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Appeal of Decision on Adequacy of ALLL (Second Quarter 1995)

A bank filed a formal appeal concerning the adequacy of its allowance for loan and lease losses (ALLL). The bank's 1994 report of examination (ROE) concluded that the balance in the ALLL account was significantly overstated.


The bank has approximately $100 million in assets. It has historically had few asset quality problems and has had low net loan losses as a percentage of average total loans— for the past three years of the average net loan losses to average total loans has been 0.42 percent. The bank has had a CAMEL rating of "1" or "2" throughout the past 15 years, with a CAMEL rating of "1" for the past three examinations.

Because of the sound condition of the bank's loan portfolio, at the bank's 1993 examination the bank was requested to cease making provisions to the ALLL until the balance declined to the $250,000 to $300,000 range and the bank's method of calculating the ALLL had been expanded to address applicable aspects of Banking Circular 201. The balance in the ALLL was $445,000 during that examination. Because the bank needed to make changes in its methodology, no negative provision was required during the examination.

However, during the 1994 examination, 18 months later the examiners discovered that the bank's balance in the ALLL had risen to $755,000. Although the bank had not made any additional provisions since their last examination, the bank had received a totally unexpected $330,000 recovery on a previously charged-off loan. The bank's analysis for the 1994 examination date (which was a quarter-end date) calculated the adequacy of the ALLL using three different methods. Each method used specific allocations on classified loans combined with an average of the bank's net loan loss history, with the first using a six-year weighted average, the second a three-year weighted average, and the third a six-year non-weighted average. Management stated that the most emphasis was placed on the first method, the six-year weighted average. The calculations showed excess reserves of $484,000, $638,000, and $431,000, respectively.

When the examiners asked management to provide them with support for the excess balances, the bank provided the examiners with the following list of six items:

  • Loan growth.
  • Lease lending with higher risk.
  • Airplane lending with higher risk.
  • Projection for economic recession.
  • Local economy only stable.
  • Imprudent practice not to increase the ALLL due to anticipated losses in the above areas.

No statistical or numerical support was presented with the list; therefore, the examiners placed limited reliance on the bank's internal methodology.

The ROE stated the following, "As of our examination date the balance of the ALLL totaled 755M. We requested management make a negative provision of 330M (total of recoveries), rendering the ALLL balance to 425M. The remaining 175M negative provision needed to reduce the ALLL balance to 250M should be taken over the next 12 months, and is subject to further periodic reviews of the account balance by management and this office." It further stated, "Your internal ALLL process is flawed as it did not provide sufficient support for maintaining a balance in excess of your calculations.

In the appeal letter the bank made the following points supporting its disagreement with the necessity of a negative provision:

Currently, the loan portfolio at the bank totals approximately $31.5MM which is up from $18.4MM 18 months ago, which represents a 71 percent increase in volume. The bank has recently entered two new areas of lending in which it does not have any experience. The first new lending area involves purchasing out-of-town and out-of-state equipment leases and the second area is national aircraft financing. The equipment leases approximate $3MM in loans, while the airplane loans are currently $500M. Aircraft financing applications are soaring and it is anticipated that aircraft lending will approximate $5-10MM in three to five years.

In addition, the appeal letter quoted several sections of Banking Circular 201 (Rev) - Allowance for Loan and Lease Losses, dated February 20, 1992.

The bank also attached an analysis for the adequacy of the ALLL for the quarter-end following the examination date. The analysis had been enhanced to include separate calculations for various pools of loans in addition to calculations for the full portfolio. This analysis also included the three previously used methods that employed a variation of the bank's net loan loss history. The results of this analysis showed significantly reduced excess reserves of $72,000, $159,000, and $10,000, for the six- year weighted, three-year weighted, and the six- year non-weighted methods, respectively. Management stated that the most emphasis was placed on the first method, the six-year weighted average.


BC-201 states that national banks must maintain an ALLL that is adequate to absorb all estimated inherent losses in the bank's loan and lease portfolio. An inherent loss is defined as an unconfirmed loss that probably exists based on information that is available as of the evaluation date. The amount of the loss must be subject to reasonable estimation. Banks need not provide in the current period for losses that may occur as a result of possible future events. The circular states:

In carrying out their responsibility for maintaining an adequate Allowance, each bank's board of directors and management must:

  • Maintain an effective loan review system and controls that identify, monitor and address asset quality problems in an accurate and timely manner. The loan review system and controls must be responsive to changes in internal and external factors affecting the level of credit risk and ensure the timely charge-off of loans, or portions of loans, for which a loss has been confirmed.
  • Adequately document the bank's process for determining the level of the Allowance, including its analysis of all significant factors affecting the collectibility of the portfolio.

Examiners will rely on bank management's estimate of an adequate level for the Allowance if the bank's process for determining an adequate Allowance is sound, based on reliable information, and well documented.

A bank's failure to maintain the Allowance at an adequate level is an unsafe and unsound banking practice. Further, a materially inadequate (or excessive) Allowance misrepresents the bank's financial condition on its Report of Condition and Income and is a violation of 12 U.S.C. 161.


Many of the factors detailed in the bank's appeal letter are appropriate reasons to maintain a balance in the ALLL greater than the specific allocations and historical net loss percentages. As the bank mentioned in its appeal letter, these factors are discussed in BC-201. Examples of some of the factors that support additional balances include:

  • The loan growth the bank has experienced during the past 18 months.
  • The bank's recent entry into two new higher risk areas of lending.
  • A change in the chief executive officer.
  • Economic factors.
  • Risks identified in the various pools of loans.

