The Office of
the Ombudsman (ombudsman) reviewed and noted that the bank's capital
levels/ratios over the last two years had remained at slightly above
the minimum requirements, and at times, had been slightly
below. Since the
examination, the bank's capital posture had strengthened through the
continued retention of earnings and a small capital injection in
December 1997.
The ombudsman
reviewed the capital levels in relation to the bank's overall risk
profile and risk management controls/processes, and agreed with the
ROE conclusion that at the time of the examination, although the
capital ratios exceeded regulatory minimums, a rating of 3 was
appropriate. Per OCC
Bulletin 97-1 (attachment, 61 FR p. 67026), a rating of 3 indicates
"a less than satisfactory level of capital that does not fully
support the institution's risk profile. The rating indicates a need
for improvement, even if the institution's capital level exceeds
minimum regulatory and statutory
requirements."
Asset
Quality
Background
The bank
appealed the rating based on the improved asset quality indicators,
the quality of the investment portfolio, the adequacy of the
allowance for loan and lease losses, and the decline of past-due and
nonperforming loans.
Also, adversely classified assets as a percent of Tier 1
capital were reduced in half from the prior exam. The bank also pointed out
that of the 29 lending relationships reviewed during the
examination, only two loans were reclassified. In response to a ROE comment
regarding the bank's shift toward larger commercial credits, the
bank indicated that it is trying to fill in a vacuum left by large
commercial banks exiting the small business market lending arena in
their service territories.
The bank did
implement several of the recommendations made in the
ROE.
Discussion
The
examination rating of 3 was based on the loan and overall asset
quality which remained less than satisfactory. Most loan quality indicators
had improved since the last asset quality review. However, while the
improvement was encouraging, all qualitative indicators remained
much worse than average and the aggregate level of loans with one or
more negative underwriting characteristics remained high. Particularly of concern, was
that these negative underwriting characteristics were present in new
loans made by the bank since the previous examination. Past dues had been high and
averaged approximately 7 percent during 1997. Classified assets were above
30 percent. Investment
quality was good; however, the investment portfolio comprised a very
small percentage of assets, while the loan and lease portfolio
comprised over 80 percent.
The level of
credit risk remained high and increasing. The aggregate credit risk
was not limited, managed, or controlled. Management and the board
continued to focus on individual credit relationships while ignoring
the aggregate risk presented by a portfolio of sub-prime
credits. Furthermore,
the tolerance for credit risk limits had not been established. Credit risk continued to
increase as the percentage of assets comprised of loans with one or
more negative underwriting characteristics increased and the loan
mix shifted toward larger commercial credits.
Credit
administration practices needed improvement. Areas where weaknesses were
noted included the following: loan policy exceptions, problem loan
identification reliant on past due status, lack of a system for
tracking financial statements, lack of a system for monitoring
concentrations of credit, and lack of a system for monitoring
expired UCC filing.
Also, although
the allowance for loan and leases losses balance was adequate, the
methodology was not reflective of the inherent risk in the
portfolio.
Conclusion
The ombudsman
acknowledged the bank's comments regarding the improvement in the
qualitative factors of the loan portfolio. However, as noted in the
ROE, the indicators still reflected an increased level of concern,
particularly given the significant growth over the last few years,
the more aggressive underwriting characteristics present in loans
made since the previous examination, and credit administration that
warranted improvement.
Furthermore, although the credit administration issues noted
in the ROE might have been individually mitigated, collectively they
presented an increased level of concern. Per OCC Bulletin 97-1
(attachment, FR 61 p. 67027), a rating of 3 is assigned "when asset
quality or credit administration practices are less than
satisfactory. Trends
may be stable or indicate . . . an increase in risk exposure. The level and severity of
classified assets, other weaknesses, and risks require an elevated
level of supervisory concern.
There is generally a need to improve credit administration
and risk management practices."
The ombudsman
agreed that at the time of the examination, a rating of 3 was
appropriate. He
acknowledged that since the examination date, management had
implemented several of the recommendations made during the
examination. These
included approval of loan limits/ parameters, and a revised loan
committee infrastructure whereby the loan committee will approve
loans greater than $200,000 and loans with policy
exceptions.
Management
Background
The bank
appealed this rating based on the knowledge and experience level of
their officers. The
individuals averaged more than 20 years of banking experience in
their specialized areas of operations. The bank also indicated that
they were actively involved in executing the board's strategic
initiatives on a daily basis.
