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Appeal of Composite and Component Ratings, Risk Assessments, Matters Requiring Attention, Violation of Law, and Loan Classifications (Second Quarter 2013)

Background

A community bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the supervisory office’s determinations in the most recent report of examination (ROE). Specifically, the bank appealed the following:

  • Composite rating from 4 to 3. Component ratings for capital, asset quality, and earnings from 4 to 3; management rating from 4 to 2; and liquidity rating from 3 to 2.
  • Risk assessments for credit risk, liquidity risk, price risk, operational risk, strategic risk, and reputation risk.
  • Matters Requiring Attention (MRAs) for (1) “repeat” designation relating to a management study, (2) audit, (3) loan workout administration, and (4) appraisals.
  • Violation of 12 C.F.R. § 34.83(b) regarding prudent efforts to dispose of other real estate owned (OREO).
  • Loan classification downgrades for three commercial loans.

Discussion 

Composite and Component Ratings

The appeal contended that the composite rating was unsupported because the bank’s risk profile was inappropriately designated as high. The appeal stated that the asset quality rating was inaccurate because examiners had not considered the reduced risk of loss due to collateral on certain classified loans. The appeal further stated that any potential loan losses were fully allocated in the allowance for loan and lease losses (ALLL), and that credit administration deficiencies were overstated or inaccurate. The appeal also stated that regulatory guidance had not been followed by examiners when downgrading loan risk ratings on certain commercial real estate loans on which payments were being made by guarantors.

With respect to the capital and earnings ratings, the appeal stated that despite losses in recent years, earnings prospects were positive due to an appropriate ALLL. The appeal stated that capital ratios also remained above regulatory minimums due to management and board actions to reduce the bank’s total assets.

With respect to the ratings for management and liquidity, the bank argued that the ratings were unwarranted. The appeal stated that the board and management had provided strong oversight and organization. The appeal further stated that despite a high level of problem assets caused by the economic downturn, the bank maintained ample liquidity.

Risk Assessments

With respect to the risk assessments, the appeal argued that the level and direction of credit risk should be designated moderate and decreasing rather than high and increasing due to improved exceptions monitoring, appropriate concentration of credit management, and collateral valuations. The appeal stated that the direction of liquidity risk should be designated stable rather than increasing due to declining brokered deposits and the availability of various funding sources. The appeal asserted that the level and direction of price risk should be designated moderate and decreasing rather than high and increasing because OREO was written down to market value and generally sold within a reasonable period. In its appeal, the bank disagreed with the rating for quality of operational risk management as weak and requested a satisfactory rating because an audit program was in place and controls have generally been satisfactory. Despite deficiencies in the internal audit program, the appeal argued that the ratings for a high aggregate level and increasing direction of operational risk should be changed to moderate and stable because the deficiencies can be easily corrected. Strategic risk and reputation risk, both rated high and increasing, were also appealed, with the bank arguing that the problems had been identified and were being addressed with an appropriate ALLL.

Matters Requiring Attention

With respect to the MRAs, the appeal argued that the “repeat” designation for the management study MRA was unfair because the previous report of examination was not received by the bank until one month before the start of the next on-site exam. The appeal argued that a statement in the audit MRA indicating there was no audit plan should be removed because the bank had an audit schedule, which the bank believed was a sufficient audit plan. The appeal asserted that the problem loan workout administration MRA should be removed because the bank’s workout plans did not commonly contain liberal terms, and criticisms of capitalizing certain loan fees were unjustified because they were industry practice. The appeal also contended that the appraisal MRA should be removed, arguing that there were limited exceptions to the bank’s appraisal order and review process and exceptions did not rise to the level of concern for an MRA.

Violation of Law

With respect to the violation of 12 C.F.R. § 34.83(b) regarding prudent efforts to dispose of OREO, the appeal stated that the bank was making efforts to prudently dispose of OREO despite several properties not being listed with realtors. The bank argued that using the bank’s Web site to list properties as well as placing for-sale signs at the properties had proved to be effective methods to dispose of the properties.

