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The board of directors (the board) appealed, on behalf of the bank, several matters in the Report of Examination (ROE). The appeal centered on three "loss" loan classifications that were directed for charge-off retroactive to year end. The bank disagreed with both the timing and the charge-off of these loans. The bank also appealed the following related matters:
The loans were carryover agricultural debt. To evaluate the credit quality of the three loan classifications challenged in the appeal, consideration was given to information available during the examination and the supplemental information provided by bank management, when warranted. This supplemental information consisted of current collateral valuations. Additionally, the Office of the Ombudsman (ombudsman) discussed the operating status of the three credits with bank management.
Finally, the guidance in "Examining Circular 222:
Agricultural Loan Classification" regarding carryover debt was also considered in reaching the conclusions in this appeal.
The first borrower had a history of poor operating performance. Over the last six years the borrower generated $150 thousand in carryover debt and paid only $36 thousand toward the reduction of carryover balances resulting in outstanding debt of $114 thousand. Bank management did not fund the current year's operating expenses, but the borrower was being financed by another institution. The borrower's cash flow projections reflected profitable operations for the current season after servicing all debt, including a portion of the bank's carryover debt and accrued interest. However, the borrower had a poor history of meeting projections. Bank management used more conservative estimates in their projections that reflected a small shortfall in the borrower's ability to meet all debt service requirements.
Equipment securing the loan was not supported by an independent valuation and, therefore, not given consideration during the examination. Subsequently, management obtained an independent auctioneer's valuation of the equipment, totaling $89 thousand. Also, $8 thousand in notes receivable were assigned to the bank. The total value of the collateral securing the carryover debt was $97 thousand compared to an outstanding balance of $114 thousand.
The ombudsman determined a doubtful classification was appropriate for borrower. The loans were appropriately placed on nonaccrual as of year end 1997 because full payment of principal and interest was in doubt. Classifying the credit doubtful recognized that, while bank management did not increase their exposure, they could benefit from the borrower's 1998 crop, as reflected in the two cashflow projections.
The ombudsman decided a dollar amount equal to the unsecured portion of this credit should be specifically allocated for in the allowance for loan and lease losses (ALLL) and the secured portion of the debt should have allocations based on the bank's formula for this risk category. Any payments received were to be applied to the oldest carryover balances.
If the borrower has another unsuccessful year of operation and is unable to meet debt service requirements, the debt should be charged-off. This should occur no later than March 31, 1999.
The second borrower was no longer actively farming because of unprofitable farm operations and had been making payments from liquidation of the farm equipment that serves as collateral on the carryover debt. The borrower's payment history revealed that the last principal reduction occurred seven months prior to the examination. During the examination, payments totaling $10 thousand were made, which management applied to interest. While the supervisory office considered the principal reduction, they were unaware payments had been made during the supervisory activity. During the examination, bank management inspected the equipment and estimated its value at $75 thousand and the hay at $8 thousand, although the hay is not collateral for the bank's debt. The borrower's estimate of value for the same equipment list totaled $151 thousand. Subsequent to the examination, management received a written cash offer of $25 thousand for a portion of the collateral, compared to the borrower's value of $74 thousand for the same equipment. The offer included an additional $3 thousand for the hay.
The borrower has unencumbered real estate that is available for sale. The borrower had expressed, in writing, his intent to apply the proceeds from the sale of the real estate to his bank debt. He had received a verbal offer on one parcel for $32 thousand; however, this included a portion of the equipment (irrigation-related) in the cash offer discussed above.
The ombudsman determined a split classification of substandard ($28 thousand) and doubtful ($29 thousand) appropriately recognized the risk associated with this credit. The loans should have been placed on nonaccrual as of year end because full payment of principal and interest was in doubt. The $10 thousand of interest payments made during the examination was inappropriate. The ombudsman directed bank management to reverse the interest and apply the payments to principal. The classification was based on:
The substandard classification represents the cash offer for a portion of the equipment. The doubtful portion of the credit recognizes the difference in value between the cash offer and the outstanding balance after the reversal of interest payments. This also considered bank management's position, that the borrower will apply proceeds from the sale of the remaining equipment and/or real estate. Land sales are best realized during the non-growing season from late November to March. Management was informed to make ALLL allocations according to the bank's formula for these risk categories. If the loans are not repaid by March 31, 1999, they should be charged off and appropriate recovery methods instituted.
