A bank
formally appealed the 3 management rating and the 3 composite rating
assigned in its most recent report of examination (ROE). Senior management and the
board believed the ratings were incorrect based on the following:
- Inappropriate
characterization of matters requiring board attention (MRBA) as a
repeat criticism; and
- Inappropriate
criticism of the new product development process, when the bank
had not yet incurred any exposure from these new products.
Factual Errors
The appeal
submission detailed what management believed were five factual
errors in the ROE:
- The statement
that the increase in nonaccrual loans was due to an OCC examination
finding.
- The statement
that qualitative factors are not used in the analysis of the
allowance for loan and lease losses (ALLL), and that management does
not review changes in the composition of classified assets
in analyzing the ALLL.
- The statement
in the ROE that financial statement spreads are incorrect, and that
debt service coverage analysis has been frequently manipulated
to show coverage in the best possible light.
- The matters
requiring board attention (MRBA) reflected as repeat
criticisms.
- The
recommendation to formalize the new product process to include
comprehensive and formalized risk analysis.
Increase in Nonaccrual Loans
In the appeal,
bank management objected to the bank initiated increase in
nonaccrual loans being reflected as OCC adjustments. Once an examination has
commenced, it is OCC procedure to reflect all loan status
changes in the examination conclusions. If the changes were a result
of management action, it is appropriate to reflect that management
initiated the changes, but this does not preclude the changes from
being reflected as part of the examination conclusions.
Analysis of the Allowance for Loan and
Lease Loss
Comments in
the ROE indicated management had not been using qualitative factors
to estimate inherent loss in the Pass portion of the loan portfolio,
such as changes in the volume and severity of past due and
classified loans. The
appeal stated the bank has been using a dual methodology for
reviewing the adequacy of the allowance for loan and lease losses
(ALLL). The bank's
methodology included a comparison to an independent benchmark
and using the format outlined in Banking Circular 201 (including
consideration of qualitative factors); and have used this
methodology for several years.
The appeal stated that for the past two years regulators and
the independent public accountant had accepted the bank's
methodology without criticism. Based on these comments,
management determined that the comment in the ROE indicating
the bank does not use qualitative factors was incorrect.
The
ombudsman's review of the work papers determined that the
supervisory office adjustments focused on two portfolios that
experienced 22 percent growth and were planned for additional 50
percent growth going forward.
ROE comments did not clearly reflect the concern with the
limited use of qualitative factors to determine the adequacy of the
ALLL.
Inaccurate and Manipulation of Financial
Statements
The appeal
stated that the ROE comments' regarding material errors in financial
statement spreads were incorrect. The ROE recommended the
establishment of quality control over the accuracy of financial
statement spreads. It
also stated that loan review had found material errors in
approximately 25 percent of cash flow statements. The appeal states that the
bank uses a computer-generated spread package that is not
changeable by the credit analysts; however, errors have been made in
the manual conversion from the standardized spread information into
a proprietary risk screening tool. Management and the
board were aware of these errors. While the ombudsman
concluded that the statement on the accuracy of the financial
statement spreads was incorrect, the issue of making decisions
on erroneous financial information is cause for
concern.
Repeat Matters Requiring Board Attention
The appeal
also noted that the OCC examination team listed matters requiring
board attention (MRBA) as repeat criticisms from the previous
ROE. The board and
management disagreed with this characterization and provided a
listing of MRBA from both examinations to illustrate their posture
on this issue. The
board and management were correct in noting that there was only
one repeat MRBA detailed in the examination being appealed;
however, weaknesses were again identified in lending, which is the
bank's most significant activity. The lending area had been
the subject of MRBA in the last three ROEs.
New Product Development
Process
One of the
issues contained in the MRBA dealt with the bank's need to formalize
a new product process.
The appeal noted that at the time of the examination the bank
was just beginning to underwrite its first live transaction in
the new financing program and found it necessary to alter some
procedures because the actual information was different than
anticipated. The bank
acknowledged their interest as an innovator and advocate for
new products. They also
maintained that there were no loans outstanding in any new product
category and the highly critical focus by examination team to new
products in the ROE was inappropriate.
The ability of
management to respond to and address the risks that may arise from
changing business conditions, or the initiation of new
activities or products, is an important factor in determining the
overall risk profile of the bank. This institution had a
history of being innovative in developing new products. The ombudsman
determined, while the bank had not booked any new products
at the time of the examination, a formalized new product process,
whether there was exposure booked or not, was a sound recommendation
for this organization, given their appetite for product
innovation.