The bank enhanced its analysis of the ALLL to appropriately incorporate these additional factors. The results of the bank's analysis showed significantly reduced excess reserves of $72,000, $159,000, and $10,000 for the six-year weighted, three-year weighted an the six-year non-weighted, respectively. Discussions with senior management about the factors in the bank's analysis demonstrated that the bank could reasonably support the additional amounts in the ALLL. Therefore, the Ombudsman's Office did not object to the bank putting the $330,000 in recoveries back into the ALLL, and the bank was not required to make any additional negative provisions. These actions were based on the understanding that the bank's accountants had reviewed and endorsed the bank's process and resulting reserve levels.

The bank's process, however, was not without flaw and warrants further refinement. The bank needs to continue to focus ongoing efforts on maintaining sufficient written documentation to support its method of calculation and the level of the reserve balance. Such documentation can help the directors in their quarterly discussions on the adequacy of the ALLL. Determination of ALLL adequacy is a dynamic process that responds to an array of internal and external factors. The bank must actively monitor ALLL levels and appropriately respond by maintaining, decreasing, or increasing the current balance as conditions change and the portfolio's inherent risk of loss is affected. The components used in the bank's analysis, and the percentages used to support them, will change over time, as more information becomes available and trends change.

Appeal of Decision on Holding of Insurance Policies (Second Quarter 1995)


A formal appeal was received regarding the holding of two insurance policies that resulted in a violation of law being cite in the bank's last report of examination (ROE). Both insurance policies were purchased in 1986. The bank had called the appropriate supervisory office before purchasing the first policy, to discuss the acceptability. The bank was not told that the purchase was illegal; the call focused on the proper booking of the policy as an other asset. During 1987 and 1988 the bank and the appropriate supervisory office corresponded again concerning the policies. One letter from the supervisory office informed the bank that, "While the bookkeeping treatment of the policy seems appropriate, it appears that the amount of insurance coverage purchased by the bank far exceeds the outstanding debt of the borrowers." In response, the bank lowered the coverage by $100,000 to bring it more in line with the amount of outstanding debt. The bank informed the supervisory office of this action and received no correspondence suggesting that further action might be needed. During subsequent examinations the bank was not notified of any problem with the holding of the policies.

Real Estate Developer Credit

The relationship involves three notes. The first is the residual amount of a $225,000 note that originated May 10, 1979. The original funds were used for real estate speculation, with repayment to come from the sale of the lots. The current balance outstanding is $132,000. The remaining lots were returned to the county for payment of taxes on August 8, 1990, so the debt is unsecured. The loan was placed on nonaccrual February 5, 1991, is currently classified doubtful, and has a specific allocation of $30,000. The second and third extensions of credit total $116,000 and are secured by a farm and office building valued at $190,000. Both credits are currently amortizing as agreed. The entire relationship is collateralized in part by a universal life policy with a face amount of $300,000. The initial cost of the policy was $398,000 with a current cash surrender value (CSV) of $580,000, which is properly booked as an other asset. The current death benefit is $880,000.

Farm Credit

This is a performing credit that has been on the bank's books since 1965 and has not been classified by the examination team. The policy was purchased in 1986 at the request of the borrower, because of the large amount of debt connected with the family farm. The borrower wanted to ensure that his family would not be negatively impacted by his untimely death. The borrower potentially owes the bank, in outstanding balances, unused commitments on a line of credit, or accrued interest, a total of $394,000. This loan is collateralized in part by a universal life policy with a face amount of $400,000. The initial cost of the policy was $124,000 with a current CSV of $182,000, which is properly booked as an other asset. The current death benefit is $582,000. In addition, the debt is secured with the liens normally used for any agricultural credit.


The authority for national banks to purchase and hold an interest in life insurance is found in 12 U.S.C. 24(7). The law provides that national banks may exercise "all such incidental powers as shall be necessary to carry on the business of banking." The OCC has further delineated the scope of that authority through regulations, interpretive rulings, and letters addressing the use of life insurance for purposes incidental to banking. Those purposes include:

  • Key-person insurance.
  • Life insurance on borrowers.
  • Life insurance purchased in connection with employee compensation and benefit plans.
  • Life insurance taken as security on loans.

There is no authority under 12 U.S.C. 24(7) for national banks to purchase life insurance for their own account as an investment.

Banking Circular 249 (Revised), Bank Purchase of Life Insurance, was issued May 9, 1991. The revised circular replaced the original circular that was issued on February 4, 1991. The circular provides general guidelines for national banks to use in determining whether the may legally purchase a particular life insurance product. The background section of the circular states "the OCC has become concerned about bank purchases of insurance products with a significant investment component, such as single premium life insurance. In some cases, those purchases have raised serious questions about whether the bank has made an illegal investment in the cash surrender value (CSV) of life insurance. The OCC is also concerned because the unsecured cash surrender value of these policies has sometimes constituted a significant percentage of the bank's capital."

The section of the circular dealing with "Life Insurance on Borrowers" states the following:

State law generally recognizes that a lender has an insurable interest in the life of a borrower to the extent of the borrower's obligation to the lender. Interpretive Rulings 7.7495, and 12 CFR 2.6 (c) and (f) are relevant for national banks. They recognize that national banks may protect themselves against the risk of loss for the death of a borrower. That protection may be provided through self-insurance in the form of debt cancellation contracts, or by the purchase of life insurance policies on borrowers.