On the third borrower the bank had a lien on irrigation equipment valued by the borrower in January 1993 at $109 thousand. As the equipment is attached to the land, management had demonstrated a reluctance to initiate repossession procedures. The borrower was uncooperative, with extremely past-due debt that had a questionable repayment source and lacked a current collateral valuation.
Based on the above, the ombudsman's office agreed with the examiners that the debt was a loss. The undeterminable collateral values and protracted collection period made the loans of such little value that their continuance as bankable assets was not warranted.
The ombudsman requested appropriate members of the bank's management team and members from the OCC's supervisory office meet to determine the impact of the reclassification of two of the three credits on the violations of law and the bank's balance sheet. The ombudsman asked that a written summary of any changes be provided to his office.
There was agreement on several risk categories; therefore, the ombudsman only addressed the four risk categories in which the board expressed a difference from the assessment in the ROE. Those risk categories were credit, compliance, reputation, and strategic. The following comments provide the basis for the decisions on those risk categories.
Credit risk was assessed as high and stable at the time of the examination. The appeal stated that it should be moderate and stable. The volume of problem credits was significant and the trend was increasing. Credit-related losses necessitated abnormally high provisions to the ALLL to cover inherent losses. Significant concentrations of credit exist in the form of agricultural and unsecured loans. Credit analyses were not comprehensive and there were weaknesses in collateral controls. The ombudsman determined that, collectively, these characteristics were indicators of a high level of credit risk.
Compliance risk was assessed as high and increasing at the time of the examination. The appeal stated that it should be moderate and stable. The bank's history of violations since 1990 was low, consisting of a few consumer protection and Bank Secrecy Act citations. The volume of violations at the examination under appeal was centered in one area (lending) and dependent on three loan classifications. However, these violations were more substantial and representative of moderate compliance risk. The bank's overall compliance program had been effective in the past in detecting, correcting, and preventing frequent violations. Based on this, the ombudsman decided the direction of compliance risk was stable.
Reputation risk was assessed as moderate and stable at the time of the examination. The appeal stated that it should be low and stable. Considering the potential negative public response or perception from the large volume of loan losses and related recovery actions, the ombudsman determined reputation risk was moderate.
Strategic risk was assessed as moderate and increasing at the time of the examination. The appeal stated that it should be moderate and stable. There was no evidence to suggest the bank's strategic initiatives would alter business plans or that they were inconsistent with the existing line of business. Therefore, the direction for strategic risk was determined to be stable.
Capital was rated 3 in the ROE. The appeal stated that it should be rated 2. The bank's level of capital did not provide the necessary base to support its current lending activities. Management is forced to sell participations on large agricultural borrowers because of the reduced legal lending limit. Earnings have not been sufficient to provide for adequate capital accretion because of the large provision expense required to replenish the ALLL. In addition, the volume of problem assets continued to strain the bank's level of capital. Based on these factors, the bank's capital was less than satisfactory for its risk profile and warranted a 3 rating.
Asset quality was rated 3 in the ROE. The appeal stated that it should be rated 2. The bank's credit quality had deteriorated, evidenced by the increasing trend in problem assets. While the bank operates in an agricultural based economy that can be affected by the weather, ineffective credit administration practices had contributed to the deterioration in credit quality. There was a need to improve credit administration practices in the following areas:
The current level of problem loans, deteriorating trends in asset quality, and weaknesses in credit administration practices provided support for the 3 rating assigned to asset quality.