Management Rating
Background
The appeal
submission states that the board and management's practices and
performance was not less than satisfactory given the nature of the
bank's activities. The
submission lists the following items as significant changes that
have occurred since the last examination:
- Significant
progress has been made in enhancing credit administration and
controls;
- Successful
execution of an initial public offering that trebled total capital
in the bank; and
- The bank has
demonstrated its ability to underwrite and service quality
commercial loans by virtue of its success in capital market
activities.
Discussion
and Conclusion
The management
rating is designed to reflect the quality of board and
management supervision of the institution. Management practices differ
depending on the size and complexity of the organization. Complex organizations
require a stronger framework of systems and controls. Having gained an
understanding of the complexity of the bank's activities and despite
the size of the bank, the ombudsman determined activities in
this institution required formalized systems and controls. Over the last three years,
significant weaknesses in risk management systems and controls
were detailed within ROEs.
While management made significant progress in some
areas, other areas lagged in implementation of appropriate processes
to identify, measure, monitor, and control risks associated
with the bank's activities.
The ROE addressed several weaknesses in risk management
systems associated with the bank's lending practices. The lending control
weaknesses dealt with the lack of officer accountability for
assigning risk rating and the volume of inaccurate risk ratings
identified during the examination. The bank had a history of
inaccurate officer ratings and lack of accountability.
OCC Bulletin
97-1, "Uniform Financial Institutions Rating System and
Disclosure of Component Ratings" (January 3, 1997), reflects an
increased emphasis on risk management processes, particularly in the
management component.
This bank's management team had experienced significant
successes, which were highlighted in the appeal. However, risk management
processes had not been commensurate with the complexity of their
activities or development of new products. At the time of the
examination, risk management activities needed strengthening to
ensure problems or significant risks were adequately identified,
measured, monitored, and controlled. The ombudsman determined the
assigned 3 management rating was appropriate given the concerns
regarding risk management systems.
Composite Rating
Background
The appeal
stated the bank's composite rating was lowered from a 2 to a 3
rating, when the financial performance of the bank had
strengthened. The bank
provided a recap of financial indicators. At the last examination
the bank's assigned C/CAMELS ratings were 2/ 233222, while at the
appealed examination they were 3/ 233122. The appeal submission stated
the only change from the prior examination was an improvement in
earnings and that the capital rating arguably could have been 1
rated. Bank management
also commented that subsequent to the examination, but well in
advance of the issuance of the ROE, a substantial amount of capital
was downstreamed to the bank, increasing the leverage ratio. In the board and
management's opinion, the OCC should not have had any material
supervisory concerns.
Discussion
and Conclusion
The appeal,
appropriately, discussed the financial performance of the
institution. The strong
capital base and level of earnings the bank generated certainly
warrant consideration when assigning the composite rating. However, those areas by
themselves are not the basis for determination of this
rating. A composite
rating should incorporate any factor that bears significantly
on the overall condition and soundness of the institution. The ability of management to
address the risks confronting an organization is an important
factor in evaluating the overall risk profile and determining the
level of supervisory attention. The board and management's
lack of diligence in effectively addressing risk control
functions detailed in previous ROEs, within appropriate time
frames, was again demonstrated with three of the four MRBA
identified in the examination under appeal focusing on this
issue. As discussed
above, the risk management concerns regarding the bank's
lending activities have received specific attention in the last
three ROEs. Left
unchecked, these concerns have the potential to become more severe
in an economic downturn, particularly because this bank's
target market is the manufacturing sector. Therefore, the ombudsman
found the assigned 3 composite rating appropriate, considering
weaknesses in the bank's risk management systems.
Appeal of Component and
Composite Ratings and Report of Examination Conclusions (ROE)
regarding the Internal Audit Process and the Custody Arrangement -
(Second Quarter 1999)
Background
A national
bank formally appealed the following:
- The
Composite Uniform Financial Institutions rating of 3, and the
conclusion that the overall condition of the bank was less than
satisfactory.
- The
ROE conclusions relating to capital adequacy, earnings, liquidity,
sensitivity to market risk, and the internal audit process.
- The
ROE conclusion that the level of supervision by management and the
board was less than satisfactory, i.e., management rating.
- ROE
conclusion pertaining to a certain custodial arrangement.
The appeal
highlighted the bank's position on each of the individual component
ratings, the internal audit process, the composite rating, and the
custody arrangement. In
this appeal summary, the discussion and conclusion on each of the
appealed component ratings and internal audit issues will be
discussed individually, followed by an overall discussion and
conclusion on the composite rating and the custodial
arrangement.