As an example, a particular loan officer personally called on
the majority of all past-due accounts and talked directly to the
customers regardless of the size of the loan. Also the chairman had
successfully raised capital on three separate occasions. Management and employees
demonstrated their commitment to the bank and its customers by using
principally their own personal funds to acquire more than 25 percent
of the bank's outstanding stock. Management's extensive
equity investment and coinciding representation on the board of
directors was a benefit, not a detriment to the bank's customers,
shareholders, and overall safety and
soundness.
Discussion
The
examination team based the 3 rating on management and board
supervision, which was deemed less than satisfactory. This resulted primarily from
continuing increases in the quantity of risk inherent in the bank's
operations and strategies combined with risk management systems that
were not adequate in relation to the quantity of risk. The ROE acknowledged
management's positive accomplishments, such as their experience
levels, success at raising capital on three occasions, improvement
in the asset quality indicators, and improvement in the bank's
earnings posture. The
ROE stated that although bank management concurred with some of the
recommendations and/or weaknesses noted in the examination, and in
fact had implemented some of these recommendations, overall,
management had not been timely or proactive in improving risk
management systems, particularly, in higher risk
areas.
Also,
independent risk control systems (i.e., loan review, internal audit,
compliance management) needed improvement. On different occasions,
management and the board have attempted to compensate for this by
retaining consultants to provide the services. The success of these
attempts has been sporadic because of unanticipated events affecting
the service providers, to which management and the board have been
slow to make alternative arrangements.
Conclusion
The ombudsman
recognized, respected, and appreciated management's depth and tenure
of experience, the positive efforts in raising new capital and the
steps taken to implement corrective measures recommended during the
examination. However,
as noted in OCC Bulletin 97-1, a rating of 3 may be assigned when
risk management practices are less than satisfactory given the
nature of the institution's activities. At the time of the
examination, the management team had not implemented risk management
processes that adequately identify, monitor, and control risk in
various key areas of the bank.
Also independent risk control systems (i.e., loan review,
internal audit, compliance management) needed improvement. Therefore, a rating of 3 was
appropriate. The rating
should not be viewed as a reflection of management or the board's
abilities or skills, but rather of risk management practices that
needed improvement.
Earnings
Background
The bank
appealed the 2 rating.
Management believed the bank's earnings were outstanding and
should have been rated a 1 based on the objective numbers,
primarily, the net interest margin above 7 percent, the annualized
return on average equity in excess of 20 percent, and the annualized
return on average assets above 1 percent. The bank indicated that
earnings had more than doubled in each of the last three years, and
that this pattern was likely to repeat again in
1997.
Discussion
During the
examination, the bank's earnings performance was considered
good. Performance had
improved as a result of continued strength in the net interest
margin and improved efficiency. Earnings performance was fee
sensitive, with fees relating to lending and leasing activities
approximating 20 percent of total interest and fees. Also, despite the noted
improvement, efficiency and overhead expense ratios remained very
high.
The ability to
sustain the trend in earnings performance was somewhat questionable
in view of the need to manage the risks associated with present
business strategies more effectively, and potential earnings
exposure to interest rate, credit, and liquidity risks. Budgeting and forecasting
processes have stalled; thus no budget and earnings forecasts were
prepared for 1997.
Also, the ROE recommended a review of the officer
compensation practices.
Commissions were paid for originating and/or purchasing loans
and leases with no qualitative controls such as independent reviews
of the assets and/or performance benchmarks, which precede
commission awards.
Conclusion
A rating of 2
indicates earnings that are satisfactory and sufficient to support
operations and maintain adequate capital and allowance levels after
consideration is given to asset quality, growth, and other factors
affecting the quality, quantity, and trend of earnings. The rating was appropriate
given the bank's earnings posture and the budgeting and forecasting
processes that have stalled.
The bank
informed the ombudsman that the bank had revised the compensation
practices, and that the board of directors' executive committee will
review officer compensation practices at least annually. Thus far, they are satisfied
that current compensation levels are in relation with the return to
shareholders, capital, and overall risk profile of the
bank.
Liquidity
Background
The bank
appealed the 3 rating based on growth of approximately $15 million
in assets since 1994 which they indicated had been well-managed and
prudent. They also
stated that the growth had come within their geographical market in
conservative products (residential mortgages, commercial loans, and
equipment leases). They
did not have any exotic investments, hedges, swaps, or other
derivatives. They do
not pay above market rates for brokered deposits and have retained
more than 20 percent of these customers and cross-sold them on other
bank products.
