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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-99-07 (December 10, 1999)

Your appeal of material supervisory determinations set forth in the April 5, 1999, joint safety and soundness examination was denied by the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) on December 7, 1999.

The State of California Department of Financial Institutions (“the State”) was provided a copy of your letter of appeal; Deputy Commissioner James E. Brodie has responded that the State concurs with the ratings and overall findings of the Report of Examination (“Report”).

Before deciding your appeal, the Committee considered your request to appear in person before the Committee for purposes of presenting witnesses and evidence in support of your appeal. Based upon the comprehensive nature of your October 18, 1999, appeal letter, the Committee concluded that the record relating to your appeal was sufficiently complete and that an oral presentation would not be productive.

The Committee has given careful consideration to the issues raised in your letter. After review, the Committee has concluded that the rating of “3” assigned to the Asset Quality component, the rating of “4” assigned to the Management component, the rating of “3” assigned to the Liquidity component, the rating of “3” assigned to the Sensitivity to Market Risk component, and the Composite rating of “3” are appropriate as reflected in the Report. The Committee also found that the apparent violation of Part 309 of the FDIC Rules and Regulations and the [Bank] (“Bank’s”), designation as a troubled institution are appropriate.

Although the Committee recognizes the generally satisfactory financial indicators regarding capital and earnings, serious deficiencies remain that warrant the CAMELS component and composite ratings assigned. The Committee recognizes that you have filed a Safety and Soundness Compliance Plan with the Regional Office, which addresses steps to correct some of the deficiencies noted in the Report. The Committee urges you to implement the Plan, and to take steps to correct the other 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 of the reason for the decision.

Asset Quality
The Uniform Financial Institution Rating System’s (“UFIRS”) definition of an Asset Quality component rating of “3” follows:

“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.”

Asset quality has deteriorated since the previous examination, which is evidenced by, among other things, an increase in the severity of classifications, with loans totaling $237,000 classified Doubtful and $512,000 classified Loss versus no Doubtful and only $67,000 classified Loss at the previous examination. While total classifications have decreased from $7 million at the previous examination to $6 million, the Committee notes that a major part of the decline in total adversely classified assets was due to the transfer of $1,400,000 in Other Real Estate (“ORE”) to a newly created Bank affiliate following the 1998 examination.

Regarding the *** ORE property, at the time of the examination, the Bank had been unsuccessful in obtaining final approval to develop the property due to access and easement problems. The Committee recognizes that the Bank has been attempting to resolve the problems. However, without resolution of these issues, the property cannot be developed and the potential value cannot be realized, therefore, there is a realistic possibility of loss. Accordingly, the Committee believes that the property meets the definition of Substandard as provided in the Division of Supervision (“DOS”) Manual and was appropriately included as a classified asset.

Deteriorating asset quality trends, in conjunction with the weaknesses in credit administration, underwriting, and the allowance for loan and lease losses (“ALLL”) methodology detailed in the Report warrant a “3” Asset Quality rating.

Management Rating
The UFIRS’s definition of a Management component rating of “4” follows:

“A rating of 4 indicates deficient management and board performance or risk management practices that are inadequate considering the nature of an institution’s activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and require immediate action by the board and management to preserve the soundness of the institution. Replacing or strengthening management or the board may be necessary.”

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

The board and operating management evidence deficiencies that expose the Bank to risk and must be corrected. Board oversight continues to be weak, and management has failed to establish a proper control environment. The Committee is very 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 continuing criticisms of internal controls and recurring instances of apparent conflicts of interest by Chairman ***. These weaknesses warrant a component rating of “4” for Management and require your immediate attention.

The UFIRS Policy Statement provides the following description for a Liquidity component rating of “3”:

“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.”

Deterioration in the Bank’s liquidity position since the last examination, as evidenced by deposit runoff and increased reliance on noncore funding sources, is a concern. However, perhaps more importantly, management’s liquidity and funds management practices need improvement. The Report details the specific concerns regarding liquidity policy weaknesses, which include lack of consideration of large deposit relationships, reliance on noncore funding sources, or unfunded commitments. Additionally, control over brokered deposits was noted as lax. Moreover, it does not appear that the implications of the Bank’s liquidity position were thoroughly considered prior to engaging in the Bank’s strategy to increase the Bank’s low loan-to-deposit ratio in response to criticism of its low ratio at a January 1998 compliance examination. Given these risk management weaknesses, and the deterioration in the Bank’s liquidity position, the Liquidity component warrants a “3” rating.

