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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-2000-02 (December 1, 2000)

On November 29, 2000, the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) considered the appeal of material supervisory determinations filed by [Bank] (the “Bank”).

After carefully considering the issues raised in your appeal letter dated September 11, 2000, together with all supporting information submitted by the Bank, the Committee concluded that the Management rating of “3”, the Capital Adequacy rating of “3”, and the composite rating of “3”, reflected in the FDIC’s April 17, 2000, Report of Examination (“Report”) are appropriate. The Committee also found that the classification of the subprime credit card portfolio, the determination concerning the adequacy of Allowance for Loan and Lease Losses (“ALLL”), the citation of apparent violations of laws or regulations, and the determination concerning the adequacy of internal controls are appropriate. The Committee therefore concluded that the Bank’s appeal should be denied.

Although the Committee recognizes the generally satisfactory financial indicators regarding asset quality, liquidity, and sensitivity to market risk, serious deficiencies remain that warrant the CAMELS component and composite ratings assigned. The Committee urges you to take steps to correct the deficiencies noted in the Report.

Finding Appealed
The Committee’s conclusions regarding the issues appealed by the Bank are presented below together with a discussion of the reasons underlying the decision.

Management Rating
The Uniform Financial Institution Rating System’s definition of a “Management” rating of “3” follows:

“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.”

Several 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 is considered less than satisfactory, 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 violations of law, poor administration of the subprime credit card portfolio, an under funded ALLL, and an ineffective loan review system. These weakness warrant a component rating of “3” for Management and require your immediate attention.

Classification of Subprime Credit Card Portfolio
The Uniform Retail Credit Classification and Account Management Policy (the “Retail Credit Policy”) issued to institutions through Financial Institutions Letter -17-99 on February 19, 1999, provides guidelines for classification of retail credit loans. In general, open-end and closed-end retail loans past due 90 cumulative days from the contractual due date should be classified Substandard. Closed-end retail loans that become past due 120 cumulative days and open-end retail loans that become past due 180 cumulative days from the contractual due date should be charged off. However, the Retail Credit Policy states that there may be instances that warrant exceptions to the general classification policy. It further provides that the Retail Credit Policy does not preclude examiners from classifying individual retail credit loans that exhibit signs of credit weakness regardless of delinquency status.

The Bank’s subprime credit card portfolio is characterized by high delinquency and loss rates. As of December 31, 1999, and March 31, 2000, the total delinquency ratio approximated 18.4 percent and 13.2 percent, respectively. Further, the Bank’s migration analysis indicates credit card loans in the 30-59 day and 60-89 day delinquency periods generally have a 30 percent and 50 percent loss exposure, respectively. These loss exposures present will-defined concerns that warrant classification. Management did not adequately monitor servicer activity. Loan losses during 1999 were exacerbated by the Bank failing to charge-off accounts in prior periods due to a programming fault that did not accurately identify delinquent accounts. Internal audit has not yet been expanded to cover the credit card area.

Based on the subprime portfolio’s poor quality, management’s weak administration thereof, and lack of audit coverage, examiners exercised the flexibility that the Retail Credit Policy provides and appropriately classified these loans.

Allowance for Loan and Lease Losses
The ALLL required a provision of between $190,000 to $290,000 to fund the ALLL to a level that was adequate to absorb estimated credit losses. Most of the shortfall was determined to be related to the subprime credit card portfolio. However, due to the inadequate loan review system, reserves for traditional loans were also deficient. Internal grading of problem loans was not accurate as approximately 28 percent of the dollar volume of traditional loans classified by examiners were correctly identified on the Bank’s watch list. The examiners recommended the Bank modify its methodology for determining the ALLL by changing its charge-off criteria for subprime credit card loans from 120 days to 90 days and providing a margin on current subprime credit card loans (10 percent rather the 3.5 percent reported loss factor). The margin is deemed appropriate to account for unknown risks in the subprime portfolio because of questionable delinquency reporting and re-aging of delinquent accounts and the unproven effectiveness of the in-house collection program.

Examiners also recommended providing for an additional two months of historical losses in the subprime portfolio. Guidance for the maintenance of the ALLL is provided in the Interagency Statement of Policy on the Allowance for Loan and Lease Losses (“Guidance”) dated December 21, 1993. Concerning estimated credit losses, this Guidance states:

“[E]stimated credit losses should reflect consideration of the institution’s historical net charge-off rate on pools of similar loans, adjusted for changes in trends, conditions, and other relevant factors that affect repayment of the loans in these pools as of the evaluation date.”

The Guidance further states: “[W]hen determining the level for the ALLL, management’s analysis should be conservative so that the overall ALLL appropriately reflects a margin for the imprecision inherent in most estimates of expected credit losses.” The additional two months losses recommended by examiners is appropriate to account for the factors and inherent imprecision described in the Guidance.

