Background
A bank formally
appealed its composite CAMELS rating of 4. The
Uniform Financial Institutions Rating System is used to rate six
components of a bank's performance:
capital, asset
quality, management, earnings, liquidity, and sensitivity to market
risk (CAMELS) in a combined composite rating. Management cited several
reasons for the appeal, including:
-
Factual errors in the Report of Examination (ROE);
-
A feeling on the part of the board of directors and management that the
examiner was overzealous, and came into the bank with a predetermined
conclusion to downgrade the bank's overall condition;
-
General statements were made in the ROE that did not have backup, or could be
considered improper statements; and,
-
The CAMELS component ratings were not justified based on the ROE and condition
of the bank, and the overall conclusions were therefore inappropriate.
Management acknowledges that many of the deficiencies identified in the ROE are legitimate and corrective action has
been implemented. However, they
state that they are at a loss as to why the rating dropped from a 2 to a 4 with
no changes in management or operations.
Discussion and Conclusions
The bank's ROE
stated the following reasons for the composite rating downgrade from
a 2 to a 4:
-
The overall condition of the bank deteriorated significantly as a result of
deficient management supervision and board oversight. Risk
management systems are inadequate, and the level of problems and risk exposure
is excessive.
-
Management and board supervision has not been effective.
-
Capital is deficient relative to the bank's increased risk profile, earnings
have deteriorated and are poor, asset quality and credit administration need
improvement, sensitivity to market risk is moderate, and liquidity is
satisfactory.
-
Supervision of management bank information systems is unsatisfactory.
The
supervisory office acknowledges that certain factual errors were
made in the ROE; although the errors are regrettable, none of the
errors affected the examination conclusions. In the appeal letter, the
board of directors stated they believed the examiner-in-charge was
overzealous and had predetermined that the bank's rating should be
downgraded. As examiner
objectivity and professionalism are fundamental elements in
effective bank supervision, this contention was taken
seriously.
After review
of related documentation and discussions with all parties involved,
the ombudsman did not find evidence that the examiner-in-charge nor
members of his staff were biased toward the bank. However, certain aspects of
the communication of the examination findings could have been
handled more effectively.
Bank management noted a number of general statements in the
ROE that they considered to be unsupported and improper. The statements referenced
were primarily those that contained adjectives such as "material,
significant, and substantive" in describing various identified
weaknesses. Since
management considers the examination conclusions and ratings to be
inappropriate, their objection to the adjectives used to describe
the identified deficiencies and exceptions is understandable. The following discussion and
conclusions regarding the assigned ratings will help resolve
management's objection to the referenced
statements.
Capital
The bank's
capital ratios declined significantly between examinations,
primarily the result of purchasing a large amount of deposits from
another bank that was closing a branch. Losses identified during the
examination also contributed to the decline in the bank's capital
ratios. The result of
the aforementioned events caused the bank's capital ratios to fall
to the "adequately capitalized" category, and the examination
resulted in capital being rated a 4. While it is apparent the
capital ratios declined significantly, implicit in a 4 rating is
concern about the viability of an institution, which was not the
situation in the case of this bank. Further, it is reasonable to
assume management's projections for profitability are attainable,
and that earnings should return to a level sufficient to supplement
capital. Therefore, the
ombudsman concluded that a capital rating of 3 was appropriate. 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, which is evident in this
case.
Asset Quality
The level of
classified assets remains high at over 60 percent of Tier 1 capital
plus the allowance for loan and lease losses (ALLL). There is little improvement
from the level of classified asset to capital ratio recorded at the
previous examination.
The level of classified assets has been high for the past
three examinations.
While some of the credit administration issues in the ROE may
individually be mitigated, collectively they represent a
concern.
As defined, a
rating of 3 is assigned when asset quality and/or credit
administration practices are less than satisfactory. Trends may be stable;
however, the level of classified assets is elevated, indicating a
need to improve risk management practices. The ombudsman concurred with
a 3 component rating for asset quality.
Management
The ROE is very
critical of "deficient management supervision and board
oversight." The ROE
states that problems and significant risks have not been adequately
identified, measured, monitored, or controlled. A number of deficiencies were
identified in the examination that support that conclusion; i.e.,
accounting errors that materially overstated earnings and capital,
ineffective strategic/ capital planning and budgeting, and
weaknesses in internal controls, audit, and management information
systems.
