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Appeal of 3 Composite CAMELS Rating of 3 and Various Component Ratings - (First Quarter 2001)


A bank formally appealed several conclusions in the report of examination (ROE), which included:

  • The composite CAMELS rating;
  • The capital, asset quality, management, and earnings component ratings;
  • The request for a provision to the allowance for loan and lease losses (ALLL);
  • The assessment of the bank's risk profile; and
  • The evaluation of the bank's internal audit function.

In addition, the appeal submission expressed a serious concern that the supervisory office had engaged in a pattern of ''vindictive treatment.''

Asset Quality (3-rated)

Discussion and Conclusion

The bank's appellate submission stated:

The ROE completely abandoned objective factors for the subjective considerations in the area of asset quality. The ROE attempts to justify a 3 rating by subjective evaluations of the bank's credit risk and credit risk evaluations, while completely ignoring the actual levels of non-performing assets and minimal level of charge-offs. An assignment of a 3 rating in this area was unwarranted because underwriting criticisms were disproportionately based on OCC's identified ''structurally weak'' loans.

The ROE concluded that asset quality was less than satisfactory and that credit risk management practices were unsatisfactory. The ROE stated the basis for those conclusions were a deficient loan policy, pervasively weak underwriting practices, an unacceptable level of nonperforming assets, aggressive loan growth, a rising level of classified and criticized assets, and the absence of risk limits for the numerous concentrations of credit.

The ombudsman conducted two meetings with bank management during the processing of this appeal. One meeting included members of the ombudsman's office and senior management in the bank. The other meeting included senior management of the bank, members of OCC's supervisory office, a member from the OCC's Credit Policy Division in Washington, D.C., and a member of the ombudsman's staff. The meetings were important to provide a better understanding of the organizational and credit cultures within this institution, and to ensure that OCC supervisory policies were being implemented as intended. The second meeting, facilitated by the ombudsman's office, provided an opportunity to gain a practical understanding of the bank's credit culture. The loan-by-loan review of the borrowers listed in the ''Loans with Structural Weaknesses'' section presented additional information and insight that would have led to the exclusion of many of these loans from that section of the ROE. Although the supervisory office personnel held discussions with senior management, in most cases, it was clear that they did not have full knowledge of the particular circumstances of the borrowers when preparing this section of the report.

Officers were able to discuss the mechanics of commercial real estate (CRE) lending and demonstrated an awareness of the related risks. The officers were successful in explaining why most of the loans on those pages were appropriately underwritten. OCC's supervisory office personnel acknowledged the ROE comments would have been more balanced had these types of discussions occurred during the examination. Members of the supervisory office agreed that the concern with underwriting, based on the discussions, resulted primarily from lack of documentation. The ombudsman reminded bank management of the importance of documented analysis becoming a part of the lending process to ensure that risks have been appropriately identified and addressed on a consistent basis.

While the discussion with management demonstrated an understanding of the risks involved with CRE transactions, the concerns expressed within the ROE, which focused on sound processes and procedures to manage the loan portfolio, were not eliminated. These were not new regulatory expectations or banking concepts. Effective loan portfolio management and recommendations detailed in the ROE included:

  • A comprehensive awareness of the regulation governing appraisals, including the establishment of a formal process to review appraisals. This is especially important for banks specializing in CRE lending.
  • An internal loan review function that accurately identifies and categorizes the risks associated with credit relationships. Additionally, the function must assess compliance with the board's established loan policy, compliance with regulatory guidelines, the adequacy of the ALLL, and the overall quality of the loan portfolio.
  • The establishment of prudent limits on concentrations of credit in terms of capital, given the potential impact large exposures to any industry/segment can have on the bank's capital base, should problems occur in that area.
  • A comprehensive understanding of the demands and other obligations of the individuals the bank is looking at to support the credit. While the borrowers' character is a vital component to consider when lending, experience has shown that during periods when the economic landscape is more difficult, a borrower's willingness to repay debt is significantly affected by the volume of contingent liabilities and unencumbered assets.

In the appellate submission and during meetings at the bank, management emphasized the initiatives taken since the examination. Many of which (independent loan review, internal appraisal review process, independent appraisal review, documentation of property inspections, and policy for construction site visits) related to identified concerns in the ROE. Credit risk management concerns had consistently been the focus of the last three examinations. While progress had been made, risk management activities had not kept pace with the bank's growth. As evidenced by management initiatives during the processing of the appeal, risk management weaknesses identified in the ROE did exist. Although the quantitative asset quality measures within the institution were not alarming, OCC Bulletin 97-1, ''Uniform Financial Institution Rating System'' (January 3,

1997) describes a 3 rating as less than satisfactory asset quality or credit administration practices. In considering the issues described above, the ombudsman concluded that the 3 rating, assigned at the time of the examination, was appropriate based on the bank's deficient credit administration practices.

