Office) and the Tennessee Department of
Financial Institutions (TDFI). Specifically, X seeks review of all six of
its component ratings Capital, Asset Quality, Management, Earnings,
Liquidity, and Sensitivity to Market Risk as well as of the composite
rating assigned jointly by the Regional Office and TDFI in the Safety and
Soundness Report of Examination (2005 Examination), dated April 18, 2005.
Accordingly, X disputes the 2 Capital, Liquidity, and Sensitivity to
Market Risk component ratings, as well as the 3 Asset Quality, Management,
and Earnings component ratings. Also disputed is the 3 composite rating.
The 2005 Examination used financial information as of December 31, 2004;
assets were reviewed as of April 18, 2005.
A. A Preliminary Matter: The 2004
This case involves allegations by the Bank of incidents of examiner
misconduct. The Supervision Appeals Review Committee (Committee) regards
such allegations with significant concern. FDIC policy prohibits any
retaliation, abuse, or retribution by an agency examiner against an
institution. Accordingly, these allegations have been directed to the
appropriate channels within the FDIC.
The issue for Supervision Appeals Review Committee Case No. 2006-01 is
whether the material supervisory determinations made by the Regional Office
withrespect to Xs six component ratings and its composite rating,
as set forth in the 2005 Examination, are supported by the facts of record.
This Decision is rendered solely with respect to that issue.
In accordance with the Guidelines for Appeals of Material Supervisory Determinations
, the Committee reviews the appeal for consistency with the policies,
practices, and mission of the FDIC, as well as the reasonableness of and
support for the respective positions of the parties. The Committee granted
Xs request to appear, and a meeting was held on June 6, 2006. Appearing on
behalf of the Bank were Chief Executive Officer *** (A), Director ***
(B), and the Banks outside counsel, *** (C). The Committee has
carefully considered the written submissions made by the Bank and the
Division of Supervision and ConsumerProtection (DSC), as well as
the oral presentations at the June 6 meeting. Under the Guidelines,
the scope of the Committees review is limited to facts and circumstances
existing at the time of the examination. No consideration is given to facts
or circumstances that developed following the examination.
The Banks oral presentation at the June 6 meeting focused on examiner
misconduct alleged to have occurred during the February 2, 2004, Safety and
Soundness Examination (2004 Examination) and the October 4, 2004, Safety
and Soundness Joint Visitation (2004 Joint Visitation). Bank
representatives further stated their belief that misconduct as well as
erroneous findings in 2004 were the underlying cause for the material
supervisory determinations made at the 2005 Examination.
While the findings and the underlying facts and circumstances of the 2004
Examination are not a subject of this appeal, the Committee, in its concern
for the serious allegations made with respect to the 2004 Examination and
2004 Joint Visitation, reconvened the independent Review Panel that
previously evaluated the Banks appeal of the material supervisory
determinations made at the 2005 Examination. The Review Panel was asked to
examine 1) the validity of the 2004 Examination and 2004 Joint Visitation
findings, and 2) whether the 2005 Examination was influenced by the
assertions or by any other factors. The Review Panel conducted a
comprehensive evaluation. This evaluation included a review of examination
and visitation reports and supporting work papers; a review of file
memoranda, emails, correspondence, and other relevant written documents; and
extensive interviews with 19 individuals.
The Review Panel found that the analyses and conclusions in the 2004
Examination were accurate based on work papers, other documents reviewed,
and the interviews of examination personnel.
The Review Panel did identify three errors in the 2004 Joint Visitation
(1) There was criticism of a loan that had been previously paid off;1
(2) In regard to the Compliance Plans requirement that the full Board
approve extensions on adversely classified loans, Xs extension of the ***
(D) loan by other than the full Board was made prior to the effective date
of the Compliance Plan and thus, this extension should not have been
(3) With respect to the Banks allowance for loan and lease losses (ALLL)
methodology, the Bank provides a 50 percent reserve against the balance in
the Late Charges Receivable account in its ALLL. The Report criticized this
practice despite the fact that X had obtained concurrence on its
acceptability from the Regional Accountant in the Memphis Area Office of the
FDIC. Further, the allocation method is allowable and should not have been
The Panel determined that these errors were not material to the 2004 Joint
Visitation findings. Overall, the Review Panel found that analyses and
conclusions in the 2004 Joint Visitation Report were accurate, based on work
papers and other documentation reviewed.