The
deteriorating condition of the bank is undeniable, and there is no
question that deficiencies in board and management supervision have
been a factor in that decline.
However, the bank's capital and earnings problems are largely
attributable to the deposit acquisition and the ALLL allocation made
at the examination in question. The large ALLL allocation
should not reoccur since it was attributable to a change in the ALLL
analysis process, and it is reasonable to assume that the net
interest margin should improve as the bank is able to gradually
employ a greater percentage of the acquired deposits into higher
yielding loans.
The ombudsman
recognized the steps management had taken to implement corrective
measures. The bank's
supervisory record with the OCC indicates that the board and
management team have been cooperative and there is no reason to
believe they cannot implement corrective action with respect to the
weaknesses noted at this examination. However, the deteriorating
condition of the bank is undeniable, evidencing a need for improved
risk management. The
ombudsman concluded that a component management rating of 3 was more
appropriate than the assigned 4. The 3 management component
rating clearly acknowledges that overall management and board
supervision warrant improvement.
Earnings
Most of the
earnings problems are attributable to onetime adjustments and the
temporary impact of the deposit acquisition. The bank achieved a small
profit for the year despite the adjustments made, and management is
projecting a return on average assets of 0.75 percent for this
year. While many of the
bank's earnings problems are attributable to a one-time adjustment,
improvements in the quality of earnings are also needed. Earnings have declined for
four consecutive years, and even if the bank meets its current
projections and achieves a return on average assets of 0.75 percent,
earnings performance would remain below average.
Per OCC
Bulletin 97-1, a rating of 3 indicates earnings that need to be
improved. Discounting
the one-time adjustment and deposit purchase, earnings may not fully
support operations and provide for the accretion of capital and ALLL
levels. The ombudsman
concluded that a component earnings rating of 3 was more appropriate
than the assigned 4.
Liquidity
While there
were several statements in the ROE that the bank disagreed with,
there was no disagreement regarding the component rating. Based on the ROE and the
bank's response thereto, improvements could be made in the accuracy
of information provided in the funds management/liquidity area. Liquidity is satisfactory
and the rating of 2 remains unchanged.
Sensitivity to Market Risk
The primary
reason for the 3 component rating in the ROE was "the bank's poor
earnings and deficient capital do not support the current level of
IRR" [interest rate risk].
While the ombudsman acknowledges the bank's level of interest
rate risk is moderate when compared to other banks, this is not the
case relative to the bank's capital and unsatisfactory
earnings. The ombudsman
found the rating of 3 remained appropriate.
Composite CAMELS Rating
The ombudsman
agreed that the bank has significant deficiencies in its risk
management processes, which have contributed to deterioration in the
bank's overall condition.
However, the deterioration was not to the point that failure
is a distinct possibility.
Management has already addressed many of the issues
identified during the examination and, with the OCC's guidance, the
bank can be returned to sound financial footing.
The composite
CAMELS rating of 4 were upgraded to a 3. As stated in the Uniform
Financial Institutions Rating System, institutions rated 3 exhibit
some degree of supervisory concern in one or more of the component
areas. Such financial
institutions exhibit a combination of weaknesses that may range from
moderate to severe.
Their management may lack the ability or willingness to
effectively address weaknesses within appropriate time frames. Financial institutions in
such a 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, financial
institutions rated 3 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. Such financial institutions
require more than normal supervision, which may include formal or
informal enforcement actions.
Failure would appear unlikely, however, given the overall
strength and financial capacity of 3-rated
institutions.
Appeal
of a Composite 3 CAMELS Rating - (Third Quarter 1998)
Background
A bank formally
appealed the composite CAMELS rating of 3 that was confirmed a
second time during a follow-up visit to the bank. Six months prior to this
visit, a full-scope examination was performed that initially
resulted in a composite rating of 3. The major reason for the
first 3 composite rating was the board's and management's failure to
correct several ongoing credit administration and risk management
deficiencies. The
credit administration and risk management deficiencies were
particularly troubling because the bank sustained 50 percent growth
during the past year.
Classified assets were relatively high, at slightly over 50
percent of capital.
Earnings performance was below average and recent trends were
negative.
