Background
A bank appealed its examiner's determination that
its commercial real estate appraisal function lacks independence
because of the reporting lines within the organization. The unit reports to a vice
chairman who also has responsibility for the credit extension,
collection, and lending policy functions. The bank's appeal to the
supervisory office was decided in favor of the
examiner.
Discussion
The function in question reports administratively
to a senior vice president responsible for collateral appraisal and
control. That
individual reports to an executive vice president with
responsibility for credit policy, commercial credit training,
portfolio analysis, and reporting. The executive vice president
reports to the vice chairman responsible for credit risk
management.
The examiner's decision was determined as
follows:
Both 12 CFR 34.45 and Banking Circular 225 (dated
December 21, 1987) required that appraisers be independent of the
lending, investment, and collection functions and not involved,
except as an appraiser, in federally related transactions. The September 28, 1992
revised issuance of BC-225 expands on this standard by stating, "In
order to avoid potential conflicts of interest, staff appraisers
should not be supervised by loan underwriters, loan officers or
collection officers."
The regulation and circulars note that in some instances it
may be necessary to use a qualified individual who is not
independent of the lending function to perform an appraisal, but
this exception is primarily intended for cases where the bank is
small and lacks the resources to retain qualified, in-house
independent appraisers.
The examiner decided this bank was large enough and
sophisticated enough to afford qualified in-house appraisers,
reinforcing the need for independence.
Although the vice chairman is not actively
involved in the daily credit approval and appraisal activities of
the bank, he is ultimately responsible for credit policy, the credit
approval process, and collection and appraisal functions. It is through his authority
that the potential for a conflict of interest could occur.
The bank based its appeal on the following
points:
1)
No one in this reporting chain has any lending or
revenue generation responsibilities. No staff appraiser is supervised,
controlled, or influenced by anyone who has direct loan
underwriting, account management, or collection
responsibilities.
Line appraisers and
reviewers are insulated from potential negative influences by
reporting to a regional manager who, in turn, reports to a chief
appraiser. The chief
appraisers report directly to the unit head.
Independence
is further supported by two senior positions strategically placed in
the unit's organization: the managers of compliance and training,
and quality assurance and audit. This is in strict compliance with
BC-225 (REV) which stipulates that "staff appraisers should not be
supervised by loan underwriters, loan officers, or collection
officers."
2)
As a diversified financial services provider, the
credit function of this bank encompasses the strategic management or
risk beyond the more traditional narrow confines of "credit risk"
relating to loans.
Transactional credit approval is totally separated from the
credit policy, portfolio management, problem loan workout, and
derivative and trading products administration activities within
this credit risk management function.
3)
Direct management and experienced senior level
oversight of the appraisal function has a necessary and logical
place within the bank's strategic credit risk management group. This
arrangement ensures the unit's independence from line management,
which is challenged and given incentives to produce volume and
expand market share, and from transaction approvers, who,
hypothetically, could succumb to direct or indirect pressure to
influence the appraisal process.
4)
There has never been any indication or suggestion that
actual or implied pressure or influence has ever been exerted on the
unit in question. A
different reporting channel simply to avoid the "credit" sphere
would negate the protective features mentioned above and the
efficient service the bank has been providing through this
arrangement.
Conclusion
The current structure of the bank's real estate
appraisal function fulfills the mandate for independence as required
by the regulation and banking circulars. Nothing was discovered to
arouse concern that appraisal independence was compromised or
threatened. Further,
the independence of the process as currently structured is not
unduly dependent on the persons presently performing those duties.
Assuming competent replacements are chosen, independence should not
be adversely affected by personnel changes.
Note: This decision is unique to the specific
facts and circumstances of the case decided. As such, it should not be
viewed as precedential.
The issue of independence is currently being reassessed, and
more specific guidance will be provided.
APPEAL OF CRA RATING (THIRD QUARTER
1994)
Background
A bank filed a second-tier appeal of the rating
and findings of OCC's Community Reinvestment Act examination
report. The bank's CRA
performance was rated "Needs to Improve Record of Meeting Community
Credit Needs" based upon alleged substantive violations of the Equal
Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA). The bank claims that OCC
criticism rests on an incomplete and inaccurate understanding of
what actually occurred at the bank. Further, apart from the fair
lending violations, the examiners found the bank's CRA performance
to be equal to or better than the performance that had been rated
"Satisfactory" at the previous CRA examination. At their exit meeting with
the board of directors, the examiners specifically confirmed that
the bank would have received a "Satisfactory" CRA rating had it not
been for the fair lending violations.
Examiners identified three instances of single
women who applied for loans reported under the Home Mortgage
Disclosure Act (HMDA) in which "protected income" was not taken into
account by the bank.
Two of the applications were for home improvement and the
third was for money to purchase a house. The protected income
involved child support, social security benefits received on behalf
of a dependent child, and part-time wages. All three applications were
denied. The examiners
also identified a case in which the protected income of the primary
applicant, Veterans Administration disability, was taken into
consideration by the bank when it made the credit decision. That application was
approved.
The bank responded that only one of the three
instances appeared to contain an error under the ECOA and this error
was due to the lending officer's honest misunderstanding of a nuance
in the protected income rules.
The loan officer believed that social security income of the
applicant's dependent son had to be excluded from consideration,
analogous to the mandatory exclusion of the income of nonapplicant
spouse. In the other
two cases, the bank claimed there was no Regulation B error. One of the applicants was
disqualified on the basis of a previous bankruptcy filing, without
respect to income. The
other applicant's protected income had been considered, but had not
been properly recorded on the internal HMDA reporting form.
At the examiner's request, the bank conducted its
own file search for the 24-month period prior to the date of
examination to identify all applicants affected by the
practice. Of the 156
approved and denied individual female applicants, management
uncovered six instances (including the three cases identified above)
in which protected income was not taken into account in the loan
applications of single women.