Based on the Review Panels findings and evaluation of the 2004 Examination
and 2004 Joint Visitation reports, the Review Panel determined that the 2005
Examination material supervisory determinations were not influenced by any
other factors and that they were based upon the financial condition and risk
management practices in place at the Bank as of April 18, 2005.
B. Factual Background: The 2005 Examination.
The Bank is a commercial bank headquartered in ***, Tennessee, in the ***
portion of the state. The Bank opened in July 2001 and conducts traditional
commercial bank operations from its main office and one full-service branch
location. X experienced rapid growth in 2002. Concerns with Management
supervision and operational weaknesses initially surfaced in the February
24, 2003, TDFI Report of Examination (2003 Report). Management was
assigned a 3 rating, based largely on identified weaknesses in the areas
of loan administration, operating policies, and managing Information
Technology (IT) and Registered Transfer Agent (RTA) functions. The TDFI
required a Board Resolution that became effective April 2003 to address the
identified weaknesses. The 2004 Examination revealed corrective measures
previously proposed by Management were not sustained, and material
deterioration was noted. Inadequate oversight and weak management by the
Banks Board; the decline of leverage capital; the rise of classified
assets; weak earnings; dependency on Internet deposits; and an inability on
the part of Management to identify, assess, monitor, or control risk in the
institution were all flagged; and regulatory concern was heightened. As a
result, a comprehensive Compliance Plan pursuant to Section 39 of the FDI
Act was implemented, which encompassed Risk Management, Bank Secrecy Act,
IT, and RTA. The Compliance Plan became effective July 26, 2004.
The 2005 Examination was delivered to X on August 31, 2005. On November 30,
2005, X filed its Request with the Acting Director of DSC. On December 22,
2005, the Acting Director affirmed the decision of the Dallas Regional
Office and determined that the ratings were consistent with FDIC policy and
existing examination guidance and appropriate, given the facts available at
the time of the examination. The Bank filed an appeal with the Committee by
letter dated February 22, 2006.
The Bank appeals all six component ratings as well as its composite rating.
While acknowledging difficulties with asset quality, business decisions, and
overall condition in the past, X argues that today the Bank is fundamentally
sound; that its asset quality has been enhanced with the implementation of
new and effective underwriting, administration, and risk identification
procedures; that its capital is well above the minimum requirements for a
well-capitalized bank; that its management has significantly improved; that
its earnings are on an upward trend; that its liquidity is excellent; and
that it has developed its sensitivity to market risk by refining its
reports, allowing management to adjust assets and liabilities to maintain a
strong net interest margin.
With respect to the 2005 Examination findings, in summary, DSC argues that,
when the Bank developed the Safety and Soundness Compliance Plan in July
2004 and thereafter implemented corrective measures, Management made
considerable efforts to correct identified weaknesses and to adhere to the
Compliance Plan. However, previous decisions and actions continued to
affect the Banks condition, including asset quality and earnings. DSC
asserts that the ratings assigned at the 2005 Examination appropriately
reflect the identified weaknesses in loan quality, Management oversight,
core earnings, and the Banks overall risk profile.
II. Analysis: The Safety and Soundness Material Supervisory
Determinations of the 2005 Examination.
The Bank disputes the Composite rating of 3, and the component ratings for
Capital of 2, Asset Quality of 3, Management of 3, Earnings of 3,
Liquidity of 2, and Sensitivity to Market Risk of 2. The Bank
seeks ratings of 2 for Management, Asset Quality, and Earnings, ratings of
1 for Capital, Liquidity, and Sensitivity to Market Risk, and a Composite
rating of 2.