Life insurance purchased on borrowers must comply with non-investment test (A) of these guidelines. For borrowers who are in good standing, a bank's potential loss is generally the principal balance of the borrower's obligations to the bank, including the maximum amount that could be borrowed under a line of credit, at the time the insurance is purchased. That amount would, therefore, be the maximum insurance coverage the bank could purchase on the borrower.

The purchase of life insurance on a borrower is not an appropriate mechanism for effecting a recovery on obligations that have been (or are expected to be) charged-off. Such life insurance purchases are not incidental to banking within the meaning of 12 U.S.C. 24(7) because the insurance does not protect the bank against a risk of loss. In the case of charge-off loans, the bank has already realized the loss, and the purchase of life insurance more closely resembles an investment to recover on that loss.

Test (A) is also defined in BC-249:

  1. (A) When the bank purchases life insurance to indemnify itself against the death of an individual (as in the case of key-person insurance or insurance purchased on a borrower), the amount of insurance coverage must closely approximate the risk of loss. For purposes of measuring insurance coverage, the OCC considers the amount of insurance to be the total death benefit to be received upon the death of the insured. This includes the face amount of the policy, any premium returned, and accrued interest and/or dividends.


Although the holding of these policies as an investment expressly violates the intent of 12 U.S.C. 24(7), it is understandable that the bank, because of its initial conversation with the OCC and the 1987-1988 correspondence, believed that the policies conformed to the law. After the bank purchased the two policies, the OCC issued BC-249 (Rev), which comprehensively discusses bank purchases of life insurance. BC-249 does not change the OCC's interpretation of 12 U.S.C. 24(7); it does, however, provide more extensive guidance.

Real Estate Developer Credit

Although the purchase of this insurance policy is not considered "an incidental power as shall be necessary to carry on the business of banking" as defined in 12 U.S.C. 24(7), the bank will be allowed to keep the policy until the time of death of one of the insured. However, the bank will not be allowed to retain any excess coverage. This is defined to be the amount by which the death benefit exceeds the total of the principal amount of loans outstanding at the time of the borrower's death, accrued interest owed and not paid, legal fees incurred by the bank to date, and the cash surrender value of the policies at the time of death. Any excess monies collected above the allowed provisions should be returned to the heirs of the deceased.

The bank will need to charge off the $132,000 lot loan at this time, as it is no longer considered a bookable asset. Because the cash surrender value of the insurance policy is accounted for as an other asset account, there is no additional collateral available to support the lot loan. The bank was informed it could retroactively charge-off the loan as of February 5, 1991, when the debt was placed on non-accrual. If the charge-off is made retroactively and constitutes a material error, then the affected call reports should be appropriately adjusted and re-filed. The bank will be allowed to recover the amount charged-off from the death benefit proceeds at the time of death of one of the insured.

The following shows an example of the process the bank should go through at the time of death of one of the insured to determine if any money is due to the heirs:

Cash Surrender Value 580.0M

Principal Amount Outstanding 116.0M

Farm RE Loan - 73M

Office Building Loan - 43M

Charge-Off Lot Loan 132.0M

Accrued Interest Owed 100.0M

Legal and Miscellaneous _ 7.5M

Total Proceeds Due to the Bank 935.5M

Death Benefit Paid 880.0M

Amount Due to Heirs of the Deceased 0.0M

In this example, no monies from the death proceeds would be given to the heirs of the deceased.

Farm Credit

To ensure consistency, the bank will also be allowed to keep this insurance policy. Similarly, the bank will not be allowed to retain any excess coverage. Excess coverage is defined as the amount by which the death benefit exceeds the total of the principal amount of loans outstanding at the time of the borrower's death, accrued interest owed and not paid, legal fees incurred by the bank to date, and the surrender value of the policies at the time of death. Any excess monies collected above the allowed provisions should be returned to the heirs of the deceased.

The following outlines an example of when death proceeds should be returned to the heirs of the deceased:

Cash Surrender Value 182.0M

Principal Amount Outstanding 300.0M

Accrued Interest Owed 3.0M

Legal and Miscellaneous _ 7.5M

Total Proceeds Due to the Bank 492.5M

Death Benefit Paid 582.0M

Amount Due to Heirs of the Deceased 89.5M

This borrower's debt is on a line of credit; the amount of debt outstanding will determine the amount owed to the heirs of the deceased. Should the debt pay out totally, the bank would be entitled only to the cash surrendered value of the policy.

Appeal of Report of Examination (Second Quarter 1995)


This bank appealed 12 conclusions from its most recent OCC report of examination. The bank's board and management believed that the local OCC field office and examination team were operating outside national policy in their interpretation and application of several regulatory issues. The bank was also concerned that the report of examination had a generally negative tone and did not include several positive findings that had been discussed with management during the examination. The bank's appeal letter claimed that OCC personnel were inflexible and seemed determined to arrive at a pre-established negative conclusion, regardless of the facts.

The bank has been subject to some type of administration action for six of the past ten years. In 1984, the board entered into a formal agreement with the OCC because of asset quality problems, poor loan administration, inadequate ALLL, and inaccurate risk identification and ratings. Classified assets peaked at 149 percent later that year and credit administration weaknesses persisted. The board signed a cease and desist order in 1985 that, among other things, prohibited the president/chief executive officer from serving in that capacity. The board hired a new president and promoted the former president to chairman of the board. OCC terminated the cease and desist order in 1987 based upon the bank's improved condition and compliance with the lending-related articles. Shortly after that, the board dismissed the president and returned the chairman to his previous role as president/CEO. The reason cited for the dismissal was that the dismissed president's ambitious actions were not in the best interests of the ownership family. Credit administration problems resurfaced in 1989 and have continued to the present. For various reasons, the bank has had seven different senior lending officers in the past 12 years. The board entered into a memorandum of understanding in 1991. OCC upgraded the action to a formal agreement in 1992, which remained in effect at the time of this appeal.