These applications were either not approved or were approved
for a lesser amount than that requested. Seven additional approved
loans were identified in which the applicant(s) had protected income
that was not included in the HMDA register and therefore was not
taken into account when making the credit decision. The bank also took
affidavits from each of the loan officers who made the 13 loans
noted above.
Discussion
The ECOA states that " [i]t shall be unlawful for
any creditor to discriminate against any applicant, with respect to
any aspect of a credit transaction. on the basis of race, color,
religion, national origin, sex or marital status or age (provided
the applicant has the capacity to contract)." 15 U.S.C. 1961
(a).
The FHA further provides that "[i]t shall be
unlawful for any person or other entity whose business includes
engaging in residential real estate-related transactions to
discriminate against any persons in making available such a
transaction, because of race, color, religion, sex, handicap,
familial status, or national origin." 42 U.S.C. 3605
Regulation B, 12 CFR 202.6(b)(5), states that
"[A] creditor shall not discount or exclude from consideration the
income of an applicant or the spouse of an applicant because of a
prohibited basis or because the income is derived from part-time
employment or is any annuity, pension, or other retirement benefit.
When an applicant relies on alimony, child support, or separate
maintenance payments in applying for credit, the creditor shall
consider such payments as income to the extent that they are likely
to be consistently made."
A violation or 12 CFR 202.6 does not
automatically result in discrimination that would violate ECOA. However, the failure to take
a protected class of income into account can result in a pattern of
loan denials that would demonstrate a pattern of discrimination, in
violation of ECOA.
The facts in this case do not support a
discrimination case based on overt discrimination, as there is no
instance of overt refusal to lend to a woman or an unmarried
person. At issue is
whether the facts support a finding of disparate treatment. In the fair housing context,
the presence of any one individual of a protected class who is
treated differently from any one, similarly situated member of the
control class is sufficient to establish a disparate treatment
case.
Conclusion
The referenced violations of ECOA did occur. The documentation was not
sufficient to support the claim that the instances identified were
simply the result of HMDA reporting errors. After conducting its own
file search, the bank initiated corrective action by sending letters
to certain applicants resoliciting credit applications. These letters include the
statement. "A review of our files indicates that we did not take the
child support (or social security benefits) listed on your
application into consideration when making our credit
decision." Based on
these letters to the affected applicants, the bank's assertion that
HMDA record-keeping and reporting errors created the appearance of
infractions of ECOA appears contradictory. Also, there was not
supporting information bolstering the loan officers' recollections
(as reflected in the affidavits included with the appeal) that
protected income was considered in their credit underwriting and
decision-making process for the referenced sample of loans.
However, despite the fair lending violations, a
rating of "Satisfactory Record of Meeting Community Credit Needs"
was assigned by the Ombudsman's Office. The quality of all other
aspects of the bank's overall CRA performance justified this
rating.
Note: A bank's fair lending performance
materially affects its assigned CRA rating. All such decisions are
unique to the facts and circumstances of each case and must be
decided on an individual, case-by-case basis.
APPEAL OF EXAMINER'S DIRECTION TO DEFER
RECOGNITION OF GAINS (THIRD QUARTER 1994)
Background
A bank appealed its examiner's direction to defer
recognition of all gains on the sale of Small Business
Administration (SBA) loans for 90 days. A provision in the sales
agreement provides for recourse if the borrower fails to make the
first three payments after sale of the loan.
The bank claims its accounting practices are in
accordance with generally accepted accounting principles (GAAP EITF
88-11). The bank's
accounting firm takes the position that the risk of returning a
premium is minimal, which has been proven through historical
experience. Further,
OCC confirmed by letter that there is no question these transactions
should be reported as sales, not financings. The bank believes that
Instructions for the Consolidated Report of Condition and Income
(call report) state clearly that if the transaction is a sale, the
gain or loss must be recorded immediately. Finally, the bank states
that there is no published rule or regulation specifically requiring
that gains on sales of SBA loans be deferred. The principle is discussed
in unpublished interpretations and opinions. The bank believes that
reliance upon the case-by-case implementation of unpublished rules
results in inequities and material inconsistency in the reporting of
financial results among peer banks.
The effects of complying with the examiner's
direction are as follows:
- The bank will fall below the "well-capitalized"
level
- The bank will find itself in noncompliance with
the capital requirements of its formal agreement.
- The bank will have to recognize expenses
incurred in the current quarter and will be unable to recognize the
related income.
The bank also appealed the examiner's requirement
that the bank amortize loan packaging fee income, net of associated
expense, over the life of the loan. It feels the loan packaging
fee has no relationship to whether or not the loan is made, and it
is not required of the customer to have a loan packaged by the
bank. The customer may
use an outside packager, in which case, no fee is charged by the
bank. If the bank
provides the packaging service, the fee is charged to cover its
expenses and make a slight profit for that service. The package
belongs to the borrower, who may take the package to another bank to
obtain the loan if desired.
Discussion
Although the accounting and reporting treatment
required for regulatory reporting is generally consistent with GAAP,
there are exceptions where the agencies have concluded a more
stringent policy is necessary for supervisory reasons. The policy on assets
transferred with recourse is one such area. The call report instructions
state that the general rule for reporting transfers ("sales") of
assets is for purposes of reporting to the bank supervisory agencies
and agency determination of capital adequacy; it is not intended to
establish presumptions about the legal or contractual rights of the
parties to the transfer.
Transactions involving the "sale" of assets are
reported either as financing or sales transactions. The general rule is that a
transfer of loans, securities, receivables, or other assets is to be
reported as sale of the transferred assets by the reporting selling
institution and as a purchase of the transferred assets by the
reporting purchasing institution only if the transferring
institution:
retains no
risk of loss from the assets transferred resulting from any cause
and
(2)
has no
obligation to any party for the payment of principal or interest
on the assets transferred resulting from:
- default on principal or interest by the obligor
of the underlying instrument or from any other deficiencies in the
obligor's performance;
- changes in the market value of the assets after
they have been transferred;
- any contractual relationship between the seller
and purchaser incident to the transfer that, by its term, could
continue even after final payment; or
- any other cause
According to the instructions to the call report,
"If risk of loss or obligation for payment of principal or interest
is retained by, or may fall back upon, the seller, the transaction
must be reported by the
seller as a borrowing from the purchaser and by the purchaser as a
loan to the seller."