Under the Federal Financial Institutions Examination Councils Uniform
Financial Institutions Rating System (the FFIEC Rating System), an
institution is expected to maintain capital commensurate with the nature and
extent of risks to the institution and the ability of Management to
identify, monitor, and control such risks. The types and quantity of risk
inherent in an institutions activities will determine the extent to which
it may be necessary to maintain capital at levels above required regulatory
minimums. Xs Capital rating of 2 indicates a satisfactory, as opposed
to a strong capital level.
X argues for a revised Capital adequacy rating of 1, contending that the
2 was assigned only because of the Banks level of classified assets. X
points to the rapidly improving trends in its asset quality and the
implementation of effective corrective action by the Board and Management.
The Bank argues its capital ratios provide more than a sufficient cushion to
cover any perceived higher risk from the classified assets, as the ratios
exceed the minimum requirements for well-capitalized banks. Further, the
Bank contends that it has been improperly criticized for lacking a capital
plan, and that, in fact, a capital plan was in place at the time of the 2005
DSC responds that the asset quality continued to show signs of
deterioration, with adversely classified assets increasing from 57 percent
to 64 percent of Tier 1 capital and the allowance for loan and lease losses
(ALLL). Nonperforming loans as a percentage of gross loans and leases
were increasing and approaching seven percent. Internally identified
Pass/Watch and Special Mention loans represented approximately 70 percent of
capital. With regard to Xs claim that it met the minimum requirements for
well-capitalized banks, adequate capital for safety and soundness purposes
may differ significantly from minimum leverage and risk-based standards.
The well-capitalized standards on which X relies are used in implementing
the Prompt Corrective Action provisions to resolve problems of insured
institutions at the least possible long-term loss to the deposit insurance
fund. Safety and Soundness concerns require institutions to maintain
capital commensurate with the level and nature of risks to which they are
exposed, and that includes the volume and severity of adversely classified
assets. Finally, the 2005 Examination specifically comments that the Bank
had not developed a formal written Capital Plan; the 2005 Examination also
notes Managements response to this deficiency was that A committed to
develop such a written Capital Plan.
The Committee finds unpersuasive the Banks argument that an improving trend
in asset quality and its well-capitalized status for Prompt Corrective
Action purposes supports a Capital component rating of 1. Most notably,
classified assets increased from 57 percent to 64 percent of Tier 1 capital
and ALLL. Further, internally identifiedPass/Watch and Special
Mention loans represented nearly 70 percent of capital. These facts do not
denote strong, or even an improving, asset quality trend. A rating of 2
indicates a satisfactory though not a strong capital level, and that rating
is appropriate here.
B. Asset Quality.
Asset quality is one of the most critical areas in determining the overall
condition of a bank. The asset quality rating reflects the quantity of
existing and potential credit risk associated with the loan and investment
portfolios, other real estate owned, and other assets, as well as
off-balance sheet transactions. A FFIEC Rating of 3, as here assigned to
X, denotes asset quality or credit administration practices that 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.
X argues that DSC considered an increase in the number of classified assets
as the sole indication of deteriorating asset quality. The Bank explains
that the number of classified assets and delinquent loans increased only
because the Bank improved its risk identification system and that the
elevated level of classified assets was temporary and caused by the very
aggressive risk identification system.
In fact, while the new risk identification system improved the Banks
ability to identify and properly monitor problem credits, the system simply
measures the continued increase in, but is not responsible for the existence
of, past due and nonaccrual loans. The 2005 Examination states that the
Adversely Classified Items Coverage Ratio was elevated at nearly 65
percent with delinquent loans approaching 7 percent. That ratio reflects
even a slight increase from the 2004 Examination, and both are clearly high,
particularly for a bank in only its fourth year of operation. As indicated
in the discussion of the Capital component, internally identified watch list
loans that are not included in the adversely classified totals were also
high, aggregating nearly 70 percent of capital. The level of problem loans
is largely the result of inadequate lending practices and decisions during
high growth periods before the 2004 Examination. The Banks Compliance Plan
required corrective action in a number of areas, including asset quality and
loan administration. The 2005 Examination takes specific account of
Managements efforts to address provisions of the Compliance Plan and
previously identified weaknesses in the Banks lending practices. The
addition of a senior vice president and chief credit officer was also
beneficial and was noted in the Report.