Allowance for Loan and Lease Losses

Discussion and Conclusion

The appeal stated an additional provision to the allowance for loan and lease losses (ALLL) is not warranted based on the level of past due and non-performing loans, and the bank's history of minimal loan losses. The appeal further noted that:

The ROE completely disregarded the bank's historical record on the incorrect basis that the lending practices and loan portfolio of the bank had changed in recent periods. And on the basis of primarily subjective analyses of the bank's risk profile and lending management, the ROE requested an additional provision. And the bank was hard pressed to justify such a drastic addition to the bank's ALLL under GAAP [generally accepted accounting principles].

The ROE comments highlighted that management's analysis was questionable because it did not incorporate reasonable, logical adjustments to historical loss experience for qualitative factors. The ROE stated, "For example, loan growth has remained high, the composition of the loan portfolio has changed, and credit risk management practices are deficient. Yet, management adjustment for these factors and other qualitative factors remained nominal."

The OCC's position on making provisions to the ALLL states the ALLL must be maintained at a level that is adequate to absorb all estimated inherent losses in the loan portfolio. One of the objectives of the examination is to evaluate the soundness of management's allowance determination process. While the bank's historical loss experience was a reasonable starting point for the analysis, adjustments for various qualitative factors to reflect current conditions are also prudent. As defined in the Comptroller's Handbook booklet, "Allowance for Loan and Lease Losses" (June 1996), these factors include:

  • Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
  • Changes in national and local economic and business conditions and developments . . . , including the condition of the various market segments.
  • Changes in the nature and volume of the portfolio.
  • Changes in the experience, ability, and depth of lending management and staff.
  • Changes in the trend of the volume and severity of past due and classified loans; and trends in the volume of nonaccrual loans, troubled debt restructurings, and other loan modifications.
  • Changes in the quality of the institution's loan review system and the degree of oversight by the institution's board of directors.
  • The existence and effect of any concentrations of credit, and changes in the level of such concentrations.
  • The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution's current portfolio.

The examination found that management's analysis did not provide prudent adjustments for qualitative factors. The analysis the supervisory office provided to bank management included adjustments to the historical loss percentage for the various qualitative factors. However, in several of the qualitative areas, the supervisory office included duplicate adjustments for underwriting weaknesses. Additionally, the supervisory office analysis inappropriately included adjustments for types of loans when the historical loss percentage was adequate.

The ombudsman concluded that correcting these adjustments reflected a need for a provision of a lesser amount. The bank was directed to re-file the bank's Call Report to reflect these changes.

Capital Adequacy (3-rated)

Discussion and Conclusion

The bank's submission noted that ''In view of the bank's maintenance of strong capital levels, significantly in excess of all 'well-capitalized' benchmarks during all recent periods, the assignment of a 3 capital rating is unwarranted as well as unsupported by the ROE. The ROE bases the downgrade of the bank's capital rating solely on highly debatable and completely subjective assertions regarding the high risk.''

The ROE stated that their assessment of capital was based on the high-risk profile of the bank and the generally inadequate risk management systems. The ROE further stated that the burden of providing a reasonable return on equity has ultimately led to subsequent increases in risk, which had not been preceded, or even accompanied, by commensurate improvements in risk management.

While the ''well capitalized'' definitions refer specifically to prompt corrective action, the OCC is authorized under 12 USC 3907 (a) (2) to establish higher minimum capital requirements, in light of the particular circumstances at a bank. Adequate capital levels should be maintained commensurate with the risk profile of the institution and management's ability to implement effective risk management systems.

The ombudsman determined that while there were risk management weaknesses in different areas of the bank, the primary risk in this institution was credit risk. As such, the risk to capital, posed by the banks lending activities, should also consider the risk of loss in the event of default. Comments in the ROE acknowledged that excessive credit losses were mitigated by the documented value of real estate collateral. Additionally, comments in the ROE acknowledged management's prior success in raising capital when warranted. The ombudsman concluded that when these factors are properly weighed, the banks capital position was more appropriately represented by the 2 rating.

Earnings (2-rated)

Discussion and Conclusion

The appeal stated that ''an assignment of a 2 rating was unwarranted, as the bank had recorded strong earnings and increased earnings in each of the last five years. In the face of the bank's consistent earnings results and historically low charge-offs, the ROE asserts that a combination of higher ALLL provisions mandated by the OCC, less than satisfactory asset quality, and purportedly high credit risk may impact the sustainability of earnings performance.''