An assistant to the ombudsman and two senior examiners visited the supervisory office and the bank to research the issues in this appeal. At the supervisory office, this appeal review team met with the field office director, the field manager, and the examiner-in-charge. The team reviewed the supervisory office's response to the appeal and the examination working papers. At the bank, the review team met with the chairman of the board, the president, and the senior lending officer.

Discussion and Conclusions

Issue 1 - Credit Philosophy and Impact of 1993 Flood

(a) Lenient Credit Philosophy. The report of examination said that OCC concerns with the quality and administration of the loan portfolio stem from a "lenient credit philosophy" employed by management and the board. A letter from the supervisory office sent after the issuance of the report of examination said that the borrowers, not the bank, too often control the lending relationship. This has led to improper loan structuring and borrower controls. The appeal requested that OCC delete from the report of examination and the supervisory office letter all comments concerning a lenient credit philosophy. The appeal also requested that OCC delete all references to the borrower being in control of the lending relationship.

Discussion: During the review team's discussions at the bank, the chairman, president, and senior loan officer acknowledged that the bank once employed a "lenient credit philosophy." The president/CEO and senior loan officer also conceded that certain borrowers have controlled the lending relationship. The Ombudsman's Office believes that the bank's credit philosophy had begun changing by the time of the onsite review of the appeal. The ombudsman's review confirmed management's assertion that the change has occurred gradually over time. The board and management committed to changing the credit philosophy in 1992. The board signed a formal agreement with OCC and appointed the current senior loan officer. However, according to management, the lending staff and customer base resisted the bank's efforts to change. The 1993 flood in the bank's region and the subsequent significant adverse impact upon many of the bank's borrowers further frustrated their efforts to clean up the troubled loan portfolio. Management intended to work with its troubled borrowers following the spirit of an OCC banking bulletin that encouraged banks to work with borrowers affected by natural disasters. The June 1994 examination occurred 18 months after the bank entered into the formal agreement. The senior loan officer claims to have been only about one-third of the way through the process of restructuring the troubled loan portfolio at that time. Because of the sense of urgency communicated at the most recent examination, management realized it needed to take more drastic measures and has since intensified its effort.

Conclusion: The supervisory office will revise the comments in the report of examination and the supervisory office letter referring to a lenient credit philosophy. These revisions will clarify and better document the bank's progress. The section "Matters Requiring Board Attention" will emphasize that the senior loan officer's progress in changing this philosophy and establishing prudent underwriting guidelines has been slow.

(b) Contribution of Credit Philosophy to Bank's Lack of Progress. The supervisory office letter made reference to a statement in the bank's response to the report of examination regarding the reasons for the bank's lack of progress in reducing the level of classified assets. In the appeal, management denied ever making this statement and requested that OCC revise the language in the letter to properly reflect the bank's response.

Discussion: The supervisory office letter misquoted part of the bank's response to the report of examination as follows:

Your response indicates that the bank's credit philosophy is encouraged by an OCC banking bulletin addressing natural disasters, and this philosophy contributed to the bank's lack of progress in reducing classified credits to an appropriate level.

The referenced statement in the bank's letter said the following:

Further, we acknowledge that our philosophy of attempting to work with troubled borrowers may have [emphasis added] contributed to a lack of a sudden and dramatic decrease in the level of problem loans.

Conclusion: The ombudsman concurred that the supervisory office letter misrepresented the bank's response to the report of examination. The supervisory office will revise its letter to more accurately represent the thought conveyed in the bank's letter. It will also express the bank's belief that management's ability to maintain a relatively stable level of classified assets despite the flood suggests that both the board and management have been working diligently to minimize potential problems.

c) Impact of 1993 Flood. The supervisory office letter also asserted that although the 1993 flood adversely affected the bank's borrowers, it was not directly responsible for increasing the volume of classified assets. The appeal requested that OCC acknowledge the major adverse impact that the flood had upon the bank and its borrowers.

Discussion: The appeal review found that the county the bank is located in, like most of the surrounding counties, was designated a major disaster area eligible for federal assistance by the Federal Emergency Management Agency. The bank identified 21 borrowers that the floods of 1993 adversely impacted. Many of these borrowers had exhibited serious financial weaknesses long before the 1993 flood. However, the bank adjusted terms on existing loans and eased credit-extension terms for new loans to these borrowers because of heavy rains associated with the 1993 flooding.

Conclusion: The report of examination did not directly discuss the impact of the flood. The supervisory office will revise the report to recognize the impact of the flood on the bank and its borrowers. It will say that the resulting short crop in the region retarded the bank's progress with certain borrowers. The supervisory office will also revise its letter to the bank.

Issue 2 - Risk Rating System

The report of examination and supervisory office letter concluded that the bank's risk rating system is inaccurate. The letter said that OCC classified 13 percent of the credit relationships, or seven credits, more severely than management. The appeal requested that OCC amend the exception rate quoted on risk rating errors to show six exceptions rather than seven, with the corresponding percentage corrected. The appeal also requested that OCC amend any statements in the report of examination to reflect the true quality of the bank's risk assessment system for loans, especially the section "Compliance with Enforcement Actions." The bank believes the overall risk rating system is adequate, with several minor rating changes recommended during the examination.