Management was rated 3 in the ROE. The appeal stated that it should be rated 2. Safety and soundness ROEs from 1994, 1995, and 1996 revealed management had made progress in several areas where there was supervisory concern. However, there was a need to improve credit administration practices and reverse the increasing trend in problem assets. The weaknesses in the bank's credit culture and processes continued to plague the overall performance of the bank with significant loan losses, high provision expenses, erratic earnings fluctuations, and minimum capital accretion. Given the nature and significance of the loan portfolio to the overall performance of the bank, the administrative weaknesses associated with lending supported a 3-rated management component.
The earnings component was rated 4 in the ROE. The appeal stated that it should be rated 3. Earnings performance in the bank had been erratic. Excluding the results of the examination under appeal, the bank recorded a net loss in two of the last five years. In addition, loan losses exceeded net income in three of the last five years. After adjusting for the changes in classifications discussed above, losses would still exceed net income. The significant provisions to the ALLL have prevented earnings from adequately increasing the level of capital in the bank. The earnings performance, erratic fluctuations in net income and insufficient accretion of capital are characteristics of a 4-rated earnings component.
A composite rating of 3 was assigned as a result of the examination. The appeal stated that the rating should be 2. At the time of the examination, the bank exhibited a significant degree of supervisory concern because of the lack of effective management and board supervision, which negatively affected the quality of the bank's loan portfolio and earnings stream. Given these weaknesses, the level of capital in the institution was strained, which lessens the ability of the bank to withstand business fluctuations that are common to banks in an agricultural based economy. Therefore, a composite 3 rating appropriately reflected the condition of the bank.
Enforcement Actions are not appealable matters. As discussed in "OCC Bulletin 96-18: National Bank Appeals Process," when the primary supervisory office determines and notifies a national bank of its intention to pursue available remedies under applicable statues or published enforcement-related policies of the OCC, the decision becomes un-appealable. Recognizing communication as an essential part of the supervisory process, the ombudsman encouraged the board to discuss the issues in the ROE with the supervisory office and specifically outline their course of action and the designated time frames for completing implementation of those actions. However, the bank was reminded that the final determination on enforcement action decisions rests with the supervisory office.
A bank formally appealed its composite rating, all component rating, bank information systems rating / year 2000 assessment (BIS/Y2K), and all risk assessment system (RAS) determinations. The assigned ratings were 4/344433 for the composite/CAMELS component ratings, respectively. BIS was rated 3 and Y2K was assigned a "needs to improve. "RAS ratings were: strategic risk-high and increasing; reputation risk-high and increasing; credit risk-high and increasing; compliance risk-high and increasing; liquidity risk-moderate and increasing; transaction risk-moderate and increasing; and interest rate risk-moderate and increasing. The Board believed the Report of Examination (ROE) presented a much distorted picture of the bank in an effort to justify certain results intended to be achieved by the supervisory office.
The appeal stated the bank was a well-capitalized institution under any benchmark of the OCC, FDIC, or the Board of Governors of the Federal Reserve and to say otherwise smacks of credulity. The appeal stated that the bank has increased capital every year for the past 50 years through its conservative nature, which is why the bank can weather the current credit problems. The ROE requests the bank adopt a capital plan. The appeal stated the bank had a capital plan in place for years and has always provided it to the examiners. The most recent plan was revised in August 1997.
The ROE stated that capital is fair based on the high and increasing credit risk, poor earnings, and ineffective control structures of the bank. Capital ratios at the time of the examination were above the requirements for the well-capitalized category; however, for the last two years capital ratios had decreased. The rate of asset growth out-paced capital accretion. The supervisory office was concerned that capital adequacy was threatened by the bank's increasing risk profile. During 1997, the board approved the formation of a holding company subsidiary to hold and sell the bank's other assets acquired from debts previously contracted. In order to capitalize the subsidiary, the bank issued a $3 million dividend to the holding company, which also contributed to the assigned capital rating.