Additionally, DSC points out that the Bank has focused on working out
problem loans and resolving other regulatory concerns since the 2004
Examination. During this low-growth period, Management has concentrated on
addressing weaknesses in the lending function. Implementation of revised
credit administration practices is relatively new and has not been tested
during a period of growth. Managements ability to maintain loan quality
during an expansion period, while continuing to address existing problem
loans, remains largely unproven.
Taking these factors into consideration the high level of adversely
classified and delinquent loans, the significant volume of internally
identified watch list loans, the increasing level of adversely classified
loans, and Managements unproven ability to manage loan quality in a growth
period the Committee determines that asset quality is less than
satisfactory, and an Asset Quality rating of 3 is justified.
Sound management is demonstrated by active Board and Management oversight;
competent personnel; adequate policies, processes, and controls; maintenance
of an appropriate audit program and internal control environment; and
effective risk monitoring and management information systems. A 3 rating,
such as that assigned to X, signals the need for improved Management and
Board performance and possible inadequate identification, measurement,
monitoring, and control of risk.
X believes that examiners ignored Managements many efforts in swiftly
identifying the causes for the Banks problems and expeditiously
implementing corrective action, thus reversing the declining trend in
overall condition and asset quality. Further, the Bank complains that in
analyzing Management, DSC heavily (and improperly) emphasized the RTA
Examination that was conducted concurrently with the 2005 Examination, thus
placing undue reliance on technical RTA issues emanating from a single
transaction. In addition, the Bank argues that all five items relating to
RTA activities in the Compliance Plan have been properly addressed. With
regard to its strategic plan and budget, X argues that DSC has an overly
formalistic approach to those documents, contending that the Banks plan and
budget are satisfactory planning tools for a community bank with less than
$100 million in total assets and that the plan and budget were reviewed and
approved by a local CPA firm.
DSC responds that Management failed to identify causes for its problems in a
timely manner. Management only began corrective action after regulatory
criticism in the 2004 Examination and the implementation of the Compliance
Plan. Asset quality was not improving but deteriorating, and the Bank had
no formal written strategic plan and was relying on an inadequate budgeting
process. DSC asserts that, with respect to its treatment of RTA issues, all
aspects of the Bank are considered in determining the capabilities and risk
management practices of Bank Management. A single transaction would not
necessarily adversely affect the Management rating. However, Xs RTA
activities have been rated a 3 in three consecutive exams. The continued
less-than-satisfactory condition is reflective of Managements weak control
and poor performance in this area. Further, the eleven apparent violations
cited in the 2005 RTA Examination were not repeat violations, and indicate a
lack of familiarity with the rules and regulations and weak risk management
practices on the part of Management. According to the 2005 RTA Examination,
only two of the five provisions in the Compliance Plan had been met. The
remaining three were not met, given Managements failure to record or
reflect the 2004 exchange of bank stock for holding company stock.
The Banks assertion that the strategic plan and budget are satisfactory is
not supported by the evidence. As of the date of the 2005 Examination, X
did not have a formal written strategic plan. Rather, the Bank was using
the Compliance Plan as its strategic plan. Moreover, the lack of adequately
documented budget assumptions and the lack of a formal budget variance
reporting process are strong indicators of a weak budgeting process. Three
budgets prepared between October 2004 and June 2005 showed a wide range of
growth projections and operating results. For example, the original budget
submitted with the October 2004 Compliance Plan progress report indicated
net operating income (NOI) for 2005 of $804,000. The revised budget
provided during the 2005 Examination (April 2005 budget) projected NOI of
$314,000, which included $5,000 in negative provisions. An addendum comment
in the 2005 Examination states that a revised budget dated June 2005
projected NOI of $367,000, which included a negative provision of $500,000.