The ROE stated that earnings performance was satisfactory due, primarily, to high loan yields and fees and well below-average operating cost. It also stated that while the quantity and trend of earnings appear satisfactory to strong, earnings were actually lower than reported and there were several factors that may affect the sustainability of earnings. Earnings were negatively affected by a reversal of a significant discount that was recognized as income in conjunction with the modification of a then problem loan and the need to increase the ALLL to an adequate level.

The ROE also discussed issues involving the sustainability of earnings, which included credit risk concerns, and a significant repricing imbalance caused by funding commercial loans, which reprice in three to five years, with wholesale funding, which reprices over the next 12 months. The earnings component is designed to reflect the quantity, trend, and quality of earnings generated by the institution. Management had been successful in generating a significant level of fee income and purchasing loans at a discount to elevate earnings performance. The level of earnings for the period was negatively affected by the reversal of income on the previously noted problem loan and a required provision to the ALLL. Additionally, there were risk management issues that will require financial resources to properly develop and implement. In considering all of these factors, earnings were sufficient to support operations and maintain adequate capital and allowance levels, even after considering the risk management issues that need to be addressed.

The ombudsman concluded that the assigned 2 rating for the earnings component was appropriate at the time of the examination.

Internal Audit

Discussion and Conclusion

The appeal stated that many of the ROE conclusions about the bank's risk management are based on flawed findings about the internal audit function. The ROE incorrectly concludes management had dismantled the internal audit function, when in fact the bank had continued the engagement of a highly respected audit firm to conduct the internal audit for the third consecutive year.''

The ROE stated that the internal audit function—temporarily improved in response to a "Matter Requiring Board Attention" comment contained in the previous ROE-was again unacceptable, having been dismantled prior to completion of even one 18-month cycle. Additionally, it noted the external audit lacked the scope required to adequately compensate for the absence of an internal audit function in such a high-risk bank.

The ombudsman's review found that the supervisory office's supporting work papers on the bank's internal audit function did not fully support the conclusion that the internal audit had been dismantled, as stated in the ROE. However, a review of the audit schedule, the completed audits, and discussion with the firm contracted to perform the internal audit function revealed that some audits were not performed in a timely fashion. The ombudsman concluded that at the time of the examination these symptoms were more indicative of a ''partially acceptable'' internal audit function.

Management (3-rated)

Discussion and Conclusion

The appeal stated that an assignment of a 3 rating was unwarranted because of the bank's successful financial performance. The appeal also noted that the management team had continually improved processes and procedures but was most capable because of its "hands on'' process. Management asserted that knowing the customer at the ownership level and personally having a senior officer visit every business site represented the most valuable component of their lending process.

The ROE stated, ''Management is less than satisfactory, as the overall risk profile remains high and risk management remains deficient. Management remains overly focused on the upside potential of business strategies at the expense of prudent considerations and control of the downside risk.'' The ROE further stated, ''Management and the board have failed to ensure the bank has a long-term well-defined business plan. And while management had made changes in response to previous supervisory concerns, the changes lack durability and integrity to alleviate the concerns.''

The management rating reflects the board and management's ability as it relates to all aspects of banking operations. The bank's senior management team had been successful in growing the bank, raising capital to support growth, and exiting product lines that were deemed unprofitable. However, at the time of the examination, concerns included credit risk activities that did not provide comprehensive oversight of the loan portfolio, an internal audit function that was only partially acceptable, compliance management weaknesses, interest rate risk monitoring systems that needed improvement, and liquidity management activities that required enhancements.

Many of these risk management concerns were highlighted in the previous ROE. The board and management had initiated actions to strengthen risk management systems after the conclusion of the examination. However, senior management had not demonstrated a willingness to maintain risk management systems commensurate with the growth and activities of the bank. Therefore, the ombudsman concluded that at the time of the examination a

''3'' rating for management component was appropriate and justified.

Composite Rating (3-rated) and

Assessment of the Bank's Risk Profile

Discussion and Conclusion

The ROE stated the condition of the bank had deteriorated and is less than satisfactory. Comments in the ROE noted the deterioration resulted from elevated risk levels combined with risk management systems that remain ineffective in relation to the level of risk.

The appeal stated that ''an assignment of a 3 composite rating and "high and increasing" risk profile is unwarranted based on objective facts and measurements. The

common thread used by the supervisory office throughout the ROE to justify downgrading the bank component and overall rating was that the risk profile of the bank is high and increasing.'' While acknowledging the risks inherent in their mix of lending, management stated in the appeal that the primary test should be their experience in controlling losses, which they point out, had been exemplary. Given the general risk management weaknesses in the bank, which have been described throughout this summary, the risk profile of the bank would be appropriately categorized as high and increasing, particularly given the concerns in asset quality, liquidity, and sensitivity to market risk.