Discussion and Conclusion
Capital-Report
of Examination Rating 3
The appeal
stated that with its existing capital ratios the bank was
"well-capitalized," yet the OCC concluded that capital was
unsatisfactory. The
appeal further stated that this was inappropriate because the OCC
should have realized that the bank's capital position would improve
in the coming months with planned reductions in certain
exposures. According to
the bank, the OCC seemed to base its conclusions on the bank's
recent rate of asset growth and on comparisons with the bank's
peers, not on the established regulatory benchmarks for
measuring capital adequacy.
A financial
institution is expected to maintain capital commensurate with
the nature and extent of its risks and management's ability to
identify, measure, monitor, and control these risks. The bank's risk profile
increased primarily due to rapid asset growth and a large
concentration of exposure in high-risk emerging countries. At the time of the
examination, the bank's criticized assets
doubled, earnings performance was only fair, and weaknesses
were noted in the allowance for loan and lease losses (ALLL)
methodology, loan administration, and operations. While the bank's capital and
strategic plans called for continued growth, efforts to increase
capital had not been successful. Although the bank met the
prompt corrective action (PCA) benchmark ratios, there were
significant qualitative factors that supported the need for
additional capital.
The capital posture did not fully support the bank's risk
profile, even though the quantitative ratios exceeded the minimum
statutory requirements.
Therefore, the ombudsman concluded that the assigned 3
rating was appropriate at the time of the examination.
Management-ROE
Rating 3
The appeal
stated that the OCC's view that management and the board did
not adequately supervise the bank was based on a faulty two-pronged
analysis. First, it
incorrectly assumed that the bank's overall condition was less than
satisfactory. Secondly,
it rested on two events that occurred at the bank, the increase in
an emerging market exposure and a certain custodial
arrangement. The
appeal stated that neither of these events was indicative of lax
supervision at the bank.
The management
rating reflects the quality of board and management supervision of a
bank. Management
practices differ depending on the size and complexity of the
organization. Risk
management practices and controls should be commensurate with the
bank's risk profile and complexity. The ability and willingness
of management to respond to changing circumstances and to address
risks that may arise from changing business conditions in a timely
manner are important factors in determining the management
rating. The ombudsman
recognized the tenure and experience of the management team and the
board; however, at the time of the examination, management had
not implemented risk management processes to adequately identify,
monitor, and control risk in key areas of the bank, such as capital,
liquidity management, concentrations, and supervision of affiliate
activities. The
ombudsman concluded that at the time of the examination, the
assigned 3 rating was appropriate.
Earnings-ROE
Rating 3
The appeal
indicated that earnings were stable and that, prior to agreeing to
record an almost $2 million ALLL provision against 1997 earnings,
the bank's return on equity would have been in excess of 13 percent
and its return on assets would have been 0.68 percent.
Pursuant to
OCC Bulletin 97-1, "Uniform Financial Institutions Rating
System and Disclosure of Component Ratings," the earnings
rating reflect not only the quantity and trend of earnings, but also
factors in events that may affect the sustainability or quality of
earnings. Earnings
should be sufficient to support operations and to provide for the
accretion of capital and adequate provisions to the ALLL. The bank's 1997 earnings
performance was sufficient to support operations and the ALLL, but
capital augmentation was minimal considering the bank's growth. Trends noted in lower asset
yields, higher deposit costs, and increased provisions were factored
into the analysis.
Based on this, the ombudsman concluded that a 3 rating was
appropriate, at the time of the examination.
Liquidity-ROE
Rating 3
The appeal
indicated that the OCC's 3 rating was based on a set of
contingencies that are highly unlikely to occur. The bank does not believe
that they are at risk of losing their ability to attract brokered
deposits, its principal source of funding. The appeal also stated that
the bank has access to substantial sources of stable capital that
could and would be used if its ability to accept brokered deposits
were in jeopardy.
The bank has
high liquidity risk based on its capital position and the
increased risk resulting from the bank's exposure in some of
their emerging markets portfolios. In addition, the bank
did not have an adequate contingency funding plan should its
eligibility for brokered deposits become jeopardized. Based on these factors, the
ombudsman determined that a 3 rating appropriately reflected the
bank's liquidity posture at the time of the examination.
Sensitivity
to Market Risk-ROE Rating 3
The appeal
stated that the 3 rating was assigned solely on the basis of a
certain foreign country exposure. The ROE stated that interest
rate and foreign exchange risks were considered low at the time of
the examination and that the rating was assigned based on the
foreign country exposure. The ombudsman concluded that
a 2 rating was more reflective of the condition of this area, at the
time of the examination rather than the assigned 3 rating.