Sensitivity to Market Risk
The UFIRS Policy Statement provides the following description for a Sensitivity to Market Risk component rating of “3”:

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

There are significant weaknesses in market risk management practices, poor board oversight of the area and management’s failure to address several weaknesses in risk management practices that were identified at the previous examination. A notable repeat criticism is that the interest rate risk policy fails to address several key components required by the Joint Agency Policy Statement on Interest Rate Risk. These components are establishing acceptable interest rate risk ranges, a regular structure for reporting interest rate risk exposure to the board, acceptable measurement systems to estimate risk exposure to earnings and capital, and procedures to be followed when exposure exceeds approved limits. Also, the complexity of the Bank’s asset structure has increased since the previous examination, as the Bank increased ite investment in callable step-up notes, which grew from 23 percent of Tier 1 capital at the previous examination to 88 percent of Tier 1 capital. These investments are subject to greater price volatility in rising interest rate environments, but the Bank does not have adequate monitoring systems in place to measure this risk.

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 details significant deficiencies in risk management practices that warrant a “3” rating for the Sensitivity to Market Risk component.

Apparent Violations of Section 309.6 of the FDIC’s Rules and Regulations
The Bank copied individual members of Congress and the General Accounting Office (“GAO”) on its appeal of the 1998 examination. Since the appeal contained confidential supervisory information, the Bank was cited for an apparent violation of Section 309.6 of FDIC Rules and Regulations, which prohibits disclosure of confidential supervisory information, without the prior approval of the FDIC.

Section 309.5(g)(8) prohibits from disclosure all “[r]ecords that are contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of the FDIC.” Information in the 1998 appeal that related to the examination, including ratings and excerpts from examination reports, clearly falls under the disclosure prohibition and the Committee denies the Bank’s appeal.

Regarding the Bank’s contention that Part 309 is not clear, and that banks, not the FDIC “own” the privilege associated with the regulation, the Bank overlooks the fact that – as displayed prominently on the front of the Report as well as in the regulation – reports of examination are property of the FDIC, and only the FDIC can authorize disclosure of information contained therein. Likewise, the bank examination and other privileges that protect information in the reports belong to the FDIC, not the Bank, and therefore can be waived only by the FDIC. The statement in your appeal attributed to Associate Director Mark Schmidt is incorrect. Mr. Schmidt indicated that the regulation protects banks from unauthorized disclosure of information, not that the “privilege” associated with the regulation belongs to banks.

The Bank’s contention that Section 309.6 is an unconstitutional prior restraint on speech is not meritorious. Nothing in the First Amendment or any other provision of the United States Constitution prohibits the FDIC from restricting the disclosure of proprietary information obtained during or resulting from the examination process and belonging to the FDIC. The Bank’s assertion that Part 309 conflicts with 12 U.S.C. Section 4806, the statute establishing the supervision appeals process is also without merit. Nothing in that statute suggests that Congress in any way sought to overturn or modify the restrictions on disclosure of exempt records set forth in Part 309.

Troubled Institution Designation
Section 32 of the Federal Deposit Insurance Act (“FDIC”) requires troubled institutions to provide the FDIC with 30 days written notice prior to the appointment of any director or senior executive officer. Section 303.101(c) of the FDIC Rules and Regulations defines a troubled institution as one with a composite rating of “4” or “5,” or subject to a formal enforcement action Order or Notice to Issue an Order, or “is informed in writing by the FDIC that it is in troubled condition for purposes of the requirements of this subpart on the basis of the bank’s most recent report of condition, report of examination, or other information available to the FDIC.”

The San Francisco Regional Office notified the Bank that it is in troubled condition, based on the findings of the April 5, 1999, examination. Given the significant weaknesses in management noted in the Report, the Committee believes that it is appropriate to designate the Bank as troubled in order to monitor the management situation at the Bank.

Composite Rating
The UFIRS’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 an inadequate board that has failed to implement appropriate controls, including lax supervision of operating management with a very dominant chairman, whose stewardship features transactions which represent or appear to represent conflicts of interest. Many of the criticisms contained in the Report are repeat criticisms from one or more examinations, indicating a disregard for regulatory recommendations and prudent banking practices.

The Report acknowledges that the capital and earnings positions are adequate at this time. However, the CAMELS rating system is designed to be prospective, as it considers not only financial condition, but also risk management practices. Risk management practices are clearly inadequate, and indeed are the driving forces behind the deterioration in asset quality, liquidity, and market risk noted at this examination. Given the foregoing, the Report findings comport with the definition of a composite “3.”

Other Matters
The Bank’s allegations of bias, discrimination, and retaliation by Regional Office staff were not specifically considered by the Committee. However, the specific examination findings on which the Bank premised its allegations were independently reviewed and are addressed above. The Office of the Ombudsman will review and respond to these allegations, independent and separate from the Supervision Appeals Review Committee process.

The Appeal further requests that the FDIC Board of Directors review the decision of the Office of the Ombudsman regarding the Bank’s 1998 appeal. This request has also been forwarded to the Office of the Ombudsman.

The Bank’s request for any response to the appeal given by the Regional Office and any evidence offered in opposition to the appeal by the Regional Office will be processed pursuant to the provisions of the Freedom of Information Act and you will receive a response from the office responsible for handling such requests under separate cover.

In accordance with the Guidelines, 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. However, the San Francisco Regional Office will consider any such efforts in its determination of the proposed supervisory response.

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.

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