Discussion: The report of examination said that the bank's problem loan identification system is accurate. The ombudsman agreed that the bank's problem loan list effectively identifies troubled borrowers. Examiners reviewed 55 credits totaling $9.2 million and only classified two loans that were not on the bank's watch/problem loan list. Management's internal list totals $2.83 million in classified loans versus $2.85 million for the OCC examination report. If special mention loans are included, the bank's total criticized loans exceed those identified by the examining team.

The categorization of individual loans, however, is another matter. The Ombudsman's Office analysis showed that there were actually 11 differences in risk ratings. In five of those instances, the bank rating is more severe that OCC's. The ombudsman appreciates the bank's desire for greater conservatism and is not critical of that. The focus of an effective risk rating system should be on identification and accurate categorization of risk. The remaining six differences represent credits on which the OCC rating is more severe than the bank's. The ombudsman considers two to these to be minor misses because of the small amount of the difference or size of the loan. Three of the misses are agricultural lines in which the bank classified only the actual carryover note; consistent with the approach used at the 1992 examination (the ombudsman's analysis of criticized loan write-ups in the 1993 report of examination was inconclusive). As noted in the bank's appeal, the 1994 examining team also classified the amortizing M&E and RE notes based on the common source of repayment. The ombudsman agrees with the philosophy used by the OCC examiners.

Conclusion: The supervisory office will revise the "Matters Requiring Board Attention" section of the report of examination and the supervisory office letter. The report and letter will say that the bank's problem loan identification system is effective, but the risk rating system needs further refinement. The number of risk rating differences will be revised from seven to six. The supervisory office will also revise the "Compliance with Enforcement Actions" section of the report, which discusses article III of the formal agreement, to say that management and the board have made progress in the identification of problem credits and loan documentation. However, the internal risk rating system and documentation tracking system both need further enhancement.

Issue 3 - ALLL Balance

The report of examination concluded that the current level of the ALLL does not adequately cover inherent risk in the loan portfolio. To address the situation, management agreed to make a $50,000 provision during the examination. The appeal requested that OCC revise the report of examination to reflect that the level of the ALLL as of the examination date was adequate. It also requested permission to reverse the $50,000 provision made at the request of the examination team.

Discussion: The examining team concluded that the bank's methodology is adequate and there is no material difference in the volume and categorization of problem loans, in aggregate. The bank does not understand how OCC determined the need for an additional $50,000 provision. Management claims the examining team refused to show the bank its calculations supporting the need for the $50,000 provision. The bank uses four methods to analyze the ALLL; 1) classification of risk, 2) specific allocations, 3) loan pools, and, 4) historical loss experience. They place the most reliance of methods 1 and 2. The examiners worked with the bank's methodologies using the revised classification numbers per the report of examination.

Conclusion: Deterioration in one of the bank's troubled loans after the examination resulted in an additional $50,000 charge-off by the bank. Management thus no longer desires to reverse the $50,000 provision requested during the examination. Nonetheless, the bank's comments on this appeal issue are understandable and appropriate. The examining team should have fully supported its request for the additional provision in the report of examination. Considering the circumstances associated with the additional $50,000 provision, the ombudsman understands how the bank might challenge the request as arbitrary. The supervisory office will delete all references to the requested $50,000 provision from the report of examination and the supervisory office letter.

Issue 4 - Loan Administration Practices

The report of examination concluded that loan administration practices remain unsatisfactory. It concluded that the volume of exceptions is not severe, but highlighted the ineffectiveness of the bank's tickler system. The appeal requested that OCC amend the "unsatisfactory" description of loan administration practices and acknowledge improvements made over the past two years. The bank also requested that OCC amend the report of examination comments concerning noncompliance with article IV of the formal agreement to reflect compliance.

Discussion: Management acknowledged that additional effort is required in this area. However, the bank has made substantial progress during the last two years in reducing the volume of documentation exceptions. In fact, documentation exceptions have been reduced to 23 percent at this examination from 42 percent at the 1992 examination. The bank believes that the examiners' conclusions are very harsh considering how much loan administration practices have improved. The 1993 report of examination stated that loan administration had improved and the bank had made good progress in complying with the formal agreement. The bank questions how the tickler system can be ineffective if exceptions are not severe and examination reports after the signing of the formal agreement reflect improvement in loan administration. The bank complains that examiners at previous examinations reviewed but did not cite several documentation exceptions listed in the 1994 report of examination. The bank also believes that some of the exceptions are questionable. The bank notes that article IV of the formal agreement does not require perfection in the area of loan administration, only improvement. Further, the article does not outline what is an acceptable level of documentation exceptions.

Conclusions: The ombudsman recommended that the bank reconsider its goal of maintaining credit exceptions and collateral exceptions each below a 10 percent level. Although OCC has not published specific guidelines for an acceptable level of documentation exceptions, the bank's target of 20 percent for the combined exceptions is high. Nonetheless, the ombudsman agreed that the examiners' conclusions are harsh considering the bank's loan administration practices before the 1992 examination. The 1994 comments are also inconsistent with the positive tone established by the 1993 report of examination. Therefore, the supervisory office will revise the 1994 report of examination to recognize the improvement in loan documentation since 1992. It will also say that further strengthening is still required.

Issue 5 - Management and Board Supervision

The report of examination said that management and board supervision over the bank is weak. It also questioned management's ability to make necessary changes. It concludes that management and the board have not provided adequate leadership to effect changes necessary to comply with the formal agreement. They have not proven effective in improving asset quality and the bank's condition continues to reflect significant loan administration and financial weaknesses. The appeal requested that OCC modify the comments throughout the report of examination to more accurately reflect the level of board and management supervision and the efforts made since signing the formal agreement in 1992. The appeal also requested that OCC remove from the report of examination comments concerning the board's failure to hold the bank's president and the management team accountable.