However, in recognition of the unique structure
of SBA loans, the staffs of the banking agencies concluded that the
optional repurchase provision contained in the loan agreements would
not prohibit sales treatment, provided the refundable premium on the
sale is deferred until the refund provision expires. This modification is
consistent with the accounting for loan securitization sales
transactions involving the use of an escrow or spread account to
absorb losses. In other
words, by deferring the premium income until it becomes
nonrefundable, a bank recognizes a sale for regulatory purposes.
Conclusion
The bank must defer SBA premium income for 90
days according to the interagency guidelines. The temporary change in
capital categories resulting from this treatment cannot be
avoided. Capital
adequacy encompasses many other qualitative factors in addition to
Prompt Corrective Action (PCA) capital category (i.e., earnings,
credit risk, funding risk, growth, management, and board
supervision, etc.). The district will emphasize, as the bank should,
the bank's overall capital adequacy and capital planning efforts
versus a temporary change in capital categories. The supervisory office
agreed to give consideration to the amount of SBA premium income
that will become available for earnings during the upcoming quarter
in their qualitative assessment of the bank's overall level of
capital sufficiency.
This does not relieve the legal requirement that the bank has
to comply with the mandates imposed by the PCA section of the
Federal Deposit Insurance Corporation Improvement Act and the
capital levels specified in the bank's formal agreement.
The agencies recognize that this policy on
recourse needs to be reviewed.
Currently, an interagency working group, under the auspices
of the Federal Financial Institutions Examination Council, is
studying the entire recourse issue in great detail. The group has already
solicited public comment on the issue and expects some proposals for
change in the near future.
Due to the immateriality of the bank's packaging
fees in relation to total income, the bank need not amortize loan
packaging fees over the life of the loan.
APPEAL OF VIOLATION (THIRD QUARTER
1994)
Background
The Office of the Ombudsman received an appeal
letter on behalf of a bank that was cited for a violation of 12 CFR
9.12 and Opinion 9.3900.
The bank invested trust funds into two mutual funds that are
advised by an investment advisory firm in which a bank director, who
also serves on the bank's trust committee, holds a 5.23 percent
interest. Neither fund
nor the investment advisory firm is affiliated with the bank. The funds were invested
without obtaining prior written authorization.
First, the bank does not believe that the
relationship between the bank and the minority investment by the
bank director constitutes an affiliation sufficient to create a
problem under 12 CFR 9.
None of the interests delineated in Section 9.12(a) are
affected in this case:
- The trust funds are not invested in stock or
obligations of the advisor.
The fund may terminate its relationship with the advisor upon
60 days notice without penalty at any time.
- No property is acquired from affiliates of the bank or
their directors, officers, or employees. The adviser does not sell
fund shares; such shares are distributed directly by the funds.
- The bank
receives no advantages from the sale of the funds nor does the
advisor.
The bank does not believe that the bank
director's minority interest of 5.23 percent is sufficient to create
a conflict of interest or a sufficient interest to fall within the
prohibitions of Section 9.12.
The bank is not purchasing services of the advisor, it is
purchasing shares of the funds, which are unaffiliated with the bank
and in which no bank director has an interest. Neither does the bank
believe that the bank director's service on the bank's trust
committee should weigh heavily in the decision. Even if a director has a
conflict of interest, traditional corporate practice, which is
recognized by OCC, holds that by abstaining from any participation
in the discussion of, or vote upon, a matter in which such director
has an interest, such director may thereby avoid an impermissible
conflict of interest under applicable law. The bank cites Alabama Code, Section
10-2A-63, 12 CFR 215.4(b) (i), Section 7.5217(a) and Alabama Code, Section
10-2A-21(d).
Second, the bank believes that the provisions of
the local law, in this case the Alabama Code, were expressly
intended to permit a bank to rely on such provisions in order to
invest trust funds in mutual funds that are advised by the bank or
its affiliates. Alabama Code, Section
19-3-120.1, expressly governs trust investments in mutual funds, and
expressly authorizes investments in mutual funds advised by bank
affiliates. In the
bank's view, 19-3-120.1 is more than sufficient for purposes of 12
CFR 9.12(a). The
absence of any "affiliation" between the bank and the funds raises a
question in the bank's mind as to whether reliance on the statutory
authorization is even necessary. Although the terms
"connection" and "interest" from Section 9.12(a) are broad, the bank
believes that with respect to trust mutual fund investments by a
trust department, the connection or interest must be an
"affiliation" in order to even need the protection provided by
19-3-120.1 for purposes of 12 CFR 9.12.
Finally, the bank believes that recent OCC
decisions allowing the bank acquisitions of companies that act as
advisers to mutual funds expressly recognized that investment
companies (mutual funds) are separate and distinct from their
advisers (decision to charter J.& W. Seligman Trust Company,
N.A. and decision to charter Dreyfus National Bank & Trust
Company). The bank also
cites First Union's acquisition of Lieber Asset Management
Corporation (93-ML-08-023) and Mellon Bank's acquisition of The
Dreyfus Corporation (93-NE-08-043 and 93-NE-08-044).
Discussion
The legal issue raised by this appeal involves
the conflict of interest that may exist given the investment of
trust assets in mutual funds advised by a company in which a bank
director owns stock. In
pertinent part, Section 9.12(a) provides:
(a)
Unless lawfully authorized by the instrument creating
the relationship, or by court order or by local law, funds held by a
national bank as fiduciary shall not be invested in stock or
obligations of, or property acquired from, the bank or its
directors, officers or employees, or individuals with whom there
exists such a connection, or organizations in which there exists
such an interest, as might affect the exercise of the best judgement
of the bank in acquiring the property, or in stock or obligations
of, or property acquired from, affiliates of the bank or their
directors, officers or employees.