Certificates of Deposit and Federal Home Loan Bank Board
advances are only two of the five primary sources of funding; others
include local customer deposits, credit union direct purchases, and
loan sales and participations.
The bank had taken steps to improve the overall risk
management.
Discussion
Liquidity was
rated a 3 based on a high and increasing level of liquidity risk
combined with ineffective liquidity risk management practices. Rapid asset growth since
1994 was funded without a defined contingency funding plan. Also, the loan-to-deposit
ratios were very high with the loan-to-deposit ratio in excess of 95
percent, and the loan-to-core-deposit ratio slightly above 100
percent. The $2 million
investment portfolio, which was 76 percent of that pledged on
March
31, 1997, provided nominal secondary
liquidity.
The elevated
risk profile had not been accompanied by an increase in the quality
of liquidity risk management.
There were no liquidity risk limits and no contingency
funding plans. While
management had enjoyed recent success in selling loans and
developing relationships with the financial institutions that had
purchased the loans, the potential risk associated with this
strategy of employing wholesale funding sources to originate,
purchase, and then sell loans had not been well-identified,
monitored, managed, or controlled.
Conclusion
The ombudsman
concurred with the 3 rating based on the funds management practices,
discussed above, which are in need of improvement. Per OCC Bulletin 97-1
(attachment, FR 61 p. 67029), institutions rated a 3 "evidence
significant weaknesses in funds management
practices."
Composite
Background
The bank
appealed the composite rating primarily on their appeal of the above
component ratings. The
board of directors believed that supervisory and examination
personnel had lost their ability to provide impartial, balanced
supervisory oversight over the bank's operations. The bank further indicated
that they felt they were suffering from retribution for its
successful appeal of its examination ratings in early
1995.
Discussion
As mentioned
throughout the discussion of the component ratings, the bank was
rated a 3 primarily as a result of a continued increase in the
quantity of risk inherent in the bank's operations and strategies,
combined with risk management systems that needed improvement. The ROE did acknowledge
management's success in increasing fee income resulting in an
improved earnings performance, the successful cultivation of
relationships with institutions eager to purchase different types of
loans, and management's ability to raise additional capital when
needed. However, the
bank had not implemented effective risk management systems
commensurate with the increased risk. Effective risk management
includes established limits on the level of acceptable risk,
controls systems, and adequate management information
systems.
Conclusion
In January
1997, the OCC in conjunction with the other federal supervisory
agencies issued a revised rating system that reflects an increased
emphasis on risk management practices. The issuance, OCC Bulletin
97-1, "Uniform Financial Institutions Rating System and Disclosure
of Component Ratings," contains explicit language emphasizing
management's ability to identify, measure, monitor, and control
risks. The federal
agencies recognize that management practices, particularly as they
relate to risk management, will vary considerably among financial
institutions depending on their size and sophistication, the nature
and complexity of their business activities, and their risk
profile. However, each
institution may properly manage its risks and have appropriate
policies, processes, or practices in place that management follows
and uses.
The
fundamental issue during any examination, and in particular this
examination, is the accurate assessment of the bank's risk profile
and the processes and controls in place to manage that risk. The ombudsman carefully
reviewed the issues highlighted in the bank's appeal letter, the
Report of Examination, and supporting documentation. Also, lengthy discussions
were held with bank management, OCC supervisory personnel, and with
key managers from the core policy unit of the OCC's Bank Supervision
Policy group. The
ombudsman concurred that at the time of the examination, the risk
management processes in place in key areas of the bank were in need
of improvement, particularly, in loan portfolio management,
liquidity, and sensitivity to market risk. The growth in the bank over
the last two years coupled with the strategy of purchasing and
selling loans necessitated a more comprehensive risk management
system. As the risk
profile of the bank increased, management did not sufficiently
enhance the bank's processes and controls. Since the examination,
management had implemented several of the recommendations made in
the ROE.
The
ombudsman's opinion on the various issues of this appeal was as
follows:
- The ombudsman
concurred with the individual component ratings assigned during the
examination as discussed above.
- The ombudsman
concurred with the assigned composite rating based on the bank's
risk profile and lack of adequate risk management processes and
controls.
- The ombudsman
recommended a prompt examination to review the bank's progress in
implementing corrective action and strengthening the bank's risk
management processes.
- The ombudsman
concluded that the supervision of the bank had not been unfairly
affected as a result of previous use of the national bank appeals
process.