Discussion: The ombudsman's onsite review confirmed that the board and management have made considerable progress since the 1994 examination. The report of examination said that the chairman of the board and president must take the lead if a change in lending philosophy is to occur. The ombudsman believes that the bank's credit philosophy is changing and that the current board and president are responsible for the change. It is difficult, however, to pinpoint exactly when this change occurred. The examining team based its conclusions upon tangible, concrete measurements evident as of the examination date.

Although asset quality is a key supervisory concern, it is not the only reason for the examining team's criticism of management. Other weaknesses include loan administration deficiencies, weak earnings, and lack of adequate accountability. Noncompliance with five articles of the formal agreement continues despite OCC criticism of many of these items dating to 1978. The examining team deliberately designed its criticism of management in the report of examination to underscore OCC's concern with the serious and continuing deficiencies in the bank's operations. Identified weaknesses in documentation and underwriting are not in the best interest of the bank or its troubled borrowers. Neither the bank nor its borrowers are well positioned for another severe downturn in the farm economy.

Conclusion: Although the ombudsman concurred with the supervisory office's conclusions concerning management and board supervision, he felt the use of the term "weak" conveyed a worse connotation than those conclusions warranted. Therefore, the supervisory office will revise all references to "weak" management and board supervision in the report of examination and the supervisory office letter to say that supervision and administration by the board and management is less than satisfactory. The supervisory office will also delete sentences in the report of examination questioning management's ability to make the necessary changes to correct the bank's problems.

Issue 6 - Violation of 12 CFR 215.5(d) (4), Additional Restrictions on Loans to Executive Officers

The report of examination cited this violation of Regulation O. The bank extended credit to its president without making the extension subject to demand any time he is indebted to any other bank(s) in an aggregate amount greater than 2.5 percent of the bank's capital and unimpaired surplus or $100,000, whichever is less. The bank believes the violation never existed and that the demand feature for the president's credits is unnecessary. The appeal requested that the Ombudsman's Office remove the violation from the report of examination.

Discussion: The bank granted a $50,000 home equity line to its president in 1989 with a 12-year maturity. Later that year, the bank also granted him a $136,000 residential real estate loan with a 14- year maturity. The appeal claims there was no specific requirement that the bank put the demand feature in writing until Congress revised the regulation in May 1992. The Federal Register entry for the revision shows that its authors viewed the additional "in writing" language not as a change in the requirement for the demand feature, but rather as a clarification that the demand feature must be written.

The appeal also contends that Regulation Z prevented home equity lines of credit from containing a demand clause until Congress amended the regulation in July 1992. That revision, long after the bank granted the loans in question, authorized demand clauses in home equity lines of credit for executive officers. It was not until September 1991 that the Federal Reserve Board informally advised banks confronted with this dilemma that Regulation O takes precedent over Regulation Z. This advisement also stated that it is not the mere presence of a demand feature that creates a conflict between the two regulations. Rather, it is the lender's exercise of the demand feature that creates the conflict.

Conclusion: The ombudsman decided that there was no specific requirement that the demand feature be in writing until the May 1992 revision of the regulation. The Federal Reserve's tacit acknowledgement that the regulation was unclear before this time confirms the uncertainty regarding the provision. The ombudsman also concurred that Regulation Z prevented home equity lines of credit from containing a demand clause until the July 1992 amendment. Because of the apparent conflict between Regulation Z and Regulation O, and because the requirement that the demand clause be written was not explicitly a part of Regulation O at the time the bank granted the loans, the supervisory office will remove the violation of law from the report of examination.

Issue 7 - Violation of 24 CFR 3500.7 (e)(1)(iii), Particular Providers Required by Lender

The report of examination cited a violation of Regulation X. If a lender requires the use of a particular provider of a settlement service, it must inform the borrower of the nature of the relationship between each provider and the lender. The bank's list of required providers of settlement services did not describe the nature of any relationship between each such provider and the lender. Instead, the bank merely informed customers it had used the servicer within the last 12 months. Management does not believe there is a violation of this regulation, which they consider to be vague. The appeal requested that OCC remove the violation from the report of examination.

Discussion: The bank prefaced each list of providers with the words: "We require the use of the following appraisers. We have used or required their use over the past 12 months." Management claims the examiners initially insisted that the bank state a percentage of times that the bank had used a particular required provider. The bank responded that such action is impossible and impractical because it uses different providers at different times of the year and the information would be misleading to the borrower. The bank claims to have later learned that for similar reasons, in July 1994 the Department of Housing and Urban Development (HUD) eliminated a statement of the percentage of times a lender used a particular provider as an acceptable option in describing the relationship between lender and provider. HUD claims that it does not now, nor did it ever, require disclosure of the percentage of times a lender used a provider. OCC and HUD recommend use of language such as "most of the time," or "frequently" to describe the nature of the relationship between the provider and lender.

Conclusion: Because of a lack of guidance available to lenders about what is required by HUD, and because the bank is now using terms similar to "frequently" and "most of the time," the ombudsman concluded that the supervisory office should remove the violation from the report of examination.

Issue 8 - Classification of a Loan

The examiners classified the non-SBA-guaranteed portion of a borrower's indebtedness as "substandard." The appeal requested that the report of examination list this credit as a "pass".