The OCC's regulation is intended to reflect and
require for national banks the duty of undivided loyalty, a basic
principle of trust law followed throughout the
United
States. Lending commentators on
trust law emphasize the importance of the duty of loyalty and the
expected adherence to the high standard. The focus of the duty of
loyalty is to deter fiduciaries from entering into positions
involving conflicts of interest.
In the present situation, although another
company is investment advisor to the mutual funds and not the bank,
the relationship of the bank director to the advisory company falls
under the circumstance proscribed by the language of 12 CFR
9.12. Here, at least
one bank director has some type of ownership in or control over the
advisory company. The
fees received by the investment advisor depend in part on the assets
invested in the mutual funds.
As such, the owners of the advisor have an interest in the
investments in the mutual funds. As directors of the bank,
this individual is responsible for directing and reviewing the
fiduciary powers of the bank.
Accordingly, in the ombudsman's view this situation falls
within the scope of the 12 CFR 9.12 prohibition regarding the
investment of funds in stock or obligations of organizations in
which there exists such an interest as might influence the best
judgement of the bank.
As provided by the language of 12 CFR 9.12(a), a
self-dealing transaction generally is permissible only when
specifically authorized by the trust instrument creating the
relationship, where a court order authorized the specific
transaction, or where local law allows the otherwise prohibited
practice. In this
bank's situation, it is not argued that the trust instruments
specifically authorize the investment of trust assets in mutual
funds that are advised by a company owned in part by directors of
the bank. Nor is there
any court order authorizing the transactions in question. While the Ombudsman's Office
is not aware of any Alabama statute that expressly states that a
bank may invest trust monies in mutual funds that are advised by a
company owned in part by directors of the bank, Alabama Code, Section
19-3-120.1 (1993), does authorize banks acting as fiduciaries to
invest in mutual funds that the bank or an affiliate advises or
provides other services:
The fact that such fiduciary or any affiliate
thereof is providing services to the investment company or
investment trust as an investment advisor,. custodian, transfer
agent, registrar or otherwise, and is receiving reasonable
remuneration for such services, shall not preclude such fiduciary
from investing in the securities of such investment company or
investment trust; provided, however that which respect to any
fiduciary account to which fees are charged for such services, the
fiduciary shall disclose (by prospectus, account statement or
otherwise) to the current income beneficiaries of such account or to
any third party directing investments the basis (expressed as a
percentage of asset value or otherwise) upon which the fee is
calculated.
Arguably, this
section thereby authorizes investment in the mutual funds where a
greater conflict exists than that in the bank's situation. Since the
Alabama
legislature specifically authorized investment in mutual funds where
the bank or an affiliate acts as investment advisor or provides
other services, it is at least arguable that the statute may include
the situation where bank directors own shares in the advisor even
though not enough shares to be an affiliate. If the directors owned a
greater percentage of the stock (creating an even more direct
conflict), and such ownership triggered affiliation between the bank
and the advisor, then the conduct would be expressly authorized by
the language of the statute.
However, we are not aware of any cases interpreting the
meaning of the statute and there is no official legislative
history.
Conclusion
Because this is a question of law without any
precedential or official legislative history, the Ombudsman's Office
chose not to render an immediate decision. The bank was asked to seek a
formal opinion from the
Alabama attorney general regarding
the meaning and intent of the statue. Although not binding for
this Office, under the rules of statutory construction, the formal
opinions of state attorneys general are normally given considerable
deference. While
waiting for receipt of that opinion, the bank was advised not to
make any more investments in the mutual funds in question and to
notify the ombudsman of the attorney general's opinion.
For reasons unique to the State of
Alabama, the bank requested as an alternative,
and the ombudsman agreed to accept, a similar ruling from the
Alabama superintendent of
banks. Kenneth R.
McCartha, superintendent of banks for the State of
Alabama, confirmed the bank's position in a
letter dated August 12, 1994, providing his official opinion
regarding the meaning and intent of the
Alabama
statue. In light of the
history of the legislation and the language of Alabama Code, Section
19-3-120.1, Superintendent McCartha concluded that banks located in
Alabama, in the exercise of their fiduciary or trust powers, are
specifically authorized by 19-3-120.1 to invest in mutual funds
where such banks, or their respective officers, directors, or
shareholders have an affiliation or lesser interest in a mutual
fund, or investment advisor, or other service providers to a mutual
fund.
Therefore, the ombudsman concluded, after careful
consideration of all the facts, that the most reasonable
interpretation of Part 9 provides an exception for the conflict in
question. This decision
is unique to the facts and circumstances of this situation and local
law. This in no way
establishes OCC precedent regarding conflicts of interest. Notwithstanding this
conclusion, the
Alabama statue requires the
fiduciary to provide disclosure to the current income beneficiaries
and/or any third parties directing investment of the basis on which
any investment advisory fee or other fee is calculated. The bank did not make these
disclosures and therefore the cited violations must stand. Although the bank may
continue investing fiduciary monies in the mutual funds in question,
the appropriate disclosures must be made in accordance with the
local law.
APPEAL OF CRA RATING (THIRD QUARTER
1994)
Background
A formal appeal was received concerning a bank's
Community Reinvestment Act (CRA) rating of "Needs to Improve Record
of Meeting Community Credit Needs." Approximately 80 percent of
the bank's business is in the trust/fiduciary area with the
remainder in commercial banking. The bank's only office is
located in a large downtown metropolitan area.
The appeal states that the fundamental flaw of
the performance evaluation (PE) is captured in the following
comment:
There are no legal
or financial impediments that inhibit the bank's ability to meet the
credit needs of its community.
The bank has made a modest response to help meet the credit
needs of the community.