Loan Classification Downgrades

Relationship (1) consisted of an interest-only note secured by land with the original intention of subdividing into lots. The supervisory office downgraded the loan from pass to substandard due to stalled development and lack of principal amortization since 2009. The appeal asserted that the loan should be designated pass because it was protected against loss by collateral and the guarantors showed the ability to make payments.

Relationship (2) consisted of an interest-only note secured by raw land and residential lots with the original intent of subdividing into lots. The supervisory office downgraded the loan from special mention to substandard due to stalled development and suspended principal reductions to allow for payment of property taxes. The appeal asserted that the loan should be designated special mention because the one year of missed principal payments was temporary.

Relationship (3) consisted of an unsecured interest-only note used to purchase a business and equipment. The supervisory office downgraded the loan from pass to substandard due to a lack of principal amortization, questionable repayment ability, and lack of collateral. The appeal asserted that the loan should be designated pass because the delay in amortizing the debt was due to illness of the owner and the credit would soon be secured and placed on principal amortizing terms.

Conclusion 

The Ombudsman reviewed the information submitted by the bank and the supervisory office. The Uniform Financial Institutions Rating System, as defined in the “Bank Supervision Process” booklet of the OCC’s Comptroller’s Handbook, was used as the standard for determining the appropriate composite rating and component ratings for capital, asset quality, management, earnings, and liquidity. The Ombudsman also relied on 12 C.F.R. § 34.83(b); the Comptroller’s Handbook booklets “Rating Credit Risk,” “Other Real Estate Owned,” and “Internal and External Audits”; OCC Bulletin 2009-32, “Commercial Real Estate (CRE) Loans: Guidance on Prudent CRE Loan Workouts”; and OCC Bulletin 2010-42, “Sound Practices for Appraisals and Evaluations.”

Composite and Component Ratings

With respect to the asset quality rating of 4, the Ombudsman found the bank’s asset quality and credit administration practices exhibited characteristics of this rating and were deficient. The level of adversely classified assets was excessive and increasing at approximately 150 percent of capital plus the ALLL. The volume of classified assets increased despite significant loan charge-offs over the past four years, reflecting deeply entrenched lending problems. Nonperforming assets, including noncurrent loans and OREO, were also well above the levels at peer banks. In addition, credit administration practices were weak, evidenced by renewals lacking complete financial information, liberal repayment terms, missing credit presentations, risk rating downgrades, and lack of a loan workout specialist.

With respect to the earnings rating of 4, the Ombudsman found the bank’s earnings exhibited characteristics of this rating and were deficient. Earnings were insufficient to support operations and maintain appropriate capital and the ALLL. Earnings have reflected large losses in recent years due to loan charge-offs and a declining net interest margin. Increasing levels of classified loans and OREO make future prospects poor.

With respect to the capital rating of 4, the Ombudsman found the bank’s capital exhibited characteristics of this rating and was deficient. The bank’s capital at the time of the examination did not support the bank’s high risk profile and needed improvement. Negative retained earnings over the past four years represented a loss to capital of approximately 25 percent. Additional sources of capital are limited.

With respect to the liquidity rating of 3, the Ombudsman found the bank’s liquidity exhibited characteristics of this rating and was less than adequate based on the bank’s risk profile. The bank remained moderately reliant on brokered deposits, and the high costs of funding had adversely affected the bank’s net interest margin.

With respect to the management rating of 4, the Ombudsman found that management and board supervision exhibited characteristics of this rating and was deficient. Increasing risk exposure, ineffective credit risk management processes, noncompliance with an outstanding enforcement action, continuing need for a loan workout specialist, lack of independence in the internal audit program, deficiencies in strategic planning, and concerns over succession planning were indicative of the need for improved actions to preserve the soundness of the institution.

With respect to the composite rating of 4, the Ombudsman found that the bank’s overall condition reflected this rating. At the examination, the bank exhibited unsafe or unsound practices as well as financial and managerial deficiencies, which were not being satisfactorily addressed or resolved. The composite rating reflected deficient capital, asset quality, management, and earnings, and less than satisfactory liquidity.

Risk Assessment System

With respect to the credit risk profile of high and increasing, the Ombudsman found the ratings to be accurate. Problem assets continue to increase from prior examinations and are at an excessive level. Increased levels of problem assets coupled with weak credit risk management practices are supportive of the increasing designation.