Discussion: The borrower is a local, incorporated drug store. The principal shareholder guarantees this debt. The notes have always paid as agreed. In the bank's opinion, the borrower's financial data reflect adequate working capital, decreasing liabilities, and increasing net worth. The bank acknowledges that sales have shown a declining trend that requires some monitoring. However, it thinks the examiners exaggerated their conclusions concerning cash flow deficiencies and does not believe that a leverage ratio of 2.19 is excessive. The bank maintains that the guarantor has sufficient liquidity as well as an adequate salary from the company to support the company's nominal cash flow shortfalls. Finally, the bank asserts that the OCC's position on this credit is in contradiction to Banking Bulletin 93-12, Interagency Policy Statement on Credit Availability, dated March 10, 1993. The bank acknowledges that it does not qualify to participate in this program without prior approval. However, its understanding is that the banking bulletin is directed primarily, but not solely, to loans which fall into the basket-of-loans category. If the OCC chooses to classify known borrowers with extended favorable payment records and good character, banks will have little incentive to extend additional credit to borrowers who have some minor flaw in their financial data. Such action has the effect of limiting credit availability.

The examiners identified several well-defined weaknesses in this credit. These weaknesses include inadequate cash flow to service the debt in 1992,1993, and 1994; declining sales due to competition from a national retailer; significant volume (55 percent) of accounts receivable over 90 days with no aging on file; and increase in accounts payable without a corresponding increase in inventory. The examiners concluded that the loan had been kept current by depleting cash reserves and extending accounts payable. A fiscal year 1994 financial statement, not available to the examining team, that was submitted during the appeals process reflects some improvement. Sales volume improved slightly over 1993, net income increased marginally, total debt declined, and net worth increased. However, the slightly improved cash flow is still insufficient to satisfy debt service requirements. The cash flow shortfall has increased steadily since fiscal year 1992. Receivables reflect an increase with no aging information available; payables are up without a corresponding increase in merchandise inventory, and day's payable increased by five days. Analysis of the guarantor's April 1993 financial statement shows that it offers more than the nominal support stated in the loan write-up. The guarantor's April 1993 personal financial statement lists cash of $39,000, marketable stocks and bonds of $19,000, and real estate of $50,000 with debt of $7,000 and net worth of $226,000.

The interagency policy statement encourages all banks to make loans to small- and medium-sized businesses and to use their judgment in broadly assessing the creditworthy nature of a borrower - general reputation and good character as well as financial condition. As further explained in Banking Bulletin 93-18, Interagency Policy Statement on Small Business Loan Documentation, dated April 2, 1993, the program also offers some relief for banks that do not qualify for the program, and for loans that are not in the exempt portion of the portfolio. However, the intention of the policy statement is to eliminate unnecessary documentation on small- to medium-sized business and farm loans for highly rated and well- or adequately capitalized institutions. The policy statement provides guidelines for some additional flexibility that institutions may apply in their documentation policies for small- and medium-sized business and farm loans without examiner criticism. Neither issuance says that examiners will not criticize the creditworthiness of loans granted on this basis. The issuances say that banks should make loans to creditworthy borrowers, whenever possible, as long as they are fully consistent with safe and sound banking practices. Although the examiners criticized this loan, they did not criticize the bank for continuing its relationship with the borrower. Further, the collateral exception cited by the examining team is not considered unnecessary. A current aged listing of receivables and payables, and details on the company's inventory, are essential to an accurate evaluation of this deteriorating credit.

Conclusion: The ombudsman concurred with the examining team that there are several well-defined weaknesses in this credit based upon the information available during the examination. He concluded that the substandard rating is correct based upon the information available during the examination. However, the supervisory office will expand the loan write-up in the report of examination to better support the reasons for classification.

Issue 9 - Classification of a Loan

The Examining team classified this borrower's loan as "loss". Management believes a more appropriate classification at this time might be "substandard." Should the borrower fail to adhere to a more reasonable repayment program and/or pledge additional collateral, the bank would be prepared to assign a more severe rating.

Discussion: The debt originated at $24,000, when the borrower assumed debt of her son-in-law. It now has a balance of $16,000. The son-in-law had used approximately $10,000 of the original amount to purchase equipment, which he pledged as collateral. However, the bank's management could not provide any documentation to support the existence or value of the collateral. The borrower used the balance of the original amount for terracing and tilling work performed on the maker's farm. The bank has not established a formal repayment plan. The borrower pays whatever she can at each annual maturity. The repayment history to date translates into a 15-year payout, a lengthy amortization for unsecured or farm equipment loans.

In the bank's opinion, the examiner's loss classification is not based upon the borrower's financial ability but rather the lack of specific documentation available for the examiners' review (i.e., current credit information, set repayment program, etc.). The bank claims the borrower has never failed to perform as requested. The bank acknowledges that this credit required additional supervision. The bank admits it did not adopt and enforce a realistic repayment program or obtain sufficient credit and collateral documentation at each renewal. However, at previous examinations, the examiners did not classify the credit. The bank, apparently with the agreement of the previous examiners, has focused its efforts on significant problems rather than exerting itself over a small credit. The bank's loan policy allows officers to lend unsecured as much as 10 percent of a borrower's net worth, absent any liquidity, leverage, or other financial concerns. This borrower has some liquidity and a reasonable net worth. There is no evidence that the borrower is unwilling to make larger payments or has any significant financial problems. The bank has not explored whether the borrower would be willing to pledge any additional collateral.