The budgeting process requires greater rigor.
In light of the weaknesses identified in Management oversight and budgeting
procedures, the Banks overall financial condition, and apparent regulatory
violations, the Committee believes the Banks risk management practices
cannot be considered adequate, given Xs size, complexity, and risk
profile. The Committee finds that Management performance needs further
improvement and risk management practices have been less than satisfactory.
The Management component is properly rated a 3.
Bank earnings, both current and accumulated, absorb losses and augment
capital. Earnings are the initial safeguard against the risks of engaging
in the banking business and represent the first line of defense against
capital depletion. The quality and quantity of an institutions earnings
are affected by inadequately managed credit risk or by high levels of market
risk that may unduly expose an institutions earnings to volatility in
interest rates. Xs rating of 3 signifies its need to improve. Under
such a rating, earnings may not fully support operations and provide for the
accretion of capital and allowance levels in relation to the Banks overall
condition, growth, and other factors affecting the quality, quantity, and
trend of earnings.
X notes that the 2005 Examination based the Earnings component rating on the
compressing net interest margin (NIM) and the rising overhead expenses,
indicating, the Bank charges, that the 2005 Examination Report does not
adequately address the fact that many of the increases in overhead expenses
are nonrecurring, resulting from corrective actions taken to meet the
requirements of the Compliance Plan. Additionally, the Bank asserts that
the 2005 Examination focused on the lack of non-core earnings, as net income
was significantly buoyed by reversing provision expenses. Moreover, the
Banks NIM continues to be above its peer group.
DSC responds that the Earnings component was based, not only on the NIM and
overhead expenses, but also on the weak budgeting process, the lack of core
earnings, and the significant negative provisions. Acknowledging that some
overhead costs may be associated with implementing the Compliance Plan, DSC
nevertheless points out that the Bank failed to provide supporting
documentation, either to the examiners in April 2005 or in its Request or
Appeal documents. Further, while concurring that the Banks NIM is higher
than peer, DSC counters that since 2002, the Banks NIM has had an aggregate
decline of more than 100 basis points, while over the same period, the
Banks peer group saw its NIM increase in the aggregate by more than 50
basis points. While the NIM level is in line with peer, the decline is
noteworthy, especially since over the same time frame, the Banks peers
moved in an opposite direction.
Given the level and declining trend in key earnings and profitability
measures, the exposure to interest rate risk, and the need to improve
budgeting processes, the Committee determines that the Earnings component of
3 is fully supported.
Liquidity, which represents the ability to fund assets and meet obligations
as they become due, is essential to compensate for expected and unexpected
balance sheet fluctuations and provide funds for growth. Liquidity risk is
the risk of not being able to obtain funds at a reasonable price within a
reasonable time to meet obligations as they become due. To qualify for the
highest FFIEC Rating of 1, an institution must not only have strong
liquidity levels, but it also must have well-developed funds management
policies. Such an institution will have reliable access to sufficient
sources of funds on favorable terms to meet present and anticipated
X argues that the Banks Liquidity rating of 2 was based wholly on the
Banks use of Internet-derived deposits, which deposits X maintains have
been a stable source of funding since the Banks establishment.
Additionally, the Bank maintains that the 2005 Examination, by discounting
the reliability of Internet-derived deposits,
takes a position that is
contrary to an article regarding interest rate risk and funds management
that appeared in the Spring 2005 issue of FDIC Outlook.