The Office of the Ombudsman (ombudsman) determined that at the time of the examination, asset quality deterioration had affected capital. Extraordinary provisions to the allowance for loan and lease losses (ALLL) eliminated earnings for the year and, therefore, earnings did not contribute to the accretion of capital. The majority of the actual capital decline in 1997 resulted from the decision to capitalize the holding company subsidiary to hold the bank's problem assets. While capital declined, this also removed, to some extent, some of the riskier assets from the bank's books. The level of identified risk and problem assets did not pose an immediate threat to the viability of the bank because of the capital base. The ombudsman's office further analyzed capital levels and determined the bank's capital base could absorb significant losses. Therefore, at the time of the examination, the ombudsman determined that a 2 rating more appropriately described the bank's capital position.
The appeal attributed the problems in asset quality to two officers that perpetrated fraudulent and unsound lending activities despite established underwriting guidelines. The appeal also pointed out that the circumvention of underwriting guidelines did not go unnoticed, but was uncovered by internal controls, specifically through delinquency reports. Loan review and audit reported exceptions to the executive officer responsible for lending who delayed responding to "cover his own tracks." The bank also noted that since the departure of the officer, asset quality trends had improved, and loan review and audit had been strengthened and refocused. Lending policies had been revised and the ALLL calculation improved.
The ROE stated asset quality is unsatisfactory based on continued declining trends, severe credit administration deficiencies, the lack of sound underwriting policies, and weak control mechanisms. Further the ROE asserted the high level of risk and problem assets were significant and expose the bank to continued credit losses. The supervisory office also noted the ALLL methodology was flawed, which resulted in questionable coverage for the inherent risks presented in the portfolio.
The ombudsman recognized that at the time of the examination, the increase in problem assets, the high level of past-due loans, and significant credit losses adversely affected asset quality and resulted in elevated credit risk. Board oversight and senior management supervision of lending activities and credit administration practices was poor. After examination charge-offs, 99 percent of classified assets were in the substandard category, indicating collateral provided some level of protection from losses. However, it was difficult to determine the true magnitude of the credit-oriented problems that confronted the bank. A significant level of underwriting exceptions occurred throughout 1997, and the majority of these credits were unseasoned. These credits possessed characteristics that mirrored the problem portfolios that had negatively affected the bank's financial performance. However, the level of identified risk and problem assets did not immediately threaten the viability of the bank because of the bank's capital position. The ombudsman determined that an asset quality rating of 3 was more reflective of the position that existed at the time of the examination.
The appeal stated that the board and senior management had successfully managed the bank for years, as supported by previous OCC comments, despite a local economy that had experienced difficulties. They made a mistake, by trusting an experienced executive officer. The appeal noted that the board recognized the limited depth of resources with the discharge of two loan officers, and had redirected personnel focus from corporate to bank matters. In addition the appeal asserted lending experience, however, remained considerable.
The ROE stated management and board oversight was deficient, given the lack of management expertise and the limited depth of resources to address the significant risks threatening the safety and soundness of the bank. The ombudsman determined, through discussion with bank representatives and the supervisory office, that management and the board did not exercise control over the bank's lending activities, which negatively affected earnings and capital at the time of the examination. The amount of resources dedicated to managing the level of risk and resolving the problems in the loan portfolio was inadequate. The loan portfolio represented the largest portion of the bank's balance sheet and the largest contributor to the income statement. Losses encountered in 1997 provide evidence the loan portfolio is significant to the bank's financial performance. Therefore, the ombudsman concluded a 4 rating was appropriate considering the deficiencies noted in overall board and management supervision of the bank's affairs.
The appeal noted earnings last year were more than adequate to support operations before increasing the ALLL to the level required by the OCC. Because all indirect loans had been credit scored, the board and senior management believed the greatest bulk of loss had been identified and appropriately reserved in the ALLL. The appeal recognized the bank's net interest margin had been declining and attributed it to competition and the rising costs of funds.