The board is urged to adopt an appropriate ALLL methodology and to periodically assess the effectiveness of the methodology. Moreover, the board must ensure that the Bank implements an effective loan review system (which includes an effective credit grading system) that identifies, monitors, and addresses asset quality problems in an accurate and timely manner.

Apparent Violations of Law and Regulation
The Report listed apparent violations involving Part 323 and section 326.8(b) of the FDIC’s Rules and Regulations 12 C.F.R. Part 323 and § 326.8(b), and the Administrative Rules of South Dakota 20:07:03:12. The apparent violations concerning Part 323 involved real estate appraisals and were deemed appropriate by the Committee. The Report describes five loans requiring appraisals as defined in Part 323. Appraisals were not acquired and used in the credit decision making process prior to the loans in question being approved and funded. Two of the five appraisals were obtained during the examination. These appraisals were dated three and five months after the respective loan dates. One appraisal had not yet been obtained and the other two appraisals were in the file but were dated nearly eight months and 11 months after the respective origination dates.

The apparent violation involving section 326.8(b) concerns independent testing of the Bank Secrecy Act (“BSA”) program used by the Bank and was deemed appropriate by the Committee. This regulation requires that independent testing be conducted at least annually and test procedures be thoroughly documented. The Report found no evidence that independent testing of the Bank’s BSA program had been completed since the October 27, 1997, FDIC examination. Furthermore, the BSA review in process during the examination was not adequate in scope and documentation.

The apparent violation of the Administrative Rules of South Dakota 20:07:03:12 concerns the Bank holding a non-permissible investment and was found to be appropriate by the Committee. While the Bank charged-off the investment in a non-rated security in August 1999, this action did not correct the apparent violation. Examination guidance contained on page 4.5-3 of the FDIC’s Manual of Examination Policies states, in part, “An illegally held or acquired asset is still illegal at its original amount, whether or not it has been partially or completely charged-off the bank's books.” Apparent violations of this nature should continue to be cited until such time as the security is either upgraded to investment grade quality, called, redeemed, or the bank otherwise divests of its interest in said security. Therefore this violation is, in fact, a correctable situation.

Adequacy of Internal Controls
The Report accurately identified a number of internal controls weaknesses, including infrequent account reconcilement, inadequate control over negotiable instruments and cash, and numerous issues involving the credit card operation. Many of these weaknesses had been identified at previous examinations and audits. While it is understood that Bank acquisitions and Year 2000 (“Y2K”) issues consumed a significant amount of management’s time, the board is ultimately responsible to ensure that management is maintaining proper internal controls. The Committee therefore found these criticisms were appropriately cited by the examiners. The addition of an internal auditor to the Bank’s staff is a positive step towards addressing this issue.

Capital Adequacy
The Uniform Financial Institution Rating System’s definition of a “Capital” rating of “3” follows:

A rating of 3 indicates a less than satisfactory level of capital that does not fully support the institution’s risk profile. The rating indicates a need for improvement, even if the institution’s capital level exceeds minimum regulatory and statutory requirements.

The Report thoroughly addresses the Bank’s risk profile and qualitative factors such as level and trend of capital, volume and trend of problem assets, adequacy of ALLL, quality of management, strength of earnings, plans for growth, access to capital and other sources of capital. The subprime credit card portfolio continues to pose a significant risk to the Bank, representing 111 percent of the Bank’s Tier 1 capital as of the examination date. Although the size of the portfolio is declining, the reduction has occurred primarily from charge-offs, which impact earnings. The ALLL is not adequately funded, and risk monitoring systems such as loan review are not properly assessing the risk in the loan portfolio. Furthermore, management has not provided adequate oversight of the subprime credit card portfolio, has increased commercial real estate lending without proper loan administration controls and risk rating, has not implemented effective internal controls, and has failed to comply with laws and regulations. Overall, these weaknesses warrant a rating of “3” for the capital component.

Composite Rating
The Uniform Financial Institutions Rating System’s definition of a Composite rating of “3” follows:

Financial institutions in this group exhibit some degree of supervisory concerning 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, summarized herein, revolve around inadequate board and management oversight of the subprime credit card operations, lax loan underwriting and administrative practices, an under funded ALLL and ineffective loan review system, apparent violations of law, and poor internal controls. While asset quality is marginally satisfactory, large credit card losses, and high overhead expenses render earnings performance unsatisfactory. Although the holding company injected capital during the first quarter of 2000, capital remains unsatisfactory and the Bank’s risk profile has been elevated by deterioration in the credit quality of commercial loans, continued losses in the subprime credit card portfolio, unsatisfactory earnings, and poor risk management practice’s.

Many of the criticisms contained in the Report are repeat criticisms from one or more examinations, indicating a lack of concern for regulatory recommendations and prudent banking practices. Given the foregoing, the Report findings comport with the definition of a composite “3.”

In accordance with the Guidelines for Appeals of Material Supervisory Determinations, the scope of this review was limited to the facts and circumstances that existed at the time of the examination; no consideration was afforded to any changes occurring after that date or to any subsequent corrective action.

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.