The overriding regulatory concern in the bank was management's unwillingness to establish and, more importantly, maintain risk management systems appropriate for the activities of the bank. In considering the composite rating definitions contained in OCC Bulletin 97-1, financial institutions that exhibit some degree of supervisory concern in one or more of the components; and, management that lacks willingness to effectively address the weaknesses in appropriate time frames generally receive a 3 rating. Therefore, the ombudsman concluded that the 3 rating was appropriate, at the time of the examination.

Pattern of Vindictive Treatment

The ombudsman views a charge of a pattern of vindictive treatment as a serious matter that always warrants careful and comprehensive review and investigation. The ombudsman reviewed the previous ROEs and there was a common thread in that each report had essentially dealt with criticisms by the supervisory office on identified weaknesses in risk management activities. Management initiated corrective action following each ROE and the supervisory office had accepted their response as an indication of their intent to address the issues.

The supervisory office had altered planned courses of action, and when warranted, upgraded composite and component ratings in subsequent examinations. However, corrective action was not always fully implemented or did not comprehensively address the concerns. Despite some comments in the current ROE that lacked balance and had an aggressive tone, there was no evidence that this represented a pattern of vindictive treatment. The ombudsman concluded that the lack of balance and aggressive tone resulted from poor communications during the examination process by both regulators and bankers coupled with the unwillingness of management to sustain progress in developing and implementing effective risk management systems.

During the processing of the appeal, which included the visits to the bank, the ombudsman had gained a healthy respect for management's business model and core abilities. However, based on the lack of follow-through on prior commitments, he expressed disappointment that management had not fully implemented a platform of effective and comprehensive risk management systems, processes, and controls. He further reminded management and the board that risk management activities were an important component of operating any financial institution in a safe and sound manner and were within management's control to develop and implement.

In addition, the ombudsman discovered that the supervisory office had not completely fulfilled its obligation to adequately communicate findings to the board and management during the examination. Thus the ombudsman also shared with the supervisory office his view that the examination should have been conducted in a manner that promoted greater communication with senior management and the board of directors.

Appeal of 3 Composite Rating


The ombudsman received a formal appeal from a bank that disagreed with their assigned 3 composite rating. The composite rating was assigned as a result of a full scope onsite safety and soundness examination. As a result of the examination, the bank entered into a Part 30 Safety and Soundness Compliance Plan. Subsequent to the full scope onsite examination, the supervisory office conducted a review of the bank to assess compliance with the plan. At that time the bank was not in full compliance with the plan and their composite rating remained unchanged. The bank's correspondence outlined the following as the basis for the appeal:

  • The bank has made significant progress in correcting and complying with the areas of regulatory concern as outlined in the report of examination and the plan.
  • The bank is well capitalized with good asset quality, and has experienced management team with a long track record of performance.
  • The bank has excellent earnings and sound liquidity.

The risk associated with the acquisition of a high level of a particular type of loan product from another financial institution was unprecedented in the history of the bank. The

OCC's supervisory office had already provided the bank with appropriate feedback on areas where more selective due diligence was warranted as well as areas where more effective risk management practices for these assets should be implemented. The most important dimension of this situation was the aggressive approach taken by management to work through the various risk related challenges associated with this pool of assets.

Although management had not anticipated or prepared for assuming the multifaceted risks associated with booking these assets on the balance sheet, the supervisory office commended the bank for the strong efforts to improve the risk management infrastructure. Additionally, a comprehensive action plan was developed to strengthen and improve the credit risk management processes. This action plan was the primary basis from which the supervisory office developed the plan. Bank management had taken notable action for achieving compliance with the Plan in a relatively short period of time, but had not achieved full compliance. The articles not in full compliance were considered critical components of the overall risk management processes.


In the attachment to OCC Bulletin 97-1, ''Uniform Financial Institutions Rating System,'':

Composite 2-financial institutions in this group 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.

Composite 3-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. 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. 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 quality of management is a key element in the operation of a national bank and is usually the factor that is most indicative of how well risk is identified, measured, monitored, and controlled. The bank's actions to strengthen its risk management infrastructure and control the risk associated with the acquired loans were reflective of a management team that is able to respond to changing, and in this case unprecedented, circumstances and business conditions. Such an infrastructure, coupled with prudent banking practices, serves as the foundation that supports sound financial institutions during periods of market or economic stress, and was more appropriate given the bank's size, complexity, and risk profile. While many of the bank's actions had been reviewed during the subsequent review, not all systems were in place at that time and the effectiveness of the overall risk management process had not been fully tested during an onsite examination.

Since an onsite examination was scheduled to commence within 30 days of the appeal, the ombudsman opted to have the risk management infrastructure fully tested during that examination. Therefore, the composite rating of 3 was upheld by the ombudsman.

Subsequent Event

The supervisory office assigned an overall 2 composite rating to the bank at the next examination.