The ROE stated earnings were unsatisfactory, insufficient to support operations, allow for appropriate capital accretion, and maintain adequate allowance levels. Future earnings streams were at-risk, given asset quality problems, the questionable adequacy of the ALLL, and strained net interest margin (NIM).
The ombudsman recognized that earnings were generated through traditional means with no extraordinary income sources. The bank relied almost entirely on the NIM coupled with low overhead and low ALLL provision expense to support its historically solid earnings. The NIM was relatively low and declining faster than for banks of similar size and characteristics over the last several years. Thus, it was important to control overhead costs and provision expenses to support net income levels. The bank's historical rate of return was not going to be recognized because of the material problems in the lending area. The capital growth would be significantly less than the bank had experienced in the past. The ombudsman determined the rapid declining NIM, the substantive drop in earnings experienced at fiscal year end, and the anticipated significant decrease in recurring earnings for the subsequent year provided support for the 4 rating assigned to the bank's earnings component.
The appeal stated the criticism of liquidity and sensitivity is lacking and further lends credence to the board's belief that the examiners needed to reach certain scoring criteria to arrive at predetermined composite rating. The bank had used a fairly detailed interest rate risk model for a number of years. To improve this risk assessment, the bank began working with a nationally recognized model, using standard assumptions until bank staff is more familiar with the model. The interest rate risk program has been complemented by the OCC in the past. In addition, the appeal noted the bank's liquidity was very strong at the date of the ROE and even stronger as of the submission of the appeal. The ROE was critical of the bank's liquidity largely on what might happen in the future. The bank's liquidity policy had never been criticized in past OCC examinations.
The ROE assessed liquidity and sensitivity to market risk as "fair." The supervisory office noted that while funds management policies and processes had been established, management remained in the development stage with monitoring and reporting mechanisms. Further, the current financial stress on the bank, the uncertainty of 1998 earnings performance, and management's response to such trends expose the bank to increasing liquidity and interest rate risk. The bank also lacked a formal liquidity contingency plan.
The ombudsman review determined the bank had a stable core deposit base and an adequate liquidity position. The amount of liquidity and the bank's policies and practices were sufficient to ensure adequate liquidity to meet funding needs. Almost 9 percent of total assets were in federal funds sold, with an additional 11 percent in unpledged investment securities. Supervision was adequate regarding liquidity and funds management practices. Based on these facts the ombudsman determined a 2 rating was more appropriate for the bank's liquidity position.
The level of interest rate risk (IRR) at the time of the examination was low and well within policy limits. In addition, the bank measured equity at risk, which also was within the bank's policy limit. Adequate risk management processes were in place to monitor sensitivity to market risk. The ombudsman concluded a 2 rating was appropriate at the time of the examination.
The appeal stated the board and senior management addressed the data processing needs, as well as Year-2000 (Y2K) compliance prior to the examination, and was clearly focused on the problem. They were committed to staying on schedule. Initial input received from OCC examiners was that the new system was a good choice and they were pleased with Y2K progress. The appeal noted that OCC rated liquidity "fair" because of events that might occur in the future, and yet rated bank information systems (BIS) "less than satisfactory" with no regard or credit given for the near future event of a complete management information systems (MIS) changeover. The bank stated this jaundiced grading lacks credibility and should be wholly discounted in the appeal.
The reasons provided in the ROE for the "less than satisfactory" rating for BIS and Y2K compliance was:
While it was true that asset quality deterioration had significantly affected the bank's earnings and overall condition, there was no evidence to suggest this would materially affect BIS activities and Y2K compliance and remediation efforts. At the time of the examination, the bank's efforts were in compliance with the established time line for the system conversion. During the processing of the appeal it was determined that bank management remained on schedule. Based on the information reviewed, the bank's Y2K compliance efforts were satisfactory and the information systems department met the FFIEC Information Systems Handbook (1996) definition of a 2-rated department.
A risk assessment system (RAS) comparison is presented on the following chart, followed by a detailed discussion of the factors contributing to the ombudsman's decision.