Conclusion: The Ombudsman concurred that the examiner's loss classification appears to be based more on the absence of both specific documentation and a realistic repayment program than upon the borrower's financial ability. The loan may be re-booked and classified doubtful/nonaccrual. This pending classification is appropriate until the next renewal. The bank can then set up a realistic repayment structure and clearly identify lien-perfected collateral.

Issue 10 - Nonaccrual Treatment of Loans

The examiners placed two loans to this borrower on nonaccrual status with accrued interest charged against earnings. The appeal requested that OCC return the two loans to accrual status.

Discussion: The borrower runs a row crop and cow/calf operation with six loans outstanding to the bank. The bank made loan 1 for the purchase of farm real estate and structured it with annual payments that are paying as agreed. The loan-to-value ratio on this note is 49 percent. The real estate is also cross-pledged to all of the borrower's remaining debt, as is a blanket security agreement on farm chattel. The overall loan-to-value ratio is 88 percent. Loan 2 was made to purchase equipment. The bank structured the loan for annual payments, which are current.

Loan 3 represents carryover operating debt going back more than a decade. This debt has been on nonaccrual since March 1992 with a partial charge-off taken in 1985. Loans 4, 5 and 6 consist of the 1994 operating line, the remainder of the 1993 operating line collateralized by grain on hand, and a loan for the purchase of livestock. These last three loans were not subject to classification because of liquid collateral and a reasonable cash flow projection evidencing the ability to repay the 1994 operating line.

The examiners concluded that loans 1 and 2 should be placed on nonaccrual, like loan 3. All three loans have the same source of repayment. The examiners concluded that there is insufficient cash flow to service the debt. The bank added $19,000 of 1993 carryover to note 3, which was already on nonaccrual, and rolled over approximately $11,000 into note 6. The term payments on loans 1 and 2 made during the past year totaled $18,000.

Banking Bulletin 91-19, Nonaccural Loan Issues, dated May 20, 1991, says that the placement of one of a borrower's loans on nonaccrual does not require that the lender treat all other loans to that borrower similarly, if the bank expects full collection of the other loans. The structure of lending arrangements and dedication of cash flows from income-producing collateral is also key considerations in applying these rules.

Following normal agricultural lending practices, the bank built into the 1993 cash flow projection the payments on notes 1, 2, and 3. It included the $15,000 payment on loan 3 in February, the $14,000 payment on loan 1 in March, and the $4,000 payment on loan 2 in September. The bank made advances for these payments as planned. Also, the senior loan officer said that the borrower prepaid $11,000 in 1994 operating expenses during 1993. This is the $11,000 "rolled over" into note 6, the 1994 operating line. At the end of the operating year, the cash flow was short by $19,000. However, had the bank scheduled the note payments to come at year-end and prioritized them to cover current operating debt, term debt, and then carryover, there would have been sufficient funds to repay all the 1993 operating expenses. The $33,000 paid on notes 1, 2 and 3 would have been available at year-end to offset the $19,000 of carryover and service the $14,000 requirement of note 1. The $11,000 prepaid expenses would have covered the $4,000 requirement of note 2. Therefore, the cash flow shortfall for note 3 is consistent with its nonaccrual status.

Conclusion: The bank may return loans 1 and 2 to accrual status and reverse the $1,287 charge-off of accrued interest. The supervisory office will revise the report of examination and supervisory office letter accordingly. The Ombudsman based this decision upon the borrower's 1993 cash flow, 1994 projections , and adequate collateral coverage. He concurs with the examining team that 1993 cash flow was tight. However, he found no evidence that it was insufficient to satisfy debt service requirements.

Issue 11 - Nonaccrual Treatment of a Loan

The examining team requested that the bank place note 1 of this credit relationship on nonaccrual. The appeal requested that OCC allow the bank to return the loan to accrual status.

Discussion and Conclusion: This request became a moot issue during the appeal review, when the bank initiated foreclosure and liquidation of the borrower's assets. The bank should categorize this loan relationship as a nonperforming asset.

Issue 12 - Board Satisfaction with Level of Classified Assets

The supervisory office letter said that the bank's Board of Directors was satisfied that management was able to maintain a consistent volume of classified assets despite the 1993 flood. The comment was based on a letter the bank sent to the supervisory office in response to the Report of Examination. Because the supervisory office letter indicated that the letter should be considered part of the report of examination, the appeal requested that OCC either delete this statement or amend the letter to accurately reflect the board's position.

Discussion: This supervisory office letter said the following:

Also, you are satisfied that management was able to maintain a consistent volume of classified assets despite the flood.

The bank's letter in response to the report of examination had stated:

  • We concur that loan quality is a concern for the bank and that it in turn negatively affects earnings performance. We recognize that additional efforts must be taken to correct asset quality as quickly as possible. We believe that our ability to maintain a relatively stable level of classified assets while experiencing a major flood disaster that affected many borrowers shows that both the board and the management ream have been working very diligently to minimize potential problems.

The board says that it is not "satisfied" with the level of problem loans and agrees that it needs to take additional efforts to improve the overall condition of the bank's loan portfolio. However, it is grateful that the bank's borrowers did not experience even greater losses than those encountered because of the flood. The board and management believe that improvement in the loan portfolio would likely have been much greater if their community had not experienced a major disaster.

Conclusion: The Ombudsman concluded that the board is not "satisfied" with the level of problem loans. The appeal letter repeatedly says that the bank needs to take additional steps to improve the condition of the bank's loan portfolio. Therefore, the supervisory office will amend its letter to more accurately reflect the bank's belief that, despite the impact of the flood, both the board and management have been working diligently to minimize potential problems.