There is a strong need for affordable housing and small
business loans within the bank's delineated community. Considering this, management
and the board actions designed to meet these needs have thus far
been fairly narrow in scope.
The
bank has not sufficiently pursued alternative means by which it can
help meet the community's credit needs.
The appeal then states the preceding is
manifestly inaccurate as the bank has made more than a modest
response to ascertain and to help meet the credit needs of its local
community and has pursued many alternatives means by which it could
help meet the community's credit needs. The bank states that the
needs of the local community are of such an obvious nature that the
credit needs and demographics within a two-mile radius surrounding
the downtown area have been well identified by the bank and steps
have been taken to help address these needs, within the limits of
the expertise and resources of the bank.
The appeal goes on to state that although only
approximately 20 percent of the bank's loans are made within its
delineated community, this does not prove that the bank in any way
fails to address its CRA responsibilities. The bank is heavily involved
in outreach programs of various sorts. Many such involvements will
lead (and are leading) to extensions of credit in the local
community, as has been shown through association with two
organizations. Because
the bank conducts private banking business, it is natural that the
extensions of credit it is willing to make available would mostly
fall within geographic areas that are not low- to
moderate-income. This
is not due to avoidance of CRA responsibilities. At the same time, as the PE
discussed, the board and management are looking for credit needs and
are open to additional extensions of credit to creditworthy
borrowers within the bank's local community. This is proven in that the
bank is making such loans as the opportunities arise.
The appeal states the bank feels that the rating
is based upon the following conclusionary statements in the
performance evaluation
- The bank's contact with community groups is
inadequate.
- The board's involvement in the CRA oversight
process is inadequate.
- The bank has no written marketing or
advertising programs.
- The bank has made limited efforts to extend
loans for small businesses, home improvement, and housing
rehabilitation throughout its community.
The appeal lists several reasons why the bank
does not feel that these are accurate statements. These reasons are summarized
below:
- Prior to the start of the examination, one of
the bank's officers had been invited to be on the board of directors
of an organization that was helping an area within the bank's
delineated community rebuild.
After the examination, another officer became a senior
advisor to this organization.
- An officer and director of the bank joined the
board of a home for children and identified the need for a loan,
which the bank made after the examination.
- The bank gave a donation and a large working
crew to a nationwide organization that rehabilitates homes of a low-
or no- income residents, including those in the bank's local
community.
- An officer has established a relationship with
a real estate developer to develop a financing proposal term sheet
to be used to obtain financing to develop low- and moderate-income
housing in a low- and moderate-income area within the bank's
delineated community.
The bank feels that this effort will result in a large loan
in which the bank would possibly participate in addition to giving
ongoing consulting.
- Members of the board of directors have been
working with a minority-owned bank regarding the establishment of a
trust capability for the bank with this bank acting as the "back
office" for the other bank.
- Bank officers and directors are working with a
group in developing and proposing a structure for a syndicated
credit facility to be used by a fund established to lend to small
businesses in a low- and moderate-income area.
- The board has been involved in the
establishment of policy for the CRA area and has met all of the
technical requirements of the act. The majority of board
members are officers at the bank. On an informal basis, the
officers/directors constantly discuss with one another the
activities that each is undertaking, including activities for
CRA. The appeal states
that it is unfair to say that such involvement is inadequate because
of the fact that the directors/officers are intimately involved in
the process on a daily basis.
Due to the small size of the staff (five commercial bank
officers), each of the officers knows what the others are dong with
respect to CRA and they discuss these matters on a continuous
basis.
- The bank has not spent heavily for written
marketing or advertising programs. However, recently the bank
has funded the placement of its name on an assistance van that tours
regularly through the bank's local community, disseminating
financial, legal and regulatory information to small business
owners. (Although this
advertising was implemented after the examination, negotiations for
such advertising were being conducted prior to the writing of the
PE). The board of
directors does not feel that it would be prudent from a safety and
soundness aspect for a bank that allocates only 20 percent of its
business to commercial banking to spend large amounts of money on
advertising.
- As pointed out in the PE, prior to the
examination, the bank made some home purchase loans in its CRA
delineated community and joined a referral program comprised of five
local banks and one savings and loan association. In addition, the
bank purchased several SBA-guaranteed loans, approximately a third
of which are in the city where the bank is located. Since the examination, the
bank purchased an additional pool of direct SBA loans, all assisting
businesses within the city in which the bank is located.
- Before the examination began, the bank joined
with other financial institutions with a mission of making loans for
multiple-unit buildings in its CRA community. Subsequent to the examination this resulted in the bank
committing funds for 30- year loans for three low-income
multifamily projects.
The appeal concludes by pointing out that the PE
observes that the bank's credit products and services are suited to
the bank's market niche.
The bank feels this is appropriate, as the bank specializes
in trust services and is designed to conduct private banking which
constitutes 80 percent of the bank's business and reflects the
expertise of the bank's personnel. Since only 20 percent of the
overall business is dedicated to commercial banking and the bank
cannot be all things to all people in its local community, the bank
feels it has chosen credit products and services with which the bank
has expertise and from which the community benefits. The appeal states that
nowhere in the statute or regulation of CRA does it require that the
bank make loans within its local community for which it has no
expertise, even if there is such a need in the community, as long as
the bank is helping to fulfill other community credit needs for
which it does have expertise.
The appeal emphasizes that the bank has geared its
CRA-related credit products and services to meet the credit needs of
the low- and moderate-income areas by, among other things, lending
to financial intermediaries and participating in loan consortia or
pools that lend directly to low- and moderate-income areas.
Discussion
Although some institutions may be subject to
statutory or regulatory constraints that prevent them from operating
as a "full service" bank, other banks may choose to voluntarily
limit or specialize their services to target particular
markets. This is fine;
however, such banks have the same continuing and affirmative
obligations as a "full service" institution to help meet the credit
needs of the entire local community consistent with safe and sound
operations. A bank's
self-imposed service or market limitations may not be used as
justification for a failure to define its local community or to
help, directly or indirectly, in meeting the credit needs within
that community, including low- and moderate-income
neighborhoods.