The board's strategic implementation of the conversion to a new computer system and Y2K had been very thorough and continued to proceed with little or no glitches. During the ombudsman's visit with the board, they discussed the bank's extensive experience in out of-territory lending, with minimum losses. However very different from its history, the bank encountered rapid growth originated by relatively new officers that assured the board appropriate steps were being taken to address potential problems and protect the bank. A high-risk assessment considers the impact that problems in indirect lending and the shortage of resources in the bank to resolve these issues had on the franchise value in 1997. The need to re-engineer the lending area, the level of unidentified risk in the indirect lending portfolio, and the negative impact indirect lending was expected to have on 1998 earnings caused strategic risk to be increasing.
The bank's vulnerability to negative market perception in light of the large losses in 1997, the volume of repossessed marine craft, and the number of accounts affected by fraudulent activities supports a high-risk assessment. The determination that reputation risk was increasing captured the uncertainty of not knowing how the community would respond to issues associated with the board's inadequate control over indirect lending and competitors' ability to use these problems in their marketing efforts.
Credit-related losses had necessitated abnormally high ALLL provisions to cover inherent losses. Exposure to earnings from credit risk was substantial, evidenced by the losses in 1997 and the budgeted ALLL provisions for 1998. At the time of the examination, the department lacked the necessary resources to work through problems within a reasonable time frame. In addition, the nature of the repossessed collateral could extend the time needed to resolve the credit problems. Based on these factors credit risk was high and increasing.
The bank had a low level of earnings exposure to interest rate risk (IRR), moderate exposure in terms of equity at risk, and satisfactory IRR measurement and monitoring. Because of the interrelationship between IRR, liquidity, and funds management practices, and because of the bank's higher volume of longer-term fixed-rate assets, moderate risk was appropriate. With improved modeling and reporting capabilities, management should be able to better monitor and control the bank's IRR exposure.
The bank had a high level of balance sheet liquidity, a solid core deposit base, sufficient off- balance-sheet sources, and adequate measuring systems in place, indicating low liquidity risk. However, there was the potential of a negative impact on liquidity at the time of the examination based on reputation risk. The issues facing the bank and the inevitable publicity that follows in a small community, caused liquidity risk to be increasing.
The bank was planning a major system conversion for the third quarter of 1998. A major conversion can and usually does increase a bank's transaction risk profile. The bank had to migrate and reconcile two sources (mainframe and PC-based) to the new system. In addition, the bank's time frame was aggressive. Therefore, transaction risk was increasing.
Management used automated tools to assist them in minimizing compliance exposure. Compliance management systems had been adequate to avoid significant or frequent violations. The moderate assessment represents an increase in compliance risk since the December 1996 compliance examination. Although at the examination, several violations of Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks (Regulation O) were identified, the bank had no history of violating this regulation. The limited compliance scope of the examination did not support a change from the stable assessment.
At the time of the examination the bank exhibited a significant degree of supervisory concern because of the lack of effective management and board supervision, which negatively affected the quality of the bank's loan portfolio and earnings stream. The level of capital support at the time mitigated a more severe composite rating. Therefore, the ombudsman determined that a 3 composite rating was more reflective of the condition of the bank at that time.
However, the ombudsman was concerned with the adverse trends that had continued to develop during the processing of the appeal. The condition of the bank deteriorated further and provided sufficient evidence to justify a higher level of supervisory concern. Asset quality problems continued to deplete earnings and trends had not reversed. A full year had expired since the problems first surfaced and the depth of the asset quality problems was still not quantified. The level of nonperforming assets was exceptionally high and there had been no comprehensive, independent evaluation of the loan portfolio to identify the full magnitude of the problem. The condition of the bank was more characteristic of a 4 composite rating, primarily because of management and the board's lack of effective steps to control the continued deterioration in asset quality and impact on the bank's earnings stream and capital base. Therefore, the ombudsman did not change the bank's overall composite rating or its capital or asset quality component ratings, in the OCC's official supervisory record.