Internal
Audit Process
The appeal
stated that the bank's internal audit process was considered less
than satisfactory by the OCC because the audit schedule had not
been completed and that the bank's audit committee had not met from
late1996 through mid-1997.
The appeal also discussed a number of events occurring in
early 1997 that adversely affected the internal audit function. The appeal stated that there
were no negative repercussions in the bank during the period in
which the events occurred.
While the
ombudsman acknowledged the bank's arguments regarding the various
audit function weaknesses noted in the ROE, there was need for
improvement, particularly in light of the high operational risks
noted in certain areas such as in Treasury. Although some weaknesses,
individually, could have been mitigated by unplanned events
that occurred during the examination, collectively they posed a
concern that warranted management and the board's attention. OCC Bulletin 98-1,
"Interagency Policy Statement on Internal Audit and Internal
Audit Outsourcing" (January 7, 1998), states in part that "In
discharging their responsibilities, directors and senior management
should have reasonable assurance that the system of internal
control prevents or detects inaccurate, incomplete or
unauthorized transactions; deficiencies in the safeguarding of
assets; unreliable financial and regulatory reporting; and
deviations from laws, regulations, and the institution's
policies. . . . Directors should be confident that the internal
audit function meets the demands posed by the institution's current
and planned activities."
Bank
management indicated to the ombudsman that most of these audit
deficiencies had been corrected subsequent to the
examination.
Composite Rating (ROE Rating 3) and
Summary
The bank's
appellate submission stated that based on the bank's discussions of
the component ratings, its overall condition during the period
covered by this examination was not less than
satisfactory. The
appeal indicated that many of the conclusions in the ROE were
reached with no factual or other evidentiary support. It further stated that the
conclusions were inconsistent with the true condition of the bank
and seemed designed to serve a justification for the 3 rating,
rather than an accurate description of the bank's
condition.
The OCC
Bulletin 97-1, "Uniform Financial Institutions Rating System,"
states:
Financial institutions . . . [rated 3]
exhibit some degree of supervisory concern in one or more of
the component areas.
These financial institutions exhibit a combination of
weaknesses that may range from moderate to severe. . . 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.
[Fed. Reg.:
December 19,
1996, Vol. 61, No. 245, p. 67026]
At the time of
the examination, the bank exhibited a significant degree of
supervisory concern because of its rapid growth, increased exposure
in particular emerging markets, and their impact on the bank's
capital, earnings, and liquidity positions. Furthermore, the bank had
not implemented risk management processes to adequately
identify, monitor, and control risk in key areas of the bank, such
as capital, liquidity management, concentrations, and
supervision of affiliate activities. Based on this, the ombudsman
determined that the 3 composite rating was reflective of the
condition of the bank at the time of the examination. Additionally, these adverse
trends and concerns continued through the processing of this appeal.
Custody
Arrangement
The bank also
appealed the OCC's conclusion that a custodial arrangement between
the bank and its foreign affiliate constituted an unsafe and unsound
banking practice and a violation of section 23B of the Federal
Reserve Act, 12 USC 371c-1. The appeal states that while
the custody arrangement with its affiliate could have been better
documented and administered, it did not constitute an unsafe
and unsound banking practice and did not result in a violation of
law as noted in the ROE.
The ombudsman reviewed this issue and carefully
considered the points of discussion in the appeal and in the
bank's outside counsel's letter.
Although
banking is characterized by risk-taking, this arrangement
reflected characteristics that were not prudent banking
practices. For example:
- The
bank's sole purpose for entering into an agreement was to
inflate the affiliate's balance sheet.
- The
bank participated in a repurchase agreement with little direct
knowledge of the foreign country's central bank custody and control
practices and had to rely on the counterparty for the expertise.
- The
officer normally responsible for administering custody and similar
arrangements was unaware of the agreement and related accounts.
- The
board was not notified of this agreement, even though they had been
previously served with civil money penalties for similar
transactions.
- No
one from the bank had signed the agreement.
- The
bank did not maintain records or statements to track and report
proceeds from any of the account
transactions, other than original wires between the bank and
its affiliate.
Furthermore,
the ombudsman determined that the arrangement was not "on terms
and under circumstances that in good faith would be offered to, or
would apply to, nonaffiliated companies." Therefore, the ombudsman
concluded that the custody arrangement was an unsafe and unsound
practice and violated section 23B of the Federal Reserve Act, 12 USC 371c-1.