The
above-mentioned risks resulted in several "Matters Requiring Board
Attention" (MRBA) comments relating to loan staffing and credit
administration, loan review, compliance, and internal audit, in the
Report of Examination.
At the time of the examination, capital was not considered a
major issue, in part because of plans to inject a large amount of
capital during the following year. The bank did not disagree
with the findings of the initial examination.
Six months
later, the follow-up visit was performed to assess the bank's
progress in correcting the MRBA comments included in the initial
Report of Examination.
The revised policies, procedures, and systems in the lending
area, the recently completed audit, loan review, and compliance
reports were also reviewed.
The results of that visit were positive. The examiners concluded that
the board and management had substantially addressed all the
deficiencies noted as MRBAs at the previous examination. The examiners noted
significantly improved risk management systems and stated the bank
now had the personnel and systems in place to provide adequate
coverage for audit, compliance, and loan review. However, the previously
assigned composite rating of 3 was maintained because of concerns
regarding the adequacy and management of the bank's capital and
earnings posture. The
bank had continued to grow rapidly between the examination and the
visit. While
substantial capital injections had taken place (although short of
the amount originally projected), management still had not developed
a realistic capital plan.
In the bank's
appeal, bank management stated the OCC had committed to upgrade the
composite rating to a 2, if the MRBAs were satisfactorily
addressed. The bank
further stated the amount of equity capital injected was sufficient
to keep the bank's capital ratios within the definition of well
capitalized.
Discussion
Composite
ratings are based on a careful evaluation of an institution's
managerial, operational, financial, and compliance performance. The six key components used
to assess an institution's financial condition and operations are
capital adequacy, asset quality, management capability, quantity,
and quality of earnings, the adequacy of liquidity, and sensitivity
to market risk. The
rating scale ranges from 1 to 5. The composite ratings of 2
and 3 are defined as follows:
Financial
institutions with a composite rating of 2 are fundamentally
sound. For a financial
institution to receive this rating, generally no component rating
should be more severe than 3.
Only moderate weaknesses are present and are well within the
board of directors' and management's capabilities and willingness to
correct. These
financial institutions are stable and are capable of withstanding
business fluctuations.
These financial institutions are in substantial compliance
with laws and regulations.
Overall risk management practices are satisfactory relative
to the institution's size, complexity, and risk profile. There are no material
supervisory concerns and, as a result, the supervisory response is
informal and limited.
Financial
institutions with a composite rating of 3 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. [From Federal Financial
Institutions Council.
"Uniform Financial Institutions Rating System," Federal
Register,
December 19, 1996, Vol. 61, No. 245, p. 67026,
attachment to OCC Bulletin 97-1.]
Conclusions
A fundamental
issue during any examination is the accurate assessment of the
bank's risk profile, and the processes and controls in place to
manage that risk. The
deterioration in the bank's financial condition noted during the
initial examination, coupled with substantive growth, warranted a
more comprehensive risk management process than existed at the
time. The detailed
MRBAs included in the initial examination helped guide management in
improving the bank's risk assessment systems. Improvement of the bank's
risk management processes was evident during the follow-up visit by
the supervisory office.
The major problems noted at the initial examination had or
were being satisfactorily resolved. Loan quality had improved,
additional staff was in place, internal audit was satisfactory and
administrative problems in the lending, and compliance areas were
significantly improved.
Based on the
bank's risk profile, it became very important for management to
maintain an adequate capital base. Equally important was the
need for a capital plan, which provides various alternatives for the
maintenance of satisfactory capital consistent with the bank's risk
profile. Management
must also develop an overall strategic plan that includes a
comprehensive focus on maintenance of adequate capitalization. This is particularly
important in light of the growth opportunities shared with the
ombudsman's office during the visit to the bank. The plan should include
growth targets, capital projections, and a determination of the
level of capital needed for the bank in both the short and long
term.
After the
ombudsman reviewed the issues noted in the bank's appeal letter, the
initial ROE, the follow-up review, and discussions conducted with
bank management and the OCC supervisory personnel, the ombudsman
concluded that a composite rating of 2 was appropriate, as a result
of the follow-up visit.
The improvements that occurred between the examination and
the follow-up visit reflected positively on the ability of the board
and management team to supervise the bank. This was a major factor in
the ombudsman's decision to change the rating.