DSC counters that Xs funds management practices also played a role in its
Liquidity component rating of 2, which is deemed a satisfactory rating,
describing an institution having access to sufficient sources of funds on
acceptable terms to meet present and anticipated liquidity needs. However,
[m]odest weaknesses may
be evident in funds management practices in an
institution with a 2 Liquidity rating. The DSC Risk Management Manual of
Examination Policies states that Internet-derived deposits may be highly
rate sensitive and can be a less stable source of funding than typical
relationship deposit customers. Accordingly, various risk management
safeguards are required to manage accounts and any other future funding
strategies. Funds management practices criticized in the 2005 Examination
included: (1) the need to establish specific goals to monitor Managements
stated plans for increasing the level of core deposits; (2) the lack of
integration of cash flow projections into the funds management process; (3)
the lack of a comparison of the cost of Internet-derived deposits to local
core deposit funding; (4) the lack of funding options other than
Internet-derived deposits; and (5) the absence of a contingency funding
plan. DSC points out that the FDIC Outlook article cited by X,
(which expresses the views of the authors and not official positions of
FDIC) never addressed Internet-derived deposits but discussed the use of
On the basis of these facts, the Committee believes that Xs Liquidity is
satisfactory and is properly rated a 2.
F. Sensitivity to Market Risk.
Sensitivity to Market Risk, for most institutions, addresses the degree to
which changes in interest rates can adversely affect an institutions
earnings or capital. The component focuses on the banks ability to
identify, monitor, manage, and control its market risk. X seeks a rating of
1, which denotes a bank with well-controlled market risk and minimal
potential that earnings performance or capital position will be adversely
affected. In a 1 rated institution, risk management practices are strong,
calibrated by the size, sophistication, and market risk accepted by the
institution. The level of earnings and capital provide substantial support
for the degree of market risk taken by the institution.
X contends that its Sensitivity to Market Risk component rating of 2 was
assigned solely because the examiners suggested some fine tuning to interest
rate and market sensitivity reports.
DSC asserts that the rating is based on Xs interest rate risk exposure,
which is considered moderate, with a highly asset-sensitive position in the
short term. The compression in the NIM is evidence that fluctuations in
interest rates have and may continue to affect the Banks earnings. (The
Banks NIM dropped 60 basis points in one quarter.) Moreover, 11 percent of
the Banks loan portfolio have reached their contractual interest rate
floors. Consequently, these loans will not reprice until the interest rate
index rises to a level that causes the contractual interest rate to exceed
the floor interest rate. Further affecting the rating are Xs capital and
earnings positions, as well as the deficiencies in risk management
practices. Banks rated 2 in Sensitivity to Market Risk have adequately
controlled market risk, with only moderate potential that the earnings
performance or capital position will be adversely affected.
The Committee is mindful of Xs interest rate risk exposure, as well as the
compression in its NIM. However, we are persuaded that its Sensitivity to
Market Risk is satisfactory and is properly rated a 2.
G. The Composite Rating.
Composite ratings are based on a careful evaluation of an institutions
managerial, operational, financial, and compliance performance. The
composite rating is not the arithmetic average of the component ratings, as
some components are given more weight than others, depending on how critical
they are to the overall health
of the bank. The Management component, for
example, is factored heavily, as weaknesses in Management oversight can
affect every aspect of bank operations. Asset Quality, too, is emphasized
because of the cumulative effect that asset problems can have on an
X asserts that the 2005 Examination overemphasizes earlier activities in
assigning a Composite rating of 3. The Bank feels that the 2005
Examination fails to focus on the timely corrective action implemented by
Management and the overall positive trend in, and future prospects of, the
Banks financial performance.
DSCs notes both asset quality and earnings have deteriorated, and there are
new apparent violations in the RTA function. Further, there are weaknesses
in the budgeting process, in liquidity and sensitivity to market risk
monitoring and reporting, and in the lack of strategic and capital plans.
Also, Bank Management did not execute timely corrective action. Rather,
such action was taken following the discovery of significant deficiencies
and their citation in the 2004 Examination. The Bank executed a Compliance
Plan specifically to implement corrective action. The Committee finds on
the basis of all this evidence that the overall condition of the institution
remained less than satisfactory and is correctly rated a 3.
For the reasons set forth above, Xs 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
November 14, 2006.
The examiner had intended to criticize a different loan, which loan was
correctly cited on a later page in the Report. The Dallas Regional Director
informed Xs President of this fact in his letter of February 9, 2005.