Whether or not a bank operates as a "full
service" entity is not a determining factor in evaluating its CRA
performance. Every bank
should be able to demonstrate that it is fulfilling its CRA
responsibilities, either within the context of its chosen service
specialties or in other ways.
The final measure of CRA performance is in the credit
benefits accruing to the bank's local community as a result of that
bank's activities, irrespective of the vehicle by which those credit
benefits are provided.
Question 29 in the January 1993 OCC book An Examiner's Guide to Consumer
Compliance discusses the Federal Financial Institutions
Examination Council's (FFIEC) view on what, in addition to
traditional direct lending activities, an institution can consider
in meeting obligations and responsibilities under the CRA. Examples of nontraditional
activities that banks may consider to help meet their
responsibilities are described, including debt investments, equity
investments, and other services and activities.
Conclusion
Review of CRA in a bank such as this, which has a
niche market in a specialty area, must be carefully analyzed to
ensure that all aspects of the bank's CRA performance are evaluated
properly. There are two
objectives that must be achieved through a bank's CRA program. The first is that results
must be apparent, and the second is that these results must come
from the bank's delineated community. The bank must find products
that both meet the credit needs of low- and moderate-income
individuals and fit into the servicing abilities of the bank's
staff.
It is reasonable that this bank would not have a
significant amount of direct lending to low- and moderate-income
individuals, because the bank's niche services (private banking) are
traditionally targeted at high-income individuals. This bank should not be
expected to develop expertise that does not pertain to the needs of
80 percent of its business.
However, the institution must find other ways to meet its
obligations under the CRA.
This bank had attempted to do this through the purchase of
SBA pools and developing relationships with groups, leading to the
financing of projects that will help meet the needs of the
individuals within the bank's delineated community. Although the bank had
instituted several programs that should improve its performance
under CRA, sufficient time had not transpired for the results of
these programs to be evident.
Based on the information included in the bank's appeal
package, coupled with a review of the examination work papers, and
discussions with an examiner experienced in CRA activities in niche
market banks, it was concluded that the appropriate ratings as of
the date of the PE remains "Needs to Improve." It was also evident that
since the writing of the PE, some of the bank's efforts were
resulting in a tangible benefit to the bank's delineated
community. For this
reason, the scheduling of the bank's next CRA review was moved up
approximately three months.
Postscript: Examiners
assigned to the district where the bank is located recently
completed a CRA examination of the bank, which resulted in a rating
of "Satisfactory Record of Meeting Community Credit Needs."
APPEAL OF DECISION CONCERNING RETROACTIVE
APPLICATION OF ACCOUNTING REQUIREMENTS (THIRD QUARTER
1994)
Background
A bank appealed a decision issued by the Office
of the Chief Accountant in conjunction with the bank's supervisory
office concerning retroactive application of two accounting and
record-keeping requirements for mortgage banking activities. First, the bank seeks to
avoid application of an initial inherent rate of return as the
discount rate for existing purchased servicing. Second, it is attempting to
avert exclusion of cash flows from existing originated mortgages in
the impairment analysis of purchased mortgage servicing rights
(PMSR).
On the fist issue (discount rate), the bank does
not want to comply with OCC and GAAP guidelines on a retroactive
basis because of the extreme amount of effort involved in
calculating the initial inherent rates for servicing purchased in
previous years. The
bank states that in mid-1992, with the concurrence of the local
examiners, it began using a pricing model (run monthly for each
product line) to ensure that prices paid for servicing did not
exceed the present value limitation established by SFAS No. 65. At the end of each quarter,
the cash flow stream for each pool is discounted using an effective
long-term rate based on an adjusted Treasury rate. With this control in place,
the bank capitalizes PMSR for each mortgage at the amount paid. As the pricing model is only
run on a product-level basis the bank does not have a record of the
initial rates of return for the PMSR of each mortgage. Further, the prepayment and
revenue assumptions that would have been used for products purchased
prior to use of the pricing model are not documented.
Management requests that the bank be allowed to
implement this change on a prospective basis with the initial
inherent rates used as the discount rate for all servicing rights
purchased after March 31, 1994. For previously purchased
servicing, the bank would utilize an internally developed discount
rate matrix that indicates an "add-on spread" for converting the
Treasury rate to an appropriate discount. The spreads were determined
based upon information obtained from the bank's external auditors
and other independent sources.
On the second issue (separation of cash flows),
the bank claims it would require many hours of data entry and
programming to re-work their model to a loan-level methodology to
exclude the cash flows from originated mortgages. Certain loan-level data has
not been maintained since late 1992. While management believes
that the amount of these cash flows would not result in a material
difference in amortization and impairment, the bank has been unable
to substantiate the exact amount of the impact to examiners without
reprogramming the model.
Further, the bank notes that the Financial Accounting
Standards Board (FASB) is reconsidering the accounting treatment
presented by SFAS No.65 specifically in regards to the treatment of
originated servicing rights.
According to the bank, it appears certain that by the end of
1994, GAAP will make no distinction between servicing rights from an
originated mortgage and a purchased mortgage. Therefore, the bank requests
that the exclusion of cash flows from originated mortgages be
implemented on a prospective basis only, with cash flows from retail
products excluded for all pools sold after March 31, 1994
Discussion
The instructions to the Consolidated Report of
Conditions and Income (call report) state that PMSR "shall be
carried at a book value that does not exceed the discounted amount
of estimated future net cash flows. Management of the
institution shall review the carrying value at least quarterly,
adequately document this review, and adjust the book value as
necessary. The discount
rate used for this book value calculation shall not be less than the
original discount rate inherent in the intangible asset at the time
of its acquisition, based upon the estimated future net cash flows
and price paid at the time of purchase."