With respect to the increasing liquidity risk profile, the Ombudsman found the rating to be accurate. The decline in asset quality may result in increased costs and restrictions on borrowings. While brokered deposits have declined, they remain high and are restricted based on an outstanding enforcement action.

With respect to the price risk profile of high and increasing, the Ombudsman found the ratings to be accurate. At the examination, the bank’s level of OREO was at approximately 30 percent of capital and had increased from past exams. Given the increased volume of classified loans and increased trends in OREO, an increasing designation is appropriate.

With respect to the operational risk profile of weak risk management, high aggregate risk, and increasing direction, the Ombudsman found the ratings to be accurate. Deficiencies requiring corrective action involved internal audit, lack of a strategic plan, succession planning concerns, and lack of a needed loan workout officer. These concerns, along with unsafe or unsound credit risk management practices, indicate a weak organizational structure affecting the overall control environment.

With respect to the strategic and reputation risk profiles of high and increasing, the Ombudsman found the ratings to be accurate. The bank’s financial condition continues to deteriorate and, as such, the potential for future losses will affect franchise value and, potentially, the ability to raise capital or find a buyer.

Matters Requiring Attention

With respect to the “repeat” designation for the management study MRA, the Ombudsman determined that the “repeat” designation should be removed. The timing of receipt of the prior ROE and management’s corrective action for this MRA made the “repeat” designation inappropriate. Therefore, the Ombudsman directed the supervisory office to correct the supervisory record.

With respect to the audit MRA, the Ombudsman determined that there was proper support for the sentence stating there was no audit plan. The “audit plan” must provide standards for audit processes and ensure effective audit coverage. The “audit cycle” refers to the actual audit schedule.

With respect to the problem loan workout MRA, the Ombudsman found that additional clarification in the ROE was warranted. Although the MRA properly criticized liberal terms on several renewed loans, examples cited in the ROE were newly criticized loans that did not have workout plans in place. Therefore, the Ombudsman directed the supervisory office to revise the examples cited in the report. The Ombudsman concurred with the supervisory office regarding the criticism of capitalizing origination and appraisal fees for workout and problem loans.

With respect to the appraisal order and review process MRA, the Ombudsman determined that the supervisory office appropriately supported this MRA. Concerns identified in appraisal reviews required follow-up and a process was warranted to ensure independence of the appraisal and review functions.

Violation of Law

With respect to the violation of 12 C.FR. § 34.83 (b), the Ombudsman determined that the bank’s OREO marketing plans constituted adequate documentation of diligent disposal efforts. There is no requirement in the regulation that the properties be listed with a realtor, only that diligent efforts are made to market each property, along with adequate documentation of those efforts. The bank had a satisfactory history of disposing of OREO in a timely manner. Therefore, the Ombudsman directed the supervisory office to remove the violation from the supervisory record.

Loan Classification Downgrades

With respect to relationship (1), the Ombudsman found that the loan exhibited well-defined weaknesses and concurred with the substandard rating. The original repayment source (sale of tracts) had stalled and repayment now relies on guarantors. Principal reductions were reasonable in 2009 but had since declined to an unreasonable amortization and interest-only terms. Therefore, guarantors have not demonstrated that they have the capacity and willingness to provide support for the credit through ongoing payments, curtailments, or re-margining.

With respect to relationship (2), the Ombudsman found that the loan exhibited well-defined weaknesses and concurred with the substandard rating. The original repayment source (sale of lots) had stalled and repayment now relies on guarantors. While past curtailments were made at each renewal, this loan did not amortize as required for a year because funds were reportedly used for real estate taxes. The guarantors’ inability to make property tax payments is, in itself, an additional defined weakness, along with the lack of curtailment and the failure of the property to sell as originally planned.

With respect to relationship (3), the Ombudsman found that the loan exhibited well-defined weaknesses and concurred with the substandard rating. The loan exhibited lax controls over draws and numerous advances over an extended period with no amortization or principal reduction. Repayment projections were questionable and would be deficient if the loan was properly amortized.