Further, the call report instructions state the
following: "In order for a bank to report such mortgage servicing
rights as intangible asset the rights must: (1) represent the bank's
obligation to service mortgage loans owned by others, (2) have been
purchased or otherwise acquired in a bona fide transaction, and (3)
provide for the receipt of future servicing revenue which is
expected to exceed the anticipated costs of providing the servicing.
The right to service a bank's own loans (whether originated directly
or purchased) shall not
be reported as an asset."
Conclusion
1)
The bank's proposal is acceptable. Using an estimated discount
rate based upon a realistic spread over Treasury securities at the
time of purchase is reasonable, given the lack of bank records
supporting the true inherent discount rate. The matrix provided by bank
management is reasonable, and may be used for establishing discount
rates for exiting PMSR.
The assigned discount rates should remain constant for the
remainder of these assets' lives. For all servicing rights
purchased in the future, the bank should use a discount rate not
less than the original discount rate inherent in the intangible
asset at the time of its acquisition. This is consistent with the way
OCC has treated other banks in the same situation.
2)
Bank management needs to address this issue to ensure
that cash flows from originated mortgages are not included in the
valuation and impairment testing process for PMSR. The latter are a separate
asset and must not be commingled with retail production cash
flows. Neither GAAP nor
RAP permit unrelated revenue sources to support the value of
PMSR.
As the bank notes, FASB is
considering a revision to SFAS No. 65 to make the accounting for
originated mortgage servicing rights more like that for PMSR. The revision would provide,
in certain circumstances, for servicing from originated mortgages to
be capitalized.
However, the initiative is only a pre-exposure draft at this
time. Further, its
provisions would only be applied prospectively, with retroactive
application prohibited.
The Ombudsman's Office believes a reasonable
alternative, based upon available bank information, is the
utilization of the original mortgage pool percentage as a means of
determining the portion of mortgage pools with retail
originations. While the
current mortgage pool percentages may be somewhat different form the
original percentages due to prepayments, defaults, etc., this
alternative provides a reasonable estimation preferred to the bank's
present approach.
APPEAL OF VIOLATION OF REGULATION
Z
Background
A formal appeal was
received concerning several violations of Regulation Z that resulted
from the implementation of a secured credit card program. These
violations included open-ended and closed-end credit
transactions.
Nine months before a
routine examination, a bank entered into a business relationship
with a loan broker. The
agreement was that the loan broker would solicit credit card
applications from individuals and would require these applicants to
pledge collateral (either cash or the cash value on a life insurance
policy) in favor of the loan broker. In exchange, the loan broker
would present the applications to the bank and offer the bank the
partial guarantee of the loan broker on the underlying obligations
of the customers. The
loan broker charged the applicants fees for its services. At the
time the bank entered into the relationship with the loan broker,
the programs were limited to "cash cards" and "insurance
cards." Four months
later the insurance card program was no longer offered. At that time, a derivation
of the cash cards called "installment loan cards" became
available. In addition
to offering the above, the bank purchased existing credit card
accounts receivables from another bank. The other bank previously
had a relationship with this loan broker. The
highlights of the agreement are detailed below.
Establishment and Maintenance
of Pool
A pool was set up at the bank that would
function as follows:
The loan broker
agreed to deposit to the pool an amount equal to approximately 50
percent of the approved line for each credit application accepted by
the bank. In addition
to the above, funds in a similar pool were transferred from the bank
in which the receivables were purchased. If a customer of the loan
broker defaulted on his or her obligation to the bank and the
default remained uncured for three billing cycles from the date of
default, the default in the credit was cured by payment in full form
the funds in the pool.
The
loan broker agreed that at all times at least 30 percent of the
dollar amount of the aggregate approved credit card lines would be
maintained in the pool.
Loan Broker's Guarantee
A partial guarantee
was set up in addition to the pool account. This guarantee functioned as
follows:
The partial guarantee
covered all amounts due to the bank in connection with the cards of
the loan broker customers to the extent such amounts were incurred
or charged within four years after the issuance date of the credit
card. The
guarantee was limited to $1MM after the bank's receipt and
application of the pool and the bank's receipt and application of
all collateral under a pledge and security agreement of the same
date.
Cash Cards
An individual would
offer cash collateral in the amount of the credit line desired. In
addition, the individual would pay the loan broker a participation
fee. In exchange, the
loan broker would agree to submit the credit card application to the
bank and to support the application with its own partial guarantee
which it collateralized with the pool account. The loan broker agreed to return the collateral to the
individual upon cancellation of the card and repayment of all
indebtedness there under.
Insurance
Cards
All customers had the following three
options for securing their credit cards:
- Provide cash collateral to the loan broker
- Provide an existing line insurance policy with
a sufficient cash surrender value to the loan broker; or
- Purchase life insurance with sufficient cash
value through the loan broker and then pledge that insurance to the
loan broker.
Once sufficient collateral was pledged to the
loan broker, the loan broker would present that application to the
bank. If the
application was approved, the loan broker would extend a partial
guarantee on the customer's indebtedness for four years. The loan broker supported
the guarantee with the deposit account described above. The pledge of the insurance
to the loan broker remained in effect only as long as the credit
card remained outstanding.
Once the credit card was cancelled the customer would own the
insurance policy free of any assignment. The insurance was universal
life insurance or whole life insurance, not credit insurance. Neither the bank, the loan
broker, nor any loan account was ever listed as a beneficiary on any
of these policies. Each
insured was at liberty to list his or her own designated
beneficiary. The bank
had no knowledge of how much insurance each customer purchased. These cards were only offered for
four months.
Installment Loan
Card
When the bank and the loan broker stopped
offering insurance cards, the bank began to offer the installment
loan card. This program
was a derivation of the cash card program, designed for persons who
did not have sufficient cash to meet the loan broker collateral
requirements. Under
this program, the loan broker would arrange a 24-month installment
loan from the bank for the borrower. The borrower would instruct
the bank in writing to disburse all of the proceeds to the loan
broker. The loan broker
would keep one portion of the loan proceeds as its fee. The loan broker would place
the remainder of the proceeds in the pool amount. In some instances, the loan
broker promised to return the portion of the installment loan that
it placed in its reserve account, less a fee. In other situations, the loan broker made no such
promise.
Once the individual made two installments on the
24-month note (the first payment being taken at the time of the
application), the bank would extend a credit card loan to the
individual. The loan broker extended its
limited guarantee to both the installment loan and the credit card
loan.
Recap of
Program
These programs ran in tandem with the bank's own
pre-existing credit card program; however, the bank offered
guarantee credit cards only to borrowers who applied through the
loan broker. The interest rates and fees
earned by the bank on its own cards versus those generated by the
loan broker were somewhat different, although the bank did not feel
they were significantly different.
Discussion and
Conclusion
The examination report listed nine violations of
Regulation Z that occurred in connection with the bank's program to
issue guaranteed or secured credit cards. Under the program, the loan
broker would guarantee borrower's loans with the bank. The bank offered guaranteed
credit cards only to borrowers who applied through the loan
broker.
The loan broker prepared the credit card
applications on behalf of these borrowers and forwarded them to the
bank for approval. For
its services, the loan broker charged the customer various
fees. The loan broker required
borrowers to provide one of three forms of collateral as detailed
above to get its guarantee.
Based on these facts, which are not disputed by
the bank, the supervisory office cited the bank for violations of
Regulation Z, including failure to disclose the proper finance
charges and annual percentage rates (APRs) for various extensions of
credit. The bank has appealed all
violations on two general grounds:
(1)
The bank did
not believe that the loan broker should be treated as a creditor but
as a third-party broker, therefore allowing the fees paid to a
third-party broker not to be considered finance charges under the
Truth in Lending Act (TILA) and Regulation Z.
(2)
The bank did
not believe the Office of the Comptroller of the Currency (OCC)
correctly calculated the amount of the finance charges.
Treatment
of Creditors and Fees Paid to Third Parties
TILA and Regulation Z require lenders to disclose
the cost of credit to borrowers, including all finance charges
associated with the loan.
See 15 U.S.C. 1637, 1637a, 1638(a), and 12 CFR 226.6, and
226.18. Regulation Z states:
The finance charge
is the cost of consumer credit as a dollar amount. It included any charge
payable directly or indirectly by the consumer and imposed directly
by the creditor as an incident to or a condition of the extension of
credit. It does not include any charge of a type payable in a
comparable cash transaction.
The loan broker imposed various fees on borrowers
who sought guaranteed credit cards from the bank. The OCC determined the bank
was required to disclose those costs as finance charges. The bank contends that these
fees were charged by the loan broker for the loan broker's benefit
and, therefore, the bank is not required to include the third-party
fees in the finance charges for the bank's loans.
The Official Site Commentary on Regulatory Z
(226.4(a) Definition, note 3) explains how charges by persons other
than the creditor are treated.
It
states the following:
Charges by third parties. Charges imposed on the
consumer by someone other than the creditor for service not required
by the creditor are not finance charges, as long as the creditor
does not retain the charges.
For
example:
·
A fee charged by a loan broker to a consumer,
provided the creditor does not require the use of a broker (even if
the creditor knows of the loan broker's involvement or compensates
the loan broker);.
In contrast, charges imposed on the consumer by
someone other than the creditor are finance charges (unless
otherwise excluded) if the creditor requires the service of the
third party. For
example:
·
A fee charged by a loan broker if the consumer
cannot obtain the same credit terms from the creditor without using
a broker.
The appeal contends that the supervisory office
is treating the loan broker as a creditor under Regulation Z by
attributing the fees charged by the loan broker to the bank. However, this
mis-characterizes the basis for the violations. The OCC is viewing the loan
broker as a third party that the bank required customers to use if
they wanted, or needed, guaranteed credit cards. Because
borrowers could obtain guaranteed credit cards from the bank only by
applying through the loan broker, the bank was required to include
the loan broker's fees in the finance charges for those extensions
of credit.
The appeal also discusses that customers were not
required to use the loan broker to obtain credit cards for the
bank. The law is clear
that a broker's fees need not be included in the finance charge if
the borrower can obtain the same credit terms from the lender
without using the broker.
In this bank's case upon the bank's own admission the loan
broker borrowers could not receive the same credit terms directly
from the bank.
Moreover, the bank required the
loan broker customers to obtain the loan broker's guarantee in order
to receive a credit card.
Amount of
Finance Charges
The loan broker offered to guarantee a customer's
credit card debt under the three different programs described
above. It was
immaterial to the bank which program a customer used since the loan
broker provided the same guarantee and collateral to the bank under
each program. However, different costs were associated with each program;
consequently, the amount of the finance charges for each loan was
affected by how the customer met the bank's requirement that the
loan broker guarantee the customer's loan.
The bank argues that certain fees imposed by the
loan broker in connection with the insurance card and installment
loan card should not be included in the finance charge under
Regulation Z. The thrust of the argument is that the bank did not
require customers to obtain insurance or take out an installment
loan to obtain a guaranteed credit card because customers had the
option of meeting the loan broker's collateral requirements by
providing cash collateral.
Although this is true, it is the purpose of Regulation Z to
assure a meaningful disclosure of credit terms so that the consumer
will be able to compare more readily the various credit terms
available to him or her and avoid the uninformed use of credit. Regulation Z requires the bank to disclose the finance charge
for the particular option chosen by each customer, otherwise the
borrower would have no way of comparing the cost of the different
finance options, a condition that the Truth in Lending Act intended
to remedy.
The bank will be required to reimburse affected
customers. Because of
the variety of different options that were offered, the appropriate
OCC District Office will provide guidance on which charges should be
included in the finance charges for each of the various
options. The District
Office will also review the bank's calculations for accuracy before
any reimbursements are made.